Bruce's Blog: Wiener Financial Management

News & Notes

The Economy Doesn't Matter

 

The stock market appears to ebb and flow with the daily news about our fragile economy.  Clearly, the health of our economy greatly affects our lives; yet, counter-intuitively, it has less to do with stock performance than you may think.  "Economic statistics have little if any value in forecasting or modeling stock prices," according to the folks who run the Marketfield mutual fund.

Financial Advisor magazine notes that the recent volatility in the stock market has led some investors to search for economic trends and cycles in an effort to predict how the stock market will perform.  After all, as Morgan Stanley points out, "equities are growth assets, so it seems obvious that equity returns should be linked to GDP [gross domestic product] growth."

Morgan Stanley argues, however, that history shows no correlation between GDP growth and stock performance -- "there is little or no link between returns and economic growth."  The Economist cites a number of academic studies that concur with this proposition. 

Ben Inker, head of asset allocation at the global money management firm Grantham, Mayo, van Otterloo & Co., stated that "investing in those countries with the higher GDP growth rate -- assuming you knew in advance what those growth rates would be -- would have failed over the [last 30 years].  There was a negative relationship between GDP growth and market performance."

Why is this the case?  The Economist suggests one answer may be that investors pile into the stocks of high growth countries, thereby driving up their prices, making subsequent returns disappointing.  In other words, the most important factor for future returns may be the relative value of stocks: Are stocks expensive or are they cheap?  Morgan Stanley posits that stock market valuation may be the best guide to future equity returns over the intermediate term.  Ben Inker claims that "the cheapest five markets outperformed the expensive markets by over three percent a year for 30 years."   

While a growing economy provides great benefits for citizens, the ultimate connection between GDP growth and the stock market is not readily apparent to those who seek easy ways to predict the future.   


Words of Wisdom

The fact that some geniuses were laughed at does not imply that all who are laughed at are geniuses.  They laughed at Columbus, they laughed at Fulton, they laughed at the Wright brothers.  But they also laughed at Bozo the Clown.
-- Carl Sagan

News & Notes

The Debt Ceiling Debacle:

A Manufactured Crisis

 

In The New Yorker this week, James Surowiecki makes a cogent argument that any problems that may arise from the failure of Congress to raise the debt ceiling limit would be a self-inflicted wound.

Surowiecki maintains that the debt ceiling is superfluous because "if Congress really wants to hold down government debt, it already has a way to do so that doesn't risk economic chaos – namely, the annual budget process. The only reason we need to lift the debt ceiling, after all, is to pay for spending that Congress has already authorized."  

Failure to raise the debt ceiling would lead to "an absurd scenario in which Congress will have ordered the President to execute two laws that are flatly at odds with each other. If he obeys the debt ceiling, he cannot spend the money that Congress told him to spend, which is why most government functions will shut down. Yet if he spends the money as Congress has authorized him to he'll end up violating the debt ceiling."

Thus, Surowiecki asserts, we don't need a debt ceiling limit. The concept is an anachronism. It was enacted in 1917 to keep the President in check at a time when he had a much greater ability to borrow and spend money without Congressional oversight. But things have changed. Since 1974 "Congress now passes comprehensive budget resolutions that detail exactly how the government will tax and spend, and the Treasury Department borrows only the money that Congress allows it to."

It seems like we're witnessing a bizarre and depressing circus that needn't be happening in the first place.
 

Words of Wisdom

Weaseling out of things is good. It's what separates us from the other animals ... except the weasel. -- Homer Simpson

News & Notes

The Confusing State of Municipal Bonds

 

Over time, some people have feared that California may slide into the Pacific Ocean due to an earthquake.  A more immediate concern is whether California will descend into an abyss due to its financial problems.  Many states and municipalities face similar difficulties, causing the safety of municipal bonds to be questioned.

Hopefully, we won't revisit the debt crisis of 1835, when the "United States succumbed to a craze for building railroads, canals, and turnpikes, all backed by state credit."  As Ron Chernow describes in the book "The House of Morgan," the state debt had been largely marketed in London to British and European investors.  Some states chose to stop making interest payments as "American legislators found it easier to pander to the hatred of foreign bankers rather than to raise new taxes to service the debt."  No wonder "British investors cursed America as a land of cheats, rascals, and ingrates."

Today, there are a number of reasons why people are worried about "munis," as they are affectionately known.  For starters, many government entities face  budget deficits, putting their ability to pay back their bonds into question.  Government revenues are recovering slowly as we come out of the recession, while demand for services has increased.  Local governments must also deal with under-funded pension plans for public employees. 

