Back in the Black

Is Black Friday a good deal?

Everybody loves a deal. And Black Friday is the biggest deal-day of the year. With door-busters being touted at Wal-Mart and Target and JC Penney and everywhere, many consumers are already starting to camp out.

But is this just retail theater? The common assumption is that retailers stock up on lots of goods in October and then mark down the ones that don’t sell. But that’s not the way it works. That $25 sweater probably cost the retailer $14. When it first goes on the rack, it gets a $50 price-tag. But the store quickly reduces that price to $45, then $32, so when they need to move the merchandise, they finally cut the tag to $25. They know most sweaters will sell there, but it takes a while to get to that price.

Stores have now trained consumers to expect bargains. Shoppers aren’t happy unless the price is at least 40% off. Ron Johnson, former CEO of JC Penney, saw the futility of this strategy. In 2011 fewer than one in 500 items sold at full price; consumers received an average discount of 60%. But they weren’t saving money—margins were stable. So he tried to shift the firm from high-low pricing to everyday-low-pricing. It didn’t work. Customers stopped shopping. Johnson lost his job and JC Penney may not survive its move back to discount-land. The stock has fallen 80% and their bonds are priced with a 70% probability of default.

But now consumers are suing the stores, claiming the discounts aren’t real. They want to know that the list price has some integrity. Still, there are real deals to be had, like $12 hoodies or $100 HDTVs. Just don’t ask me to camp out five days in the snow to get one.

Douglas R. Tengdin, CFA

Chief Investment Officer

Good and Bad

Why do good people do bad things?

Recently we’ve been treated to a spate of bad behavior by otherwise successful, sensible individuals. A couple of Credit Suisse mortgage traders intentionally mis-marked their portfolios as the housing market crumbled around them. LIBOR traders systematically manufactured false readings of this key global index in order to help their firms’ derivatives desks. And then there’s Rajat Gupta, the former Chief Executive of McKinsey & Co., who served on the Goldman Sachs Board of Directors. Gupta was convicted of felony conspiracy and securities fraud for disclosing confidential Board-level information to a hedge-fund. These people have shipwrecked their careers and served time in prison for their crimes. How can such smart people be so dumb?

The common factor in all these stories is their social context. The Credit Suisse executives headed up their structured credit group in a high-flying financial powerhouse. The LIBOR traders were part of an elite fraternity of dealers who talk to one-another constantly, exchanging jokes, favorite restaurants, and personal information. Gupta is a prominent Indian-American, and his information helped another member of that community—even though he did not personally profit.

What’s striking is that these people didn’t just break the law, they also violated company and professional ethical codes that they personally signed and supported. But “bad company corrupts good morals.” What someone would never do alone can seem acceptable or even praiseworthy when it’s part of a group’s behavior.

Aristotle observed that we are social animals, hard-wired to want to fit in. All the more reason to be careful where and with whom we associate. Because if you lie down with dogs, it’s no surprise when you get up with fleas.

Douglas R. Tengdin, CFA

Chief Investment Officer

50 Years Ago …

50 years ago I was a little boy watching a funeral on TV. The grown-ups were hushed. The images from Washington, DC played to a nationwide audience.

50 years ago there wasn’t a conspiracy industry. There wasn’t a Sixth Floor Museum, dedicated to an assassination. Three presidents prior to Kennedy had been shot, and the crime had been pursued. The Cold War was real, and ever-present. Duck-and-cover drills were part an ordinary elementary school day.

50 years ago the stock market was in the middle of an 85% rally that lasted four years, that would take it to a level—Dow 1000—that it would keep coming back to for another 15 years. The US and global economy were in the midst of an industrial boom, still satisfying pent-up consumer demand. President Kennedy’s assassination was a small setback amid those larger economic forces, and the market kept on growing.

50 years ago we re-learned that our nation is an idea, and a set of ideals, that is greater than one charismatic leader. While great people—and small ones—can change history, there are underlying dynamics that move at their own pace. Continued economic growth, and the uneven expansion of the market in response, is one of those ideas.

Life is fragile, and a lone lunatic can create great tragedy, but life also moves on. That’s another lesson from 50 years ago.

