Foreign Exchanges

How much is a dollar worth?

Photo: Katrina Tuliao. Source: Wikipedia

One of the most vexing problems in economics is accounting for exchange rates. In theory, currency exchange rates should harmonize the value of goods and services across countries. That is, foreign exchange rates should rationalize global trade and investment.

But the volume of foreign exchange transactions dwarfs that of global trade. Annual currency transactions equal almost 50 times what is necessary for international trade and direct investment. The exchange rate markets are driven by people trying to figure where higher rates of return will be available in the future, while simultaneously trying to manage their various risks.

That’s why currencies are so volatile. They quickly react to any new information about their respective economies – and often in ways you might not expect. During the Financial Crisis, many thought that the value of the US Dollar would plunge, since US real estate was the epicenter of that financial earthquake. After all, economic growth should be lower if you have to recover from a burst asset bubble.

But instead of falling, during the crisis, the Dollar rose. Its safe-haven status trumped muted growth expectations. And that often seems to happen: the US is the most stable and open economy on the planet. As a result, when there is an emergency, assets come rushing onto our shores – kind of like the way political refugees flee danger in their home countries. This means the Dollar tends to be overvalued when there is financial instability anywhere around the world.

Source: Bloomberg

Every time an exchange rate moves, some segments of the economy win and others lose. An overvalued currency favors importers; an undervalued currency favors exporters. About one-third of the countries in the world have totally floating exchange rates – most manage their currencies, at the risk of being labeled “manipulators.” They don’t dare leave themselves open to all the fluctuations of the marketplace, but they also don’t dare lock in a rate that can’t adjust to changes in interest rates, economic growth, and other financial variables.

Long experience has taught that having fixed exchange rates among many countries for an extended period of time is impractical and can have some very bad consequences. That’s what happened with the global gold standard in the late 19th century and the Bretton Woods agreement in the mid-20th century, and what may be happening with the Euro today. An exchange rate is a price – a relative price between two economic zones. Fixed prices create distortions that only worsen over time.

An economist once quipped that there are three great questions: what is the meaning of life, what is the central equation in quantum mechanics, and what’s happening in the markets. The volume of forex transactions makes short-term fluctuations inevitable. But when we focus on the fundamentals, longer-term trends become clear. The Dollar had been weak for a while. But it looks now like it’s getting stronger.

Douglas R. Tengdin, CFA

Imports, Exports, and Economic Identities

Do imports reduce the size of our economy?

Source: Econstories

It’s not as simple as you think. Yes, C+I+G+X-M = Y. Consumer spending plus business Investment plus Government spending plus eXports minus iMports equals the total economy. On its face, if you reduce what you’re subtracting, the sum total should be bigger, right? It’s a little more subtle than that, though. It’s unclear which comes first, the size of the inputs or the size of the economy. Just because an equation describes something doesn’t mean you can change one element without affecting the others.

Think of it like this: suppose you run a computer company that sells hardware and support services. Revenues equals Hardware plus Service: R=H+S. But the hardware division uses some of your support services, and the service people use your hardware: you need to subtract intra-company sales to get total revenue. So R=H+S-I.

As CEO, you want your sales numbers to grow. You look at this equation and think, gee, if we got rid of these intra-company transactions, we’d boost total sales, right? That’s what the equation tells me. So you tell the hardware people to use outside support, and you tell your support people to use non-company computers. You prohibit intra-company transactions. Would that increase revenues?

Photo: Victor Hanacek. Source: Picjumbo

Of course not. Your sales numbers come from how much outside demand there is for your goods and services. Telling your divisions that they can’t do business with one another won’t change that any more than trying to boost sales by selling more products inside the company. In fact, it will probably hurt performance, as folks would be forced to use products and services they’d rather not.

You can’t change an economic or accounting identity by focusing on one of the inputs. A CEO that wanted to boost revenues by cutting intra-company transactions would get a quick lesson from the market. And a country that tries to improve its economy by limiting imports will likely be disappointed. 

Douglas R. Tengdin, CFA 

(Price) War and Peace

Is a price war coming to our mobile phone networks? Photo: Linzy. Source: Morguefile

Verizon recently followed its rivals in offering an unlimited data plan. They’ve long had the broadest network, but they’ve been losing revenues by 1% per year for the past several years. By rolling out unlimited data priced right around what AT&T and T-Mobil offer, Verizon hopes to recapture some of the market share that they recently lost.

I remember gas price wars in the mid-‘70s. There would be gas stations on all four corners of an intersection, and when one dropped its price, the others would follow suite, eventually pushing prices down to the wholesaler’s level. The stations tried to distinguish themselves from one another, but they weren’t successful. People saw gasoline as a generic product whose principal feature was its price. 

