Investing for Sustainable Gains

Thoughts on this:

http://seekingalpha.com/article/241172-stay-away-from-muni-bonds

Thanks for the fearmongering, but I don’t think it’s quite so bad.

Four points:

(1) The pension problem has been festering for a long time, and I just don’t see a kill-the-market catalyst or crisis other than the banking system having another liquidity crisis (like 2008).  But Bernanke has made it clear liquidity will be unlimited (for at least the next 3 years, eh) and the banks still own Congress behind-the-scenes and will not vote their own suicides. So unlike 2008, the market is unlikely to crash this time.

(2) The ongoing budget problems can and will (eventually) be met with rational cuts to “fluff” services, plus tax increases on those willing to put up with them.  Not to mention the monetary inflation that Bernanke is pumping into the system on a weekly basis!

(3) The ongoing, happening-right-now solution to the pension underfunding issue — once people wake up to the problem — has been (1) stop the bleeding – cease enrolling new employees in the troubled pension system and (2) make the workers pay for the pension – force current members of the plan to contribute to the pension out of a salary paystub percentage (e.g. “your 2% COLA raise is now your pension contribution”).  This wave hasn’t reached all shores yet, but it’s visible — even in California (e.g. the University retirement system).  And retiree medical is just gone, at least until this nation gets serious about having a first-world medical system.  The public unions are still kicking, but the writing is on the wall… even in California.

(4) You claimed “My best guess is that two states go down — Illinois and California…” and then “If you have to own munis, own the better-quality states – in fact, own bonds that have first claim on revenues rather than general obligation debt.”  But you neglected to mention that in many states, including California, debt service payments are protected in the state’s Constitution.  Therefore a CA general-obligation bond is in fact quite like a revenue bond, protected by the tax revenues of the entire state.  That doesn’t make them risk-free, but they could well be lower-risk bonds than those issued (at currently lower rates!) by states which currently appear “better-quality” (short-term)!  Because those other states may have a more vulnerable (less diversified) economic base and lack the constitutional default protection…

In short, it might be quite profitable to do your own due diligence here, and wait for these fearful guys to bid up your preferred market after the crisis passes.

A recent post by Calculated Risk reminded me to comment that the Federal Reserve’s “EMRATIO” metric is worse than it looks (and it looks bad already).  EMRATIO is frequently misreported as being “the employment to population ratio”. Sometimes the writer aims to be less inaccurate and says it’s the “fraction of adults who are employed”.  EMRATIO is really meant to measure how much of the potential labor force is currently working, and typically runs around 0.6, meaning 60% of the “adult population” is “employed”. EMRATIO has recently been declining as a result of job losses during the recession, which is bad enough.  But there is a demographic issue in play as well, because of the aging population, and EMRATIO doesn’t capture this very well.  In EMRATIO, the “population” not only excludes children, it also excludes “institutionalized” adults (who still need to be fed … and many of whom could be productive).  EMRATIO doesn’t include the military – it’s just “civilian” employment. And EMRATIO also appears to include working teens in the employment number, but not in the “adult population” number.  So EMRATIO is really an approximate “civilian employment to adult workforce ratio”.  Which is fine, but not if everyone thinks it’s the actual employed workforce divided by the total population… because that number is substantially lower!  The employed workforce has to feed not only the unemployed adults but also the children, the military and the “institutionalized” adults (including criminals and more).

So EMRATIO is useful, but misleading.  I think what really matters is the “Mouths To Feed Ratio”, that is the number of “mouths to be fed” divided by the “number of workers” – and there’s a way to generate that using the Federal Reserve’s FRED graphs database:

What this shows is that during the Baby Boom years of the 50’s and 60’s, when there were a lot of single-worker households and a lot of children, there were 2.6 to 2.8 people per worker.  From the early 60s until 2000 or so, that number trended down.  Each worker had fewer and fewer mouths to feed, as demographics became more and more favorable.  But that situation has reversed.  The 2003-2008 boom failed to bring in enough workers to bring the MTF ratio back down, and the Great Recession’s job losses, together with older workers retiring, have sent the MTF ratio back up to levels last seen in the early 1980s.

In fact, if we invert the MTF ratio, we can compare it directly to EMRATIO, and we see that the MTF ratio is about 13% lower than EMRATIO.  I am surprised that this ratio isn’t smaller still, since there should be enough children to take it down 20-25%.  But clearly less than half of the nation is currently employed:

Finally, the last plot below shows the two components of the MTF ratio (but beware the suppressed zero in the graph).  Both have trended upwards and basically doubled in the past 60 years, but in the last decade the population growth has outstripped the employment growth.

