Dynamic Portfolio Allocation

March 27, 2016

Happy Easter!

Before I take a look at a dynamic allocation model for older readers, I’ll quote from a paper published in the last decade: “adequate savings is the primary driver of retirement success and is approximately 5 times more important than Asset Allocation.”  For readers who are not near retirement, what is called the accumulation phase of life, the one word that sums up a lot of financial advice is “Save.”

A reader sent me an article that recounts several common sense strategies for investors nearing or in retirement.  I was especially interested in a strategy for recent retirees: to have a cautious 30/70 stock/bond allocation in the first years of retirement and transition to a more agressive 60/40 portfolio over 10 – 15 years. Is this madness?  Conventional advice advocates more caution in the later years of life.

The initial conservative approach is designed to minimize the negative effects that a bear market would have on a portfolio in the first years of retirement.  At seven years old, the current bull market is long in the tooth, so to speak. One of the authors of the article is Wade Pfau, whose Retirement Researcher site I include in my blog links in the right column of this blog.  I have a lot of respect for Mr. Pfau’s work and his sensibilities so I was inclined to trust this recommendation.

In order to forecast, one has to backtest, and the authors have more sophisticated portfolio allocation testers than many of us have.  I have recommended before a free allocation tester at Portfolio Visualizer.  Their web site also has a free Monte Carlo simulation tool (MC).  What the heck is that, you ask?

For Dr. Who fans, an MC is like a time trip in the doctor’s Tartus.  First we set the thing jab on the whozee panel, spin the furbee wheel clockwise to go forward in time, then stand one pace to the left – do not stand on the right! – of the big lever as we pull the lever knob.

For those of you without a Tartus, an MC uses historical returns and creates a number of what-if possibilities based on variable parameters like the period of time to run the simulation, the inflation rate, the withdrawal amount or rate, the asset mix, etc.  If I start out with $1M in savings at age 65, for example, and I take out $40,000 each year adjusted for inflation, what are the chances I will have any money left after thirty years, at age 95?  Will the Daleks catch up with my savings and exterminate it?  No, not the Daleks!

The remaining balance, the money a person would have left, is ordered by percentile: 25%, 50%, the median, and 75% are common. Example:  A remaining balance of $500K for a certain allocation at the 75% percentile means that 75% of retirees will have less than that amount.

A success rate is computed; a 75% success rate means that you don’t run out of money in 75% of the simulations.  What about the other 25% of the time?  Care to roll the dice on that one? A 90% success rate is considered a desireable minimum in the industry.  I tend to focus on both the success rate and the median balance.

If using historical asset prices as a basis for computing future possibilities, an important assumption is the time period.  If the past forty years have included some really good returns for a few decades, then the MC results will be optimistic.  What if the next twenty years are not so good?  Move in with your kids?

Using the historical data of the past 20 years or 40 years as a basis for future returns is a bit optimistic, I think.  During this past twenty years, bond prices have been inflated by extraordinarily low interest rates set by the Federal Reserve.  The price of a composite of intermediate corporate bonds, Vanguard’s VFICX mutual fund, has almost quadrupled since 1995.  A 60/40 stock/bond mix has returned 9.5% over the past 20 years.  We are unlikely to see such returns in the future.  My gut instinct is to err on the side of caution and assume a 7.5% return on a 60/40 mix, and a 6% return on a 30/70 mix.

Here’s the assumptions:  $1M initial portfolio; 30 year future period; withdraw an initial $45K adjusted annually using a 3% inflation rate.

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Stock/Bond % Success Rate Median Bal
30/70 57 $278K
60/40 73 $1.6M
30/70 –> 60/40 92 $1.7M

Using a 30/70 mix for the first 5 years and a 60/40 mix for the following 25 years gives a median balance of $1.7M after 30 years, about the same as the 60/40 mix above BUT the success rate shoots up to 92%.   The authors suggest a gradual transition but this simple simulation shows the advantage of a dynamic allocation strategy.

In short, this does look like a good strategy.

