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Bob's Journal 
What's this?______________________________________________ NOTE FOR MEMBERS: An expanded and more frequent version of Bob's Journal now appears on the members' site at www.RetirementWatch.com. Check in there for more commentary and insights on all the financial aspects of retirement.
June 19,
2008 10:30 a.m. The optimists about the economy are finding fewer hooks on which to hang their hats. We are neither consistently bullish nor consistently bearish at Retirement Watch, but we have had a heard time finding things to be optimistic about for the last year. For most bullish arguments, we find counterarguments or points the bulls are missing. Here are some examples. Exogenous factors—forces outside the markets—are important in the direction of the economy and markets. One strong exogenous factor is hedge fund redemptions. In the past we presented evidence that the declines in November 2007, January 2008, and March 2008 likely were caused or exacerbated by hedge funds having to sell positions. Some of the selling was forced by lenders demanding additional collateral or calling in their loans. The rest was caused by the need to meet redemption demands from investors. It is likely that a lot of the selling so far in June was caused by leveraged hedge funds raising capital to meet redemptions that will be due June 30. This is part of the deleveraging that is holding back the economy and markets. Inflation is rising. Some analysts point out that wage growth is not high, and higher consumer prices cannot continue without wage growth. But we live in a global economy now. Wages are rising in many countries outside the U.S., especially the emerging economies. These consumers compete with U.S. consumers for goods and commodities. While U.S.-based services compete only for U.S. wages, the rest of purchases compete with global wages. Those prices will rise as global wealth increases. Another exogenous factor could affect inflation: the floods in the Midwest. A fair amount of crops and farm land could be lost for the year, further forcing food prices higher. Two factors are likely to keep consumer deleveraging and curtail their spending. Home prices continue to fall in many areas. As consumers believe they are less wealthy, they save more and spend less. There often is a lag before consumer perception catches up with their actual wealth picture, so we might only be starting to see the change in consumer behavior. Already, auto makers report that they cannot sell large, gas guzzling vehicles while consumer seek out smaller, more efficient cars. The other factor affecting consumer behavior is consumer sentiment. It recently was 28-year lows. Unless the news on prices, home values, and the economy improves, consumer sentiment is likely to stay low. Finally, there is the financial and banking situation. So far, those who have called the end or the bottom of the crises have been wrong. Those who bought financial stocks thinking they were at a bottom have lost money. Some point out that many banks have dividend yields exceeding treasury yields. That is true, but it doesn’t matter if the dividends are cut or the stock prices continue to fall. It is likely that many banks with high dividends will reduce them. They also will continue to write off loans and asset values and seek new capital to bolster their balance sheets. All these actions will harm current shareholders. They also will mean continued deleveraging in the economy. We continue to look for investment opportunities, but they must have a margin of safety. We are starting to see some opportunities in the credit markets and select other investments and anticipate recommending them over the summer or fall. But be wary of those who believe all the problems are behind us and who recommend indiscriminate investments in the markets.
June 11,
2008 9:30 a.m. There are some interesting things happening with interest rates and oil. The two markets together do not forebode a great time ahead for the economy. Investors need to pay attention to the story interest rates and oil markets are telling. When the mortgage and credit crises first became apparent a little less than a year ago, I said we would watch several indicators to chart whether the crises were subsiding. One of those indicators was interest rates on short-term treasury debt. When the crises emerged, investors sold all risky assets and purchased only short-term treasury bills. All this buying drove down the yields on treasury bills. A rise in yields on short-term bills would indicate the fear had passed and investors were willing to take more risk. Short-term rates have been rising, but not for the reason I was hoping. All the liquidity pumped into the system in the last year has raised both inflation and inflation expectations. Federal Reserve officials have started to talk about the threat of inflation and the possibility of their raising the discount rate. Investors have responded by demanding higher yields from short-term debt. The rise in the two-year treasury yield over the last two days is the largest in two years. The yield on the two-year note is below 3%, so a move of 0.50% in two days is significant. Other important interest rates also are drifting higher. The 10-year treasury yield is back above 4%, and rates on conventional 30-year mortgages are back to their highs of 2006, which are the highest levels since the downturn of 2002. It would be nice if yields were rising because of higher economic growth expectations, but that does not appear to be the case. Growth is slow, and there are few signs of improvement. There are many people forecasting a resumption of growth later this year, but there are no signs it is occurring. Instead, rates are rising because inflation is rising. The food and energy price increases do not appear to be temporary. The two-day move in oil price increases last week was historic and drove oil prices when adjusted for inflation to their highest levels ever. Rising food prices also appear to be sticky, not temporary. We address this in the July issue of Retirement Watch. Inflation is rising in emerging market countries, and they are raising prices of items they export. Inflation has not crept significantly into the core CPI in the U.S. largely because unit labor costs have not increased as much as commodity prices. Producers have been able to use higher productivity and low cost global labor to offset higher costs of things. That trade off could be coming to an end. For years now, inflation has not been a serious concern to investors, businesses, or policymakers. The recent surge in prices in the aftermath of the credit and mortgage crises have changed the situation. Inflation and inflation expectations have increased, and investors need to consider seriously the possibility of continued increases.
