William Shakespeare: Security Analyst

You know the story:

The grand prize is hidden behind doors number one, two or three. Pick the right door, and you’re rich. Pick the wrong door, and you get a booby prize. The stage from “Let’s Make a Deal?”

No, it’s the casket scene from Shakespeare’s Merchant of Venice. The heroin, Portia, must wed; her suitors are required to choose one of three chests. The chests are made of gold, silver, or lead, and each has a small riddle outside. If the suitor chooses correctly, he will Portia’s find portrait inside and may marry her—and enjoy her large inheritance. If he is mistaken, he must promise to forswear marriage.

We know how this story ends: the hero, Bassanio, chooses the lead casket and wins both Portia and her money—after two fruitless attempts by suitors who fail due to their insecurity or arrogance. As he examines the boxes, he comments: “The world is still deceived by ornament,” citing examples from law, religion, war, and fashion. The correct casket appeals to him precisely because it is so plain.

What investors can learn is more than “Don’t judge a book by its cover.” The unsuccessful suitors fall short because they see themselves in their choices. By contrast, Bassanio is able to get outside himself. Successful investors get past their own expectations and desires—even as they acknowlege them—and try to see the world as it is, without ornament or veil.

Shakespeare shows us how to find reality: by not looking at the flash, but the flesh behind all the numbers.

Douglas R. Tengdin, CFA

Chief Investment Officer

Shakespeare: Risk Manager

Why diversify?

Mark Twain once famously claimed that the best way to invest is to put all your eggs in one basket — and watch that basket! And there’s a lot of insight there. Concentrating your energy and your attention is a good way to grow a business or develop yourself professionally. It’s a reasonable approach to managing risks you can control.

But diversification is the way to manage risks that you can’t control. The economy, weather, government shutdowns—there’s not much you or I can do about these. So dividing assets among different ventures reduces your dependence on any single investment.

Shakespeare understood this four centuries ago. Early in The Merchant of Venice one of his main characters says , “My ventures are not in one bottom trusted; / Nor to one place; nor is my whole estate / Upon the fortune of this present year.” Splitting up his interests makes him more secure.

Diversification is the compliment that wisdom pays to prudence—because we don’t know the future. Specialization may build wealth, but diversification preserves it.

Douglas R. Tengdin, CFA

Chief Investment Officer

Elections Uber Alles (Part Zwei)

Maybe they’ll care now?

On Sunday Germany’s electorate gave Angela Merkel a stunning victory, increasing her party’s share of the vote from 33.8% to 41.5%. It’s the best result for the Christian Democrats since 1990, when Helmut Kohl won a third term. In fact, she almost won an outright majority in the Bundesrat, Germany’s lower house. Now she has to form a coalition.

The CDU’s current partner, however, is not available. The Free Democrats’ share fell from 14.6% four years ago to 4.7% now—not enough to send delegates to Parliament. It’s a painful comedown for a party that has frequently played the role of kingmaker in German politics. Because their libertarian philosophy is adaptable, they have been a junior partner in several government coalitions.

Merkel’s most obvious associate is now the Social Democratic Party, which also picked up seats. This election saw the center-left and center-right parties gain seats, while the more extreme parties lost them. So a national unity government seems possible.

Such a combination would provide strong support for the Euro. While there is still considerable skepticism regarding bailouts—the anti-Euro party gained share, but no seats—a CDU-SPD government would have enough votes to amend Germany’s constitution, if necessary, to sustain the common currency.

The Euro has always been a political project. Germany’s voters just gave Merkel—one of the currency’s most powerful sponsors—the political strength she needs to keep the project alive.

Douglas R. Tengdin, CFA

Chief Investment Officer

Our Wages, Our Selves

Why don’t wages fall during a recession?

That’s the question a lot of economists ask when there’s a downturn. After all, the theory goes, if employers cut wages, their profits would go up they wouldn’t have to fire people. And if workers didn’t like the wage cuts, the recession would make it difficult for them to find a job elsewhere.

A researcher from Yale went out and interviewed over 300 employers, labor leaders, unemployment counselors, and business consultants and asked just this question. The answer: businesses are obsessed with morale. If they cut compensation, workers get discouraged and resentful. And bad morale leads to poor worker productivity. Unhappy workers are not productive workers.

