This article was originally going to be titled, “Dying Cities, Dying States, Dying….”  I thought that would be correct but too pointy.  The key to thinking about pensions is to look at the likely cash flows for current and former employees.

Here’s my scenario: a municipality decides to terminate its overly generous defined benefit [DB] plan, and though it is 30% underfunded, they agree to not let underfunding get greater than 30%.  Sadly, the discount rate on the pension cash flows is 8%/yr, but the likely investment earnings rate is 6%/year.

Here’s the graph of pension payments to beneficiaries, and contributions to the plan:

Pension Payment curve_14804_image001

At the beginning of this scenario, pension payments were 10% of the municipality’s budget.  Assuming taxes only grow at the rate of 2%/year,  contributions to pensions are not less than 10% of the municipality’s budget until 2049.  As a share of the budget, it peaks out at 32% from 2032 to 2035.  It’s over 20% from 2022 to 2043.

30% underfunding isn’t that uncommon, and discount rate assumptions of 8% aren’t that uncommon either.  Would that all municipalities were at discount rates of 6%, or at my more likely view, 4%.

But it doesn’t matter.  We can argue over assumptions.  The cash flows actually paid to beneficiaries do not rely on assumptions.  The assumptions exist to try to allow pre-funding, so that municipalities fund their plans to the same degree that benefits are accrued.  Some municipalities have done that with pensions, almost none have done it with retiree healthcare, but the retiree healthcare promise is much weaker one.  You can turn it from a Cadillac plan to hospice care, in many cases.  In this case the state constitution matters a great deal, so do your own homework here.

Part of my advice to you is to watch weaker states and municipalities, like Puerto Rico, Illinois, Chicago, Pittsburgh, and many others.  I don’t have all of the data in front of me.  This is one of those cases where relative standing is important.  People will migrate out of areas with low funding, and high expected payments, and into municipalities with higher funding, and lower expected payments in relative terms.

You will see municipalities depopulate, because the taxes are disproportionate to the increasingly slim services rendered, because much of the revenue pays for the overly generous past promises to retirees.  As a result, you will see more municipal bankruptcies.  I would expect that you would see most of the bankruptcies in the 2020s.

I know that’s vague, but I think it is more defensible than Meredith Whitney’s notable statement a few years ago.  The pension cost curve is inexorable, and I suspect most municipalities can bear it for the next six years, but will have a hard time with it as the tail end of the Baby Boomers retires in the 2020s.

Advice

1) If you are in an area under pension stress, if you at all can, not harming your existing earnings, move to an area not under that stress.  Remember, as other people move, it will become increasingly difficult to maintain existing services.  Think of the slow police response times in Detroit, and packs of stray dogs that roam the city.

2)  If you work for a municipality, consult your state constitution to see what you are guaranteed.  In many cases, healthcare will not be covered.  Even existing pension benefits in payment now may be under threat in a default.  Be aware.

This is one of those cases where the rich will get richer, and the poor will get poorer — better to be on the rich side of the line, and sooner.

Final Note

All that said, we face the same issues with Social Security and Medicare, though both are unfunded.  At present, Social Security’s payments will be cut by 25% or so in 2026, unless some adjustment is made to the system.  Medicare is another issue, and the question is what will it cover.  It could be stripped back a great deal when the US realizes it can’t fund a generous system that extends life a few years at high cost.

My main point to all of my readers is to be aware of the imbalances in the existing systems, and be ready for the coming adjustments, because the US economy will not be willing to make all of the payments that have been promised to oldsters who have served the public.

September 2013October 2013Comments
Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace.Information received since the Federal Open Market Committee met in September generally suggests that economic activity has continued to expand at a moderate pace.No real change.  What economy are they watching?
Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated.Indicators of labor market conditions have shown some further improvement, but the unemployment rate remains elevated.Weasel words because the participation rate is falling, and wages are stagnant.
Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth.Available data suggest that household spending and business fixed investment advanced, while the recovery in the housing sector slowed somewhat in recent months. Fiscal policy is restraining economic growth.No change.
Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.No change.  TIPS are showing similar inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.57%, down 0.12% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.No change.

Emphasizes that the FOMC will keep doing the same thing and expect a different result than before. Monetary policy is omnipotent on the asset side, right?

The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall.Financial conditions are looser.  That’s largely due the end of imminent tapering.  Also that the economy is weak.
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.No change.  CPI is at 1.2% now, yoy.
Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.Taking into account the extent of federal fiscal retrenchment over the past year, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.No change.  This notable paragraph, saying that the “taper” is not starting because fiscal policy is not as stimulative as the Fed wants.
Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change.

Operation Twist continues.  Additional absorption of long Treasuries commences.  Fed will make the empty “monetary base” move from $3 to 4 Trillion by the end of 2013.

 

Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless comment.
In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.No change.
Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases.Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.No change.

Promises that they won’t change until the economy strengthens.  Good luck with that.

