The Law of Unintended Consequences (Part 6)

So what do we do?

With interest rates at the zero-bound, and government bonds—the most stable asset class—providing yields that are below inflation, how should investors respond? How do we achieve the yields we need to live without risking the principal we need to live on?

Probably the most rational response is to continue to diversify your financial holdings, and consider every asset class. That includes stocks and investment-grade bonds, but it also should include international bonds, high-yield bonds, real estate investment trusts, and master limited partnerships that have arcane tax implications. This is a time to cast as broad a net as possible to catch even a few basis points of extra yield.

Be careful about extending the maturity of your portfolio, however. Interest rates are extremely low right now, but once the economy normalizes they will move back up. And it could be difficult to respond to such a move in a timely manner, as everyone who has extended their duration rushes to the exits at the same time. Interest rates can move sharply, as they did in 2005, 1994, and 1989.

Don’t get freaked out when self-serving analysts trash a fundamentally sound sector, as Meredith Whitney did with municipal bonds in late 2010. That was one of the most profound misuses of notoriety I have ever seen by an investment analyst. She was rightly praised for her correct call of financial unsoundness in the largest banks in 2007, but she misused that prominence and scared millions of investors out of fundamentally sound holdings when she imprudently predicted 50-100 major municipal bankruptcies resulting in hundreds of billions in losses within a year. It didn’t happen.

Keep an open mind. The forces of globalization and technology will continue to disrupt some markets and open others. New markets and asset classes can generate significant returns, but only if their growth is premised on a rational basis. A diversified approach that capitalizes on these opportunities is still the best way to generate sustainable investment income over the long haul.

It’s not a free lunch. But if you do your homework, it’ll keep you fed.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Law of Unintended Consequences (Part 4)

So what’s going to happen to the average investor?

With rates so low for so long, people have are motivated to find ways to create income from their investment principal. And there are people out there ready to exploit this situation for their personal benefit.

Savers are getting flyers addressed “ATTENTION CD OWNERS” promising 5, 6, or 7% returns with principal and interest guaranteed. There’s a lot of ways for scam artists to play this. The interest might apply to just the first $500 of a $35,000 product; or it might pay a teaser rate for only the first month of a two-year period; or the guarantee might cover one tenth of the principal; and so on. The qualifications are buried in the fine print, but the liars can claim that they disclosed the limitations in writing.

Structured products are another way to fleece savers. They generate big commissions for the seller, and they might have a legitimate guarantee from an insurance company, but the money is locked away for up to 20 years with huge surrender charges against early withdrawal.

And then there are garden-variety Ponzi schemes: the Bernie Madoff version, where investments are never made and statements are fabricated; or the Alan Stanford approach where the CD is from a foreign bank with no deposit insurance. These are just outright theft.

So a side-effect of low rates is an increased in financial fraud. Don’t be a victim! If it sounds too good to be true, it probably is.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Law of Unintended Consequences (Part 5)

And unintended consequences are everywhere.

One of the continuing consequences of the bailouts in 2008 and 2009 is a general mistrust of “bankers.” The capital issues at banks like Citi, Bank of America, and Morgan Stanley required a massive equity buy-in by the Treasury in order to maintain their solvency. But the term “banker” became a four-letter word—bankers like Dick Fuld of Lehman or Ken Lewis at Bank of America collected seven-figure bonuses even as their institutions either originated or acquired other banks that originated “ninja” mortgages: borrowers with no income, no job, and no assets.

But the bankers I know are members of the Rotary, serve as volunteer firefighters, coach their kids’ soccer team, and help out the United Way. They’re engaged with their communities, taking local deposits and turning them into local commercial and residential loans. But it’s really easy to talk about tar and feathers, when what’s needed is nuance and understanding.

Now Sheila Bair is weighing in with her memoir of the crisis. Not surprisingly, she tells a sordid tale of bailouts and missed opportunities, and casts herself as the tragic hero. She ticks off a list of all the things they didn’t do: help homeowners with underwater mortgages, clean up bank balance sheets, and so on. Of course, when you have a debt overhang, it’s easy to talk about debtor relief. Bair doesn’t offer any specific plan—just a vague sense that the government spent too much on bank bailouts and not enough on consumer bailouts.

But that’s the rub, isn’t it? We’re still in an economy where perhaps 10% of the housing stock is still under water. Every time the economy ticks up, along comes another over-levered sector to smack it back down. That’s why it takes some time to get out of a debt overhang.

Talk is cheap. It’s the only thing politicians never seem to run short on.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Law of Unintended Consequences (Part 3)

How should investors respond to a zero rates world?

When the Fed first lowered rates to near zero in late 2008, many investors thought it would be a temporary situation; that short-term rates would rise at least to the inflation rate when the economy recovered. But rates have been here nearly four years now, and the Fed has made it clear that they will remain here for a considerable period. The extended outlook for extremely low rates has also affected yields on long-term bonds. We now live in a low rate world.

