Unintended Consequences...John Mauldin's weekly e-letter
The Unintended Consequences of Underfunded Pensions
Nightmare on Pension Fund Street
Can It Get Worse?
Index Funds Complicate the Markets
Why the Market Rallied
What Will Go Wrong?
It is the flea which worries me.
By John Mauldin
Each week, I typically sit down at noon on Friday to write this letter.
Quite often I stare at a blank screen pondering what to write about. Last
week, and this week, my task has been to decide what NOT to write about.
There is just so much that is worthy of our attention: pensions, indexing,
Iraq, the drop in gold and the rise in stocks, international turmoil, the
misleading headlines in the investment media and more. I have to leave the
office without fail at 5:30 (kids come first), so let's see how much we get
covered.
The context for this week's thoughts was provided to me by Art Cashin, head
floor trader at UBS Warburg and also of CNBC fame. He writes a privately
circulated and brilliant daily letter which is absolutely one of the most
fun and informative tomes I read every day, without fail. His bosses need
to allow him to circulate it to a wider audience. He wrote last Monday
about unintended consequences, and provided the following story. My reading
this week has brought to my attention a wide variety of unintended
consequences. But first, Art's story:
"On this day (approximately) in 1349, in the midst of the infamous Black
Plague epidemic, the forces of government, science and academia came
together with a plan to save the people. As you recall from earlier
episodes, the Black Plague had spread from the eastern Mediterranean
throughout most of Europe killing millions over the preceding three years.
People searched everywhere for the source of the plague...a heavenly curse;
a burden of immigrants; the result of spices in the food. It was tough to
figure, however, since whenever they held a conference either the host area
caught the plague or the visitors did...so...not too many conferences.
"Then in the six months preceding this date the death rate leveled off...or
seemed to. So in castles and universities and town halls across Europe,
great minds pondered the cause of the plague. And they came pretty close.
The collective governmental/academic wisdom was that the source of the
Black Plague was fleas - (absolutely correct).
"So the word went out from town to town across Europe - to stop the plague
- kill the fleas - by killing all the dogs. And immediately the slaughter
of all dogs began.
"But like lots of well-intentioned governmental/academic ideas it was
somewhat wide of the mark...and had unexpected consequences. The cause was
fleas all right, but not dog fleas...it was rat fleas. And in the 1300's
what was the most effective way to hold down the rat population? You
guessed it - dogs. So by suggesting that townsfolk kill their dogs, the
wise authorities had unwittingly allowed the rat population to flourish and
thus a new vicious rash of Black Plague began. Before it was over, three
years later, nearly 1 out of 3 people in the world had died of the plague.
"(Historic footnote...Published sources say that with so many people dying,
millions of estates had to be settled - result...the fallout of the plague
was a huge growth in....the number of lawyers.)"
The Unintended Consequences of Underfunded Pensions
I have written extensively about how corporations are misrepresenting their
pension fund liabilities. Steven Kandarian, head of the US Pension Benefits
Guarantee Agency which insures pensions and is financed by company-paid
premiums, told the Senate Finance Committee that inadequate requirements
have led to a $300-billion shortfall in the assets of company plans.
Typical is General Electric Co. which reported Friday that its pension plan
contributed $806 million pretax to earnings in 2002. A footnote on page 27
in its annual report showed that it actually lost $5.25 billion, equal to
29% of the company's pretax earnings.
They can do that because they assume their pension plans, which invest in
stocks and bonds, will grow at 9%. Since bonds are only paying 6% or so,
this means they assume the stock market will grow at 10-12% a year. If that
happens, they will not have to take from profits and fund the pension
plans. Of course, if the market does not grow that much, then they will
have to take a hit to profits.
If actual pension liabilities had been counted in financial statements,
aggregate earnings for the S&P 500 would have been 69 percent lower than
the companies reported for 2001, or $68.7 billion rather than $219 billion,
Credit Suisse First Boston Corp. found in a research study on pension
accounting published in September. Morgan Stanley says the S&P 500
companies have $220 billion dollars in unfunded pension liabilities as of
the end of last year.