Muni bonds also seem less attractive because most insured bonds have to stand on their own as far as credit-worthiness.  A large percentage of munis were insured by private, AAA-rated companies, making the bonds seem extremely safe.  But these insurance companies lost their AAA status in the recent credit crisis and are no longer trusted to cover a bond's payment obligation in the case of a default.

The bleak status of municipal bonds may, however, be exaggerated for the following reasons:
 

• States are not facing a particularly large debt crisis.  State debt is around 7.3% of gross state product.  By comparison, the troubled European countries have debt-to-GDP ratios above 100%.
• Most state constitutions require that they have balanced budgets each year.
• State governments are not allowed to file for bankruptcy.  Although half the states allow local governments to file for bankruptcy, this has been a rare occurrence.
• Local governments' debt service on its existing bonds are relatively low -- around 4% to 8% of total expenditures per year.
• General obligation bonds are backed by the taxing power of the entity that issued the bond.  Revenue bonds are backed by the money generated from the asset built with the bond money; e.g., toll roads.
• States and local governments rely on issuing bonds to raise money, so they are very careful to avoid harming their ability to raise more capital in the future.
• Under-funded pension liabilities, although serious, are a long-term matter and do not impinge on governments’ ability to service their current debt.

At the end of the day, investing in municipal bonds has become more complicated.  Greater due diligence is necessary before buying individual bonds.  A reasonable alternative is to utilize mutual funds, which can offer diversification and professional management; although, you still need to determine that the bond fund is not taking on more risk that you are comfortable with.

Words of Wisdom

Governments are like underwear.  They need to be changed often and for the same reason. -- Italian Proverb

News & Notes

What Lawyers, Farmers, and Factory

Workers Have in Common


Try to imagine a group of aging rock stars putting on a benefit concert to assist lawyers who have lost their jobs. Admittedly, this is not a likely scenario. Yet it seems that even lawyers are feeling the consequences of technology-based efficiency gains, just like farmers and factory workers before them.

With respect to lawyers (for those who still respect them), new, advanced software can review thousands of documents infinitely faster and much cheaper than their human counterparts. As the New York Times described in a recent article, law firms can dispense with highly-paid lawyers poring through files in large litigation and use "e-discovery" at a fraction of the cost.

The tale of the American workplace being affected by technology is an old one. In the early 1900s, farming was a very labor intensive endeavor--41% of our workforce was employed in agriculture according to the U.S. Department of Agriculture (USDA). But the efficiencies gained by technological advancements have greatly reduced the need for farmers. By 1945, 16% of the workforce was employed in agriculture. The number dropped to just 1.9% in 2000.

Nevertheless, as the USDA points out, the "output from U.S. farms has grown dramatically, allowing consumers to spend an increasingly smaller portion of their income on food and freeing a large share of the population to enter nonfarm occupations that have supported economic growth and development."

A similar phenomenon is occurring in manufacturing. A study at the University of Michigan-Flint found that manufacturing output has more than doubled in almost 40 years, even though U.S. manufacturing employment has dropped by over 25%. Overall, about 8% of the workforce currently hold manufacturing jobs as compared to 28% fifty years ago. Technology has greatly increased the efficiency of the manufacturing process.

We noted last time that manufacturing in the U.S. is not dying, it is evolving due to efficiency. Manufacturing continues, but just as the agricultural economy gave way to the manufacturing economy, the manufacturing economy has been superseded by the service economy. The Cato Institute declares that manufacturing is relatively less important to the U.S. economy today because our consumption has changed. We now spend less money on goods, such as food and manufactured products, and more on services.

Given this situation, the difficult task becomes finding new sources of high paying jobs as traditional manufacturing jobs constitute a smaller portion of our nation's economy. Creating a more highly educated, skilled workforce that is competitive in the world economy seems one likely answer. Staying at the forefront of technological advancement is clearly another.


Words of Wisdom

I call my lawyer and ask, "Can I ask you two questions?" My lawyer says, "What's the second question?" –-Henny Youngman

News & Notes

Questioning Common Knowledge—Part III

 

After exposing a few myths recently, this next one is going to shock you: "America remains the world's leading manufacturer by far.  In fact, if U.S. manufacturing were a national economy, it would be the eighth largest in the world," according to Robert Turner, chairman of Turner Investment Partners in an article in Institutional Investor. 

Turner explains that domestic manufacturing is not dying, it's changing.  The U.S. is "making products that require a high degree of innovation and technological content," which is subject to less foreign competition. Inevitably, "some low-value-added commodity products like textiles, toys and TVs are being made in [other] countries" where workers earn lower wages.

