Where Are We?

As 2013 ends, how is the economy doing?

There are many ways to answer that question, but one the clearest is to compare employment, economic activity, and the market. Since the Financial Crisis, both the market and the economy have recovered and hit record levels, while employment is still below its 2007 peak. This gap—sometimes call the output gap—is a big source of concern for economists and analysts.

The economy is now producing $850 billion more in inflation-adjusted output with 2 million fewer workers than it had in 2007, so corporate profits are at record levels and over 40% higher than their pre-recession peak. This is a principal reason why the stock market has advanced so significantly, now 17% above its October 2007 record.

Why this is happening isn’t so complex, either. Capital is cheap; labor is expensive. The Fed has kept short-term rates below inflation since late 2008. Only now are they beginning to take baby-steps to normalize this situation, although many expect rates to remain low for a long, long time.

If the economy strengthens and unemployment falls, can profits stay this high or will they revert? That’s the 20 trillion dollar question—the size of the US stock market.

On Dasher, On Dancer …

Is the EPA going to play Scrooge?

A team of researchers at the Oregon State University has noted that with all the concern about the effect of carbon emissions on the global climate, a major greenhouse gas is being overlooked: methane. And methane is over 20-times more powerful than carbon dioxide in trapping heat.

Cows, sheep, goats, and other ruminants produce tons of methane in their digestive systems. Over the past 50 years the population of these animals has risen from 2.4 to 3.6 billion animals. Reducing demand for ruminant products could help achieve substantial greenhouse gas reductions.

An important—though unusual–use for ruminants in today’s economy is transportation. One northern-latitude animal crucial to global commerce at this time of year is the reindeer. They provide critical transportation services for specialized delivery vehicles in high demand during late December. Their methane emissions occur in the stratosphere, so their activity could be restricted in the next round of global climate change negotiations.

The reindeer herds need a special exemption if Christmas gifts are to arrive on time. Pigs and poultry may be able to produce meat, but they can’t replace Rudolf when it comes to lighting the way for Santa’s sleigh.

Merry Christmas to all!

Douglas R. Tengdin, CFA

Chief Investment Officer

100 Years Ago …

Happy Birthday, Federal Reserve!

100 years ago Woodrow Wilson signed the Federal Reserve Act, the culmination of a legislative effort that began seven years earlier. In 1906 the San Francisco earthquake had far-reaching effects. Insurance payments from London insurers were massive, and money was in short supply. Interest rates soared, and a monetary panic ensued. Stock markets collapsed. The panic didn’t end until J.P. Morgan famously locked 40 top banking officials in his library on a Saturday night and didn’t let them out until they reached an agreement to shore up shore up the banking system the following morning.

The Panic of 1907 led to a huge recession, and the Chairman of the Senate Finance Committee thought it was a bad idea for the US banking system to depend on the financial acumen and personal resources of one man—who reportedly worked two hours a day and often could not be reached as he travelled in Europe. Nelson Aldrich lead a commission that studied banking systems around the world, and concluded that the US needed a central bank, something it had not had since 1836.

In order to avoid concentrating too much power, Congress adopted a plan that created 12 regional banks, governed by public officials, bankers, and business leaders. This hybrid system became the lender of last resort, that could lend freely to member institutions. It didn’t end the occurrence of financial panics, but it did give policy makers a better tool to deal with them. Before long, the Dollar supplanted the Pound as the world’s reserve currency.

So Happy Birthday, Fed. And many happy returns.\!

Douglas R. Tengdin, CFA

Chief Investment Officer

Ho Ho Hold Onto Your Credit-Card!

Looks like Target is getting a big lump of coal in its stocking this Christmas.

The big-box retailer disclosed yesterday that some 40 million credit and debit-card accounts had been compromised in a data breach that ran from November 27th until December 15th. Apart from jokes about “don’t be a Target” for cyber-crime and their having their logo—the big, red bull’s-eye—painted on their corporate backs, what can we learn from this?

First, technology is vulnerable to fraud and abuse—especially outdated technology. Charge-cards are the worst: a static, unchanging number that stays with the card and has no natural way to verify that the person making the charge is authorized to do so. Improved security methods have been around for a while: smart-cards with embedded chips that create unique transaction numbers; biometric identification that uses a fingerprint; and pass-phrase confirmation–combining something you have, something you are, and something you know to authorize a purchase.

