Junk Bond Bust by Guest Blogger Buck Klemkosky

There are problems in the junkyard. Liquidation of the largest mutual fund since 2008, Third Avenue’s $800b Focused Credit Fund, has intensified concerns about the health of the high-yield bond market.  Third Avenue had invested in high-risk illiquid bonds and as redemptions poured in the fund sold liquid bonds first but at the end could not sell the $800b of illiquid bonds and halted redemptions until assets can be sold. 

Another high-yield fund also stopped redemptions and one other liquidated. This was a wake-up call for investors who had been chasing yield without assessing the potential risk of high-yield bonds. The amount of money invested in high-yield bond funds has quadrupled since 2009.

High-yield, high-risk bonds are commonly referred to as junk bonds. People who work and invest in this area of the bond market would prefer the high-yield label but junk is used as often as not. Bonds are rated investment grade or speculative. Investment-grade bonds are further categorized into high-grade (AAA and AA ratings) and medium-grade (A and BBB ratings). High-yield bonds (rated BB or B or CCC) are considered speculative with only moderate protection of principal and interest. Bonds can be rated lower than CCC but usually not at issuance.

There are only three AAA-rated corporations left in the U.S.: Johnson & Johnson, Exxon-Mobile and Microsoft. Twenty-five years ago there were nearly 100 U.S. companies with AAA ratings so they are a dying breed. There has been a long-term downgrading of corporate bonds globally; for example, in 2015 more than $1t of corporate bonds have been downgraded and less than $500 B upgraded in the U.S. alone.

Prior to the 1980s, only investment-grade bonds could be issued. Any bonds rated lower than BBB had been downgraded. Mike Milken of Drexel Burnham fame started the junk-bond revolution by convincing investors to buy high-yield bonds at issuance. He has long since departed the industry as has Drexel Burnham but the high-yield bond market continues to thrive. High-yield bond issuance has set records the past five years as has the issuance of investment-grade corporate bonds.

One result of the record amount of high-yield bond issuance and consistent downgrading of investment-grade bonds is today $2t of global corporate bonds are rated speculative or junk. Corporations have been motivated to issue bonds because of low interest rates and tax advantages while investors have chased yield because high-yield bonds provide 4-5% annual yield more than investment-grade bonds. Recently AA-rated bonds yielded 2.61%, BBB-rated 4.27% and high-yield 8.5-8.8%, up from 5.8% earlier in 2015. In the bond markets, the higher the risk, the higher the return. If you really have an appetite for risk, the CCC-rated bonds yield over 18%. However, as junk-bond yields have increased and prices declined, they will suffer negative returns for the first time since 2008. A popular high-yield bond index has fallen 13.6% since mid-April 2015, prompting investor selling.

What is the downside of having $2t of corporate bonds rated junk? Evidence shows that the probability of default is much higher for junk bonds; over a 30-year period, 3.8% of these bonds defaulted annually. In 2015, the default rate was 2.6% versus 2.1% in 2014. The default rate is expected to be above 4% in 2016. During periods of crisis such as 2007-2009, the default rate skyrocketed to 15%. About 25% of high-yield bonds have been issued by energy, mining and commodity-based companies which are now experiencing financial stress. 111 companies have defaulted on $80b of debt in 2015, the highest number since 2009. High-yield promised returns look appealing in a low-interest rate world; returns after default don’t look nearly as attractive as promised yields. Unfortunately many investors have chased yields without fully understanding the risk that entails.

Is the Stock Market Over-Valued?

The stock market swooned last week and has been bouncing around ever since. “Surely the market is over-valued” is a comment that you hear frequently.  Agreement with such a statement means that many people will be very worried because it implies that stocks have peaked and will stop rising.  Retirees never like to hear that since their future incomes are tied to future growth in stock values. But all of us are concerned – no one wants to see wealth disappear. Simply – whether you are young and beginning to save or old enough to be on a regular diet of prunes – it hurts when stock prices stop rising. It hurts even more when they fall.

So what is the truth here? Are stocks going to stop rising? Fall? Or is all of this nonsense and stocks will continue rising?

Below you will see why I am not pessimistic about stocks. But let’s begin at the beginning. What does it mean when people say stocks are over-valued? If your boss tells you that you are over-valued, you know it isn’t a compliment and it probably means no wage increase is imminent. The word “value” is a common one that most of us understand. All things have value. Even my old pair of jeans has value to someone. 

Value, however, can be a tricky thing. How about those old jeans? Some of my well-dressed friends would toss a pair of old jeans as soon as the fading begins. In contrast, my hippie friends won’t even wear a new pair of jeans until they have washed them enough times that they are not only faded but have holes in the knees. Point – the same product might have very different values to different people.

Economists recognize this dilemma but point out that markets are places where values are assigned through prices. If a house sells for 1 million dollars, that’s the value of the house. The seller may be unhappy with that price and the buyer ecstatic – but the economist records $1 million. That’s the price at which both parties agreed to the transaction.  So – implicit values can be almost anything but market price is an objective criterion widely accepted as value. If we want to know if stocks are over-valued then we use stock prices. 

