"It seems like kicks just keep getting harder to find,
All your kicks ain't bringing you peace of mind,
Before you find out it's too late,
You'd better get straight," - The Monkees
Substitute the word "returns" for "kicks" in the classic Monkees hit and you get an updated boomer generation anthem. (Or maybe Peter, Paul and Mary singing "Where have all the returns gone? - a long time passing.") This week we look at issues involving pension funds, muse upon the size of the financial service industry (is it a bubble?) and speculate about Chinese currency manipulations. There's a lot of interesting ground to cover.
But before we get into our main topics let me recommend a few books I've had the pleasure to read while traveling over the past few weeks. While I was turned off by the title of the book " Freakonomics," I found the content fascinating. Basically, the author's probe the relationship between cause and effect. Who knew you could compare the Ku Klux Klan and real estate agents? Well-written, thought-provoking, and generally fun, it ought to be on your summer reading list.
In the same vein, I would commend to you the book by Malcolm Gladwell called "Blink," subtitled "The Power of Thinking Without Thinking." Gladwell suggests to us that we train our mind to focus on the most relevant facts in our decision-making process. Less input, as long as it is the right input, is often better and leads to better decisions. We all have the ability to analyze and come to conclusions. Gladwell helps us to learn how we do what we do, and hopefully makes us better.
He also analyzes the dark side of "blink," where our prejudices and snap decisions can create true grief for ourselves and those around us, as well as where the marketing types can manipulate us. Gladwell weaves one story after another into a spellbinding explanation of the human thought process. The story about how one military commander embarrassed the entire US military in recent war games is as instructive as it is unsettling. By the way, Gladwell is also the author of "The Tipping Point." If you have not read that book you should order both.
All three books can be read over a weekend or a long plane trip. You can get them at www.Amazon.com and get free shipping.
Pension Plan Problems
Last weekend I had the pleasure of participating in a unique economic forum. Good friend Rob Arnott of Research Affiliates hosted a small gathering (approximately 20) in Napa Valley to look at several of the fundamental economic questions of the day. The participants were a very diverse group of money managers, academics and analysts. There was well over $1 trillion (with a T) of managed assets represented in the room, as well as hundreds of academic papers and numerous books. The presentations and the debates were lively. While there was no consensus developed on the several topics discussed, I would like to offer a few of my impressions.
Keith Ambachtsheer led off with a presentation entitled "The Stealth Bubble: Is the Financial Services Industry Set for a Fall?" He wasn't seemingly too worried about the large representation of the financial services in the public equity markets, but rather about the structural issues the industry faces.
There seemed be a general consensus in the room that we are in a low return environment for both equities and bonds in the near-to-midterm future. This presents a problem for both pension funds and financial managers. While there might not have been agreement as to what the words "low return" mean, I think it was understood that the 8% annualized returns implicit in many pension fund and retirement plan projections are unlikely to be achieved.
Long-time readers know that we have looked into these problems on more than one occasion. A flat (or very low) equity return environment over the next 7-10 years would mean that public pension plans would be underfunded by somewhere close to $1 trillion. The shortfall would have to be made up by taxpayers. The underfunded element for defined benefit pension plans, while not so huge, is still significant and would have to be made up by shareholders.
Keith raised for me what is an interesting point: who is negotiating on the behalf of the next generation? We have committed our children to paying not only for our Social Security and Medicare benefits, but for government employee pension programs (at all levels) and a host of private defined benefit programs (many of which will default and become the property of the government and thus funded by taxpayers). And we expect them to do it with a shrinking population base. In 20 years, they may not be all that happy about the proposition and wonder why they should feel obligated?
While there are no easy solutions in the US, the problems are worse in Europe and Japan. It was easy for government officials, politicians and management to make promises about the future when they do not have to write the checks to deliver on those promises.
