Tuesday, June 27, 2017

Are ETFs Driving The Market Higher?

Evelyn Cheng of CNBC reports, Goldman says there's one major force behind the market's gains this year: ETFs:
Passive investing is taking a bigger share of the stock market, helping to drive gains.

Exchange-traded funds, or ETFs, owned nearly 6 percent of the U.S. stock market as of the end of the first quarter, their greatest share on record, according to analysis by Goldman Sachs.

Known as passive investments, ETFs are baskets of stocks tracking various market indexes and have grown in popularity for their relatively low fees. In contrast, mutual funds that involve higher-cost active stock picking have declined in popularity, and their ownership of the U.S. stock market has fallen to 24 percent, the lowest since 2004.

ETFs purchased $98 billion worth of stocks in the first quarter, putting them on pace to buy $390 billion of stock this year, more than the last two years' combined total of $362 billion, according to the Friday note by a group of analysts led by Goldman's chief U.S. equity strategist, David Kostin. Goldman based its analysis on the Federal Reserve Board's June 8 report on first-quarter U.S. financial accounts.

ETF ownership of equities is at the highest level on record, as of the first quarter (click on image):

Source: Federal Reserve Board and Goldman Sachs Global Investment Research.

Analysts said the growth of ETFs can help explain why stocks have gained this year despite delays in passing the Trump administration's pro-growth proposals and increased geopolitical worries.

"I agree that ETFs have been a big driver," Ilya Feygin, managing director and senior strategist at WallachBeth Capital, told CNBC in an email. "The market has often made strong gains in weeks of strong inflows even in the face of bearish macro news. It has paused when there is not much inflow or the inflow went to international ETFs instead of U.S."

In a sixth straight quarter of gains, the S&P 500 climbed 5.5 percent in the first quarter to record highs. The index is tracking for gains of more than 3.5 percent this quarter.

Corporate buybacks and foreign investors also have driven demand for U.S. stocks.

Share buybacks were still the largest source of demand for stocks in the first quarter at $136 billion, or 46.6 percent of purchases, the Goldman report said, while the first quarter marked the second time in the last eight quarters that foreigners bought more U.S. stocks than they sold.

Momentum behind U.S. stocks could fade

That said, Kostin doesn't expect the strong demand for U.S. stocks in the first quarter to hold.

Goldman's year-end target for the S&P 500 is 2,300, about 5.7 percent below Friday's close of 2,438. U.S. stocks were slightly higher Monday, with the S&P near its record high hit June 19.

Expectations for a slight decline in U.S. stocks should lead to "a modest deceleration in ETF purchases" in the second half of the year, the report said, while a switch to passive management will add to mutual fund withdrawals.

Since 2007, $3.1 trillion has flowed into passive bond and stock funds, while $1.3 trillion has flowed out of actively managed bond and stock funds, according to a Bank of America Merrill Lynch report Thursday.

Cumulative active vs. passive flows to bond & equity funds ($ trillions)

Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global

Stock buybacks are also on the decline and should weigh on market returns. Kostin cut his forecast for corporate buyback growth this year to 2 percent from 11 percent.

"Our new estimate excludes any boost from tax reform in 2017 and also accounts for weaker activity in 1Q," Kostin said in the report. He previously expected tax reform this year to result in firms bringing back cash from overseas and using those funds to buy back shares.

Over the 12 months ended in March 2017, buybacks for S&P 500 companies declined 13.8 percent from a record high in the same period a year ago, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

Second-half fund flows should support overseas markets

On the other hand, improved growth in Europe and the rest of the world should benefit stocks outside the U.S.

Goldman expects the Europe STOXX 600 to gain 6 percent over the next six months in local currency terms, Japan's Topix to climb 2 percent and the MSCI Asia-Pacific ex-Japan Index to rise 1 percent.

"Higher return potential in major non-US equity markets vs. the US and a political stalemate in Washington D.C. suggest foreign investors will be net sellers of US stocks in 2H," Kostin said in the report.

Kostin also expects better returns overseas to attract U.S. buyers, who already bought $83 billion in foreign equities in the first quarter, reversing a trend in five of the last six quarters of selling more foreign stocks than buying.
When Goldman talks, investors listen. Alright, let me begin by stating there is a giant passive 'beta' bubble going on driven by the increasing popularity of exchange-traded funds (ETFs) and digital (aka robo) advisors. I've written all about it in my comment on the $3 (now $4) trillion dollar shift in investing,

Jack Bogle has revolutionalized the investment world for the better but in the process of doing so he may have created a monster that will sow the seeds of the next major financial crisis. This may be the Mother of all beta bubbles but it's very hard for people to realize it until the crisis hits and the dust settles.

And if history is any guide, these bubbles last a lot longer than investors can fathom. Martin Lalonde, manager of Rivemont, sent me a nice comment by the Collaborative Fund, The Reasonable Formation of Unreasonable Things, which you can read here (this is an excellent read).

Nevertheless, one thing is for sure, even if the stock market is on a tear, the US economy is slowing as I discussed here and here. At one point, the liquidity party will dry up, credit spreads will widen, and companies won't be able to borrow as much to buy back shares which will pretty much spell the end of the bull market (share buybacks have been the biggest factor driving shares higher).

Having said this, it's very hard calling a top when there is still plenty of liquidity driving risk assets higher. Sure, stocks are not cheap based on the CAPE ratio or "Shiller PE" but as Charlie Bilello of Pension Partners notes in his comment, Is This 1929 or 1997?, relying on this indicator to predict future returns isn't particularly wise.

As I end this brief comment, markets are selling off. I was busy earlier today attending a CFA luncheon where I enjoyed listening to macro views from some astute market observers. I will share some thoughts from this luncheon in a follow-up comment.

As far as what's driving the market higher, I would say central banks, share buybacks, ETFs and animal spirits. Is passive investing going to continue growing? Of course, but this growth will present opportunities to active managers especially when markets tank again.

