Getting Stung

How do we avoid investment scams?

Poster for The Sting by Richard Amsel. Source: Wikipedia

Investment scams are everywhere. From Ponzi schemes to obscure bank instruments to penny stock pump-and-dump operations, the internet and email seem designed to encourage fraudsters to try to bilk us out of our savings. What are some of the signs that someone is trying to swindle you?

First, check the pitch. What are they appealing to? Is it fear? Greed? Envy? Scam artists usually play to our lower nature. Get-rich-quick schemes appeal to sloth: “Get rich and retire early!” Ponzi schemes offer steady, unsustainable returns—usually in the high double-digits—appealing to greed. Obscure investment instruments give us a window into supposedly secret knowledge—calling on pride. For every human foible, there’s a con that goes with it.

The “Seven Deadly Sins” is a list of vices first compiled in the fourth century, whose sources go back to the Bible and early Greek philosophy. You could run down the list—pride, envy, greed, lust, gluttony, wrath, and sloth—and think of scams associated with each.

Allegorical illustration of the seven deadly sins. Source: Wikipedia

Second, ask yourself, what makes you so special? Why did this investment opportunity come to you? What is your relationship to the investor? This isn’t a sure test; Bernie Madoff knew many of his marks, and stayed in touch with them. But it’s far more likely for us to get bilked by someone we don’t know personally. Con artists know how to present themselves professionally, so we can’t judge a book by its cover—or even the first few pages. Take the time to see what’s inside.

Which brings us to the third test: take some time to examine the opportunity. Good investments—like good investment principles—stick around. Read legal documentation, check references, contact regulatory agencies, and evaluate credentials. Anyone can create a social media profile and put together a slick-looking web site. But it takes a while to establish a track record. Investing isn’t like buying avocados: they’re rarely “available for only a limited-time.”

Finally, examine your personal investment objectives and limitations. Even a legitimate investment vehicle may be inappropriate if it doesn’t fit your needs. For example, there are lots of things that don’t belong in an IRA—the tax treatment and liquidity requirements create specific issues. Similarly, if you need cash from your portfolio, an insurance product—like an annuity—or limited partnership is rarely the way to go.

Investment scams—and the people they target—come in all shapes and sizes. Today’s volatile stock market can be scary. Con artists know this and play to our fears. But there are no secrets in money management. There is no secret club, secret formula, or easy way to wealth. The Book of Proverbs has the final word: “Dishonest money dwindles away; but those who gather money little by little make it grow” (13:11).

Douglas R. Tengdin, CFA

Chief Investment Officer

Relatively Speaking

If everything is so great, why does it feel lousy?

Salvadore Dali: The Persistence of Memory. Source: MOMA

There’s a disconnect in the economy: the statistics generally look pretty good. But if you ask people how they’re doing, you don’t get a lot of positive feedback. There aren’t a lot of layoffs, but people aren’t getting big raises, either. What’s going on?

Part of the answer has to do with the time-lags inherent in the economy. The price of oil started falling almost two years ago, and oil exploration companies immediately started cutting back on their capital spending plans. But it’s taken a while for the extra cash from lower gas prices to find its way into consumer spending. It will get there, eventually. But it’s taken longer than many thought it would.

There’s also the local effect. Our conversations are limited in scope. We simply can’t talk to the millions of people who make a modern economy—people in all different kinds of occupations and walks of life. So our experiences—and those of our friends and families—play a much bigger role in our perceptions. That’s why it’s said that the plural of anecdote is not data.

But another big reason is the “nominal effect.” Economists talk about the real economy—adjusting for inflation. And that makes sense. If your paycheck goes up 2%, but the price of everything goes up by 4%, you aren’t any better off, are you? Economists apply “deflators” to their statistics to get a sense of how many cars, haircuts, and knee replacements we are producing and consuming. And the real level of economic growth has been pretty steady. Not great, but around 2% for the last five years. That’s just a little less than it was for the five years before the financial crisis. And a five year expansion is pretty long, historically.

