Returns After Inflation

“So how has your stock portfolio done the past ten years?”

” Well, not good but after the run-up this year, not bad. I think I’m about even.”

The Dow Jones index is about the same as it was 10 years ago, a fact that might mislead some investors into thinking that they have broken even during the past decade. They would be wrong. Adjusting for inflation, the Dow is down about 25% over the past ten years. Think that’s bad? Fly across the pond to Europe and look again at the U.S. market. In Euros, the Dow has lost 25% in nominal terms since 1999 without accounting for inflation. If we adjust for inflation … well, we better not. It’s too depressing.

Returns on any investment have to account for inflation, which averages about 3% over the past several decades.

Easy Money

A Future of Finance article in a December 2009 Financial Times quoted a partner at a leading London law firm: “There are huge piles of toxic debt on these [bank] balance sheets but much of it isn’t being recognized. Loans are being rolled over. There is a saying in banking circles now that ‘a rolling loan gathers no loss'” The same article also quoted Raymond Baer, chairman of Swiss private bank Julius Baer, who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”

In a WSJ op-ed 10/16/09, Ann Lee, a former investment banker and hedge fund partner, writes that banks are hoping that by rolling over the loans at negotiated terms borrowers will eventually be able to make payments. She predicts that this cycle of rolling debt, reminiscent of what happened in Japan during the 1990s, could continue for a decade. With so much unrecognized bad debt, banks have little incentive to increase their lending. Instead, they borrow from the Federal Reserve at near zero interest rates and use the money to buy Treasury bonds, pocketing the difference in interest rates as profit. Since Treasury bonds are taxpayer IOUs, taxpayers are effectively subsidizing the profits of Wall Street banks. Ben Bernanke, head of the Federal Reserve and chief architect of this subsidy scheme, was recently reappointed by President Obama.

In late November, Standard & Poors released their analysis ranking of 45 leading banks in the world, using a new risk adjusted capital ratio (RAC), which will probably be adopted in 2010. This ratio gauges a bank’s leverage of assets to equity with greater attention paid to the risks of those assets than the current Tier 1 capital ratio does. According to this more rigorous metric, banks like Japan’s Mizuho and Sumitomo Mitsui, Citigroup, and Switzerland’s UBS have a particularly weak capital base. Just nine of the 45 banks rated by S&P had an adequate risk adjusted capital.

Big Government

In the past 50 years, which administrations have shown the most restraint in federal spending? The answer surprised me. As this Heritage Foundation chart shows, they were all Democrats: Johnson, Carter and Clinton. Who were the big spenders? Bush and Reagan top the charts, besting even Johnson. Despite rhetoric about small government, Republican administrations have shown that they are the party of Big Government.

The Heritage Foundation, a conservative think tank, has culled data from a number of sources and presents them in colorful charts that make the data easier to understand. Here is a summary of various charts on federal spending.

David Walker, the former head of the General Accounting Office (GAO) under the Clinton and Bush Administrations, now heads a nonpartisan group that put together a documentary movie, “I.O.U.S.A”, that was released in 2008. You can view a 30 minute shorter version of the movie at You Tube.

Capitalism Vote

In November, the BBC released a survey of almost 30,000 people around the world about their views of capitalism. Twenty years after the fall of the Berlin Wall and the much vaunted “victory” of capitalism, those responding to the survey had mixed reviews of free market capitalism. That might not surprise many in the U.S., but what does surprise is that only 25% of respondents in the U.S. thought that capitalism was working well.

Over half of those surveyed thought that regulation and reform could help solve capitalism’s problems. Two thirds of respondents wanted governments to take a greater role in redistributing wealth.

Disposable Personal Income

Disposable personal income is a benchmark that is used to assess aspects of our financial condition, like debt and wealth. What is it? It is gross income, including any transfer payments like Social Security that we receive, less taxes.

Discretionary income is what we have left of disposable income after paying our rent or mortgage, utilities, food and clothing – the essentials. Discretionary implies that we have some choice about whether to spend the money or not. What is discretionary to one person may seem like a necessity to another person. For those of us who are having some financial difficulties, it can be both fruitful and painful to reassess our guidelines for what is a necessity. A cell phone, once regarded as a luxury item, is now considered by many to be a utility like electricity. Is the monthly $100 voice/data plan we are on a necessity or could we get by with a $30 monthly voice plan instead? As I said, these reassessments can be painful.