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.Not a time limit but economic limits from inflation and employment.

Just ran the calculation – TIPS implied forward inflation one year forward for one year – i.e., a rough forecast for 2015, is currently 1.52%.  Here’s the graph.  The FOMC has only ~1% of margin in their calculation.

 

In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen.No change
Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.No change.  George continues to make her point that is the same as mine in my piece Easy In, Hard Out; that the Fed may have greater problems as a result of its abnormal policies, whatever they do in the future.

 

Comments

  • This announcement was a nothing-burger.
  • No taper yet.  Equities, and long bonds fall.  Commodities do nothing. Feels like some market participants expected more QE.
  • The FOMC says that any change to policy is contingent on almost everything.
  • They think that if they use more words, they will be clearer.  Longer statements are harder to parse and understand.
  • Current proposed policy is an exercise in wishful thinking.  Monetary policy does not work in reducing unemployment, and I think we should end the charade.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • GDP growth is not improving much if at all, and much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.

I’m reading an investment book that is arguing for market timing.  I’m not impressed with the line of argumentation so far.  I just finished a chapter where the authors pointed out that security price movements are more volatile that the normal distribution would admit.

This is a well known result, or at least it should be well-known.  What I hope to contribute to the discussion is why the tails are fat, and skewed negatively.  There is a famous saying in investments:

Cut your losses, and let your winners run

I regard this saying as vapid, because I have had so many investments where the price action was bad initially, but ended up being incredible investments.  I have also had companies stumble after prior gains, and persevere for greater gains.  Intelligent asset management does not react to the past, but analyzes future prospects, and looks at current margin of safety.

But imagine a situation where many parties have their plans, and they are all similar.  I’ll give a few examples:

  • Institutional investors decide in 1986 to follow the momentum, but be ready to sell if the momentum breaks.  They want upside, but want to protect the downside.
  • Japan was a total momentum market up through 1989, and the reverse thereafter.  Loose monetary policy was an aspect of that, as was a loss of fear, warrant speculation, etc.
  • Those investing in hot emerging markets in the mid-90s did not recognize valuations getting stretched, and the inability of the countries to maintain stimulative policies amid falling currencies.
  • The guys at LTCM were geniuses until they weren’t.  They had no idea of the risks they were taking.  They did not have an ecological view of investing.  Essentially, they thought liquidity was free, until the jaws of the trap snapped shut, and they died.  Taking a concentrated position is a risk, because the investing typically pushes up the price.  When you are so big in a position that you are affecting the market price, that is a bad place to be for two reasons: 1) if you sell, you drive down the price for future sales, and 2) you no longer know what the fair price would be if you weren’t there.
  • Aside from that with LTCM, their brokers mimicked their trades, accentuating the boom-bust, but the brokers had risk control desks that forced them to sell out losing trades, which further hurt LTCM.
  • Think about residential mortgage bonds in 1994.  So many players thought that they had mastered the modeling of prepayment risk only to find amid a Fed tightening cycle that many wanted to limit their interest rate risk as rates skyrocketed, fueling a self-reinforcing panic.
  • Consider tech stocks 1998-2000.  Momentum ran until the sheer weight of valuations, together with insolvencies, crushed the market as a whole, and tech stocks more.  Think of European financial institutions getting forced by regulators to kick out US stocks in September 2002, putting in the bottom.  Regulators almost always act too late, and exacerbate crises, but they should do that, because worse things would happen if they didn’t.  (Later = bigger crisis, Earlier = Some Type II errors, regulating where it was not needed).
  • Finally, consider the housing/banking crisis in the US 2005-2009.  People bought homes with a lot of debt financing, and short-dated debt financing.  Banks levered up to provide the financing.  Shallow credit analysis allowed banks to take on far more risk than they imagined.  It all ended in a trail of tears, with many personal, and not enough corporate bankruptcies, with the taxpayers footing the bill.

In each of these cases, you have correlated human behavior.  The greed of investors gives way to fear.

Now if you are thinking about Modern Portfolio Theory, where market players have perfect knowledge, this doesn’t make sense.  These crises should not happen.  But they happen all too regularly, and I will explain why.

Men are not greedy as much as they are envious.  This leads to mimicking behavior when things are going well.  Those not currently playing want a piece of the action, and so they imitate.

Modern Portfolio Theory implicitly assumes that market players don’t react to the actions of other market players, but that is false.  Most market players don’t think; they mimic.

That is what leads to fat tails, because when people move as a herd, you get dramatic price moves.  Because fear is a greater motivator than envy, that is why the big downward moves are almost always greater than the big upward moves.

Add into that the credit cycle, because gains on credit-sensitive bonds are small, but losses are huge when they occur.  The distribution of outcomes has a long left tail.

The main point here is that price movements are non-normal because market players act as a group.  Their behavior is correlated  on the downside, and to a lesser extent on the upside.

