Fed To Markets: Never Mind

Fed To Markets: Never Mind

Photo: NBC Television. Source: Wikipedia

When I read the latest policy statement coming out of the Fed on Wednesday, I was reminded of how the character Emily Litella from Saturday Night Live would always close our her commentary: “Never mind.”

This is a critical time for the Fed. Their very legitimacy has been called into question. So they’ve been trying to guide the markets, to make sure we aren’t blindsided by a sudden action. Some Fed Ph.D. must have concluded that market volatility is associated with restrictive financial conditions. As a result, they’ve concluded that when it comes to monetary policy, the best surprise is no surprise.

But all this guidance is guiding us in different directions. Last summer they steadily prepared us for a rate liftoff. Then China’s market moves scared them, and they guided rates lower. Then employment growth picked up in the fall, and they guided rates higher, actually achieving liftoff in December. Stanley Fischer got excited, and told the markets that four rate hikes in 2016 was “in the ballpark.”

Source: Bloomberg

Now we’re right back where we started from. This time, the drop in oil prices scared the Fed, so they shaded the language in their statement. They said that household spending is moderate, not improving. They took out their “balanced” view of the risks to the economic outlook. And they added that they will watch the data and global markets closely.

Well, of course the Fed watches the markets and the data. This is news? What’s news is they’re telling us. What’s news is Mr. Fischer had to backpedal. What’s news is the Fed is guiding us lower again. Watching the Fed these days is like watching the surf when there’s been a storm offshore: some waves are big, some are little. It’s hard to tell what’s coming next.

For the past five years the Fed has been too optimistic about the economy. We’re stuck in a slow-growth, low-inflation cycle, where oversupply keeps the price of everything down. It’s clear that they’ve been “talking their book,” trying to be optimistic. After all, if we all get a little more optimistic, we’ll all spend more, right? Only it doesn’t work that way. We only spend more when we earn more.

If the Fed wants to reduce market volatility, they should be more consistent in their communication. But sometimes the best way to communicate is to stop talking.

Douglas R. Tengdin, CFA

Chief Investment Officer

Outcomes and Incomes

Incomes and Outcomes

Are you interested in scoring? Or winning?

Photo: Gabor. Source: Morguefile

Traditionally, companies are organized around their products. Proctor and Gamble sell shampoo; GM builds cars; Disney makes movies. But what people really want is to get a job done. They don’t want a car as much as they want transportation; they don’t want to make a phone call, they want to communicate. Understanding the difference can be life-changing.

20 year ago Cordis Corporation was a bit player in angioplasty devices. Those are the small balloons doctors thread into the heart to clear blockages and avoid a heart attack. But customers didn’t want angioplasty. They wanted healthy hearts. So Cordis talked to doctors, nurses, patients, and administrators to see how they could do things better.

The result wasn’t just incremental improvement, it was a totally new product. In their conversations, Cordis found that the biggest problem was that the blockages would come back. So they redesigned their device, eventually introducing stents as a way to keep the coronary arteries clear. They saw their market share grow from 1% to nearly 10% in the US, and a few years later, Johnson and Johnson acquired them.

Cordis Stock Price. Source: Bloomberg

Outcome-driven investing should follow the same approach. What does the client want? Income? How much income? How much growth? Typically, investors compared their portfolios to the S&P 500 or some other index to see how they’ve done. But that can be misleading. Beating the index is cold comfort if you need to earn a 4% income stream and the index only yields 2%. Conversely, if the investor’s goal is to double size of the portfolio over the next 10 years, generating current income isn’t a priority. Too often, we focus on the product or the process, rather than the ultimate objective.

An outcome-orientation can help you get away from the day-to-day ups and downs of the market’s latest obsession with Chinese industrial production or European Central Bank policy. What matters is what’s important to you, not some random fact about someplace you’ve never heard of.

In sports, the objective isn’t to score points, it’s to win. There’s a difference. With investing, the goal isn’t necessarily to earn more, it’s for your money to help you to live the life you choose. It’s our choices that really define who we are.

Douglas R. Tengdin, CFA

Chief Investment Officer

Show Us The Money

Why don’t people trust bankers?

Source: Gallup

In a survey of how people rate the honesty of folks in different lines of work, medical professionals came out on top; members of Congress and car dealers were on the bottom. Bankers, lawyers, and journalists were pretty much in the middle. Confidence in financial professionals took a big hit after the latest financial crisis and Madoff scandal, as it did after the S&L crisis of the early ‘90s.

