Tuesday, August 31, 2010

Magna Cum Laude?

CBC News reports, Magna, Stronach deal to go ahead:

Magna International said Tuesday it will move ahead with a deal worth nearly $1 billion to have founder Frank Stronach give up control over the auto parts giant.

Dissident shareholders opposed to the plan have notified the Aurora, Ont.-based company that they do not intend further legal appeals, Magna said in a release.

A day earlier, the Ontario Divisional Court upheld a lower-court ruling approving the proposal.

The dissident shareholders included the Canada Pension Plan Investment Board, Ontario Teachers' Pension Plan, OMERS, the Alberta Investment Management Corp. and British Columbia Investment Management Corp.

They had opposed the size of the premium over the present value of the company's shares — about 18-fold — to be paid to the Stronach family trust, and argued it would set a dangerous precedent for similar, future deals in terms of the loss of shareholder value.

The deal provides for Stronach to receive $300 million US in cash, $120 million in consulting fees over the next four years, nine million single-vote shares of Magna and control over a new joint venture focused on electric vehicles.

Shares Rise

Magna shares closed up $3.43, or 4.3 per cent, to $83.04 Tuesday on the Toronto Stock Exchange.

Magna said it planned to implement the change after the close of markets Tuesday.

"We are very pleased with the court's decision and that we are finally in a position to close the arrangement, which has received strong support from Magna's shareholders," Magna CFO Vince Galifi said.

"With the transaction completed, we can refocus on pursuing our long-term growth strategy, including further investments in both innovation and emerging markets, in order to continue to serve our customers around the world."

If you read the comments on this article posted on the CBC website, they range from "what a crook!" to "he deserves his payday". Let me go over a couple of comments below. The first one blasts institutional shareholders:
The institutional shareholders obviously don't like the plan that was approved by 75% of shareholders. This makes them minority shareholders, and they have a tried-and-true recourse - sell their shares and move their money elsewhere. They simply seem bitter that the "big guns" of the giant pension plan don't control what happens to this company. As long as Frank Stronach remains in control, they never will be. The irony is that after Stronach is gone, CPP, Omers, Teachers and the rest can work on buying a majority of shares. If they do that, you can bet the farm they will not be worried about what minority shareholders think...

Personally, we need more companies run by individuals. Investment corporations don't care what they invest in - they only care about the money. They sell RIM in droves because record profits weren't high enough, they sell Tim Horton's because the gain from one year to the next was not big enough. We need Carnegies and Fords and Gateses, who care about the company they started and don't run for greener pastures at the drop of a hat.
I take issue with this statement because pension funds are by far more long-term in their investment approach than mutual funds or hedge funds. If anything, you'd want to have more pension funds as shareholders to take decisions that are in the best interest of long-term shareholders.

True, it's individuals who start companies and grow them, but once they pass a certain critical mass, these companies become behemoths and there is nothing that suggests to me that pension funds do not act in the best interest of all shareholders. In fact, it's quite the opposite.

To highlight this point, the second comment that struck me on CBC's website took issue with Canada's dual voting shares:
"75% of shareholders voted in favour of the deal". Does that include Frank's votes which are worth 51% of all shareholder votes? Democracy in action...

By far the simplest solution would have been for the Canadian securities regulators to outlaw dual voting shares, as is the case in most other civilized financial constituencies. Why does Canada permit this abusive malpractice?
Opposition to dual-class shares has been growing in recent years. In August 2005, Tara Gry of the Canadian Library of Parliament wrote an excellent comment on dual-class shares and best practices in corporate governance.

More recently, the Ontario Teachers' Pension Plan posted a highly critical analysis of the Magna-style dual share collapses, asking whether class B shares are worth $863 million (click on images to enlarge):

Magna’s Class B shares have not traded publicly since 2007. One proxy for their value could be the price the company paid in 2007 to repurchase all Class B shares from holders other than Mr. Stronach in a complex deal involving Russian billionaire Oleg Deripaska.

In that transaction, the Class B shares were valued at $114 each, representing a 30% premium over the trading value of the Class A shares at the time. (Teachers’ was a vocal critic of the 2007 transaction as one that was too rich and unfair to the Class A shareholders.) A 30% premium over the pre-announcement trading price of the Class A shares on May 6, 2010, (approximately $64) would be roughly $83 per Class B share, or $63 million in total, far below the proposed payment of US$863 million.

A better proxy may be the historical relative market prices of the Magna Class A and B shares from 2001 until 2007 (when the Class B shares ceased trading publicly). It is interesting to note that the average price premium from 2001 to 2007 of the Class Bs over the Class As was just 4.2%. This can be taken as a clear signal from the market that the value of the Class B shares during that period was effectively the same as the Class A shares. We ask ourselves, what has changed since 2007 to justify such a massive premium?

With these comparisons in mind, it is difficult to understand the basis for the US$863 million payment Magna proposes for Mr. Stronach. We found nothing in the management information circular in the way of a detailed rationale for the proposed payment. We consider this to be especially important given the current value of Magna’s Class A shares (which the Class B shares used to track closely) and the precedent transactions where no premium was paid to holders of multiple voting shares when dual class share structures were eliminated.

In the end, despite opposition from several large Canadian public pension funds, Frank Stronach's $1-billion payday arrived:

In all, the payout is valued at roughly $1-billion – an unprecedented 1,800% premium and dilution compared to other conversion deals.

The Canada Pension Plan Investment Board, and other shareholders, like the Ontario Teachers Pension Plan, have fought the plan of arrangement before an Ontario Securities Commission hearing in June, as well as before Ontario Superior Court of Justice earlier this month, and the Divisional Court last week.

They argued the payout to Mr. Stronach was “abusive” and would set a dangerous precedent for other conversion deals.

Ultimately, however, the three-judge Divisional Court panel ruled late Monday that it was satisfied that the plan of arrangement met the court’s “fair and balanced” test, and should be allowed to proceed. They agreed with the lower court that a shareholder vote, in which 75% of Magna’s common shareholders approved the plan, should be given significant weight.

Linda Sims, CPPIB spokeswoman, said the country’s largest pension plan was “disappointed” by the outcome, but would not appeal the decision.

“As an ongoing shareholder of Magna, we intend to engage with the company on its governance structure and practices under the revised ownership arrangement,” she said in an email.

Was the payout to Frank Stronach "abusive"? Any reasonable analysis would suggest so, but this battle was lost. While recognizing and appreciating that entrepreneurs like Mr. Stronach are the backbone of our economy, founding companies that create lots of jobs while taking on enormous personal financial risks (see video below), I also share the concerns of institutional investors who feel this decision will set a dangerous precedent for other conversion deals.

Monday, August 30, 2010

Our Ever Shrinking Pension Payouts?

Becky Barrow of the London Mail reports, Our ever shrinking pension payouts: The millions facing lowest returns on investments since records began:

Millions approaching retirement could be devastated by the worst pension payouts since records began.

Despite saving the same amount of money into their pensions, they face the dire prospect of getting about half the income they would have received 15 years ago, research reveals today.

It comes on top of the collapse in final salary pension schemes, with millions locked out of the best type of retirement provision.

Experts said employees who want to retire are facing a nightmare which no previous generation has had to cope with. The plunge in pension payouts is because annuity rates have nose-dived. Annuities offer a guaranteed monthly income to those who have saved into a pension pot.

But over the last month several major investment firms, such as Aegon, Aviva and Legal & General, have started to cut their annuity rates.

Their rivals are almost certain to follow and experts predict that rates will fall even lower over the coming months. Around 50,000 people a year buy an annuity, with up to £20billion of their hard-earned cash ploughed into the investment products.

The decision about which annuity to buy, when to buy it and which company to buy it from is one of the biggest financial decisions a person ever has to make.

Because it dictates how much money a pensioner will get every month for the rest of his or her life, it can mean the difference between enjoying a comfortable retirement, and a retirement surviving at the most basic level.

Today's research, from the financial information firm Moneyfacts, looked at the annuity which a £10,000 pension pot can buy.

In 1995, a 65-year-old man buying an annuity would have received an average annual payout of £1,111. Today, a man of the same age with the same pension pot would get just £606 a year, a drop of 5 per cent which shows how rapidly annuity rates have plummeted.

Just 12 months ago, the same fund would have bought a pension of £647 a year.

The average pension pot is about £30,000. For a man aged 65, this would have resulted in an annuity worth around £3,300 a year in 1995, compared with just £1,800 today.

The report's author, Richard Eagling, said the findings would be 'a rude awakening for many'.

The victims will be 'baby-boomers', born after the end of the Second World War who are now starting to retire.