Eventually, marginal gas stations dropped out. We didn’t need so many vendors. The losers tended to be independent stations who couldn’t get price breaks from their distributors. But consumers won; despite many fears, prices didn’t jump right back after the marginal players dropped out.

We’ll see what happens with our mobile phones. Verizon and AT&T are the dominant providers, and people see cell-phone service as a generic product. The main feature to the consumer is price; the main feature for the investor is the dividend. These aren’t growth stocks in a growth industry anymore. With AT&T running a 15% operating margin and Verizon at 22%, there’s room for both to cut prices a little more.


Photo: Victor Hanacek. Source: Picjumbo

With their stronger network and higher margins, Verizon looks like it could win this war. But the real challenge for the victor won’t be winning the war. It will be winning the peace. Anyone can cut prices. It takes a lot more to satisfy customers.

Douglas R. Tengdin, CFA

A Regulatory Pendulum

How much regulation do we need?

Photo: Arnaud Clerget. Source: Wikipedia

After the financial crisis, Congress enacted new regulations on the financial system. The concern was that big banks had gotten us into an awful mess through their reckless lending, so we needed to put new rules in place to make sure they never did that again.

Dodd-Frank has been in effect for over six years now, and it’s reasonable to ask if anything has changed. The logic behind most regulation is simple: our economy runs on self-interest and profits. Regulation tries to keep things within the lines—limiting systemic risk and concentration of power, and rooting out and punishing fraud. If professional ethics, self-regulation, and concern for reputation did the job, we wouldn’t need formal laws. But self-control isn’t enough. Every major economy is also a regulatory state.

But regulators are human, too. Regulations are enforced by imperfect, self-interested people, and the rules can get out of hand. It’s easy to write rules, but they often seem to be like old generals fighting the last war. Strict rules become outdated and the regulators themselves are hired by law firms that want to circumvent them. And the proof is in the pudding: before the crisis, people thought that unregulated hedge funds would cause massive problems. But in fact, regulated banks are what spread the financial contagion. 

Illustration: Farcaster. Source: Wikipedia

Because both free markets and regulation are imperfect systems peopled by imperfect actors, we will never strike a perfect balance. Instead, the pendulum will swing from one extreme to the other. Under Obama, the focus was enacting new regulations. Now, the emphasis is on deregulation. Our financial system will continue to be imperfect, working well 95% of the time for 95% of the people. But a huge economy with huge banks will create huge risks.

Money is a social convention and financial rules will always be with us. Free markets do the best job of allocating resources towards their most efficient use; but the ride will always be bumpy.

Douglas R. Tengdin, CFA

Timeless Investing Truths

Why is investing so rewarding?

Photo: Victor Hanacek. Source: Picjumbo

Investing is fascinating. It’s not just the financial returns, significant as those may be. But investing is valuable in its own right. The profession is intellectually demanding, the competition is consistently stimulating, and the relationships with clients and colleagues are priceless. Here are some timeless truths about investing that have impressed me over the three decades I’ve been investing and the ten years I’ve been writing about it.

First, be humble. You don’t know what you don’t know. Socrates, Confucius, and Solomon noted that confessing your own ignorance is the beginning of any true wisdom.

Second, be patient. Time is on your side. Albert Einstein noted that compound interest is the eighth wonder of the world. Those who understand it earns it, those who don’t, pay it.

A corollary rule is to borrow sparingly. Leverage can multiply your returns, but it can also wipe you out. If you put $10,000 in the market in 1970 you would have almost a million dollars. If you invested $20,000 – with half of it borrowed – you would have been wiped out.

Pay attention to taxes. It’s not what you earn, it’s what you keep.

Keep the big picture in mind. Asset allocation is the dominant driver of returns. Since 1970 stocks have returned over 10% per year. Bonds have earned 7%. Cash has yielded 5%. And not investing gets you nothing. So get started. A journey of a thousand miles begins with a single step.

A related rule is to diversify. While bonds and cash may drag on returns, they add stability to a portfolio. If their security allows you to sleep at night and stay the course through the ups and downs of the stock market, they’ve earned their keep.

Finally, be generous. The time is always right to do the right thing. This will help you to keep money in its place. Wise people have money in their heads, not their hearts. The surest way I know to keep money from taking hold of my soul is to give it away.

These are just some of the lessons I’ve gained through the booms and busts, the crashes and melt-ups, the history and finance and human nature we’ve seen the markets bring out. There’s always something to learn. That’s the biggest lesson of all.

