Thursday, August 28, 2014

What Will Derail the Endless Rally?

Gene Marcial of Forbes reports, Ride With The Bulls Even As Warnings Of A Big Correction Are On The Rise:
With the market’s major indexes continuing to climb to new all-time highs, investors are getting increasingly jittery about the incorrigible bears’ warnings that the huge correction they have been predicting is on its way. The selloff will signal the market has hit its peak, they assert. What to do?

Ride with the bulls — and face any pullback with enough cash firepower to buy the battered shares of fallen angels with proven track records. The proven antidote to a massive pullback is to embrace it and prepare to buy shares of companies that are fundamentally sound and equipped to thrive after a market pullback. The key is to be prepared – not by selling but to be an opportunistic buyer as prices plummet.

“The bears keep seeing market tops as the bull charges ahead,” notes Ed Yardeni, president and chief investment strategist at Yardeni Research. Even some of the bulls had warned about an imminent correction but instead, after a 3.9% drop from July 24 through Aug. 7, the S&P 5000 made a new record high on Monday, Yardeni points out.

But should perplexed investors really worry about the coming of a Big Correction? Not if you listen to savvy market watchers and analysts who recommend running with the bulls. True, the bull market is over five years old now, but Yardeni looks at it this way: “It seems to be maturing rather than aging. It is certainly less prone to anxiety attacks, and has treated buying dips as buying opportunities.”

Indeed, although the market continues to gain and treks to higher grounds, it appears more persistent in climbing walls of worries in the U.S. and overseas.

“While the bears continue to look for signs that the bull market is about to break up, I don’t see any significantly bearish divergences, or decoupling, between key internal stock indicators and the overall market,” says Yardeni. “It’s a well-adjusted bull,” is how Yardeni describes it.

The market’s technical picture looks particularly healthy, according to some veteran technical analysts. “The trend remains bullish and an extension above 2,000 (in the S&P 500) would favor a strong push higher into 2030, where we would expect some initial profit taking,” says Mark D. Arbeter, chief technical analyst at S&P Capital IQ. He notes that the S&P 500 has been in an uptrend within an ascending trend channel for the last few years.

So where is the index headed from here?

“The long-term outlook is pointed higher, while above support at 1,838 – 76. Only a drop below the lower trend channel boundary and support at 1,738 would substantially damage the structure of the big picture rally,” says the analyst.

And based on the fundamentals, the market’s outlook seem as positive, as well. “Indeed, the market may be feeding off of consensus expectations for a near 11% climb in yearly earnings-per-share growth through the second quarter of 2015, as compiled by Capital IQ,” says Sam Stovall, chief investment strategist at S&P Capital IQ. He sees the S&P 500′s “fair value around 2,100 a year from now, based on earnings per share growth forecasts, the expectation that inflation will remain around 2%, and that we get a meaningful digestion of gains along the way,” says Stovall.

Meanwhile, the bears aren’t getting much confirmation for their bearishness, notes Ed Yardeni – not even from the Dow Theory, which postulates that the Dow industrials and transportation groups should both be moving higher in a sustained bull market. Well, both the Dow Jones Transportation and the S&P 500 Transportation indexes rebounded to record highs in recent days, notes Yardeni.

Now that the S&P 500 is almost at our 2014 yearend forecast of 2014 for the S&P 500, well ahead of schedule, we remain bullish and continue to favor financials, health care, industrials and information technology.

These groups appear to be the stocks of choice for continued strength and stamina in this long-running bull market? As the S&P Investment Policy Committee sees it, the energy, health care, industrials, and information technology are the attractive sectors, which they recommend to clients to overweight in their portfolios. The committee rates the financial sector as “underweight.”
In my last comment on the real risk in the stock market, I discussed why I believe the real risk in the stock market right now is a melt-up, not a meltdown that many bears are warning about.

Admittedly, my thinking centers around the big picture, meaning there is an abundance of liquidity in the global financial system -- even if the Fed continues tapering -- and some risky sectors of the stock market are going to take off.  If the ECB finally engages in quantitative easing to combat the euro deflation crisis, it will unleash another massive dose of liquidity which will further bolster global equities and other risk assets.

Soon after I finished writing my comment yesterday, perma bear David Tice,  President of Tice Capital, came onto CNBC calling quantitative easing a "short-term economic fix" and warning that a 50% correction in coming. Abigail Doolittle, Peak Theories founder, also appeared on CNBC proclaiming that the range has started to reverse the QE 3 uptrend, and a major move down is coming.

Another perma bear, SocGen's Albert Edwards, wrote a note to clients warning the S&P is running on fumes:
With U.S Federal Reserve policy easing drawing to a close, Societe Generale's uber-bearish strategist Albert Edwards predicts that a bubble in stock markets is on the verge of bursting.

"Is that a hissing I can hear?" Edwards quipped in his latest research note, published on Thursday.

Edwards claimed the "share buyback party"—which some analysts see as the key driver for recent record Wall Street highs—was now over.

"Companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes," Edwards said.

Buybacks occur when firms purchase their own shares, reducing the proportion in the hands of investors. Like dividend payments, buybacks offer a way to return cash to shareholders, and usually see a company's stock push higher as shares get scarcer.

According to Societe Generale's research, share buybacks fell by over 20 percent the second quarter versus the first quarter. However, TrimTabs Chief Executive David Santschi said in a research note on Sunday that buyback announcements were "solid" as earnings season wrapped up.

Some firms borrow cash to buy back their shares, taking advantage of ultra-low interest rates in the U.S. and other developed nations. Edwards warned that as companies had issued cheap debt to buy expensive equity, a "gargantuan" funding gap could yet emerge.

"The equity bubble has disguised the mountain of net debt piling up on U.S. corporate balance sheets. This is hitting home now QE has ended. The end of the buyback bonanza may well prove to be decisive for this bubble," Edwards wrote.

Edwards is known for his markedly pessimistic predictions, and regularly touts the idea of an economic "Ice Age" in which equities will collapse because of global deflationary pressures.

Some analysts remain unconvinced. MacNeil Curry, head of global technical strategy at Bank of America Merrill Lynch, sees no imminent hit to equities. He predicts further upside for the S&P 500—currently near all-time highs—over the next few weeks, and sees the benchmark index reaching 2,050-to-2,060 points by late September.
Global deflation is coming and the bond market knows it, but Edwards is wrong if he thinks the S&P is running on fumes and won't continue to grind higher. Some of the riskiest sectors, like biotech, are booming again after a spring selloff. When the ECB starts engaging in massive quantitative easing, risk assets (and gold) will really take off.

Of course, nobody really knows where the stock market is heading. A million things can derail this rally and cause jittery investors to pull the plug and sell their stocks. But with pension deficits rising as bond yields fall, pensions will be forced to take on more, not less risk. And where will they be taking that risk? Stocks, corporate bonds and alternative investments like real estate, private equity and hedge funds.

I leave you with an interesting clip below. Charles Biderman, TrimTabs Investment Research CEO, analyzes current market conditions saying the market is essentially rigged and you have to "ride the tide." You sure do but make sure you're in the right sectors because some tides will be a lot bigger than others.

Wednesday, August 27, 2014

The Real Risk in the Stock Market?

Alex Rosenberg of CNBC reports, The strange dynamic that’s guiding stocks higher:
The S&P 500's surge past the 2,000 level this week for the first time ever is just the latest milestone for the great rally that stocks have enjoyed over the past 5½ years. But Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, doesn't think the latest splashy market headlines will do anything to bring in the many retail investors who have long been staying on the sidelines.

Individual investors are "still nervous, they're concerned," Silverblatt said on CNBC's "Futures Now" on Tuesday. "Even though we're into this rally over five years now, and they're getting very little if they're sitting in a bank or some alternatives, they are not moving back into the market." And he said the S&P's crossing of 2,000 won't lure retail investors.

After all, many small investors will not soon forget the market collapses of 2000/2001 and 2008/2009, which robbed them of their confidence in stocks. And in fact, the S&P has taken more than 16 years to get from 1,000 to 2,000—yielding a mere 6.2 percent annualized compound return, including dividends, from then to now.