Among other things, this means Modern Portfolio Theory is wrong, and needs to be severely modified, or abandoned.  It also means that we need to watch the credit cycle, and speculative activity to get a sense of how committed the hot money is to risk assets.  Hot money follows trends.  Cold money estimates likely returns over a market cycle, and invests in the best ideas when they are out of favor.

I don’t think timing the market is easy.  I do think that fundamental investors have to look at whether they have a lot of opportunities, or few, and vary their safe assets opposite to opportunities.

So beware the fat tails — we haven’t had a lot of volatility recently.  Maybe we are due.

The more that markets are united through derivatives, the more systemic risk is created.

Derivatives exist to subvert regulations, at least the regulations that don’t involve derivatives.  Ideally, derivatives allow those that want to take on a given risk, to have the ability to do so.  And the same for laying off risk.

But here’s the difficulty.  You can create all the derivatives you want, but total risk never goes away, it is only shifted.  There are many idiosyncratic risks for which there is no natural counterparty, i.e., one that faces the opposite risk.  What does it take to get someone to speculate on a risk?  Well, you have to offer them good terms, such that on average, they have the expectation of a profit.  The speculator may try to delta-hedge, and/or cross-hedge his risks, or he may not.  But the speculator is usually in a weaker financial position than the hedger.  Let me give an example:

In the insurance world, with a few exceptions, large direct writers have higher ratings than reinsurers.  And for what few reinsurers of reinsurers there are (“retrocessionaires”) they usually have lower ratings than the reinsurers.  There is a tendency for the economic world to arrange itself like a Collateralized Debt Obligation.

Think about it.  In a CDO, the junior tranches insure those that are more senior against loss.  In exchange, they are offered a higher yield.  That’s what goes on with those that speculate with derivatives.  The one being insured typically gives up some economics to the speculator.

Now if this goes on in a small way, there is no trouble.  But if large numbers of parties lay off their risks in this way, a large amount of  risk is in the hands of speculators which don’t have the best balance sheets.  It’s not as bad as people holding stocks in 1929 on 10% margin, but you get the idea.

Anytime risk is concentrated in the hands of those less well capitalized, there is heightened systemic risk.  Think of AIG writing gonzo amounts of subprime AAA RMBS CDS for a pittance.  Everyone on Wall Street took advantage of them, except for one thing — because everyone was insured by AIG, no one was truly insured by AIG.  If the Fed hadn’t stepped in, who knows who could have been insolvent — and that’s what should have happened, with the regulators letting holding companies fail, but protecting regulated subsidiaries, so that ordinary people would not be harmed.

When risks are in the hands of those with weak abilities to bear risk, not only are the weak affected but the strong also.  The strong, thinking their risks are covered, lever up more because they aren’t worried about the risks.  When the weak fail, and the strong find that risk is shifting back to them, they find that they themselves are hard-pressed, because they don’t have so much equity to cushion the losses.

There is no free lunch with risk.  The most we can do is try to analyze who is bearing the risk.  If it is in strong hands, we don’t have to worry.  If it is in weak hands, perhaps it is time to reduce risk, and not synthetically, but by genuine sales of assets.

If we want to solve this problem we should require insurable interest, and only let hedgers initiate transactions.  But who will take on the lobbyists?

I write this because my friend Tom Brakke is putting together a book.  He wrote a series that started with a letter to a young analyst.

I have sympathy for those that are starting out in finance.  It’s tough.  My own route to where I am today was longer than most. In some ways, I have advantages, because I worked inside regulated financial firms, and I saw the pathologies that exist within them.  But here was my path:

  • Junior Actuary
  • Actuary for Annuity Lines
  • Investment Actuary for tihe Pension Line
  • Investment Actuary for the Annuity Line
  • Mortgage Bond Manager, and Risk Manager
  • Corporate Bond Manager, advising the Chief Investment Officer on insurance issues.
  • Buy-side Analyst of Insurance Companies for a hedge fund
  • Chief Research Analyst for a minority broker-dealer
  • Principal of Aleph Investments, LLC

Look, it’s tough to be inexperienced.  I’ve been there.  I really wish I understood the accounting rules, and laws/regulations regarding insurance better, when I was new to my work.  That said, I wish the older guys would have handled the issues better, and not made a neophyte deal with tough issues without advice.

It’s hard, but to the extent that you can, think about analytical issues at their most broad and qualitative levels.  Anyone can put numbers into a formula, but few can understand what the numbers and formulas mean.  Formulas are abstractions, and like all abstractions, they distort reality.  The analyst that can adjust the model to reflect reality will be far ahead of the one that “plugs and chugs.”

A Picture is Worth 1000 Words

Let me tell you about one of my greatest failures.  My division at AIG had a new CEO, and he was an actuary.  We felt like we had lifted from the basement into the stratosphere.  I went to the new CEO, and showed him my proposal for crediting rates.  Most of the presentation was visual, with many graphs.  It was stunning; I walked out of the meeting knowing that I had deeply convinced the CEO.

