Tag Archives: pension

Democrats Stop Worrying & Learn To Love Deficits

I was stunned by a recent article from Marshall Auerback via The Nation entitled “Why Democrats Need To Stop Worrying And Love The Deficit.”

“Delivering on big progressive ideas like Medicare for All and the Green New Deal will never happen until Democrats get over their fear of red ink.”

While the article is long, winding, and a convoluted mess of ideas, the following is the all you really need to read:

The perceived problem:

“In an environment increasingly characterized by slowing global economic growth, businesses are understandably hesitant to invest in a way that creates high-quality, high-paying jobs for the bulk of the domestic workforce. The much-vaunted Trump corporate “tax reform” may have been sold to the American public on that basis, but corporations have largely used their tax cut bonanza to engage in share buybacks, which fatten executive compensation but have done nothing for the rest of us. At the same time, private households still face constraints on their consumption because of stagnant wages, rising health care costs, declining job security, poorer employment benefits, and rising debt levels.

Instead of solving these problems, the reliance on extraordinary monetary policy from the Federal Reserve via programs such as quantitative easing has exacerbated them. In contrast to properly targeted fiscal spending, the Federal Reserve’s misguided monetary policies have fueled additional financial speculation and asset inflation in stock markets and real estate, which has made housing even less affordable for the average American.”

The Non-Solution

According to Mr.  Auerback is the solution is simple:

“Democrats should embrace the ‘extremist’ spirit of Goldwater and eschew fiscal timidity (which, in any case, is based on faulty economics). After all, Republicans do it when it suits their legislative agenda. Likewise, Democrats should go big with deficits—as long as they are used for the transformative programs that progressives have long talked about and now have the chance to deliver.”

This is essentially the adoption of Modern Monetary Theory (MMT), which, as discussed previously, is the assumption debt and deficits “don’t matter,” as long as there is no inflation.

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy, which means government spending is never revenue constrained, but rather only limited by inflation.” – Kevin Muir

However, the solution isn’t really a solution.

Mr. Auerback suggests the Democrats should go big with deficits to fund the “transformative programs” they have long talked about. These programs are, as we know, socialistic from government-run healthcare to more social welfare, to free college.

The problem is that these progressive programs lack an essential component of what is required for “deficit” spending to be beneficial – a “return on investment.” 

This was a point addressed by Dr. Woody Brock previously in “American Gridlock;”

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse and waste of it.

John Maynard Keynes’ was correct in his theory that in order for government “deficit” spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

Currently, the U.S. is “Country A.” 

The programs that Mr. Auerback suggests the Democrats pursue with deficit spending, only exacerbate the current problem. According to the Center On Budget & Policy Priorities, roughly 75% of every current tax dollar goes to non-productive spending. (The same programs the Democrats are proposing.)

To make this clearer, in 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.

In other words, if 75% of all expenditures go to social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of the total revenue coming in. 

Currently, because of corporate tax cuts, a slowing economic environment, and weak wage growth, tax revenues have declined as federal expenditures have surged.

The result of unbridled fiscal largesse is a surging deficit that must be met by growing debt issuance.

Debt Begets Debt

There used to be an actual debate between “Austerity” and “Spending.” Conservatives in Government used to at least talk a “good game” about cutting spending, budgeting, and debt reduction. Now, that is no longer the case as during the past several Administrations, both “conservative” and “liberal” have opted for more “fiscal largesse.”

The irony is that increases in debt only lead to further increases in debt as economic growth must be funded with further debt. As this money is used for servicing debt, entitlements, and welfare, instead of productive endeavors, there is no question that high debt-to-GDP ratios reduce economic prosperity over time. In turn, the Government tries to fix the “economic problem” by adding on more “debt.” The Lowest Common Denominator provides more information on the accumulation of debt and its consequences.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-year period, from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater. If you subtract the debt, there has not been any organic economic growth since 1990. 

What is indisputable is that running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

Whistling Past The Graveyard

Let me be clear.

As Dr. Brock notes, deficit spending can be beneficial when the debt is used in a productive manner. The U.S. has the labor, resources, and capital for a resurgence of a “Marshall Plan” which could foster the development of infrastructure with high rates of return on each dollar spent.

However, that isn’t what Mr. Auerback, the Democrats, are suggesting or offering. The Government has already delved into the MMT pool over the last 40-years spending trillions bailing out banks, boosting welfare support, supporting Wall Street, and reducing corporate tax rates, which all have a negative rate of return.

The results have been disappointing, and suggesting that more of the same will produce a different result is the precise definition of “insanity.” 

In the meantime, the aging of the population continues to exacerbate the underfunded problems of Social Security, Medicare, and Medicaid, which is roughly $70 trillion and growing. It is simply a function of demographics and math.

As Dr. Brock noted:

“Mathematics and Sex create performance anxiety in men – because you can’t fake the outcome of either.”

Two recent studies show the problem clearly.

Demographics is an easy problem to see and mathematically calculate. The ratio of workers per retiree, as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers), present a massive headwind to economic solvency. 

The Institute for Family Studies, published a report showing the decline in the fertility ratio to the lowest levels since 1970,

With fertility rates low, the future “support-ratio” will continue to be a problem.

The second, and more immediate, problem is the vastly underfunded savings of the “baby boomer” generation heading into retirement. To wit:

” Anxiety over retirement and how to support oneself after calling it a career is impacting many Americans. A recent poll found that one in three adults has less than $5,000 in retirement savings.”

This is simple math.

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. A vast majority of them are “under saved” and primarily unhealthy.

This combination ensures the demand on the health care system, along with Medicaid and Medicare, will increase at a rate faster than it can supply. Bankruptcy, without substantive changes, is inevitable.

Of course, it isn’t just the social welfare and healthcare system that is effectively “broken,” but the economic model itself.

The current path we are on is unsustainable. The remedies being applied today is akin to using aspirin to treat cancer. Sure, it may make you feel better for the moment, but it isn’t curing the problem.

Unfortunately, the actions being taken have been repeated throughout history as those elected into office are more concerned about satiating the mob with bread and games” rather than suffering the short-term pain for the long-term survivability of the empire.

In the end, every empire throughout history fell to its knees under the weight of debt and the debasement of their currency.

As Dr. Brock suggests – it is truly “American Gridlock” as the real crisis lies between the choices of “austerity” and continued government “largesse.”

One choice leads to long-term economic prosperity for all, the other doesn’t.

“Today we are borrowing our children’s future with debt. We are witnessing the ‘hosing’ of the young.”

“The Art Of The Deal” & How To Lose A “Trade War.”

This past Monday, on the #RealInvestmentShow, I discussed that it was exceedingly likely that Trump would delay, or remove, the tariffs which were slated to go into effect this Sunday, On Thursday, that is exactly what happened.

Not only did the tariffs get delayed, but on Friday, it was reported that China and the U.S. reached “Phase One” of the trade deal, which included “some” tariff relief and agricultural purchases. To wit:

“The U.S. plans to scrap tariffs on Chinese goods in phases, a priority for Beijing, Vice Commerce Minister Wang Shouwen said. However, Wang did not detail when exactly the U.S. would roll back duties.

President Donald Trump later said his administration would cancel its next round of tariffs on Chinese goods set to take effect Sunday. In tweets, he added that the White House would leave 25% tariffs on $250 billion in imports in place, while cutting existing duties on another $120 billion in products to 7.5%.

China will also consider canceling retaliatory tariffs set for Dec. 15, according to Vice Finance Minister Liao Min. 

Beijing will increase agricultural purchases significantly, Vice Minister of Agriculture and Rural Affairs Han Jun said, though he did not specify by how much. Trump has insisted that China buy more American crops as part of a deal, and cheered the commitment in his tweets.”

Then from the USTR:

The United States will be maintaining 25 percent tariffs on approximately $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately $120 billion of Chinese imports.”

Not surprisingly, the market initially rallied on the news, but then reality begin to set in.

Art Of The Deal Versus The Art Of War

Over the past 18-months we have written numerous articles about the ongoing “trade war,” which was started by Trump against China. As I wrote previously:

“This is all assuming Trump can actually succeed in a trade war with China. Let’s step back to the G-20 meeting between President Trump and President Xi Jinping. As I wrote then:

‘There is a tremendous amount of ‘hope’ currently built into the market for a ‘trade war truce’ this weekend. However, as we suggested previously, the most likely outcome was a truce…but no deal.  That is exactly what happened.

While the markets will likely react positively next week to the news that ‘talks will continue,’ the impact of existing tariffs from both the U.S. and China continue to weigh on domestic firms and consumers.

More importantly, while the continued ‘jawboning’ may keep ‘hope alive’ for investors temporarily, these two countries have been ‘talking’ for over a year with little real progress to show for it outside of superficial agreements.

Importantly, we have noted that Trump would eventually ‘cave’ into the pressure from the impact of the ‘trade war’ he started.

The reasons, which have been entirely overlooked by the media, is that China’s goals are very different from the U.S. To wit:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk-off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 4-years at most. It is unlikely as the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that won’t be supported in the future is doubtful.”

As noted in the second point above, on Friday, Trump caved to get the “Trade Deal” off the table before the election. As noted in September, China had already maneuvered Trump into a losing position.

“China knows that Trump needs a way out of the “trade war” he started, but that he needs something he can “boast” as a victory to a largely economically ignorant voter base. Here is how a “trade deal” could get done.

Understanding that China has already agreed to 80% of demands for a trade deal, such as buying U.S. goods, opening markets to U.S. investors, and making policy improvements in certain areas, Trump could conclude that ‘deal’ at the October meeting.”

Read the highlighted text above and compare it to the statement from  the WSJ: on Thursday:

“The U.S. side has demanded Beijing make firm commitments to purchase large quantities of U.S. agricultural and other products, better protect U.S. intellectual-property rights and widen access to China’s financial-services sector.”

What is missing from the agreement was the most critical 20%:

  • Cutting the share of the state in the overall economy from 38% to 20%,
  • Implementing an enforcement check mechanism; and,
  • Technology transfer protections

These are the “big ticket” items that were the bulk of the reason Trump launched the “trade war” to begin with. Unfortunately, for China, these items are seen as an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program.

The USTR did note that the Phase One deal:

“Requires structural reforms and other changes to China’s economic and trade regime in the areas of intellectual property, technology transfer, agriculture, financial services, and currency and foreign exchange.”

However, since there is no actual enforcement mechanism besides merely pushing tariffs back to where they were, none of this will be implemented.

All of this aligns with our previous suggestion the only viable pathway to a “trade deal” would be a full surrender.

“However, Trump can set aside the last 20%, drop tariffs, and keep market access open, in exchange for China signing off on the 80% of the deal they already agreed to.”

Which is precisely what Trump agreed to.

This Is The Only Deal

This is NOT a “Phase One” trade-deal.

This is a “Let’s get a deal on the easy stuff, call it a win, and go home,” deal.

It is the strategy we suggested was most likely:

“For Trump, he can spin a limited deal as a ‘win’ saying ‘China is caving to his tariffs’ and that he ‘will continue working to get the rest of the deal done.’ He will then quietly move on to another fight, which is the upcoming election, and never mention China again. His base will quickly forget the ‘trade war’ ever existed.

Kind of like that ‘Denuclearization deal’ with North Korea.”

Speaking of the “fantastic deal with N. Korea,” here is the latest on that failed negotiation:

“Reuters reported Thursday via Korean Central News Agency (KCNA) that, even if denuclearization talks resumed between both countries, the Trump administration has nothing to offer.

North Korea’s foreign ministry criticized the Trump administration for meeting with officials at the UN Security Council and suggested that it would be ready to respond to any corresponding measures that Washington imposes. ‘The United States said about corresponding measure at the meeting, as we have said we have nothing to lose and we are ready to respond to any corresponding measure that the US chooses,’ said KCNA citing a North Korean Foreign Ministry spokesperson.”

While Trump has announced he will begin to “immediately” work on “Phase Two,” any real agreement is highly unlikely. However, what Trump understands, is that he gets another several months of “tweeting” a “trade deal is coming” to keep asset markets buoyed to support his re-election campaign.

Not Really All That Amazing

While Trump claimed this was an “amazing deal” with China, and that America’s farmers need to get ready for a $50 billion surge in agricultural exports, neither is actually the case.

China did not agree to buy any specific amount of goods from the U.S. What they said was, according to Bloomberg, was:

  • CHINA PLANS TO IMPORT U.S. WHEAT, RICE, CORN WITHIN QUOTAS

Furthermore, there is speculation the agreement is primarily verbal in terms of purchases, and the actual agreement of the entire trade deal will never be made public.

But let’s put some hard numbers to this.

Currently, China is buying about $10 billion of farm produce in 2018. That is down from a peak of $25 billion in 2012, which was long before the trade war broke out.

Since the trade war was started, China has sourced deals from Brazil and Argentina for pork and soybeans to offset the shortfall in imports from the U.S. These agreements, and subsequent imports, won’t be cancelled to shift to the U.S. since at any moment Trump could reinstate tariffs.

More importantly, as noted by Zerohedge on Friday, if this “deal” was as amazing as claimed, the agricultural commodity index should be screaming higher.

Importantly, even if China agrees to double their exports in the coming year, which would be a realistic goal, it would only reset the trade table to where it was before the tariffs started.

While China may have “agreed” to buy more, it is extremely unlikely China will meet such levels. Given they have already sourced products from other countries, they will import what they require.

Since most don’t pay attention to the long-game, while there will be excitement over a short-term uptick in agricultural purchases, those purchases will fade. However, with time having passed, and the focus of the media now elsewhere, Trump will NOT go back to the table and restart the “trade war” again. As I wrote on May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations. What the current administration fails to realize is that China is not operating from short-term political-cycle driven game plan.

As we stated in Art Of The Deal vs. The Art Of War:”

“While Trump is operating from a view that was a ghost-written, former best-seller, in the U.S. popular press, XI is operating from a centuries-old blueprint for victory in battle.”

Trump lost the “trade war,” he just doesn’t realize it, yet.

No More “Trade Tweets?”

Since early 2018, and more importantly since the December lows of last year, the market has risen on the back of continued “hopes” of Federal Reserve easing, and the conclusion of a “trade deal.”

With the Fed now signaling that they are effectively done lowering rates through next year, and President Trump concluding a “trade deal,” what will be the next driver of the markets. While will the “algo’s” do without daily “trade tweets” to push stock markets higher?

While I am a bit sarcastic, there is also a lot of truth to the statement.

However, what is important is that while the Trump administration are rolling back 50% of the tariffs, they are not “removing” all of them. This means there is still some drag being imposed by tariffs, just at a reduced level.

More importantly, the rollback of tariffs do not immediately undo the damage which has already occurred.

  • Economic growth has weakened globally
  • Corporate profit growth has turned negative.
  • Tax cuts are fully absorbed into the economy
  • The “repo” market is suggesting that something is “broken.”
  • All of which is leading to rising recession risk.

In other words, while investors have hung their portfolios hopes of a “trade deal,” it may well be too little, too late.

Over the next couple of months, we will be able to refine our views further as we head into 2020. However, the important point is that since roughly 40% of corporate profits are a function of exports, the damage caused already won’t easily be reversed.

Furthermore, the Fed’s massive infusions of liquidity into the overnight lending market signal that something has “broken,” but few are paying attention.

Our suspicion is that the conclusion of the “trade deal” could well be a “buy the rumor, sell the news” type event as details are likely to be disappointing. Such would shift our focus from “risk taking” to “risk control.” Also, remember “cash” is a valuable asset for managing uncertainty.

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. 

I am not suggesting you do anything, but just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

The Difference Between Investing & Speculation (10-Investing Rules)

Are you an “investor” or a “speculator?” 

In today’s market the majority of investors are simply chasing performance. However, why would you NOT expect this to be the case when financial advisers, the mainstream media, and WallStreet continually press the idea that investors “must beat” some random benchmark index from one year to the next.

But, is this “speculation” or “investing?” 

Think about it this way.

If you were playing a hand of poker, and were dealt a “pair of deuces,” would you push all your chips to the center of the table?

Of course, not.

The reason is you intuitively understand the other factors “at play.” Even a cursory understanding of the game of poker suggests other players at the table are probably holding better hands which will lead to a rapid reduction of your wealth.

Investing, ultimately, is about managing the risks which will substantially reduce your ability to “stay in the game long enough” to “win.”

Robert Hagstrom, CFA penned a piece discussing the differences between investing and speculation:

“Philip Carret, who wrote The Art of Speculation (1930), believed “motive” was the test for determining the difference between investment and speculation. Carret connected the investor to the economics of the business and the speculator to price. ‘Speculation,’ wrote Carret, ‘may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.’”

Chasing markets is the purest form of speculation. It is simply a bet on prices going higher rather than determining if the price being paid for those assets are selling at a discount to fair value.

Benjamin Graham, along with David Dodd, attempted a precise definition of investing and speculation in their seminal work Security Analysis (1934).

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

There is also very important passage in Graham’s The Intelligent Investor:

“The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against.”

Indeed, the meaning of investment has been lost on most individuals. However, the following 10-guidelines from legendary investors of our time will hopefully get you back on track.


10-Investing Guidelines From Legendary Investors

1) Jeffrey Gundlach, DoubleLine

“The trick is to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.”

This is a common theme that you will see throughout this post. Great investors focus on “risk management” because “risk” is not a function of how much money you will make, but how much you will lose when you are wrong. In investing, or gambling, you can only play as long as you have capital. If you lose too much capital but taking on excessive risk, you can no longer play the game.

Be greedy when others are fearful and fearful when others are greedy. One of the best times to invest is when uncertainty is the greatest and fear is the highest.

2) Ray Dalio, Bridgewater Associates

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”

Nothing good, or bad, goes on forever. The mistake that investors repeatedly make is thinking “this time is different.” The reality is that despite Central Bank interventions, or other artificial inputs, business and economic cycles cannot be repealed. Ultimately, what goes up, must and will come down.

Wall Street wants you to be fully invested “all the time” because that is how they generate fees. However, as an investor, it is crucially important to remember that “price is what you pay and value is what you get.” Eventually, great companies will trade at an attractive price. Until then, wait.

3) Seth Klarman, Baupost

“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”

Investor behavior, driven by cognitive biases, is the biggest risk in investing. “Greed and fear” dominate the investment cycle of investors which leads ultimately to “buying high and selling low.”

4) Jeremy Grantham, GMO

“You don’t get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.”

