Unified Finance Theory

In physics, people are looking for a unified theory. It’s possible one doesn’t exist.

Ever since Maxwell discovered the way to combine the forces of electricity, magnetism, and light, physicists have sought a unified theory that ties all the forces in the universe together. Einstein worked to describe both electricity and magnetism, but there are other forces in the universe—the forces that hold a stable atomic nucleus together, or tear it apart when it’s radioactive.

Scientists haven’t yet figured out a uniform way to describe these various phenomena. There are competing models with names like String Theory, Brane Theory, or Warped Gravity. They’re all highly complex mathematical approaches to difficult problems. There’s no consensus on a single solution.

In finance as well, people look for singular answers. What’s the best portfolio? What’s the best accounting method? Which stock is hot right now? In finance, as in physics, it depends on your perspective.

The best portfolio is the one that meets your individual needs over time. If you need income, a fast growing private equity portfolio doesn’t work. If you’re a 20-something saving for retirement, a ladder of T-Bills doesn’t fit the bill, either. There’s no single approach that’s ideal for everyone. There are an array of individual requirements and limitations that have to be applied by each investor before anything is ever bought or sold.

Responsible financial professionals understand that life is complex. Anyone who tells you otherwise is probably selling something.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Now He Tells Us

Larry Summers is out of government. And he’s talking (and talking, and talking …).

In a recent interview Summers proclaims that Keynesian economics has been totally vindicated, because, as he says, “macroeconomics is about filling in the gaps, not smoothing the cycle.” In other words, economics is about stopping the bleeding, not about getting the patient healthy.

Well you could have fooled me.

The Keynesian in the Treasury Department argues that cutting spending, even when tied to lower taxes, will contract the economy. It was Keynesians in the ‘60s and ‘70s that declared the business cycle dead. It’s Keynesians who say it’s all about demand; that the current economic slowdown has nothing to do with a skills mismatch between unemployed construction workers in Arizona and HTML coders needed in Silicon Valley. Keynesians were right that spending in ’08 and ’09 plugged the hole that the economy started to fall into. But they ignore the long-term consequences of their policies.

Long-term, if you support failed enterprises, you end up with an economy full of failures. Long-term, if the government is the employer of last resort, the government turns into the first resort. People won’t look for work if they don’t have to.

America is exceptional because the people and the institutions are remarkably flexible. Necessity is the mother of invention. Keynes may have stopped the bleeding, but it will take the right incentives to get the competitive juices flowing effectively again.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Flying On One Engine?

Many of those observing the debates in Washington and Brussels have compared our fiscal issues to household finance, complete with kitchen table discussions, bill-paying, and saving for a rainy day. But to my mind, it’s the language of flight that is more telling.

Economies buffeted by turbulence, approaching stall-speed, policymakers at the controls, trying to avoid a crash or a hard landing—these are all images from the flight-deck. And like the most successful pilots, policymakers with poise and experience will make all the difference to the outcome of today’s trials. Think of “Sully” Sullenberger and the Miracle on the Hudson in January of 2009. Officials face three distinct challenges.

  1. Deleveraging is sucking the oxygen out of the plane. The global financial system got over-levered during the ‘02-‘08 boom. Now consumers, businesses, and governments are all seeking to increase savings and reduce debt. Officials need to figure out how to get the masks to deploy and keep us all breathing.
  1. Slow economic growth is making the controls mushy and unresponsive. Because delevering makes us less inclined to borrow, easy money isn’t as stimulative. That doesn’t mean they should change the policy and raise rates. It means more patience than usual is necessary.
  1. Communication is critical. When Captain Sullenberger faced his emergency, he made it clear what everyone needed to do and what they could expect. Our political leaders need to do the same.

Like a pilot facing unusual circumstances, those in charge need to focus, prioritize, and execute. Let’s hope they’re up for the job!

Douglas R. Tengdin, CFA
Chief Investment Officer
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Producing Incentives

I don’t know why so few jobs are being created. But here’s one idea:

In a normal market, you have three main economic actors: owners, workers, and customers. Customers want the most good at the lowest price. Workers want the most pay for the least work. And owners want the most return for the lowest risk. These conflicting objectives come together and you get reasonable goods at a reasonable cost delivered by reasonably paid workers and a reasonable return to the owners.

The marketplace is designed to reconcile these conflicts among self-interested actors and provide goods and services in an efficient manner. A case in point is McDonald’s. Around the world, you can walk in and get decent food at a fair price.

Now look at the jobs that have been created in the US over the past 20 years. Almost all of them have been in health care, education, and government. Who are the owners and who are the customers? The usual roles are turned on their heads.

The normal economy has been highly innovative, creating high-paying knowledge jobs that compete with the best in the world. But the service economy has generated jobs in compliance, accounting, and customer service.

If we want lots of jobs, fast, it may come at the price of efficiency and global competitiveness. Given how stagnant wages have been, I don’t think we can afford that. The only other way is to encourage quality and innovation, and work through the current unemployment slump.

Douglas R. Tengdin, CFA
Chief Investment Officer
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South of the Border

Borders is going out of business. Why now?

It’s reasonable to ask why they’re liquidating right now. Yes, the franchise has operational problems: they were slow to embrace eReaders, and their web site is a joke. But in their official filings, they listed assets of $1.28 billion and liabilities of $1.29 billion. Surely something could have been worked out.

The reason is a new law: it’s because of 40 stores.

Congress restructured bankruptcy laws a couple years ago. In that revamp, bankrupt companies were given a seven month grace period before they had to assume their leases and promise to pay them in full. That allowed landlords to evict delinquent lessees if their bankruptcy proceedings were taking too long. This protects landlords and allows their claims against a bankrupt company to jump to the front of the line.

