Wrong-Footed

How did so many folks get it wrong?

Source: Morguefile

The Brexit vote reminds me of the comment that came from a New Yorker writer who was shocked by the 1972 landslide re-election of President Nixon. “I only know one person who voted for him,” she noted.

There was a lot of insularity and wishful thinking in the analysis of and reaction to the Brexit vote. Folks who live in cosmopolitan London—where most of the British press is located—favored Remain. And why not? They vacation in France, get nannies from Hungary, and drink duty-free Italian wine. The no-borders free-trade Eurozone is working pretty well for them. Why wouldn’t everyone want it to keep going?

In theory, we all live in a perfect market for information. We ought not to be surprised by any emerging trend. All we have to do is pull up Google Trends to see what’s hot. But we tend to select—and friend and follow—folks we agree with. We’re more comfortable with them. Call it tribal thinking, or the Big Sort, or whatever you want. We block out information that threatens our prior assumptions about the world.

Source: Google Trends

The Brexit race was tight. All the polls showed that. But the Scottish independence referendum in 2014 polled tightly, and undecided voters broke decidedly in favor of the status quo. So on the day of the Brexit vote, stocks around the world rallied on the expectation that this vote would go the same way—towards Remain, which represented the status quo. And most market-makers in London wanted Remain to win. It was hard to find a financial analyst from the UK who thought Leave was a good idea. When Leave won, markets got caught leaning the wrong way. That’s one reason why the market’s reaction on Friday was so sharp.

“The wish is father to the thought,” Shakespeare wrote. Wanting something to be true won’t make it true. We need to be sure we test counterfactuals and seek out contrary opinions. The future is uncertain. Be sure you don’t invest yourself emotionally when you invest your money.

Douglas R. Tengdin, CFA

Chief Investment Officer

Discounts and Discount Rates

Are equities cheap or expensive?

Photo: Joe Zlomak. Source: Morguefile

Earlier this year we discussed what goes into determining the fair value of a stock. It’s sum of all the future cash flows, discounted to present value.

The lower the discount rate used to calculate present value, the higher the present value. That’s why it’s called a discount rate. If the discount rate is 5%, then a dollar a year into the future is worth 95 cents today. If the discount rate is 2%, that same dollar is worth 98 cents. The same company with the same earning power can be worth more – can have a higher “fair” value – if interest rates are lower.

That’s the problem with historical comparisons. Compared with history, the stock market seems a little expensive.

50-year history of S&P 500 and its PE ratio. White-S&P(log scale); Green-PE; Yellow-Avg PE

Source: Bloomberg

Calculated on a trailing 4-quarter basis, the S&P 500 has a price-earnings ratio of about 18.8 right now. The 50-year average PE (covering bubbles, panics, inflation, and deflation) is 16.5. So its PE is about 15% above its long-term average. But interest rates are way below average.

10-year Constant Maturity Treasury. Source: Fed, Bloomberg

The average yield on 10-year US Treasury Notes has been 6.5%. Currently, they yield around 1.8%–70% below average. If you want to compare the market’s valuation to its historical average, you should also compare the inputs—and the discount rate is a major input—in your valuation model to their historical average. That’s why PEs were in the single digits for so long in the late ‘70s and early ‘80s. Interest rates were really high.

Now, I’m not going to get uber-bullish and say that the market is massively cheap. Adjusting PE ratios to current yields is tricky. Low yields now also reflect our slow-growth economy. But if the economy keeps growing, and rates stay low, and we don’t get into a shooting war or a trade war or have some other kind of crisis, the stock market looks like it’s fairly valued.

Douglas R. Tengdin, CFA

Chief Investment Officer

“With or Without You”?

Now what?

U2 Performing “With or Without You.” Source: Wikipedia

The short answer is, volatility will increase. But it doesn’t take the deductive powers of Sherlock or Mycroft Holmes to figure that one out. It’s cold comfort to investors who have lost money to know that most other investors did as well. And comments about this taking us back to the days of the Maastricht Treaty of 1992 aren’t helpful. This isn’t 1992, and Brexit isn’t taking us back there.

