Engineering Regular Income and Profits from Your Trading

Today's article is from my trading partner, Brian McAboy of Inside Out Trading.  Brian is a retired engineer and has a rather unconventional yet very effective approach to helping people become successful traders.  He's been helping traders for over 11 years, so he's been around long enough to know what works and what doesn't.

Take just a minute for this.  You'll be glad you did.

There are two very specific success traits that pertain to you and your trading. The first one is absolutely necessary for you to give yourself a reasonable chance of making it. And the second one is to keep you from wasting tons of time, money and psychological capital

Now as you know, trading is not a "get rich quick" kind of activity. This is NOT a place where anyone off the street can stroll in, grab a system, start throwing money at the markets and live happily ever after. Just doesn't work like that

Trading IS a true profession, a skill based occupation, and not a place for the squeamish or weak of heart. So for a person to expect to be "living the lifestyle" overnight is just not realistic. But the question then becomes, "How long should it realistically take?"

Too many traders let things go way too long in a less than satisfactory state

They simply let time to continue to pass, doing things generally the same way they have been for months on end, with the same disappointing results, well beyond what is really a reasonable time to allow

You see, there are generally two aspects of patience when it comes to trading:

1. You have to be patient enough for things happen, for your trading to develop and mature.
2. The other side of patience is knowing when you've reached a point where it's pretty obvious that your current approach just isn't working and it's time to stop, reassess, and change course.

"How long should it take?" is a common question, and the real answer is that you can get to the point of real, business like, reliable consistent profits in 3 to 6 months, a year at the outside

If it's taking YEARS, then something is wrong and you're really just spinning your wheels, wasting time and money and cheating yourself out of the success that you should be enjoying. There is also a huge personal cost to letting things take longer than they should

One trader expressed this very well,

"I've been trading futures for about 9 years now with inconsistent results.  I've made the usual mistakes, buying too many courses, focusing on the results not the process and being too impatient to trade to wait for valid setups. 

After listening to your video this weekend where you make the distinction between being patient in the beginning and giving yourself time, and beyond a certain point (3 - 6months) considering that it may be time to be impatient about your progress, this made me realize I've been allowing myself to coast for far too long, and that's impacted my confidence and the belief that I can turn trading into a business with a consistent return." 

Complacency, NOT being impatient when it's time to, is one of the biggest cost centers many traders have

There's the financial cost of missed profits and unnecessary losses, plus the opportunity costs of not enjoying the fruits of your time being spent on other matters of course, but she noted the personal, psychological cost as well

The thing is, you chose trading so that you could have freedom, financial and time freedom, not a J-O-B. You wanted trading to be a truly enjoyable activity that generates income and wealth and provides security and peace of mind

If you've been trading for more than a year, and your trading is not where you want it to be, nor is it really even close, and looking at the trajectory that you're now on, it doesn't look like you're going to get there anytime soon, then perhaps it's time to consider a different approach. That's why I suggest that you check out the training masterclass I created for you

Here are the details on the masterclass,

 "Rewrite Your Trading Story"

How to become a confident, consistent and profitable trader in 60 days or less even if you've never had a profitable month.

Here's what you will discover....

• The "Little 3" and the "Big 3" and Why the Wrong Focus Will Have You Chasing Profits Forever
• "The Gap" and How It Keeps Traders Jumping From One System to the Next, Without Ever Realizing The 'Easy Consistent Profits' Promised by the System Sellers
• One Specific 'Hidden' Lie Traders Tell Themselves That Continually Drains Your Time, Capital and Confidence
• Why Self Sabotage Goes On For YEARS For Most Traders, And How To Permanently Eliminate It From Your Trading
• The Four Stage Process To Make YOUR Trading Profitable And Predictable

Click here to register and move the needle in your trading

See you in the markets!
Brian McAboy
Trading Business Coach

Is 70 the New 65?

By John Mauldin

As some of us know far too well, forecasting the future with any precision is extremely difficult. There’s at least one exception to the rule, though. Population trends show themselves decades and even centuries in advance. If we know how many people were born in a given year, we can extrapolate what the population will look like far in the future.

On the other hand, demographic forecasting still requires assumptions. At what age will people start having children, and how many will they have? How will new medical advances affect life spans? When will people start working, stop working, and enter retirement? Small changes in any of those assumptions can quickly affect population numbers.

Today’s Outside the Box wrestles with that last question. In the United States we allowed the federal government to set 65 as the retirement age by making Social Security available to most workers at that point in their lives. The retirement age is going up to 67 for the younger members of the Baby Boom generation, but even that may be too “young” to retire in the future.

We Baby Boomers were never big on conformity. Voluntarily or not, a large number of us fully intend to stay in the workforce to age 70 and beyond. If 70 is the new 65, we will see significant changes in the ways people spend their money and the kinds of investments they want.

Matthew Tracey and Joachim Fels of PIMCO outline some of the possibilities in this report. I found it very interesting, and I think you will, too.

Speaking of things changing, the weather in Texas has been nothing like anything in the past. It is mid-February and I’m having to turn the air conditioner on at night. The forecasters tell us it’s going to get into the 80s on Friday. Talking with my long-term Texas friends, none of us can remember weather like this. Cooler than normal summers, milder than normal winters. I guess it’s a good thing it’s not like this every year, because then we’d have a wave of tax refugees showing up from California. Then again, this is Texas. If we wait a bit I’m sure we’ll get our usual ice storms and other nasty stuff. Winter is coming. Maybe.

I am struggling to keep up with the research my 20 some teams are developing for the chapters of The Age of Transformation. Thankfully I have a small team helping me review the research, which is on top of the research I’m doing for the five or so chapters that I’m personally writing. Plus, there’s my regular reading for doing the weekly letters and so forth. It is forcing me to sort through the pile of items in my inbox as to what is must read, what can wait, and what I just don’t have time for. I really am learning to depend on people to make sure the things that I must read get on my radar screen.

I’m going to go ahead and hit the send button, as I have to prepare for an interview with CNBC Asia on Japan and related topics. You have a great week, and I hope that wherever you are, your weather is as good as ours.

Your marveling at the speed of things changing analyst,

John Mauldin

70 Is the New 65: Demographics Still Support 'Lower Rates for Longer'

By Matthew Tracey and Joachim Fels
PIMCO.com, February, 2016
The so-called demographic cliff remains at least a decade away; meanwhile, global demographics should continue fueling the savings glut.

Is global aging about to end the savings glut? Some observers think so. More and more baby boomers are reaching retirement age, and they will soon not only save less but also start to dump their accumulated assets to fund retirement … or so the story goes. If this were true, the consequences for interest rates would be profound. The real long term equilibrium interest rate, which has been on a secular downtrend for decades partly due to strong working age cohorts saving hard for retirement, would start to rise – and what we here at PIMCO call The New Neutral might soon be history.

We strongly disagree with that thesis of an imminent demographics induced savings drought. Rather, we have argued in recent work that the global excess supply of saving over investment, which has been largely responsible for the secular decline in equilibrium interest rates, is not only here to stay but likely to increase further in the coming years for a host of reasons including demographics (see PIMCO Macro Perspectives, “No End to the Savings Glut,” September 2015). As a consequence, we continue to expect the fundamental forces of elevated desired saving to keep the equilibrium real rate depressed and to limit the extent to which other (cyclical) factors can drive up market interest rates.

However, given the popularity of the thesis that demographics will soon end the savings glut, we undertook a deep dive into the data to investigate the link among demographics, saving behavior and the demand for fixed income assets – with some surprising results. Here’s what we found.

A ‘demographic reversal?’ Not so fast!

People of the world, we’re getting old. It’s a well-known fact that, after decades of decline, the global dependency ratio – traditionally defined as the ratio of individuals younger than 15 and older than 64 to the working-age population aged 15-64 – is now rising (see Figure 1).

Some financial market observers argue that this demographic trend reversal will begin to drive interest rates higher, and soon. Why? First, a declining share of high-saving workers and a rising share of dissaving elderly will (the argument goes) erode the demand for saving – and drive interest rates higher via the savings-investment equilibrium. Second, these observers argue, a rapidly growing share of retirees will have to consume (i.e., sell down) their financial asset holdings to fund spending in retirement, and these drawdowns will create selling pressure in financial markets that pushes asset prices down and interest rates up.

Our core thesis in a nutshell: Yes, global aging may someday drive U.S. interest rates structurally higher. But “someday” remains at least a decade away – for two reasons. First, we proffer that global saving will remain stronger than many expect, supporting a low global neutral interest rate. (As investors, we care about the neutral rate because it anchors fixed income yields in the market.) Second, U.S. demographic demand for fixed income assets should remain robust until at least 2025 – and in the meantime should continue to put downward pressure on market yields, all else equal. Combine a low global “anchor” and strong domestic fixed income demand, and what do you get? Lower rates for longer in the U.S.