One final note on ETFs and the VIX (or fear) index. As mentioned in this article, the rise of ETFs is impacting the volatility index through hedging activities:
Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.

With the S&P 500 stock index .SPX near a record high, demand for these is quite strong.

For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX.P), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating steady demand for VIX futures that the hedge funds are only too happy to supply.

"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.

Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.

It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
Below, Bloomberg Intelligence's Eric Balchunas and Bloomberg's Julie Hyman look at claims that ETFs are inflating stock prices and creating a market bubble. They speak on "Bloomberg Markets" (March 24, 2017). Good discussion, listen carefully to his comments but keep in mind the trend that Goldman notes above.

Monday, June 26, 2017

Will Public Pensions Sink Illinois?

The Associated Press reports, Illinois debt is about to be rated 'junk.' What that means:
Illinois is on track to become the first U.S. state to have its credit rating downgraded to "junk" status, which would deepen its multibillion-dollar deficit and cost taxpayers more for years to come.

S&P Global Ratings has warned the agency will likely lower Illinois' creditworthiness to below investment grade if feuding lawmakers fail to agree on a state budget for a third straight year, increasing the amount the state will have to pay to borrow money for things such as building roads or refinancing existing debt.

The outlook for a deal wasn't good Saturday, as lawmakers meeting in Springfield for a special legislative session remained deadlocked with the July 1 start of the new fiscal year approaching.

That should alarm everyone, not just those at the Capitol, said Brian Battle, director at Performance Trust Capital Partners, a Chicago-based investment firm.

"It isn't a political show," he said. "Everyone in Illinois has a stake in what's happening here. One day everybody will wake up and say 'What happened? Why are my taxes going up so much?'"

Here's a look at what's happening and what a junk rating could mean:

Why now?

Ratings agencies have been downgrading Illinois' credit rating for years, though they've accelerated the process as the stalemate has dragged on between Republican Gov. Bruce Rauner and the Democrats who control the General Assembly.

The agencies are concerned about Illinois' massive pension debt, as well as a $15 billion backlog of unpaid bills and the drop in revenue that occurred when lawmakers in 2015 allowed a temporary income tax increase to expire.

"In our view, the unrelenting political brinkmanship now poses a threat to the timely payment of the state's core priority payments," S&P stated when it dropped Illinois' rating to one level above junk, which was just after lawmakers adjourned their regular session on May 31 without a deal.

Moody's did the same, stating: "As the regular legislative session elapsed, political barriers to progress appeared to harden, indicating both the severity of the state's challenges and the political difficulty of advocating their solutions."

What is a 'junk' rating?

Think of it as a credit score, but for a state (or city or county) instead of a person.

When Illinois wants to borrow money, it issues bonds. Investors base their decision on whether to buy Illinois bonds on what level of risk they're willing to take, informed greatly by the rating that agencies like Moody's assign.

A junk rating means the state is at a higher risk of repaying its debt. At that point, many mutual funds and individual investors — who make up more than half the buyers in the bond market — won't buy. Those willing to take a chance, such as distressed debt investors, will only do so if they are getting a higher interest rate.

While no other state has been placed at junk, counties, and cities such as Chicago, Atlantic City and Detroit have. Detroit saw its rating increased back to investment grade in 2015 as it emerged from bankruptcy — an option that by law, states don't have.

What will it cost?

Battle says the cost to taxpayers in additional interest the next time Illinois sells bonds, which it inevitably will need to do in the long-term, could be in the "tens of millions" of dollars or more.

The more money the state has to pay on interest, the less that's available for things such as schools, state parks, social services and fixing roads."

For the taxpayer, it will cost more to get a lower level of service," Battle said. Comptroller Susana Mendoza, who controls the state checkbook, agreed.

"It's going to cost people more every day," she said. "Our reputation really can't get much worse, but our state finances can."

Other impacts?

Because the state has historically been a significant funding source to other entities, such as local government and universities, many of them are feeling the impact of Illinois' worsening creditworthiness already.

S&P already moved bonds held by the Metropolitan Pier & Exposition Authority and the Illinois Sports Facilities Authority — the entities that run Navy Pier, McCormick Place, and U.S. Cellular Field — to junk. Five universities also have the rating: Eastern Illinois University, Governors State University, Northeastern Illinois University, Northern Illinois University and Southern Illinois University.
Cole Lauterbach of the Illinois News Agency also reports, Lawmakers spend Sunday talking pensions; still no budget:
Illinois House lawmakers used one of their final days of the special session discussing the merits of different pension reform proposals. No votes were taken on it or a budget.

After quickly going through the motions to enter and exit the special session mandated by Republican Gov. Bruce Rauner and passing a couple non-budgetary items, panel discussions continued.

The state's official estimate of unfunded pension liabilities is $130 billion, but Moody's places the state's shortfall at closer to $250 billion. Both numbers are higher than nearly any other state. Illinois' annual pension obligation is around 25 percent of its annual budget. That's set to increase based on the changes to reforms made by lawmakers and former Gov. Jim Edgar.

Lawmakers on both sides of the aisle have filed reform proposals for pensions. They make a number of changes ranging from limiting cost-of-living increases in exchange for other benefits, to creating a new classification for teachers with a different structure of benefits.

Virtually all of the panelists that testified Sunday had union connections, and they were cool to any proposal that made pensions more affordable to taxpayers. They said the proposed reforms would diminish pensions, deemed unconstitutional by the Illinois Supreme Court.

"Pensions are good public policy," said Daniel Montgomery, president of the Illinois Federation of Teachers, who opposed changes to the current systems beyond those that would lead to better funding. "We've had a long history of not funding them properly."

Others said the changes did nothing to solve the massive fiscal crisis.

"Taxpayers have put in $20 billion more than the 'Edgar ramp' originally called for and yet, despite those billions more, pensions are going bankrupt," said Ted Dabrowski, vice president of Policy for the Illinois Policy Institute. "We may soon have the first junk bond rating of any state. Pensions are a driver of that. Illinois needs the boldest reforms. The two bills in question would only perpetuate the crisis and make things worse."

