The
BIG Picture Transcript
April 12, 2008
Part 1 Real
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Media | Mp3
Part 2 Real
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Part 3 Real
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Bailouts,
Stimulus II & Other Interventions
Inside
the Oreo
Part
2
Taxes
& Trade: What not to do
Planning
for Retirement - Part 3
Part
3
Q-Calls
Bailouts,
Stimulus II & Other Interventions
JOHN: Well, the picture is actually beginning to look a little interesting now. For the first time, this week our respected Fed Fuhrer Ben Bernanke has said, “you know, there is the possibility of a recession.” Now that is the first time that he has done that from sort of a formal position on high. But surveys taken so far, 3-to-1 economists believe we are in a recession, three-quarters of those said we haven’t hit bottom yet. That’s an important thing to understand. We’ve had three consecutive drops in unemployment, sales are weak, so there would be a lot of corroborating evidence to suggest we truly are in a recession. And the real question is right now: What it’s going to look like as we go forward? Because it would seem like a lot of our Congress critters are determined to keep this very sick patient alive on life support as long as they can – throwing everything at it they possibly can.
So the first topic of conversation today is bailouts, stimulus and other interventions. It’s irresistible for politicians. It’s like bugs to those ultraviolet lights, Jim.
JIM: [Jim laughs]
JOHN: Well it is. You know, when they do it you don’t hear the gratifying bzzzip. Oh, there goes another Congressman, hooray!
JIM: You don’t get the zap or something.
JOHN: No you don’t.
So how far do you think they’re going to take this anyway?
JIM: First, John, it was goldilocks. Then they were going to engineer a soft landing. And even as far back as February when Bernanke was on for his semi-annual meetings with Congress he was talking about, “well, we don’t think we’re going to be in recession, growth will slow down and then it’s going to pick up in the second half.”
Now, there’s just overwhelming evidence –whether you’re looking at industrial production, whether you’re looking at retail sales which have been weak, or you’re looking at the jump in the unemployment rate (we’ve gone from roughly 4.4% to 5.1 – and there are many economists thinking by the time this is done the unemployment rate should jump around 6%). So there is just too much evidence in the credit markets, the financial sector’s contracting, there’s talk of maybe 200,000 people will lose their job in the financial industry. We know the construction industry has been pulling back. So there’s just overwhelming evidence. Plus the trade deficit figures picked up in the month of February, especially with what’s going on with oil and we were importing capital goods in the month of February; so the higher the trade deficit, the lower the economic numbers. So it looks like in the first half I think they’re finally openly admitting, “hey, okay, we’ll give it – it’s a recession.”
But everything is going to be rosy as we get into the second half and probably what is more dangerous in all of our lives is Congress is back in session this week and we’re going to get into the various bailout and stimulus packages. And remember, when they put together the stimulus package, this tax rebate which is going to go out beginning in roughly next month between the month of May and June, we said back then: This is stimulus number one, there will be other stimulus packages because everybody knows a quick rebate isn’t going to do anything in terms of other than a short term stimulus. And so now we need to start talking about some of the things that they are considering in terms of bailing out the housing industry, the lenders and ultimately sort of trying to arrest the decline in housing, which is the opposite of what they should be doing because housing has become unaffordable – even with today’s interest rates.
And so how do you get yourself out of a bubble, you allow that bubble to deflate, you allow the houses to be liquidated at lower prices. Eventually, when the prices fall far enough then you get buyers who start to come in because they recognize the value in the property. In other words, you could start buying homes for much, much less than it would cost you to go out and build a new one. But they’re not going to do that. [4:31]
JOHN: Okay, what will the long term consequences be of this; and we also need to look at what the plans are because there are three different bailout plans out there: the President has a plan etc. Everybody has got a plan so far and maybe we should see what the devil in the details are.
JIM: Well, the president has got a plan that as much as possible he’s trying to avoid having taxpayers bailout homeowners. He calls this plan FHA Secure. It’s anticipated that it could maybe help maybe half a million homeowners hit by the housing slump; the Mortgage Bankers Association are estimating that probably 2% of the nations 46 million mortgage loans were in the foreclosure process in the fourth quarter of last year, while delinquency rates for homes hit almost 6%.
Now, the President’s plan is a little bit more moderate. What they’re trying to do here is to encourage lenders to write down the mortgage. And essentially what happens in a foreclosure -- as many people know, housing values have fallen, people have lost the equity in their homes, so they’re walking away. And so let’s say a house has fallen from let’s say, a 125,000 down to 100,000 the mortgage is at 100,000. What the President is encouraging some of the lenders to do is to say: “Look, if you have to dump that house on the market, you’re probably going to sell it and usually foreclosures are sold at anywhere from 20 to 30% below market value. So if you take this home back in the foreclosure process you’re going to turn around and dump, sell it for 70 to 75,000; you’re going to be paying real estate commissions. So rather than incur that loss, why don’t you lower the mortgage from 100,000 down to maybe 80,000 and renegotiate it and we’ll have FHA come in and underwrite the mortgage at a lower interest rate and allow this homeowner to stay in their home.”
And so the President is looking, “okay, you have a choice: Either foreclose on the property and then sell the real estate and take a big hit, or take a smaller hit by reducing the mortgage.” And what the President is trying to do is keep the program to a minimum and hopefully assist some homeowners that are probably making their payments. But one of the problems you have right now in the credit markets is, let’s say a person is making their payments, they would refinance but because they no longer have positive equity in the home they can’t finance because the home is worth less than the mortgage. So there’s one of the problems that we’re having; one of the bottlenecks that we’re having in this mortgage market.
So the President has a plan and the FHA would come and insure the mortgage at somewhere between 90 and 97% of the new value of the home – given the fact that in many areas you’ve seen home prices drop between 20 and 30%, especially in the bubble areas like California, Nevada, Phoenix, and also Florida. [7:44]
JOHN: All right. This reminds me of a quiz show, you know, behind door number one is the presidential plan and then we have door number two, which is Senator Dodd’s plan and then door number three is Congressman Barney Frank; and these are frankly different plans.
JIM: Oh, absolutely. Now, in the Senate plan that Senator Dodd is working on, in addition to the bailout of homeowners, there’s – let’s put it this way, there’s an excess of inventory on the market right now and that inventory isn’t going down because as you have more homes go into foreclosure that means more homes are coming on the market. You sell a few but you’ve got more coming online because of bankruptcies and foreclosures.
What Dodd would like to do is in addition to bailing out the homeowners, in order to get rid of the inventory there would be tax breaks. What they would want is tax breaks for homebuilders to go out and build more homes because they’re worried if the housing industry contracts further, there’s going to be more unemployment because homebuilders lay off workers as they cut back on building. So the Dodd plan would have tax breaks for homebuilders; there would also be tax credits for investors.
So let’s say if you’re an investor and the bank is selling a home in foreclosure, you could get up to a $7,000 tax credit for going and buying a home that has been put on the market. So what they’re trying to do is you know, John, instead of allowing prices to fall to the point where they reach an equilibrium where people say, “oh my goodness, I can buy this property for 60 cents on the dollar. In other words, it would cost me a dollar to build a new home, but I can buy a resale home in foreclosure for 60 cents on the dollar because the prices have fallen.” So what they want to do is encourage the homebuilders to keep building; they want to encourage investors to come in and start buying. And then they would also have anywhere from 10 to 20 billion that they would make available to states and have states go in and start buying foreclosed properties because 42 states are running budget deficits. And here in California we sort of narrowed our budget deficit during the real estate boom as property prices appreciated and people flipped in and out of homes, the State of California took in higher property tax revenues. Now that process is reversing as homes go into foreclosure. The new homeowner is going to be paying property tax on a lower priced home. So it is definitely a situation where you have additional stimulus that they want to come in and create on the buy side. And then in addition to that, you would have almost 300 to 400 billion dollars of refinanced mortgages that would be backed by the American taxpayer. [10:48]
JOHN: And the ultimate end result of this is going to be where? I mean obviously you know, let’s look at the lender issue to begin with: If we tell lenders that they’re going to write certain things down, then that’s forcing a loss on to somebody.
