Style and Substance

Was the stock market rally just based on sentiment?

Chrysler Tower with Ravenswood power plant in the background. Photo: Eric Drost. Source: Wikipedia

After our presidential election, global equity markets rose about 10%. The common explanation was that a pro-growth agenda could help the economy get out of its doldrums and reaccelerate. This would support profits and the stock market.

With the failure of Congress’s repeal-and-replace attempt with healthcare legislation and other policy initiatives seemingly stalled, shouldn’t the markets fall back to where they were before the election? And shouldn’t investors protect themselves against such a crash?

The short answer is no. Economic data were improving before the “Trump bump.” The latest report from the Commerce Department gives us proof. Fourth quarter economic growth was revised slightly higher, based on higher consumption numbers. This is an important indicator, since consumption is about two thirds of the economy. But the real news was the continued improvement in corporate profits.

Graphics Source: WSJ

Through most of 2015 we had an earnings recession: four successive quarters of lower corporate earnings, pressured by lower oil prices, a strong dollar, and weak global growth. The stock market went nowhere in 2015. Often, corporate earnings are a leading indicator, since companies won’t hire more workers if their profits aren’t growing.

But starting in early 2016, profits began to recover. For all of 2016, profits rose 4.3%, and look to continue their trend – with or without the initiatives that may or may not come from Washington. If this earnings recovery continues, it will end the longest earnings recession since 1987 that didn’t result in a real recession.

Just because the news programs are obsessed by what happens in Washington doesn’t mean we have to be. Stocks lead earnings which lead the economy. Hopefully, corporate earnings will continue to grow.

Douglas R. Tengdin, CFA

Bonded Returns

What good are bonds?

Source: Credit Suisse

Since the beginning of the 20th century, stocks have returned almost 10% per year while bonds have returned about half that. Because of compounding, though, a dollar invested in equities from 1900 forward would now be worth more than 140 times what a dollar invested in bonds would. And this is only reasonable. The best you can do when you buy a typical bond is get your money back, with a little bit of interest. But some stocks offer significant returns – like Amazon or Apple – as they grow from obscurity to commercial dominance. As the economy grows, stocks grow.

So why bother to own bonds in a portfolio at all? Over the long term, any money allocated to bonds has been a drag on total portfolio performance. There are even periods when bonds haven’t done as well as cash or inflation, most notably in the early 1920’s and the mid and late 1970’s, when inflation was rising and bonds’ fixed payments weren’t keeping up with prices.

The answer lies not in the assets themselves but in our needs and plans. If we don’t need the money, then there isn’t any need for bonds in a portfolio. But most of us don’t have “forever” time horizons. We’re saving for retirement or for our kids’ education or to have a nest egg where the interest income can supplement our lifestyle. We certainly can’t wait 116 years to touch the money. Even colleges that have been around for centuries tap into their endowments every year.

Great Wave off Kanagawa. Source: Metropolitan Museum of Art

Bonds provide an island of stability in a sea of uncertainty. We don’t know the future. All we have are promises and intentions. Bonds are a senior, legal claim on cash flow. Some bonds are even secured by real estate. In case of bankruptcy, bonds get paid first. And bonds almost always come with a maturity date: you know when your money should be paid back. So it makes sense that, over time, bonds are less risky. But they also return less.

Equities represent intentions: management intends for their company to grow; directors intend to pay dividends; employees intend to do a good job. But there are no guarantees. Good companies can fall on hard times and have to cut their dividends. Good employees can be on the wrong side of a merger or corporate restructuring and lose their jobs. Good managers can still run afoul of fickle markets or politics or circumstances. So even the best companies can suffer. That’s why the residual claims – stocks – can be so volatile.

It’s easy to forget, when times are good, that we don’t know the future. A well-constructed portfolio should be able to provide enough cash, over a full market cycle, so investors don’t have to liquidate positions when the market is unfavorable. Because markets fluctuate. It’s what they do. And the surest way to convert a temporary fluctuation into a permanent loss is to sell out when it’s down. That’s why having a series of maturing bonds – a bond ladder – can help investors stay on course amid uncertain markets.