June 4,
2008 10:15 a.m. Ever since the mortgage and credit crises began, the disconnection between the views of public officials and those of market players has been remarkable. I saw this firsthand recently when I attended a conference in Vancouver. Janet Yellin, President of the San Francisco Federal Reserve, gave a detailed presentation on the origins and scope of the crises. She concluded with an optimistic personal forecast. Yellin believed that inflation would not become a problem, the housing situation would stabilize in the latter half of 2008, and economic growth would accelerate again in late 2008 after a slowdown that will not become a recession. This forecast differed significantly from those of the bond market players who spoke. The bond investors say portions of the markets still are not functioning properly. They also believe that the residential housing market is not bottoming. They believe the decline in home prices will reduce consumer spending. If these trends do not cause a recession they at least should cause growth to be very slow for the rest of 2008 and into 2009. Either scenario could turn out to be correct, but at this point there is no clear sign that either is right. Yellin is counting on current trends reversing soon, while the market players assume the trends will continue indefinitely. Rather than trying to forecast, investors should invest where there is a margin of safety. We are taking positions which will not generate severe losses if the pessimists are right. That is the way for investors to position their portfolios until the end of the crises is more than a hope.
May 28,
2008 10:15 a.m. Successful investing is more about risk management than seeking the highest return. Avoid the large losses, and the gains will take care of themselves. Concentrate on seeking high returns and you are likely to lose significant capital in a market downdraft. We saw classic examples recently in the credit markets where very conservative investors suffered significant losses. In the mid-2000s investors and economists faced what Alan Greenspan call a conundrum. Longer-term interest rates were falling as the economy grew and the Fed tried to raise short-term rates. In addition, the gap between yields on treasury debt and other types of debt continued to narrow. As we moved into 2007, the yield gaps were quite narrow, at historic lows in many cases. We warned consistently that income investors were not being paid for taking the additional risk outside of treasury bonds and also were not being paid enough to take the risks of longer-term bonds. It was time to hunker down in safety and wait for the markets to return to normal levels. Some investors decided to seek higher yields wherever they could find them. Financial services companies responded by offering “yield plus” funds that were described as conservative ways to earn higher yields. Investors poured billions into such funds. When the credit and mortgage crisis hit, investors found that there was no free lunch. They were taking risks they did not realize and lost considerable capital. Here are some examples: Schwab Yield Plus: This fund lost some value in the initial phase of the credit and mortgage crises, but held up reasonably well. In March 2008 when the markets hit their worst period, the fund declined from about $8.75 to $6.75. It owned a number of illiquid securities that were not trading, so they had no market value. The fund’s value has continued to decline, and investors are suing Schwab. SSgA Yield Plus: This ultra-short term bond fund was supposed to be almost like a money market fund but with a higher yield. Its securities primarily were top-rated. But a high percentage of those holdings were subprime mortgage securities. When the crises hit, the values of these securities declined. The fund lost value steadily. The losses precipitated redemptions, forcing the fund to sell its securities at whatever prices they could. Losses continued to grow, and the managers were replaced. There are only a few assets left in the fund, and it probably will be liquidated at some point. Regions Morgan Keegan Select High Income: The fund for years earned higher yields by investing in less liquid and less well-known types of securities. But subprime home equity and asset-backed securities were not the place to be recently. The fund lost 68% over a year. Between declining values and redemptions, assets under management fell from $1.2 billion to $118 million. Each of these funds was offered by an established, reputable firm and had some period of success before imploding. Yet, they were under pressure to earn higher yields wherever they could find them. The managers assumed that the markets they invested in always would function and have liquidity and that the credit ratings of the securities were accurate and would not change. Investors failed to take note that the markets were paying only marginally higher yields to take greater risks. They also did not realize that despite the AAA ratings of many securities held by these funds, the markets do not pay higher yields unless there is higher risk.
