The National Debt Problem

Despite what the title above may imply, there are many that do not see the dramatic rise in government debt as a problem. In fact, very few nations see their sovereign debt as an issue, despite the unprecedented rise in borrowings over the past several years. Most recently China, whose total debt has now risen to eye-popping levels, was quick to dismiss their levels of indebtedness as a reason for concern.

Let's put this in perspective for China. According to a recent study published by McKinsey & Co, in 2000, total China debt was roughly $2 trillion. By 2007, China debt had risen to $7 trillion and by 2014 to a whopping $28 trillion. In fourteen years, China's debt has grown by 600%. Yet, Chinese officials are eager to dispel any concern by claiming just earlier today that there is no problem with the debt, as long as GDP continues to grow.  

This has always been the rationale, hasn't it, or at least for the past ten years when debt in China, the US and around the world has exploded higher? The argument is supported by the primary metric for evaluating sovereign debt, the ratio of debt to GDP. China's total debt is currently 250% of GDP and, as shown from the chart to the rights, is expanding at an alarming rate. 

US debt, both total and US federal direct borrowing is also a key problem, however, and here's why. First, let's look at the US national debt and it's growth over the past ten years. Total US government debt in September 2015 was $18.1 trillion, according to official records of the US Treasury Department. In 2007, or eight years prior, the national debt was $9 trillion, representing growth of roughly 100% over this period. Eight years prior to this, or 1999, US government debt was $5.6 trillion, implying a growth rate of 60%. So clearly, the rate of growth is accelerating, in this case, by a factor of 2/3rd.  But let's leave this aside and return to the argument that it is only the ratio of debt to GDP that is relevant in quantifying the level of debt burden of the American people.

This ratio, as well, paints a fairly stark picture as can be seen from this graph of the Federal Reserve Bank of St. Louis.  But this chart shows Federal debt at just over 105%, a level that the government would argue is manageable given the breadth of the US economy. 

But is this metric of debt to GDP even meaningful? Let's remember that the government's ability to pay the interest (and principal) on the national debt is derived from tax revenue. Now while taxes are collected on economic activity, or GDP, it follows that the greater the GDP, the greater the tax revenue, etc.  But is this reasonable if US tax revenue represents a fairly small share of total US economic activity?

According to the Tax Policy Institute, total US tax revenue currently represents just 17% of GDP. With the national debt at $18 trillion and 2015 tax revenue of $3.2 trillion, the ratio of debt to tax revenue (or the portion of GDP that relates to the Federal government) was 562% at the end of last year! Now what other corporation or individual borrower in the United States has a debt to income ratio of 562%? Exxon, one of America's largest companies and with substantial capital investment, had total debt in 2015 of $20 billion. With annual revenues of $51 billion, however, a debt to income ratio of 562% would support debt of $286 billion (it would also make them insolvent to the tune of $116 billion). Perhaps the board of Exxon has considerably more common sense in its judicious use of debt than the US Congress, in its unwillingness to take cover in this questionable metric of debt burden.

Valuing Stocks in a World Gone Mad

An abundant supply of capital sloshing around the global markets in search of return. The idea has been discussed extensively over the past few years. The argument was first made that excesses found their way into mortgages and mortgage backed securities, then US and Japanese bonds and ultimately, US and foreign equities. In times of bubbles or "irrational exuberance" as Fed Chairman Greenspan was fond of saying, investors tend to find rationales that fit otherwise irrational investment decisions, thus allowing bubbles to form. This may be true of stock valuation metrics, as well.

What prompts me to get into this topic was an episode from earlier in the week of Mad Money, where TV persona Jim Cramer, ever the bull, argued that the drop in stock prices over the last few days was a "blip" presenting a trading opportunity for smart investors. His choice sector for the next rotation of our sloshing mound of capital: consumer staple stocks. This on a day, most interestingly, when leading hedge fund manager Stan Druckenmiller advised investors at the Sohn Conference to sell stocks and head into gold. Given Druckenmiller's stellar investment performance, it's a notion we can hardly dismiss.

But let's look at a few names Cramer threw out as investment ideas, raising the much larger question of how and when the metrics for stock valuation had changed so dramatically. The first name Cramer offered was Clorox (CLX). Clorox trades at a trailing price/earnings multiple of 25.33x. Higher than the broad market multiple, and significantly greater than the historical trading average of the S&P, but not stratospheric. But at $129, Clorox is trading above its five year average multiple, of a still aggressive 21x.  If Clorox were to simply trade at its historic multiple, the price would drop to around $111.

Let's take another example. Colgate Palmolive (CL) at $71.88 is trading at 47.5x trailing 12 month earnings, well above its lofty 5-year average of nearly 26x.  Proponents of the stock, however, will make two arguments. First with interest rates as low as they are, they would argue, stocks "deserve" a higher multiple (as if companies have an inherent right to the higher stock price). Hmm. They will also point to the far more reasonable forward p/e projection to justify the price - and this is the fundamental point to be made here.  

The forward multiple for Colgate is now just under 26x, wholly in line with the company's historic 5-year multiple. But here's the point. To roughly halve the multiple on a forward basis (i.e., from from 47.5 to 26) requires earnings to grow over the next 12 months at roughly double the level of the past 12 months, or by 100%. More specifically to Colgate, for the company's annual earnings to align with a 26 p/e at the current stock price would require earnings to climb from the roughly $1.3 billion they made in 2015 to $2.6 b in 2016!

Now, here's the rub. That basic math would be true, but only if the share count outstanding remained fixed. But Colgate, as true of many consumer staple and industrial companies in this environment, is buying back shares, reducing the number of shares outstanding by some 15 million per year. They've done this at the expense of adding leverage, or debt, to the balance sheet, but we'll leave that issue aside for now.

But even with the adjustment, or on a constant share basis, Colgate would need to grow its earnings by 80% in 2016 to achieve a 26x multiple at the current stock price. All this, for a company whose net income has declined sequentially in each of the past five years. I can't help feeling that Druckenmiller might be right.  With these kind of metrics, how will we ever get the toothpaste back in the tube?

