Subprime mortgage contagion, earnings shortfalls, a slowdown in consumer spending - What? Me Worry?
Economics / Subprime Mortgage Risks Apr 21, 2007 - 02:27 AM GMTBy: John_Mauldin
This week I am in La Jolla for my annual Strategic Investment Conference, co-hosted by my partners Altegris Investments. This week's letter is the basis for the speech I will be giving Saturday afternoon on a few of the items in my long-term worry closet.
What? Me Worry?
It will come as no surprise to this audience that there are a few things that worry me. I often write about problems in the markets. Subprime mortgage contagion, earnings shortfalls, a slowdown in consumer spending are all on my worry list.
But I am not just your average amateur worrier. I am a professional worrier. I get paid to worry. For a professional, worrying is an art form. The amateur worrier spends way too much time worrying about events that are likely to happen. A true professional worries about the unlikely events that create the most problems. It is the things we are not worried about which can cause us the most harm.
For instance, I am not worried that the subprime mortgage debacle might cause a recession. I think it will bring us a garden-variety recession. I have lived through five recessions, a few market crashes, and other economic upheavals in my adult life and expect to live through that many more problems in the future. My portfolio and business are built to withstand a recession or two, so I don't worry about it.
What worries me about the problems in the mortgage market is the possibility, however small, that we will see a credit liquidity crunch that will bring about more than a simple recession. I think it unlikely, but I can see a path that makes it possible. The capital ratio at US banks is at its lowest level since 2001, and with more losses coming from mortgage and consumer lending, it is possible that banks will tighten up lending practices. We are already seeing some anecdotal evidence of tighter lending standards and a reduction in consumer lending. Enough to throw us into a serious recession? While unlikely, it is something to pay attention to, because that would change things and maybe require some portfolio adjustments, as well as bring new opportunities.
In what may seem like a contradiction, a professional worrier must be an optimist. Spending too much of your time worrying can lead to inaction and not getting into the fray. There are two types of people who lose in today's markets. First, there are those who are pessimists and do not get into any investments at all, staying in cash. That is a strategy that is guaranteed to lose you buying power, as inflation and taxes eat into your portfolio.
Second, there are the unabashed bulls that chase the latest investment fad, often when it is coming to an end. $90 billion dollars went into mutual funds in January of 2000. I am told that 80% went into Janus funds, some of which went down by 75% or more. Sometimes they do ring a bell.
The correct position is cautious optimism. At the risk of repeating myself, the way to be in the top 10% of all investors in 2017 is to simply be above average each and every year for the next ten years. That is harder than it sounds. Many investors create portfolios based on historical data that is unlikely to repeat, or choose investments which may well be outstanding in most years but have some awful years as well. The enemy of compounding is losing. You can and should be cautious, but you need to be in the game if you are going to be above average.
Past Performance Predicts Future Disaster
I was at Rob Arnott's Advisory Panel meeting last week, coincidentally here in La Jolla. I had the great pleasure of listening to Professor Harry Markowitz (who developed Modern Portfolio Theory and got the Nobel Prize for it) comment at length on the presentations. He told one story that I have to share with you, as it illustrates quite well the problems faced by professional worriers.
It seems his son is an attorney (of whom Harry was clearly quite proud) and was defending an interesting client. The case involved the client, who had lost $100 million for a group of Indian tribes, and they were upset. However, they weren't quite the innocents. It seems they were not satisfied with typical returns and wanted to make a little more. They specifically instructed the money manager to invest in loans which paid 22%. Basically, these were loans to resorts and vacation spots. The manager, in an effort to protect the principle, diversified the loan portfolio by making lots of loans, thus trying to insulate the portfolio from the problem of any one or two loans going bad. 22% a year can make up a lot of losses if you can keep the losses small.
What happens, however, if a majority of the loans go bad all at once? That would clearly be a bad thing, but how could that happen? Past performance of the loans suggested that the concept was sound. However, a bad thing did happen as vacation travel plummeted after 9/11 and the follow-on recessions. Evidently, projects were cancelled or halted and the tribes who thought they were diversified against risk found they were not. Whether it was property in the US, the Caribbean, or wherever, they all were hurt in the aftermath.
Interestingly, there were five different expert witnesses (both for the defense and the tribes) that testified on diversification and modern portfolio theory. Evidently all were aware of the irony of being questioned by the son of the developer of the theory.
Long Term Capital Management is another case in point. The Nobel laureates associated with that firm had run extensive risk analysis on all the historical data. These were not wild gunslingers. They were clearly convinced that they had covered the risks.
And they had covered all the risks that were in the historical databases. However, there was one piece of data that was not in the historical numbers, and that was the effect of Long Term Capital itself. LTCM became the market and the connection between markets that had never shown any correlation. As they had to sell seemingly unconnected investments to meet margin calls, the pressure on all of the markets ratcheted up simultaneously. And the more they had to sell, the worse it got.
