Bob Carlson

Your IQ changes over time. Scientists now think they can identify the factors that trigger the changes. This especially important to people in the second part of life who want to stay mentally agile and even increase their mental acuity. While some studies show that problem-solving skills peak around age 53, that’s not the case for everyone and maybe it doesn’t have to happen. Read the WSJ article. (Subscription might be required.)

There are practical steps people can take to see longer-term IQ changes. A 30-year study at the National Institute of Mental Health found that people whose work involves complex relationships, setting up elaborate systems or dealing with people or difficult problems, tend to perform better over time on cognitive tests. Test scores of people whose jobs are simple and require little thought actually tend to decline, according to the research, published in 1999 in Psychology and Aging.

New tasks stimulate the brain most. When researchers at the University of Hamburg subjected 20 young adults to one month of intense training in juggling, they found an increase in the corresponding gray matter in the brain as early as seven days after the training began. The added gray matter receded when the training was stopped, although the participants were still able to juggle, says the study, published in 2008 in PLoS One.

The increasing wealth gap in the U.S. has been a bubbling topic for several years, but it received more headlines with the Occupy Wall Street movement. But there are a lot of different ways of looking at the wealth and income numbers, and much of the discussions in the media don’t use good data or paint the full picture. For example, are government transfer payments (which don’t show up in tax returns) included in the numbers? The Congressional Budget Office recently analyzed data from 1979 to 2007, and the analysis as reported by the House budget Committee provides some interesting information. Take a look at this summary by Michael Barone.

Perhaps even more surprising, federal transfer payments have done much more to increase income inequality than federal taxes. That’s because, in Ryan’s words, “the distribution of government transfers has moved away from households in the lower part of the income scale. For instance, in 1979, households in the lowest income quintile received 54 percent of all transfer payments. In 2007, those households received just 36 percent of transfers.”

In effect, Social Security and Medicare have been transferring money from low-earning young people (who don’t pay income taxes but are hit by the payroll tax) to increasingly affluent old people.

Standard & Poor’s downgraded the credit ratings of all the major banks and related firms. The move effects many of us. It makes it more expensive for the banks to be in business, because it increases the interest they pay on debt. These firms operate with a lot of leverage, so an interest rate increase is important. It also means the banks might have to raise capital so they can reduce debt. The bottom line for most bank users is higher fees and other costs on their banking products, because banks need the money. For investors, it’s another reason not to invest in the banks. While bank stocks are cheap by many measures, the history of banking valuations doesn’t matter. They’re moving from growth companies to highly-regulated utility-like companies that have their activities and potential profits limited by the government.

Several official reports and analyses have been published explaining the causes of the financial crisis and how government officials missed the developing problem. The latest is from Simon Potter, economist of the New York Federal Reserve. The NY Fed is key, because it oversees the Wall Street banks, works closely with them, and essentially represents their views and interests to policy makers. Potter examined forecasts by the Fed, especially the NY Fed, compared them with private sector forecasts, and tries to explain why the Fed’s staff forecasts were off the mark. Potter makes no effort to argue that the forecasts were reasonable or essentially accurate. In fact, he documents how poor the 2007-2009 forecasts were, and points out that the 2010 forecasts were very accurate while the 2011 forecasts have not been.

Potter believes three factors caused the forecasting failures. The Fed misunderstood the housing boom, believing there was no overvaluation or a likelihood for a decline in home prices. The staff also relied on efficient market theory instead of analysis to understand the changes in mortgage finance. Finally, the staff didn’t understand how a financial crisis would affect the real economy through feedback loops.

However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants.

Potter really doesn’t try to explain in great deal how the crisis developed or what caused it. Instead, he addresses those issues through the back door while explaining how the Fed staff missed the consequences in its economic forecasts.

No question is more important to stock investors today. Stocks are being supported largely by historic profit margins. When margins exceed the long-term average, so far they’ve always declined back to the average or below. Will it happen again. Jeremy Grantham of GMO says it has to, while Bob Doll of BlackRock sees no reason for them to decline. He believes technology, efficiency, and low labor costs will keep profit margins healthy. Read their back and forth and other arguments.

“The implication for the stock market is ugly, because it means earnings are unsustainably high,” Grantham’s colleague Ben Inker, GMO’s director of asset allocation, said in a telephone interview. GMO, an investment manager that oversees $93 billion, puts the fair value of the Standard & Poor’s 500 Index at between 950 and 1,000, compared with the 1,158.67 level at which it closed last week.

U.S. companies’ ability to squeeze more profit from each dollar of sales is pushing earnings higher, even as the economy has grown at a below-average clip since the recession ended in June 2009. Grantham, who called corporate profits “freakishly high” in an August commentary, sees wide margins as an aberration. Some of his competitors say changes in the economy and the way firms operate could keep them near peak levels for another year or two.

It’s part of the current uncontroversial investment wisdom. Corporate balance sheets are in the best position they’ve ever been in. Cash balances are high, and the stocks of some companies are priced so that you buy the cash balances and get the company operations almost free. John Hussman of the Hussman Funds has a different take in the current Weekly Commentary. Compiling data from different sources, Hussman concludes that while cash balances are high, they aren’t particularly high relative to debt burdens and are only slightly higher than previous highs relative to net worth and asset values. He also shows that corporations have been issuing more debt than ever and their financial positions are declining when measured as debt to net worth or debt to total assets.

