Monday, February 28, 2011

This is the Place Between A Rock and A hard place

People are beginning to ask the question, how did Wisconsin and 42 other states find themselves in such serious financial difficulty? In many cases, as I said in the last blog, the states made promises they couldn’t keep. 

Everything starts out with an assumption and if your assumption is wrong and you don’t change it you get deeper and deeper in a hole. The actuaries in the United Kingdom made the assumption that most males under the public pension would die by 76 and females by 82. There was no room in their assumptions for the fact that thousands if not hundreds of thousands of men and women would live past 100. The increased longevity has drained the public funds and now they are looking for ways to solve the problem.

As you can see from the chart at the top of this article the median return for pension funds is 3.42% for the last 10 years. Now compare this to the assumed return that the state pension funds have used for the last 10 years of 8% per year. Benefits are paid in dollars not percentage points. Let’s look at the numbers. We will use $100,000,000 for our example. If over 10 years you actually earned 3.42% then in 10 years on a compounded return you would have $103,112,223. If you were supposed to earn 8% for the same 10-years you expected to have $199,900,463. The shortfall amount between what you actually earned and what you projected you would earn was, in our example, $98,788.240. 
In Sunday’s New York Times magazine supplement an interview with New Jersey Governor Chris Christie revealed the investment performance problem for New Jersey. It had an assumed rate of return of 8.25% and for the last 10 years it has actually earned 2.6%.  One of the other parts of the problem is that for 17 years the State of New Jersey, and in some cases the local governments, have  failed to make their full contribution to the pension plan. Between 2006 and 2009 under the then governor John Corzine 49% of the mandatory increases went to salary and benefit for employees. The auditors now feel that based on the current level of benefits the plan is $100 billion under funded. Richard Keevey who was budget director for both a Democrat and Republican governor said. “You couldn’t tax your way out of this problem.” When you told your retirees that you would pay them based on what you expected to earn, you sell bonds in the market to make the current payments then you have to make the interest payments on the bonds and continue to make the level of payments to the retirees and in some case to increase the payments based on the CPI. 

Another issue that is not being discussed is that most people think that the state funds should reduce their expected return to something more close to what they have actually earned. If they did that over the last 10 years the amount of money that would have to be added to the fund would be astronomical. My guess would be that it would take most of the state revenue to fund the pensions. Now do you understand why nobody wants to talk about the real problem of public pensions and retirement health care? Some governors realize the problem and are looking for the employees to start paying more for their pensions and retirement heath care. The money that will be necessary to fund the shortfall will have to come from both the employee and the local and state governments. If you need 8% in return and you are only earning 3.42%, you are in trouble. The longer you wait to address the problem the faster it grows. We are far from solving this problem any time soon. I’m very concerned that if we don’t get this problem under control the stock markets will be in serious trouble.
Dan Perkins      

Monday, February 21, 2011

Did Lincoln in the 1850’s pave the way for Wisconsin today?

I believe we may be at a major inflection point that is so important that the outcome could go down in American history as more important than World War II. The newly elected governor of the State of Wisconsin took his election mandate to do something about the out of control budget in his state. The current projection is that unless something is done the state will have about a $150 million deficit this year and then ballooning to over $3 billion next year.
He wants to cut entitlements including retirement benefits and health-care for all public employees in the state and reduce retirement benefits for those former employees already in retirement, among other things.  In order to try to prevent this from happening the Democrats in the state legislature, as they say “left the building” leaving the remaining Republicans without a quorum.
When Lincoln was elected along with 8 other friends to the Illinois State Legislature they were called the “Long 9.” They got this nickname for the fact that all of them were over 6 feet tall. The house meeting room was on the first floor of the building and if they didn’t like what was going on they just jumped out of the widow and there was no longer a quorum.
The state Senators in Wisconsin didn’t jump out of the window but they did leave the building so there was no longer a quorum to deal with the budget issue. If you have seen the stories in the paper or on TV you see state employees in the rotunda protesting the cuts in benefits and the collective bargaining process. If the elected officials in Wisconsin face down the problem in their state I believe the effect will be like falling domino's across the country. Elected officials in other states which have budget problems, at least 43, will have to pay attention. Should the officials in Wisconsin fail to act then I would suspect that elected officials in other states will “Chicken Out” and not deal with the problems of not having the money to pay for the benefits.
Lincoln’s home state of Illinois has a serious budget problem and they increased income taxes 65%, raised taxes on corporations and now they say that less than 30 days after increasing tax and not cutting budgets they will have a $15 billion deficit this year. Now what? If the states can’t get their houses in order how can the US Congress get our Federal government in order?
I have written to you in the past that I’m very concerned about the municipal bond market. If Wisconsin can’t deal with the problem then why would the other 43 states want to try to deal with it. If Wisconsin walks away then our economy and both the bond and stocks markets are in serious, very serious, trouble.
I understand that many of the employees are saying, “But you promised…,” well GM made a promise to their employees and so did Chrysler and many other companies that had pension plans. They just made bad assumptions. The promise was changed to reflect the reality of what is going on today. When you borrow money to buy a house you sign a contract that you promise to pay the loan back. But, if you lose your job you can’t keep the promise because you have no income. The states just don’t have the money and they will find it more and more difficult to borrow money to pay today’s expenses. Very soon we will find out whether we will be acting responsibly or acting like the Wisconsin Senators who left the building or Lincoln and the “Long 9” who jumped out of the windows to avoid the problems.
I do not think the financial press is spending enough time telling Americans just how serious this problem is and what it can mean to all of us. In America, change has to start at home and as we work to get our households in financial order we move up the line to our school boards, our cities, our states and finally the federal government.
Let us hope that the leaders in Wisconsin make the right decision as it has the potential to affect all of us.
Dan Perkins