JIM: Well, the governments view is, look, if you take the home into foreclosure you’re going to lose money anyway, so why don’t you write down the mortgage, give this homeowner a break and then we as the government will come in and refinance it because the bank doesn’t want to do it. So they’re going to finance the powers of Fannie and Freddie to come in and refinance it. You would also have the government getting in the housing business, backed by the American taxpayer. [11:28]
JOHN: I can see two things in this whole thing, Jim. Number one –and this is something that I think we talked about a few years back on the program as I recall, back in the dark dawn of Financial Sense – was the fact that what we’re doing is we’re gradually seeing the transfer property ownership indirectly to the Federal government by the means of this mechanism. You can see if this follows it logically through.
But second of all, where do we get the bailout money. That’s what always troubling me – no free lunch.
JIM: No. The bailouts would be paid for by tax increases coming next year and we’ll get into that, the tax increases that are coming, probably the largest tax increase in US history because you can’t bailout 3- or 400 people, create tax credits for the builders, tax credits for investors, that money has to be paid by somebody. And what’s going to happen is they’re going to have to raise taxes. In other words, you and I as American taxpayers are going to pay for this. But you’re right, John, because the Barney Frank program, which is very similar to Senator Dodd’s the government would guarantee 3 to 400 billion and what would happen is the government would come in and underwrite a new mortgage based on the new value of the home. Let’s say that the house was formerly selling at 130,000; now the house has fallen by 30% - the new value of the house is 100,000. So what would happen is the lender would have to write the mortgage down, the government would come in and give a loan for almost 90% of the value of the home, and the lender would get 85% of the mortgage and then the government would get to pocket 5% of the mortgage.
So you’re absolutely right. Now you have the government getting into the housing industry where the government has a stake in these mortgages so they own part of your home. So in effect, now in addition to paying income taxes you would also be paying interest payments to the government in many ways. So the government has a 5% equity interest in your home, so we’re definitely moving into new territory regarding property rights because what the government is trying to do through the bully pulpit is to convince lenders, “look, property prices are falling, wouldn’t it be better to renegotiate than for you to put this into foreclosure.” But we’re moving into major property rights territory here in that we’re making property rights in this country less secure because if we set this precedent in this bubble, what do we do in the next bubble? What if it’s – who knows? – let’s bail out big investors in the stock market, hedge funds and things like that. So let’s see what happens there. [14:14]
JOHN: But more noticeably, if you see this transfer process going on, it takes money from one group of people to now ownership on the part of the Fed government supporting another group of people. And so what we’re doing is they’re actually taking somebody else’s money to buy property for themselves – the government is. That’s what is effectively happening here.
JIM: Yeah, so we’re getting into a very, very risky situation here regarding property rights. And as many have pointed out, this is also going to impact future lending practices because if you are a lender loaning on a piece of property, remember, there was also a proposal here – now, so far they’ve booted it out in terms of the negotiations between both sides of the aisle, but they wanted to allow judges to determine what your new mortgage and interest rate is. So imagine what a lender would do if you get to a situation where a lender may not be secure on the loan. In other words, I make a loan today at x dollars and I’m charging a 6% interest rate, but arbitrarily some time in the future I could have this interest rate reneged on and I might be forced to take all these losses on properties. So like I said, we’re entering into brave new territory when it comes to property rights. [15:41]
JOHN: Yes, and we are only at the beginning of it, we haven’t seen where this is going to spool when it finally goes down hill.
If we look at the issue here, the government wants – government doesn’t do it, it makes you and I do it – taxpayers to stand behind 300 to 400 billion worth of refinancing. And maybe we should point out as we do this that, what was it? About 40% of taxpayers in the country don’t pay taxes, so the burden is being shifted over in that direction. This is going to result in big losses for lenders among other things.
JIM: Yeah, it definitely will mean further write-downs coming in the second and third quarter if these programs are implemented, and there is enough bipartisan cooperation – after all, this is an election year. And it’s amazing because if you look at the public opinion polls, 95% of people in this country are making their mortgage payments, and the overwhelming sentiment in the country is, “my goodness, I’m playing by the rules; I’m working my fanny off to make my mortgage payments and make ends meet, and you’re bailing out my neighbor who was irresponsible.”
Let’s say on a block of 20 homes you’ve got one guy who got into the neighborhood with no money down – maybe he falsified his loan application because almost 60% of the defaults last year were related to falsified mortgage applications and especially when lenders were going to what we call ‘no-doc’ loans. And so you’ve got a situation there that you’ve got a moral hazard that’s being created. And despite the unpopularity in the general public over this whole issue for whatever reason, either they’re scared or they think this is going to buy them votes when it comes to election time. [17:24]
JOHN: If we look at what these packages really mean, about 10 to 20 billion dollars is going to have to be ponied up right up front for the whole thing. Funny we should mention this, but the government gets 5% fees on the repackaged loans – how did they swing that one? I’m wondering about that. Taxpayers are ultimately going to be on hook for the falling prices, and the state governments, by the way, are getting into this mix too as far as refi-ing this whole thing. But as the prices roll over that’s going to impact what’s happening out in the market and what taxpayers have to do. And theoretically, this is all going to be paid for by new taxes which will come into effect after the election next year we should point out.
JIM: Well, that pretty much summarizes it. [18:04]
JOHN: Notice how the timing on this is run there, Jim! But I think the biggest thing is the moral hazard if you’re an investor, you know, what does this mean ultimately?
JIM: Let’s say that you have somebody that’s paying their mortgage, but with this new bailout program you’re thinking, “okay, my house is worth – I bought the house for 130, it’s only worth 100, my mortgage is 125,000 on the house. Gosh, I’d like a lower mortgage and a lower payment.” So in many respects we’re also creating an incentive for people who are working and paying their mortgage, so you’re creating this incentive to default and get in on the bandwagon. I mean, why not, if you’re carrying a $125,000 mortgage and your neighbor just had his mortgage written down by the lender and he got a repackaged new Fannie Mae loan at a lower interest rate. Do you see, John, where it creates the incentive for many people to do the same thing? [19:01]
JOHN: Yes, absolutely. In other words, that’s what you’re opening up here is a real can of worms. Then you have to come up with more regulations to prevent this…and you can see where this one is going. It just bangs back on that.
You know, if we actually rotate back to your Oreo theory, when the first proposal for bailout came along earlier on, you were predicting the fact that there were going to be more of them and that’s pretty much what we’re seeing right now. In other words, one was not going to do it, and we’re seeing more. We’re not even sure if we’re done with these so far.
JIM: Yeah, and what you have to do before you get to this creamy filling is a number of issues are going to have to take place – we’ll get into this in the next segment – but the bailout program which will reassure the credit markets, in other words, the American taxpayer is now being brought into the equation to stand behind these loans. When you say the government stands behind them, no, the government doesn’t stand, the American taxpayer stands behind them. And that’s exactly what you’re seeing. And then in addition to that, John, in terms of the moral hazard you also have the Federal Reserve which is also going to get involved in this process because the Fed will be talking about creating different programs that it may use…because remember, banks are tightening lending standards and so what the Fed may want to do, it may have to go in if credit contracts in order to spur credit because the banks are tightening. The Fed will get into the lending business.
