Why do some economies grow, while others don’t ?

Why do some economies grow, while others don’t?

In his magnum opus, “The Origins of Political Order,” Francis Fukuyama argues that democracy is a stool that stands on three legs: a centralized state, political accountability of the state’s leaders, and the rule of law. Without any one of these elements, democracy is not possible. By happenstance, those three factors correspond to the three branches of US Government—executive, legislative, and judicial. Contrary to some utopian dreams, a truly weak state doesn’t safeguard liberty. It facilitates the rise of gang warfare and the rule of tribal warlords. Continue reading Why do some economies grow, while others don’t ?

(post) Modern Portfolio Theory – Part 2

What’s the ideal investment portfolio?

Most people think of investments as a way to earn money by having their money work for them, and that’s as good an approach as any. The problem is, any investment entails risk, because we don’t know what the future holds. 50 years ago Harry Markowitz won the Nobel Prize for noting if we graph out a portfolio’s long-term risk and return, it normally has an upward slope, in which more return requires more risk.

His colleague Bill Sharp extended this work and created the Sharp Ratio, a simple measure for comparing portfolios on a risk-adjusted basis. But they had to define risk and return mathematically. Return is easy: how much you make divided by how much you start with. But risk is more challenging. They used the notion of variability of returns, or standard deviation. Thus was born Modern Portfolio Theory: diversify your assets to reduce your risk, and there is an ideal combination that maximizes return.

But people don’t invest in a vacuum. They have goals, whether it’s saving for college or planning for retirement or buying a home. These objectives imply a certain required return. But investors don’t have the same ends, and their resources apart from their investments vary. Investments are part of total financial picture: other assets, debt, income, and cash-flow. These are different for every investor. So while it may not be “efficient,” the optimal portfolio will be different for every investor.

Modern Portfolio Theory (MPT) posits that there is one ideal portfolio. Post-MPT challenges this: every perspective is unique. The key is to meet your goals in a way that fits you.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Home Sweet Recovery

Is the housing sector recovering?

One of the most frustrating aspects of this recovery has been the behavior of housing. Because the financial crisis was primarily caused making and securitizing subprime mortgages, the housing sector overshot and collapsed. This created an inventory overhang in single family homes, and millions of folks in the home building and real estate industry were put out of work.

So any recovery in new home sales is especially important. After all, it’s home construction that adds the most to employment. And the latest figures continue to be encouraging. After peaking in 2005 at an annual rate of almost 1.4 million, new home sales fell 80% over the next five years to a rate of 300 thousand per year. But it clearly bottomed in 2010 and 2011, and is now on an upswing. The latest data show that people are buying an average of 350 thousand homes a year, an increase of about 20% from a year ago. And the inventory of new homes is quite reasonable, at about 4.9 months of current sales. By contrast, that figure stood at 12 months supply in early 2009.

Of course, these figures can be and are revised when the Commerce Department gets better data. But those revisions seem to be improving as well. In 2006, every time the data was revised, it was revised downwards—an indicator that things were getting worse. Now every time new figures are announced, the old figures have been revised upwards.

Of course, we’re far from the peak we saw in the heady days of ’05 and ’06. But a recovery is based not on the level of sales, but on the change. It seems clear from the data that home construction is finally recovering. If so, the economy may finally be heading up. And just in time.

Douglas R. Tengdin, CFA
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Strategy versus Tactics

What is strategic investing, and how does it differ from tactical investing?

Strategic investing is investing for long-term needs. It looks at the world in terms of structures and institutions, and invests in those areas that respect property rights, the rule of law, and that allow capital to flow freely. It understands that small companies, troubled companies, and junior claims on cash flow are more risky, and so their returns are more volatile. But if the investor is able to wait long enough—sometimes decades—that volatility can turn into higher returns.

Strategic investing works, but only if the investor lets it work.

Tactical investing looks at things here-and-now and switches readily between companies, sectors, styles, and asset classes. It examines the current circumstances and situations as dispassionately as possible to choose which road to follow. Sometimes the well-travelled road is the best choice; sometimes a narrow, rocky path will be better. Tactical investors don’t care. Cash, bonds, real-estate, and stocks are all tools used to achieve higher returns.

Tactical investing also works, but only if the investor makes it work.

Both approaches have their strengths and weaknesses. Tactical investing tends to be expensive. Strategic investors need to be patient. Tactical investing necessitates volatile activity. Strategic investing focuses on volatile markets.

Whether an investor wants to be tactical or strategic is both a matter of taste and resources. An investor who wants to be strategic but doesn’t have the time or perseverance to wait through the dark periods shouldn’t choose that route. Conversely, an investor who wants to minimize costs—research, transactions, custodial fees—shouldn’t try to be tactical.

An investment approach needs to fit an investor’s mindset and resources like a hand in a glove. And a glove that doesn’t fit is best set aside.