Dabrowski advocated eliminating defined benefit pensions for new state hires, which he said are unaffordable to taxpayers and going bankrupt. Instead, new state employees should be enrolled in a defined contribution plan similar to 401(k)'s that most private businesses have converted to. This would give the employees control of their retirement funds and prevent politicians from under-funding them.

While the thought of having a lifetime guaranteed paycheck from a pension sounds appealing, there are setbacks. Should a teacher spend a decade in a classroom, decide to change course and pursue another career, their pension would not be portable. That decade of contributions would be lost. Members of some pensions are also ineligible for Social Security benefits, making their defined-income plans their only offered source of income in retirement beyond a separate plan. And some, such as Dabrowski, fear Illinois' pension systems are so underfunded that they face bankruptcy, which would lead to reduced benefits.
What a mess. I've been watching the slow motion train wreck of Illinois's public pensions for years, especially the Teachers' Retirement System (TRS).

The Illinois House and Senate recently passed legislation to reform teacher pension funding but the situation is so grave that Illinois Governor Bruce Rauner, a former private equity executive before his 2014 election to the governor's office, has made several new appointments to the board of the $46 billion pension plan and named Marc Levine chair of the Illinois State Investment Board (ISIB) and to the teachers' retirement board.

As far as reforms, I don't agree with Dabrowski who advocates eliminating defined-benefit pensions for new state hires. Illinois's teachers and public sector employees know all too well about the brutal truth on defined-contribution plans.

Importantly, shifting public or private sector workers out of DB into DC plans just doesn't make sense. It's dumb public policy because it will exacerbate pension poverty over the long run and detract from Illinois's economic activity over the long run.

But the unions can't have their cake and eat it too. Illinois teachers need to accept some form of risk-sharing in their plan just like Ontario's teachers did, which is why their plan is fully funded while Illinois's TRS is still on death watch, chronically underfunded and in need of major reforms.

The other thing that the Ontario Teachers' Pension Plan has is first-rate governance, separating government out of investment decisions and paying its pension managers properly to attract and retain talent to bring assets internally.

It looks like Marc Levine is trying to reform the way Illinois public pensions are doing business but the situation is so grave that they absolutely need concessions from unions to share the risk of their plan. I've discussed all these issues in my comment on the pension prescription where I also discussed the big squeeze fees have on these pensions.

As far as the issue of pension portability, I don't understand why teachers who leave their work after a certain number of years cannot leave their pension money in a DB fund and get reduced benefits in the future. If they want to receive a lump-sum payment to put it into their 401(k) plan, sure, but my advice would certainly be against this.

Honestly, what Illinois and other states that suffer from similar pension woes need is to amalgamate all these public pensions at the state level, introduce better governance, adopt a shared-risk model, and get real on investment  returns even if this means higher contributions from employees and the state government (these plans need be jointly sponsored).

But none of these reforms are being discussed. Instead, lawmakers want quick fixes which will make things worse for everyone, including Illinois taxpayers.

In the meantime, rating agencies are taking notice, targeting chronically underfunded US state plans,  much to the dismay of state governments and taxpayers. Not that the rating agencies have much of a choice but to take notice. The pension storm cometh and it will crush many chronically underfunded mature state pension plans.

In fact, ValueWalk recently did an analysis stating that US pensions funds have a $4 trillion hole and even a 5% decline could be catastrophic. But it's even worse than that because this analysis only focuses on assets, not liabilities. If rates plunge to record low levels and stay there, the catastrophe will be much worse than anything we can imagine (remember a decline in rates impacts pension deficits a lot more than a decline in assets because the duration of liabilities is a lot bigger than the duration of assets).

The situation really scares me because it will impact millions of workers and beneficiaries of these state plans as contributions rise and benefits decline. It's not just GE that botched it pension math, it's pretty much the majority of US public plans, and when it hits the fan, it will be devastating.

Maybe I'm too cynical, perhaps I'm not seeing a silver lining in this grim situation, but I doubt it. I've been looking at this from all angles and it's just ugly and getting worse. But if you see some hope in this US public pension catastrophe, feel free to email me your thoughts at LKolivakis@gmail.com.

Below, Marc Levine, chairman of Illinois State Board of Investment, talks about the hedge fund wrecks and which ones he actually trusts. The “Fast Money” traders weigh in.

Over the weekend, I listed Penta's top 100 hedge funds on LinkedIn but didn't notice any of the three hedge funds mentioned in the clip below, which isn't necessarily a bad thing. In fact, I quickly looked at the portfolio and AUM of HR Vora Capital Management which was among the three mentioned below and liked what I saw (take all these top hedge funds lists with a shaker of salt!!).

But like I said when I went over GE's botched pension math, more hedge funds and private equity funds aren't the solution to America's public pension crisis. So, no matter what Mr. Levine and his team do on that front, it won't make a big difference when it comes to public pensions sinking Illinois.

Friday, June 23, 2017

The Bezos and Buffett Effect?

Matthew Boesler of Bloomberg reports, Amazon Has at Least One Fed Official Rethinking Inflation:
News that rocked the retail world last week is coming at just the wrong time for U.S. central bankers already puzzling over why inflation is conspicuously absent.

When online retail giant Amazon.com Inc. announced last Friday that it would purchase Whole Foods Market Inc., a plunge in retail and grocery stocks reinforced the disinflationary tone set by three straight months of disappointing data on consumer prices. It’s an example of the technological forces that are increasing competition and further limiting companies’ ability to pass on higher wage costs to customers.

“That normally indicates that somebody thinks that they are not going to be earning as much as they were,” Federal Reserve Bank of Chicago President Charles Evans said of the market reaction to the deal while speaking with reporters Monday evening after a speech in New York.

“For me, it just seems like technology keeps moving, it’s disruptive, and it’s showing up in places where -- probably nobody thought too much three years ago about Amazon merging with Whole Foods,” he said.