So if that's the case, what explains the market's drumbeat of new highs? Silverblatt looks to the other key group in the market.

"On the other side you've got institutions, who are sitting in the market. They're reallocating somewhat, but they're not pulling out. These institutions appear to be more concerned with missing out on potential gains than the market declining."

"Both of these groups are just sitting tight," Silverblatt added. "And the market, in between, has taken small steps upward."

So what will shake the confidence of institutions or the reticence of retail investors?

"I'm not sure what kind of event, ... but it's going to be major," Silverblatt said. These two groups are "really difficult to move."
I'll tell you what I'm positioned for, a major melt-up in stocks, especially in biotech and social media sectors, which ironically are the two sectors Fed Chair Janet Yellen warned about. There will be a few more corrections along the way but they will be bought hard as we're fast approaching the "Houston, we have lift off!" phase of another historic parabolic move in stocks that will likely be the Mother of all bubbles.

Why am I so sure? Because there is unprecedented liquidity in the global financial system and the European Central Bank (ECB) is getting ready to crank up its quantitative easing to counter low growth and slowing inflation. Never mind Fed tapering, the baton has been passed to ECB President Mario Draghi, and there is plenty of liquidity to drive risk assets much, much higher.

And that scares the hell out of institutional investors, especially nervous hedge funds that are turning defensive on concerns over asset prices:
Equity long-short managers cut net exposures on average to 40%-45% from 50%, said Anthony Lawler, who manages portfolios of hedge funds at GAM.

Some managers are also using put options—the right to sell at a predetermined price—to protect against market falls, taking advantage of what some investors say is low pricing in these instruments.

Anne-Sophie d'Andlau, co-founder of Paris-based investment firm CIAM, bought puts at the end of June, citing market nervousness over the timing of a rise in U.S. interest rates and possible "negative surprises" in the European Central Bank's review of euro-zone bank assets, which is set to be completed later this year.

Ms. d'Andlau, whose fund is up 12.3% in the year to the end of July, said she was "not so confident on the direction of the market."

"Our analysis is that the current environment is more unstable on a macroeconomic level," she said. "You're buying puts for almost nothing."

Pedro de Noronha, managing partner at London-based Noster Capital, which runs $100 million in assets, has owned default protection on emerging-market sovereign debt for some time but recently sold some stocks and is holding more cash. He said he wanted "to make sure I have dry powder for a tough September/October. I see the market as offering very little value, and this is one of the times where the opportunity cost of sitting on the sidelines isn't so big."

But while funds have generally reduced their bets on rising prices, few believe that markets are in a speculative bubble such as the dot-com boom of the late 1990s, which preceded tumbles in stock markets.

"This isn't a greedy rally," said Chris Morrison, portfolio manager on Omni Partners LLP's Macro hedge fund, which made 5.8% in July as a call against U.S. small-cap stocks paid off. "I don't see people high-fiving. They're not saying 'get your moon boots, this stock is going to the moon.' It has been driven by a desperate need to earn a return."
This isn't a greedy rally? Maybe not but check out some of the monster moves in the biotech sector which are worrying some market watchers, and you'll see the beginning of the next major bubble brewing. And wait, Janet Yellen hasn't seen anything yet. By the time it's all over, she'll need a bottle of the next anti-anxiety biotech breakthrough to calm her nerves.

But be careful with all this bubble talk on biotechs and social media stocks. I happen to think we're at the cusp of  a major secular uptrend in these sectors and talk of bubbles just scares many retail and institutional investors away. I see plenty of great biotech stocks that have yet to take off and Twitter (TWTR) remains my favorite social media stock (it can easily double from here).

Which biotechs do I like at these levels? My biggest position remains a small cap biotech, Idera Pharmaceuticals (IDRA), a company that has revolutionary technology that is grossly underestimated by the market. But there are others I like a lot at these levels like Biocryst Pharmaceuticals (BCRX), Catalyst Pharmaceutical Partners (CPRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA).

The thing with biotech is there is a lot of hype which is why it's best to track the moves of top funds that specialize in this space. For example, Perceptive Advisors' top holding is Amicus Therapeutics (FOLD), a stock that has taken off in recent weeks. The Baker Brothers which focus exclusively on biotechs made a killing when InterMune (ITMN) got bought out by Roche for a cool for $8.3 billion earlier this week. I track their portfolio closely but be careful as all these biotechs are very volatile.

Big pharma is hungry for the next big blockbuster drugs. Just like big hedge funds, they are large and lazy, so they'll be looking to gobble up smaller and more productive biotech players which are actually discovering amazing drugs which are more specific and have less side-effects.

But it's not just about biotech and social media. The big deal earlier this week was Burger King's (BKW) acquisition of Tim Hortons (THI), sending both stocks way up. Hedge fund manager Bill Ackman, who runs Pershing Square Capital, had a huge payday on Monday, cementing his top spot among large hedge funds this year.

And maybe there won't be any parabolic move in stocks, just a slow, endless grind up. One pro who appeared on CNBC earlier this week said we're only 5 years in a 20-year bull stock market:
As the S&P 500 topped 2,000 for the first time Monday, Chris Hyzy said that the stock market is just five years into a 20-year bull market.

"I know it sounds easy to say," U.S. Trust's chief investment officer said on CNBC's "Halftime Report." "When you really think about this, this is an elongated business cycle. You're going to have fair value through most of it. You're not going to get a lot of overvaluation."

Hyzy identified what he saw as key for the continued bull market.

"You're going to have some very big opportunities inter-sector and themes. M&A is running wild. But the key to all of this is the manufacturing in the next decade," he said. "It's already happening. You've got energy independence on its way. The private sector's piercing through whatever restrictions are being put out there, and you've got technological advancement that we haven't seen since the early 1990s.

"That sets us up for an elongated business cycle, which is about five years into a pretty long secular market."

Hyzy, who expects GDP growth of 3 percent to 3.25 percent for the United States this year, said that he liked the financial sector best of all, with selected technology and oil-service plays.

Europe, he added, resembled Japan at the outset of its 20-year deflationary spiral. With credit growth contracting, weakness in Germany and French bond yields below that of the U.S., European Central Bank President Mario Draghi "has to act at some point, and it's a little too late."

"I would argue that the first movement on QE in Europe is a good thing for low-quality assets," Hyzy said. "You'll get the big rally. And then you'll levitate for a while if growth doesn't get there."
Are we only 5 years into another 20-year bull cycle? I doubt it but with bond yields at historic lows, stocks are the only real game to play but you have to pick your spots right or you won't make money.

That's why it's increasingly important to really drill down and understand the portfolio moves of top funds. Ignore Goldman Sachs' top fifty stocks hedge funds are shorting like crazy or the top fifty hedge funds love the most. Most of the time, you're better off taking the opposite side of these trades, and the Goldman boys don't tell you the top fifty stocks hedge funds should be buying going forward (like Twitter!).

There is a lot of garbage out there, stock market porn, and it's no wonder very few retail and institutional investors make money actively managing their portfolios. And it's not just about picking stocks right, you got to get the macro calls right, which very few people seem to be doing.

Just yesterday, I watched and interesting interview with Ambrose Evans-Pritchard posted on Zero Hedge (see below). I agreed with him that the U.S. will remain the economic superpower over the next century but was baffled by his call that rates will rise because "wage pressures" will pick up significantly.

I've said it before and I'll say it again, after we get a huge liquidity driven spike in stocks, we'll see asset prices across public and private markets deflate and a long period of deflation will settle in. There is simply too much debt out there and it won't end well (listen below to Chris Martenson's interview with Hoisington's Lacy Hunt to understand why).

But remember the wise words of John Maynard Keynes, "markets can stay irrational longer than you can stay solvent." The events I'm describing above won't happen in the next year or even five years. So while the Zero Hedge bears keep posting scary clips, relax and mark my words, the real risk in the stock market is a melt-up, not a meltdown, and institutions betting on another crash will get clobbered.

Tuesday, August 26, 2014

The Myths of Shared-Risk Plans?