But the “lookback” commentary has a point. Brexit represents a break in 70 years of European integration. Since World War II, European nations have been moving closer, driven by a commitment to never experience such a huge global cataclysm again. The UK has always been ambivalent about this project, in part because for them, World War II is a point of pride. It was “their finest hour,” and popular culture still make reference to a greatest generation that won the war.

The EU Treaties. Source: Wikipedia

Brexit is part of a deglobalization trend that has been growing since the Financial Crisis. In hindsight, the Crisis will be seen as the last time the global community came together to solve a common problem. Central banks and national leaders coordinated monetary and fiscal stimulus and support for systemically important institutions. There was great resentment, however, that a real-estate boom and bust in the US should lead to a global economic downturn.

In April 2009 Bill Gross—then at PIMCO—suggested that looking forward, deglobalization would become increasingly important. He expected that the future would be characterized by more trade barriers, financial mercantilism, and government support for local companies. He could add to this list “nationalist populism”: a desire by everyday citizens to take their countries back from a supranational, cosmopolitan elite—the folks who gave us the Financial Crisis, then profited from the subsequent bailouts.

It’s my flag too and I want it back.” Lyrics from ‘Roots’ by Show of Hands. Photo: Brian Marks. Source: Wikipedia.

The UK’s referendum is part of this deglobalizing trend. Concern about immigration and an economy that leaves a good part of its population behind has crystalized behind a desire to use local money used for local purposes. For example, the “Leave” campaign argued that their EU dues could be re-directed to support Britain’s National Health Service.

Brexit doesn’t enact any law. That will require an act of Parliament. The 1972 European Communities Act hitherto ensured that the UK would automatically incorporate EU directives into law, establishing the priority of EU law where it contradicts British law. This was a key part of the sovereignty argument behind Brexit. This law will have to be replaced.

Brexit will not stop Britain from trading with the rest of Europe or the world. But it represents a break with the past, and it raises the specter of more referendums in other countries—notably France, which is truly at the heart of Europe. In 1992 France narrowly supported the Maastrict Treat with just 51% of its people in favor. Opponents included the French Communist Party and the far-right National Front—similar to the left-right opponents to global trade in the US. In 2005, France and Holland both voted overwhelmingly against adopting the EU Constitution.

So get ready for some significant swings in stock and bond markets around the world. There will be risk-off days when bonds and gold rise, and risk-on days when stocks and high-yield debt rally. Volatility will increase, although not to the levels of 2008 and 2009. Bonds issued by peripheral European countries will sell off, as they are not borrowing in their own currency—they can’t just print money to pay them off. The ECB has said they will do “whatever it takes” to hold the Eurozone together. We’ll soon see if they have what it takes.

At times like this, it makes sense to take some time and resist making any rushed investment decisions. The current market sell-off may represent a buying opportunity in equities, especially in the short term. We want to be greedy when others are fearful, and there’s a lot of fear in the market right now. Longer term, however, the future is murky. Brexit has the potential to change the world. Right now, though, it’s unclear precisely how.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Few Quick Thoughts …

In no particular order:

Source: Econlib

Scottish independence: the conventional wisdom is that Scotland will now have a referendum and vote to leave the UK and re-join the EU—even the Euro-zone. This will be messy. During the last Scottish independence vote, they wanted to immediately adopt the Euro, but Brussels said the Scots would have to apply like any other nation—a process that would take years. A new independence referendum must be authorized by the British—not Scottish—Parliament. They’re going to be pretty busy. I don’t think we will see an independent Scotland anytime soon.

European Euroscepticism: the Brexit vote strengthens the hands of those who want to see “Frexit” in France, “Nexit” in Holland, Czexit, and so on. Demands for referenda around Europe will only go up. The combination of economic stagnation at home and radical Jihadism coming from the Middle East feeds a nationalistic xenophobia that is anti-trade and anti-capital.

