"Unemployment is sky-rocketing; deflation is in our future for the first time since the Great Depression. I don't care whose fault it is, it's the truth." - John Mellencamp
Economics is a very strange discipline. It tries to work out what will happen to an economy given certain inputs and structural changes. For example, how will a change in the tax rate help or hurt the economy or how will massive stimulus from the Federal Reserve stimulate economic growth? The problem with economics is that there are just so many moving parts that the chances of actually get the answer right is pretty much impossible. What you can do is hypothesis about the future and base it on historical data points and then rely on your instinct to guide you. Changing your mind is part and parcel of the process as new data is constantly available and there is always the Black Swan event lurking around that will throw all assumptions out of the window and create havoc with your hypothesis.
When I look at the massive quantitative easing program of the Federal Reserve the questions are is it working and will it result in inflation? Consensus says that it is working (at least that is what it appears when you look at the stock market) and that inflation, while it will rise will be moderate. At present I disagree with both of these views which is why I am in the camp that is negative on the market because if it is not working and inflation will not be moderate in the future then the market is setting everyone up for a massive reversal.
Now what if we are all wrong? What if inflation not only remains subdued but due to all of the easing we end up with deflation? I have mentioned in last week's blog that Japan is already exporting deflation to the rest of the world, but what if deflation takes hold globally? If I look at the Federal Reserve who has increased their balance sheet by almost $3 trillion you would expect massive inflation but at present it seems relatively mute.
Consider this equation created by Irving Fisher that GDP = MV. That is to say the size of the economy is equal to the money supply multiplied by the velocity of money. Now if the velocity of money remains constant (does not change) then by increasing the supply of money through the Federal Reserve monetary expansion then GDP has to increase. This is inflation. Now as there is minimal inflation at present and GDP is not growing very fast (if at all) let's dig a bit deeper to see what is going on in the inner workings of the equation.
Money supply as measured by M2, the monetary base, expanded by $277.5 Billion last quarter as the Federal Reserve expanded its balance sheet by that amount. M (money supply) however declined by $55 Billion to $10.45 Trillion. This is only possible if the money multiplier shrank. The money multiplier is the value assigned to the expansion of the money supply when a bank lends out a dollar. This expansion occurs because the dollar lent does not just stay in your wallet but is used to buy goods and services and is then spent again and again. This one dollar multiplied itself by a factor of 9 in 2007 when the economy was booming, but today that number has fallen to 3.6. So the first problem that the Federal Reserve has is that it cannot create demand by printing money.
The second part to the equation is the velocity of money. Velocity of money was thought to always remain stable but it turns out that this too is a variable. It appears that the only way in which the velocity of money can remain stable or expand is through lending to increase production. Lending to finance consumption does not generate a productive income stream and it cannot create resources to repay the debt so therefore velocity collapses. In fact the current velocity of money stands at a six decade low.
Now the inflation advocates point to the fact that once things turn around you will have an increase in the velocity of money and an increase in the money multiplier and a huge increase in the monetary base and this will lead to outlandish inflation. The problem is that the money printed is being used to finance consumption and this could result in a spiral into the abyss that is deflation. This is what Japan has been dealing with for decades. They too have and are pumping money into an economy in the hopes that it will eventually get their economy started but after more than 20 years there is still no sign of life. Worse than that they now owe more than 200% of GDP in government debt.
This could easily be the outlook for the United States and if it is then the euphoria of the stock market will quickly turn to dismay. The reason is that deflation is the worst possible world for the stock market. The economy is essentially shrinking as prices fall and consumers put off purchasing goods and services as they learn that these will be cheaper in the future. Businesses struggle to grow and can only keep profits up by stealing market share from others or by cutting overhead such as labor. If this sounds familiar then you are right as this is where the United States is now. The problem is that the market and most pundits expect inflation to begin any time soon and as the market looks forward the expectations for inflation are now baked into the prices. Should this expectation change as the reality sets in then the market will be in for a long downward spiral. In Japan the market has recently rallied to over 13,000 but that is still a long way from 38,916 which was the all time high set in December 1989!
Friday, April 26, 2013
Friday, April 19, 2013
A Shudder Is Felt
"Excuse me, why have the engines stopped? I felt a shudder." - Rochelle Rose as Countess of Rothes in Titanic
This week it was evident that there is trouble in global markets. Now not to discount the fact that the Federal Reserve and other central bankers of the world will rush to support the one beacon of success the stock market, surveying the movements in the markets this week seems to point to a shift in the bullish stance.
The first graph that I look to in these times is our old friend Dr. Copper. As you can see from the chart below there is a lot of concern about global growth. China in particular is looking weak and this is feeding into global growth projections and notably the copper price.
Gold also took a tumble recently as concerns for inflation are being replaced with concerns for deflation. That said I still believe in the value of allocating a portion of your portfolio to this metal as it appears that the gold haters one this round but the long run bull market for gold is still intact.
Deflation is being fueled by the Bank of Japan's massive quantitative easing program as their disdain for their currency is giving them the ability to undercut their rivals and hence export their deflation to the world. This in turn is fueling their stock market which too is spiralling higher, but the repercussions of Japan's move will be felt throughout the globe and will not have a pleasant impact on their trade partners. As an example expect Toyota to take market share from the resurgent US automaker as they will be able to under cut their their American competitors.
All of this news and some poor earnings from the some of the US bell weather stocks is having an impact on the performance of the stock market. As I mentioned before though the Federal Reserve will put in a big effort to support this market as it is the shining beacon of its success.