Hassan Yussuff, President of the Canadian Labour Congress, wrote a special for the Financial Post, Why there’s no benefit in target benefit pensions:
So-called ‘shared risk’ plans have nothing to do with sharing

Every child grows up learning the importance of sharing. It’s also fundamental to the labour movement. Unions bargain with employers to ensure that workers share in the fruits of their labour. This makes for a stronger, stable economy and a fairer society.

Sharing is also at the heart of workplace pensions. Part of the wages and salaries that unions bargain get deferred until retirement, in the form of pensions. When our negotiated pension plans experience funding shortfalls, as they have in the last six years, unions have stepped up and agreed to pay more into the pension fund, even temporarily cutting back on benefit levels. In return, unions expect that employers will live up to their commitments and pay retirees the pensions they’ve earned over a working lifetime – the essence of the defined-benefit (DB) pension deal.

Even as our pensions return to health, however, employers are looking for ways to rid themselves of the cost and headache of pension plans altogether. And the federal government is lending a hand. In April, the federal government announced that it is proposing target-benefit plans or so-called “shared risk” pension plans in the federal private sector, and for Crown corporations.

In fact, so-called “shared risk” plans have nothing to do with sharing. Let’s look at some of the myths around these plans:

Myth 1: “Shared-risk” plans split the risk and rewards between employers and employees.

These plans don’t “share” risk; they dramatically reduce employers’ risk by shifting it onto plan members and pensioners. Employers would enjoy cost-certainty and strict limits on future risk, while plan members face an open-ended risk of benefit cuts, even when retired. Employers converting their existing DB plans would be able to turn promised pension commitments (once a legal obligation that could not be revoked) into fully reducible “target benefits” that may or may not be delivered.

Myth 2: “Shared-risk” plans strike a balance between worker-friendly DB plans and the defined-contribution (DC) plans that employers prefer.

For employers, switching to a “shared-risk” plan brings significant advantages: Employer contributions are capped, no pension guarantees of any kind are made to employees, and no pension liabilities appear on the employer’s financial statements. Plan members, however, experience a massive loss of security: The legal protection for already-earned benefits is taken away, and everything can be reduced, including pension cheques being mailed to retirees.

Myth 3: If benefits are reduced in a “shared-risk” plan, they will only be temporary reductions.

In fact, there is no requirement in a “shared risk” plan that benefit reductions only be temporary. Permanent benefit reductions are indeed a possibility in this model. This means, absurdly, that temporary shortfalls in the plan could lead to permanent reductions in benefits.

Myth 4: The “shared-risk” plan is a hybrid, in which some benefits are guaranteed and some (like inflation protection) are conditional.

Not true. There are no legal benefit guarantees of any kind in “shared risk” plans. All benefits (whether basic pension benefits, or additional benefits like inflation indexing) can be legally reduced without limit.

Myth 5: Unions have embraced the “shared-risk” model.

The vast majority of unions do not support the conversion of DB plans into “shared-risk” plans. Faced with the distinct possibility that their pension plan would be wound up, a small number of New Brunswick bargaining units supported “shared risk” plan conversions for a few severely-underfunded pension plans. By contrast, “shared risk” conversions are now being proposed for healthy and sustainable pension plans, across the country.

The fact of the matter is that the “shared-risk” approach is about one thing: reducing employers’ risk and cost. But Canadians cannot allow the conversation to be restricted to just employers’ costs. We have to talk about adequacy and security of retirement income, and in that respect, we’re not making progress. Access to pensions at work continues to dwindle as a share of the working population, and a growing number of families face a retirement plagued by financial insecurity.

Over 60% of working Canadians have just one pension plan at work: the Canada Pension Plan or the Quebec Pension Plan. These plans are truly shared, paid for equally by employers and employees. The Canadian Labour Congress calls on the federal government to expand the Canada Pension Plan and Quebec Pension Plan. The government’s misguided shared-risk initiative will only further undermine the retirement security of Canadians.
In my last comment on whether Quebec is pulling a Detroit on pensions, I argued that it's about time Quebec tackles its pension deficits and introduces real risk-sharing in their municipal and other public pension plans.

In his comment above, Mr. Yussuff argues that shared-risk plans have nothing to do with sharing and only benefit employers, while severely undermining the retirement security of employees who could potentially face "permanent" cuts to their retirement benefits which they are legally entitled to.

Is Mr. Yussuff right? Yes and no and let me explain why. I went over New Brunswick's pension reforms and followed up in another comment where I revisited these reforms, discussing why Bernard Dussault, the former Chief Actuary of Canada working for the Common Front, thought New Brunswick's shared-risk was nothing more than risk-dumping:
  • although not properly identified and designed in Bill C-11, the proposed increase in PSPP members’ contribution rates and the proposed increase from 60 to 65 in the age at which PSPP members become entitled to a normal (unreduced) retirement pension, respectively, are the only areas of remedies that are relevant to the unfavourable financial findings identified in the April 1, 2012 actuarial report on the PSPP;
  • it is unfair, as it does make pension indexation, both active and pensioned members, dependent upon the ongoing financial experience of the PSSA through the use of inappropriate actuarial and accounting mechanisms that properly account for indexation in the contributions and assets of the PSPP but not at all in its liabilities;
  • it fails to show the proportion of the PSPP cost that will be shared by active PSSA members; and
  • it is too complex, which was publicly acknowledged by the Minister of Finance, as he did himself publicly stated that he does not fully understand it, and as its implementation, management and day to day administration would be an overly expensive and intricate endeavour.
In this case, I agreed with Bernard, there were irregularities in the terms for pension indexation and what proportion of the PSPP cost will be shared by active PSSA members.

But that doesn't mean that shared-risk plans should be scrapped because they are inherently unfair to employees. This is pure rubbish and I have a bone to pick with Mr. Yussuff and the Canadian Labour Congress for spreading some blatant lies and falsehoods in the comment above.

A perfect example of a defined-benefit plan that is fully-funded and has implemented a shared-risk model is the Healthcare of Ontario Pension Plan (HOOPP). In fact, HOOPP is now overfunded and looking at ways to increase benefits to its members, which can include cuts in contributions or better indexation. In this case, shared-risk doesn't mean risk-dumping on employees; it goes both ways.

Another example is the Ontario Teachers' Pension Plan (OTPP), which has also adopted a shared-risk model with its members. For all effective purposes, OTPP is fully-funded, which is quite remarkable given the Oracle of Ontario uses the lowest discount rate in the world among public pension plans to discount its future liabilities.

But both these plans did implement some forms of risk-sharing in the past to temporarily deal with their shortfalls when times were tough. In particular, they temporarily cut the cost of living adjustments to members for a period of time until their plan became fully-funded again.

In doing so, both employers and employees benefited because the contribution rates stayed the same. Pensioners temporarily suffered a marginal cut in cost of living adjustments but it wasn't a huge or permanent hit to their benefits.

There is another problem with Mr. Yussuff's comment, one that really irks me. Sometimes I feel like these unions live in a bubble, completely and utterly oblivious to what is going on in the private sector and completely clueless about how unfunded liabilities are a debt and can severely impact a country's debt rating. And he completely ignores the demographic shift and the rising challenge of measuring and managing longevity risk.

Once again, let me go back to what happened in Greece. In order to avert a full default, which would have been catastrophic to Greece and spelled the end of the eurozone, Greece had to accept savage cuts in wages and pensions forced upon them by troika which represented bondholders.

And in Greece, public employee unions were living in a bubble, completely oblivious to the plight of the private sector and the economic realities of a country living way beyond its means. What happened? The private sector in Greece had to borne the brunt of the savage cuts and only later did public employee unions succumb and accept cuts to pensions and wages.

But till this day, hardly any public sector employee in Greece lost their job. Sure, their wages and pensions were cut in half or by two-thirds, but the massive unemployment that Greece experienced in the last few years was all in the private sector. This is where troika and the bondholders really screwed things up with their myopic and idiotic austerity measures. When 50% of the Greek working population has a public sector job with the benefits that go along with these jobs, there is a serious problem. The cuts should have been in the public sector, not the private sector.

Anyways, don't get me started on Greece and troika, my blood boils. Let me get back to Canada and Mr. Yussuff's comment above. I think he's intentionally exaggerating his points and spreading lies and falsehoods to make public sector employees be the victims of shared-risk plans, but this is pure rubbish.

