Small Futures

Is small business the future?

Both of the major presidential candidates are on the stump extolling the virtues of small business. And it’s true that small businesses create the majority of new jobs in our economy. But actually, it’s young businesses that create jobs. Small businesses that have been small for the past 5 years tend to create jobs at the same rate as big businesses.

it’s also true that, over time, small-cap companies outperform large-cap companies. They have better sales growth, better ROE, and better stock market returns. Part of this is due to their higher volatility—small businesses are just riskier. They have less capital and their managers have less experience. But part of this is due to the fact that it’s easier, just as a matter of math, for small businesses to grow.

So when I hear politicians say they want to favor small businesses, I think they’re missing the point. To borrow from General George S. Patton, no small business ever succeeded by staying small; it succeeds by growing to become big. There are already too many set-asides and special perks in the tax code. Another special provision for small businesses just makes for more paperwork.

And it increases taxes on the margin. Because as they grow, at some point those small companies will no longer qualify for those special provisions—they have to be phased out. And that phase-out effectively raises the marginal tax rate on companies who are growing. So something designed as a support becomes a disincentive to grow.

It’s no great shame to be small. Of course, it’s no great honor, either.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Storm Busters!

Who ya’ gonna’ call?

That’s the question lots of us have about Sandy. Sure, we can go to Weather.com or Ready.gov to get storm information, but once the power goes out, it’s not so easy to stream videos or post pictures on Facebook. And with most folks getting their TV via cable or satellite, local news stories are pretty hard to find, too.

That leaves us with that old standby, the transistor radio. Surprisingly, none of the government’s websites lists local radio stations or emergency phone numbers. The closest you can get to a phone listing on the FEMA website are instructions on how to get their monthly preparedness tips via text message. That’s a help.

And while we’re on the subject of phones, remember landlines? It used to be that the phone lines would get jammed during a storm. But now that so few people remain on landlines, those lines are clear. If you can find an old-fashioned phone that hooks directly to the wall-jack, not a cordless job with built in caller-id, messaging, and call-waiting. Those need electricity.

As we get increasingly high-tech, it takes some low-tech (or mid-tech) equipment to get us out of a jam: radios, landline phones, cars, and maybe a chain saw. And an old-fashioned list of important numbers: police, fire, the power company, and the local Department of Public Works.

New Englanders pride themselves on their resourcefulness and readiness. But when things get dicey, it helps to know who to call.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Stormy Weather

How does weather affect the economy?

As Hurricane Sandy bears down on the East Coast, it’s worth asking how storms impact the way we live. In years past this was a foolish question. After all, in an agricultural society unusual weather has a direct impact on food production. 1816 was the year without a summer in northern New England. Over a foot of snow fell in early June, and there was a killing frost in mid-August. That winter cattle starved for lack of hay, and people sustained themselves on boiled nettles and porcupines.

As we shifted to an industrial economy, people were less dependent on month-to-month changes in the climate. Year-round production was imposed on a summer-winter schedule, but vestiges of our agricultural heritage remain: school schedules that used to accommodate working in the fields; financial stresses that climaxed in the fall because the economy’s cash needs at harvest-time.

But as a consumer-economy, the weather still has an effect, particularly on retail sales. Usually an individual storm like Sandy just defers purchase plans—what we don’t buy this week we’ll make up next week. But when storms impact holidays (like Halloween) some of those purchases never happen. Last year’s warm winter meant that winter clothes were never purchased and planned ski vacations were just cancelled.

The National Oceanic and Atmospheric Administration sponsored research that indicated that weather events can reduce our economy output by up to $500 billion. Different states have differing levels of vulnerability. New York was seen as the most vulnerable; Tennessee the least.

But preparation helps. As we batten down the hatches and prepare for Sandy’s impact, we can be thankful that we’re ready. Because what’s really disruptive isn’t the weather, but the surprise.

Douglas R. Tengdin, CFA
Chief Investment Officer
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(P)Reserving the Fed

Is Fed-bashing a new spectator sport?

Criticizing the Fed has been a political trope for years. It’s easy to do: find an economic trend, look at the point when it became visible in the data, then disparage the Fed for not picking up on what was, in retrospect, obvious. If you can find a couple of financial columnists or academics who mentioned the emerging problem at the time, so much the better: then it looks like the Fed was ignoring what was obvious to “everyone,” even if “everyone” was just a couple of obscure cranks.

There is a legitimate public policy debate regarding the Fed and central banking: what’s the best way to regulate the banking system; what’s the best way to set interest rates; how should we manage the money supply. These are good questions, and it’s reasonable to examine history and the practices of other countries to try to find the best possible system.

And then there’s carping: grumble about something you have no prospect of fixing. Current critics of the Fed remind me of the scene in Monty Python’s “Life of Brian” where a rebel group meets to complain about their rulers: “Apart from better sanitation and medicine and education and irrigation and public health and roads and a freshwater system and baths and public order,” John Cleese asks, “What have the Romans ever done for us.”

I feel that way about the Fed: apart from price stability, a sound banking system, solid US credit, international currency stability, economic research, educational resources and a growing money supply, all without political or financial scandal, what has the Fed ever done for us? And to those who would replace it—what evidence can you show that your replacement would work better?

Douglas R. Tengdin, CFA
Chief Investment Officer
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Grading the Fed

Remember the Fed?