But advanced technology is also running against the disturbing, surveillance culture that has grown out of our high-speed , always-on, everywhere online society. It creeps people out to think that their music downloads, restaurant purchases, and library borrowings can be accessed by the NSA, KGB, or Google. And Target’s data-breach just reinforces these two conflicting trends.

For now, Target’s new motto should be changed to “Expect more, pay less, and bring cash.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Christmas Economics

Does America run on Christmas?

Christmas is the retail event of the year. Stores begin stocking up in September, finalizing marketing plans in October, and the period from Thanksgiving to Christmas is one nonstop retail rush to electronics stores and grocery stores and clothing stores and big-box retailers. It’s common knowledge that 70% of America’s economy is driven by consumer demand, and that about half the economy is related to retail and wholesale trade. With anywhere from a third to a half of all sales stemming from the holidays, the gift-giving season has become an essential part of our economic landscape.

And yet there are always Grinch-like economists who remind us that many people prefer a check to ill-fitting sweaters, that most toddlers like the boxes toys come in better than the toys themselves, that charities often do better with cash donations than canned goods, and that Amazon is making brick-and-mortar stores obsolete.

As long as we’ve exchanged presents there have been admonitions not to let the season become too commercial. Indeed, that’s the central message of the classic Grinch and Charlie Brown Christmas stories. And it’s a good message.

But gift-giving often isn’t just about the item. It’s about participation in each other’s lives—in a family, in a workplace, in a community. That involvement may be inefficient, but there’s more to life than getting more done.

Gift-giving may not be productive, but it lets us share our joy. And that’s good for everyone.

Douglas R. Tengdin, CFA

Chief Investment Officer

Public Promises and Pensions

What’s wrong our public pensions?

On the face of it, the promises are too big and the funds are too small. We’ve underfunded our pensions because contributing a dollar today requires taxes today, taxes that have to be approved by politicians who can be punished at the ballot box. At the same time, pension benefits promise a dollar tomorrow, dollars that earn worker loyalty and union support today. A tax today is penalized; a future payment is rewarded.

But it goes deeper. There’s a deeply corrupt public pension culture in which audits are scarce, board members owe seats to politicians—politicians who receive political contributions from those who directly benefit from the system—retirees, unions, consultants, and investment managers. Those board members are rarely investment or actuarial experts themselves; instead they rely consultants who charge fat fees to give plain-vanilla advice that comports with the wishes of the most powerful pols.

In order to supplement the budget, public pensions act as a private piggy-bank for stealth borrowing. And multi-billion dollar pension funds are awfully tempting targets. Underfunding thrives in a place that tolerates corruption. The solution is a culture of accountability and transparency that punishes covering up. Sunlight is the best disinfectant.

Douglas R. Tengdin, CFA

Chief Investment Officer

Success and Failure

Loehmann’s is filing for bankruptcy. Are the bad times coming back?

Probably not. While the 92-year old New York discount clothing chain is an icon in the Northeast, it has been a regular visitor to the bankruptcy court. They might even want to get a frequent-filer card. The firm filed Chapter 11twice before: in 1999 and 2010. It’s hard for small chains—Loehmann’s has just 39 stores—to keep up with behemoths like Target or TJX, which has 3200 stores. In addition, lots of retailers have struggled—like Sears, JC Penney, and Gap.

Indeed, some of these chains wouldn’t still be around if it hadn’t been for the Fed’s ultra-low interest rate policy. Rates have been so low for so long that these firms have been able to secure financing even though their sales have been flagging. Sears used to have a 3% market share as recently as 2005—now it’s down to less than 2%. But the firm was able to get a $1 billion loan in October to help restructure its business.

In addition, bankruptcy is a lagging indicator. It takes years for a company to run out of cash, and since management is frequently replaced in a reorganization when the equity is wiped out, it’s usually the last resort as debt-holders sue to get their money back. And the number of business and non-business filings has fallen every year since it peaked in 2009. It’ s now 20% below its high.

Bankruptcy is how the system tells a business that what it’s doing isn’t working. It’s how our economy evolves. Just because an iconic company goes down doesn’t mean we’re going backwards.

Douglas R. Tengdin, CFA

Chief Investment Officer

Growing Old, Growing Smart?