Douglas R. Tengdin, CFA

Chief Investment Officer

Dow 16,000!

How is this going to end?

With the Dow hitting milestones and the economy looking like it’s strengthening, investors are partying like it’s 1999. The Senate looks likely to confirm Janet Yellen, a confirmed policy dove. She’ll likely keep the punch-bowl filled and interest rates low, so investors can keep on keeping on.

But every thousand-point climb makes some investors that much more nervous. They remember the euphoria when the Dow first hit 10,000 shortly before the internet bubble burst, and the way it blew through 13,000 and 14,000 in short order, just before the Financial Crisis of 2007. So is 16,000 a signal to sell, or even short the market?

Don’t bet on it. Interest rates are low because the economy is slow. But slow isn’t stopped. We’ve recovered from fears of a double-dip or another financial meltdown; just because the market’s at new highs doesn’t mean it’s about to crash. And even if these levels are irrational, markets can stay irrational for an irrationally long time. These low interest rates mean current and future company earnings are more valuable. And that translates into higher stock prices.

Mr. Market keeps climbing a wall of worry—about the Fed, about earnings, about geopolitics. If you ask him why, he’ll likely respond: “Because it is there.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Fed Up?

Charles Plosser is worried.

The Philadelphia Fed President is a member of the Federal Reserve Open Market Committee. As such he helps set monetary policy. In addition to the seven members of the Board of Governors, the Open Market Committee includes the nine regional bank Presidents, five of whom vote on policy in any particular year.

Next year Plosser becomes a voting member, along with Richard Fisher of Dallas, and the Presidents of the Cleveland and Minneapolis Fed. Plosser and Fisher are policy hawks, more concerned about inflation than unemployment—which will change the Fed’s composition, although Janet Yellen’s dovish preferences will dominate policy discussions.

Recently Plosser gave a presentation in which he proposed limiting the Fed’s power to containing inflation, with only a nod towards unemployment and bank oversight. And he recommended restricting the Fed’s discretion in pursuing this, arguing that people have come to expect too much from monetary policy. If the Fed makes a mistake, he fears the resulting backlash will threaten the central bank’s independence—which would be a real problem. Politically independent central banks are a critical component to modern economies.

It’s not often that a key policy-maker proposes limiting his own authority in pursuing a goal. Plosser’s proposal may not go anywhere, but it’s refreshing to see an official acknowledge his own limitations.

Douglas R. Tengdin, CFA

Chief Investment Officer

The $13 Billion Question

How do you lose $13 billion?

JP Morgan recently agreed to a civil settlement worth $13 billion. The numbers stagger the imagination. That’s more than the market cap of most business. What did they do to earn such a fine?

At issue was a 2006 decision by JP Morgan managers to accept mortgages from Greenpoint Mortgage, despite their substandard nature, and bundle them into mortgage-backed securities that JP Morgan sold—without warning investors that some of their collateral was substandard. Well, “substandard” is generous: these loans wouldn’t even qualify as sub-prime. They had inflated appraisals and overstated income, and even then had lousy ratios.

Fair disclosure is critical to well-functioning markets. If investors want to buy Workday—the high-flying cloud-based payroll manager that hasn’t made money in 8 years whose stock price is soaring—that’s their business. Hope springs eternal in the high-tech world. But when investors buy supposedly safe bonds based on false promises—as opposed to faulty premises—that’s different. It isn’t just foolish, it’s fraudulent.

So now $4 billion will go for mortgage relief and $9 billion to the Federal and State governments. Which leaves just one question: are there more lawsuits to come?

Douglas R. Tengdin, CFA

Chief Investment Officer

Shelling Out?

Is fracking the future?

That’s been the assumption of the energy market for a while. Hydraulic fracturing has been the drilling method of choice since 2010. While the technology has been available since the 1950s, it gained widespread currency after the oil-price run-up in the mid-2000s.Now it’s being used to extract oil, gas, and even uranium from previously inaccessible deposits. Because fracking has become so widespread, it has been estimated that the US will become the world’s top oil producer by 2015.