Readers who want to use the more optimistic historical returns of the past 20 years would see these simulation results:

Stock/Bond % Success Rate Median Bal
30/70 92 $2.7M 10 times higher!
60/40 88 $4.3M
30/70 –> 60/40 92 $4.3M

Using historical returns for the past 20 years sure pumps up the median balance on the conservative allocation.


Existing Homes

Existing Home sales fell 7% in February.  Mortgage rates are at all time lows.  What’s going on?
Below is a chart of the ratio of Existing Home Sales to New Single Family Homes.  As you can see, the ratio has remained fairly steady over the past several years.  The spike in the ratio in early to mid 2013 coincided with historically low mortgage rates (Money) .   In the last quarter of 2015, this ratio started sinking despite the stimulus of low interest rates.  Are home buyers at all levels being priced out of the market?


The Immigration Carousel

The 1900 census counted a total population of 78 million, of which 13% were foreign born. Responding to a growing hostility toward immigrants, Congress passed strict quota laws for immigrants in 1921 and 1924. Regarded as lazy, shiftless, boorish, stupid, or criminal, southern Europeans were among the undesireable groups.  During the 1920s, the foreign born population began to decline and, beginning with the 1950 census, stayed below 8% for 40 years.

The 2000 census counted 11% of the population as foreign born. The 2010 census counted 13% foreign born, so that our population mix now matches that of the early 20th century.

It is hardly surprising then to see a growing antipathy towards immigrants in the past decade.  Donald Trump’s candidacy is partly fed by the same anti-immigrant sentiment prevalent in the America of one hundred years ago.  We like to think we have put some crude and cruel instincts behind us, but we are again confronted with our “herdness.”  We will tolerate “others” as long as their percentage of the herd remains relatively small. In America, that tolerance limit seems to be 10% foreign born. How does America compare to other countries?

The Donald and the Washington Post

March 22, 2016

The editorial board and several other employees at the Washington Post recently sat down with Donald Trump.  Here is a transcript of the conversation .

Here are some highlights.   Donald rambles a lot but I think I got the kernel of his responses.  I think my edited version does Donald more justice than the sometimes incoherent responses he actually gave. He really is not ready for prime time. At this point in the campaign his responses to questions about foreign policy, international trade, and other issues mentioned on the campaign trail should be more practiced, not the rambling sentiments that any of us might have in a conversation with a co-worker at a lunch break.

WP = Editorial staff at Washington Post, DT = Donald Trump.  I’ve included some context where I thought it might be needed.

WP: “is there a secretary of state and a secretary of defense in the modern era who you think have done a good job?”

DT: “I think George Shultz [Reagan’s Sec’y State] was very good, I thought he was excellent.”  “I think your last secretary of state [Hillary Clinton] and your current secretary of state [John Kerry] have not done much.”  Trump uses the word “your” to indicate that media institutions are partisan and biased, and including the WP in the liberal media. It indicates that Trump’s essential sense of the world is polarized, a game of warball.  That may be the case in Washington but it mutes Trump’s appeal among independent voters who have less polarized outlooks. Trump offered an example of Kerry’s bad negotiating tactics with Iran: “We should have had our prisoners before the negotiations started.”

In response to a question about promoting values like democracy and freedom around the world,
DT: “I don’t think we should be nation building anymore,” indicating that he is not a neo-con. “We’re sitting probably on a bubble and, you know, it’s a bubble that if it breaks is going to be very nasty. And I just think we have to rebuild our country.”   Trump is not the only person who thinks that extremely low interest rates for seven years have over inflated stock, bond and housing values.  Trump immediately changes the subject and endorses infrastructure spending, aligning himself with economists Paul Krugman, Robert Frank, and others who recommend large Federal stimulus programs to repair infrastructure and employ those with low to modest educational backgrounds.  Trump recalls that we built schools in Iraq, and rebuilt them several times when they got bombed “and yet we can’t build a school in Brooklyn. We have no money for education, because we can’t build in our own country. And at what point do you say hey, we have to take care of ourselves. “

WP: “So what would you do for Baltimore [as an example of a city with troubled inner neighborhoods]”

DT: “I’d create economic zones. I’d create incentives for companies to move in. I’d work on spirit because the spirit is so low… unemployment for black youth in this country, African American youth, is 58-59 percent.”  These are called enterprise zones and have been used with mixed success in the U.S. but particularly in Britain.  See this article

WP: “in general, do you believe there are disparities in law enforcement?”