Some regard a new car every three years a necessity while others view it as a luxury. In any assessment of our personal expenses, it is frightingly easy to lie to ourselves, to convince ourselves that something really is an absolute necessity and to line up several reasons why a particular item is a necessity.

Of the two income benchmarks, disposable personal income (DPI) is easier to measure and to gauge our debt. Household debt, which includes both consumer and residential mortgage debt, was about 80% of disposable personal income during the 1980s and 1990s. Household debt is now 122% of DPI, down from 129%. Americans are saving more but they have quite a ways to go to decrease their debt levels.

Credit Guard has a good guide to personal budgeting.

Health Care Conundrum

In an op-ed in WSJ 10/17/09, Vernon Smith, a Nobel Laureate in economics, explained the problem with health insurance in simple terms that any layperson can understand. Health care provider A recommends to patient B the services that B should buy from A. C, either the government or an insurance company, pays A. “This structure defines an incentive nightmare,” Mr. Smith writes and presents a seemingly unsolvable problem.

The Senate recently passed its version of health care reform. House and Senate committees will meet in January to start reconciling differences in House and Senate versions. During the health care debate this year, and for the past century – Theodore Roosevelt tried to institute a public health care system – the focus has been on solutions to a number of problems: the number of uninsured, ballooning costs, the alarming number of bankruptcies because of medical bills, insured patients who are cut off because their benefits exceeded a lifetime maximum, those people denied affordable coverage because of pre-existing conditions.

Various players in the medical care provider market have voiced objections to proposed solutions when the impact of a solution would be negative on them. Perhaps we should all admit that we will never fix this intractable problem. Like many cancer therapies, the “solution” may be to manage the problem, not solve it. Only when all parties give up the notion of finding a solution will we be able to sit down at the table and come up with a framework for managing this problem.

This idea was first conceived by James Madison, the chief architect of the U.S. Constitution. Unable to resolve the decade old dispute between advocates for a strong federal government and those who championed individual and states’ rights, Madison had the genius to incorporate the struggle between these two ideologies directly into the Constitution, thereby providing a structured debating platform for this continuing argument and struggle for power.

Buffalo Stampede

From the stock market low in March through the end of September, retail investors, who own half of the U.S. equity market, had put only $2.5B into mutual funds and exchange traded funds for equities, largely missing out on the market’s 60% rise. Investors had pumped $254B into bonds during that time, a ratio of 100-1 of bond to equity investment.

Forget about the bulls and bears. Markets, both up and down, behave more like buffaloes.

Home Equity Loans

Since the credit crisis in September 2008, home equity loans have declined – little surprise there. The steepness of the decline, however, is a bit astonishing. In a Dec. 25th article, AP details the 87% drop in loans in 2009 compared with loans in 2006, when the housing market was booming.

A lot of kitchens and baths are not getting remodeled, garages are not being built, college educations are not being funded. The reduction in remodeling projects has dealt a blow to the construction industry but the sharp reduction in home equity lending has a wider impact on many varieties of small businesses. Home Equity loans provide the start up funds for new businesses and can provide a more cost effective way for small businesses to build seasonal inventories. In a July article, CNN looked at this aspect of the credit crunch.

Small businesses, not the mega corporations or the financial bank giants, create the majority of new jobs in this country. Unemployed people sap the resources of local, state and federal government. Employed people contribute to those resources with payroll and income taxes, as well as sales taxes. It would be good public policy to implement an incentive program to encourage private banks to loan to small businesses.

Consumer Confidence

The Conference Board recently released its November Consumer Confidence Survey. The index stood at 49.5, little changed from October. In 2000, the index was about 140. It declined to 60 in 2003, rose to over 100 in 2007 and plunged to under 30 in 2008. A component of the index, the Present Situation index, is at a low level last seen in 1983.

Business Outlook Survey

Each month for the past forty years, the Federal Reserve conducts a survey of businesses, attempting to ascertain both current conditions and future anticipations of orders, costs, inventory levels, and employment. December’s survey shows continued improvement in current activity but there is a disturbing decrease of confidence in the future in those businesses surveyed.

In 2010, the businesses surveyed are expecting their costs to increase about 8% in two areas: energy and health care for employees. They project only moderate increases of about 2% in other costs. Only 12% anticipate lowering prices, while 12% project higher prices.
Welcome to the “New Normal”.