He was fired the next week by M. R. Greenberg.  He did not understand the politics of AIG, and questioned one of Greenberg’s deeply held convictions.

And so, young analysts, you may do superior work, and it ends up being nothing for reasons outside your control.  What should you do?  Keep up the good work, because most of the time, good work triumphs.

Study the Greats

For what it is worth, I am a lifelong learner.  Though I try to develop my own methods, I study the methods of others.  There is no “not invented here” attitude at Aleph Investments.  Rather, it is more akin to the mid-90s Microsoft motto: “We embrace and we extend.”

I have studied many different types of investors, and many different types of investments.  The breadth of understanding can allow you to analyze odd situations, where the rule books may not have opined yet.  It is good to be curious, and learn things a jump or two outside your circle of competence.  That is what expands your circle of competence, and deepens your knowledge at the core.

Learn the Tools

Even if it just being an Excel expert, learn your tools well.  If you can, be the “local expert” on how to get the most out of the common bits  of software used for analysis.  I still remember the looks on the faces of guys 20 years younger than me as a I showed them how to create deeply nested string functions that solved critical problems in a small space.\

Get the CFA Charter and More

It’s not that the CFA Charter confers great knowledge — I drifted through it with little difficulty.  Your mileage may vary.  But it does give a reasonably balanced treatment of the settled finance literature, while teaching ethics.  The ethics part is important.

Many of us want to “make good,” while few want to “do good.”  But what if the key to prosperity it putting the client’s interests first?  Even on Wall Street, as a corporate bond manager, I looked out for the interests of my brokers.  By being willing to help when they were in trouble, it brought me more than enough “good deals” because they wanted to help a friend who wasn’t playing for the last nickel on every deal.

Investing is a people business.  Do you make your clients happy?  Do you explain to them what you are doing?  Do you answer their intermittent questions?  Even the dumb ones?  If you aim for the good of others, good things will come back to you.  It may seem less direct than most marketing, but it is far more sticky.

As Jesus said, inverting Hillel, “Do unto others as you would have others to do to you.”  As Buffett said, “Don’t do anything you wouldn’t want to see on the front page of the newspaper.”  Jesus was more complete — do what is in the best interests of your clients, and ethical problems go away.

Conclusion

As an acquaintance of mine once said, “This is the greatest game in the world, and they pay us to play it.”  True enough, though many of us are in the top decile of ability, we compete against those in the top percentile.  It’s a tough world, and the competition means risk-adjusted profits are few.  Maybe we should all be wealth managers, sucking alpha out of the tax code, until the government changes the rules.

Be aware that in mid-life you might wonder what good your life has been.  Aiding the efficiency of capital markets is a good thing, but it may seem thin relative to jobs that obviously help other people.

A defense to that is managing money for the good of others, and not just for yourself.  Modest fees, where you have your own assets invested alongside your clients, is a great thing to do, and assures clients that you care for them.

“Care for them,” those words strike me.  Most amateur investors buy near the top and sell near the bottom.  We can be their shepherds, holding their hands during the bad times, and telling them to calm down during the good times.  We can try to limit their risks so that they do not panic or get greedy.

There is real good to be done people and institutions as an investor, but the first thing to learn is control yourself, and all of your emotions.  Once you do that, you can do good things for your clients.

From John Mauldin’s latest book, Code Red:

Investors should ask themselves: if central bankers couldn’t manage conventional monetary policy well in the good times, what makes us think that they will be able to manage unconventional monetary policies in the bad times?

I would point my readers to two of my detailed pieces on monetary policy:

What Mauldin says is common sense, and is a summary of my own views.  The Fed missed many opportunities to tighten monetary policy enough during the good times.  They tried to be short-term heroes, not willing to take the heat like Martin and Volcker did.

So why should we entrust these losers with “more powerful” tools (that have never been shown to work), when they can’t use the normal monetary policy tools right?  By over-provisioning liquidity from 1986-2004, the Fed created the trap that we are all in now.

I don’t see a good way out of this, and as for investing, I am mostly holding companies that can pass inflation through, with strong balance sheets, should there be deflation.

Many people are amazed at the valuation of Amazon.com.  How can a company receive such a high valuation when it earns so little money?  And how can it grow so fast?

The second question is easier.  They are reinvesting their free cash flow, which is different than profits. You can only reinvest excess (free) cash. Profits do not measure what you can reinvest, because profits do not represent change in unencumbered cash received.

In the past Amazon grew off of its free cash flows.  In the last year, they needed to borrow $3.2 billion.  Truth, AMZN’s balance sheet is not all that strong — a lot depends on the value of their intangibles. Their brand is so strong, the intangibles have value. The question is how much.

We could figure out the value of the intangibles if Amazon raised its prices a touch, and saw how much free cash flow increased, and market share decreased.