Investing in Utility Stocks

Those who read my post from early January, "What's Working in this Market Correction", will know I favor utility stocks in the current market.  In fact, the utility ETF, XLU rose from 43 on January 4 to 50 on March 28, or a gain of 16% in 12 weeks.  It's since backed off, now trading at 48.  I'll explain why in a moment.  First, why I like utility stocks and what their performance this year says about the economy.

XLU

Utility stocks essentially trade like bonds.  Known for consistent and high dividends, investors buy utility stocks as they would fixed income securities, for their predictable level of dividend payments.  The dividend yield, or the relationship between the annual dividend and the stock price, is often equated to a bond yield for more traditional fixed income securities.  Utility stocks are not pure dividend plays, though, and we'll get to this issue in a moment, as well.

Trading like bonds, of course, means that price and yield vary inversely.  As interest rates rise, the price of bonds and utility stocks decline.  As rates decline, utility stocks tend to appreciate. Over the past two months, since the lows of the stock market in February, stocks have rallied following a risk on momentum trade.  Bonds have weakened.  The US 10-year has traded as low as 1.63% and as high as a 1.97% over this period.  

If this risk on rally that has been leading momentum into the least favored sectors of the market is about to turn once again, however, the focus will shift back to the continued weakness in GDP, consumer spending, capital investment, durable goods orders, commodity prices and corporate earnings.  This perceived weakness will damage stocks, but boost fixed income securities that rally in the face of low growth and inflation.

This being said, while factors favor utility stocks, I don't prefer the ETF alternatives, and here's why.  Utility stocks largely trade like bonds, but not entirely.  Their values also swing based upon forecasted revenue on energy sales to their customer base.  In some regions of the country, that customer base can be heavily industrial, for instance Texas, Oklahoma and much of the mid-west.  If the economy is in fact slowing, industries in these regions will likely reduce their consumption of power, impacting utility revenues.

Residential demand for power, on the other hand, is highly stable and far less impacted by economic cycles.  For this reason, better opportunities present themselves in utilities with higher residential customer profiles, than what might be achievable with the XLU.  A few large utilities that fit this profile and should be considered are Duke (DUK) with 6.2 million of its total customer base of 7.2 million being residential, Southern (S0) and Exelon (EXC).

San Bernardino's Pension Fiasco

New details emerged this week on the City of San Bernardino's bankruptcy recovery plan. Reuters reported a proposed settlement with two of the creditors of the city's 2005 pension obligation bonds. That plan calls for bondholders to write off as much as 60%, or $30 million of their original $50 million investment. 

The bonds in question were originally issued by the City back in 2005 to help shore up the city's struggling public employee pension fund, held by the California Public Employee Retirement System, or CalPERS.  Unable to come up with the funds to fulfill its commitment to retirees, the city turned to the public bond markets, selling bonds and using the proceeds to pay CalPERS. In being granted authorization under law to issue the pension bonds in 2005, the city obtained a court ruling confirming that the city wasn't issuing new debt, per se, but rather refinancing debt it owed to the CalPERS pension fund.

By July 2012, though, soon after it filed for bankruptcy, the city failed to make required semi-annual payments on the bonds, throwing the bonds into default.  Interestingly, in its bankruptcy filing, the city blamed the high costs of its fire and police labor contracts, including pensions as the main issue forcing the bankruptcy filing. Now in bankruptcy, the city failed to make payments on the bonds funding that pension liability, as well.

The two principal holders/guarantors of the bonds sued the city soon thereafter, arguing that the bonds should be paid on an equal basis with the city's continuing obligations to fund its pension account at CalPERS.  But in the end, the powerful, $300 billion CalPERS prevailed in court. In May 2015, a bankruptcy judge threw out the bondholder suit, allowing the city to proceed with its plan to make pension payments to retirees in full, while forcing bondholders to suffer significant losses on their loan to the city.

Now let's step back here a moment and take a look at what has actually transpired.  The city, through negotiation with its employee unions, had agreed to make a certain level of lifetime pension payments to retired city employees. Unable to come up with the funds from tax revenues and other sources to do so, the city borrowed $50 million from investors. It deposited these funds with CalPERS, the pension trustee, on the city's behalf.  

Now, in cramming down a loss of $30 million (or 60%) to bondholders, the city is arguing that it doesn't have the funds to make full repayment. However, it actually does. The full $50 million that the city borrowed, plus interest, remains on deposit in the city's pension account with CalPERS. So, in effect, what has happened is that the city effectively stole $30 million from investors (the difference between the original borrowing and the amount to be repaid) using the money to make whole on its pension commitment to employees.

Now, here is where this gets truly galling. As reported in our blog from May 2015, a study of salaries of the 120 highest paid firefighters in San Bernardino reported by Bloomberg shows the top one-third drawing an average salary of $190,000 per year; the next third $166,000 (this is in a city where the median household income is $52,112 per year). In retirement, as early as age 50, these firefighters may be eligible for annual pensions of up to $171,000 per year, an obligation the city will need to pay for many years to come. This might, in part, explain the types of management decisions that led up to the city's bankruptcy and its nearly unconscionable deal with its bondholders.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com. 

The Dash For Trash in Stocks

Following an unusually rough start to 2016, the last four weeks have seen a dramatic turn of events in stocks, oil and commodity prices. The question we ask is "what has changed?" Unfortunately, not very much. Our concerns entering 2016 are still with us: record low commodity prices, weak oil, widening junk bond yields, declining corporate profits and a less accommodative Fed.  These concerns are superimposed upon a bleak macroeconomic picture, with many starlets of the emerging markets stumbling, including China, and others falling hard, like Brazil.

Amidst this backdrop the rally in stocks has been puzzling. Driving these gains, in part, was a race to hastily cover short positions in oil, as a rumored OPEC alumnae reunion quickly sent the price of oil up by 50%.  Oil analysts, though, shrug off the effect of a plan to freeze production at today's record levels (even assuming parties would hold to it) as having little impact on ever-growing inventories.  However, as weak shorts run to cover in oil and beaten down oil stocks, hedge funds and algorithmic traders have been quick to ride the tailcoats of all the buying.