So you’ve got the Fed currently weighing several new options that they’re considering. One would be for the Treasury to issue a bunch of loans – more than it needs to finance the deficit, and then deposit those Treasuries at the Fed so the Fed can use them in its lending operations. You have proposals for the Fed to go out and raise money in an issue. And what they’re looking at is ways to expand their balance sheets without getting into monetization of debt which would create further inflation. So surprise, surprise, what are we seeing today? We’re seeing inflation rise all across the front.
And what is absolutely fascinating to see unravel here is things play out according to Austrian business cycle theory because one of the problems we have seen is whenever you create a boom as we have talked about here, there is a growing consensus in Washington over the last couple of decades, is we can’t afford to take the medicine or the consequences of our actions; so you have government intervention just like in the 2001 recession.. you had Greenspan slashing interest rates down to levels we haven’t seen in half a decade, and then you had those interest rates brought to a very, very low level and kept there for a long period of time. That encouraged the housing boom, it encouraged the credit boom and you had people simply taking advantage of a loose monetary policy. Now we’re dealing with the credit bust and a housing bust, and now look what we’re doing: We’re talking about taxpayer bailouts, we’re talking about the government coming in, owning a piece of a person’s mortgage, we’re talking about forcing lenders to write off debt, we’re talking about all kinds of unusual measures by the Federal Reserve to get involved in terms of I mean the Fed is now loaning money to the investment bankers. And as a consequence we are seeing inflation rise all across the globe.
And the one thing that we are not addressing when they talk about inflation is, “well, it’s higher oil prices, or it’s higher food prices,” they’re not talking about the expansion of money and credit which is why we are experiencing higher inflation rates, not just here but globally. So they talk about inflation in terms of the symptoms rather than the cause – an issue that we have been addressing here quite frequently on the program. [23:09]
JOHN: To sum it all up, Jim, if we look at the Oreo theory – and this is wonderful because we are going to sail through the creamy filling this summer and that means it’s a good time in the summer, you know. We have bailouts coming, stimulus programs, federal intervention. I’d like to say that we have entered the era of big government. In reality we have entered the era of much bigger government before again when we get to the end of the year this is all going to unravel. Like we said, the consequences of what we’re doing now will not begin to unravel until after the elections. There was an article in the Wall Street Journal this week – I think you saw that too – what the consequences of the proposed tax changes will be if nothing is done (if the Bush tax cuts are left to expire). The middle class can look to a 25% jump in their taxes overnight. And that’s all going to come crashing in around 2010 or so. But we’re in a creamy filling for a while before we get to the crunchy other side, right?
JIM: Yeah, and like I say, eventually if you throw enough stimulus and print enough money you get the artificial high that you get when you ingest a drug. In this case, the drug is money and credit. But there are consequences to that and the result is going to be taxes and inflation. And I don’t think anybody would say that, “gosh, my cost of living is only going up at the core rate of 2%.” People are experiencing on a first hand basis, higher rates of inflation. Whether it’s services, whether it’s food, whether it’s energy, whether it’s utilities, everywhere you look, John, the cost of living is going up probably closer to 8% for most Americans. [24:49]
JOHN: And likely to continue doing so. And the problem is the average American doesn’t understand why, and that’s why we go where we do politically. If they did, then the whole proposed answer would be something totally different.
You’re listening to the Financial Sense Newshour at www.financialsense.com, online all the time.
I’m Andy Looney. Sandy and I filled out our tax forms this week and like most Americans we were shocked to see just how much the government was taking from my annual salary. Sandy thought she was going to have to call 911. Holy cow! Just think what I could do with all that extra money every year, but government officials think they know how to spend my money more wisely than I do. Let me see what I got from tax dollars. They sent billions to Iraq for reconstruction which didn’t reconstruct as much as it was supposed to and they can’t figure out where the money went. They paid for a public education system which slips further and further behind the rest of the world and where political correctness runs amok. No wonder so many kids are dropping out. I don’t know. The politicians’ answer is just spend more money and collect more taxes. They paid for Congress and the bureaucrats’ salaries so they can waste more of my money and make my life miserable with regulations. Then they tell me this week that government employees were buying Christmas presents for their families with government credit cards. Hey, that’s my money you’re spending.
My friend Charles says that they even have seven different programs to make me feel better about my car. One program would probably be more than enough. Heck! If they really want me to feel better, all they have to do is give me back all my tax money and I’ll buy a new car myself – probably a Lexus. What do you think, Sandy? That will make me feel really good. How about you? I would. Sandy does.
So here’s my advice to the presidential candidates:
Presidential
candidates, before you plunder,
the economy’s weak so you might wonder
if raising taxes would be a blunder
because that would really make us all go under.
I’m Andy Looney for Financial Sense. I’m going to file bankruptcy. See you later. [27:25]
JOHN: Well, you know, cookies don’t just happen. I’m not talking about the cookies that get put on your browser – I’m talking about cookie cookies. I mean if you’re going to have a sandwich cookie, you have to make sure that there are notches on them. Have you ever noticed that, Jim? Notches that go on the top and then you have to make sure the notches are top-notched on the top to make them work, so that the sandwich goes together; right.
And this may sound funny, but I actually wrote a letter to a company one time that I get finding in every package in their cookies one of the cookies was inverted like the Oreo, and the notches weren’t on top. And I wrote them a whole letter about that – it wasn’t top-notch. And they sent me a whole box of cookies. They loved the publicity and they sent me a whole box.
Anyway, if we’re going into this creamy filling, obviously this isn’t going to happen by magic; certain things have to happen. First of all, they’ve got to get the ducks in a row (the ducks here being the central banks of the world) and they’re going to have to cooperate on this. But that’s not the only thing that’s going to have to happen to hold the creamy center together for a while here.
JIM: Yeah, we talked in the last segment about the bailouts that are going to come for homeowners, for investors and for homebuilders and then also another stimulus program. So Congress is working on – I’ll tell ya, the kind of money these guys are going to be spending and what the American taxpayer is going to be guaranteeing. But this is what they feel is necessary to create this temporary patch in the credit crisis.
And so before we get to the creamy filling we had the IMF –for example, the G-7 countries are meeting in Washington this week – urging central bank cooperation. They’re also recommending that central banks and governments use public resources to support the financial system, including contingency plans to purchase or gobble up large impaired assets, basically mortgages or mortgage debt.
And so we’ve got central bank cooperation needs to take place, fiscal stimulus, and we’re seeing that right now, and loan guarantees. And all of them are being worked on as we speak. Congress was back in session this week, they’re moving forward with bipartisan cooperation. Some kind of mortgage bailout program is going to come into play. Now you’ve had the Bank of England cut interest rates this week, so you’re going to have other central banks eventually come in and inject and buy this impaired debt.
Once you get all three of those then you’re moving closer to that creamy filling where stock prices start to go higher. [30:07]
JOHN: You realize you’re taking on some kind of a challenge because when we’re talking today, let me see, the Dow is down 200 points.
JIM: 250
JOHN: 250, I stand corrected. Dow down 7% over the year, S&P down 9%, NASDAQ down 13, European stock markets 16, Asian market is down in the double-digit range; but you’re thinking that stocks are going to turn around and bounce back up.
JIM: That’s what I believe is going to happen. And this will probably shock people. I think we may even hit new records on the blue-chip averages this year, both on the S&P and the Dow. [30:42]
JOHN: But that will then be trumpeted as being recovery.