The Federal Reserve just held a two-day meeting of its open market committee and decided to change almost nothing. Their formal statement contained about half a dozen word changes. Their policy remains as it was: add to the money supply, keep rates at zero, and monitor the economy. It’s been that way for the past four years or so. Yawn.

Time was when we waited on the Fed’s pronouncements with bated breath. Fed-watchers would gauge the size of the Chairman’s briefcase to divine whether he would advocate higher or lower rates. Now it comes as a surprise that the Fed is meeting. The response is often, “Really? So close to the election?” or “Why do they even bother? What do they have to decide?”

But the Fed has a continuing role to play in this recovery. The banks they oversee talk about the three-C’s of credit: Cashflow, Capital, and Character. Those are the principal factors banks use to evaluate a company’s ability and willingness to pay back its loans.

Well, the Fed can be judged on a three-C framework too. Only these C’s aren’t measuring whether they’ll pay back a loan, but whether they’ll keep money flowing through the economy. The Fed’s three-C’s are: Communications, Commitment, and Credibility. Communications are how they manage expectations—forecasts, statements, and press briefings. Commitment is their willingness and ability to keep policies in place. And credibility is their true stock-in-trade: the assurance that they will do what they say.

The three-C’s of credit are a good way to evaluate how risky a loan might be. The three-C’s of central banking give us a tool to tell how trustworthy the Fed is as well.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Fiscal Cliffhanger

Is the Fiscal Cliff the Y2K of 2012?

Remember Y2K? Interminable meetings discussing scenario tests, date resets on our desktops, and getting new checks printed, all because some punch-card designers decided to save two digits in the date field on an 80 character punch card 70 years ago!

But after the zero-hour came and went, and we didn’t lose power, we didn’t lose our phones, and our bank balances were still there, everyone pretty much stopped worrying. Equities at 30x earnings? No problem! Look at all that cash we have in the economy! The Fed put it there to make sure we didn’t have a banking crisis caused by a massive system failure over the turn of the millennium, but then when they mopped that up with higher interest rates, that caused the recession that popped the internet bubble. We’re still recovering from that one.

The Fiscal Cliff of today looks like Y2K of 13 years ago. Everyone frets about it; some have discounted it; many are planning for it. But it’s not the known unknown like the Cliff that kill your portfolio, it’s the after-effects. And valuations.

The bond market today is reminiscent of the equity market of 1999. Yields just keep going lower, just as equity prices kept rising back then. There are all sorts of rational explanations why bond yields have fallen and they can’t get up–the “New Normal,” global wage deflation (from Chinese labor), natural gas surpluses–just like there were reasonable justifications for the ebullient equity valuations of 1999. Those rationalizations didn’t hold water.

In the end, the market couldn’t sustain equity market multiples that were twice their historic average. And long-term bond yields probably won’t remain at less than half of their normal level, either.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Golden Futures

What function does gold serve in the economy?

For more than three millennia, gold has served as both a unit of exchange and a store of value in the global economy. The stock of gold is relatively stable. There are about 155 thousand tons of gold in the world, and each year the world’s mines supply some 2600 additional tons of the metal. It’s chemically stable, and surprisingly malleable. It has sometimes been referred to as a currency without a country.

But the growth in supply has varied over time. In the 17th century, gold from the New World flooded Spain’s economy, causing rampant inflation—one of the underlying factors that led Spain to attack England via the Spanish Armada. In the late 19th century, the gold supply couldn’t keep up with rapid productivity growth in the US, leading to significant deflation and social disruption. William Jennings Bryan’s famous “Cross of Gold” speech was a protest against the gold standard.

As a result, many people have a deep seated conviction that gold is a useless, barbarous relic of a bygone era with no yield and a volatile price. Others feel that it is a hedge against inflation, since the supply of gold cannot be manipulated. Certainly as the Fed monetized the deficit and inflation grew during the ‘70s the price of gold grew eight-fold. But inflation has been remarkably low over the past 5 years, even as gold prices have risen again.

So is gold money? Money serves three purposes: a unit of exchange, a unit of account, and a store of value. Gold has served the latter purpose since the late-‘90s, but cannot serve the first without government sanction, and it’s never been an accounting standard—that’s always been Dollars or Deutschmarks or Pounds.

Unless inflation reemerges in the global economy, gold is unlikely to regain its early prominence. Were it to reemerge as a currency standard, Congress (or the Fed) would have to set the amount backing a dollar—something they could change. And growth in the supply of gold would once again become a concern.

So unless inflation accelerates and prices begin to rise dramatically, it’s hard to see how gold adds economic value to a portfolio. The price of gold is a curious thing, but over the long run it’s more of a curiosity than a serious consideration.

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

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Hunger Games

Hunger Games – Are we running out of food?

This seems like a silly question today, but it wasn’t so foolish 30 years ago. Food prices had doubled in the early ‘70s, and many economists thought we were running into the “Limits to Growth,” a doomsday scenario where global scarcity and resource constraints would force the world’s economy into an economic scenario labeled, “overshoot and collapse.” The solution, according to some, was voluntary simplicity, living simply so that others might simply live. Continue reading Hunger Games

The Paradox of Plenty?

The Paradox of Plenty?  –  Are natural resources a blessing or a curse?

The intuitive answer is that they should be a blessing. All things being equal, one would rather live in a country rich in energy, minerals, and other wealth than in a poor country. But if you study the “resource curse” you see that all things are not equal. Countries with lots of energy or mining resources tend to grow more slowly than other countries. Why should this be? Continue reading The Paradox of Plenty?