One area where I do agree with Mr. Yussuff and the Canadian Labour Congress is that it is high time the boneheads in Ottawa enhance the CPP for all Canadians, regardless of whether they work in the public or private sector.

I have a vision for Canada's retirement security. In my ideal world, OTPP, HOOPP, AIMCo, OMERS, Caisse, bcIMC, and other large public and private defined-benefit pensions will be working for all Canadians, just like CPPIB is doing right now. It's akin to what they have in Sweden where you have a series of large, well-governed state plans serving all Swedes but even better because the Swedes didn't get everything right.

In my ideal world, you'll have true shared-risk among all Canadians and the benefits that go along with that. There will be pushback by some banks, mutual funds and insurance companies but in time, even they will see the benefits of this approach which brings true retirement security and pension portability to all Canadians.

Below, Angela Mazerolle, Superintendent of Pensions and Superintendent of Insurance at New Brunswick's Financial and Consumer Services Commission, shares insights from her session "Shared-Risk Pension Plans" while at the International Foundation's 46th Annual Canadian Employee Benefits Conference in San Francisco. Listen to her comments and keep an open mind on share-risk plans, they aren't as bad as Mr. Yussuff claims.

Monday, August 25, 2014

Quebec Pulling a Detroit on Pensions?

Don Pittis of CBC reports, Workers not to blame for Quebec pension problem:
A deal's a deal, right? Well, not when it comes to the province of Quebec and the pensions of its municipal employees.

And if Quebec gets away with cutting municipal worker pensions, which have been eaten away through mismanagement by the very people doing the cutting, then watch this phenomenon spread.

Quebec is pulling a Detroit. About a year ago, I pointed out that the shattered dreams of Detroit pensioners should be a warning to the rest of us. But unlike Detroit, Quebec is trying to snatch back promised pension money by fiat through its proposed Bill 3 pension reform legislation, without the inconvenient legal process of bankruptcy.

To read many of the stories about these Quebec pension cuts you would think that it was the pensioners' fault. The same kind of thing happened in Detroit. Outraged taxpayers inveigh against government employees for sucking money out of the public purse for a cushy retirement. It's as if by choosing a job with a pension and keeping to their side of the contract, the workers are taking advantage.

"Right now, municipalities are taking all of the risk on the payouts and employees are taking relatively none of the risk," said economist and McGill Professor Brett House on CBC's Montreal's radio morning show.

Such comments anger Bernard Dussault, the architect of the Canada Pension Plan and former Chief Actuary for the Government of Canada. The CPP is well known around the world because, unlike many government plans, it is properly funded and can pay out forever (as I've mentioned before, the flaw with the CPP is the actual payout is too small, barely covering rent in many Canadian cities). In fact, this week the chief executive of Hong Kong's social services said he is studying CPP as a model for the reform of the territory's pension system.

As an actuary, Dussault is a sort of super statistician who studies lifespans, average investment yields and the cost of risk. He says that if you do your calculations right, update them frequently and set enough money aside, there is almost no risk involved with pensions.

He says "risk" is not the reason Canadian pension plans are facing problems, and he points out that Quebec is not an exceptional case.

"There are plans with problems all across Canada," says Dussault.

In every case, he says, the problem is a simple failure to set enough money aside.

Many blame the market crash of 2008 for shortfalls in pension plan investment returns. Dussault agrees that was a setback, but adds that it's a weak excuse, because as I write this the Toronto stock exchange has just hit another all-time record high. Yes, it's higher than the peak before the crash. And any pension contributions invested since the crash have seen extraordinary gains.

That assumes, of course, that the pension plans have collected enough money in contributions from both employer and employees, and have actually invested it. And therein lies the flaw.

In Quebec's case, the pension deficit can be traced back, in part, to a previous attempt to balance the province's books. Back in the nineties, Quebec downloaded hundreds of millions in costs to the municipalities. To help them deal with those expenses, since pension plan investment returns were strong at the time, municipalities were permitted to take a pension-contribution holiday.

Brett House agrees that pension holidays were a mistake, and regular contributions should have continued. "By any historical measure, those were exceptional surpluses that should have been saved rather than disbursed."

Actuaries know that even if things look really good one year, that only makes up for other years when things look really bad.
In the dark

And unless they did some serious homework, the workers wouldn't even know the pension pot wasn't full.

Their monthly contributions would come off their paycheques. They would get periodic pension statements showing their accrued benefits based on the promises in their contract, but the accounting in those documents was imaginary. By this year the province, which is ultimately responsible for municipal debts, was in the hole by almost $4 billion for municipal pension deficits.

Just like Detroit, just like the car companies, Quebec and its cities negotiated these pension contracts with their unions with their eyes wide open. Now they are planning to walk away from those deals. Years after you've signed a deal with the bank you can't go and say, "You charged me too much for my mortgage; I'm taking it back." Try it and see what happens. But that is what the province is saying to city workers.

And in their negotiations for improved pensions, the workers traded away other benefits, like better pay. "We’d rather have taken our salary raises," says the head of the Gatineau police union.

"It is terrible because it is stealing money that has already been accrued," says Dussault.

He adds that Canada has a good financial reputation because it regulates banks, insurance companies and pension funds.

"So now we allow pension plans to renege on their obligations," he says. "We will next allow banks and insurance companies to renege on their obligations?"

Dussault points out that Quebec is not the first to take away pensioners' accrued benefits. New Brunswick did the same thing and pensioners are still not happy about it. And he says if Quebec succeeds, it won't likely be the last.

Perhaps the most underfunded pension plan in the country belongs to the federal government. Federal employees have pension contributions deducted and they go into a "fund," but that fund is based on what Dussault calls "notional bonds." Essentially, the contributions are on the government's books, but they go into general revenue and no outside assets are purchased to cover them — ultimately the payment to the pensioner will come out of future general tax revenue.

"All this accounting is theoretical. It is not real money," says Dussault. "I don't see the federal government reneging on its obligations, but there are more and more pressures. And that frightens me."

Despite the theoretical accounting, Canada's federal government more or less has its financial house in order. But as we saw in Detroit, other governments — and many companies — have shown a willingness to hide disturbing amounts of financial trouble by sweeping it under the carpet of pension deficits.

It may be a painful process, but it appears that Quebec workers will be forced to negotiate a new pension deal. As they do so they should study other arrangements, such as the Ontario municipal pension fund OMERS and the Ontario Teachers Pension Plan. Those pension plans are fully funded and about as well managed as any pensions anywhere.

The difference? It's certainly not risk. They were exposed to the same market crash as everyone else.

What is different is where the money goes and who manages it. Contributions from both the employees and employer go straight into a fund. No notional bonds. No deficits. No promises to pay later.

And the fund is invested and controlled by the employees. The only way the government will get that money back is in the income tax those pensioners pay as they live out a comfortable retirement.
In her article, Ingrid Peretz of the Globe and Mail reports, Quebec pension status quo ‘no longer option’ says Montreal mayor Coderre:
Montreal Mayor Denis Coderre said he would “never give in to thugs” as the province’s political leaders appeared ready to take on restive public-employee unions over Quebec’s controversial pension-reform plans.

Hearings into the Liberal government’s pension legislation opened in Quebec City against a backdrop of heightened security and noisy street protests by municipal workers furious about the bill.

As employees protested outside, Mr. Coderre and the mayor of Quebec City, Régis Labeaume, both outspoken proponents of the pension changes, said taxpayers couldn’t keep sustaining the current pension regime.

“The status quo is no longer an option,” Mr. Coderre said. “We’re now confronted with a financial reality we can no longer ignore.”

Pension costs in Montreal have more than quadrupled since 2002 and now eat up 12 per cent of the municipal budget, the mayor said. Mr. Coderre said he was open to compromise with the unions but wouldn’t countenance the rowdy spectacle that unfurled at City Hall Monday night, when protesting firefighters and other municipal employees surged into the historic building and littered it with papers and other debris.

“The last few weeks have been hectic and even emotional for many people,” Mr. Coderre said. “But now, time has come to work together.”