So whether this is just a brief pullback or the start of something bigger the global metrics continue to point to weakness and this will fuel a large pullback at some point in the near future. I believe though that when that time comes, much like the Titanic, there will be little time to exit so make sure you heed the warnings early.
This week it was evident that there is trouble in global markets. Now not to discount the fact that the Federal Reserve and other central bankers of the world will rush to support the one beacon of success the stock market, surveying the movements in the markets this week seems to point to a shift in the bullish stance.
The first graph that I look to in these times is our old friend Dr. Copper. As you can see from the chart below there is a lot of concern about global growth. China in particular is looking weak and this is feeding into global growth projections and notably the copper price.
Gold also took a tumble recently as concerns for inflation are being replaced with concerns for deflation. That said I still believe in the value of allocating a portion of your portfolio to this metal as it appears that the gold haters one this round but the long run bull market for gold is still intact.
Deflation is being fueled by the Bank of Japan's massive quantitative easing program as their disdain for their currency is giving them the ability to undercut their rivals and hence export their deflation to the world. This in turn is fueling their stock market which too is spiralling higher, but the repercussions of Japan's move will be felt throughout the globe and will not have a pleasant impact on their trade partners. As an example expect Toyota to take market share from the resurgent US automaker as they will be able to under cut their their American competitors.
All of this news and some poor earnings from the some of the US bell weather stocks is having an impact on the performance of the stock market. As I mentioned before though the Federal Reserve will put in a big effort to support this market as it is the shining beacon of its success.
So whether this is just a brief pullback or the start of something bigger the global metrics continue to point to weakness and this will fuel a large pullback at some point in the near future. I believe though that when that time comes, much like the Titanic, there will be little time to exit so make sure you heed the warnings early.
Friday, April 12, 2013
A Lot of Data
"This is referred to as data mining. They slice and dice these numbers a thousand different ways. They analyze patterns. If your NSA, you look for suspicious patterns." - Leslie Cauley
The first thing that you always have to be careful of when look at a lot of data points is that you are not mining data to fit your theory rather than looking at all the data points from a rational perspective. It is an easy trap to fall into as we are normally biased towards our own opinions and can spend hours explaining the virtues of our position (just listen to any sports enthusiast arguing about the referee calls). However when the data points overwhelmingly in your favor you have to act and that is one of the arts of trading.
Recently there has been a slew of poor information and it all points to the economy slowing and at a far more rapid pace (actually all the analysts are expecting growth) than was anticipated by the market consensus. The first and most recent data point was that PC sales fell by 14%. This is the largest decline in the history of PC sales. Pundits tried to push this aside as a migration to the tablet and the mobile phone and while I will admit that a lot of people have migrated to those platforms the underlying trend is worrying.
There is no way that the market implosion of PCs is only related to tablets. This is a direct result of very weak consumer spending and a weak global economy. Ask anyone who owns a tablet how much business they actually do on a tablet and the answer is normally not much. This weakness will feed into weak chip sales, chip development, software and numerous other industries. Remember when the NASDAQ was flying and technology was the place to be well it appears that those days are over and to me this is even more scary as without a technological recovery I am not sure what other industry can drag the global economy back on its feet.
The next data point is poor consumer spending numbers which have fed poor retail sales. As I have mentioned repeatedly, the tax effects and increased costs of health insurance and other expenses combined with little to no job growth or increases in pay will have a massive impact on consumer spending. This is starting to raise its ugly head as retail sales fell 0.4% in March. Following this up was another poor number out of the consumer as consumer sentiment fell again in April. Admittedly this is a preliminary number but it is not a good omen.
The final data point I want to talk about is the revelation from Pimco's Bill Gross that the Federal Reserve is now publishing different reports for different groups. The Federal Reserve issues a separate release to lobbyists and congressional staffers. In addition there are certain funds and banks that receive the data sooner than others! Now why is it that some are insiders and others are not? So much for independence and for looking out for the benefit of the economy! No it is certain that they are cherry picking those who they want to benefit at the expense of everyone else and this is outright discrimination and needs to be stopped immediately.
Outside of that they did caution that the duration of their quantitative easing strategy was under consideration to be shortened. In effect they are finally admitting that it is not working as why else would they start talking about curtailing it when nothing has recovered? Should they stop printing I would expect a huge market correction for the simple reason that they are manipulating the market openly. Stop manipulating and down it goes as all that the market will have for a backstop then will be poor economic data and outlook.
As you all know I have been calling for this for a long time and I have been wrong to date but until the economic indicators turn themselves around there is no reason to be long the market particularly when the people controlling it are openly manipulating the data and providing it to their friends first!
The first thing that you always have to be careful of when look at a lot of data points is that you are not mining data to fit your theory rather than looking at all the data points from a rational perspective. It is an easy trap to fall into as we are normally biased towards our own opinions and can spend hours explaining the virtues of our position (just listen to any sports enthusiast arguing about the referee calls). However when the data points overwhelmingly in your favor you have to act and that is one of the arts of trading.
Recently there has been a slew of poor information and it all points to the economy slowing and at a far more rapid pace (actually all the analysts are expecting growth) than was anticipated by the market consensus. The first and most recent data point was that PC sales fell by 14%. This is the largest decline in the history of PC sales. Pundits tried to push this aside as a migration to the tablet and the mobile phone and while I will admit that a lot of people have migrated to those platforms the underlying trend is worrying.
There is no way that the market implosion of PCs is only related to tablets. This is a direct result of very weak consumer spending and a weak global economy. Ask anyone who owns a tablet how much business they actually do on a tablet and the answer is normally not much. This weakness will feed into weak chip sales, chip development, software and numerous other industries. Remember when the NASDAQ was flying and technology was the place to be well it appears that those days are over and to me this is even more scary as without a technological recovery I am not sure what other industry can drag the global economy back on its feet.