Successful investors avoid “risk” at all costs, even it means under performing in the short-term. The reason is that while the media and Wall Street have you focused on chasing market returns in the short-term, ultimately the excess “risk” built into your portfolio will lead to extremely poor long-term returns. Like Wyle E. Coyote, chasing financial markets higher will eventually lead you over the edge of the cliff.

5) Jesse Livermore, Speculator

“The speculator’s deadly enemies are: ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal….”

Allowing emotions to rule your investment strategy is, and always has been, a recipe for disaster. All great investors follow a strict diet of discipline, strategy, and risk management. The emotional mistakes show up in the returns of individuals portfolios over every time period. (Source: Dalbar)

Dalbar-2015-QAIB-Performance-040815

6) Howard Marks, Oaktree Capital Management

“Rule No. 1: Most things will prove to be cyclical.

Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.”

As with Ray Dalio, the realization that nothing lasts forever is critically important to long term investing. In order to “buy low,” one must have first “sold high.” Understanding that all things are cyclical suggests that after long price increases, investments become more prone to declines than further advances.

7) James Montier, GMO

“There is a simple, although not easy alternative [to forecasting]… Buy when an asset is cheap, and sell when an asset gets expensive…. Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance.”

“Cheap” is when an asset is selling for less than its intrinsic value. “Cheap” is not a low price per share. Most of the time when a stock has a very low price, it is priced there for a reason. However, a very high priced stock CAN be cheap. Price per share is only part of the valuation determination, not the measure of value itself.

8) George Soros, Soros Capital Management

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

Back to risk management, being right and making money is great when markets are rising. However, rising markets tend to mask investment risk that is quickly revealed during market declines. If you fail to manage the risk in your portfolio, and give up all of your previous gains and then some, then you lose the investment game.

9) Jason Zweig, Wall Street Journal

“Regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

The chart below is the 3-year average of annual inflation-adjusted returns of the S&P 500 going back to 1900. The power of regression is clearly seen. Historically, when returns have exceeded 10% it was not long before returns fell to 10% below the long-term mean which devastated much of investor’s capital.

10) Howard Marks, Oaktree Capital Management

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

The biggest driver of long-term investment returns is the minimization of psychological investment mistakes.

As Baron Rothschild once stated: “Buy when there is blood in the streets.” This simply means that when investors are “panic selling,” you want to be the one they are selling to at deeply discounted prices. Howard Marks opined much of the same sentiment: “The absolute best buying opportunities come when asset holders are forced to sell.”

As an investor, it is simply your job to step away from your “emotions” for a moment and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question, but to manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

As I stated at the beginning of this missive, “Market Timing” is not an effective method of managing your money. However, as you will note, every great investor through out history has had one core philosophy in common; the management of the inherent risk of investing to conserve and preserve investment capital.

“If you run out of chips, you are out of the game.”

The $6 Trillion Pension Bailout Is Coming

Fiscal responsibility is dead.

This past week, Trump announced he had reached an agreement with Congress to pass a continuing resolution which will suspend the debt ceiling until July 2021.

The good news is that it will ONLY increase spending by just $320 billion. 

What a bargain, right?

It’s a lie.

That is just the “starting point” of proposed spending. Without a “debt ceiling” to constrain spending, the actual spending will be substantially higher.

However, the $320 billion is also deceiving because that is on top of the spending we have already committed. As I noted just recently:

“In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in.” 

Do some math here.

The U.S. spent $986 billion more than it received in revenue in 2018, which is the overall “deficit.” If you just add the $320 billion to that number you are now running a $1.3 Trillion deficit.

Sure enough, this is precisely where I forecast we would be in December of 2017.

“Of course, the real question is how are you going to ‘pay for it?’ On the ‘fiscal’ side of the tax reform bill, without achieving accelerated rates of economic growth – ‘the debt will balloon.’

The reality, of course, is that is what will happen because there is absolutely NO historical evidence that cutting taxes, without offsetting cuts to spending, leads to stronger economic growth.”

More importantly, Federal Tax Revenue is DECLINING. Such was NOT supposed to be the case, as the whole “corporate tax cut” bill was supposed to lift tax revenues due to rising incomes.

More spending, less revenue, equals bigger deficits, which equates to slower economic growth.

“Increases in the national debt have long been squandered on increases in social welfare programs, and ultimately higher debt service, which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt versus economic growth is all too evident, as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.”

“The irony is that debt driven economic growth, consistently requires more debt to fund a diminishing rate of return of future growth. It now requires $3.02 of debt to create $1 of real economic growth.”

Over the next 12-18 months, spending will expand, and the deficit will quickly approach $2 Trillion. 

But, here’s the worse part: The projected budget deficits over the next couple of years are coming at the end of a decade-long growth cycle with the economy essentially at full employment. This is significant because, while budget deficits can be helpful in recessions by providing an economic stimulus, there are good reasons we should be retrenching during good economic times, including the one we are in now.

As William Gale stated:

“As President Kennedy once said, ‘the time to repair the roof is when the sun is shining.’  Instead, we are punching more holes in the fiscal roof. The fact that debt and deficits are rising under conditions of full employment suggests a deeper underlying fiscal problem.”

During the next recession, revenue will drop sharply, deficits will explode, and the Government will be forced into another round of bailouts.

Congress is already committing you to pay for it.

The $6 Trillion Bailout

I previously penned an article discussing the “Unavoidable Pension Crisis.” 

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, or future expected contributions, or investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

Since then, we have gotten some updated estimates. Surely, after 3-years of surging stock market returns things have gotten markedly better, right?

“Moody’s Investor Service estimated last year that the total pension funding gap in the US is $4.4 trillion. A few months ago the American Legislative Exchange Council estimated it at nearly $6 trillion.”

Apparently, not.

Don’t worry, Congress has your back. 

In “The Next Financial Crisis Will Be The Last” I stated:

“The real crisis comes when there is a ‘run on pensions.’ With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the ‘fear’ that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are declining will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.”

Fortunately, Congress has made some movement to get ahead of the problem with the Rehabilitation for Multiemployer Pensions Act. The legislation, if passed, is an attempt to address the multi-trillion dollar problem of unfunded pension plans in America.

By the way, this isn’t JUST an American problem, it is a $70-Trillion global problem, as noted recently by Visual Capitalist.

“According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…

The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050, or about five times the size of the global economy today.”

This is why Central Banks globally are terrified of a global downturn. The pension crisis IS the “weapon of mass destruction” to the global financial system, and it has started ticking.

While pension plans in the United States are guaranteed by a quasi-government agency called the Pension Benefit Guarantee Corporation (PBGC), the reality is the PBGC is already nearly bust from taking over plans following the financial crisis. The PBGC is slated to run out of money in 2025. Moreover, its balance sheet is trivial compared to the multi-trillion dollar pension problem.

The proposal from Congress is simply to use more debt. According to the new legislation, whenever a pension plan runs out of funds, Congress wants the pension plan to borrow money in order to keep making payments to beneficiaries.

Think about that for a moment. 

Who would loan money to an insolvent pension fund?

Oh, that would be you, the taxpayer.

In other words, the Government wants you to bail out your own retirement fund.

Genius.

But it’s going to get far worse.

We Are Out Of Time

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. And many of them are public-sector employees. In a 2015 study of public-sector organizations, nearly half of the responding organizations stated that they could lose 20% or more of their employees to retirement within the next five years. Local governments are particularly vulnerable: a full 37% of local-government employees were at least 50 years of age in 2015.

The vast majority of these individuals, when they retire, will depend on their pension (if they are in the 15% of the population that has one, and Social Security for a bulk of their living expenses in retirement.

The problem is that pension funds aren’t going to be able to keep their promises. Social Security, according to its own annual report, will run out of money in 15 years. Medicare has a massive underfunded problem as well.

But yet, the current Administration believes our outcome will be different.

More debt, and lack of any budgetary controls, will somehow lead to surging levels of economic growth despite no historical evidence of that being the case.

The reality is that the U.S. is now caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs. Combine this with:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The combined issues of debt, deflation, and demographics will continue to push the U.S. closer to the “point of no return.”

As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

It’s an unsolvable problem.

It will happen.

It will devastate many Americans.

It is just a function of time.

“Demography, however, is destiny for entitlements, so arithmetic will do the meddling.” – George Will

But here is the real question that needs to be answered:

“Who is going to buy all the debt?”

F.I.R.E. – Ignited By The Bull, Extinguished By The Bear

Do you remember this commercial?

The Etrade commercial aired during Super Bowl XLI in 2007. The following year, the financial crisis set in, markets plunged, and investors lost 50%, or more, of their wealth.

However, this wasn’t the first time it happened.

The same thing happened in late 1999. This commercial was aired 2-months shy of the beginning of the “Dot.com” bust as investors once again believed “investing was as easy as 1-2-3.”

Why this trip down memory lane? (Other than the fact the commercials are hilarious to watch.)

Because this is typical of the mindset seen at the end of extremely long “cyclical” bull market cycles. 

Investing is simple. Just throw you money in the market and it goes up. Its so easy a “baby can do it.”

Here is something else you see at the end of bull market cycles:

 “This couple retired at 31 with $1 Million: Want to retire early? How “going against the grain” allowed this FIRE couple to ditch their jobs and travel the world.

How did they make this happen? Shen and Leung, who was also a computer engineer, are part of the FIRE movement — which stands for Financial Independence, Retire Early — where the goal is to save a lot so you can retire early. The couple retired at 31 with roughly $1 million in the bank. They’re currently withdrawing 3.5% a year from that nest egg, and say they can easily travel the world on that money — as they’ve got lots of practice being frugal.”

First, I want to give the couple a “fanatical thumbs up” for saving $1 million by their 30’s. That is an amazing feat which deserves respect and acknowledgment. 

Secondly, they are very budget conscious and willing to sacrifice the luxuries most people long for to live their dream.

Another “thumbs up.”

However, the rise of the “F.I.R.E.” movement is symptomatic of a late stage bull market advance. More importantly, we can also predict how things will turn out for Shen and Leung.

For this discussion I want to use the data provided by Shen and Leung to build our examples.

  • Invested asset value:  $1 million
  • Annualized withdrawal rate: 3.5%
  • Annualized return rate: 6% (Not specified but a reasonable estimate)
  • Living needs: $35,000 annually.
  • Life expectency: 85-years of age.

With these assumptions in place we can begin to do some forecasting about how things eventually turn out. However, we also have to assume:

  • The couple never has children
  • Never requires serious medical care (hopefully)
  • Never considers buying a house
  • Has no major life events, etc.

First, we need to start with the cost of living. As I showed recently in Part 1 of “Everything You’ve Been Told About Savings & Investing Is Wrong” is that the cost of living rises over time due to inflation. However, for most the increase in living costs rises dramatically more as needs for housing, children, education, travel, insurance, and health care occur through stages of life.

For this exercise, we will assume our example couple never changes their lifestyle so only inflation is a factor. We will use the historical average of 2.1% and project it out for 50-years.

Understanding this, we can now take their $1 million, compound it at 6% annually (the preferred mainstream method), and deduct 3.5% annually adjusted for inflation over their 50-year time horizon.

We need to assume that since our couple is in their 30’s, the investable assets are in taxable accounts. Also, if this is the case, and they are not touching the principal, then we need to adjust the annual withdrawals for capital gains tax. The bottom two area charts adjust for 2.1% annual inflation and inflation plus a 15% tax on withdrawals. (Tax is paid on the gains taken to fund the withdrawal and the dividends paid in on an annual basis)

Not surprisingly, if our couple can indeed live on $35,000 a year, even when adjusting for inflation and taxation, a $1 million portfolio growing at 6% annually can indeed support them for their entire lifespan.

Reality Is Different

In Part 3 of our recent series on “saving and investing,” we laid out the issue, and importance, of variable rates of return. To wit:

“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what happened to their money is substantial over long-term time frames.”

The chart below is exactly the same as above, however, this time we have used the average annual 50-year returns from previous periods in history where starting valuations were greater than 20x earnings as they are today. (High starting valuations beget lower future returns historically speaking.) 

Over a 50-years, our couple will get the benefit of complete valuation and market cycles. In this case, since they are starting with high valuations at the outset, the first 30-years contains a long-period of lower returns, but that last 20-years receives the benefit of higher returns due to valuation reversion.

Due to market volatility and periods of negative growth, the original $1 million portfolio only grows to $3 million when including nominal spending. However, when accounting for volatility, inflation, and taxes, the survival rate of the portfolio diminishes sharply due to two reasons:

  1. Down years reduce the growth rate of the portfolio over the given time frame.
  2. Withdrawals in down years exacerbate the decline in the portfolio. (i.e. Portfolio declines by $65,000 plus the $35,000 annual withdrawal increases the 6.5% decline to 10%.)

Obviously, not accounting for volatility when planning to retire early can have severe future consequences. In this case they will run out of money in year 47.

The Big Bad Bear

As I said at the beginning of this missive, the “F.I.R.E.” movement is the result of a decade-long bull market cycle.

Most likely, our young couple will be met with a “bear market” sooner, rather than later, in their early retirement. If we use the return model from our recent article on “investors and pension funds,” we see a rather dramatic shift in life-expectancy of the portfolio.

“The chart below is the S&P 500 TOTAL REAL return from 1995 to present. I have projected an average return of every period in history where the market peaked following P/E’s exceeding 20x earnings. This provides for variable rates of market returns with cycling bull and bear markets out to 2060. I have also projected ‘average’ returns from 3% to 8% from 1995 to 2060. (The average real total return for the entire period is 6.56% which is likely higher than what current valuation and demographic trends suggest it should be.)”

The benefit of this model is that it shows the impact to portfolio returns when bear markets are “front-loaded,” as will likely be the case for most the “F.I.R.E.” followers. (Note, in the return model above the “bear market” is 5-years into the future)

The reason for the dramatic short-fall is that a major, “rip your face off,” bear market will cut asset values by 50% very early on. All of a sudden, the annual withdrawal rate of 3.5% becomes 7%, which outpaces the ability of the portfolio to grow fast enough to catch up with the withdrawal rate and the loss of principal. In this more realistic example, our couple will run out of money in 30 years.

This is the exact problem “pension funds” face currently.

The Other Problems From “Playing With F.I.R.E.”

While we have mainly addressed the issues surrounding assumptions being used by the ‘F.I.R.E.” movement in having enough assets to retire, there are some other important issues which should be considered.

  1. Loss of your skill set. In retirement it is probable your skill set erodes and becomes outdated over time. New technologies, trends, innovations, etc. are running at a faster pace than ever.
  2. Becoming unemployable. One of the things seen following the financial crisis was employers preferring to hire individuals who were already employed rather than hiring those out of work. The reasoning was that if you were good enough to keep your job during the recession, you obviously have a valuable skill set. Once you are out of the “labor force” for a while, it becomes more difficult to regain employment as employers tend to prefer those with a very steady work history, a growing career, and relevant skill sets.
  3. Life. Besides simply running out of money sooner than you planned because of a bear market, a rising cost of living more than you counted on, or higher taxes (all of which are very likely in the near future) there is also just “life.”  It doesn’t matter how carefully you plan; “S*** Happens!” More importantly, it always happens when you least expect it and at the worst possible time. These things cost money and impact our best laid spending and saving plans. The problem with “retiring early,” is that it leaves plenty of time for things to go wrong. 
  4. Unplanned Accident/Medical Problem. Young people suffer from an “invincibility syndrome.” They tend to not carry insurance, due to the cost, because they “never get sick.” While we certainly hope it never happens, a major accident or health issue can extract tens to hundreds of thousands of dollars of capital critically impairing retirement plans.
  5. Too Old To Do Anything About It. The biggest problem for “F.I.R.E.” practitioners is that running out of money late in life leaves VERY few options for the rest of your retirement years. If our math above is even close to correct, which history suggests it is, then our young couple will be faced with going back to work in the 70’s. That is not exactly the retirement most are hoping for. 

As I stated in our previous series, retiring early is far more expensive than most realize. Furthermore, not accounting for variable rates of returns, lower forward returns due to high valuations, and not adjusting for inflation and taxes will leave most far short of their goals. 

While it sounds like I am bashing the “F.I.R.E. Movement,” I am not. I am for ANY program or system that gets young people to save more, stay out of debt, and invest cautiously. The movement is a good thing and it should be embraced.

But, it is also a symptom of a decade-long period of making “easy money” in the financial markets.

These periods ALWAYS end badly and the next “bear market” will quickly “extinguish the F.I.R.E.” as losses mount and dreams have to be put on hold.

It will happen. It always appears easiest at the top.

And, given one of E*Trade’s latest commercials, the next bear market may be coming sooner than we expect.

The One Lesson Investors Should Have Learned From Pension Funds

Just recently I ran a 3-part series on the variety of things individuals believe about saving and investment which is either erroneous or misunderstood. (Part 1, Part 2, Part 3)

The feedback I get when challenging some of the more commonly held beliefs is always interesting. In almost every single case, the arguments against “mathematical realities” comes down to either:

  1. An inability, or unwillingness, to sacrifice today to save more for the future, or;
  2. A “hope” that markets will continue to create returns which will offset the lack of savings.

Okay, it is just a reality that most people don’t want to sacrifice today, for the future tomorrow.

“Live like no one else today, so that you can live like no one else tomorrow.” – Dave Ramsey

Unfortunately, that is the same problem that plagues pension funds all across America today.

As I discussed in “Pension Crisis Is Worse Than You Think,”  it has been unrealistic return assumptions used by pension managers over the last 30-years, which has become problematic.

“Pension computations are performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. The biggest problem, following two major bear markets, and sub-par annualized returns since the turn of the century, is the expected investment return rate.

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system

Pensions STILL have annual investment return assumptions ranging between 7–8% even after years of underperformance.”

However, why do pension funds continue to have high investment return assumptions despite years of underperformance? It is only for one reason:

To reduce the contribution (savings) requirement by their members.

As I explained previously:

“However, the reason assumptions remain high is simple. If these rates were lowered 1–2 percentage points, the required pension contributions from salaries, or via taxation, would increase dramatically. For each point of reduction in the assumed rate of return, it would require roughly a 10% increase in contributions.

For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Since, for many plan participants, particularly unionized workers, increases in contributions are a hard thing to obtain. Therefore, pension managers are pushed to sustain better-than-market return assumptions, which requires them to take on more risk.