Continuing robust demographic demand for saving

Remember the link between saving and interest rates: In the savings-investment equilibrium, rising demand for saving pushes down the equilibrium (or neutral, or natural) rate of interest, all else equal, and vice-versa. Our task, then, is to assess how demographic changes affect aggregate saving. We find that the traditional “dependency ratio,” used in many other studies on this topic, is flawed.

We suggest two modifications to address those flaws. First, the young, considered “dependents,” contribute very little to global saving and dissaving in dollar terms (they’re “non-savers”). We therefore prefer to focus on the ratio of “Peak Savers” (mature adult workers who earn and save a lot) to “Elderly” (who save less as they age and ultimately consume their savings in retirement). Let’s preliminarily define “Peak Savers” as individuals aged 35 to 64, for two reasons:

• People 35–64 have generally exhibited much higher savings rates than people in younger and older age groups;
  
• People 35–64 earn considerably more income than people younger and older – so for any given savings rate, this age group’s saving behavior will have an outsized effect on saving and investment flows in dollar terms.
  

Let’s preliminarily define “Elderly” as everyone 65 and older (the traditional definition). Thus, the global Peak Savers versus Elderly ratio in Figure 2 reflects a static 35–64 Peak Saver cohort – and reveals what appears to be a demographic cliff in about year 2010. Those who argue that demographic support for saving will fall sharply in the coming years typically will try to prove their point using a ratio like this one.

But we ask: Is it sensible to define the Peak Saver and Elderly groups by the same static age ranges over long periods of time? Put differently: Might working and saving behavior evolve over time, warranting a dynamically modified dependency ratio? Seniors’ ability to work (and save) later in life should continue to rise; in our increasingly services-based “knowledge economy,” jobs are becoming less physically demanding and often require more experience, while advances in health technology boost functional age in life’s later stages. Seniors’ willingness (and incentives) to work longer also should rise along with their ability.

True, the retirement age, globally, has not kept pace with rising longevity. But policymakers are slowly catching on. In the U.S., the Social Security full benefit retirement age is increasing to 67 and will go higher still – a government incentive telling people to stay in the workforce. Meanwhile, years of low interest rates have left impending retirees playing catch up in retirement saving. More generally, around the world, longer lives must ultimately be supported by longer working lives. Anything less will prove unsustainable. Our colleague Jim Moore summed up the state of affairs (in the U.S.) in a PIMCO Viewpoint from 2012: “Work a little longer. Save a little more. Get by with a little less.¹

We think this insight applies abroad as well. In fact, global trends already underway support our argument that people will work later and later in life. In many economically important geographies – notably the U.S., eurozone, UK and Japan – senior (age 65+) labor force participation has been trending higher. And China is contemplating steadily raising its retirement age in the coming years.

However, what matters most for global saving demand are those who earn the most income. Consider the U.S. as an example. Top-income-quintile households control nearly two-thirds of U.S. household income, three-quarters of household wealth and more than 80% of household financial assets. Apart from the major social ramifications of wide (and widening) income and wealth inequality, the implications for aggregate saving are critical: Rather obviously, high earners’ working and saving behavior has an outsized effect on global saving in dollar terms.

If the highest earners are working (and saving) later in life, we should pay attention. Witness the dramatic rise in labor force participation within the top income quintile (Figure 3): Over 60% of top-quintile individuals in the 65–74 age group are employed or seeking work, a 19-percentage-point increase in participation over the 15 years through 2013. ² Moreover, participation among top-income-quintile seniors 75 and older has more than doubled over the same period.^4,/sup>

What about seniors’ late life saving behavior? Consider the top two income quintiles, collectively accounting for about 80% of U.S. personal income. Based on 2014 data from the BLS’s Consumer Expenditure Survey, these high earners exhibit no decline in savings rates as they enter retirement (due in part to a strong bequest motive and high conservatism). In Figure 4, note how high and consistent these top earners’ savings rates remain even in their late 60s and 70s.

(Aside: We find it curious that savings rates, based on the BLS’s Consumer Expenditure Survey, do not become negative for lower income quintile seniors even in their late 70s. We suspect that other data sources may show a negative savings rate for these elderly groups, likely due to methodological differences in data collection. Our focus here, however, is on age-related trends in saving behavior rather than savings rates themselves.)

To recap: The most impactful seniors are working (and saving) later in life as functional age and the duration of retirement both increase.³ Therefore, our preferred measure of the demographic support for saving is a dynamic, not static, ratio that accounts for the trend toward longer working lives. Let’s revisit our Peak Savers versus Elderly ratio from Figure 2. In decades past, age 64 may well have been the sensible upper bound for the Peak Saver group.

But what about the coming decades? In Figure 5, we have added a dynamic ratio (red line) that assumes seniors work roughly five years later in life in 2050 than they did in 2000. In other words, our age definition of “Peak Saver” evolves dynamically from 35–64 in 2000 to 35–69 by 2050, and consequently our definition of “Elderly” evolves dynamically from 65+ to 70+ over the same period.

What a different picture the dynamic ratio paints! It suggests that demographic support for saving could well be as strong a decade from now as it has been in recent decades – and illustrates the extent to which traditional static ratios may be flawed.

We concede that our dynamic ratio forecast is only a guess as to what the future may look like if current trends persist. But there is some method to the madness. For example, the reason we start to phase the 65- to 69 year olds into our Peak Saver group specifically in 2000 is that senior labor force participation began to rise rapidly in that year (after two stagnant decades).

Our five years later in life by 2050 employment assumption is slightly more arbitrary, but reasonable given that, globally, the largest increases in retirement age likely lie ahead of us. And our dynamic ratio does not account for the rising share of seniors 70+ who remain working, introducing an element of conservatism to our assumptions. So while our dynamic ratio embeds some simplifying assumptions, to be more scientific risks missing the forest for the trees.

Almost regardless of the assumptions used, if you define a dependency ratio dynamically – based even loosely on observable trends – you are likely to paint a very different (and more accurate) picture of the future than you will paint using a static ratio.

What about the rest of the world? It appears we’ve made an argument about global demographics supported mainly with U.S. data. However, publicly available data for other economically significant regions does not permit as granular an analysis as we have shown for the U.S. We do have reason to believe similar trends are occurring outside the U.S.: Elderly labor force participation is rising in Europe, the UK and Japan, and some countries – including China – are contemplating raising the retirement age.

In Japan, whose demographic cliff materialized many years ago, senior labor force participation has been trending higher, and as a result the labor force shrank only about 0.8% over the past decade even as the “working-age population” (aged 15 to 64) fell almost 9%. Patterns like this one are likely to repeat in other aging countries as societies adapt to meet their demographic challenges.

Bottom line: The people who move the needle most in saving demand, the highest earners, are the people working and saving later in life. This trend should be a tailwind for saving demand in the years to come that will push the global demographic cliff at least a decade into the future – and support a low global neutral interest rate, per the savings-investment equilibrium. 70 is the new 65!

U.S. household (demographic) demand for fixed income assets: a decade-long tailwind for bonds

We’ve just argued that demographics should help keep the global neutral rate low over the coming decade – which means that market yields in the U.S. should have a low “anchor.” But waves of baby boomers are retiring (albeit, as we have argued above, increasingly later), and many will eventually draw down (i.e., sell) their financial asset holdings to fund late life consumption. Are we fast approaching the point when boomer drawdowns create selling pressure in fixed income markets that pushes interest rates higher? Or might U.S. aging (boomers included) actually bolster the (net) demand for bonds and help maintain a low ceiling for market yields?

Consider two key observations.

• First, as we should expect, investors generally de-risk away from equities and toward fixed income with age – most aggressively once they reach their 60s (and beyond).⁵
  
• Second, individual asset accumulation and drawdown patterns vary significantly by income level. In the U.S., individuals in the lowest income quintile tend to sell their limited financial assets beginning in their 50s and completely exhaust their assets by, or before, death (relying on social assistance to meet their basic needs in life’s latest stages). Middle-income individuals tend to draw down financial assets beginning in their 60s but not at a rate that would deplete their assets before death. Individuals in the highest income quintile, however, are shown to have rising financial asset balances until roughly age 80 (after which they decline only very gradually). In other words, for top-income-quintile individuals, portfolio drawdowns don’t tend to begin until roughly age 80 (an important point). 
  