But let's look at one non-oil, non-mining blue chip stock to see what has happened to valuations over the past several weeks. Boeing Corp (BA) bounded off its mid-February lows of 108, to now trade at a robust 130.  Little has actually changed at the company over this period. In fact, the company announced in late February that it would be laying off employees, including highly paid engineers, as it faces stiff competitive market pressures, principally from Airbus. This news followed a downbeat earnings report for 2015 Q2, released on January 27, in which the company lowered forward earnings guidance on an expectation of slower 2016 sales. Boeing's net in 2015 Q4, it turns out, was $1.03 billion, down from $1.47 billion in the same quarter a year earlier. 

Yet despite this 29% drop in Q4 earnings and lowered guidance for 2016, Boeing stock is up a stunning 20% from its February 11 low.  So how is this possible?  Multiple expansion. Today, BA trades at 17.15x twelve month trailing earnings, above its 5-year historical range of 16.19x. But with earnings projected to decline, even if not nearly to the degree the company experienced in 2015 Q4, this TTM multiple will jump significantly, without any further gain in the price of its stock.

Now this isn't to say that Boeing is a weak or troubled company. It is an outstanding company, with excellent long term prospects. But these prospects must be set against global macroeconomic conditions that support, or in this case, limit growth. This issue, in fact, is precisely what the company warned in its Q4 earnings statement.

Meanwhile far trashier stocks, like Chesapeake Energy (CHK) are up 201% over the past four weeks, while Freeport McMoran (FXC) is up 187%.  It's much more difficult to value these stocks on a TTM p/e basis, because these stocks do not have earnings.  Not by a long shot. FXC lost $12.2 billion in fiscal 2015. If you think this might give pause to the reasonableness of a 187% rise in FXC's stock price, you might want to consider treading cautiously in this newfound market rally.

The Rising Mountain of New Jersey Pension Debt

This week, the Supreme Court of the United States moved to uphold a 2015 ruling of the New Jersey Supreme Court, thereby defeating a challenge to the state's plan of pension funding brought by public employee labor unions. The unions sued the state over the underfunding of the state's staggering employee pension deficit. The unions alleged that in 2014 Governor Christie failed to fund the plan at an agreed upon level, per a deal negotiated by state legislators and the unions in 2011.

To understand where this story begins, or just how dire the circumstances are surrounding the New Jersey Public Employees Pension Fund, a bit of background is required. In 2014, the State of New Jersey deposited roughly $700 million of taxpayer dollars into its employee pension fund. The State spent an additional $2.8 billion of public monies to fund retiree health care benefits. Yet, despite these significant investments in shoring up the retirement plan of its past and current employees, the State actually underfunded its statutory funding obligations by nearly $3 billion.

To understand how this is possible, we need to delve into the murky world of state and local government accounting. To fully fund the state's requirements, simply to keep pace with current pension costs - with no effort to catch up on past underfunding - would have required the State of New Jersey to contribute $6.5 billion of taxpayer funds, or 20% of the entire state budget to its pension funds. So the state "saved" $3 billion by underfunding in 2014. But year after year of these kinds of "savings" or deferrals, simply builds one heck of a mountain of debt, or pension liabilities, for the state (or more specifically, taxpayers) to climb in the future. In fact, by 2015, New Jersey's total benefits liabilities had reached a staggering $90 billion - $37 billion in unfunded pension liabilities and $53 billion in unfunded health benefits.

Now back to the Supreme Court. The case revolved around the agreement negotiated in 2011. In order to gain concessions from the unions on greater employee pension contributions, the state agreed to gradually increase its funding of pension contributions in each year, until reaching the required annual level. And in fact, things proceeded just this way in 2012 and 2013.  But in 2014, in an effort to pass a strained budget, the state reduced its annual pension contribution by the aforementioned $3 billion. Governor Christie claimed financial hardship. The unions sued saying the stated had breached its 2011 deal. The Supreme Court has now sided with the state, allowing the State of New Jersey further leeway in kicking the can down the road on its pension obligations.

Looking ahead, for the state's fiscal year 2017 beginning on July 1, the Governor has proposed $1.86 billion in pension contribution, or just 40% of its required annual contribution. And while this may help the state balance its 2017 budget, the state's pension mountain continues to rise before New Jersey public employees and cast an ever-greater shadow over its taxpayers.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com. 

Retail Spending and the Consumer

I had lunch recently with a friend in a fashionable urban restaurant. When the conversation came around to the economy he said, just look around. Everywhere I go restaurants and retail shops are crowded with people eager to spend. From Fifth Avenue to Rodeo Drive. From San Francisco to Miami Beach, restaurants are crowded and consumers are spending, spending, spending.

The problem with this image, of course, is consumer behavior in these tony high end locations tells us very little about the overall health of the American consumer. How little, may be just 1%. 

For the month of January, total retail sales grew by 0.2% over the prior month. These weak results were at least partially due to falling gas prices - a good thing for consumers. Retail sales ex-auto, gasoline, building materials and food services (i.e., core retail sales) were up 0.6%. While not stellar, the January report followed an outright decline in core retail sales of 0.3% in December. Not great, but certainly not recessionary. Bear in mind also that retail sales figures are not adjusted for inflation. So 2% sales growth in an economy with 2% inflation, would mean essentially flat unit sales. 

Against this backdrop, consider that four states are already officially in a downturn, as reported by Bloomberg News: Alaska, North Dakota, West Virginia and Wyoming. Likewise, other states are threatened, as well, including Louisiana, New Mexico and Oklahoma, according to Moody’s Investors Service. And of course there is Texas, which is also struggling with plunging oil prices, layoffs and reduced consumer spending.