All kinds of schemes have been tried, like cutting wages for new hires, or replacing the entire workforce with a new one at a lower wage scale, but inevitably these schemes fail. Productivity depends on trust, and an employer that takes advantage of its workers when the economy goes south won’t get any extra effort from its workforce.

Culture matters and a healthy culture depends whether people think they’ve been treated fairly. When a company starts cutting nominal wages, watch out.

Douglas R. Tengdin, CFA

Chief Investment Officer

Hamlet at the Fed?

Is the Fed having difficulty making up its mind?

When the Fed announced that they would put off changing their asset purchase plans, I wondered if Ben Bernanke was playing Hamlet: “To taper or not to taper, that is the question.” All along, he and the other governors have been uncertain as to what they might or might not do, because the economy is uncertain.

It reminds me of Shakespeare’s great play, where the hero learns that his uncle had murdered his father in Act I, and is ready to kill his uncle in Act III, but at the last moment puts up his sword because the time isn’t right. Indecisiveness proves to be Hamlet’s undoing.

Is indecisiveness plaguing the Fed? We’re certainly seeing it in other branches of government: Larry Summers will be the next Chairman, then Janet Yellen will; we’re about to bomb Syria, then we aren’t; the House will vote to de-fund Obamacare, or won’t. Everyone’s getting into the act.

But indecision breeds uncertainty, which isn’t good for the economy or for markets. There may have been a relief rally in stocks and bonds on Wednesday, but it’s unclear how long it will last. It is hard for managers to move forward when they don’t know what will come next out of Washington.

And where will this lead? Hamlet postpones action in Act III, and Act V doesn’t end well. Let’s hope the Fed’s irresolution doesn’t fall on all our heads.

Douglas R. Tengdin, CFA

Chief Investment Officer

Taper, Schmaper

What is the Federal Reserve doing?

In its statement yesterday, the Fed noted that they decided to wait for more economic data before tapering their asset purchase program. In his press conference afterwards, Chairman Bernanke blamed tightening financial conditions and a soft labor market—along with a shot at the Federal Budget sequester—for delaying the taper process. He counseled patience—patience with the Fed, patience with the economy, patience with the process—to markets that have been itching to move.

The reaction was anything but. Bond yields dropped point-one-five percent, stocks hit all-time highs. Everyone had been expecting the Fed to start cutting purchases of Treasuries and MBS in September, and their statement yesterday even shaded economic growth higher. So now the whole thing’s on hold?

After June’s meeting, Bernanke announced the Fed’s intentions and the market freaked out. Interest rates went up too far, too fast, and Fed officials got out and walked it back. Yesterday’s announcement continued that process. The Fed needs lower interest rates to keep the economy growing, especially in the housing sector.

Formulating Fed policy is deliberative, messy, and fraught with uncertainty. Like sausage-making, the end product may be attractive, but the process can sure make you lose your appetite.

Douglas R. Tengdin, CFA

Chief Investment Officer

Thank You For Not Smoking?

Does anyone smoke anymore?

The ‘90s were a decade of tech booms and S&L busts. Of budget surpluses and Monica Lewinski. And tobacco litigation. 46 states sued the major tobacco companies, claiming that smoking raised Medicare costs. Rather than fight it out, the parties agreed to settle. The states dropped their lawsuit, and the tobacco companies agreed to pay over $200 billion to the states over the next 25 years—the largest civil settlement ever.

Many states didn’t just wait for the payments; instead, they securitized them, pledging the expected payment stream and borrowing against it. But increased state and federal cigarette taxes have pushed sales down, and most of these bonds are now junk-rated.

In essence, too many people are quitting. Only 19%of Americans smoke now, significantly lower than the 25% who smoked at the time of the settlement. That’s good for their health, but bad for the health of these bonds.

Recently cigarette bonds rallied, based on a new court ruling that frees up more cash for bond payments—but it’s only temporary. When a product kills off its customer-base, it’s usually a bad investment.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Exceptional Reflections

Is America exceptional?

Last week’s spectacle of Russia’s President writing an op-ed in the New York Times chiding Americans was surreal. Especially when he all but quoted the Declaration of Independence to admonish us for considering America as exceptional. What’s going on?