What does it mean for stock prices to be under-valued? There is no single meaning. The popular way is to use something called a price/earnings ratio. P/E has two parts – a stock price and an earning figure. Think of a single firm. Suppose its stock price closed at $100.  When you buy that stock for $100 you are hoping it will be a good investment. For the moment forget the capital gain you might receive by buying low today and selling high in the future. What’s left is a dividend you might receive from that share. Let’s suppose the earnings of the company are only $1. In that case, since dividends reflect earnings, the most you would expect to receive for your $100 investment is $1. That’s a 1% return. Ugh.  That stock is over-valued at $100. If you had paid $20 for the stock, then your return would have been a much better 5%.

Some of you are waving your hands! Larry – when you pay $100 for a stock you have it for more than one year. So what matters is not just one year of dividends or earnings – but what happens to earnings over the future. And for that question/comment you get a gold star. But that’s what gets us into trouble with this price/earnings approach. The current price and earnings data are known but are not perfect. But to use future earnings brings in unknowns and expectations and lots of different opinions. Ron might think a stock is vastly under-priced because he sees large increases in future earnings. James is more pessimistic about earnings and thinks today’s stock is highly over-priced.

So while the price/earnings approach is one that is widely used – it isn’t perfect for determining when and if the stock market will fall or rise in the future. It is a valuable approach but it leaves room for other ways to think about stock prices. Since I am about as boring as a rock in a stream, I like intuitive simple approaches. Consider some facts about the market. Here I am using the S&P500 price index. I downloaded data for the time period from 1950 to September 2014 from a website (https://finance.yahoo.com/q/hp?s=%5EGSPC+Historical+Prices ).  I then graphed the data. I converted all this daily data to annual averages. My limited abilities mean I couldn’t get the graph on this page. But you can find a graph at the link above.

·        Similar to my waist size – the S&P500 has had up and down cycles many times but it has trended upward.

·        The value of the S&P index in 1950 was about 17 and now hovers at about 2000. You math jocks can figure out the rate of return of $100 invested in 1950.  It is a pretty big number. If you gave that money to Uncle Charlie (or Uncle Sam) in that year, your return might not have been so good.

·        During those years there were many times when the market surged ahead only to return to more sober (lower) values. Many analysts point out a period from the early 1970s to the early 1980s when the market was essentially flat. But that is about the only time since 1950 when the market did not pop back in a more reasonable period of time.

·        Looking at the graph from 1995 to 2000 and then from 2003 to 2007 the increases where spectacular. Both peaks were followed by declines that lasted 2-3 years. The declines were followed by more increases.

·        There were also interesting time periods when stock prices rose precipitously but did not fall for extended time periods. If you start in about 1975 the market rises through the early 2000s with several major spurts followed by shorter setbacks.

The above points are pretty well known but they do underscore one fact – market gains always have setbacks but those time periods vary greatly in their intensity from a couple of months to several years. Gains do not necessarily imply a seriously stagnant market price.

Now one more point. If you put money into the S&P500 in 1995 or 1996 and held it until it reached 2000 last month – your annualized continuously compounded yield would have been around 7%. That annual appreciation is very much in line with stock returns over a much longer period. An average market, therefore, is expected to give you about 7% per year. Now consider the recent time periods of so-called explosive growth. If you invested money in the year (first column below) and sold when the market hit 2000 recently*, your investment would have earned the average compounded rate (column 2) over those number of years (column 3):

1997      4.5%   17

1998      4.3%   16

1999      3.0%   15

2000      2.4%   14

2001      5.2%   13

2002      7.8%   12

2003      6.5%   11

2004      6.0%   10

2005      5.6%    9

2006      5.2%    8

2007      3.9%    7

2008      9.4%    6

2009    13.6%    5

2010    15.1%    4

2011    20.9%    3

2012    17.8%    2

2013    18.9%    1

*Rates of return in the table are calculated from September of each year given through September of 2014.

From the above table you can see dramatic growth of the last five years. Those are indeed spectacular returns. But if your eyes move up the table you see that even with these fantastic stock increases, the annual average returns from money invested anytime between 1997 and 2007 yielded below historical averages. Thus even with spectacular growth of the last few years – the longer term returns in the market are well below average.

What do you make of this? The answer is that there is no way to know the future. Price/earnings ratios are interesting but don’t tell the whole story. Returns of the last five years are indeed spectacular. But even with stock price increases in those five years, money that got invested 7 to 17 years ago are not impressive. Stocks could rise several more years before that money earned the average annual return.

Will the market peak soon and swoon? Will it remain at present levels for 10 years? I don’t know. But the answer is clearly not a slam dunk. 

Fed Policy: Chicken or Egg?

When it comes to chickens & eggs or climate change & Al Gore, we don’t know which came first. We take this to mean that we don’t know what is the ultimate cause of these things though I suspect Al Gore came from another planet. Regardless, the topic today is the Federal Reserve or as we lovingly call it – the Fed. The Fed says they will keep interest rates low. I doubt they can do it. 

There is a widely shared belief that the Fed controls interest rates. Thus we could say that the Fed causes interest rates and not vice versa. When Ms. Yellen proclaims that interest rates will remain low until Clint Eastwood stops making movies, that gives us the illusion that the Fed can and will keep rates low for a very long time. But this illusion, while technically correct, for most purposes can be highly misleading. This post suggests that interest rates will begin to rise soon, with or without the Fed’s permission.

