Benefits to Trade

What’s your favorite business movie?

Fair Use. Source: Wikipedia

One of the best is “Trading Places,” a modern take on Mark Twain’s Prince and the Pauper starring Dan Ackroyd and Eddie Murphy. It tells the story of a privileged commodities broker and a homeless street hustler who are thrown together when they are made the unwitting subjects of an elaborate bet. Apart from a minor role by now-Senator Al Franken, it also includes a fairly accurate description of the commodities business, with scenes from the open-outcry pits at the New York Mercantile Exchange, formerly located in the World Trade Center.

The Nymex floor used to house precious metals, cotton and sugar, petroleum futures, and – the subject of this movie – frozen concentrated orange juice. Contrary to the story, “FCOJ” was never a major contract. That would have been gold and crude oil. But the movie’s plot-line – involving secret crop reports, the US Department of Agriculture, and circus animals – made for some entertaining scenes, including ones with the Minnesota Senator.

The open outcry system isn’t around anymore. Most futures pits closed in 2015 – a result of computerized screen-trading. Electronic systems were faster and less expensive. They started replacing the open outcry system in the early 00’s. Options trading, which is more complex, still took place in the commodities pits, but that was replaced by automated exchanges late last year. The main reason big stock exchanges still have physical trading floors now is marketing – offering listing firms (and others) an opportunity to “ring the bell” to begin trading on a special day. Open outcry trading now serves mainly as a backup for when computer systems go down.

Source: CME, WSJ

Commodities used to be the other side of the tracks – where someone with ambition and hustle could make it without having to go to college. They also provided a great backdrop for a funny movie. Now, graduate degrees in math, physics, or computer science seem to be necessary. The quantitative, scientific approach to trading has reduced costs and increased market efficiency. But I wonder what we have lost?

Douglas R. Tengdin, CFA

Taxes, Income, and Freedom

It’s April. Do you know where your income taxes are?

Photo: Steve Buissine. Source: Pixabay

Around the country people are reviewing their income from last year and calculating their taxes. Tax day is an extraordinary event: a couple years ago 140 million Americans told the government that they earned $9.7 trillion and paid $1.4 trillion in taxes. The lion’s share of those taxes came from the highest earners: the top 50% of taxpayers paid 97% of the taxes collected, and the infamous top 1% paid 40% of all the income taxes collected.

And the 1% pays a higher effective tax rate: 27%, versus an average rate of 14% for all taxpayers. This is how our system is designed to work. Folks who have higher incomes are supposed to contribute more, because they have benefitted more, economically from the institutions the government provides: defense, police, courts, roads, sewers, and schools.

Source: Tax Foundation

April is also significant because it usually is the month for tax freedom day – the dayit is estimated that our tax burden is complete. Last year, nationwide, it fell on April 24th, although it varies by state: in New Hampshire it was April 22nd; in New York it was May 11th. Last year we spent almost $5 trillion on federal, state, and local taxes – about 25% of our $19 trillion economy.

Most people don’t get too upset about their taxes – if they think their money isn’t wasted. Police, roads, courts, fire, sewers and schools enjoy widespread support; corporate bailouts and special provisions, not so much. The US has a voluntary tax-reporting system, where we make detailed disclosures every year about some of our most personal financial information. And we have a very high level of compliance. In Italy, by contrast, the former Prime Minister is serving time for tax-evasion while he was in office.

The Revolutionary War was fought, in part, to promote the notion of no taxation without representation. But as many have observed, taxation with representation isn’t always so hot, either.

Douglas R. Tengdin, CFA

Homeward Bound

Is now a good time to start international investing?

Photo: Victor Hancek. Source: Picjumbo

Most investors have a home-bias in their portfolio. That is, they own a higher percentage of domestic stocks than a globally diversified portfolio would indicate. This is true for folks who tout indexing as well as for active managers who pick stocks. US-based investors prefer US stocks; UK investors prefer shares listed in London; Japan-based investors prefer Japanese stocks, and so on.