The pension legislation, Bill 3, seeks to have municipal employees in Quebec assume a larger share of their pensions by requiring workers and cities to split the cost of covering their plans’ $4-billion deficit.

The proposal has morphed into the first major test for Premier Philippe Couillard, who has made belt-tightening a byword of his four-month-old government. He has vowed to stand firm on pension reform.

As expected, unions are up in arms over the proposals. Serge Cadieux, secretary-general of the Fédération des travailleurs du Québec, told the hearings Wednesday the bill was inequitable, set a bad precedent and was probably unconstitutional.

City unions in Montreal have never shied from a forceful fight with their bosses. Blue-collar workers have a track record of militancy: A former, high-profile union leader, Jean Lapierre, appeared at a demonstration in Montreal on Wednesday to announce that protest actions would get more “radical” and this was “only the beginning of hostilities.” Police officers in camouflage pants and fire trucks plastered with stickers have become routine in labor conflicts.

But it’s unclear whether the public will side with the unions this time. Several observers say Monday’s vandalism at City Hall may have cost the unions some public sympathy; police officers were seen on site standing by without reining in the rowdy demonstrators.

The head of Montreal’s police union, Yves Francoeur, defended his members on Wednesday, saying they never got the green light from senior officers to step in and carry out crowd control. Even after the boisterous mob had entered City Hall, police sought the go-ahead from their superiors to do their job, Mr. Francoeur said. But the rank-and-file officers were told no, because city hall had not requested police intervention. Mr. Francoeur referred to the incident as a “comedy of errors.”

Hearings into Bill 3 continue on Thursday.
There is a lot to cover in these articles. First, let me agree with Bernard Dussault, Canada's former Chief Actuary, Quebec's pension deficits were exacerbated by the 2008 crisis, but the real problem can be traced back to balancing the books by neglecting to top up pensions. These "contribution holidays" sounded good at the time because markets were roaring and interest rates were much higher, so many pension plans had surpluses instead of deficits.

However, contribution holidays ended up being a disaster for many Quebec, Canadian and U.S. plans. In fact, fast forward to 2014. While stocks and other risk assets pensions invest in (like corporate bonds) have soared to record highs in the last five years, interest rates keep declining to historic lows, and that spells trouble for pension plans.

Why? Because the decline in interest rates is a much more important factor in terms of impact on pension deficits than soaring asset prices. And if rates keep falling because global deflation takes hold, watch out, asset prices and interest rates will tumble, and pension deficits will explode throughout the world (like 2008 only much worse because it will last a lot longer).

Why is the decline in interest rates a bigger factor on pension shortfalls than soaring asset prices? Because future liabilities on pensions are typically discounted using market rates and if interest rates decline, pension deficits widen even if stocks and corporate bonds are doing well. In finance parlance, the duration of pension liabilities is a lot longer than the duration of pension assets, so a decline in interests rates will disproportionately impact liabilities a lot more than a rise in asset values. 

This is where I part ways (somewhat) with my good friend, Bernard Dussault. Given where we are now in 2014, and given the immense risks of global deflation that I see ahead, I'm not at all comfortable with the current risk-sharing aspects of Quebec's pension plans and have expressed my concerns here and here.

In my opinion, if Quebec doesn't slay its pension dragon once and for all, it will head the way of Greece where bond vigilantes rammed through savage cuts on public (and private) pensions and wages.

This is very important and I want people to fully comprehend the point I'm trying to convey here. Quebec is a lot richer than Greece but there are eery parallels in the way public finances have been mismanaged between the two and the insane power that public employee unions hold. In fact, one of my friends is dead serious when he warns me: "Mark my words, when the shit hits the fan, Quebec is the next Greece."

This might sound crazy but to those of us who know Greece and Quebec very well, there were a lot of promises made over the last three decades to buy votes from public employee unions, and everyone knew these promises cannot be kept in the future. But politicians being politicians were only thinking of gaining political power, not the powder keg they were creating in the future.

It's nice to retire at 55 or 60 after 30 years of working with a guaranteed pension till you die but is it affordable and realistic? These promises were made at a time when the demographics were favorable to pension plans, ie. when you had more active workers relative to pensioners and people weren't living as long as they do now. This is no longer the case. As the baby boomers retire, we will see a lot more pensioners relative to active workers and these pensioners are living longer. The ongoing jobs crisis plaguing the developed world will only exacerbate this trend.

Of course, it's not all driven by demographics because the reality is that investment gains in well governed defined-benefit plans account for 2/3 of most pension pots, and only 1/3 comes from employee and employer contributions. 

So what do we need to do now? We need to consolidate many municipal and city plans in Quebec to create a new municipal employee retirement system akin to OMERS in Ontario.Then we need to implement world class governance, adopting best practices from around the world, not just Canada.  Lastly and most importantly, we need to implement real risk-sharing so employees and employers share the risks of these plans equally so taxpayers don't foot the bill if pension deficits explode.

If you look at most fully-funded pension plans in Canada, whether it's HOOPP, Ontario Teachers or CAATT, the employees and employers share the risk of their plan. This means, if markets go sour, they implement measures to reduce the pension deficit by increasing contributions or decreasing pension benefits (like cost-of-living adjustments).

This is where a funding policy is critically important. I recently discussed PSP"s funding policy, going over some of the problems mentioned above with the federal government's pension plans. It's not yet clear what the federal government will do but my advice would be to have PSP manage the assets and liabilities accrued before 2000 of these federal plans and adopt risk-sharing measures. If that happens, the funding policy will be even more critical.

I know this is a long comment and pensions are an emotional subject for many people who have contributed to their pension plan over many years and expect the pension promise to be delivered. But the pension chicken has come home to roost, not only in Quebec but all around the world. 

I agree with Denis Coderre and Philippe Couillard, pension reforms cannot wait. If public employee unions don't sit and negotiate some form of risk-sharing in good faith, there will be a day of reckoning for pensions, and when it comes it will be too late. The bond vigilantes will impose savage cuts on public pensions and wages just like they did in Greece.

I'm not being a scaremonger here. I'm being brutally honest. While I agree with many of the comments of Bernard Dussault, the economic and political reality is that pension reforms cannot wait any longer. I'm all for defined-benefit plans but you have to get the governance and risk-sharing right or else they are doomed to fail spectacularly.

If you have any comments, feel free to email me at Please remember to contribute to this blog via PayPal at the top right-hand side. I thank the institutions that have contributed and ask many more to do so.

Below, as Quebec workers vow to keep up the pressure over a proposed increase in their pension costs, I embedded an older clip where thousands of Greek pensioners have taken to the streets of the capital Athens to protest against government cuts to their income.

If you think this will never happen in Quebec or Canada, you're dreaming.  When the money runs out, Quebec and the rest of the world will head the way of  Detroit and worse still, Greece where savage austerity measures have been imposed by the bond vigilantes.

Of course, I agree with France's economy minister, German austerity is not the answer and it will only exacerbate the euro deflation crisis. It's time for Quebec, Canada and the U.S. to implement real pension reforms before we reach a critical point of no return, leaving the decision up to bondholders.

Wednesday, August 20, 2014

Leverage Spells Headline Risk for SDCERA?

Dan McSwain of U-T San Diego reports, Leverage spells headline risk for pension fund:
By tradition, a public pension fund is safe and boring.

If you run one of these multibillion-dollar funds, replacing a lost benefit check should be your biggest problem on any given day. Same goes for taxpayers who support the pension system, and retirees who depend on it.

Here’s what you don't want: A front-page article about your fund in The Wall Street Journal.

Yet that’s precisely where San Diego County’s fund landed Thursday morning, as it has on many U-T San Diego covers in recent years.

Here’s how Journal reporter Dan Fitzpatrick described the situation: “A large California pension manager is using complex derivatives to supercharge its bets as it looks to cover a funding shortfall and diversify its holdings.”

That sounds neither safe nor boring.

Until the 1980s, when pension managers began adding stocks to portfolios, most funds were restricted to ultrasafe government bonds. But by the 2000s, many had added hedge funds, commodities, private equity and other alternative investments.

