Archive for October, 2008

When will recovery begin?

0 Comments

If you are expecting a quick recovery from the market problems that began in 2000 and have brought both losses and great volatility, don’t count on it! Those financial firms selling securities would have you believe otherwise. Without security sales, their income is zip, a big zero!

 

So what will really happen?

 

First, the government will have to stabilize the credit markets. This could easily take several years because foreclosures will be spread out in time. Even though home prices may be less than mortgage values, people do not decide to abandon a home on quick notice. They have to carefully consider their alternatives including whether the housing market will recover and the desirability to move to a different location. This is extra tough when people can’t qualify for new mortgage because their credit rating was destroyed by abandoning a mortgage.

 

It can’t be long before credit card defaults hit the banks really hard thereby aggravating the situation. The top six credit card companies hold $639 billion credit card debt. Then there are $365 billion securities backed by that debt. These are bundled into groups of credit-card receivables and sold to investors, insurers and hedge funds which likely find their way into other derivatives. It’s the mortgage problem all over again because about 30% of credit card debts are from low-credit-score people. Business Week (10/20/08) predicts that this is the next big blowup ahead.

 

In the meantime, people should develop a better appreciation for the fact that they should be saving. The decline of savings started two decades ago from 9% national savings rate to minus numbers today. Failure to increase savings rates is surprising because of the large number of baby boomers who are starting to reach retirement age and the long-term trend of industry to go from pension plans to savings plans.

 

As a consequence of saving too little, incurring large debts and losing conventional pensions, people will have to save more—lots more and start quickly.

 

When the savings rate finally increases to the extent necessary, much of the resulting investment would help the stock market. It would also bring back some of the national debt from overseas, thereby strengthening the dollar and reducing the cost of imports. But this will take years, not days or months and will be softened by slower business growth.

 

By necessity, many are going to have to retire much later. This is good news if they still have updated skills and the physical capability, but they will face a difficult labor market. On the one hand, demographics show there will be proportionately fewer young people entering the work force. That would bode well for seniors trying to retain jobs. On the other hand businesses will be facing many difficulties. This is likely to be overwhelming for a number of years.

 

Businesses will have lower volume when consumerism declines—as it must with increased savings! At the same time, employers will also face higher taxes, at least at the state and local level if not at the federal level. Heavy industries will face costly capital improvements for environmental and energy reasons. All of these things put pressure on labor as well as encourage businesses to look abroad for less expensive sources of materials and components–if not total assembly. Lower market volumes mean less need for commercial real estate, so there will be trimming there as well.

 

Another new impediment is put on businesses that offer pensions when the stock market falls and shows definite signs of slower growth. As an example, suppose that a pension trust’s securities fall 10%. Then the company has to either come up with 10% more funds (think of a huge number) to add to the trust. If the forecasted growth rate for their securities in the trust drops only 1% point, they will need about 15% additional assets in the trust. Firms like General Motors and Ford are already reeling from pension promises that are beyond their capability to fund. This is also likely true for government pension promises—only more so because most government pensions have cost-of-living-adjustments which require higher reserves than fixed pensions of private enterprise.

 

Another consideration is that the cost of government itself will go up. More regulation and health insurance administration will add significant government employment. Many government employees enjoy automatic cost-of-living adjustments to their paychecks. And government employees on the average make more than the average employee in the private sector. If the business share of higher government costs goes up, the product costs go up thereby aggravating inflation.

 

Some people think that higher corporate taxes reduce will reduce personal taxes. Not so, higher corporate taxes are simply passed on as higher product costs so that everyone pays—just as with a national sales tax.

 

The net result of reduced consumerism, increased savings and higher taxes will take some time to evolve before business earnings stabilize at a lower level. When that happens, stock price-to-earnings ratios likely will seek lower values than the historical norms for decades. That’s because of at least two factors: (1) People have got to make up a large part of the savings shortages of the last two decades or face poverty in retirement, and that will take many years of cumulative effort. (2) The outlook for growth will be tempered by the consequences of an aging population that has a much different budget distribution than that of the youth. Consumerism is a disease of youth. Lower price-to-earnings ratios combined with lower earnings do not bode well for the stock market for a very long time.

