a post-election scoreboard: day one of outlining a strategy for 2017

Financial markets around the world have been remarkably active since the improbable election of Donald Trump as the next president of the United States.

  1.  The S&P 500 has risen by 5.8%
  2. The dollar has risen by 5.6% against the euro
  3. The dollar has risen an amazing 13.5% against the yen
  4.  The Eurostoxx 50 has gained 7.0%, meaning US$ investors have a loss of about 1.5% from holding large-cap Euroland shares
  5. The Nikkei 225 is up by 11.4%, meaning US$ investors have a loss of about 2% from investing in Japanese stocks.

These are all big moves.

To my mind, in the US the correct way to interpret them is this:   Wall Street believes paralysis in Washington is at an end and that resulting fiscal stimulus will allow the Fed to raise interest rates from their current extraordinary lows.  Put it another way, the focus of treatment for the economy will be away from life support and toward a return to health.  The enhanced potential for future earnings growth is generating both upward stock movement and higher interest rates.  The latter is causing the dollar to rise.

For the rest of the world, I think, a different, more derivative, dynamic is at work.  If investors are looking to the US as the locomotive that will pull Japan and the EU out of their current malaise, I think that’s a secondary effect.  I think the rise in those markets is being driven by the spur to their export-oriented industries given to them by the  precipitous falls in their currencies.

(An aside:  there’s a certain irony in having the professed (but looney-tunes, in my view) Trump agenda of bringing low-wage low-skill jobs back from developing economies having been so immediately, and deeply, undermined by post-election currency movements.)

What to make of all this?

I interpret what’s happening as the start of a very traditional stock market pattern.   When an economic upturn is beginning,  commodities-related industries react in an anticipatory way to expected future events and then move more or less sideways until there’s clear evidence in earnings that the anticipation is correct.  Earnings gains create a second, earnings-based upward movement.

Put a slightly different way, the market moves from having a bad future priced in to a neutral position.  It then reacts to good things as and when they begin to occur.

A third formulation: the post-election move is akin to the beginning of a business-cycle driven bull market.  That’s a little strong, since I don’t think the typical 30% gains of a bull market are in store for us over the next couple of years.

But I do believe we should be thinking aggressively, not defensively.

What would change my mind, or at least cause me to rethink?  …weakness in the US$, or some sign that the new administration has no intention of carrying out its agenda of breaking with business as usual in Washington.

More tomorrow.





casino gambling in Japan

Last week the Japanese Diet approved the creation of the first Las Vegas-style casinos in Japan.  Most Japanese citizens appear to be indifferent, but introducing a new form of legal gambling has been a priority for the political establishment for some time.  Although the standard rationale for legalizing gambling anywhere in the world is to take money away from the local underworld, the main reason in Tokyo seems to be to attract more foreign tourists–and keep them in Japan longer.

It will be a while before gambling consortia of construction companies and resort developers, presumably with foreign partners providing the expertise, are formed and for the precise rules about allowed games and taxation to be articulated.  But two issues are already clear:

–over the past ten years or so, there has been a dramatic expansion of the casino business in Macau, as well as in Singapore/Malaysia, the Philippines, Korea and, to a lesser extent, in Australia.  At some point, the market in this part of the world will become saturated.  Then, the fact of gambling won’t be enough.  The quality of the operations will count for a lot more.  So I don’t think Japanese casinos are sure-fire winners.  We have seen this already in Macau, where SJM, once the monopoly operator, continues to lose market share.  Will Japan push the region as a whole into maturity?

–who will run the casinos?  Presumably Wynn, Las Vegas Sands and Galaxy Entertainment will all be interested.  My guess is that groups including each of the three will be the key contenders for licenses.  Will each get a license?  Will that be a good thing?  Will Wynn Macau and Sands China be involved?  Certainly, Galaxy will be, since the Macau operations and the main company are the same.  In the other cases, it’s not so clear.  If investment capital were no object, my guess would be no.

traditional pension plans in the US: trouble (ii)


The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members.  That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?


Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

bonds first.  Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on.  When we’re there, CalPERS can earn the coupon each year by holding them, or 4%.  A 4% return on half the portfolio is a contribution of 2% to the entire portfolio   Note:  we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

stocks.  To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total.  This means achieving an average 11% annual return on the stock half.  How reasonable is this?  Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year.  If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return.  Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks.  But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up.  The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well.  It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle.  But most hedge funds continually produce returns to clients that are below the S&P 500.  And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%.  To me, this is clearly the right thing to do, and the sooner the better.  But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest.  It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California.  But what about the country’s government pension fund basket cases, like Illinois and New Jersey?  Following suit will show voters for the first timethe reality of how bad the situation is there.


traditional pension plans in the US: trouble ahead

the basics

Corporate pension plans of one type or another have been around in the US since the late nineteenth century.  In their simplest form, they offer specified payments in retirement to company workers who meet criteria spelled out in advance.  Since 1974, these plans have been subject to federal regulation under the Employee Retirement Income Security Act (ERISA) which sets out standards companies must comply with.

Although pension plans are an obligation of the firm, companies don’t ordinarily keep on hand in the plan today enough money to meet all future obligations.  Instead, they (or outside actuarial firms they hire) make intricate calculations of what future payments are likely to be and when they are likely to occur.  Then, using the investment returns that on average they believe their investment managers can achieve, they figure out how much must be in the plan right now to fund expected obligations.

open secrets, sort of

–We know professional analysts have a hard time forecasting what will happen even one year ahead.  What does this say about forecasts that claim to look decades into the future?

–Most traditional pension plans have less in the till today than actuarial calculations say they need.

–The return assumptions used are typically, let’s say, heroic.

public sector workers

The uncertainty inherent in what I’ve just written is why most publicly traded US companies have long since switched from traditional pension plans, where the corporation has responsibility for the risk of miscalculation, to 401ks, where the employee bears it.

There still are significant numbers of traditional pension plans, however.  They’re in the public sector.

dealing with underfunding

To my mind, a substantial reason for the popularity of hedge funds over the past fifteen years or so has been their claim of superior performance as far as the eye can see.  The director of an underfunded pension plan knows that his story is not going to end well as things stand now.  He has two choices:  ask his boss, the governor/legislature, for instance, to fix the problem by allocating (a ton of) more money to the plan; or he can find managers who can consistently exceed the returns the actuaries assume and gradually close the funding gap that way.  Not wanting to be the bearers of bad news, directors have by and large chosen door #2.

the actuarial assumptions

Adding to the woes of pension plan directors, the California Public Employees Retirement System (CalPERS), a leader in the public pension plan sphere, has begun to call into question the assumption that it can churn out average annual gains of +7.5%.

The surprise here, if any, is that CalPERS has finally decided to deal with this chronic problem.

More tomorrow.




US corporate tax reform (ii)

There are likely to be losers from corporate income tax reform.  They’re likely to be of two types:

–companies that currently have sweetheart tax deals, which, as things stand now (meaning:  subject to the success of intensive lobbying), will go away as part of reform.  A related group is multinationals who’ve twisted their corporate structures into pretzels to locate taxable income outside the US

–companies making losses currently and/or that have unused tax-loss carryforwards.  The value of those unused losses will likely be reduced by a lot.  This is a somewhat more complicated issue than it seems.  In their reports to public shareholders, money-losing firms can use anticipated future tax benefits to reduce the size of current losses.  The ins-and-outs of this are only important in isolated cases, so I’ll just say that for such firms book value is likely overstated

Another potential consequence of tax reform is that investors may begin to take a harder look at tax-related items on the income and cash flow statements.  Could markets will begin to apply a discount to the stocks of firms that use gimmicks to depress their tax rate?  Thinking some what more broadly, it may mean the markets will take a dimmer view of other sorts of financial engineering (share buybacks are what I personally hope for).  It might also be that companies themselves will reemphasize operation experience rather than financial sleight of hand when choosing their CEOs.