April 28,
2008 02:15 p.m. Investors in bond and equity markets are feeling optimistic, and it is easy to see why. Some of the signs of panic and risk aversion are abating. Treasury yields, especially the short-term yields, have increased significantly over the last two weeks. Normally, that is a negative sign. But yields were extremely low because of panic and the flight to safety. Higher treasury yields mean investors are coming out of their bomb shelters and seeking investments with more risk. Also, high yield bonds scored some gains in the last few weeks, and the yield spread between treasuries and high yields has declined a bit. Real estate securities have scored some gains, and the gap between GNMA debt and treasuries is smaller. Equities, of course, have staged a good rally with the major indexes scoring good returns since the March bottoms. Even small company stocks are doing well, returning about 10% since the mid-March lows. All these returns result from the optimism that followed the demise of Bear Stearns. Investors began to believe the worst was over and that it was safe to start coming out of their caves and shelters. While the worst of the credit and mortgage crises might be over, the situations are not resolved. Perhaps even more important, other factors are a drag on the economy and have not been resolved. Banks still are not lending. Individuals and businesses are not borrowing. The job market is not in great shape. Higher energy prices are shifting consumer cash from other expenses, hurting retailers, restaurants, and the travel industry. The economy is growing slower than its long-term average and too slow to keep unemployment from rising. The question for investors is: Will these trends reverse as the credit and mortgage crises abate, or will lower consumer spending trigger a new phase to the economic decline? It appears to me that investors are over optimistic. They take the view that since things no longer are getting progressively worse, things are good. Stocks rose, for example, because earnings were not as bad as they could have been. As a risk manager, I see more risk than opportunity in the markets. The odds are that we have seen a bear market rally. As has happened several times since the crises began in the summer of 2007, investors probably are anticipating an end to the problems based more on hope than facts.
April 21,
2008 02:45 p.m. After a widespread financial disaster was avoided in the Bear Stearns affair, investors seem to be convinced that a new boom is set to begin. All good news is given the best possible interpretation, while bad news largely is ignored. Investors might be too optimistic. One day last week in almost identical words The Wall Street Journal, in two separate articles, reported that investors were bidding stock prices higher based on “less-than-awful earnings reports.” Key businesses, including major banks, reported earnings lower than a year ago but better than analysts were expecting the day before the reports. Looking strictly on a year-to-year basis, the earnings trends were bad. But compared to expectations developed during the gloom of March, the reports were considered positive. Another trend behind last week’s surge in stocks is the bifurcated economy. Earnings from financial services companies were dramatically lower than a year ago; in fact they were losses, not earnings in most cases. Retailers and homebuilding-related companies also are doing poorly. Companies in other sectors of the market, however, are doing well. Reports from Google and Caterpillar highlighted the trend. So far, earnings from non-financial companies in the S&P 500 are up 8%, and they are expected to be up about 9% from a year ago after all the reports are in. Global growth and exports are big contributors to the growth. Yet, this does not mean that the rest of the economy will avoid being hurt by the financial services problems. Bank still are not lending much, and businesses and individual aren’t borrowing much. Interest rate spreads between treasuries and other types of debt still are high, though lower than the peaks of March. There still are many signs that the financial system is not working in many areas. Investors have to consider the possibility that the effects of the mortgage and credit crises on other sectors of the economy are delayed rather than avoided. Those rushing into stocks recently might find themselves regretting the move. Investors also need to consider that last week’s surge in stocks might be a bear market rally. The major indexes have been in a trading range for a while. The latest rise might simply be a combination of a bounce off the bottom of that range, and a move by short sellers to cover their positions. A collapse of the financial system seems to have been avoided. But that does not mean the economy is about to return to robust health. A financial system that avoids collapse is not the same a healthy financial system. A weak economy will further hurt financial services companies in addition to the companies that so far have been immune to most of the problems. At Retirement Watch we don’t try to time the markets or pick bottoms in the economy or markets. Instead, we avoid large losses by managing risk. When risks seem reasonable, we invest in an asset. Otherwise, we wait until we see a margin of safety. While risks in the economy and stock markets are lower than a few months ago, they still are high. A forecast and a leap of faith is required to take major positions in the stock markets before seeing if the rest of the economy will continue to avoid adverse effects from the financial and housing problems.