So people are pretty excited about what this new technology could do for the US economy. But is George Mitchell—the person who pioneered this technique—destined to become an icon of American business, like Henry Ford or Bill Gates? Royal Dutch Shell recently took a $2.1 billion write-down on its US shale beds. Other companies have found shale oil hard to discover and develop. And there are environmental concerns.

Some analysts are projecting only a marginal effect from fracking on the US economy. But this seems wrongheaded. Cheap—or at least stable–energy prices will invigorate energy-intensive industries like chemicals and steel. It’s the inverse of the ‘70s and early ‘80s, when economists underestimated the effects of higher oil prices.

Fracking may not cure everything that ails the US economy, but it sure won’t hurt. With employment growth modest and demand stagnant, we can use all the help we can get.

Douglas R. Tengdin, CFA

Chief Investment Officer

Private Lives

Are the smartest folks in the room changing their minds?

For years, Private Equity has been the holy grail of investing. With superior accountability, accountancy, business planning, and investor access, investors (who could afford it) loved what private equity could do for their portfolios. The appeal is clear: if a company’s CEO behaves badly in the morning, he’s out by the afternoon. If you question the company’s accounting, you can bring in your own accountants. A company can be run for cash or market share or long-term growth, depending on the circumstances. What’s not to like?

But some sovereign wealth funds and university endowments are starting to scale back their allocation to Private Equity. Yale has reduced its commitment from 35% to 31%. Harvard Management’s CEO sent a nasty-gram complaining of underperformance to several fund-providers. And a few prominent sovereign wealth funds have hired personnel with PE backgrounds to keep a closer eye on these investments.

Private Equity investing demands a multi-year commitment and can require cash-injections on short notice. If investors can’t fulfill their cash-calls, the consequences could be disastrous. It’s not for everybody, and it’s not a free lunch. But for those who can manage it, private equity offers a way to get around some of public equity’s challenges.

Douglas R. Tengdin, CFA

Chief Investment Officer

Beyond Excel

Why is finance so dumb?

In the era of smartphones and 3-D printing, financial analysis is stuck in the ‘80s. The principal tool of the analyst is the spreadsheet—something that Lotus 1-2-3 popularized in 1983. While our PCs can access cloud-based massively parallel computing, our spreadsheets still have the same machine-code A1 cell-structure. The most advanced Excel function is a macro.

So finance hasn’t moved past summing up columns and rows. Big data and XBRL should make real-time analysis of corporate financials possible, but spreadsheets aren’t granular or fast enough. And getting programmers to work on such analysis is hard. The way to lure competent coders away from Apple’s and Google’s cool campuses has been to dangle a big check in front of them—the kind that only hedgies and Wall Street can afford. And then all they do is algorithmic trading.

But hopefully this will change. We can design web-sites without HTML; we can build databases without C++; there’s no reason why we shouldn’t get real-time estimates of Wal-Mart sales using feeds and tweets without depending on a few computational finance gurus to program in Matlab and Simulink.

Get ready: the future of finance is the Twitter-feed balance sheet.

Douglas R. Tengdin, CFA

Chief Investment Officer

Questions, Questions, Questions

Janet Yellen is answering Senator’s questions this week. Here are a few that I would love to ask:

1. Is there any limit to the Fed’s balance sheet? Before the crisis the Fed owned about $900 billion in securities. In five years that has more than quadrupled to $3.8 trillion. Has anyone ever done this before? How big is too big?

2. Is the Fed’s supervisory role compromised by its monetary mandate? Might bank regulators be tempted to go easy at the wrong time? Is this a public choice problem?

3. Speaking of regulation, what do you think of the Consumer Finance Protection Board? It’s nominally under the Fed. What tools or training does the current Fed need to oversee this new agency?

4. Finally, what is the mechanism that translates asset purchases by the Fed (QE) into higher employment? How do lower mortgage rates and higher stock prices create middle-class jobs? Are we trying to spin straw into gold?

I have great respect for Dr. Yellen’s work; I believe that she will make fine Fed Chair. (Anyone wanting to read her speeches can go here or here.) But we’re in uncharted policy waters. I don’t think anything like these questions will be asked. But it would be great if they were.

Douglas R. Tengdin, CFA

Chief Investment Officer