French Roast

French Roast

Who says populist politicians are too serious?

Harper’s Weekly cover from 1900. Public Domain. Source: Wikipedia

A lot of folks have compared the current economic and political environment to that of the late 19th century. And there are a lot of similarities. Rapid technological change has brought the world closer than ever before. Millions of people fled low-wage, dictatorial regimes for better opportunities in the US and Canada. Free trade swept the world—growing from 5% to 8% of global GDP.

These changes spread the benefits of the industrial revolution, but they also worsened inequality. As a result, populist movements grew up, including a takeover of the Democratic Party in the US. William Jennings Bryan’s Cross of Gold speech was a high-point of “prairie populism.”

Now we see nationalistic populism growing around the world. Over the next year there will be a series of high-stakes elections in France, Holland, Germany, and possibly Italy which will test the staying power of the European Union. The National Front in France has established itself as a major political force, and its policies are anti-trade, anti-immigration, and anti-Euro. The uncertain status of the EU has kept valuations depressed in European markets.

Some see the British “Brexit” referendum as a sign of things to come—an national in-or-out vote on whether countries are better off with lower or higher trader barriers. Since the benefits of free trade are unevenly distributed, it’s not clear how people will vote. And—as happened after the Brexit vote and the November elections in the US, it’s not clear how markets will react.

Recently, Robert Sanchez—a National Front mayor of a small town near Marseille in southern France—named one of his streets “Rue de Brexit.” He said he wanted to pay tribute to the British voters who chose to leave the EU. Significantly, he placed it next to “Rue Robert Schumann” and “Rue Jean Monnet”—two men who helped lay the foundation for the post-WWII European Union.

Beaucaire, France. Source: Google Maps

But here’s the funny part: Rue de Brexit is a commercial ring road: a circular street in a gritty industrial zone that goes nowhere. Think of it: a small-town mayor with a Spanish surname uses an English election result to display French national pride—with Gallic irony. Even folks opposed to trade can’t help but show that we live in an increasingly small world.

Happy New Year!

Douglas R. Tengdin, CFA

Chief Investment Officer

[nationalist populism, history, France, Euro, Brexit]

Retirement Dreams

Why is saving for retirement so hard?

Photo: Ahborson. Source: Morguefile

We often hear that there is a saving crisis. People don’t save enough today to fund their retirement tomorrow. And with the national savings rate somewhere around 5%, that seems pretty accurate. After all, if you save 5% of your salary for 40 years—and just put it in the bank—by the time you retire you’ll have only two times your salary socked away. If you spend 5% of your savings every year in retirement, you’ll only replace 10% of your final salary.

Personal Savings Rate—the different between Personal Income and Personal Consumption. Source: FRED

For most folks, that’s not enough. People want or need something more like 70% of their final salary to retire comfortably. But how do we get there? Social Security only replaces some of that need. A recent analysis indicates that by setting aside 20% and investing it conservatively, a 40-year career should be enough to fund a 20+ year retirement. And our 5% national savings rate is a bit misleading. Life-cycle savings peaks between ages 50 and 60 at a much higher rate—after the kids are out of the house but before retirement. But it’s hard to set more aside when the tax-code punishes prudence.

The alternatives to saving more are clear, though: work longer—don’t retire; work harder—take a second job; or cut expenses by moving in with your parents—or kids. When we see these choices, it’s not so hard to save.

Douglas R. Tengdin, CFA

Chief Investment Officer

Inflation Ahead?

Is inflation finally headed higher?

Core Personal Consumption Inflation. Source: Bureau of Economic Analysis

It sure doesn’t look that way. The broadest measure of consumer prices, the deflator for personal consumption expenditures, was flat November. That’s because incomes were flat, and consumption was flat. Most economists believe that a reacceleration in consumption will be the overarching economic theme for 2017. But this isn’t set in stone. If employment growth slows and wages stall, then we’ll still be stuck in the rut we’ve been in for a while.

Over the past 12 months core inflation has growth about 1.7%–up slightly from a year ago, when prices were growing only 1.4% per year. There’s a slight upward trend, but only very slight. And the latest dip in the rate will put downward pressure on the trend. This is a far cry from the fears of accelerating inflation that accompanied the Fed’s unconventional policy initiatives five or so years ago.

Inflation is important. If prices rise too fast, purchasing power erodes and people can’t make ends meet. In the ‘70s and ‘80s, when prices were spiraling out of control, it was hard for businesses to plan for the future, and investment spending a productivity lagged. But if prices decline – deflation – firms have difficulty financing their debt. Business leaders become cautious about expanding, because the price of what they sell may fall. That’s why many folks think productivity is lagging today.