Douglas R. Tengdin, CFA
Chief Investment Officer
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(post) Modern Portfolio Theory

What’s the best way to put a portfolio together?

There’s a school of thought that says people are basically alike: apart from their individual tolerance for risk, they desire a modest amount of income and capital growth from their investment portfolios, so they should combine a balance of index funds together to have a low-cost, broadly-diversified portfolio.

There’s a lot to be said for this approach: it’s inexpensive and it gets people started on the investment process. And people usually get more conservative with their money as they age, so reducing risk by increasing the bond allocation isn’t unreasonable.

But this ignores some basic facts. People aren’t all that similar. Once you scratch beneath the surface, most folks have very different hopes, desires, fears, and concerns. And everyone brings a different set of resources to the table: financial, emotional, intellectual, and so on. Using a “cookie-cutter” approach of mutual funds and investment models neglects these assets.

Building an investment portfolio is like constructing a house. Yes, people have a common need for shelter, but no two living spaces are alike. The structures may all have a foundation, four walls, and a roof, but the similarities usually end there. And homes in southern California are very different from dwellings in New England—or anywhere else! Like a home, an institution’s or family’s investments need to fit their current lifestyle and their future plans. It needs to use the materials at hand to provide resources for the future.

Investing, like all of life, is complex and multifaceted. Managing your money is as much an art as it is a science. Some generalizations may be useful, but at its core all finance is really personal finance

Douglas R. Tengdin, CFA
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Burgernomics

Economics has been called the “dismal science,” and economists are stereotyped as dour, unsmiling grumps immersed in their data and charts. But sometimes they have flashes of whimsy and caprice.

Such is the case with the “Big Mac Index.” Since 1986 The Economist magazine has published the price of a Big Mac, around the world, in order to compare which currencies appear to be overvalued and which look undervalued. Since Big Macs are perishable and can’t easily be transported across national borders, the Big Mac Index is an intuitive way to present how the notion of purchasing power parity—that a dollar of income in America or China or Norway can buy the same basket of goods—doesn’t hold up very well in practice.

And what does the Big Mac Index show? Not surprisingly, Scandinavia is more expensive than the US, with the “free currencies” of Switzerland, Norway, and Sweden, the most expensive. In those countries a Big Mac costs around $6, about 45% more than the average US price of $4.20. And in the developing world, the iconic McDonald’s sandwich is cheaper. In the Philippines, Hungary, Russia, and Indonesia it costs about $2.50, or 40% less.

But there are a few surprises. A Brazilian Big Mac costs $5.70, almost as much as Sweden, and even in Argentina—the home of gauchos and wide Patagonian plains—it costs $4.60. And across much of the Euro area—a multi-city average—the two all beef patties cost approximately the same is over here, in spite of their higher permitting costs and more rigid labor requirements.

To be sure, not all the variation in price is due to currency factors. Differing labor costs, the cost of sourcing local ingredients, and advertising expenses will vary from place to place. Still, it gives an intuitive picture of how fairly valued currencies are. And it can make changes in exchange rates a little more digestible.

Douglas R. Tengdin, CFA
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Backwards Day

241 years ago, Lord Cornwallis surrendered to George Washington on the plains of Yorktown, Virginia. 10,000 British troops were captured, effectively ending the Revolutionary War. Tradition has it that during the formal surrender ceremonies, the British band played the ballad, “The World Turned Upside Down.”

Has asset management turned upside down? The riskiest assets are deemed safe, and the safest are certifiably risky. Cash, considered the safest of safe havens, is losing value relative to inflation. Inflation has been running between 2 and 2 ½ percent, but since late 2008 cash has paid almost nothing. Short-term bonds of other AAA governments are trading at negative nominal yields.

At the same time, investors are being encouraged to invest in stocks for their income stream, treating some high-dividend stocks as if they were variable-price bonds, and looking to high-yield debt and even emerging market debt as a safe haven against the political turmoil and long-term fiscal issues facing the US and other developed nations. After all, the populations and economies of the developing world are growing

But high-yield debt can default, and emerging market nations can do irrational things, as recently happened when Argentina seized control of the an oil company to avoid an energy crisis—without compensating the owners. Political risk and default risk are real, despite interest rates insure a loss of purchasing power. Meanwhile, stocks are still the last link on the corporate cash-flow food chain. If anything happens with pension funding or tax payments raw material costs, those dividends—which aren’t contractual—could be cut.

So the risk hierarchy—cash, bonds, stocks—hasn’t been inverted, and the rules of asset management haven’t been repealed. We’re living through an historic period of financial deleveraging and slow growth, in the midst of continued globalization and financial liberalization. The first rule of risk management is still to focus on the safe return of your money, not just the return on your money.

Douglas R. Tengdin, CFA
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Changing Direction?

Is the economy giving us a head-fake?