The highest earners have historically been able to fund retirement consumption from income (generally employment income, investment portfolio income and annuitized income), “leaving their financial assets virtually untouched.”⁶Here’s the key: Top-income-quintile households own over 80% of U.S. household financial assets. Consider how significantly this group’s future asset accumulation and drawdown profile will impact financial markets!

Back to our question about whether U.S. demographics will be a headwind or tailwind for bond flows in the years ahead. For starters, we assess when (demographics-driven) bond buying might peak relative to bond selling. We define “Bond Buyers” as individuals aged 60–74 and “Bond Sellers” as individuals 80 and older.

These age definitions are somewhat arbitrary, but they’re based on the two previously introduced empirical observations about households in the top quintile of the U.S. income distribution (which hold over 80% of U.S. household financial assets):

1. Bond buying tends to peak during individuals’ 60s and early 70s (aggressive de-risking);
   
2. Bond selling tends to peak in the years after age 80 (as individuals sell down their financial assets to fund consumption in retirement).
   

Figure 6 shows the ratio of Bond Buyers to Bond Sellers, which we use to gauge when net demographic buying demand might theoretically peak. On this metric, U.S. demographic demand for bonds should continue to rise in the next five years or so before peaking and may still be as strong in 2025 as it is today. (Our age definitions are based on patterns observed among U.S. households, so we focus primarily on the blue U.S. line in the figure. We include a global version of the Buyers versus Sellers ratio as well – the green line – which reveals an even later potential peak in global demographic demand for bonds.⁷

Our interpretation of this Buyers versus Sellers ratio assumes that each buyer exerts about the same influence on markets as each seller, an assumption that may be conservative given high-earning sellers draw down their portfolios only very gradually, whereas buyers likely will be de-risking aggressively in their 60s and early 70s. We “stress test” this assumption and result with scenario analysis in the Appendix.

Next, we explore the demographics of U.S. financial asset ownership at a very high level. Figure 7 shows household financial asset holdings by both age and income.⁸

^{Click to enlarge}

The lion’s share of the $31 trillion in U.S. household financial assets⁹ ($21 trillion, or about 70%) is held within – or over the next 10 years will be held within – age cohorts that typically need to grow their fixed income allocation. This $21 trillion, outlined in green in Figure 7, is expected to remain in an accumulation or de-risking phase and won’t enter a drawdown phase within the next decade (based on the age-related asset drawdown patterns we described earlier). This $21 trillion will likely be a demographic tailwind for bonds over the next decade (especially for municipal bonds given high earners’ need for tax-free income). Conversely, only about $5 trillion (approximately 15%) of household financial assets seems likely to be a headwind for bonds during this period (outlined in red).

One caveat: Many factors other than demographics influence investors’ asset allocation decisions – among them changes in valuations, evolving expectations about future asset returns, individual risk preferences, U.S. investor preference for domestic versus foreign assets, foreign investor preference for U.S. assets, and market disruptions that may trigger significant portfolio rebalancing. Our analysis here focuses only on demographic effects, holding all else equal.

Now let’s go a level deeper. In the Appendix we model the potential demographics-related asset flows we might see over time from the gradual de-risking and drawdown of household financial assets. We analyze 10 unique scenarios in order to test a range of assumptions. Our “baseline” scenario reflects a set of assumptions about de-risking behavior and asset decumulation that we think is realistic (and possibly conservative) based on historical patterns. Our modeling suggests that U.S. demographics driven fixed income inflows are likely to be almost as strong 10 years from now as we project them to be today – and that demographics may not be a material headwind for bonds until the 2030s.

How can we explain these conclusions? In our analysis, for at least the next decade, de-risking flows and rebalancing flows into fixed income more than compensate for seniors’ portfolio drawdowns. In stress testing our baseline assumptions we found it hard to come up with a plausible scenario in which U.S. demographics become a fixed income headwind within 10 years. Yet we found it easy to imagine realistic scenarios in which demographic demand for bonds remains robust for the next 15 years or more.

Consider as an example the high-earning elderly, for whom longevity risk is rising rapidly as life-extending medical technologies proliferate. High earners, historically, have been overly cautious in recalibrating their spending to meet anticipated future needs – a finding that could warrant an even more gradual asset-drawdown trajectory for this next generation of retirees than we have modeled based on historical experience. See the Appendix for our assumptions, baseline scenario modeling and alternative scenarios.

A brief aside: Our focus here has been U.S. demographics and, implicitly, U.S. fixed income. However, U.S. demographics are likely to influence global fixed income markets given U.S. households account for over 40% of global household financial assets. For context, Western Europe and Asia each account for about 25%.¹⁰

Finally, a quick note on changes in the composition of household retirement savings. The shift from defined benefit (DB) to defined contribution (DC) plans in the U.S. persists, and in our estimation U.S. DB plans hold a lower allocation to bonds than a market-average glide path suggests is optimal for DC participants.¹¹ In aggregate, therefore, the continued shift toward DC may represent an additional tailwind for bonds in the coming years.

Bottom line on U.S. aging and the demand for bonds: Persistent demographic support for fixed income should, all else equal, drive net flows into bonds and help maintain low yields over the next decade.

‘Speed read’ and key conclusions

Some financial market observers believe in the following dramatic scenario:

• We’ve just gone over a demographic cliff; globally, the ratio of high-saving adult workers to dissaving elderly is now declining. This demographic reversal will erode the demand for saving.
  
• The global savings glut will reverse as the demand for saving falls, pushing the global neutral interest rate higher.
  
• Baby boomers in the U.S. will compound the problem as they sell their financial assets (including bonds) to fund retirement consumption, driving U.S. fixed income yields higher.
  

In this note, we challenge traditional thinking about the timing of the feared “demographic cliff.” A demographics-induced structural rise in U.S. interest rates remains at least a decade away:

1. Global demand for saving will remain robust, supporting a low global neutral interest rate (the “anchor” for U.S. fixed income yields):
   • Traditional dependency ratios – which use fixed, static age definitions – are flawed because they fail to account for how the world is changing.
     
   • U.S. elderly, especially the highest earners, are working and saving later in life. High earners matter a lot because they drive the lion’s share of global saving. 70 is the new 65.
     
   • Similar trends can be observed in economically significant economies outside the U.S.
     
   • We argue for a dynamic, not static, ratio of mature adults to elderly that does account for how working and saving behaviors are changing. Our dynamic ratio suggests that demographic support for saving may be as strong over the next decade as it has been over the past several. Possibly stronger.
     
   • Strong saving demand should support a low global neutral interest rate in the coming years – and should continue fueling the global savings glut.
     
2. In financial markets, strong U.S. demographic demand for fixed income assets should – all else equal – help maintain low U.S. bond yields over the next decade:
   • The lion’s share of U.S. household financial assets is held within age cohorts that will need to grow their fixed income allocation over the next ten years.
     
   • Top-income-quintile households own over 80% of these assets, and high earners sell financial assets only very gradually in retirement to fund consumption.
     
   • For another decade or more, demographics should remain a net contributor to fixed income flows, as high earners’ de-risking into bonds should dominate bond outflows due to portfolio drawdowns.
     

Combine a low global neutral interest rate and strong domestic demand for bonds, and what do you get? Lower rates for longer in the U.S.
The authors would like to thank PIMCO colleague Jim Moore for his contributions.

Appendix: U.S. household financial assets and fixed income flows – scenario analysis

This Appendix details the assumptions used in our baseline scenario for U.S. (demographics-driven) fixed income flows and offers a number of alternative scenarios.
Baseline scenario assumptions:

• Financial asset portfolios consist of two asset types (for simplicity): “risk assets” (excluding fixed income) and fixed income.
  • Long-term annual risk asset return: 5% nominal.
    
  • Long-term annual fixed income return: 2.5% nominal.
    
• Investors de-risk their portfolios into fixed income over time according to a market-average glide path,¹² interpolated as necessary. (We conservatively assume that de-risking into fixed income ceases at age 75 and that investors’ asset allocations remain constant thereafter. This assumption is driven by a lack of available data on market-average glide path allocations for ages older than about 75.)
  
• Each year, top-income-quintile households re-optimize to draw down 50% of their financial assets by the end of their planning horizon, beginning at age 80 and ending at age 95. (50% may be a conservatively high drawdown percentage.)
  
• Each year, households in the bottom four income quintiles re-optimize to draw down 75% of their financial assets by the end of their planning horizon, beginning at age 65 and ending at age 90. (75% may be a conservatively high drawdown percentage.)
  
