Looking Forward, Looking Back (Part 1)

Looking Forward, Looking Back (Part 1)

Where is the market taking us?

Source: Wikipedia

The ancient Romans worshipped the god Janus, the god of beginnings and transitions. He had two faces, one looking forward and one looking at the past. The month of January is named for him. In order to prepare for the future, it was thought, we have to be aware of and understand the past.

While we don’t invoke Janus any more when we start something new or pass through a door, looking both forward and back around the beginning of a new year isn’t a bad idea. So what have we learned?

This was a tough year for almost all the markets. After doube-digit returns in each of the last three years, the S&P 500 was barely positive. Global stocks were negative, especially resource-oriented emerging markets. And bonds just managed to squeeze out a gain, based on their income. The best markets were growth stocks, REITs, and emerging market bonds; the worst were high-yield bonds, emerging market stocks, and energy stocks. A year ago the price of crude oil had fallen 50% to $55 per barrel. No one expected it to fall another 30% to $35.

Returns through 12-30-15. Source: Bloomberg

Investments that were touted as “sure things” turned out to be not-so-sure. REITs may have done well, but they were led by apartments, not health-care. And there were some surprises. The best international markets turned out to be Japan, Russia, and China—despite the turmoil of the energy markets, and Chinese markets.

The biggest lesson from all this is that markets are unpredictable. Last year’s best-performing sector—utilities—was one of the worst this year. High-yield bonds were supposed to be a refuge from rising rates, but they ended up vulnerable to weak oil prices. And sometimes a market or sector can be strong or weak several years in a row.

We don’t know the future. Just because US stocks have been the strongest performers doesn’t mean they’ll keep doing so. Stay diversified.

Douglas R. Tengdin, CFA

Chief Investment Officer

Investment Management / Self Management

Do our emotions work against us?

Source: Wikipedia

They can with investing. Our own fears or doubts or arrogance get in the way. For example, most of us are afraid of losses: the pain of losing money is a lot worse than the regret we might feel by missing out in an up market. So we leave our money in safe, low-interest bank deposits rather than risk it in a volatile market, even though we know inflation is eating it away. On the other hand, we also suffer from hindsight bias: in retrospect, an uncertain outcome seems obvious. And we kick ourselves for missing out on Apple or Amazon’s meteoric rise.

To be successful, we need to manage our passions as much as we manage our money. Shakespeare understood this. His plays are full of characters undone by their emotional state. Macbeth’s fears lead him first to murder his king, then his best friend. Hamlet’s doubts prevent him from accomplishing his personal mission just when it might have been successful. Coriolanus’ pride and disdain for the masses keep him from showing off when it might have saved him.

Their own flaws are what bring these heroes down. The lesson is that we need to have strategies for dealing with our fears, rashness, overconfidence, or procrastination. There are ways to do this: hiring a money manager, or avoiding listening to daily market chatter in order to stick to a long-term strategy. But we need to manage ourselves first.

Being emotional is part of being human. But we need to rule our feelings, not let our feelings rule us.

Douglas R. Tengdin, CFA

Chief Investment Officer

If Only, If Only …

Can we learn from our mistakes?

Scuptor: Luigi Bartolini. Source: Art Parks International

We all have regrets. Why didn’t I finish my degree? We should have gone camping last summer. Why did I send that email? “If only” thinking plays a big role in our lives. In general, our emotions send us helpful messages. Ignoring them can mean we persist in counterproductive behaviors and we miss opportunities to improve ourselves.

But not always. When it comes to investing, “if only” thinking can lead you to chase the latest hot stock or asset class. In our portfolios, if we measure our success by comparing all of our investments to the top performers, then we’re doomed to be unhappy.

