Learning to Spend

Why does college cost so much?

It’s a relevant question as students await the “fat envelope frenzy” that accompanies college acceptance and their parents fill out confusing financial aid applications. Increases in tuition have long outpaced inflation. In inflation-adjusted terms, tuition is roughly triple what it was in the ‘70s. A small, private college in Sewanee, Tennessee made national headlines when it cut its total price tag by 10%. When’s the last time we saw that?

And it’s not just private residential schools. For-profit and community colleges have seen the same trends. Part of the reason is capital costs. Students need big computing resources and other high-tech equipment because future employers demand this. But the main reason is that education is labor-intensive where most of the expenses are salaries and benefits. In this it is similar to health-care. But they have to compete with industries that can offset higher payrolls with greater productivity. Colleges can’t do this. The process of mentoring students hasn’t changed in millennia.

This situation is self-perpetuating. Higher education does lead to higher real wages, but those are captured by future education costs. Is this a problem? Sure it is. Those high sticker prices discourage otherwise qualified applicants. And the byzantine financial aid system is a disincentive to save or earn more, with an effective marginal tax rate in excess of 100%.

What’s the solution? As in most other economic challenges, the solution to higher prices is higher prices. If something cannot continue it will stop. Higher prices create incentives for creative destruction. A simple need-based tuition formula that requires college-prep work would go a long way. But the market will figure that out. In the meantime, we’ll all be filling out those forms.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Yesterday’s News

So the Huffington Post took over AOL. Or, wait, did it go the other way? Yawn.

Newies have gotten all het up over the AOL/Huffington Post transaction. For anyone outside the media echo chamber, the Huffington Post is the lefty New Media publication created by Arianna Huffington. Early this month, AOL announced that it would acquire the HP for $315 million in cash. AOL is a shadow of its former self. Once the titan that would combine content and delivery, it failed to embrace the bandwidth revolution and is now primarily the owner of some popular blog sites.

AOL chief Tim Armstrong says that they are now poised to become one of the world’s chief content creators, rivaling the New York Times and CNBC. Arianna herself is now in charge of a large stable of online brands.

The problem is, the online news business stinks. There’s free content festooned with pop-ups that’s optimized to get the highest Google score, and there’s subscription content which provides highly-researched, specialized information. In between are the old-media giants like the Times or the Washington Post.

But that business model is struggling. Those companies have tried different payment schemes, and none has worked so far. The Wall Street Journal has always been subscription-based; Bloomberg subsidizes its news operation from its sophisticated investment application subscription. But when the Times tried to go with a subscription model, it was a disaster. Where will the Huffington Post go?

My guess is nowhere. It will lumber along on political junky news until after the next election, then fade away. Maybe that’s why Arianna took cash.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Middle East Musings

In the past several weeks the Middle East has been rocked by successful anti-government protests in Tunisia and Egypt. In both cases, entrenched dictators were ousted by a popular uprising. This has not been an Islamist movement; rather, it has been a quest for jobs and an increased democratic voice. Now the demonstrations have moved to Bahrain, Algeria, Morocco, Jordan, Yemen, and Libya. Across the Arab world, people are taking to the streets to demand greater economic and political freedom.

No one can predict what the next step in this progressive awakening will be. Generations of intelligent, ambitious young people have graduated with engineering and business degrees only to face economies beset by corruption, nepotism, and incompetence. Roughly 60 years of state-managed economics have created structural inefficiencies that appear all-the-more unfair when the leader’s family can secure lucrative banking and construction projects worth billions. This frustration reached a boiling point when food prices spiked, severely affecting most families.

Our take has been that a move to democracy in the Middle East, although messy, is a good thing for the world’s economy. Approximately 250 million people have lived under autocratic governments; now they have the opportunity to express their economic potential. As to the markets, they may well trade off on the uncertainty, but we have not been inclined to sell on this kind of weakness. Indeed, folks who sold in January on the unrest in Egypt missed the markets further advance.

Of course, every situation is different. I lived in Tunisia for 2 years; it’s a fairly uniform place. Egypt has a significant Coptic Christian minority. Bahrain is split between ruling Sunnis and majority Shiites; Libya is an oil-rich country of three major tribal groups held together by a 70-year old strongman who has been in place over 40 years. But in each case, a leaderless opposition is demanding democratic and economic reforms. The threats to the global oil supply have led to increased volatility.

If the market’s volatility makes clients nervous, we can reduce equity exposure to their “sleep point.” But if it falls further, we may use this as an opportunity to buy. On the other hand, if the market keeps rallying beyond the sleep point, we’re inclined to take further profits. At this point their asset allocation should be a strategic factor that can be used as a tactical tool. That is, we want to allocate strategically and rebalance tactically. What we don’t want to do is sell everything now and hope to buy after the market sells off. As the events of March 2009 demonstrated, very few have the fortitude to buy when the market is looking its darkest.

We recommend that people wait to see how these events will shake out. The fundamental strength of the world’s economy isn’t significantly altered by these events. The region needs to sell its oil, and the protesters there may be using this as a bargaining chip to gain leverage with the government. Time will tell how things work out.