Interest Rates: the 10-year UK Treasury Note now yields less than 1%–down from over 2% at the end of last year. Interest rate cuts and quantitative easing from the British central bank are now likely. This—along with a falling Pound—will support the UK economy. It may stumble—after all, everyone’s going to pull in their horns a bit here—but their economy won’t fall off a cliff.

Takebacks: there are reports of people who want a Brexity do-over, who voted thinking that their “Leave” vote would lose, who just wanted to send a message. So many UK voters have signed a petition on the House of Commons website for another vote. But unless the petition gains more signatures than there were “Leave” votes—17 million—there will be no second referendum.

Silver linings: it’s possible the Brexit vote will lead to a growth in free commerce between the UK and the US, Canada, Australia, and New Zealand. The EU is statist and anti-democratic, after all. But if the forces that won Brexit did so by appealing to anti-trade sentiment, a pro-trade outcome seems unlikely. Ditto for a de-regulated City of London attracting more global banking. That’s whistling past the graveyard. “Leave” means leave.

Lehman: is this a “Lehman moment”—comparable the Lehman bankruptcy during the Financial Crisis? Like Lehman, it caught most people by surprise. Like Lehman, it was part of a larger trend. And like Lehman, there are broad implications, many most of which we don’t understand, yet. But unlike Lehman, this won’t take down the banking system. A referendum is a vote, and requires enacting legislation to implement any changes. This will take time. There is no web of short-term debt to cause a cascade of insolvency. But political contagion across the rest of Europe is possible.

Bottom Line: Brexit is neither the first nor the last word on de-globalization, Euro-skepticism, and nationalist populism. But it is the loudest voice heard so far on the global stage. And that voice is calling for change in the status quo. Uncertainty is increasing, and most investors will be looking for safety. But the best returns will come from taking careful, prudent risks.

Douglas R. Tengdin, CFA

Chief Investment Officer

Brexit Blues

After the Brexit vote, will London Bridge come falling down?

Source: Morguefile

Like most observers, I was surprised by the Brexit vote. Yesterday the betting markets in London had the odds of a “Leave” vote at 25%. This morning, European markets are adjusting to the new reality: UK shares are down 5%; German and French stocks are down a little more; global interest rates are falling as investors look for shelters from the coming market storm.

EU leaders will meet next week in Brussels to determine what happens next. The most cogent economic argument that the “Leave” campaign had was that the UK would be better off if it didn’t tie its financial future to a troubled Continent. The current government, which was pro-Remain, will resign, creating a great deal of political uncertainty. Eurosceptic forces in the rest of Europe will be strengthened by this development.

UK Referendum Map. Red = Leave. Source: Politico

The result will now trigger a two-year disentangling process where London and Brussels will negotiate the terms of a messy divorce. For US companies that use the UK as a staging ground for entry into the rest of Europe, the vote will bring hard choices about what to do next. The “Leave” vote means the British access to the European market will be impaired.

This vote is consistent with the trend of de-globalization and economic populism that has grown in recent years. There are a lot of folks who have been left behind by the current economy; there are “two Americas” as well as “two Britains” and “two Europes.” The “Leave” vote will strengthen the dollar, depress interest rates, and roil the markets—something that the populists seemingly welcome—“shaking the Etch-a-Sketch.”

In the midst of the turmoil, it’s important to remember: even if the political map changes, the global economy will largely continue as it has. BAE will still build the Harrier; London will remain a center for currency trading; the UK is still the 4th largest economy in the world—although now they will have to re-negotiate their trade arrangements. But countries don’t trade with other countries—people and companies trade with one another. Governments simply assist or impair that process.

Hopefully, the British people—as well as the global markets—will take to heart the message of the old World War II poster: “Keep Calm and Carry On.”

Source: Wikipedia

Douglas R. Tengdin, CFA

Chief Investment Officer

The Myth of New

The Myth of “New”

We’ve never seen this before!

Meerkat. Source: Animal Photos

That’s what people say when they run into a novel situation. Whether it’s Brexit or Venezuela’s economic meltdown or Puerto Rico’s default, people want to marvel at their situation’s unique status.