People don’t buy and sell with inflation-adjusted dollars, though. They use nominal dollars—the ones we’re paid with and put in the bank. And in nominal terms, this has been a lousy time. During the 80’s and 90’s, our nominal economy grew by about 6 ½% during expansions. Even during a downturn, the nominal economy grew by 2%.

But during this latest period we’ve only managed to eek out 3 ½% growth—about half of the last couple expansions, and just above the previously recessionary level. This is part of the “butterfly effect” of global deflation. Falling prices overseas are limiting inflation here. Too many cement kilns in Shandong, China really do impact the animal spirits in Kalamazoo, Michigan. And animal spirits are what lead us to start businesses, invest in disruptive technologies, and pioneer new innovations—the real engines of economic growth.

Nominal GDP. Source: Bloomberg

Still, real effects do matter. Lower inflation for the past two years means that real incomes have been rising—and rising more rapidly in recent months, as the labor market has gotten tighter. The numbers don’t lie—the economy really is getting better.

But like the old Louis Armstrong song, it takes time—and a little animal spirits—to make it happen.

Douglas R. Tengdin, CFA

Chief Investment Officer

Investment Boredom

Are your investments boring?

Photo: Rachel Calamusa. Source: Wikipedia

Investing is often portrayed as exciting: the flashing monitors, microsecond algorithms, people at exchanges shouting at each other and running around. That’s what attracts a lot of people to this business: the adrenaline rush of a winning trade, or the gut-wrenching dread of a plunging market.

But the best investments are often boring affairs. Philip Morris made billions for its investors by successfully manufacturing and marketing cigarettes; Wal-Mart used sophisticated supply-chain management to lower prices to rock-bottom levels; Ray Croc pioneered franchised fast food at McDonalds. These innovations were ground-breaking, but there wasn’t a lot of romance to their ideas. Assembly lines and franchise agreements aren’t typically the stuff of best-seller novels.

Photo: Octavio Lopez. Source: Morguefile

Even so, these companies created hundreds of billions of dollars for investors over several decades. They had to overcome a lot of skepticism along the way, but by satisfying their customers over and over again the companies built brands that thrived through wars and depressions and inflation and financial panic. This value didn’t arrive overnight, though. It took years of engineering trials (and errors), human resource management, and patient, steady leadership.

Investing is like gardening: there’s a time for planning, a time for planting, and a time for harvesting gains. The growth itself may be imperceptible. But a good strategy will let you sleep at night, and will be more productive that you might imagine—if you let it work.

Douglas R. Tengdin, CFA

Chief Investment Officer

Bumps in the Road

There are frost-heaves ahead. Is your portfolio ready?

Photo: Kevin Connors. Source: Morguefile

At this time of year in New Hampshire we have to deal with frost heaves. Rain and melt-water from winter storms seep into the road-bed, then lift the road when the water re-freezes. How we deal with the bumps says a lot about what kind of people we are.

Some folks sail blithely through, figuring that their car’s shocks can handle the stress. That’s fine as long as long as they have a good suspension—and strong stomachs! Some of the bigger bumps can really rattle you. Others slow down, picking their way through, creeping over the biggest heaves. That’s fine as long as you don’t need more momentum later, like when you’re going uphill on a snowy day.

Still others start to cruise moderately through, but they seem to find perfect speed to maximize effect of the bumps. Their vehicles shake more and more violently, until it looks like their cars are skipping and hopping. From behind, you can see them bouncing inside the car. My engineer daughter tells me that they’ve found a resonance frequency that does the maximum damage.

It’s like this in investing. If you see a rough patch ahead, you can just cruise through, riding down and riding back up, if you have the stomach for it—and no loose fillings! Or you can raise cash, lowering your expected return in the short run in exchange for the peace-of-mind that comes from having dry powder. That’s the go-slow approach. But you really don’t want to be shaken around and panic, selling as the market tanks and buying back in after things get more expensive. That’s a sure way to bottom out—or get launched right off the road!