The chart below is the S&P 500 TOTAL REAL return from 1995 to present. I have projected an average return of every period in history where the market peaked following P/E’s exceeding 20x earnings. This provides for variable rates of market returns with cycling bull and bear markets out to 2060. I have also projected “average” returns from 3% to 8% from 1995 to 2060. (The average real total return for the entire period is 6.56% which is likely higher than what current valuation and demographic trends suggest it should be.)

This is also the same problem for the average American faces when planning for 6-8% annual returns on their investment strategy.

Clearly, there is no reason you should save money if the market can do the work for you? Right?

This is a common theme in much of the mainstream advice. To wit:

“Suze Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.” 

Ms. Orman’s statement, while very optimistic, requires the 25-year old to achieve an 11.25% annual rate of return (adjusting for inflation) every single year for the next 40-years.

That certainly isn’t very realistic.

More importantly, as I explained previously, $1 million today, and $1 million in 30-years, are two very different issues due to a rising cost of living over time (a.k.a. inflation.) 

Pick a current income level on the left chart, the number on the right is the current income inflated at 2.1% (average inflation rate) over 30-years. Then pick that level of income on the right chart to see how much is needed to fund that amount annually in retirement at 4% (projected withdrawal rate.) Click to enlarge

What pension funds have now discovered, and unfortunately it is far too late, is that using faulty assumptions, and not requiring higher contributions, has led to an inability to meet future obligations.

“Pensions across the U.S. are falling deeper into a crisis, as the gap between their assets and liabilities widens at the same time that investment returns are falling, according to Bloomberg

The average U.S. plan has only 72.5% of its future obligations in 2018, compared to more than 100% in 2001. The Center for Retirement Research at Boston College attributes the deficit to recessions, insufficient government contributions, and generous benefit guarantees. Importantly, the underfunded status is still based on 7% annual return assumptions. 

Unfortunately, the problem will only get worse between now and 2050, according to Visual Capitalist:

“According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050, or about five times the size of the global economy today.”

It isn’t just Pension Funds

Importantly, this is the same trap that individual investors have fallen into as well. By over-estimating future returns, future retirement values are artificially inflated, which reduces the required savings rates. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.

Using the long-term, total return, inflation-adjusted chart of the S&P 500 above, the chart below compares $1000 compounded at 7% annually to the variable-rate of return model above. The bottom part of the chart shows the difference between actual and compounded rates of return.

This is the “pension problem” the majority of individuals have gotten themselves into currently.

As I wrote previously:

“When imputing volatility into returns, the differential between what individuals are promised (and this is a huge flaw in financial planning) and what actually happens to their money is substantial over the accumulation phase of individuals. Furthermore, most of the average return calculations are based on more than 100-years of data. So, it is quite likely YOU DIED long before you realizing the long-term average rate of return.”

Excuses Will Leave You Short

I get it.

I am an average American too.

Here are the most common excuses I hear:

  1. I “need” to be able to enjoy my life today. 
  2. I have “plenty of time” to save up for retirement.
  3. “Budget,” what ‘s that?
  4. I have social security (or a a pension plan), so I don’t really need to save much.

Let’s talk about that last point.

If you have a public pension plan, congratulations, you are in the 15% of workers that do. Future generations won’t be as fortunate. Moreover, with the underfunded status of pensions funds running between $4-5 Trillion, this may not be a “safety net” to bet your entire retirement on.

Social security is also underfunded and payout cuts are expected by 2025 if actions are taken to resolve its issue. The same demographic trends which are plaguing pension funds also weigh heavily on the social security system.

As stated above, the biggest problem for Social Security is that it has already begun to pay out more in benefits than it receives in taxes. As the cash surplus is depleted, which is primarily government I.O.U.’s, Social Security will not be able to pay full benefits from its tax revenues alone. It will then need to consume ever-growing amounts of general revenue dollars to meet its obligations–money that now pays for everything from environmental programs to highway construction to defense. Eventually, either benefits will have to be slashed or the rest of the government will have to shrink to accommodate the “welfare state.” 

It is highly unlikely the latter will happen.

Demographic trends are fairly easy to forecast and predict. Each year from now until 2025, we will see successive rounds of boomers reach the 62-year-old threshold.

Excuses aside, continuing to under-save, and counting on social security and a pension fund to make up the difference, may have very different outcomes than many are currently planning on.

Simple Is Not Always Better

“All you have to do is buy an index fund, dollar cost average into it, and in 30-years you will be set.”

See, it’s simple.

It is why our world has been reduced to sound bytes and 280-character compositions. Financial, retirement, and investment planning, while complicated issues in reality, have become “click bait.”

But a “simple and optimistic” answer belies the hard-truths of investing and market dynamics.

It’s what Pension Funds banked on.

Simple isn’t always better.

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached, or will reach, retirement age by 2030. Unfortunately, the majority of these individuals are woefully under saved for retirement and are “hoping” for compounded annual rates of return to bail them out.

It hasn’t happened, it isn’t going to happen, and the next “bear market” will wipe most of them out permanently.

The analysis above reveals the important lessons individuals should have learned from the failure of pension funds:

  • Lower expectations for future returns and withdrawal rates due to current valuations, interest rates, and long-run economic growth forecasts.
  • With higher rates of returns going forward unlikely, increase savings rates.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered; it’s better to overestimate.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • Future income planning must be done carefully with default risk carefully considered.
  • Most importantly, drop compounded, or average, annual rates of return for plans using variable rates of future returns.

The myriad of advice suggesting one can undersave and invest their way into retirement has a long and brutal history of leaving individuals short of their goals.

If even half of the mainstream commentary on investing were true, wouldn’t there be a large majority of individuals well saved for retirement? Instead, there are mountains of statistical data which show the majority of American’s don’t even have one-year’s salary saved for retirement, much less $1 million.

Yes, please be optimistic about your future and “hope for the best.”

However, if you plan for the “worst,” the odds of success become much higher.

It’s a lesson we can all learn from Pension Funds.

Everything You Are Being Told About Saving & Investing Is Wrong – Part 3

Click Here For Part 1 – The Savings Error

Click Here for PART 2 – You Don’t Get Average Or Compound Returns

This final chapter is going to cover some concepts which will destroy the best laid financial plans if they are not accounted for properly. 

Just recently, CNBC ran a story discussing the “Magic Number” needed to retire:

“For many people who adhere to the mission, there’s a savings target they want to hit, at which point they will have reached financial independence, as they define it. It’s called their FIRE number, and typically, it’s equal to 25 times a household’s annual spending, invested in low-cost, passive stock funds. Many wannabe-early retirees aim to save between $1 million and $2 million.”

This was the savings level we addressed in part one, which is erroneous because it is based on today’s income-replacement level and not the future inflation-adjusted replacement level, as it requires substantially higher savings levels. To wit:

“The chart below takes the inflation-adjusted level of income for each bracket and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.”

“If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.”

The Cost Of Miscalculation

As noted in the CNBC article above, it is recommended that you invest your savings into low-cost index funds. The assumption, of course, is that these funds will average 8% annually. As discussed in Part One, markets don’t operate that way. 

“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.”

During strongly trending bull markets, investors tend to forget that devastating events happen. Major events such as the “Crash of 1929,” “The Great Depression,” the “1974 Bear Market,” the “Crash of ’87”, the “Dot.com” bust, and the “Financial Crisis,” etc. often written off as “once in a generation” or “1-in-100-year events.” However, these financial shocks have come along much more often than suggested. Importantly, all of these events had a significant negative impact on an individual’s “plan for retirement.”

It doesn’t have to be a “financial crisis” which derails the best laid of financial plans either. An investment gone wrong, an unexpected illness, loss of job, etc. can all have devastating impacts to future retirement plans. 

Then there is just “life,” which tends to screw up things without a tragedy occurring. 

Making the correct assumptions in your planning is critical to your eventual success.

Your Personal Returns Will Be Less Than An “Index”

One of the biggest mistakes made is assuming markets will grow at a consistent rate over the given time frame to retirement. As noted, there is a massive difference between compounded returns and real returns as shown above. Furthermore, the shortfall is compounded further when you begin to add in the impact of fees, taxes, and inflation over the given time frame.

The chart below shows what happens to a $1000 investment from 1871 to present, including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio.)

There are other problems with chasing an “index” also:

  • The index contains no cash
  • An index has no life expectancy requirements – but you do.
  • It doesn’t have to compensate for distributions to meet living requirements – but you do.
  • It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  • It has no taxes, costs or other expenses associated with it – but you do.
  • It has the ability to substitute at no penalty – but you don’t.
  • It benefits from share buybacks (market capitaliziaton) – but you don’t.

As an individual you have very little in common with a “benchmark index.” Investing is not a “competition” and treating it as such has had disastrous consequences over time. 

Financial Planning Gone Wrong

I know, you still don’t believe me.  Let’s use CNBC’s example and then break it down.

For instance, imagine a retiree who has a $1,000,000 balanced portfolio, and wants to plan for a 30-year retirement, where inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially, and then adjust each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.”

Over the last 120-years, the market has indeed averaged 8-10% annually. Unfortunately, you do NOT have 90, 100, or more years to invest. All that you have is the time between today and when you want to retire to reach your goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, which happens with some regularity, the odds of achieving goals are massively diminished.

But what drives those 12-15 year periods of flat to little return? Valuations.

Understanding this, we can use valuations, such as CAPE, to form expectations around risk and return. The graph below shows the actual 30-year annualized returns that accompanied given levels of CAPE.

The analysis above reveals the important points individuals should consider in their financial planning process:

  • Expectations for future returns and withdrawal rates should be downwardly adjusted.
  • The potential for front-loaded returns going forward is unlikely.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

  1. Save More And Spend Less: This is the only way to ensure you will be adequately prepared for retirement. It ain’t sexy, or fun, but it will absolutely work.
  2. You Will Be WRONG. The markets go through cycles, just like the economy. Despite hopes for a never-ending bull market, the reality is “what goes up will eventually come down.”
  3. RISK does NOT equal return. The further the markets rise, the bigger the correction will be. RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
  4. Don’t Be House Rich. A paid off house is great, but if you are going into retirement house rich and cash poor, you will be in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
  5. Have A Huge Wad. Going into retirement have a large cash cushion. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining. This compounds the losses in the portfolio and destroys principal which cannot be replaced.
  6. Plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plans, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.

Most likely what ever retirement planning you have done is most likely overly optimistic.

Change your assumptions, ask questions, and plan for the worst. 

The best thing about “planning for the worst” is that all other outcomes are a “win.” 

Everything You Are Being Told About Saving & Investing Is Wrong – Part 2

Click Here For Part 1 – The Savings Error

Click Here For PART 3 – Flaws In Financial Planning

It is always interesting reading article comments as they are generally full of excuses why saving money and building wealth can’t be done. The general thesis is that as long as you have social security (which is threatening payout cuts over the next decade) and/or a pension (which only applies to 15% of the country currently,) then you don’t need to save as much. 

Personally,  I don’t want my retirement based on things which are a) underfunded 2) subject to government-mandated changes, and 3) out of my control. In other words, when planning for an uncertain future, it is always optimal to hope for the best but plan for the worst.

However, the premise of the article was to clear up the disconnect between the cost of living today and 30-years into the future, as well as the amount of money needed to be financially independent for the entire lifespan after retirement.

Yes, we can all get by on less, in theory. But an examination of retirement savings statistics and the cost of healthcare in retirement (primarily due to poor healthcare habits earlier in life) doesn’t necessarily support those comments that saving less and being primarily dependent on Social Security is optimal. 

The Investing Problem

While “Part One”  focused on the amount savings required to sustain whatever level of lifestyle you choose in the future, we also need to discuss the issue of the investing side of the equation. 

Let’s start with a comment made on Part-One of this series:

“If you want to play it safe just buy a no-load, low fee, index fund and index into it regularly. Pay yourself first. Let the power of compounding do its magic.”

See, it’s so easy. Just buy and index fund, dollar cost average into it, and “bingo,” you have got it made. 

Okay, I’ll bite. 

If that is the case, then why this?

“More than half of Americans who were adults amid the Great Recession said they endured some type of negative financial impact, Bankrate found. And half of those people say they’re doing worse now than before the crisis.”

Or this:

“According to a brand new survey from Bankrate.com, just 37% of Americans have enough savings to pay for a $500 or $1,000 emergency. The other 63% would have to resort to measures like cutting back spending in other areas (23%), charging to a credit card (15%) or borrowing funds from friends and family (15%) in order to meet the cost of the unexpected event.”

As I stated in the previous article, I am all for any program and process which encourages people to save and invest for their retirement. My hope is that we can clear up some of the “misconceptions” to improve the chances that retirement years are not spent collecting food stamps and shopping at the local “Goodwill” store, 

Let’s start by clearing up the numerous erroneous comments on the previous article with respect to returns and investing. 

Compound & Average Are Not The Same Thing

” Markets have returned roughly 10% per year of compounded growth, INCLUDING the down years.”

What the commenter is confused about is, as stated previously, is that markets have variable rates of returns. Historically, over the last 120 years, the market has AVERAGED roughly 10% annually. (6% from capital appreciation which is equivalent to the long-term economic growth rate, and 4% from dividends. Today, economic growth is averaging 2%ish since 2000 and dividends are 2% so do the math for future return expectations. 2+2=4%. (Since 2000, average growth has been just a bit more than 5% and the next bear market will roll that average back to 4%)

The chart below shows the difference in nominal values of $1000 invested on an actual basis versus a compounded rate of return of 6% (For the example we are using capital appreciation only.)

Mathematically, both of those lines equate to a 6% return.

The top line is what investors THINK they will get (compound returns.) The bottom line is what they ACTUALLY get 

The difference is when losses applied to invested dollars. The periods of time spent making up previous losses is not the same as growing money. (Bonds, which mature at face value and have a fixed coupon, have had the same return as stocks since the turn of the century.)

This “math problem” is the reason there is a pension fund crisis in the U.S. The massively underfunded pension system was caused by depending on 7%-annual returns in order to reduce saving rates. 

Variable Rates Of Return Change The Game

In Part 1, we laid out a simple example of various current incomes adjusted for inflation 30-years into the future. I am presenting the chart again so the subsequent charts have context.

Now, let’s look at the impact of variable rates of returns on outcomes.

Let’s assume someone starts a super aggressive program of saving 50% of their income annually in 1988. (This was at the beginning of one of the greatest bull market booms in history giving them every advantage of front loaded returns and they get the benefit of the last 10-year long bull market.)  Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

Wow, they certainly saved a lot of money, and they met the amount need to completely replace their inflation-adjusted living standards for the rest of their lives.

Unfortunately, our young saver didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

Given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is likely unrealistic. If it wasn’t then we would not have statistics like this:

Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually. (Which is theMagic Number” for success)

Okay, it’s not so “Magic.” 

There are two important things to note in the charts above. 

The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 13-year period from 2000 to 2013 which left individuals far short of their retirement goals. 

What the majority of investors misunderstand when throwing around numbers like 6% average returns, 10% compound returns, etc., is that losses matter, and they matter a lot.

Here are the TWO most important lessons:

  1. Getting back to even is not the same as making money.
  2. The time lost in reaching your financial goals can not be recovered.

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is during these long periods where valuation indicators “appear” to be “wrong” that investors dismiss them and chase market returns instead.

Such has always, without exception, had an unhappy ending. 

Things You Can Do To Succeed

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting”events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. As an example, the chart below shows how using a simple 12-month moving average to avoid major drawdowns can impact long-term returns. We used the same 10% savings rate as above, dollar cost averaged into an S&P 500 index on a monthly basis, and moved to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually. It doesn’t matter what methodology you use to minimize risk, the end result will be same if you can successfully navigate the full-cycles of the market.  

You Can Do This

Last week, we laid out some suggestions on what you can do to build savings. This week will add the suggestions for the investing side of the equation.

  • It’s all about “cash flow.” – you can’t save if you don’t have positive cash flow.
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over spending is “social media” and “keeping up with the Jones’.” If advertisers were getting your money from social media they wouldn’t advertise there.
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Expectations for future returns should be downwardly adjusted. (You aren’t going to make 6% annually)
  • The potential for front-loaded returns going forward is unlikely.
  • Control investment behaviors and emotions that detract from portfolio returns is critical.
  • Future inflation expectations must be carefully considered.
  • Account for “variable rates of returns” in your plan rather than “average” or “compound.” 
  • Understand risk and control drawdowns in portfolios during market declines.
  • Save money regularly, invest when reward outweighs the risk. Cash is always an alternative.

Lastly, remember that “time” is your most valuable commodity and is the only thing we can’t get more of. 

Everything You Are Being Told About Saving & Investing Is Wrong – Part I

Click Here for PART 2 – You Don’t Get Average Or Compound Returns

Click Here For PART 3 – Flaws In Financial Planning

Let me start out by saying that I am all for any piece of advice which suggest individuals should save more. Saving money is a huge problem for the bulk of American’s as noted by numerous statistics. To wit:

“American have an average of $6,506 in credit card debt, according to a new Experian report out this week. But which expenses are adding to that balance the most? A full 23% of Americans say that paying for basic necessities such as rent, utilities and food contributes the most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt.”

That $6500 credit card balance is something we have addressed previously as it relates to the ability of an average family of four in the U.S. to just cover basic living expenses.

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is a $3200 annual deficit that cannot be filled.”

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

Flawed Advice

The media loves to put out “feel good” information like the following:

“If you start at age 23, for instance, you only have to save about $14 a day to be a millionaire by age 67. That’s assuming a 6% average annual investment return.”

Or this one from IBD:

“If you’re earning $75,000, by age 40 you need 2.4 times your income, or $180,000, in retirement savings. Simple as that.” (Assumes 10% annual savings rate and a 6% annual rate of return)

See, it’s easy.

Unfortunately, it doesn’t work that way.

Let’s start with return assumptions.

Markets Don’t Compound

I have written numerous times about this in the past.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.

Here is another way to look at it.

If you could simply just stick money in the market and it grew by 6% every year, then how is it possible to have 10 and 20-year periods of near ZERO to negative returns?

The level of valuations when you start your investing journey is all you need to know about where you are going to wind up.

$1 Million Sounds Like A Lot – It’s Not

I get it.

$1 million sounds like a whole lot of money. It’s a nice, big, round number with lot’s of zeros.

In 1980, $1 million would generate between $100,000 and $120,000 per year while the cost of living for a family of four in the U.S. was approximately $20,000/year.

