No Guarantees in Fiat Currencies or Retirement

One of our younger relatives told my wife and me years ago that he couldn’t settle down because he had “too many questions in his head.”  Unknowingly he repeated what market sages for years have stated, that the market needs “certainty.”  Thus both the young and the wise are grappling with an unknown and perhaps more correctly, an unknowable future.

To answer our basic concerns, the strongest human marketing powers in business, government, science, and religion have repeatedly provided generally accepted guarantees that answer our concerns. During the current period of global neurotic economic stress, one wonders whether the title of Andy Grove’s book, “Only the Paranoid Survive”  is relevant. I am suggesting that as with all well-marketed messages, guarantees provide necessary comfort, but they may not be complete in each individual case. Given the uncertainties facing the modern world, the backing behind each guaranty needs to be understood.

Briefly this blog will touch on some of the accepted guarantees involved with retirement income and the value of money. As usual at the end of this blog I will suggest investment implications to these views. (Many of the views expressed will be provocative and will hopefully generate feedback.) 

The Promise

The heart or essence of any guaranty is the promise that under specifically-stated events or occurrences a predetermined reaction will automatically be triggered. In effect, the promise is a contract, often ill-defined or in some cases not even written down. As time passes, what is remembered is what someone believes to be the promise, without any review of the contract. In typical wedding vows, the only exit is by death. There is no mention of actions and attitudes that lead to today’s large number of divorces. In Europe and elsewhere, the fear of either the marriage contract or divorce has led to a large portion of the population living together for extended periods of time rather than marrying.

Retirement Income

Rational people for ages have been saving money, in part to meet a future period where they will no longer be sufficiently economically active to provide for their own needs. For centuries hoarders have converted much of their stash of wealth into savings. In turn some or all of their savings have been entrusted to various financial instruments and institutions. Since the 19^th century and that great “humanitarian” Otto van Bismarck, people have increasingly relied on taxing authorities to supply retirement income.  (Bismarck created the first social security system which would pay retirement income starting at age 65. He picked that age because he believed that very few would reach that age.) In a more modern era, recognizing that most employees would not have enough discipline to save for themselves, companies would defer some current compensation to be paid out later in retirement. Unfortunately, these two sources, the government and various employers, represent the bulk of the expected retirement income for those that had a career of working. For the most part these people are not worried now and don’t expect to be worried in the future because they believe that they have been guaranteed these payments.

These guarantees are increasingly being issued by some  entities  that are having their own financial difficulties. Most federal and some state and municipal governments around the world are operating at a deficit. We, the citizens, consciously or involuntarily are consuming more from the government than is being taxed. Almost all now recognize that this deficit production cannot continue forever. The two standard solutions are to cut expenses or raise taxes. Somewhere in between these two difficult choices there is a stop-gap measure of changing the payment schedule assumed by the government.  Delaying debt repayment to foreign borrowers can lead to materially higher borrowing costs in the future. One can see the possibility that the government could materially change the net effective payment of social security payments. After all, it is difficult or almost impossible to sue the US government without its permission. Most beneficiaries may not realize it, but social security payments are already effectively means tested. The amount of the payment which becomes reportable as taxable income is based on the level of other income received. Remember that half of the benefit received came from your employer or you as self-employed. Changing the date of full retirement is another way of changing the shape of the government debt. For some time I have warned all of my young employees that they should view that FICA (social security) taxes withheld from their pay and matched by their employer are tax payments and they will be unlikely to receive any real retirement income from their tax payments.

What is probably a larger problem for some is the so-called Pension Guaranty Corp, a government body that is meant to guaranty some pension payments for corporate pension plans of bankrupt US corporations. With the government proclivity to bailout pre-packaged bankruptcies of companies with large union member work forces, the guarantor will run out of money and will have to raise fees on those declining number of defined benefit plans or get an infusion from the US Treasury through an act of Congress. Both are uncertain.

Other ways to save are through various financial instruments directly or thru financial institutions. These are only as good as their continuing credit conditions.

Bottom line:  the various sources of retirement income are not perfectly secure under all conditions. The prudent saver needs to be aware that the expressed guarantees have some limits.  