The news of failed giants like General Motors overshadows the growth of small manufacturing companies in this country.  "According to the Cato Institute, for every U.S. manufacturing industry suffering a decline in revenues and profits, two U.S. industries are growing."

Moreover, foreign manufacturers are increasingly making things in the U.S. for reasons such as "gaining marketing opportunities, earning tax credits and—brace yourself—exploiting cost advantages."  For example, Turner cites a Chinese company that moved to South Carolina for much lower electricity costs.

Nevertheless, America still suffers from a huge trade deficit—we import significantly more than we export.  While the U.S. can greatly seek to improve its ability to export manufactured goods, it still ranks third, behind Germany and China, in exporting merchandise.  If you were to add services into the calculation, "the United States exports more than any other country" according to researchers at the Brookings Institution.

The Wall Street Journal reported that exports increased nearly 17% in 2010.  (Of course, some of this may have occurred due to a weak U.S. dollar, making our goods and services more attractive abroad.)  The huge trade deficit exists because we remain addicted to cheap foreign goods and the cost of importing energy continues to skyrocket.

If U.S. manufacturing is "not dead yet," then what explains the common belief that it is in such a dismal state?  Turner suggests that a reasonable explanation is the substantial loss of jobs in the manufacturing sector due to technological advances.  We will explore this concept next time when we discuss what machine workers, farmers, and lawyers have in common.

 

Words of Wisdom

I think it's wrong that only one company makes the game Monopoly.
—Steven Wright

News & Notes

Capitalism Gone Wild –

Wall Street's Mortgage Mess

 

Government regulation is often viewed as a costly impediment to business.  Companies are best able to determine the most efficient allocation of their resources.  The genius of this system has led to the United States' growth over the last two centuries.

The problem arises when certain business practices harm the public at large.  When the writer Upton Sinclair exposed the horrors of meat packing plants in "The Jungle" in the early 1900s, regulating the industry seemed a reasonable response—we all want wholesome food produced in sanitary conditions. 

The trick is to determine the appropriate level of regulation in order to let business prosper while leaving the public protected.  Finding the appropriate amount of regulation of our financial industry has proved to be particularly difficult.

We are slowly recovering from the repercussions of the Wild West activities engaged in by Wall Street, otherwise known as the mortgage-backed bond market.  Unfettered capitalism fueled by greed and a lack of self-control helped cause the biggest economic downturn since the Great Depression.

We can easily blame many parties for the drunken excess that became the housing bubble—mistaken government policies, incredibly low interest rates set by the Federal Reserve, individuals buying houses they absolutely could not afford, and mortgage brokers who provided loans to anyone who could fog a mirror.  However, pointing the finger at other bad actors does not absolve anyone of their misdeeds.

In his book "The Big Short," Michael Lewis brilliantly indicts the "geniuses" of Wall Street for exacerbating the situation by issuing shaky mortgage-backed bonds and then creating ways to bet on these bonds that increased the risk to our financial system.

The main thing to realize about mortgage-backed debt is that Wall Street pooled groups of home loans—often risky sub-prime loans—into bonds.  The bonds were rated by Standard & Poors and Moody's, but Wall Street leaned on them to make the bonds seem more attractive than they really were.  The bonds were then sold to institutions that relied solely on the ratings without investigating the actual underlying investment. 

But it gets worse.  The supply of sub-prime loans was limited and Wall Street desired to make even more money.  So they started selling bets on the mortgage pools without having any ownership interest in the actual bonds themselves.  These bets, known as derivatives, constituted billions of dollars more than the actual underlying mortgages.  Institutions like AIG and investment companies like Merrill Lynch leveraged their capital by 30 and 40 times.  This insane amount of speculation exacerbated the problem of the risky loans that existed. 

Here's the final piece—only a handful of people really understood how these derivatives worked.  For the most part, the geniuses on Wall Street, the ratings agencies who blessed these instruments and the ultimate buyers were mostly clueless as to the intricacies of these deals.

Eventually, the music stopped and the whole house of cards collapsed.  Those holding the dubious bonds and the bets made on them lost billions of dollars.  The resulting crisis was so bad that it threatened the functioning of our financial system such that the federal government stepped in to insure its solvency.

How could Wall Street have been so stupid, even if blinded by greed?  The answer is that they were playing with other people's money.  The big investment firms used to be partnerships whose partners were concerned about their personal status and liability.  But then the firms went public and started playing with their shareholders money.  The Wall Street elite were paid huge bonuses by taking huge risks.  When the bets failed, the investment bankers kept their bonuses and the shareholders and bond owners suffered the consequences.  It was a classic case of "heads I win, tails you lose."