When we look at stock and bond returns over the past decade, US stocks have returned about 7.5% per year, while US bonds and international equities have returned about 4.5%. Does that mean it was a mistake to include bonds and global stocks in a portfolio? Not necessarily. During the financial crisis, bonds were an island of stability in a period of global tumult. And just because non-US equities have lagged the US lately doesn’t mean that will continue to do so. By many valuation measures, global stocks are significantly cheaper than their domestic cousins.

Source: Bloomberg

If every sector in your portfolio is doing really well, you’re either really lucky or too concentrated. Diversification is the complement that humility pays to uncertainty. We don’t know the future, so we spread our bets across as many different asset classes, industries, sectors, and countries as is reasonable. Being truly diversified means that there will always be a part of a portfolio that looks awful.

The math of diversification makes sense, providing the best risk-adjusted returns over time. The psychology of diversification can be challenging, though, especially when we’re tempted to think, “If only I had put all my money into Apple or Amazon 10 years ago. It would have grown over 10-times!”

But this decade’s Apple could turn into the next decade’s oil patch. Sure things are never sure, and what seems obvious in retrospect isn’t clear ahead of time. It’s good to learn from our mistakes, but only if we take away the right lessons. Jumping on the latest fad is a pretty predictable way to under-perform. But we also need to acknowledge that while diversification is good for our portfolio’s health, it’s a medicine that tastes bitter at times.

Douglas R. Tengdin, CFA

Chief Investment Officer

Above Average Investing

Can we all be above average?

Source: College Board, ETF Reference

Of course not. That’s mathematically impossible. By definition, half the people surveyed for any characteristic will be above average, and half will be below average. But if you ask a group of people to rate themselves in many traits—driving, or generosity, or leadership skills—a vast majority will rate themselves above average. Supposedly, this overconfidence is a source of investing difficulties

But that’s only true for some characteristics. If you ask people to rate their artistic ability, or how beautiful they are, or the quality of their singing voice, a vast minority will say that they’re above average. It seems that we overestimate our abilities when the skill is intangible, like intelligence, and we underestimate our abilities when the results are easily seen—like drawing or musical abilities. And we’re especially likely to rate ourselves below average for these skills in a social setting where we know the other people in the group.

This does have profound investment implications. When people are convinced that their view of the world is “right,” they invest accordingly. In financial markets, we can generate an informed opinion by reviewing other research, examining company financials, and looking at price action. When the market confirms (or denies) our expectations, our confidence grows. But we’re selective in what we remember, so we become irrationally over (or under)-confident.

This can lead to market manias and bubbles—as well as crashes and depressions, where prices diverge widely from their fundamental values. Prices go up because they go up, and down because they go down. Price momentum builds on itself, until valuations reach absurd levels. (Perhaps explaining why FANG stocks are currently priced at 100 times earnings—“priced for perfection”?)

Source: Bloomberg

Eventually, though, reality has its revenge. The world never turns out to be as rosy or as gloomy as momentum-driven market prices predict. Value-oriented investment strategies eventually outperform, but they sometimes have to endure long periods of underperformance to get there.

John D. Rockefeller once said that good leadership consists of inspiring average people to do superior work. In the same way, good investing is finding average companies that can deliver superior performance.

Douglas R. Tengdin, CFA

Chief Investment Officer

Reindeer Blues?

Is Santa contributing to global warming?

gmu151222_1Global Warming Culprit? Source: Morguefile

A team of researchers at Oregon State University has noted that with all the concern about the effect of carbon emissions on the global climate, a major greenhouse gas is being overlooked: methane. Methane is over 20-times more powerful than carbon dioxide in trapping heat.

Cows, sheep, goats, and other ruminants produce tons of methane in their digestive tracts. Over the past 50 years the population of these animals has risen by 1.5 billion. Reducing demand for ruminant products could help achieve substantial greenhouse gas reductions.

An important—though unusual–use for ruminants in today’s economy is transportation. One northern-latitude animal crucial to global commerce at this time of year is the reindeer. They provide critical transportation for specialized vehicles in high latitudes in late December—sometimes making all-night deliveries. Their methane emissions occur in the stratosphere, so their activity is especially harmful. They should have received special attention during the Paris climate conference, but the Swedes and Norwegians resisted. In the end, they only got a passing reference.