HMS Blonde by Robert Dampier. Public Domain. Source: Wikipedia

Bonds are ballast to a portfolio amid stormy circumstances. And if you don’t have enough ballast to stay on course, you’ll never reach your destination.

Douglas R. Tengdin, CFA

Commuting Costs

Is commuting worth it?

Traffic jam in Germany. Source: Wikipedia

I have a pretty easy commute. Living and working in New Hampshire, winter storms affect my driving more than other drivers. But it hasn’t always been that way. For a while I worked in Boston, racing along I-95 to then take a commuter train to work downtown. And for a short time I lived in Brooklyn and commuted to Queens along the Brooklyn-Queens Expressway, “the world’s longest parking lot.”

When people live and work in major cities like New York, London, or Tokyo, they have to deal with hoards of other folks trying to get to their jobs around the same time. Sometimes, an idiosyncratic schedule can be a blessing. When my brother worked for a financial firm in San Francisco, he had to be at work at 5 in the morning. The roads weren’t too crowded then, or when he got out, at 3 in the afternoon.

Most big cities use rail and other mass transit vehicles to shuttle people around. But that can be uncomfortable, costly, and smelly. The subways in Tokyo are famously so crowded that the transit authority employs “pushers” to jam as many people as possible into the cars. There’s a big difference between a relaxing ride listening to an audiobook and a smelly, standing commute where you’re all squashed together.

Subway pusher in Tokyo. Source: Wikipedia

The Financial Times compiled an index of commuting costs for six global cities, in which they evaluated time, costs, and timeliness of commuting to the city-center from different locations. They tried to use property values to evaluate the commute from comparable locations. It’s interesting to see how the different places stack up. London appears the most costly; Shanghai, the least.

Source: Financial Times

Generally, cities in Asia have shorter, cheaper commutes. That may be due to the fact that their commuting systems are newer. The London Underground, after all, is over 150 years old. And older systems are less reliable, needing repairs and refurbishment.

People put up with the hassles of commuting because the cities are where the jobs are. Putting people together who have similar skills creates opportunity and value. It’s why different industries seem to settle in the same geographical region: Detroit for cars, Silicon Valley for tech, New York City for finance. Ultimately, folks have to decide for themselves how best to handle the trade-offs and hassles that come with travelling over an hour each way to get to their jobs.

I’m just glad I don’t have to deal with subway pushers here.

Douglas R. Tengdin, CFA

The Fickle Finger of Fraud

How do you smell a rat?

Charles Ponzi, author of the first Ponzi scheme. Source: Boston Public Library

Detecting financial fraud can be challenging. We know there are lots of people who want our money. It takes decades, sometimes a lifetime, to build a nest egg. It’s important to safeguard it. But in the real world people lie, cheat, and steal. Financial products are especially prone to distortion and deception, with complex legal provisions and mind-bending mathematical formulas. How can we protect ourselves?

First, be suspicious. Ask questions. Double-check the answers. If it’s taken years to grow your wealth, spend a few weeks or months checking out a potential advisor’s references and reputation. Second, don’t lose sight of your money. Regular statements—or online access—should be available. Question anything that’s not clear. Third, remember that risk is part of the game. We live in an uncertain world, where unexpected things happen. If someone offers you a risk-free product with guaranteed returns, they’re probably lying. Don’t just walk away, run away and warn off anyone else. One common factor for those swindled by Bernie Madoff was they didn’t probe deeply enough about his investment methodology.

Bernie Madoff mugshot. Source: Department of Justice

Finally, follow the money. It may seem rude, but you should feel free to ask any financial professional how he or she is paid. Incentives matter. You shouldn’t feel that your savings are supporting someone else’s lavish lifestyle.

All this has been written about before – by Shakespeare, of course. In Act 2, Scene 1 of Henry V, the Bard shows how young King Henry uncovers an assassination plot just before he embarks on his invasion – by asking his advisors questions, keeping them close, and examining their finances. That’s how he learns that the French king had suborned three of his nobles. It’s a key scene that shows how Henry has matured from being a young, carefree rascal to a ruthless, efficient sovereign. We need to mature in the same way. We’re the ones that need to look after our finances – by asking questions and following the money.