Evans, a voter on the Federal Open Market Committee this year who supported its decision to raise interest rates last week, says he is less confident than most of his colleagues that inflation will soon rise to their 2 percent target.

A big reason for his ambivalence: Deflationary competitive pressures could have become more important for the overall trend in prices than the so-called Phillips Curve relationship, which links inflation to the state of the labor market. That model, coined almost 60 years ago, is the basis for the Fed’s outlook for continued gradual rate increases.

In order for it to work, though, businesses need to be able to raise prices to offset increases in labor costs as unemployment falls and available workers become more scarce. But a stumble in corporate profit margins suggests companies are struggling to raise prices.

“That’s one of the things that makes me nervous, that I think there’s something possibly going on, some secular trend, that isn’t just a U.S. story,” Evans said.

“We know that technology is disruptive. It’s changing a number of business models that used to be very successful, and you have to wonder if certain economic actors can continue to maintain their price margins, or if they are under threat from additional competition,” he said. “And that could be an undercurrent for holding back inflation.”

Every indication from FOMC leadership is that continued tightening in the labor market will lead to higher inflation, despite the recent wobbles in the inflation data, which Fed Chair Janet Yellen called “noisy” in a press conference following last week’s meeting.

“We think if the labor market continues to tighten, wages will gradually pick up, and with that, we’ll see inflation get back to 2 percent,” William Dudley, who as New York Fed president is also vice chairman of the FOMC, said Monday in Plattsburgh, New York.

Such remarks reinforce expectations that policy makers will hike again before the end of the year, as signaled by their latest forecasts for interest rates.

Evans isn’t ready to abandon that logic yet, either, but he does sound more skeptical.

“I can’t say that the Phillips Curve isn’t going to lead to higher inflation, but I worry that it’s very flat and it’s not going to,” he told reporters Monday. “It’s still very early in this process.”

The Chicago Fed chief is not alone in thinking about the impact of disruptive technologies on prices. Dallas Fed President Robert Kaplan -- another FOMC voter this year -- describes such forces, and the uncertainty they generate, as currently the most intense he’s ever seen.

Ultimately, if the unemployment rate continues to fall and inflation doesn’t respond, the Phillips Curve may fall further out of favor as a guide to inflation dynamics, and by extension, interest-rate policy, as Evans hinted at Tuesday in a follow-up interview on CNBC.

“If that’s the case -- and I think that’s just speculative at this point -- then it means we need even more accommodation to get inflation up,” he said.
You can read Federal Reserve Bank of Chicago President Charles Evans's speech here. Take the time to read through this speech, it's excellent.

Last Friday, I discussed whether the Fed is making a huge mistake tightening as the US economy slows. I went over a comment written Minneapolis Fed President Neel Kashkari explaining why he dissented again.

In that comment, I stated the following:
I've been warning of the risks of debt deflation for a very long time, long before I began writing this blog in 2008 right before the financial crisis hit full force.

In a recent comment of mine where I discussed why Citadel's Ken Griffin is warning of inflation, I went over yet again six structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  • The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  • Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  • The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  • Excessive private and public debt: Rising government debt levels and consumer debt levels are constraining public finances and consumer spending.
  • Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality, is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  • Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics,  and other technological shifts that lower prices and destroy more jobs than they create.
Now, we can argue about the importance of each structural factor but there is no arguing that an aging population, a less-than-spectacular labor market, the global pension crisis, excessive public and private debt, rising inequality and technological shifts are all deflationary.

All this to say that I agree with Neel Kashkari, I think it's silly for the Fed to raise rates in a deflationary environment, especially now that the US economy is slowing. Not surprisingly, institutional investors are "increasingly uncomfortable" with the Fed tightening during a slowdown.
I don't just think it's silly for the Fed to raise in a deflationary environment, I'm equally perplexed when I read comments on why the Bank of Canada is all of sudden in a hurry to raise rates. On LinkedIn, I posted this comment regarding this article:
"I think it is highly unlikely the Bank of Canada will hike in July if oil prices keep dropping from now till the meeting. If the BoC hikes, it will only exacerbate deflationary pressures. The only rational argument I've heard for hiking is to cool speculative activity in the housing market, but the market is already taking care of that. Having worked with Steve Poloz at BCA Research a long time ago, he might like to suprise people once in a while, but he's no cowboy and is well aware of the deflationary risks I'm talking about."
Speaking of BCA Research, I agree with Anastasios Avgeriou, BCA's Chief Equity Strategist, no matter what Pimco's Ivascyn says, this time isn't different, the inverted yield curve is signalling a US recession ahead:

I warned my blog readers in April that the next economic shoe is dropping and more recently to prepare for a US slowdown

The US slowdown is already underway and next will follow Europe, Japan, China and the rest of the world. This is why I remain long US long bonds (TLT), the US dollar (UUP) and select US equity sectors like biotech (XBI) and technology (XLK) and I'm underweight/ short energy (XLE), materials (XME), industrials (XLI), financials (XLF) and emerging markets (EEM).

In fact, had you loaded up on biotech (XBI) prior to the US presidential election back in November when I wrote about America's Brexit or biotech moment and loaded up on US long bonds (TLT) at the start of the year when I explained why it's not the beginning of the end for bonds, you would have made great returns and thrown me a bone via a donation or subscription to this blog (I remain long biotech but took some profits and added to my US long bonds).

Anyway, I'm talking up my book and getting off track. Back to the Bezos or Amazon effect. I was talking to a buddy of mine earlier this week about Amazon's impact on inflation. He mentioned to me "it's like the Wal Mart effect that happened in the 90s but on a much bigger scale and much more pervasive."