To understand this point we have to go back and read several tons of text books or you can wake up and just read the next few paragraphs. Like there are many different kinds of Kentucky bourbons, there are many different interest rates. An interest rate tastes like chicken. No it doesn’t. An interest rate tells you how much you earn on a financial instrument. If you put money into a bank saving account your money would be earning about .02%. Invest your money in a government bond that matures in 30 years and you might get 3.5%. Corporate bonds might give you a little higher rate. These rates are market determined. That means that while a Fed policy might influence these rates, the Fed has no direct control over them. The buying and selling of these financial instruments by individuals and institutions change the prices and rates every day.

The one rate the Fed does have almost total control over is called the Federal Funds Rate (FFR). I say “almost” because even that rate is not dialed up or down in a mechanical fashion by the Fed. The FFR is mostly affected by banks borrowing money from each other. On a day when many banks want to borrow the rate goes up. When many banks don’t want to borrow from each other, the rate goes down. But unlike the other rates I mentioned above, the Fed considers the FFR as a target of monetary policy. When the Fed swears on a stack of Tim Geithner novels to keep interest rates at zero – we take this very seriously. We wait from Fed meeting to Fed meeting to learn of any real or imagined changes in the value of the Fed’s goal for the FFR.

It is easy for the Fed to control this rate. If bankers want to borrow a ton of money from each other on Tuesday then the FFR starts rising. The Fed watches and Yellen says – geez guys. I promised the FFR will stay at zero and today the rate is rising. So Janet knows what to do. She pumps money into the system so banks have plenty of money. They don’t need to borrow from other banks – the Fed intervenes and gives it to them. The FFR rate goes back down to zero. Like water on a fire, when the fire rares up just pour on more water.  The Fed apparently controls the FFR. 

But does it? Technically it does. It can do the actions of the last paragraph forever since the Fed has permission from the Koch brothers to increase money at will. No digging up gold is necessary. But the trick here is whether or not they can make their policy stick. You can pour water on a fire but if it a grease fire it might actually make the fire worse. In the case of the Fed policy, the focus is on the market factors responsible for driving up the FFR. Perhaps the FFR is just following other market-determined interest rates. Suppose the economy is stronger and inflation expectations are rising. These are factors that usually drive up market rates, including the FFR.

If markets are driving up interest rates then a one-time injection of money will take the FFR back down to zero. But will it stick? If the economy and its inflation rate are rising, then there will be continuous pressure on the FFR to rise. You might say that is no big deal because the Fed can just pump in more money. But here’s the challenge. If each time the Fed pumps in money this stimulates output, inflation, and credit demand, then there is EVEN MORE pressure on rates to rise…here is a very technical schematic:

      Rates rise – Fed pumps – rates fall – expectations rise – rates rise even more.

At this point the best way for the Fed to keep rates from rising is to stop pumping in more money. When people start to recognize that the Fed will stop stimulating the economy then they will reduce their expectations about economic strength and inflation. This reduced expectation brings rates back down.

So who controls interest rates in the economy? The answer is that it depends. If rates are being strongly driven by economic fundamentals it is not easy for the Fed to have much sway. They will have a very difficult time stopping rates from rising and attempts to do so may make matters even worse. Of course if the economy is not thrusting rates higher, this gives the Fed more room to maneuver. But if that is the case, it isn’t clear why the Fed would want to reduce rates. The market is already doing that trick. 

To modern progressives, this sounds strange and it should. Monetary activists think the Fed is all-powerful and should regularly employ countercyclical policy. But not everyone is a monetary activist. Milton Friedman and other monetarists have warned for decades about the unintended consequences of monetary activism. Today we have a very activist Fed under the guidance of Janet Yellen – a Fed that will promise lower future interest rates despite an inability to bring out that result. Bet on higher rates in the coming 6-12 months.

Happy Fifth Anniversary by Guest Blogger Buck Klemkosky

It all began on March 9, 2009 – a time of skepticism, despair and pessimistic thinking. Some were even questioning the future of capitalism. It had been a turbulent decade in the stock market with the S&P 500 peaking at 1527 in March 2000 before falling 49 percent to 777 in October 2002. The market then rallied 101 percent to peak at 1565 in October 2007 before suffering a 57 percent decline to close at 677 on March 9, 2009. The U.S. was in its worst recession since the 1930s, the financial system had nearly collapsed and housing prices had also declined for the first time since the 1930s. In total U.S. households had lost more than $13 trillion of wealth from the stock market ($9 trillion) and housing ($4 trillion). Investors had plenty of reason to be pessimistic.

While difficult to do psychologically, investing during pessimistic times provides opportunity, and March 9, 2009 would have been one of the best stock buying opportunities in two decades. The S&P 500 has increased 177 percent from March 9, 2009 to March 7, 2014 and total returns, including dividends reinvested, have exceeded 200 percent. During the five-year period, $15 trillion of wealth was created in U.S. stocks. A good five years to be invested in the stock market for sure.

Unfortunately, many investors have not participated in the bull market. Using mutual fund flow data, individual investors were net sellers of equity mutual funds every year from 2008 to 2012, to the tune of $500 billion. Equity fund investors did turn optimistic in 2013 and purchased a net of $19 billion. The opportunity costs of keeping the money in cash would have been huge given the low Fed-induced interest rates. Net inflows into bond funds during this period were $1 trillion, much greater than the net outflows from equity funds. An indexed bond fund would have provided five-year annual returns of 4.42 percent, much less than equity returns of 24 percent, but better than cash.

The sectors of the market that did the best and outperformed the S&P 500 during this five-year bull market were the ones that did the worst during the bear market and recession, namely consumer discretionary, financials, industrials, technology and materials. The more stable sectors of the economy, health care, energy, consumer staples, telecom and utilities, underperformed the S&P 500, although all had positive five-year returns.

