Fall and Rise and ???

Last night’s win by the Red Sox was sweet.

Those of us who pulled our hair out year-after-year as Boston’s baseball franchise regularly faded in August and September feel vindicated as the team came back from its disastrous 2012 season with an epic turnaround. General Manager Ben Cherington deserves a lot of the credit. Last year’s mega-swap with the Dodgers freed up capital and allowed him to invest in steadier, lower-cost assets. The team also made good use of their home-grown talent—players in their first six years of service.

But there’s a problem in paradise. Even though this year’s Series had over 10% more viewers than last year, the audience is getting older. According to market research firms, the average fan this year was 54.4 years old, up from 49.9 in 2009. Kids age 6 to 17 were only 4.3% of the audience for the League Championship Series this year, compared with 7.4% a decade ago.

Not all of those missing kids are watching baseball on their smartphone apps. In spite of a higher population and 10 million app downloads this year, participation rates are falling: 500 thousand fewer kids are playing Little League now than in the late ‘90s. This isn’t good. Children who grow up playing the game and rooting for the home team are far more likely to be fans as adults.

If baseball were a stock, analysts would approve of its recent performance but worry about its long-term prospects. The sport has to do something to improve mind-share among its future audience. Otherwise, baseball will go the way of boxing—a once great game whose star has faded.

And that would be a shame. Big Papi and those goofy beards deserve better.

Douglas R. Tengdin, CFA

Chief Investment Officer

Irreducible Complexity

Is investing today too complicated?

Hedge funds, ETFs, high-speed trading, flash crashes—is the market today too multifaceted and treacherous for the average investor to even understand, much less profit from?

It certainly can seem that way. Because computerized exchanges have largely replaced the physical hustle and bustle of the trading floor, the market now handles far more volume at far higher speeds than it ever could before. This has opened the way for a lot of new products, some of which represent real advances for investors—like exchange-traded funds based on efficient, low-cost indices. These allow the average person to invest bite-sized sums in a broadly diversified manner.

But many products aren’t advances. They’re just a way for clever marketers to convert your investment performance into their fee income. There’s a certain irreducible complexity to modern finance that precludes an easy understanding of its implications. Unscrupulous operators take advantage of this fact. That’s why ethics is the most important part of any finance curriculum.

Complexity is part of life. It’s the price we pay for efficiency. But now, as always, it pays to have a trusted guide.

Douglas R. Tengdin, CFA

Chief Investment Officer

Winners and Losers

Can we improve our investments by thinking backwards?

Investing has been called a loser’s game. A loser’s game is one where winners simply outlast their opponents by minimizing stupid mistakes. In tennis, it’s avoiding the unforced error. In golf, it’s keeping the ball on the fairway and staying out of the bunker. And with investing its staying away from the Lehmans and Madoffs of the market.

Investing legend Charlie Munger understands this when he says that many hard problems are best solved when addressed backwards. An example from everyday life might be parenting. Raising children is incredibly complex, but thinking backwards helps. Imagine all the things that a bad parent would do–losing your temper, yelling, acting arbitrary—and shun these. If you want to foster innovation on the job, think of what would stifle new ideas and stop doing that.

Thinking forwards and backwards works because every avoided Enron adds to performance. And it’s a lot easier to avoid stupidity than to find brilliance.

Douglas R. Tengdin, CFA

Chief Investment Officer

Fail-Safe or Safe-Fail?

Are computer systems the problem?

A little over a year ago Knight Capital–a small broker with a large trading presence—suffered a computer glitch which cost it almost $500 million dollars, wiping out its capital and destroying the company. Newly-installed computer code didn’t interface well with legacy systems: overdrawing some accounts by billions and setting massive short positions in others. In the course of 45 minutes, the firm was gone.

By contrast, it took months for Bruno Iksil, the famed London Whale, to accumulate oversized derivative positions that ultimately generated over $5 billion in losses for JP Morgan—about a quarter of a year’s earnings. Part of the reason he could establish such a large position was because entire spreadsheets were manually copied from one computer to another, and a coding error in a single cell cascaded through the system.

IT systems fail all the time; they just usually don’t make headlines. That’s because they’re essentially an art-form, with equal parts planning, experience, and coding skill. If any piece is missing, the system will crash. Major failures this year include airlines, phones, banks, and—right now—health-care.

Failure happens. The key is to make sure initial failures are small–and to have enough capital to cover the large ones.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Sky is the Limit?

What happens at a market top?

One advantage of living through the internet and housing bubbles is seeing market behavior at the extremes. There are two major players in the stock market: buyers and sellers—or issuers and investors. When equities topped out in 2000 and ’07, investors and issuers responded differently to the market’s financial incentives. What does this look like?

Investors begin to be driven by momentum strategies. Momentum doesn’t care about value, it just evaluates the trend. Newsletters focus more on the 50-day moving average and less on valuation, which starts to look more and more absurd. Prominent investors pull out, or say they just don’t “get” this new market. Growth dominates value as a strategy. Pundits on television start to look younger and younger.

Issuers respond as well. IPOs get bigger and bigger, even as their quality declines. Dividend yields get smaller, while stock buybacks grow. Meeting quarterly earnings goals becomes paramount, at the expense of cashflow, sales, and balance-sheet quality. Innovative financing and securitization techniques abound. Financial engineering sets the agenda.

Are we near a market top now? It doesn’t look like it yet. There are some extreme valuations, but earnings seem to be keeping up. As risk of a melt-up grows, investors seem to have nothing to fear but nothing to fear.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Tale of Two Downturns

It was the best of recessions, it was the worst of recessions.