In going through the Flow of Funds data this week, I thought a few other features of the data were interesting. First, was the profound decline in tangible assets as a percentage of total corporate assets since 1980. This decline goes hand-in-hand with an increase in financial assets held by non-financial companies. At present, more than half of the total assets held by non-financial companies in the U.S. represent financial assets such as debt securities and equities. This is striking, in that we presently have a menu of prospective returns on financial assets that is among the most dismal in history. While the move toward zero interest rates has certainly been excellent for bonds when we look in the rear-view mirror, the fact that prospective rates of return are now so low suggests that a large portion of corporate assets are unlikely to achieve very much in the way of future returns, barring a decline in those asset prices. Something to think about.

When investors are worried about bank stocks, they’re worried about the economy and sending warning signals. That’s the assertion in this op-ed from The Wall Street Journal, and its authors say bank stock prices are sending warning signals now.

From mid-August through last week, bank volatility has been over 3%. The market for bank stocks is now sending a bright red warning signal that conditions are ripe for another potentially disastrous financial panic.

The new stress test the Fed announced last week is a sign they recognize the problem and a step in resolving it. But more needs to be done, including further reducing the leverage in the banks.

Policy makers need to focus on both short-term and long-term solutions to the debt crisis, says economist Michael Boskin of Stanford and formerly of the George W. Bush administration. A government has only three ways to solve its debt crisis: economic growth, borrowing costs (the interest rate it pays), and its annual budget deficit or surplus. Boskin argues that the social welfare programs in Europe and the U.S. need to be reformed to bring the third leg in line with any other actions that are taken.

The social-insurance systems in Europe, as in the United States, Japan, and elsewhere, were designed under vastly different economic and demographic circumstances – more rapid economic growth, rising populations, and lower life expectancy – from those prevailing today. Governments (the focus is on Greece and Italy at the moment, but they are not alone) have promised too much, to too many, for too long. My 1986 book Too Many Promises pointed to the same problem with America’s social-welfare system.

This fundamental problem has now manifested itself in these countries’ unsustainable debt dynamics. Euro membership, which temporarily enabled massive borrowing at low interest rates, merely aggravated it.

Boskin says that any other actions taken won’t matter unless the countries reform their social welfare programs.

While the federal government was constructing bank bailout plans and funneling billions of dollars to banks via programs such as TARP, the banks were receiving billions of dollars in secret, low-interest loans from the Federal Reserve Bank. The loans were secret even from the government officials who were putting together the other bailout programs. The banks used these loans to bolster their balance sheets and earn income through loans and investments.

The Fed and the banks fought for two years to keep the details of these loans from being released to the public. First, after much delay, they released the big picture numbers for the loans. Recently, they finally released the bank-by-bank details, and they’ve been published by Blomberg.

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.

Did the Fed do the right thing in lending money to these banks at below-market rates? The case in favor of the program is that we were in a financial spiral and at risk of entering another Depression. Markets largely froze after the bankruptcy of Lehman Brothers. The Fed’s liquidity was needed to keep the financial system operating.

“Supporting financial-market stability in times of extreme market stress is a core function of central banks,” says William B. English, director of the Fed’s Division of Monetary Affairs. “Our lending programs served to prevent a collapse of the financial system and to keep credit flowing to American families and businesses.”

The Fed has said that all loans were backed by appropriate collateral. That the central bank didn’t lose money should “lead to praise of the Fed, that they took this extraordinary step and they got it right,” says Phillip Swagel, a former assistant Treasury secretary under Henry M. Paulson and now a professor of international economic policy at the University of Maryland.

The case against the loans is that inefficient, poorly-run institutions were saved. Especially bad is that the people who foolishly lent money to these overleveraged firms were made whole instead of losing money. Taxpayers and the Fed bailed out the creditors of these firms. The creditors at the end of the line were the ones who created and enabled the financial bubble, because none of the other events would have happened if the creditors hadn’t been willing to make short-term loans to the over-leveraged firms so that they could play in the mortgage market and other places.

There are a few articles worth your time in this week’s Barron’s, whether you read it online or in print.

The cover story is the annual article on sources of high-yield investments. There’s nothing new in the piece, but it’s a good collection of the options for investors seeking a yield of 6% to 7% or more. The shortcoming of the piece is that it doesn’t stress enough the risks of many of the investments, especially how their principal value will rise and fall with economic growth or the stock market.

Another article points out that investors shouldn’t be too excited about the recent rise in retail sales, as I’ve been pointing out to Retirement Watch subscribers. The reason is that the sales aren’t financed by rising wages or hours worked. Instead, the sales are financed by reduced saving. That won’t last long, especially since there isn’t much growth in private credit. Unless the economy kicks into a much higher gear soon, retail sales grwoth is likely to fall considerably.

An interview with the head of Goldman Sachs Asset Management Jim O’Neil makes the case that the emerging markets are likely to be powering global growth in coming years. He selects the countries Goldman believes will lead that growth.

There’s also a brief piece about the retirement of Bill Miller from Legg Mason Value fund.

Since it’s the rare Barron’s reader who doesn’t know about Miller’s 15-year record of beating the S&P, or his ignominious fall from grace, let’s dispense with the requisite performance rehash quickly. Miller’s hot streak followed an inauspicious 1990, when the fund lost 17%, trailing the S&P by almost 14 points. He then turned in 15 calendar years—an arguably arbitrary marker—of market-beating performance. In 2006, thanks to big bets on technology and home builders and an avoidance of energy stocks, Miller’s fund started to trail the market. By a lot.

What’s more interesting is that in the past 21 years (through Sept. 30), the fund has returned just 7.37% a year, on average, failing to beat the S&P’s 7.65% return. In fact, according to Janet Brown of DAL Investment, which designs portfolios of no-load funds, Value Trust ranks 188th of 306 diversified growth funds over that period.