One person asked me whether Amazon becoming subject to state sales taxes would be a good test of the franchise, even though Amazon receives none of the proceeds.  I replied,

“That could be a good test. Not sure $AMZN will share that data with us, but that would be a good thing to analyze. Doesn’t matter that the money doesn’t go to Amazon — it will show how sensitive demand is to price changes. Then Amazon could get an idea of what an additional price change would do for them.

But maybe it is Amazon’s strategy to chase out all competitors now, and wait for the payoff day to come. That said, especially on the internet, competitive advantages are hard to sustain. People adjust rapidly to changing incentives.”

That brings me back to the first question: How does Amazon get such a high valuation?  Think back to the cable company stocks, which plowed all of their debt and free cash flow into growth.  They had little if any taxable income.  They acted like private equity companies, but were publicly traded.  That is how Amazon is acting now, and so people are valuing it on the hope that when is gets to maturity, it will be an actual near-monopoly, having a lot of power to raise margins with impunity.

I should mention that this is a dangerous strategy, particularly with an internet company, because the costs of switching are low for customers.  Can Amazon make itself so irreplaceable that a future Amazon will have little difficulty passing through price increases?

As for current Free Cash Flow, Amazon does not help — they do not split out maintenance capital expense.  (Hey, let FASB justify its existence and require that maintenance capital expenditure be a separate line item.)

But imagine for a moment that Amazon’s operating cash flow is the free cash flow.  No maintenance capital expenditure.  Should Amazon trade at a 30+ multiple of free cash flow?

No.  And that is a biased measure, because maintenance capex is not considered.  I expect there to be a correction in he stock price of Amazon, unless it moves to increase its gross margins.  If it can’t do it, it will not prosper.  Good company management aims for free cash flow.  It does not aim for big returns far in the future.  The future is far more variable than most believe, so intelligent businessmen give light weight to the far future, because their view of what might happen is unlikely.

Interest Rates

  • How Sensitive we are to Interest Rates: A Scary Picture? http://t.co/gkKi3sSLbs Argues moderate rise in rates inverts banks & governments $$ Oct 25, 2013
  • Fixing Economy As Easy As 1-2-3 http://t.co/sbW97kL2n7 Axel Merk says 2 make policy predictable, let interest rates rise & allow failure $$ Oct 25, 2013
  • Low Rates Bring Bond Bonanza http://t.co/f8gQ0rjcTB Corporations act to lock in cheap long-term financing 2pay dividends & buy back stock $$ Oct 25, 2013
  • Fed QE Taper Seen Delayed to March as Shutdown Bites http://t.co/v2Bo85GP9m Would not b so sure here; this is only a survey of economists $$ Oct 20, 2013
  • The ‘Rate Gap’ Is Rising http://t.co/w9dSYfQCl5 Gap between deposit rates & borrowing rates is higher than it’s been in 32 of last 40 yrs $$ Oct 20, 2013
  • Alan Greenspan: Where the Economy Went Wrong http://t.co/a7t3RGvbSZ Fed does not get they created the housing bubble; learn the bond math $$ Oct 20, 2013
  • Javelin Files 2 Trade Interest-Rate Swaps, Spurring SEF Shift http://t.co/B6KOHsmmpy Smart. Start w/simple liquid derivatives @ exchanges $$ Oct 20, 2013

 PPACA/ Obamacare

 

  • Court could block Obamacare subsidies in 34 states http://t.co/ej65x9fALf Legal challenge could knock out the federal exchanges $$ Oct 25, 2013
  • Botched Launch of Health Site Blamed on Poor Coordination http://t.co/iwH5vsbftX The software developers point the finger at one another $$ Oct 25, 2013
  • Federal Centers 4 Medicare and Medicaid Services acted as its own systems integrator for the site: unusual arrangement 4a complex project.$$ Oct 25, 2013
  • White House Sets Late-November Target for Fixes to Health Site http://t.co/WebNZLBebq UnitedHealth Group Unit Tapped to Oversee Repairs $$ Oct 25, 2013
  • Obama Says Health Care Law More Important Than Website http://t.co/SopPqG99ky If a law can’t b administered properly what good is it? $$ Oct 25, 2013
  • Why Obamacare Is Like Three Mile Island http://t.co/STOU4Ng3KL Problems in overall plan design were foreseeable; not merely and accident $$ Oct 25, 2013
  • Noonan: ObamaCare Takes On Water http://t.co/cpKjIyJZWg Software development is difficult when no single party responsible for everything $$ Oct 25, 2013
  • Contractors See Weeks of Work on Health Site http://t.co/WUoqiaiMtZ Have friends that once worked 4 CGI; to them this is no surprise $$ Oct 22, 2013

Rest of the World

 