Douglas R. Tengdin, CFA

Golden Delicious

Golden Delicious

Is Apple the greatest cash machine in history?

Photo: Leeroy Source: Life of Pix

Apple recently reported its 2016 financial performance. Last year the company sold $215 billion worth of products and earned – after expenses, amortization, and taxes – over $45 billion. By contrast, conglomerate GE sold $120 billion and earned $10 billion. Smaller companies may have larger margins, but nothing has ever come close to Apple’s scale. The company has amassed a cash reserve of $250 billion. Enough, if they wanted to, to purchase the entire US auto industry.

But why would they want to? They’re doing what they do so well. And what they do is build beautiful smartphones. Phones that help us manage our lives, that enable the apps that we need to tell us where to find gas, when to pay our credit cards, and what’s the latest email. Oh, and they let us talk on the phone, too.

But nothing fails like success. Many people look at Apple – where three quarters of their revenues come from products that had just been introduced a decade ago – and see the ultimate disruptor: a force of nature ready to create a wearable computer market or smart, self-driving cars or personal passenger drones or something else revolutionary. And they have $250 billion to do it with.

But as one of the world’s biggest companies in a fast-evolving market, Apple is now far more likely to be disrupted than to be the disruptor. The firm has over 100,000 employees, many of whom are world-class experts in their own right who have their own goals and aspirations. It’s far more likely that Apple’s success in smartphones will inspire competitors that cut into sales and put downward pressure on margins. Slowing growth and declining margins will be balanced by rising dividends and stock buybacks. This is the typical progression of a maturing industry. Going forward, investor returns should continue, but they will be normal, not explosive.

Source: Bloomberg

Indeed, they have to be. Over the past 14 years the share price has grown over 40% per year. If such growth continued, Apple would comprise over half of the entire stock market in less than 10 years. As the economist Herb Stein once observed, if something cannot continue, it will stop.

Douglas R. Tengdin, CFA

“Just So” Snowflakes

Who’s in charge?

Wilson Bently, “Studies Among Snow Crystals.” Source: NOAA

That’s what we often ask about all kinds of complex systems: traffic, language, markets. It often turns out that no one is in charge, that order emerges from the various parts of the system. If you look at any particular automobile, you can’t predict that Route 128 outside of Boston will be bumper-to-bumper at 8:00 am on a snowy Tuesday morning. But if you get a bunch of cars together, work schedules, commuting patterns, and a weather report into the mix, you’ll have a pretty good idea where and when traffic jams will form.

It turns out that in many cases no one is in charge, that things just happen, and they happen the way they do because of how their components are organized – like snowflakes forming crystals and plates, because of water’s hydrogen bonds, dust in the air, turbulence, humidity, and temperature. Systems that develop this way – with no one in charge – are called “emergent” systems. They have their own organizational principles and structure, which can’t be inferred from their constituent parts.

In many ways, our minds are emergent systems. We have sensory zones, autonomous functions, and reflex areas that all interact. Sometimes our brains act more like traffic cops than decision-makers. And yet, we do make decisions. But how?

From studying the reasoning of certain patients, researchers have found that we often decide what we’re doing before we’re even aware of making the decision. Then we develop a narrative to explain it. If I’m hiking on a trail and see a snake, I jump back and tell myself that I jumped because I saw the snake. But the reality is that I jumped back after I saw the snake, but before I was aware of the snake. That is, awareness and the cognitive processing that it requires takes more a lot more time than my initial reaction. So the process goes: I see the snake, I jump back, I process the information, I tell myself a story about the snake.

Photo: Claudia Peters. Source: Pixabay

That’s how things work in markets as well. The market will react to new information before a narrative can form to explain the reaction. We saw this after Election Day in 2016, when stock market futures were down over 5% before reversing themselves and finishing up 1% that day – on their way to a 10% rally. People were initially confused. The narrative hadn’t had a chance to catch up with the markets. A similar thing happened last summer after Britain’s “Brexit” vote.

S&P 500 Futures. Source: Bloomberg

So be careful when you hear explanations about why the market did this or that. Such stories may be helpful, or they may turn out to be post-hoc rationalizations – “just-so” stories we concoct to cope with chaos and uncertainty. In essence, we tell ourselves tales around the campfire to keep out the dark.

But these rationalizations may not hold up in the long run. They may prove as ephemeral as snowflakes in the summer sun.

Douglas R. Tengdin, CFA

Luxury Goods

Is the market expensive now?

Superyacht “Eclipse.” Photo: Moshi Anahory. Source: Wikipedia

The stock market has been on a run. Since October of this year the stock market has hit a succession of new highs. A lot of folks look at this market and say that that the market is pricey. When you divide the market’s valuation by the last 12 months’ worth of earnings, the aggregate price-earnings ratio – currently 23 times earnings – is higher right now than it has been 87% of the time since 1936.