Five years on, the bull market celebration continues. How does this one compare with prior post-WWII bull markets? Bull and bear markets are arbitrarily defined as market moves of +20 or -20 percent respectively. By that definition, there have been seven bull markets in the post-WWII era and the present one is the sixth longest and still counting; two more months and it will move up to number four. The granddaddy of all bull markets was the one that lasted from October 1987 to March 2000, 4,494 days, compared with the present one of 1,824 days as of March 7, 2014. This bull market’s return of 202 percent would rank it second to the one in 1987-2000.

Corrections of 5 to 10 percent are normal for any bull market, and the present one is no exception. The S&P 500 experienced declines of 16 percent in 2010, 19.4 percent – almost a bear market – in 2011 and declines of 9.9 percent and 7.7 percent in 2012. Volatility wise, this has been a fairly normal bull market.

Is this bull market starting to look long in the tooth? It may be starting to show its age but certainly hasn’t reached an exhaustion stage yet. Most investors have been skeptical of this bull market, which is understandable given the two bear markets since March 2000. It has climbed a wall of worry and skepticism with little of the speculative euphoria seen in the 1990s and other bull markets. The market is fairly valued by most valuation metrics but these are not normal times with historically low interest rates, strong corporate balance sheets, a stronger financial system and less-indebted households. Still, expectations of a growing U.S. economy and higher corporate revenues and earnings will have to materialize in order for this bull market to continue past its fifth anniversary.

Bear Case by Guest Blogger John Succo

John Succo graduated from Indiana University with a graduate degree in finance concentrating in option pricing theory in 1984. His work bio includes stints at Morgan Stanley, Paine Webber, Lehman Brothers, Alpha Investments, and Vicis Capital. In 2012 he became an adjunct professor for Indiana University and created IU Capital, a synthetic multi-asset fund where students manage risk around a variety of asset classes including equities, fixed income, currencies, commodities and derivatives.

 

SP500 companies’ adequate profits have been due to increasing margins on slow (if not now stagnant) revenue growth. Margins are at all-time highs and have been driven by lower interest expenses, stock buybacks (which retire outstanding shares and increase per share earnings at the expense of more leverage, making earnings "riskier"), and wage compression (wage participation of earnings are at recent history all-time lows). It will be extremely difficult for companies to improve these margins further.

There is negative margin pressure now building. Interest rates must normalize at some point and we are seeing pressure for that now. QE by the Fed has artificially kept interest rates low: they have been buying 70-90% of all treasury issuance causing their balance sheet to explode to $4 trillion and owning nearly 30% of the entire publicly traded treasury market. Interest rate risk is very high and just a 100 bps rise in rates would destroy the Fed's capital. The Fed's objective has been to drive investors into risky assets by creating no alternative; they have also targeted low volatility as a secondary measure to keep investor sentiment high, which is at all-time extremes right now. But tapering their asset purchases are now a function of risk and will continue. The Fed, BOJ, and to some extent the ECB have no way to "ease" except for asset purchases, so any new "weakness" in economic activity cannot be met by monetary policy and the markets will quickly lose confidence, which is the primary driver (psychology) of higher asset prices at this point.  Wage compression is now at the point where it will begin hurting consumption and work against margins. Higher rates will make it difficult to continue stock buybacks at the current pace and cause interest expense to rise. Corporate cash is a function of high corporate debt and rolling the debt will be more expensive.

Total debt in the economy is still 350% of GDP, levels that cannot be sustained. Some mortgage debt has been destroyed but an increase in public debt has offset this. Public debt is the least productive debt and as rates rise will become unserviceable: current interest expense is $450 billion a year and every 100 bps rise increases that expense by $200 billion. The treasury is now being forced to extend maturities and just normal rates will cause that annual expense to rise to nearly $1 trillion, creating systemic untenable deficits and crowding out of capital (even higher than normal rates). Additionally margin debt is at an all-time high, which is a precursor for too much risk and price inflation in financial assets.

As this process begins risky asset prices will suffer dramatically, normalizing rates and bottoming those prices but at much lower levels. Valuations by any measure are at least 30% overvalued and much more so if we truly are in a stagnant revenue paradigm. The Shiller P/E, the best measure of relative valuation, is over 26x, 56% higher than average. Pre-1987 crash gold went down and the 10 year yield rose 200 bps, very similar to today.

S&P Newtonians – Have they lost their apples?

As November came to an end and shoppers duked it out at Macy’s and Victoria Secret, the financial news heralded the stellar performance of the stock market. Much of the news documented in one way or another how much the stock market valuations have grown this year and in the past few months. Some Newtonians concluded that what goes up must come down. Other analysts believe there is more room for stock prices to rise. Which is it—up or down?

As you know I am a humble macroeconomist and not a finance whiz and therefore I admit to treading in shark infested waters. What I read tells me that the risks lie toward mean-reverting behavior. After stocks have gone up so much it seems reasonable that they would take a breather. While that sounds pretty rational I think that view is missing some vital information. I see several reasons why stocks could continue rising and therefore I am more optimistic than many of the pundits.