If population growth continues to exceed employment growth, there will be ever more Mouths To Feed per worker.  This in turn puts pressure on workers to lower their savings rates and defer retirement, or to lower their personal standards of living in order to support household dependents. It also creates pressure on both workers and employers to pay more in taxes, to maintain benefits for an increasing number of non-workers, via Social Security, Medicare, education and so on.  This will be a major challenge for public policy, and it also has major implications on the sustainability of economic growth and the current high level of corporate profits relative to GDP.

Footnote:  My data is from the FRED site; I would appreciate clarifications if anyone who reads this has some good links.

I ran across a fine posting tonight at Illusion of Prosperity which raised a topic that has been puzzling me for some weeks.  Why are TIPS yields so low, can they go any lower, and are the “inflation expectations” implied in the TIPS-Treasuries spreads meaningful?  The implied inflation expectations have been trending down through 2010, into the 1-1.5% range and well outside the 2-3% zone that the market lived in from 2004-2008, and the Fed is clearly worried about this.

Mark pointed out that those worried about deflation will pick Treasuries since in that case TIPS have zero yield.  Those worried about serious inflation will invest in hard assets. So why are so many people buying TIPS?

I had two comments regarding the TIPS:

First, not everyone is absolutely convinced that deflation is imminent, nor is everyone convinced that inflation is imminent.  But many are convinced that we’re going to have one or the other, but are just not sure which, as that appears to be a political choice. For those people, TIPS until recently made a decent “safe either way” option, particularly for tax-protected accounts. [Note: at current yields I no longer think TIPS are a safe choice against inflation… we are currently letting our TIPS ladder run off and finding other uses for the money until TIPS yields recover. ]

Second, I think it’s a serious flaw in Fed policymaking to assume that the TIPS and Treasuries markets are efficient enough to produce a meaningful “inflation expectations” measure through the relative yields.  One of the great lessons of the 2008 crash is that modern portfolio theory and the efficient markets hypothesis are both deeply flawed. I suspect it would be very interesting to plot the “TIPS/Treasuries Inflation Expectations” chart against actual 5, 7- and 10-year CPI growth, and see how accurate the metric has(n’t) been!  For instance, in 2003 the implied 5/7/10 year inflation expectation was about 1.5%/year, and the actual 5/7 year inflation was 2.5-3.0%. Similarly, in 2008 the implied inflation swung from 2.5% to -1% within a few months, and of course most of that range will prove in a few years to have been grossly wrong.

For my part, I find the TIPS yield alone to be very provocative. Bonds historically are expected to return 2-3% above inflation.  So the current 10-, 20- and 30-year TIPS yields of 0.7-1.5% could be taken, in and of themselves, to imply a negative inflation rate.  Alternatively, the 0% yield on the 5-year (and the other anomalously low yields) could be seen as implying that other asset classes look so overpriced (or corrupt and unappealing?) as to make even a 5 year zero real return rate look attractive!

Or maybe it just means that Treasury needs to issue more TIPS relative to Treasuries, to bring supply back in line with demand!  In that mindset, one can take the “implied inflation expectations” with a grain of salt, since Treasury controls the relative supply and can therefore radically influence the yield spread!  The U.S. recently tripled the annual issuance of Treasuries…  and the Fed is in QE mode… so what else would one expect but low real TIPS yields?  The real mystery may not be why are TIPS yields so low, but why are Treasury yields so low?  Higher Treasury yields are vital to increasing the “inflation expectations” implied in the Treasuries-TIPS spread… yet the Fed is actively buying Treasuries as it rolls over its (illegal) MBS holdings, and presumably (if it goes into the QE mode promised in this week’s FOMC statement) will buy even more!

A tangled web, indeed…

A few months ago, Kinder Morgan Energy partners came up on a stock screen of mine.  The stock has been performing well and the company is in a vital economic sector, so I was attracted to it.  But when I was reviewing the financials, I couldn’t help wondering about the apparent fact that the dividend payout currently exceeds the earnings cash flow.  KMP has been bulking up its capital and using some of the proceeds to maintain its dividend.  This smells Ponzi to me!  And given the forward economic climate, this also smells very risky.

When it was just KMP making me nervous, I didn’t feel like posting it, but I’ve seen a few other stocks looking the same way recently — particularly a couple of dividend-yield stocks in the telecom sector — and now I’m wondering just how deep the rot goes.

I know from a separate screen that there are very, very few U.S. companies with excellent financial ratings and low debt-to-earnings ratios. And the ones that I saw generally didn’t have exciting future prospects.

I haven’t seen the “deleveraging” that we were promised, and which I believe is vital to getting the next long bull run of economic growth rolling, so I expect a lot more stock-price volatility within the next couple of years.