DT: “I’ve read where there are and I’ve read where there aren’t…I have no opinion on that.  We have to create incentives for people to go back and to reinvigorate the areas and to put people to work…we have lost million and millions of jobs to China and other countries.”   When Trump doesn’t like the topic, law enforcement, he switches subjects to an old refrain, jobs lost to China, and now Mexico. “Mexico is really becoming the new China.”

WP, returning to the topic:  “There is disproportionate incarceration of African Americans vs. whites. Is that something that concerns you?”

DT: “It would concern me. But at the same time it can be solved to a large extent with jobs.”  Some economists and social scientists have championed this idea that people in poor neighborhoods will choose  legal employment if presented with better job prospects.  Over time, residents in the area will become more committed to the neighborhood, to the protection of their property, to law and order.

WP: “Baltimore received a lot of federal aid over the years. What’s different specifically about your approach to these issues from what’s been tried in the past, because a lot of effort has been put in just the direction you just described.”

DT: “I think what’s different is we have a very divided country.”  He goes on about how divided the country is, as if we didn’t already know that.  How does that answer the question about Baltimore? “I thought that President Obama would be a great cheerleader for the country. And it just hasn’t happened. You have to start by giving them hope and giving them spirit and that has not taken place. I actually think I’d be a great cheerleader for the country.”

WP: “What presidential powers and executive actions would you take to open up the libel laws?”

DT: “I’ve had stories written about me … that are so false, that are written with such hatred.  I think libel laws almost don’t exist in this country.  I think that [the media] can do a retraction if they’re wrong. They should at least try to get it right. And if they don’t do a retraction, they should, they should you know have a form of a trial. I don’t want to impede free press, by the way.”

WP: “So in a better world would you be able to sue [the Post]?”

DT: “In a better world I would be able to get a retraction or a correction. Not even a retraction, a correction.”

WP: “Would you require less than [actual] malice for news organizations?”  “Actual malice” is a legal standard, a criteria for liability for libel set up the Supreme Court in 1964.  See below.

DT: “I would make it so that when someone writes incorrectly, yeah, I think I would get a little bit away from malice without having to get too totally away.”  What does that mean?

WP: “How are you defining ‘incorrect?’ It seems like you’re defining it as fairness or your view of fairness rather than accuracy.”

DT: “Fairness is… part of the word. I’ve had stories that are written that are absolutely incorrect. I’ll tell you now and the word ‘intent’, as you know, is an important word, as you know, in libel.”  Trump then gives an example of a news account of a protester at a Trump rally.  The video tape is edited to make Trump supporters look guilty of unprovoked violence.  Trump says these are professional protesters with trained voices that can be heard throughout a large hall in order to disrupt Trump’s speech or a question from the crowd.  Trump says that news media accounts do not potray these incidents accurately.

Through several questions various people from the Post try to get Trump to acknowledge that Trump condones violence.  Trump insists that he supports law and order, not violence.  Trump’s campaign manager notes that there are repeated public service messages before every rally that the audience should not confront protestors and to let security personnel do that.  Trump repeats that some protesters, when interviewed, say they don’t know why they are there, implying that the protesters are paid agitators by those who want to make Trump rallies look violent.  Some protesters simply interrupt his speeches with shouted obscenities.  Out of 20,000 attending a rally, Trump claims that there are just a few protesters and that they are strategically placed at the rally venue.

WP:  “given the Supreme Court rulings on libel — Sullivan v. New York Times — how would you change the law?”  New York Times v. Sullivan is a 1964 decision by the Supreme Court that there must be a malice standard applied before reporting about a public official can be considered libel.  “Actual malice” is a legal concept that the media outlet knew the information was incorrect or should have known, i.e. that they exercised little or no effort to find the correct information.  After this decision, a person claiming libel in the U.S. must prove the untruth of something published.  This departed from centuries of common law precedent.  In Britain, for example, the defendant of a libel claim must prove the truth of the information they published.

