Friday, March 25, 2011

More on bonds

Following up on my previous post on the S&P - there is another part of my entire deflation theme. Normally, one would think with the government issuing Treasuries like a pimp with one night to live would normally cause bond yields to spike once the Fed stops monetizing the debt.

However, one key thing to remember is that pension funds will have to be major purchasers of fixed income securities over the next twenty years - whether they like it or not. This will have many unintended consequences. Most major Western defined benefit pension plans are in the payout phase of their existence. With the baby boomers entering retirement - more and more of pension fund assets will be used to pay current benefits. This contrasts with the prior twenty years of the stock market boom where pension funds were more concerned with growing assets in order to meet future obligations.

As a result, pension funds will be shifting away more and more from total return models to duration based models - where the duration of the portfolio should be in the same range as the duration of the benefits paid (if you treat the obligation payments as a reverse bond). If you assume that equities exhibit behavior of an ultra-long term bond (i.e. a duration of 50+), we can see the overal duration of pension portfolios dropping dramatically to match their funding obligations.

This will mean a massive shift of pension assets from equities, private equity and other long-duration investments to shorter duration fixed income investments. This shift over the next few years means that there will be a lot of demand for high quality fixed income product that should keep yields suppressed for the immediate future.

The major unintended consequence of this will be that the actuarial assumptions of portfolio returns will have to be reduced significantly. Most U.S. public employee pension funds use unrealistic return assumptions; CALPERS (the California State Employees Pension Plan) assumes a 7.75% return. This return has shown to be unrealistic over the past ten years with the fund heavily invested in equities and "alternative investments", resulting in massive unfunded pension liabilities that the taxpayers are on the hook.

Even though the states are trying to grapple with these unfunded liabilities with modest reforms, they will get socked again as the actuaries have to start reducing their return rates as the funds shorten the duration of their portfolios to meet their current obligations. They will not be able to grow their way out of this mess as they will have significantly reduced equity exposure. State and local governments will be forced to allocate more and more scarce tax revenues to meet their obligations. Sadly, the bulk of the governments have not seriously addressed these problems, and the power of public employee unions bankrolling politicians (i.e. Democrats) will ensure that there ultimately will be tax hikes to make up the shortfall. These state and local tax increases (no deficit spending as they are required to balance their budgets - although they try with accounting gimmickry) will depress aggregate demand on top of the de-leveraging by the American consumer, making the deflationary cycle worse.

Ultimately, I am coming to the conclusion that defined benefit plans should be outlawed and transitioned in an equitable way to defined contribution plans. They are inherently risky for both the funders (as they will have the largest contributions required during down markets, when they are least able to do so) and beneficiaries (the risk of bankruptcy - ask the retired managers of Delphi who had their pensions cut). Add to that the political incentives for mischief (politicians let the Delphi management retirees take a haircut, but he UAW retirees, part of a favored political constituency, didn't; or the political deals to create obscene pension benefits for state employees that were hidden from the electorate) and the conclusion becomes clear: ALL DEFINED BENEFIT PLANS MUST GO!

When thinking of that last sentence, why does Oliver Cromwell come to mind?

Thursday, March 24, 2011

Whiskey Tango Foxtrot

I write this today after looking at the S&P 500 stay around 1,300 or so.

Fundamentally speaking, I do not understand how equities can keep these valuations. Under classic valuation methods, a stock should be worth the net present value of its future projected cash flows. Let's keep this simple and put the time period for projecting cash flows as the next ten years.

First we need a macroeconomic view. As we are in the midst of a massive 30 year credit bubble imploding, we need to look at previous credit bubbles for guidance. If we look at the great Depression, the 1907 banking panic, the Kansas land bubble of the 1840's, etc - what we learn if after a credit bubble, we should expect deflation from depressed demand as consumers de-leverage from high debt levels. The past 30 years of debt fueled consumption has brought future consumption into the past - whether it be houses, cars, or other goods. The consumer (especially the American consumer - who has single handedly developed the Asian export market), spooked by too much debt and fearful of his employment prospects, curtails spending in order to pay off debt and save. This will curtail demand for goods - whether it be housing, electronics, cars, or any other discretionary good. All the money printed by the government will not stimulate demand. All this reflating is doing for now is increasing the national debt; when the consumer is done saving and paying off debt, he will have more taxes to pay in order to pay off government debt. All of this will keep demand suppressed and will exacerbate the deflationary cycle. Only after years of deflation from the aftershocks of the credit bubble will rapid inflation come with a vengeance.
This means that corporate earnings will remain weak going forward. Yes, companies will still restructure and increase productivity, but will be continuously cutting prices in order to maintain capacity. Couple this with expected tax increases and earnings will not be strong going forward.

Until this credit bubble is finally resolved (which will take years to unravel as the central banks and financial institutions of the world continue their "extend and pretend" strategy), stocks cannot keep up this valuation for the foreseeable future. I see the S&P 500 challenging the early 2009 lows of 800-900 range.

I think that this will pop when people finally realize that the other shoe hasn't dropped yet. It will be the banks taking massive write-downs on commercial real estate loan portfolios and a flurry of corporate defaults. But once people realize that we're not through this mess by any stretch, the stock market will eventually tank.