The same thing with Amaranth last fall. They had PhDs running around doing analysis on risk, based on historical data, but someone forgot to factor in what it means when you become such a large part of a relatively small natural gas market that you can no longer meaningfully hedge or exit a losing position. They were averaging down into a losing trade, which is nearly always a mistake, but their market activities were of such size they distorted the market signals. Before they realized, they were getting margin calls, and the size of their own trades to raise cash was making the market move against them.
Interestingly, the trader (Brian Hunter) and his team that lost $6 billion at Amaranth are now raising money for a new fund. According to people who have read their material, there is a great deal of emphasis on risk control. Imagine that. How special. Even more amazing is that he has reportedly gotten commitments for several hundred million dollars. As an aside, you will not see that fund on any platform offered by myself or my partners. Sometimes the best risk control is to avoid it altogether.
A few years ago, I took the due diligence questionnaires for hedge funds from a number of firms (I think it was approaching ten) that analyze hedge funds, and then worked through them to compare the various documents. They all had different sets of questions. After a while I think I spotted a pattern. You could see that the differences were basically in things that had probably caused problems for the firm. They added a series of questions that were designed to make sure they never had those problems again.
I can tell you that my analysis has more depth to it than five or ten years ago, or even a few years ago. Every time there is a problem, and you hope it is the other guy and not you having it, a new set of questions appears to try and deal with that risk in the future. And you can make book on the fact that in five years the questionnaires for fund managers will have even more questions. It is always the questions that you don't ask, the data that you didn't know about, that is the problem.
The Surprise of the Black Swan
This is what Nassim Taleb calls the black swan problem. You can have a database with 4,000 white swans. History and the data tell you that swans are white. But the absence of a black swan doesn't mean there isn't one.
As John Kay writes in this week's Financial Times :
"Every sophisticated institution has its own models back-tested against the experience of that institution. But this illustrates that the analytical problem is fundamental. The data used to back-test, of necessity, is drawn from a period when the institution did not experience the problems the risk models are designed to anticipate. The one thing we know with certainty about the banks, insurance companies and hedge funds that compete for our business is that they did not go bust in the period from which their historic data are drawn.
"That, unfortunately, is the only thing we know with certainty. The risks models financial institutions use insure that it is very unlikely that these institutions will fail for the reasons that are incorporated into the model. That does not mean they will not fail, only that they will fail for different reasons."
They will fail with the appearance of the black swan. Black swans are not in the models.
I am asked all the time if I worry about another Long Term Capital. The answer is no. Don't get me wrong, there will be big funds that fail from time to time. It is just that the next time it will not threaten to destroy the entire financial complex of the developed world. Every big institution that got burned on that one has safeguards to make sure it doesn't happen again. Next time the world is taken to the brink it will be something different, a new appearance of yet another black swan.
As Jon Sundt pointed out in his speech, the likelihood of a one-day market crash the size and magnitude of the '87 crash is statistically extremely unlikely - one to the power of minus 460! But it did happen, even though the historical data said it was improbable. The fingers of instability that connect seemingly random patterns struck all at once.
So as a professional worrier, I really focus my attention on what is not in the historical data that can create a black swan. Or maybe more accurately, what can change the data in such a way that a new pattern emerges, one for which we are not prepared.
We go through this process with the funds we manage and invest in, with portfolio analysis, and in general with every part of our business. You should do it as well for your business and portfolios. Will we find or think of everything? Of course not. There is always a black swan lurking somewhere. That is what keeps me up at night.
But rather than focus on smaller potential issues, today we will look at two distinct changes in the coming years that will alter the patterns that we have become used to. I think there is the potential for more than a few black swans to emerge. One change will create havoc with the retirement plans of many people, and the second is going to change who we compete with for our jobs. The earth is going to get a lot flatter. The good news is that these changes will be slow to come about, so that active managers and investors who are paying attention will hopefully be able to take advantage of them.
The Boomers Break the Deal
My grandfather's generation made a deal with my children's generation. It goes like this. If you will pay into Social Security and pensions so we can retire now, we agree to die on time, or at least in a predictable manner. The Boomer generation is going to break the deal. We are going to live longer, and maybe a lot longer. And that is going to cause problems in pension plans and government retirement programs all over the world.
Medicine as practiced today is still of the hammer and nails approach of the past 100 years. Our tools are better today, but the approach is the same. We wait for something to get bad and then we try and fix it. We get regular check-ups to try and diagnose any problems, and our ability to diagnose is getting better, but we still miss a lot. We work at doing what we can to prevent sickness, but our tools are not as good as we would like - basically, diet and exercise and a few medicines that try to prevent disease.