I agree, Amazon has forever changed the retail landscape which is why many retail stocks (XRT) have gotten killed over the last year (click on image) :

Now, before you go buying the dip on retail stocks, let me show you a scarier chart that goes back over ten years (click on image):

I'm not saying we are going to revisit the 2008 financial crisis levels but I would be very cautious on retail stocks. In fact, if you want retail exposure, you're probably better off sticking with Amazon (AMZN), the online retail goliath that has been growing by leaps and bounds over the last ten years, succeeding in online shopping and its cloud business (click on image):

Still, I think it's best to temper your enthusiasm on any retail stock, including red-hot Amazon as we head into a US and global recession.

Also, following Amazon's Whole Foods deal, I saw some grocery stocks like Kroger (KR) get killed as if it's a done deal (it's not) and as if grocery stores will never be able to compete against Amazon (click on image):

Kroger's stock is way oversold (resting on its 400-week moving average) and although I'm not particularly bullish on it, I think this is a gross overreaction and if a recession hits, you want to have defensive stocks like grocers in your portfolio.

Anyway, there is little doubt Amazon has an impact on inflation just like Uber, Nexflix (NFLX) and Tesla (TSLA) do. In fact, my buddy shared this me earlier this week:
"The biggest influence on inflation is oil. Tesla is changing the automobile market and as demand for electric cars picks up, it will impact oil prices over the long run. Why do you think the Saudis are selling Aramco? They see the writing on the wall and need to diversify their economy. Netflix is also impacting inflation. As people stop going ot the movies, they stop going out and spending on restaurants and order more as they stay home."
I told him that explains why shares of Domino's Pizza (DPZ) have been on a tear over the last five years while other restaurant stocks haven't been sinking (click on image):

Now, this comment is called the Bezos and Buffett but so far, I've only focused on Amazon.

Matt Scuffham of Reuters reports, Shares in Canada's Home Capital surge as Buffett rides to rescue:
Warren Buffett's Berkshire Hathaway Inc (BRK) is providing a C$2 billion loan to Home Capital Group Inc (HCG.TO) and taking a 38 percent stake in the mortgage lender, a move which is pressuring short sellers who targeted the stock as Canada's housing market has turned riskier.

Shares in Home Capital closed up 27 percent on Thursday.

Shares in other Canadian alternative lenders also rose on Thursday. Equitable Group Inc (EQB.TO) closed up 12.5 percent. Street Capital Group (SCB.TO) closed up 8.3 percent. Shares in mortgage insurer Genworth MI Canada Inc (MIC.TO) were up 11.5 percent.

The deal may bring to a close a two-month effort by Home Capital's board, and advisers RBC Capital Markets and BMO Capital Markets, to replace a costly credit facility with the Healthcare of Ontario Pension Plan (HOOPP) and shore up the lender's balance sheet.

The credit facility was arranged earlier to provide funding for Canada's largest non-bank lender which had suffered from the withdrawal of 95 percent of its high interest deposits in the past two months.

Alan Hibben, a former Royal Bank of Canada executive who was recruited to the Home Capital board last month, said over 70 parties had expressed interest in investing in the lender. In an interview, Hibben said Home Capital was drawn to Berkshire Hathaway because of Buffet's credibility with both investors and depositors.

"The board decided it would be nice for a sponsor to give us a view where somebody could say 'wow, if that smart person thinks the Home Capital business model and portfolios are good, I'm going to think that'," he said.

Hibben said Buffett had become involved "later in the process" with Home Capital approaching Berkshire Hathaway rather than the other way round.

Home Capital has played an important role in Canada's mortgage market, lending to new immigrants and self-employed workers who may not be able to get loans from the country's biggest banks.

But home prices in Toronto and Vancouver have fallen after the government introduced measures to cool overheating prices with household debt in Canada has reaching record levels.

Investors are wondering whether the deal will be as successful as Buffett's decidedly bigger deal to buy Goldman Sachs preferred shares during the global financial crisis in 2008.

“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” said Berkshire's chairman Warren Buffett, in a statement on the deal released by Home Capital on Thursday.


Short sellers are continuing to take positions in Home Capital though, aiming to profit by selling borrowed shares on the hope of buying them back later at a lower price.

Combined short interest in the company's Canadian and U.S.-listed shares stands at about $183 million, up $62 million this month, according to data from financial analytics firm S3 Partners.

Marc Cohodes, a short seller who has been betting against Home Capital for two years, said on Thursday he continued to do so.

"If it wasn't Warren Buffett's name, the stock would be way, way way, down today," he said in an interview.

Home Capital was forced to raise new capital after depositors rushed to withdraw funds from its high-interest savings accounts. They pulled 95 percent of funds from Home Capital's high-interest savings accounts since March 27, when the company terminated the employment of former Chief Executive Officer Martin Reid.

The withdrawals accelerated after April 19, when Canada's biggest securities regulator, the Ontario Securities Commission, accused Home Capital of making misleading statements to investors about its mortgage underwriting business.

Home Capital reached a settlement with the commission last week and accepted responsibility for misleading investors about mortgage underwriting problems.

"The 'endorsement' from Warren Buffet may prove to rehabilitate depositor confidence, thus turning deposit flow positive," said National Bank of Canada analyst Jaeme Gloyn.

The Berkshire credit agreement comes with an interest rate of 9.0 percent, with a standby fee on funds not drawn down of 1.0 percent, compared with 2.5 percent previously.
Katia Dmitrieva and David Scanlan of Bloomberg also report, The real reason Warren Buffett is rescuing Home Capital:
Warren Buffett has become the lender of last resort for Home Capital Group Inc. The billionaire investor agreed to buy shares at a deep discount and provide a fresh credit line for the Canadian mortgage company, tapping a formula he used to prop up lenders from Goldman Sachs Group Inc. to Bank of America Corp.

Buffett’s Berkshire Hathaway Inc. will buy a 38 per cent stake for about $400 million and provide a $2 billion credit line with an interest rate of 9 per cent to backstop the embattled Toronto-based lender, Home Capital said late Wednesday in a statement. The interest on the one-year loan would net Berkshire at least $180 million if it’s fully tapped.

