The Kindzia Blog

That Didn't Take Long - November 1, 2011

 

Happy November.  October was a wild ride wasn't it?

After Wall Street declared it was "party-time" last week over the European debt deal, it only took a few days for people to realize, "we didn't really solve anything."  Nothing was solved.  You can't solve a debt crisis with more debt.

Banks may end up getting a margin call on Italian debt as the bond spreads moved beyond 450 basis point.  That should make for a fun day for European banks.

In the last few days we've come down hundreds of points on the Dow.  Dow is down about 258 at the time of this writing.  The actual number isn't as important as the day to day volatility which is tremendous.  What are retirees supposed to do in investment climates such as this where markets can move hundreds of points in weeks, days, hours and sometimes minutes.

French banks are down about 15% today.  Is this investing or is this a crapshoot without the Vegas Showgirls and free booze?

A quick letter to clients for those interested - Download What Would You Risk

We have no idea of what is going to happen in the short run over in Europe.  Today Greece announced an unexpected referendum vote on their bailout package sending the rest of Europe scrambling for cover.  What we really don't know is what our real downside is here.

Humans have a tendency to assess risk very poorly.  We tend to think that everything will be ok, or that someone else will come in and save the day.  On top of that, we are natural procrastinators.  We push off important things that are non-urgent until they become critically urgent.  Then we scramble to find a solution to a complex problem under duress and lack of time.

Be cautious, be skeptical, be defensive.  This is not a time to be cute and risky with an investment strategy.

How The Feds Are Screwing The States - October 25, 2011

The Federal Reserve knows it has a giant pickle on its hands.  Mainly, the U.S. government in all of its infinite and well managed wisdom has borrowed a shit-load of money (and that's a lot - more than a crap load...)

For reference sake, interest rates should exceed the rate of inflation by about 150 to 200 basis points (that's financial lingo for 1.5% to 2.0%).  Talking in basis points is secret code for finance dudes.

Now the inflation rate just got bumped up from 3.8% to 3.9%.  So using the above interest rate historical info, interest rates should be about 5.4% to 5.9%.  It's important that interest rates EXCEED the inflation rate or the lender (the bond holder) is losing purchasing power.

But we see this is not happening in this environment.  Long term interest rates (as designated by the 10 year treasury) are about 2.2%.  Now any investor should be asking themselves, "If interest rates are 2.2% but inflation is 3.9%, is this a good risk/return investment not even considering taxes and interest rate risk?  (Interest rate risk impacts bond holders because if interest rates rise, the value of the bond falls leading to a capital loss for the bondholder.)

But why are interest rates only 2.2%?  Great question.  The interest rates are being manipulated downward by the Federal Reserve because they are trying to bail out those who are over-leveraged (homeowners) and if interest rates go back to market rates, our U.S. government would get completely squeezed on our budget because we couldn't afford our interest expense.  Our government already ran a $1.3 trillion dollar deficit last year (our third trillion dollar deficit in a row).  What would our deficit be if our interest expense doubled?  How much faster would we spin out of control?

Now, back to the states.  We are going to see how unintended consequences play out in the markets.  The states have a similar problem in that they borrowed too much money and are running monster deficits.  Low interest rates does allow them to borrow funds cheaper.  However, one of the biggest problems on the state level is underfunded pensions.  Some analysts and organizations put the unfunded pension obligations of the states in the trillions of dollars.

But how are low interest rates screwing the states?  We need to understand how pension funds are managed.  Pension funds invest contributions in stocks and bonds.  As you may be aware, stocks have not been performing too hot lately.  And "safe" bonds (i.e. 10 year U.S. Treasuries) are only yielding 2.2%.  Pension funds are using a long term compounded rate of return of 8% for most of their models.

But think through the math.  Let's just pretend pension funds use a simple asset allocation model of 1/2 in stocks and 1/2 in bonds.  If 1/2 the pension funds are invested in bonds yielding 2.2%, what does the rate of return have to be on the equity position to meet the model returns of 8%?  The answer would be 14%.  But stocks can't grow unless corporate earnings grow.  And corporate earnings can't grow unless the economy grows.  And currently we are in a no growth or low-growth economy.  So equities (stocks) aren't going to grow 14%.  They probably aren't even going to grow at 6%.  So if 1/2 your pension fund is going to earn 6% (on stocks) and the other 1/2 is going to earn 2.2% from bonds, the total rate of return is going to be closer to 4% which is far from 8% that the models are using.