JIM: It’ll be trumpeted as a recovery but you have to remember it’s going to be as a consequence of a lower dollar. Normally when you see countries that are undergoing steep currency depreciation, an outlet for devaluing assets as the currency loses its value has always been the stock market. When you had the debacle in Argentina many years ago, their stock market took off. The same thing happened in Russia in the late 90s; it happened in Turkey. So it becomes an outlet for all of this intervention and money expansion as a currency gets debased by the government. [31:22]
JOHN: Basically – well, this is nothing new anyway – you’ve been stepping out on a limb for a long time, but you seem to be out there given the current sentiment of the market. Of course, current sentiments never tell you where things are going, they only tell you where things are.
JIM: And that’s what I see, John. I mean there are a number of things that I’m watching and observing, and that’s why I think that when this turn around happens, it’ll be so quick and furious you’re going to wake up one morning and say, “what the heck has just happened?”
And we’ve already seen that. We’ve seen a couple of days here in the last month where the market was up nearly 4%. [31:56]
JOHN: Assuming that the turnaround does happen because basically we’ve been sitting in a bear market now, which has had about a 20% correction, what would the indicators then be that we should be monitoring to confirm that is exactly what is going to happen – that we really are going to turn around and bounce back up here?
JIM: There are a number of issues that we’re monitoring. Number one, most bear markets probably last 8 to 9 months and if you take a look at probably this really began with the breakdown of stocks early last summer and so we’re almost close to that 8 to 9 month period typical of bear markets; we’ve had the 20% pull-back, so that would be one issue in terms of a pull-back in the market, in terms of how long this bear market would last. And once again, getting back to the stimulus that is coming into this market.
Another factor that we’re looking at, you know, you have spreads between the two year Treasury note, and the Federal Funds rate now. There’s only roughly about a 50 basis point, or ½ percent difference between the two and assuming that at the end of this month the Fed will cut interest rates a ¼ of a point, we’ll be down to 2; and maybe they go again in May or June another ¼ point and maybe we get down to 1 ¾. So the spread between these two are narrowing versus there was a huge, huge gap towards the end of last year where a lot of people said the Fed wasn’t getting aggressive enough.
And John, just look at the sentiment indicators everywhere that you look at. I mean the articles that you read in the press, a depression – although I think one is coming down the road, depending on the outcome of what happens this November – but the sentiment indicators are very negative.
And the other thing too is this huge spike that we’ve seen in volatility. When you see high volatility that is more reminiscent of market bottoms than it is market tops. And you can see the same kind of pattern going back between 2001 and 2002, so we had these huge volatility increases and that’s usually what you get toward the bottom – everybody is a nervous Nellie, and you get these big selling climaxes. And John, do you know anybody that isn’t negative about the economy or negative about the financial system? It’s almost the ‘end is near’, you’ve got people standing on the cliff or ready to jump out of windows; it’s just absolutely amazing. Usually when sentiment gets this extreme that’s usually when you’re getting closer to a bottom than you are to a top. [34:41]
JOHN: We know when we talk about the future, if you realize that the media – we talk about the sentiment of the market, the media even more so are looking in the rear view mirror to see where they’re going, and that’s why when something happens you always hear these cries of “who could have imagined this.” Well, people did imagine it – you know, every time there’s one of these moves. And obviously when you make a market move there are catalysts. So if we’re going to get into the Oreo filling, and the market is going to turn around, what would the catalyst be that would drive this now?
JIM: Well, first of all, it’s going to be the movement of money. And if you take a look to when this crisis hit last August, there’s been a huge movement of money out of the stock market as people tried to get liquid and looked for safety, there was this huge move into the bond market; and if you want to look at a bubble right now, the bubble in my opinion is in the bond market. So if we look at Treasury yields last summer, in June, the 10 year Treasury note got up to a yield of 5.3%, then as the crisis began to unfold during the summer we’ve seen the yield on the 10 year Treasury note come down from 5.3% to 3.5%. So we’ve almost seen this huge 2% reduction which has been a major reduction in interest rates; and a lot of that was just a flight to quality. It’s like all this problem that started to surface in the credit markets with these mortgage-backed securities that were supposed to be Triple-A rated, all of a sudden people started hopping out of these things, they started selling them, the stock market started to sell off, you had another big downturn at the beginning of the year. In fact, you could almost see this reversal on times the market has rallied, interest rates have gone up and when the stock market goes down the Treasury market goes up. So they’ve been moving almost in opposite directions.
So I see three catalysts here. One of them is a massive move out of Treasuries because if you take a look at bond yields today they’re hardly competitive. I mean you have headline inflation rate of over 4%, you’ve got two year Treasury notes at less than 1 ¾%, you have 10 year Treasury notes at less than 3 ½, and you have 30 year Treasury bonds less 4.3%. And T-bills are under 1%. So the first catalyst is this movement out of Treasuries.
The second movement and catalyst is there is an incredible amount – I forget what the figures are – 3 ½ or $4 trillion that is sitting in money market funds that are making less than 1%. So that’s the second one.
And then the third one is when this money starts coming off the sidelines, out of cash and out of the bond market there are massive short positions in the stock market right now.
So when the stock market starts to move then that’s what equates for a lot of these 3 ½ to 4% rallies that we’ve seen here in the last month. So a huge movement out of Treasuries, a huge movement off the sidelines from cash - in other words, when the frightened money says “okay, the taxpayers are standing behind the mortgages, the government’s bailing everybody out, we’ve got a reprieve in the crisis” and given the low yields that we’re seeing in the bond market and the money market funds this money moves en masse off the sideline into the equity market. I mean you’ve got dividend yields today on blue chip growth companies that are above the 10 year Treasury note; and we’ll get into that when we talk in the second hour about planning for retirement because we’re going to cover the investment environment today.
So those are three catalysts.
Then the other catalyst, the fourth catalyst is going to be the depreciation of the dollar. And anytime you have – as we pointed out earlier – depreciating currencies, people look for things that have value or that can maintain their value. They’re looking for higher returns and when you have the kind of inflation that we’re experiencing today that if we reported it accurately would be closer to probably high single digits. In fact, John Williams thinks it’s higher than that. How can you stay even. You die a slow death from inflation by staying in these yields that are less than 1% if you’re in a money market fund, or less than 2% if you’re in Treasuries. And John, that’s before taxes. [39:23]
JOHN: If we do expect to see the stock prices head higher, and assuming we are indeed moving into the creamy filling, there are places to place your money for investment. Where would you do it in this kind of environment, as long as it lasts?
JIM: I would say probably one of the big areas that you want to be in are the industrial stocks, especially those that are involved in infrastructure. I mean you’re talking literally about trillions of dollars that are going to be invested in Asia, India and some of these developing, emerging economies that will build out these modern economies.
And we’ve often cited here, I mean just take a look at what’s happening in this country, look at the number of airlines that are going under. We had a bunch of guests over the weekend, and one gentleman was supposed to arrive in San Diego at 6:10; we called the airlines. His flight was delayed till 7:30. Well, he didn’t get in until 9:30. He was waiting on the ground for almost an hour on the plane because they were waiting for connecting flights to bring in 30 other passengers because they didn’t want to put the bird up in the air with the plane only two-thirds full because of the cost of fuel. So there are so many things that we have to rebuild in this country.
And by the way, getting back to the stimulus package, Congress is working on an infrastructure stimulus spending program because they know long term investments are what build an economy and not these helicopter drops that they’re talking about in the first stimulus program. So industrial stocks, especially those involved in infrastructure, and especially those involved with economies overseas where you’re seeing the largest growth rate.
Another factor is going to be energy. On the day you and I are talking, we’re still looking at oil prices close to $110 a barrel, we’re looking at natural gas prices at around $10. Energy and energy is extremely undervalued as we’ve pointed out in the first hour when we talked with Bill Powers.