Today, there is about a $40,000 shortfall between the income $1 million will generate and the cost of living.

This is just a rough calculation based on historical averages. However, the amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal.

If you are part of the F.I.R.E. movement and want to live in a tiny house, sacrifice luxuries, and eat lots of rice and beans, like this couple, that is certainly an option.

For most there is a desire to live a similar, or better, lifestyle in retirement. However, over time our standard of living will increase with respect to our life-cycle stages. Children, bigger houses to accommodate those children, education, travel, etc. all require higher incomes. (Which is the reason the U.S. has the largest retirement savings gap in the world.)

If you are in the latter camp, like me, a “million dollars ain’t gonna cut it.”

Don’t Forget The Inflation

The problem with all of these “It’s so simple a cave man could do it” articles about “save and invest your way to wealth” is not only the variable rates of returns discussed above, but impact of inflation on future living standards.

Let’s set up an example.

  • John is 23 years old and earns $40,000 a year.
  • He saves $14 a day 
  • At 67 he will have $1 million saved up (assuming he actually gets that 6% annual rate of return)
  • He then withdraws 4% of the balance to live on matching his $40,000 annual income.

That pretty straightforward math.

IT’S ENTIRELY WRONG.

The living requirement in 44 years is based on today’s income level, not the future income level required to maintain the current living standard. 

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.

If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.

Things You Can Do To Succeed

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

  • Pay yourself first, aggressively. Saving money is how you pay yourself for working. 30% is the real magic number. 
  • It’s all about “cash flow.” – you can’t save if you spend more than you make and rack up debt. #Logic
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over-spending is “social media” and “keeping up with the friends.” If advertisers were not getting your money from social media ads they wouldn’t advertise there. (Side benefit is that you will be mentally healthier and more productive by doing so.)
  • Pick up a side hustle, or two, or threeOnce you drop social media it will free up 4-6 hours a week, or more, with which you can increase your income. There are tons of apps today to let you earn extra money and “No” it’s not beneath you to do so. 
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Future inflation expectations must be carefully considered.
  • Expectations for compounded annual rates of returns should be dismissed 

Don’t misunderstand me….I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

There is one sure-fire way to go from “being broke” to being “rich” – write a book on how to do it and sell it to broke people. (See “Broke Millennial” and “Millennial Money.”– but hey that’s capitalism and you can do it too.)

But, if investing were as easy as just sticking your money in the market, wouldn’t “everyone” be rich?

QE – Then, Now, & Why It May Not Work

Since the beginning of the year, the market has rallied sharply. That rally has been fueled by commentary from both the Trump Administration and the Federal Reserve of the removal of obstacles which plagued stocks in 2018. The chart below is an abbreviated, and a bit sarcastic, version of events.

While the resolution of the trade war is certainly beneficial to the economy, as it removes an additional tax on consumers, the biggest support for the market has been the assumption the Fed will return to a much more accommodative stance.

As we summed up previously for our RIA PRO subscribers (try it FREE for 30-days)

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes in 2019 and more in 2020.
  • The pace of QT, or balance sheet reduction, will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets. It is expected the Fed will announce in March that QT will end and the balance sheet will stabilize at a much higher level.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

In mid-2018, the Federal Reserve was adamant a strong economy, and rising inflationary pressures, required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their $4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

The Fed isn’t alone.

China has launched its version of “Quantitative Easing” to help prop up its slowing economy.

Lastly, the ECB downgraded Eurozone growth, and as announced today, not only will they not raise rates in 2019, they also extended the TLTRO program, which is the Targeted Longer-Term Refinancing Operations scheme which gives cheap loans to struggling Eurozone banks, into 2021.

But there is nothing to worry about, right?

Think about this for a moment.

For a decade the global economy has been growing. Market participants are crowing about the massive surge in asset prices as clear evidence of the strength of the economy.

However, such hasn’t been the case. As I discussed previously for the Fed, China, and the ECB, are signaling their concerns about “economic reality,” which as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

More importantly, monetary policy never really impacted the economy as prolifically as was anticipated following the financial crisis. The two 4-panel charts below show the percentage change in the Fed’s balance sheet from 2009-present (309%) versus the total percentage change in various economic components. I have also included the amount of stimulus required to create those changes.

First, it is interesting to note that despite headlines of strong employment growth, the percentage of people considered “Not In Labor Force or NILF” has grown more than full-time employment. Of course, and not surprisingly, the biggest beneficiary of monetary policy was…corporate profits.

Secondly, where monetary policy did work was lifting asset prices as shown in the chart and table below.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1.

Clearly, QE worked well in lifting asset prices, but not so much for the economy as shown above. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE4 will be implemented at the first hint of a more protracted downturn in the market. However, as we noted above, QE will likely only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications, as discussed recently, the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is what is interesting, as reported by Jennifer Ablan:

So, 2-years ago David lays out the plan and yesterday Williams reiterates that plan.

Does the Fed see a recession on the horizon? Is this the reason for the sudden change in views by Powell in recent weeks?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. This was something I pointed out previously:

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been “blown out,” deviations from the “norm” are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable that the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed’s hope has always been that at some point they would be able to wean the economy off of life support and it would operate under its own strength. This would allow the Fed to raise interest rates back to more normalized levels and provide a policy tool to offset the next recession. However, given the Fed has never been able to get rates higher than the last crisis, it has only led to bigger “booms and busts” in recent decades.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great. But as investors, with our retirement savings at risk, what if it doesn’t.

The Fed Doesn’t Target The Market?

Earlier this month, I penned an article asking if we “really shouldn’t worry about the Fed’s balance sheet?” The question arose from a specific statement made by previous New York Federal Reserve President Bill Dudley:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

As I noted, there is a specific reason why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

As he noted, the Fed specifically targeted asset prices to boost consumer confidence. Given that consumption makes up roughly 70% of economic growth in the U.S., it makes sense. So, not surprisingly, when the economy begins to show signs of deterioration, the Fed acts to offset that weakness.

This is why the slowdown in global growth became an important factor behind the central bank’s decision to put plans for interest rate increases on hold. That comment was made by Federal Reserve Vice Chairman Richard Clarida during a question-and-answer session last week.

“The reality is that the global economy is slowing. You’ve got negative growth in Italy, Germany may just grow…1% this year, [and] a slowdown in China. These are all things that we need to factor in. 

Slower global growth would crimp U.S. exports and could also negatively influence financial and asset markets, a primary transmission mechanism for monetary policy.”

As we noted previously in “Data or Markets,” the Fed is not truly just “data dependent.” They are, in many ways, co-dependent on each other. A strongly rising market allows the Fed to raise rates and reduce accommodative as higher asset prices support confidence. However, that “leeway” is quickly reduced when asset prices reverse. This has been the Fed cycle for the last 40-years.

The problem for the Fed is they have now become “liquidity trapped.”

What is that? Here is the definition:

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The chart below shows the correlation between the decline of GDP and the Fed Funds rate.

There are two important things to notice from the chart above. The first is that prior to 1980, the trend of both economic growth and the Fed Funds rate were rising. Then, post-1980, as then Fed Chairman Paul Volker and President Ronald Reagan set out to break the back of inflation, each successive cycle of rate increases were started from a level lower than the previous cycle.

The difference between the two periods was the amount of debt in the system and the shift from an expansive production and manufacturing based economy to one driven primarily by services which have a substantially lower multiplier effect. Since 1980, it has required increasing levels of debt to manufacture $1 of GDP growth.

In every case, the rate cycle increase ALWAYS led to either a recession, bear market, crisis, or all three. Importantly, those events occurred not when the Fed STARTED hiking rates, but when they recognized that their tightening process was confronted by weakening economic growth. 

The Trap

The problem for the Fed is that while lower interest rates may help spur economic growth in the short-term, the growth has come from an increasing level of debt accumulation. Therefore, the economy cannot withstand a reversal of those rates. As shown above, each successive round of rate increases was never able to achieve a rate higher than the previous peak. For example, in 2007, the Fed Funds rate was roughly 5% when the Fed started lowering rates to combat the financial crisis. Today, if the Fed started lowering rates to combat economic weakness,  they would do so from less than half that previous rate.

As Richard Clarida noted in his speech, one of the potential risks to Central Banks globally is the lack of monetary policy firepower available. We previously pointed out that in 2009, the Fed went to work to rescue the economy with a $915 billion balance sheet and Fed Funds at 4.2%. Today, that balance sheet remains above $4 trillion and rates are at 2.5%.

It isn’t lost on the Fed that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not be enough to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

However, even that may not be enough as both Ben Bernanke and Janet Yellen have acknowledged that they were aware that each successive round of QE was somewhat less effective than the last. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

For the Federal Reserve, they are now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 30-years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process.

The One Thing

However, the one statement, which is arguably the most important for investors, is what Bill Dudley stated relative to the size of the balance sheet and it’s use a tool to stem the next decline.

“The balance sheet tool becomes relevant only if the economy falters badly and the Fed needs more ammunition.”

In other words, it will likely require a substantially larger correction than what we have just seen to bring “QE” back into the game. Unfortunately, as I laid out in “Why Another 50% Correction Is Possible,” the ingredients for a “mean-reverting” event are all in place.

“What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe. There are many factors that can, and will, contribute to the eventual correction which will ‘feed’ on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The biggest risk to investors currently is the magnitude of the next retracement. As shown below the range of potential reversions runs from 36% to more than 54%.”

“It’s happened twice before in the last 20 years and with less debt, less leverage, and better-funded pension plans.

More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history which suggests that a mean reversion will be large as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already pushing the longest economic growth cycle in modern American history, such a risk which should not be ignored.”

While Bill makes the point that “QE” is available as a tool, it won’t likely be used until AFTER the Fed lowers interest rates back to the zero-bound. Which means that by the time “QE” comes to the fore, the damage to investors will likely be much more severe than currently contemplated.

Yes, the Fed absolutely targets the financial markets with their policies. The only question will be what “rabbit” they pull out of their hat if it doesn’t work next time?

I am not sure even they know.

The Fed Conundrum – Data Or Markets?

Following the Fed’s last meeting, we published for our RIA PRO subscribers (use code PRO30 for a 30-day free trial) a simple question:

“What does the Fed know?”

Of course, this meeting followed the stock market plunge at the end of 2018 where their tone that turned from “hawkish” to “dovish” in the span of just a few weeks. Seemingly, despite the previous commentary about concerns over rising inflationary pressures, it was pressure from Wall Street and the White House that quickly “realigned” the Fed’s views.

  • The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes this year.
  • The pace of QT or balance sheet reduction will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.

This change in stance, not surprisingly, buoyed the stock market as the proverbial “Fed Put” was back in place.

But the change view may have also just trapped the Fed in their own “data dependent” decision-making process.

The Fed Should Be Hiking Rates

As we noted in our RIA Pro article:

“During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore.

In response, Powell stated:

‘We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.'”

Powell’s awkward response, and unsatisfactory rationale to a simple and obvious question, the question must be asked if it is possible that economic or credit risks are greater than currently believed which would account for the policy U-turn?

However, given that the Fed’s two primary mandates are supposed to be “full employment” and “price stability,” the conflict between managing inflation and supporting the markets is a conundrum.

For example, there is currently sufficient data which suggests “real inflationary pressures” are mounting in the economy. For example, with a 300,000 job print in January and rising wage pressures, the Fed should raise interest rates. The chart below of labor costs clearly show the problem business owners are facing.

As noted employment remains strong and data suggests there is upward pressure on companies to hire more workers.

That pressure to hire is coming from the reality there are currently more demands on labor than there are people to fill them.

Wage pressures are clearly rising in recent months putting additional upward pressures on pricing as companies pass on higher labor costs.

More importantly, inflationary pressures as measured by both PPI, CPI, and the Fed’s preferred measure of Core PCE, continue to rise as well.

The chart below is the spread between PPI and CPI, historically, when “producer price” inflation rises faster than consumer prices, it has impacted economic growth by suggesting that inflation can’t be passed on to consumers.

The composite inflation index is also screaming higher suggesting that if the Fed pauses they could potentially get well “behind the curve.” 

Even the Federal Reserve’s favorite measure of inflation, PCE, is also suggesting the Fed should be hiking rates rather than pausing.

All of this data clearly suggests that the Fed should be hiking rates currently, rather than pausing. 

The Conundrum

However, all of this data is also consistent with the end of an economic cycle rather than a continued expansion. As we quoted last week from John Mauldin:

I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

That loss of confidence is already beginning to show signs as noted recently by Zerohedge:

“American small-business owners are growing increasingly anxious about a looming economic slowdown.

After a report published last week by Vistage Worldwide suggested that small-business confidence had collapsed with the number of small business owners worried that the economy could worsen in 2019 numbering more than twice those who expected it to improve, the NFIB Small Business Optimism Index – a widely watched sentiment gauge – apparently confirmed that more business owners are growing fearful that economic conditions might begin to work against them in the coming months.”

Furthermore, most of these data points are at levels that typically precede economic slowdowns and recession, so hiking rates further from current levels could exacerbate the recessionary risk.

The problem the Fed faces currently, as we discussed previously, is that when the last recession started the Fed Funds rate was at 4.2% not 2.2% and the Fed balance sheet was $915 billion not $4+ trillion.

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But…what do you do?

The Trap

There are clearly rising inflationary pressures on the market, which are also beginning to impede economic growth. Those pressures, combined with a sharp decline in asset prices, spurred the Fed to react to political and market pressures.

The Fed is most likely aware that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not provide enough benefits to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

Sure, Powell might be taking a dovish tone to placate the markets, the President and his member banks and concurrently buying time to further normalize the balance sheet? But this approach is like pouring liquid out of your cup so you can add more when the time is right. You would do this because it is not clear just how much “the cup” will ultimately hold.

Bernanke and Yellen have both acknowledged that they were aware that each successive round of QE was somewhat less effective than prior rounds. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

If this is the case, Powell will continue to publicly discuss minimizing reductions to the balance sheet and refrain from further rate hikes. Despite such dovish Fed-speak, he would continue to shrink the balance sheet at the current pace. This tactic may trick investors for a few months but at some point, the market will question his intentions and damage Fed credibility.

So, therein lies the trap. Do you hike rates and reduce the balance sheet anyway to be better prepared for the onset of the next recession, OR reverse policy to try to “kick the recession can” down the road a bit which leaves you under-prepared for the next crisis?

For the Fed, it is a choice between the lesser of two evils. The only question is did they make the right one?

While the Fed has a long history of using economic jargon and, quite frankly, non-truths to help promote their agenda, they also have a long history of making the wrong policy moves which spark either some sort of crisis, recession or both.

As Michael Lebowitz concluded for our RIA PRO subscribers last week:

“The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not.”

But, exactly what is it?

Recession Risks Are Likely Higher Than You Think

It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.

The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:

“Bull markets are more fun than bear markets.”

Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.

economic_cycle-2

Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the risk of a recession, investors have historically been repeatedly crushed by the inevitable completion of the full market and economic cycle.

But after more than a decade of an economic growth cycle, investors have become complacent in the idea that recessions may have been mostly mitigated by monetary policy.

While monetary policy can certainly extend cycles, they cannot be repealed.

Given that monetary policy has consistently inflated asset prices historically, the reversions of those excesses have been just as dramatic. The table below shows every economic recovery and recessionary cycle going back to 1873.

Importantly, note that the average recessionary drawdown historically is about 30%. While there were certainly some recessionary drawdowns which were very small, the majority of the reversions, particularly from more extreme overvaluation levels as we are currently experiencing, have not been kind to investors.

So, why bring this up?

“In the starkest warning yet about the upcoming global recession, which some believe will hit in late 2019 or 2020 at the latest, the IMF warned that the leaders of the world’s largest countries are ‘dangerously unprepared’ for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms — such as central bank swap lines — has been undermined.” – David Lipton, first deputy managing director of the IMF.

Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well.

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal a recession.”

John Mauldin also recently noted the same:

“This next chart needs a little explaining. It comes from Ned Davis Research via my friend and business partner Steve Blumenthal. It turns out there is significant correlation between the unemployment rate and stock returns… but not the way you might expect.

Intuitively, you would think low unemployment means a strong economy and thus a strong stock market. The opposite is true, in fact. Going back to 1948, the US unemployment rate was below 4.3% for 20.5% of the time. In those years, the S&P 500 gained an annualized 1.7%.”

“Now, 1.7% is meager but still positive. It could be worse. But why is it not stronger? I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

The yield spread between the 10-year and the 2-year Treasury yields is also suggesting there is a rising risk of a recession in the economy.

As I noted previously:

“The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that ‘risk-based’ investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become ‘obvious’ the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the ‘yield curve’ as a ‘market timing’ tool, it is just as unwise to completely dismiss the message it is currently sending.”

We can also see the slowdown in economic activity more clearly we can look at our RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

With the exception of the yield curve, which is “real time,” the rest of the data is based on economic data which has a multitude of problems.

There are many suggesting currently that based on current economic data, there is “no recession” in sight. This is based on looking at levels of economic data versus where “recessions” started in the past.

But therein lies the biggest flaw.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

The issue with a statement of “there is no recession in sight,” is that it is based on the “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER called an official recession that began in December of 2007.

But this is almost always the case. Take a look at the data below of real (inflation-adjusted)economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.  In 1957, 1973, 1981, 2001, 2007 there was “no sign of a recession.” 

The next month a recession started.

So, what about now?

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.0% on an inflation-adjusted basis, there is no recession in sight.” 

Is that really the case or is the market telling us something?

The chart below is the S&P 500 two data points noted.

The green dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession. The yellow dots are the official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

At the time, the decline from the peak was only considered a “correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in waiting for the data to catch up.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

There are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

As Doug Kass noted on Tuesday there are certainly plenty of risks to be aware of:

  1. Domestic economic growth weakens, Chinese growth fails to stabilize and Europe enters a recession
  2. U.S./China fail to agree on a trade deal
  3. Trump institutes an attack on European Union trade by raising auto tariffs
  4. U.S. Treasury yields fail to ratify an improvement in economic growth
  5. The market leadership of FANG and Apple (AAPL) subsidies
  6. Earnings decline in 2019 and valuations fail to expand
  7. The Mueller Report jeopardizes the president
  8. A hard and disruptive Brexit
  9. Crude oil supplies spike and oil prices collapse, taking down the high-yield market
  10. Draghi is replaced by a hawk

While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

Pay attention to the message markets are sending. It may just be saying something very important.