Few people have experienced real losses when it comes to banking—as opposed to investing in the stock market. (Stockbrokers—as opposed to bankers—have a very low approval rating.) So their low opinion of bankers isn’t based on experience. Rather, it’s a matter of their public profile. But the professions that are rated highest—doctors, teachers, clergy—are ones where we remember a positive experience. Conversely, the lowest-rated jobs are ones where people have been personally swindled. Maybe we were laid off by an incoming business executive who then collected a fat bonus. Or that fancy car I just bought turned out to be a lemon.

Bob Hope once quipped that a bank is a place that will lend you money–if you can prove you don’t need it. Money may be a necessary evil, but we need to trust those who keep our cash. For people to trust a profession, they have to benefit personally. For bankers and finance professionals to improve their public image, it has to be more about the client, and less about the money.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Fourth Industrial Revolution

Are we in the midst of a new industrial revolution—a wave of creative destruction?

Photo: K.Connors. Source: Morguefile

Beyond the daily blather about oil prices, China, quarterly earnings, and Presidential politics, new technologies are changing the way we live, work, and relate. It’s impossible to walk down the street without seeing over half the people staring at their smart-phones. “Walking-while-texting” is a major safety hazard. Some have called this the fourth industrial revolution.

The first industrial revolution was based on steam power, the second on electricity, the third on computers, and now this one on robotics and mobile computing. It has the potential to dramatically boost global productivity. Disruptive technologies combined with changes in our everyday lives are what’s behind the eye-popping valuations of Netflix, Amazon, and private companies like Uber and other unicorns.

But we need to remember that it took decades for steam power, electricity, or PCs to affect how people live and work. Investors need to be patient. And we need to understand that new ways of providing goods and services often kill off old industries before the full benefits of the new technologies are realized. This is why political revolution often follows technological change. Think of France, Russia, and the many colonial independence movements of the 20th century.

Cyberpunk author William Ford Gibson says that the future is here, it’s just not evenly distributed. We don’t know who the winners and losers will be. But we do know that a tsunami is coming.

Douglas R. Tengdin, CFA

Chief Investment Officer

Standing on Principals

Do we have too many principals?

Principal-Agent Illustration. Source: Wikipedia.

40 years ago we didn’t. That’s when several researchers described the “agency problem,” where principals own the assets, but agents make the decisions. This can lead to conflicts, like when executives decide commercial air travel is too inconvenient, so they buy a corporate jet instead. Who decides whether the jet is a productivity tool or a luxury?

When executives use corporate resources for cushy perks, it’s bad for shareholders and bad for the economy. So firms designed compensation structures that aligned the interests of shareholders and managers—the principals and the agents: options, restricted stock, and other benchmarks. Under this theory, executives would do well when the shareholders did well.

But it hasn’t worked out that way. Companies perform in the real market, but equities go up and down in an expectations market. The market expects so many earnings, so much revenue, such-and-such cash flow. If these expectations aren’t met, share prices fall. This can create perverse incentives. For example, when new CEOs are hired, it’s in their interest to lower expectations, diminishing the firm’s prospects. That way, when options are struck, the bar is set a lot lower. It’s easier to outperform and make more money. Conversely, when executives are about to retire, it’s in their interest to talk up the shares—improving their payout—irrespective of the underlying reality.

Photo: Lisa Runnels. Source: Morguefile

And company managers may engage in more than just talk. Channel-stuffing—where sales are inflated by forcing inventory through a distribution channel—is common when sales don’t meet expectations. Software firms, drug companies, even doughnut shops have been known to inflate their sales numbers in this way. An investor was once at the loading dock of a consumer products company on September 30th, and asked the dock foreman during his lunch break how the quarter had gone. The foreman responded that he didn’t know, the day was only half over.

Regulators have tried to prohibit accounting tricks that allow executives to manipulate earnings, but this is a whack-a-mole exercise. As fast as one loopholes is closed, another is created. Eventually the accounting rules become so Byzantine that they distort financial reporting by their very complexity. By several measures, stock-based compensation has had little or no net benefit to shareholders over the long run.

The solution is to provide incentives based on real-world performance. These don’t have to be complex: just earnings, sales, and market share. Let the investors invest. And encourage managers to manage.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Impossible Trinity

The Impossible Trinity

Is China attempting the impossible?

Temple of Heaven. Source: Photo Everywhere

This week the Chinese monetary authorities announced that they were dropping their Dollar peg. Instead, they want to tie their currency to a basket of global currencies—presumably the Euro and Yen. Good luck with that.