The Value of Money

In the US, much of life’s activities are ultimately measured by colored pieces of paper approximately 6 by 2 ½ inches called the dollar. The pretty paper which circulates around the world in various denominations has little face value, but has substantial spending and trading value based on the belief that there is some almost universally accepted value because of a series of ill-defined guarantees.  Thanks to President Nixon,  the US dollar no longer has direct backing of gold or even now a fixed basket of currencies. As long as others will exchange goods and services for these painted pieces of paper, the dollar and other fiat currencies have value. Around the world the dollar trades against other currencies 24/7. In theory the Federal Reserve currency  has the vastly expanded Fed balance sheet as backing. These are supported by various issues of  US Treasuries that are the debt of the US government. What makes this curious to a financial analyst is that we have never seen a published balance sheet for the US government. We can speculate as to the enormous value of the government’s real and intellectual property. Most of us don’t know the size of the debt against these assets, particularly the future contingent debt. Value-oriented investors regularly arbitrage the difference between a quoted price and its intrinsic value. I cannot perform this equation as I lack any sort of precise knowledge as to the value of the dollar other than what is trading for now versus other currencies, including gold. Thus, I do not recognize fiat currencies such as the dollar have a guaranteed conversion price.

The Terrible Link

Both the value of future retirement income and the value of the dollar are linked to the rate of future inflation, which itself has no guaranty. The value of the current dollar, euro, pound, yen, and Renminbi is exclusively based on what they can buy today in the way of goods and services. If one isn’t going to spend currency today, one must be concerned as to its future value. Often its future value will be dependent on the path of relative prices. This is particularly true for the retired when an expenditure is likely to draw down retirement income or capital. As these are unknown or probably unknowable, I seriously question the certainty of both currencies and retirement capital that people are using.

 Investment Strategies in a World of Questionable Guarantees

First is my guaranty. My guaranty is that I won’t guaranty any specific future scenario or strategy that will produce only winners.

Second, in a period of increasing uncertainty, excessive concentration is dangerous. 

Third, as I believe significant inflation is eventually probable, I believe up to a quarter of one’s portfolio should be in an inflation defensive mode to include TIPS and selected foreign treasuries of up to five year maturities issued by  small population/commodity rich governments with small to no deficits.

Fourth, all equities should have a global orientation. These companies should have some of these characteristics: exporters, foreign operations, net royalty recipients and managements that think beyond their local borders.

Fifth, technology developers and users should play dominant roles.

Sixth, put at least 25% of your or your clients’ portfolio into stocks of companies that are more flexible than their large competitors. This puts one into smaller capitalization securities.

Seventh, as only a few mutual funds are constructed exactly along these lines, a portfolio of funds that appropriately counterbalance their portfolios will be needed and selected carefully.

Feedback Sought

Please share with me your thoughts on the guarantees discussed and or how one should construct a portfolio for such uncertain times.

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Inducing a Recession, Opportunities?

Reading the general and financial media, be it print or on a screen, most of us see disappointment. In part because of our disappointments with political leaders around the world, we are taking away their firepower by inducing a recession. We are disappointed with the various politicians for their reluctance to solve the growing gulf between what we want to receive as a society, and what we are willing to pay for in the way of taxes and fees. Since political leaders wish to get elected, they are reluctant to force the narrowing of this gap.

As political leaders like spending as much as getting elected, we are pressing them to cut expenses, mostly by cutting the other person’s entitlements or benefits. This less spending without an offsetting increase in the private sector will shrink the size of the global economy. Since the expected general level of demand will be reduced thus creating a recession, many are already cutting back on expenditures and have a pessimistic attitude toward investment obligations to themselves and others.

Two extreme behaviors

The first extreme behavior assumes the worst is compounded into tragic levels. Since politicians won’t lead, in this scenario we will see the equivalent of the “Man on Horseback” taking charge and forcing a solution, usually by attacking one or more groups. The dastardly actions of various dictators of the 1930s who “solved” the crushing debts of their country are the source of some people’s paranoia. Following historical precedents, the group to be attacked are the wealthy people, who fear a pillaging of their assets. This fear is palpable today for some. In an investment group meeting last week, we were informed by a third generation dealer in gold bars and coins that sales of these items for personal delivery are skyrocketing. The announced intended purpose for this portable wealth is to pay bribes to cross a border. For some, this was experienced during their lives or their parents' lives in Europe and Asia. Others feel that their wealth is threatened by various left leaning governments, including the present gang in Washington. Their demand for physicals is such that new vaults specifically designed to hold gold, and to some degree silver, are being sold in London and elsewhere. Perhaps another example of this conversion of fiat currencies is that the highest priced real estate properties are selling very well.