• Financial asset drawdowns occur proportionally across risk assets and fixed income. (This assumption is fair to conservative, given there is evidence that people draw down their riskiest assets first.¹³)
  
• Financial asset portfolios do not exist in perpetuity; mortality effects (based on the most recent mortality tables from the Society of Actuaries) lead to bequests that generate “re-risking” flows from fixed income into risk assets.¹⁴
  

Alternative scenarios:
Each alternative scenario represents a modification relative to our baseline scenario.

• Alternative 1: De-risking into fixed income proves significantly faster than expected (ultimate fixed income allocation of 50% is reached 10 years earlier than baseline glide path suggests).
  
• Alternative 2: De-risking into fixed income proves significantly slower than expected (ultimate fixed income allocation of 50% is not reached until 10 years after baseline glide path suggests).
  
• Alternative 3: Seniors 50+ ultimately de-risk much less significantly than baseline glide path suggests (fixed income allocation reaches 15% at age 50, per glide path, but then flat-lines for 10 years before gradually increasing to a level only half that suggested by baseline glide path, i.e., a terminal allocation of 25% instead of 50%).
  
• Alternative 4: Annual fixed income returns equal annual risk asset returns, such that market-return-driven rebalancing flows no longer support fixed income (5% annual nominal return assumed for both asset types). (This scenario has a natural hedge property; if ex ante fixed income returns ever were expected to equal ex ante risk asset returns, the relative attractiveness of fixed income probably would increase on a risk-adjusted basis, likely triggering non-demographics-related reallocations into fixed income – which we have not modeled here.)
  
• Alternative 5: Top-income-quintile households re-optimize each year to ultimately draw down 75% of their financial assets by the end of their planning horizon, while households in the bottom four quintiles re-optimize to draw down 100% (for both groups, a far higher drawdown percentage than is likely).
  
• Alternative 6: Top-income-quintile households commence drawdowns a full decade earlier than history suggests is likely, i.e., at age 70 (if anything, as life expectancies and planning horizons lengthen, one might expect drawdowns to begin later).
  
• Alternative 7: A combination of alternatives 5 and 6 (i.e., a highly conservative mix of assumptions).
  
• Alternative 8: Households commence drawdowns five years later and lengthen their planning horizon by five years (optimistic, but plausible given rising longevity risk and rising labor force participation among the high-earning elderly).
  
• Alternative 9: Top-income-quintile households re-optimize to draw down 25% of their financial assets by the end of their planning horizon (instead of 50%), consistent with a high bequest motive and historical excess conservatism during retirement.
  

The chart below shows our estimate of future demographics-driven U.S. household fixed income flows by scenario. These projections are NOT meant to be interpreted as forecasts of the actual dollar volume of flows, in part because the $31 trillion stock of household financial assets used to model these flows omits certain large asset pools (see our technical note further on). So focus on the trends depicted, not on the dollars.

As you can see in the chart, across almost all of our scenarios demographics remain a fixed income tailwind for the next 10 years, and in most scenarios longer. Note that this analysis may lean conservative in that we have modeled potential flows based only on the existing stock of financial assets. Yet every year, mature adult workers (especially the high income earners) will invest some portion of their savings in financial assets, including bonds, both inside and outside their retirement plans. These flows, all else equal, represent a tailwind for all financial assets that we haven’t attempted to model.

Finally, a technical note on our primary source for U.S. household financial asset data: the Federal Reserve’s 2013 Survey of Consumer Finances. To our knowledge, there are two primary sources for U.S. household balance sheet detail: the Federal Reserve’s Survey of Consumer Finances (“SCF”), a triennial survey of a cross-section of U.S. households, and the U.S. national flow of funds accounts. We use the SCF, which is widely used in Federal Reserve analysis, academic research at major economic research centers, and private financial industry analysis and writings. The SCF is, to our knowledge, unparalleled in its demographic granularity across age groups, income quintiles and other key variables.

Significant differences are worth highlighting between the SCF and the household balance sheet data contained in the U.S. national accounts. Of note, the 2013 SCF excludes about $19 trillion in DB pension entitlements and $2.4 trillion in assets of nonprofit institutions. As a result of these and certain other omissions, the SCF identifies a materially lower total value for U.S. household financial assets than the national accounts identify. The question, for us, is whether there is any reason to think that the omissions made by the SCF, notably DB pension entitlements, will bias our results. 

We see no obvious bias. At a high level, DB pension plan asset allocations tend to be a function more of the level of interest rates and plan funding status than of the age profile of plan beneficiaries. Also, as we’ve argued in the body of our note, as the U.S. shifts from defined benefit to defined contribution schemes we may see additional support for fixed income given that DB plans seem to allocate less to bonds than a market average glide path suggests is optimal for DC participants. For these reasons, we think using a source that excludes DB pension entitlements likely leads us – if anything – to underestimate demographics-related fixed income demand over the next decade.

See the recent research paper linked below, from the Federal Reserve, for a more detailed explanation of the differences between SCF data and data from the U.S. national flow of funds accounts, as well as a defense of the use of SCF data in economic research: http://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf

Works consulted

• Mercedes Aguirre and Brendan McFarland, “2014 Asset Allocations in Fortune 1000 Pension Plans,” Towers Watson, October 2015.
  
• Robert Arnott and Denis Chaves, “Demographic Changes, Financial Markets, and the Economy,” Financial Analysts Journal Volume 68 Number 1, 2012.
  
• Charles Bean et al., “Low for Long? Causes and Consequences of Persistently Low Interest Rates,” Geneva Reports on the World Economy 17, International Center for Monetary and Banking Studies, October 2015.
  
• Lisa Dettling et al., “Comparing Micro and Macro Sources for Household Accounts in the United States: Evidence from the Survey of Consumer Finances,” Finance and Economics Discussion Series 2015-086, Washington: Board of Governors of the Federal Reserve System, 2015.
  
• “The Eurosystem Household Finance and Consumption Survey,” Statistical Paper Series No 2, European Central Bank, April 2013.
  
• “2013 Survey of Consumer Finances (SCF),” Federal Reserve, September 2014.
  
• Michael Gapen, “Demand for safe havens to remain robust,” Barclays Equity Gilt Study, February 2013.
  
• Michael Gavin, “Population dynamics and the (soon-to-be-disappearing) global ‘savings glut,’” Barclays, February 2015.
  
• Charles Goodhart et al., “Could Demographics Reverse Three Multi-Decade Trends?” Morgan Stanley, September 2015.
  
• Dr. Michaela Grimm et al., “Allianz Global Wealth Report 2015,” Allianz SE, August 2015.
  
• Markus Lorenz et al., “Man and Machine in Industry 4.0: How Will Technology Transform the Industrial Workforce Through 2025?” Boston Consulting Group, September 2015.
  
• Dr. Susan Lund, “The Impact of Demographic Shifts on Financial Markets,” McKinsey Global Institute, June 2012.
  
• “Pension Markets in Focus,” The Organisation for Economic Co-operation and Development, 2015.
  
• James Poterba et al., “The Composition and Draw-Down of Wealth in Retirement,” NBER Working Paper 17536, October 2011.
  
• Karen Smith et al., “How Seniors Change Their Asset Holdings During Retirement,” Center for Retirement Research at Boston College Working Paper 2009-31, December 2009.
  

¹ PIMCO Viewpoint “What’s Your Number at the Zero Bound”, by Dr. James Moore, 2012.
² 2013 represents most current data available.
³ Our argument would be even stronger if we could show that the personal savings rate among high-earning seniors in their late 60s and early 70s has been increasing over time (parallel to the rise in labor force participation). However, the BLS has advised us that a comparison between 2014 data and prior-year data may be misleading due to recent changes in survey methodology.
⁴ From 2000 to 2050, our dynamic ratio – mechanically – is a weighted average of two individual static ratios (35–64 versus 65+ and, separately, 35–69 versus 70+); the weights change each year to reflect our assumption about rising longevity.
⁵ See, for instance, “The Impact of Demographic Shifts on Financial Markets” (McKinsey Global Institute, 2012).
⁶ “How Seniors Change Their Asset Holdings During Retirement” (Smith et al, 2009).
⁷Validity of global Buyers versus Sellers Ratio depends on the extent to which asset accumulation-drawdown patterns among the high-earning elderly outside the U.S. mirror the patterns observed among U.S. elderly. We have not explored this question empirically and include the global ratio only for interest and context.
⁸ See Appendix for a technical note on our choice of the Federal Reserve’s Survey of Consumer Finances for U.S. household financial asset detail.
⁹ U.S. household financial assets, as depicted in the Federal Reserve’s 2013 Survey of Consumer Finances, total $31 trillion across all age groups.
¹⁰ Source: Allianz Global Wealth Report, 2015.
¹¹ For color on U.S. DB pension plan asset allocations, see, for example, the OECD’s “Pension Markets in Focus” (2015) and Towers Watson’s “2014 Asset Allocations in Fortune 1000 Pension Plans” (2015).
¹² Source: NextCapital.
¹³ See “Demographic Changes, Financial Markets, and the Economy” (Arnott and Chaves / CFA Institute, 2012).
¹⁴ For simplicity, we assume that anyone who dies younger than age 65 bequeaths assets to a spouse of comparable age (i.e., no change in asset allocation) while those who die at or after age 65 bequeath assets to someone (presumably children) 30 years younger (i.e., a generation earlier in risk tolerance). We recognize that not every elderly person bequeaths assets to a younger heir; some assets are passed on to charitable organizations and friends or other family members of comparable age, for instance. We assume, arbitrarily, that 50% of financial assets are passed to younger heirs. Our general results are not particularly sensitive to changes in these assumptions.