In the end, we’re optimistic. These people want jobs and economic freedom, with a political say in their own destiny. This is not fertile ground for Islamism. It seems similar to the “color revolutions” of Eastern Europe of the mid-90s. What matters for markets are earnings, and nothing in these developments makes us pessimistic that earnings will be significantly hurt. But history never perfectly repeats itself. The revolutions of the 1990s were unique, with unique cultural and demographic factors. What is not unique is that people who have labored under repressive regimes yearn for freedom. Hopefully, the birth of a truly democratic Arab world is at hand.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Inflation Nation?

Is inflation overseas headed our way?

That’s the question on a lot of people’s minds these days. In England, inflation is running at 4% and headed higher. In China inflation is 5%. In Brazil it’s 6%. Could their inflation come our way?

Certainly the headlines are worrisome. Commodity prices are soaring: wheat, sugar, cotton, even industrial metals like zinc and lead are soaring. Growing economies in Asia and Latin America–notably China and Brazil—are boosting global demand for raw materials. But because poorer countries spend proportionately more on food and energy than we do, those commodities play a larger role in their price indices.

But there’s another angle. Unemployment in Brazil is 5%, in China it’s 4%. The largest component of inflation is labor costs. In the US, with unemployment at 9%, it’s assumed that inflation can’t get out of control. But that was the assumption in the ‘70s, when inflation accellerated from 3% in 1972 to 10% in 1975 at the same time that unemployment rose from 5% to 9%.

The inflation we experienced then wasn’t imported. Easy money led to excess demand even as investment in new production fell. Rising prices triggered adjustments in labor contracts, which became part of a structural inflation problem. Up until now, that hasn’t been part of this cycle. But when too many dollars chase too few goods, that kind of monetary inflation takes drastic measures to tame.

Excess inflation doesn’t have to be imported. We are quite capable of growing our own.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Do the Continental

Figures don’t lie, but liars sure can figure.

That’s what I thought when I read about the proposed merger between the New York Stock Exchange and Deutsche Bourse AG. Apart from any new names—Wall Strasse, anyone?—the combination will strengthen the trend towards accounting convergence.

What’s convergence? Up until now convergence has mostly been a theoretical exercise for senior accountants and academics that served as an excuse for five-star junkets to London, Tokyo, and Zurich. It’s an attempt to harmonize accounting rules around the world. There were some questions about how to deal with stock options and mark-to-market, but most of those could be handled via email. The real convergence came when foreign stocks wanted to raise capital in the US. When they trade in our markets, they need to follow our rules.

But that may change with the merger. US companies need to file quarterly financials. Most foreign firms only file twice-a-year. The US generally has much stricter rules. It may be that US standards will prevail, as Michael Bloomberg recently predicted on a New York radio show. But it’s also possible that the Germans may want a say.

And accounting ambiguity creates opportunities for mischief. We’ve seen it before: Enron, Ahold, Parmalat—the list goes on and on. Promises of unfettered earnings growth were fulfilled by fraudulent paper profits. Accounting matters. This merger isn’t just about global markets. Regulators need to know who’s going to do the counting.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Simplify, Simplify?

Is our financial life too complex?

Among the various causes of the financial crisis, one of the least cited has been complexity. Complex financial firms bought complex financial instruments that had a complex relationship to less-than-ideal creditors and collateral. When the system began to unravel, investors switched to the simplest securities possible—US Treasury Notes—and shunned anything else even modestly complicated.

We saw this borne out even within the US Treasury market. Inflation-linked securities (TIPs) fell dramatically in price relative to traditional notes. There is no difference in the credit. The bonds are guaranteed by the full faith and credit of the United States. But because the interim payments are based on an arcane formula that involves the unweighted Consumer Price Index, investors found them less attractive.

This is a good illustration of the liquidity crisis that was a large part of the crash. Complexity led to illiquidity—and a fat pitch for investors who understood the risks.

It’s a fair question to ask why finance has to be so complex. At its heart, finance boils down to three basic questions: what is your income versus expenses, what are your assets against your debts, and how are you using your cash. Yes, there are judgment calls and grey areas, but not so many that would lead to the crippling complexity we see in almost every large company.

It seems that complexity has grown because life itself is more complex than it used to be. Cars have onboard computers. Cell phones have built-in satellite navigation systems. Finance merely echoes this change. It we want to remain connected, we need to prepare for the occasional failure.

Douglas R. Tengdin, CFA
Chief Investment Officer
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A Little Perspective

The global media don’t help us understand the relative importance of things very much.

In a recent movie, a food critic asks the waiter at a much-hyped restaurant for a little perspective. “You supply the food, and I’ll supply the perspective,” he notes, dryly. It seems like that with many of the biggest news stories these days. Egypt is unquestionably important, but how many people know that this country of 85 million people only has an economy a little bigger than New Hampshire?

It’s the same way with the US economy. State and Local government layoffs are an important part of the employment picture, but did you know that they’ve only fallen by some 200 thousand in the last year? In an economy with 150 million workers, that’s hardly even a rounding error.