So what's going on? Fortunately, the Commerce Department, in its monthly report of consumer spending, gives us a broader view of how people are spending, or not spending. If we drill down into the January Retail Sales Report, here's what we find beneath the headlines. On a year over year basis, food and beverage store sales were up just 1% (the CPI in January on a year over year basis was up 1.4% so sales grew by an amount less than inflation). But sales at bars and restaurants were up a solid 5.4%, indicating a preference for meals out to those at home for many consumers. Yet, furniture and home furnishings grew by just 1.4% (about the rate of inflation) while clothing stores were flat (no increase in sales, before inflation). And department store sales fell 4.5%, while electronics stores were off 5.4%.

So while the anecdotal evidence of a healthy consumer eating out more often and buying lavish clothes may be what some of us see, others see a far more bleak picture of retail spending, lending yet further support to the case for an impending recession.

How to Spike Your Pension

When Marty Robinson was elected Chief Executive of Ventura County, California in 2008 supporters cheered her appointment. A councilwoman from the Ventura County city of Oxnard claimed, “That’s a glass ceiling broken”. At her retirement ceremony in 2011, her colleagues offered tributes that lasted nearly two hours. The Board of Supervisors renamed a stretch of the County Hall of Administration, “The Marty Robinson Trail”. Ms. Robinson’s compensation that final year? She was paid a total of $330,000.  

Startling as this may be for a public servant, this level also forms the basis by which her lifelong pension payments will be calculated. Her highest year compensation of $330,000 entitles Ms. Robinson to lifetime annual retirement benefits of $272,000, an amount it turns out, that is actually higher than her base salary for the year of $228,000.  By adding unused vacation time, overtime, car allowances and other perks, Ms. Robinson was able to significantly raise (or "spike") her final year compensation as the basis for all future pension benefits she will receive in her retirement. While this practice was outlawed by the California Public Employees Retirement System (CalPERS) in 1999, counties like Ventura who do not participate in CalPERS, but rather manage their own internal employee retirement systems are free to allow the practice to continue. In fact, twenty of the state’s fifty-eight counties run pension plans that are outside of this CalPERS mandate, following a 1937 law that granted counties a choice between joining the statewide retirement system and creating their own. These twenty counties, known as 37 Act counties, are not required to follow mandates of CalPERS or other statewide directives.

Assuming Ms. Robinson lives to age 85 and the CPI averages three percent over the next twenty years, Ms. Robinson will receive total retirement benefits from Ventura County of $15,702,608 (or $24,221,167 should she live to age ninety-five).  Now here’s where it gets interesting.  Had she not tried to manipulate the system by spiking her final year income - artificially boosting her salary in the manner described above - her total retirement benefits to age eighty-five would still have totaled $10,849,000, placing her in the top 0.01% of retirees.  

Sadly for us, as taxpayers, Ms. Robinson is not alone. Despite a $761 million unfunded pension liability for Ventura County, 84% of its retired county employees earning more than $100,000 per year pre-retirement saw higher income in retirement than they did as employees on the job. The former Ventura County Sheriff is reportedly receiving $272,000 per year in retirement pay (twenty percent higher than his salary) while the former county Undersheriff is receiving $257,997, a full thirty percent above his base due to spiking.

Following these and other alarming details of the Ventura County retirement system, a measure was placed on the November 2014 ballot called the Sustainable Retirement System Initiative, designed to stop these and other abuses. Among other reforms, the Sustainable Retirement System Initiative would shift new county employees to a 401(k) style defined contribution retirement plan, thereby relieving county taxpayers of future pension liability for these employees. Proponents argued that the measure could save county taxpayers millions. 

A group backed by the Ventura county employee unions quickly sued, however, arguing that if such a measure were to be approved, the county would face great difficulty in recruiting new employees (i.e., if their benefits more closely resembled those of private sector employees). Before taxpayers could have a say one way or the other, on August 4, 2014, Ventura County Superior Court Judge Kent Kellegrew ordered the item be removed from the ballot, thus denying taxpayers an opportunity to vote on the proposal. One last thing in case you are wondering. Yes, County judges are covered by the same Ventura County pension plan.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com. 

Next Bubble to Burst

Many today believe the 2008-2009 recession was caused by a credit crisis in the banking system. They view the levels of debt that had built up in the consumer and financial sectors as excessive and somehow "blowing up" like a form of spontaneous combustion. The credit crisis, however, was preceded by a number of developments, not the least of which was the vast expansion of debt and the instruments that created and compounded that debt. But, the most immediate precursor of the crisis was a sudden and rapid repricing of risk that was well underway by the middle of 2007. In the years prior to 2007, risk had largely been discounted in the corporate, financial and consumer sectors, as yield spreads narrowed to historic lows. By 2014-2105, junk bonds were trading at yield levels below that of high grade corporate bonds throughout much of the 1990s.

Credit spreads, or the yield differential of a corporate bond, mortgage security or other debt instrument, relative to the US Treasury benchmark rate, is at the center of the way in which bonds are priced in the capital markets. The lower the credit rating, or the higher the perceived riskiness of a bond, the greater the yield spread relative to a Treasury bond of equivalent maturity.

Now the thing is, credit spreads are not static, but rather vary from time to time. During periods of relative calm and optimism in the financial markets, credit spreads tend to compress (often just as lending criteria become more relaxed). In times of uncertainty or distress, credit spreads widen. In the period 2003-2007, high yield bond spreads declined to levels that were absurd, with junk bond spreads compressing to less than 2.5%. By the time the 2008 recession was fully underway, however, these spreads would widen to an all-time high of 21.0%!

As can be seen from the graph below, debt levels are now once again at record levels, although today the debt is concentrated in the corporate and sovereign sectors, rather than the mortgage and financial sectors, as was the case leading up to the financial crisis. In fact, absolute debt levels in the US today are much higher than they were before the 2008 financial crisis.