The second extreme behavior is that some are buying in the face of plunging stock prices around the world. The buyers could well be traders who recognize, using the past metrics, that both the S&P 500 and the MSCI EAFE are oversold by a significant amount, at least as of Thursday’s close. The other possibility is that the buyers are really investors who know something. My brother points out that our grandfather, based on decades of Wall Street experience, told us that the person on the other side of a trade may know as much, if not more, than we do.

Asian Lessons

Perhaps the rumored flirtation of the Chinese for Italian debt was aborted by their analysis that the rating agencies would lower the credit rating on both the sovereign debt and two of the largest banks in Italy, which occurred last week. A more difficult factor to consider is the announcement last week that FedEx is significantly lowering its estimate of the growth in revenues of expected parcel traffic from Asia for the rest of the year. What requires more study is whether the projected drop in growth is due to an expected dip in the sales of Christmas items in the US. Historically, we have thought of Asia primarily as exporters to the US and Europe. However, our Asian portfolio managers point out that over half of Asian exports are now done within Asia. If the expected decline in the growth of air freight shipments is due to an expected weakness in the Christmas trade, that fits with the induced recession scenario. If on the other hand, the growth of consumer demand within Asia is softening, this could be much more serious. The continued growth in Asian consumer demand is critical to my long term investment philosophy, and to others as well.

What is happening in the “Real World?”

According to a survey done by JP Morgan Chase, 75% of small company CEOs are planning to add people in the coming six months. They may feel that they have a chance to fill a void left by their larger competitors who are pulling back. What appeals to me is that there is an abundance of high quality talent available, either already separated from their employers, or people who are available for the first time.

What should Investors Do Now?

We are reducing our fixed income exposure for our long term accounts who perceive that they have extended obligations to various beneficiaries. Soon the only high quality fixed income that we intend to own will have short maturities. Periodic, planned increases in equities make sense for many of our institutional and High Net Worth clients.

What are you doing with your portfolios?
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Add to the Dialogue:

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Are the New York Jets an Answer to the Bubble Of Pessimism?

This week’s communication was purposely delayed as I wanted to watch the football game between the New England Patriots and the New York Jets. As the market would be closed on the day following the game due to the celebration of the life of Martin Luther King Jr., I felt the delay would not hurt anyone’s trading procedures.

For the international members of this community let me point out that the New England Patriots are generally viewed as the single best team in professional football. Most observers also believe that their coach is the single best coach in professional football. Prior to the game, I was discussing the match-up with a close associate who lives a few miles from Foxborough Stadium (where the game was played); I was assured that the locals were convinced that the New England Patriots would once again win. The New York Jets home base is in New Jersey, and their practice field is supported by the hospital group whose investment committee I chair. Thus, I am a supporter of the Jets. My reaction to my Massachusetts associate before the game was that I would be happy if the score would be closer than the 45-3 shellacking that the Patriots delivered to the Jets in their previous game in December.

The reason I link last night’s game to the investment game is that there were a number of lessons to be learned. I found it curious that when these two competitive teams met last night the gross total of points achieved was very similar to their last meet. In the December game there were 48 total points scored. In last night's game there were 49. The big difference was the distribution. In the second game the team with the fewer victories to that point scored 28 points, while the perceived better team scored only 21. One of the statistical lessons from this comparison is that the distribution of numbers within a numbers’ set is extremely important, even if the numbers’ set appears to be identical to a past experience. The second lesson from this game is learned from how the New York Jets changed their game. The Jets introduced four new defensive schemes which confused and/or delayed the superior quarterback of the Patriots. The lesson from this tactic is that defense is critical not only in football, but also in investing (i.e. don’t lose money), and also that competitors learn to come up with new solutions for their problems.