The next data point is poor consumer spending numbers which have fed poor retail sales. As I have mentioned repeatedly, the tax effects and increased costs of health insurance and other expenses combined with little to no job growth or increases in pay will have a massive impact on consumer spending. This is starting to raise its ugly head as retail sales fell 0.4% in March. Following this up was another poor number out of the consumer as consumer sentiment fell again in April. Admittedly this is a preliminary number but it is not a good omen.
The final data point I want to talk about is the revelation from Pimco's Bill Gross that the Federal Reserve is now publishing different reports for different groups. The Federal Reserve issues a separate release to lobbyists and congressional staffers. In addition there are certain funds and banks that receive the data sooner than others! Now why is it that some are insiders and others are not? So much for independence and for looking out for the benefit of the economy! No it is certain that they are cherry picking those who they want to benefit at the expense of everyone else and this is outright discrimination and needs to be stopped immediately.
Outside of that they did caution that the duration of their quantitative easing strategy was under consideration to be shortened. In effect they are finally admitting that it is not working as why else would they start talking about curtailing it when nothing has recovered? Should they stop printing I would expect a huge market correction for the simple reason that they are manipulating the market openly. Stop manipulating and down it goes as all that the market will have for a backstop then will be poor economic data and outlook.
As you all know I have been calling for this for a long time and I have been wrong to date but until the economic indicators turn themselves around there is no reason to be long the market particularly when the people controlling it are openly manipulating the data and providing it to their friends first!
Friday, April 5, 2013
Markets Rise Everywhere With No Jobs To Support Them
"Double, double, toil and trouble; Fire burn and cauldron bubble." - The witches chant from William Shakespeare's Macbeth
This morning the United State reported disastrous employment news. It really should not have come as a surprise as I have been reading of layoffs from large and small companies across the country for months now. I am now also watching as the S&P 500 which dropped over 1% on the news claw its way back towards the gain line once again. It is certainly apparent that no matter what the news, the markets are going to go higher and if you listen to CNBC or one of the other market cheer leading channels within minutes you will be told just why things can only go higher from here!
Let me lead you through a number of very poignant metrics and you can make your own conclusions.but suffice it to say that I have now put on some S&P puts! Not a large amount but enough to make me feel better. :)
First off you need jobs to create a strong economy. Look at any model of economic strength and you will see a low unemployment number. Jobs are the economy. No jobs, no economic recovery period. At present looking across the globe you have the Euro zone with unemployment above 12% the highest it has ever been and this masks the disasters that are Greece and Spain where unemployment is well past the Great Depression levels. The United States has unemployment at north of 14% if you include the underemployed and some metrics have it as high as 20%. Worse still is that 48 million people are now on food stamps in America up from 28 million just 5 years ago. That is 11% compounded annual rate of growth! What portfolio would not die for that number over the last five years? So we have mounting unemployed and 15% of the people cannot feed themselves without government aid and the United States is supposedly the richest country in the world.
Without jobs the consumer has no spending power. With no spending power companies cannot sell their products and profits slip (I expect a lot of companies to miss or lower their earnings targets going into this quarter's earnings reports). So why is the market continuing higher? It is very simple, the Federal Reserve is pumping money into the system and that money has to be invested. With bond yields at historic lows the stock market and real estate are the direct beneficiaries. Real estate is up over 8% nation wide while the yield on junk bonds has fallen to less than 3%. Both of these are unsustainable. First off housing prices cannot keep up this pace as consumers do not have the ability to purchase the houses. The house prices are being propelled by large funds that are scooping up millions of houses at once because they can borrow money for next to nothing and this investment creates a better yield on their investment than the bond market. This is not consumer demand this is speculation at its worst.
Furthermore with treasury yields falling to next to nothing bond buyers have once again ratcheted up the risk by buying junk. This demand has pushed the price of these high risk bonds up reducing the yield to next to nothing. The risk is not being met with commensurate return and this is a disaster waiting to happen. To me it is not a case of if it will unravel but when. Trying to even hazard a guess as to when this will unravel is futile as it will only occur when there is a loss of faith in the Federal Reserve's ability to control the markets.
For this reason sentiment indicators are worth watching and the most recent one was consumer confidence which dropped precipitously to 59.7 in March from 68 in February. Consumers are starting to feel the very real pinch of lower income as another bite is being taken out of their pay with the tax increases, health care increases and gasoline and food price increases. While this is not a good signal the Federal Reserve continues to believe that printing more money is the answer and is cajoling money printers around the world in Britain, Japan, Switzerland and others to join in the party. This juice is what is fueling these speculative frenzies in the stock, bond and real estate markets. Switch this juice off (which they will have to eventually) and all of these markets die virtually instantly as we have seen with the end of each of the previous 3 rounds of quantitative easing (or is it four, there have been so many I can barely keep up).
Do not get sucked in. Keep your money in cash, gold or something that is safe and protected against a downturn as that is the best way to survive the storm as it appears that there are more than a few black clouds on the horizon.
This morning the United State reported disastrous employment news. It really should not have come as a surprise as I have been reading of layoffs from large and small companies across the country for months now. I am now also watching as the S&P 500 which dropped over 1% on the news claw its way back towards the gain line once again. It is certainly apparent that no matter what the news, the markets are going to go higher and if you listen to CNBC or one of the other market cheer leading channels within minutes you will be told just why things can only go higher from here!