Dalio’s Fear Of The Next Downturn Is Likely Understated

“What scares me the most longer term is that we have limitations to monetary policy — which is our most valuable tool — at the same time we have greater political and social antagonism.” – Ray Dalio, Bridgewater Associates

Dalio made the remarks in a panel discussion at the World Economic Forum’s annual meeting in Davos on Tuesday where he reiterated that a limited monetary policy toolbox, rising populist pressures and other issues, including rising global trade tensions, are similar to the backdrop present in the latter part of the Great Depression in the late 1930s.

Before you dismiss Dalio’s view Bridgewater’s Pure Alpha Strategy Fund posted a gain of 14.6% in 2018, while the average hedge fund dropped 6.7% in 2018 and the S&P 500 lost 4.4%.

The comments come at a time when a brief market correction has turned monetary and fiscal policy concerns on a dime. As noted by Michael Lebowitz yesterday afternoon at RIA PRO

“In our opinion, the Fed’s new warm and cuddly tone is all about supporting the stock market. The market fell nearly 20% from record highs in the fourth quarter and fear set in. There is no doubt President Trump’s tweets along with strong advisement from the shareholders of the Fed, the large banks, certainly played an influential role in persuading Powell to pivot.

Speaking on CNBC shortly after the Powell press conference, James Grant stated the current situation well.

“Jerome Powell is a prisoner of the institutions and the history that he has inherited. Among this inheritance is a $4 trillion balance sheet under which the Fed has $39 billon of capital representing 100-to-1 leverage. That’s a symptom of the overstretched state of our debts and the dollar as an institution.”

As Mike correctly notes, all it took for Jerome Powell to completely abandon any facsimile of “independence” was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.

In other words, the Federal Reserve is now the “market’s bitch.”

However, while the markets are celebrating the very clear confirmation that the “Fed Put” is alive and well, it should be remembered these “emergency measures” are coming at a time when we are told the economy is booming.

“We’re the hottest economy in the world. Trillions of dollars are flowing here and building new plants and equipment. Almost every other data point suggests, that the economy is very strong. We will beat 3% economic growth in the fourth quarter when the Commerce Department reopens. 

We are seeing very strong chain sales. We don’t get the retail sales report right now and we see very strong manufacturing production. And in particular, this is my favorite with our corporate tax cuts and deregulation, we’re seeing a seven-month run-up of the production of business equipment, which is, you know, one way of saying business investment, which is another way of saying the kind of competitive business boom we expected to happen is happening.” – Larry Kudlow, Jan 24, 2019.

Of course, the reality is that while he is certainly “spinning the yarn” for the media, the Fed is likely more concerned about “reality” which, as the data through the end of December shows, the U.S. economy is beginning to slow.

“As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

Limited Monetary Tool Box

As Dalio noted, one of the biggest issues facing global Central Banks is the ongoing effectiveness of “Quantitative Easing” programs. As previously discussed:

“Of course, after a decade of Central Bank interventions, it has become a commonly held belief the Fed will quickly jump in to forestall a market decline at every turn. While such may have indeed been the case previously, the problem for the Fed is their ability to ‘bail out’ markets in the event of a ‘credit-related’ crisis.”

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion dollar balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But it isn’t just the issue of the Fed’s limited toolbox, but the combination of other issues, outside of those noted by Dalio, which have the ability to spur a much larger

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2016 Survey of consumer finances found that the mean holdings for the bottom 80% of families with holdings was only $199,750.

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.

However, that is for those with financial assets heading into retirement. After two major bear markets since the turn of the century, weak employment and wage growth, and an inability to expand debt levels, the majority of American families are financially barren. Here are some recent statistics:

  1. 78 million Americans are participating in the “gig economy” because full-time jobs just don’t pay enough to make ends meet these days.
  2. In 2011, the average home price was 3.56 times the average yearly salary in the United States. But by the time 2017 was finished, the average home price was 4.73 times the average yearly salary in the United States.
  3. In 1980, the average American worker’s debt was 1.96 times larger than his or her monthly salary. Today, that number has ballooned to 5.00.
  4. In the United States today, 66 percent of all jobs pay less than 20 dollars an hour.
  5. 102 million working age Americans do not have a job right now.  That number is higher than it was at any point during the last recession.
  6. Earnings for low-skill jobs have stayed very flat for the last 40 years.
  7. Americans have been spending more money than they make for 28 months in a row.
  8. In the United States today, the average young adult with student loan debt has a negative net worth.
  9. At this point, the average American household is nearly $140,000 in debt.
  10. Poverty rates in U.S. suburbs “have increased by 50 percent since 1990”.
  11. Almost 51 million U.S. households “can’t afford basics like rent and food”.
  12. The bottom 40 percent of all U.S. households bring home just 11.4 percent of all income.
  13. According to the Federal Reserve, 4 out of 10 Americans do not have enough money to cover an unexpected $400 expense without borrowing the money or selling something they own. 
  14. 22 percent of all Americans cannot pay all of their bills in a typical month.
  15. Today, U.S. households are collectively 13.15 trillion dollars in debt.  That is a new all-time record.

Here is the problem with all of this.

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect is nearly entirely mitigated when only a very small percentage of the population actually benefit from rising asset prices. The problem for the Federal Reserve is in an economy that is roughly 70% based on consumption, when the vast majority of American’s are living paycheck-to-paycheck, the aggregate end demand is not sufficient to push economic growth higher.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy. It hasn’t. The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history.

The real problem for the economy, wage growth and the future of the economy is clearly seen in the employment-to-population ratio of 16-54-year-olds. This is the group that SHOULD be working and saving for their retirement years.

The current economic expansion is already set to become the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

To Dalio’s point, the real crisis will come during the next economic recession.

While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Furthermore, the already grossly underfunded pension system will implode.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

The massive amount of corporate debt, when it begins to default, will trigger further strains on the financial and credit systems of the economy.

Dalio’s View Is Likely Understated. 

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in the coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

The issue for future politicians won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

The good news, if you want to call it that, is that the next “crisis,” will be the “great reset” which will also make it the “last crisis.”

F.I.R.E.’d Up – A Million Ain’t What It Used To Be

The FIRE (Financial Independence Retire Early) Movement is literally on “fire” after Suze Orman recently suggested that one would need $5 million if they wanted to retire early.

“You need at least $5 million, or $6 million. … Really, you might need $10 million,” she said — short of that, it’s just not going to be enough for most people.

“You can do it if you want to. I personally think it is the biggest mistake, financially speaking, you will ever, ever make in your lifetime. I think it’s just ridiculous. You will get burned if you play with FIRE.”

FIRE supporters immediately leapt to the movement’s defense and criticized Orman’s view.

Here is the interesting part – both are right and wrong.

The amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal. In other words, how much money will you need in the future, on an annualized basis, to live the same lifestyle you live today?

In other words, you have to adjust for inflation.

Suze Orman suggests that number will be a lot larger due to “life,” increased healthcare costs as we get older, etc.  She’s right, but $5 million is a number completely out of touch for most Americans and larger than most would actually need.

FIRE supporters are right in that you will need 25x your income to fund living costs, but they are also wrong in basing it on current income rather than future inflation-adjusted income.

Let me explain.

The basic FIRE premise is that you need to save 50% of income until you have saved 25x your annual income. Then you live on a 4% withdrawal rate. Here is an example:

Current annual income is $50,000 x 25 = $1,250,000 at 4% = $50,000 

It’s simple math.

As I said, it’s wrong because it is based on TODAY’S income level and not that of future income requirements.

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire FIRE premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of 25x of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to the FIRE recommendation of 25x current income.

Suze was right.  If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years. For the FIRE followers, not adjusted for inflation is going to leave you short.

The FIRE Movement Fizzles For Most

A new study notes the U.S. retirement savings shortfall is worse than even we previously discussed. The study by the National Institute on Retirement Security, using data from the U.S. Federal Reserve, shows that retirement savings “are dangerously low” and that the U.S. retirement savings deficit is between $6.8 and $14 trillion.

Worse, the median retirement account balance is $3,000 for all working-age households and $12,000 for near-retirement households, the study reports.

This was also something I discussed recently in“80% of Americans Face A Retirement Crisis.”

“Those fears are substantiated even further by a new report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.”

Here are some additional findings from the report:

  • Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
  • The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
  • Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.

So, FIRE should solve that problem right.

Just save 50% of your income and you are good to go.

Maybe not.

“Why do so many Americans face a retirement crisis today after a decade of surging stock market returns? A survey from Bankrate.com touched on the issue.

’13 percent of Americans are saving less for retirement than they were last year and offers insight into why much of the population is lagging behind. The most popular response survey participants gave for why they didn’t put more away in the past year was a drop, or no change, in income.’

In other words, the “inability” to save is a huge issue for the FIRE movement.

Buy And Hold Won’t Get You There

The other problem for the FIRE movement is current valuations. With the markets currently at the second highest level of valuations in history, returns going forward are likely not going to work out as planned.

However, let’s give FIRE the benefit of the doubt and assume that someone started the program in 1988 at the beginning of one of the greatest bull market booms in history. They also got one to end with one as well. Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

As shown, the FIRE program certainly works.

You just didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

But given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is simply unrealistic. Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually.

There are two important things to note in the chart above.  The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 20-year period from 1997 to 2009 which left individuals far short of their retirement goals. 

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is these long periods where valuation indicators “appear” to be wrong where investors dismiss them and chase market returns instead.

Such has always had an unhappy ending.

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting” events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. The example below uses a simple 12-month moving average to explain the importance of avoiding major drawdowns. It is the same 10% savings rate as above, dollar cost averaging into an S&P 500 index on a monthly basis, and moving to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually.

Don’t misunderstand me….I love the FIRE program.

I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

In 1980, a million dollars would fund a healthy retirement.

That isn’t the case any longer as rising inflation eats away at the purchasing power of individuals.

It’s true when they say: “A million dollars sure ain’t what it used to be.”

The Risk Of An ETF Driven Liquidity Crash

Last week, James Rickards posted an interesting article discussing the risk to the financial markets from the rise in passive indexing. To wit:

“Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

This is the problem of ‘active’ versus ‘passive’ investors.

The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.”

Evelyn Cheng highlighted the rise of passive investing as well:

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets, according to a new report from JPMorgan.

‘While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,‘ Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates ‘fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.

‘Derivatives, quant fund flows, central bank policy and political developments have contributed to low market volatility’, Kolanovic said. Moreover, he said, ‘big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.’”

The rise in passive investing has been a byproduct of a decade-long infusion of liquidity and loose monetary policy which fostered a rise in asset prices to a valuation extreme only seen once previously in history. The following chart shows that this is exactly what is happening. Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while $2.0 trillion has been withdrawn from active-strategy funds.

As James aptly notes:

“This chart reveals the most dangerous trend in investing today. Since the last financial crisis, $2.5 trillion has been added to “passive” equity strategies and $2.0 trillion has been withdrawn from “active” investment strategies. This means more investors are free riding on the research of fewer investors. When sentiment turns, the passive crowd will find there are few buyers left in the market.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.”

He is correct, and makes the same point that Frank Holmes recently penned in Forbes:

“Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. New research shows that it has inflated share prices for a number of popular stocks. A lot of trading now is based not on fundamentals but on low fees. These ramifications have only intensified as active managers have increasingly been pushed to the side.”

“This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro-strategist at INTL FCStone.

If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares.”

As Frank notes, the problem with even 35% of the market being “passive” is the liquidity issues surrounding the market as a whole. With more ETF’s than individual stocks, and the number of outstanding shares traded being reduced by share buybacks, the risk of a sharp and disorderly reversal remains due to compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities, and contagion across asset markets.

The risk of a disorderly unwinding due to a lack of liquidity was highlighted by the head of the BOE, Mark Carney.

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

In other words, the problem with passive investing is simply that it works, until it doesn’t.

You Only Think You Are Passive

As Howard Marks, mused in his ‘Liquidity’ note:

“ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

What Howard is referring to is the “Greater Fool Theory,” which surmises there is always a “greater fool” than you in the market to sell to. While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

More importantly, individual investors are NOT passive even though they are investing in “passive” vehicles.

Today, more than ever, advisors are actively migrating portfolio management to the use of ETF’s for either some, if not all, of the asset allocation equation. However, they are NOT doing it “passively.”

The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks, rather than individual securities, it is not a “passive” choice, but rather “active management” in a different form.  

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall – “passive indexers” will quickly become “active sellers.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic, and damaging, ending.

It is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

The reason that mean-reverting events have occurred throughout history, is that despite the best of intentions, individuals just simply refuse to act “rationally” by holding their investments as they watch losses mount.

This behavioral bias of investors is one of the most serious risks arising from ETFs as the concentration of too much capital in too few places. But this concentration risk is not the first time this has occurred:

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that
  • “Portfolio Insurance” was the “thing” in the mid -80’s
  • Dot.com anything was a great investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
  • Today, it’s ETF’s 

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing.

Until it goes in the other direction.

The sell-off in February of this year was not particularly unusual, however, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time.

It should serve as a warning.

When “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Fortunately, while the price decline was indeed sharp, and a “rude awakening” for investors, it was just a correction within the ongoing “bullish trend.”

For now.

But nonetheless, the media has been quick to repeatedly point out the decline was the worst since 2008.

That certainly sounds bad.

The question is “which” 10% decline was it?

Regardless, it was only a glimpse at what will eventually be the “real” decline when leverage is eventually clipped. I warned of this previously:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.”

Make no mistake we are sitting on a “full tank of gas.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

So, what’s your plan for when the real correction ultimately begins?

“If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.” – John C. Bogle.

Party Like It’s 1992?

Last week, Mark Hulbert warned of an indicator that hasn’t been this inflated since the “Dot.com” bubble. To wit:

“It’s been more than 25 years since the stock market’s long-term trailing return was as low as it is today. Since the top of the internet bubble in March 2000, the S&P 500 has produced a 1.4% annualized return after adjusting for both dividends and inflation. “

Whoa! How can that be given the market just set a record for the “longest bull market” in U.S. history?

This is a point that is lost on many investors who have only witnessed one half of a full market cycle. It is also the very essence of Warren Buffett’s most basic investment lesson:

“Price is what you pay. Value is what you get.”

Over the last 147-years of market history, there have only been five (5), relatively short periods, in history where the entirety of market “gains” were made. The rest of the time, the market was simply getting back to even.

Where you start your investing journey has everything to do with outcomes. Warren Buffett, for example, launched Berkshire Hathaway when valuations, and markets, were becoming historically undervalued. If Buffett had launched his firm in 2000, or even today, his “fame and fortune” would likely be drastically different.

Timing, as they say, is everything.

It is also worth noting, as shown below, that valuations clearly run in cycles over time. The current evolution of valuations has been extended longer than previous cycles due to 30-years of falling interest rates, massive increases in debt and leverage, unprecedented amounts of artificial stimulus, and government spending.

This was a point I discussed last week:

“There are two important things to consider with respect to the chart below.

  1. The shift higher in MEDIAN valuations was a function of falling economic growth and inflationary pressures.
  2. Higher prices were facilitated by increasing levels of leverage and debt, which eroded economic growth. “

But with returns low over the last 25-years, future returns should be significantly higher. Right?

Not necessarily. As Mark noted:

“Your conclusion from this sobering factoid depends on whether you see the glass as half-full or half-empty. The ‘half-full’ camp calls attention to what happened to stocks in the years after 1992, when stocks’ trailing two-decade return regressed to the mean — and then some: equities skyrocketed, elevating their trailing 18.5 year inflation-adjusted dividend-adjusted return to 11% annualized.

This optimistic view is the most pervasive. Return estimates for the S&P 500 have steadily risen in recent months as earnings have been buoyed by massive amounts of share buybacks and tax cuts.

With earnings rising, what’s not to love?

I get it.

But I disagree, and here’s why.

Throughout history, there is an undeniable link between valuation and return. More importantly, it is the expansion, or contraction, in valuations which are directly tied to the cycles of the market. When investors are willing to “pay up” for a future stream of cash flows, prices rise. When expectations for future cash flows decline, so do prices.

For those expecting a repeat of the post-1992 period, they are likely to be disappointed. As shown, in 1992, the deviation from the long-term median price/earnings ratio (using Shiller’s CAPE) was just below 0%. This gave investors plenty of room to expand valuations as inflation and interest rates fell, consumer and government debts surged, and the general masses swept into the “Wall Street Casino.” 

Today, valuations are at the second highest level in history. Despite the massive surge in earnings due to tax cuts – inflation and interest rates are low, revenue growth is weak as consumers, government, and corporations are fully leveraged, and households are “all in” the equity pool.

This is an important point which should not be overlooked.

The bullish premise has been that since tax cuts will cause a surge in earnings which we reduce valuations back to their long-term average. However, such is true as long as prices don’t increase during the period earnings are rising. But such as NOT been the case. Currently, the market has continued to “price in” those earnings increases keeping valuations elevated. 

As noted by Mark:

“Unfortunately, the CAPE today is back to within shouting distance of where it stood at the top of the internet bubble. It reached 44.2 then, and is 33.2 today. At no time in U.S. history other than the internet bubble has the CAPE been as high as it is now.”

CAPE Is B.S.

It is not surprising that during periods of valuation expansion that investors eventually come to the conclusion that “this time is different.” The argument goes something like this:

“Sure, the CAPE ratio is elevated but had you sold, you would have missed out on this booming bull market.”

That statement is 100% true.

However, it grossly misunderstands the “value” of “valuations.” 

Valuations are not, and have never been, useful as a market timing indicator. Valuations should not be used as a “buy” or “sell” indicator in a portfolio management process.

What valuations do provide is a very clear understanding of what future expected returns will be over the next 10-20 years. Bill Hester wrote a very good note in this regard in response to critics of Shiller’s CAPE ratio and future annualized returns:

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns.

It is also the same over 20-year periods even on a rolling 20-year real total-return basis.

“Even on a 20-year real total return basis, there was a negative return period. But while the three other periods were not negative after including dividends, when it comes to saving for retirement, a 20-year period of 1% returns isn’t much different from zero.”

There is also a reasonable argument that due to the “speed of movement” in the financial markets, a shortening of business cycles, changes to accounting rules, buyback activity, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the financial markets currently.

Therefore, in order to compensate for the potential “duration mismatch” of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.

The high correlation between the movements of the CAPE-5 and the S&P 500 index shouldn’t be a surprise. However, notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.

