Gut Check?

Should investors “trust their gut”?

Luke Skywalker: “I have a bad feeling about this.”

Source: Wikipedia

We make dozens of decisions every day. Most are inconsequential–“Should I wear black or brown socks? Should I have toast or grapefruit for breakfast?” Sometimes they’re critical, like who to hire for a new position. To help us make decisions, we use informal rules, or heuristics—like drawing a picture, or solving an easier problem first. Often, we draw on experience. If I see a set of flashing blue lights on the highway, I know I need to slow down.

Investors make decisions about their portfolios all the time: does the mix between stocks, bonds, and real estate in my portfolio need revising? Is this company over or under-valued? Is the market at a turning point? All these decisions potentially have significant financial consequences. And just leaving a portfolio alone is a decision. Not to decide is to decide.

“Girl with a Book” by Jose Ferraz de Almeida Junior. Source: Sao Paolo Museum of Art.

Frequently, we use intuition—drawing on a mix of experience, inference, and analysis—to guide us. But how successful are our “gut feelings”? When we measure the outcomes, intuition is less effective than we think. That’s because we tend to look backward selectively—remembering the good choices, forgetting our errors. And we become overconfident.

So it’s important to have a disciplined process. An elite army combat unit was choosing new members and had the interviewers focus on just one topic, rating each candidate on a 1 to 5 scale—just in their one area of expertise. Interviews done this way were much better at predicting subsequent performance than the old, free-flowing discussions—which had no predictive value.

The problem with intuition is that it comes too fast. We form our judgements before we have a chance to consider all the data. We think that what we see is all that there is, we form a verdict, and then we look for information that confirms our conclusion and ignore any dissonant data—all in a flash. It’s why our brains are subject to optical illusions. We think too fast; we need to slow down.

Optical illusion. Source: Wikipedia

That’s why investment rules usually outperform subjective judgements. Whether it’s to rebalance a portfolio or sell a stock at a certain point above its fair value, a rule has no prejudice and no selective hindsight. But because the world is dynamic, rules need to be updated. What worked in the past won’t always work in the future.

When it comes to investing, Obi-Wan Kenobi was wrong: we can’t just trust our feelings. The only investment-force is sound judgement, backed up by rigorous, disciplined analysis. Snap decisions are the “dark side.”

Douglas R. Tengdin, CFA

Chief Investment Officer

The End of Ownership

What drives economic growth?

250 years ago, wealth came from the soil. Economies were driven by agriculture. In The Wealth of Nations when Adam Smith explains the advantages of free trade he illustrates the point with an agricultural example, noting it’s better for everyone to trade Scottish wool for Portuguese wine, than for Scots to use greenhouses and mirrors to make their own wine.

Source: Wikipedia

A century later wealth came from industry. Railroads crossed the country, connecting mines and mills and markets. Titans like Rockefeller and Vanderbilt and Leland Stanford endowed universities to perpetuate their legacies, and the money to do this came from their oil, steel, and railroad enterprises. Karl Marx argued in Das Kapital that their fortunes really belonged to the workers that labored in the factories, rather than to the factory owners.

After World War II, information drove the economy. IBM and Intel figured out how to process more information more quickly. Companies can’t function any more without computers to process their purchasing, production, and payrolls. By learning how to process information, technology entrepreneurs like Bill Gates and Larry Ellison become some of the wealthiest people in history.

Graphical illustration of Moore’s Law. Source: Wikipedia

Today, however, wealth seems to come from ideas. The iPhone isn’t just a phone, it’s the idea of having a globally-connected computer in our pockets. World-class universities are crucial to economies now because they encourage people to originate and develop new concepts and creations. But who owns these ideas?

Almost 100 years ago Universal Studios hired Walt Disney to create a new form of entertainment—the animated funny animal film. He developed a new character, Oswald the Lucky Rabbit, which became a major hit. In 1928 Universal tried to cut Disney’s pay by 20%. An economic downturn was coming, they thought, and they “owned” Oswald. Disney would have no choice, they thought. But Disney did. He quit. The next year he introduced Mickey Mouse. And after that, Disney Studios came out with the first animated feature film, Snow White.

The famous “Heigh-Ho” sequence from Snow White. Source: Wikipedia

Who owns an idea isn’t nearly as important as the ability to create an idea. Disney Studios now goes to great lengths to protect the intellectual property of its characters. But their value pales in comparison to what has been created by other authors, later—Luke Skywalker, Vito Corleone, Scarlet O’Hara. And authorship isn’t limited to literature. You could say that Steve Jobs “authored” the iPhone, that Bill Rasmussen “authored” ESPN, that Ben Graham “authored” value investing. While there are legal rights to the creations (and their associated cash flow), no one owns the creators.