For now, the reindeer herds need a special exemption for their December deliveries if Christmas gifts are to arrive on time. Pigs and poultry may be able to produce meat, but they can’t replace Rudolf when it comes to lighting the way for Santa’s sleigh.

Merry Christmas, everyone!!

Douglas R. Tengdin, CFA

Chief Investment Officer

Of Silk Purses and Sow’s Ears

Collateral dominates structure.

gmu151221_1Photo: Scott Liddell. Source: Morguefile

That’s an investor’s way of saying that you can’t make a silk purse out of a sow’s ear, or that you can’t turn lead into gold. It’s been an investment theme of mine for as long as I’ve been managing money.

I got my start trading bonds in the mid-‘80s. Mortgage-Backed Securities were a little less than a decade old. Investors were just beginning to learn about prepayment risk, as interest rates fell and everyone started refinancing their double-digit mortgages. All those full-faith-and-credit Ginnie Maes were paying off early, and investors who paid premiums for fat coupons found that prepays could sometimes give them a negative yield, if enough of the pool paid off at once.

So some Wall Street types created Collateralized Mortgage Obligations—CMOs. By bundling a bunch of securities together, then sequencing the payments, investors could get a mortgage bond that behaved more like a traditional bond—paying just interest, and then paying off all its principal quickly. By structuring the principal payments, CMOs were supposed to reduce or eliminate prepayment risk. Only they didn’t. Collateral dominates structure. When 30-year mortgage rates fell to 5% in 1993, those CMOs paid off as quickly as anything else.

gmu151221_2Fannie Mae 10% Mortgage Prepayments. Source: Bloomberg

Fast-forward 20 years. Mutual funds offer daily liquidity in all kinds of assets: emerging market stocks, foreign government bonds, currencies, non-investment grade bonds. But daily liquidity wasn’t all that easy—investors still needed to wait for the market’s close. Exchange Traded Funds offered exchange-based liquidity—trading every minute, or even more frequently. It made it seem that investments that were difficult to trade could be bought or sold at a moment’s notice.

And while the exchange-traded funds are liquid, the underlying instruments haven’t changed. Illiquidity is still illiquidity. Whether it’s high-yield bonds or micro-cap stocks or “jump-z” CMO tranches or private real-estate trusts, a collective instrument must carry the risk-characteristics of its underlying constituents, even if it has a blue-chip financial architecture designed by a top Wall Street legal firm and approved by the SEC. Collateral dominates structure—kind of like the mathematical law of identity: A equals A.

That’s why junk-bond ETFs usually trade at a modest premium or discount to their net asset value—although sometimes they’re way off. These bonds are hard to buy or sell, and when a significant amount of money flows into or out of the fund, its price has to reflect the expected transaction costs. It’s not that the index value is bogus, it’s just its decimal-point precision doesn’t allow for the nuances of a bid/ask spread in the bond market. And when big news or fund-flows hit an illiquid market, the bid/ask spread gets wider.

gmu151221_3Junk Bond ETF discount/premium to Net Asset Value. Source: Bloomberg

Structure can’t take risk out of a market. Over the years, Wall Street has tried to repackage risk into different types of vehicles. But prepayment risk and interest rate risk and credit risk and illiquidity risk weren’t removed, they were just hidden for a while, waiting for the right circumstances to bring them back out into the open. If investors think the underlying risks have been eliminated, can be hazardous to their financial health.

It isn’t just what we don’t know that gets us into trouble. It’s what we think we know that turns out to be wrong. That’s where the real danger is.

Douglas R. Tengdin, CFA

Chief Investment Officer

SAT Investing

Can investors learn something from the SATs?