That aside, let's look at another problem a low return environment poses. It is not one that the vast majority of my readers will feel especially concerned about, but one that should strike a great deal of trepidation into the hearts of those of us who are in the industry. Right now we live off the fees generated by managing assets, in one form or another. Whether its insurance or pension plans or bank loans or mortgages or mutual funds or managed accounts or mortgage servicing or hedge funds, there are fees associated with that management and services.
The financial services industry is one of the most profitable industries as a group (on a percentage basis). As long as our investors were making 10% or more there was not a great deal of concern about fees. What happens when the return environment goes to 3-4%? 80% of mutual funds do not beat their benchmarks. How long will they be able to stay in business with such a performance? Can you sell an annuity with a 3% cost that only pays 4%?
It is one thing to underperform and still make 10%. It is quite another to underperform and make 3%. 10% will get an investor to his retirement goals. 3% means that they are working longer after their dreamed for retirement date.
This underperformance is going to cause a squeeze on profits for the financial services industry up and down the line, both as assets do not grow and clients vote with their feet. Financial services as a group has been one of the best- performing sectors and is responsible for a good deal of the last two year bull market. If there is a squeeze on profits (and I think there is the serious possibility to consider) that suggests the potential for that sector to underperform is quite real. Since the financial services industry is 20% of the US stock market that makes the potential for overall market returns even less.
Kicks Just Keep Getting Harder to Find
"It seems like kicks just keep getting harder to find,
All your kicks ain't bringing you peace of mind,
Before you find out it's too late,
You'd better get straight," - The Monkees
Substitute the word "returns" for "kicks" in the classic Monkees hit and you get an updated boomer generation anthem. And that was a theme for much of the conversations this weekend. Where can you find returns?
If you go to the S&P web site, you find the P/E ratio for core earnings for the S&P 500, which is a good proxy for corporate America, is still a quite high 21. That easily puts it in the top 20% of all the years for the past 100 years. And as I have often noted, when P/E ratios are in their top 20% range, the return for the next 10 years averages approximately 0. Now that is what I call a low return environment.
This week, we find Bill Gross suggesting that the yield on the 10 year bond is going to 3%. With all due respect to Gary Shilling, who's been suggesting that very thing for almost 20 years, when Gross, who is sitting on the largest pile of bonds in the world, finally comes around to such a view it is newsworthy. 3% long bonds is a low return environment.
Has anyone noticed the change in Fed-speak in the last few months? They are starting to make suggestions that the housing market might be, at least in certain parts of the country, a bubble. When up to a third of homes in some areas are bought for re-sell (flipping) with no interest loans, is that not a speculative bubble?
(While one can be critical of Greenspan, his latest suggestion that Fannie and Freddie be required to reduce their mortgage portfolios is spot on. This needs to be done sooner rather than later. Next time you see your congressman or senator ask them why they are subsidizing private profits with government guarantees?).
Most hedge funds are admittedly in a slump. Commodities have had a big run. Where is there real value today? Possibly in some foreign currencies, but do we want to become a nation where our pension plans are currency speculators?
Let's do a little back of the napkin calculation. Let's assume the standard 60% equities - 40% bonds pension plan portfolio. 8% total returns are what most pension plans are currently assuming. If you can get a 5% return on bonds, you have only grown your portfolio by 2%. To therefore see your pension plan grow by 8% a year you need to see a 10% return on your equity portfolio. That suggests that the Dow will be a 21,000 in seven years. It also assumes that earnings will compound at 10% with no recessions in the intervening years. Such a scenario is unlikely in the extreme.
Over the long-run earnings are likely to grow no more than (read, almost impossible) GDP plus inflation, which is typically 6-7%. Even if we assume that earnings can grow at that level, such an earnings growth level will be a disappointment to investors. Disappointed investors reward stocks with lower price-to-earnings ratios. It would be unusual for P/E ratios not to drop into the low teens in a secular bear market cycle. I say unusual, but what I really mean is without precedent. There has never been a secular bear market cycle that has not ended with low double-digit P/E ratios. Quite often they are single- digit ratios.