For our economy, today, it’s creators who generate value. The people who really shape an economy are the ones who can change what an economy makes.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Undersea World of Negative Interest Rates

What happens when rates go under water?

Source: NOAA

Growing up, one of my favorite TV shows was “The Undersea World of Jacques Cousteau.” For an hour my family and I would sit in rapt attention, fascinated by the images of life in a coral reef, or under the polar ice cap, or even in a beaver pond. The series gave us a window into a strange, different world, where normal rules of gravity and body mass don’t apply—or, rather, apply in totally different ways.

We’re starting to experience a strange, new world in finance: the world of negative interest rates. Beginning in 2012 in Denmark, then Switzerland, and finally last year in the Euro-zone, European central banks have begun to charge member banks for the privilege of keeping money with them. This supposedly will encourage the banks to lend money to businesses and consumers. Instead of spurring lending, however, interest rates on low-risk government bonds have gone below zero. Just a few days ago, fourteen different European nations had negative two-year bond yields.

2-year Government Bonds on 10/22/15, Source: Bloomberg

When interest rates are negative, the normal rules of finance no longer apply. Future cash flows are no longer less valuable to an investor—they’re more valuable. That’s the implication of a negative discount rate. Also, instead of spending more as rates fall, consumers in Denmark have responded to negative rates by saving more. After all, when rates go negative, compound interest doesn’t help you reach your goals, so you have to set more aside. Finance has entered an underwater realm—a twilight zone.

Central bankers used to worry about what would happen at the “zero lower bound,” when rates approach zero. But zero doesn’t appear to be a boundary any more, it’s just one more rate level. Investors currently expect the ECB to lower their deposit rate from -0.20% to -0.40% at their next meeting. This policy isn’t unconventional, it’s experimental–an experiment in an $18 trillion economic zone with 300 million consumers. And the authorities are acting as if conventional laws of finance still work.

Some have written that central banks need to get rates back above zero, that savers and pensions and other investors need positive interest rates in order to survive, that capitalism itself is threatened by this experiment in emergency monetary policy. But the market is very inconsiderate: it doesn’t produce positive yields and returns just because we need them. Negative yields are here because of a host of factors. Central bankers aren’t leading the economy. On the contrary, the global economy is leading the bankers.

When Captain Cousteau explored the marine world, he found that different rules apply down there. It’s taken decades for us to understand and apply them. Hopefully, it won’t take that long to learn the rules of negative interest rates. Because the longer rates stay below zero, and the lower they go, the more pressure everyone will feel.

Douglas R. Tengdin, CFA

Chief Investment Officer

Let There Be Markets

“Let There Be Markets”

Is there a “unified market theory”?

Source: Wikipedia

In the late 1800s, James Clerk Maxwell sought to understand how electric and magnetic fields interact. He formulated the Maxwell Equations to explain them. Ever since then, physicists have sought a unified theory to tie all the forces in the universe together. Einstein tried—and failed–to connect electro-magnetism with gravity. But other forces—the nuclear weak force, the sub-nuclear strong force, and light—have been joined.

But there’s no way to pull everything together. There are competing models with names like String Theory, Brane Theory, or Warped Gravity. They’re all highly complex mathematical approaches to difficult problems. There’s no consensus on a single solution.

Copyright Sidney Harris. Source: Science Cartoons

In finance too, people look for singular answers. What’s the ideal portfolio mix? What’s the best accounting method? Which company will be the next “Apple”? In finance, as in physics, it depends on your perspective.

The best portfolio is the one that meets your individual needs over time. If you need income, a fast growing private equity portfolio won’t work. If you’re a 20-something saving for retirement, a ladder of Treasury Notes won’t generate growth. There’s no single approach that’s ideal for everyone. Investors need to understand their own individual requirements and limitations before anything is ever bought or sold. Menken writes that for every complex problem there is an answer that is clear, simple, and wrong.

Life is complex. Responsible people understand this. Anyone who says otherwise is selling something.

Douglas R. Tengdin, CFA

Chief Investment Officer

Workforce Worries

Where have all the workers gone?

Photo: Doug Tengdin

Ever since the late ‘90s the labor force participation rate has been falling. There are now over 92 million adult Americans who aren’t working and aren’t looking for work. On its face, that’s a shocking number—almost a third of the population. And 20 million of these folks are in their prime working years. Where did they all come from? And what are they doing?

