California Sleeping

What’s up with California?

Long the home of bleach-blonds and beach boys, California has been in an economic funk that has hit harder and lasted longer anywhere else in the nation. In 2007, unemployment averaged 5.4%, before rocketing to 12.4% in 2010. And it’s still at 10.7%–well above the national average, and twice that of New Hampshire at 5.4%.

This is important, because California’s economy is one-eighth of the nation as a whole. If California were a country, its $1.9 trillion economy would be the 9th largest in the world—just below Italy, and ahead of Canada and Spain. Output from the California economy exceeds that of Norway, Sweden, Finland, and Denmark combined.

Even today, there are areas of California—the agriculturally rich Central Valley or Imperial County—where unemployment is above 15%, or even 20%. For a state with a world-class university system, with global leaders in the technology, entertainment, and defense industries, that has seen double-digit growth in its population every decade since the 19th century, this is remarkable. What has gone wrong?

Certainly California was especially hard-hit by the housing boom and bust. The Central Valley has a lot of land and is an extended commute from San Francisco and Silicon Valley. So prices for starter homes roared and crashed. It’s no surprise that it was hit much worse than the Bay Area, where construction is restricted. But the rest of the State still seems to be doing so poorly.

A related issue has to do with energy and agriculture. If you look at a county-level map of unemployment in the US (http://www.bls.gov/lau/maps/twmcort.pdf), one striking feature is the low level of unemployment down the Great Plains. These areas are much more oriented towards commodity agriculture (wheat, corn, soybeans) that are capital-intensive, rather than California’s specialty products like wine and nuts that are labor-intensive. Low interest rates really help farmers buy tractors—but they don’t help them hire seasonal grape-pickers. In addition, restrictions on energy production have kept the State from benefitting from the trebling of oil prices since the mid 2000s.

California’s economic funk is an outgrowth of the labor-intensive nature of its economy. It doesn’t help that its political system seems dysfunctional, at least from the opposite coast. The US economy won’t feel like it’s doing much better until this huge portion of our country begins to get back on its feet.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Great Wall of Worry

What caused the financial crisis?

Some say it was excessive leverage at the investment banks. Some blame Fannie and Freddie. Nearly everyone points at greedy bankers and clueless borrowers taking out no-income, no-job, no asset loans on D-class properties via sub-prime mortgages. And of course, there’s Greenspan, Geithner, Bernanke, Barney Frank, Hank Paulson, and George W. Bush. But until now, no one has really blamed the Chinese.

A recent study notes that the Chinese trade surplus of mid-decade led to massive savings that, combined with Fed policy, kept interest rates low, facilitating mortgage borrowing and fueling the housing bubble. The integration of China and India into the global markets added over 2.3 billion producers and consumers–providers of core goods and services and as consumers of non-core commodities. Their mercantilist trade policies and 30% personal savings rate fed the “global savings glut” that kept mortgage rates low even as the Fed raised short-term rates from 1% to 5.25%.

But pinning the blame on Chinese mercantilism or Wall Street fat cats or sleazy mortgage brokers is a fool’s errand. Finding the source of the trouble is an exercise in infinite regress: economies are adaptive, filled with feedback loops and dynamic incentives. People change their behavior as conditions change, and conditions are always changing. The global financial system created the financial crisis. And we’re all part of that system.

If we’re looking for lessons learned from the financial crisis so we don’t make the same mistakes again, good. There’s plenty to be learned. But if we want a scapegoat to pin the blame on and feel better about ourselves, don’t waste the time or energy. We should just fix what we can, and adapt.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Phone(y) Wars?

The phone wars are heating up.

When Apple entered the consumer electronics business with the iPod 10 years ago, a lot of skeptics said, come on in, the water’s warm. They noted that consumer electronics is littered with failed brands and obsolete hardware: the boom box, walkman, and transistor radio speak to the faddish, temporary nature of consumer taste.

But they underestimated how revolutionary Apple’s plan would be, with the iPod, iTunes Store, iPhone, and iPad. Originally Apple was a computer hardware company; increasingly it’s a software company with a dedicated hardware platform, putting computing power in your pocket, purse, or portfolio. Its operating system can accommodate various dedicated tasks, like streaming video, news feeds, and games, so the smartphone and app-store has become increasingly popular.

Success spawns imitation, so it’s no surprise that multiple models of the touchscreen phone and tablet would pop up, using various operating systems. Google and Samsung’s models were just a little too much like Apple’s, though, and a Cupertino jury decided to award Apple $1 billion dollars.

Microsoft may be the real winner of the Apple-Samsung lawsuit, as appeals and countersuits make their way through the system. Their Windows 8 operating system is build around mobile computing, and is nothing like Apple’s. Blackberry, whose email-ready phones used to dominate corporate computing, may soon be looking down from smartphone heaven.