That means it is quite possible we could go for the next five or even 10 years without a new high on the Dow or the S&P 500. I have presented the historical studies in this space quite often. For readers unfamiliar with the concept of a secular bear market I suggest you go to the first six chapters of my book "Bull's-Eye Investing." If you are counting on an 8-10% compound return in your retirement portfolios to get you to retirement Nirvana it is especially important that you read them. "Before you find out it's too late, You'd better get straight."
(There is now a new paperback edition for only $11.53. Since I only get something like $.50 of that, it is not entirely self-serving of me to suggest you read the book. I really do think every investor needs to understand the investment environment that we face in the next 10 years. www.amazon.com/bullseye)
One of the most difficult things that I face when sitting down with most investors is to convince them that we're not going to be making 10% compound returns for the next 10 years. There will indeed be some portfolios which will do that, but they will be taking a much more aggressive posture. Retirement portfolios should not be taking such risks.
What seemed to be the consensus around the room? A low return environment coupled with a low savings environment means that most boomers are going to be working well past 65.
Of course we have to be careful what we wish for. A high savings environment by default means lower consumer spending. Lower consumer spending would almost certainly mean a recession. (More on this later.)
A Financial Services Bubble?
Is there a bubble in financial services? While there was no consensus, my take away is that the answer is roughly no. There are several reasons. First, the P/E ratios for most financial services companies are not in nosebleed territory. While they may be high, they do not look like the NASDAQ in 2000 or California real estate today. That doesn't mean that prices can't (or won't) fall during the next recession, but simply that a drop that is characteristic of bubbles doesn't seem to be in the cards.
Secondly, many of the US financial services companies are globally diversified. Many get more than half their earnings from outside the US. These earnings show up in the US equity values and are not really part of a possible US financial services bubble. Given the leadership of the US in financial services globally it should be expected that a significant portion of our market capitalization would be in financial services.
Finally there is some precedent for financial services being a significant portion of the total equity market. At some point in time, it is simply part of a natural evolution, and will change over time. Such was the condition in England in the 1840s, yet new ventures eventually reduced the percentage of the financial service industry in the overall equity markets. In the coming decade, when brand new industries are created from biotech and nanotech innovations, and these industries begin to participate in the equity markets, it is quite likely that we will see a reduction in the portion of the financial services industry in the equity markets.
So is there a bubble? I don't think so. Will there be pricing issues in the future? Highly likely. Stay tuned.
Exactly What is China Manipulating?
The dictionary definition of manipulation is: "exerting shrewd or devious influence especially for one's own advantage." One politician after another is lining up to accuse China of manipulation of their currency. Recent Bush administration reports stop just short in using the word manipulation. China is everyone's favorite whipping boy. If we can just fix our China problem by having them revalue their currency our trade deficit would go away, our manufacturing jobs would cease to go overseas and all would be right with the world.
I suppose using the word hypocrisy and politicians in the same sentence should not be too much of a stretch, but it really isn't strong enough. Let's look at exactly what the devious Chinese have done. It seems that way back in 1994, after their currency had lost 75% of its value in a very short time, they decided to fix their currency to the dollar. What a smart thing to do they were told by all and sundry. As the dollar rose in value, especially against their Asian competitors, no one in the United States was complaining.
All they have done since then is maintain their peg to the dollar, much like numerous other countries (although smaller) around the world. If they could see the current situation back in 1994, they are a lot more shrewd and cunning than even their most ardent admirers would suggest.
Do you want to see manipulation? Let's look at China's neighbors. Japan spent an unprecedented Y34 billion in 2002-3 trying to hold down the value of the yen. Now that's manipulation. Every one of China's neighbors has aggressively worked to hold down the value of their currency relative to China and the dollar to try and keep a competitive advantage. Japan? Korea? Taiwan? Thailand? Malaysia? Singapore? Why are senators not foaming at the mouth about these nations and their competitive advantages?