Source: St. Louis Fed

Actually, it’s not that big a mystery. When the Census Bureau conducts its monthly survey, it asks people what they’re doing. If they aren’t working or looking for work, they usually say why. By comparing their answers from fifteen years ago with now, we get a sense of what’s happening in the labor force, and why people aren’t working.

As with most large statistical trends, a lot of different factors are at work. The data show that young people are staying in school longer and getting more training. In addition, older folks are retiring earlier and living longer. And more middle-aged people have are receiving disability payments—most likely because screening criteria have been relaxed. In some cases, now, SSDI functions as extended unemployment insurance.

Source: Wall Street Journal

Our missing workers aren’t really missing. Young people eventually enter the labor pool. The economy demands more skills, and they need more training. A machinist may need to use calculus, now, to program a cutter tool along nine different axes. Older people are living longer, and many are retiring early. But changing our disability system would be a mess.

The workforce is constantly evolving, adapting to our changing economy. The low unemployment rate isn’t a false indicator. Eventually, companies will have to increase wages. And a new stage of economic growth will begin.

Douglas R. Tengdin, CFA

Chief Investment Officer

Buy and Hold?

What’s going on with consumers?

Photo: Tim Gouw. Source: Picography

Personal consumption is incredibly important. We’re constantly told that consumers make up more than 2/3rds of our economy, although that probably overstates the case. Medical expenses, for example, are considered part of consumer demand, even though the government pays for about half of our health care.

Still, it’s important to understand what consumers are doing. The stock market almost never suffers a significant decline except during a recession, and it’s hard to have a recession unless consumers are pulling back. So what are consumers doing? A couple of researchers at the Federal Reserve Banks of Cleveland and Boston looked at retail sales county-by-county for the past fifteen years. What they learned is fascinating.

Retail Sales, County data, Year-over-year. Source: Boston Fed, Moody Analytics

First, all consumption is local. Even during the dot-com and housing bust, purchases in some counties grew by over 20%. Conversely, during the housing boom, consumption shrank in some places by the same amount. Second, the current “tepid” recovery is actually stronger than the housing boom. Not only are median expenditures higher, but the areas that are worst off are still doing about twice as well as a decade ago. Finally, consumption doesn’t happen in a vacuum. When they tried to create a mathematical model to explain consumer behavior, they had to include unemployment, income, and debt in their equations. This both highlights and limits how market observers should look at economic data. The Labor Department’s monthly employment report is pivotal. But analysts need to look at other factors, too.

Retail Sales excluding Autos and Gasoline, Year-over-year. Source: Census Department

At present, consumers appear to be pretty healthy: incomes are growing, debt burdens are modest, and unemployment is falling. The stock market has been volatile, but that seems to relate to concerns about corporate profits, the strength of the dollar, and lower oil and commodities prices.

It’s ironic that for an economy to be healthy, people need to spend more. But my expense is someone else’s income—we’re all linked in an intricate, multi-level financial matrix that’s constantly shifting. The more we understand our connections, the better we can adjust our plans. In the long run, we’re all planners.

Douglas R. Tengdin, CFA

Chief Investment Officer

Making Dragons Grow

Source: Wikipedia

Do you believe in dragons?

That’s the question in a children’s book I used to read with my kids. A young boy finds a dragon and brings it home. His mother says, “There’s no such thing as a dragon.” As long as she denies that it’s real, the dragon gets bigger and bigger, eventually carrying the house on its back. Finally, when she asks what the dragon is doing with their home, it shrinks back to a manageable size. “He just wanted to be noticed,” the boy concludes.

Companies seem to be recognizing the dragons in their corporate structure. HP is splitting into a business-services division and a hardware company. Yum brands is spinning off its Yum-China division and everything else. Their Chinese franchises have been plagued by several food-safety scandals and increased local competition. A good bank / bad bank structure was used several times during the Financial Crisis to get poorly performing assets off of bank balance sheets. And in an inverted variation, several years ago Phillip Morris separated its fast-growing international division from its US-based enterprise.

Isolating a problem can be a good way to focus and make sure it isn’t avoided or concealed. When the sole purpose of your business is to manage your way out of a hole, it’s less likely that you’ll forget about the hole. At the same time, it’s important not to ignore the rest of the business, which still needs attention. Businesses don’t just manage themselves. There are decisions to be made about personnel, marketing, operations, finances—the list goes on and on. But senior managers only have so much attention.

By spinning off the problem child, companies can make sure their issues get addressed. Problems often require their own specific processes. But it’s important to start out right. If the new organization doesn’t assert control quickly, it can devolve into a downward spiral, where good people leave, the business declines, causing more people to leave.