Amidst this expansion of debt, a similar pattern of ultra-low risk premiums has been underway for several years, as a rapid expansion of liquidity by world central banks flowed into the sector. By mid-2014, high yield credit spreads had fallen to 3.3%. But now, the tide is once again turning. Rapidly widening credit spreads for high yield bonds are again underway, showing a similar pattern of risk re-repricing to what we saw in 2007. Today, the high yield index shows a credit spread of just under 8.0% (roughly the same levels as 2008).

The near default in Venezuela, deepening recession in Brazil and devastation in the energy sector has us also wondering about the vulnerability of bank stocks, with material emerging markets and oil patch exposures for these institutions. If the value of publicly held high yield debt is rapidly deteriorating (as price moves inversely with yield) mustn't the same value deterioration be equally true of these bank loans?  JPM Chairman, Jamie Dimon was quick to play down the issue of his bank's risk profile in energy, arguing that the bank is well reserved against potential losses. As if to further comfort JPM investors, Dimon continued to offer that bank loans to oil and gas companies are asset backed; that is, losses would be offset by the realization of collateral.

The question, of course, remains as to what these assets would be worth in an environment of plunging oil prices, record excess capacity and massive inventory build. Taken in the context of the repricing of risk, the high yield bond market does appear to be telling us something about the near-term future of the economy that is increasingly difficult to ignore.

Hillary Clinton's Plan for Social Security

Faced with increasing pressure from Bernie Sanders for the Democratic nomination, the Clinton camp has recently found it necessary to finally address the issue of Social Security, a topic widely discussed by Senator Sanders. We've written at length about the issues facing Social Security, as well as the flaws in Bernie Sanders' well-intentioned plan for revitalizing this program, upon which so seniors widely rely.

Ms. Clinton's proposal, however, not only lacks substance, but credibility. After all, in previous mention of the topic, her comments have been limited to "don't touch it". Then, as now, not touching Social Security puts us on a path to the program's demise. This is not our view, but that of the Trustees of the Social Security Administration. And lest you believe as Ms. Clinton proclaims that the whole idea of Social Security insolvency is a myth promoted by the GOP, consider that the Trustees of the Social Security Administration, the same ones attempting to alert the public to the impending disaster, are all Obama appointees - and all Democrats.

Clinton's plan to fix Social Security is, first, to kill the notion of privatizing the system. Well, she may be right about this, but killing a proposal hardly provides a fix. Second, she'd "consider" raising the cap on wages subject to the Social Security tax (currently $118,500 per year). Lastly, she'd like to make some sort of adjustment for women, seeing that women often work less years than men, and therefore accrue less Social Security benefits. And, sorry folks, that's about it.

Just to recast the problem, quoting the 2015 report of the Social Security Administration, the present value deficit of the Social Security Trust Fund, in other words, the difference between what is projected to be paid in benefits and what is expected to be gathered in taxes and investment income, is roughly $10 trillion. Removing the cap on wages alone (which goes somewhat beyond what the candidate has proposed) is a relative drop in the bucket. And this is the only aspect of her plan that can actually be quantified.

Here's the basic problem. With an aging society and demographic imbalances, the current level of tax and earnings will only float the Trust Fund until 2034, or roughly another 20 years. After that, benefits, already meager, would have to be reduced by a third. Now here's the tough part, There are only two possible solutions for addressing this crisis: either increase taxes, or cut benefits, or provide some combination of the two. The subtlety comes in how this is done. How do you raise taxes fairly and keep from cutting benefits to those who need them the most? For this, we've previously provided our views, available here.

What's Working in this Market Correction

The New Year starts with a bang, with hundred points swings in the Dow Jones Industrial Average each day this week. Unfortunately, the swings have all been to the downside, with the S&P falling nearly 5.0% this week. In this environment, investors may be tempted to throw up their hands and sell everything, or watch from the sidelines like a deer in the headlights as portfolio values head ever lower. Let's look at what's actually working.

First, while some portion of the selloff was likely initiated by the Fed's modest rate hike in December, the 0.25% increase has all been directed at the short end of the yield curve. Bonds, especially long-dated bonds have performed quite well, with the yield on the 30-year UST falling below 3% (2.93% as of this writing) from a level of 3.04% just last week. Eleven basis points of declining yield has the price of the US Treasury 2x ETF (UBT) rising from $73 to $76 over the same period. That's a 4% gain for the week, while everything else seems to be swimming furiously in a sea of red.

This leads us to our first trade for the New Year, bonds, and specifically UBT as an ETF play available to retail investors. UBT is levered 2x which means that a rise in long term interest rates would also cause this instrument to fall disproportionately in value. But if your view is that the economy may be hitting a rough patch, where stocks are susceptible, then bonds may provide a safe port in the storm. This is especially true if you believe economic growth and inflation, the principal enemies of bonds, will continue to be subdued. It's also worth noting that UBT traded as high as 97 back in February 2015, when the long bond traded at 2.25%. Not to say this is where things are headed, but with the softness we're seeing in global markets, difficult to rule it out either.

Oil continues its rapid decline, now bordering on a free-fall. The inverse leveraged ETF, SCO, has done especially well over this period, rising from $80 in the beginning of November to its present level of $160. How much lower oil can go is anyone's guess, but WTI is now roughly where it was during the 2009 recession (along with other commodity prices). Hard to believe it falls much further, yet SCO may still form a reasonable hedge against long positions, certainly in energy and perhaps, also, industrial stocks.

SKF, the inverse leveraged ETF on financial services stocks, also has our attention. This instrument can not only provide a hedge against other long equity positions, but highlight the risks specific to the financial services sector. Some concern with financial services profits may be warranted following the poor performance of markets in the latter part of 2015 and the disastrous 4th quarter results posted by Jefferies on December 15. Customarily a harbinger of things to come at the larger Wall Street names, our concern can only be amplified by the exposures of these firms to deteriorating credits in the oil patch.

On the long side, defensive sectors like healthcare and utilities may prove a good place to hide, collecting dividends and waiting for markets to sort themselves out. As to cash, which investment advisors tend to dismiss, it's beating stocks by 4.89% this year.