"The Big Short" causes us to question how Wall Street can argue against stricter regulations after its actions resulted in a major financial disaster.  If Wall Street can jeopardize the global economy without taking any responsibility, it seems to deserve to be regulated more closely. 

We can only hope that the government correctly determines the appropriate type and level of regulation.   After all, we still rely on our financial institutions as part of a healthy business environment.  Excessive restrictions on Wall Street can hamper the recovery or our economy.

Words of Wisdom

I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth—one shred of evidence. -- Paul Volcker, Former Federal Reserve Chairman [who also said that the biggest innovation in the financial industry in the last 20 years was the ATM.]

News & Notes

Housing, Unemployment, and Causality

 

The relationship between the troubled housing market and the high level of unemployment seems pretty straightforward. With so many people out of work, the demand for housing remains weak and prices stay depressed.

What is less obvious is the impact that a poor housing market has on unemployment. The United States has always had a mobile workforce. As jobs became available in different parts of the country, workers tended to migrate there. But with so many people owning houses that are worth less than their underlying mortgage, such flexibility has been curtailed.

The Economist recently reported on findings by the International Monetary Fund: "Homeowners that are reluctant to default but unable to sell at a loss are left stuck where they are. A recent IMF paper attributes 0.5 to 1.25 percentage points of America's unemployment rate to this factor."

Besides being an interesting concept, it also points out the multi-faceted nature of causality. The ability to discern which factors impact a certain result are not always clear.

Nassim Taleb provides an excellent example of the precariousness of finding causality in his book "Fooled by Randomness." Let's say a general executes an extremely successful military campaign. The general returns home feted by his country as a genius. Yet, if you were somehow able to run a computer analysis of the general's strategy, you would find out that he used a very risky approach that would only lead to victory 10% of the time. In other words, the general was incredibly lucky, not smart.

Taleb argues that we love to see "cause and effect" where often it is only randomness. Acknowledging this idea can be helpful when it comes to investing. Take note how many times you see commentators state that an action will lead to a definite result -- thereby making a particular investment decision obvious -- yet the predicted outcome does not necessarily occur. 

This does not mean that causality does not exist. Nor does it mean that the examples given with respect to the housing market and unemployment are not true. It's just that in a complex world causality remains a murky thing. Being prepared for unexpected results is a useful mindset.

Words of Wisdom 

I sold my house this week. I got a pretty good price for it, but it made my landlord mad as hell.
-- Garry Shandling

News & Notes

What are the French Complaining About Now?

 

As surely as the seasons change, the French find a reason to take to the streets in protest.  This time they are up in arms over the proposed increase in the retirement age for full pension benefits from 60 to 62.  In the United States, the retirement age is now between 65 and 66, depending on your date of birth; it increases to age 67 if you were born in 1960 or thereafter.

A bit of historical perspective is in order.  As The Economist notes: "When Otto von Bismarck introduced the first pension for workers over 70 in 1889, the life expectancy of a Prussian was 45... By 1935, when America set up its Social Security System, the official pension age was 65 – three years beyond the lifespan of the typical American."

The original state-sponsored plans were clearly for those few who lived beyond their normal life expectancy. Today, pensions are more generous and cover the average person for a much longer period of time.

According to the Organization for Economic Cooperation and Development (OECD), the average age for a pension in 30 of the most developed countries is 63 for men and 62 for women. But the average life expectancy in OECD countries has risen rapidly to around 82 years. And it continues to grow.

The result is that governments are facing ever growing pension liabilities as its citizens have the "audacity" to live longer. Generous benefits appear unsustainable for countries already facing severe budget problems.

The workers in France may have to postpone retirement for a couple of years comforted only by a 35 hour work week and over a month of paid vacation.  C'est la vie.

Words of Wisdom

Boy, those French. They have a different word for everything.
-- Steve Martin

News & Notes

Are Stocks Attractive Now? Part II

 

People love sales.  Finding a bargain at a store can bring on feelings of utter bliss.  The lower the price, the better. 

When stock prices go down, however, people get scared.  A stock market decline brings fear.  It confirms all the bad news that is floating around.  People are more apt to want to buy stocks when prices rise.  An appreciating stock market brings on a feeling that all is right with the world and the good times will continue.  

Stocks should be viewed more like consumer items -- some prices are more attractive than others.  The key issue becomes, of course, trying to determine what is a good price. 

