Thursday, March 8, 2012

The gig of returns on assets is up

I wrote this in response to a post on Karl Denningers Market Ticker.  Assets can only exist to the extent the profits can be transferred from one group to another.  When the pool of assets grows beyond the capacity of the economy to pay the required return, the expansion is over.  This is true whether we are talking capital investments or debt instruments.  The value of the capital instruments are merely lost.  The current rally in stocks has nothing to do with the capacity of these assets to produce a return, but instead the massive intervention of more government debt and the asset inflation policies of the various central banks around the world.  These profits are necessarily loaned to the consumers to support their consumption.  In the end the returns will be false.  We witnessed the asset inflation in Japan that hasn't been solved after 20 years.  Japan is currently trying to solve the problem by shrinking the yardstick from 36 inches to maybe 15.

I am going to nail this one on the head. It is called compound return. It doesn't make any difference what you call it, printing, savings, cash, stocks, houses. They all are bought to provide a return and a growth rate. Savings is debt. Stcok prices require a yield as do mortgages and free and clear real estate. When XYZ public employee, who in a lot of places is under paid and may not even have any benefits and in other parts of the country is paid like he does something besides drive around town with a gun on his hip and a ticket pad. I will bet driving a taxi is more dangerous than being a cop, though the cop likely has to be aware of potential danger all the time, but this is besides the point.

The point is the entire economy can only be carried by shrinking the package paid in return. Watch what Bernanke is really trying to do. Interest rates near zero. Bankers can't pay so we are now letting them pay nothing. Bankers customers can't pay, so Bennie is trying to put more money in the system, shrinking what the debtors have to pay. Business is on its ass, though you would think they were making money hands over feet. This is mere deception, funded by $2 trillion a year through the back door. Bernanke is funding their profits at the expense of our savings. It is an attempted back door bail out of the public pension funds, but in reality it is nothing more than a transfer of what we need today to an expense for tomorrow.

There is no such thing as a permanently funded pension fund where liabilities grow to the sky. The question that must be asked to start is why do we even need a fund, unless we are going to pay these benefits, then default? The value of assets is unstable as we reach the point where the return cannot be drawn from the economy on a compounded basis. What we really have is a pile of funds for Wall Street to manage and draw massive fees, dump over-valued assets and then demand more, because their phony models can't be satisfied.

In a pension plan, there are 2 expenses, what is coming out and what needs to go in to fund the future. The only real expense is what is coming out. What goes in doesn't count, because it is pure speculation. All we are really liable for is what comes out. What is piled up can never be large enough in sum, as it is a fiction and the failure of what is amassed can wipe out the entity liable to fund it.

I venture the funds have never been necessary, but are political plums for bankers and politians to play with. History has provided us with a stock market that has registered between 40% and 80% of GDP in value. Not this stock market, which has hit peaks of 200% of GDP in 2000 and bottomed at 100% in 2002 and likely in the 70% to 80% range in 2009. Stocks aren't cheap today and they haven't been cheap for nearly 2 decades now. To make 8% or 10% or whatever nonsense is spouted can only be done in stocks with inflation or low valuations. The rest of the story is fiction. How do you draw 8% out of 200% of the GDP and leave anything out there that doesn't have to be funded by debt? We are currently at over 100% of GDP and much less if you take out the government, which is nothing but an expense anyhow. 8% of 200% is 16%, which is the limit Karl has said the federal government can get out of the economy and we haven't even made it to the various debt instruments and free and clear real estate net of debt instruments out there. The concept of continuing returns on a growing amount of assets in a zero inflation environment is fantasy. Drawing a return off the pool of yield or profit making enterprises is limited to what those not engaged can pay. We are limited to the amount of bad debt the system is willing to extend and nothing else.

Here is the problem we face. If we are dealing with having to inflate, as Jim Grant said yesterday, we are merely shrinking the package, making smaller pounds and gallons. The numbers become meaningless. Also, pension expenses are figured on what size pool of money at the current interest rate over life expectancy. What is fundable at 6%, becomes impossible at 2%. To tell me the best way to do this is to amass a pool of money so large that all future costs can be paid out of it? Why the fuck give an insurance $2 million (an amazing number of these public pensions cost $2 million or more), when you can write the pensioner a check for $100K a year? 10 years ago, the same pension needed maybe $1 million to fund. It doesn't even make sense to pay for the management of money at 2%, much less treat as permanent what may be very temporary.

Remember this adjustment has to be made on the entire pool. Not only have the assets performed poorly, because it is a mathematical fact you can't get 8% exponential growth at top value against something that can only pay 4%. Not in real terms. Bernanke can fold the dollar in half and tell you to look at both sides of the bill and pretend you have 2, but this is a fiction and has nothing to do with real values.

My problem with public employees isn't so much the pensions and the compensation in general. Even though a million isn't what it used to be, a small minority of Americans have a million dollar net worth on hand and if you take out the value of their home, the list gets much smaller. The typical cop and firefighter in California gets a pension that costs upwards of $2 million or more. This is guaranteed, just stay on the job and do nothing stupid. That is unless they have bankrupted the system from which they draw.

There is a maximum for what level real values can be supported. The implied risk on the SPX is 6%, if you are going to get 9% returns at 3% inflation. I have done the numbers over history. The modern history of stock market returns(the last 30 years) have been supported only by inflation of the money supply to effect asset inflation. Jim Grant pretty much put this idea out in a way that probably went past the average person on CNBC yesterday. The game is up once gross net worth of an economy reads near zero relative to total assets, that is net of debt, which is owed on one side and owed to on the other. This idea includes equity in real estate and the stock market.

The question is, how do you get this 6% without stealth inflation, which is nothing more than the expansion of credit? I think you can only get it with very low valuations. The valuation model in pensions presents a paradox, in that existing assets have an inverse relationship to interest rates, which means that the model can't be fixed. The benefit of higher interest rates would assist the pension in its pay out expense, but it would deplete the value of the assets on hand significantly. We are seeing inflation today, but it isn't credit inflation so much as it is asset inflation, which includes storable commodities. The problem here is the credit inflation isn't making it to the end consumer, so the gap can't be supported for long.

If I was going to work out the public pension problem, I would move to a pay as you go system. I would fire my manager, bring in someone for an annual analysis and fund my costs on a pay as you go payout. Selling a fixed amount of assets and putting the rest on the current budget. The shortfall is impossible to fund and if it was attempted, would only serve to push up the prices over the short term of what I had to buy to fund the plan. This would get the money out of the hands of Wall Street and eliminate the uncertainty of asset value fluctuations. The same holds true for Social Security, which is an ongoing expense where a actuarial fund has no place, especially since it is only funds the government pretends to have that they don't have.

1 comment:

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