Because if something sounds too good to be true, it probably is.

Douglas R. Tengdin, CFA

Time for Value?

Are stocks expensive now?

Photo: Victor Hancek. Source: Picjumbo

That depends on what you mean by expensive. Unlike rare art, fine wine, and gold, stocks have an intrinsic value. They represent ownership in an enterprise that can potentially generate earnings and dividends for investors. This leads us to the fundamental paradox of investing: 100% of what we know about a company is based on the past, but 100% of a company’s value is based on a forecast of the future: future sales, future earnings, and ultimately future free cash flow available to investors.

In most cases, the past is prologue. What has happened in the recent past is likely to continue into the near future: Apple will keep selling iPhones, Ford will build cars, and Colgate will offer products to make our teeth clean and healthy. But every few years something comes along to disturb this pattern. In 2008 and 2009, homebuilders like Lennar couldn’t give away their products – and BankAmerica and Citigroup could write mortgages. There was a lot of uncertainty about the future, and the market’s valuation was a lot lower.


If you look at stocks around the world, some places stand out. Markets in countries with a lot of uncertainty in their economic and political outlook look cheap when compared to their earnings. Markets will a lot more political and financial stability look expensive. High PE countries are ones where the market expects a lot of stable growth. Low PE countries, not so much.

Valuation is always a question about the future. When growth looks like it’s picking up, market multiples move higher. When growth is slowing, multiples move down. Deciding whether a stock or stock market is expensive or cheap depends on your outlook for growth. If you expect growth to move sustainably higher, then a high valuation might be justified. But if you think growth is likely to fall back to its median rate, then a median valuation is more appropriate.

Photo: David. Source: Pixabay

The question of whether stocks are expensive reminds me of that old rejoinder of the New England farmer when someone asked how he was doing: “Compared to what?” Every day, the market votes on earnings, growth, and stability. In many ways, it’s like the weather. If you don’t like what it’s saying right now, stick around. It will change.

Douglas R. Tengdin, CFA

Moral Marketing

Are companies selling, or preaching?

Source: Coca-Cola Company

In 1971 Coke produced their “Hilltop” ad, where 500 young people sing about furnishing a home with love, and buying the world a Coke. The ad cost over $250 thousand to produce, a staggering amount at the time. The multi-racial chorus hold bottles of Coke labeled in English, Arabic, Hindi, and Afrikaans. The message is clear: if we can just have a Coke together, the world could be a more harmonious place.

The ad went viral. Listeners called radio stations, begging to hear it again. The company received over 100,000 letters about the commercial. A new musical group called themselves “The Hillside Singers” and released a record version, which went straight to the top of the national charts. The ad has been re-made multiple times, with a Christmas version, a Disney version, even a NASCAR version. It was even featured in the final scene of “Mad Men” a couple years ago.

But did it sell soda?

The commercial has consistently been voted one of the best of all time, and the sheet music still sells today. Glee clubs and church choirs and marching banks perform it all over the world. It didn’t just promote a soft drink. It presented a world view.

Source: Toponehitwonders

The ad is part of a whole strain of moralizing marketing, where Airbnb touts acceptance, Starbucks brags about hiring vets, and Panera Bread adopts the slogan, “Food as It Should Be.” These ads aren’t just promoting stuff, they’re making a moral argument – encouraging us to be more inclusive and accepting by buying their wares. The companies are trying to win converts, not customers.

Ads are the stories we tell ourselves about ourselves. “Hilltop” worked dramatically well because it fit a cultural moment when race riots and war protests and “mutually assured destruction” were exposing national rifts that had everyone worried. The ad suggested that we could create connections and help heal the world by just drinking a Coke. Who wouldn’t want to do that?

Douglas R. Tengdin, CFA

Dangerous Toys

Dangerous Toys

“Your masters let you play with dangerous toys.”

Ancient Greek toy horse. Photo: Sharon Mollerus. Source: Wikipedia

That’s a line from a work of science fiction written over seventy years ago – before star-fighters and warp drives. Two characters confront one another for the first time, and one believes that the other doesn’t know what he’s talking about. They do end up cooperating, though, and the forces they harness are incredibly powerful.