DT: “I’d have to get my lawyers in to tell you, but I would loosen them up.”  Although Trump is not specific on this, I’m guessing that he would like some balance between the strict U.S. system and the Briitish system.  U.S. precedent was based on a problem that existed in the southern states during the early 20th century.

WP: “Would that be the standard then? If there is an article that you feel has hatred, or is bad, would that be the basis for libel?”

DT: “The Washington Post never calls me. I never had a call, ‘Why – why did you do this?’ or ‘Why did you do that?’ It’s just, you know, like I’m this horrible human being. And I’m not.”  If a news organization makes no effort to validate information, is that cause for libel?  “I want to make it more fair from the side where I am, because things are said that are libelous, things are said about me that are so egregious and so wrong, and right now according to the libel laws I can do almost nothing about it because I’m a well-known person.”

WP: “can you talk a little bit about what you see as the future of NATO? Should it expand in any way?”

DT: “Ukraine is a country that affects us far less than it affects other countries in NATO, and yet we are doing all of the lifting, [European members of NATO are] not doing anything.”

WP: “Could I ask you about ISIS, speaking of making commitments, because you talked recently about possibly sending 20 or 30,000 troops”

DT: “I said the generals, the military is saying you would need 20- to 30,000 troops, but I didn’t say that I would send them. I would put tremendous pressure on other countries that are over there to use their troops and I’d give them tremendous air … support because we have to get rid of ISIS. I would get other countries to become very much involved.”

WP: “What about China and the South China Sea?”

DT: “We have trade power over China. I don’t think we are going to start World War III over what they did, it affects other countries certainly a lot more than it affects us. I always say we have to be unpredictable. We’re totally predictable.  And predictable is bad. Sitting at a meeting like this and explaining my views and if I do become president, I have these views that are down for the other side to look at, you know. I hate being so open.”

WP:  Asks about Iraq and ISIS

DT: “We then got out [of Iraq] badly, then after we got out, I said, “Keep the oil. If we don’t keep it Iran’s going to get it.” And it turns out Iran and ISIS basically—”  Trump is interrupted but I wonder if he was going to say that Iran and ISIS were conspiring to get Iraq’s oil?  Iran and ISIS are blood enemies.  Iran embodies the Shia sect of Islam, ISIS is Sunni.

WP: “How do you keep it without troops, how do you defend the oil?”

DT: “I would defend the areas with the oil [with U.S. troops].”  Asserting that Iran is out for Iraq’s oil, Trump says, “Iran is taking over Iraq as sure as you’re sitting there. And I’ve been very good on this stuff. My prognostications, my predictions have become, have been very accurate, if you look.”

WP:  Asks Trump about his claim that he could use trade as a diplomatic cudgel against China’s territorial ambitions in the South China sea.  These disputes involve Vietnam, the Phillipines, and Malaysia.

DT: “You start making it tougher [for Chinese exporters]. They’re selling their products to us for… you know, with no tax, no nothing. If you’re a manufacturer, you want to go into China? It’s very hard to get your product in, and if you get it in you have to pay a very big tax.” “I don’t like to tell you what I’d do, because I don’t want to…”

WP: “This theory of unpredictability …there are many people who think that North Korea invaded South Korea precisely because [Secretary of State Dean] Acheson wasn’t clear that we would defend South Korea. So I’m curious, does ambiguity sometimes have dangers?”  Acheson served under Truman from 1949 to 1953.  In 1950, the N. Korean People’s Army crossed the 38th parallel to invade South Korea.

DT: “President Obama, when he left Iraq, gave a specific date – we’re going to be out. I thought that was a terrible thing to do. [The enemy] pulled back, and after we left, all hell broke out, right?”

WP: “What you’re saying [about European NATO members] is very similar to what President Obama said to Jeffrey Goldberg (Atlantic article) in that we have allies that become free riders. Do you have a percent of GDP that they should be spending on defense? Because it’s not that you want to pull the U.S. out [of NATO].”