Thursday, February 10, 2011

Fallacy #1

Fallacy #1, the bond traders control the long-end of the maturity curve while the Fed controls the short-end of the curve because it sets short-term interest rates is very stable. I believe that as a percentage of price the short-end of the yield curve is more volatile than the long-end and the chart below shows the yield changes of the 90-Day T-Bill for the 12 months ending 2/10/2011.

So those who doubt the swings in the yields of 90-Day T-Bills may want to look at the second chart which shows the volatility of the 90-Day Bill vs, the 2 year T-note. The white line on the chart is the 90-Day Bill and the yellow line on the bottom is the 2-year note. Again you see the volatility of the three month bill. One thing to see in the chart is the calamitous decline during he flash crash of the stock market in May when the bill plummeted and traded at a negative return. I'm working on he 30 chart and as soon as I get it I will forward it to you.

Dan Perkins

Wednesday, February 9, 2011

Flash Repot on housing


The number of borrowers who owe more on their mortgages than their homes are worth, called negative equity, took a huge leap in the fourth quarter of 2010. A full 27 percent, over 1 in 4 mortgages of borrowers are now “underwater” on their mortgages, up from 23 percent in the previous quarter, according to a new report from Zillow. They believe that the foreclosure moratoriums and falling home prices are to blame.

Adding to a slew of negative reports on home prices, Zillow found home values posted their largest quarter-over-quarter decline, 2.6 percent, since the beginning of 2009.  Home prices plunged 5.9 percent compared to the fourth quarter of 2009.

Florida, California and Arizona that suffered most from the sub-prime mortgage collapse continue to post high negative equity rates, other less likely candidates are climbing.  Over one third of Chicago borrowers owe more than their homes are worth, and in Atlanta over half are underwater.  Denver and Minneapolis are also well over the national rate.

It is hard for me to believe that the Fed will increase interest rates until jobs expand and the housing market at least stabilizes. We will have to wait and see the impact of the lifting of the foreclosure moratoriums will have on both supply and prices before we can look for a bottom in the real estate market.

Dan Perkins

Sunday, February 6, 2011

Something Got to Give

I watch interest rates continue to increase and the stock market indexes continue to rise. I do not believe that both can go up forever. As the old saying goes, “Something's got to give.” If I were a betting man I would say the stock markets would be the first to flinch and break. My problem is that I don’t know when this will happen. I have no doubt that it will but when is the issue. 

I was looking for a way to show you what has happened to the stock market and the bond market since the Fed said that it will have round two of quantitative easing. You do need to know how to read the chart above. The top line in Red, not my choice of color to show positive returns, is the upward movement of the S&P 500. The bottom line in black, which should be red, is an indicator of the price of the 30-year T-Bond,

The interesting thing is that if prices rise then yields fall. What is important about this chart is how the divergence has widened over the time period without any significant correction in either market. When we had a small correction in the stock market in December there was no corresponding rally in bond prices.

 As you can tell by looking at the chart the stock market is up about 15% and the bond market is off about 9%. Now let’s put both of these moves in historical context. The average return over the last 100 years in the S&P is about 8%. Over the same period of time the average return on the bond is about 5%.

 The current yield on the 30-year T-Bond is a touch under 4.75% or just over one quarter of one percent away from its historical average. The stock market on the other hand is almost 90% above the historical average. As the yield on the 30-year gets closer to 5% money will move out of either cash or stocks into bonds.

Going back to our historical numbers again, if the stock market is going to grow by 8% on average and the bond market was yielding 3.75% you might want to put more money in stocks as they may have more opportunity than bonds. If, on the other hand, the yield on the 30-year T-Bond hits 5% or even close to 5% then look for the market to run out of steam. This past week I saw an article about some money managers encouraging the Treasury to issue a 100-year bond. As long-term interest rates continue to rise look for more talk about offering bonds with maturities greater than 30 years. 

 As I said, I don’t know when the correction will happen but the stock market looks tired to me. It has to labor every day for smaller and smaller gains. So the correction, when it comes, may not be a quick sell off, but a small grind down. People who have gains will be reluctant to sell expecting the bounce off the short-term low. We could have a situation where the market grinds down slowly and then we have a blow off that take us down very quickly. 

 The greatest risk at the moment is emotional risk. The fear of not being in the market as it goes up sometimes causes investors to jump in to buy more than they would under normal circumstances. This time around buying the dips may be the wrong decision.   

Dan Perkins