That’s the way I often feel about academic finance. Researchers blithely discuss factor investing and debt overhang and capital structure, but I get the sense that most of these folks haven’t done much more to invest other than contribute to their Universities’ 403(b) plans, much less ever advised someone else. There’s a sort of breezy indifference to the implications of their work – as if statistical significance matters more than client outcomes.

And the results can be quite influential – like option pricing or corporate governance. Who serves on a company’s Board of Directors, for example, can have a huge impact on the lives of thousands of people. But for every study that points one way, there seem to be others headed in the opposite direction – like medical researchers who find that wine, coffee, and beef both cause and prevent cancer.

Source: AJCM, Vox.

One analyst estimates that only 6% of peer-reviewed medical research is well-designed or relevant enough to inform patient care. And this is understandable: researchers need to “publish or perish,” and editors are busy with their own projects and priorities. It’s no surprise, then, that a prominent editor of a prestigious finance journal accused his profession of data-mining: dredging through studies and results until a statistical relationship can be found, then concocting a narrative to justify the correlation. He calls this practice “p-hacking”: evaluating the data from different perspectives until a suitably high t-statistic – and low p-value – can be produced (and published).

Example of spurious correlation. Source: Wikipedia

Researchers are people too, and journal editors compete for citations and web-traffic. Public choice theory shows government officials respond to incentives, and this also applies to academics. Perhaps this is why debates in academic finance seem like those of scholastic monks determining how many angels can dance on the head of a pin. They need to get their findings into a top journal in time to impress the tenure committee.

So I don’t get too worked up when the “dangerous toys” of statistical analysis seem to predict that firms with meaningful stock ticker symbols or companies with Board members who own cats tend to do better. Such studies won’t change our practices. It just seems like a lot of research should come with a warning label.

Douglas R. Tengdin, CFA

Activist Investing

What are activist shareholders?

Photo: Taryn. Source: Wikipedia

An activist is someone who buys a stake in a company to make a change. Their goals can be financial, social, or governance-driven. They might want to increase dividends, reduce managements’ salaries, or divest from particular countries or activities.

30 years ago these folks were often called corporate raiders, forcing management to take action or buy them out, often at a fat premium to the current stock price. This sort of “greenmail” seemed deeply unfair. More recently they have been more like investment prospectors, looking for shareholder value in unlikely places – like undervalued real estate that should be sold, or byzantine corporate structures that can be simplified.

Not surprisingly, corporate managers aren’t particularly fond of activists. Often, activists want management to distribute excess cash. That cash can be a security blanket – a rainy-day fund in case something goes wrong. But the cash belongs to the owners, not the executives. When it builds up on the balance sheet, management can be tempted to do something stupid – like overpaying for an acquisition, or engaging in high-profile vanity projects.

Activist investors should have a strategic view, and not just focus on short-term returns. Twenty ago, cash was 40% of Ford’s market value. Ford paid out half of this cash-hoard in a special dividend. If they hadn’t distributed this to shareholders, they could have bought a lot of very cheap factories and businesses during the financial crisis, when no one had any cash. But the activists weren’t looking that far forward. Strategic, long-term thinking is rare.

Still, activists can be catalysts, unlocking the value in a firm. That’s why share prices often rise dramatically when their interest is reported. Active investing can beat passive indices when the activists are effective.

Investment protesters just need to be sure that they’re part of the solution, not part of the problem.

Douglas R. Tengdin, CFA

Mom, Kant, and Mutual Funds

What if everyone did that?

Immanuel Kant Postage Stamp, 1974. Source: Wikipedia

That’s the question my mother would often ask me when I started on some hare-brained teenage-boy adventure, like taking the summer to canoe down the Mississippi River to the Gulf of Mexico, or letting my friends in the exit doors of a local movie theater. The question is a good one, and it comes from a solid philosophical foundation.