DT:  “No, I don’t want to pull it out. NATO is costing us a fortune and yes, we’re protecting Europe but we’re spending a lot of money.”  Again, nothing specific in answer to the question.

WP:  “does the United States gain anything by having bases [in Japan and S. Korea]?”  The Post cites an unnamed public source that the U.S. pays 50% of non-personnel costs to maintain the bases.

DT: “I think we were a very powerful, very wealthy country. And we’re a poor country now. We’re a debtor nation.  We’re spending that [money] to protect other countries. We’re not spending it on ourselves. We have armor-plated vehicles that are obsolete. The best ones are given to the enemy.”  Donald relates that the son of one of his friends has served three tours in Iraq and Afghanistan.  “He said the enemy has our equipment – the new version — and we have all the old version, and the enemy has our equipment.  “We send 2,300 Humvees over, all armor-plated. we have wounded warriors, with no legs, with no arms, because they were driving in stuff without the armor. And the enemy has most of the new ones we sent over that they captured. And he said, it’s so discouraging when they see that the enemy has better equipment than we have – and it’s our equipment.”

There was more, including someone at the Post asking about the size of Donald’s hands.

Free Trade

March 20, 2016

This week’s blog will be about free trade.  Donald Trump first made it one of two signature Presidential campaign issues, then Bernie Sanders joined the chorus and now Hillary Clinton has made it part of her campaign speech. Have trade agreements with other countries put Americans at a disadvantage?

Most economists will not even entertain the idea.  The benefits of free trade are ultimately based on the benefits of specialization, the idea that everyone benefits when the most efficient producers supply a good or service.  Each producer achieves a comparative advantage (CA) in that specialization.   First formalized by economist David Ricardo in the 19th century, CA has long been a bedrock of micro-economic theory and introductory economics textbooks.

Greg Mankiw’s Prinicples of Economics cites the example of a rancher and farmer, who both benefit when they specialize.  The rancher concentrates on raising beef, the farmer raises potatoes and they produce more beef and potatoes at a lower cost than if the rancher and farmer did both. (Chapter 3)

A key concept to understanding CA is another bedrock economic principle:  opportunity cost, or what someone has to give up (the cost) to get some good or service (opportunity).  Each person, each country wants to minimize the cost to take advantage of the opportunity.

The same principle can be extended to international trade.  If a Mexican company can produce a good at a more efficient cost than an American company, then Americans will benefit if they buy the good from Mexico and sell something to Mexico which an American company can produce at a cheaper cost.  The ill effects in a particular part of the country are balanced by the good effects in another part of the country or economy, and lower prices benefit all Americans.

When countries impose tariffs on imports, those goods become more expensive for consumers. Economists talk about the “deadweight loss” from tariffs. Here is a graph of the negative effects of tariffs and more discussion on the topic.

The matter would seem settled then, as economist Paul Krugman noted in a 1987 paper : “the underlying commonality among conventional trade models is such that until a few years ago international trade theory was one of the most unified fields in economics.”

As early as the 1960s, economists questioned some aspects of conventional trade models, leading to the development of new models. Krugman notes, “The new view of international trade holds that trade is to an important degree driven by economies of scale rather than comparative advantage, and that international markets are typically imperfectly competitive.” [my emphasis]

Economies of scale. What’s that? This idea, also called increasing return, is when a producer gets a greater growth in outputs than the growth in inputs.  Increasing returns become a force separate from comparative advantage that leads to a “geographical concentration of production of each good,” or regional oligopolies.  We see this phenomenon in southeast Asia, Indonesia and Australia, where a complex web of materials and components production dominates the global electronics market.

“The view that free trade is the best of all possible policies is part of the general case for laissez-faire in a market economy, and rests on the proposition that markets are efficient. If increasing returns and imperfect competition are necessary parts of the explanation of international trade, however, we are living in a second-best world where government intervention can in principle improve on market outcomes.” [my emphasis]  The new idea in trade models is that strategic trade policy by a government “can tilt the terms of oligopolistic competition to shift excess returns from foreign to domestic firms.”  On the campaign stump, Trump makes the same case, although a bit less elegantly; that the U.S. government should make trade deals that shift the benefits of trade back to American workers and producers.  Is Trump channeling Paul Krugman?