Let’s face it the majority view has a lot going for. For one thing a look at stock market behavior over time does underscore a tendency of markets to deviate from and then return to longer term trends. And the famous PE (price to earnings) ratios mostly support the view that stocks cannot keep up rapid price increases. Stock prices have raced ahead of earnings – especially since earnings are slowing down. If you expect earnings to continue to slow as the world economy struggles then price to future earnings look high today – thus there is plenty of room from the PE camp to suggest a slowing or a retraction in stock prices.

So how can I support a more optimistic view of future stock prices? One point is that earnings have been volatile. During the recession them plummeted. After the recession earnings moved dramatically upward. It is natural they would fall off that rapid acceleration to something more normal. Thus, a slowing in earnings does not bode poorly for now or for the future.

My second point is based on an even longer-term view of stock prices. I am going to use the S&P 500 average for my analysis but what I am about to say works for most broad measures of US stock prices. The S&P 500 bottomed out in the recession at 676 in March 2009. That represented a major contraction relative to the heady days of pre-2008. Since March 2009 the S&P 500 rose to around 1,800 . From the bottom in March 2009 to July 2013 the S&P 500 rose by 166%.  That is pretty spectacular and you can see why some people think that behavior cannot be maintained.

But there is more to the story. If you compare this so-called high stock price level in November 2013 to the previous peak in November of 2007 of 1,520, you see that in a time period of six years the market has gone above that previous peak but is only 18% higher.  A gain of 18% in four years is not spectacular. Do not forget that those stock returns buy less because the prices of goods and services were rising during those six years. The Consumer Price Index rose by 14% in those six years. So you could conclude that in purchasing power terms, the peak level of the S&P 500 is only about 4% higher than it was six years ago. That peak resembles the humble Smokies more than the Rockies!

If we compared today’s so-called high level of stock prices to the previous peak in 2000 of 1,527, then today is 18% above that peak. Today’s peak is only 18% above the peak of 13 years ago! With inflation of 37% since 2000, the buying power of today’s market high is about 19% less than the peak in 2000.

We have a market high recently but when we compare it realistically to previous highs, it doesn’t look very spectacular and therefore does not imply a major contraction is ahead of us. The S&P 500 would have to rise from the 1,800 range to something greater than 2,200 to be comparable in buying power terms to the peak of 2000.  I am not predicting anything like that. But the US economy is growing. Companies are making profits. The fear of another major global collapse is receding. Employment is gathering steam. Smaller investors are getting back into the US markets. There is no reason why stock prices cannot continue their upward trajectory. If only the Fed and Congress would do their respective parts by not mucking up the economy.

Don't Stop Believein' by Guest blogger Jerry Lynch

Jerry Lynch has been an economics professor at Purdue for over 30 years.  He also served as Associate Dean and Interim Dean of the school in various past fits of insanity.  He has returned to teaching the core Macro Policy class in the MBA program and is pleased to have this blogging opportunity to spout off.

Don’t Stop Believin’

                Just a city boy

                Born and raised in South Detroit

                He took the midnight train goin’ anywhere

The headline news just one month ago, now usurped by the crisis in the Middle East, was that the City of Detroit had filed for bankruptcy claiming to be unable to meet the payments to its creditors.  One of the questions asked when it first filed was whether or not it was legal for a city to file for bankruptcy.  That question seemed to be answered on a federal level when the city of Stockton was allowed to file last April.  However, a state judge ruled that the Detroit bankruptcy petition violates the Michigan state constitution. 

The declaratory judgment came in lawsuits filed by Detroit pension funds, retirees and workers, which sought to prevent a bankruptcy filing that would ultimately impair retirement benefits in violation of constitutional protections for those benefits.

Legally Detroit is at an impasse now on its bankruptcy proceedings.  While the legal wrangling is of interest to many, of more interest to me as an economist is the role that pension funds played in getting Detroit to where it is.  Let’s start by exploring pensions in general, then look to the specific case of Detroit, and finish with a little speculation about how far this might go in terms of other municipalities meeting their pension obligations.

There are essentially two kinds of pension plans, a defined benefit plan and a defined contribution plan.  In a defined benefit plan the benefit that a retiree receives is based on some formula that typically includes years of service times some multiplier per year times some final earned value.  For example, a pension may pay 2.5% per year worked times the last year’s earnings.  If someone worked thirty years then their benefit would be 30 (years) * 2.5% (per year) * last year’s earnings or 75% of their last year’s earnings.  There are many variations on this in terms of the multiplier or last year versus average of the last x number of years.  However, all defined benefit plans carry this in common -- Once you are retired, your employer/sponsor will pay you that benefit for as long as you live.  The complete liability for the program falls on the employer/sponsor.

In a defined contribution plan either you, your employer, or in combination make a defined contribution each month into a pension plan.  Typically your contribution is pre-tax.  Once you retire, you have that pot of money and can pretty much choose to draw it out any way you like.  Once you retire, your employer/sponsor has no liability for you.  You are on your own.

The defined benefit plan is going the way of the dinosaur in the private sector.  Employers do not want that liability. Shareholders in public corporations do not want it either as there is uncertainty about the present value of that future liability.  The defined benefit plan, however, is alive and well in the public sector as 88% of public employees are covered by a defined benefit plan.  The municipal employees of Detroit are “covered” under this type of program.  There are charges of abuse of the system in that employees will work a lot of overtime their last year of work so that the base for their pension is higher.  While that is no doubt of some concern, it is not the major reason why Detroit and other municipalities are in trouble.  A question you may ask yourself is, if I promise to pay you x number of dollars per year until you die, how much money will I need to set aside?  Good question, even if I had to prompt you to ask it.