Back in the Cretaceous Era, I played a little football. And one of the first moves I learned was a ball-carrier’s head fake. When approaching a defender, a ball-carrier will look and lean in one direction, then change at the last minute. If the defender has been watching the carrier’s head, he’ll be deceived and miss his tackle.

For in 2010 and 2011, the economy gave investors a head-fake. Initial strength in employment and production faded over the summer, and by early fall recession fears were rampant. But then those fears failed to materialized, the economy continued to grow, and the market rallied into year-end, confounding the bears who had been convinced that the economy was about to roll over.

Are we experiencing another head-fake now? Certainly there has been a raft of weak data lately—employment growth has been anemic, retail sales declined for three months in a row, and consumer sentiment remains weak. But the way to guard against a head-fake is to watch the runner’s hips, not his head. The way to avoid a head-fake in the economy is to watch what consumers are doing, not what they’re saying.

And consumers are still spending. Yes, retail sales are lower, but a lot of that can be explained by lower gasoline prices and a hot summer that sends people to the beach rather than the malls. But home prices are actually going up for the first time in years; the portion of homes undergoing distressed sales is falling across the country; consumer credit is rising; and auto sales have been unexpectedly strong, in spite of a lackluster model year.

It’s easy to be swayed by the doom-and-gloom talking heads, and forget that the economy is still growing, albeit slowly. Investors need to beware of the head-fake, invest with their heads, and watch the economy’s heart.

Douglas R. Tengdin, CFA
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Child Tax Cliff

Lost in the debate over how the looming fiscal cliff might affect taxes on the rich and cuts in defense spending is a little-followed portion of the Bush tax cuts: the child tax credit. Unless Congress renews the law, the $1000 refundable tax credit is scheduled to be cut in half at year-end.

The child tax credit is one of those rare Washington accomplishments: a left-right compromise. Conservatives like the credit because it reduces taxes and supports families. Liberals have supported it because its benefits are progressive and provide aid to some of the most vulnerable populations.

But in the hurly-burly of the budget debate, the child tax credit is mentioned as a major tax expenditure that adds to the deficit. According to the Joint Committee on Taxation, the combined cost of the child tax credit and the earned income tax credit comes to about $77 billion per year. That compares with $110 billion for the mortgage interest deduction and the exclusion of capital gains on principal residences, or $42 billion for the tax exemption on interest income from municipal bonds. It’s real money.

And the credit has other, pernicious effects. Because the benefit phases out over time, it has the effect of increasing the effective marginal tax rate of people who receive it. Right now, for people earning between $15 and $40 thousand a year, if their income goes up $10 thousand, their net take-home pay only goes up between $1 and $2 thousand. That’s a powerful disincentive!

And because of different rates for married couples versus singles, the credit creates a significant marriage penalty for moderate-income families. A working single mother who marries will lose a host of federal and state support payments, totaling up to $20 thousand.

So some lawmakers want to scrap the credit altogether, removing the distortion and reducing the deficit at the same time. That would be a mistake. Our economy depends on having an expanding workforce, and raising children is expensive. Support from the tax code is modest, compared with the rest of the world.

The child tax credit is worth saving. Let’s hope policymakers can cut the Gordian Knot of tax policy, and reduce how it warps our economic and social systems.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Too Complex to Fail

Is our financial system too complex?

With LIBOR scandals, commodity-broker fraud, and big bank bailouts still making the news, many people are saying, “Stop the financial system, I want to get out!”

But exiting our current financial system just isn’t practical. Sure, you could move off the grid, raise your own wheat, and exit the cash economy, but that’s all you would do. Moving back to an 18th century lifestyle would mean moving back to an 18th century standard of living, where basic survival was a priority and pestilence and famine weren’t that uncommon.

And 18th-century life wasn’t financially that simple, either. There were competing gold-based, silver-based, and paper currencies, some of which were “not worth a Continental.” The first Bank of the United States was a political hot-potato, dishing out equal parts scandal and graft. It gradually evolved into our modern central bank.

And our current financial system isn’t so much a complex system as a highly interconnected one. We have local banks, global banks, brokers, insurance companies, mutual funds, and hedge funds all playing in the same sandbox. There isn’t enough hierarchy and modularity, so a few centralized players become “too big to fail” and a potential insolvency could threaten to pull down the entire financial infrastructure. That’s what TARP was all about.

What we need is a modular system, where one sector’s failure wouldn’t threaten the others. That’s what we see in biological systems, where a broken bone doesn’t endanger our heart, or in education systems, where problems in elementary schools are distinct from issues in community colleges or research universities. That’s what the proponents of a return to Glass-Steagall are getting at, even if their attempts to turn back the clock are misguided.

A modular financial system could still be complex enough to handle the modern world, but would have subsystems whose failure wouldn’t endanger the others. Yes, our financial world is complex—always has been. But it could be safer.

Douglas R. Tengdin, CFA
Chief Investment Officer
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