Not quite.  Krugman notes three sometimes vociferous criticisms of government intervention. 1) The difficulty in measuring, understanding and modeling imperfect markets makes it impossible to formulate just the right policy.  2) If the government is going to intervene, companies will devote some resources to compete for favors from government, a process called “rent-seeking.” 3) Markets will make adjustments to offset intervention.  Other governments will initiate policies to counter the effects of a government’s intervention.

Krugman concludes “This is not the old argument that free trade is optimal because markets are efficient. Instead, it is a sadder but wiser argument for free trade as a rule of thumb in a world whose politics are as imperfect as its markets.”  This is the argument that Adam Smith made for laissez-faire capitalism, finding it undesireable but better than the alternatives.  Smith spent considerable effort in his book The Wealth of Nations to recount the degree of political corruption that distorted economies and society, that poisoned the human character.

That Krugman disregards those cautions when he favors government intervention within domestic markets confirms the fact that economists are human.

Economist Ian Fletcher presents far more arguments against free trade than Krugman. I would add an additional consideration.  When economists compute the costs of free trade policies, they use a model which does not include the economic benefits provided to workers displaced by free trade policies.  The costs are presumed to be offset by higher taxes from those areas of the country which benefit from free trade.  Admittably, these costs and additional tax revenues attributable to free trade policies are difficult to measure.  However, I do think that the effort should be made.  I suspect that the benefits paid to dislocated workers and the total negative effect, the multiplier, of the lost economic activity have not been fully accounted for and that free trade is much more costly than conventional models portray.

Even if we can measure and agree on the facts, we can not agree on what those facts mean.  Whatever the facts, we prefer our familiar and favorite idea.  They not only reassure us but are also well integrated into our values, and our philosophical sense of life.

Building Or Not

March 13, 2016

There are some upcoming changes to claiming rules for Social Security (SS) that take effect at the end of April.  A few weeks ago, Vanguard posted an article explaining some of the changes.

1) The end of “file and suspend,” the strategy where one half of a married couple, “John” we’ll call him, files for SS, then requests that those benefits be suspended.  The spouse, “Mary”, claims a spousal benefit while John’s benefits continue to grow at 8% per year until John is 70 years old.

2) The end of the “restricted application” strategy that allowed a person between the ages of 62 and 70 to collect benefits based on either their work history or their spouse’s history.  This allowed married couples to suspend taking benefits so that they could grow as under the file and suspend strategy.


You Didn’t Build That
In a 2012 campaign speech, President Obama infamously said, “If you’ve got a business — you didn’t build that. Somebody else made that happen.”

With the aid of teleprompters (only $2700) Mr. Obama  is a stirring orator, unlike his predecessor, Mr. Bush, who struggled with pronunciation, cadence and tone.  In contrast to his sweeping rhetoric, impromptu remarks by Mr. Obama are notoriously equivocal or inartful.  This remark was one of those.  Later on in the speech, Obama clarified his sentiments, “we succeed because of our individual initiative, but also because we do things together.”

In the 2012 election, Republican nominee Mitt Romney used Obama’s own words against him many times.  Many small business start-ups fail and when they do, the bank does not say, “you don’t need to pay your business loan back.  Somebody else made that failure happen.”  In Obama’s philosophy, failure is our personal responsibility but success is not?  It doesn’t play well in the small business community.

In response to February’s job report released last week, Mr. Obama is quite willing to take credit for the jobs created in the past seven years: “the plans that we have put in place to grow the economy have worked.” (Video and transcript) Mr. Obama doesn’t specify what plans.  The President and Congress, Democratic and Republican, have failed to enact fiscal policies that will help American businesses grow.  These leaders, these lifeguards of the economy, can not swim.  The Federal Reserve has had to implement extraordinary monetary policy to keep Americans from drowning.  0% interest rates for SEVEN years and $4 trillion of asset purchases by the Fed have reinflated the stock market and housing prices, the life raft of wealth for most Americans.