Defined benefits programs can either be funded or unfunded.  In an unfunded program no assets are set aside and the employer pays out of current revenue as needed.  This is also known as PAYGO for pay as you go.  Up until the early 1970s about all defined benefit plans were unfunded.  Companies figured that revenue would keep growing and they would be able to pay pensioners out of those funds.  This is essentially how Social Security works but we’ll save that for another day.  As retirees started living longer the liability of the pension payments increased and the extent of underfunding grew.   Recognizing the impending storm the Employee Retirement Income Security Act (ERISA) was passed in 1974 that put restrictions on private pension funds and also required them to participate in the Pension Benefit Guaranty Corporation (PBGC) an independent agency of the government that insures pensions.  One of the restrictions imposed on private pension funds by ERISA was that an unfunded/PAYGO system would no longer be allowed.  Thus corporations, and probably also their employees, have to contribute to a pension fund even if it is a defined benefit program.  By the way, General Motors went from a defined benefit program to a 401(k) in the spring of 2012.  ERISA does not apply to public pension funds and they are not insured by the PBGC.

Back to Detroit.  Detroit has a defined benefit program that is neither unfunded nor funded.  It has what is the most common type of defined benefit fund today, an underfunded one.  Back to our question above, how much money needs to be set aside to fund the defined benefit obligation of Detroit and other municipalities?  The biggest uncertainty in all of this is the expected rate of return on the funds set aside to make future payments from.  If I expect to get, say, an 8% rate of return, I need to set aside a lot less than if I expect a 5% rate of return.   Detroit’s impending financial problems led Governor Rick Snyder to appoint Kevyn Orr as Emergency Manager of Detroit’s finances.  Mr. Orr, a former bankruptcy attorney for the Jones Day law firm in Washington DC, says the pension fund has underestimated the present value of its future liabilities by assuming a nearly  8% return on assets.  Not all of Detroit’s problems are related to its pension obligations.  The city’s population is half of what it was in the 1960s which has obviously reduced tax revenue.  It also has a history of corruption and overspending in awarding contracts, former Mayor Kwame Kilpatrick is awaiting sentencing in October 2013 for a pattern of extortion, bribery and fraud.   

Still, the pension fund is a large contributor to the problem.  Mr. Orr says Detroit has $18 billion in debt which includes $3.5 billion in unfunded retirement liabilities. The managers of the city pension fund said in a news release earlier this summer that they are no more than $700 million short.  Still not a comforting thought.  Their disagreement hinges on the expected return the pension fund will earn and thus what discount rate to use when bringing future liabilities back to their present value. A conclusion on how underfunded the pension funds are has more than academic implications as it will impact how much of a haircut both bondholders and the city’s pensioners are going to be asked to take.

News about Detroit’s troubles have temporarily taken a backseat to the conflict in the middle east and A-Rod’s steroid use but it is not a problem that will go away by ignoring it.  And, it is not Detroit’s problem alone.  Cities across the country with defined benefit programs assume they are adequately funded because they are assuming relatively high returns.  An argument over the appropriate discount rate to arrive at the present value of the pension liability will determine in large part what the payout of pension funds will be.  The Government Accounting Standards Board last year called for underfunded pension plans to use a discount rate in the 3 to 4 percent range. That is well less than most pension funds expect to earn and, if followed, will likely lead to pensioners receiving less in benefits.  Don’t expect this issue to be resolved any time soon.  As unglamorous as a defined contribution fund may be, at this point, be happy if you have one.

Biases in Processing Information by Guest Blogger, Buck Klemkosky

The world is awash in data, so much so that a new field has evolved called “big data.” The explosion in data can be attributed to three factors: the increase in computer processing power at lower costs, the start of the World Wide Web in 1990, and the development of cellular technology. The explosion of digital data can only be compared with printed material in the Western world after Gutenberg invented the printing press in 1440.

How much digital data is available? No one knows precisely, but that doesn’t stop people from making estimates. In digital terms, everything starts with bits (short for binary digits, 0 or 1, computers use to store and process data) and bytes (8 bits, which is the basic unit of computing). It escalates from there:

kB kilobyte = 1,000 bytes                               PB petabyte = 1,000 TB

MB megabyte = 1,000 kB                               EB Exabyte = 1,000 PB

GB gigabyte = 1,000 MB                                ZB zetabyte = 1,000 EB

TB terabyte =1,000 GB                                  YB yottabyte = 1,000 ZB

Remember that the first personal computer had 56 kilobytes of memory and todays’ usually have a couple of gigabytes. But the total data in the world is estimated to be several zetabytes with more being produced every day.

As mentioned previously, most of the data in existence is noise and not useful for making decisions. But we try to decipher and glean from all of the data useful information. Our brains are surprisingly powerful processors of data and information, but selecting information to be used in decision making is hampered by several psychological biases.

It is only human nature that we get more pleasure from being right than wrong. So if we have beliefs or have made a decision, we become selective in collecting and using only confirming information. We filter out and reject information that is contrary to our beliefs and decisions. It’s much easier to support

than contradict. Sometimes we even use ambiguous and perhaps wrong information as supportive.

Investors are especially subject to confirmation bias. Once we buy a stock or bond, we are much more receptive to supporting information than contradiction. Some investors have strong opinions about the direction of the market in general, short term and long term. If you are a perma (long-term) bull or a perma bear, eventually you may be right, but it’s those intervening years that hurt.

