Moving the Goal Posts

Americans will do almost anything to avoid saving money. They hate it like a five-year-old hates broccoli. And just like that five- year-old, they will grimace, whine, kvetch, and, yes, even lie to avoid doing what is good for them.

They will tell themselves that stocks always go up in the long run … or that their home equity is all the “savings” they will ever need. But such comforting delusions seem to be colliding head-on with a very different reality. America is “savings-lite” — a condition that is likely to weigh on corporate profits and stunt economic growth for years to come.

Most Americans don’t save enough money in a year’s time to buy a week’s worth of groceries. And what’s true at the individual level is also true collectively. Our government is borrowing about half a trillion dollars a year, just to make sure that the barrels never run low on pork. At the same time, America’s pension plans – – both in the private and public sectors — are woefully underfunded.

“For the past three years,” Business Week observes, “the damage from corporate pension-plan losses has been piling up like a slow-motion train wreck. As stock prices stayed low and interest rates declined, on average, plan assets have lost 15% of their value, while their liabilities have soared 59%, according to money manager and researcher Ryan Labs. The squeeze has vaporized surplus assets in nearly all funds. Pension plans of companies in the Standard & Poor’s 100 index were showing a 16% deficit to liabilities at year end, down sharply from a 30% surplus two years before.”

Underfunded Pensions: $13 Billion Swing

Meanwhile, the accounts of the Pension Benefit Guaranty Corp. (PBGC), the federal government-sponsored insurer of most pensions, have swung from a surplus of $7.7 billion last year to a deficit of $5.4 billion in the past 18 months.

Out in the public sector, a record 79% of U.S. public pension plans are underfunded, according to Wilshire Associates of Santa Monica, Calif. “The phrase ‘unfunded pension liability’ has returned to public officials’ vocabularies,” writes Bloomberg’s municipal bond guru, Joe Mysak. “And to the vocabulary of bankers. States and municipalities are thinking about selling more than $20 billion in pension obligation bonds.” Is it not American ingenuity at its finest, this idea of selling bonds to plug the gap created by non-saving? Somehow, an apparently dysfunctional American system seems to work, over and over again.

But maybe, the age of easy accommodation has about run its course. Maybe the slumping dollar is signaling a change in the wind. Maybe our savings-lite nation will not be able to borrow money as effortlessly as it has in the past.

Underfunded Pensions: America’s Savings Deficiency

The bear market of the last three years has exposed America’s savings deficiency like a low tide exposes skinny-dippers. We’ve been “swimming naked” for years, hidden from public view by a bull market in stocks that kept us all chest-deep in capital gains. But now, as the stock market ebbs, pension plan liabilities flow. The PBGC estimates that the U.S. private pension system alone is underwater by over $300 billion.

It’s hardly surprising, therefore, that CFOs are scared to death about the pension plan underfunding crisis. “Global outsourcing and consulting firm Hewitt Associates found that pension shortfalls, pension regulations, and pension accounting are high on CFOs’ lists of concerns these days,” CFO Magazine reports. “More than half of the CFOs and treasurers at the 174 midsize to large companies in the survey said they will need to fund a pension liability this year…. More than 60% of the respondents believe that pension cost volatility is either a major problem or a serious concern.”

Not only do the mounting corporate pension liabilities threaten to divert cash flow away from productive uses like investing in R&D, but also from unproductive uses like boosting corporate executive compensation packages – including the packages CFOs receive. These high-priced accountants thus have a very personal vested interest in re-jiggering the pension accounting assumptions, rather than taking legitimate measures to shore up the financial integrity of the plans under their stewardship. Re-jiggering rather than repairing is precisely the tack that Congress seems to be taking.

Underfunded Pensions: Constraining Profit Growth

One prudent response to pension underfunding might be to rein in costs while simultaneously accelerating contributions. But that two-pronged approach would be painful, and, besides, it would severely constrain the “profit growth” of many American corporations…which could severely constrain the desire of investors to pay 35 times earnings for stocks. And if investors won’t pay 35 times earnings for stocks, share prices might fall. And if share prices fall, the pension plan deficits would become an even bigger problem.