A fundamental theme of many elections is “It’s the economy, stupid,” a core mantra of the 1992 Clinton campaign coined by strategist James Carville.   Race and bigotry, defense and security play a part in a candidate’s appeal, but jobs, wages, benefits and taxes motivate voters to pull the lever in a voting booth.  The two outsider candidates, Bernie Sanders and Donald Trump, play to these economic concerns by promising jobs, or free college and medical care. Both candidates have been accused of being unrealistic and dangerous.

Once in office, most Presidents come to realize the reduced power they have in a Constitutional framework of checks and balances.  Each President must cooperate with a Congress easily swayed by lobbying interests, and fifty state legislatures with varying priorities and interests.

FDR exerted king-like powers during the multiple tenures of his Presidency thanks to the unprecedented majorities in both the House and Senate during the 1930s.  In the 1937-38 session, the Senate was dominated by 76 Democrats out of 100 members.  334 Democrats overwhelmed the 88 Republican members in the House.  During those years, the Supreme Court radically shifted the permissible Constitutional role of the Federal government in our lives.  The four generations that have lived since those policies were enacted continue to struggle with the social and financial consequences of those policies.

We are unlikely to repeat the lopsided majorities of that era simply because we recognize that unrestrained legislative power is dangerous and unhealthy for both our society and economy.  The Parliamentary systems of other developed countries allow a minority of citizens to have it their way, to dominate the policy choices of the majority.  The republican (small ‘r’) and federalist values embedded in the U.S. Constitution make it so much more difficult for a group of American citizens to get their way.  While this is often a source of frustration to policy advocates, we don’t veer off center as easily as other countries.

Focused on the 2016 election, voters may not notice the creeping dangers implicit in the extraordinary monetary measures and debt accumulation of the past twenty years.

Growing Government Debt

March 6, 2016

Earlier this year and again last week I suggested that a broad index of energy companies would probably be a good investment for the long term investor.  This week’s inventory report from the U.S. Energy Information Administration (EIA) showed that crude oil inventories continued to climb but that demand for gasoline is up a strong 7% over last year.

The latest Baker Hughes rig count showed an 11th week of declines in North America.  Oil rigs are now at levels last seen in early 2008 and gas rigs are at a 70 year low.

In response to demand growth and a steadily declining supply, crude oil prices climbed almost 10% and energy ETFs like XLE and VDE climbed almost 8% this past week.


Constant Weighted Purchasing Index (CWPI)

At the beginning of each month I update an index that is based on the Purchasing Managers Index (PMI) using a methodology initially developed by financial economist Roland Pelaez in 2003 as a possible forcasting indicator for recessions.  I modified that to include the dominant non-manufacturing part of the economy, and called this combined index the CWPI, which I have included in my blog for three years.

The PMI is a monthly survey of Purchasing Managers throughout the country that gauges expansion or contraction in several aspects of their business.  The two most important components in the model are employment and new orders.

For the first time since last October, the manufacturing component of the index rose but is still contracting slightly.  Export manufacturers have had to overcome a strong dollar in the past 1-1/2 years, which makes American made products more expensive overseas.  The services sector is still expanding and the composite reading is still strong, indicating that there is little risk of recession in the near term.

Although Friday’s employment report showed strong job gains of 240,000, growth in the employment component of the services sectors is slowing.

Mr. Pelaez has recently published  a peer reviewed recession forecasting tool that I have not reviewed yet but I do look forward to reading his insights. Recessions come infrequently, about once a decade, but a long term investor who can switch out of stocks and into Treasuries to avoid these recessions could theoretically triple their wealth.

A word of caution.  There are several inherent problems with trading models based on infrequent economic events like recessions: 1) backtesting can help one develop a model or trading rule that does little more than fit the historical data;  2) backtesting uses revised economic and financial data.  Unfortunately, we don’t get to make decisions with historically revised data.