S&P 500 over last 20 years. Source: Bloomberg

Frost heaves present us with bumps in the road—like the squiggles and jiggles of the market. It’s good to know how to deal with them. Because after they subside, it will be time for mud-season.

Douglas R. Tengdin, CFA

Chief Investment Officer

Revising the Limits

Are we seeing the limits to demand?

Copyright: Dennis Meadows. Source: Amazon

Back in the early 1970s, a think-tank called the “Club of Rome” published a little book called the “Limits to Growth.” It used a fairly simple computer model to predict that unless people radically changed the way they lived, we would run out of some of the key resources necessary for modern life. They described our expected population growth-path as “overshoot and collapse.” The book predicted that because we were continually increasing our standard of living and human populations keep growing, we would overshoot the earth’s sustainable carrying capacity—like white-tailed deer on the Kaibab Peninsula.

Needless to say, their predictions didn’t pan out as expected. Technology made it not only cheaper but also easier to produce more goods and services using fewer resources, and population growth slowed dramatically in country after country once industrialization arrived and child mortality fell. People aren’t ungulates overgrazing their feeding grounds. The ultimate natural resource is human creativity—especially when it‘s brought to bear on problems critial to our survival.

Photo: Sgarton. Source: Morguefile

But the predictions seemed to make sense when everything was getting more and more expensive: gas went from 7 cents a gallon to 25 cents, then to $1.50. Houses that cost $5000 to build went to $25,000, then $100,000. Inflation was running in the double digits, and we could see starving masses in China and Biafra on television every night. What we couldn’t see was technology-driven green-revolution crops and integrated microprocessors that would make life radically better for billions of people. Who thought computers would both predict and solve the problems of scarcity?

Now we’re facing new limits: limits to demand. The problem isn’t inflation, it’s deflation. We don’t have too many dollars chasing too few goods, we have too few dollars and too many goods. We don’t have too little computing power, now we all have an Apollo 11 computer in our back pockets, tied to a networked database with the world’s knowledge available with one spoken search string. And lots of cat videos.

CRB Commodity Index. Source: Bloomberg

In the ‘70s Keynesian economists tried to fine-tune demand when demand was rising and supply was stagnant. The result was too much demand and too little supply—a recipe for accelerating inflation. Since then a global supply-side revolution has created an age of over-abundance where resource deflation threatens the financial economy that made all this production possible in the first place. The result is falling demand and increasing supply.

35 years ago I actually worked and studied with two of the authors of “Limits to Growth,” Dana and Dennis Meadows. But today we’re not seeing limits to growth. Rather, it’s the limits of growth.

Douglas R. Tengdin, CFA

Chief Investment Officer

Father of the Financial Crisis?

Did David Bowie help cause the financial crisis?

Photo: Adam Bielawski. Source: Wikipedia

Among the many tributes to musician David Bowie last month after he died was a description of “Bowie Bonds.” These were asset-backed securities issued in 1997 that securitized royalty payments from 25 different albums. Bowie was concerned that the rise of digital music would impinge on music sales, so he “pre-collected” his royalties by using them to secure these bonds.

The bonds paid almost 8% interest—about 1 ½% more than Treasuries at the time. They were an early example of unconventional asset-backed bonds. After they were issued, other novel securities followed. Bonds were secured by all kinds of things: equipment receivables, loans to auto dealers, lottery winnings, even mortgages at 125% loan-to-value. These latest bonds were initially considered lower risk than conventional loans, because they were less likely to be paid off early. In the ‘90s, people were more worried about prepayment risk than credit risk.