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The article Outside the Box: 70 Is the New 65 was originally published at mauldineconomics.com.

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The Options Market Has Changed and Here's Why

As you know, bigger changes in the market bring potential for bigger profits. This isn’t a new concept. However, I bring it up because Doc Severson just released a new video tutorial detailing a major change making its way through the options.

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See you in the markets,
Stock Market Club

P.S. What we’ve seen lately with how the global economy has affected U.S. markets is only part of the story....Get the full story here.

How the Chinese Will Establish a New Financial Order

By Porter Stansberry

For many years now, it’s been clear that China would soon be pull­ing the strings in the U.S. financial system. In 2015, the American people owe the Chinese government nearly $1.5 trillion.

I know big numbers don’t mean much to most people, but keep in mind… this tab is now hundreds of billions of dollars more than what the U.S. government collects in ALL income taxes (both cor­porate and individual) each year. It’s basically a sum we can never, ever hope to repay – at least, not by normal means. Of course, the Chinese aren’t stupid. They realize we are both trapped.

We are stuck with an enormous debt we can never realistically repay… And the Chinese are trapped with an outstanding loan they can neither get rid of, nor hope to collect. So the Chinese govern­ment is now taking a secret and somewhat radical approach.

China has recently put into place a covert plan to get back as much of its money as possible – by extracting colossal sums from both the United States government and ordinary citizens, like you and me.

The Chinese “State Administration of Foreign Exchange” (SAFE) is now engaged in a full fledged currency war with the United States. The ultimate goal – as the Chinese have publicly stated – is to cre­ate a new dominant world currency, dislodge the U.S. dollar from its current reserve role, and recover as much of the $1.5 trillion the U.S. government has borrowed as possible.

Lucky for us, we know what’s going to happen. And we even have a pretty good idea of how it will all unfold. How do we know so much? Well, this isn’t the first time the U.S. has tried to stiff its foreign creditors.

Most Americans probably don’t remember this, but our last big currency war took place in the 1960s. Back then, French President Charles de Gaulle denounced the U.S. government’s policy of print­ing overvalued U.S. dollars to pay for its trade deficits… which allowed U.S. companies to buy European assets with dollars that were artificially held up in value by a gold peg that was nothing more than an accounting fiction.

So de Gaulle took action...…

In 1965, he took $150 million of his country’s dollar reserves and redeemed the paper currency for U.S. gold from Ft. Knox. De Gaulle even offered to send the French Navy to escort the gold back to France.

Today, this gold is worth about $12 billion.

Keep in mind… this occurred during a time when foreign govern­ments could legally redeem their paper dollars for gold, but U.S. citizens could not. And France was not the only nation to do this, Spain soon re­deemed $60 million of U.S. dollar reserves for gold, and many other nations followed suit. By March 1968, gold was flowing out of the United States at an alarming rate.

By 1950, U.S. depositories held more gold than had ever been assembled in one place in world history (roughly 702 million ounces). But to manipulate our currency, the U.S. government was willing to give away more than half of the country’s gold. It’s estimated that during the 1950s and early 1970s, we essentially gave away about two thirds of our nation’s gold reserves, around 400 million ounces, all because the U.S. government was trying to defend the U.S. dollar at a fixed rate of $35 per ounce of gold.

In short, we gave away 400 million ounces of gold and got $14 billion in exchange. Today, that same gold would be worth $620 billion, a 4,330% difference. Incredibly stupid, wouldn’t you agree? This blunder cost the U.S. much of its gold hoard. When the history books are finally written, this chapter will go down as one of our nation’s most incompetent political blunders. Of course, as is typical with politicians, they managed to make a bad situation even worse.

The root cause of the weakness in the U.S. dollar was easy to understand. Americans were consuming far more than they were producing. You could see this by looking at our government’s annual deficits, which were larger than ever and growing… thanks to the gigantic new welfare programs and the Vietnam “police ac­tion.” You could also see this by looking at our trade deficit, which continued to get bigger and bigger, forecasting a dramatic drop (eventually) in the value of the U.S. dollar.

Of course, economic realities are never foremost on the minds of politicians – especially not Richard Nixon’s. On August 15, 1971, he went on live television before the most popular show in Ameri­ca (Bonanza) and announced a new plan. The U.S. gold window would close effective immediately – and no nation or individual anywhere in the world would be allowed to exchange U.S. dollars for gold. The president announced a 10% surtax on ALL imports!

Such tariffs never accomplish much in terms of actually altering the balance of trade, as our trading partners simply put matching charges on our exports. So what actually happens is just less trade overall, which slows the whole global economy, making the impact of inflation worse. Of course, Nixon pitched these moves as patriotic, saying: “I am determined that the American dollar must never again be a hos­tage in the hands of international speculators.”

The “sheeple” cheered, as they always do whenever something is done to “stop the speculators.” But the joke was on them. Within two years, America was in its worst recession since WWII… with an oil crisis, skyrocketing unemployment, a 30% drop in the stock market, and soaring inflation. Instead of becoming richer, millions of Americans got a lot poorer, practically overnight.

And that brings us to today…..
Roughly 40 years later, the United States is in the middle of anoth­er currency war. But this time, our main adversary is not Europe. It’s China. And this time, the situation is far more serious. Our nation and our economy are already in an extremely fragile state. In the 1960s, the American economy was growing rapidly, with decades of expansion still to come. That’s not the case today.

This new currency war with China will wreak absolute havoc on the lives of millions of ordinary Americans, much sooner than most people think. It’s critical over the next few years for you to understand exactly what the Chinese are doing, why they are doing it, and the near certain outcome.
Regards,
Porter Stansberry

(This is an adaptation of an article that was originally published in Porter's Investment Advisory.)
Editor’s Note: Because this risk and others have made our financial system a house of cards, we’ve published a groundbreaking step by step manual on how to survive, and even prosper, during the next financial crisis.

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The article was originally published at internationalman.com.

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Interested in Directional Trading Strategies?

The recent bear market has led a LOT of people to reconsider how to best trade it. And the best way might be directional trading. And the best person to show you how just might be Bruce Marshall of Simpler Options.

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He shows you LIVE how it works on October 7th from 8 - 10 pm est

Hope to see you there!
The Stock Market Club



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I still believe this is when everything changed for the average trader. It was only weeks later that the talking heads on CNBC were offering up their own versions and books about trading options in this way. That's right, I honestly believe that our good friend and trading partner John Carter of Simpler Options wrote the book on options trading. Literally.

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      See you in the markets,
      The Stock Market Club


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See you in the markets!
Ray @ the Stock Market Club



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The Stock Market Club

P.S.  While you are waiting for this weeks webinar take a minute to download Guy's free eBook and start learning some of his methods traders have been using for years.....Get Free eBook Here

Income Inequality? American Savers Treated Like Dogs

By Tony Sagami

One of the hot political topics these days is income inequality, but one of the groups of Americans that’s the most mistreated by Washington DC is the millions of Americans who have responsibly saved for their retirement.

When I entered the investment business as a stock broker at Merrill Lynch in the 1980s, savers could routinely get 7-9% on their money with riskless CDs and short term Treasury bonds.

In fact, I sold multimillions of dollars’ worth of 16 year zero coupon Treasury bonds at the time. Zero coupon bonds are debt instruments that don’t pay interest (a coupon) but are instead traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

At the time, long term interest rates were at 8%, so the zero coupon Treasury bonds that I sold cost $250 each but matured at $1,000 in 16 years. A government-guaranteed quadruple!

Ah, those were the good old days for savers, largely thanks to the inflation fighting tenacity of Paul Volcker, chairman of the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987.

