Jobs Programs

Milton Friedman once visited a developing country where they were building a canal. He remarked to his host how surprised he was that the workers only had shovels. For a large excavation project, heavy earth-moving equipment would be typical.

“You don’t understand,” his host noted. “This is a jobs program.”

“If it’s a jobs program,” Dr. Freidman replied, “why don’t they use spoons?”

The illogic of being deliberately inefficient is clear when it’s as egregious as digging a canal with a shovel. The wasted time, manpower, and money could be better used elsewhere. The entire society is impoverished when resources are wasted.

We have all sorts of “jobs” programs here in the U.S. In New Jersey gas sold on the Turnpike has to be pumped by attendants. In Illinois all cash-payment toll booths are staffed. They don’t use automated machines. Across the country inefficient processes produce protected jobs.

What we have is an issue of the seen and unseen. We can see the jobs inefficiency creates, but we can’t see the hidden costs: wasted time, wasted labor, and wasted money.

If our fiscal crisis forces states to do away with make-work inefficiency, it may be an ill wind that blows some good.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Diversify, Diversify

We live in risky times. Banks fail. Governments fail. How to we deal with this?

One way to manage risk is to control it. That is, if you have a business, know your customers, know your suppliers, and know your employees. Continually update your systems and procedures. Then, if disaster strikes, you’ll have a recovery plan in place to minimize the damage.

But sometimes this doesn’t stop an errant oil rig from creating billions of dollars worth of damage. Is there another way?

That way is diversification. By having many small exposures you can minimize the chances that any one of them will create significant harm. But if the exposures are linked to a common factor—like housing prices or government debt—a downturn in that area can affect your whole portfolio. So is there a third way?

Sure. One final approach is to take no risks. Stay in bed, turn off the TV, and have your food tasted. Only that approach isn’t very productive. Not to mention boring.

Risk is part of life. Control it where you can, diversify it where you can’t. And if disaster hits in spite of your efforts, remain calm. Panic may be rational, but it’s never your friend.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Carpe Diem

Yesterday I discussed seizing the opportunities that a risky world presents. What do I mean by that?

I’ve discussed before how rebalancing a portfolio regularly adds value because of mean reversion. Mean reversion is just a fancy way of saying that markets don’t go up or down forever. Improving markets inevitably attract competitors. The increased competition lowers margins and restricts profits. Deteriorating markets inevitably force weak companies out. This creates opportunities for stronger players to improve their earnings. What goes up comes down, and vice-versa.

So much for normal mean-reversion. In times of crisis, the news-cycle has a tendency to build upon itself, until otherwise rational investors capitulate and sell out just because everyone else does. The storm clouds are all dark, and no silver linings are visible. At all.

It’s times like these the long-term economic investors like Warren Buffett step in. Shepherding their cash during the good times, they take advantage of the panic of the moment to take significant stakes in fundamentally sound businesses at bargain prices. Call it survival of the patient.

Mean reversion works best with market segments; Buffett-style bargain hunting works best with high-margin companies on the wrong side of a market panic. With the European debt-crisis and BP disaster we may be in the early stages of both opportunities. Only time, and the market, will tell.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Equal Opportunity

For people who think failure is a product of either government or the markets, the past few years can support either view.

The sub-prime debacle was a failure of markets; the BP disaster was a failure of regulators. From 2004 to 2007, expansion of lending to sub-prime borrowers combined with innovative securitizations feeding additional return to yield-starved investors fed a real-estate bubble whose subsequent collapse threatened the globe’s financial infrastructure. The government’s response will slow the flow of credit through the economy.

From 2004 to 2008 careless regulators inked over some energy company’s own safety reports to approve a careless safety regime whose inevitable failure now threatens a host of fragile ecosystems and by extension the nation’s energy infrastructure. It’s inevitable that the response will reduce deepwater drilling and raise the price of oil.

In both cases a combination of regulatory capture, corporate momentum, and willful blindness to risk—so far so good—have combined to create a cascade of failures that will have repercussions for years.

The solution isn’t just more and better regulation or more transparent markets—it’s both—but also an understanding that as the world’s economy grows, risks will grow as well. We need to be prepared manage our risk and seize the opportunities.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Succeeding at Failure

Americans are great at going broke.

This may seem like a strange kind of success story. After all, no one goes into business expecting to fail. But at its heart, bankruptcy gives people a fresh start.

The US abolished debtor’s prisons in 1833. For the next 60 years, the judicial system erected a common-law bankruptcy system until 1898 when Congress systematized this via the bankruptcy code.

Bankruptcy in America has been a way for businesses that are viable to restructure their finances and keep going. It allows people that otherwise could be productively employed to get out from what could be a crushing debt load. By doing this, it frees people and allows them to go back to work.

The world changed in 1978 when Penn Central went bankrupt—the first truly massive failure which brought Wall Street into the business. But our system—improbably designed during the horse-and-buggy days—has proven highly flexible, accommodating the restructuring of railroads, telephones, and banks. The genius of the system is that it has a minimalist structure to encourage filing and moving on.

America has always been about the future. Paradoxically, dealing effectively with failure makes the future better for everyone.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Studying Success

What else has been going right?

In the midst of a market correction, it helps to understand what we do well. Sure, like everyone else, I’m concerned that the current correction could spiral out of control and turn into a rout. But the US economy has been getting stronger, companies have been hiring new workers, and consumers have been making up for lost time. So what’s going well?

One clear success has been the American research university. Whether public or private, American universities are the envy of the world when it comes to scholarship and education. In 2009, all of the academic Nobel prizes were awarded to men and women who teach or recently taught in the US university system. What do we do right?