By paving the way for eccentric financial instruments, Bowie may have unwittingly contributed to the financial crisis that came a decade or so later. For a long time, analysts were convinced that the security structure around asset-backed bonds was air tight—that it would be almost impossible for these bonds to suffer credit losses. So bankers got more imaginative, eventually issuing sub-prime mortgage loans, Collateralized Debt Obligations (CDOs) secured by the loans, and bonds secured by the CDO payments themselves (CDOs-squared). All this exotic finance ultimately made cut-rate mortgages more available and fueled the housing bubble. When that bubble burst, it brought these structures down with it. Many of these bizarre financial instruments were featured in “The Big Short,” the hit movie about the financial crisis.

Photo: Chelle. Source: Morguefile

David Bowie was an artistic visionary who pioneered electronic music and other genres who also worked as an actor and record producer. He was an active performer for over five decades. Given how prevalent securitization has become, it seems likely that if he hadn’t issued his “Bowie Bonds,” someone else would have pioneered the concept. Still, it’s interesting to consider that Ziggy Stardust might have helped crash the housing market.

Douglas R. Tengdin, CFA

Chief Investment Officer

Driving, Putting, and Asset Allocation

“Drive for show, putt for dough.”



Bob Hope putting in the Oval Office. Photo: Oliver Atkins. Source: National Archives.

That’s an old golf saying – attributed to Bobby Locke, the South African golfer dominant in the ‘40s and ‘50s. He won the British Open four times in eight years. He was so good that he was banned from the PGA Tour. He didn’t drive the ball very far from the tee, but on the putting greens he was a genius. He had an unorthodox style that put a tremendous amount of overspin on the ball, and he had a great eye for reading breaks.

Putting isn’t very flashy or photogenic. It doesn’t generate those iconic images of golfers with a club over the shoulder, staring down the fairway. But skill on the greens can take a lot of strokes off your score. After all, on an average golf course you use your driver 14 times or so, and your putter 30 or 40 times.

In investment management, there’s a similar expression: forecasts are for show, investment policy and asset allocation are for dough. It’s exciting to talk about what the market is doing, what the next challenge is for the economy, what Washington might or might not do with tax policy. Forecasts get featured on in the papers and on financial news shows. It’s wonky to get into earnings and revenue projections for the entire market and for individual securities.

But it’s in the nitty-gritty of investment policy and financial planning that the real money is made. What’s the money for? Could we tolerate a 50% downturn? How quickly will we need to use these funds? These kinds of questions don’t make headlines, but they’re the real money-makers for individuals and institutions putting cash to work in the markets. It’s been estimated that asset allocation is responsible for 70% to 90% of the variation in investment portfolio performance.

Source: Wikipedia

So don’t get freaked out by the latest news about North Dakota’s budget problems or Chinese industrial production or some mega-store’s earnings-per-share. These things are interesting, but what really counts how our investments fit into our lives—or our organization’s income and expenses. In other words, what our investment policy is. That’s the simplest way to take “strokes off the game” in finance.

Because it doesn’t matter that much how far you drive off the first tee. It’s the final score that counts.

Douglas R. Tengdin, CFA

Chief Investment Officer

Did Atlas Shrug?

What’s holding the market up?

Atlas in the Naples Archeological Museum. Source: Wikipedia

It’s not what it used to be. From 2012 to 2015, the market was led by Apple, Microsoft, Google, Wells Fargo, and Gilead. Those five mega-cap stocks accounted for over 10% of the market’s 58% move. But since July, things have changed. Microsoft and Google have continued to rise, while Apple, Wells, and Gilead have led stocks downward. Some of this is normal profit-taking. After all, trees don’t grow straight to heaven. It makes sense that people would lock in some of their gains. Apple was up 68%; Gilead was up over 200%. And there are fundamental concerns about how much more a giant company like Apple can grow when they already sell $230 billion in devices every year—more than the economies of half of the States in the US.

But part of what’s happening is a shift in leadership. The rally was dominated by tech stocks and banks, along with some big drug companies. Since that time, conservative companies like consumer staples, telecoms, and utilities have supported the market—firms like Wal-Mart, Verizon and Proctor & Gamble. If the economy is slowing, goes the thinking, then it’s best to invest in places where people will still spend no matter what happens.