2016 Market Predictions

It's time to take stock of markets in 2015 and provide our thoughts on where things are headed in 2016. Before we get to the predictions, let's take a look at the consensus view of economists and market mavens heading into 2015 to see what they got right, and what they got wrong.

Consensus forecast for 2015 GDP by economists under a survey conducted by the Philadelphia Federal Reserve Bank at this time last year was for 3.00% growth. This view was confirmed in a similar survey of the Wall Street Journal on January 5, 2015.  Now, with only one day remaining in the year, it looks like 2015 GDP will be closer to 2.00%, a substantial miss. Not surprising, really. In a recent report of Goldman Sachs, researchers found that the consensus forecast for GDP has been wrong in 13 of the past 16 years with economists consistently erring on the side of optimism.

Stock market predictions are equally skewed it turns out. With the S&P 500 wavering on either side of flat for the year, the consensus forecast of stock gurus by CNN Money for 2015 was for a gain of 8% on the year (the index is at 2063 as of this writing, in the red for the year). Nonetheless, stocks still trade at over 19x trailing earnings, a historically high market multiple.

Predictions for the bond market were even further from the mark, with market forecasters expecting a substantial rise in bond yields (and decline in bond prices) for several years now. Yet the UST 10-year currently stands at 2.29% (versus 2.22% this time last year). Hardly the drubbing professionals were expecting. 

This having been said, let's take a look at where things could be headed in 2016.

GDP will likely slow further from its tepid pace of 2015 as the dollar strengths, global demand weakens and oil (as well as other commodities) continue to drag down the energy and materials sectors. With the economy reaching full employment (irrespective of the falling labor participation rate) gains in personal income will likely be limited. While the argument can be made that a low unemployment rate increases the leverage of workers over management, income gains from this source will be far lower than moving people from unemployment to employment, as reflected by a lowered unemployment rate. 

At the same time, consumers continue to be concerned about the economy and their personal levels of savings, as reflected in a rising savings rate. Rising savings with limited income gains spells trouble for retailers and consumer spending more generally. Don't look for any gains in governmental spending either in an election year. At the same time, a strengthening dollar jeopardizes corporate profits and exports. Piece it all together and it's hard to make an argument for rising GDP in 2016.

In this environment, and with stocks at lofty levels, the market will be vulnerable. Against a backdrop of Fed tightening volatility will be inevitable. Profit margins will compress and if p/e multiples contract, the downside for stocks could be pronounced.

US Treasury bonds may present the best opportunity for gain, if the foregoing conclusions about growth and corporate profitability are plausible. With slower growth comes lower inflation, benefiting holders of fixed income instruments. While the Fed may be tinkering at the short end, their ability to control the long-end (absent an unwind of long QE positions) is limited. With a lowered Federal budget deficit forecast for 2016 comes lower Treasury issuance, with an emphasis on the short end, as the Treasury has already so indicated. If there is global turmoil in the year ahead, the fear trade will rush investors into UST, with significant price appreciation a distinct possibility.

Banks Hike Prime Rate, but leave Savings Rates Untouched

Yesterday, in what must be the most telegraphed increase in interest rates in American history, the Federal Reserve Bank moved to increase interest rates by 0.25%. Major US banks quickly followed suit, hiking the Prime Lending Rate by the same amount. But banks have left the deposit rate paid on consumer savings at close to zero. First reported by ZeroHedge, banks one after the other, including Wells Fargo, Citi, JP Morgan and US Bank moved within minutes of the Fed hike to raise their bank's Prime Lending Rate to borrowers.

What's shocked investors is that after seven years of near zero rates of interest on savings and money market balances at banks, the Fed's long awaited rise in interest rates would have no corresponding increase, not even a comment, on raising the rate of interest for savers on bank deposits. But when you look at how banks have managed the interest rate cycle following the financial crisis, it's really no surprise.

While corporations and banks alike have seen their cost of borrowing fall precipitously following the financial crisis, banks by and large have been unwilling to pass these savings onto consumers through lower interest rates on credit card balances and consumer loans. Banks, who have been able to borrow at interest rates near zero and have paid substantially less than 1% of interest on consumer deposits for the past seven years, have held credit card rates near their all-time high. 

Data of the Board of Governors of the Federal Reserve in a 2012 report to Congress on trends in bank credit card pricing found that average bank rates had fallen from 14.68% in the period leading up to the recession to just 13,09% by 2011. By November of 2014, this rate had fallen to just 12.89%. At the same time, the average rate of return on assets of large US credit card banks had climbed from 2.75% to 5.25%. With the funding cost of banks near zero for this period and the interest rates charged on consumer loan balances stuck at 13%, it's quite shocking that returns on bank assets weren't actually far higher.

This points to the great failure in Federal Reserve monetary policy over the past seven years and why US economic growth isn't far more robust, following seven years of zero interest rates and $4 trillion of bond purchases under the Fed's program of Quantitative Easing. The answer, in short, is that the benefits of easy money and ultra-low interest rates have been retained by the banks, rather than passed along to consumers. With the banks serving as the Fed's only transmission mechanism for monetary policy, this is not only unfortunate, it's unconscionable. 

Dark Clouds on the Horizon

It's that time of year again when financial markets are dominated by trading for year-end tax purposes, to clean up portfolios and to window dress statements for investors. Volatility is expected. This December certainly hasn't disappointed, with triple digit swings in the DJIA in each of its eight trading days.

But beyond the customary year-end positioning, there's a sense of real trouble brewing in markets for 2016. Here's what concerns us about the economy and financial markets for the New Year:

Plunging Commodity Prices - By mid-year 2015, the Bloomberg Commodities Index fell to a 16 year low, falling to levels below that of the 2009 Great Recession. The Index has since continued its downward spiral through year-end in sectors ranging from oil to natural gas to precious and industrial metals. The plunge in commodities has taken with it resource laden emerging market currencies whose economies and production capabilities had boomed in prior years. The culprit, many suspect is China, having pulled back from its massive infrastructure build of years prior, its financing of still empty cities and its failed attempts to spur internal consumption. Of a scale never quite seen before, in December of 2014 Forbes reported that China had used more concrete in the prior three years than the US used in the entire 20th Century. With the spigot dialing down, demand for raw materials worldwide is plummeting. But our concern is that falling commodities prices bring with them more that just price deflation, but also income, employment and consumption implications, as producers realize substantially less income for the same resources and production expense. A recent New York Times article chronicled the impact of declining commodities here at home upon America's Heartland.