Now here is the scary part.  Even using the 8% future growth projections, the states are WAY underfunded.  Lowering that growth rate to more realistic numbers based on market and economic realities means that the states are even MORE underfunded.  The only way to make up the difference is to increase contributions towards the pension funds.  Contributions + Growth = Future Pension Assets.

But what are we seeing in reality; too little contributions, too little growth = Bankrupt and insolvent pension plans.

And the more the Fed drives down interest rates, the more they are screwing the states and forcing them into bankruptcy because of the underfunded pension obligations.

Low interest rates are actually contributing the escalation in the states fiscal wounds.  Another example of "unintended consequences."

Welcome Rhode Island - October 25, 2011

I'm clearly on a debt kick lately.  That is, stories related to personal, municipal, state, and national debts keep beeping on my radar.  I'm drawn to these stories like bugs on a night zapper.  They are electric!

So when I came across this story on Rhode Island, it hit the nail on the head - The Little State With A Big Mess

 

Now the important point in all of this is for us to be in a position where we could connect the dots and follow the bouncing ball. Specifically, "why should we care?" Why does understanding this global debt crunch matter to us as an individual investor?

And we need to think about it from a big picture macro situation. Let's first shrink it down to an individual level where we have an easier time grasping debt loads. Let's say that person has $50k in annual income. And over the past few years, that person not only spent their entire $50k in income but they also tapped into their home equity (because their home price skyrocketed) and they also rang up some credit card debt.

In this scenario, the person not only spent all of their normal income but greatly exceeded their income. Extrapolate this scenario across all consumers. And consumers make up 70% of GDP. And GDP growth is important to tax revenues to fund the federal and state governments. And the Fed and States and Cities and Towns also did some over-zealous spending. They spent on projects before they had the cash. And they also spent cash that was falsely inflated because consumers were spending more than they were actually making.

Ok, so now what? We fast forward a few years. Individuals are now tapped out on debt. They can't get new debt or don't want anymore debt. The interest expense is now eating into their budget.

Let's follow the bouncing ball. The same person who was making $50k but spending far more than $50k on consumption now has the opposite issue. Not only are they not spending more than $50K, they are spending far less than $50k because of the interest expense and the repayment of principal on loans as they de-leverage themselves. And that's how we are getting these really large swings in the economy. We went from overheated to ice-cold. People can't afford to spend the same amount of money. Many can't afford to spend any money because now they don't even have their $50k job. They either lost their job or were forced to take a lower paying job or are settling for part-time work. But that didn't eliminate their interest expense and principal payment obligations now did it?

Debt is a really fun game isn't it?

And we'll continue to see these stories playing out over and over again for years to come. We had about a 10 year over-zealous boom in the economy. It's like college kids getting drunk. It's a lot of fun for them while they are partying hard and acting stupid. It's not so much fun the next day when they are puking their guts out. Of course each of them says, "I'll never do that again" until the next time rolls around.

Human nature. It's awesome.

Good Risk Positions - October 21, 2011

I have a couple of questions for readers;

Inflation is 3.9%.  Interest rates should be about 150 to 200 basis points above inflation.  Let's call it 5.4% to 5.9% if we didn't have manipulation in the interest rate markets by the FED.  Question, if a 10 year bond is paying 2.2% and inflation is 3.9% and we have taxes and inflation risk to also factor in, is that a good risk/return profile?

The average dividend yield on S&P stocks is 2.4%.  This looks attractive compared to manipulated interest rates.  But if dividend yield is 2.4% and you have to pay taxes on that, and inflation is 3.9%, is that a good risk/return profile?  The only way to get long term growth in a stock is to get long term growth in earnings.  Earnings are (as a whole) contingent on the economy (as a % of GDP).  How does the investor expect to get constant growth in earnings (and dividends) if the economy is stalled and not growing.

If corporate profits as a % of GDP is usually around 4% to 6% and we are now at levels of 11 to 14%, how does the investor expect this trend to continue?  The reason that corporations have been able to keep corporate profits so high the last few years is not because revenue growth and expansion is taking place, it's because they slashed labor, slashed capital expenditures and in many cases reduced R&D in lieu of piling up cash.  This makes it looks like productivity is outstanding but can that productivity be sustained and if not, what should we expect if it stalls or returns to the mean?

Individuals, towns, cities, states, nations, and now entire economic zones (like the European Union) are borrowed to such extremes that many of these entities can never repay the borrowed funds.  How would an investor believe that this scenario is the prelude to an economic expansion?