 

An aging population brings lower national income, more government outlays for entitlements, and a disproportionate increase in the need for services, particularly medical related services. The service industry does not have as great a multiplication factor for support jobs as does manufacturing. Further, it means a significant increase in the number of retired people to the number of workers. In a couple of decades the number of retirees will be one retiree for every two workers compared to one retiree for every three workers today. By itself, that means a 50% increase in individual workers’ burdens and even more with more people on government welfare.

 

The part of the economy that will continue growing is the government, but it is the least productive part of the service industry. It has virtually no productivity gain. Politicians are reluctant to propose cuts in government payrolls, in part because they are part of it, but also because government workers probably constitute at least 20% of the voting public. Benefits for government workers grow disproportionately as well. Government pensions most often have cost-of-living adjustments, i.e., COLAs, and savings plans too. 80% of private sector employees do not have pensions at all, and virtually none have COLA pensions. The number of government employees with pensions is fast approaching the number of people in the private sector that have pensions. That’s because of the double whammy of the private sector reducing the number of pensions while the government’s size is increasing.

 

The changes from these effects do not occur in days or months. They take years to evolve. To recoup the lost savings of the past twenty years in the next twenty years would require more than a 20% reduction in consumption. This implies savings rates comparable to that only achieved in World War II when most things you could buy were rationed and little else was available. Further, virtually everyone worked and provided income for the family during the war. Saving was politically correct and even school children saved stamps to accumulate savings bonds.

No, don’t look for any rapid improvement in the stock market. There may be spurts as occasional good news is highlighted to improve the economy, but the long-term effects described above will dominate the economy for several decades. There is no quick fix for our past savings deficiencies, record borrowings, unstoppable government growth, automatic entitlement growth and inevitable demographic creep to an aging population with greater demand for services, not hard products.

 

At the same time, even though stock prices will seek a lower level and grow more slowly in real terms, stocks may still be one of the better hedges against inflation. Inflation will increase the apparent earnings and business assets. Since we are living in a world of ever increasing prices, everything is relative. Inflation is very hard on fixed-income investments because the real value of the principal goes down. Owning a house with a mortgage may be one of the best investments since the value of equity increases disproportionately as the price escalates with inflation and the relative value of the debt goes down. Of course this assumes that we are willing to sell our houses later on, go into smaller homes and invest the savings in something that’s liquid so we can spend it.

 

As bleak as the picture is as painted above, it can get worse. One of the ways to solve part of the debt problem is for the government to let inflation increase above what we consider to be acceptable levels today. That has happened to numerous other countries and our own as well. Inflation is particularly hard on retirees who are trying to live on fixed incomes. It’s not so bad for government retirees that get a kick upward every year.

 

It was very poor public policy to pressure lenders to make loans to people who could not afford them. The resulting boom in housing prices made it seem that a home was a great investment and worth some speculation—even by those who could not afford the payments, much less all of the other costs of home ownership. People started to consider their home as their primary retirement resource even though a house is about as illiquid as an investment can be and has negative interest. Further this policy exacerbated the lack of mobility of our work force and made people look furtively for new jobs only close to their homes.

 

But some good came from the resulting crash. My view is that this mortgage crisis has kick-started us on a better path in the long run. It’s better in that less consumption eventually will help provide more for the aging population and less of a burden on our children than continuing this economic madness for many more years. We’re all going to be poorer, but less poor than we would be otherwise. We may still live more comfortably than most other nations. Hopefully the troubles we suffer in the meantime will bring more economically savvy politicians into office. Perhaps they will reduce government growth and entitlements that otherwise will be an unbearable tax burden on future generations.

The sky WILL fall on many people.

0 Comments

Let’s start with some of the known problems before we go to the consequences and actions needed to protect individuals from something I believe is inevitable for the U.S. as a whole.

 

At the federal level, we have amassed at least $55 trillion of national debt and unfunded obligations for Social Security and Medicare.  That’s $184,000 for every man, woman and child in the country.