230 years ago Immanuel Kant outlined the basis for what could be considered a moral – and immoral – action. Rather that judge actions based on their outcomes, they should be evaluated on their own merits. That is, stealing isn’t wrong because you get caught, it’s intrinsically wrong. Kant called this his “categorical imperative,” and he put it this way: act in such a way that what you do could become a universal principal. So, stealing is always wrong, because the victim could not possibly consent to it. After all, if they consented, it wouldn’t be theft. Slavery is inherently wrong, because the world can’t become a slave to itself. And everyone can’t take the whole summer off.

That’s something I’ve considered recently as investment capital seems to flowing in greater and greater quantities from active management to passive management. Citing long-term performance, advocates of passive index funds claim that most investors should have most of their money in the S&P 500 or some other large-cap equity fund. It is based on the observation that a broad collection of market-cap weighted stocks has outperformed most stock-picking managers, over the long run. This debate has been going on since the first passive funds were designed over 40 years ago. There are actually many active decisions to be made, like which index to use, whether to adjust the weighting for available shares, how to rebalance, and so on. But I’d like to look at this in terms of my mother, Kant, and market efficiency.

Source: Morningstar, Wall Street Journal

What if everyone indexed? What if the vast majority of investors tied their fortunes to a cap-weighted index of US or global stocks? What would happen to the market, to corporate governance, and to the economy as a result? I think we’re starting to see the consequences now, as hundreds of billions move away from active managers and flow into passive funds. Vanguard Group – the world’s largest purveyor of passive funds – has been doing a series of victory laps, claiming its methodology has been vindicated.

But nothing fails like success. When everyone invests in an index, the components of the index will remain unchanged in relation to one another. That’s why, currently, expensive stocks tend to remain expensive, and cheap stocks tend to stay cheap. If the new money flowing into the stock market is flowing into the companies with the biggest capitalizations, then big companies like Apple and Google and J&J and Wells Fargo. The rich get richer and the poor get … red.

Market cap map, colored for one-year performance. Source: Finviz

Over the long run, this will tend to have a negative effect on corporate governance, innovation, and the economy. One way managers are held accountable for their performance is through active managers who can sell their shares – or at least ask pointed questions at earnings conference calls. If everyone is a passive investor, who will hold the CEO’s feet to the fire? In theory, passive investors could influence firms through proxy voting, but they don’t allocate a lot of resources to this function.

We’ve seen this movie before. During the go-go ‘60s, a lot of corporate America became complacent, failing to innovate and invest because that didn’t improve their short-run financial performance. The result was a stagnant corporate sector and the malaise – and economic contraction – of the ‘70s.

It’s safe to assume that my mother never studied Kant, and Kant could never have conceived of cap-weighted index funds. But “what if everyone did that” is a reasonable question. When it comes to passive investing, the answer might surprise you.

Douglas R. Tengdin, CFA

TV Land

How do you spend your leisure time?


Leisure time is increasingly important. The time we spend working has declined over the past decade, and the time spent in leisure activities has increased. But what do we do? Increasingly, we watch TV. Millennials don’t watch as much as older folks – and they may watch TV on their phones – but watching TV constitutes the lion’s share of our down-time.

Every year, the Census Bureau surveys a representative sample of American households to find out what we do with our days. Researchers use this data to get a better picture of what we do – work, childcare, volunteering, sleep, etc. This helps get information on labor productivity, among other factors. And time is a non-renewable resource. Each of us gets exactly 1,440 minutes per day and 168 hours per week – no more, no less.

And when it comes to leisure, TV rules the roost.

Source: BLS

Americans have a little over five hours per day to kick back, and they spend over half that time watching TV. That’s higher than it was ten years ago, especially for older folks. Young people are spending a little less time watching TV and more time on their computers and cell phones, but television is still the dominant way that people relax.

A great deal of this time comes from retirees, who may spend over 50 hours per week in front of the tube. And television is an inexpensive form of entertainment, compared with monthly cell phone bills and data charges.

These data remind me that I’m a bad example of a typical household. We own a TV, but we haven’t turned it on in years. We used to use it to watch DVDs, but streaming videos is now so much more convenient. Still, it astounds me that the “boob-tube” can be so popular. It reminds me of the old jibe from radio personality Fred Allen: “Television is a medium, because anything well-done is rare.”

Douglas R. Tengdin, CFA