For investors who depend upon their portfolios’ income, this is a trying time. They can’t just reinvest cash from maturing bonds or CDs and expect that the income will be adequate. Portfolios with such a “bond ladder” have seen their earnings decline steadily over time, and so their owners will have to find other ways replace that income.

Sometimes this can be done, but the challenge is to alter your strategy without reducing your standards. Strategies can evolve; a bond portfolio that was limited to Treasury and Corporate debt might add Mortgage-backed and Asset-backed debt without adding to its risk; a total-return equity strategy could be tweaked to include more dividend-growth stocks and fewer zero-dividend companies.

But lowering standards—reducing credit criteria; extending maturities; investing in illiquid instruments with lock-ups and complicated legalese—has had a long and unhappy history. Sometimes it works out and can be a temporary accommodation to an extraordinary situation. But usually it ends in tears.

There are ways to maintain or even enhance income in a low-rate world. But reaching for yield by lowering the bar shouldn’t be on the list.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Law of Unintended Consequences (Part 2)

Are there limits to the Fed’s effectiveness?

As the Fed continues to provide monetary accommodation, it’s reasonable to inquire whether it will work. After all, low interest rates aren’t a boon for everyone. When short-term rates are below the inflation rate, savers lose purchasing power as prices rise. In effect, savers are subsidizing borrowers. So how do low rates help?

In the short run, low interest rates help the housing sector as they make periodic mortgage payments cheaper. They also make it easier for governments to finance deficit spending, and they reduce the cost of capital for large corporations. These short-run effects can encourage economic growth. But over time, as people come to expect ultra-low rates to last forever, they start to make decisions based on these rates that become distorted.

One clear effect is with government spending. Since the marginal cost of additional spending is minimal, there is an increasing demand for government services. As a result, the size of government relative to the economy increases. At the same time, there is no incentive to increase taxes in order to reduce the deficit, as taxes will have a dampening effect on the economy. The result is an explosion in the deficit and a deterioration in our country’s long-run fiscal stability—our credit rating.

Free money isn’t free. It’s partly why S&P and Egan-Jones downgraded US Government debt. So it’s important for investors to ask, “What comes next?”

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Law of Unintended Consequences (Part 1)

Are low interest rates a free lunch?

On its face, it sure looks like it. Low interest rates reduce government interest expense, make it cheaper to borrow, and stimulate the economy. They especially prop up the housing sector, which goes a long way towards recapitalizing the banks. And ultra-low short rates allow the banks to borrow short and lend long, boosting their net interest income. What’s not to like?

But ultra-easy monetary policy will have unexpected second and third-order effects. For example, low rates are a real problem for savers. With inflation at 2%, zero percent short-term rates means that purchasing power is eroding year-by-year. As investors’ bond portfolios gradually mature, the interest income they can earn on new investments is significantly lower. Many people who live off their interest income are now getting squeezed. Now they are asking where they can cut back.

These investors are also exploring alternative ways of generating income. Some are looking at dividend stocks: others are using real-estate investments; high-yield bonds or other alternatives are also being considered. In any case, income-sensitive investors are taking more risk in order to continue to generate the required interest.

This additional risk will come back to bite the unwary. Longer-term bond portfolios are much more sensitive to interest rates; dividend-growth equity strategies make a portfolio more volatile when used as a substitute for bonds, and so on. Risk is part of investing. But if it’s not managed properly—if investors reach for yield and get burned in the process—the entire economy will suffer.

There’s still no such thing as a free lunch.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The SWAT Team

The US economy needs a turnaround. How do we get there?

When consultants look at an ailing business, they do a SWOT analysis: strengths, weaknesses, opportunities, and threats. If you can seize the opportunities, playing to your strengths—avoiding weaknesses and be mindful of the threats out there, often you can spin straw into gold and create growth where previously there was only stagnation. So what would SWOT analysis say about America?

Clearly, we are strong in design and innovation. The iPhone 5 and latest genetic therapies show the US is on the technological cutting edge, creating products and services in use around the world. Where we are weak is in consumer demand: we’re still repairing our balance sheets and recovering from the housing hangover. So where are the opportunities? Emerging economies—Latin America, Africa, and Asia—have been soaring. Those areas, with an emergent middle class, have plenty of growth. And threats? The usual suspects: the Middle East, leftover weapons from the Cold War, and our own stultifying politics.

Notice that China is not on the “threat” list. It really represents an opportunity for us. They may be able to reverse-engineer the last iPhone, but they can’t come up with the next one. And it’s more effective to employ their engineers at Foxconn where they work for Apple and Cisco. Then Chinese workers have a vested interest in US patent rights.