Let me lead you through a number of very poignant metrics and you can make your own conclusions.but suffice it to say that I have now put on some S&P puts! Not a large amount but enough to make me feel better. :)
First off you need jobs to create a strong economy. Look at any model of economic strength and you will see a low unemployment number. Jobs are the economy. No jobs, no economic recovery period. At present looking across the globe you have the Euro zone with unemployment above 12% the highest it has ever been and this masks the disasters that are Greece and Spain where unemployment is well past the Great Depression levels. The United States has unemployment at north of 14% if you include the underemployed and some metrics have it as high as 20%. Worse still is that 48 million people are now on food stamps in America up from 28 million just 5 years ago. That is 11% compounded annual rate of growth! What portfolio would not die for that number over the last five years? So we have mounting unemployed and 15% of the people cannot feed themselves without government aid and the United States is supposedly the richest country in the world.
Without jobs the consumer has no spending power. With no spending power companies cannot sell their products and profits slip (I expect a lot of companies to miss or lower their earnings targets going into this quarter's earnings reports). So why is the market continuing higher? It is very simple, the Federal Reserve is pumping money into the system and that money has to be invested. With bond yields at historic lows the stock market and real estate are the direct beneficiaries. Real estate is up over 8% nation wide while the yield on junk bonds has fallen to less than 3%. Both of these are unsustainable. First off housing prices cannot keep up this pace as consumers do not have the ability to purchase the houses. The house prices are being propelled by large funds that are scooping up millions of houses at once because they can borrow money for next to nothing and this investment creates a better yield on their investment than the bond market. This is not consumer demand this is speculation at its worst.
Furthermore with treasury yields falling to next to nothing bond buyers have once again ratcheted up the risk by buying junk. This demand has pushed the price of these high risk bonds up reducing the yield to next to nothing. The risk is not being met with commensurate return and this is a disaster waiting to happen. To me it is not a case of if it will unravel but when. Trying to even hazard a guess as to when this will unravel is futile as it will only occur when there is a loss of faith in the Federal Reserve's ability to control the markets.
For this reason sentiment indicators are worth watching and the most recent one was consumer confidence which dropped precipitously to 59.7 in March from 68 in February. Consumers are starting to feel the very real pinch of lower income as another bite is being taken out of their pay with the tax increases, health care increases and gasoline and food price increases. While this is not a good signal the Federal Reserve continues to believe that printing more money is the answer and is cajoling money printers around the world in Britain, Japan, Switzerland and others to join in the party. This juice is what is fueling these speculative frenzies in the stock, bond and real estate markets. Switch this juice off (which they will have to eventually) and all of these markets die virtually instantly as we have seen with the end of each of the previous 3 rounds of quantitative easing (or is it four, there have been so many I can barely keep up).
Do not get sucked in. Keep your money in cash, gold or something that is safe and protected against a downturn as that is the best way to survive the storm as it appears that there are more than a few black clouds on the horizon.
Friday, March 29, 2013
Another Ticking Time Bomb
"Now, stop that whining, Willard!...
Willard, I know this is dangerous, but if we can save one human life...
Oh, that's the way you feel about, huh?...
Look Willard, control yourself now...
Listen Willard, according to this, there's a... Er, how long has that thing been ticking?...
About 5 - 6 minutes, huh?...
Huh?
Oh!... Er... nothing, Willard, nothing... we're just gonna have to work a little faster than I thought!" - more of Bob Newhart's Defusing A Bomb skit
As I mentioned last week, in this blog I will delve into the United States pension funds as the second in my two part series on Black Swans. As I mentioned before, there are plenty of other problems but these two struck me as the most plausible and threatening of the multitude of issues facing the globe and in particular the United States.
According to a survey conducted by Towers and Watson a consulting firm, the United States pension assets stand at $30 trillion. This is an enormous figure (as are all numbers these days). The problem however is not the size of the number, it is the way that the benefits are calculated.
The first thing we need to do is gain an understanding of how a pension fund works. A pension fund is a legal entity into which tax payers or workers add money and out of which retirees draw payments. Over the years assets accumulate and it is expected that this fund earns returns which offsets inflation expectations and preserves the life of the fund. So there are two things to consider here; first off is how much is being added to or subtracted from the pot in the form of contributions and distributions, and second is what are the expected returns to the asset pile versus the expected payouts and inflation.
The first part to the equation is based on demographic shifts. If you have a large base of young employees and a small base of retirees the incoming payments from the workers more than offset the withdrawals. Once the balance changes withdrawals exceed incoming payments. As the baby boomers are rapidly aging and retiring this shift is happening right before our eyes. Drains are being felt in Social Security and other pension funds that for years have relied on an ever increasing pile of assets to cover the payouts.
In this case the future retirees have to rely on the returns of the assets to cover the expected future payouts. This is similar to a life insurance company which calculates the average life expectancy of the policy holders and then factors in the returns on the policy payments to come up with a cost for the insurance. The problem is that a large number of these pension funds have underestimated the life expectancy of the retirees AND have over estimated the annual returns.
With the rapid improvement in medicine people are living longer and longer. As I mentioned before, the life insurance industry is now running life expectancy tables to age 120. The longer that people live the more that the funds have to pay out. In the past retirees left the workforce around the age of 60 but life expectancy was only 10 years more. Now life expectancy has increased by 50 years but people still expect to retire at 60 and live off their pensions. This is a complete mismatch and spells disaster for these funds as the assets will be exhausted way before the youth of today retire. This problem however is easily solved, just raise the age at which you are able to draw on the fund and voila, instantly fixed. The problem is that this is political suicide so as long as it can be reported that the funds are solvent everyone can brush this under the rug for another year.