A key “warning” for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. The two most recent declines in the CAPE-5 also correlated with drops in the market in 2015-2016 and the beginning of 2018.

To get a better understanding of where valuations are currently relative to past history, and why this is likely NOT 1992, we can look at the deviation between current valuation levels and the long-term average. 

The importance of deviation is crucial to understand. In order for there to be an “average,” valuations had to be both above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time which is why the further the deviation is away from the “average,” the greater the eventual “mean reversion” will be.

The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.

Currently, the 76.15% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed two (2) other times in history – 1929 and 2000. As stated above, while it is hoped “this time will be different,” which were the same words uttered during each of the two previous periods, you can clearly see that the eventual outcomes were much less optimal.

However, as noted, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.

Again, as with the long-term view above, the current deviation is 61.8% above the Post-WWII CAPE-5 average of 17.27x earnings. Such a level of deviation has only been witnessed one other time previously over the last 70 years as we headed into the “Dot.com” peak. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.

Is this a better measure than Shiller’s CAPE-10 ratio?

Maybe, as it adjusts more quickly to a faster moving marketplace. However, I want to reiterate that neither the Shiller’s CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be “market timing” indicators.

Since valuations determine forward returns, the sole purpose is to denote periods which carry exceptionally high levels of investment risk and resulted in exceptionally poor levels of future returns.

Currently, valuation measures are clearly warning the future market returns are going to be substantially lower than they have been over the past ten years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.

Does that mean you should be all in cash today? Of course, not.

However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next “reversion” when it occurs.

My client’s have only two objectives:

  1. Protect investment capital from major market reversions,  and;
  2. Meet investment returns anchored to retirement planning projections.

Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.

Or, you can just hope it all works out.

For 80% of Americans, it just simply hasn’t been the case.

The Ingredients Of An “Event”

This past week marked the 10th-Anniversary of the collapse of Lehman Brothers. Of course, there were many articles recounting the collapse and laying blame for the “great financial crisis” at their feet. But, as is always the case, an “event” is always the blame for major reversions rather than the actions which created the environment necessary for the crash to occur. In the case of the “financial crisis,” Lehman was the “event” which accelerated a market correction that was already well underway.

I have noted the topping process and the point where we exited the markets. Importantly, while the market was giving ample signals that something was going wrong, the mainstream analysis continued to promote the narrative of a “Goldilocks Economy.” It wasn’t until December of 2008, when the economic data was negatively revised, the recession was revealed.

Of course, the focus was the “Lehman Moment,” and the excuse was simply: “no one could have seen it coming.”

But many did. In December of 2007 we wrote:

“We are likely in, or about to be in, the worst recession since the ‘Great Depression.'”

A year later, we knew the truth.

Throughout history, there have been numerous “financial events” which have devastated investors. The major ones are marked indelibly in our financial history: “The Crash Of 1929,” “The Crash Of 1974,” “Black Monday (1987),” “The Dot.Com Crash,” and the “The Financial Crisis.” 

Each of these previous events was believed to be the last. Each time the “culprit” was addressed and the markets were assured the problem would not occur again. For example, following the crash in 1929, the Securities and Exchange Commission, and the 1940 Securities Act, were established to prevent the next crash by separating banks and brokerage firms and protecting against another Charles Ponzi. (In 1999, legislation was passed to allow banks and brokerages to reunite. 8-years later we had a financial crisis and Bernie Madoff. Coincidence?)

In hindsight, the government has always acted to prevent what was believed to the “cause” of the previous crash. Most recently, Sarbanes-Oxley and Dodd-Frank legislations were passed following the market crashes of 2000 and 2008.

But legislation isn’t the cure for what causes markets to crash. Legislation only addresses the visible byproduct of the underlying ingredients. For example, Sarbanes-Oxley addressed the faulty accounting and reporting by companies like Enron, WorldCom, and Global Crossing. Dodd-Frank legislation primarily addressed the “bad behavior” by banks (which has now been mostly repealed).

While faulty accounting and “bad behavior” certainly contributed to the end result, those issues were not the cause of the crash.

Recently, John Mauldin addressed this issue:

“In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

While the idea is correct, this assumes that at some point the markets collapse under their own weight when something gives.

I think it is actually a little different. In my view, ingredients like nitrogen, glycerol, sand, and shell are mostly innocuous things and pose little real danger by themselves. However, when they are combined together, and a process is applied to bind them, you make dynamite. But even dynamite, while dangerous, does not immediately explode as long as it is handled properly. It is only when dynamite comes into contact with the appropriate catalyst that it becomes a problem. 

“Mean reverting events,” bear markets, and financial crisis, are all the result of a combined set of ingredients to which a catalyst was applied. Looking back through history we find similar ingredients each and every time.

The Ingredients

Leverage

Throughout the entire monetary ecosystem, there is a consensus that “debt doesn’t matter” as long as interest rates remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase” and has fostered a massive surge in debt in the U.S. since the “financial crisis.”  

Importantly, debt and leverage, by itself is not a danger. Actually, leverage is supportive of higher asset prices as long as rates remain low and the demand for, rates of return on, other assets remains high.

Valuations

Likewise, high valuations are also “inert” as long as everything asset prices are rising. In fact, rising valuations supports the “bullish” thesis as higher valuations represent a rising optimism about future growth. In other words, investors are willing to “pay up” today for expected further growth.

While valuations are a horrible “timing indicator” for managing a portfolio in the short-term, valuations are the “great predictor” of future investment returns over the long-term.

Psychology

Of course, one of the critical drivers of the financial markets in the “short-term” is investor psychology. As asset prices rise, investors become increasingly confident and are willing to commit increasing levels of capital to risk assets. The chart below shows the level of assets dedicated to cash, bear market funds, and bull market funds. Currently, the level of “bullish optimism” as represented by investor allocations is at the highest level on record.

Again, as long as nothing adversely changes, “bullish sentiment begets bullish sentiment” which is supportive of higher asset prices.

Ownership

Of course, the key ingredient is ownership. High valuations, bullish sentiment, and leverage are completely meaningless if there is no ownership of the underlying equities. The two charts below show both household and corporate levels of equity ownership relative to previous points in history.

Once again, we find rising levels of ownership are a good thing as long as prices are rising. As prices rise, individuals continue to increase ownership in appreciating assets which, in turn, increases the price of the assets being purchased.

Momentum

Another key ingredient to rising asset prices is momentum. As prices rice, demand for rising assets also rises which creates a further demand on a limited supply of assets increasing prices of those assets at a faster pace. Rising momentum is supportive of higher asset prices in the short-term.

The chart below shows the real price of the S&P 500 index versus its long-term bollinger-bands, valuations, relative-strength, and its deviation above the 3-year moving average. The red vertical lines show where the peaks in these measures were historically located.

The Formulation

Like dynamite, the individual ingredients are relatively harmless. However, when the ingredients are combined they become potentially dangerous.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, in the short-term, this particular formula does indeed remain supportive for higher asset prices. Of course, the more prices rise, the more optimistic the investing becomes as it becomes common to believe “this time is different.”

While the combination of ingredients is indeed dangerous, they remain “inert” until exposed to the right catalyst.

These same ingredients were present during every crash throughout history.

All they needed was the right catalyst.

The catalyst, or rather the “match that lit the fuse,” was the same each time.

The Catalyst

In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became “active,” monetarily policy-wise. As shown in the chart below, when the Fed has embarked upon a rate hiking campaign, bad “stuff” has historically followed.

With the Fed expected to hike rates 2-more times in 2018, and even further in 2019, it is likely the Fed has already “lit the fuse” on the next financially-related event.

Yes, the correction will begin as it has in the past, slowly, quietly, and many investors will presume it is simply another “buy the dip” opportunity.

Then suddenly, without reason, the increase in interest rates will trigger a credit-related event. The sell-off will gain traction, sentiment will reverse, and as prices decline the selling will accelerate.

Then a secondary explosion occurs as margin-calls are triggered. Once this occurs, a forced liquidation cycle begins. As assets are sold, prices decline as buyers simply disappear. As prices drop further, more margin calls are triggered requiring further liquidation. The liquidation cycle continues until margin is exhausted.

But the risk to investors is NOT just a market decline of 40-50%.

While such a decline, in and of itself, would devastate the already underfunded 80% of the population that is currently woefully under-prepared for retirement, it would also unleash a host of related collapses throughout the economy as a rush to liquidate holdings accelerates.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

All the ingredients for the next market crash are currently present. All that is current missing is the “catalyst” which ignites it all.

There are many who currently believe “bear markets” and “crashes” are a relic of the past. Central banks globally now have the financial markets under their control and they will never allow another crash to occur. Maybe that is indeed the case. However, it is worth remembering that such beliefs were always present when, to quote Irving Fisher, “stocks are at a permanently high plateau.” 

The Coming Collision Of Debt & Rates

On Tuesday, I discussed the issue of what has historically happened to the financial markets when both the dollar and rates are rising simultaneously. To wit:

“With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.”

I wanted to reiterate this point after reading a recent comment from Jamie Dimon, CEO of JP Morgan, whom, as I have previously written about, makes rather “disconnected” statements from time to time.

“We’re probably in the sixth inning (of this economic cycle), and it’s very possible you’re going to see stronger growth in the U.S. I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”

First, while he talks about banks being much better capitalized, the interesting question is:

“If banks are so well capitalized, why hasn’t FASB Rule 157 been reinstated?”

As I noted previously, FASB Rule 157 was repealed during the financial crisis to allow banks to mark bad assets to “face value” making balance sheets stronger than they appear. This served the purpose of reducing panic in the system, supported “Too Big To Fail” banks, and kept many banks in operation. But if banks are once again so well capitalized, leverage reduced and the economy firing on all cylinders – why is that repeal still in place today? And, if the financial system and economic environment are so strong, then why are Central Banks globally still utilizing “emergency measures” to support their economies?

Likely it is because economic growth remains tepid and banks are once again heavily leveraged as noted by Zero Hedge:

“It is by now well known that consolidated leverage in the system is at an all-time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all-time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.”

However, let me address the leverage issue from an economic standpoint. Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.

This leverage issue is more clearly revealed when we look at non-financial corporate debt and assets as a percentage of the gross-value added (GVA). Again, as above, rising rates have historically sparked a rapid reversion in this ratio which has generally coincided with the onset of a recession.

With leverage, both corporate and household, at historical peaks, the only question is how long can consumers continue to absorb higher rates?

While Mr. Dimon believes we are only in the “sixth-inning” of the current economic cycle, considering all of the economically sensitive areas which are negatively impacted by higher rates, one has to question the sustainability of the current economic cycle?

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) One of the main arguments of stock bulls over the last 5-years has been the “stocks are cheap based on low interest rates.”

5) The massive derivatives and credit markets will be negatively impacted. (Deutsche Bank, Italy, etc.)

6) As rates increase so does the variable rate interest payments on credit cards and home equity lines of credit. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a contraction in disposable income and rising defaults.

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend payments have been done through the use of cheap debt, which has led to increased corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on lower borrowing costs. Higher borrowing costs leads to lower CapEx.

10) The deficit/GDP ratio will rise as borrowing costs rise. 

You get the idea. Interest rates, economic growth, and credit are extremely linked. When it comes to the stock market, the claim that higher rates won’t impact stock prices falls into the category of “timing is everything.”  

If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes. With rates now at extensions only seen in 7-periods previously, there is little room left for further acceleration in rates before such an outcome spawns.

As Bridgewater just recently noted:

“Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.”

Here are the things that you need to know:

1) There have been ZERO times when the Federal Reserve has embarked upon a rate hiking campaign that did not eventually lead to negative economic and financial market consequences.

2) The median number of months following the initial rate hike has been 17-months. However, given the confluence of central bank interventions, that time frame could extend to the 35-month median or late-2018 or early-2019.

3) The average and median increases in the 10-year rate before negative consequences have occurred has historically been 43%. We are currently at double that level.

4) Importantly, there have been only two times in recent history that the Federal Reserve has increased interest rates from such a low level of annualized economic growth. Both periods ended in recessions.

5) The ENTIRETY of the“bullish” analysis is based on a sustained 34-year period of falling interest rates, inflation and annualized rates of economic growth. With all of these variables near historic lows, we can only really guess at how asset prices, and economic growth, will fair going forward.

6) Rising rates, and valuations, are indeed bullish for stocks when they START rising. Investing at the end of rising cycle has negative outcomes.

What is clear from the analysis is that bad things have tended to follow sustained increases in interest rates. As the Fed continues to press forward hiking rates into the current economic cycle, the risk of a credit related event continues to rise.

For all the reasons currently prognosticated that rising rates won’t affect the “bull market,” such is the equivalent of suggesting “this time is different.”

It isn’t.

Importantly, “This Cycle Will End,”  and investors who have failed to learn the lessons of history will once again pay the price for hubris.

70 Is The New 90: The Psychological Impact Of Higher Oil Prices

Today, more now than ever, we are barraged with economic data of which most is lost on the average person. One data point, however, that everyone understands is the price of oil as it directly impacts the average American where it counts the most, in the “wallet.”

The price of oil is plastered just about everywhere from a litany of daily articles to Government policies, the Internet and, ultimately, at every gas station you drive by. Oil prices affect us every day in more ways than just what we are paying for a gallon of gasoline. It affects the cost of just about everything we wear, consume, or utilize, from hard products to services due to rising input costs, fuel surcharges, etc.

This is one reason when the government reports the consumer price index (CPI), and then strips out food and energy to report the core inflation index, it almost always elicits a negative response. Back in 2011, then Fed President William Dudley got a street-corner education in the cost of living when he tried to sell the Fed’s monetary policy to “average Americans.” Dudley tried to explain that while some commodity prices are rising, other prices are falling.

“Today you can buy an iPad2 that costs the same as an iPad 1 that is twice as powerful, you have to look at the prices of all things.”  

What he is addressing here is called “hedonics”. Antony P. Mueller wrote a great piece on the “Illusions Of Hedonics” stating that:

“The Bureau of Labor Statistics (BLS) applies “hedonics” when calculating the price indices and for the computation of the real gross domestic product and of productivity.  The idea behind hedonics is to incorporate quality changes into prices. This way, a product may be on the market at a higher price, but when the product qualities have augmented more than the price in the eyes of the BLS, it will calculate that the price of this product has actually fallen.

Applying the hedonic technique to a host of goods and services means that even when prices were generally rising, but product improvement are deemed to be larger than the price increases, the calculated inflation rate will fall.  With a lower inflation rate, the transformation of nominal gross domestic product (GDP) into real GDP will render a higher result.  Likewise, given a constant labor input, productivity will increase. Hedonics opens the door to producing magical results: a lower inflation rate with generally rising prices, a higher growth rate although the economy may be weaker, and a higher productivity number, although productivity would have been declining without the hedonic imputations.”

It is important to understand this concept as it is why Bill Dudley was immediately lambasted by reporters in the audience following his iPad statement with;

“I can’t eat an iPad” and “When was the last time YOU went to a grocery store?”

The reason the “average American” can’t grasp things like “hedonic” adjustments to the inflation index, or even the idea of stripping out volatile food and energy components of CPI to get a core index, is because they live in a world where their daily lives are affixed to the disposable personal income they bring home. The average American gets a paycheck and then must pay not only for rent, utilities, and health insurance, but also food and gas. In their mind why should you exclude the two items that are currently consuming roughly one-fifth of their wages and salaries?

While there has been a lot of pandering from the talking heads about rising oil prices, but what is more important to note is how these price increases in oil “feel” to the average American. The thing that the Fed and most economists miss, in my opinion, is that the average “American” is dealing with a lot of rising cost pressures that aren’t necessarily included in the inflation calculation. Furthermore, while prices of things like oil, commodities, college costs, insurance, healthcare, etc. have been rising; disposable personal incomes have grown at a much slower rates as shown below.

But even that measure of disposable personal incomes in deceiving because the top 20% of wage earners overly skew the data versus the bottom 80%. For the bottom 80% of income earners, disposable incomes are actually more disappointing.

Therefore, even small price increases have a more dramatic effect on the limited amount of disposable personal incomes available to the consumers in the bottom 80%. For many individuals today, the effects of the “financial crisis” have yet to fade as they are still unable to meet the required costs for their standard of living.

United Way has done a study on a group of Americans they call ALICE: Asset Limited, Income Constrained, Employed. The study found that this group does not make the money needed “to survive in the modern economy.” Between families living below the poverty line due to unemployment or disability, and ALICE, the study discovered that 43% of Americans were struggling to cover basic necessities like rent and food.

But even for those who are making ends meet, they aren’t saving either. Northwestern Mutual’s 2018 Planning & Progress Study, which surveyed 2,003 adults, found that 21% of Americans have nothing saved at all for their golden years, and a third of Americans have less than $5,000. To put that into perspective, it means that 31% of U.S. adults could last only a few months on their savings if they had to retire tomorrow.

That data supports the chart below which shows the gap between the inflation-adjusted median standard-of-living versus the disposable income and credit required to pay for it. Beginning in 2007, even after all the disposable income had been spent and credit cards maxed out, there is a growing deficit (currently over $7000) to support the living standard. This is why more individuals than ever are working multiple jobs, not retiring, or just curtailing spending.

Only So Much To Go Around

Of course, when the consumer is under pressure at home, they eventually must reduce consumption. The chart below shows inflation-adjusted oil prices as compared to inflation-adjusted disposable personal income and oil prices. Since oil prices are a direct input cost to so many different aspects of the daily lives of the average “American,” price spikes in oil have a very real impact on the way that consumers “feel” about their ability to make ends meet.

What we find is that when oil prices spike there is an immediate shock to the disposable personal incomes for individuals. For example, during the Iran crisis oil peaked at $109 per barrel, but for consumers it “felt” like $242 a barrel. Then at the peak of the oil market in 2008, when oil traded for $138 a barrel, it felt much closer to $258 as real disposable incomes had declined. Today, as oil trades around $71 a barrel, consumers “feel” like it is closer to $90.

This psychological “cost pressure” obviously impacts the way that consumers behave with their money. While the government tries to massage the differences in inflationary pressures to suppress adjustments to Social Security and Medicare; the average American is rapidly coming to grips with reality.

At some point the process of kicking the can down the road will meet its inevitable conclusion in this game of chicken as consumers continue to leverage themselves to extremes and neglect to save in order to support their standard of living. The evidence is clear that Keynesian economics is a failure, not just recently, but over the last 40-years as increased monetary supply, and lower interest rates, have led to declining wages, savings and the dollar which in turn induced malinvestment.

