ETFs, Ticker-Tapes, and Black Days

Are the bears on the prowl?

Photos: Alamy, Aurora Photos, Getty Images. Source: Bloomberg

Last week’s market mayhem was made worse by some of the innovations we’ve created to try to control risk. Exchange Traded Funds allow investors to buy and sell large baskets of securities in real time—except when they don’t. Last Monday some of the largest and most diversified ETFs opened down over 30% from their previous close—way below where they should have been based on their holdings.

When the market sold off in the first few minutes of trading, many stocks triggered temporary “circuit breakers”—trading halts that force market participants to pause and catch their breath. But these pauses made it impossible for ETF market-makers to calculate the underlying value of the funds, so they widened the spread between their bids and offers.

When sell orders came flooding in as the market opened, ETF prices plummeted, forcing other prices down. The selling fed on itself, until short-covering lifted prices. The result was a wild ride. During the week the Dow traveled over 10,000 points.

Last week’s action was nothing like 1987, when 2/3rds of the stocks in the S&P 500 had no market for hours and interest rates on Treasuries moved over 5% in a single day. But in one way they are comparable: the information provided by the market itself was stale—it didn’t reflect what was going on at the time.

On Black Monday in 1987 equity futures traded at a deep discount to the stock market’s reported value, because of delays in reporting transactions and computing the averages. This was similar to Black Thursday in 1929, when the ticker-tape machines fell behind the market by several hours. Even in our current era of microsecond trading and supercomputer-calculated averages, it’s still true that only the players inside the exchange know what’s really going on. And now the “exchange” is a black box just off I-95 in Secaucus, New Jersey.

Some investors use automatic orders to try to protect their positions. Last week those orders automatically generated 30% losses—a big disappointment. There’s no shortcut to safety. When markets get crazy, the best way to protect yourself is to at least act like you’re sane.

Douglas R. Tengdin, CFA

Chief Investment Officer

Retiring On Snacks

Can we retire on spare change?

Photo: Skeeze. Source: Pixabay

It’s worth thinking about. After all, most of us have coins in our pockets after running errands or grabbing a cup of coffee. What would happen if we invested that money, instead of losing it in the couch?

The short answer is, it depends. It depends on how much we save, how long save, and what the return is. So let’s assume you’re a 50-something who has about $2 of loose change each workday–$10 by the end of the week. You don’t want to take too much risk, so you only earn 4%. Can you retire on that? No: after 20 years you’ll only have $16 thousand—maybe enough for a used fishing boat.

Real savings has to be more deliberate. If you are able to save $200 per week and you earn 8%–a reasonable long-term return on stocks–you’ll have over $500 thousand in 20 years. Not bad. But if you’re able to start saving in your 40s and have 30 years, those same savings will grow to a $1.3 million nest egg.

The magic of compound interest comes from the amount of time that you give it to work. That’s why it’s important to start early. If you want that $1.3 million nest egg, you need to put aside $200 per week for 30 years, or $85 per week for 40 years, or $38 per week for 50 years. The earlier you start, the less you need to set aside. The secret to saving for retirement isn’t market timing, it’s time in the market.

You really can win the lottery—not by buying tickets, but by investing enough for long enough. In the short run, the stock market may be volatile. But over the long haul, it’s the greatest wealth-building machine ever invented.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Sleepwalking Economy

What’s wrong with the economy?

Photo: Arielle Jay. Source: Morguefile

Economic growth seems to have stalled. Since the last recession, GDP has grown at a measly 2% real rate. To put that into context, economic growth after a significant downturn usually booms, as it did after the recessions in the ‘60s, ‘70s and ‘80s. In the four years following those recessions, the economy average 5% growth. But in the ‘90s and early ‘00s, we only grew 3%. And this recovery has been anemic.

Some blame our poor economic performance on outsourcing, Congressional gridlock, and the Fed–a favorite “whipping boy.” But the entire economic engine seems to have slowed.

Source: Bloomberg

During the immediate post-World War II period, the economy averaged a 4% real growth rate. But something happened in the ‘70s. Following the 1972 downturn, we only averaged 3% growth, up until 2000. Since then, we’ve only averaged 2% growth. And this has been a global phenomenon. You can’t blame Congress or the Fed or fluoridated water.

I would suggest that this change in economic structure has to do with technology and the nature of our infrastructure. During the postwar period we had an industrial economy. Productivity was enhanced by infrastructure that helped us move stuff more efficiently: highways, ports, rails. Starting in the ‘70s, we developed an information economy. Technology improvements focused on helping us understand and manage data—mainframes, PCs, databases, spreadsheets, email, and graphics.