Did you notice what’s missing from this discussion? Oil companies. They’ve been volatile lately, but not the market leaders everyone assumes. During the rally, giants like Exxon and Chevron didn’t move very much. While many describe the energy market of a couple years ago as an “oil-bubble,” these firms were consistently priced below the market’s valuation ratios.

S&P 500 weekly chart. Source: Bloomberg

This is helpful when you consider that what’s in the news isn’t necessarily what’s driving the market. We live in a dynamic, fluid economy where different factors dominate at different times, and what’s up one period could stall out, or could continue. The trend is your friend until it ends. Still, if market leadership is shifting to more conservative companies, this could indicate that it’s time to consolidate some of your gains.

Just don’t panic. Bob Dylan wrote that “the times, they are a’changin’.” But they don’t necessarily change that fast.

Douglas R. Tengdin, CFA

Chief Investment Officer

Banking on Trouble?

What’s wrong with the banks?

Photo: IvoShandor. Source: Wikipedia

So far this year, equities are down about 10%. Shares of financial firms have led the way, down about 15%. And longer term, bank stocks still haven’t recovered from their losses during the financial crisis. What’s wrong with them?

You could throw up your hands and attribute it to random price action, but that doesn’t make sense. Even though they’re hard to predict, there’s still some semblance of rationality to stock prices. When oil prices plunged, the energy sector fell at the same time. When that same drop in oil prices put more money into consumers’ pockets, consumer stocks rallied. So what’s the market telling us about the financial sector?

Some worry about the strong dollar and a weakening corporate profit picture, but that affects mostly exporters, who fund themselves in the capital markets, not via the banks. Others point to the increased regulatory burden caused by Dodd Frank and other post-crisis regulations, but those have been with us for a while. My bet is that global deflationary fears are infecting the financial sector. Deflation is like kryptonite for banks. Even a whiff weakens them. And it makes sense: banks are levered institutions. When the assets that secure their loans go down in price, those assets are more risky. A higher risk-premium is going to depress the value of bank shares.

Source: Financial Times

That’s why both stock and bond prices have fallen lately for banks around the world. The global economy isn’t necessarily headed for a recession, but it’s a risky place. Bankers could do everything right—control their credit risk, make sure they’re operationally tight, know their customers—and still hear politicians and regulators calling for Congress to break them up. Too big to fail is too big, they say. And banks are bigger now than they were in 2007, before the crisis.

That’s what’s weighing on banks. Just remember: banks are leveraged. They magnify the downside of things, but when the world doesn’t end, they have a way of roaring back.

Douglas R. Tengdin, CFA

Chief Investment Officer

Wagging the Dog

Wagging the Dog

Where does finance fit into the economy?

Photo: David Whelan. Source: Morguefile

Time was that the real economy was considered the dog and the financial economy the tail. Except for an occasional bubble, the tail didn’t wag the dog. What people ate and how they dressed was critical; how the saved and where they invested wasn’t. Now it’s not so clear.

The world produced about $80 trillion in goods and services in 2015. At the same time, public and private markets were worth over $250 trillion–more than 3 times global GDP. And this doesn’t even consider the $640 trillion in swap contracts outstanding. Even if you allow for some overlap—levered banks that own public debt, etc.—that’s a lot of money! Without a doubt, what goes on in the market affects the real economy.

This wasn’t always so clear. In 1955 future Nobel laureate Harry Markowitz almost didn’t receive his Ph.D. because his ground-breaking work on portfolio selection wasn’t considered an economic topic. His insight didn’t fit into the categories of the time. How could finance be considered part of economics?

How much the world has changed! Today, if there’s a cash-flow, we securitize it. If someone discovers a new gene, they patent it and go public. We live in a financial age.

It’s another reason that the Fed needs to consider global deflation in their deliberations. Because whether the tail wags the dog or the dog the tail, if the pooch is shaking, someone had better take note.

Douglas R. Tengdin, CFA

Chief Investment Officer