The Collapse of Emerging Markets - Emerging markets currencies have been falling throughout 2015, following devaluations in China and Vietnam and trading weakness in Russia, Turkey, Malaysia and Brazil. The plunge in EM is driven by commodities prices, but also by the high levels of US dollar denominated borrowings in these countries, and borrowers now faced with paying back their loans against a strongly appreciated dollar. But others have questioned whether the ephemeral commodities demand from China is only half the problem. The corollary concern is that ultra-loose monetary policy drove capital to flow into these markets, with that capital now being repatriated as GDP and return prospects for EM countries flounder. Foremost among troubled EM countries is Brazil, once a stalwart of the Emerging Market BRICs, now in a full-scale economic depression. Goldman Sachs believes that a developing crisis in EM is the third wave of the Great Recession; the first being the US housing crisis, the second the European Sovereign Debt Crisis (i.e., Greece, Portugal, Spain, etc.)

Distress in the High Yield Bond Market - Credit spreads in the high yield bond market have been blowing out all year, with CCC rated junk bond prices down 20% from mid-2014.  And bond maven, Jeff Gundlach, head of DoubleLine Capital believes the carnage is about to get a whole lot worse as the markets prepare for liftoff by the Fed.

Weakness in Retail - A slew of third-quarter earnings reports of retail giants Macy's, Nordstrom's and Tiffany's and smaller hot retailers like LuLuLemon, have sent share prices of these companies down 10-20% in a single day following their release of dismal same store sales, top line revenues and earnings. While some of this retail demand may have been made up by online shopping, it's unnerving in what it says about the state of bricks and mortar retail and the US consumer.

Shrinking Corporate Profits - Corporate earnings for 2015 Q4 are estimated to decline -4.3%. If so, it will mark the first three consecutive quarters of year over year earnings declines since 2009 Q3.  A total of 83 companies have issued negative guidance for 2015 Q4. With the S&P 500 currently trading at 17x forward earnings, shares prices could decline amidst falling earnings while still leaving us at historically high valuations. And if both earnings and multiples contract, look out below.

Fed Policy - the 800-pound gorilla of market worries is the Fed, as it prepares to raise interest rates for the first time in ten years. While some believe the impact has been built into the markets, given its long-telegraphed move, concern is growing that implementation may be far more difficult and disruptive to markets that anyone believed.

While there are other concerns looming that bullish investors tend to dismiss, arguing "the market likes to climb a wall of worry", adages aside, investors are wise to take note of what increasingly appears to be a gathering storm.

Can the Fed Raise Interest Rates?

With talk in financial markets this month once again focusing on a Fed rate hike, many are wondering, why so much controversy over a mere 0.25% rise in the Fed Funds rate? Viewed from this perspective, it is of course, puzzling. After all, the Fed Funds rate has been pegged to a range of 0-0.25% for seven years. Will a modest rise in the range to 0.25-0.50% even make a difference?

In terms of corporate and consumer borrowing costs, an increase in the Fed Funds rate of this magnitude will do little to slow borrowing and investment. The concern in financial markets, though, is increasingly focused on how the Fed gets there. Even in this topsy-turvy world of the Federal Reserve, the Fed can't simply will it and it will be so. In other words, the Fed will be required to intervene in financial markets to engineer a rate rise, even as small as 0.25%. And given the massive amounts of liquidity it has supplied, this may not be easy.

Fed policy is largely carried out through Open Market Operations: the buying and selling of US treasury securities between the Fed and its universe of primary dealers, typically large Wall Street banks. These banks are required to bid on the sale and purchase of securities at the Fed's request. While the Fed does buy and sell securities directly, as it did to the tune of $4 trillion through its program of Quantitative Easing, its operations are more commonly carried out in the market for repurchase agreements.

Repurchase agreements, or REPOs, involve short-term loans secured by the pledge of US treasury securities as collateral. When the Fed wants to loosen monetary policy, or increase liquidity, it does so by lending to the banks through the REPO market. Banks pledge US treasuries against short term loans from the Fed. The flow of cash (or credits) to the banks, increases liquidity in the banking system.

Now, to drain liquidity and drive the trading range of Fed Funds higher, the Fed does the exact opposite, or as they have imaginatively called it "Reverse REPOs". In reverses, the Fed pledges its collateral against short term borrowings from the banks. The operation serves to drain reserves from the banking system, thereby tightening credit and raising short-term interest rates.

This is all basic to the monetary system. The question that now arises is just how much reverses the Fed must do to get the desired 0.25% effect on the Fed Funds rates. For this, no one really knows. After all, we're through the looking glass on everything that financial markets professionals have learned in business school. This remains the question and that is why markets are so focused on not only when, but how, the Fed will drive interest rates higher.

A Bloomberg article of Sep 16, 2014, estimated the volume of reverse repos necessary to drive interest rates higher at $250 million per day. A hefty chunk of change. But that was a good fifteen months ago. An article in US Today from earlier this year questioned not how much, but whether or not the Fed could raise interest rates. From their report: "Nobody's ever done this before," says Jon Faust, director of the Center for Financial Economics for Johns Hopkins University and special adviser to the Fed's board of governors until last September."  Their argument being, that with $2.5 trillion of excess reserves in the banking system, the Fed has lost the ability to engineer monetary policy with anything less than dramatic intervention in the financial markets. 

But a recent article by the Mises Institute goes even further, questioning whether the Fed even has the tools any longer to effectively raise rates. They highlight Japan's dismal experiment with monetary policy that has now led to sub-1% interest rates for twenty years. One way or the other, it looks like we may soon find out the answer.