Monetary policies couldn’t be more different under Alan “Mr. Magoo” Greenspan, “Helicopter” Ben Bernanke, and Janet Yellen. This trio of hear see speak no evil bureaucrats have never met an interest rate cut that they didn’t like and have pushed interest rates to zero.

The yield on the 30 year Treasury bond hit an all time record low last week at 2.45%. Yup, an all time low that our country hasn’t seen in more than 300 years!

These low yields have made it increasingly difficult to earn a decent level of income from traditional fixed-income vehicles like money markets, CDs, and bonds.

Unless you’re content with near-zero return on your savings, you’ve got to adapt to the new era of ZIRP (zero interest rate policy). However, you cannot just dive into the income arena and buy the highest paying investments you can find. Most are fraught with hidden risks and dangers.

So to fully understand how to truly and dramatically boost your investment income, you absolutely must look at your investments in a new light, fully understanding the new risks as well as the new opportunities. There are really two challenges that all of us will face as we transition from employment to retirement: longer life expectancies; and lower investment yields.

Risk #1: Improved health care and nutrition have dramatically boosted life expectancies for both men and women. We will all enjoy a longer, healthier life, which means more time to enjoy retirement and spend with friends/family, but it also means that whatever money we’ve accumulated will have to work harder as well as longer.

Today, a 65 year-old man can expect to live until age 82, almost four years longer than 25 years ago; the life expectancy for a 65 year old woman is also up—from 82 years in the early 1980s to 85 today.

The steady increase in life expectancy is definitely something to celebrate, but it also means we’ll need even bigger nest eggs.

Risk #2: Don’t forget about inflation. Prices for daily necessities are higher than they were just a few years ago and constantly erode the purchasing power of your savings.

The way I see it, your comfort in retirement has never been more threatened than it is today, and it doesn’t matter if you’re 20 or 70.

The rules are different, and you only have two choices:

#1. spend your retirement as a Walmart greeter (if you’re lucky enough to get a job!); or

#2. adapt to the new rules of income investing.

Today, the new rules of successful income investing consist of putting together a collection of income focused assets, such as dividend paying stocks, bonds, ETFs, and real estate, that generate the highest possible annual income at the lowest possible risk.

Even in an environment of near zero interest rates and global uncertainty, there are many ways an investor can generate a healthy income while remaining in control. Income stocks should form the core of your income portfolio.

Income stocks are usually found in solid industries with established companies that generate reliable cash flow. Such companies have little need to reinvest their profits to help grow the business or fund research and development of new products, and are therefore able to pay sizeable dividends back to their investors.
What do I look for when evaluating income stocks?

• Macro picture. While it’s a subjective call, we want to invest in companies that have the big-picture macroeconomic wind at their backs and have long-term sustainable business models that can thrive in the current economic environment.

• Competitive advantage. Does the company have a competitive advantage within its own industry? Investing in industry leaders is generally more productive than investing in the laggards.

• Management. The company’s management should have a track record of returning value to shareholders.

• Growth strategy. What’s the company’s growth strategy? Is it a viable growth strategy given our forward view of the economy and markets?

• A dividend payout ratio of 80% or less, with the rest going back into the company’s business for future growth. If a business pays out too much of its profit, it can hurt the firm’s competitive position.

• A dividend yield of at least 3%. That means if a company has a $10 stock price, it pays annual cash dividends of at least $0.30 a year per share.

• The company should have generated positive cash flow in at least the last year. Income investing is about protecting your money, not hitting the ball out of the park with risky stock picks.

• A high return on equity, or ROE. A company that earns high returns on equity is usually a better-than-average business, which means that the dividend checks will keep flowing into our mailboxes.

This doesn’t mean that you should rush out and buy a bunch of dividend-paying stocks tomorrow morning. As always, timing is everything, and many—if not most—dividend stocks are vulnerably overpriced.

But make no mistake; interest rates aren’t rising anytime soon, and the solid, all weather income stocks (like the ones in my Yield Shark service) will help you build and enjoy a prosperous retirement. In fact, you can click here to see the details on one of the strongest income stocks I’ve profiled in Yield Shark in months.


Tony Sagami

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Income Inequality? American Savers Treated Like Dogs was originally published at mauldineconomics.com.

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How Global Interest Rates Deceive Markets

By John Mauldin

 “You keep on using that word. I do not think it means what you think it means.”

– Inigo Montoya, The Princess Bride

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”

All right class, it’s time for an open book test. I’m going to give you a list of yields on various 10 year bonds, and I want to you to tell me what it means.

United States: 1.80%

Germany: 0.36%

France: 0.54%

Italy: 1.56%

UK: 1.48%

Canada: 1.365%

Australia: 2.63%

Japan: 0.22%

I see that hand up in the back. Yes, the list does appear to tell us what interest rates the market is willing to take in order to hold money in a particular country’s currency for 10 years. It may or may not tell us about the creditworthiness of the country, but it does tell us something about the expectations that investors have about potential returns on other possible investments. The more astute among you will notice that French bonds have dropped from 2.38% exactly one year ago to today’s rather astonishing low of 0.54%.

Likewise, Germany has seen its 10-year Bund rates drop from 1.66% to a shockingly low 0.36%. What does it mean that European interest rates simply fell out of bed this week? Has the opportunity set in Europe diminished? Are the French really that much better a credit risk than the United States is? If not, what is that number, 0.54%, telling us? What in the wide, wide world of fixed-income investing is going on?

Quick segue – but hopefully a little fun. One of the pleasures of having children is that you get to watch the classic movie The Princess Bride over and over. (If you haven’t appreciated it, go borrow a few kids for the weekend and watch it.) There is a classic line in the movie that is indelibly imprinted on my mind.
In the middle of the film, a villainous but supposedly genius Sicilian named Vizzini keeps using the word “inconceivable” to describe certain events. A mysterious ship is following the group at sea? “Inconceivable!”

The ship’s captain starts climbing the bad guys’ rope up the Cliffs of Insanity and even starts to gain on them? “Inconceivable!” The villain doesn’t fall from said cliff after Vizzini cuts the rope that all of them were climbing? “Inconceivable!” Finally, master swordsman – and my favorite character in the movie – Inigo, famous for this and other awesome catchphrases, comments on Vizzini’s use of this word inconceivable:

“You keep on using that word. I do not think it means what you think it means.”

(You can see all the uses of Vizzini’s use of the word inconceivable and hear Inigo’s classic retort here.)
When it comes to interpreting what current interest rates are telling us about the markets in various countries, I have to say that I do not think they mean what the market seems to think they mean. In fact, buried in that list of bond yields is “false information” – information so distorted and yet so readily misunderstood that it leads to wrong conclusions and decisions – and to bad investments. In today’s letter we are going to look at what interest rates actually mean in the modern-day context of currency wars and interest-rate manipulation by central banks. I think you will come to agree with me that an interest rate may not mean what the market thinks it means.

Let me begin by briefly summarizing what I want to demonstrate in this letter. First, I think Japanese interest rates not only contain no information but also that markets are misreading this non-information as meaningful because they are interpreting the data as if it were normal market information in a familiar market environment, when the truth is that we sailed beyond the boundaries of the known economic world some time ago. The old maps are no longer reliable. Secondly, Europe is making the decision to go down the same path as the Japanese have done; and contrary to the expectations of European central bankers, the potential to end up with the same results as Japan is rather high.

The false information paradox is highlighted by the recent Swiss National Bank decision. Couple that with the surprise decisions by Canada and Denmark to cut rates, the complete retracement of the euro against the yen over the past few weeks, and Bank of Japan Governor Kuroda’s telling the World Economic Forum in Davos that he is prepared to do more (shades of “whatever it takes”) to create inflation, and you have the opening salvos of the next skirmish in the ongoing currency wars I predicted a few years ago in Code Red. All of this means that capital is going to be misallocated and that the current efforts to create jobs and growth and inflation are insufficient. Indeed, I think those efforts might very well produce a net negative effect.

But before we go any farther, a quick note. We will start taking registrations for the 12^th annual Strategic Investment Conference next week. There will be an early bird rate for those of you who go ahead to register quickly. The conference will run from April 29 through May 2 at the Manchester Grand Hyatt in San Diego.

For those of you familiar with the conference, there will be the “usual” lineup of brilliant speakers and thought leaders trying to help us understand investing in a world of divergence. For those not familiar, this conference is unlike the vast majority of other investment conferences, in that speakers representing various sponsors do not pay to address the audience. Instead, we bring in only “A list” speakers from around the world, people you really want to meet and talk with. This year we’re going to have a particularly large and diverse group of presenters, and we structure the conference so that attendees can mingle with the speakers and with each other.