Source: Bureau of Labor Statistics, Bloomberg

The post-election rally has been based on the expectation that tax reform and regulatory relief could boost the economy and get us out of the slow-growth low-inflation rut we’ve been in for the past six years – ever since the Financial Crisis and Great Recession. But we’ve been in a disinflationary trend for the past 30 years. If inflation stays low or moves even lower, we may not see the faster growth everyone is hoping for.

Douglas R. Tengdin, CFA

Chief Investment Officer

Low Vol – High Vol – Big Vol

Well that was fast.

Performance of Low Vol / High Dividend Strategy vs. S&P 500. Source: Bloomberg

For the past year the investment world has been buzzing about the success of “low volatility” strategies. The idea is that less-volatile stocks can give you just as much performance as highly-volatile stocks, without all the heartache. In other words, in the great risk-return tradeoff, there may be a something like a free lunch—more return with less risk. Like the old Bud Lite commercial: great taste and less filling.

But it doesn’t usually work out that way. As the chart above shows, low-vol strategies have languished since July. That’s because the stocks that comprise that portion of the index have been in the doghouse: healthcare firms have been beaten up over worries about health care legislation, and a lot of consumer products firms – which are big exporters – have been roiled by a stronger dollar. A strong dollar makes overseas sales less valuable to US dollar-based investors.

But is this just a seasonal turn? Let’s look at the underlying premise. Do low-volatility stocks perform just as well as the overall market over the long run?

Source: Bloomberg

The short answer would seem to be no. Since 1994 the broad market has grown 9.5% per year, while low-vol stocks have returned about 1.2% less than that. It’s possible that you could lever the returns of low-vol stocks to get them higher, but then the leverage would add volatility and you’d be right back where you started.

There is no secret sauce to the stock market to create higher returns with lower risk. It may seem that such an approach is working, but often that’s a statistical quirk—something that asserts itself over a short period of time, to be disproven as later periods favor new factors.

Source: ETF Trends

The market is always shifting. As soon as you think you’ve figured out the key, it changes the locks.

Douglas R. Tengdin, CFA

Chief Investment Officer

Christmas Economics

What is the economic impact of Christmas?

Photo: Andree Autza. Source: Morguefile

There are lots of ways that people celebrate Christmas. There’s the religious holiday, which is outside the scope of this blog. There is the secular holiday, where people take time off to be with family and friends. It’s been noted that a lot of homeless shelters are pretty empty at Christmas—it’s the one time of the year many of those folks have someone to take them in. And then there’s the economic holiday—the massive retail rush to clothing stores and grocery stores and—increasingly—online shopping sites. For some retailers, up to a half of all their sales come during the holiday season. No wonder Christmas has become so embedded into our economic landscape.

But have you ever considered the wealth of expertise that sits underneath a Christmas tree? From planning to engineering to manufacturing to distribution, each present is a marvel of cooperation. Just consider the humble Christmas sweater: sheep are raised in some cooler climate, their wool fleeced, spun, and dyed, the sweater designed, knitted, and basted together, then the whole thing marketed and distributed to where it needs to be for a holiday purchase. (Triple the complication if the sweater has flashing lights.) And all this coordinated with no central plan, just a lot of people working together voluntarily.

Public Domain. Source: Wikimedia

Yes, there are Scrooge-like economists who remind us that many people prefer a check to ill-fitting sweaters, and that most toddlers play as much with the boxes that their toys came in as they do with the toys themselves. But gift-giving isn’t so much about the presents as it is about participation in each other’s lives: in our families, our workplaces, and our communities. That may not be very efficient, but there’s a lot more to life than just doing more stuff.

Let’s remember this as we celebrate the holidays. The miracle of the market is that we all benefit from the countless people who know how to do things we don’t. The miracle of this season is that—despite our personal follies—we all have others who care for us.

Merry Christmas to all!

Douglas R. Tengdin, CFA

Chief Investment Officer

The Dangers of Success

The Dangers of Success

What happened to “The Maestro”?

Public Domain. Source: IMF

Alan Greenspan chaired the Federal Reserve from 1987 to 2006. He’s a fascinating character: a mostly self-taught economist, a jazz clarinet player, a policy advisor and skilled political operator. He understood how political power ebbs and flows, and used that understanding to direct Fed policy for almost 30 years—an eternity in Washington.

His greatest success came when he successfully intuited that productivity was growing much faster in the mid-‘90s than initially reported in the economic statistics. That understanding led him to oppose raising interest rates prematurely, potentially killing off what turned out to be a period of exceptional economic growth. This insight is what earned him the moniker “Maestro”—applied in Bob Woodward’s early biography.

Greenspan was a devotee of libertarian philosopher Ayn Rand in his youth, and he retains many of his early libertarian commitments—as do a lot of Republicans. But Greenspan is no free-market ideologue. Indeed, his willingness to use the Fed’s lending, supervisory, and monetary powers to support the financial system during various crises was later called “The Greenspan Put.” This options-market term implied that investors could exercise a “put option” and sell their holdings to the Fed if markets got in trouble.

