Charter Trust - Global Market Update

What can The Hobbit teach us about investing?Like all literature, the real subject of Tolkien’s Hobbit isn’t the story it sets out to tell. Its subject is human nature, in all its infinite variety. As such, the story has a lot to say to investors, because investing is just another way of addressing our human nature—fear, greed, mania, complacency—where the tally is marked in dollars and cents, rather than in words on a page.And what can investors learn from Bilbo Baggins’ adventures? At least three lessons stand out: diversification, flexibility, and perseverance. Diversification is easy to see. Thorin Oakenshield’s troop of dwarves contained many types—fighters, scouts, cooks—but it didn’t have anyone good at being quiet. That’s obvious both in the book and in the movie. Bilbo is selected for just this purpose. He might not be skilled with a sword—at least, not to start—but he has abilities they will need later. In the same way, a diversified portfolio will contain all kinds of investments. Not all are ideal in all environments, but each has its place.Flexibility is necessary when you deal with the unknown; investing for the future is an exercise in forecasting, analyzing, and adjusting your plans—because the best laid plans often go astray. So when you own Apple and it declines from $700 to $500 per share, do you buy more or sell out? If you planned to steal a troll’s purse and get grabbed by the troll instead, how do you respond? Bilbo shows imagination and initiative. And he is thoroughly versed in the fundamentals of troll-dom.Finally, investors need perseverance when things don’t go well. That was clearly the case in The Hobbit when Bilbo found himself alone and lost in a tunnel at the root of the mountain. He kept moving forward with little to guide him. In the same way, investors need to know when to stick to their guns when things look dark—as they did in the winter of 2009. Often you have to hang in there in spite of the news.Diversification, flexibility, and perseverance all require us to lean against our nature, when we would rather narrow our focus and hole up, or give up. But they are good tools with which to approach markets. Tolkien’s work offers sound—and profitable—lessons to us all.

What can hobbits teach us about economics?In J.R.R. Tolkien’s first major work of fiction, Bilbo Baggins, a Hobbit from an agricultural land known as “The Shire” sets out on an adventure with a troop of dwarves that are determined to recover their gold—and their kingdom—from a dragon called Smaug. The book and movie focus on their adventures getting to the mountain and freeing its golden hoard, but there are lessons to be learned from Bilbo’s quiet homeland. First, we learn that it is a peaceful, prosperous place. While most of the drama in the book and film comes from fights with wolves, orcs, and other creatures, the hobbits’ homeland is a place of fields and farms. Perhaps unintentionally, Tolkien is saying something about the economic role of the military. A large army may be necessary for defense, but it is at best peripheral to productivitySecond, the Shire’s economy focuses on agriculture. From the time of the ancient Greeks, thinkers have noted that a key to economic prosperity has been the principle of specialization. By focusing on what we do best and trading with others who do what they do best, everyone benefits. In Tolkien’s world, different races have different strengths: the dwarves are miners and smiths, the elves care for the woodlands, men are traders, and hobbits are farmers.Finally, the hobbits’ happiness comes mainly from their contentment. Throughout his adventures, Bilbo pines for his cozy hobbit-hole with its simple pleasures. Near the end of his life, the leader of the dwarf-band tells him, “If more of us valued food and cheer and song above hoarded gold, it would be a merrier world.” It’s paradoxical, but another key to prosperity is recognizing when you have enough.Fictional works often illustrate deeper truths. Tolkien was no economist, but the economy of his world still rings true today.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