Now fund managers are reconsidering whether the returns have justified the additional risk. On Monday, The Wall Street Journal reported that managers of CalPERS, the nation’s largest fund, are considering a move away from alternatives.

The trend leaves San Diego County increasingly alone at the cutting edge of complexity.

And this story isn't over, because members of the fund’s governing board face important decisions about how their manager will make highly leveraged bets.

In April, the fund’s governing board voted unanimously for a new investment strategy.

Under the previous strategy, the county fund was among the nation’s most aggressive in its use of leverage. The board allowed investment strategist Lee Partridge of Houston to effectively borrow 35 percent of the fund’s assets for bets on Treasury prices.

But now, as of July 1, Partridge has a green light for 100 percent leverage, according to Brian White, the fund’s chief executive.

Put another way, Partridge can leverage the county’s $10 billion retirement fund, using derivatives, to place at least $20 billion at risk in stock, bond and commodities markets.

I use the term “at least” advisedly, because board member Richard Vortmann estimated at a July 17 board meeting that the actual leverage could easily approach 150 percent.

Partridge didn't correct him. Nor did officials with Wurts Associates, the independent consultant hired to monitor the fund’s risk management.

Given the history of spectacular collapses of leveraged investment funds, why does the county use such complex financial tools?

Because it needs money.

Partridge and Wurts have forecast average annual returns of about 6 percent over the next decade, using a traditional investment portfolio of 60 percent stocks and 40 percent bonds.

This would be very bad news for the county’s fund, which assumes it will earn at least 7.75 percent a year to meet retirement obligations.

For perspective, the fund’s actuarial debt to its members increased 4.7 percent last year to $2.45 billion — mostly because its portfolio earned 7.73 percent. Cutting returns to 6 percent could add billions to its liability.

So the fund’s board, in the clearest terms possible, has instructed Partridge to boost those returns. His strategy, stated explicitly in public meetings, is increasing risks to the pension fund — using leverage — to raise returns.

“We’re trying to bring up the risk, not keep the return and dial down the risk,” he said in April.

To be clear, Partridge and Wurts officials say there are plenty of circuit breakers built into the strategy to prevent the entire fund from disappearing.

However, large “downdrafts” are possible, Partridge said. Such losses could very well equal those of a traditional pension fund, which holds 60 percent in stocks and 40 percent in bonds, he said.

At its Sept. 18 meeting, the board could approve an “investment policy statement,” a document following the April decision that is supposed to define the fund’s complex strategy.

The effort has not gone well. In July, the board rejected the 18th draft of this key document.

What’s been missing is much discussion of the fund’s headline-grabbing history with leverage.

In 2001, the San Diego County Board of Supervisors approved a 50 percent increase in lifetime benefits to retirees, instantly creating $1.4 billion in debt for the pension fund, which was worth $3.7 billion at the time. The board then borrowed $900 million.

In 2006, an $87 million county investment collapsed after a young trader at a “multistrategy” hedge fund lost $6 billion in a week. Then, in 2008, the county’s portfolio lost 25 percent of its value, much of it on leveraged equity hedge funds.

Like most funds, the county’s has bounced back, earning an average 9.7 percent a year since 2009.

But the board's fondness for risk is still earning it headlines.
Last year the fund sent three board members to a training session in Hawaii, where one of the sessions was called “Avoiding a Front Page Scandal at Your Pension Fund.”

Perhaps they weren't taking notes.
Brian White, SDCERA's CEO, responded to these claims in a comment published in U-T San Diego,  SDCERA uses smart investment strategy for pension fund:
Recent media coverage of the San Diego County Employees Retirement Association (SDCERA) has suggested its retirement fund’s portfolio managers have recklessly pursued riskier investments in pursuit of higher returns to close the pension funding gap. In fact, nothing could be further from the truth. SDCERA is answering the real concern impacting public pensions by using tried and true principles of asset liability management and diversification, and not relying heavily on more volatile equities to close this gap.

The fund is responsible for paying the retirement benefits for thousands of individuals, and has done so consistently since 1939. SDCERA’s administration of the retirement contributions and the fund’s investment earnings have pre-funded 80 percent of the assets necessary to pay for members’ promised future benefits. SDCERA’s Board of Retirement, which includes county representatives, active employees, and retirees, monitors the risk in the portfolio and periodically adjusts the strategy to account for changing macroeconomic and market conditions.

For the past decade, San Diego County and its employees paid 100 percent or more of their annually required contribution to the SDCERA retirement fund. Consistent employee and employer contributions over the years have laid a foundation for investment gains and asset growth. SDCERA’s investment strategy helps the employer’s budgeting process and stabilizes employer costs by reducing the volatility of returns and steadily achieving the rate of return needed to fund the benefit.

At $10 billion, the SDCERA fund is able to pursue certain investment strategies that larger plans like CalPERS cannot access and smaller plans do not have the resources to deploy. SDCERA’s investment strategy is purposely designed to be no riskier than traditional pension fund asset allocation strategies. Risk-parity and trend strategies, which utilize leverage, are limited to 25 percent of the SDCERA portfolio, not the entire set of portfolio assets. The other 75 percent of the portfolio is managed using traditional asset allocation and rebalancing approaches.

SDCERA focuses on controlling the volatility of the investment portfolio and diversifying across a range of investments suited for a variety of economic environments. The use of leverage is a useful and effective tool that allows us to increase exposure to diversifying assets while reducing exposure to more volatile assets like equities. Different portions of the portfolio have different levels of risk, all of which together contribute to a diversified fund designed to moderate risk over the long term across different economic conditions.

SDCERA utilizes leverage in an attempt to obtain superior risk-adjusted returns and long-term, prudent growth through diversification, not to achieve higher returns or reduce funding shortfalls. This point has been discussed in public at many SDCERA board meetings since before the initial adoption of the strategy in October 2009. At that time, SDCERA adopted an investment strategy with the objectives of diversifying the portfolio across a wide range of economic scenarios; managing exposure levels to various asset classes more dynamically to maintain predetermined risk and diversification targets; and adopting a more conservative approach, as measured both by the variability of returns and by the reduced likelihood and potential magnitude of a significant loss of capital. With this investment strategy in place, SDCERA’s portfolio has performed as expected — preserving capital in difficult markets and generating strong returns in up markets.

Of course, no investment program offers guaranteed success, and as shown throughout history, drawdowns can have an enormously negative impact on the overall financial health of an investment program. With these important considerations in mind, SDCERA’s board adopted an asset allocation designed to serve the dual objectives of maximizing the fund’s likelihood of meeting its return objective while minimizing the risk of significant loss. This is clearly much different from using leverage to increase risk in an ill-conceived pursuit of higher returns. This change was adopted by a unanimous vote of SDCERA’s board after months of public discussion, consideration of a wide range of options, and stress-testing in various economic conditions.

SDCERA’s meticulous risk management is the opposite of “gambling” — it is prudent governance. Managing risk exposure has been a long-standing practice at SDCERA, and one that continues in the fund’s current investment strategy. This context is crucial to fully understanding SDCERA’s approach to portfolio management.
Last week, I posted a comment on how some pensions are using more leverage to combat pension shortfalls, discussing SDCERA's use of leverage. Following my comment, Doug Rose, a former trustee at SDCERA (served from 2002- June, 2014) and a long time reader of my blog, shared these comments with me:
It’s unfortunate that the Wall Street Journal relied on the report of a local business columnist in writing about the SDCERA portfolio, as what that columnist wrote and what the facts are happen to be exactly opposite. For example, the leverage is not across the entire portfolio. I won’t go point by point--- I have attached below the SDCERA response printed today in the local newspaper.

I noted you poked around the SDCERA website. I am proud to say that SDCERA is one of the most transparent pension funds in the country. Since 2010, every meeting is broadcast live over the internet, with all supporting documents the trustees use posted on the broadcasts as well. In addition, those meetings are then archived so that anybody can review the meeting and the documents at a later time. The link is found at the “meetings online” section of the website, where you can scroll through to any meeting you want. The discussions of the trustees and staff, and the documents that we relied on are publicly available—see the “investment meetings” dating back through last year when discussion of the structure of the current portfolio first began, and investment meetings going back to 2010 where the prior portfolio with similar objectives was first constructed.