But there’s nothing really new under the sun. The writer Malcom Muggeridge once observed that there’s no new news, just old news happening to new people. Take the immigration crisis in Europe. While millions of people coming into Europe from Syria is a new development, wars have always generated refugees. It’s partly why so many people moved to the United States in the late 19th century. Our economy boomed—the additional labor helped run factories in the cities and settle the frontier.

Source: Eurostat, Wikipedia

While the latest developments may be new to many news reporter, they’re unlikely to be truly unique. History may not repeat itself, but it does rhyme. So don’t let alarmist headlines freak you out. As Calvin Coolidge once said, if you see ten troubles coming down the road, you can be sure that nine will run into the ditch before they reach you.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Myth of Equilibrium

Will we ever get back to normal?

Photo: Reza Tizz. Source: Morguefile

Everyone wants the economy to normalize—normal interest rates, normal economic growth, normal inflation. But we never seem to get there. Something always seems to come up.

Ten years ago, the wheels came off the bus with the housing boom and financial crisis. Five years ago we had a Euro crisis and fears of “Grexit.” Now it’s “Brexit” and the most bizarre presidential contest in memory. Economists are debating whether we’re in a “new normal” or secular stagnation or if the rising “gig economy” will turn us all into innkeepers and taxi drivers.

Some see the market as an evolutionary mechanism, gradually adapting to change. But I see it as a complex ecosystem, with stresses that come from invasive species, severe weather, over-harvesting, and all kinds of other factors. If you walk into a forest, nothing is really stable. It’s always in a transition from something old to a new new thing.

I don’t believe in a past, present, or future economic equilibrium. The economy we see is the economy we have to work with. The market is always shifting, violating the most nuanced and elegant models. The market doesn’t do elegance. If you want elegance, go see a tailor.

Douglas R. Tengdin, CFA

Chief Investment Officer

Borrowing the Future

Are young people being eaten by their student loans?

Source: St. Louis Fed

The outstanding level of student loans has increased by 10% per year for the past 9 years. The amount student borrowing has grown from about $540 billion in 2007 to over $1.3 trillion now, surpassing the level of credit card and auto loan debt. With college enrollment increasing and the cost of college rising, this balance is only going to grow.

On one level, this is encouraging: kids are investing in themselves at an increasing rate. In our dynamic knowledge-based economy, people have to have advanced skills to improve their chances of getting and keeping a good job. On another level, however, it is concerning. The heavy debt-loads assumed by students and their parents may be crimping the economy—discouraging folks from other kinds of economic activity. Among people under 30, over almost half have student loans to pay off. And much of the increased spending on college is just going to price increases, although lately the rate of tuition hikes has been slowing.

Year-over-year increase, college tuition and fees. Source: BLS

Not all student debt is productive. With college enrollment rising, graduation rates have been falling. At many schools, less than half the freshman class receives an undergraduate degree. If students don’t graduate, they’re not much better off in the job market than folks with no college at all. So delinquencies on student loans have been rising. Currently, about 20% of student loans nationwide are delinquent—adjusting for those that are still in their deferral period, where no payments are due. For the past two years, though, the delinquency rate has been stable.

There’s no evidence right now that we’re in a student loan “crisis”—although, with annual tuition and fees that exceed many families’ annual incomes, some folks are in over their heads. People need to take “buying” an education seriously. For the amount of student debt they incur, many young people could own a small house. But there’s no re-sale value for three quarters of a college degree. You can’t sell the asset and pay off the loan.

Source: cambridgeusa.org

Student debt is a necessary evil. We have the best colleges and universities in the world, in part because they compete with one another for students, grants, and faculty. For low-income students, the most economical choice is to take their first two years at a local community college, then transfer to a state school—hopefully one within commuting distance.

But an undergraduate degree isn’t necessary for all occupations, and it shouldn’t be used as a marker to screen applicants. For many, college is an unforgettable experience. But as Dear Abby once wrote, if we could sell our experiences for what they cost us, we’d all be millionaires.

Douglas R. Tengdin, CFA

Chief Investment Officer

Growing, Growing, Gone

Is growth worth it?