“While the terms of the new credit line with Berkshire Hathaway remain harsh, we believe the purpose of this loan is to motivate Home Capital’s management to bolster their own funding sources,” said Hugo Chan, chief investment officer at Kingsferry Capital in Shanghai, which owns shares in Home Capital. “This again shows Mr. Buffett’s masterful capital allocation skills,” said Chan, citing his investment motto: “be greedy when others are fearful.”

Home Capital shares surge as Warren Buffett rides to the rescue

The financial backing from the billionaire investor is poised to send the stock higher Wednesday, though it comes at a cost, in keeping with his past bailouts of financial firms. Buffett has buoyed some of the biggest U.S. corporations in times of trouble, including a combined $8 billion injection to prop up Goldman Sachs and General Electric Co. when credit markets froze during the 2008 financial crisis.

Berkshire’s purchase of $5 billion of Goldman Sachs preferred stock paid Buffett’s company an annual dividend of 10 per cent, and the billionaire also got warrants he later used to get more than $2 billion of the bank’s shares in a cashless transaction.

Deal Discount

In the Home Capital deal, Buffett’s firm agreed to pay an average price of $10 a share, a 33 per cent discount to yesterday’s closing price of $14.94. Berkshire would become the largest shareholder in Home Capital, which has a market value of $959 million.

“If you have the Warren Buffett seal of approval, people will take you more seriously than if you don’t,” said Meyer Shields, an analyst with Keefe, Bruyette and Woods. “So you sort of look beyond the settlement and say, ‘OK, what matters most now is that Warren Buffett trusts this company. And that in turn, allows Warren Buffett to get much better returns on capital than maybe some other lender would have been able to.”

The $2 billion credit line is only marginally cheaper than the emergency credit provided by the Healthcare of Ontario Pension Plan, which company directors have termed as “costly.”

Under the new credit agreement, the interest rate on outstanding balances will fall to 9.5 per cent, from 10 per cent under the existing HOOPP line. The rate will drop to 9 per cent after the initial investment is completed. The standby fee on undrawn funds will dip to 1.75 per cent from the current 2.5 per cent, then fall further to 1 per cent. The credit line is for one year. Home Capital has drawn about $1.65 billion from the HOOPP loan.

The investment “is a strong vote of confidence,” in the long-term value of the business, Brenda Eprile, Home Capital’s chairwoman, said in the statement.

New Terms

The move is the latest sign of a turnaround in the 30-year-old lender after a regulator in April accused it of misleading shareholders on mortgage fraud, which sent its shares tumbling, sparked deposit withdrawals and threatened to disrupt Canada’s real estate sector. Earlier this week, Home Capital agreed to sell a portfolio of commercial mortgages to affiliates of KingSett Capital Inc. for $1.16 billion in cash.

“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” Buffett said in the statement.

The share purchase will be done in two parts: an initial investment of $153 million for about a 20 per cent equity stake, then an additional investment of $247 million taking the stake to about 38 per cent. The second phase requires extra approvals.

Berkshire will not be granted any rights to nominate directors and has agreed to only vote shares representing 25 per cent of the company’s stock, Home Capital said.

Home Capital shares have almost tripled since bottoming in May when its troubles began to accelerate, though remain about 73 per cent down from their peak in 2014. The company last week took full responsibility over allegations the lender misled shareholders about mortgage fraud and agreed with three former executives to pay more than $30 million to reach settlements with regulators and investors.

Buffett’s Berkshire Hathaway is wading into a tense Canadian housing market, with Toronto house prices cooling after being hit with a 15 per cent tax on foreign buyers and tighter mortgage regulations, and confidence shaken by the Home Capital drama. Meanwhile, prices are surging in Vancouver again after being sideswiped by similar policy moves.
There's no doubt the "Buffett effect" boosted shares of Home Capital Group this week but I would seriously take any profits if you risked capital and bought shares at the bottom (click on image):

I didn't buy shares of Home Capital when they tanked because I don't have Buffett's deep pockets and because I don't like the sector from a macro perspective. I can also guarantee you Buffett won't make anywhere near the killing he made when he bought Goldman Sachs's preferred shares during the crisis.

But I had a feeling something was going to happen after I wrote my comment on Canada's pensions to the rescue where I noted that pension heavyweights Claude Lamoureux, Ontario Teacher's former CEO, and Paul Haggis, the former CEO of OMERS are joining Home Capital's Board.

Home Capital approached Warren Buffett but don't kid yourselves, Claude Lamoureux, Paul Haggis and even former Board member, HOOPP CEO Jim Keohane certainly had something to do with facilitating this deal.

[Note: I send my blog comments to Warren Buffett's Executive Assistant, Debbie Bosanek, but I doubt he reads them. The Globe and Mail reports that Buffet's interest in rescuing Home Capital Group was piqued by an email from 82-year-old Don Johnson, a Canadian banker who sends his thoughts to the investment guru now and then.]

I asked Jim Keohane how this deal will impact HOOPP's investment earlier today and he replied: "Buffet will provide a line of credit at a slightly better rate and Home will pay ours off.  Our loan was always intended to be a short-term liquidity fix and we expected that we would get paid back in a relatively short time frame."

Jim is at an offsite strategic retreat discussing HOOPP's long-term strategy (I wish I was a fly on the wall there to listen in).

Anyway, I wish all of you a great weekend and all Quebecers a Happy St-Jean Baptiste Day! Please remember to support my blog by donating or subscribing via PayPal at the top right-hand side under my picture.

Below, Federal Reserve of Chicago President Charles Evans speaks to CNBC's Steve Liesman about the Fed's inflation target, the outlook for rate hikes and the state of the US economy.

And Alan Hibben, Board member at Home Capital, explains how the company secured a $1.5 billion lifeline from the Oracle of Omaha. Again, there was a process, and whle the provincial government didn't have anything to do with this deal, I'm sure Claude Lamoureux, Paul Haggis and Jim Keohane did facilitate this deal. They all have solid reputations that helped ease Buffett's concerns.