 

This does not include international balance of payment deficits nor state, county and municipality debts nor unfunded future obligations.  It does not include company indebtedness that we pay for with reduced stock returns and higher product costs.  Nor does it include personal debts such as home mortgages, home equity loans, reverse mortgages, student loans, auto loans and credit card debts.  Whether it’s been greedy companies buying other companies, individuals on a consumerism binge, importing more than we export, government overspending or employers/government promising far more employee future benefits than they can pay, the debt obligations are horrific.

 

Now we see that the credit markets are in dire trouble, so the government is anticipating a $700 billion bailout after already paying about $300 billion to salvage Bear Sterns, Fannie Mae, Freddy Mac, AIG, Lehman Bros., Merrill Lynch, and Washington Mutual.  This is supposed to cover unsupportable home loans including ARMs and option ARMs which were destined to be disastrous from the beginning.

 

This is only the beginning.  The AIG $85 billion credit default swap infusion was a drop in the bucket compared with some estimate as $58 trillion of unregulated credit default swaps in the rest of the finance industry.  There are other derivatives that will start showing their ugly heads.  Consider Exchange Traded Notes, ETNs, the cousin of Exchange Traded Funds, ETFs.  These notes don’t even have to own the securities implied by their description.  Or how about the high-risk part of the tranches of Collateralized Debt Obligations held by many seeking higher returns?  Or those who bought factored loans?

 

It’s certain that pension trusts now are much below the amounts required to sustain future payments.  Furthermore, the pension trusts’ projections have depended on ever-hopeful forecasts of returns from future glorious stock market returns as well as bonds that won’t lose value.  Because of Accounting Board Standards, this means that states, government and industry are going to have to start pumping lots of cash into pension trusts—and many industries like the auto producers just aren’t going to be able to do this—and will come begging to the government.

 

Then there is the as-yet-unquantified number of people that will be added to the government payrolls to investigate and administer as-yet-undefined procedures.  All we can say for sure is that this can be more costly than the mandated Medicare overhead that outweighs the costs of the actual medical treatments and can take years to get payments to doctors.  Further, we know that the average person in government is compensated about 50% more than the average person in private industry, in part due to lavish government COLA pensions and extensive health insurance benefits.   So government will grow by leaps and bounds.   As those of us who spent a lot of time working in the defense industry know, surveillance cost are high both for the government and the companies that have to respond to the mandates, data and reviews imposed by the government.

 

Let’s just make the terribly oversimplifying assumption that the average person’s share of this country’s debt and unfunded obligations is $250,000 per person or $1 million for a family of four.   Considering all of the above, this is probably a huge understatement.  If we don’t do anything to retire any of the debt and obligations, and only pay interest at say only 4%, that’s an interest burden we bear a cost of $10,000 per person per year.  If, in addition to paying the interest, we set about to retire those debts and obligations in 30 years, we would each have to contribute $14,500 each year.   So a family of 4 would have to make annual payments of $40,000 each year just for interest or almost $58,000 a year if we don’t want to leave any of this problem to our grandchildren.

 

Some think that we can pay for this by relegating the payments to the top 5% of our population.  If that’s so, every family of 4 supported in that top 5% would have to pay $800,000 just for the interest and $1,160,000 to pay for interest and principal.  That’s PER YEAR for 30 years.  So even without any additions to social programs, there is no way that those who make under $250,000 a year will not see higher taxes.  This is a problem that is going to be solved ONLY if people start saving money and everyone pays something in higher taxes.

 

We are clearly talking about the end of the consuming generation of reckless spenders.  These include people at all levels that have their own image of being able to live like the Jones.  Low income people just can’t enjoy the benefits of higher income people, and higher income people just can’t afford to live like royalty.

 

The end of consumerism has a huge impact on the economy as we know it now.   When we become savers, we have to stop spending as much.  If we would start a full fledged recovery program right now with the objective of having individual finances get back to where savings rates were a little over two decades ago, and if we wanted to recover the lost savings during those two decades in the next 20 years, our national savings rate would have to exceed 20% per year–plus we’d still have to pay at least the interest on all of the debt we and our government have incurred.  Consumer spending constitutes 70% of our gross domestic product so that if we use 20% of our income to pay off the national obligations, our economy will contract sharply.