So in order to keep the game alive, the powers that be must prevent the grim reality of pension underfunding from encroaching upon the delightful fantasy of a bull market at 35 times earnings. The solution is obvious, move the goalposts. In other words, change the underlying assumptions about future expenses or future pension plan asset growth.

To illustrate, let’s imagine a hypothetical family breadwinner who earns $80,000 per year. Now imagine that the breadwinner’s family spends $100,000 per year. (Sadly, this scenario is all too easy for many of us to “imagine.”)

The breadwinner is in deficit to the tune of $20,000 per year…unless he changes his assumptions to achieve a balanced budget, pension-accounting style. Which means he could either assume expenses of $80,000, even though they are actually $100,000, or he could assume annual income of $100,000, even though it is actually $80,000.

Eventually, of course, the real-world gap between income and expenses would produce unavoidable insolvency. But in the meantime, the breadwinner and his family could enjoy the happy illusion of budgetary balance, without having to curtail their outsized spending.

This “solution,” self-evidently, would be nothing more than a charade, a tragic farce. But it would make life much more enjoyable for a while…and that, dear reader, seems to be the spirit of the new Portman-Cardin bill that is currently snaking its way through the House of Representatives.

Underfunded Pensions: Actuarial Sleight-of-Hand

For starters, the pension bill would let companies use a separate mortality table for blue-collar workers. “In essence,” the Rocky Mountain News notes, “companies would not be required to pay as much into the pension plan because they could assume blue-collar workers will die sooner than other employees.”

Such actuarial sleight-of-hand would be welcome relief for companies like General Motors Corp. and Deere & Co., two companies with the ignominious distinction of having amassed pension plan deficits that exceed their respective market capitalizations. Not coincidentally, these two companies also share the distinction of having been selected as promising short-sale candidates by Apogee Research.

GM, which strains under the weight of a monstrous $25.4 billion pension plan deficit, possesses a market capitalization of only $19.67 billion.

Another of the bill’s ingenious measures is to allow the companies with the most severely “funding-challenged” plans to reduce their insurance premium payments to the PBGC, the federal pension fund insurer. In other words, the companies that are most likely to require a government bailout would pay the least amount for insurance.

The last innovation proposed in the House bill would reduce the present value of future pension liabilities, simply by changing the interest rate used in the calculation. Specifically, the bill would replace the 30-year Treasury bond rate with a higher- yielding corporate bond index, thereby reducing the present value of future liabilities by an estimated 10% to 15%. All together, the House bill could save a company like GM about $2 billion per year…for a while. And that would be welcome and immediate relief for the cash-strapped automaker.

Underfunded Pensions: Deferral Is Not Elimination

Sadly, however, none of the maneuvers proposed by the Portman-Cardin bill would fortify our nation’s pension plans. To the contrary, they would weaken them, and further jeopardize their ability to meet future obligations. The “good news” is that corporations with underfunded plans could continue to report illusory earnings growth while retaining cash for other uses like research and development, capital investment and executive compensation.

We will not quarrel with the possible merit of deferring pension plan contributions. But we will point out that deferring the Day of Reckoning does not eliminate it.

The pension-plan funding crisis will likely weigh on corporate earnings for years. Likewise, the national savings shortfall will probably stunt economic growth for years to come. “In order to get out from under the 16-ton sledgehammer of debt, companies use cash flow to build reserves or retire bonds — they don’t invest,” observes Bill Gross, the legendary bond fund manager. “Consumers begin to put away money instead of spend…. And the combination induces a negative spiral or vicious cycle of even more conservative behavior including job layoffs, which leads to muted growth in personal income…. As the U.S. private sector retrenches to a more normal historic average level of total savings, it necessarily acts as an economic drag.”

The Day of Reckoning beckons…

Eric Fry,
The Daily Reckoning
Baltimore, Maryland
May 29, 2003


The way to make money in stocks, said the old-timers, was to buy solid companies that paid good dividends. You make money by reinvesting the dividends, thus letting the new money breed with the old. Over time, you’d get an expanding population of dollars.

The idea of buying stocks in hopes that they would go up in price seemed reckless and absurd. Stocks were risky; they might just as well go down in price as up. And the companies they represented might go out of business. So stock investors wanted a ‘risk premium’ — a little extra dividend from stocks, as compared to bonds, to make up for the risk of losing money.