April 17,
2008 01:30 p.m. One of the keys to successful investing is to filter the daily market noise from real news and information. For the last few days, it appears to me that noise is overwhelming the real news in the minds of most investors. A fresh rally has taken hold, and analysts are saying that the economy has turned or is about to turn the corner. The optimistic view looks at past market cycles and applies their lessons to today. That requires overlooking several unique characteristics of today’s economy and markets. In the past, substantial interest rate cuts by the Federal Reserve were sufficient to reverse an economic slide. Here are some of the factors that are different today: ? While the Fed has slashed the federal funds rate, consumers and businesses face essentially the same interest rates they did a year ago. Longer-term rates have not declined enough to induce borrowing. ? Banks and other lenders have significantly tightened credit availability and lending standards. There is less capital available to the economy. ? Short-term treasury rates still are very low, indicating that investors are avoiding risk at levels similar to the height of the panic in the summer of 2007. ? Retail sales are weak. ? All aspects of the housing market still are at or near historic lows. ? Inflation is high, though yesterday’s producer price index report is giving some investors hope that it has peaked. ? Commercial paper and asset-backed securities markets remain at distressed levels. The Federal Reserve has done what it can to abate the crises and get the economy back on track. But consumer sentiment remains low, and businesses for the most part are not optimistic. Investors need to remain cautious for now and choose their opportunities carefully.
April 8,
2008 09:40 a.m. In The New Rules of Retirement I argued that retirement was changing and would continue to change. One likely change would be a reversal of the long-term trend of earlier and earlier retirements and a gradual increase in the average retirement age. An April 1 article in The Wall Street Journal affirms that this trend has begun. Declines in real estate and equity markets combined with lower interest rates on bonds convinced a number of people that they really could not afford to retire just yet. The article has a graph showing a steady rise in the portion of people age 55 to 64 in the labor market. The percentage was steady just above 55% in the early 1990s and began a steady rise around 1995. Then, the rise accelerated around 2001-2002. Now, almost 65% of people age 55 to 64 are in the labor force. I expect this trend to continue for several reasons. Because of improvements in health and longevity, 60 is too young for many people to begin a life of leisure that could last another 20 years or more. Financially, most people are not prepared to fund 20 or more years from their investments. The volatility and relatively low returns of the traditional markets also cause people to shy away from retiring early. A traditional portfolio could decline by 20% or more in a short period of time and seemingly safe investments become insecure almost overnight. Those conditions make it difficult for people to walk away from a steady working income for the uncertainty of retiring and becoming dependent on the investment markets.
April 3,
2008 04:00 p.m. Readers of my book, Invest Like a Fox…Not Like a Hedgehog and of Retirement Watch know that the traditional investment models are wrong. The contagion in subprime mortgages, overleveraging, and other problems in today’s markets are a direct result of many investors missing important points. Investors should know that risk management is at least as important as potential returns. That is why we focus on a margin of safety in our investments. Investment firms that used a lot of leverage had much higher returns than we did when the markets were rising, but they have lost all their gains plus a lot of their principal in only a year. Gains don’t count unless you keep them through the cycle. Historic data must be used with caution. Markets are dynamic, because they are composed of people acting. People learn and change over time. Too many investors try to apply scientific and mathematical principles to portfolio management. Models and math are useful, but ultimately judgment and discretion count more. The unexpected and unlikely events happen. They happen in your lifetime, and they happen more than once. In investment professional talk, events such as today’s mortgage and credit crises are “fat tails.” They happen more than the mathematicians say is possible. That is why in news stories about the crises you will see, for example, employees of Bear Stearns saying that what happened to them couldn’t possibly happen. Our themes were picked up in today’s fortune.com interview with Nassim Taleb, author of Black Swan. Taleb agrees with us on many points and makes them eloquently in this interview.
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E-mail: BCarlson@ Bob's Journal Archives March 2008
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