Amidst all this volatility, one thing is certain: consumers are seeing more choices and better products because of all this competition. Apple’s iPhone may have been one of the first models, but it’s unlikely to be the last word.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Guts Value of Money

An old saw says that a cynic knows the price of everything and the value of nothing. Nowhere is this more true than in investing.

In the investment world, prices are everywhere. Stock prices combine to form indices; bond prices determine yield. Price-action is the main determinant of investment performance. Hundreds of millions of investors interact every day to buy and sell tens of thousands of securities and determine their prices.

But the price is not the value. The value of a stock or a bond is determined by its fundamentals—its balance sheet, revenue, income, and cash flow—present, and future. The key to generating returns that exceed the indices is distinguishing between price and value. So the most basic question an investor can ask is, how much of the future is reflected in the current price?

But this is really hard. Aristotle famously noted that people are by nature social animals, and it’s uncomfortable to be by yourself, either physically or in your actions. So when fundamentals are good, people want to buy and prices get pushed up, and when they’re bad people sell and prices go down. This herd-action causes price and value to diverge—sometimes dramatically—but also makes it hard to exploit. Buying into a falling market feels like catching a falling knife, and selling a booming market is like standing in front of a freight train.

That’s why finance professors are so smug when they condemn active management. The very thing that causes the market to be inefficient makes it hard to exploit. But it is possible. What it takes is an eye for value and the guts to stand alone.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Chinese Bubblenomics?

Is China in an economic bubble?

From some reports it looks that way. Three decades of torrid growth fed by inexpensive exports to America and Europe have led managers to plan for continued growth, where construction managers build plants to satisfy the demand from other plants opening. Eventually the music stops and you end up with overcapacity and excess inventory. That seems to be happening now as unsold cars, solar panels, and bedsheets fill showrooms and clog factory floors.

Because of initiatives called for in their latest centralized economic plan, Chinese auto manufacturing is on track to continue to increase until it nearly equals that of the United States. For a country with a population three times that of the US, that might not be a problem; but their economy is still only a third as large as ours. If inventories are piling up, production needs to slow, not expand.

In a normal economy, it would slow, and consumers would reap a bonanza as dealers cut prices to clear out their showrooms. But in this managed economy manufacturers are holding wholesalers to their earlier purchase agreements, and the cars keep churning out, in spite of the lack of infrastructure for commuting, parking, and gassing up. The result is monster traffic jams and serious pollution problems.

The question is whether this is like the America of the ‘50s or the Russia of the ‘80s. Both of those economies had significant government intervention, pollution problems, and issues with managing growth. But the US overcame its issues via gradual decontrol while the Soviet Union stumbled along until the economic contradictions of centralized planning eventually caused it to break up.

In any case, the investment opportunities in China are significant. But so are the risks.

Douglas R. Tengdin, CFA
Chief Investment Officer
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NY Fed Flacks

Is “Munigeddon” upon us and we just didn’t know it?

A recent New York Fed article examined the difference between defaults on rated municipal bonds and unrated bonds. They found, unsurprisingly, that unrated bonds default at a higher rate than rated bonds. But the level of defaults was alarming—in fact, so alarming that the New York Times discussed the Fed’s obscure blog post in recent story. Instead of there being only a few dozen defaults over the past 30 years, as Moody’s and S&P reported, the Fed found over 2500. Since half of the $3.6 trillion muni market is held by individuals, a lot of individual investors are worried that their bonds may be in trouble.

But they shouldn’t be. The vast majority of defaults of unrated bonds are by special revenue districts and “industrial revenue bonds,” (IDRs) where State governments issue bonds backed by special projects that may or may not work out. For example, if Intel wants to build a plant in the State of New Mexico, the State can set up a special trust solely backed by Intel’s credit that borrows at a tax-exempt rate and funds the construction of that plant. If Intel goes bust, those bonds default.

Those bonds aren’t government debt any more than race car drivers are daily commuters. Lumping IDR defaults in with government bankruptcies like Jefferson County, Alabama or Stockton, California is like aggregating race-car crashes in with normal traffic accidents and saying that driving is a lot more dangerous than previously reported.

It’s frustrating to read posts like these because the average person is likely to say, “Wow, muni bonds are a lot more risky than I thought; look at all these defaults the so-called experts missed!” But in fact they didn’t miss them—unrated bonds are unrated for a reason, and doing a little digging isn’t very hard. Contra some analysts, disclosure in the muni market is pretty good. Unrated bonds sold for private purposes by an issuer without the ability to raise taxes or rates and mainly sold to institutions may involve credit risk. Did that really merit the New York Fed’s attention?

We have yet to see the “hundreds of billions” in defaults so recently predicted. We’re not likely to see them, either.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Rise of the Machines

It used to be that we had rogue traders. Now we have rogue programs.