I am often told by attendees that this is the best economic and investment conference they attend in any given year. I think it is a measure of the quality of the conference that many of the speakers seek us out. Not only do they want to speak, they want to attend the conference to hear and interact with the other speakers and conference guests. This conference is full of speakers that other speakers (especially including myself) want to hear. And you will, too. Save the date and look for registration and other information shortly in your mail.
Now let’s consider what today’s interest rates do and do not mean as we navigate uncharted waters.

Are We All Turning Japanese?

Japan is an interesting case study. It’s a highly developed nation with a very sophisticated culture, increasingly productive in dollar terms (although in yen terms nominal GDP has not moved all that much), and carrying an unbelievable 250% debt to GDP burden, but with a 10 year bond rate of 0.22%, which in theory could eventually mean that the total interest expenses of Japan would be less than those of the US on 5 - 6 times the amount of debt. Japan has an aging population and a savings rate that has plunged in recent years.

The country has been saddled with either low inflation or deflation for most of the past 25 years. At the same time, it is an export power, with some of the world’s most competitive companies in automobiles, electronics, robotics, automation, machine tools, etc. The Japanese have a large national balance sheet from decades of running trade surpluses. If nothing else, they have given the world sushi, for which I will always hold them in high regard.

We talk about Japan’s “lost decades” during which growth has been muted at best. They are just coming out of a triple dip recession after a disastrous downturn during the Great Recession. And through it all, for decades, there is been a widening government deficit. The chart below shows the yawning gap between Japanese government expenditures and revenues.



This next chart, from a Societe Generale report, seems to show that the Japanese are financing 40% of their budget. I say “seems” because there is a quirk in the way the Japanese do their fiscal accounting. Pay attention, class. This is important to understand. If you do not grasp this, you will not understand Japanese budgets and how they deal with their debt.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: How Global Interest Rates Deceive Markets was originally published at mauldineconomics.com

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Third Quarter Review from Hoisington Management

By John Mauldin

I featured the thinking of Dr. Lacy Hunt on the velocity of money and its relationship to developed-world overindebtedness and the potential for deflation in this week’s Thoughts from the Frontline, and I thought you’d like to peruse Lacy’s entire recent piece on the subject.

Lacy takes the US, Europe, and Japan one by one, examining the velocity of money (V) in each economy and bolstering the principle, first proposed by Irving Fisher in 1933, that V is critically influenced by the productivity of debt. Then, turning to the equation of exchange (M*V=Nominal GDP, where M is money supply), he demonstrates that we shouldn’t be the least bit surprised by sluggish global growth and had better be on the lookout for global deflation.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

I am writing this note in a car going to Athens, Texas, where I’ll join Kyle Bass and friends at his Barefoot Ranch for a huge macro fest. October is one of my favorite times of the year to be in Texas, and the ranch is a beautiful venue. I am sure I will have some challenging conversations.

Last night in Chicago I was picked up by Austyn Crites, who drove me downtown in rush-hour traffic, which gave us a lot of time to talk about his current passion, high balloons. I have been fascinated with them for some time, but there hasn’t been a lot of reliable information.

Basically, Google and Facebook are both planning to launch very large helium balloons full of radios and cameras and float them up to 60,000+ feet. The concept is working in several remote locations now. It’s a way to get full wireless internet coverage. With about 40,000 balloons you can blanket the earth. Literally. Full connectivity. Everywhere. Austyn wants to design a new type of balloon and be the manufacturer. It’s tricky as you need a VERY thin balloon envelope (that does not leak) the size of small house in order to get enough payload that high.

But he thinks the final cost of the balloons will fall dramatically and that you might be able eventually to pull off the operation for a billion or so a year (since balloons eventually come down and need to be replaced).
But if you are Google and you get the search revenue from connecting an additional five billion people?

Chump change. Same for Facebook. But what if Apple or Samsung want to make it so that their phones are afforded free or very cheap access? A consortium of consumer companies could easily see free wifi as a tool for branding. Current telecoms will have to get in the business to compete.

I kept coming back to the costs and tech issues. There are new things that will have to be invented, but nothing as complex as some of the problems that have already been overcome. They will be rolling out in parts of the world in a few years. Coming to a region near you in 5-10 years. Total game changers. While a hundred other game changers are coming down the tunnel.

Austyn's company’s challenge is to be the little guys who don't know they can't invent a new process that the big guys are working on as well. Can he pull it off? He has the passion and drive. I love meeting young people like him doing their part to change the world. They are everywhere, too. It's why I’m optimistic about the future of the human experiment, if just a tad bearish on governments. You can follow Austyn at his website.

Time to hit the send button, as we are getting close and I don't want to miss a minute. I will report back what I can. Have a great week.

Your dreaming of really, really cheap, ubiquitous connectivity everywhere analyst,

John Mauldin, Editor
Outside the Box

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Hoisington Investment Management – Quarterly Review and Outlook, Third Quarter 2014

Faltering Momentum

The U.S. economy continues to lose momentum despite the Federal Reserve’s use of conventional techniques and numerous experimental measures to spur growth. In the first half of the year, real GDP grew at only a 1.2% annual rate while real per capita GDP increased by a minimal 0.3% annual rate. Such increases are insufficient to raise the standard of living, which, as measured by real median household income, stands at the same level as it did seventeen years ago (Chart 1).



Over the latest five years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per capita GDP recorded a dismal 1.4% annual growth rate over the past five years, 26% less than the long-term growth rate. A large contributor to this remarkable downshift in economic growth was that in 1999 the combined public and private debt reached a critical range of 250%-275% of GDP. Econometric studies have shown that a country’s growth rate will lose about 25% of its “normal experience growth rate” when this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have found the negative consequences of debt on economic activity actually worsens at a greater rate, thus becoming non-linear. The post-1999 record is consistent with these findings as the U.S. debt-to-GDP levels swelled to a peak as high as 360%, well above the critical level noted in various economic studies.

In terms of growth, it looks as if the second half of 2014 will continue to follow this slow growth pattern. Although all of the data has not yet been reported, it appears that the year-over-year growth in real GDP for the just ended third quarter period is unlikely to exceed the 2.2% pace of the past five years. Economic vigor is absent, and the final quarter of the year looks to be weaker than the third quarter.

Poor domestic business conditions in the U.S. are echoed in Europe and Japan. The issue for Europe is whether the economy triple dips into recession or manages to merely stagnate. For Japan, the question is the degree of the erosion in economic activity. This is for an economy where nominal GDP has been unchanged for almost 22 years. U.S. growth is outpacing that of Europe and Japan primarily because those economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in the U.S. stands at 334%, compared with 460% in the 17 economies in the euro-currency zone and 655% in Japan.

Economic research has suggested that the more advanced the debt level, the worse the economic performance, and this theory is in fact validated by the real world data.

Falling World Wide Inflation

In this debt-constrained environment, it is not surprising that inflation is receding sharply in almost every major economy, including China. The drop in price pressures in the U.S. and Europe is significant, and the fall in Chinese inflation to 2%, from a peak of nearly 9% in 2008, is notable.

In the latest twelve months, the CPI in the euro currency zone rose a scant 0.3% (Chart 2), the lowest since 2009, while the core CPI increased by 0.7%, near the all time lows for the series. The yearly gain in the U.S. for both core and overall CPI was 1.7%. Since 1958 when the core CPI came into existence, it and the overall CPI have increased at an average annual rate of 3.8% and 3.9%, respectively, over 200 basis points greater than the current rates. Both the overall and core personal consumption expenditures U.S. price indices rose by 1.5% in the twelve months ending August of 2014. Both of these are near the all time lows for their respective series.



The risk of outright deflation in Europe with inflation at such low levels, and the danger of similar developments in the U.S., should not be minimized as inflation has fallen in almost every previous U.S. and European economic contraction. Lower inflation is, in fact, almost as much of a hallmark of recessions as is decreasing real GDP. From peak-to-trough the rate of CPI inflation fell by an average of slightly more than 300 basis points in and around the mild U.S. recessions of 1990-91 and 2000-01. Starting from a much lower point, the CPI in Europe at those same times dropped by an average of 150 basis points. Given that inflation is already so minimal in both the U.S. and Europe, even the mildest recession could put both economies in deflation.

Japan’s recent quantitative easing has helped devalue its currency by 44% versus the dollar, since the 2011 lows. This import- dependent country has therefore seen its costs rise dramatically. This, along with higher consumption taxes, has created a current year- over-year inflation rate of 3.3%. These higher prices are an enormous drag on economic growth as incomes fail to rise commensurately. Thus negative GDP growth will result in a continuing pattern of deflation. Japan’s CPI has been zero or negative on a year over year basis in 16 of the last 23 quarters.