In the Borders bankruptcy, 90% of the landlords agreed to extend this deadline. But forty landlords—of the most economically valuable properties—did not. They wanted to re-let their stores to someone else and get cash now, rather than wait for a further restructuring. Borders couldn’t survive without these profitable stores.

10% of the landlords are in effect forcing Borders’ liquidation so they can get back their properties—and causing 10 thousand layoffs in the process. Bankruptcy law is supposed to protect the greater good. In this case, it did not.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Greek Butterflies

Is it possible for the Greek debt crisis to unravel the Euro?

That’s what it looks like may happen. A country whose GDP is about 2.5% of the Eurozone has gotten into fiscal trouble, and now hedgies are running a bear raid on Italy, a core European country whose $2.1 trillion economy is larger than California’s. If Italy goes down, the Euro is at risk.

How did we get here? It’s not as if the Greek debt problems are breaking news. Their bloated debt and chronic deficits are the stuff of legend. The EU’s dithering, and especially the European Central Bank’s tightening credit in the teeth of a balance sheet crisis in Greece, Portugal, and Ireland have convinced many that the Euro may not have the support many thought it did.

Accordingly, some aggressive traders are trying to drive Italian and Spanish interest rates to unsustainable levels. This will be harder than it appears at first. Italy’s government is running a primary (ex-debt service) budget surplus, and they have significant public assets they can sell. Even so, this crisis can end in only one of three ways:

First, the European nations can arrange a bail-out. This is hard in the case of Italy, which has $2.2 trillion in debt. Nevertheless a Hamiltonian debt assumption and re-issuance under a central authority is possible. Europe is still a powerful economic engine. Second, default is possible. That would likely lead to multiple banking crises across the continent, and if the sovereign has defaulted, the sovereign can’t shore up its banks. But some kind of controlled, limited restructuring is possible. The third possibility is monetization. The ECB could buy the troubled debt and expand its balance sheet. We know where that leads: inflation. There is no free lunch.

There may be another way for Europe to muddle through, though I can’t see it. One thing is certain—there is more pressure for integration than most people realize. That’s why I continue to expect a resolution.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Time Machine

Imagine you had a time machine and could go back to 1986. Congress was discussing a sweeping bipartisan tax reform plan. Billions in deductions would be eliminated in favor of lower rates. The debate was intense. Fast forward 25 years. Why are House Republicans opposing this?

Corporate tax rates are being cut while special subsidies are being eliminated. Personal tax rates are being lowered somewhere between 6 and 12 percent from current levels. Social Security and Medicare would be shored up through changes in their inflation adjustments. A Republican Senator with strong anti-spending credibility has helped put the proposal together. And a Democratic President has signed on.

This sounds and looks like the tax reform plan President Reagan got through a Democratic House 25 years ago. President Reagan is an icon in the Republican pantheon. House Republicans are now opposing a Reaganesque supply-side initiative. The irony is overwhelming.

Economist Gary Becker outlined the needed components of a solution to our fiscal mess over a year ago: slower entitlement growth; lower tax rates on a broader base; and long-term economic growth, supplemented by regulatory, educational, and immigration reform. What’s needed now isn’t rocket science, but vision and leadership.

“Without a vision the people perish.” And without leadership, nothing gets done.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Regulating Pendulums

How much regulation do the banks need?

The Dodd-Frank bill has been around for a year now, and it’s reasonable to ask if anything has changed. The logic behind Dodd-Frank is simple: our capitalist system runs on self-interest and profits. Regulation is necessary to make sure things stay within reasonable limits—things like systemic risk, concentration of power, and prevention of fraud. If professional ethics, self-regulation, and a sense of limits could be counted on, we wouldn’t need formal laws. Sadly, they can’t.

But regulators are human and regulations are crafted by imperfect people. It’s easy to write hard-and-fast rules, but entrepreneurs are all about innovation; regulation often seems to be fighting the last war. Strict rules become outdated and get circumvented. And the proof is in the pudding: the regulated banks were ground-zero for the last crisis; the unregulated hedge funds largely went unscathed.

Because both free markets and regulation are imperfect systems peopled by imperfect actors, we will never strike a perfect balance. Instead, the pendulum will swing from one tendency to the other. Our financial system will continue to be imperfect, working well 95% of the time for 95% of the people. But it will create large risks the rest of the time.

Money is a societal convention and financial rules will be ever with us. Free markets do the best job of allocating resources; but the ride will always be bumpy.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Giving China Credit

Is China a triple-A credit?

Many people think so. China’s economy has surpassed Japan’s as the second largest in the world, it’s growing at 10% per year, and it has currency reserves equal to ¾ of its economy. By contrast Japan’s economy is stagnant, they have a net debt level about equal to their GDP, and their aging electorate seems vote for a new prime minister every year. But the rating agencies have them both notched at AA-.

Some folks think that China is being disrespected here. They think that China’s net creditor status should give it a better rating than many Aaa countries. Indeed, in the markets today writing a guarantee for China’s debt is cheaper than writing one for Austria, France , or Italy. Austria, by the way, has a 50% debt/GDP ratio, 4% economic growth, a 3% budget deficit, 2% inflation, and 6% unemployment. It’s not a fiscal basket case.

But the market is judging China’s debt to be safer than many core European countries because of its growth and trade surplus. But there is a matter of transparency, continuity, and rule-of-law. China unquestionably is a growth dynamo. But this has come in part via an unreported credit expansion. Many of China’s banks will be saddled with bad loans as a result.

This doesn’t mean that China is going to crash. Their currency reserves almost guarantee that they won’t. But reserves can be squandered; and growth can be volatile. In evaluating China, it’s important to note that while dragons may be able to fly, they also can burn you.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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