That is getting ready to change. Image scanners are becoming ever more fine-grained. Just a few years ago it was 32 lines per inch. Then it went to 64, 128, and now 256. 512 is only a few years away. Recognize that pattern? It is going the same way as chips and storage media. Within 5 years we will see a new generation of scanners that will make today's obsolete. Within 10-12 years we will be doing scans that will allow for much more detail in full three-dimensional color. They will be seeing the early formation of plaque and tumors and have the therapies to deal with them before they become a matter of life and death.
They are building chips which can diagnose all manner of disease by simply putting a drop of blood on the chip. Today, the chips can only diagnose a few diseases, but within 15-20 years it will be a thousand or more. Chips will be cheap and you will be able to get yourself checked often. Hopefully they will allow them to be hooked into your home computer and notify your health care provider if there is an issue. It will be a hypochondriac's heaven.
There are almost a dozen new technologies for dealing with Alzheimer's, most of which are already in human trials. Sometime in the next decade, Alzheimer's and dementia may be a thing of the past, assuming you take charge.
New genetic therapies are cropping up on almost a daily basis. Mice have 99% of the human genome, so we experiment on them a lot. There are mice that cannot get fat, no matter how much they eat. Mice that do not lose muscle mass. Couch potatoes of the world, unite! Mice that live 30% longer with the addition of just one hormone, the same hormone that is in our bodies. They are growing new liver cells from adult stem cells. The list goes on and on.
Of course, these are not yet in human trials, and skeptics suggest it will be a long time before they do go into human trials. I am not so sure. They are using adult stem cells in Brazil on patients with a certain type of very nasty disease caused by a bug bite, which creates problems in the heart that show up later in life. It is 100% fatal once it starts. For some reason, Brazilian doctors decided to inject adult stem cells into their patients. Taking adult stem cells seems to slow or halt the effect on the heart. They don't know why it works, but the point is they are doing it. Ad hoc human clinical trials. What will be the next thing tried? And where?
We may not see a lot of the human trials in the US with some of the more intriguing therapies, but it is my bet that we will see them elsewhere. Living 30% longer? No fat? No muscle loss? Someone, somewhere, is going to start the testing. I am not arguing the pros and cons of making humans guinea pigs (and I am not volunteering), just noting that I think it will happen.
In short, we are going to start diagnosing and fixing things before they go wrong. Let's say for the sake of argument that by the end of the next decade it is likely that the average person will live 5 years longer and by 2025 will be living 10 years longer, numbers that Dr. Michael Roizen ( YOU: The Owner's Manual ) says are reasonable guesses. You can make a real case for those numbers. Some would say they are conservative. We are not talking immortality. Just that the diseases that kill people today will be dealt with. More people will live long enough to die of simple old age.
Living longer is a very good thing, so why should I worry about that? Because I see the potential for black swans. Today, if you make it to 60, the odds are that you will live at least another 20 years and the last surviving spouse will live for 30 years. What if that goes to 25 and 40 years?
My friend Ed Easterling at Crestmont Research did some very interesting analysis a few months ago. You have saved and invested, and now you want to retire. You decide to take out 5% of your total portfolio to live each year and increase the amount for inflation, so that you can maintain your lifestyle (a number which a surprising number of investment advisors would say is ok). Let's say you are an aggressive older couple and decide to stay in the stock market because that is where you are told that you can get the best returns over time. And you know that you have the probability of living 30 years. On average you are going to get 7-8% or more, right?
Ed calculates what you would get for 78 different 30-year periods since 1900. Let's say you start with a million dollars. On average, this has been a good bet. You could maintain your lifestyle and end up with $3.6 million. You've been pretty conservative, right?
Wrong. Because the returns you get over the next 30 years are highly dependent on the P/E ratios at the beginning of those 30 years. Let's break up those 30-year periods into four quartiles of beginning valuation. If you start in a period when P/E ratios are in the highest quartile, you find that over 50% of the time you end up penniless, on average within 22 years. Here's that data from Ed:
Where are we on valuations today? You go to S&P's web site and you find that core P/E's are 17.4, at the upper end of the second highest quartile. Notice that even when starting with the lowest-quartile valuations that 5% of the time you ran out of money within 23 years. Want to take a lifestyle bet that you have a 1 in 20 chance of losing? As Ed points out, it will not be fun to have to go to work as a WalMart greeter at 80.
Now, let's throw my assertion that one of the surviving spouses is going to live on average 10 years longer. The failure ratio, meaning that you run out of money, gets a lot higher. And it gets worse if you use a traditional mix of stocks and bonds, because bonds lower the overall return.
