Thursday, October 28, 2010

It is time to talk about expectations.



As we approach the mid term election next week I think it is time to talk about expectation for returns going forward. The day after the election the Chairman of the Federal Reserve will be meeting with the members of the Open Market committee to discuss QE2, not the boat, but Quantitative Easing Part 2 of monetary policy. The president, on the other hand, is leaving for Pakistan two days after the election. My guess is that it is better to be out of the country when you know what will hit the fan on Tuesday.

The Fed is concerned that the economy, jobs and the price of housing are not moving fast enough in the upward direction. The Fed is thinking about spending more money to buy longer date Treasury bonds in hopes of driving interest rates down. They already have the short end of the yield curve close to zero and they feel that if they can bring down longer term interest rates they can spur the economy.  Part of the logic is that lower interest rates will force people to buy stocks, houses and inspire companies to hire more people and therefore, in turn, make the economy grow. People who need fixed income investments to supplement their social security and pension will find their total income decline. With interest rates low at the short end of the yield curve people were forced to go out further on the duration curve to try and get yield. If the Fed is successful, through its purchases, in driving longer-term interest rates down then people will find their income dropping even further.

As one client pointed out to me recently, the money I have for him in growth mutual funds has gone up and of course has gone down, but in the interim they have not paid a lot in dividends. He said to me “I guess I’m not getting paid enough to take the risk in common stock.” We spent some time talking about what are reasonable expectations for returns going forward.

Before I talk about future expected returns I want to apprise you of two things that could happen in the next 30 days that could have significant impact on future investments. The trustees of the Social Security Trust fund have given indications that there will be no cost of living adjustment for beneficiaries in 2011. That would mean that beneficiaries will have had no adjustment for the last 2 years. Secondly, the Presidential Commission on Tax Policy which is charged with reducing the deficit is due to release it’s report with recommendations to the President by December 1, 2010. The commission has sent up three trial balloons. 
 
The first is the elimination of the mortgage interest tax deduction. This elimination would grandfather existing mortgages but going forward all new mortgages would lose the interest deduction. Our children would  not be able to buy a house and deduct the interest on the loan, which would make the expense of owning a home more of a drain on household income. I could do a whole blog on this issue and just may if it comes to be. The second deduction they propose to eliminate is the personal exemption for children. As grandparents we don’t take that deduction but as the children were growing up the tax benefit helped to offset the significant cost to raise a child. Again the impact would be to put a further drain on household income to pay the expenses and not be able to claim any of the money spent as a personal exemption. If you don’t own a home and have a mortgage you are safe with the first two items, but nobody, and I mean nobody, would escape the third test balloon; that of the VAT (value added tax). Everything we buy would have an additional tax all the way through the building and distribution process to you the consumer. A VAT, in my mind, is a progressive tax in that once it is in place the Congress can increase the percentage without asking us. If any of these three items are enacted then more money will be spent in direct and indirect taxes and all of us will have less to spend.

In the past I have told clients that I expect, over a 5-year period of time, to earn between 6% and 8% after fees and expenses. Based on what I see at the moment I have to ratchet down the expected returns to 4% to 6% return. Public and private pension funds will have to reduce their expected returns from 8% perhaps to 6% or less. Lower expected returns will strain the balance sheets and I see the only possibilities are reduction of existing benefits and retirees paying a larger share of post retirement healthcare. PIMCO the largest bond manager in the world has created a new phrase called the, “New Normal”. They believe “New Normal” will be lower growth, higher unemployment and low inflation.

I have said many times before in this Blog that I believe we are in for a Japanese type of recovery much like what PIMCO is projecting. If we are correct then return expectations have to come down. The real question is how low is low enough?

Dan Perkins
     

Sunday, October 17, 2010

Just when you thought the all clear had been sounded--doubt creeps back into the banking system.



 The bond markets are telling us that they are concerned about the problems with foreclosures. All of the major bank stocks have taken a hit over the last few days. Just one example of the decline is Bank of America. On October 5th the stock was priced at $13.56 a share. As of October 15 the share price is down to a low of $11.74 for a decline of $1.82. The percentage decline is just under 13% in 10 days. A recent article stated that Bank of America might have to buy back $70 billion in foreclosed mortgage loans.
 
The problem in the foreclosure market place is, in simple terms, fraudulent foreclosure documents. I saw an article that shows three different signatures on various foreclosure documents and perhaps none was the signature of the real borrower. So, as Ronald Reagan once said, “there you go again.” The mortgage and housing problems are still significant trouble in our financial system.
 
Doubt will start creeping back into the banking system if it hasn’t already and bankers will be asking themselves, “Do I want to deal with this bank when I don’t know their exposure to the foreclosure problem”? The chief financial officers of both public and private corporations will again be asking the same question about their money on deposit at banks.
 
There are risks in keeping large sums of money in the bank. Regardless of the amount of money you have in a bank the maximum FDIC insurance on deposits is $250,000 per tax ID number per institution (bank). If you have more than $250,000 on deposit, regardless of the type of the account, the amount in excess of that $250,000 makes you a general creditor of the bank. As a general creditor you have no real way of knowing what the bank is doing with your money.  In the accounts I manage for my clients I have no more than $250,000 in all accounts per tax ID number on deposit at any one bank. I do not need to take the risk.
 