And then here’s one that’s probably going to shock people: Technology. It’s absolutely amazing to me is if you go back eight years ago to the year 2000 when you had a lot of these technology companies that were selling at PE ratios that were just absolutely looney. You were talking about companies that were selling at 60, 70 times earnings, 100 times earnings, a couple of hundred times earnings or companies having no earnings at all. And now one of the strongest trends is going to be technology and technology is going to be involved with clean energy but now nobody loves them! Nobody wants to buy them, where eight years you couldn’t own enough of them. I can remember back in the year 2000, it wouldn’t be unusual to find a mutual fund that had 70% of its assets invested in technology companies. [42:21]
JOHN: Do you have some examples of that.
JIM: If you take a look, I don’t care if you’re looking at Microsoft which is just a huge cash machine, you take a look at Dell Computer which is selling at around 12 times earnings, it has a market cap of roughly about 36 billion; Dell is sitting on 16 billion in cash on its balance sheet. And so it’s amazing, if you look at this company – this will just give you an example of how sentiment has changed dramatically here – Dell, in July of 2000 was selling at 76 times earnings and now it’s selling at 12 times earnings. They loved it when it was selling at 76 times earnings, and now they hate that it’s selling at 12 times earnings. You can see the same thing with companies like Microsoft which if you look at back in the year 2000, the same thing: right around the summer of 2000, Microsoft was selling at close to 50 times earnings, now it’s selling at 15 times earnings, it’s generating huge amounts of cash. And I can go on. If you take a look at Cisco and we’ll just take some of the big stocks here, if you look at Cisco back in the summer of 2000, Cisco was selling at 165 times earnings; now it’s selling at 15 times earnings and nobody wants it. So technology would be another sector. [43:49]
JOHN: You’ve been favoring resources for some time here, would that be included in this area or anything else.
JIM: Oh absolutely, I mean I love some of the commodity producers of base metals, and we already talked about energy. The agriculture sector I think is getting pricey. I would look for a pull-back, although if you look closely there are ways you can participate in this sector; a couple of companies are involved in it which nobody knows about and they’re selling at high dividends, but you have to be a little bit more selective there. [44:22]
JOHN: And obviously you’re big on gold, the gold market is still going to do okay here?
JIM: I think it’s going to do okay. And one of the surprises might be that as the stock market takes off you see gold equities which have been underperforming the bullion, you start to see the equities take off, and especially I believe the juniors. You’ve already seen a couple of mergers already, I expect to see more. And the one thing, these things have just been beaten up and trashed. I mean I have two screens and I have 100 mining companies on these screens from large producers to mid-tiered producers to juniors; everywhere I go I mean there are massive short positions that have come in. And during this little pull-back these short positions have gotten even larger. I mean the short position in Minefinders has gone up nearly 50%; the short position in Kimber has gone up again; you’ve seen short positions go up in Silver Standard; you’ve seen short positions go up…I mean I don’t care where you’re looking at whether you’re looking in the junior space, if you’re looking at some of the large cap producers, if you’re looking at some of the mid-tiered producers, if you’re looking at the juniors, massive, massive amounts of short positions.
Now, I could understand short positions in, I don’t know, the producers. You might be doing that as a hedge, but to short juniors that sometimes you can see the trading in juniors thin out and become very short where the volume just kind of dries up, shorting these things with massive short positions. I think when these shorts have to cover and the bullion markets and the equity market -- in other words, when I see the stock market coming back in the creamy filling, the area that I think that is going to respond this time and the area that is undervalued in comparison to the rest of this sector is not only the mining equities, but specifically within the mining equities the junior producers and the junior development companies. [46:27]
JOHN: Financial Sense Newshour, we are here at www.financialsense.com online all the time.
JOHN: One of the biggest challenges for anybody who’s trying to get to the bottom of issues in politics is cutting through the crud long enough to find out what truly is going on because everyone is very busy spinning the appearance of things to fit their own agendas or ideas or where they want to take things rather than a sober, clear look at exactly the real world existence of various things such as tax policy. I think there were two very important articles that have appeared recently; one is called The Coming Tax Bomb, it was written by John Cogan and Glenn Hubbard on April 8th, it was in the Wall Street Journal in the Opinion Page; and also from Fortune magazine, dated April 14th – that’s the April 14 issue – The Tax Debate We Should Be Having: a shrinking minority of Americans are paying most of Washington’s bills and that’s not good. Now, The Coming Tax Bomb shows what happens if we do nothing. Remember from logic, Jim? Failure to make a decision is a decision. Even if the new Congress and new President don’t do anything to increase taxes simply by letting current tax law expire the middle class alone is going to see hideous jumps in their taxes.
JIM: You know, it was amazing because when Bush cut taxes the argument was, well, gosh, most of this went to the rich. And the way this debate is distorted, actually the percentage cuts – and I’m talking percentages – were largest for the poor and middle class; and we’ll see that just as, for example, we now have under Bush a 10% tax rate, if Bush’s tax cuts get repealed the tax rate goes up to 15%. Now, you may not say, “well, gee, that’s a 50% increase in that tax rate but you know, for people at the lower income level having their tax rate go from 10% to 15% that makes a heck of a lot of difference; or, seeing a person go from a 15% tax rate to a 28% tax rate because what was never framed in the debate is the largest percentages in actually cutting tax rates occurred at the lower levels of low income individuals – and I’m talking about, for example, if you lower the tax rate from 15% to 10%, that is almost a 33% cut in taxes at that level, versus for let’s say the upper end tax bracket, if you reduce it from roughly 40% to 36%, that’s a 10% cut in taxes.
And what was distorted in this debate – well, let’s take two individuals. Let’s say you have one individual who pays $10,000 a year in taxes, and you have another guy, Larry Lots A Bucks that pays $100,000 in taxes per year. All right. The guy in the upper end has his tax rate cut from 40% to 36% roughly, so his taxes go down 10%, so instead of paying 100,000 he now pays 90,000 in taxes. He’s saved $10,000 under the Bush tax cuts.
Now you take Manny Middle Class and let’s say he’s paying 10 grand in federal income taxes, his tax bracket is cut by 25%, or almost 30%. So instead of paying 10 grand in taxes, he pays $7500 in taxes, so he’s saved 2500 bucks. So what the class envy group and the liberals are doing is they’re saying, “gosh, Larry Lots A Bucks saved $10,000 in taxes compared to middle class tax cuts were only 2500.” But they’re not talking about the percentage increase or decrease was much larger. Somebody having their taxes drop by 25% given their income levels has a much greater impact than somebody who has their taxes cut by 20%. But the difference, and what they don’t talk about, is the high level of taxes these people pay. [4:20]
JOHN: The statistics are really sobering when you look at what’s really happening tax-wise. The bottom 40% of Americans actually had negative tax rates, what that means is they got more back than they ever put in, largely from the Earned Income Tax Credit. But if we look at those who did file, half of them – the ones who did file – counted for 97% of the Treasury’s total income tax revenue. So even if everybody who is filing for some reason or another, there is still an even smaller group accounting for the actual bulk of the payments. The top half share of total payments has been growing steadily for the past 20 years. The 10% of tax payers put in about 70% of total income tax and the famous 1% top – you know, the rich that people are always talking about – paid almost 40% of all income tax and it’s a proportion that has jumped dramatically since 1986. So when people talk about fair taxes, or paying more – I’ve always laughed at the phrase “paying more of your fair share” – if you’re paying a fair share how can you pay more of it? But the share now is becoming very unfair. [5:25]
JIM: Well, absolutely and one of the things that they talked about that if the rich are paying more income tax, yet are being taxed at a lower rate there can only be one explanation: their incomes must be growing much faster than the rest of the population. And this is quoting once again from Fortune, and that is exactly what happened. Back in 1986 an income of 119,000 got you in the top 1% bracket in this country. By 2005, because of inflation you had to earn 365,000 to get into that same club. Those numbers, you know, so what has happened is the price of admission rose by 72%. By contrast, the inflation-adjusted definition of a median tax payer, that is someone in the 50th percentile didn’t budge. So now consider some of these heated controversies: Did Bush cut taxes for the rich? Yes, but he cut taxes for the poor even more. And we’ll see this as we talk about what’s going to happen if they are repealed.