Not so many years ago rogue traders could bring down a bank, or at least a bank’s trading floor. In 1996 Nick Leeson lost about $1.3 billion, forcing Barings Bank into the arms of Dutch giant ING. In 2002 John Rusnak lost about $700 million for Allied Irish Banks trading foreign exchange options. Societe Generale Bank and Union Bank Switzerland both lost billions when two of their traders—Jerome Kerviel and Kweku Adoboli–went rogue.

It’s so easy to do, or at least it used to be. Trading transactions were done over the phone. Interaction among traders was constant. There was a continual buzz around the firm’s trading desk, with cries of “Done!” or “Not done!” flying out. Amidst all the noise and confusion, a few trades could be hidden away. When you deal with hundreds of transactions every day, setting one or two aside is tempting. After all, the thinking went, a losing trade can be reversed; all it takes is one more winner, with just a little higher stake.

But if the losses mount up and the trader’s activity is revealed, the music stops and there’s an investigation. Often these rogue traders are found to have violated securities laws and go to jail for several years.

But with Knight Capital the game has changed.

Over the last several years traders have been increasingly replaced by algorithmic programs. First stocks, then government bonds, and soon foreign exchange and other financial instruments are being exchanged from firm-to-firm on a microsecond basis by competing computers. This increased interaction improves the market’s liquidity, at least in theory. Earlier this month, though, an errant program at a small market-maker transacted billions of shares of stock over two hours rather than two weeks. Knight was forced into the arms of another firm.

As labor is replaced by capital, rogue traders will go the way of the snake oil salesman. But watch out for the algorithms!

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Search for Safety

For many, safety means credit risk, full stop. Johnson & Johnson bonds are less risky than Ford bonds—the company has less leverage, stronger cashflow, and more steady revenue growth. But safety is more than just having a AAA rating. In August the US was downgraded from AAA to AA by S&P and interest rates still fell sharply. Clearly, the market was looking at something other than credit risk.

Liquidity risk is real as well. In that regard, nothing can rival the US Treasury market. There are over $8 trillion in bonds in circulation, and billions outstanding in any single issue. The bonds are used to collateralize loans, other bonds, and derivative contracts.

By contrast, the most creditworthy nation in the world currently is Norway. They have a modest operating surplus in their government account, but the nation’s tremendous oil wealth is funding a long-term sovereign wealth fund that is professionally managed and that is growing steadily. To many, Norway is the epitome of sound fiscal management.

But there’s a problem in paradise. If people want to use Norwegian bonds as collateral, it’s hard to find them. And if they do find them, and need to sell them, there aren’t a lot of buyers. The market for Norwegian debt is thin: a small change in supply or demand can move the market a lot. By contrast, you could buy billions of dollars of US Treasuries and barely make a ripple in rates.

Safety isn’t just the assurance of getting your money back. It’s getting your money back when you want it. Smaller bond markets simply can’t do this. For that you need liquidity. And that makes US Treasuries the safest asset in the world. Let’s hope we can remain so.

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

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What Do Investors Want?

Everyone wants to make money. The question is how.

Once upon a time, a college endowment was managed by a famous investor. The investor did well; sometimes very well. But a time came when that investor underperformed. He didn’t lose a lot of money, but he didn’t do as well as his peers. During the late ‘90s, while the world was going all techie, he was busily investing in infrastructure and finance. After a very bad year, they hired someone else.

Eventually, his approach was vindicated. Tech stocks pulled back and value stocks recovered. Fortunately for the college the new manager didn’t load up with tech stocks at the top. But the value-manager was gone. Did he do anything wrong?

The short answer is no. He had an investment style that worked, stuck to his guns, and was ultimately vindicated. But there was a problem: a school is a public institution. Alumni and other donors watch how its endowment does and compare it to their own investments. If the school doesn’t do as well as them it’s easy for a large donor to tell the President: “Look, I love your school, but why should I give now, when my money is growing faster than yours? I can always donate later.” Ouch!

The investor erred because he didn’t understand all the pressures a big school faces. In order to be able deliver long-term performance, an investor needs to provide short-run satisfaction. This includes all constituencies. For a school it means donors, alumni, administrators, and trustees. For a family this might mean a husband, a wife, and several generations. Expectations matter.

Investment isn’t just about making money; it’s about satisfying financial needs, both now and in the future.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Three Crises in One

Do bad things come in threes?

The European crisis isn’t just one crisis, but three interlocking ones. A banking crisis, a sovereign debt crisis, and a growth crisis all connect and make it difficult to find a comprehensive solution. The banking crisis is pretty straightforward: the major European banks are undercapitalized and face liquidity issues. This has been an issue for a long time, but it was worsened by our mortgage crisis. The losses that large European banks took on mortgage bonds that were supposed to be rated AAA cut dramatically into their capital. Continue reading Three Crises in One