I could do a whole letter on public company pension fund problems. But for
most of us, the problem is not one which affects us directly. We can simply
sell the stocks of companies which have pension fund problems, and we don't
have to buy S&P 500 index funds.
But there is a pension funding problem which dwarfs the public company
problem, and which will directly affect your pocketbook. Let's look at
government pension plans, which your tax dollars must fund.
Wilshire Associates does an annual review of state pension funds. They
released the 2002 study this week. Ugly does not begin to describe this
paper. Let me give you a few of the more salient findings.
Of the 123 state retirement systems covered in the study, 79% are now
underfunded. In 2000 only 31% were underfunded. At least nine states have
pension fund liabilities that exceed their annual budgets. Nevada would
have to devote 267% of its annual state budget to make up its current
shortfall. Illinois would need 144% of its current annual budget.
It's actually worse, as the study was done on reports from the retirement
systems that were mostly done in June or July of 2002. Since the average
fund has 63% of their investments in equities (both domestic and
international) and the markets are down by 20% since last summer, it is
very possible total pension assets might be down another 10% or close to
$200 billion in fiscal 2003 unless we see a substantial rise in the stock
market in the next three months.
As of the report, state retirement systems only had 91% of the assets
needed to fund liabilities. This is down from 115% only two years ago. It
is not unrealistic to think that it might be as little as 80% by the middle
of this year.
And, of course, I have to go on to note that it gets uglier. Wilshire
assumes that these funds will get a 7.5% return per year on total assets,
which is only 0.5% less than the 8% the average state plans assumes they
will get.
How realistic is that? As noted above, the average fund has 63% of its
assets dedicated to equities, down from 64% last year. Since the stock
market had a large drop in 2001-2002, that means they were selling bonds
and putting any new revenue into stocks to maintain their stock/bond
ratios. The consultants tell the boards this is a smart thing to do,
because you don't want to miss the next bull market. The boards buy into
the logic, because the alternative is too hard to contemplate: lowering
assumptions of future returns and thus requiring the states to ante up more
money.
If you assume you can get 6% on your bond portfolio (which is aggressive,
as most retirement funds are required to invest in high quality bonds which
do not pay more than 6%), this means the average fund is assuming they are
going to get returns of 10% per year on their stock market investments.
They basically assume that the market will double in the next seven years:
Dow 15,000 here we come! An S&P 500 of 1700 is right around the corner.
I wrote a few weeks ago about the tables at www.decisionpoint.com which
shows the current P/E ratio for the S&P 500 is 27.59. I can find no period
in the history of the US markets in which 7 years after such a nosebleed
level the stock market has averaged even 1%, let alone 10%. You can make an
argument that from periods where P/E ratios hit their highs (generally in
the area of 22-23), there were some periods where the markets averaged 3%
the next seven years, but you can also find periods where the next 7 years
showed actual losses.
But there are no examples of 10% from the P/E levels which we are at today.
None. Nada. Zippo.
This week, the Financial Accounting Standards Board decided unanimously to
review how options should be accounted for. As I predicted early last year,
I believe they will decide to require companies to expense options. This
will be a significant drag on earnings for many companies. Along with other
stricter accounting requirements (see more below), the chances that
earnings in corporate America are going to grow by 10% a year for the next
seven years are remote.
There are those who will argue (and do so aggressively) that investors will
ignore the new earnings and focus on pro forma earnings, and thus earnings
could rise by 10-15% or more per year. I politely reply, "Nuts."
After the next recession, and even more earnings disappointments, investors
are going to be even more conservative than they are today in how they view
earnings. The standards will get stricter, and many companies will have to
work to get back to what they reported only a few years ago.
Nightmare on Pension Fund Street
Let me start with a worst case scenario, and then see if we can find a way
to paint a better picture.