  • Top China Banks Triple Debt Write-Offs as Defaults Loom http://t.co/DYNZ8shAV5 They trying to get ahead of the problem, but it’s too big $$ Oct 26, 2013
  • Local Governments Have Borrowed a Pile of Money in Recent Years, Leaving Even Beijing Wondering How Much $$ http://t.co/YZKTKDUjs0 Oct 25, 2013
  • Jail Time No Bar to Tea-Server Turned Top Woman Bureaucrat http://t.co/WKWO4MmPwu While detained, she used the free time 2 read 150 books $$ Oct 25, 2013
  • Yakuza Bosses Whacked by Regulators Freezing AmEx Cards http://t.co/qCKQI7Mo4s Money is often the easiest thing to track; leaves a trail $$ Oct 25, 2013
  • I realize that @Borderscrossed , & I phrased that tweet wrong — the Chinese typically play w/lower risk ventures. This is unusual 4them $$ Oct 25, 2013
  • China Inc. Battles Big Oil for Century’s Biggest Find http://t.co/CCm4QxgpC8 They have capital, but not expertise, & r rolling the dice $$ Oct 25, 2013
  • Obama Joins Putin War as Syria Jihadists Stalk Olympics http://t.co/zxwpTvWiv1 The Winter Olympic games in Sochi could be a real blast $$ 😉 Oct 25, 2013
  • Saudi Women Plan to Hit Roads in New Push for Right to Drive http://t.co/Iu78Zmsxp0 Fear: if they r allowed 2 drive, will drive out of SA $$ Oct 25, 2013
  • 40 Years After Embargo, OPEC Is Over a Barrel http://t.co/6CcliMnOkv Few things r truly certain. Dead Worries: OPEC, Russia, Japan, China $$ Oct 20, 2013
  • The Chinese Characters Dictation Competition Is a Test Few Could Pass http://t.co/5MnpMaMozF Chinese spelling bee w/ideographs; tough $$ Oct 20, 2013

US Politics & Economics

 

  • Financial Report of the US Government http://t.co/9rknzA89Te Here’s my piece. The unfunded liabilities of the Fed Govt r ~$78T $$ 5x GDP Oct 26, 2013
  • If you call a crash & you get the reason right, that *is* impressive; timing is always tough. Hint: look for a arb that has gone negative $$ Oct 25, 2013
  • ‘Outrageous’ tax loopholes in Democrat’s sights http://t.co/ibntGjND15 Every loophole has coalition to block its elimination; won’t work $$ Oct 25, 2013
  • Budget Discord Simmers Among Democrats http://t.co/gdNJqQTXEI Some Liberal Groups, Lawmakers Worry About Cuts 2Entitlements $$ biggest issue Oct 25, 2013
  • Treasuries Lose Cachet on Lowest Foreign Demand Since ’01 http://t.co/0PhlcmXXqv Bondholders have short memories; wouldn’t worry $$ $TLT Oct 25, 2013
  • Hillary Clinton’s 2016 Chances: The Coming Train Wreck http://t.co/JN61FbNNrY Will test whether having a long political resume is good $$ Oct 25, 2013
  • Never believe anything in Washington, DC until it is explicitly denied. The US Government has lied to us in the past $$ Oct 25, 2013
  • The Lessons of Classified Information: From Mossadegh to Snowden http://t.co/Ab7ytJrdRA CIA plot in Iran widely suspected, now confirmed $$ Oct 25, 2013
  • Middle Class Americans Face a Retirement Shutdown; 37% Say “I’ll Never Retire, But Work Until I’m 2 Sick or Die,” $$ http://t.co/oGDNMful7I Oct 25, 2013
  • Reality is setting in if 37% think they won’t b able to retire. http://t.co/LA9KI4Tvrx Reality will arrive when number is 80% $$ $TLT $SPY Oct 25, 2013
  • Selling the Good Life on the Great Plains http://t.co/fKl4Jh8syI Rural areas pitch the slower pace to city dwellers in order to survive $$ Oct 25, 2013
  • Stanley Druckenmiller: How Washington Really Redistributes Income http://t.co/Cbkv9FyRu9 Baby Boomers suck the blood of those younger $$ Oct 20, 2013
  • Banks Pushed by Regulators Send ‘Nastygrams’ to Car Dealers http://t.co/W9RC6BJP7x Discrimination in lending is taking heat from the CFPB $$ Oct 20, 2013
  • Two articles on States Clamping Down on Workers as Contractors http://t.co/QQXoTSRZOU & http://t.co/a1OUq8MvNE Develop significant skills $$ Oct 20, 2013

Companies & Industries

 

  • Abby Johnson, the rarely seen face of Fidelity http://t.co/6dJHDIm7ES Wonder if the Washington Post pulled the story under pressure $$ $WPO Oct 25, 2013
  • Might Google Have a Sly Motive Behind Motorola? http://t.co/FwtqFYXYoV Argues that $GOOG bot Motorola 2 poison profits 4 $AAPL & $SSNLF $$ Oct 25, 2013
  • Cruise Prices Sinking: Some Now Cheaper Than Motel 6 http://t.co/dhjvxc8ytS They will leave the light on 4u; the buffet will b open 2 $$ Oct 25, 2013
  • Buffett says he passed on buying Washington Post http://t.co/dvZciwJDJh Definitely one to avoid, or throw in the “too hard” bin $$ $WPO Oct 25, 2013
  • Wal-Mart Now Draws More Solar Power Than 38 US States http://t.co/ysFvCFHWgr Drop the solar subsidies, and see if $WMT would still do it $$ Oct 25, 2013