After a lifetime of saving into a pension, many will be shocked and disappointed by the income that they will get from it, and feel that they are being forced into staying at work.

Dr Ros Altmann, a pensions expert and former Treasury adviser, said: 'Pension savings are being decimated by these appalling annuity rates.

'These poor people have saved all their lives, and they are being locked into these terrible annuity deals for the rest of their lives.'

Tom McPhail, head of pensions research at the independent financial advisers Hargreaves Lansdown, predicted that the worrying situation will get even worse.

He said: 'This is a retirement crisis that is happening now. Annuity rates are likely to fall further in the immediate future.'

He urged people to shop around when they come to cash in their pension, rather than take out an annuity with their pension company.

About two-thirds of people fail to look elsewhere, despite the fact that it is almost always possible to find a better deal.

The rates vary according to key issues, such as age, gender and physical health.

The annuity rate crisis highlights the growing pensions apartheid in Britain between public sector workers and everybody else.

State workers get a gold-plated 'defined benefit' pension, which means they do not have to buy an annuity.

The majority of private sector workers do not even have a pension. If they do have one, it is likely to be a 'defined contribution' pension, which means they do have to buy an annuity.

More than 40 per cent of employers are threatening to slash the amount of money they pay into their workers' pensions over the next few years.

At present, bosses are under no legal obligation to pay into a pension for workers, but from October 2012 they must pay at least three per cent of salary into a retirement pot for every employee.

A survey by the Association of Consulting Actuaries of firms employing more than 1,000 people found that 41 per cent of bosses may cut the amount they currently pay into their existing pension scheme, or close existing generous pension schemes and sign everybody up into a new, less generous pension.

Pension poverty is a recurring theme on my blog. I saw this coming years ago, but it's much worse than I envisioned. Oddly enough, some people think we shouldn't address the retirement crisis, just let these people suffer and live on a fraction of what they were expecting to retire on comfortably.

Anything we do now is too late. It's a disaster and what's going on in the UK is happening across Europe and will soon reach North America. Historic low rates have decimated savers, forcing them to speculate in the markets to try to make up for the lost income due to low annuity rates. But in this wolf market, forcing people to speculate is like herding lambs to their slaughter.

Policymakers around the world need to first admit there is a retirement crisis and then have to formulate a comprehensive strategy to reform the financial system and retirement systems so that they limit the damage as much as possible. Too many people are slipping through the cracks, and my biggest fear is that the retirement crisis will get much worse as demographic pressures swamp us.

Below, listen to an interview with Dr. Ros Altmann which took place last year. If we ignore this crisis, it will spread and end up costing us a lot more than if we took measures to address it now. If there was ever a time for pension reform, now is it. This should serve as a wake-up call for those politicians and analysts who foolishly believe that everything is fine. Nothing can be further from the truth.

Sunday, August 29, 2010

Where We Are?

My last comment on economic hypochondria generated a great deal of anger on Zero Hedge where the comments got nasty, so I want to address some of the valid criticism.

Mr. Wesbury's assertion that the economy is "fine" is ridiculous, and I did edit my post to bluntly state this. When the official unemployment rate stands close to 10% and wider measures of unemployment are almost twice that figure, things aren't "fine".

But I agree with Mr. Wesbury that far too many people have taken gloom & doom views to the extreme, and that the US economy might be in better shape than these people are willing to admit.

Last week, the Liscio Report posted an interesting comment on their blog, Where we are?:

Here’s an updated guide to “where we are”—how the U.S. economy is faring relative to the average of previous financial crises around the world. Though individual details vary, we’re following the script pretty well.

In the graphs of four major indicators (click on chart above), the lines marked “average” are the averages of fifteen financial crises in thirteen rich countries since the early 1970s, as identified by the IMF. GDP isn’t shown because the experiences were so varied that the averages were meaningless. But for the indicators shown, the averages do illustrate some tendencies worth taking seriously.

Though the U.S. peaked later and bottomed earlier than the average, and also rose higher and fell harder, the trajectories of the two lines are still remarkably similar. Note that after hitting bottom, employment in the average experience grew very slowly. If we’re in for anything like that average, then we’re likely to see employment growth of only about 35,000 a month over the next year—less than a third what’s necessary just to accommodate population growth. That suggests that we could see an unemployment north of 10% in about a year.

Given the gyrations in energy prices over the last couple of years, reading the headline CPI has been very difficult. But the gyration does seem to be around the average line. And core CPI—for which we don’t have international data—is tracking the average pretty tightly. If inflation follows the script, it should continue to decline into next year. With core inflation at around 1%, it’s reasonable to expect that we could go into mild deflation sometime over the next few quarters.

Interest Rates
Rates on 10-year Treasury bonds have fallen harder in the U.S. than in other crisis-afflicted countries, but the trend is typically down for almost four years after the onset of crisis. Further declines in U.S. rates seem like a stretch, but the likelihood of an upward spike looks remote.

Stocks fell much harder in the U.S. than they did in the wake of the average financial crisis, though they did enjoy five quarters of nice recovery. As with interest rates, further declines seem unlikely; in fact, the average increase from here would be around 7% over the next year.

So, all in all, we’re getting pretty much what we might expect out of our major economic and financial variables: a weak, choppy recovery with a deflationary undertow.

I think this is a fair and balanced comment, but again, it's a very US-centric view of the world. If you factor in robust growth from emerging economies, central bank intervention and the extraordinary liquidity in financial markets, the path to recovery might surprise the staunchest naysayers.

Finally, it's Sunday, and I'll leave you with some food for thought from George Friedman, CEO of STRATFOR, who believes China “will collapse” in the coming decade and that America will be the primary beneficiary. Mr. Friedman's views are controversial but well worth listening to.

Saturday, August 28, 2010

A Bad Case of Economic Hypochondria?

Following my latest post on whether the Fed has defused the neutron bomb, a senior pension fund manager sent me a link to AXA Investment Managers' latest weekly comment by Eric Chaney, Deflation may have won a battle, but not the war.

It is an excellent read which demonstrates why any discussion on the inflation/deflation debate that doesn't take into account what's going on outside the US is missing the bigger picture. I quote the following:
Although contemporaneous estimates of output gaps are somewhat elusive, the broad picture is clear: a growing portion of the global economy is facing inflation risks and the bulk of developed economies is no longer in the deflation danger zone. This uneven dynamic distribution matters a lot for investors, who need to make up their mind about inflation. One key lesson from the past cycle is that price movements have a larger common component than in previous times; call it the globalisation factor. Matteo Ciccarelli and Benoît Mojon estimated that “(inflation rates of) OECD countries have a common factor that alone accounts for nearly 70% of their variance” (ECB working paper, October 2005), a finding that is consistent with later research by Haroon Mumtaz and Paolo Surico (Bank of England working paper, February 2008). In such a world, the fact that China, India and Brazil have entered into the inflation risk zone matters more than Spain, Ireland and Greece being on the brink of deflation.
Mr. Chaney concludes by stating:
In sum, there is no evidence that deflation has gained much ground during the summer. For sure, a double dip of the US economy would tick a few boxes in the deflation camp. Yet the most likely scenario in our view is that the US has embarked on a slow growth cycle, the mirror image of the artificially debt-fuelled previous decade, rather than on a stop-and-go cycle. Once the markets get a clearer picture of business cycle developments, which may unfortunately take several months, there are good reasons to believe that the current deflation buzz will be quickly replaced by its opposite. In the meantime, enjoy the bond rally!
There are other encouraging signs suggesting that the global recovery is back on track. This past week, the CPB Netherlands Bureau for Economic Policy Analysis released its World Trade Monitor for June 2010, showing that world trade was up 0.7% month on month after an upwardly revised 2.3% increase in May.

Why is this significant? Because, as Yanick Desnoyers, Assistant Chief Economist at the National Bank of Canada discusses below, Global trade volume finally back to its previous peak:
According to CPB Netherlands Bureau for Economic Policy Analysis, the volume of world trade grew 0.7% in June after an upwardly revised 2.3% gain in May. This represents the ninth increase in ten months. Global trade volume is now expanding at a 21.2% growth on twelve month basis, just shy of the 23% peak registered in May. In the second quarter as a whole, global volume trade was up a significant 15.3%. As today’s hot chart shows (click on char above), it took only about a year for world trade volume to virtually get back to its previous peak.