Apart from the irony of seeing our former Cold War antagonist lecture Americans on American values, does he have a point? Is it truly dangerous to encourage people to see themselves as exceptional? I would submit that it depends on what the exception is. If a people see themselves as especially chosen to bring civilization or prosperity or purity or character to a benighted world, that can be dangerous. That view arguably led to all kinds of abuses during the Age of Empires—and even World War I and the Russian Revolution.

But if the exceptionalism is one of origins, of coming together rather than going out, of ideals rather than ideology, that’s different. And it can be measured. Just look at the number of people who want to move here: almost 140 million, by one estimate—over three times the next most popular destination, England. (And 25 times the number who would rather move to Russia.)

That’s an exceptionalism that seeks to be a light, not a burden—that has a decent respect for all peoples. One based on choice and trust.

Douglas R. Tengdin, CFA

Chief Investment Officer

Lehman Lessons (Part 4)

After five years, what have investors learned from Lehman?

Lehman’s bankruptcy and the pricking of the housing bubble created chaos, disruption, and market opportunities on a scale that hasn’t been seen in the markets for decades. Indeed, not since 1974, with double-digit inflation at home and foreign policy failures abroad had the market been so cheap. The bear market of the ’70s offered its own lessons to investors–inflation matters, price matters, government policies can change–which were incorporated into the bull market of the ’80s. Does the financial crisis offer similar schooling?

One clear instructional gem is that diversification works, but only if you let it. A portfolio of 25 banks is not diversified; a portfolio split between government bonds, muni bonds, large-cap stocks, and small-cap stocks is. Many all-stock portfolios went down 50% or more after Lehman failed; balanced portfolios declined about half as much. And that diversification served you well, if you had the stomach to rebalance during the Winter of Discontent in 2009.

But that’s another lesson: it’s much easier to say "I’ll be greedy when others are fearful" than to act on the principle. Almost everyone–including myself–should have been more aggressive when the market crashed. But it’s hard: all those negative stories with fears of bank nationalization and Great Depression 2.0 were paralyzing for many. Just riding out the cycle was a white-knuckle experience.

And five years on we’re back to all-time highs in the market. That’s the final lesson. Recessions happen. Bubbles happen. Keeping your head and viewing the market in perspective is hard, but if you did, you saw some outstanding bargains: excellent companies offered at excellent prices. There were also some value traps. But the opportunities created by the general panic were real, and level-headed investors bought in and then moved on.

Investing is hard work. But if you can keep your head when everyone else is panicking, the market is yours.

Douglas R. Tengdin, CFA

Chief Investment Officer

13 September, 2013 10:04

Lehman Lessons (Part 3)

What are the lessons of Lehman’s failure?

It’s important to look at the failure in context–in the context of the economy at that time, and also in relation to other financial institutions. Bear Stearns had been bought by JP Morgan in a Fed-engineered takeover in March; mortgage giants Fannie Mae and Freddie Mac were put into a Federal conservatorship the week before. On Friday, September 12th, 2008 many market participants thought the same fate awaited Lehman. The stock might be wiped out, but the bondholders would be made whole.

But that’s not what happened. The next Monday the company filed for Chapter 11, its senior bonds traded down to 30 cents on the dollar, and a financial panic ensued, with the market falling over 30% within a few weeks. How did otherwise free-market advocates come to expect federal intervention and support?

One culprit is the culture of bailouts that had been growing since the early ’90s. Mexico received US support in ’94; Long Term Capital was taken over in a Fed-supported bailout in ’98; investors had been discussing the "Greenspan Put" for years: the belief that if the market traded down, the Fed would lower interest rates to support asset prices. The expectation of government support led to widespread moral hazard–where firms take on risk believing that if it works out they make money, but if the venture fails, they’ll get government support. This didn’t happen with Lehman; try as they might, Federal officials couldn’t find an excuse–or deep-pocketed partner–to bail them out.

Government support can make a crisis worse when it leads them to take risks they otherwise would leave alone. In 2008, what should have been a moderate recession almost became another Great Depression because financial intermediaries doubled down. Instead of reducing risk, the entire financial system became more fragile.

There are not atheists in foxholes, and no conservatives when bailouts are at hand. Beware of governments bearing gifts.

Douglas R. Tengdin, CFA

Chief Investment Officer