But in the Great Boom of the last 25 years of the 20th century changed attitudes. People began to think that the old fuddy duddies were wrong; the new way to make money was faster and easier. All you had to do, they said, was to buy stocks…and then sell them later (when you needed the money for retirement) to some Greater Fool who would come along at just the right moment, his pockets bulging with lucre.

The Dow crested in 2000 at 11,722. It dropped as low as 7,286…and now seems to be on a modest rebound. Three years into a Great Bust, people still believe in the promise of the boom. They buy stocks at an average P/E that would have made the old- timers gasp. Investors still believe that someone will come along to buy them at higher prices. But where will the greater fools come from?

Foreigners have taken huge losses from their dollar-based assets. Europeans, for example, are down 25% since the beginning of the year because of the dollar. And the pool of buyers in the U.S. is threatened by two things: demography and economics.

The worldwide boom has turned into a worldwide slump. Incomes are barely rising. And overseas manufacturers are undercutting prices.

Meanwhile, people in the developed countries are getting older. As the years pass they become less willing to wait for the next fool to come along, no matter how great he is; they need income.

Not only that, people facing retirement strain the entire boom- time financing system. Instead of borrowing, spending and investing, they turn to saving. Believe it or not, savings rates are edging up — even in America.

Before he joined the unemployed, Paul O’Neill, then U.S. Treasury Secretary commissioned a study of how much it would cost for the government to keep its promises to the baby boomers. Now completed, the Financial Times, had this comment:

“The study’s analysis of future deficits dwarfs previous estimates of the financial challenge facing Washington. It is roughly equivalent to 10 times the publicly held national debt, four years of US economic output or more than 94 per cent of all US household assets. Alan Greenspan, Federal Reserve chairman, last week bemoaned what he called Washington’s “deafening” silence about the future crunch….”

The studiers concluded that an immediate tax increase of 66% is needed.

The fuddy-duddies would be shocked again. How can you expect a man to stomach a huge tax increase when he is already up to his neck in debt and living paycheck to paycheck, he would want to know?

The baby boomers who are buying stocks might pause for a question too. Where will the greater fools get the money to buy their stocks? Why will they want to?



Eric Fry writing from Wall Street…

– The stock market continued its bull-market-esque performance yesterday – gaining ground for the fifth straight day. The Dow added 12 points to 8,793, while the Nasdaq jumped about half a percent, to 1,563. But even as the virile stock market continues its advances, the economy hesitates like a coy virgin. Durable goods orders dropped 2.4% in April, the fourth decline of the past six months.

– Nevertheless, most financial market participants seem to believe that the economy is all but certain to recover during the second half of the year. Accordingly, government bonds fell for a second straight day and the dollar rebounded a bit against the euro. The 30-year Treasury bond fell half a point, pushing its yield up to 4.42% from 4.39% on Tuesday.

– Despite the expectation that the economy will soon start flexing its muscles, the long-dated treasury bonds seem to be priced for recession or deflation, or both. As such, the mere suggestion that consumer prices might rise more than 1% or 2% per year could send shock waves through the bond market.

– The current macro-economic environment is nothing if not conflicted. Deflationary phenomena seem to be just numerous as inflationary phenomena. Therefore, while your New York editor is satisfied that inflationary auguries abound, your Paris-based editor observes numerous symptoms of deflation coursing through the US economy…Like job losses, for example.

– “America’s biggest export is jobs,” your Paris-based correspondent observed last week at the gathering on Amelia Island. It’s true, the US manufacturing sector has suffered mightily during the last three years. More than two million manufacturing jobs have disappeared over that time frame — and most of those jobs have disappeared for good…or else they will be reincarnated as low-paying jobs working the deep-fryer at Kentucky Fried Chicken…The GM welder who loses his job this month, may have little choice but to become a Starbucks barrista next month.

– However, while “smokestack America” struggles, the erstwhile New Economy seems to be reviving…ever so slightly. “Yesterday’s technology bust has purged much of the capital spending excess of the bubble,” says Morgan Stanley’s Richerd Berner, “and today a tech revival is the main island of strength in an otherwise dreary manufacturing outlook.