Source: Pixabay

It may be only a few more days to Christmas, but it’s also college application season. A lot of high-school seniors are filling out the Common App, writing and re-writing essays, and anxiously awaiting their latest test scores. And there’s a test-taking technique that kids use to improve how they do on standardized tests that can help investors.

It’s elimination. When they come to a question to which they don’t know the answer, they can improve their scores by eliminating what is most clearly wrong. In a multiple-choice test, someone just filling in the circles gets 20 or 25% correct by random chance. But by eliminating the obviously wrong answers, students can better their odds. They won’t guess right every time, but they’ll do better than if they had left the answer blank.

In the same way, investors can do better by eliminating what’s wrong. If a company’s business model makes no sense—if you can’t figure out how they earn their money—then don’t own that business. If management seems to focused more on politics and celebrity than capital investment and HR, don’t buy the stock. This is a variant of The Loser’s Game by Charlie Ellis. We can be smart by avoiding dumb ideas.

For example, in December of 2000 Enron employed 20,000 people and claimed revenues of over $100 billion. But some analysts started looking in depth at their derivative books and couldn’t figure out how the company was earning all their money. There was a gap between what was reported and what they could confirm. We know how this story ends: Enron filed for bankruptcy in December 2001. The executives used a willful, systematic, and intricately planned accounting fraud to inflate their earnings.

Enron stock. Source: Bloomberg

Investors would have improved their relative performance by avoiding Enron. That was difficult to do: the company was a media-darling, considered a high-flying harbinger of the new economy. It had tremendous price momentum. But it was hard to see how they could turn 2% growth in utility revenues into consistent double-digit earnings growth for themselves.

By looking under the hood—understanding the business, reading the financials—investors can sometimes avoid the big flops. And just like when kids take the SATs, if you can improve your odds—in a low-return world—that just might be enough.

Douglas R. Tengdin, CFA

Chief Investment Officer

Interest Rates, Janet Yellen, and The Bard

What did the Fed just do?

Narrowly considered, the Fed simply changed the wording in their periodic statement, announcing that the range for inter-bank interest rates—Fed Funds—would go from zero to .25% to .25% to .5%. In other words, the rate will move from “essentially zero” to “almost zero.” Practically, if a bank borrows $1mm from another bank overnight, they’ll have to pay $13.89 rather than $6.94. You could almost call this the “Macbeth” interest rate move: full of sound and fury, signifying—nothing.

But it’s not really nothing. Rate increases are like potato chips: the Fed can’t do just one. They’ve started to raise rates 12 times since World War II. In 11 of those 12 times, they’ve kept going until the economy tanked. That’s why Chair Yellen was at pains to emphasize the moderate pace of rate increases she and the Committee expect to take. Between the official statement, her opening remarks, and the subsequent Q&A session, Yellen used the world “gradual” or “gradually” at least 10 times. Message sent.

And it appears that the message was received. Normally, the stock market falls when the Fed raises rates. But this time stocks rallied: the Dow rose over 200 points; the S&P and Nasdaq went up 1.5%; stocks in Europe and Asia rose over 2%. Even bonds did well. After some volatility, the 10-year US Treasury note now yields roughly what it did three days ago, and less than it did a month ago.

What’s next? It all depends on the economy. If we continue to live in a slow-growth, low-inflation world, nothing much will change. Consumers will keep spending, companies will keep hiring, markets will expand. But it never works out that way. Something unexpected will come along that shocks us. How efficiently our economy adjusts, how resilient we are—to borrow another line from Shakespeare—that is the question.

Douglas R. Tengdin, CFA

Chief Investment Officer

Maple Bandits

History repeats itself.

Photo: Jim Mauchly. Source: Mountain Graphics

That’s what I thought when I read about Quebec’s maple syrup rebels. Quebec is the Saudi Arabia of maple syrup, producing 70% of the world’s supply. And it’s no wonder: with its cold winters and long, muddy springs, the province’s climate is ideal for creating a long, active run for their millions of acres of maple trees.