So the way to take care of this problem is to produce returns high enough to cover all of the expected withdrawals. At present a lot of these funds have modeled 8% returns. The idea is that you can go out and borrow money around 4% and then earn 8% and the spread will magically cover the future draws on the fund. This is a huge leap of faith and one that is creating an even bigger future problem. Sure this solves the problem of reporting but the gap between actual returns and budgeted returns is large and growing. In the current market environment where the 10-year treasury is yielding only 2%, to think that you can earn a blended rate of return north of 6% is madness. In order to achieve this huge risk has to be taken and that is not a word that should be attached to a retirement account!
The rub is that for the last few years this risk trade has been working admirably. The stock market is up over 100% so achieving these goals has been relatively easy. The problem is that when the market corrects these funds are going to be left high and dry. As Warren Buffet says, "You never know who is swimming naked until the tide goes out." If and when the tide goes out these funds will be left owing not only their retirees but also the investors lending them the money. Essentially these funds in a vein attempt to "protect" the fund have margined the account. Margin increases risk as you are leveraging the asset base to maximize profits. Just like the banks are dong with derivatives. As an interesting side note it came out that when JP Morgan had its "Whale" problem at one point they lost $415 million in one day!
Consensus says that if the government was prepared to bail out GM and Goldman Sachs how could they let the pension fund of say California die? And certainly they cannot, but the burden that this will place on the Federal Reserve would be so extreme that I find it hard to believe that there would not be a market panic far worse than that felt in 2007. Should this ever occur the taxpayer (you and I) would now be footing the bill for government pensioners and this would not be met with open arms, not to mention that the municipal bond market would suddenly be lumped into junk status.
Willard, I know this is dangerous, but if we can save one human life...
Oh, that's the way you feel about, huh?...
Look Willard, control yourself now...
Listen Willard, according to this, there's a... Er, how long has that thing been ticking?...
About 5 - 6 minutes, huh?...
Huh?
Oh!... Er... nothing, Willard, nothing... we're just gonna have to work a little faster than I thought!" - more of Bob Newhart's Defusing A Bomb skit
As I mentioned last week, in this blog I will delve into the United States pension funds as the second in my two part series on Black Swans. As I mentioned before, there are plenty of other problems but these two struck me as the most plausible and threatening of the multitude of issues facing the globe and in particular the United States.
According to a survey conducted by Towers and Watson a consulting firm, the United States pension assets stand at $30 trillion. This is an enormous figure (as are all numbers these days). The problem however is not the size of the number, it is the way that the benefits are calculated.
The first thing we need to do is gain an understanding of how a pension fund works. A pension fund is a legal entity into which tax payers or workers add money and out of which retirees draw payments. Over the years assets accumulate and it is expected that this fund earns returns which offsets inflation expectations and preserves the life of the fund. So there are two things to consider here; first off is how much is being added to or subtracted from the pot in the form of contributions and distributions, and second is what are the expected returns to the asset pile versus the expected payouts and inflation.
The first part to the equation is based on demographic shifts. If you have a large base of young employees and a small base of retirees the incoming payments from the workers more than offset the withdrawals. Once the balance changes withdrawals exceed incoming payments. As the baby boomers are rapidly aging and retiring this shift is happening right before our eyes. Drains are being felt in Social Security and other pension funds that for years have relied on an ever increasing pile of assets to cover the payouts.
In this case the future retirees have to rely on the returns of the assets to cover the expected future payouts. This is similar to a life insurance company which calculates the average life expectancy of the policy holders and then factors in the returns on the policy payments to come up with a cost for the insurance. The problem is that a large number of these pension funds have underestimated the life expectancy of the retirees AND have over estimated the annual returns.
With the rapid improvement in medicine people are living longer and longer. As I mentioned before, the life insurance industry is now running life expectancy tables to age 120. The longer that people live the more that the funds have to pay out. In the past retirees left the workforce around the age of 60 but life expectancy was only 10 years more. Now life expectancy has increased by 50 years but people still expect to retire at 60 and live off their pensions. This is a complete mismatch and spells disaster for these funds as the assets will be exhausted way before the youth of today retire. This problem however is easily solved, just raise the age at which you are able to draw on the fund and voila, instantly fixed. The problem is that this is political suicide so as long as it can be reported that the funds are solvent everyone can brush this under the rug for another year.
So the way to take care of this problem is to produce returns high enough to cover all of the expected withdrawals. At present a lot of these funds have modeled 8% returns. The idea is that you can go out and borrow money around 4% and then earn 8% and the spread will magically cover the future draws on the fund. This is a huge leap of faith and one that is creating an even bigger future problem. Sure this solves the problem of reporting but the gap between actual returns and budgeted returns is large and growing. In the current market environment where the 10-year treasury is yielding only 2%, to think that you can earn a blended rate of return north of 6% is madness. In order to achieve this huge risk has to be taken and that is not a word that should be attached to a retirement account!
The rub is that for the last few years this risk trade has been working admirably. The stock market is up over 100% so achieving these goals has been relatively easy. The problem is that when the market corrects these funds are going to be left high and dry. As Warren Buffet says, "You never know who is swimming naked until the tide goes out." If and when the tide goes out these funds will be left owing not only their retirees but also the investors lending them the money. Essentially these funds in a vein attempt to "protect" the fund have margined the account. Margin increases risk as you are leveraging the asset base to maximize profits. Just like the banks are dong with derivatives. As an interesting side note it came out that when JP Morgan had its "Whale" problem at one point they lost $415 million in one day!