I want you to imagine an individual.  Let's say that this individual had income of $50,000.  And over the past few years, the individual spent all of the $50,000 but also spent more via credit cards and tapping into home equity.  So their real consumption was far greater than $50,000.  But fast forward to where we are now.  The individual is completely maxed out in debt.  So now they are no longer spending far greater than $50,000 on consumption of personal items.  Now they are spending less than $50,000 because they have to pay interest and principal on all the debt that they incurred from their recent spending binge.

Now that you understand the scenario for the individual, extrapolate that over all individuals, all towns, all cities, all states, and most nations.  Should we be expecting more consuption or less consumption when people are maxed out on debt and are struggling to make their minimum payments?

It's a big economic bummer and I don't like our economic prospects but it's important that we take a step back and just look at the big picture.

Friday Valuation Report - October 21, 2011

Corporate earnings this season are holding up (better than expected) by most standards.  If you compare the corporate earnings yield to the 10-year treasury for a relative valuation between the bond market and the equity market, you would be a screaming bull mortgaging your house and buying stocks like crazy.

And maybe that is catching up with equity prices in that people are big believers in the values of equities?  It's tough to say with all of the trash coming out of Europe (the old, "Trust us, we have a plan to come up with a plan that will lead us to a concrete plan to implement a plan to save ourselves from imploding on the excessive debt loads...")

Here's something that I want to throw out for you to ponder;  The 10 year is 2.2% which makes equities appear attractive at these levels.  But consider this, if the interest rate markets were not manipulated and forced down through economic distortions, what should interest rates be?  What if free markets were in effect (it's scary to think how far we are straying from real free markets).

Inflation just got bumped up to 3.9%.  Long term interest rates should always compensate the investor for long term inflation.  If inflation is 3.9%, we should be adding about 150 to 200 basis points (1.5% to 2.0%) to the rate of inflation.  Thus, we should have interest rates of 5.4% to 5.9% if the Fed wasn't manipulating the market.  What would valuations be if we had free market interest rates?

And although we have to acknowledge that we don't have free market interest rates (you can't ignore reality) how long can the FED manipulate interest rates?  Until the TWIST is completed?  Months or years?  Japan has long term rates of 1% but they also put themselves into a devastating downward deflation spiral.

Which leads us to trying to figure out what this market is really worth?  What if Europe dumps over?  What if China has a harder landing?  What if we get a political party that runs or doesn't run more monetary policy?  What if we can't get our fiscal house in order?  How many years of $1 trillion + dollar budget deficits can we run (so far we are at three) without "shit hitting the fan?"

At the end of the day, what we really have is a market scenario where it really is impossible to value on a day to day basis (probably leading us to a VIX level of 30+ that we've had now for weeks and weeks and weeks.)

These are just not rational, sane, quantifiable markets.  We can estimate/quantify our upside (and we do have some upside potential in the short and medium term) but we have no way of understanding or quantifying our downside.

 

How Bad Is Greece - October 14, 2011

I'm reading an excellent book by Michael Lewis on the sovereign debt mess in Europe.  It's a very good read (as are all of Michal Lewis' works).  I enjoy them because they are informative, educational and highly entertaining.

Here are some statistics obtained from one of the chapters;

• Greece has 11 million residents (for comparative purposes, greater Los Angeles has about 13 million.
• Greece owes about $400 billion in government debt.  The country has another $800 billion in promised pension liabilities. 
• Thus, total liabilities are now $1.2 trillion which is about $250,000 for every currently working Greece citizen.

The average public job in Greece pays about three times the pay for a private job (Who would you want to work for?)

The retirement age for most professions are 55 for men and 50 for women.  And then the pensions kick in!

Any wonder why Germans are a bit angry for being on the hook to bail them out?  Although you have to question Germans ability to manage risk at this point.  They loaded up on CDS (collateralized Debt Securities) tied to sub-prime mortgages in the last crisis.  And now they are on the hook for billions and billions of loans to a country that is ass-backwards and completely unable to repay the debts. 

Almost makes you think; who's dumber?

 

 

 

You Guess Which Weeks - October 14, 2011

For those that feel that they aren't making much progress in their investments the last few years, I have a little game for you to play. I love history and I love statistics so you are going to have to humor me with my games.

Below are 10 weeks. The object of the game is to pick out which weeks that the Dow Jones Index was at a level of 11,000 within that week (I'll give you a hint, there are multiple weeks below where the Dow was at 11,000). So the game is basically to select which of these weeks had a level of Dow 11,000. OK, here we go;

• May 3, 1999
• November 15, 1999
• April 3, 2000
• May 21, 2001
• February 13, 2006
• July 3, 2006
• July 7, 2008
• April 12, 2010
• October 4, 2010
• October 3, 2011

Any guesses? We have over 12 1/2 years worth of time span up there from Spring of 1999 to the fall of 2011.