Currency pegs work until they don’t. The Dollar peg worked for the Chinese as long as the Dollar was falling. But the greenback started rising against the Euro and the Yen in 2011, and really took off when oil started to fall in 2014. Whatever the Chinese economy gained from falling oil prices they lost from a higher currency. So now they want to use a currency basket—in effect, devaluing the Yuan.

This won’t help. You can’t have a fixed exchange rate, free capital flows, and an independent monetary policy. Economists call this the “impossible trinity.” You can only have two of the three. Fixing the exchange rate too high or too low creates massive capital flows that overwhelm monetary policy. Giving up a sovereign monetary policy ties an economy to its more prosperous neighbor. That’s what the Euro-zone is—a fixed exchange rate among the its members, with monetary policy set by the Germans. This also creates regional pressures within Europe.

Impossible Trinity. Source: Wikipedia

The Chinese authorities are trying to shift their economy from being export-led to a consumer-led, service-oriented mix, and they’ve made tremendous progress. But everything takes time. The stronger Dollar—and stronger Yuan—are crimping China’s exports to Europe and Japan just as they shift to an inherently slower growth rate. But a basket won’t fix this. Only a free-floating currency can allow a country to balance the competing pressures of capital and trade flows. But the Chinese don’t think they’re ready for this.

This is what happened in 1998 with the Asian Contagion. Stability creates instability. Expect more volatility.

Douglas R. Tengdin, CFA

Chief Investment Officer

Five Year Old Finance

Five-Year Old Finance

Can we learn about finance from toddlers?

Photo: Dedulo Photos. Source: Morguefile

In 1972 a Stanford psychologist studied self-control in youngsters. He put a marshmallow in front of a child and told the kids that if they could wait 15 minutes, they could have two. Of the 600 children in the study, about a third were able to earn the second marshmallow. In two follow-up studies, those who waited had significantly better results in school and higher test scores, even decades later.

Self-control matters in life. It matters with investments, and it matters with public policy. If you can get past the latest headline screaming sell or buy and lean against the wind to rebalance, you’ll end up buying low and selling high. A case in point is what has happened in with investments over the past 20 years: since 1996 the stock market has returned 8.2% per year—with some pretty significant downturns–while bonds have returned about 5.4%. But if we rebalanced out of stocks when they made up too much of our portfolios, and out of bonds when they were overweight, we would have had a lot fewer headaches along the way.

Source: Bloomberg

Looking at our economy, it’s clear that we needs job. But one of the best ways for the government to help create jobs is by establishing the legal and intellectual infrastructure for productive, sustainable employment, like the Bayh-Dole Act of 1980 which gave universities legal title to their own research, even if it was funded with government money. Such “table-setting” efforts create sustainable businesses, but they take a lot more time than fixing bridges or laying cable.

If we can show the self-control of a 5-year old, we can strengthen our economy and build portfolios that will enrich us over the long term. But if we go for the short term fix, all we’re left with will be a sugar rush and the certain knowledge that we could have done better.

Douglas R. Tengdin, CFA

Chief Investment Officer

Going Really Negative

We’ve seen negative interest rates. Are negative prices next?

Negative 2-year European Government Interest Rates. Source: Bloomberg

In Europe, the central bank charges members to leave deposits on reserve. That, and the central bank’s policy of purchasing government debt, has driven short-term interest rates into negative territory. Negative interest rates make a lot of economic and finance theories blow up, but their major effect is to push banks to lend more. In some European countries, consumers can even see their mortgage rates go negative.

As bizarre as negative interest rates seem, negative prices appear even more strange. That’s where a merchant pays you to take their goods. I’ve seen this from time to time—when I used to clip coupons to go grocery shopping. Sometimes, by combining a double-coupon with a store discount, the price for an individual item would be negative.

Well, this sort of discounting has gotten into the oil patch. As you may know, there are many different types of crude oil, and they sell for different prices. They vary by how thick they are, and their sulfur content, and where they’re produced. High-sulfur oil is considered “sour,” while low-sulfur oil is “sweet.” In North Dakota, most of their oil is sweet. But some of their production is sour. Sour oil needs special refining methods to turn it into a useful product. Because North Dakota doesn’t have a lot of pipeline capacity, some refiners are paying—and producers are accepting—negative prices to take that crude off the producers’ hands. So the producers have to pay the refiners to take their product.

Varying Crude Oil Grades. Source: EIA

Obviously, that kind of product won’t be pumped for very long—there’s no incentive for producers to look specifically for and extract more North Dakota sour. But if this type of oil is an unavoidable by-product of an otherwise profitable oil field, it may be considered one more cost of production, and get priced in, like other costs—like labor and equipment.