Economic (and investment) success comes from finding sources of growth and catering to that demand. As emerging economies begin to consumer more, developed economies can advance by designing products that meet their needs. That way we can all prosper.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Risky Business

What is risk-parity investing?

Risk-parity investing looks at a portfolio’s variability–and the cause of that volatility—and says: maybe we can do better. It focuses on the allocation of risk rather than the allocation of capital. It uses borrowing to do this, but it asserts that when asset allocations are either levered up or levered down to the same risk level, an optimum combination can achieve higher returns per unit of risk and be more resistant to market downturns than a traditional portfolio. The performance of a number of risk parity funds during the financial crisis and its aftermath have made it quite popular now with investment consultants and the asset allocation industry.

In a nutshell, the thinking goes like this. In a traditional 60% stocks / 40% bonds portfolio, 90% of the risk comes from the equity side. That is, the bonds are pretty stable, and the stocks jump up and down. If you take some bonds—like Treasury, Corporate, and Mortgage-Backed bonds—and lever them up, you can achieve stock-like risk, but the returns will be higher. And if you take stocks and lever them down—combine stock holdings with cash—their risk will be lower. Then, using optimization software, the assets are combined to achieve the desired risk level, and returns are—hopefully—enhanced.

This approach has done quite well in recent years as interest rates have fallen and stocks have languished. Since the internet bubble popped, equities have gone sideways—with a big hiccup in the middle—while bonds have boomed. But risk parity investing confuses cause with effect. Investment returns don’t come from risk; investment returns come from participating in an economy’s capital structure. Bonds will always be senior to stocks; but their returns will vary based on the challenges an economy faces and investor psychology: just look at what happened in the ‘70s!

Correlation is not causation, and capital confusion is stupid. Levered bonds portfolios have excelled as rates have gone to zero, but all the optimization software in the world won’t repeal the law of gravity: what goes up must come down. When rates come back, a lot of backward-looking optimizers will look pretty foolish.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Evil Twins?

Some people don’t know when to quit.

The Winklevoss twins were Harvard students along with Mark Zuckerberg in 2003. They hired him (with no pay and with no contract) to do some work on a website initially called “Harvard Connection,” and later, “ConnectU.” At its height, the site had fifteen thousand users at two hundred colleges. In a Federal lawsuit, the twins claimed that Zuckerberg stole their ideas when he started Facebook. Eventually, they settled their suit for $20 million in cash and $10 million in Facebook stock—which is now worth about $40 million. ConnectU was abandoned shortly after they received their settlement.

The twins and their roommate, Divya Narenda, have decided that social networking is too important to pass up. So they’ve decided to start up a new social site organized around investment analysis, called SumZero–which about sums up the concept.

The idea is that investment analysts can share their insights with others online. Say you’ve done an in-depth review of Johnson and Johnson’s balance sheet and you’re convinced they have undervalued assets; or you personally know Alex Gorsky, the new CEO. You could post your idea and read the thoughts of other analysts. Narenda says he has received hundreds of applications to be part of the new network, and is rejecting three quarters of them.

The appeal is clear: spread the word about investments you own, and promote your holdings. In some venues we would call that pump-and-dump. Portfolio managers have lost their jobs by talking up stocks they were really selling. This just takes it to a social-network level. From a fiduciary standpoint this is a profoundly stupid idea.

It’s easy to dismiss the Winklevoss twins as uber-WASPy jocks who had a good idea and were out-hustled by a nerdy computer entrepreneur. But I think they symbolize something more: the triumph of the litigant. As Zuckerberg himself said, every time you do something successful, somebody tries to get a piece of the action. But this time they’re the ones likely to get sued.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Open Door Policy

The Fed just approved an open-ended balance sheet expansion.

In its announcement on Thursday, the Federal Reserve set the scene for continued monetary accommodation. They publicized their intention to purchase $40 billion of Mortgage Backed Securities per month. That’s on top of $30 billion they’re already buying, which now should absorb 75-80% of new mortgage production. And they didn’t set an end date. Until unemployment falls, this new policy could be in place for a long, long time.

Naturally, with the Fed supporting the market, stocks are rallying. “Don’t fight the Fed,” goes the saying. As long as the central bank keeps the tap open and dough keeps flowing, the market will remain well-bid.

The same thing is happening in Europe. Mario Draghi announced that the ECB will buy an unlimited amount of government bonds of up to 3 years’ maturity. Also, the Euro Stability Mechanism (ESM) can directly fund member governments—something the German Constitutional Court affirmed on Tuesday. The Fed and the ECB have committed themselves to using the heavy artillery of monetary policy—and now they have an unlimited supply of ammunition!

Global Central Banks have given notice: “We have a bazooka and we know how to use it!.” Don’t fight the Fed, but look out for the law of unintended consequences!

Douglas R. Tengdin, CFA
Chief Investment Officer
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