So how bad is the foreclosure problem? If the banks are forced to stop all foreclosure proceedings until the regulators can figure what to do about the problem it could take to well into 2011 before we see some resolution and the housing market will shrink dramatically. As more and more information starts to come out I will watch several indicators that you can watch with me. Please keep in mind that a house that is in foreclosure in Florida may have a mortgage owned by an investor in Europe or the Far East so this problem may have international implications.
 
What to watch:
 
The yield on the 10 year T-Bond
 
The yield on 30-day and 90-day LIBOR
 
The PJB which is an ETF of the major banks
 
If the credit markets fear another major problem with foreclosures it will show up in these three areas. I do not think we can get out of the foreclosure problem regardless of the forged documents, until we get millions of people back to work.
 
The election in two weeks is about jobs and only jobs. If you don’t have a job nothing else matters.
 
Dan Perkins

Friday, October 1, 2010

30 Days to Change?

One month from Tuesday you will be going to the polls to what some have called the most significant midterm election in recent history. Since I will be in Florida I have already voted. 

If the Republicans gain control of the house they might be able to stymie the rest of the plans of the Obama administration and the liberal Democrats. There are suggestions that perhaps a Republican majority in the house might try to repeal some of the passed legislation.
  
Based on recent polls it appears that the Republicans may have a chance at taking control of the House. I saw a projection today from Dick Morris. He is saying that he thinks the Democrats will lose 100 seats in November. Prior to today the highest prediction I saw was 75 seats.  I think the most difficult thing to predict is how mad the electorate is. If they go into the voting booth in November really mad then it could be a blood bath for Democrats and some Republicans.  One thing that could keep them mad is the jobs number next week. If the unemployment rate inches closer to 10% a greater number of people will react to a bad number. On the other hand should the number be a surprise to the downside perhaps some of the steam will come out of the tea pot. So, people have been saying that the government has postponed the jobs number because it is a bad number I'm not a believer that the administration is playing with the jobs number.

If the Republicans do gain the majority then the leadership will change in the House. We could have a split Congress and I believe the tension between the two parties will be ramped up looking forward to the Presidential election in 2012.  

While I can’t call the outcome of the election I can give you my best guess about what I think would happen in the markets with different outcomes. Then I will give you a twist that perhaps you have not thought about.

Scenario # 1 The Republicans gain control of the House and the Democrats retain the control of the Senate.
 
I think the S&P 500 would rally by as much as 100 points within a 3-week period of the election; in essence a Santa Clause year-end rally. Once the euphoria wore off I would expect the markets to focus on the tax bill, how much more all of us would pay, and the problems of jobs and housing.

Scenario # 2 The Republicans gain control of both the House and Senate.

I think the market would rally initially by 100 points, take a breather, and go up almost 150 points by year-end. The Republican control of both houses would create the feeling that the newly elected have a mandate to fix the problems and undo what has been done. I think it might well be like the time when Reagan took over from Carter and the whole tone of the country changed for the positive. We would still have problems, but we should have the resolve to fix the problems. The Bush tax cuts would be made permanent.

Scenario # 3  The Republicans get control of the House and the Democrats retain control of the Senate by one vote.
 
In his 19 months in office President Obama has issued 64 executive orders. By contrast, in the eight years George W Bush was in office he only issued a total of 279 executive orders. We know that the president issued an executive order to halt deep water drilling in the Gulf of Mexico and even though the court over turned the ban the administration will not lift the ban.

What if the President decides that congress can’t function, i.e. give him what he wants towards his agenda? Is it possible that for the first time in the history of the United States the executive branch of the government takes over the responsibility of the legislative branch (Congress) and uses the executive order power to get what it wants?

Is he willing to become a one term president to make the changes he wants regardless of the Congress or the wants of the people? With two years to go in his first term would the new Congress (Democrats) want to support impeachment proceedings against him for his flagrant violation of the Constitution because they see him as unelectable in 2012?

I realize that this last Scenario may seem a bit off the wall but as they say “Politics makes for strange bedfellows.” The last two months of 2010 could be very volatile in both the markets and the emotions in the country.

What if there is a Scenario #4 The Democrats retain both houses?

If that were to happen look for the market to sell off big time and we would have to look at a whole new approach to how we are investing money. If that were to happen I would expect another flash crash in the equity markets, but no quick recovery. The dollar would come under tremendous selling pressure and we could see September 2008 all over again but with one major difference; there aren’t many bullets left in the arsenal of the Fed. We could be in for serious panic. I saw what happened in October of 1987 and September 2008, and I think if Scenario #4 were to play out then November of 2010 could be very scary.

You are asking yourself how could this happen? There are two reasons; jobs and housing. The unemployment rate is close to 10% and people may be so scared that they vote to keep the Democrats in control because they are scared about what the Republicans might do to their unemployment and health care benefits. Fear is a powerful motivating force.

I hope I’m wrong. However, if I’m right, you’ll know were you heard it first.

Dan Perkins
Don’t forget to exercise your responsibility to vote