The declines in income, which have been covered up by increased household leverage as shown above, leaves little true disposable income with which to absorb higher costs from health care, energy, rent and food costs.

At some point, the Fed may well witness another type of deflation, but this time it won’t be just falling prices. Rather, it will be from the masses struggling to maintain a shrinking standard of living as the change shrinks from “Let Them Eat iPads” to just “Eat This!”

China Is Winning The “Trade War” Without Firing A Shot

This past weekend, the Administration announced a tentative deal with China to temporarily postpone the burgeoning “trade war.” While the details of the deal are yet to be worked out, the concept is fairly simple – China will reduce the existing “trade deficit” by over $200 billion annually with the U.S. by reducing tariffs and allowing more goods to flow into China for purchase. On Monday, the markets reacted positively with industrial and material stocks rising sharply as it is expected these companies will be the most logical and direct beneficiaries of any deal.

Unfortunately, there are several reasons the whole scenario is quite implausible. Amitrajeet Batabyal recently explained the problem quite well.

“With China, the U.S. imports a whopping $375 billion more than it exportsHow could it whittle that down to $175 billion? There are three ways.

  • First, China could buy more U.S. goods and services.
  • Second, Americans could buy less Chinese stuff.
  • Finally, both actions could happen simultaneously.

The kinds of Chinese goods that Americans buy tend to be relatively inexpensive consumer goods, so even a dramatic decline is likely to have only a trivial impact on the deficit. And since China explicitly controls only one lever — its imports — it’ll have to buy a lot more American-made things to achieve this goal.

For this to happen, without upsetting other trade balances, the American economy would have to make a lot more than it currently produces, something that isn’t possible in so short a time frame.”

While the Administration will be able to claim a “trade victory” over a deficit reduction agreement, such is unlikely to lead to more economic growth as promised.

If we assume China does indeed spend an additional $200 billion on U.S. goods, those purchases will increase flows into the U.S. dollar, causing dollar strengthening relative to not only the Yuan but also other currencies as well. Since U.S. exports comprise about 40% of domestic corporate profits, a stronger dollar will counter the benefits of China’s purchase as other foreign importers seek cheaper goods elsewhere.

For China, a stronger dollar also makes imports to their country more expensive. To offset that, China will need to “sell” more of its U.S. Treasury holdings to “sanitize” those transactions and stabilize the exchange rate. This is not “good news” for Treasury Secretary Steve Mnuchin who would lose the largest foreign buyer for U.S. Treasuries.  This particularity problematic with the national debt expected to increase by at least one trillion dollars in each of the next four years.

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to 2011. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (The vertical dashed lines denote similar rate increases previously.)

It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. From 2014-2016China was dumping U.S Treasuries, and converting the proceeds back into Yuan, in an attempt to stem the outflows and resulting depreciation of their currency. Since 2016, China has been buying bonds as the Yuan has appreciated.

If China does indeed increase U.S. imports, the stronger dollar will increase the costs of imports into China from the U.S. which negatively impacts their economy. The relationship between the currency exchange rate and U.S. Treasuries is shown below.

With respect to the “trade deficit,” there is little evidence of a sustainable rise in inflationary pressures. The current inflationary push has come primarily from the transient effect of a disaster-related rebuilding cycle last year, along with pressures from rising energy, health care, and rental prices. These particular inflationary pressures are not “healthy” for the economy as they are “costs” which must be passed along to consumers without a commensurate rise in wages to offset them.

Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed U.S. bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has only been one previous period when this relationship failed which was in 2007 and 2008.

With the Chinese financial system showing signs of increasing stress, any threat which devalues the currency will lead to further selling of Treasuries. Rising import costs due to a forced “deficit balancing,” will likely have more of a negative impact to the U.S. than currently believed.

Sum-Zero Game

While much of the mainstream media continues to expect a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then productivity, population, wage and consumer debt growth become key inputs into that equation. Unfortunately, productivity is hardly growing in the U.S. as well as in most developed nations. Further, wage and population growth remain weak as consumers remain highly leveraged. This combination makes a surge in economic growth highly unlikely particularly as rate increases reduce the ability to generate debt-driven consumption.

With unemployment rates near historic lows and production measures near highs, the problem of meeting Chinese demand will be problematic. As Amitrajeet states:

“That’s because when a nation’s economy is using its resources to produce goods efficiently, economists say that it has reached its production possibility frontier and cannot produce more goods.”

This makes Chinese promises largely illusory given the structural hurdles in China to allow for increased purchases of American exports much less the sheer amount of goods the United States would have to produce to meet Beijing’s demand.

As stated, with the United States economy already running near its full productive capacity, it is virtually impossible to produce enough new goods to meet Chinese demands, especially in the short term.

Sure, the United States could stop selling airplanes, soybeans and other exports to other countries and just sell them to China instead. Such actions would indeed shrink the United States trade deficit with China, but the trade deficit with the entire world would remain unchanged.

In other words, it’s a sum-zero game.

More importantly, if the U.S. cannot deliver the goods and services needed by China the entire agreement is worthless from the start. More importantly, China’s “concessions,” so far, are things it had planned to do anyway. As noted by Heather Long via the Washington Post:

“The Chinese have one of the fastest-growing economies and middle classes in the world. Chinese factories and cities need more energy, and its people want more meat. It’s no surprise then that China said it was interested in buying more U.S. energy and agricultural products. The Trump administration is trying to cast that as a win because the United States will be able to sell more to China, but it was almost certain that the Chinese were going to buy more of that stuff anyway.

What Trump got from the Chinese is ‘the kind of deal’ that China would be able to offer any U.S. president,’ said Brad Setser, a China expert at the Council on Foreign Relations. ‘China has to import a certain amount of energy from someone and needs to import either animal feed or meat to satisfy Chinese domestic demand.’

China has been buying about $20 billion worth of U.S. agricultural products a year and $7 billion in oil and gas, according to government data. Even if China doubled — or tripled — purchases of these items, it won’t equal anywhere near a $200 billion reduction in the trade deficit.”

But where China really won the negotiation was when the United States folded and agreed to suspend “trade tariffs.” While the current Administration is keen on “winning” a deal with China, without specific terms (such as a defined amount of increased purchases from the U.S. and the ability to meet that demand) the “deal” has little meaning. China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.

“Yes, it’s good for both sides not to be in a trade war, but the Chinese had more to lose economically from the tariffs. The Trump administration rolling back its $150 billion tariff threat against China is a good ‘get’ for the Chinese.”

As with all things, there are always two sides to the story. While the benefits of reducing the trade may seem like a big win for America, reality could largely offset any benefits. If the goal was simply to be seen as the winner, Trump may have won the prize. But, it will likely be China laughing all the way to the bank.

American Gridlock

Over the weekend, I was digging through some old posts and ran across a speech given by Dr. Woody Brock in 2012. Dr. Brock, is an economist who holds 5-degrees in Math and Economics. He is also the author of “American Gridlock” which is must read for anyone investing money in the markets.

The speech is as important today, as it was in 2012.

There is a huge debate over “Austerity” versus “Spending.” While conservatives in government talk a “good game” about cutting spending, budgeting and debt reduction, the exact opposite has been the case over the past several Administrations both “conservative” and “liberal” alike.

The irony is that increases in debt lead to further increases in debt as economic growth must be funded with further debt. As this money is used for servicing debt, entitlements, and welfare, instead of productive endeavors, there is no question that high debt-to-GDP ratios reduce economic prosperity over time. In turn, the Government tries to fix the “economic problem” by adding on more “debt.” The Lowest Common Denominator provides more information on the accumulation of debt and its consequences.

However, the word “deficit” has no real meaning.

Dr. Brock used the following example of two different countries.

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Keynes’ was correct in his theory. In order for government “deficit” spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

The problem, as noted by Dr. Brock, is that government spending has shifted away from productive investments, like the Hoover Dam, that create jobs (infrastructure and development) to primarily social welfare, defense and debt service which has a negative rate of return.  According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

In other words, the U.S. is “Country A.” 

As Dr. Brock aptly stated in his speech:

“Today we are borrowing our children’s future with debt. We are witnessing the ‘hosing’ of the young.'”

Whistling Past The Graveyard

The U.S. has the labor, resources, and capital for a resurgence of a “Marshall Plan.” The development of infrastructure has high rates of return on each dollar spent. Instead, the government has spent, and continues to spend, trillions bailing out banks, boosting welfare support, supporting Wall Street and reducing corporate tax rates which have a negative rate of return.

In the meantime, the aging of the population continues to exacerbate the underfunded problems of Social Security, Medicare, and Medicaid which is roughly $70 trillion and growing. It is simply a function of demographics and math.

As Dr. Brock noted:

“Mathematics and Sex create performance anxiety in men – because you can’t fake the outcome of either.”

Two recent studies show the problem clearly.

Demographics is an easy problem to see and mathematically calculate. The ratio of workers per retiree, as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers), present a massive headwind to economic solvency. 

Just last week, the Institute for Family Studies, published a report showing the decline in the fertility ratio to the lowest levels since 1970,

With fertility rates low, the future “support-ratio” will continue to be a problem.

The second, and more immediate, problem is the vastly underfunded savings of the “baby boomer” generation heading into retirement. To wit:

” Anxiety over retirement and how to support oneself after calling it a career is impacting many Americans. A recent poll found that one in three adults has less than $5,000 in retirement savings.”

This is simple math.

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. A vast majority of them are “under saved” and primarily unhealthy.

This combination ensures the demand on the health care system, along with Medicaid and Medicare, will increase at a rate faster than it can supply. Bankruptcy, without substantive changes, is inevitable. The Affordable Care Act is a prime example of wrongly directed resources. While the goal of “affordable health care for everyone” is noble, the legislation only acted to massively increase the costs of healthcare, and the demand on the system, without improving the delivery and supply of the care itself. The shift of demand, without an equal shift in the supply, ensures that the entire system eventually bankrupts itself.

Of course, it isn’t just the social welfare and healthcare system that is effectively “broken,” but the economic model itself.

The Real Crisis

The real crisis that is to come will be during the next economic recession. While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

With consumers again heavily leveraged with subprime auto loans, mortgages, and student debt, the reduction in employment will further damage what remains of personal savings and consumption ability. That downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers.

At some point, the realization of the “real American crisis” will be realized. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

For many, retirement years will not be golden. They will simply be more years of working to make ends meet as the commercials of “old people on sailboats,” promoted by Wall Street, will become a point of outrage. While the media continues to focus on surging asset prices as a sign of economic health, the reality is far different.

The real financial crisis in the future won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

As Dr. Brock suggests – it is truly “American Gridlock” as the real crisis lies between the choices of “austerity” and continued government “largesse.” One choice leads to long-term economic prosperity for all, the other doesn’t.

No Strategy Works All The Time & The 10-Rules That Do

I was recently reviewing some old notes and ran across a comment made by David Merkel from the Aleph Blog back in 2013. The discussion centered around the impact of volatility on investment disciplines. The most important concept is that most investors tend to chase performance. Unfortunately, performance chasing occurs very late in the investment cycle as exuberance overtakes logic which leads to consistent underperformance. What David touches on is the importance of being disciplined when it comes to your investment approach, however, that is singularly the most difficult part of being a successful investor.

“One of the constants in investing is that investment theories are disbelieved, prosper, bloom, overshoot, die, and repeat. So is the only constant change? That’s not my view.

There are valid theories on investing, and they work on average. If you pursue them consistently, you will do well. If you pursue them after failure, you can do better still. How many times have you seen articles on investing entitled ‘The Death of ____.’ (fill in the blank) Strategies trend. There is an underlying kernel of validity; it makes economic sense, and has worked in the past. But any strategy can be overplayed, even my favorite strategy, value investing. 

Prepare yourself for volatility. It is the norm of the market. Focus on what you can control – margin of safety. By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.

Finally, don’t give up. Most people who give up do so at a time where stock investments are about to turn. It’s one of those informal indicators to me, when I hear people giving up on an asset class. It makes me want to look at the despised asset class, and see what bargains might be available.

Remember, valid strategies work on average, but they don’t work every month or year. Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.”

When it comes to investing it is important to remember that no investment strategy works all the time.

Most guys know that in baseball a player that is batting .300 is a really solid hitter. In fact, according to the “Baseball-Almanac,” the ALL-TIME leader was Ty Cobb with a lifetime average of .366. This means that every time that Ty Cobb stepped up to the plate he was only likely to get a hit a 36.6% of the time.  In other words he struck out, or walked, roughly 2 out of every three times at bat. All of a sudden that doesn’t sound as great, but compared to the performance of other players – it was fantastic.

The problem is a .366 average won’t get you into the “investor hall of fame”; it will likely leave you broke. When it comes to investing it requires about a .600 average to win the game long-term. No, you are not going to invest in the markets and win every time. You are going to have many more losers than you think. What separates the truly great investors from the average person is how they deal with their losses – not their winners.

10-Rules That Work

There are 10 basic investment rules that have historically kept investors out of trouble over the long term. These are not unique by any means but rather a list of investment rules that in some shape, or form, has been uttered by every great investor in history.

1) You are a speculator – not an investor

Unlike Warren Buffet who takes control of a company and can affect its financial direction – you can only speculate on the future price someone is willing to pay you for the pieces of paper you own today. Like any professional gambler – the secret to long-term success was best sung by Kenny Rogers; “You gotta know when to hold’em…know when to fold’em”

2) Asset allocation is the key to winning the “long game”

In today’s highly correlated world there is little diversification between equity classes. Therefore, including other asset classes, like fixed income which provides a return of capital function with an income stream, can reduce portfolio volatility. Lower volatility portfolios outperform over the long term by reducing the emotional mistakes caused by large portfolio swings.

3) You can’t “buy low” if you don’t “sell high”

Most investors do fairly well at “buying,” but stink at “selling.” The reason is purely emotional, which is driven primarily by “greed” and “fear.” Like pruning and weeding a garden; a solid discipline of regularly taking profits, selling laggards and rebalancing the allocation leads to a healthier portfolio over time.

4) No investment discipline works all the time – Sticking to a discipline works always.

Like everything in life, investment styles cycle. There are times when growth outperforms value, or international is the place to be, but then it changes. The problem is that by the time investors realize what is working they are late rotating into it. This is why the truly great investors stick to their discipline in good times and bad. Over the long term – sticking to what you know, and understand, will perform better than continually jumping from the “frying pan into the fire.”

5) Losing capital is destructive. Missing an opportunity is not.

As any good poker player knows – once you run out of chips you are out of the game. This is why knowing both “when” and “how much” to bet is critical to winning the game. The problem for most investors is that they are consistently betting “all in all of the time.” as they maintain an unhealthy level of the“fear of missing out.” The reality is that opportunities to invest in the market come along as often as taxi cabs in New York City. However, trying to make up lost capital by not paying attention to the risk is a much more difficult thing to do.

6) Your most valuable, and irreplaceable, commodity is “time.”

Since the turn of the century investors have recovered, theoretically, from two massive bear market corrections. It took 14- years for investors to get back to where they were in 2000 on an inflation-adjusted total return basis. Furthermore, despite the bullish advance from the 2009 lows, the compounded annual total return for the last 18-years remains below 3%.

The problem is that the one commodity which has been lost, and can never be recovered, is “time.” For investors getting back to even is not an investment strategy. We are all “savers” that have a limited amount of time within which to save money for our retirement. If you were 18 years from retirement in 2000 – you are now staring it in the face with a large shortfall between the promised 8% annualized return rate and reality. Do not discount the value of “time” in your investment strategy.

7) Don’t mistake a “cyclical trend” as an “infinite direction”

There is an old Wall Street axiom that says the “trend is your friend.”  Investors always tend to extrapolate the current trend into infinity. In 2007, the markets were expected to continue to grow as investors piled into the market top. In late 2008, individuals were convinced that the market was going to zero. Extremes are never the case.

It is important to remember that the “trend is your friend” as long as you are paying attention to, and respecting its direction. Get on the wrong side of the trend and it can become your worst enemy.

8) If you think you have it figured out – sell everything.

Individuals go to college to become doctors, lawyers, and even circus clowns. Yet, every day, individuals pile into one of the most complicated games on the planet with their hard earned savings with little, or no, education at all.

For most individuals, when the markets are rising, their success breeds confidence. The longer the market rises; the more individuals attribute their success to their own skill. The reality is that a rising market covers up the multitude of investment mistakes that individuals make by taking on excessive risk, poor asset selection or weak management skills.  These errors are revealed by the forthcoming correction.

9) Being a contrarian is tough, lonely and generally right.

Howard Marks once wrote that:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

The best investments are generally made when going against the herd. Selling to the “greedy” and buying from the “fearful” are extremely difficult things to do without a very strong investment discipline, management protocol, and intestinal fortitude. For most investors, the reality is that they are inundated by “media chatter” which keeps them from making logical and intelligent investment decisions regarding their money which, unfortunately, leads to bad outcomes.

10) Benchmarking performance only benefits Wall Street

The best thing you can do for your portfolio is to quit benchmarking it against a random market index that has absolutely nothing to do with your goals, risk tolerance or time horizon.

Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that ‘everyone else’ made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.

The only benchmark that matters to you is the annual return that is specifically required to obtain your retirement goal in the future. If that rate is 4% then trying to obtain 6% more than doubles the risk you have to take to achieve that return. The end result is that by taking on more risk than is necessary will put your further away from your goal than you intended when something inevitably goes wrong.

It’s all about the risk

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecasted. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty.

It should be obvious that an honest assessment of uncertainty leads to better decisions. It may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of “acknowledged uncertainty” is it keeps you honest. A healthy respect for uncertainty, and a focus on probability, drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.

The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Retirees Face A “Pension Crisis” Of Their Own

A couple of weeks ago, I discussed the coming “Pension Crisis.”  The important point made was the unrealistic return assumptions used by pension managers in order to reduce the contribution (savings) requirement by their members.

“However, the reason assumptions remain high is simple. If these rates were lowered 1–2 percentage points, the required pension contributions from salaries, or via taxation, would increase dramatically. For each point reduction in the assumed rate of return would require roughly a 10% increase in contributions.

For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Since, for many plan participants, particularly unionized workers, increases in contributions are a hard thing to obtain. Therefore, pension managers are pushed to sustain better-than-market return assumptions which requires them to take on more risk.