What makes Warren Buffett such a successful investor is that he actually seeks out nonconfirming information. He has billions of dollars of his wealth, almost all, invested in Berkshire-Hathaway stock. At this year’s annual meeting, for example, he invited one of the most negative investors concerning Berkshire-Hathaway to address the 20,000 shareholders. This investor had taken a large short position in the stock, expecting it to decline in price.

In addition to confirmation bias, investors also have a tendency to use readily available information that can be easily recalled, which is called the availability bias. We also have a recency bias by giving more weight to more recent information and events and less to that more distant in time.

Investors also generalize with insufficient information, which means we use a small statistically insignificant sample or anecdotal evidence as information to make decisions. Most often it represents our own experience or something we are familiar with. The future looks like something we know or are familiar with based upon recent events or frequency of events. This is one of the reasons individual investors have been reluctant to invest in stocks again after the bear markets of 2000-2002 and 2007-2009, even though the market has appreciated 150 percent since the S&P 500 lows in March 2009.

It is easy to have opinions about almost everything. It is much more difficult to have informed opinions. But we never know if we are fully informed or not. Even though we may believe that we have correct information, it has a high probability of being biased. That is why uncertainty always prevails, especially in the financial markets. 

Real Interest Rates, Fremont, and the Land of Oz

Happy summer solstice.  I recently attended the Fremont Solstice parade and for those of you who know anything about that Seattle event, I can tell you that there is nothing I could write about in this blog that could ever be as exciting and fun as that parade.  But those visual images cannot compare to the parade going on in our financial markets!

About a year ago in June I posted an article about negative real interest rates. It turns out that it has been the most popular by far of all my postings.  http://larrydavidsonspoutsoff.blogspot.com/2012/06/negative-real-interest-rates-cannot.html

The main point of that article was to underscore how low real interest rates were last summer.  I am not sure why that post hit the mark but in any case I think it is time to update the results to summer 2013. My conclusion is that real rates are on the rise, the Fed is not soon going to change its policies, and every time the Fed tries to do the right thing the financial markets will get hysterical like they did last week.

After the Fed’s announcement that they might begin to taper the famous quantitative easing programs as early as later this year, market rates have started to rise. Expectations can be a powerful factor in credit markets, so the mere notion that rates “might” rise in the future can send them surging today. The benchmark 10 year government treasury rate increased half a point in the last month and almost 90 basis points since last summer.  So for sure – market rates are rising.

What happens to real interest rates, however, depends also on another fragile psychology factor – inflationary expectations. Most measures of expectations of future inflation rates have moved slightly downward since last year – meaning markets and surveys currently do not soon expect markedly higher inflation.  Economic problems among our main trading partners suggest continuing slack in our export sales and possibly even lower inflation in the near future.

With market interest rates rising and expected to keep rising and with inflation expected to remain stable or fall, we have to conclude that real interest rates are headed upward in the very near term. What about after that? Since market interest rates are well below their norms, it is not easy to see a reversal. But the inflation factor offers more room for story-telling and rising uncertainty. In two recent postings I made the point that just like interest rates, inflation today is well below normal values. It is only a matter of time before the effects of monetary policy, a stronger domestic economy, and a declining value of the dollar begin to push inflation back closer to 3%.

So while real interest rates are rising right now, there is still some question as to their continued future course. What happens to real interest rates will be the outcome of a race between market rates and inflationary expectations. The more inflationary expectations rise relative to market rates, the less increase there will be in real interest rates. But that outcome misses the well-known effect of changes in expected future inflation on market interest rates. The higher is expected future inflation the higher are market interest rates. In sum – this is what the medium terms holds for the real interest rate:

·        Stuff causes market rates to rise and the real interest rate to rise

·        Inflation expectations rising causes real interest  rates to fall

·        Inflation expectations rising causes market rates to rise and real interest rates to rise.

·        Result – real interest rates will begin rising with or without a rise in inflationary expectations.

And, of course, that matters because it is the real interest rates that measure the payoff to saving and investing. Significantly rising real interest rates favors savers over investors.  Rising real interest rates also cause slower economic growth so in today’s uncertain economic environment rising real interest rates are not welcome. This puts pressure on the Fed to continue its quantitative easing as markets seemed to be shouting last week.

Could the markets' lamentations be correct? What is true is that most of us do not react well to change. A change in Fed policy now is simply that – a big fat change in your face.  So the market cries out. But when the surgeon begins to wean you off the pain medicine and you cry out, at some level you understand that your future is one with zero pain  medicine. You are glad that the doctor is reducing your dose because you know it is the right thing to do.

It is the same with real interest rates. They are rising and they are going to keep rising. But Dr. Bernanke and his gang of associates are not ready to reduce the pain medicine. Investors are not convinced that the patient is healed. So the big question is when will the patient be ready. When will the Fed announce that the patient is healed and when will the patient believe it? Okay Doc I am ready to reduce the medicine because I know I don’t need it anymore.

I can’t see this happening for a while. Sure, there are numerous signs that the US economy is on the mend. But then again there are just as many worrisome signs both at home and abroad. How long will Europe’s economy struggle? Will it get worse before it gets better? China is also facing rising interest rates? Can China rein in excessive credit growth and inflation without causing an even bigger economic slowdown? Will Japan’s three-part program work after decades of stagnation? If all these places slow how will Brazil and other emerging nations manage to recover?  The world’s post-crisis economy is not back on track and this does not help confidence in the US economy.