If we look at the measure that really matters – the change in the effective tax rates – the bottom 50% got a much bigger tax cut than the top 1%. And that is an irrefutable fact. In fact, we’re going to have somebody from the National Taxpayers Union, which is a non-partisan organization. And so what you have here is an issue is what you do is you talk about, well, if somebody pays 40% of the country’s taxes, and they get a tax cut, obviously because they paid the bulk of the country’s taxes, you know, they’re going to get a larger [tax cut], even if their percentage cut was smaller but they pay a larger percentage of the overall tax. [7:17]
JOHN: Now we need to look at the coming tax bomb, which was the title of the article by John Cogan and R. Glenn Hubbard in the Wall Street Journal. These aren’t new taxes really, these are sort of letting all of the tax cuts that have been put in place before, which would really result in federal government revenues relative to GDP to 20%; this is the largest tax increase since World War Two. And when you itemize exactly what’s going to happen and point out that most of it’s going to happen to the middle class, it’s really breath-taking.
JIM: Well, if you take a look at government revenues as a percentage of GDP, they’ve averaged roughly about 15%, then during the five years during the Clinton administration between 1996 and 2000, that percentage went up to a higher percent and what happens is if we let the Bush tax cuts expire, it’s going to drive personal income tax burdens up to 25% of GDP, and that will be the highest in the history of this country. In other words, government will be taking one out of every four dollars in terms of tax revenues. And most people don’t realize because the way it’s being portrayed right now is that, gosh, we’re going to get the rich people. But what they don’t understand is, no, we’re getting to get the poor and the middle class even more. [8:39]
JOHN: Well, Jim, maybe what we should do is what we’re always being told to do on our income tax forms, let’s itemize shall we. If we say that the economy that the next tax rates will take about 25% of the economy, why is that? Let’s itemize bullet by bullet exactly what this is going to do. If the Bush tax cuts are repealed, in other words, everything is allowed to expire, not only does the government take 25% of the economy, if they do then the marginal tax rates rise across the board. They go up 13% for the highest income bracket tax payers to 50% faced by the lowest households. Remember again, also, that 40% of the country right now is paying no tax whatsoever. The marriage penalty comes back. And what that means is that married couples pay more in taxes per capita than unmarried people do; the Child Credit is cut back to $500 per child, per dependant. At the same time, long term capital gains rates will go up to 28% from where they are right now; 15% in the top bracket for that. And then the top tax rates on dividends triples – now, this is important for investors – from 15 to 39.6%. It was nice of them to put the 0.6 there, that was really good.
Now, the estate tax, what they call the Death Tax –and this is what is seriously unfair in my mind, I would abolish the whole thing – it’s close to immoral that a family should have to put themselves in hock to pass their family business on to their children. Okay. The exemption drops down from right now it’s $2 million, it goes back to $600,000. That’s quite a whack. That means the amount of money that is totally exempt – now, think about this, Jim, in a time of inflation when houses now, you could own a fairly nice house and just passing on the house might wipe out what’s left of your exemption. So anything on top of that is obviously taxable. The top estate tax rate goes back to 55% and it also eliminates what is called the ‘step up’ on death of the first spouse, so that means an estate would have both an income tax plus an estate tax.
Can you explain that to people – that’s a complicated idea. [10:46]
JIM: This came into play with Ronald Reagan and what would happen is let’s say…let’s take an example, you have a million dollar estate today – and you know, in California that can mean you just own your home, but you have a million dollars – they take the exemption back down to 600,000. So that means you have out of your million dollar estate, you now have 400,000 that is subject to estate taxes. All right, the government is going to take half of that, let’s say roughly 50% just to round the number. So your heirs now owe the government $200,000 in estate taxes. Well, they don’t have the cash. Let’s say the main asset was a house, or a business. So what they have to do now is go put the house up for sale. Let’s say they sell the house or it’s a rental property or it’s a stock portfolio –whatever it is – now, when they sell they’re going to also get hit with a 28% capital gains tax. And what Reagan did is he said, look, because a lot of family farms were being lost and then they were getting hit with a double whammy. They were getting hit with the estate tax and then when they had to liquidate assets to pay the estate taxes they got hit with capital gains.
So what they said is, all right, we’re going to give you a step up, and right now – I’ll give you an example. Let’s say you had a $500,000 stock portfolio that you paid $100,000 for, and so you have a $400,000 capital gain, you get a step you to market value on the death of a spouse – especially in a community property estate (in other states you only get a step up in half of the value of the assets). But it was done or put in place so that the heirs of a business or farm would not get hit with the double whammy, in other words, they wouldn’t get hit with a 55% estate tax and then another 28% capital gains tax as they liquidated assets.
Well, guess what? They eliminate the step up so now you would have estates not only subject to the estate tax but then also to the capital gains tax. And that’s what was eliminated with the Bush – well, Reagan gave us the step up and then under Bush, what they did is they started – they didn’t do away with the estate tax but they increased the exemption. It eventually goes to like 3 million up until the year 2010. So all of these things are coming back. We’re going right back and one of the reasons that they see is we have an aging population – especially the World War Two generation that is dying off now, and the government sees this, you know, as a big way to grab money – a dead person can’t vote. And so it’s an asset grab in addition to an income tax grab. This is what they’re not telling people. And once again, the wealthy had their taxes reduced 10% under Bush, the poor people had their taxes reduced by 50%, and the middle class had their taxes reduced by anywhere 30 to 40%. And now, if this is repealed, that’s what’s going to happen.
And this is the debate. As the Fortune article talked about the cold reality is that none of the presidential candidates want to tell you is a shrinking number of Americans are bearing an ever bigger share of the nation’s income tax burden. And they talk about this sort of class war that people are coming into play, and we’re going to get into as we get into manufacturing because a lot of the nation’s wealthy people are actually, John, small businesses. That’s who’s creating all of the jobs. And all these small businesses would get hit hard; they’d get hit hard by a repeal of the tax rates, and then they’re going to get hit again with the estate tax rates and the capital gains tax rates to pay the estate taxes. So there’s a lot of stuff here and I’m glad to see that people like Fortune magazine and the Wall Street Journal are talking about, “wait a minute, this is a debate that we’re not talking about and the politicians aren’t telling the voters the truth behind these measures.” [15:06]
JOHN: The second half of what we were going to discuss is the concept of trade – trade as a matter of fact, our trade deficit is actually doing somewhat well right now and that’s one part of the economy that’s chugging right along unless they kill it with tariffs or taxes.
JIM: This is one of the most alarming trends. If you talk about something on the bright side on the economy because, you know, everybody is talking about a lot of the gloom and doom stuff, but one of the brightest aspects has been a reemergence of American manufacturing. You have our exports are growing at 1 ½ to 2 times the rate of our imports. And if you take a look at our trade deficit over the last probably what, year and a half, you know, the trade deficit peaked in 2006 and since 2006 it’s been gradually coming down. And the reason is our exports are growing faster than our imports.
And one of the big damaging things – and I’ll get into this in just a minute – has been our increase in petroleum products – we’re annualizing right now about 400 billion that we’re transferring to people that provide us energy that don’t particularly like us and would like to blow us up. And that’s another disturbing fact.