My pessimism as to the outcome of the game last night is instructive and similar to my outlook on the current state of the markets. The initial pessimism about the game was based on a lot of the aforementioned facts, but similarly in reading about the long-term outlook for investing I was impressed by the litany of unsolved problems that were identified by many as a follow-up to their near-term bullishness.

Bubble of Pessimism

The much-used term “bubble” identifies a series of market disruptions that veer from an extreme of high money-making to an even bigger period of money-losing. The current bubble of pessimism is international (not only the US) and rests on five related elements.

• The first element is the absence of jobs for those who want to work.
  
  
• The second element is deficits; both in terms of governments (societies) spending more than they are collecting in taxes; as well as a banking system that has loaned more money out than it has appropriate collateral. To correct these two components of deficits there is a strident call by some to raise taxes. The problem is those who pay taxes are increasingly a minority within the society and these tax payers are the same people providing capital to create jobs.
  
  
• The third element is the value of paper money. Fiat currencies (currencies that are not backed by hard assets) are dependent on others seeing that a currency is a store of value. With the escalating rise in the price of commodities in general (and specifically in gold), some in the market place are questioning the value of the currencies.
  
  
• Then comes the fourth element: inflation. Some of this is caused by the aforementioned concern for currencies, but there are other contributors such as the scarcity of newly available natural resources as well as the US government’s attempt to induce more inflation into our economy through the manipulation being caused by quantitative easing.
  
  
• The fifth and final element in the bubble is deflation. The fear here is that lower prices will not only affect the prior identified inflation, but will cause various businesses to shut down as they cannot re-capture enough income to pay their bills.

This is a very distressing list.

The Other Side of the Coins

Just as the Jets surprised the Patriots as well as their own fans, some good things can happen.

• First, in those countries that restrict immigration (one needs to include the U.S. in this list), the absence of new immigrant employees, and to some degree their families, is restricting business and individual consumers from the options of buying goods and services at lower prices. One of the reasons that some point out that the U.S. will have a better future than “Old Europe,” is that we have some immigration and often do a reasonable job of assimilating these newcomers. The developed world (with the exception of the US) is now producing future wage earners in a smaller number than the recent past which will be compounded by those who will soon retire. Further, at the intellectual upper-end of the spectrum, the U.S. has some of the best universities in the world. But as mentioned in previous blogs, our students are not among the leaders in all subjects, specifically science, reading and math. Currently our prime universities are attracting brilliant minds as students (and where possible, faculty) but due to limited visa opportunities, these brilliant minds are not staying here. I am hopeful that the change in focus on the part of the Administration and members of the House of Representatives is such that we will start to untie the Gordian Knot of Immigration. I believe our society would be better off having people who want to work rather than carrying too many of those that are restricting their own job opportunities for one reason or another.
  
  
• The next positive element is technology, which for the most part develops labor-saving devices and procedures that allow capital to be re-deployed into higher returns, both here and overseas. From time to time there will be important technological breakthroughs that will solve, or at least ameliorate many of life’s problems. Not only will these be found through our health care innovations, but they will also aid in improving our deteriorating infrastructure and education. Currently, both use too much labor to produce mediocre results.
  
  
• Another element that makes me caution the long-term is the increase in the level of consumption in what we used to call the “developing world” and hopefully now will call “clients.” As these new world consumers want more and better products and services, they should increasingly become our clients.
  
  
• The final element is what we saw the Jets do to the Patriots. The Jets came up with new ways to play aggressive defense while the Patriots were slow to adapt. As the members of this blog community have learned, I focus an inordinate amount of time on the financial services industries, in part because I manage portfolios (both personal and for others) that invest in financial services. While we can debate the wisdom of the Dodd Frank Bill and the Credit Card Act, for the moment they are the law. I find that it is encouraging that two of our leading financial services companies, Goldman Sachs and J.P. Morgan Chase have already instituted new programs that will over time, replace threatened revenues, while also enlarging their customer set. Jefferies & Company is also filling a perceived void in the global middle markets.

Conclusions

Just as I was surprised on the upside by the Jets’ victory, I suggest that we should not swallow all of the bubble of pessimism, but rather we should use it to develop new ways to make money. While not cheap by historic standards, the current market is not terribly expensive either; leaving room in the long run for much higher prices.

Onto the next game.
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