Ok, here's your answer - ALL OF THEM! The Dow traded at a level of 11,000 in every single one of these weeks. Are you surprised? I bet you are. I'm afraid to ask if you are depressed.

I showed this to my wife and said that I wanted to share it with my clients. She thought I was absolutely off of my rocker for sharing this with them. She said, "Why would you share this with them?" My thought was, "Why should I not?" It's the truth. My job isn't to sugar-coat, fool, excuse, cover-up anything. My job as an investment advisor and wealth manager is to help people build wealth and make proper decisions for themselves. This includes helping them understand risk/return, possibilities and probabilities. I can't control markets, nor could anybody else (other than the FED perhaps...at least temporarily)

And does this mean that since the Dow or S&P went absolutely nowhere for 12 1/2 years that your net worth went nowhere? Absolutely NOT. That's the point of wealth building. Wealth building is increasing assets while reducing liabilities. It obviously is expedited by growing asset prices (stocks, bonds, houses, businesses, etc.) But wealth is built upon following the four basics which is;

• Making a strong living
• Living below your means
• Investing prudently over long periods of time
• Reducing and eliminating debt

I can assure you that there are plenty of Americans that have drastically increased their wealth in the last 12 1/2 years even with indexes being flat. Are you one of them?

I Hate Crap-Shoot Investing - October 14, 2011

 

I hate crap-shoot investing and so should you. Crap-shoot investing is where the results and returns come down to more or less a complete crap-shoot. That doesn't always mean the odds of success are 50/50 but more the results are skewed towards the extremes of either a big gain or a big loss. It's like betting black at a roulette table. Black you double your bet, red you lose your chips. You should be able to guess what happens over long stretches of time if you keep playing that game. I'm sure it's fun while you score some wins but the losses end up depressing all life out of the player.

It's pretty hard to explain to others just how risky and uncertain markets and the economy are right now. Europe is in a complete political and economical gridlock and on the verge of unraveling. Although now that I have gone back and studies the last few years of Europe's problems, I am more confident in their abilities to push the problems off into the future (see Japan)...(see the United States). The question then becomes, when do the wheels actually fall off the wagon?

With the manipulation of interest rates by the Fed, bond investors are yielding a negative return. How is that possible? Well, inflation is about 3%. A 10 year treasury is yielding around 2% +/-. So holding bonds over extended periods of time allows you to lose more and more purchasing power while subjecting yourself to interest rate risk (bonds incur capital losses when rates rise) along with default risk (not counting the risk that inflation overheats because of incorrect monetary policy). What does this mean in plain English? Bonds aren't attractive at all. It's just a way to spread the chips in case the world goes to hell.

Investors (especially those in or close to retirement or those under-capitalized) can't (or shouldn't) put take on too much risk in stocks. If Europe rolls over, the U.S. rolls over, China rolls over, stock declines can be rather painful (more painful than people tend to remember).

I like asking this to my clients, "Client...you have $1 million bucks right now. We are in risky markets. I understand you want positive returns with no risk (who doesn't). I want you to imagine that the best case scenario for the economy and stocks doesn't play out. What if a less than desirable scenario plays out? What if the worst case scenario plays out? Can you handle the real downside if you are wrong? If your retirement funds get cut in half, can you live with that crap-shoot?"

And if they say yes, then I'm not dealing with a rational investor. I'm dealing with someone who will eventually self-implode, if not now, then later. And I don't need that kind of explosion on my watch.

The question investors should always be asking themselves is, "Can I obtain a good return or an adequate return for the risk that I am taking?" Is the upside worth the downside? The main struggle with retail investors is that they always feel that they HAVE to be invested 100% of the time. We've been trained to believe, "Buy and hold forever. Invest for the long run."

In the long run, we're all dead. We need to make sure we are defining our long run. In the meantime, be cautious of investing in crap-shoot environments. You are better off waiting for things to stabilize where downside risk is much reduced. Markets that move 100's of points in minutes, or hours, or days are not rational markets. Markets that move 1,000 points within days are far from rational. The only way you win on that crap-shoot is if a whole second round of investors step in that are willing to buy at even higher prices in a volatile market that is filled with uncertainty.