But on the bright side, the one thing that’s going well is exports. They’re growing at a faster rate than imports – that’s positive – and John, these are manufacturing jobs, they’re service jobs, technology jobs, capital goods that we’re exporting. If you take a look at exports are now making up almost 30% of GDP, so the last thing that we want now is a trade war. I mean you had this week, Nancy Pelosi through some new maneuvering she changed the rule and blocked the Colombia free trade bill from going through as sort of a pay-off to the union members; and that’s putting her at odds with another Democrat Charlie Rangel who was for this bill. And what is amazing is that right now 90% of Colombian imports enter the US duty free and what this would do is open the Colombian market to American goods that face tariffs as high as 35%.
And so you know, starting a trade war with the one thing that is working with this country which is manufacturing revitalizing itself. Even though it’s slowed down, it is the one sector that is holding up. And you’re talking about high paying jobs. And it’s not just on the manufacturing jobs, you know; if you sell somebody capital goods overseas, also a lot of these companies are coming in and they’re selling service agreement. In other words, like you take a company like a Caterpillar Tractor, or a John Deere, they sell some expensive machinery but then they sell...it’s just like a warranty agreement, or you can get a warranty that guarantees that you won’t have to pay anything if it breaks down for three to five years. So there’s also service agreements.
And also, we’re exporting a lot of the – one of the areas that we think will do well in this market bounce is technology because technology companies get a good portion of their sales overseas. And so it’s capital goods, it’s industrial supplies, it’s technology, it’s pharmaceuticals, it’s agricultural goods; and John, you know what happens with a trade war? “Hey, if you’re going to do that to us, we’re going to respond in kind.” And that’s exactly what happened with the Smoot-Hawley tariff during the Great Depression. I’m absolutely amazed you have politicians that haven’t read a history book and think you can start a trade war and that nobody is going to respond back to you. [18:58]
JOHN: Jim, you know, we always talk about Smoot-Hawley, it’s just occurred to me – maybe we should tell people exactly what the tariff was, when it was enacted and why was this put in and its ultimate real damaging effects on the economy.
JIM: It was put in to effect basically back in 1930. It raised US tariffs on over 20,000 imported goods to record levels and even though the opinion of most economists said, “don’t do this.” They were telling Hoover not to do this. The idea was Hoover began to think we were not consuming enough and therefore what we are consuming we don’t want any competition coming in from any other place because that would divert consumption from American-made goods to foreign-made goods. And what happened, John, is when we enacted this it was enacted by Senator Reed Smoot, he was a Republican from Utah, and Willis Hawley, he was a Republican from Oregon – and remember, Hoover who was a Republican president at the time, so it was the Republican party that put this in place – and despite objections on even Hoover’s economic consulting staff saying don’t do this.
And what happened is a retaliation began long before the bill was enacted into law. As it passed the House of Representatives boycotts broke out, foreign governments moved to raise rates against US state products even though rates could be moved up or down by the Senate in a conference committee. In all, 34 protests were lodged within the State Department by foreign countries. Canada’s retaliation was striking; on May 1930, a month before the bill was passed Canada had fired a shot across the US bow by establishing new duties on 16 products involving almost 30% of all the US merchandise exports to Canada. So what happens is the effect of this is it cut trade and there was just one-upmanship: we would do this, they would do that and it cut off trade.
And John, right now we have the financial sector that’s weak because of the credit crisis; we have the construction industry that’s weak because of the housing bubble unwinding, and the thing that is working is our exports, our manufacturing sector. You even have now countries that are opening up plants here; you have the foreign car dealers, Honda, Mercedes, Toyota, BMW opening up plants here. There’s even talk now about Airbus opening up a plant here and the problem is there won’t be union plants which is what the unions object to because unions are grossly inefficient – just look at any union run industry. And so what this is is it’s a pay-off to the unions and, John, that’s what they want. They want a trade war and they think we can go to these protectionist measures and there will not be an equal response in kind from our foreign competitors. And unfortunately, unlike the 1930s we’re no longer energy sufficient anymore; in fact, if we look at the trade deficit figures for the month of February we spent $38 billion on energy; the month before, 40 billion. And at the rate that we’re going right now, in 8 months we’ve spent 260 billion sending money overseas on petroleum imports and we’re on track – it’ll actually get worse as we get into the fall where energy demand starts to go up – to spend 400 billion. So, you know, we are playing with fire here in terms of wanting to kill the economy. And that’s why –a comment I’ve used – recessions are part of the boom-and-bust cycle but it takes a politician to turn a recession into a depression. [22:53]
JOHN: And you’re listening to the Financial Sense Newshour at www.financialsense.com. Coming up next, we’ll talk about financial planning Part 3 of our series on the whole subject. And in the next hour we’ll take your calls on the Q-Lines. We shall return.
Planning
for Retirement - Part 3
JOHN: A couple of weeks ago we began a series called Planning for Retirement and this is Part 3 of that series. It’s a four part series and we’ll finish it up next week here on the program. Now we want to talk about investing for retirement. That’s an important consideration, especially if –as we were listening to John Williams in the second hour –it’s going to be harder and harder to have access to your Social Security so you’re going to have to look more and more to your own sufficiency as far as planning for retirement. And part of that is generating income and wealth by means of investment.
And something, before we go actually into the investments, Jim, is we have talked about in the past assumptions that people are making about retirement. One of the hardest issues is to plan for things that are constantly changing like inflation. So let’s go back through those assumptions and then we can see how they would apply in the area of actually planning for investment.
JIM: They’re all sort of related but probably one of the biggest mistakes that people make in planning for retirement is they don’t have a plan. It’s just all of a sudden you plan on working to a certain age and then all of a sudden a health condition emerges out of the blue, or your industry changes – the company that you’re working for is being sold, it’s being taken over, it’s being merged with somebody or the conditions get worse and they have to lay off – and all of a sudden you’re saying, “I didn’t plan for this to happen, I thought I had a lot more time.” So not having a plan…
And the other thing that we mentioned last week is something that people really have not thought about, but with medical technology is longevity risk. We talked about last week, a male has a 50% chance today of living till age 85, 25% chance of living to age 92 for females. There’s probably about a three or four year difference. A 50% chance a woman could live till age 88; a 25% chance to 94. And if you look at a couple – a 50% chance of living to 92, and a 25% to 97 (joint life expectancy). So underestimating life expectancy – in other words, you live a lot longer than you thought you were going to live.
Some other common errors that we see is low balling your spending. You tend to be conservative a lot of times projecting annual expenses and especially spending on discretionary items that you know, you’ve got the basics down but discretionary items can add up. And then along with that, not planning for the unexpected extras that can show up, healthcare issues, housing issues, car issues. And speaking of health care is overlooking rising healthcare costs; and one thing that I expect to see as they go to means testing on Social Security, I can almost guarantee that in the next decade – another one will be having individuals pay more and more of their Medicare costs.
And then, John, something that we’ve been talking about here, gosh, for the last four or five years: ignoring the impact of inflation. [26:50]
JOHN: We said that tracing inflation say, for example, is hard to do. Why don’t we do something interesting here. Punch up your spreadsheet there and let’s spreadsheet some scenarios very quickly here for people 5, 10, 15 years out in retirement and what the income requirements are going to have to be. How does that sound?
JIM: Okay. And we’re going to use a couple of monthly income figures – somebody that would need 3,000 a month to live on: 5,000 a month to live on and 7,000 a month to live on.