It seems like we’re seeing a bubble in cliffs.Everybody knows about the fiscal cliff. That’s what’s going to happen January 1st if Congress and the President can’t put aside their differences long enough to avoid $500 billion in tax hikes and spending cuts over the next year. The combination of spending cuts and tax hikes could cause a mild recession early next year.But the metaphor has proven to be so popular that we’re now looking at a milk-price cliff, a container cliff, and—I kid you not—a copyright cliff in 2013. These are all part of the long-term consequences of Congressional actions some years ago. The milk-cliff is due the reinstatement of a 1949 farm law that is scheduled to go into effect that could effectively double the price of milk in the New Year.The “container cliff” has to do with a potential strike by the Longshoremen’s Union in ports on the East Coast. Federal mediators need to work out a compromise on per-container royalty fees. The copyright cliff is the outworking of a 1976 law that allows artists to reclaim the rights to their works after 35 years. For the struggling music industry, this could be a lethal blow, as revenues from classics from 1978 like “Shattered” by the Rolling Stones or “Because the Night” by Patti Smith revert to their creators.These issues have come up because Congress doesn’t always plan for the long-term consequences of its legislation. Perhaps they can’t with only two-year terms. But it raises this verbal question: if pro is the opposite of con, what’s the opposite of progress?Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Adapt or die.That’s the lesson of the ICE/NYSE merger. The Intercontinetal Exchange—an internet-based operator of energy and commodity futures and over-the-counter contracts—has bid for the New York Stock Exchange. Unlike NASDAQ’s bid, which ran into regulatory antitrust issues, or the offer by Deutsche Bourse, which was blocked by the European Commission, the merger with ICE will likely go through.In this merger of non-equals, a tech-savvy startup with sound growth prospects and abundant cash purchases a centuries-old iconic brand mired in the past. We’ve all seen the pictures of the trading floor at the corner of Wall and Broad, heard the bell ring on special days, and watched movies where frantic runners carry paper orders to anxious specialists staring at monitors. But those images are fiction. Now trades are executed on electronic exchanges and the profits are measured not in pennies, or tenths of pennies, but in hundredths of pennies. Discount brokers started the trend in the ‘70s that has led to today’s world of dark pools and high-frequency trading. In this dog-eat-dog world, the NYSE’s arcane approach made it look like a golden retriever competing with a pit bull. It wouldn’t be surprising if ICE spins off the equity business in a year or so. Equity trading is important, but the real growth is in swaps and derivatives—a business with a notional value four times that of the global economy, and growing. In that business, branding matters. Thanks to the merger, ICE is about to get a great one.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Newsweek is publishing its last printed issue. Eighty years ago Newsweek pioneered the use of global wire services and produced its first issue, which cost a dime. In 1961 the Washington Post valued the company at $100 million in today’s dollars, and bought a controlling share. Two years ago they sold the company for $1 to a private investor, who merged its operations with The Daily Beast, an internet news-aggregator with some high-profile features and op-ed pieces.The idea was to have The Daily Beast provide the headlines, while Newsweek would connect the dots and provide in-depth analysis. But it hasn’t worked out. Ad pages at the print publication have plummeted by 80%, and its subscriber base has fallen 50%, from 3 million to 1.5 million, while the online edition has been treading water.Newsweek is a victim of the digitization of the news: computers, tablets, and smart-phones make a weekly newsmagazine redundant. We don’t need someone else to filter our newswire fees—Google and Yahoo news do that just fine, thanks. And Newsweek’s edgy covers just aren’t worth $5 a pop.We’re seeing this all over: oldline companies are being gobbled up or hollowed out by online competitors. Whether it’s news, or retail, or finance, the principle is the same: adapt, or die. And when global news is just a click away, you better have something pretty special if you want to charge for it.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

The Native Americans had “potlatch.” Pacific Islanders had “Aropa.” Techies today have open-source software. And most people exchange gifts at Christmas-time. But is gift-giving rational?A lot of economists say no. The look at the all the fruit cakes sent but never eaten or the ugly ties politely acknowledged and then tucked away and see nothing but a loss of hard-earned cash. One study estimates that as much as a third of the money spent on Christmas presents is wasted. They recommend people give money for Christmas, or give nothing.But these modern incarnations of Ebenezer Scrooge miss the social importance of presents. Your kids may groan when they open the sweater from Aunt Polly, but you understand the time and energy she took to knit it. It strengthens your relationship. And the best gifts satisfy a need someone else has but doesn’t really know they have.Such presents require a significant social investment—thinking like the person, getting into their head, imagining their world. We’re all prisoners of our own perspective and have a hard time seeing the world like someone else. But when we make that effort, our friendships and social bond are strengthened. And we know that strong and resilient social connections help everyone--physically, emotionally, and in many other ways. It’s not rational, but it’s real.And as Linus told Charlie Brown at the pageant, isn’t that the real meaning of Christmas? “For unto you a Son is given.” Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Big Banks, Big Problems, Big Fines - UBS is paying a fine of $1.5 billion. That’s a lot of money.As the derivatives market grew in the last decade, a number of banks used their role in the rate-setting process to artificially raise or lower rates. They were able to make bets on LIBOR, and then help set LIBOR. They were like big-league sports players betting for or against their own team.When I say that the derivatives market grew, I mean it really grew. LIBOR is now a benchmark for almost $350 trillion in financial products. A misstatement of just .01 percent means a $35 billion change in payments. The stakes are huge. It’s no surprise that during the financial crisis LIBOR manipulation was an open secret.When the authorities calculate LIBOR, a select group of big banks are supposed to submit the actual interest rates that they pay to borrow from other banks. But since the banks are able to make multi-trillion dollar bets for their own books, their incentives to game the system are too big to pass up. At UBS, at least 45 bank employees were involved in the scam, and another 70 were included in open chats and messages where rate manipulation was discussed. Some traders set up payment systems to encourage others to cooperate with the scheme—up to $100,000 per year.But once the con was made public, a host of borrowers—mortgagees, municipalities, corporations—noted that the rate manipulation cost them billions, while the banks brought in billions. The litigation costs, reputational costs, and fines are now expected to depress bank earnings for years.When athletes bet on their own performance, they’re banned from the sport for life. Compared to being cut out the money markets, $1.5 billion may turn out to be cheap at the price.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