I am often criticized for my Muddle Through philosophy. I see neither a great boom nor a repeat of the Great Depression. Rather, a slow growth economy, punctuated by a few recessions, as the world becomes more balanced. I recognize that the imbalances are significant, but I believe the entrepreneurial ability of American business people will overcome the worst effects. It will not be pretty, but we will survive, thank you very much.
(I suppose my rather benign view might seem cavalier if you need to work an extra 5-10 years in order to save enough to retire. That might seem more than Muddle Through to you. But for the economy as a whole it will be Muddle Through. Small comfort if you are the one working, though, and I realize that.)
I've always had an asterisk or a caveat to my view. The one thing that could cause serious financial upheaval is a global move to protectionist markets and trade barriers. Nothing would be more devastating. The following note from Stephen Roach, writing this morning, sums up the situation well:
"Meanwhile, back home, the US government has unleashed a multi-pronged assault on Chinese trade. The Commerce Department has imposed "surge protection" quotas on the imports of several categories of textile products made in China. The Treasury Department has issued the functional equivalent of an official ultimatum on the currency issue -- making it crystal-clear that China is on the brink of being found guilty of manipulating the renminbi. And the US Congress is moving full speed ahead in the consideration of a more broadly based scheme of stiff tariffs on all Chinese-made products shipped to the United States. Reflecting the confluence of lingering angst in a tough US labor market and a China-centric trade deficit, the scapegoating of China has now become the favorite political sport in Washington. Never mind, the flawed macro logic behind this potentially tragic outbreak of protectionism. US politicians seem increasingly united in their efforts to blame China for America's massive foreign trade and current-account deficits.
"The real test for China comes from the potential interplay between these two sets of forces -- internal measures aimed at containing the property bubble and external measures aimed at constricting Chinese trade. This could be an exceedingly difficult set of circumstances for an unbalanced Chinese economy, whose growth dynamic is powered by two major drivers -- exports and export-led investment. Collectively, exports and fixed investment now make up about 80% of total Chinese GDP. By going after the property bubble, Beijing is attempting to squeeze the biggest piece of that -- domestic investment -- whereas Washington is taking aim on the export component. This potential double whammy is especially disturbing in that China lacks the backstop of internal private consumption; in 2004, household consumption fell to a record low of 42% of Chinese GDP -- the smallest consumption share of any major economy in the world. (Note: While investment, exports, and private consumption collectively account for more than 100% of Chinese GDP, a negative offset of some 34% of GDP comes from imports, while another 12% shows up in the form of government consumption).
"This could well be modern-day China's toughest macro challenge. Time and again -- but especially over the past eight years -- the Chinese economy has had to cope with very tough external and internal circumstances. The Asian financial crisis of 1997-98, the synchronous global recession of 2001, and the SARS outbreak of early 2003 were all formidable threats that most in the West thought would derail the Chinese economy. Yet China barely skipped a beat on all of those occasions. This time the challenge is very different and potentially much more significant -- ironically, coming just when the world has become convinced that the Chinese growth miracle is here to stay. If Beijing gives on the currency front after having just taken actions to pop the property bubble, the risk of a major shortfall of Chinese economic must be taken seriously.
"But the real problem is political: China and the United States are on very different pages when it comes to assessing the reactions to these tough macro circumstances. The Chinese leadership is filled with indignation over Washington's protectionist leanings. But it seems unwilling or unable to recognize the political aspect of this threat. Instead, senior Chinese officials are very focused on the macro origins of America's external imbalances as being deeply rooted in an unprecedented shortfall of domestic US saving -- a case that I have made repeatedly in my own presentations in Beijing and around the world over the past several years. What Beijing seems to be missing is that Washington politicians could care less about macro -- they are focused are pinning the blame on someone else. Today, that someone else, unfortunately, is China.
"What worries me most is that both nations -- China and the US -- are painting themselves into political corners from which there are no easy exits. Chinese officials speak repeatedly of the currency issue as a matter of "national sovereignty" -- stressing that any external pressure to change will be counter- productive for a nation that places great emphasis on its newfound pride. At the same time, Washington seems increasingly convinced that the US body politic is finally prepared to say, "enough is enough" on the trade deficit."