Those are global worries – but there are plenty of domestic ones to boot. Will our dysfunctional government grow even more dysfunctional this year? Will we postpone once again legislation that address our financial and economic problems? Is the recent housing boom just a bubble? Will labor market trends swamp any reductions in the unemployment rate that might be part of moderate growth. Is higher inflation going to erode already marginal income gains?

The upshot is that the Fed is in a pickle. Everyone knows the Fed must reverse its policy. Everyone knows that rising real interest rates are coming. Yet global and domestic worries prevent the Fed from making any changes to its current policy. Every time it even imagines a change in policy the financial markets are going to be hysterical. 

We could learn some lessons from Oz. The scarecrow always had a brain and the cowardly lion was always brave.  We didn’t need three rounds of quantitative easing and we didn’t need endless stimulus from the government. From the beginning of the economic recovery we have needed good policies that aim at real problems: housing, banking, finance, immigration, healthcare costs, etc. Without apparent progress on these real problems, the Fed is stuck in a no-win position, Some people want more drugs and despite the rationality of tapering any deviation from the current stimulus will be met with chaos that will whiplash our precious portfolios. 

Why We Are Lousy Investors by Guest Blogger Robert Klemkosky

 We have known for a long time that greed and fear play a prominent role in investors’ decisions. A mix of both is healthy for the markets; greed makes us strive for higher returns, which also entails higher risk, and fear makes us avoid excess risks or reckless risks. The trouble starts when greed or fear gets out of control. Too much greed and asset prices go up too much and bubbles form, such as technology stocks in 1996-2000. Too much fear and selling occurs and asset prices plunge. Of the two, fear can be a more powerful force than greed because it can turn into a panic and result in a financial pandemic such as what just occurred in 2008 with stock prices and the credit markets.

In reality, investors should follow the advice of Warren Buffett and buy on fear and sell on greed. But emotions and psychology prevent most investors from doing that consistently. Investors do the wrong thing at major turning points in the market, such as buying record amounts of mutual fund shares at market peaks (first quarter of 2000) and selling record amounts of mutual fund shares at market bottoms (fourth quarter of 2002). And selling stocks at the bottom of the bear market in March 2009 only to see the stock market go up 100 percent in the next nine months.

We all like to think of ourselves as rational and logical, but there is much evidence that we are far from national and logical when making investment decisions. Behavioral finance is a discipline that analyzes how our emotional inclinations and psychological biases affect and influence our investment decisions, both as individuals and collectively.

Overconfidence is one of the major biases that affects investment decisions. We consistently overestimate our knowledge, skills and abilities. We have illusions of control even if events are more random. We overestimate the precision of information and underestimate risks. If we have been successful, we have a tendency to become more overconfident and take on more risk. So don’t always assume that you have better knowledge and skills than others and don’t ever equate stock market performance during a bull market with investor IQ.

There is also a disposition effect in that investors have an aversion to losses. They hate losses about twice as much as they like gains, and will take risks to avoid losses but not gains. One result is that investors sell winners and keep losers, exactly the opposite of what they should do, especially for tax purposes. Investors  hate to admit mistakes which include stock market losses, so there is also regret aversion.

Investors have a tendency to extrapolate the past, especially the recent past. The human mind is not good at figuring out the probabilities of future events, so the easiest thing to do is assume past trends will continue. We expect bull markets to continue as well as bear markets. We select stock or funds that have done well in the past, expecting that performance to continue in the future. We miss major turning points in the market.

Investors have beliefs and convictions about stocks and the market. When presented with information, they have a tendency to accept or listen only to information that confirms and supports their beliefs and filters out information that conflicts with their beliefs and experiences. The rational thing to do would be to seek out information that does not support our beliefs and convictions. This is referred to as confirmation bias.

When we look back, things seems much more obvious and we delude ourselves into thinking that events were predictable and we had the foresight to make those predictions. In other words, we forget our original forecasts or thinking and use the outcome as if it was our original forecast. We think events that happened were predictable and events that didn’t happen were unlikely. It’s  why we take credit for our successes and blame others for our failures.

Lemmings are rodents that would follow each other over a cliff to their deaths. Their behavior explains a lot about investor behavior and is sometimes called herd mentality. Investors are very comfortable going along with everyone else which is usually what happens in bull and bear markets. It seems investors get greedy together or get fearful together, which is why we have the bull and bear markets.

People feel comfortable investing in companies they work for or companies in their locale. It’s a reason why investors are underrepresented in stocks outside their country. But what happened at Enron, Lehman Brothers and other companies shows the risk of investing in company stock to the detriment of a diversified portfolio. We also become very loyal and attached to a stock that, for example, has performed well and has made us a successful investor. So investors have a tendency to ride it up and ride it down. They forget that a stock doesn’t love them and doesn’t even know they own it.

Individuals have a money illusion bias in that they don’t factor inflation into long-term financial decisions, such as providing college educations for their children or retirement. At 4 percent inflation, money loses half its value in approximately 10 years, and goods and services cost about 50 percent more in nominal terms. People also underestimate the power of compounding. If you invest $1000 at 6 percent for 30 years, you have wealth of $5144 at the end of the period. If you take on a little more risk and invest at 8 percent, you nearly double your ending wealth, $10,002, versus investing at 6 percent.

Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.

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