On the global industrial output side, the index is already in an expansion mode with a 0.7% gain above its previous peak, despite the fact that IP is still down 10% in advanced economies. After all, it seems that fears of sovereign debt contagion from the Euro zone earlier in the spring did not have a material impact on global trade volume. Despite an upcoming slowdown in the U.S., we are still forecasting an above 4% global GDP growth in 2010.
What this tells you is that this cycle is different than previous cycles because the emerging economies are the source of growth. Too many analysts are focused solely on what is going on in the US and other developed economies. I too had written about Galton's fallacy and the myth of decoupling, but maybe this view needs to be revisited.

And even in the US, I tend to think there is way too much gloom & doom, a point underscored by Ross DeVol, executive director of economic research at the Milken Institute, who wrote an op-ed in the WSJ this past week, The Case for Economic Optimism:

Gloom and doom is the hallmark of the current economic debate, as the most recent congressional testimony from Federal Reserve Chairman Ben Bernanke demonstrates. Despite Mr. Bernanke's generally upbeat message on the Fed's official forecast, which calls for moderate economic growth of somewhere between 3.0% to 3.5% this year, the market and the media fixated on his acknowledgment that the outlook was "unusually uncertain." Those words have only reverberated in the past few weeks, bolstering economic pessimists.

There's a point at which pessimism becomes a self-fulfilling prophesy, scaring businesses away from investing or hiring. The dark tone of today's discourse is at risk of doing just that.

The Milken Institute's new study, "From Recession to Recovery: Analyzing America's Return to Growth" is based on extensive and dispassionate econometric analysis. It concludes that the U.S. economy remains more flexible and resilient—and has more underlying momentum—than is generally acknowledged. In fact, our projections show cause for measured optimism: A return to modest but sustainable growth is close at hand.

America's businesses are capable of navigating around policy uncertainty and the twists and turns of a volatile global economy. While slow private-sector job growth is to be expected in the early stages of a recovery, the U.S. should add 1.5 million jobs in 2010, 3.1 million in 2011, and 2.6 million in 2012. That will translate into real GDP growth of 3.3% in 2010, 3.7% in 2011, and 3.8% in 2012.

In this pessimistic climate, this forecast will likely be considered contrarian. So why is our economic outlook more sanguine than the current consensus? For one, robust (albeit moderating) economic growth in developing countries, particularly in Asia, will provide support for U.S. exports. Look no further than Caterpillar, which reported a doubling of its earnings in the second quarter of 2010 and whose product line is sold out for the rest of the year.

Improved business confidence is already spurring strong investment in equipment and software. Record-low U.S. long-term interest rates are supporting the recovery. And the benign inflationary environment allows the Fed to keep short-term interest rates near zero until late this year, or even into 2011 if it desires.

Historical context offers further reason to expect a rebound. The peak-to-trough decline in real GDP during this recession was 4.1%, making it the most severe downturn since World War II. But throughout the postwar period, the rate of economic recovery from past recessions has been proportional to the depth of the decline experienced. While this relationship has been somewhat variable, it is well-established. Our projections for GDP growth are above consensus but are substantially below a normal rate of recovery after a recession of this severity.

The naysayers are right that there's a "new normal" economy, but it's not that the potential long-term growth rate of the U.S. is substantially diminished, as they say. It's that this time, the fulfillment of pent-up demand will be subdued because consumers were living so far above their means during the bubble years. Nevertheless, consumer durables and business investment in equipment will see some previously postponed purchases finally happen—if not this year, certainly by 2011 and 2012.

What needs to happen on the policy front in order to build momentum?

In the first place, small businesses need access to more bank credit to create jobs. Banks feel conflicted by calls from the Obama administration to increase lending while regulators are instructing them to add to their reserves. Regulators need to be reminded that some risk is necessary in a market economy.

The White House also should press Congress to pass legislation modernizing Cold War–era restrictions on exports of technology products and services that are already commercially available from our allies. This would boost U.S. exports and reduce the deficit. And if the White House is serious about doubling exports by 2015, it needs to push trade deals with South Korea, Colombia and Costa Rica through Congress.

For its part, Congress must move immediately to restore the lapsed R&D tax credit. Even better, it should expand the credit and make it permanent.

Congress also should pass legislation to temporarily extend the Bush tax cuts that are set to expire at the end of this year. It's important not to remove any economic stimulus as long as the sustainability of the recovery is in question.

Another must-do: by 2012, Congress needs a credible long-term plan in place to reduce the deficit. If it doesn't, international financial markets might force our hand by demanding a higher rate of return on U.S. Treasurys.

Washington has to focus like a laser on helping businesses create jobs, while the rest of us should avoid talking ourselves out of a recovery by dwelling on the doom and gloom. The U.S. economy has already adapted to serious imbalances in record time: There's ample reason to believe in its dynamism in the months and years ahead.

While US consumers were living beyond their means, they're paying down debts fast. The amount consumers owed on their credit cards in this year's second quarter dropped to the lowest level in more than eight years as cardholders continued to pay off balances in the uncertain economy.

Moreover, the FT reports that US credit-card losses are falling faster than expected, with the six largest card issuers expected to earn nearly $10bn more in the coming 12 months than predicted, says a study by Moody's:

Historically, US credit-card write-offs have tracked the unemployment rate. But for the first time in a decade, loans considered uncollectible by lenders are falling faster than the jobless rate, prompting analysts to revise earnings models.

The divergence from past experience reflects bank efforts to weed out risky borrowers, moves by consumers to pare back debts after the excesses of the past decade and new credit card rules intended to discourage reckless lending.

“We are getting back to an old-fashioned basis of lending, providing credit only to people who have the ability to repay,” said Curt Beaudouin, an analyst at Moody’s.

Finally, while everyone is focused on weakness in the job and housing market, listen to Brian Wesbury of First Trust Advisors below who thinks the US economy is fine and that the country's just suffering from a case of what he calls "economic hypochondria."

Wesbury blames stimulus for delaying the recovery, which is arguable, and his assertion that the economy is "fine" is ridiculous, but I think he's right on upward pressure on growth, expecting the economy to accelerate over the next year.

Friday, August 27, 2010

Has the Fed Defused the Neutron Bomb?

Bruce Friesen of Global Investment Solutions forwarded Randall Forsyth's article which appeared in Barron's earlier this week, Deflation: the Neutron Bomb of Balance Sheets:

Low interests rates have made these the best of times for borrowers but the worst for savers and investors.

Blue-chip corporations never had it so good with the likes of Dow Jones Industrial Average members International Business Machines (IBM) able to issue new three-year notes at 1% and Johnson & Johnson (JNJ) paying less than 3% for new 10-year debt.

But these historically low bond yields have a darker side: According to a new report from Fitch Ratings, ultra-low interest rates will exacerbate the underfunding of many U.S. corporations' pension plans.

Just as with American workers who have failed to save enough for retirement and have seen their assets lose value, companies also will have no choice but set aside more of their earnings. And just as that means belt-tightening for consumers, it means corporations have less to distribute to their shareholders.

The burden of funding traditional pension plans—known as defined-benefit plans—is why they have waned in Corporate America. More common are defined-contribution plans—such as the ubiquitous 401(k)s—that have supplanted DB plans in the private sector. As has been reported widely, DB plans remain the standard in the public sector, which are decimating budgets of many states and municipalities.

But, according to Fitch, the low-yield, deflationary environment is adding to the problems of underfunded corporate pension plans. Again, the problem is two-fold: The decline in the values of investments, such as traditional stocks and commercial real estate, has hurt the asset side. The rush into so-called alternative investments such as hedge funds right at their peaks didn't help. The flip side is that low interest rates increase the present value of future liabilities.

(Time out for those who aren't finance geeks. If you put $1 in a savings account at 7%, in 10 years you would have $2. Trust me on that. That means the future value of $1 in 10 years, compounded at 7%, is $2. Conversely, the present value of that $2 invested for 10 years is $1.

But what if interest rates are just half as high, or 3.5%, a far more realistic yield for a 10-year, high-grade corporate bond? The present value of that $2 in 10 years is $1.42. Trust me again on that, or get a financial calculator or find one on the Web. In other words, where it took only $1 for you to wind up with $2 in 10 years if you invest at 7%, it takes an investment of $1.42 to end up with that same $2 in 10 years at 3.5%. That means you have to set aside 42% more today to meet your savings goal a decade hence.)

Thus, a decline in bond yields can be as devastating to a savings plan as a drop in the stock market. According to Kenneth S. Hackel, president of CT Capital, a financial advisory firm, 1% cut in a retirement plan's assumed rate of return is roughly equal to a 15% decline in stock prices.

Fitch's analysts find the mean assumed return for corporate pension plans in 2008 and 2009 was 8%. That's with an allocation to fixed-income assets of 34% of the total. Treasuries and investment-grade corporate bonds yield far less than 8%, which is closer to the very long-term return from equities, which means they haven't locked in much of yesterday's higher yields. And, in case you need to be reminded, over the past decade or so, the return from stocks has been practically nil.