We need a slow and steady policy. Pushing china to take steps which endanger her economy is not prudent. The world does not need a China going into recession. It will have serious negative repercussions in the US. What Sen. Charles "Smoot- Hawley" Schumer and company propose will send us into a deep recession, at best.
There is an odd balance in the current world situation. Asia, and especially China, save a great portion of their income. They also export massive amounts to the US. Their exports are financed by their savings. For our part, the US has been willing to go into debt in order to be able to buy their goods.
Paul McCulley, with his dry humor, pointedly suggests that the role of the US in the current world order is to be a hedonist. While this offends many with a Calvinist heritage, it appears that we are quite good at being hedonists. It seems to be one of our unique giftings. We have assumed our role with relish. We run massive government deficits, borrow against our home values and increase our personal debt levels to all-time highs. To make sure that we fulfill our role as hedonists to the world we spend more than we make.
Do you want to solve the trade deficit, Senator Schumer? All you have to do is balance the US budget and provide incentives for increased personal savings. Of course it will mean a serious recession, but it will solve the trade deficit. Of course, it is easier to demonize China than to tell US citizens we need to raise taxes or drastically cut spending, and by the way, you should spend less and save more.
Let's be clear. Getting to global balance is going to take more than just China allowing its currency to float. It is going to require the US to take action. That action can either be taken pro-actively or it can be forced upon us, but it will happen. Since Congress (both craven sides) does not have the stomach for dealing with the problem, it will come the old fashioned way, by market forces.
Sadly, it will require at least one recession and possibly two. This will of course make it more difficult to balance the US government budget. But it will slow consumer spending. Those recessions are baked in the cake. They are going to happen. But they do not have to be 70's style deep recessions. Unless, of course, Congress becomes protectionist as a way to blame our problems, which we have created ourselves, on those devious manipulative foreigners. And it goes without saying that the rest of the world needs to keep focused on the longer term picture as well.
Hopefully, cool heads will prevail and protectionism will be kept to slogans and political rhetoric. But we are getting ever closer to the End Game. We could see the current "Bretton Woods 2" start to unravel in the next few years. The pressures for protectionism will be the greatest when they would be the most harmful.
And the mechanisms of global rebalancing is just another reason why we are in a low return environment. Stay tuned.
Chicago, Mavericks and Napa Valley Restaurants
Rob made sure that we did our part for American hedonism last weekend. He hosted two meals. One was at The French Laundry, which many consider to be the finest restaurant in the US and one of the top ten in the world. Rob took the whole restaurant for the night. We sat through 12 courses and ten wines. It was pure decadence and something my daughter Tiffani and I will always remember. Thanks, Rob.
While it is terribly difficult to get a reservation for The French Laundry, Rob took us the first night to a newer establishment called Stomp in Calistoga. I think we had a mere seven course and six wines. For my money (even though it was Rob's) I thought the dinner at Stomp was outstanding and the wine pairings were better than The French Laundry. If you are in the area, give owner Robert Simon a call and tell him I sent you. Your taste buds, if not your waist line, will thank you.
I will be in Chicago June 7-8 and La Jolla June 15-18. Tonight I take some of the girls (and their boyfriends) to the Dallas Mavericks play-off with the Phoenix Suns. Hopefully the real Dirk Nowitski, who has been AWOL for much of the play-offs, will show up as well.
Ah, the optimism of youth. I mentioned to my daughter that I was thinking about an early October trip to Europe. "But, Dad, you will miss the Texas Ranger play- offs." Sadly, I told her, unless we find some new pitching we will be watching the play-offs on TV and not from the office. I think I will go ahead and schedule the trip. Although I might wait until the All-Star Break. Just in case. You never know. It could happen.
Your hoping to see a Mavs championship series analyst,