Consensus says that if the government was prepared to bail out GM and Goldman Sachs how could they let the pension fund of say California die? And certainly they cannot, but the burden that this will place on the Federal Reserve would be so extreme that I find it hard to believe that there would not be a market panic far worse than that felt in 2007. Should this ever occur the taxpayer (you and I) would now be footing the bill for government pensioners and this would not be met with open arms, not to mention that the municipal bond market would suddenly be lumped into junk status.
Friday, March 22, 2013
A Ticking Time Bomb
"Now, you're perfectly safe, Willard, there's nothing to worry about as long as
it's ticking...
Er, when it stops ticking, that's something else again, Willard.
Now, listen Willard, get control of yourself...
You and I are going to disarm that thing...
I've got the instruction manual...
Well, no! I'm not coming down there, Willard...
Well, I mean I can't just leave the office anytime I want to!...
NO!!!...
DON'T BRING IT IN HERE, WILLARD, NO!!!" - An exert from Bob Newhart's skit on Diffusing a Bomb
Nassim Taleb, the world famous crisis trader, looks for Black Swans. His theory is that there is only one thing we can be certain of and that is there will be another collapse. He has no idea where or when or how but he knows that the markets will at some point in time take a nose dive. As such, rather than try to time the market he bets all the time on the market dying. Normally he losses but the days when he wins he wins so big that it takes care of the losses and makes him a lot of money.
Now a Black Swan event is an event that is completely unknown and therefore takes the markets by complete surprise however some times there are things that build to a point where it is relatively obvious that this is a problem but for some reason the markets choose to ignore them (think greed or fear). Take as an example the NASDAQ bubble or the housing bubble, these were pretty obvious to see. These bubbles do not derail the markets while they are held together, but when they burst the Black Swan is discovered and this has catastrophic consequences on most portfolios.
To me there are two very obvious problems that unless resolved soon will rear their ugly heads at some point in the future and will make the housing problems look tame. The first is derivatives held off the balance sheets of the major banks of the world and the second is the underfunding of US Pension Funds. I will deal with the first in this blog and will return to the second next week.
Derivatives are contracts written against an underlying asset. For example you can write an option to buy a house at a specified price and at a specified time. The seller of this option pockets the premium that is paid to the buyer giving the buyer the right to buy the house. This option has value all the way up to the exercise date when if the value of the house is less than the price agreed to in the option the contract is worthless. In this example this option really creates no problem or concern.
Now what if we magnify this derivative, create ever more complex derivatives and start to sell them in truck loads? In fact forget about truck loads as that is too small, what if we sold them in trillions? Well that is precisely what has happened. The notional value of the over the counter derivatives market is roughly $650 trillion. Yes that is not a misprint. The vast majority are derivatives related to interest rate swaps but there are derivatives written on essentially everything. I will not go into detail about this market but suffice it to say this is an enormous market which is largely unregulated.
Now I have been watching a show on TV about the planets and the big bang theory and one thing rings true about that as with this market. Big bang theory states that everything came from nothing for the simple reason that for every positive energy there has to be a countering negative energy. The one offsets the other and sums to nothing. Well the same is basically true in the derivatives market. While the notional value is $650 trillion one side offsets the other so the actual value is relatively small. For this reason there is not a lot of press on this subject and banks are able to push the risk off their balance sheets. This is fine while everything is working well, but what happens when the market has its next Black Swan event?
Years ago I worked on the Enron bankruptcy, not at Enron but at Aquila energy. When Enron went down the derivative contracts that were written were taken under the control of the bankruptcy court and the rules in bankruptcy court are very different from those on the exchanges. The bankruptcy code said that any contract where Enron was making a profit they could keep the money and any contract where Enron was losing they could get the money back from the counter party. The chain was broken and it took Aquila down. This is a small example but you can see that should any one of the major banks have a problem it will have the effect of dragging the others down.
This is why when Lehman and AIG went down the Federal Reserve was required to come to their rescue as without their guarantee to protect these contracts the notional value, not the netted value, is what comes into play. Remember that during the housing bubble $30 trillion of global wealth was created and vanished and we are still dealing with the mess. Taking this number to $650 trillion is a number that is far too large even for a unified global effort to repair.
The problem is that unless this market is more strictly regulated banks will continue to add to their portfolio of derivatives creating a larger and larger problem. If history is anything to go on then it will only be after the fact when the regulation will be enacted. By the way the regulatory environment was put in place after Long Term Capital Management went down but the Glass-Steagall Act was repealed in 1999 and since then it has been another Black Swan in the making.
Er, when it stops ticking, that's something else again, Willard.
Now, listen Willard, get control of yourself...
You and I are going to disarm that thing...
I've got the instruction manual...
Well, no! I'm not coming down there, Willard...
Well, I mean I can't just leave the office anytime I want to!...
NO!!!...
DON'T BRING IT IN HERE, WILLARD, NO!!!" - An exert from Bob Newhart's skit on Diffusing a Bomb
Nassim Taleb, the world famous crisis trader, looks for Black Swans. His theory is that there is only one thing we can be certain of and that is there will be another collapse. He has no idea where or when or how but he knows that the markets will at some point in time take a nose dive. As such, rather than try to time the market he bets all the time on the market dying. Normally he losses but the days when he wins he wins so big that it takes care of the losses and makes him a lot of money.
Now a Black Swan event is an event that is completely unknown and therefore takes the markets by complete surprise however some times there are things that build to a point where it is relatively obvious that this is a problem but for some reason the markets choose to ignore them (think greed or fear). Take as an example the NASDAQ bubble or the housing bubble, these were pretty obvious to see. These bubbles do not derail the markets while they are held together, but when they burst the Black Swan is discovered and this has catastrophic consequences on most portfolios.