In microcosm, this is what’s ailing the capital markets right now. The oversupply created by the massive restructuring of the Chinese economy has generated massive surpluses in all sorts of industrial commodities—from oil, to copper, to zinc, to scrap steel. They’re about 10% of the global economy, but—until recently—they consumed half of the world’s commodities. A modern, service-oriented economy doesn’t need all that productive capacity.

This oversupply threatens the profitability of other producers around the world. Negative price shocks mean that oil fields and copper mines that used to be viable are no longer so. But—temporarily—there are incentives for existing producers to dump their product on the market, to try to hang on until other producers go under and prices get back to a sustainable level.

In the meantime, consumers enjoy a windfall of lower prices—and sometimes even negative prices. Eventually, consumption will increase, production will decrease, and the situation will get closer to “normal.” The laws of supply and demand cannot be repealed. But for the moment, we can enjoy the prospect of banks paying us to take loans, and service stations paying us to fill up our tanks. Fill up!

Douglas R. Tengdin, CFA

Chief Investment Officer

[negative rates, China, oversupply, oil prices]

Irrational Political Economy

Are voters rational?

Direct Democracy in Switzerland. Source: Wikipedia.

It’s primary season in my home in New Hampshire right now, and it’s impossible to get through dinner without receiving a phone call from a political polling organization. Every candidate is trying to get a feel for the state, where our opinions and moods lie, and what we think is important.

Some see this whole process as irrational, a leftover artifact of a bygone era, where uninformed voters select self-interested politicians who manipulate and deceive their constituents into favoring policies that allow the pols to dish out favors to big donors. By this view, the process is inherently corrupt. But if our system were so deeply flawed, how has it managed to adapt and persist for almost 230 years, through invasion and civil war and global strife?

Some would say that we’ve never seen these sorts of trials before—global deflation, geopolitical chaos, and a complex economic system. By this reckoning, disaster is just around the corner. But that’s akin to saying it’s different this time. And it’s hard to see that our current problems are greater than those of the Depression or Civil War or the political corruption of the Robber Baron era. How did we manage to survive those crises?

The answer lies in the adaptability of our system. Having three co-equal branches of government—with varying levels of accountability and interest—allows us to change, gradually, as our circumstances and challenges change. At the same time, there was a certain genius to the founding era—a center of white-hot political energy that was ready to try something new: the “American Experiment.” Something awakened in the minds and spirits of the people then that changed the way the world thinks.

Growth of democracy over time. Source: Wikipedia

So I’m glad to take the calls and tell the pollsters—or robo-pollsters—what I’m thinking. I’m following the horse-race like everyone, but I won’t move to Canada or Ireland if my preferred candidate loses. It’s easy to find faults with the system. As Winston Churchill said, democracy is the worst form of government, except all those other forms that have been tried.

Douglas R. Tengdin, CFA

Chief Investment Officer

Ecologists and Engineers

Are you an ecologist or an engineer?

Source: Wikipedia

An ecologist looks at a river or mountain or a forest and says, “What a fascinating community. How do all the creatures and systems interact?” An engineer looks at the same vista and thinks, “We can build a bridge here. We could improve the river’s flow, or make the conditions less harsh.” Engineering and ecology aren’t so much opposed, as they look at the world in totally different ways.

America was built by engineers—men and women who saw a vast, undeveloped landscape with virtually limitless potential. Thomas Paine wrote, “We have it in our power to begin the world over again” (Common Sense, 1776). Farmers engineered the prairies into wheat-fields; loggers engineered the forests into lumber; we build roads and bridges and dams and sent electricity to every corner of the country.

But the continenet was explored first by ecologists, who wanted to know how everything fit together. The Lewis and Clark expedition was one of scientific study as well as an attempt to find a land route to the Pacific Ocean. Ecologists try to understand how systems grow and develop and fit together over time.

Lewis and Clark, by Charles Russell. Source: Wikipedia

It seems that in economics we have ecologists and engineers—ecologists who want to observe and comprehend how the banking system or market structure or transportation infrastructure work to facilitate economic growth, and engineers who see market failure or predatory pricing or asymmetric information and want to help them work better. Personally, my family is filled with engineers—but I studied ecology in school, and I think it’s often possible to over-engineer things. G.K. Chesterton once noted that just because you don’t see why a fence should be somewhere doesn’t mean it’s a good idea to pull it down.

The markets are deeply complex systems, with market-makers, brokers, and investors all transacting to get their own jobs done. We all interact with the market in many different ways. But it’s not enough just to understand how things work. We also need to fix them, when they’re broken.

Douglas R. Tengdin, CFA

Chief Investment Officer