– “While the tech revival is healthy,” Berner continues, “so far it’s really just about ‘maintenance and repair.’ …The evidence for revival: Nominal bookings for information technology gear jumped 25.3% at an annual rate in the first quarter, the strongest pace in three years. Accordingly, output for computers, communication equipment, and semiconductors accelerated to a 15.3% annual clip in the three months ending in April.”

– The lumpeninvestoriat has acknowledged the molehill-sized recovery in the tech sector with a mountain-sized Nasdaq rally. The tech-powered index has soared a remarkable 40% since last October.

– Are the financial markets as conflicted as the economy? Bridgewater Associates points out that stocks rarely rally while bond yields and the dollar are both tumbling. And yet, that’s exactly what’s been happening for the last couple of months. Typically, rising share prices signal economic expansion, which typically coincides with rising bond yields and a strong dollar. What do the current divergences imply? Which market is correct? Are any of them correct? If forced to hazard some guesses, we’d say that the bond market is delusional, the stock market is over- anxious and the dollar market is right as rain…But we’re just guessing.

– “Listening to the incredible comments being made by U.S. policymakers these days,” observes Stephanie Pomboy of MacroMavens, “one can’t help but feel trapped in a bizarre dream where the most bedrock of principles bend under the weight of abstraction like the watches in a Salvatore Dali painting…Things first took a turn for the surreal last November when Ben Bernanke made his now famous speech [about printing dollars for almost no cost]…Bernanke’s speech deserves a prominent place in the annals of dollar history. With it he ushered in a new phase for the dollar…one in which its weakness is exploited as a means to buoy exports and restore domestic pricing power. But will it work?”

– Well, we suspect the endeavor to create a feeble dollar will succeed. But as for the “buoyed exports” and “restored pricing power” part of the plan, we have our doubts.


Bill Bonner back in Baltimore…

*** When stocks get this high, Richard Bernstein recently figured, the likelihood is that they will lose a third of their value over the next 10 years.

*** The trade deficit gets worse. West Coast ports at Long Beach and Los Angeles report that in-bound cargo traffic is up 7% over last year. Outbound, traffic is down 3%. And 29% of outbound containers are empty…a number that is more than half those coming in.

*** is at a 52-week high. We repeat our comment from yesterday: ha ha ha ha ha….

*** There is a record number of unsold homes in the Denver area. House prices in the UK are falling.

*** The money supply (M3) is increasing at a 7.2% annual rate. It rose by $10 billion last week. But the Fed is stepping up its purchases of treasury bonds at an 11% annual rate. Normally, this would be seen as a sign of impending inflation. But bond investors are unconcerned. TIPS, the 10-year inflation adjusted treasury notes, are priced to yield just 1.78%. A regular 10-year note yields 3.47%. The difference — a rough measure of what bond buyers expect from inflation — is only 1.69%.

*** We were down in Amelia Island, Florida, last week at a private conference for investment analysts, gurus and financial advisors. We have been meaning to report to you some of the best investment suggestions that were presented at the conference, but have not gotten around to it. Nor will we mention any today.

Instead, we pass along this anecdote.

On their way to a restaurant, a group of us boarded a bus, which stopped to pick up other Amelia Island vacationers. An attractive, bejeweled older woman sat down next to your editor and struck up a conversation.

“What brings you gentlemen down here?”

“We’re financial writers and analysts.”

“Oh…I put all my money with a guy in Miami. Do you know him? His name is Feldman, with Atavistic Capital…or something like that. I just found him. A friend of a friend introduced him.”

“What kinds of investments does he look for,” we asked.

“Well…I was in stocks. And then I lost a lot of money…I guess everybody did. Now, he’s putting me in bonds. That seems to be what everybody is doing, isn’t it?”

The woman got off at the next stop. Our group looked at each other. Without a word, we all began to laugh.

*** By the way, in case you didn’t know… we’re planning another a get together. This one’s in San Francisco in August – and you’re invited. It’s Agora’s annual Wealth Symposium. This year promises to be quite a gathering; Agora’s top analysts and our associates will all be there. (Click on a link to view the list…)

If you plan to join us, tell us quickly so we can reserve you a spot. We plan to give everyone a pre-release copy of “Financial Reckoning Day” our book being published by John Wiley & Sons in September.

You may also want to make a vacation out of it… immediately following the Symposium the Oxford Club sets sail on an investment cruise to Alaska…