In 2008 we popped the housing bubble; in 2000 it was the internet bubble; before that we had commercial real estate, biotech, LDC debt, and the oil patch. Every few years a bubble starts brewing, and when it pops investors lose and the economy goes into a funk. So where’s the next one? To avoid the next bubble, we need to understand the last one. Sub-prime loans at insanely low rates enabled people to build and buy way more house than they needed or could afford. But hey, housing prices always go up, right? Cut rate margin loans allowed people to speculate on tech stocks who never should have been day-trading. But the internet promised a new era through productivity and efficiency, and hey, these stocks can only go up, right? LDC debt financed infrastructure construction and natural resource development in less-developed countries with newly found mineral wealth. Bankers flocked to snap up these loans, because hey, countries don’t go bankrupt, right. Critical to any bubble is financing. What’s common in these three scenarios from the 00s, ‘90s, and ‘70s was cheap financing and an asset that seemed to only get more valuable. When you have a no-fail asset in a hot sector, bankers compete to lend against it, and the item grows in price exponentially. Speculators play the market with other people’s money, and when the price falls, the banks are left holding the bag. So what can’t fail these days? Government. Many say that it never shrinks, in spite of the fact that as a percentage of the economy, the Federal government has fallen many times—under Republicans and Democrats.  But with the Fed holding rates near zero, there is little to check the growth of government spending. A $1 trillion deficit now costs less than a billion dollars a year to finance. And with the Fed buying Treasury debt, the cost is even less. Bond mutual funds keep growing even as yields fall to record lows. But hey, the government always grows, right? Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @GlobalMarketUpd

Is the Federal Reserve irrelevant?There used to be a time when the markets would hang onto every stray word that a Fed official would utter. There used to be a time when we would wait for the outcome of Federal Reserve meetings with bated breath. There used to be a time when the Fed’s Chairman was considered the second most powerful person in the country.Not any more.For the past year or so—ever since the Fed began offering quarterly press conferences—the markets have issued a collective yawn around the time of Fed meetings. It’s as if more information has resulted in less impact. Has Ben Bernanke’s march towards greater transparency resulted in rules and pronouncements that make Fed policy perfectly predictable? Are markets now able to see right through the Fed’s decisions, so they can discount Fed decisions before they happen?I don’t think so.The increased transparency has occurred during the Fed’s period of extraordinarily low rates. Rates have been at or near zero for four years now. That’s an unusually long period for rates to be stuck in one place. Part of the reason the markets don’t seem to care about what the Fed does is that they are backward-looking: because Fed policy has been stable, they are predicting that it will continue to be stable. That doesn’t always turn out so well.Another reason no one seems to care is that it’s hard to point to any marginal effect from the latest Fed decision. It’s hard to say what it means for the economy if the 10-year Treasury yields 1.5% versus 2%.Finally, bonds and cash seem to be perfect substitutes right now. So for the Fed to expand its balance sheet—and grow from $50 billion in 2008 to $2 trillion now and perhaps  $4 trillion in a couple years doesn’t mean anything—no stimulus, and no hyperinflation either. The economy’s problems aren’t monetary, so monetary policy can’t fix them.But the Fed will continue to make its pronouncements and enact its extraordinary measures, if only to justify its own existence. Just don’t expect it to make any difference for a while.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Sometimes we need to stop for a moment and reflect. This commentary is focused on markets and the people who make them, but circumstances require something deeper today. The horrors inflicted upon the children and adults at Sandy Hook Elementary School last Friday are both repugnant and mesmerizing. We are repelled by the brutality, but curious about what could have motivated such cruelty. Over the weekend I found myself repeatedly drawn to the news only to turn away in disbelief and disgust. But people have been facing such tragedies ever since the first murder (although not on this scale). Our hearts cry out to understand how such things are possible. A hundred years ago the writer Joseph Conrad wroteHeart of Darkness, where he uses a river journey into central Africa as an extended metaphor about the darkness within every human heart. And we’ve seen this—in Norway, on 9/11, in the atrocities of the 20thcentury—some individuals become unhinged and commit unspeakably heinous acts. Conrad writes that we may start out with dreams of commerce, or fame, or adventure, but often end up unintentionally exploiting everything around us. Whether we misuse nature, or science, or other people, what begins well-intentioned becomes bent and twisted. Another 20th century writer has noted that the line between good and evil runs not between nations or parties, but through the middle of every human heart. So we rely on institutions and each other to restrain our nature and draw out what is good. Sometimes these fail. The genius of our society is we adapt and move on. But after this heart-wrenching story let’s remember to care. Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @GlobalMarketUpd