Why the GOP's Flat Tax is a Terrible Idea

Over the past few weeks, GOP presidential hopefuls began offering their views on US tax reform. From Rubio to Cruz to Ben Carson, the idea of a flat tax, a single tax rate applied to all taxpayers, has become the rallying cry of GOP candidates. Simple, swift, fair, except for the fact that it would be an outright disaster. 

In October, the Wall Street Journal ran an opinion column by GOP candidate Rick Santorum entitled, A Flat Tax is the Best Path to Prosperity, heralding the coming of a new, just and simplified tax system. In it, Santorum proposes a single tax rate of 20% that would be applied to all income in the US. His plan would eliminate the marriage penalty, the death tax and the alternative minimum tax, pernicious taxes paid by a great number of Americans. In its place, each taxpayer would be given a $2,750 standard deduction, as most other deductions and credits would be eliminated. Santorum estimates that his tax plan will reduce federal tax receipts by $1.1 trillion over ten years, to be paid for in part, he explains, by repealing Obamacare. Hmm.

But a flat tax ignores several important realities about the US economy and its tax base. First, among these is the fact that 43% of American taxpayers pay nothing in federal income tax. Moreover, roughly 14% of US households pay neither federal income taxes nor payroll taxes (with two-thirds of these taxpayers being elderly). The reason for the low rate of tax participation, according to the Tax Policy Center, is fairly straightforward: half simply earn too little, while the other half reduce their taxable income through the earned income and child tax credit.

Now we can argue that these individuals are not paying their fair share, but the fact is, a flat tax would devastate these households, already stressed to make ends meet on marginal incomes. Moreover, tax collections from this population, in light of their resources would make this proposal not only unfair, but also highly unlikely.

Now the question remains, if 43% of taxpayers pay no federal income taxes, who does pay? Apparently, 83% of the $1.26 trillion in total US income taxes collected in 2014 came from the top 1/5th of taxpayers. The top 20% accounted for 51% of total US personal income and 83% of total personal income taxes (the reason the latter number is higher than the first is, of course, due to the progressive tax system currently in effect).  

A flat tax of 20% would greatly reduce the income collected from this higher income group, while doing little to raise tax collections from the 80% of US taxpayers that account for the remaining 17% of total federal income tax. In short, a flat tax would be a disaster. And while proponents of the flat tax will argue that lower tax rates will incentivize greater production and therefore raise the total level of income subject to tax, there's simply no reliable data to support this conclusion. As we enter the new year, the GOP needs to drop the flat tax and move on to a more sophisticated tax plan if it intends to capture the imagination of the voting public.

Award-Winning Finalist in the Business: Personal Finance/Investing Category of the 2015 USA Best Book Awards

Up In Smoke: How the Retirement Crisis Shattered the American Dream was awarded the Finalist designation in the 2015 USA Best Book Awards category of Business: Personal Finance/Investing.  The book was one of two finalists in the category and the only self-published work to receive this award. Up In Smoke chronicles the underpinning of a crisis in American retirement funding from Social Security to public pension systems, 401(k), IRA and private retirement savings accounts. It is required reading for anyone interested in the state of US retirement savings, the implications for the US economy and the crisis facing 70 million baby boomers now approaching their retirement years. The full list of 2015 USA Book Award recipients can be found here.

Why You Need to Pay Attention to the Retirement Crisis (even if your retirement is fully funded)

A recent survey in Forbes of attitudes toward retirement revealed 18% of Americans believe they are very prepared for the expenses of retirement. A report of the Employee Benefit Research Institute, however, estimates that 43% of Americans believe they are unprepared. The remaining 39% are uncertain about their ability to support themselves in retirement. Many of those who are unprepared believe the government will find a way to support them in their golden years. While those comfortable in their own plans believe the retirement crisis is simply "not their problem". Both groups are wrong. Here's why.

Currently in America, half of pre-retirees (age 55-64) have no retirement savings, while the half that do show median savings of $111,000. The median retirement savings of this age cohort as a whole (including both those with and those without funded accounts) is only $14,000. By 2030, just fifteen years from now, Americans age 65 and over will total 70 million. Half, or 35 million people, will have no retirement savings. The median balance of those with savings will support retirement income of about $370 per month. So, another 17.5 million will be grossly underfunded in their retirement savings. Roughly 9% of this group, or 6.3 million work for public sector agencies, often with good retirement plans and benefits. This means roughly 46 million people will neither have the benefit of public employee pension plans, nor adequate personal retirement savings. By 2030, US total population is projected to be on the order of 375 million people, so this group of economically distressed seniors will represent an estimated 12.3% of the nation's population.

First, as to why the government can't make this problem go away. The 2015 Trustees Report of the Social Security Administration shows a projected date of insolvency of the Social Security Trust fund of 2034. By that date, the Trustees predict, Social Security will only be able to pay roughly 75% of annual benefits. Now, median annual benefits of Social Security last year were just $15,000, so (in current dollars) median benefits would be reduced down to $10,000 per year (75% of $15,000), substantially below the poverty line. For the fund as a whole, the present value deficit of Social Security today, again per the Trustees report, is a staggering $10.7 trillion.

Now, why this is your problem, even if you believe it is not. If you've been reading along, you have a sense of the magnitude of the retirement crisis and can begin to imagine the consequences to the economy of a burden of 46 million seniors living in poverty. But consider this. In addition to the under-funding of personal retirement accounts and Social Security mentioned above, US state and local government pension plans are underfunded by an estimated $4 trillion. These are funds that governments are legally responsible to pay retirees. To raise the funds necessary to pay their pension obligations, governments will turn to...taxpayers. There is no one else. Now, don't shoot the messenger, as bad as the problem is, it's still better to be aware of the issue now, while some solutions still exist. 

If you'd like to read more about the retirement crisis and what can be done about it, please check out my new book, Up In Smoke: How the Retirement Crisis Shattered the American Dream, available now on Amazon.com.