The point is that retirement planning is going to get a lot more difficult. And we are going to have a generation who will be in their '70s when they realize the good news is that they will live longer but the bad news is that they can't afford it. And the bad news is that they are going to want the government to step in and help. And by that I mean they are going to need more tax dollars.
Let's think of some of the implications. First, we already know that the large majority of US citizens have not saved enough for retirement. But for those that think they have, they may be budgeting for a future that is going to be a lot longer than they plan.
Second, this is going to cause a massive problem with pensions and annuities. Defined-benefit pension funds and annuities are based on current mortality tables. If you add 10 years to their future budgets in 2025, they become massively underfunded at some point in the latter part of the next decade. This is especially worrisome for smaller annuity firms, as they have no source of new infusions. They were funded on the basis of an initial cash input.
Third, public pension funds at the state and local levels will be in real trouble. They are already underfunded by perhaps as much as $1 trillion. In 40 states it is illegal to cut or change pension guarantees. Many cities are already battling with underfunded fire and police pensions, as politicians made deals with unions that future generations will have to pay for.
In both Europe and the US, where governments have promised pension benefits, their costs are going to go up. Social Security in the US will start to be more painful in just 15 years than the pain we have already projected today. Don't even get me started on Medicare. Yes, we will be less sick, but those new treatments and therapies will not be cheap. And since the largest part of medical expenses occur in the last year of life, we will just be postponing the costs, not getting rid of them.
For most of the people in this room, living longer is not going to be a financial issue. But it is sobering to think about the societal issues with which we will be dealing.
Let's look at some of the consequences. Because of the ever-increasing costs of public pensions, you can look for substantially higher local taxes in cities where they have old legacy pension programs. That will mean that newer cities which did not make the pension fund promises will have a relative advantage. As we will see from the next trend, moving to and working from lower tax venues is going to be easier than ever.
You can count on higher income taxes in the US, and a shift in where funds are spent in Europe. Most agricultural subsidies will be history by the middle of the decade in both the US and Europe. Ethanol subsidies will go by the end of the next decade.
You can make book that Social Security and their equivalents in Europe will be means tested and taxes raised. Pension payouts from private funds will have to be scaled back. All this will cause a lot of angst among voters, and politicians will put off any meaningful reform until there is a true crisis.
But there are a few opportunities. Life insurance companies are going to benefit, as their payout schedules will lengthen due to longer-lived policy holders. Major new health-care and drug companies will be created. We will need more housing, as longer-living Boomers will need to live somewhere. I think there will be a real opportunity in real estate in certain countries where it is cheaper to retire. (My friends at International Living write about living outside the US, and often write about locations with great climates and low costs. You can read more here ).
Quickly, there are some things that should be done to mitigate the problems, but they are unlikely to be done in the current political environment. We should raise the retirement age more quickly. When Social Security was started, the average lifespan was 65. We have only added a few years to the age when you can first receive benefits.
We should go ahead and put Boomers on notice that means testing will gradually be introduced. We should make the growth of the payments less in the early years. We should encourage more immigration so as to have more people paying into the system.
The likelihood of any of these happening in the next six years is slim to none, and Slim left town, as my Dad would say.
And this is where I have to end it for you readers. It is time to hit the send button. Next week's letter will deal with a second paradigm change.
La Jolla, Moving, and Graduation
I am in La Jolla as I finish this letter, at my Strategic Investment Conference co-hosted with Altegris Investments. Their staff has done a superb job of creating the conference. Each year I wonder how we can top the previous year, but we have done it. The general presentations are really good, and the quality of speakers is truly top-notch. I am proud of the quality of the hedge fund managers presenting at this conference. Jon Sundt, Matt Osborne, Michael Ding, and their research team have really done a marvelous job of finding talent. (We are going to make some of the general presentation speeches available to you later.)
If you would like to get my free Accredited Investor E-letter and find out more about the world of alternative investing, simply go to www.accreditedinvestor.ws and sign up. Someone from my worldwide network of partners will call you and help you see what is "behind curtain #3." (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member NASD.)
I am moving next weekend, so there is a lot to do. Moving takes a lot of planning, and just the actual packing and sorting through what goes and what gets given away or donated is time-consuming, so I may not be in the office on Friday.
And the Friday after that I will be in Tulsa as my daughter Amanda graduates from ORU. (Her twin Abigail will finish next year.) We will see if I get a letter out that week. (I have most of next week's letter already written.)
I have got to run, as my daughter Tiffani is pointing out that I have a lot of friends waiting for me downstairs. This is the 4th year we have done the conference. It is our largest, with over 200 attendees, some of whom have attended every one of them. It is fun to see old friends and make new ones each year.
Have a great week.
Your having more fun and planning to live longer doing it analyst,
By John Mauldin
Frontlinethoughts.com
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.
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