Over the Edge? - Why is it always cliffs and crises?If you’re like me, you’re thoroughly sick of all the talk of fiscal cliffs, budget deadlocks, and back-room last-minute deals that will or won’t avert some Congressional deadline that does or doesn’t threaten to push us over an economic precipice.Part of the reason we’re so tired of the subject is that it always comes up and no one ever seems to deal with it. It’s like we have chronic fatigue syndrome with regards to the deficit: Reagan deficits, Bush deficits, Obama deficits—it seems that the deficit is perennially criticized by the party that’s out of power, while the party in power funds its pet projects.It’s important to understand, though, that our current trajectory of debt and deficits is well outside the norm. While the deficit isn’t anywhere close to an emergency, we really don’t want to fritter away any opportunity to deal with it. If you examine a graph, a pattern of volatile but growing deficits emerged starting in 1970, briefly interrupted in the late ‘90s by the peace dividend (from the end of the Cold War) and revenues from the dot-com boom. Well those days are over.It’s been clear for decades that the US budget would run into trouble when the Boomers started retiring. Before the Financial Crisis, we thought we had 20 years to tweak Social Security formulas and deal with rising health care costs. Now, with the economy weaker and another layer of debt built up from the recession, it’s more like 10 years.Economist Herb Stein once quipped that if something cannot continue it will stop. Well, it’s time for the brinksmanship and partisan bickering to stop. Because these deficits cannot continue.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