“Enchanted Forest.” Photo: Dave Meier. Source: Picography

We live in a deflationary time. Excess investment in productive capacity has provided more and more goods at cheaper and cheaper prices. Global trade and technology means that the marginal cost of labor minimal. Even professional services will be affected by globalized labor. The Microsoft-LinkedIn merger means that there will be millions of human “Clippies” waiting for us inside our Word or Powerpoint files, offering to do our animations and graphics or edit our documents for just a few dollars.

“Clippy.” Source: Wikipedia

Falling prices for goods and services around the world means that future money is more valuable than it is right now. It’s the opposite of an inflation problem. It’s why interest rates are so low right now. It’s also why safety is so important. Deflation creates credit issues for everyone except sovereign borrowers. In an age of deflation, countries can print their own currency without the normal inflationary worries.

The increased value deflation puts on future cash flow is why companies that can squeeze a little growth out of a depleted economy’s toothpaste tube have such high valuations—some of them eye-popping.

Source: Finviz

(The 40 “PE” for US Treasuries is just the 2.5% yield on 30-year bonds inverted, so that it is comparable with stock market price-earnings multiples.)

This helps explain why growth companies have outperformed value for the past several years. Deflation puts a premium on growth, because future cash will be worth more, if deflation continues. That of course, is the rub. Nothing continues indefinitely. As a Greek writer noted 2500 years ago, the only constant is change. No one steps into the same river twice.

Investors, policy-makers, and businesses have placed their bets that the economy will change back towards “normal”—towards 2% inflation and 1.5% economic growth. When we read the Fed’s minutes and speeches, it’s clear that committee members are concerned that inflation will pick up soon and they will have to raise rates rapidly to avoid falling behind the curve. They fear this would be disruptive.

But the that was the issue 20 years ago. Resources would get scarce and push prices higher, lifting inflation and inflation expectations. Now excess capacity is lowering prices, leading to deflation and putting a premium on growth. And what if deflation intensifies? We know things will change. But which direction with they go?.

Science fiction writer William Gibson says, “The future is already here—it’s just not evenly distributed.” With inflation and deflation both vying for significance, we don’t know what future that will be.

Douglas R. Tengdin, CFA

Chief Investment Officer

Rating Agency Issues

Can the ratings agencies be saved?

Blind Justice. Photo: Itojyuku Themis. Source: Wikipedia

Investors, companies, and regulators all benefit from having a cheap and easy way to measure credit risk. There are all kinds of institutions with a public mission that need to invest in bonds, and they need their bonds to be low-risk. Investment-grade or A-level credit ratings provide this. But the credit agencies are paid by the bond issuers—a clear conflict of interest. Can this be solved?

This conflict has been with us a long time. It became significant when the agencies succumbed to the collective insanity from 2004 to 2007—some bonds were rated ultra-safe that never should have been issued. Banks, pension funds, towns, and insurance companies all suffered losses.

This issue—the agency issue—is the same problem that accountants, newspapers, psychologists, and just about all professionals have. It’s hard for people to criticize someone if that person is paying them. The professional would be acting against his own interest; the people paying don’t usually like to be criticized.

Take auditors. In the light of Enron, we were shocked, shocked that their accountants helped conceal Enron’s fraud. But Enron was a plum assignment, yielding millions in consulting contracts. The partners at Arthur Anderson were getting rich. Or newspapers: has a critical story ever been spiked because the subject of the criticism buys a lot of ads? Of course it has. The writer Upton Sinclair used to say that it’s difficult to get someone to understand something when their salary depends on not understanding it.

Principal-Agent Problem. Source: Wikipedia

There has never been “golden age” where independent professionals completely subjugated their personal interests for the greater good. Everyone is conflicted in one way or another. The solution lies not in greater regulation but in more competition and more transparency. When a competitor stands to benefit if you fib on behalf of a client, you tend to be more careful.

Professional agencies need to take the agency problem seriously. But everyone’s an agent. We need to admit this and disclose our conflicts.

Douglas R. Tengdin, CFA

Chief Investment Officer