A great example of this:  at the June 2008 meeting of the Fed, three months before the financial crisis imploded, the majority of economists at the meeting felt that the economy had skirted a recession.  As more data for the first and second quarters of 2008 showed a definite decline in GDP, the NBER actually marked the start of the recession six months before that meeting, in December 2007.  You want perfect?  Next universe that-a-way.


Debt Doubts

In December 2009, I mentioned  a comment by Raymond Baer, the 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.”

That time has come and gone but these things don’t run on a calendar.  As the book “The Big Short” noted, a person has to be right and timely.  Some who bet on the implosion of the housing bubble ran out of money before the bubble burst.

Taking advantage of extremely low interest rates, companies continue to borrow.  Levels of corporate debt are nearly a third of GDP.

Instead of bringing some of its cash profits back into the U.S. and triggering a tax expense, Apple has borrowed money to fund operations and investment.  Banks and investors would rather loan money to Apple than some medium sized business.  How good is that for the long term health of the economy?

To understand the makings of a debt bubble, let’s compare rates of return on investment and debt. Let’s say that a 50/50 balanced portfolio can earn 5.5% per year; 7.5% for stocks, 3.5% for bonds.  If a mortgage can be had for 4%, then it makes sense to NOT pay down the mortgage.  A car lease or loan at a 2% interest rate?  Keep rolling the loan or lease.  A company like Johnson and Johnson can borrow money for 25 years at the same 4%.  Why would they pay down debt?

Debt continues to grow because there is no financial incentive to pay it down.  Some families may pay down debt out of conservative prudence but there is no economic sense in doing so as long as money can be borrowed at a rate that is below what one can earn with the money.

As an example, let’s say that a family is considering paying off the remaining $100K on their mortgage.  They can get a new mortgage for 3.5% – 4%.  If they can earn 5% on that money, why bother paying off the mortgage?  Persistently low interest rates cause families and businesses to make short term decisions that make sense – until they don’t.  Some families will pay off debt as a matter of prudence but the low interest rate environment encourages families and businesses to NOT pay off debt.

In 2009, Raymond Baer was referring to the amount of corporate debt that was being rolled over at the time in order to avoid taking a loss on the loan.  Central banks have helped subsidize that rising corporate debt with low interest rates.  Banks reciprocate by buying government debt.

Global government debt has DOUBLED from $28 trillion in 2007 to almost $56 trillion in 2015 (Global debt clock).  China’s government debt-to-GDP ratio has more than doubled from 21% in 2007 to an estimated 54% in 2008 (S. China Post)

In the U.S. and Europe, government banking agencies reciprocate by requiring banks to hold little if any reserve collateral for the Federal or central government debt the banks purchase.  It’s a great financial buddy system – until it’s not.  We have never lived in a world where central banks can create so much money with an entry in a ledger.  As long as no one runs for the exits, everything is OK.

Under the Dodd-Frank rules, the Federal Reserve does not rate state and municipal debt with the same safety it accords U.S. Treasury debt.  This forces banks to hold more collateral against the debt, making it less attractive.  The Dodd-Frank test is whether banks can survive for thirty days during a financial crisis.  Since municipal and state bonds don’t trade very frequently, their lack of liquidity makes them more susceptible to downward price pressures in a crisis.  The Fed wants banks to offset that risk.  Cities and states complain that this forces them to pay higher interest rates on their debt and gives them less access to the bond market.  What do governments do when they don’t like the judgment of finance professionals?  Get their legislators to pass laws to override that prudence.  Several bills in both the Senate and House have been proposed.  This is how the world goes to hell.  One step at a time. (WSJ article on municipal debt)


Bonds Bust ZLB

Howz dat for a headline?!  ZLB means “Zero Lower Bound”, or 0%. Last Monday, the central bank of Japan sold almost $20 billion of 10-year government bonds that paid a negative interest rate.  Buyers are paying the Japanese government a fee to loan the government money.  Bizarro world!  While I don’t know the details, the buyers are probably Japanese banks who “take one for the team” – lose money – to implement a plan that the central bank hopes will combat the threat of deflation.