But therein lies the problem.

The chart below is the S&P 500 TOTAL return from 1995 to present. I have then projected for using variable rates of market returns with cycling bull and bear markets, out to 2060. I have then run projections of 8%, 7%, 6%, 5% and 4% average rates of return from 1995 out to 2060. (I have made some estimates for slightly lower forward returns due to demographic issues.)”

“Given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% in order to potentially meet future obligations and maintain some solvency.”

It is the same problem for the average American who plans on getting 6-8% return a year on their 401k plan, so why save money? Particularly when the mainstream media, and financial community, promote these flawed claims to begin with. To wit:

“Suze Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.” 

Ms. Orman’s statement is correct. It just requires the 25-year old to achieve an 11.25% annual rate of return (adjusting for inflation) every single year for the next 40-years. (That’s not very realistic)

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating future returns, future retirement values are artificially inflated which reduces the required saving amounts need by individuals today. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.

The Real Math

As shown in the long-term, total return, inflation-adjusted chart of the S&P 5oo below, the difference between actual and compounded (7% average annual rate) returns are two very different things. The market does NOT return an AVERAGE rate each year, and one negative return year compounds the future shortfall.

When imputing volatility into returns, the differential between what individuals are promised (and this is a huge flaw in financial planning) and what actually happens to their money is substantial over the accumulation phase of individuals. Furthermore, most of the average return calculations are based on more than 100-years of data. So, it is quite likely YOU DIED long before you realizing the long-term average rate of return.

Too Simple

I get it.

I am an average American too. I don’t want to be told what I can, and can not, spend or do today because I have a required savings goal to meet future needs. After all, that is YEARS into the future and I have plenty of time to get caught up. The words “budget” and “saving” might as well be lumped into the “4-letter word” category.

We all want a simple answer. If you do “X” then “Y” will be the outcome.

See, simple. It is why our world is being reduced to sound bytes and 140-character compositions. Financial, retirement and investment planning are no different. Just give me an “optimistic” answer.

For example, as shown in the chart below courtesy of Michael Kitces, the common assumptions made in retirement planning are simple. The chart assumes a retiree has a $1,000,000 balanced portfolio and is planning for a 30-year retirement. It assumes inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially and then adjusts each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.

The next chart takes the average of all periods above (black line) and uses those returns to calculate the spend down rate in retirement assuming similar outcomes for the markets over the next 30-years. As above, I have calculated the spend down structure to include inflation and taxation on an initial $1 million portfolio.

As you can see, under this scenario, due to the skew of 1934 and front-loaded returns, the retiree would not have run out of money over the subsequent 30-year period. However, once the impact of inflation and taxes are included, the outcome becomes substantially worse.

The chart below shows the same as above but with the 1934 period excluded. The outcome, not surprisingly, is not substantially different with the exception of the retiree running out of money one-year short of their goal rather than leaving an excess to heirs.

Important Considerations For Retiree Portfolios

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached, or will reach, retirement age by 2030. Unfortunately, the majority of these individuals are woefully under saved for retirement and are “hoping” for compounded annual rates of return to bail them out.

It isn’t going to happen and the next “bear market” will wipe most of them out permanently.

The analysis above reveals the important points individuals should start giving serious consideration to:

  • Lowering expectations for future returns and withdrawal rates.
  • With the potential for front-loaded returns going forward unlikely, increase savings rates.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered, it’s better to overestimate.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • Future income planning must be done carefully with default risk carefully considered.
  • Most importantly, drop compounded annual rates of return for plans using variable rates of future returns.

In this Central Bank driven world, with debt levels rising globally, interest rates rising, economic growth weak with a potential for a recession, and valuations high, the uncertainty of a retirement future has risen markedly. This lends itself to the problem of individuals having to spend a bulk of their “retirement” continuing to work.

Of course, this could be why there are currently more individuals over the age of 65 still in the workforce than ever before in history.

Oh, and there also the tiny fact the majority of American’s don’t have $1 million saved for retirement. For most it is less than $250,000.

But that is an entirely different problem.

Everyone Is On The Same Side Of The Boat

In early 2018, I penned a post which illustrated the legendary Bob Farrell’s 10-investment rules. Bob, one of the great investors of our time, had a very pragmatic approach to managing money. Investing rules, and a subsequent discipline, should be a staple for any investor who has put their hard earned “savings” at risk in the market. Unfortunately, far too many invest without either which leads to less than desirable outcomes.

As of late, there has been a lot of excitement over two areas of the market in particular: interest rates and oil prices. In fact, at this moment the speculation in these two areas is at record levels.

Why is that important?

First, the speculation that oil and interest rates will go higher are the two areas which have the greatest negative impact on economic growth and earnings. Rising interest rates increase borrowing costs and higher oil prices increase input costs for manufacturers. As I noted previously, with a heavily indebted consumer, there is little ability to pass on higher costs which, if absorbed, reduces profits.

Secondly, the speculation brings forward two of Mr. Farrell’s most important rules:

  • Rule #2: Excess in one direction will lead to an opposite excess in the other direction, and;
  • Rule #9: When all the experts and forecasts agree – something else is going to happen.

Currently, when it comes to oil prices, there is little room left for more bullishness. As oil prices have risen due to concerns over the potential supply concerns from geopolitical tensions, the price of oil is now as overbought and extended as at every other prior peak.

Of course, the cycle of rising oil prices leading to increased optimism which begets bullish bets on oil continues to press prices higher. However, it is also the exuberance which has repeatedly set up the next fall. As shown below, bets on crude oil prices are sitting near the highest levels on record and substantially higher than what was seen at the peak of oil prices prior to 2008 and 2014.

Importantly, while bullish bets on oil are at extremes, there is also a high correlation between the direction of oil and the S&P 500. (Importantly, rising oil prices have been a major contributing factor to the rise in earnings for the S&P 500. A reversal in prices will be problematic as well.)

As JPM recently noted, via Zerohedge,

“The sharp increase in oil prices over the past month has been accompanied by a further rise in spec positions, which as JPMorgan notes, has now risen to new record highs. This suggests that hedge funds and other speculative investors have been at least partly behind the recent sharp spike in oil prices.

As JPM further notes, both Systematic and Discretionary hedge funds have been building up long positions in oil, with the former induced entirely by momentum and positive carry, while the latter have rushed in due to geopolitical issues, continued inventory declines in the US and expectations of Saudi Arabia engineering a higher oil price ahead of privatizations next year.

Bloomberg confirms the recent surge in commodity fund inflows, noting that hedge funds investing in oil are luring capital at the fastest pace in more than a year. After years of pain, commodity funds have recovered the client outflows they suffered last year. According to eVestment data, investors allocated $3 billion to commodity-focused hedge funds from January through March, the most since the third quarter of 2016

But it is not only speculative investors such as hedge funds, systematic or discretionary, responsible for the rise in oil prices, it is also real money investors such as retail investors and asset allocators that have been buying oil indirectly via purchases of commodity tracking funds as they seek to increase their overall allocation to commodities.”

The last paragraph is problematic as retail investors are always “late to the party.” From a contrarian standpoint, this alone should be worrisome. However, with speculators pushing prices higher, the economics of the cycle are very mature. Higher prices has led to a surge in production to an all-time record. However, demand, which has started to deteriorate over the last 12-months, remains stagnant and more representative of the economic demand-driven side of the equation.

With oil, a direct cost to consumers, the surge in prices acts as an additional tax on consumers which detracts from other economically sensitive discretionary purchases. With production at records, along with net speculative long-positioning by investors, the risk of a reversion caused by an economic slowdown or recession is problematic.

This is where the second “overly crowded trade” comes into play. 

The rise in commodity prices, combined with the Fed’s instance on hiking interest rates, has led to a belief that demand-driven inflation is finally set to return to the U.S. This has led speculators to build the largest net-short positioning in U.S. Treasuries on record.

Once again, we see Bob Farrell’s rule in action. Previously, such record net-short positioning has been more indicative of peaks in the interest rate cycle as opposed to the beginning of higher rates. You can see this more clearly if we strip out all of the positionings except those periods where net-short contracts exceeded 100,000.

With the net-short positioning on the U.S. Treasury at records, the net-short positioning on the Eurodollar has also reached a record. Once again, what we find is when the net-short positioning starts to get overcrowded, that too has been a good indication of a bottom in bond prices (or a peak in rates.)

The problem is the tentative rise in inflation is driven by higher costs being pushed onto consumers. This is the wrong type of inflationary rise which negatively impacts economic growth. As opposed to rising prices driven by rising demand, cost-push inflation simply eats away at discretionary incomes reducing consumptive spending which is 70% of economic growth.

With positioning on the U.S. Dollar net-short, along with interest rates and the Eurodollar, there is plenty to suggest that traders, and investors, have all rushed to the same side of the boat.

As our analyst Jesse Colombo explained last week:

“If another wave of dollar strength occurs, it would be very bad news for crude oil and the overall energy sector (crude oil and the dollar trade inversely). The U.S. dollar’s surge in 2014 and 2015 was the trigger for the violent crude oil bust. Even more concerning is the fact that the ‘smart money’ are more bearish on crude oil now than they were immediately before the 2014 oil bust, as I discussed in greater detail last week. While oil’s short-term trend is still up for now, and I believe in respecting the trend, there is a very real risk that another violent liquidation sell-off may occur when the trend changes.”

Like all rules on Wall Street, Bob Farrell’s rules are not meant has hard and fast rules. There are always exceptions to every rule and while history never repeats exactly it does often “rhyme” very closely.

Nevertheless, one thing is true, in the short-term it may well seem that everyone is correct in their thesis of higher rates, inflation and oil prices. However, history has a pretty clear record to suggest that when “everyone in on the same side of the boat” it has generally often paid to put on a “life vest.”

The Pension Crisis Is Worse Than You Think

Last year I penned an article discussing the “Unavoidable Pension Crisis.” 

“Currently, many pension funds, like the one in Houston, are scrambling to slightly lower return rates, issue debt, raise taxes or increase contribution limits to fill some of the gaping holes of underfunded liabilities in their plans. The hope is such measures combined with an ongoing bull market, and increased participant contributions, will heal the plans in the future.

This is not likely to be the case.

This problem is not something born of the last ‘financial crisis,’ but rather the culmination of 20-plus years of financial mismanagement.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

With employee contribution requirements extremely low, averaging about 15% of payroll, the need to stretch for higher rates of return have put pensions in a precarious position and increases the underfunded status of pensions.”

But it is actually worse than we originally thought as Aaron Brown recently penned:

“Today, the hard stop is five to 10 years away, within the career plans of current officials.  In the next decade, and probably within five years, some large states are going to face insolvency due to pensions, absent major changes.

If we extrapolate from the past, rather than use promises in the state budget, current employees plus the state will contribute about $25 billion over those seven years, which could provide another few years before the till is empty. But it will also add around $60 billion of future liabilities to current employees. The system probably breaks down before the pension fund gets to zero, for example if assets were to fall below $30 billion while projected future liabilities exceeded $300 billion. Even the most optimistic people would have to admit the situation is unsustainable. This could happen in three years in a bad stock market, or perhaps 10 with good stock returns. But fund assets are so low relative to payouts that good returns aren’t that helpful.

The next phase of public pension reform will likely be touched off by a stock market decline that creates the real possibility of at least one state fund running out of cash within a couple of years. The math says that tax increases and spending cuts cannot do much.

But the problem is not just in the United States, but the mismanagement of assets combined with irrational and flawed return expectations has spread globally. Visual Capitalist recently took a look at the global pension problem stating:

“According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…

The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050, or about five times the size of the global economy today.”

“The graphic illuminates a growing problem attached to an aging population (and those that will be supporting it).

Since social security programs were initially developed, the circumstances around work and retirement have shifted considerably. Life expectancy has risen by three years per decade since the 1940s, and older people are having increasingly long life spans. With the retirement age hardly changing in most economies, this longevity means that people are spending longer not working without the savings to justify it.

This problem is amplified by the size of generations and fertility rates. The population of retirees globally is expected to grow from 1.5 billion to 2.1 billion between 2017-2050, while the number of workers for each retiree is expected to halve from eight to four over the same timeframe.

The WEF has made clear that the situation is not trivial, likening the scenario to ‘financial climate change.’

Like climate change, some of the early signs of this retirement savings gap can be ‘sandbagged for the time being – but if not handled properly in the medium and long-term, the adverse effects could be overwhelming”

While we all want to ignore the problem, it is isn’t going away. More importantly, there is nothing that can, or will, change the two primary problems fueling the crisis.

Problem #1: Demographics

With pension funds already wrestling with largely underfunded liabilities, the shifting demographics are further complicating funding problems.

One of the primary problems continues to be the decline in the ratio of workers per retiree as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers.) However, this “support ratio” is not only declining in the U.S. but also in much of the developed world. This is due to two demographic factors: increased life expectancy coupled with a fixed retirement age, and a decrease in the fertility rate.

In 1950, there were 7.2 people aged 20–64 for every person of 65 or over in the OECD countries. By 1980, the support ratio dropped to 5.1 and by 2010 it was 4.1. It is projected to reach just 2.1 by 2050.

Of course, as I have discussed previously, the problem is that while the “baby boom” generation may be heading towards retirement years, there is little indication a large majority of them will be actually retiring. As Richard Eisenberg recently noted:

“The dark, depressing and sometimes physically painful life of a tribe of men and women in their 50s and 60s who are surviving America in the twenty-first century. Not quite homeless, they are ‘houseless,’ living in secondhand RVs, trailers and vans and driving from one location to another to pick up seasonal low-wage jobs, if they can get them, with little or no benefits.

The ‘workamper’ jobs range from helping harvest sugar beets to flipping burgers at baseball spring training games to Amazon’s “CamperForce,” seasonal employees who can walk the equivalent of 15 miles a day during Christmas season pulling items off warehouse shelves and then returning to frigid campgrounds at night. Living on less than $1,000 a month, in certain cases, some have no hot showers.

Many saw their savings wiped out during the Great Recession or were foreclosure victims and, felt they’d spent too long losing a rigged game. Some were laid off from high-paying professional jobs. Few have chosen this life. Few think they can find a way out of it. They’re downwardly mobile older Americans in mobile homes.”

They, of course, are part of a large majority of individuals being dependent on the various pension systems in retirement, and the ultimate burden will fall on those next in line.

Problem #2: Markets Don’t Compound

The biggest problem, however, is the continually perpetrated “lie” that markets compound over time. Pension computations are performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. The biggest problem, following two major bear markets, and sub-par annualized returns since the turn of the century, is the expected investment return rate.

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system.

It is the same problem for the average American who plans on getting 6-8% return a year on their 401k plan, so why save money? Which explains why 8-out-of-10 American’s are woefully underfunded for retirement.

As shown in the long-term, total return, inflation-adjusted chart of the S&P 5oo below, the difference between actual and compounded (7% average annual rate) returns are two very different things. The market does NOT return an AVERAGE rate each year and one negative return compounds the future shortfall.

This is the problem that pension funds have run into and refuse to understand.

Pensions STILL have annual investment return assumptions ranging between 7–8% even after years of underperformance.

However, the reason assumptions remain high is simple. If these rates were lowered 1–2 percentage points, the required pension contributions from salaries, or via taxation, would increase dramatically. For each point reduction in the assumed rate of return would require roughly a 10% increase in contributions.

For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Since, for many plan participants, particularly unionized workers, increases in contributions are a hard thing to obtain. Therefore, pension managers are pushed to sustain better-than-market return assumptions which requires them to take on more risk.

But therein lies the problem.

The chart below is the S&P 500 TOTAL return from 1995 to present. I have then projected for using variable rates of market returns with cycling bull and bear markets, out to 2060. I have then run projections of 8%, 7%, 6%, 5% and 4% average rates of return from 1995 out to 2060. (I have made some estimates for slightly lower forward returns due to demographic issues.)

Given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% in order to potentially meet future obligations and maintain some solvency.

They won’t make such reforms because “plan participants” won’t let them. Why? Because:

  1. It would require a 40% increase in contributions by plan participants which they simply can not afford.
  2. Given that many plan participants will retire LONG before 2060 there simply isn’t enough time to solve the issues, and;
  3. The next bear market, as shown, will devastate the plans abilities to meet future obligations without massive reforms immediately. 

In a recent note by my friend John Mauldin, he discussed an email Rob Arnott, of Research Affiliates, sent regarding this specific issue.

If our logic is sound, we earn 0.8% from our bonds (40% allocation x 2% return) and 2% to 3.2% from our stocks (60% x 3.3%, or 60% x 5.4%). Add up the return from stocks and the return from bonds, and we get 2.8% to 4% from our balanced portfolio.

Bottom line … US public service pensions are toast. One of three constituencies gets nailed: 

  • The taxpayer (keeping in mind that the affluent are mobile!),
  • The current and/or future pensioners (keep in mind that private-sector pensions are now far less generous than public pensions … there’s an inequity here!), or;
  • The public services that are on offer to our citizenry, net of sunk costs from servicing past generations.

Most likely, it’ll be a blend of the three.”

Exactly right, and the chart above of projected stock market returns agrees with that assumption.

We Are Out Of Time

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. And many of them are public-sector employees. In a 2015 study of public-sector organizations, nearly half of the responding organizations stated that they could lose 20% or more of their employees to retirement within the next five years. Local governments are particularly vulnerable: a full 37% of local-government employees were at least 50 years of age in 2015.

It is no surprise that public pension funds are completely overwhelmed, but they still have not come to the realization that markets do not compound at an annual return of 8% annually. This has led to a continued degradation of funding levels as liabilities continue to pile up. 

If the numbers above are right, the unfunded obligations of approximately $4-$5.6 trillion, depending on the estimates, would have to be set aside today such that the principal and interest would cover the program’s shortfall between tax revenues and payouts over the next 75 years.

That isn’t going to happen.

With rates pushing higher, economic growth slowing and Central Banks extracting liquidity, we are already closer to the next major bear market than not.

The next crisis won’t be secluded to just sub-prime auto loans, payday loans, student loans, and commercial real estate. It will be fueled by the “run on pensions” when “fear” prevails benefits will be lost entirely.

It’s an unsolvable problem. It will happen. And it will devastate many Americans.

It is just a function of time.

“Demography, however, is destiny for entitlements, so arithmetic will do the meddling.” – George Will

Whatever amount you are saving for retirement is probably not enough.