One unique aspect is the combination of education and research. By focusing on education, professors are continually challenged to develop the next generation of researchers. But by focusing on research, they have to look into new questions that keep their approach to the material fresh. As a Shakespeare scholar recently noted, “If I didn’t do research, I’d be bored out of my skull and would bore my students to tears.”

The last thing universities do well is struggle for funding. Let’s face it: schools never get all the money they want. But this keeps them tied to their communities—of either alumni or State officials. People engaged in the real world are less likely to fly off on tangents. This keeps our system grounded.

Because of our universities, folks from around the world come to America for their education. This is one more strength of our open society.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Manufacturing Health

If you want to know what the economy will do in the near future, look at the leading indicators. One well-established factor is the average hours worked per employee. Before companies hire new workers, they tend to have their existing employees work more hours. Similarly, before they lay people off, they tend to reduce hours people put in

Well, buried inside the latest employment report is the average hours worked by industry. It’s an obscure but important indicator of what’s going on in the economy. By looking at changes in the composition of the jobs out there we can get an idea of what the next few months will bring.

Average hours worked is going up modestly, so many expect employment to continue to expand slowly. But most interesting is the fact that manufacturers are growing their hours quite aggressively—by 1.4 hours per week over the last year. And interestingly, health care has been reducing its average hours worked per employee, in spite of the aggressive hiring this sector has undertaken.

This implies that jobs involved in making stuff will grow, while hiring for health care, and specifically health care administration, will likely slow down. The reason this is good for the US is because those stuff-making jobs tend to pay a lot better than the service-oriented jobs in health care. So we expect that consumer incomes will improve pretty rapidly in the near future, and that has broad implications—for consumer spending, for credit quality, and even for the housing sector.

By examining changes in the structure of our economy, we get a good idea where things are going. And right now, it’s fairly encouraging.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Book ‘Em

The Justice Department has indicted some major players in the municipal finance business. I’d call that looking for snow at the North Pole.

The Muni bond market totals $2.4 trillion, and covers everything from AAA bonds from the State of Maryland to speculative debt from housing projects in New York. Allegedly some major players paid kickbacks to an advisory firm in order to rig bids on billions of dollars in deals. The corruption was so commonplace that people discussed it openly on phone lines that they knew were being recorded. Now conspirators are being rolled and cutting deals to name names.

It stems from the ubiquity of municipal finance, the low pay-grade of municipal employees, and its tax-exempt status. Issuers often borrow money in large chunks and then invest it tax-free until it’s needed. They can earn a spread on the difference, but if the rules aren’t followed, all kinds of penalties apply. But since the IRS doesn’t have inspectors to audit every deal, lots of folks game the system. According to Justice, several bankers paid consultants kickbacks for setting up the scam.

In a former role, I bid on municipal borrowings and deposits myself for a mid-sized bank. Sometimes we guessed that other bidders might be cheating, but we didn’t really know anything. All we could do was provide honest advice about what the law required.

Any cheaters exploited the municipalities and stole money from taxpayers across the country. Good for Justice for indicting these creeps. And good for us all if it helps clean up a dirty backwater in the financial markets.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Ratings Kool-Aid

Why did the ratings agencies do such a bad job?

The standard answer is that their business model is flawed. Ratings agencies assess credit risk and are paid for their services by the issuers. Aren’t they conflicted?

Not really. The ratings agencies started out with a subscription model where the users paid, but switched to issuer-pays in the ‘70s, when photocopiers made it impossible for them to protect their reports. But there has been no upward drift in ratings since then. The number of triple-A companies has gone from 58 in the mid-‘70s to 22 in 2000 to only 9 now. Some grade inflation!

If it becomes known that an agency’s good ratings can be bought, the ratings and ratings agencies will become worthless. Sure, raters are subject to financial, political, and bureaucratic pressures; but so is every large company. And this isn’t the first time the agencies blew it: Enron was still rated investment grade just four days before it declared bankruptcy.

No, these agencies were subject to the same errors that every human agency is: humanity is born to trouble as the sparks fly upwards. Small errors by the raters cascaded to larger errors by investors which led to systemic problems in the economy. Increasing political control or adding to disclosure rules won’t change this. The only solution is increased investor skepticism and vigilance. As one old hand has said, “Moody’s never paid a coupon.”

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Crash of 2:45

When a lot of snow falls on a steep slope, things can get scary.

If the wind blows just right, the snow forms a deep hardpack and the crystal connections break down. A fracture in this crust can then spread and a slab can dislodge, displacing other slabs and starting a chain-reaction. A slide’s destructive power is truly awe inspiring. During a storm, most people stay out of avalanche terrain. But even in fine weather pockets of instability can form, and a stray hiker or skier can trigger an accidental event.

That’s what seemed to happen in the stock and bond markets last week. The Euro crisis was loading us with instability, and a couple of large trades triggered a cascade of events that created 30-90% price moves within minutes. Circuit-breakers at the NYSE helped, but for that period many trading systems assumed that the computers were down and went to other venues. Those smaller exchanges were overwhelmed, and Accenture and Excelon went to less than a penny.

Just as avalanches spend their energy and run out on the flats, so this panic reversed itself pretty quickly. The EU’s trillion-dollar package helped. But pockets of instability in the markets remain. Market regulation needs to catch up with the latest technology.

Its long past avalanche season, but slides and market panics can still happen. The best approach to both is to keep your eyes open and stay out of the way.

Douglas R. Tengdin, CFA
Chief Investment Officer
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