In line with Hackel's rough calculation, Fitch reckons a 1% cut in the assumed discount rate for companies' DB plan can result in a 10%-20% increase in the present value of future liabilities. How to bridge that gap?

"The fact is that there are no shortcuts—prudent management will likely require contributions well in excess of the minimum required given low yields and low equity returns," Fitch analysts write. Simply hoping for higher equity returns or bond yields simply isn't prudent, they add.

So, what's the answer? You know those hefty cash holdings on corporate balance sheets on which the bulls keep harping? Fitch thinks pension funding requirements will have dibs on corporate cash flows, and then the stock of cash on companies' balance sheets.

That's the thing about deflation; it's like a neutron bomb for corporate, public-sector and consumer balance sheets. Asset values and returns get decimated while liabilities remain standing. Except that falling interest rates make those future liabilities more onerous, requiring more belt-tightening, which only exacerbates the deflation.

As I've repeatedly stated, deflation is the arch nemesis of the financial sector and the Fed will do whatever it takes to avert it. Moreover, in order to address pension deficits, you need a rise in bond yields (lowers present value of future liabilities) and a rise in asset prices. In other words, you need a lot more days like Friday where stocks took off and bond yields backed up.

The Fed's policy has been geared towards the big banks and their big hedge fund clients. Reflate and inflate is the official policy. By borrowing at zero and investing in higher yielding Treasuries, banks lock in the spread, making instant profits which they then use to trade risk assets all around the world.

Is this policy succeeding? Yes and no. It's helping banks shore up their balance sheets and some elite hedge funds who thrive on volatility, but doing little to help the real economy which remains weak at this stage of the cycle.

However, that all may be changing. Over the weekend, I'll go over some encouraging signs that receive little or no attention in mainstream media. Below, listen to an interview with Nigel Gault, chief U.S. economist at IHS Global Insight as he discusses his views on the US economy and his take on Ben Bernanke's speech at the Fed's annual Jackson Hole confab.

Thursday, August 26, 2010

Public Pensions and California's Fiscal Future

Governor Schwarzenegger wrote an op-ed piece for the WSJ, Public Pensions and Our Fiscal Future:
Recently some critics have accused me of bullying state employees. Headlines in California papers this month have been screaming "Gov assails state workers" and "Schwarzenegger threatens state workers."

I'm doing no such thing. State employees are hard-working and valuable contributors to our society. But here's the plain truth: California simply cannot solve its budgetary problems without addressing government-employee compensation and benefits.

As former Speaker of the State Assembly and San Francisco Mayor Willie Brown pointed out earlier this year in the San Francisco Chronicle, roughly 80 cents of every government dollar in California goes to employee compensation and benefits. Those costs have been rising fast. Spending on California's state employees over the past decade rose at nearly three times the rate our revenues grew, crowding out programs of great importance to our citizens. Neglected priorities include higher education, environmental protection, parks and recreation, and more.

Much bigger increases in employee costs are on the horizon. Thanks to huge unfunded pension and retirement health-care promises granted by past governments, and also to deceptive accounting by state pension funds (such as unreasonable projections of investment returns), California is now saddled with $550 billion of retirement debt.

The cost of servicing that debt has grown at a rate of more than 15% annually over the last decade. This year, retirement benefits—more than $6 billion—will exceed what the state is spending on higher education. Next year, retirement costs will rise another 15%. In fact, they are destined to grow so much faster than state revenues that they threaten to suck up the money for every other program in the state budget. (See the nearby chart.)

I've held a stricter line on government employment and salary increases than any governor in the modern era (overall year-to-year spending has increased just 1.4% on my watch). Nevertheless, employee costs will keep marching upwards because of pension promises, and they will never stop doing so until we get reform.

At the same time that government-employee costs have been climbing, the private-sector workers whose taxes pay for them have been hurting. Since 2007, one million private jobs have been lost in California. Median incomes of workers in the state's private sector have stagnated for more than a decade. To make matters worse, the retirement accounts of those workers in California have declined. The average 401(k) is down nationally nearly 20% since 2007. Meanwhile, the defined benefit retirement plans of government employees—for which private-sector workers are on the hook—have risen in value.

Few Californians in the private sector have $1 million in savings, but that's effectively the retirement account they guarantee to public employees who opt to retire at age 55 and are entitled to a monthly, inflation-protected check of $3,000 for the rest of their lives.

In 2003, just before I became governor, the state assembly even passed a law permitting government employees to purchase additional taxpayer-guaranteed, high-yielding retirement annuities at a discount—adding even more retirement debt. It's as if Sacramento legislators don't want a government of the people, by the people, and for the people, but a government of the employees, by the employees, and for the employees.

For years I've asked state legislators to stop adding to retirement debt. They have refused. Now the Democratic leadership of the assembly proposes to raise the tax and debt burdens on private employees in order to cover rising public-employee compensation.

But what will they do next year when those compensation costs grow 15% more? And the year after that when they've risen again? And 10 years from now, when retirement costs have reached nearly $30 billion per year? That's where government-employee retirement costs are headed even with the pension reforms I'm demanding. Imagine where they're headed without reform.

My view is different. We must not raise taxes or borrow money to cover up fundamental problems.

Much needs to be done. The assembly needs to reverse the massive increase in pension formulas to government workers (including already retired workers) that it enacted 11 years ago. It also needs to prohibit "spiking"—giving someone a big raise in his last year of work so his pension is boosted. Government employees must be required to increase their contributions to pensions. Public pension funds must make truthful financial disclosures to the public as to the size of their liabilities, and they must use reasonable projected rates of returns on their investments. The legislature could pass those reforms in five minutes, the same amount of time it took them to pass that massive pension boost 11 years ago that adds additional costs every single day they refuse to act.

And after they've finished passing those reforms, they could take another five minutes to pass legislation terminating the annuity give-away they passed in 2003 and ending the immoral practice of pension fund board members accepting gifts or even campaign contributions from lobbyists, salesmen, unions and other special interests.

Reforming government employee compensation and benefits won't close this year's deficit. It will, however, protect the next generation of Californians from overwhelming burdens. The same is true with respect to the other reform I'm demanding, including the establishment of a rainy-day fund so that legislators can't spend temporary revenue windfalls.

All of these reforms must be in place before I will sign a budget.

I am under no illusion about the difficulty of my task. Government-employee unions are the most powerful political forces in our state and largely control Democratic legislators. But for the future of our state, no task is more important.

Governor Schwarzenegger is in for the fight of his life. Reading the daily headlines on Jack Dean's Pension Tsunami gives you a flavor of just how dire the fiscal situation is. Without serious public pension reforms, California is heading towards fiscal hell.

And it's not just California. Other states will suffer the same fate if they refuse to reform public pensions. You simply can't promise more than you can afford to pay out. At one point, you have to address the problem or face much higher borrowing costs. Raising taxes is not a long-term solution to mounting pension costs. It's akin to placing a band-aid over a tumor.

With so much economic pain and uncertainty, it's irresponsible to ask more from the private sector to deal with public sector pension shortfalls. I sympathize with many hard working public sector employees who had nothing to do with the financial crisis, but I also realize that pension apartheid is not the solution. You can't expect people who lost considerable sums in their 401K plans to pay more in taxes to make up for public sector pension deficits.

Stakeholders need to sit down and figure out a way to reform their public pensions. And it's not just about cutting benefits, raising the contribution rate and retirement age. They need to introduce meaningful, comprehensive reforms which include world class governance standards so that the public and stakeholders are reassured that pension monies are being managed properly and in everyone's best interest.

Finally, listen to New Jersey's governor, Chris Christie, below on how he handled powerful public sector unions and introduced measures to address the state's fiscal woes. Nobody likes reforms, especially when it hits their pockets, but ignoring the problem is only delaying the day of reckoning.

Wednesday, August 25, 2010

Pension Ponzi Scheme $16 Trillion Short?

Laurence J. Kotlikoff, professor of economics at Boston University and author of “Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking”, wrote an op-ed piece for Bloomberg, Retiree Ponzi Scheme Is $16 Trillion Short:

Social Security just celebrated its 75th birthday. Love it or hate it, it has done its job and should retire. We need a new system, the Personal Security System, which retains Social Security’s best features, scraps the rest, and covers its costs.

Social Security’s objective -- forcing people to save for retirement -- is legit. Otherwise millions of us would seek handouts in our old age.