The Triumph of the Small - What’s the advantage of being small?For small investors, it’s a lot. They have less bureaucracy and office politics to deal with, they can just focus on investing and client service. And they have a much bigger universe of stocks to pick from. Small, illiquid issuers of stocks or bonds can’t be purchased by big institutional funds in adequate size to make a meaningful difference in performance. If the big boys can’t buy a stock, they’re not going to spend time researching it.That means there are many unexplored investment gems out there for smaller investors to explore. If big institutions aren’t buying the shares, brokerage analysts aren’t going to spend time on them, either. That’s why a lot more analysts follow Kraft Foods than Crumbs Bake Shop.It used to be that being big was an advantage in other ways. You could get company management to pay attention and talk to you; you could afford sophisticated software to make sure your trades settled properly and to present your performance in the best light; and you could hire a host of analysts dedicated to crunching numbers and creating spreadsheets that tracked fundamental financial performance.But the internet and networking have changed all that. SEC regulations and the ease of webcasting make it simple for anyone to listen live as the most obscure CFO discusses her quarterly cash-flow. And trade performance data that used to cost millions to develop and run can now be leased on a mobile platform for a few thousand dollars a year.So expect that successful portfolio managers will continue to leave the big firms and set up shop on their own. Increasingly, a large asset size is a handicap for both managers and investors, rather than an advantage.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Backwards Backup - Backwards Day strikes again! A couple months ago I wrote about “Backwards Day”: the day back in high-school where if someone asked how you were, you said “bad” if you meant good, people walked backwards down the halls, and put as many of their clothes on backwards as they could. Up was down; no was yes.I noted that with capital gains tax rates going up, it’s backwards day in tax-planning. Well, now it’s backwards day in corporate finance, too.Companies are declaring special dividends and paying bonuses early. They’re expecting that treatment of dividends will shift from the capital gains rate to ordinary income, and that income tax rates and theObamacare surtax will push rates up for the highest earners. And it doesn’t matter if Congress doesn’t enact a final rule until later in the year; in August of 1993 Bill Clinton signed a tax bill that was retroactive to the first of the year. In fact, Congress has enacted retroactive taxes 26 times since the Federal Income Tax was imposed a hundred years ago.So early payment of dividends and bonuses doesn’t guarantee protection from the long arm of the government. Still, it beats the alternative of sitting around waiting for the IRS to compute higher withholding tables. Thus far 144 companies have announced special dividends in the fourth quarter totaling $21.4 billion. Accelerating bonuses into 2012 can be more complicated, but many finance, law, and consulting firms are doing that as well. It doesn’t cost the company more than a few administrative headaches, and it increases the employees’ take-home pay, so why not?All this tax-planning is putting cash into government coffers now, at the expense of next year. So expect to hear stories about how the deficit has magically shrunken, or how incomes have risen. Don’t believe it: that money is just pulled forward from early 2013. Government revenues in early 2013 will be depressed. Because the government gives, and the government takes away. And when they take it away early, there’s less for them to take later.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Finding Financial Reality - What good are financial statements?That may seem like a funny question from a financial analyst. But financial statements can distort, rather than reveal, the nature of a company. Beyond outright fraud, where managers just make things up, there are counterintuitive accounting practices that are misleading, like marking liabilities to market. For example, during the financial crisis, when banks got into trouble and their debt was downgraded, that created an earnings boost, as all those mark-to-market liabilities got cheaper. Financial statements are a necessary—but not sufficient—component of understanding a company’s economic reality. Most of us know what McDonald’s sells, but did you know that less than a third of their sales come from the US? The fact that so many firms generate so much revenue from non-US sources creates a complex situation where different legal standards, accounting issues, and currency regimes make it difficult for the most scrupulous manager to communicate what’s really happening. Add to this the misaligned incentives that corporations sometimes attach to their financials, and you have a recipe for disaster.But throwing up our hands and giving up isn’t an option. Financial statements can and should be combined with other sources of information about a company. These include management’s discussion of their results, the conference calls that accompany earnings reports—especially the Q&A sessions—and site visits, to store locations and management headquarters.In the end, all of these factors help us learn more about a company—what they do, and how things are going. It’s like a jigsaw puzzle: every piece is important, and taken together they paint a picture. We don’t have to like it, but we do need to understand it.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd

Inside Out? - Only Nixon could go to China.That’s what I thought when I heard that Phil Hanlon, Dartmouth Class of 1977 and AD Fraternity brother had been selected to become the 18th President of Dartmouth College. Hanlon has a Ph.D. in Mathematics from Cal Tech and is currently Provost at the University of Michigan, where he also teaches undergraduates. He’s stated that he expects to focus closely on the college’s cost structure and finances. “We can’t continue superinflationary tuition increases,” he has noted.He’s right about that. Last year Dartmouth increased its tuition by 4.9%, 3% above the inflation rate. Indeed, it has grown by 3% more than inflation for the past 30 years. Tution now totals almost $44 thousand / year. As always, the school notes that tuition and fees only cover half their costs. But why does it cost so much? As a career academic, educator, and administrator Hanlon has the credibility to dig into the finances and find where the bodies are buried.But there’s another area of college life that needs examining—less critical than finance, but still important. It’s the social scene that revolves around partying and binge drinking. As a bro at AD in the mid-‘70s, Hanlon experienced the frat scene that served as a model for the movie Animal House. It was a tumultuous time: a few years after Hanlon graduated the faculty proposed abolishing all fraternities at Dartmouth—a “modest proposal” that didn’t get very far. Since then reform efforts have come and gone. Houses have been suspended or kicked off campus. But nothing material has changed.Costs and frats are perennial problems for colleges. Perhaps someone from the inside—with the credibility of a bro—can cut these twin Gordian Knots. Here’s to hope.