To me there are two very obvious problems that unless resolved soon will rear their ugly heads at some point in the future and will make the housing problems look tame. The first is derivatives held off the balance sheets of the major banks of the world and the second is the underfunding of US Pension Funds. I will deal with the first in this blog and will return to the second next week.
Derivatives are contracts written against an underlying asset. For example you can write an option to buy a house at a specified price and at a specified time. The seller of this option pockets the premium that is paid to the buyer giving the buyer the right to buy the house. This option has value all the way up to the exercise date when if the value of the house is less than the price agreed to in the option the contract is worthless. In this example this option really creates no problem or concern.
Now what if we magnify this derivative, create ever more complex derivatives and start to sell them in truck loads? In fact forget about truck loads as that is too small, what if we sold them in trillions? Well that is precisely what has happened. The notional value of the over the counter derivatives market is roughly $650 trillion. Yes that is not a misprint. The vast majority are derivatives related to interest rate swaps but there are derivatives written on essentially everything. I will not go into detail about this market but suffice it to say this is an enormous market which is largely unregulated.
Now I have been watching a show on TV about the planets and the big bang theory and one thing rings true about that as with this market. Big bang theory states that everything came from nothing for the simple reason that for every positive energy there has to be a countering negative energy. The one offsets the other and sums to nothing. Well the same is basically true in the derivatives market. While the notional value is $650 trillion one side offsets the other so the actual value is relatively small. For this reason there is not a lot of press on this subject and banks are able to push the risk off their balance sheets. This is fine while everything is working well, but what happens when the market has its next Black Swan event?
Years ago I worked on the Enron bankruptcy, not at Enron but at Aquila energy. When Enron went down the derivative contracts that were written were taken under the control of the bankruptcy court and the rules in bankruptcy court are very different from those on the exchanges. The bankruptcy code said that any contract where Enron was making a profit they could keep the money and any contract where Enron was losing they could get the money back from the counter party. The chain was broken and it took Aquila down. This is a small example but you can see that should any one of the major banks have a problem it will have the effect of dragging the others down.
This is why when Lehman and AIG went down the Federal Reserve was required to come to their rescue as without their guarantee to protect these contracts the notional value, not the netted value, is what comes into play. Remember that during the housing bubble $30 trillion of global wealth was created and vanished and we are still dealing with the mess. Taking this number to $650 trillion is a number that is far too large even for a unified global effort to repair.
The problem is that unless this market is more strictly regulated banks will continue to add to their portfolio of derivatives creating a larger and larger problem. If history is anything to go on then it will only be after the fact when the regulation will be enacted. By the way the regulatory environment was put in place after Long Term Capital Management went down but the Glass-Steagall Act was repealed in 1999 and since then it has been another Black Swan in the making.
Friday, March 15, 2013
A Way Out
"The only thing that's correlated 10% with job creation - and particularly good job creation - is business investment. It is our reduced level of capital investment that has produced our low GDP growth rates and our high unemployment." - Fred Smith CEO of FedEx
By any metric the economy is sputtering. The economy barely grew in the last quarter and unemployment levels are still elevated. All of this comes more than four years after the Great Recession began and after more than $3 trillion of stimulus. This is the largest stimulus ever undertaken and still it is like throwing a bucket of water onto a forest fire, eventually the forest fire will die down but the bucket of water is not making much of an impression. For a better understanding of why this is let's take a look at some basic economics (I know it may seem tedious but I am sure you will learn something so bear with me).
Basic economic accounting will show that the total amount of savings in an economy must equal total real investment in the economy. There is no other possible way for this relationship to exist as remember that real investment is net of any debt. So increasing real investment will result in economic expansion or in other words increasing total savings will result in economic expansion.
Let's first look at Foreign Savings. Foreign Savings is a bit of a misnomer in that this amount is subtracted from savings. The more that is imported the lower the savings rate. For this reason governments try to stimulate exports which is normally done by weakening the exchange rate so that exports become cheaper and imports more expensive. The problem is that countries around the globe are all trying to do the same thing so this is being met with limited success. It is also clear why China, who for decades kept their exchange rate low, ended up with such a huge foreign capital savings balance.
Now we will turn to Government savings. Well if ever there is an oxymoron this is it. Government and Savings are two words that should be the first and last words in the dictionary they are so far apart. The problem is that in this equation there is no way for everyone to be a saver and the Keynesian economists will argue that during weak economic times it is imperative that the government be a net spender in order to absorb the increased level of saving from the private sector. This recession has been particularly bad for the simple reason that the private sector took on too much debt and this debt is being offloaded at a very fast pace. If the government tried to save as well, the corrosion to the economy would be such that an economic implosion would surely have happened. However the Keynesians take it a step further saying that it is this increased savings is what causes the recession.
Their theory is that if you lower interest rates and force consumers to stop saving that this will result in an expansion to the economy and all will be well. For this reason the Federal Reserve is holding interest rates down, taxing savers and throwing huge sums of liquidity into the market. The problem is that all this is doing is promoting speculation rather than investment. The reason for this is that the Keynesians pay little attention to the productivity of the spending but expect that government spending and investment works just as well as private investment and spending. I don’t know about you but I have never seen a government that spends money as efficiently as private business.