Declining Money Velocity A Global Event

One factor that connects poor growth with the low inflation and low bond yields evident in the U.S., Europe and Japan is that the velocity of money (V) is falling in all three areas.

Functionally, many things influence V. The factors that could theoretically influence V in at least some minimal fashion are too numerous to count. A key variable, however, appears to be the productivity of debt. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then V will rise since GDP will rise by more than the initial borrowing. If the debt is unproductive or counterproductive, meaning that a sustaining income stream is absent, or worse the debt subtracts from future income, then V will fall. Debt utilized for the purpose of consumption or paying of interest, or debt that is defaulted on will be either unproductive or counterproductive, leading to a decline in V.

The Nobel laureate Milton Friedman, as well as economist Irving Fisher, commented on the causal determinants of V. Friedman thought V was stable while Fisher believed it was variable. Presently, the evidence suggests that Fisher’s view has prevailed. Fisher would not be at all surprised by the current impact of excessive debt since he argued in his famous 1933 paper “The Debt-Deflation Theory of Great Depressions”, that falling money velocity is a symptom of extreme over indebtedness.

Tracking that theory, it is interesting to note that velocity is below historical norms in all three major economic areas with existing over indebtedness. The U.S. V is higher than European V, which in turn is higher than Japanese V. This pattern is entirely consistent since Japan is more highly indebted than Europe, which is more highly indebted than the U.S. Unfortunately, broad monetary conditions (M2 money growth and velocity) are deteriorating, with 2014 displaying conditions worse than at the end of last year. The poor trend in the velocity for all three areas indicates that monetary policy for these countries is not a factor in influencing economic activity in any meaningful way.

United States. The U.S. year-over-year M2 growth has remained at about 6%, an annual growth level that has been consistent since 2008 (Chart 3), and the velocity of money has trended downward by about 3%. In the first half of 2014, V declined at a rate of 3.6%, but it is still too early to tell if this represents a new V deceleration to the downside (Chart 4).




According to the equation of exchange (M*V=Nominal GDP), the expected growth of nominal GDP is constrained to no more than a 3% increase with velocity declining by 3% and money supply expanding by 6%. However, when assessing the type of debt currently being employed (unproductive, at best) the risks are for lower growth levels. 2014 has witnessed a resurgence of consumer auto and mortgage lending that was achieved by a lowering of credit standards. The percentage of subprime consumer auto loans (31%) returned to the peak levels reached prior to 2008. Such lending has historically turned counterproductive. If this were to occur again, velocity would accelerate to the downside, resulting in a sub 3% path for nominal GDP.

Europe. V has only been available in Europe since 1995 as that is the starting date for GDP in the euro-currency zone. During the span from 1995 through 2013, V averaged 1.4, dropping from a peak of about 1.7 in 1995 to 1.03 in 2013 (Chart 5). Over that span, therefore, euro V has been trending lower at about a 2.6% per annum rate. On the money side, euro M2 increased by 2.4% in 2013, which is weaker than the average growth in the last four years (Chart 6). If the trend rate of decline in V remains intact, then nominal GDP in the euro zone could be flat. Inflation of any magnitude would result in a negative real GDP outcome.




Japan. From the start of the comparable M2 and nominal GDP statistics in 1969 in Japan, V in Japan has averaged 1.0, dropping from 1.54 in 1968 to a record low of 0.57 in the latest year (Chart 7). Thus, over this period V was falling at an average rate of 2.2% per annum. M2 in Japan increased 3.6% in 2013, which is slightly higher than the growth rate of recent years (Chart 8). If V’s downward trend remains intact, nominal GDP would be estimated to grow by 1.2%. However, inflation is currently running at 3.3%, suggesting real GDP could decline by over 2% in the next twelve months. This circumstance illustrates the double edged sword caused by a sharply depreciating currency. The weaker yen boosts exports but raises domestic inflation. Japanese inflation is already exceeding the rise in wages and household spending. These events are consistent with a contraction in economic activity and are the expectation derived from the analysis of money growth and its velocity.

Debt Research

Important new research by four distinguished economists (three in Europe and one in the U.S.) is contained in a report titled "Deleveraging? What Deleveraging?" (Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart, Geneva Reports on the World Economy 16, September 2014). It provides additional evidence on the role of “debt dynamics” and the state of the global debt overhang. They write, “Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs.” Further, it is a "poisonous combination" when world growth and inflation are lower than expected and debt is rising. “Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown.”

This research also identifies two other highly significant trends. First, global debt accumulation was led by developed economies until 2008. Second, the debt build-up since 2008 has been paced by the emerging economies. The authors write that the rise in Chinese debt is especially “stunning”. They describe China as “between a rock (rising and high debt) and a hard place (lower growth).” In addition to China they identify India, Turkey, Brazil, Chile, Argentina, Indonesia, Russia and South Africa as belonging to the “fragile eight” group of countries that could find themselves in the unwanted role of host to “the next leg of the global leverage crisis.”

We interpret this research to mean that the monetary policy may begin to become ineffective at emerging market central banks, just as has happened in the U.S., Europe and Japan. Weaker growth conditions in the emerging markets are thus likely to accentuate, rather than ameliorate, poor business conditions in the major economies. Indeed, this year’s downturn in global commodity prices is consistent with the beginning of such a phase. The huge jump in emerging market debt is also significant because research has found the severity of economic contractions is directly related to the leverage in the prior expansion.

Asset Bubbles

Historically, in our judgment, the most important authority on the subject of asset bubbles was the late MIT professor Charles Kindleberger, author of 20 books including the one of the greatest books on capital markets Manias, Panics and Crashes (1978). He found that asset price bubbles depend on the growth of credit. Atif Mian (Princeton) and Amir Sufi (University of Chicago) provided confirmation for Kindleberger’s pioneering work and expanded on it in their 2014 book House of Debt. Chapter 8, entitled “Debt and Bubbles,” contains the heart of their insights. Mian and Sufi demonstrate that increasing the flow of credit is extremely counterproductive when the fundamental problem is too much debt, and excessive debt can fuel asset bubbles.

Based on our reading of these two books we would define an asset bubble as a rise in prices that is caused by excess central bank liquidity rather than economic fundamentals. As Kindleberger clearly stated, the process of excess liquidity fueling higher prices in the face of faltering fundamentals can run for a long time, a phase Kindleberger called “overtrading”. But eventually, this gives way to “discredit”, when the discerning few see the discrepancy between prices and fundamentals. Eventually, discredit yields to “revulsion”, when the crowd understands the imbalance, and markets correct.

Economists have commented on the high correlation between the S&P 500 and the Fed’s balance sheet since 2009. From 2009 to the latest available month, the monetary base (MB) surged from $1.7 trillion to $4.1 trillion. We ran the MB increase against the S&P 500 and found a very high correlation of 0.69. While correlation does not prove causality, the high correlation is certainly not inconsistent with the idea that the Fed liquidity played a major role in boosting stock prices. However, even as the MB has exploded since 2009 and stock prices have soared, the U.S. economy has experienced the worst economic expansion on record. In spite of a further large rise in the base this year, the GDP growth has subsided noticeably and corporate profits after taxes and adjusted for inventory gains/losses (IVA) and over/under depreciation (CCA) has declined 10% in the latest four quarters. Such discrepancy between the liquidity implied by the base and measures of economic performance could indicate the process of bubble formation. Kindleberger’s axiom that asset price bubbles depend on excess liquidity may yet face another test.

Still Bullish on Treasury Bonds

With the nominal growth trajectory extremely soft, U.S. Treasury bond yields are likely to continue working lower as similar circumstances have created declines in government bond yields in Europe and Japan. Viewing the yields overseas, it is evident that ample downside still exists for long U.S. Treasury bond yields, as the higher U.S. yields offer global investors an incentive to continue to move funds into the United States.

Another factor suggesting lower long- term U.S. Treasury yields is the strength of the U.S. dollar. In many industries, the price leader for certain goods in the U.S. is a foreign producer. A rising dollar leads to what economists sometimes call the “collapsing umbrella”. As the dollar lifts, the foreign producer cuts U.S. selling prices, forcing domestic producers to match the lower prices. This reinforces the prospect for lower inflation as nominal GDP wanes. This creates a favorable environment for falling U.S. Treasury bond yields.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

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The article Outside the Box: Hoisington Investment Management Quarterly Review and Outlook: Third Quarter 2014 was originally published at mauldin economics

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