Since the year 2000, mobile computing and personal technology has facilitated what I would call an entertainment economy. Productivity enhancements have gotten ever-more personal. Whether or not you like ESPN and Amazon, March Madness betting pools and buying barbeque sauce on our smart-phones doesn’t help us get more work done.

These changes have been gradual, but they’ve been like continental drift: you don’t notice them until the entire landscape has shifted. So don’t expect too much from politicians or policy. Until the economy changes to help us do more, I think we really are stuck in a new normal.

Douglas R. Tengdin, CFA

Chief Investment Officer

Pump and Dump?

Why do the Saudis keep pumping oil?

Saudi Arabia’s “Empty Quarter.” Photo: Nepenthes. Source: Wikipedia

Oil prices are down over 50% from a year ago. They’re at a six-year lows, and apart from the Financial Crisis, the last time we saw crude below $40 was in 2004. If prices stay this low, gasoline should cost less than $2 per gallon soon.

Basic economics teaches that when prices fall, producers adjust by reducing their output. After all, higher prices made it profitable to bring more product to the market—at a higher marginal cost. Why aren’t lower prices creating production cuts—a supply response? But in July, OPEC increased its production, and it has remained stubbornly high.

Crude Oil Price (white) and OPEC production (yellow). Source: Bloomberg

The short answer is, they need the money. These producers have government budgets that depend on their oil revenues. The more prices fall, the more they need to pump to make up their deficits. In the short run, it costs them so little to get oil out of the ground that their fields are still profitable, even at lower prices.

The main impact of the current price level has been to cut back on new drilling, rather than slowing the flow of oil from existing wells. That means that lower prices today impact future supplies more than present production. Right now, the excess inventory is likely to persist, or even grow, until demand catches up with supply.

So who’s going to win this price war? On the one side is OPEC, with the biggest and cheapest oil fields in the world and budget deficits that need more cash; on the other side are US-based frackers, with hedged production, local demand, and political stability. OPEC needs to keep pumping, the frackers need to drive down costs.

Whichever side triumphs, one group has clearly come out on top: consumers. Low oil prices are going to be around for a while.

Douglas R. Tengdin, CFA

Chief Investment Officer

Time for a Panic—or a Picnic?

Are global markets melting down?

Photo: Cai Tjeenk Willink. Source: Wikipedia

Yesterday felt like one of the most bizarre days I’ve seen in the 30 or so years I’ve been following the markets. I’ve seen selloffs, panics, corrections, and crashes. This wasn’t like any of them. It had its own peculiar logic.

It started out with some follow-through from last week. Since the sell-off started with China, it made sense that China would lead in any further market action. When I woke up, I noted that Dow futures were down a couple hundred points—bad, but within reason. Then it got crazy. Futures went down dramatically, the market opened down, then we rallied. We were still down a couple hundred points, but it felt like we were up, sold off into the close. In the end, the market had one of its biggest losses ever, in terms of absolute level—despite the lack of negative economic news. In fact, the US economy has been doing fine, even if it’s not booming.

Here’s my take: three different strands are impacting global equities. First, the sell-off in oil continues to rattle. Saudi Arabia has been pumping as much as possible, pushing oil prices lower. Global demand is up, but it hasn’t grown fast enough to absorb the excess supply. The resulting excess inventory is weighing on the market. Folks are questioning whether lower oil prices are simply a result of over-supply, or if there is something else going wrong.

Second, China’s currency devaluation took most observers by surprise. They had held the Yuan steady through two successive crises—the Asian Contagion in 1998 and the Financial Crisis of 2008. But Chinese authorities want the Yuan to be part of global capital flows, and for that they need a freely traded currency. So after July’s exports were reported down 8% from a year ago, they announced a modest drop in the Yuan’s target level. After all, that’s what forex traders would do. But the Chinese stock market has panicked.

Finally, the Fed’s long-expected interest rate party has been the talk of the market for—well, it feels like forever. Rising interest rates can affect capital markets, economies and equities in unpredictable ways. At a minimum, they increase the discount rate at which to value future cash flows. By itself, this would lead to lower equity market valuations.

Taken together, these three factors led to yesterday’s sell-off.

Source: Finviz

These all came together just when we had a late-summer lack of liquidity. Many major market participants are away from their desks right now. The beach can be beautiful in August, even if it its crowded. The result has been our summer swoon.

What will happen next is anyone’s guess. In the short-run, the market will be jumpy. Volatility breeds more volatility. But in the long run, the stock market will go up because economies grow. One thing is certain: six months after the market turns, everyone will claim to have called it.