The next problem with the way that the Federal Reserve is handling the issues is that during a recession the normal mix of goods and services demanded changes. Goods supplied are suddenly not wanted or not affordable so there is a buildup of unwanted inventory. Until the system changes through innovation this unwanted inventory sits idly on shelves taking up valuable investment dollars. Pumping money into the system without targeting proper investments such as factories, equipment, research and development and capital goods that are demanded by the consumer is just promoting more of the same and is wasted. Furthermore without targeting the benefits employment levels remain low.
In order to stimulate an economy real investments must be stimulated which unfortunately is not being done. Paying people to remain idle or buying toxic debt has not, is not and will not help the general economy. It has the effect of helping a select few at the expense of the majority. While the quote above is fairly accurate the actual level of correlation between domestic investment and unemployment is roughly 80% (not 100% quoted). Stimulating direct investment therefore would have a profound effect on the unemployment rate however it appears that companies are currently reducing domestic investment. The result of this will surely be a higher unemployment rate in the near future the exact opposite of what the Federal Reserve is trying to achieve.
So in order to get this economy in gear government spending should be targeted on increasing direct investment. This can easily be done through things such as investment tax credits, accelerated expensing of investments, R&D incentives and other similar programs that I have mentioned in previous blogs. Until current policies target the issues the only people that will be rewarded are the banks and the few that speculate on the markets. This is not a sustainable solution as trying to stimulate an economy by taxing savers with low interest rates has proven time and time again. So although Mr. Bernanke and his cohorts are patting themselves on the back as the market reaches all time highs it is definitely time to defend your investments or understand that you are now not investing but joining the market of speculation.
By any metric the economy is sputtering. The economy barely grew in the last quarter and unemployment levels are still elevated. All of this comes more than four years after the Great Recession began and after more than $3 trillion of stimulus. This is the largest stimulus ever undertaken and still it is like throwing a bucket of water onto a forest fire, eventually the forest fire will die down but the bucket of water is not making much of an impression. For a better understanding of why this is let's take a look at some basic economics (I know it may seem tedious but I am sure you will learn something so bear with me).
Basic economic accounting will show that the total amount of savings in an economy must equal total real investment in the economy. There is no other possible way for this relationship to exist as remember that real investment is net of any debt. So increasing real investment will result in economic expansion or in other words increasing total savings will result in economic expansion.
|
I
|
=
|
(Y - C - T)
|
+
|
(T - G)
|
-
|
(M - X)
|
|
Gross
|
|
Private
|
|
Government
|
|
Foreign
|
|
Investment
|
|
Savings
|
|
Savings
|
|
Savings
|
Let's first look at Foreign Savings. Foreign Savings is a bit of a misnomer in that this amount is subtracted from savings. The more that is imported the lower the savings rate. For this reason governments try to stimulate exports which is normally done by weakening the exchange rate so that exports become cheaper and imports more expensive. The problem is that countries around the globe are all trying to do the same thing so this is being met with limited success. It is also clear why China, who for decades kept their exchange rate low, ended up with such a huge foreign capital savings balance.
Now we will turn to Government savings. Well if ever there is an oxymoron this is it. Government and Savings are two words that should be the first and last words in the dictionary they are so far apart. The problem is that in this equation there is no way for everyone to be a saver and the Keynesian economists will argue that during weak economic times it is imperative that the government be a net spender in order to absorb the increased level of saving from the private sector. This recession has been particularly bad for the simple reason that the private sector took on too much debt and this debt is being offloaded at a very fast pace. If the government tried to save as well, the corrosion to the economy would be such that an economic implosion would surely have happened. However the Keynesians take it a step further saying that it is this increased savings is what causes the recession.
Their theory is that if you lower interest rates and force consumers to stop saving that this will result in an expansion to the economy and all will be well. For this reason the Federal Reserve is holding interest rates down, taxing savers and throwing huge sums of liquidity into the market. The problem is that all this is doing is promoting speculation rather than investment. The reason for this is that the Keynesians pay little attention to the productivity of the spending but expect that government spending and investment works just as well as private investment and spending. I don’t know about you but I have never seen a government that spends money as efficiently as private business.
The next problem with the way that the Federal Reserve is handling the issues is that during a recession the normal mix of goods and services demanded changes. Goods supplied are suddenly not wanted or not affordable so there is a buildup of unwanted inventory. Until the system changes through innovation this unwanted inventory sits idly on shelves taking up valuable investment dollars. Pumping money into the system without targeting proper investments such as factories, equipment, research and development and capital goods that are demanded by the consumer is just promoting more of the same and is wasted. Furthermore without targeting the benefits employment levels remain low.
In order to stimulate an economy real investments must be stimulated which unfortunately is not being done. Paying people to remain idle or buying toxic debt has not, is not and will not help the general economy. It has the effect of helping a select few at the expense of the majority. While the quote above is fairly accurate the actual level of correlation between domestic investment and unemployment is roughly 80% (not 100% quoted). Stimulating direct investment therefore would have a profound effect on the unemployment rate however it appears that companies are currently reducing domestic investment. The result of this will surely be a higher unemployment rate in the near future the exact opposite of what the Federal Reserve is trying to achieve.
So in order to get this economy in gear government spending should be targeted on increasing direct investment. This can easily be done through things such as investment tax credits, accelerated expensing of investments, R&D incentives and other similar programs that I have mentioned in previous blogs. Until current policies target the issues the only people that will be rewarded are the banks and the few that speculate on the markets. This is not a sustainable solution as trying to stimulate an economy by taxing savers with low interest rates has proven time and time again. So although Mr. Bernanke and his cohorts are patting themselves on the back as the market reaches all time highs it is definitely time to defend your investments or understand that you are now not investing but joining the market of speculation.
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