But Social Security has also played a central role in the massive, six-decade Ponzi scheme known as U.S. fiscal policy, which transfers ever-larger sums from the young to the old.

In so doing, Uncle Sam has assured successive young contributors that they would have their turn, in retirement, to get back much more than they put in. But all chain letters end, and the U.S.’s is now collapsing.

The letter’s last purchasers -- today’s and tomorrow’s youngsters -- face enormous increases in taxes and cuts in benefits. This fiscal child abuse, which will turn the American dream into a nightmare, is best summarized by the $202 trillion fiscal gap discussed in my last column.

The gap is the present value difference between future federal spending and revenue. Closing this gap via taxes requires doubling every tax we pay, starting now. Such a policy would hurt younger people much more than older ones because wages constitute most of the tax base.

What about cutting defense instead? Sadly, there’s no room there. The defense budget’s 5 percent share of gross domestic product is historically low and is projected to decline to 3 percent by 2020. And the $202 trillion figure already incorporates this huge defense cut.

The 3-Year-Old Vote

Reducing current benefits, most of which go to the elderly, is another option. But such a policy is highly unlikely. The elderly vote and are well-organized, whereas 3-year-olds can neither vote, nor buy Congressmen.

In contrast, cutting future benefits is politically feasible because it hits the young. And that’s where Congress is heading, starting with Social Security. The president’s fiscal commission will probably recommend raising Social Security’s full retirement age to 70 from 67, for those who are now younger than 45. This won’t change the ages at which future retirees can start collecting benefits. It will simply cut by one-fifth what they get.

Some political economists point to Social Security’s 2010 Trustees Report and say, “Leave it alone. The system won’t run short of cash until 2037.”

Misleading Accounting

Unfortunately, the Trustees’ cash-flow accounting, like all such accounting, is arbitrary and misleading. In fact, Social Security is broke. Its fiscal gap, which the Trustees measure correctly, is $16 trillion.

This gap is small compared with the U.S.’s overall $202 trillion shortfall, not because the Trustees treat Social Security’s $2.5 trillion trust fund as an asset (a questionable choice), but because they credit one-third of federal revenue to the program.

But dollars are dollars. If we re-label Social Security “payroll” taxes as “general revenue wage taxes,” Social Security’s fiscal gap increases by $60 trillion, and the fiscal gap of all other government activities falls by $60 trillion, leaving the overall $202 trillion gap unchanged.

Even by the Trustees’ measure, there’s a massive problem. Coming up with $16 trillion requires permanently raising revenue or cutting benefits by 26 percent, starting now. In other words, the program is 26 percent underfunded.

Hitting Young People

Now cutting benefits of new retirees by 20 percent, with an increase in the so-called full retirement age, starting 20 or so years from now isn’t the same as immediately cutting the benefits of all retirees by 26 percent. Hence, the fiscal commissioners will need to hit young people with an even bigger whammy if they really want to solve Social Security’s long-term woes.

Most likely, Washington will simply raise the retirement age and kick the can further down the road. This is what the Greenspan Commission did in 1983, knowing full well that by 2010 the system would be in even worse shape.

I say, retire Social Security and replace it with a version that works. Do this by freezing the current system, paying today’s retirees their benefits, while paying workers only what they have accrued so far once they retire.

Next, have all workers contribute 8 percent of their pay to the new system, with half going to a personal account and half to an account of a spouse or legal partner. The federal government would make matching contributions for the poor, the disabled and the unemployed, permitting the system to be as progressive as desired.

Going Global

All contributions would be invested in a global, market- weighted index of stocks, bonds, and real estate. The government would do the investing at very low cost and guarantee that contributors’ account balances at retirement would equal at least what was contributed, adjusted for inflation.

Between ages 57 and 67, each worker’s balances would gradually be swapped for inflation-indexed annuities sold by the government. Those dying before 67 would bequeath their account balances to their heirs.

While this plan has private accounts, Wall Street plays no role and makes no money. Additional contributions would be used to fund life- and disability-insurance pools.

Our nation is in terribly hot water. Business as usual is no answer. The only way to move ahead is to radically reform our retirement, tax, health-care and financial institutions to achieve much more for a lot less.

The Personal Security System is a major step in that direction. It meets all the legitimate goals of Social Security without the system’s waste and penchant for robbing the young.

Wall Street plays no role and makes no money? Who are we kidding here? Wall Street wolves are hungry and they want a piece of the Social Security (SS) pie. In fact, conspiracy theorists will tell you that this whole financial crisis was manufactured with the ultimate goal of privatizing SS, allowing the fat cats on Wall Street to make even more money as they find new sources of revenues to fund prop desks, hedge funds, private equity funds and real estate funds.

But there is a legitimate argument to be made for properly diversifying SS. Back in 2002, Mark Sarney and Amy M. Preneta of the Social Security Administration’s Office Retirement Policy wrote a discussion paper on The Canada Pension Plan’s Experience with Investing Its Portfolio in Equities.

The paper is outdated but very relevant and well written. In particular, there is an excellent discussion on governance and oversight on the Canada Pension Plan Investment Board, including measures to ensure accountability to the public:

  • It is subject to special examination at least every 6 years by the federal finance minister in consultation with the participating provinces.
  • It must provide quarterly financial statements and annual reports on the performance of the CPP Investment Fund to the federal and provincial finance ministers and the federal Parliament. The CPPIB also issues quarterly statements to the public, though it is not required to do so by legislation.
  • It undergoes a performance evaluation as part of the Triennial Review, a required review of the financial status of the CPP that includes issuing an actuarial report on the CPP.
  • It must hold public meetings to discuss its performance at least every 2 years in each participating province (Human Resources Development Canada 1997, 10-11).

The result of having these accountability measures is that the board’s activities and finances are overseen by several entities: the government’s Chief Actuary, the federal Parliament and the legislatures of the participating provinces, the 10 finance ministers, and the public. In addition, the board has an outside firm conduct an audit of its finances for its annual report.

Canadians are lucky that they have the Office of the Chief Actuary of Canada (OCA) playing a key role overseeing the activities of the Canada Pension Plan Investment Board (CPPIB). In my opinion, the OCA sets the bar in terms of professionalism and accountability when it comes to how Canadian federal government entities run their operations.

And while CPPIB has its critics, the reality is that they are very well managed and take governance issues very seriously. My concern with CPPIB and other large public pension funds is that they're too big. I prefer splitting up CPPIB, the Caisse, CalPERS, and other large public pension funds because at one point, size is an issue and it becomes harder to deliver the required actuarial returns without taking undue risk. But that's a discussion for another time.

Getting back on topic, is the Pension Ponzi $16 trillion dollars short? No, it's worse if you factor the trillion dollar gap of underfunded state retirement systems. Most state retirement funds lack the governance standards of their Canadian counterparts. [Note: Read on how trustees of the Kentucky state retirement system will re-open an investigation into payments to investment middlemen.]

One thing is for sure, the US and other developed nations face a huge retirement problem and if they don't take measures and introduce proper reforms, which includes the highest governance standards and proper funding of these systems, then they're heading for a major collision somewhere down the road.

Finally, as long as they reform retirement systems, maybe authorities can finally introduce meaningful reforms to financial markets. On Wednesday, the Council of Institutional Investors applauded the Securities and Exchange Commission’s (SEC) adoption of a rule that gives shareowners a bigger voice in electing corporate directors.

Great but this is the tip of the iceberg. Much remains to be done to clean up financial markets from the crooks and banksters who routinely and legally steal money from individual and institutional investors. Before you privatize SS, make sure you restore confidence and faith by cleaning up markets once and for all. On that last point, listen to Jim Puplava's recent interview with Laurence Kotlikoff below.

TRS Responds to "Death Spiral" Comments

In response to my last comment on whether pensions are the next AIG, Dave Urbanek, Public Information Officer at the Teachers’ Retirement System of the State of Illinois (TRS), sent me this message:

Please remove your post of Tyler Durden’s inaccurate analysis of the Illinois Teachers’ Retirement System. It is not excellent. It is wrong.

TRS is not in a death spiral. We’ll still be operating and paying pensions for years to come.

We could potentially sell $3 billion in assets if the Illinois General Assembly does not come up with its annual contribution to TRS. The state owes us $2.35 billion. Two other state pension systems are also selling assets until the state makes its payments to them. That is the only reason we are selling assets.

We are not selling assets because we are on the risky side of any investments, as Mr. Durden claims. Here are the facts: We could potentially sell $3 billion in assets. Last year our investment income totaled $4.6 billion – a 13 percent return. We did not lose money. We have $33 billion in total assets. We will pay $4.1 billion in pensions and benefits during the current fiscal year. Do the math. We are not in a death spiral.