Today, there is something north of $1 trillion dollars in equity assets in
the 123 state pension funds covered in this study. My back of the napkin
analysis shows that pension fund estimates assume that the equity portion
of the pension fund assets will grow by 10% or around $100 billion per
year.
That means in 7 years and at 10% compounding, they are assuming there will
be approximately $1 trillion dollars in growth from the equity portion of
their assets.
If the stock market is flat, they will be short $1 trillion in only 7
years, from a "mere" $180 billion shortfall today. If the market grows at
3%, the states will be down $750 billion from their estimates.
Can It Get Worse?
The Texas legislature is in session. In Texas, we regard large groups of
politicians in one place as dangerous, so we only let the state legislature
meet for five months every two years. I called one of the most
knowledgeable long-time veterans in the legislature today and asked him how
we are dealing with our Texas sized $19 billion dollar, public pension
shortfall.
Bottom line: we aren't. It is not on the "leadership" radar screen. For the
first time, Republicans finally control both houses of the legislature and
statewide offices. They ran on a no new taxes platform. They are
scrambling, as is almost every state, to balance a huge budget deficit
without raising taxes. It is doubtful they will be able to do it. It they
had to kick in another $3 billion a year, or close to 5% of the state
budget, just to get us to balance within 10 years, there would be panic in
Austin. There is no way they could find another $2-3 billion a year without
substantial new taxes.
This is typical of states throughout the union. It is much easier to assume
10% equity growth, increase funding a little and hope the problem goes
away.
If we see a sustained secular bear market, there is no way that state
governments can meet the kind of pension shortfalls I am suggesting are
possible, which is precisely what I think is going to happen.
What will happen? Will the public pension fund world come to an end? No,
politicians will eventually step in, when things start to get grim. There
will be declarations of crisis and emergency, and to "save the system,"
benefits are going to be cut or frozen. Future retirees will not be happy.
It is probable in many states that defined benefit plans will be changed to
defined contribution plans. Some states will honor current retirees, but
younger employees will not be able to retire under the current system.
The longer this secular bear market goes, the worse things will get and the
more money states will have to come up with in the future.
The unintended consequences of the current policy of benign neglect will
mean either future tax increases, cuts in services or both. As medical
costs rise, the state funded portion of those costs will rise as well. The
pension benefits for younger workers will be cut, and they will be forced
to either save more or face a less robust retirement.
Unless steps are taken soon, it is possible we could see shortfalls
approaching $1 trillion dollars in state sponsored funds by the end of the
decade. A deficit of this size on state levels can truly be called a
crisis. A tax increase or other adjustments to fund this will be a large
drag on the economy.
This does not take into account the many municipal (police, fire and
employees) and county pension funds, which have the same underfunding
issues. The problem, in reality, is much larger than the 123 state funded
plans discussed above.
Index Funds Complicate the Markets
Wall Street loves index funds. They are the largest of mutual funds. They
are sold as less volatile instruments than single stocks, and investors
have flocked to them. Mutual funds use spiders and QQQ's and other exchange
traded index funds to simulate markets. Longboat Global Advisors recently
commented that an unintended consequence of the growth of index funds is
"We believe that indexing via market capitalization is destroying whatever
remains of pricing efficiency in the American market and is a primary
reason for the bear's grip and the concurrent expansion of volatility, very
simply put, every time a market cap index is bought, the fattest stocks
receive sponsorship by the sole criteria of their inclusion in the index...
[regardless of the actual prospects or value of the company]."
In April of 2002, Mr. Jean Claude Trichet, Governor of the Banque de
France, in a presentation at the Federal Reserve Bank of Chicago, gave
indexing as one of four reasons that markets appear less efficient. He
stated that index management helps "to amplify market trends, buying more
as the market rises and liquidating more as the market drops. It can be
argued that index funds distort the price of the targeted indices and that,
as a result, the indices end up creating rather than measuring
performance."
In essence, buying a NASDAQ index fund supports the price of large NASDAQ
stocks even as the prospects for profits of the individual companies
decline.