And Berkshire Hathaway's Warren Buffett discusses Jeff Bezos' extraordinary success with Amazon, calling him 'the most remakable business person of our age'. No doubt, Bezos is changing the world in ways we can't imagine, but my fear is the world isn't ready for such disruptive change and we need to address this and rising inequality in order to sustain a vibrant and healthy democracy.

Remember what Buffett once said:"The marginal utility of an extra billion to me is not as much as it can be to millions of others in desperate need."

Interestingly, Jeff Bezos hasn't signed the Giving Pledge that Buffett, Gates and other billionaires have signed but he is now looking to donate billions to philanthropy and is looking for help (see clip below).

There are many great philphilanthropic causes but I would urge Bezos and the world's billionaires to figure out ways to help the poor and disabled to earn a living and stop being marginalized by society.

Thursday, June 22, 2017

GE Botches Its Pension Math?

Nir Kaissar of Bloomberg reports, GE Botches Its Pension Math:
It’s time for General Electric Co. to do some soul-searching about its pension problem.

As Bloomberg News reported last week, GE’s pension was underfunded by a staggering $31.1 billion at the end of 2016 -- the biggest shortfall among S&P 500 companies.

So far, GE seems to be pointing fingers at everything but itself. Company spokeswoman Jennifer Erickson has attributed the pension predicament to the 2008 financial crisis and subsequent low interest rates.

In fairness, GE’s pension was in good health before the financial crisis. It was overfunded every year from 1999 to 2007, and GE’s surplus was $15.2 billion at the end of 2007. But in 2008, the pension portfolio tumbled by roughly 28 percent, and suddenly it was underfunded by $6.8 billion.

Turning Point

GE's pension fell deeper into the red after the 2008 financial crisis (click on image):

That’s when GE made some classic blunders. First, it panicked when markets declined and sold its risky assets when it should have hung on to them -- or bought more of them. GE allocated 80 percent of its pension portfolio to risky assets during the boom years leading up to the crisis from 2003 to 2006. The decline in the value of those assets in 2008 reduced GE’s risk allocation to 68 percent. But after the recovery in 2009, GE lost its nerve and sold some risk assets. By the end of 2010, GE’s allocation to risk was 66 percent, which is roughly where it remains today.

All Shook Up

GE lost its taste for risk after the 2008 financial crisis (click on image):

GE also blundered by chasing alternative investments after the crisis. From 1999 to 2008, the pension had no alternative investments. But by the end of 2009, GE had allocated 14 percent of its portfolio to alternatives.

It’s easy to see why alternatives were appealing at the time. Alternatives held up far better than the market during the crisis, in large part because of their ability to short stocks. The HFRI Fund Weighted Composite Index was down 19 percent in 2008, while the S&P 500 was down 37 percent, including dividends. Overseas stocks fared even worse.

Traumatized by the crisis and dazzled by alternatives, GE sold more of its beaten-down risk assets to make room for alternatives -- a classic case of looking in the rear-view mirror instead of the windshield. The S&P 500 has returned 18 percent annually since March 2009 through May, while the HFRI Index has returned just 6.2 percent. Overseas stocks, too, have outpaced the HFRI Index by a wide margin.

GE’s biggest blunder, however, predates the financial crisis. A critical assumption in every pension plan is the expected return from the pension’s portfolio. The higher the expected return, the less the company must contribute to its pension to meet future obligations, and vice versa.

In 1999, GE assumed that its pension portfolio would return 9.5 percent annually. At first glance, that seems like a reasonable assumption. GE’s pension portfolio is highly correlated with a 75/25 portfolio of U.S. stocks and bonds, as represented by the S&P 500 and long-term government bonds. That correlation was 0.92 between 1999 and 2016.

This 75/25 portfolio returned 9.4 percent annually from 1926 to 2016, including dividends -- the longest period for which returns are available.

But the devil is hiding in that return. It happens that the two decades before GE chose its expected return of 9.5 percent in 1999 included one of the biggest bull markets in history. From 1981 to 1998, the 75/25 portfolio returned 16 percent annually. Before that, it had returned half as much, or 8.3 percent annually, from 1926 to 1980.

Given the moment, the prudent assumption in 1999 would have been that returns would be lower over the next two decades. And that’s exactly what happened. That 75/25 portfolio returned 6.4 percent annually from 1999 to 2016, far lower than GE’s expected return of 9.5 percent. GE’s portfolio returned roughly 6 percent annually over that period.

In Step

GE's pension portfolio has been highly correlated with a simple portfolio of U.S. stocks and bonds (click on image):

GE has since tempered its expectations. It now assumes a 7.5 percent annual return. But that may still be too high. Long-term government bonds currently yield 2.2 percent to 2.7 percent, depending on maturity. The S&P 500’s earnings yield is roughly 4 percent, based on 10-year trailing average positive earnings. Earnings yields are higher for overseas stocks, but even so, it’s hard to cobble together an expected return of 7.5 percent.

Lower Expectations

I suspect GE knows all this, which points to a bigger problem than basic arithmetic. A lower expected return would require GE to increase its pension contributions. That would strain GE’s financial condition in the near term -- and by extension its stock price. That’s not what shareholders want to hear.

But GE has little choice. The longer it puts off the hard decisions, the costlier its pension problem will become. The market will eventually acknowledge that reality, and perhaps it already has. Since Bloomberg reported GE’s pension woes last Friday, its stock is down 3 percent through Tuesday, while the S&P 500 is up 0.2 percent.

The right answer is simple. The only question is whether GE has the stomach to acknowledge it.
Michael Hiltzik of the Los Angeles Times also reports, GE spent lavishly on shareholders, shortchanged pensions and still landed in a deep hole:
It’s customary to laud a departing corporate chief executive as a giant of industry and a management genius. That’s the tongue bath General Electric’s Jack Welch received when he retired in 2001. Not so much his successor Jeffrey Immelt, whose legacy already is being panned weeks ahead of his Aug. 1 scheduled departure.