So it’s important to get started. Because the surest way to make a problem worse—or a dragon to grow—is to deny that it’s there.

Douglas R. Tengdin, CFA

Chief Investment Officer

Autonomous Autos?

Are self-driving cars in our future?

Photo: Steve Jurvetson. Source: Wikipedia

I sure seems like it. Self-driving cars have been in the news. Honda, Toyota, and Nissan all recently announced that they plan to sell cars with automated highway driving functions by the year 2020–the year of the Tokyo Olympics. Traditional automakers are trying to get ahead of tech firms like Google, which has been testing a prototype. There are also reports that Apple is studying the technology.

Inventors have been experimenting with autonomous vehicles since the 1920s—when radio controls and servo-motors allowed a remote operator to direct a car through the thick of New York City traffic, up and down Fifth Avenue. In the 1990s an Italian Lancia traveled over 1,000 miles in northern Italy in fully autonomous mode. Now there are dozens of projects around the world, with governments, universities, and corporations holding competitions and offering prize money.

Photo: Steve Jurvetson. Source: Wikipedia

The potential benefits are huge: increased energy-efficiency, fewer accidents, less demand for parking, increased car-sharing—even reduced law-enforcement, since the cars would naturally be programmed to follow all traffic regulations. Of course, a lot of other issues would need to be worked out: liability, privacy concerns, and software security. Hacking could be a serious problem. On the other hand, hot-wiring will be pretty hard. Passwords and cryptography will become even more important.

Still, for all these concerns, self-driving cars seem inevitable. Transportation is a basic human need. And once we build a machine, we want it to go somewhere. We just need to be sure it goes where it’s told.

Douglas R. Tengdin, CFA

Chief Investment Officer

Above Average Investing

Above Average Investing

Photo: Jim Machley. Source: Mountain Graphics. Used by permission

“Raise your hand if you’re an above-average driver.”

Ask that question in any group and see how many hands go up. Usually it’s way more than half. That’s because we’re pretty overconfident. We think we know more than we do, and we think that we’re better than we are.

This isn’t because we’re naturally arrogant. It’s because the folks who lack a true expert’s abilities simply can’t discern what makes someone really good at something. For example, if you’re not very good at learning languages, you might not be able to tell that you’re not very good, because the skills you’d need to tell a good language-learner from a bad one—an ear for sounds, a broad vocabulary—are the ones you lack.

This has broad implications for investing. It’s fairly easy to measure investment return, but it’s difficult to evaluate risk. Most occasional investors never consider the risks that they’re taking when they measure their investment returns. So they may have a great run, but usually it’s because they’re taking significant risks that they’re not even aware of.

All the more reason to be humble about our investment prowess. There are some real tools investors can use to improve their performance, but they’re mostly humdrum matters of policy, discipline, and humility. Investing is a game of inches, and little things add up to improve performance.

Investment skill is real, and above-average performance is possible. But this isn’t Lake Wobegon: not everyone can be above average.

Douglas R. Tengdin, CFA

Chief Investment Officer

“Plays Well With Others …”

What jobs are growing today?

Photo: Iris Hamelmann. Source: Pixabay

Increasingly, it’s jobs that combine math and social skills. An economist interested in education and its long-term effects looked at jobs that have been growing or shrinking as a share of the economy since 1980. This is an interesting question. More and more occupations are being automated, even high-skill, quantitative occupations.

Learning math and computer science, it seems, is not enough. Increasingly, employers are looking for teamwork, cooperation, and communication skills. And work that involves collaboration and quantitative analysis is especially important. For example, writing computer code is often a group effort, now. Two programmers will work in pairs on the same workstation, with one entering code and the other reviewing each line as it’s typed in, as well as thinking about the program’s strategic direction.. This doesn’t work if either partner tries to dominate the process.

Source: New York Times

This has implications for the way we teach and learn. The old lecture-hall, homework model may have served when individuals were headed to assembly-line jobs. But our workplace doesn’t look like this anymore. Instead, we collaborate on projects where the goal itself may be constantly shifting—requiring agile teams to modify their methods and direction.

More and more routine work is being automated and outsourced, and the labor market is adjusting. Some have said we are in a “jobless recovery,” but that’s not accurate. There are lots and lots of job openings out there–a record number by some counts. Many of these positions go unfilled, though. If we can prepare workers for the new jobs—jobs that include social engagement as well as technical expertise—our economy could really soar.

Douglas R. Tengdin, CFA

Chief Investment Officer

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