The Financial Sector

 

  • Margin Debt Hits New High http://t.co/r0bXQwBs6X Where will additional buying power come to push up stock prices? Only game left is QE? $$ Oct 25, 2013
  • House flipping makes a comeback http://t.co/VAIcl86lQk Speculation returning to housing market; remember, only cash flows matter 4 prices $$ Oct 25, 2013
  • PCAOB Warns on Internal-Control Problems http://t.co/ZKZQwBnICe 15% of Auditors didn’t get enough data on internal control effectiveness $$ Oct 25, 2013
  • Weitz to Yacktman Hold Cash as Managers Find Few Bargains http://t.co/RXFoMbBJfX Not many places 2 compound value w/margin of safety $$ Oct 25, 2013
  • US extends backing for higher-priced mortgages http://t.co/Yk5zHr9CcW Continuing to subsidize overinvestment in residential real estate $$ Oct 25, 2013
  • Buffett Says Gains in Housing Fall Short of Equilibrium http://t.co/aMp5aawapZ Rare wrong Buffett; US overinvests in residential RE $$ Oct 25, 2013
  • Dollar Drops to 8-Month Low as Risk Appetite Swells on Fed Bets http://t.co/KtQDmkS4Yf Fed surprising w/unexpected looseness so $$ falls Oct 20, 2013

Other

 

  • A CIO’s First Task: Understanding the Culture http://t.co/4cg1GdKBZo Understanding the culture is a key to most leadership roles $$ Oct 25, 2013
  • Never Shop in October and Other Secrets From a Retail Guru http://t.co/KoWB9NYsmt Tips on how to avoid how retailers try 2 influence u $$ Oct 25, 2013
  • The Boss Is Watching: Tracking Technology Shakes Up Workplace http://t.co/WDAzYg1MJK Little brother watches 4 employees who shirk $$ Oct 25, 2013
  • Ex-Madoff Employee Tells Jury of ‘Cut And Paste’ Trades http://t.co/SJCd2TU13b Employees claim they were duped by Madoff. Q: were they? $$ Oct 25, 2013
  • Book Review: ‘Johnny Carson’ by Henry Bushkin http://t.co/OTB8HMQK6e Bombastic Bushkin gets 2 dance on the grave in this tell-all book $$ Oct 20, 2013
  • So You Want to Go to Winemaking School? http://t.co/JdpI5QCE6t Visit the UC-Davis viticultural & oenology program. $$ #wine Oct 20, 2013
  • It isn’t only one of the oldest winemaking programs in the country, but arguably the most prestigious $$ #wine Oct 20, 2013
  • The First Car You Can Build Yourself… in an Hour http://t.co/bZF43gH3ti Pretty cool for a little more than $8000 $$ Ships in a box Oct 20, 2013
  • The Gap Between Schooling and Education http://t.co/zJGqxgkoTT @AnnieLowrey interviews author of forthcoming book: http://t.co/bgftBBsT7d $$ Oct 19, 2013
  • Schools amplify parenting cultures. Motivated parents create good schools; too many top-down demands on schools inhibits true learning $$ Oct 19, 2013

Wrong

  • Wrong: Another billionaire is predicting doom. Ignore him. http://t.co/qh8BBp0izo Rather ignore this writer; doesn’t understand the stats $$ Oct 26, 2013
  • Wrong: Does the United States have $128 trillion in unfunded liabilities? http://t.co/D5Z3dkPICT Writer does not understand the figures $$ Oct 26, 2013
  • Wrong: Stanley Druckenmiller crisis predictions: Anyone can call a bubble years in advance. http://t.co/0W9FhMyHKT But few succeed $$ Oct 25, 2013

Retweets, Replies & Comments

  • I wrote about that more than once @DividendMaster . E.g. http://t.co/SrBiSHsHVZ $$ Oct 25, 2013
  • “They are reinvesting their free cash flow, which is different than profits.…” — David_Merkel http://t.co/bt0CCZW9zH $$ $AMZN Oct 25, 2013
  • Same Old Amazon: All Sales, No Profit http://t.co/FL6ZbcGh8j $AMZN borrows2fund investment & uses free cashflow, much like private equity $$ Oct 25, 2013
  • RT @JimPethokoukis: 11.2%: What the unemployment rate would be if labor force participation was the same as when the recession started Oct 23, 2013
  • Experian Sold Consumer Data to ID Theft Service http://t.co/tjJbAXXxuN @japhychron yes, significant reason to worry & watch 4 ID theft $$ Oct 22, 2013

I am one of the endorsers of the INFORM Act.  I have believed for over 25 years that younger people need to understand the costs that they are undertaking for the comfort of older people.  The government has resisted such clarifying measures because they don’t want younger people to know how badly they are getting hosed.  Since the creation of Social Security and Medicare, each succeeding decade of people has gotten w progressively worse deal.  Young people should know that they are going to get a decidedly negative return out of Medicare, so that they can be politically active to reduce their losses.