There are several reasons behind this. Familiarity bias means we prefer what we know to something we haven’t heard of before. This holds true in many areas of life, not just investments. Localism also means we tend to “root for the home team,” so we’re over-optimistic about the growth potential of our home country. Availability affects investors – it can be hard to purchase many good companies because of the costs of setting up accounts overseas, and they may not have shares listed here. And risks of overseas investing can be overstated. Foreign companies are often listed as among the riskiest investments, despite the well-documented risk reduction that global diversification brings.

In the US, investors today also experience recency bias: what has happened most recently is assumed to be the normal state of things. For four of the last five years, the US has done better than the rest of the world, and over this period it has done dramatically better – growing 6% per year more than non-US markets.

Source: Bloomberg

So is this the time to go global, and shift some of those high-performing US assets to overseas markets? The inverse question is also relevant: is this the time UK or Japan-based investors who have US-domiciled assets to “come home,” or at least reduce their exposure to US equities? After all, mean-reversion is a well-studied phenomenon: trees don’t grow to the sun, and markets can’t diverge forever. If markets mean-revert, non-US markets should eventually do better that the US.

A lot of people also point to relative market valuations as a red flashing light. High P/E or P/B ratios can’t head higher forever. But when you consider the recent financial performance of US markets, the ratios don’t seem especially out of line.

Source: Morningstar, 361 Capital

The US is about 50% more expensive than Emerging Markets or Asia, but it’s ROE (return on equity) and ROA (return on assets) are about 50% higher. It’s about 10% more expensive than Europe, but its financial performance has been about 10% better. In only one area the ratios for the US raise concerns: it’s debt-to-capital, which is also elevated. That’s arguably a lot higher because of US tax policy, which favors corporations’ issuing bonds to buy back equities. In the long run, an elevated debt-to-capital ratio creates more risk. But the biggest debt issuers also have large cash deposits frozen in overseas accounts – another factor driven by tax policy. Still, a higher debt level increases risks for equity investors, who have fewer rights if something goes wrong.

In the end, the strongest case for diversifying globally doesn’t come from anticipating returns but from reducing risk. “Give portions to seven, even to eight, for you do not know what disaster may come upon the land” (Eccles. 11:2). US markets have been strong, and may continue to be strong. But the US economy isn’t the only source of wealth in the world.

Douglas R. Tengdin, CFA

Price, Quality, and Value

Which is more important: price or quality?

Photo: Victor Hanacek. Source: Picjumbo

Ideally, you’d like to have both. But there’s an old saying in business: quality is remembered long after the price is forgotten. This quote is frequently attributed to Aldo Gucci, the founder of the Italian fashion company, but it had been a marketplace maxim long before he was around. It presents a bit of business common sense: people often forget how much they paid, but how a product performs is in their face all the time.

The same is true with stocks. How much you pay matters. It matters a lot. Getting in at the top of a market, during enthusiasm and mania can depress your returns for years to come. But the quality of what you buy matters more. If a firm is on its way to bankruptcy, no entry price is low enough. There was never a good time to buy Enron, Worldcom, or Lehman.

But a high-quality company can overcome a bad entry point. A lot of great firms have stumbled over the years: Coca-Cola, Johnson & Johnson, Microsoft. In each case, the strength of their management team and their resources allowed them to work through their troubles and resume growing.

But how do we measure quality? I look at three things: management strength, financial performance, and the actual products they sell. Analysts often seem to ignore that if someone sells junk to their customers, eventually those customers stop buying their products.

These factors aren’t foolproof, but they give us a sense of how resilient a firm will be when hard times come. Because if you can buy good quality at an attractive price, that’s real value.

Douglas R. Tengdin, CFA

Risky Profiles

What’s a risk profile?

South face of Annapurna I. Photo: Gianni Scopinaro. Source: Flikr

A risk profile is one of those questionnaires you fill out when you open an investment account. To many people, the task seems silly. We just want our money to work for us. And we often have multiple goals: saving for retirement, preserving a nest-egg, maybe a down payment on a house. The questions seem to push us into a box.

Like many apparently pointless things in our lives, these forms – either online or paper – are there to satisfy a regulation. In this case, Rule 2111 of the Financial Industry Regulatory Authority (FINRA), which requires that investment firms gather information on a customer’s “risk tolerance.”