Investing always encompass some level of risk, some level of uncertainty, some level of unknowns. That will always be the case. And there is nothing wrong with taking high risk bets so long as you are playing with capital that you could afford to lose. If you could afford to lose it and not have it impact your financial future, that's a good place to be and you have earned the right to play for higher profits. But if you are under-capitalized, under-saved, taking more risk will usually just end up with you having to start over again as you blow out your account and lose precious time and capital while regrouping to only roll the dice again. That's not wealth building, that's gambling. That's taking a crap-shoot.

Europe Can No Longer Finance Their Social Model - October 12, 2011

Europe can no longer finance their social model.  In a wonderful article that was the cover of USA Today, the day of reckoning may be upon us (and especially those in Europe).  To view the article (highly recommended), see here - USA Today Cover Story

It's interesting to hear the blame in situations like this.  Greece residents are actually mad at the European Union and others for "lending them money."  This reminds me of homeowners in the United States that are mad because banks lent them money that they could not pay back.  Their assumption is, "It's obviously someone else's responsibility to tell me what I can and cannot afford."  Thus, I'm mad at you because you allowed me to borrow money.

Now it's true, banks shouldn't lend to others who can't pay it back.  That's just bad business.  And that's the issue.  When banks are backstopped by taxpayers, all risk management goes out the window.  And it's clear that banks are back stopped by taxpayers through this mess.

An interesting point in the article is how they describe the choices of the Europeans at this point.  They either have to quit or become the United States of Europe.  But the question is, "Why should any country at this point wish to replicate or mimic the United States of America?"  That's making the case that we are a model of success.  It's almost humorous at this point for others to mimic us.  We are only one step behind Europe in our fiscal crisis.  Over-promised, under capitalized, over-levered, under-growth, and fooling ourselves.

The cracks are already showing up on an unstable bridge to the future.  Yesterday Harrisburg, PA filed for bankruptcy - Harrisburg, PA Files Bankruptcy

If you think this is an isolated case, think again.  California is just about bankrupt and some of the municipalities are already broke.  See the outstanding article by Michael Lewis in Vanity Fair here - California and Bust

Once we look under the hood, it doesn't take a genius to conclude that at all levels, we are in some serious trouble caused by debt.  The pain isn't done, nor have we reached maximum pain just yet.  And the problem is now up and down the food chain.  Individuals are up to their eyeballs in debt.  Towns are up to their eyeballs in debt.  Cities are up to their eyeballs in debt.  States are up to their eyeballs in debt.  Nations are up to their eyeballs in debt.

And it's not likely that any of these entities are going to be entering a growth phase anytime soon.  You can't grow when you have shrinking revenues, increased interest costs, and you still haven't paid down a penny of principal.

Incorrect Criticism By Gary Kaminsky - October 12, 2011

Gary Kaminsky bitched up a storm in his article criticizing Meredith Whitney regarding her Muni Bond Prediction. See article here - http://www.cnbc.com/id/44670656/

I'm starting to get frustrated with this type of journalism. What this sort of criticism does is slow down the ideas and data sharing by other analysts (both independent and for hire). There is nothing wrong with debating the facts. But I don't feel Gary Kaminsky debated the facts.

Last night Harrisburg, PA filed for Bankruptcy. Were there reporters who wrote on the story going all the way back to the spring of 2010 (or prior)? Yes, it was covered in the Wall Street Journal. Harrisburg staved off bankruptcy for an additional 18 months but ultimately time ran out. And maybe there were some analysts out there that said that they thought Harrisburg, PA would file for bankruptcy within months of their analysis. Did that mean that they didn't add value to investment community? Did that not raise other red flags about other towns and cities that may have similar problems?

What would be helpful to the investment community is if people debated the underlying facts of the analysis. Maybe by saying municipalities have plenty of cash, plenty of tax revenues, plenty of margin of safety, etc. But just criticising an analyst for being wrong on timing alone is contributing to the problem.

There have been plenty of analysts that have added real value to the sovereign debt mess over in Europe including Greece. Some of them may have predicted that Greece would have defaulted by now. The fact that Greece hasn't defaulted is secondary to the value of bringing up the analysis and explanation of why they thought Greece would default.

Of course every talking head on CNBC could (and does) proclaim, "I wasn't wrong, I was just early." It's true, we all can claim that on our predictions. But we should be putting more weight on the underlying facts and data of the argument rather than just the overall call and prediction. After all, the facts change over time as should our opinions.

I think we should all do a better job of debating the data and the facts rather than the absolute prediction on the outcome.