His legacy has been tainted, though, by the Fed’s actions—or inactions—in the period leading up to the Financial Crisis. Greenspan knew that markets could go off the rails, and he was concerned that home prices were growing too fast as early as 2004. Indeed, the Fed began raising rates in June of that year, despite the fact that unemployment was still up at 5.6%—one percent higher than it is now. The Fed would go on to raise rates at the next 16 consecutive meetings. Some people think the Fed should have been more aggressive in raising rates. But that’s 20-20 hindsight. At the time, most folks thought a gradual increase in rates would be the best way to gradually curb the excesses building up in the economy.

S&P 500 During Alan Greenspan’s tenure as Fed Chair. Source: Bloomberg

Greenspan didn’t oppose aggressive action by the Fed ten years ago because he was opposed to regulation or because he wanted let the market just sort it out. Greenspan knew—better than most folks—that financial instability can pose significant risks to the real economy. He just didn’t have a crystal ball telling him that key funding and securitization markets would collapse in 2008. No one did.

It’s inevitable that someone who dominated a critical institution like the Fed for as long as Greenspan did will be subject to criticism—both fair and unfair—for his actions, or inactions. We just need to be sure we learn the right lessons. Markets—like democracy—may be the worst way to inform policy and allocate assets. Except for all the other ways that have been tried.

Douglas R. Tengdin, CFA

Chief Investment Officer

Warmer Weather Ahead?

Warmer Weather Ahead?

What’s the forecast?

Source: NOAA

The short answer is, no one really knows. There were very few prognosticators that predicted a Trump victory, and even fewer who thought a sweep by the Republicans would lead to a major stock market rally and bond market selloff. But that’s where we find ourselves. Stocks are up in the US in the low teens—almost 10% more than most folks expected a year ago. Interest rates are up modestly. A year ago, many thought the Fed would steadily raise rates. An early market sell-off put them on hold.

The consensus expectation for next year is for continued economic growth and modestly rising markets and interest rates. The prospect of regulatory and tax reform along with some fiscal stimulus means that the Fed is no longer the only game in town. For years people complained that the Fed was single-handedly supporting the economy, but that ultra-low interest rates were distorting incentives. Who thought that a populist real-estate developer would shock the system out of its slow-growth equilibrium? But that’s what seems to have happened.

The market’s consensus for 2017 is for slightly higher growth in the economy, a modest push upwards in interest rates, and for a modest increase in the stock market. I see no major reason to disagree. The mood noted by corporate managers is significantly more upbeat than it was a year ago. There’s optimism, but no big orders yet. Retail sales seem to be in good shape, especially online sales. But a strong dollar, rising interest rates, and modest growth overseas will make it difficult for growth to take off.

S&P 500 over the past 5 years. Source: Bloomberg

Still, the economy — and markets — are full of surprises. In many ways, forecasting the market is like forecasting the weather. There are all kinds of cross-currents and complicating factors. The only thing that is certain is that the outlook will change.

Douglas R. Tengdin, CFA

Chief Investment Officer

Scientific Recruitment

Do we need more science majors?

Photo: Analytical Mechanics Association. Source: NASA

That’s what a lot of people think. And as a science major myself, the husband of a science major, and the father of four science majors, I certainly believe in the utility and importance of studying science in college. It helps young minds develop rigorous, analytical thinking, along with quantitative skills.

But some proposals to provide special encouragement for kids to study science seem misguided, like college-loan forgiveness or different tuition rates for different majors. These will just lead institutions to game the system. Incentives are already out there for all to see: last year’s top-paying majors were systems, aerospace, and chemical engineering. The bottom-paying fields were social work, culinary arts, and family studies.

Sometimes an industry has a potential talent shortage and needs to take action to encourage, recruit, and retain talent. This happened with nuclear power 20 years ago. Nuclear power wasn’t “cool.” It was where Homer Simpson worked, and the workforce was aging. But employers worked with universities, community colleges, unions, and the military to find good workers. Now nuclear engineering majors are also among the highest paid groups.

These kinds of micro-initiatives are much more successful than massive programs. Big plans require rigid rules that people can play with and distort to reclassify cooking into alimentary-engineering. And most of the new money gets eaten up by bureaucratic bloat.

The marketplace knows what skills it needs and pays people accordingly. It’s called supply and demand. That’s the most scientific recruitment tool I know.

Douglas R. Tengdin, CFA

Chief Investment Officer

Passion and Performance

Why is passion so powerful?