But they don’t specify what they mean by risk. So some firms have a one-line form: state your risk tolerance – low, medium, or high. Not very helpful. Others have a 50-question maze, collecting data on our income, savings, favorite sports, and whether we put cream and sugar in your coffee (I made that last one up). But the forms aren’t always followed. In one study, questionnaires were filled out in the most conservative way possible by a set of researchers. The firms then came up with an equity allocation that ranged from 0% to 70%. Another academic analyzed more than 180,000 brokerage accounts and found that risk tolerance explained about 13% of the share of risky assets in the portfolios.

Risk isn’t a one-line item, or even a five-region zone, like the elements of taste on the tongue. It’s an ever-evolving matrix of our preferences and aversions, and it’s highly sensitive to our context. Suppose you had $100 investment and it lost $10, would you buy more or sell? Only a few would sell. But if we start with $10 million and lost $1 million, a lot more of us would sell – that’s real money! But we know that the question is identical, in percentage terms.

Source: CFA Institute

The regulation isn’t pointless. Some people want to be more conservative with their money, and for good reason. They may have had a bad experience, or they may have just retired and aren’t earning a paycheck anymore. Our tolerances and preferences are real, and need to be respected. It’s just that our tools for assessing it are primitive.

Instead of just filling out a form to satisfy a compliance officer, advisers need to understand that helping clients understand their personal attitude towards risk and uncertainty is one of the most important parts of their job. Our family history, a history of our financial transactions – especially what we did during the financial crisis and the bull market afterwards – and our life circumstances all help paint a more complete picture.

Photo: Dave Meier. Source: Picography

No one really likes generic questionnaires. They seem heartless, and they often appear pointless. Instead, we need to have ongoing conversations about risk – our history, our aspirations, our goals, and our concerns. Only then can we craft portfolios that meet our goals – all of our goals.

Douglas R. Tengdin, CFA

Mile High Munchies

Well, no one saw this coming.

Denver skyline Photo: Larry Johnson. Source: Wikipedia

There’s a touching scene in Peter Hessler’s book “Country Driving” where a family in a small Chinese village receives a gift from the local Communist Party. It’s a framed skyline of a gleaming foreign city with a digital readout of the temperature, time, and date. The unnamed city was supposed to represent China’s bright future. The city was Denver; the year was 2005.

Through foresight or good fortune, the Chinese Communist Party got it right: over the last decade, Denver has been on a roll. Last year US News ranked it as one of the best places to live in the country. The population has been growing, and the city is particularly popular with millennials – supported by growth in the technology, energy, and financial industries. A boom in restaurants has followed, transforming a sleepy Southwestern culinary scene into a vibrant foodie culture.

But there’s a problem in paradise. Colorado’s Amendment 64 – which legalized marijuana for recreational use starting in 2014 – is making it a lot harder to hire and retain restaurant staff. It’s not just the $20 / hour with full benefits that cultivators can earn. It’s also working regular hours in a climate-controlled greenhouse, versus a hot, stressful kitchen. Some restaurant chain operators see workers leave for the pot industry every few weeks. It’s also hard to find entry-level workers in other industries, like construction and retail.

Marijuana greenhouse workers. Source: GGS-Greenhouse

In addition, pot smokers aren’t drinking as much beer and wine with their meals – and alcohol always has a big mark-up. As a rule of thumb, a bottle of wine that costs $20 in a liquor store will cost $60 in a restaurant. Since restaurants operate with razor-thin margins, the bar tab really helps keeps them profitable. Many Denver eateries are now seeing their alcohol sales fall by 2-4%.

What all this adds up to is higher prices for eating out. If restaurants need to pay more for labor and are selling fewer high-margin drinks, menu prices will have to rise in order for them to stay afloat. But this could eventually work out. Higher wages for entry-level work should attract more labor. And demand should increase: marijuana tourism has boosted travel to Colorado, and hey, maybe they’ll all get the munchies.

Source: Denver International Airport

For now, though, the cost of eating out in Colorado will go up. You can’t repeal the laws of supply and demand – or the law of unintended consequences – when the political and social framework changes. Denver still has a bright future. The Mile High City may just have to pay a little more for a night on the town.

Douglas R. Tengdin, CFA

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

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