US corporate tax reform

 why look at the corporate tax rate?

As I’ve mentioned on occasion in other posts, one of the features of today’s US stock market is that it seems to pay no attention at all to the rate at which publicly traded companies pay tax.  All that counts is (after-tax) eps and eps growth.

A generation ago, when I entered the market, the opposite was the case.  Acting on the assumption that a company couldn’t sustain a super-low tax rate for a long time, analysts scrupulously adjusted, or “normalized,” a company’s tax rate, usually to the statutory maximum.  Of course, it has turned out that some firms–and some industries–have been able to maintain a sub-par tax rate for far longer than anyone imagined possible back then.

the US tax system

There are two main issues with the current US corporate tax system, as I see it.  The statutory rate of 35% is very high in comparison with the world average of around 20%.  So, if there isn’t a crucial reason to locate here, the US is financially a bad place for a company to have operations.  Also, politically savvy industries–oil and gas drilling, for example–have been able to lobby for special breaks that make the tax code unduly complex and the amount that the IRS collects less than it should be.

reform likely

President-elect Trump is promising to address this issue by lowering the federal corporate tax rate to perhaps 15%.  Implied, but not yet stated, is that the tax code will also be simplified by wiping out special exemptions for certain industries.  There seems to be widespread support for both parts of such reform.  So it seems to me that the effort, which has always previously been derailed by special interests, has a good chance to succeed.

market consequences

This means, though, that for the first time in a long while, analysts will be scrutinizing company financials to try to separate winners from losers.

potential winners

The obvious winners are firms that have large amounts of US taxable income and that pay cash taxes at the full 35% rate.  The pharmaceutical industry is one.  No surprise that most of the tax inversions of the recent past have been in pharma.

More tomorrow.



more oil production cuts announced

the news

Over the weekend, a group of non-OPEC oil producing countries, including Russia and Mexico, announced they will pare their collective crude oil output by 500,000 daily barrels.  About 60% of the total reduction will come from Russia.

On hearing that, Saudi Arabia said it would reduce its liftings by more than its already-promised 486,000 daily barrels.  The kingdom didn’t specify an amount, however–and the wording of its statement suggests the number will be small.

Nevertheless, the combined declarations have been enough to raise the price of oil in commodity trading by about 5% today, and 10% in total.

To put these figures into perspective, world crude production is around 98 million barrels per day.  So we’re talking about less than a 2% reduction in total output.

for oil producing countries

In one sense, the agreements have already been a financial success for the countries involved.  For most, they’ll reduce future output by, say, 2% and are already receiving 10% more for the 98% they are still selling.  That combination brings in 8% more dollars.

On the other hand, a $50+ price per barrel gives new life to shale oil producers in the US.  All to that that a fracking-friendly administration in Washington and the likelihood is that crude oil output from the US will begin to rise rapidly next year, offsetting at least some of the near-term output reductions now being achieved.

for investors

For us the situation is not so clear.

–Oil exploration and development companies in the US have already risen substantially on the original OPEC cutback announcement

–We’re also only about six weeks away from the beginning of the seasonally weakest part of the year for oil.  Crude oil bought in late January can’t be refined into heating oil and delivered to retail customers before the winter is over.  The driving season doesn’t begin in earnest until April.  So demand for the two principal refined products will be at a low ebb from January – March.  Soft demand usually translates into weaker crude prices.

–At some point, we’ll begin to see US crude output pickup

–The promised output cuts won’t take effect until the new year, so it’s impossible to find countries cheating on their output reduction pledges today.  The history of all commodity cartels tells us, however, that cheating will happen.  And if past is prologue, evidence of cheating will trigger a substantial price decline.

So we can reasonably expect a substantial bump in the crude-can-only-go-up-from-here road shortly.

Although I’m not doing anything at the moment, my reaction to all this is that I’m closer to being a seller of oil exploration firms than a buyer.  If I had a relatively large position (I don’t.  I only own one e&p stock), I’d be trimming it today, with an eye to possibly buying back in late January.