I encourage you to support the INFORM Act — after all, what should be the problem with telling the American people the truth?

Sometimes I over-commit my time.  That’s been the last few days.  Recently I went to visit a friend who had lost his job at a large company, to look over his severance papers, and advise him.  He is older, a “minority,” and only been with the firm 5-6 years.

Severance agreements have gotten a lot tighter since the two that I have personally experienced.  Corporations dangle some compensation to eliminate possible future legal costs.  I pointed out to my friend the most likely reasons he might sue, but added two things:

  • The company has a large number of sharp lawyers, so you had better have an open-and-shut case.
  • We’re Christians, so we don’t go to court over small matters.

But what impressed me in reading the agreement was how airtight it was — can’t sue over Federal, State, Local, or common law offenses, or anything else.  Which made me think about another thing… the connection between entrance and exit doors.

In investing, people are more wiling to invest if they can have their money back at any time.  With employment, it is the same — employers are more willing to employ if they can fire people for any reason.

Every protection for those employed makes it harder for those without work to be employed.  This also forces jobs to go underground — if advertising them publicly subjects them to regulation, then the good jobs will be filled via “word-of-mouth.”

This takes me back to the early days of the Reagan Administration.  They deregulated a lot of things, and the economy grew far more rapidly.  We could do the same now, starting with labor and healthcare.

My friend may do fine, but the things that “protected” him at his last job now hinder him in seeking another job.  Better to eliminate the protections, and let people compete based on skill and assiduousness.

Part Two

Then I was a judge in a financial analysis competition at a local college.  The analysis involved a stock that faced a large investment decision, larger than the current enterprise value of the junk-rated company.  Should the hedge fund buy, sell short, or do nothing with the stock?  The simple part of the case study was working through the intricacies of the discounted cash flow model, together with changes to the assumptions about cash flows and the weighted average cost of capital.

What I found interesting was the lack of attention to:

  • Details of the case study — did you even read it?
  • Common sense — we are sorry, but a stock can’t lose 113%.  Perhaps you would like to tell us to short the bonds?
  • Limitations of complex techniques in finance.  Yes, there’s many nifty formulas available to you, but do you understand what they really mean, and what limitations they imply?  When are they not valid?
  • What markets can and can’t do.  No, you can’t do an public issuance of junk debt at the level of current debt.  You can’t do an issuance longer than ten years.  You can’t do one that is really big without changing market pricing (and the answers from the case study had this wrong as well).  Same applies to large secondary IPOs for equity.

Now, I know these are students.  They can’t know what an experienced market professional does.  To their credit, they dug up many bits of useful data that the case study did not contemplate.  But the case study itself should have noted these things, and to that degree I fault Darden for writing up a subpar case study.

The main thing I would say again to the students is to ignore the academic models with their false certainty, and try to understand the qualitative aspects of the business, out of which the quantitative modeling will grow.

When we were done, each of the judges gave comments to the students.  I started off with, “Sorry for being such a hard-nose.”  I got a decent laugh from the students, and then explained to them what I have said to you.

Part Three

That evening I went to a talk by CareFirst on the PPACA/Obamacare.  It was a genuinely useful 20-minute presentation, with one annoying thing: all of the pictures in the slide deck were of healthy smiling people.  If you are healthy, you will pay more, unless you are really poor.  A realistic presentation would have had people that are stoic, sad, or crying, if they are healthy and not poor.

The best part of what CareFirst gave me was premium rates for PPACA.  The lowest level plan would increase my premiums by 50%, and would increase the areas in which I would have to pay.  More expensive in every way.

It is only an affordable care act to those who were previously uninsurable; to those who were insurable it is a tax on your health and income.  In 2016, we will rip it out by its roots, and have people pay for healthcare directly, with no tax deduction for employer-provided healthcare.  That will reduce healthcare spending, and shrink healthcare to a more reasonable part of the economy.

If you want healthcare to be affordable, get the government out of it in entire.

Part Four

Dr. Kathryn Crecelius spoke to the Baltimore CFA Society on Thursday.  She is the Chief Investment Officer of my alma mater, The Johns Hopkins University.  She talked to us about endowment investing.  Very common sense stuff, very well said, and much like you would hear from me.  I found myself nodding through the whole talk.  It was all very much like my last piece on endowment investing.  I learned a lot, which makes me happy, because I always like to learn.

My travels are done for a while.  I like that too, because being home is a happy place.