There is no real solution, as you can't ban index funds. But it does affect
the market. As an aside, the 15 companies which the S&P 500 dropped from
the index lost an average of 73% in 2002 and were down 91% from their
highs.
Why the Market Rallied
I must confess to getting apoplectic every time I hear that "the markets
rallied because of news that the Iraq war might not happen." It is utter
drivel, and only someone desperate for a headline could propose such. The
markets and traders know there will be a war, and are driven to try and
anticipate what the public reaction will be. The current betting by real
traders is that there will be a war rally after the war is over, or very
soon after it starts, assuming it is as successful as it now appears it
will be. Since it appears it could start within days, no trader wants to be
caught short overnight, or going into this weekend. As I have written, a
short-covering rally of significant proportions, followed by a momentum
rally is possible.
It is nice to get solid thinking from market veterans like Art Cashin or
Dennis Gartman. I also receive a daily update from Ramsey King called the
King Report, written for larger institutions and traders on world events
and trading advice. This Thursday AM he wrote, long before the market
opened:
"Stocks will try to rally after Wednesday's bounce off important technical
levels. Also, since it's Thursday, beware of the usual late rally attempt.
With a good deal of war liquidation complete, the expectations of a monster
rally when war commences will now force short covering and induce bargain
hunting in the believe the war could start on Tuesday, which coincides with
an FOMC meeting at which the Fed is expected to cut rates. Plus next week
is expiration week, and as we recount every month, upward expiry bias
commences on either the Thursday or Friday of the week that precedes expiry
week - that means today or tomorrow. Technicals are at extremely oversold
levels and the just-mentioned factors augur for a short-term rally.
Furthermore, Monday's 90% down day indicates a snap-back rally is imminent.
And that's why thinking operators acted yesterday."
Art Cashin noted that the rally got momentum on the rumor that the CIA is
negotiating with Iraqui generals for the surrender of whole divisions,
which will in turn march on Baghdad. It was not the postponement of war,
which no one believes is really possible, but the possibility of it being
swift and painless that got the "animal spirits" of traders moving. If the
war does go well, they expect a war rally a la 1991.
Of course, contrarians say we saw the war rally this week. Do you buy the
rumor and sell the news?
It could go any of a dozen ways. Since we are in a secular bear market and
the long term trend is still down, this is not the time to jump in for a
long term investment. This is a trader's and stock picker's market. It is
not time to buy and hold.
Finally, a few comments on the possibilities for unintended consequences
resulting from the coming invasion of Iraq.
The French are openly dismissive of an American president, who does not
understand how important it is to listen to world opinion, and especially
that of France. They are determined to have their way, even though
Americans have sacrificed much to support France in the past.
Bush in 2003? No, it was Woodrow Wilson after World War One. France (and
Britain) were determined to punish Turkey (the Ottoman Empire) for
supporting Germany and insisted on carving it up. They created whole new
countries, like Iraq, that had never existed, lumping in tribes and regions
with long histories of fighting. They split families and regions as they
carved up the Middle East as they expanded the colonial empires, over the
protests of Wilson.
The most negative unintended consequence was the removal of a central
Islamic religious authority in the caliphate and the establishment of some
Saudi tribal princes as leaders who were under they sway of the Wahhabi
sect, a radical and militant group within Islam founded by Abdul Wahhab
(1703-1792), known for its strict observance of the Koran and flourishing
mainly in Arabia. With the finding of oil, Saudi princes have bought off
this group by funding their schools and mosques, and their adherents have
"grabbed the mike" in most mosques throughout the world. In 1920, they were
a distinct minority and few, if any, Islamic scholars of the day were
associated with them. Today, they are the principal sponsors of religious
based terrorism.
Islam is not the enemy of the West. Wahhabis are a different matter. Those
who listen to them are taught to hate us. They are an unintended
consequence.