A lack of perspective seems to infect everything. China is frequently touted as having 1.3 billion consumers, when about 90% of the population still lives in a subsistence economy, mostly eating and wearing what they can produce with their own labor. Similarly, it is frequently noted that if the past 10 years’ growth rates are extrapolated, China’s economy will be larger than the US economy in about 15 years. But at that time per capita income in the US will still be five times that of China, even assuming growth trends continue, which is itself questionable.

It’s a fact of life: big numbers sell stories, and putting them into context takes work. It doesn’t help that a lot of folks are just innumerate, struggling over basic mathematical relationships. But the fact remains—a fact without a context is more likely to misinform than to inform.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Failure to Participate

In “Cool Hand Luke” Strother Martin famously tells Paul Newman that his serial escape attempts are due to “failure to communicate.” Now our labor economy seems increasingly beset by a failure to participate.

The monthly Employment Situation Report compiled by the Labor Department is filled with useful analyses. Some of them are less noisy than the headline numbers, and they can capture broad trends in the economy. One of the most interesting is the labor force participation rate. This is compiled from the monthly household survey, and it measures the ratio of the total workforce to the working-age population.

It actually peaked around the year 2000 and has been in decline ever since. The fall has been particularly sharp among college-age workers. It peaked in this group in the late ‘80s, but that didn’t affect the overall number because starting in the early ‘90s workers aged 55 and above dramatically increased their rate of participation. During the recession, however, that increase stalled out, and now the decline in younger workers is visible in the broader statistic.

This decline in younger workers has been in place for almost 25 years. Presumably, it is related to the increased level of education now necessary in order to find suitable employment within the US. If a college degree is now a requirement for most jobs, we shouldn’t expect the broader participation rate to reverse any time soon. This has two significant implications.

First, the increase in productivity that US businesses have enjoyed may not be cyclical, but structural. As we find more and better ways to work, business profits can continue to increase. Second, the unemployment rate may decline more quickly than previously thought, even if payroll employment grows more slowly. This could pressure the Fed to raise rates sooner.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Who’s In Charge, Here?

Congress is mulling legislation that would allow States to seek bankruptcy. Is that a good idea?

In the past couple of weeks several proposals have surfaced that would allow States to declare bankruptcy. Some lawmakers have said they are concerned that some fiscally challenged States may seek a Federal bailout. After all, isn’t California too big to fail as well? Under Federal law, only cities and localities in some states may file. If a town fails to pay principal or interest in a timely manner, the lawsuits begin to fly, writs of mandamus are issued, and local officials become consumed with legal matters. Bankruptcy offers them time to organize their finances and address their financial problems in an orderly fashion.

But bankruptcy is overseen in Federal Court. And State bankruptcy would raise thorny Constitutional issues, because States are sovereign entities. Also, municipal bankruptcy is a long and tedious affair. Because judges have no power to raise taxes, cut spending, or force asset sales—liquidation is not an option—Chapter 9 proceedings usually last for years, especially when a large entity is involved.

Moreover, no governor or state is asking for a bankruptcy solution. California treasurer Bill Lockyer put it succinctly: “To the folks in Congress cooking up this baloney: Don’t bother. States didn’t ask for it. We don’t want it. We don’t need it.” There’s widespread speculation that the real target is union contracts. Because politicians fear the political clout of the unions, they might use the power of a federal judge to help them re-write pension contracts.

But municipal bankruptcy is always voluntary. A politician can’t blame a judge for re-writing a contract if that politician asked the judge to re-write the contract in the first place. Sovereign states have to deal with their own issues.

Bankruptcy would take a wrecking ball to a State’s economy. Hopefully this proposal goes nowhere.

Douglas R. Tengdin, CFA
Chief Investment Officer
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AIG – “All In, Guys”

At the heart of the Financial Crisis AIG needed over $80 billion in support from the Federal Government. Now they’re talking about paying it all back. What’s going on?

Was AIG simply a group of well-run companies that was undone by a rogue trader who got onto the wrong side of the Credit Default Swap market in residential mortgages? No, they also made massive investments in residential mortgages throughout the company.

AIG and its far-flung operations were part of a financial machine, where money serves not just as a medium of exchange or a store of value, but as the raw material in a gold-breeding operation that makes money from money. Finance is supposed to be about the efficient allocation of capital, and insurance is supposed to be about pooling risks. But AIG got swept up in the housing bubble and placed in effect a huge bet on residential mortgages. It needed a giant hard-money loan to make good when that bet went south. The US Government was the only one with enough cash on hand to help them cover.

At its heart, the risk-pooler AIG failed to manage its risk and misallocated capital to the wrong sector. From 1968 to 2005 Hank Greenberg managed the company with himself as the key risk-control officer, but by the time of his ouster (amidst an accounting scandal) AIG was already “all-in” with its housing bet. Its AAA rating was at risk–and with that, its business–and nobody knew.

The temporary loans have allowed AIG to dismember itself gradually, paying them back over time, but it’s now a shadow of its former self. Its outsized bets created huge financial losses that have been borne by the shareholders. AIG serves as a huge lesson in a global morality play: know yourself.

Douglas R. Tengdin, CFA
Chief Investment Officer
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