Douglas R. Tengdin, CFA

Chief Investment Officer

“What is it Good For?”

Is this the beginning of a currency war?

Ruins of Guernica. Photo: Bundesarchiv, Bild 183-H25224. Source: Wikipedia

It sure feels like it. The Chinese devalued, then Malaysia, Vietnam, and Kazakhstan. Asian stock markets have hit the skids, impacting other markets around the world. The Dow has fallen over 10% since it peaked in May. In the face of the market’s turbulence the Fed may have to put off raising rates.

China’s modest devaluation initially seemed a normal reaction to the rise in the Dollar, which had gone up over 20% in the past year. The Renmimbi is tied to the Dollar, and China’s economy has been slowing. But now further doubts are spreading. China’s exports were down 8% in July from a year earlier. Chinese authorities had been intervening to keep stocks from crashing, but their market has continued to fall.

Are we headed for a new bear market? There’s no question that China’s stock market bubble has popped. Its recent fall has erased all of the gains from 2015. Will this affect consumers? Chinese stocks represent only 7% of urban Chinese household wealth. China’s economic slowdown has been driven by traditional industries.

This is what a correction feels like. Our economy continues to grow, and Europe’s will be strengthened by the fall in oil prices. Market analysts had noted that we were long overdue for a 10% pullback. In fact, the last time the market fell significantly, in 2011, many analysts thought the US was headed for a double-dip. At present, no one thinks that we’re headed that way. And China, while slowing, is still growing.

In a trade-dominated world, currencies have to adjust to reflect their underlying economies. So far, the adjustments have been modest. But if countries start to compete to devalue, that’s a competition that no one will win.

Douglas R. Tengdin, CFA

Chief Investment Officer

Slipping on Oil?

Are oil prices close to a bottom?

Source: US Department of Energy

A year ago oil prices had just started falling. Many thought that the pullback was temporary. Now the price of crude oil has plunged almost 60%, and producers are still pumping as much oil as possible—Saudi Arabia, Iraq, Russia, US shale drillers. It seems like they’re playing a global game of chicken, daring one another to cut production first. And with a deal pending to end the international sanctions on Iran, they could begin ramping up. That would only add to the current glut.

Lower prices have encouraged global demand to grow almost 2 million barrels per day from a year ago. But that’s not enough to absorb the excess supply, which is up 3.5 mmbd. So inventories have been climbing. It’s estimated that the US has around 1.2 billion barrels of crude in inventory—not including the strategic oil reserve. Some think that this could push prices down another 40%.

Source: International Energy Agency

But it’s important to keep some perspective. Our massive inventory only represents about 60 days of supply. Gasoline prices have been unusually high relative to crude oil prices, because several refineries have been off-line. There was recently a breakdown in a BP refinery outside Chicago. Still, they’re about 75 cents lower than they were a year ago.

It doesn’t take much of a shift in production and consumption to change these dynamics. There are currently fewer than half the number of oil rigs in operation in the US now than there were in August of 2014. This will cut into production. And sales of pickup trucks and SUVs have risen dramatically. This will increase demand.

Many worry that the collapse in oil prices presages a collapse in the global economy. But there’s no evidence of a credit crunch due to problems in the oil patch. Yes, in the short run we will see layoffs among oil producers. But this is all part of a normal supply and demand cycle. In the long run, the cure for low oil prices is low oil prices.

Douglas R. Tengdin, CFA

Chief Investment Officer

Of Risk and Return (Part 3)

How do we control risk?

Photo: Douglas Tengdin

Good investing is like good building. You can’t really judge the quality of the work until something goes wrong. This summer we’ve been remodeling our kitchen. It’s been an adventure. Changing the flooring exposed our plumbing (I’m not making this up …), which needed to be brought up to code. As we got into the project, other areas had to be addressed—electrical, insulation, windows. We found that our quirky house had a lot of issues—issues that weren’t visible, but might have caused problems if something went wrong.

It’s like that when you look at investments. Unless you know what you’re looking for, you might never know about potential problems buried in a portfolio. In the early ‘90s, I managed a money-market fund. Some of the more popular instruments at that time were “structured notes” issued by federal agencies, like Fannie Mae or the Federal Home Loan Bank. On their surface, structured notes looks like a plain-vanilla short-term triple-A bonds. But inside, there are some special features.

The bonds pay an above-market interest rate, so many portfolio managers buy them to enhance their yields. But if something happens—say, interest rates go outside of a narrow band, or prepayments on mortgages rise, or stock prices fall (again, I’m not making this up …), the coupon payment goes to zero.