As far as Chris Tobe goes, let me be blunt----he’s full of crap. The “whistleblower” he refers to is an investment analyst who was fired for repeatedly disclosing confidential documents to the press. That firing was upheld by a Civil Service Commission following a three day hearing, and his federal lawsuit against SDCERA for his firing was dismissed by the judge. There aren’t shady dealings at SDCERA, nor dozens of articles about the shady dealing at SDCERA.

Short term performance is meaningless to draw conclusions about a portfolio, but while we are on the topic—the SDCERA portfolio, designed to minimize volatility and guard against downside risk, returned 6.5% in fiscal year 2012, vs equity heavy peers that were negative or returned 1-2%. As expected, last year SDCERA returns lagged more equity heavy peers, and in every year where equity markets soar, SDCERA will lag but still beat its assumed rate of return.
I thank Mr. Rose for sharing these comments with my readers and I am glad SDCERA is very open and transparent about their board meetings (other public funds should follow this level of openness).

I think the intelligent use of leverage can actually increase risk-adjusted returns, but SDCERA needs to be very careful in implementing this "risk-parity" strategy at this point in time. Go read my previous comment on Leo de Bever discussing the long, long view. Listen carefully to his presentation and the follow-up discussion where he discusses how the intelligent use of leverage can decrease risk of the overall fund, as well as the risks of implementing risk-parity and the LDI approach at this time.

But Leo is outspoken on the terrible returns for bonds he sees over the next decade and he discusses the perils of implementing risk-parity strategies and liability-driven investment approach (LDI) at this time (roughly 45 minutes into the clip).

However, I received this comment from an astute investor who agreed with me and disagreed with Leo on where rates are heading:
The advice to stay short duration in fixed income was pretty much good advice from about a year post credit crisis, more or less til this year. Short and long rates have since been falling, and the yield curve is flattening. Despite all central bank efforts, I tend to see a mild deflation scenario playing out, something you have commented on. With that in mind, I think fixed income holders are best served to be diversified in credit and interest rate duration, and currency, definitely avoid an all in directional bet on rates.
Go back to read my comment on the Caisse warning of headwinds ahead. I discuss my views on why I think deflation is the ultimate endgame and why rates aren't going to rise anytime soon.

I have a question for all of you who see "terrible" or "disastrous"returns on bonds over the next decade. Where are the jobs going to come from? Where is wage pressure? Where is inflation except for risk assets which can collapse at any time?

I'm trying to be optimistic but the global economy isn't exactly firing on all cylinders. Employment growth is picking up in the U.S. but too many consumers are just getting by, saddled with unprecedented debt. The euro deflation crisis will drag Euroland into a protracted period of subpar growth. Japan is pulling out all the stops to lift inflation expectations but that country is not out of deflation yet. And if Abenomics fails, watch out, it's headed for an even worse bout of deflation.

What about emerging markets? They have staged a comeback in recent months, but growth prospects remain tempered and uneven in various countries and the threat of geopolitical turmoil, Fed tapering and lower oil and commodity prices can wreak havoc in these markets. And despite the secular trend of growth, it's still unclear how this growth will develop and what pitfalls investors will endure along the way.

All this to say that the biggest risk out there, in my humble opinion, remains deflation, not inflation. If that's the case, pension funds should still be adopting an LDI approach despite historically low rates (see Jim Keohane's comments here) and/or increase leverage to implement a risk-parity framework despite the dangers of fighting the last investment war.

The most important question for any pension fund or asset manager going forward is who will win the titanic battle over deflation? I've repeatedly warned you that deflation is coming and it will expose naked swimmers. That's why bond yields are falling even though the Fed is tapering. And despite unprecedented monetary stimulus, there is a jobs crisis and private debt crisis going on all over the world and the risks of deflation remain high.

The only place where I see inflation is in risk assets like stocks and high yield bonds. But you have to pick your spots right and deal with huge volatility or else you'll get crushed. This is one reason why I think the Caisse has opted to invest $25 billion in a global portfolio made up of major companies positioned for growth in emerging markets, including Procter & Gamble Inc., Unilever Group and Nestlé SA. In a deflationary world, they're opting to focus on big, safe companies with pricing power.

That is one approach but another one which I recommended is to co-invest with top hedge funds they're investing with or just track my quarterly comments on top funds' activity and take smarter risks in public equities as opportunities arise.

For example, when Twitter (TWTR) fell below $30, I would have been pounding the table at the Caisse or PSP to pounce and take an overweight position. Admittedly, I'm getting a little ahead of myself but there are some dips on specific stocks pension funds have to buy -- and buy big. Why should they pay some hedge fund 2 & 20 when they can do it themselves?

The same thing goes for the biotech companies I recommended. It's still early in the game but when I tell you there is a biotech revolution going on, I know what I'm talking about. I'm not just looking at the Baker Brothers' portfolio, I've got real skin in the game. I was diagnosed with MS almost 20 years ago and have tracked unbelievable advances in drug therapies and other treatments which include stem cells and advances in genomics. I see the future now and taking part in drug trials that are revolutionary!

Too many pension funds are not thinking long term. They're working in silos, worried about ramping up a specific asset class, listening to recommendations from their useless investment consultants. They are not thinking about investing through the cracks or taking risks where others refuse to take risks.

Anyways, everyone has their views on how to manage pension assets. I happen to think that far too many pension funds are worried about headline risk and not rocking the boat with their board of directors. They're not thinking about using their long, long investment horizon to take intelligent risks across all asset classes, in between asset classes and in under-invested sectors (like biotech, renewable energy, big data, etc.).

I know, it doesn't pay to be a hero, you risk getting your head handed to you, especially if your timing is off by several years. I know the Fed is tapering but I'm warning all of you, there is plenty of liquidity to drive risk assets much, much higher. And all the sectors Fed Chair Yellen warned about (biotech,  social media, etc.) are where the biggest moves will happen and short sellers focusing their attention in these sectors are going to get killed. I stick by this call even if we get a mild or severe correction this Fall.

Below, Bob Rice, general managing partner with Tangent Capital Partners LLC, explains "Risk Parity" in an older Bloomberg clip (June, 2013). And Bloomberg's Scarlet Fu displays the current valuations of biotech and internet stocks compared to the bubble of 1999. She speaks on "Bloomberg Surveillance."

The second clip is almost a month old and since then, both these sectors have continued rising on growth prospects. And just wait, it's far from over which is why the Fidelities and Blackrocks of this world continue to ramp up their exposure to these sectors.

Finally, take the time to listen to Janet Tavakoli on the return of the complex financial instruments that fuelled the 2007 credit bubble. Great interview with a very sharp lady who really knows her stuff.

Tuesday, August 19, 2014

The Long, Long View?

Joel Schlesinger of the Winnipeg Free Press reports, The long, long view:
It's safe to say many Manitobans aren't familiar with Leo de Bever, the CEO of AIMCo.

For that matter, most people have no idea what AIMCo is.

It's likely equally true many Albertans whose pension and public assets were under management with AIMCo during de Bever's six-year tenure don't know too much about this wealth-management entity, either.

Yet AIMCo -- or the Alberta Investment Management Corporation -- is one of Canada's largest institutional-management organizations. With about $75 billion under management, it's the fifth-largest investment-management company in Canada, and it's responsible for Alberta's largest public pension funds, endowments and government funds and the renowned Heritage Fund that has contributed $36 billion to health care and education in Alberta since its inception in 1976.

All these assets were brought under one umbrella -- AIMCo -- in 2008 with de Bever at the helm, and since then, the fund has added more than $21 billion to its net worth.

Now, de Bever is leaving the firm.

Certainly his career has been illustrious by Canadian investment-industry standards. An economist born and raised in the Netherlands before coming to North America to pursue graduate studies, de Bever has worked at Manulife Financial, the Ontario Teachers' Pension Plan and the Bank of Canada, to name a few.

Recently, he was a guest speaker at the CFA Institute's summer analyst seminars in Chicago, discussing the difficulties of managing public money for the long term in a short-term world.