German Wright Flyer stamp. Source: Wikipedia

We all know that 113 years ago the Wright Brothers were first to fly an airplane. But did you know that they had a well-financed, expert administrator as a rival? Samuel Pierpont Langley wanted to build the first airplane. He was Secretary of the Smithsonian and taught at Annapolis. He obtained a grant from the War Department and hired engineers, inventors, and a test pilot. What he didn’t understand—like the internal combustion engine—he contracted out. He courted the press and famous writers, like Rudyard Kipling. He conducted his tests close to the corridors of power, in Washington, DC. How could he fail?

But in Dayton, Ohio, Orville and Wilbur were tinkering in their bike shop. Their team didn’t have a lot of credentials. None of them had ever attended college. In fact, neither Wright brother ever received a high school diploma. They didn’t have much money. But they had what money can’t buy: passion.

In 1878 Milton Wright came home with a cork, bamboo, and paper toy. When he tossed it into the air in front of his boys, it flew across the room and fluttered against the ceiling. The brothers were mesmerized. They played with it until it broke, then built their own. They were hooked. A decade or so later they opened their bike shop so they could work together and finance their flying experiments. Neither brother ever married: they were wedded to their work. Wilbur later told reporters that he didn’t have time for both a wife and an airplane.

First flight of Wright Flyer. Photo: John T. Daniels. Source: Library of Congress

In December 1903 the Wright Brothers made the first controlled, powered, and sustained heavier-than-air human flight near Kitty Hawk, North Carolina. To do this, they had to re-envision what was needed to fly. It wasn’t not enough to get the machine into the air; they saw that they needed better controls. By using meticulous wind-tunnel experiments, they figured out how to simultaneously manage the aircraft’s roll, pitch, and yaw. Today, every student pilot has to understand the three axes of flight.

Why did the Wrights get there first? It wasn’t luck. Both teams had motivated, scientific minds. Both teams were talented and worked hard. But for the Orville and Wilbur, human-powered flight wasn’t a hobby or pet project. It was their life. Their passion was infectious, and it inspired others. Their bike shop employee, Charlie Taylor, designed and built an aluminum water-cooled engine to run the Wright Flyer—in just six weeks. Nothing else available was powerful and light enough.

Source: Farnum Street Blog

Have you ever worked on a project you loved? One you were so absorbed with that you didn’t notice the time? You have to remember to eat, you wake up in the middle of the night and scribble notes, you devour everything you can read on the subject. Some of your best ideas come to you while exercising or in the shower. It consumes you. Work doesn’t feel like work, it’s more like scratching an itch—the more you scratch, the more it itches.

Winning teams live, eat, and breathe their products. When Warren Buffett wanted to meet with Chick-fil-A’s executives, they ordered—naturally—Chick-fil-A sandwiches for lunch in their boardroom. Great leaders inspire followers with more than money. Inspired people overcome obstacles and change everything.

Calvin Coolidge once noted that the world was full of educated and talented derelicts. It’s passion—the slogan “Press On!’’—that wins the day.

Douglas R. Tengdin, CFA

Chief Investment Officer

Setting a Higher Standard

How do we raise the bar for ourselves?

Photo: Douglas Tengdin

People face ethical issues every day. How meticulous do I need to be with my records? Could accepting a gift affect my objectivity? How responsible are supervisors for the actions of their subordinates? Most people can agree on a basic moral framework —universal rules like don’t lie, don’t steal, respect everyone, be kind, generous, and fair. But how do we work that out in practice? How can we hold ourselves accountable to do what’s right, not just what’s expedient?

We all have an endless ability to rationalize our own behavior. We justify small compromises, and small things end up becoming big things. That’s the lesson behind fictitious bank accounts at Wells Fargo, the way VW manipulated emissions tests for its diesel cars, and Bernie Madoff’s mammoth Ponzi scheme. All these folks justified their own actions – until they got caught.

That’s why objective standards are so important—like corporate credos, or professional codes. Johnson and Johnson has its credo chiseled in granite outside of the corporate headquarters. It outlines their responsibilities to customers, employees, communities, and shareholders. Their credo established a firm moral compass that helped guide management during the Tylenol crisis 35 years ago. Now J&J is one of the most trusted brands in the world.

Source: Johnson & Johnson

In finance, ethics have to be central to what we do. We’re dealing with other people’s money. The CFA Institute established an ethical code and standards of professional conduct 50 years ago, and has further articulated it over the years. It addresses things like maintaining adequate records for investment recommendations, or disclosing conflicts of interest. Members need to uphold the standards, and supervisors who are members are responsible to see that their staff follow them.

We all face multiple duties: to our profession, to our clients, to our employers, and to our families. A code of ethics isn’t just a theoretical construct; it can be a practical guide to give clear direction when circumstances seem murky. After all, it’s impossible to be objective when you’re personally involved.

And when you’re riding, the best way to raise the standard is to ask someone else to lift the bar.

Douglas R. Tengdin, CFA

Chief Investment Officer