What Mr. Durden doesn’t say – and won’t because it ruins his story – is that TRS sold $1.3 billion in assets last year for the same reason: The General Assembly hadn’t yet come up with its annual contribution. The state ultimately sold bonds and made the payment, and we not only got our money back from the assets we sold but did not have to sell any further assets.

Repeating Mr. Durden’s incorrect rants on your blog is highly irresponsible.

I thank Mr. Urbanek for his response and I am glad TRS is not in a "death spiral". I never claimed they were, just that they're forced to liquidate stocks at the worst possible time and are taking riskier bets to cover their shortfall. In particular, did TRS sell billions of derivatives (mostly CDS) to bet on a rising market/ collapsing spreads (aka the AIG trade) and are they still betting on a drop in Treasuries (rise in yields)?

What remains to be seen is how TRS and other mature public pension plans suffering from ever widening deficits will respond to long-term structural issues plaguing the pension industry. Tough choices lie ahead, and there are no simple solutions to the pension crisis.

I will update this comment if further information is provided by TRS. You can also click here to get more information on TRS's investments and click here to access their publications, including their latest comprehensive annual report.

Tuesday, August 24, 2010

Are Pensions the Next AIG?

Tyler Durden of Zero Hedge posted an excellent comment, Illinois Teachers' Retirement System Enters The Death Spiral: AIG Wannabe's Go-For-Broke Strategy Fails As Pension Fund Begins Liquidations.

I quote the concluding remarks, but it's worth reading the entire comment:
Alas, at this point it is too late: for TRS, and likely for many, many other comparable pension funds, which had hoped that the Fed would by now inflate the economy, and fix their massively incorrect investment exposure, the jig may be up. As liquidations have already commenced, the fund is beyond the point where it can "extend and pretend", and absent the market staging a dramatic rally, government bonds plunging, and risk spreads on CDS collapsing, the fund is likely doomed to a slow at first, then ever faster death.

Then one day, Goldman's risk officers will call the TRS back office, and advise them that due to its "suddenly riskier profile" established in no small part courtesy of Goldman's investment allocation advice, the collateral requirements have gone up by 50%. The next step is either Maiden Lane 4... or not. For the sake of the 355,000 full-time, part-time and substitute public school teachers and administrators working outside the city of Chicago, we hope that the TRS has now been inducted into the hall of the Too Big To Fail, as otherwise roughly $34 billion in (underfunded) pensions are about to disappear.
You can read the Bloomberg article, Illinois Pension May Sell $3 Billion of Assets to Pay Benefits as well as the Chicago Tribune article. According to Barry Burr of Pensions & Investments, the system is the fifth Illinois statewide defined benefit plan to sell off investments this fiscal year to pay benefits:

Illinois State Universities Retirement System, Champaign, expects to sell $1.2 billion in investments from its $12.2 billion defined benefit fund this fiscal year to raise liquidity to pay benefits to participants.

The Illinois State Board of Investment, Chicago, could sell $840 million investments from its $9.9 billion fund to pay benefits of the Illinois State Employees' Retirement System, Illinois Judges' Retirement System and Illinois General Assembly Retirement System. ISBI oversees the investments of the three systems.

The liquidity stress from the investment sales at the five plans could force each of them to restructure their strategic asset allocations, terminate investment managers and search for new managers.

Illinois Teachers sold $290 million in investments so far this month and $200 million last month because of a lack of state contributions.

“Without the monthly state contribution, TRS estimates sales of roughly $3 billion for the entire fiscal year, or approximately $250 million every month,” Mr. Urbanek said in a statement in response to an inquiry.

So far, TRS has accomplished the investment liquidation through “appropriate rebalancing,” Mr. Urbanek said in the statement. “As the year progresses, this approach will no longer be sufficient to cover the total amount of benefit payments and more targeted asset sales will need to be considered.

“TRS staff continues to study the impacts of the current liquidity situation on the total portfolio and recommendations will be made as necessary to adjust targets. These changes could include revisions to the system's target asset allocation and termination of investment manager relationships as 10% or more of the portfolio is liquidated to pay benefits this fiscal year,” he said.

Mr. Urbanek said the investment sales could force changes in the system's current asset allocation impacting whether it could meet its current 8.5% target rate of return.

“In the current market environment, there are significant market opportunities to institutional investors with available capital. In the absence of the required contribution from the state, TRS and the other Illinois pension systems will no longer be able to participate in these opportunities,” he said.

R.V. Kuhns, the system's investment consultant, is evaluating possible allocation changes for liquidity needs as they arise, Mr. Urbanek added. He said it was “impossible” to know details of possible searches or terminations at this time.

Since the start of the fiscal year on July 1 through Aug. 20, the system has received only $90 million in contributions from the state. For the current fiscal year, ending June 30, 2011, the system requested $2.35 billion in contributions from the state, Mr. Urbanek said.

In the last fiscal year, the system sold $1.3 billion in assets to pay pension benefits; it received $170.4 million in employer contributions and $899 million in member contributions, while requesting $2.08 billion in employer contributions alone.

TRS' current asset allocation is U.S. equities, 30.5%; international equities, 20.3%; fixed income, 17.5%; real estate, 9.6%; real return, 9.3%; private equity, 8.3%; absolute return, 3.6%; and short-term investments, 0.9%.

When the financial crisis erupted, it first hit banks, insurance companies, hedge funds, real estate/ private equity funds, asset managers, and then hit pension funds. But pensions remain very vulnerable because as interest rates fall and assets dwindle, their pension deficits explode, and if they need money to cover benefits, well guess what, they're forced to sell liquid stocks to meet those obligations.

And they typically sell stocks at the worst possible time. This is what happened to the Caisse in 2008 when they lost $40 billion and got whacked hard with non-bank asset-backed commercial paper (ABCP), forcing them to shore up liquidity at the worst possible time.

Other funds like PSPIB also got hit with ABCP (to a lesser extent), but they benefited from net inflows, so they weren't forced to sell stocks to meet pension obligations. The same goes for CPPIB, which suffered a 19% loss in FY2009, but kept buying stocks throughout the crisis.

But unlike the Caisse, PSPIB, and CPPIB, the Illinois TRS is not managed anywhere near as well, and they took stupid risks to meet unrealistic investment targets. Moreover, instead of learning from their mistakes, they continued taking excessive risks to try to address their widening pension deficit.

When you're a mature pension plan, you got to manage your liquidity risk very carefully. Go back to read my conversation with Jean Turmel who sits on the board of Ontario Teachers' Pension Plan (OTPP). They manage liquidity risk looking ahead 18 months. The folks over at Illinois TRS should fly over to Toronto and have a serious discussion with OTPP's senior managers.

Finally, today I read that Nortel retirees stand to lose one third of their pension and that Ontario will toughen pension funding requirements for companies and bolster its guarantee fund as it works to fix a pension system hit hard by the financial crisis (better late than never).

While pensions are finally getting the attention they deserve, I'm worried that they're the next AIG (but much, much bigger). The Fed is going to do what it can to bail out pensions, but I have serious doubts that even they are fully aware of the magnitude of the pension Ponzi and how it could easily topple the global financial system (ever tried quantifying total aggregate pension leverage and counterparty risk? Good luck!).

When pensions are forced to liquidate to meet pension obligations, we should all be concerned. Luckily, there are some huge sovereign wealth funds that stand ready to pick up shares from struggling US pension funds, but if this becomes a pattern among US (and global) pension funds, watch out, the pension tsunami will have far reaching effects which will make the whole AIG fiasco look like a walk in the park.

***TRS responds***

Please see TRS's response to "death spiral" comments.

Monday, August 23, 2010

Financial Retraction Ahead?

James Mackintosh of the FT reports, Wolf’s frustration bodes ill for investment flock (HT: Pierre):
Stanley Druckenmiller, one of the masters of the investment world, this week announced his retirement saying that he had become frustrated over the past three years with his inability to make outsize returns.

After 30 years running Duquesne Capital Management – while also spending time with George Soros, when he helped make $1bn on Black Wednesday by forcing the pound out of the European exchange rate mechanism – he is due some quality time with his fortune.

He is not, however, alone in his frustration. Fellow managers of “global macro” hedge funds, which bet on currencies, bonds and equity markets, have been having a rough time this year. In theory, the wild swings in the value of the main currencies and dramatic shifts in government bond yields should be the perfect environment for macro managers.

In practice, it turns out that even the smartest investors find these markets hard to navigate. By the end of July this year, the average macro fund had lost 1.2 per cent, after small gains last year, according to Hedge Fund Research. By contrast, global equities are down 5 per cent since January, while US 10-year Treasury bond investors have made about 10 per cent.