While geared for investment professionals, much of what he discussed also applies to the average mom-and-pop investors as much as it does to managers of vast amounts of capital.

De Bever took time out from his busy schedule to speak to the Free Press about some of the issues he touched upon in Chicago.


Bonds have presented a conundrum for institutional investors as much as they have for retirees looking to make their savings last. Pension funds and insurers, for example, had relied on bonds to generate steady returns to meet their liabilities. But in this ultra-low interest rate environment, bond yields are low -- often not enough to meet financial commitments such as paying the benefits of a growing number of pensioners. Consequently, institutional investors have relied more on stock market returns. They have also sought out alternatives, such as investing in infrastructure and real estate. But like most investors, the big guys still need to invest in bonds.

De Bever said bonds have a major role to play in most investors' portfolios -- even though we are facing an interest-rate hike that would send most bond portfolios' values tumbling.

"So if you're going to be in bonds, be in high-quality bonds that have a short duration of three or four years," said de Bever. "If you're going to get hit as interest rates go up, it won't be that bad, and you still get the incremental yield along the way."

Other low-cost alternatives are exchange-traded funds that invest in floating-rate-style, fixed-income investments such as PowerShares Senior Loan Portfolio ETF, which is traded on the New York Stock Exchange.

"It's in loans that are tied to prime, so that means if rates go up, the interest-rate return goes up with it, but the problem with it is there's been a lot of inflow into these assets, and you start to wonder if there is a bit more risk than there was a year ago," said de Bever. "But at least you can make three or four per cent on something that is tied to short-term interest rates."

Yet investors with a long time horizon, those under age 40, can and likely should be taking on more stock-market risk in their portfolios.

"I would say if you're young and you can withstand the fact that every five or six years you're going to have a stock-market correction, it's still a good idea in my mind to undertake equity risk."

Of course, that comes with one important qualification -- you must have the risk appetite for it.

Stocks don't come cheap

One problem with equity markets is the stock prices of companies are outpacing their revenues. That's led many observers to forecast a correction is coming. So investing in stocks today involves a high probability your capital could fall 10 to 20 per cent a short time down the road, de Bever said. Conditions are such that the markets could keep going upward, he added.

"The only reason you could argue that stock markets aren't overvalued is there is so much productivity that even with slow growth in top lines (revenues), the bottom lines (profits) seem to be holding up really well," he said. "The question is, how much of that is sustainable?"

Needless to say, there's just as much short-term uncertainty with stocks as there is with bonds, but investors with a short time horizon for their money will likely find the stock market too much of a stomach-churning ride for their taste.

"If you have a five- or 10-year horizon or more, though, I would still have a lot of my portfolio in stocks compared to bonds," said de Bever.

Technological panacea

Tech stocks have produced tremendous returns recently, but demand for them is now arguably outpacing their value. Today, newly listed tech stocks -- social-media firms in particular -- are commanding high valuations without any profit. The situation seems quite a bit like the late 1990s and early 2000s, when web-based firms with no profits had skyrocketing values, only to crash by 2002.

Yet de Bever said technology is undoubtedly a driving force going forward, and institutional investors have a major role to play in funding promising firms with innovative technologies that can have a dramatic impact on the world. The problem for retail investors is these companies are not yet listed on stock exchanges, so we average folks can't get much or any exposure to promising new firms (nor would they necessarily want to).

"These are companies that have gone past the lab stage and the initial verification stage, but they still need a lot of money to build a pilot plant and work out the kinks in making a commercially viable proposition," said de Bever. "You need to have that long, patient capital, and a mutual fund structure wouldn't be amenable to that." This is largely because retail investors bail out of these funds when they suffer losses. But even the big dogs with billions to invest are new to this part of the tech sector. De Bever said he even had to convince AIMCo's board this alternative investment area holds tremendous promise. AIMCo is trailblazing with this strategy, and forging new opportunities surprisingly isn't all that common in his industry, he said.

"The typical discussion I have with other pension managers is along the lines of 'You're absolutely right. We should be doing that,' but few of them actually are."

Understanding the J-curve

One of the problems with investing in early-stage technologies with long-term upsides is getting over the initial jitters. This often comes down to understanding the 'J-curve' associated with up-and-coming firms. The term refers to what these firms' growth looks like on a chart over long periods of time. It's shaped like the letter J because, initially, their value usually falls and stays down for some time until their innovative product or service reaches the commercialization stage, when it starts to increase in value. De Bever said the J-curve illustrates the benefits of taking the long view to investing.

"That's often easier said than done because human nature is to say 'Yes, I understand that,' but when times get a little tough, they say 'I didn't know I was buying into that kind of potential outcome.' "

Big investors for the public good

Investing in developing technologies also takes truckloads of investment acumen -- deep knowledge of the sector as well as an ability to read between the lines of hundreds, if not thousands, of pages of reports.

Few investors have the ability or time to do that. But institutional investors often do. That's why de Bever believes they can be a driving force in developing new technologies that will improve health care, education and infrastructure. More importantly, pension funds and other large investors can fund innovation to reduce our impact on the environment, including our footprint in the oilsands. He says companies involved in the industry have a difficult time convincing their shareholders to invest in long-term innovation because there is often no immediate short-term payoff.

That's where institutional investors can step in, he said.

"When we started talking to them (energy companies), a lot of them would say 'This is exactly what we're looking for.' "

Public pensions -- something's got to give

It's no secret public defined-benefit pensions are facing future difficulties as retirees live longer with fewer workers contributing to plans to support their benefits.

"It used to be that you had four workers for every retiree," de Bever said. "Now with most pension plans, it's become one worker for each retiree, so the burden of active members to pensioners is just too high."

This is unsustainable. In fact, many defined-benefit pension plans are now underfunded. "And I can't think of any that are fully funded on an honest discount-rate basis," said de Bever.

Many plans that are fully funded are using a rate of return of about six per cent, he said. But when that expected return falls by two per cent, a once fully funded pension plan could find itself underfunded by 30 per cent. De Bever said what's needed now is action to ensure these plans, which are the best retirement-savings vehicles around, remain solvent. The biggest obstacle is the options often involve some financial hardship for all stakeholders. Still, they're likely necessary.

"I firmly believe you have to tell your clients what they need to know, not just what they want to know, because eventually it will catch up with them," said de Bever. "It's very tough to do because in the current environment, the only way out is to either increase the retirement age, cut pension benefits, which is tough to do, or increase premiums, and premiums are already very high."
I liked this interview which is why I'm posting it. You can read my previous comment where Leo discusses the next frontier of investing.

Most recently, AIMCo acquired a $520 million mortgage portfolio from the Ontario Municipal Employees Retirement System, commonly known as OMERS:
AIMCo says the acquisition of 50 high-quality and geographically dispersed Canadian mortgages fits well with its existing holdings secured by institutional quality, income-producing properties.

No other details on the deal were disclosed.

AIMCo, which invests on behalf of 27 pension, endowment and government clients in Alberta, is one of Canada's largest and most globally diversified institutional investment managers with assets under management of more than $80 billion.

With $3-billion in loans, AIMCo is also one of Canada's leading mortgage lenders.

OMERS, with more than $65 billion in net assets, provides pension administration and products and services to almost 440,000 members in Ontario.
I received this comment from an astute investor:
The advice to stay short duration in fixed income was pretty much good advice from about a year post credit crisis, more or less til this year. Short and long rates have since been falling, and the yield curve is flattening. Despite all central bank efforts, I tend to see a mild deflation scenario playing out, something you have commented on. With that in mind, I think fixed income holders are best served to be diversified in credit and interest rate duration, and currency, definitely avoid an all in directional bet on rates.
Go back to read my last comment on the Caisse warning of headwinds ahead. I discuss my views on why I think deflation is the ultimate endgame and why rates aren't going to rise anytime soon.

Below, Leo de Bever discusses taking the long view on pensions. Take the time to listen to his presentation and the follow-up discussion, they're both excellent.

I also embedded Basil Gelpke and Ray McCormack's ground-breaking film on Peak Oil, A Crude Awakening. I'm not a big believer in Peak Oil and catastrophic doomsday scenarios but the film is well worth watching to get the long, long view on oil and energy.