Source: Maple Syrup World

Since the Province dominates production, they can control the market. 25 years ago, maple syrup prices were rock bottom—half of what they are now. Farmers organized a cartel—the Federation of Quebec Maple Syrup Producers—to control how much of Quebec’s syrup could be exported. They set the price for how much they pay producers, and they charge a 12-cent fee for every pound sold.

Producers can only sell a very small amount independently—just to visitors to their farms, or to local markets. And they still have to pay the commission. Under the Federation’s control, prices have almost tripled.

The result is what happens whenever a cartel raises prices: producers start cheating. Their individual benefits outweigh the cost to the total system from over-production. They also claim that the arrangement means they don’t own their own syrup any more. So they smuggle their syrup across the border into New Brunswick, or find other ways to outfox the system.

Illustration: William De La Montagne, c. 1870. Source: Wikipedia

Naturally, the Federation has taken a dim view of such activities. Backed by the Canadian courts, they have their own security staff, and can impound production and sue producers for selling syrup outside their system—sometimes amounting to hundreds of thousands of dollars.

Cartels usually fail because they can’t enforce production quotas. They usually last a few years, then break up. This cartel has lasted longer, in part because Quebec is so dominant, and because maple syrup is homogeneous: you can’t taste much difference between Ohio’s grade-A syrup and Quebec’s. Also, demand for the syrup is fairly stable. But more efficient farmers are penalized: they should be able to profit more from greater production, but there’s less incentive for them to innovate.

Eventually, low-cost producers will find a way to get their product to the market. Either that, or Vermont and New Hampshire will learn how to frack their maple forests.

Douglas R. Tengdin, CFA

Chief Investment Officer

Rollover Ahead?

Is the market rolling over?

Source: Volvo Cars, NA

“Rollover” was a B-movie from the early ‘80s starring Kris Kristofferson and Jane Fonda. It was about a financing crisis at a bank and a chemical company that spills over into a general panic. It got Kristofferson a Worst Actor award from Razzie. A market rollover is what market participants are worried about right now, with the S&P 500 at the low end of its recent trading range. The pending Fed move and seasonal funding pressures have investors spooked. But is something more going on?

Economic indicators are mixed. Employment numbers continue to be healthy, but industrial production and manufacturing are not. Some of this is due to a strong dollar and restructuring in the oil patch, but there is concern that China’s restructuring and Europe’s malaise may be affecting global aggregate demand.

Financial activity is brisk. Mega-mergers are being announced almost every week. The Dow/DuPont merger is one of the most innovative—two chemical giants are combining, then breaking up into three dominant players in each of their respective markets. But these deals often depend on cheap financing. With the Fed poised to raise rates, their capital may more expensive. That would reduce mergers and acquisitions as a source of support.

Market action has been narrow. Only a few momentum-driven stocks are hitting new highs, and hese seem over-valued by most traditional measures. Companies like Facebook, Amazon, and Netflix are priced for revolutionary growth. It’s true that they have spearheaded our mobile-connected on-demand world, but they won’t be able to grow like this forever.

Consumer spending has been buoyed by low oil prices, but much of that spending power has gone into automobile purchases, which are still recovering from the Financial Crisis. The average age of vehicles on the road in the US continues to climb. Demand for other consumer products is lagging. Many retailers are struggling.

Source: US Department of Transportation

So are stocks headed lower? My sense is that market-leadership is shifting. This year, consumer stocks led the way. Next year, it will be something new. There’s always a sense of indecisiveness when circumstances change. And with oil hitting post-crisis lows, the Fed raising rates, and China’s economy continuing to shift from manufacturing to services lots of circumstances are changing.

But change doesn’t mean loss. It’s almost always a mistake to bet against the American consumer. As long as consumers keep spending, companies will find a way to grow their profits. And growing profits should lead the market higher.

Douglas R. Tengdin, CFA

Chief Investment Officer