Behind the poor returns for the modern masters of the universe lies one of the biggest concerns investors face: uncertainty. Ben Bernanke, chairman of the US Federal Reserve, warned of an “unusually uncertain” economic outlook in July and since then pretty much everyone has come around to the same view. This lack of clarity has further split an already unusually divided investment community.

Think of investors as a flock of sheep, all tending to move in vaguely the same direction, with the flock as a whole moving relatively slowly. There are always a few black sheep in the corner of the field ignoring the rest, and some lambs gambolling away from the flock. But the bulk of investors huddle together for safety, and rush to join the rest if they are left behind.

Today, the field is more spread out. The flock is smaller and there are far more investors heading out on their own. One group has headed off to join the permabears – finally getting airtime for their deflation forecasts – in the corner, while another group, led by big hedge funds, has barbecued the lambs and buried its assets in gold to protect against inflation. The shrunken flock now spends its time rushing from the deflation crowd to the inflation huddle, creating a binary market far more sensitive to economic data than in the past.

The scale of this change can be seen in the inflation options market. Back in January 2008, British investors thought there was less than a 10 per cent chance that in six to seven years we would have either deflation or inflation of more than 5 per cent (measured on retail prices). That combined probability now stands at more than 30 per cent.

In the less-developed US options market, the risk of consumer price deflation in three years is priced at 23.7 per cent, according to Royal Bank of Scotland calculations. Yet there is about an equal chance of inflation of 4 per cent, more than double the Fed’s unofficial target, suggesting investors are even more divided in the US than in the UK.

In statistical speak, the distribution of investors now has fat tails. This has profound implications for investment.

The most significant effect of the uncertainty is the “risk on/risk off” trade. For three years, any given day in the markets could be seen as a day when people wanted risky assets – equities, emerging markets currencies, peripheral European government bonds – or wanted safer assets, such as the yen, US Treasury bonds, British gilts or German Bunds. With more people taking extreme positions, the markets swing further and faster than usual.

With this comes short memories. Markets always look to the future but the impact of any given piece of economic data suggests investors have, to mix the metaphor, developed goldfish memories. The latest news seems to trump less recent data, even if it covers the same period – and much of it is likely to be revised heavily in future.

For now, the bond markets may be right that the global economy is heading downhill rapidly. Economic data from the US have been terrible, with this week’s jobless claims hitting 500,000 again for the first time since November.

It will not take many signs of green shoots, however, to have the sheep rushing back across the field and bond yields jumping, just as they did in 2003; bond investors will need to be nimble to avoid getting left behind if this happens.

Mr Druckenmiller was more likely to run with the wolves than the sheep. If even he cannot make serious money, lesser investors should beware.

It's not just Mr. Druckenmiller. Paolo Pellegrini, the hedge fund manager who was instrumental in John Paulson shorting the subprime mortgage market, reportedly is returning money to outside investors:

He will continue to manage internal money at his hedge fund firm PSQR Management, according to a report in The New York Times.

Although he earned billions for his former boss, John Paulson, by deducing that soaring housing prices in the 2000s were a true bubble, PSQR’s flagship fund was down 11% through July, The Times said.
And on Monday, Warren Buffett's semi-secret stock picker, Lou Simpson, announced that he is retiring at the end of the year after a long career at the helm of Geico's investment portfolio.

Meanwhile, Prem Watsa, the "Oracle of the North" who runs Fairfax Financial, is preparing for what he perceives to be the next big risk:

Recently, in its second-quarter results, Fairfax revealed major shifts in its $22.6 billion portfolio. First, the company increased its short positions on the general market to hedge 93% of its equity portfolio. It shifted nearly half a billion dollars into long-term U.S. Treasuries this year.

Most disturbing of all, Fairfax purchased $23 billion worth of protection (notional value) against the threat of deflation in the coming 10 years.

Each move points to a similar prognosis: slow U.S. growth, intermittent deflation, and a generally poor environment for common stocks. It is noteworthy, too, that Fairfax became worried and implemented its short hedge at an average S&P 500 price of 1,063 -- slightly below where it trades today. Seeing such a great investor turn bearish is a disconcerting sign.

Before you liquidate your portfolio, keep in mind that as an insurance company, Fairfax is playing by a different set of rules because they have to manage their assets and liabilities more carefully than most investors.

Moreover, equity and related investments still represent more than 20% of the portfolio, while cash and Treasuries make up a more modest sum. Prior to the financial crisis, Fairfax held more than half its portfolio in Treasuries and cash, and it was much less willing to take on equity risk. Now, its portfolio is only a quarter Treasuries and cash. And while the company has been cutting its exposure in equities, it has maintained its large position in two companies: Johnson & Johnson (NYSE: JNJ), and Kraft (NYSE: KFT). They also do a large percentage of their business abroad.

Still, one wonders why are well known managers retiring and others reducing their risk? Economic uncertainty remains the single biggest factor weighing on all investors which is why Raghuram Rajan, the IMF's former chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed:

Interest rates near zero risk fanning asset bubbles or propping up inefficient companies, say Rajan and William White, former head of the Bank for International Settlements’ monetary and economic department. After Europe’s debt crisis recedes, Fed Chairman Ben S. Bernanke should start increasing his benchmark rate by as much as 2 percentage points so it’s no longer negative in real terms, Rajan says.

“Low rates are not a free lunch, but people are acting as though they are,” said White, 67, who retired in 2008 from the Basel, Switzerland-based BIS and now chairs the Economic Development and Review Committee at the Paris-based Organization for Economic Cooperation and Development. “There will be pressure on central banks to follow an expansionary monetary policy, and I worry that one can see the benefits, but what people inadequately appreciate are the downsides.”

He and Rajan will have the chance to make their case at the Fed’s annual symposium in Jackson Hole, Wyoming, this week. In 2003, White told attendees central banks might need to raise rates to combat asset-price bubbles. In 2005, Rajan, 47, said risks in the banking system had increased. They were met with skepticism from then-Fed Chairman Alan Greenspan, 84, and Governor Donald Kohn, 67.

I doubt Mr. Rajan and Mr. White will persuade the Fed to raise rates anytime soon. As I've repeatedly stated, the Fed's policy is geared towards big banks, allowing them to borrow at zero to purchase higher-yielding Treasuries (locking in the spread) and to trade risk assets all around the world. Basically, it's reflate and inflate your way out of this mess, which is why we have a wolf market that's scaring small investors out of stocks into bonds.

Will economic uncertainty persist and are bonds really in a bubble? If you listen to David Rosenberg, Chief Economist & Strategist at Gluskin Sheff, financial retraction is ahead (watch interview below). Moreover, there is no shortage of US Depression data.

Nonetheless, there are some positive signs worth mentioning too. In his latest weekly comment, Yanick Desnoyers, Assistant Chief Economist at the National Bank of Canada wrote the following comment:

The Q2 real GDP data published this past July 30 came with a major revision of historical data by the Bureau of Economic Analysis (BEA). The economic analysts of the world were slack-jawed by the disappearance of $100 billion from U.S. GDP for 2010Q1. Consumption alone was revised down $134 billion. As a result, instead of being in expansion territory, it turns out consumption is actually only midway up the recovery curve. As the level of resource utilization in the economy as been pegged back, this implicitly modifies the impact of past monetary easing by the Federal Reserve.

On a more positive note, the level of labour productivity in the U.S. seems to have hit a wall in the short term. For the first time since the start of the recession, the composition of GDP growth has been geared towards employment rather than productivity. This said, if the unemployment rate does not begin to trend down, the Fed will have no choice but to step in once again.

Indeed, US productivity fell unexpectedly in the second quarter for the first time since late 2008, suggesting that productivity is reaching its limits. And with temporary employment picking up and leading full-time employment, a turnaround in the US labour market might be materializing (click on chart above).

If job growth doesn't pick up, expect the Fed to step in and do whatever it takes, including outright purchases of stocks, to reflate and inflate out of this mess. And if these policies fail, more people will be forced on a diet of macaroni & cheese. Come to think of it, maybe Kraft is an excellent investment for these uncertain times.

Sunday, August 22, 2010

Welcome to the Wolf Market?

A couple of interesting articles appeared this Sunday. Graham Bowley of the NYT reports, In Striking Shift, Small Investors Flee Stock Market:

Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

If that pace continues, more money will be pulled out of these mutual funds in 2010 than in any year since the 1980s, with the exception of 2008, when the global financial crisis peaked.