Among other things, a close look is being taken at Immelt’s lavish spending on stock buybacks, especially over the last two years at the behest of the company’s biggest and richest shareholders. A new analysis by Bloomberg contrasts the nearly $46 billion GE spent to appease those shareholders in 2015 and 2016 with its chronic and growing underfunding of its pension plans.

By Bloomberg’s reckoning, the $31-billion shortfall in all GE’s pension plans — about 30% — is the biggest among companies in the Standard & Poor’s 500 by far. Rectifying the shortfall could create a long-term drag on earnings for Immelt’s successor as CEO, John Flannery.

Despite that, Flannery delivered the obligatory paean to Immelt’s leadership when his ascension was announced. (Immelt will remain chairman until Dec. 31.) “I am privileged to have spent the last 16 years at the company working for Jeff, one of the greatest business leaders of our time,” Flannery said, praising Immelt for having “created a vision for the GE of the future.”

Yet Immelt’s tenure has been nothing for investors to laud. Since he took over in September 2001, GE shares have returned a total of about 18% in price appreciation and dividends. In the same period, the S&P 500 has returned 195%.

Immelt gained nothing by paying off investors such as Nelson Peltz, whose Trian Partners held a $2.5-billion stake in GE as of October 2015. Peltz proposed that GE return to shareholders as much as 40% of its market capitalization (then about $260 billion) by the end of 2018, a process he said would raise its share price to $40 to $45 by the end of this year.

As we write, GE is short of both goals: Its current share buyback program totals $50 billion, about half what Peltz advocated, though the company has said that buybacks, dividends and spinoffs will return $90 billion to investors by the end of next year. Its share price is just shy of $29, never having risen higher than $30.86 (last December).

The company’s share repurchases coincided with a distinct underfunding of its pension plans. The buybacks came to $23.7 billion in 2015, including the equivalent of $20.4 billion from its spinoff of much of its GE Capital unit as Synchrony, and $22 billion more in 2016. Meanwhile the pension plans received only about $2 billion.

Partially as a result, the company’s financial disclosures show the shortfall growing within its main plan, covering 231,000 retirees and families and about 242,000 current and former workers and other plans, including those inherited via acquisitions, covering about 120,000 current and former workers. In 2015, the pension obligations of those plans came to about $90.3 billion and their assets to $63.1 billion, for a shortfall of about 30%. Last year, obligations had grown to about $94 billion and assets to about $63 billion, for a shortfall of about 33%.

As Bloomberg observes, GE’s options for closing the gap are limited. It could borrow to cover the expense, except it’s already a highly leverage corporation. And its expectation for long-term growth within the pension portfolio is 7.5% annually, which implies it will have to keep the portfolios heavily stocked with equities, which currently constitute about 56% of their holdings. One analyst cited by Bloomberg suggests that, given the ramp-up in premiums being charged on underfunded plans by the government’s Pension Benefit Guarantee Corp., which insures corporate pension plans, it may be worthwhile for GE to spend less on share buybacks and use the money to close the pension gap.

As a final irony, consider that Immelt has little to worry about in his own pension. As part of his retirement package, according to corporate disclosures, he’s due personal pension benefits worth nearly $82 million.
Of course, what else is new? Corporate America's CEOs have discovered the value of pensions -- their own pension -- as a source of lucrative compensation to add on top of their already egregious compensation package which they manipulate through share buybacks, all part of profits without prosperity.

Now, I'm not going to castigate Jeff Immelt, the outgoing CEO. GE is a monster conglomerate and I personally think even if God was its CEO, it wouldn't have made much of a difference. In my opinion, GE is way too big, too bulky, too lethargic and needs to rethink its entire strategy, talk to Blackstone and other PE shops to sell off more assets and refocus its strategy.

But GE's pension problem won't go way. I read Bloomberg's analysis on the $31 billion pension hole and I'm afraid to say, it's only going to get worse in the next few years as rates plunge and stay at ultra-low levels, and risk assets get clobbered.  The pension storm cometh and it will impact all pensions, public and private.

This is why it's hard for me to get excited about GE's stock (GE) going forward. Yes, the company pays out a decent dividend but a slowing US and global economy and growing pension problem don't bode well for its shareholders in the future, which is why I would be cautious buying shares at these levels (click on image):

Sure, the company can increase share buybacks but not if its pension deficit keeps growing and not if credit markets get roiled, which will make it more difficult for a highly levered GE to borrow to buy back shares or to contribute to its pension plan.

While GE needs to rethink its pension strategy, I strongly believe America needs to rethink its pension policy as public and private pensions crater, leaving millions exposed to pension poverty.

Let me be blunt. In order to "make America great again", you need to bolster corporate and public defined-benefit plans, introduce realistic investment assumptions, improve governance, and adopt some form of risk-sharing when plans run into trouble (read more about this in my comment on the pension prescription).

Is the solution to GE's pension woes more hedge funds and more private equity funds? I actually would beef up alternatives in a deflationary environment but I would choose my partners and strategies very carefully.

But let me be clear, more alternative investments won't cure America's growing pension crisis. I personally think the time has come to enhance Social Security to adopt a similar model to what we have in Canada with CPP assets being managed by the CPPIB. In order to to do this properly, they need to get the governance right.

In fact, I envision a future where all corporations get out of the pension business to focus only on their core business and retirement will be handled by the federal and state (provincial) governments using large, well-governed public pension plans. There will be resistance to such change but it's the only way forward and it makes good pension and economic sense to do this.

One thing is for sure, the status quo isn't working and is leaving too many Americans exposed to pension poverty. It's not just GE's botched pension math that worries me, it's that of the entire country where too many public and private pensions are chronically underfunded.

Below, Bloomberg reports GE's new head will focus on cash and growth. Mr. Flannery will need to focus on a few things, including the pension time bomb. I suggest he talks with the folks at the Caisse who just signed a deal with GECAS. They are in a better position to guide him on how to address the company's growing pension woes. All I can say is don't ignore this problem, it will get much worse.