How do prices look today?  Viewing the stock market as a whole, the evidence is mixed.  Clearly stocks are less valuable now after the recent run-up than they were at lower levels earlier in the year.

J.P. Morgan Asset Management believes that the best way to look at the relative value of the stock market is to determine how much you are paying for the future earnings of the underlying businesses.  After all, investing in a stock is nothing more than buying a share of the future earnings stream that the business will generate.

Based upon projections of the future earnings of the companies in the S&P 500, the stock market is priced today at around 12.4 times earnings.  This "price" for the market is at the historically low end.  Over the last 18 years, the average price was 16.6 times earnings.

Of course, some people feel that earnings can be manipulated by companies, so there are other metrics, such as price-to-sales and price-to-cash flow.  Even using these factors, J.P. Morgan Asset Management has found stocks to be relatively cheap on a historical basis.

There are other valuation methods that make stocks appear less attractive.  The Yale economist Robert Shiller takes the 10 year inflation-adjusted average of earnings to smooth out the volatility that prices and earnings can exhibit.  Shiller's approach indicates that stocks are priced at over 21 times earnings.  Shiller has shown that when stocks are this expensive, they tend not to perform well in the near future.

J.P. Morgan Asset Management counters that Shiller is looking at past earnings whereas what is really important is what companies will earn in the future.  Of course, as I mentioned in a previous article, the precarious nature of the world economy makes such predictions quite difficult.  Shiller's approach has the advantage of not having to estimate the future.

We end up in a bit of a conundrum.  Stocks look somewhat undervalued if the consensus projections as to future earnings hold true.  Yet the fragile economy takes away some of the comfort that such predictions will come to fruition. 

While investing in stocks has always held some level of uncertainty, it is not, as a learned colleague of mine has said, entirely a crap-shoot.  My friend goes on to say that when you are investing in stocks you are participating in the ownership of real operating businesses -- the question becomes separating out price from value.  The value of a company's underlying business may not have deteriorated as much as its price.

There are no sure things.  There is only a record of the growth of the world economy and stocks over time punctuated by painful periods when that is not the case.

Words of Wisdom

It will fluctuate.
--  J.P. Morgan, when asked what the stock market will do.

News & Notes

Are Stocks Attractive Now? Part I

  

The answer depends on whether you focus on the world economy or corporate profits.  Those seeking a definitive conclusion may be disappointed.  Nevertheless, reviewing the factors that the experts are debating is helpful.

The global economy has moved away from the brink of a depression.  Yet there remain a number of outstanding issues: the uncertain effectiveness of the policy decisions made by major economies; the impact of the European debt crisis; the willingness of banks to start lending again; and, the burden of high unemployment in the developed world. 

The International Monetary Fund believes that such factors pose a risk to financial stability.  The IMF declared that the strong showing of the global economy at the beginning of this year has begun to lose steam.  We can already see signs of a slow-down in the U.S. –- our gross domestic product grew, according to Barron's, "only 1.6% in the second quarter [of 2010], down from 3.7% in the first quarter and 5% late last year."

On the other hand, many individual businesses have shown surprising strength.  As a percentage of national income, after-tax profits in the second quarter of 2010 were the third-highest since 1947 according to The Wall Street Journal.  Barron's points out that there are many well-run companies with robust profits and improving balance sheets.  Of particular note is the large amount of cash being held –- they are at levels that have not been seen since the Eisenhower era.

Corporations have succeeded by using the recent crisis to cut costs –- including reducing their workforce.  Analysts are questioning the ability of corporations to continue earning strong profits as the ability to cut costs diminishes.  Moreover, a weak economy and high unemployment will limit the ability of corporations to grow.

The tension between a slowing economic recovery and the relative health of many businesses is compounded by the angst of an unpredictable future.  There are any number of experts who caution about another "lost decade" due to the severe damage caused by the recent financial meltdown.

Others are more optimistic.  Warren Buffet declared he is "a huge bull on this country… we won't have a double dip recession."  McKinsey & Company surveyed 2,000 executives last month –- 60% said the economy is in recovery and most expect profits to rise from last year.

In the next newsletter, we will look at another factor to consider with respect to the attractiveness of stocks: price.  Are stocks priced like the high-end clothes at Nordstrom or the sales rack at TJ Maxx?  Although the future remains murky, it may be that stocks are too good of a bargain to pass up.

 

Words of Wisdom

More than any time in history mankind faces a crossroads.  One path leads to despair and utter hopelessness, the other to total extinction.  Let us pray we have the wisdom to choose correctly. -- Woody Allen