Source: Morningstar, 361 Capital

But the valuation is a terrible timing tool. If you avoided investing in the stock market when valuations had spiked, you would have missed out on some of the greatest bull runs ever. What’s more, comparing the current level of earnings to something recorded 80 years ago is foolish. Accounting rules have changed dramatically. Foreign currency transactions, construction work-in-progress, stock options, and countless other items are now included in a company’s earnings. It’s anachronistic to put our current measure of earnings into the same denominator as those from 20, 40, or 80 years ago.

You might as well say that bread is cheap now because in 1930 a loaf cost 4.5 times what a chocolate bar cost, and now a loaf costs twice as much as the candy. But a lot of things have changed – the size of the loaf, the size of the chocolate bar, and the ingredients of both the loaf and the chocolate.

Photo Evan-Amos. Source: Wikipedia

Right now, valuation measures are high because we are coming out of a 6-quarter long earnings recession. In fact, this may be the longest earnings recession ever that hasn’t led to a general downturn. But remember: the definition of earnings has changed. So, unless you can go back and re-state 80-years of history, maybe this has happened before.

I’m not saying looking at ratios is meaningless. You just have to be aware of what’s different. Accounting standards have changed. Human nature – and the desire by managers to look good – hasn’t.

Douglas R. Tengdin, CFA

Snow Days?

How do storms impact the markets?

Source: NOAA

We seem to be in a storm cycle. We just had a couple nor’easters, and it looks like more snow is on the way. At times like these, people wonder just how much weather can affect the economy. Last year was a great case-study. For the previous several years we’d had heavy weather disrupt the first quarter’s economic growth. Last year we had a mild winter, along with low energy prices. Economists were curious whether lower heating bills would boost consumer spending.

It did, but only a little. Much of that money was saved. It turns out that capital spending and job security are a lot more important economically than the weather forecast. Storms may shut us in temporarily, but they don’t keep us down for long. Consumption delayed is not consumption denied. And of course with so much available on-line, we don’t even have to go to the hardware store to buy a snow shovel or ice melt. Amazon will deliver them.

There may still be some disruption from power outages and travel bans, which makes me wonder why we don’t bury our power lines, like the Nordic countries. They have some experience with nasty weather. And, of course, the evacuation out in California is extremely disruptive. In general, though, stormy weather to the economy is like driving in heavy snow: it may make you slide around, but it shouldn’t affect your transmission.

Douglas R. Tengdin, CFA

Cyber (In)Security

How secure are our computer systems?

Photo: Kerstin Riemer. Source: Pixabay

Computer security is essential to everyday life. There are dark places and dark minds out there, who want to hack into our computers and devices and steal or corrupt our information. There’s viruses, malware, bots, and tracking cookies can compromise our personal and professional systems. These hackers are intelligent and motivated. What can we do protect ourselves?

For most of us, cyber-security begins with a user name and password. Behind that mundane entry-point is a host of firewalls, protocols, and server restrictions that we hope will keep us safe. Security is omnipresent: American smartphone users unlock their phones, on average, 80 times per day. Prior to using our fingerprints, most devices required PINs – something far less secure. But how secure are our PCs?

Poster from movie “Hackers.” Source: Wikipedia

When organizations require long, random passwords that change every 30 days that require two upper-case letters, two lower-case letters, two numbers and special characters that change from site to site, it’s no surprise that we continually circumvent and misuse the controls designed to protect us and our organizations. Some of the most common workarounds include post-it note stalactites with passwords, or notebooks in desk drawers, or spreadsheet files entitled “passwords” saved among the user’s most accessed documents. Proximity sensors designed to log us off when we’re not there have Styrofoam coffee cups placed over them. Junior team members are detailed to regularly push the space bars on everyone’s keyboard during meetings to keep everyone logged in.

Folks don’t see these workarounds as hacking. They’re just trying to do their jobs. But when these security circumventions become part of a new worker’s de-facto job orientation, greater security becomes lower security – or even no security. The weakest link in the chain is the one that will break when it’s stressed. And a padlock that’s left open because the lock is rusted provides no protection at all.


With self-driving cars that talk to each other and wearable tech that allows us to receive advanced medical treatment at home, cyber-security is more important than ever. It’s equally important, though, that these protections be realistic and usable – like touch ID on our phones, or two-stage authentication. Otherwise, they’ll be circumvented. And that won’t be good for anyone’s security.

Douglas R. Tengdin, CFA