Let us make no mistake, for good or ill, Bush is going to remove Saddam. US
polls (Fox News) show a growing 71% behind the war (this probably means
that 71% of my U.S. readers are behind the war and 29% are not, with the
reverse of these percentages for my European readers) with a growing
percentage wanting it done now. Polls show Bush would lose a significant
percentage of his support if he does not act soon. He will. The war may
start before next weeks letter reaches your email box, or shortly
thereafter.
For the record, this war is not about oil, despite the conspiracy theory
buffs. It is not about America wanting an empire, despite George Soro's
insipid accusations. It is not about the Carlyle Group wanting to rule the
world.
I know George W. Bush somewhat, having dealt with him on occasion as I was
involved in Texas politics when he was governor. I think I know somewhat of
his character and personality. He is an impressive man, but more than that
he is a genuine man. One of my minor regrets in my life is that I did not
get to know him before he ran for governor. He is precisely the type of man
you want to have as a friend.
This president was profoundly animated by 9/11. He does not want another
event like that to happen on his watch, or because he left a problem to the
next generation. It is as simple as that.
Conspiracy theories, oil cartels, empire and world domination and the like
are a lot more fun to think about. But sometimes the real reason is the
most simple. In this case it is.
What Will Go Wrong?
The things that concern me are not the ones most discussed in the media. I
am not worried about a break in US European relationships. If you count
countries, there is a clear majority of European countries supporting the
US position, something like 15 to 5, with a few neutral countries. My
friend Dennis Gartman, speaking at a conference in Portugal, writes of a
very moving speech by the Portuguese president on why Portugal is
supporting the US.
Since the actual people (and voters) of Europe are against the war by an
overwhelming majority, are European politicians suicidal in their support
for the US?
No, they are not. If you ask most Europeans in the countries which are
supporting the US, they will say they are against the war. But there is
more to the story.
In polls in the US, people overwhelmingly think the US education system is
bad, but their schools are good. The medical system needs reform, but their
doctor is just fine, thank you.
In Europe, the Iraq war is not something that will change the lives of most
citizens. While the average voter is against the US war, they are far more
concerned about how a French and German led Europe might force their
nations to adhere to rules which would not be good for their countries,
could hurt their opportunities for growth and limit their freedoms. A
powerful US who would only like to do business is far less a personal
threat than a French hegemony which would like everyone to conform to their
work rules, tariffs and economic plans and lessen competition from other
countries.
European politicians know that the Iraq war will be forgotten soon. The
issue in the next round of elections will be who will run the European
Union and how it will affect their country.
I can see the large dollar costs of the Iraq war. I can see a possible
increase in terrorism. I can also see a possible growth in democracy in the
region. I can see good outcomes and bad outcomes.
The things which worry me are the negative unintended consequences that we
cannot even imagine. Churchill would not have created Iraq, and the French
would not have installed the Saudi tribes, if they could have foreseen
today.
It is the flea which worries me.
Christoph Amberger wrote an essay for the Daily Reckoning yesterday which
was absolutely brilliant. Amberger was born in Berlin and remembers another
cowboy American president coming to Germany, where there were protests from
the same people who march today and oppose American power.
But Reagan persevered, and the Berlin Wall came down. Those who opposed
America at that point were wrong. You can read his moving essay at
dailyreckoning.com . This link will also give you
an opportunity to subscribe to the free Daily Reckoning e-letter. You can
get to Christoph's essay by scrolling about halfway down.
It is approaching 5:30 and I must go. My sons are waiting. I have to fly
for a quick meeting in DC on Monday but will return the next day. I will be
in Austin on Monday of the following week speaking at the Texas Public
Pension fund conference.
I leave you with this quote dug up by Bill Fleckenstein:
"It is very rare that you can be as unqualifiedly bullish as you can be
right now." Alan Greenspan on January 7, 1973, two days after the market
peaked on its way to declining 50% over two years as we endured the worst
recession since the depression."
Your rushing out the door analyst,
John Mauldin |