Are our employers responsible when we mess up?

That’s the question before the Supreme Court in a dispute between Fifth Third Bank and some of its employees. The workers invested in the company’s 401(k) program. Like many companies, Fifth Third had lots of options—stocks, bonds, cash, and company stock. During the Financial Crisis, Fifth Third’s stock fell 97%–from $40 per share in June of 2007 to a dollar in February of 2009. Since then, the stock has come back about half way, to $20.

Fifth Third’s story isn’t unlike that of many banks during the crisis. Loans went south when the housing bubble burst, and banks that focused on mortgage-lending were in deep trouble. Some were wiped out. Key Bank, Sun Trust, Zion National, Regions Financial—all had their stock fall to almost nothing and then come gradually back. Fifth Third’s situation was made worse by its Ohio base, in the heart of the auto-country.

Lots of people invest in their own company’s stock as one of their choices when deciding what to do with their retirement savings. After all, doesn’t it make sense to “invest in yourself?” But Fifth Third was and is a $110+ billion bank with diverse businesses subject to economic, financial, competitive, and regulatory risks. In this case the employees claim that the bank should have stopped offering its stock as an option. Any reasonable administrator would have done so, they say, since the stock was falling like a rock. But the bank claims it wasn’t in dire straits. The market was in a panic, but the bank had reserves and contingency plans. In the end, they borrowed $3½ billion in TARP funds, which they later paid back.

401(k) plans give us the ability to take our retirement savings with us if we move from job to job. In exchange, we need to take responsibility for how much we save and what we invest in. That’s the deal. Sometimes our choices go bad. As my high-school German teacher used to say, “We grow too soon old, and too late smart.”:

Douglas R. Tengdin, CFA

Chief Investment Officer

Expectation Nation

What do you think the market will do?

I get that question all the time, especially this time of year. And it’s reasonable to ask someone who makes his living dealing with the ups and downs of the Dow and interest rates whether he thinks next year’s markets will behave like Santa Clause or the Grinch.

In the long-run, markets are moderately predictable. Bonds are actually very predictable. If you buy a 10-year Treasury bond at a yield to maturity of 2.9%, you can confidently expect that you will receive about 30% over 10 years. (That extra 1% is due to reinvesting the coupon payment.) Low yields lead to low returns. Conversely, high yields lead to high returns.

How about stocks? The data is less decisive, but still indicates that valuation matters. Cyclically adjusted earnings yield is positively associated with returns—especially when the market is at an extreme—as it was in 2009 or 2007. But even in times of normal valuation—which is what I would maintain we are in right now—there’s a positive correlation. But the data is messy. Equities are a residual claim on a volatile earning stream, and subject to manias and panics. Still, low valuations lead to higher returns, and vice-versa, over the medium to long run.

But what do I think the market will do next year? Short-term data are much less dependable. Stay diversified! Diversification is the compliment that humility pays to uncertainty. We don’t know the future. We can only plan for volatility.

Douglas R. Tengdin, CFA

Chief Investment Officer

Fed Follies?

Has the Fed lost its way?

The Federal Reserve System celebrates its 100th birthday this year. Rather than hold a self-congratulatory party, the Philadelphia Fed convened a policy forum that looked at current policy in an historical context, asking what the Fed is doing wrong and whether it is straying from established principles of sound central banking.

While there was some criticism of the Fed’s role in the Financial Crisis and evocations of Walter Bagehot, the focus was more on what the Fed is doing now—particularly on Quantitative Easing and asset purchases. While QE1 succeeded in shoring up the economy, it’s unclear whether QE2 and QE3 have accomplished much beyond expanding the Fed’s balance sheet. Inflation seems tame, but a review of the ‘60s and ‘70s is cautionary: in 1970 inflation appeared low and the Fed became highly stimulative—just on the eve double-digit price rises.

Going forward, the Fed is likely to reduce its asset purchases and rely more on forward-looking communications. But transparency is not a panacea: economic conditions are bound to be more complex than we think, and too-frequent communication and revision can confuse rather than clarify.

As long as we use money, monetary policy will be controversial. Serious self-criticism is a hopeful sign that we won’t simply repeat the mistakes of the past.

Douglas R. Tengdin, CFA

Chief Investment Officer