 

There has only been one time in our modern history when people had a national savings rate of 20% in this country.  That was during World War II when almost everything was rationed from gasoline to sugar, there were no new cars, store shelves were empty, all able people worked at a job, and it was patriotic for everyone to save war bonds—even school children.  There’s more on this in my book, Getting Started in a Financially Secure Retirement published by John Wiley & Sons, 2007.

 

The only people who may come out of this situation with some semblance of the American Dream are those who have already saved and those who will start saving and stop spending NOW!  That’s true if we don’t have something like the revolt against imperial Russia where real estate ownership disappeared, homes were shared by many families assigned by the government, and savings were taken away and consumed largely by the government.

 

Those that will save, and those who already have saved, will be asking, “Where shall we put our money?”  I certainly don’t see the financial market future any better than anyone else, so I can only tell you what I am doing.  I effectively divide my investments into three parts.  The first part assumes that I want to be able to live through the Great Depression II.  The second part assumes that it will take people a number of years to wake up to the problems, so this part is very conventional mix of stock and bond funds.  The third part assumes that we will have hyper inflation.  Only the Great Depression II and hyper inflation provide environments to solve the huge debt problem:  the former by defaulting on loans and the latter by so cheapening the value of the payments that debt payments are a small part of a huge income denominated in almost worthless money.

 

The largest part of my own investments is conventional, but the amount I have in the hyper inflation portion and Great Depression II are sufficient to get me by, especially if the conventional part ends up having some value and not wiped out entirely.  Those who would do similar splits would end up with the sizes of the three parts dependent on the extent of their savings, age, employment security, expectations for the future and probably lots of other factors.

 

Understand that I don’t pretend that I am wise about what to do in either of these extremes.  Still, my own choices for a hyperinflation scenario include candidates like leveraged real estate, stocks, I Bonds, TIPS and inflation-adjusted immediate annuities.  I have been thinking about this for years and so built up my supply of I Bonds when you could buy large amounts at interest rates of over 3% plus inflation.  I know that others more venturesome than I am would now add commodities as well as metals such as gold and platinum.  Very wealthy people often gain inflation protection by saving valuable art and rare collectibles.  Art and collectibles are beyond my financial capability, just as some of my choices are beyond the capability of other people.  For example, a young person probably doesn’t have the resources to buy an immediate annuity and should never buy one in the first place.

 

The Great Depression II portfolio is much more difficult.  My choices here would include money markets, CDs, EE Bonds, treasuries and debt-free real estate.  I know that my parents would add another category.  My parents were struggling young adults during the great depression and gave us children strong encouragement to learn at least one musical instrument so we could earn something even if we lost our regular jobs.  I played the piano, flute and trumpet—not knowing what I might need.  I learned something about diversification even then.

 

Perhaps the best protection during the Great Depression II outcome would be strong and varied work skills.  Even non working spouses and older children should learn some work skills that could bring income if necessary.  Think Rosie the riveter during World War II as opposed to soccer mom.  Learning to be frugal combined with doing as many home, car and clothes repairs yourself is important in a depression environment as could be supplementing your food supply with a home garden.  You might want to store some vegetable seeds for next year.

 

The nation’s debt problems are so large that the sky will fall on the majority.  I firmly believe that to survive, people will have to save—lots.  They will also have to invest it well.  We can’t tell which direction the economy will turn, but we know it has to make drastic changes.  Hence, in addition to having good work skills and savings lots, it’s important to be well diversified and include some things that might help in the Great Depression II or hyper inflation.

 

Of course, we could also have both Great Depression II combined with hyperinflation, sort of stag-flation cubed.  Don’t wait to start your own defensive actions.  Do them now!  The reductions in future benefits will be small if the economy would turn around quickly (which I doubt), but the benefits from taking action now will be huge otherwise.

NewRetirement Blogs Home