In financial parlance, the portfolio manager sells options on an unlikely event. The agency pays for these options with a higher interest rate. By putting a lot of these into a short-term fund, managers can make their funds look pretty good. And the only people who know that these land-mines are there are the managers and folks who patiently look up the tickers from the funds’ quarterly holdings report. Managing risk can get pretty tedious.

Photo: Butkovicdub. Source: Morguefile

That’s why risk is so hard to see, and why it can’t be reduced to a single number. These bonds were bombs just waiting for the right trigger to set them off. When interest rates rose in the mid-‘90s, that’s exactly what they did. Many of the money-market funds that bought them had to be bailed out by their parent companies when they “blew up.” (For the record, our funds didn’t blow up, which was a credit to my boss, Bentti Hoiska.)

That’s what Warren Buffett means when he says that a rising tide lifts all boats, but when the tide goes out you find out who’s been skinny dipping. Just because a portfolio isn’t volatile or doesn’t blow up doesn’t mean it’s safe. Risk control may be present in good times, but it can’t be seen because it hasn’t been tested. But it’s critical to control risk, because good times can easily turn into bad times.

But you can’t eliminate all risk. That would reduce your return to zero. It’s an investor’s job to take intelligent, manageable risks and get paid a fair—or more than fair—return for them. Sometimes you have to go out on a limb, because that’s where the fruit is. A skillful investor welcomes risk at the right time, in the right circumstances, at the right price.

Photo: DuBoix Source: Morguefile

Eventually, our kitchen remodeling will be finished, and many parts of our home will be brought up to code. In building as well as investing, you need to have someone who can spot potential problems before they became outright disasters.

Douglas R. Tengdin, CFA

Chief Investment Officer

Of Risk and Return (Part 2)

How do we manage risk?

Photo: Dodgerton Skillhause. Source: Morguefile

The first step is to acknowledge that it’s there, and it’s not our friend. Unworried investors are their own worst enemies. The Financial Crisis came about mainly because investors thought they were living in a low-risk world. They purchased novel and complex instruments in greater amounts than ever before. They borrowed money to buy them, which multiplied losses when they had to sell. Leverage works both ways.

The world is always risky. It’s not easy to see, and it can’t be captured in a single number. Risk is uncertainty about how the future will play out, and the chance of taking losses when bad things happen. Since risk is about losses, higher prices lead to higher risk. One of the best ways to manage risk is to limit the prices we are willing to pay. In the run-up to the Financial Crisis, investors were willing to pay too much for bonds backed by lousy loans. This make the whole market more risky.

Worry, distrust, skepticism, and reticence are essential elements to proper risk management. This is why Sir John Templeton said that bull markets are born on pessimism and die on euphoria. Euphoric investors drive up prices and drive up the riskiness of the market.

Although risk exists only in the future, managing risk doesn’t require us to make predictions. We just have to recognize what’s happening now. The more fear we see in the market, the less risky it is. This is the “paradox of risk”: overconfidence leads to danger, but healthy skepticism creates safer portfolios.

Douglas R. Tengdin, CFA

Chief Investment Officer

Of Risk and Return (Part 1)

What is financial risk?

Photo: Vanio Beatriz. Source: Wikipedia

Risk is the chance that something bad will happen. When we invest, we don’t want bad things to happen to our money. So we try to avoid risky situations. The problem is, there’s no way to insure against all the risks we face with our money. There seems to be an infinite number of flavors of financial risk: credit risk, liquidity risk, inflation risk, longevity risk, shortfall risk, earnings risk, market risk, fraud risk. The list goes on and on.

All risks involve an unknown outcome. Some risks we know: the known unknowns. We can compute their odds. In backgammon we never know what a single roll is going to be, but the chances of rolling double-sixes on the next roll are always one in 36. Some risks we don’t know—unknown unknowns. It’s the unknown unknowns that scare us. When I played backgammon for money in college, there was always the possibility my opponent would overturn the board walk away. I couldn’t calculate those odds.

Financial economists and quantitative analysts use volatility as a proxy for risk. It provides them with a way to measure the variability of returns. But this tells only part of the story. The market’s volatility has been quite low over for several years now, but that doesn’t mean it hasn’t been risky.

Source: Finviz

The best money managers are also risk managers. The key is understanding both measured and unmeasured risks, and knowing when a risk is worth taking, and when it isn’t.

Douglas R. Tengdin, CFA

Chief Investment Officer