Many investors have now lived through two 50% downturns. When the dot-com and housing bubbles both burst, they devastated their respective sectors and bankrupted a lot of companies. It took five years from the market bottom in 2002 for equities to surpass their previous record; it took only four years from the depths of 2009 to get back to new highs.

And yet the recovery from the dot-com bubble seemed so much more complete. By 2005 the economy had made up all its lost jobs, but we won’t get back the jobs lost since 2007 before the middle of next year. What made this downturn so vicious and the recovery so tepid?

The difference is finance. The epicenter of the dot-com downturn was technology, but when the housing bubble burst it also busted the financial sector. And while technology is an important part of the economy, banking is its life-blood. To use a medical analogy, a broken leg is painful and makes it hard to move, but a heart-attack changes everything. We’re still recovering from the global coronary brought on by the housing bubble.

It’s possible to recuperate from a heart-attack, but your lifestyle needs to change. Right now, our economy is still adjusting.

Douglas R. Tengdin, CFA

Chief Investment Officer

Turning Japanese?

Is Abenomics working?

Almost one year ago, Abenomics surfaced in Japan. Last November Prime Minister Shinzo Abe and Bank of Japan Governor Haruhiko Kuroda unveiled a strategy of monetary reflation, fiscal stimulus, and structural reforms aimed at ending deflation and reinvigorating a sclerotic economy. How’s it going?

The strength of the recovery in the first half of the year has been striking. The stock market is up 41% in Yen terms year-to-date, and the Yen has fallen 26% from its level a year ago. GDP growth reached an annualized rate of almost 4% in the first half of the year. Year-over-year inflation turned positive in June, lifted by energy and import prices. But core prices continue to fall.

The government plans to increase the VAT—or consumption tax—from 5% to 8% in 2014 and to 10% in 2015. That will show that the they are serious about tackling its debt—but it could also undo the stimulative effect of the lower yen. Far better would be an increased estate tax—taxing holders of government debt to pay down government debt.

A year ago Japan was entering its third recession in five years. The road ahead is bumpy, but Abenomics just may turn Japan’s economy around.

Douglas R. Tengdin, CFA

Chief Investment Officer

[category Global Market Update]

Double Debt Dealing

Is American $17 trillion in debt?

That’s the headline number that’s referred to in all the debt-ceiling budget-busting filibustering debate. That’s the total of US Treasury debt that’s owned by the public, the Fed, and the Social Security Administration—along with various trust funds. But some people are challenging that figure. Stanley Drukenmiller—a legendary investor, who famously helped break the Bank of England in 1992—maintains that the national debt is actually $205 trillion. That’s the present value of all Federal promises from here to eternity–healthcare, social security, highway maintenance, everything. It’s roughly 13 times the size of the economy.

But there’s another way of calculating the debt—as debt held by private bondholders. By this calculation—subtracting out Social Security and the various Federal Trust Funds—the Federal Government owes a little less than $12 billion—about two-thirds of the economy.

So which is it? In a way, both figures are right. Our iron-clad court-tested obligations are relatively modest. But our expansive current system—with healthcare and an inflation-indexed annuity guaranteed by the Federal Government—is huge. If something cannot continue it will stop. But promises mean something—and changing them costs something.

The contractual promises of the Government are modest. But the political promises are immense. If we can’t find a way to make our reach fit within our grasp, our economy will not lead the world. And that will be a shame.

Douglas R. Tengdin, CFA

Chief Investment Officer

One Word …

Is plastic the future?

In the movie The Graduate, a minor character tells Dustin Hoffman that the future is in plastics. Strong, cheap, and light, the miracle material seemed to offer endless possibilities. That line may have been parodied endlessy since the 1967 film first came out, but many manufacturers have used plastic to make their products cheap and light.

The problem is, a premium product that uses plastic may just seem cheap, and fail to justify its premium price. That’s what may be happening with Apple’s iPhone 5c. Rumors are swirling that Apple is cutting production of the model, even while boosting output of the 5s. Apparently people don’t want to pay over $500 for a plastic phone.

There’s always a risk when companies develop a down-market model that over-exposure can tarnish the image and hurt sales of their premier product as well. That doesn’t seem to be happening to Apple, as sales of the 5s seem to be doing just fine. And Apple may be expanding its product line in order to begin segmenting the market and learn about consumer price-sensitivity.

In any case, it appears that Steve Jobs’ strategy to focus on high-end consumer products that carry cachet is still working. It’s branding—not plastic—that continues to be the future.

Douglas R. Tengdin, CFA

Chief Investment Officer

Lather, Rinse, then What?

Could we please not do this again?

240 years ago John Adams reportedly said that one useless man is a disgrace, two become a law firm, and three or more become a congress. After barricading tourists inside the Old Faithful Inn and practically stranding our astronauts in space, the Republicans and Democrats got—what exactly? The opportunity to plummet in the polls to the point where only blood relatives have a positive view of Congress? Seriously?

Standard & Poor’s estimates that the 16-day shutdown cost the economy $24 billion—that’s about $1 million per minute. Economic uncertainty has a real cost. Businesses that don’t know if their clients will pay them on-time for their scale back expansion plans, begin demanding cash for services, and are slower to hire.

America has significant balance sheet issues: public debt almost equal to its GDP; projected obligations over four times the size of the economy; Social Security Disability Insurance will be insolvent by 2016. And if running into the debt ceiling is like maxing out the credit card, then the solution isn’t just to keep raising the ceiling but to evaluate spending.

Washington’s antics may serve as guerilla theater to make people aware the debt and deficit. But as the pending debt downgrade from Fitch makes clear, this is no way to run a Aaa country.

Douglas R. Tengdin, CFA

Chief Investment Officer