Small investors are “losing their appetite for risk,” a Credit Suisse analyst, Doug Cliggott, said in a report to investors on Friday.

One of the phenomena of the last several decades has been the rise of the individual investor. As Americans have become more responsible for their own retirement, they have poured money into stocks with such faith that half of the country’s households now own shares directly or through mutual funds, which are by far the most popular way Americans invest in stocks. So the turnabout is striking.

So is the timing. After past recessions, ordinary investors have typically regained their enthusiasm for stocks, hoping to profit as the economy recovered. This time, even as corporate earnings have improved, Americans have become more guarded with their investments.

“At this stage in the economic cycle, $10 to $20 billion would normally be flowing into domestic equity funds” rather than the billions that are flowing out, said Brian K. Reid, chief economist of the investment institute. He added, “This is very unusual.”

The notion that stocks tend to be safe and profitable investments over time seems to have been dented in much the same way that a decline in home values and in job stability the last few years has altered Americans’ sense of financial security.

It may take many years before it is clear whether this becomes a long-term shift in psychology. After technology and dot-com shares crashed in the early 2000s, for example, investors were quick to re-enter the stock market. Yet bigger economic calamities like the Great Depression affected people’s attitudes toward money for decades.

For now, though, mixed economic data is presenting a picture of an economy that is recovering feebly from recession.

“For a lot of ordinary people, the economic recovery does not feel real,” said Loren Fox, a senior analyst at Strategic Insight, a New York research and data firm. “People are not going to rush toward the stock market on a sustained basis until they feel more confident of employment growth and the sustainability of the economic recovery.”

One investor who has restructured his portfolio is Gary Olsen, 51, from Dallas. Over the past four years, he has adjusted the proportion of his investments from 65 percent equities and 35 percent bonds so that the $1.1 million he has invested is now evenly balanced.

He had worked as a portfolio liquidity manager for the local Federal Home Loan Bank and retired four years ago.

“Like everyone, I lost” during the recent market declines, he said. “I needed to have a more conservative allocation.”

To be sure, a lot of money is still flowing into the stock market from small investors, pension funds and other big institutional investors. But ordinary investors are reallocating their 401(k) retirement plans, according to Hewitt Associates, a consulting firm that tracks pension plans.

Until two years ago, 70 percent of the money in 401(k) accounts it tracks was invested in stock funds; that proportion fell to 49 percent by the start of 2009 as people rebalanced their portfolios toward bond investments following the financial crisis in the fall of 2008. It is now back at 57 percent, but almost all of that can be attributed to the rising price of stocks in recent years. People are still staying with bonds.

Another force at work is the aging of the baby-boomer generation. As they approach retirement, Americans are shifting some of their investments away from stocks to provide regular guaranteed income for the years when they are no longer working.

And the flight from stocks may also be driven by households that are no longer able to tap into home equity for cash and may simply need the money to pay for ordinary expenses.

On Friday, Fidelity Investments reported that a record number of people took so-called hardship withdrawals from their retirement accounts in the second quarter. These are early withdrawals intended to pay for needs like medical expenses.

According to the Investment Company Institute, which surveys 4,000 households annually, the appetite for stock market risk among American investors of all ages has been declining steadily since it peaked around 2001, and the change is most pronounced in the under-35 age group.

For a few months at the start of this year, things were looking up for stock market investing. Optimistic about growth, investors were again putting their money into stocks. In March and April, when the stock market rose 8 percent, $8.1 billion flowed into domestic stock mutual funds.

But then came a grim reassessment of America’s economic prospects as unemployment remained stubbornly high and private sector job growth refused to take off.

Investors’ nerves were also frayed by the “flash crash” on May 6, when the Dow Jones industrial index fell 600 points in a matter of minutes. The authorities still do not know why.

Investors pulled $19.1 billion from domestic equity funds in May, the largest outflow since the height of the financial crisis in October 2008.

Over all, investors pulled $151.4 billion out of stock market mutual funds in 2008. But at that time the market was tanking in shocking fashion. The surprise this time around is that Americans are withdrawing money even when share prices are rallying.

The stock market rose 7 percent last month as corporate profits began rebounding, but even that increase was not enough to tempt ordinary investors. Instead, they withdrew $14.67 billion from domestic stock market mutual funds in July, according to the investment institute’s estimates, the third straight month of withdrawals.

A big beneficiary has been bond funds, which offer regular fixed interest payments.

As investors pulled billions out of stocks, they plowed $185.31 billion into bond mutual funds in the first seven months of this year, and total bond fund investments for the year are on track to approach the record set in 2009.

Charles Biderman, chief executive of TrimTabs, a funds researcher, said it was no wonder people were putting their money in bonds given the dismal performance of equities over the past decade. The Dow Jones industrial average started the decade around 11,500 but closed on Friday at 10,213. “People have lost a lot of money over the last 10 years in the stock market, while there has been a bull market in bonds,” he said. “In the financial markets, there is one truism: flow follows performance.”

Ross Williams, 59, a community consultant from Grand Rapids, Minn., began to take profits from his stock funds when the market started to recover last year and invested the money in short-term bonds, afraid that stocks would again drop.

“We have a very volatile market, so we should be in bonds in case it goes down again,” he said. “If the market is moving up, I realized we should be taking this money and putting it into something more safe rather than leaving it at risk.”

So what is causing all this anxiety among retail investors? Economic uncertainty, lack of confidence and lack of leadership are all factors. And maybe they're realizing the game is rigged so only a few elite hedge funds and big prop traders at major banks make money while the retail crowd keeps getting suckered into the markets only to see their savings dwindle.

Moreover, as Kristina Peterson of the WSJ reports, Not Bull, Not Bear: Meet the Wolf Market:

Out of the quest to accurately describe hybrid concepts came the spork, brunch, pluot and mule. One investor's struggle to characterize the U.S. stock market's recent twists and turns led to new market terminology.

Welcome to the "wolf" market.

The wolf market is characterized by a tight trading range, increased volatility, high stock correlations and quick reversals, said its coiner, Michael Purves, chief global strategist and head of derivatives research at BGC Financial. Choppy trading makes it hard to pick stocks based on fundamental qualities, leaving shorter-term options and technical analysis better tools for navigating its bounces, he said.

"I was walking around the block one night and thought, you know, we need another animal," Mr. Purves said. "A wolf is clearly a smaller animal than a bull or a bear, but it's very quick and decisive."

Mr. Purves dates the start of the wolf market to late April although its origins reach further back, he said. In the rally from the March 2009 lows, investors priced in expectations of a faster recovery than has yet materialized. The market has struggled to find direction, balancing the drag from the late spring European sovereign-debt crisis and the recent slew of lackluster economic data with the more encouraging second-quarter earnings. That has left trading trapped in a tight range, subject to sharp ups and downs.

On the bearish side, Mr. Purves doubts the Standard & Poor's 500 index will be able to break above its April high of 1225 by the end of the year. But bulls can point to strong second-quarter earnings and demand from growing economies such as China, keeping a floor around 1010 in the S&P 500, he predicted. Meanwhile, the CBOE Market Volatility index, known as the market's fear gauge is likely to stay elevated between 25 and 35 for longer than normal. The VIX closed Friday at 25.49.

Of course, low volume during August trading has exacerbated market swings. Monday's trading volume was the lowest of the year and isn't likely to substantially increase until September.

"This is a market that's trying to feel its way and it's feeling its way during an extremely slow period in which many folks are out on vacation," said Robert Pavlik, chief market strategist at Banyan Partners. "We've obviously exited the recession, but people are still nervous about the conditions."

With stocks trading closely together as macroeconomic issues dominate the market, investors are relying more heavily on technical analysis, Mr. Purves said.

In part, the rise of algorithmic trading already has made the market's moves more closely tied to technical triggers. Also, an environment where interest rates are close to zero makes cash-flow analysis of companies difficult.

"In the absence of something else, technicals loom larger," Mr. Purves said. He also advocates turning to options to make shorter-term bets in a murky market.

The wolf market may be here to stay, at least until the economic recovery accelerates or another catalyst prompts the market to find footing. Mr. Purves believes the wolf market will last into 2011.

"It's going to take a long time to reverse to a classic economic cycle," he said.

The wolf market is also a byproduct of the Fed sponsored liquidity tsunami. With so much money flowing into the financial system, and so many hedge funds and prop desks chasing "alpha", we shouldn't be surprised to see volatile markets at this stage of the cycle.

Will the wolf market last a long time? It's possible, but my biggest fear is that the "wolves" behind these markets will end up cannibalizing each other, and society will end up paying a high price for their reckless greed.

Update: Watch 60 Minutes video below on high frequency trading.