JOHN: You mean starting today. We want to say…
JIM: Yeah, starting today, Day One. Okay. So we’ve got a couple that needs 3,000 a month to live on – and we’re going to use three inflationary scenarios by the way: a 4% inflation which is what the government tells us that inflation is today; a 6% rate and an 8% inflation rate. And as we saw in the Second Hour, John Williams tracking the old CPI is showing close to 11% which is pretty close to what people are experiencing. But at $3,000 a month and five years at an inflation rate of 4%, you would need to have 3650 a month to stay even; at a 6% inflation rate you’d need over 4,000; and in five years at an 8% inflation rate, you’d need almost $4400.
If you look at that inflation rate going out 10 years, in 10 years at a 4% inflation rate you would need $4,440 to live the same way 3,000 buys today; at a 6% inflation rate that number moves to 5,373; and at an 8% inflation rate which is probably closer to where we are today, your $3,000 of income would have to grow to 6,477 – or roughly 6,500. [28:37]
JOHN: Okay now, and let’s go to 15 years because this is the real breath choker so to speak.
JIM: Yeah, because there’s a good reality with the longevity that we’ve been talking about. In 15 years, if you’re currently living on $3,000 in retirement now. In 15 years at a 4% inflation rate, you’d need 5400 to break even and live like you are today; at a 6% inflation rate, you’d need almost $7,200 of income; and at an 8% inflation rate, you would need $9,500 worth of income.
We’ve computed these – let me just give these to extreme or get something to what we think is closer: $5,000 of income today you would need: in 5 years, almost 7400 at an 8% inflation rate; in 10 years, you would need almost 11,000; and in 15 years, you would need a figure that’s closer to 15,000.
And if you take somebody that’s making $7,000 a month that they’re living on, you would need: with a 4% inflation rate, 8500 in five years; over 10,300 at an 8% inflation rate; in 10 years, a 7,000 a month person would need 15,000 at an 8% inflation rate; and at 15 years from now, at an 8% inflation rate, a person earning 7,000 would need over 22,000.
So there are two factors that people fail to plan for: one is longevity, meaning you live a longer number of years in retirement; and secondly, the other issue is the impact of inflation. And I would not count on a government that has 60 – I think John Williams has estimated according to the latest fiscal report it’s 62 – trillion of unfunded liabilities that we’re going to have deflation especially with all the things that the Fed and the government is thinking of doing now. [30:42]
JOHN: Okay, given the fact that there’s a ramp up here going in terms of what you’re going to have to return in terms of investments then where do you invest in order to do that?
JIM: There’s something that’s a much bigger picture here. And that is in your plans, if you’re looking at taking into consideration longer life span, inflation and if you think there’s going to be inflation then you need to adapt your portfolio to account for inflation because if you don’t – many people who work in the private sector if they get a pension plan from a company if they’ve worked at a company long enough that pension – whatever that figure is, if it’s 1500 a month, $2,000 a month – it’s going to be that way for the rest of your life.
Now, some people are fortunate enough if you work for the government – whether federal government or state government – some of these retirement plans are indexed to a low rate of inflation so maybe you get a 2% increase. But most Americans are going to be dependent – especially the boomers – very few boomers have worked for a company for 30 years and you get the Timex watch and a defined benefit pension plan. Companies started doing away with defined-benefit pension plans back in the 80s, so what they went to is profit-sharing plans and 401(k) plans. So what people have to retire on is what they put away in their 401(k) program.
So now what you have to look at is if this is what’s going to be the primary source of your retirement income, what kind of portfolio is going to keep you even with inflation during your retirement years because putting your money in bonds today with interest rates at half the inflation rate, you know, those figures that I just gave you, I mean what are you going to do if we experience 6 and 8% inflation a year and you’re in bonds paying, you know, a 10 year Treasury note doesn’t even pay 3 ½%. [32:43]
JOHN: The typical recommendation here is something like this: about 60% of your assets in fixed areas; 25% liquid assets, largely CDs and money market funds; 15 to 25% in what?
JIM: Stocks.
JOHN: Stocks, okay.
JIM: Yeah, so the first standard thing that they tell people when you retire is you’ve got to reduce your stock exposure because now you’re needing income. But that might have been true for the decades that we had a disinflation in the 80s, where gosh, I can remember in the 80s, we did primarily bonds, a lot of bonds. It was very hard to convince people to put money in stocks, especially after almost an 18 year bear market that lasted from 1966 to 1982. But back then in the 80s, I mean we could get what? Gosh, I can remember getting 15% on a Treasury note in 82 and 83. I can remember getting 12, 14% on government Ginnie Maes; heck, you could have got 12% at the bank. So the interest rates were much, much higher.
Today, you have a situation where the interest rates offered on safe bonds are far below the inflation rate – less than 3 ½% on a 10 year Treasury note is less than the official CPI rate and we know that’s understated. So this old rule that there are these cookie-cutter formulas...and you’ve seen these, they have money market funds now, they call them ‘lifestyle’ funds where based on your age they shift you into a lifestyle fund that goes more to fixed income and cash as you head closer towards retirement.
But I think the big factor that is not being addressed here is what kind of environment would you face over the next 10 to 15 years in retirement. Is it going to be a disinflationary environment, a deflationary environment or an inflationary environment? And if you expect that there’s going to be an inflationary environment then you better have something in your portfolio that’s going to go up, either a portfolio like that’s one of the reasons I like large cap big multinational blue chip companies that have businesses that are very stable and that increase their dividends each year. Wouldn’t it be nice if you had a stock portfolio of blue chip stocks that are increasing the dividends at 10% a year. That way you have your income is going up each year so as your cost of living goes up, you’re getting a rising stream of dividends. And there are companies out there –especially in the natural resource sector in the medical field and energy – that are increasing dividends at higher rates than that.
We often talk about companies that have had a history of long, and I talk about a long history of raising dividends every single year. That’ll tell you more about the business and the nice thing about what we recommend when somebody retires is you put together a blue chip portfolio because you know what, you’re not going to worry about Exxon going out of business or a Johnson & Johnson or a General Electric or a DuPont or any of the large stocks in the Dow 30 or even the top 100 stocks in market cap in terms of the S&P 500, or what we like is not only just domestic multinational companies but we like foreign companies because you get the double whammy: you’ve got assets denominated in a foreign currency and also that’s where some of the largest growth rates that we’re seeing. [36:20]
JOHN: Well, you know, then there’s always the issue that you’re assuming inflation rates are going to stay right where they are. What happens if inflation rates go even higher. I mean a lot of people are up the creek without a paddle at this rate alone, not to mention anything that could go worse.
JIM: One of the things that we have talked about here and we did this in the last program, I think two of the tools people are going to have to used 1) is downsizing and 2) relocation. In other words, if you’re in a eastern or west coast city where the cost of land and homes has just gotten so prohibitive you sell the big house, you downsize to a smaller house, you move to a state where the cost of living or you move to a community where the cost of living for housing is much, much less.
Secondly, you want to move to a state that doesn’t have a large welfare system where they have to impose huge punitive tax rates. I think there are seven or eight states here that have no income tax, so you can move to an area – Washington is one, Nevada, Texas, Florida, Tennessee and some of these other states where you can bring down the cost of your housing, you can bring down your taxes by relocating.
And then thirdly, another factor is people working part-time during retirement. And that could be fulfilling and especially if you get into something that maybe it was something that you wanted to do during your working career and never got around to it. So we talked about that.
But I think the other factor is putting a good portion of your portfolio in well secure international blue chip companies; companies that make a product, have a strong balance sheet, have a history of raising dividends because what else are you going to do? In the next decade we are looking at a decade where the government is going to go to means testing on Social Security, they’re already making movements to make individuals receiving Medicare pay more and more of their medical expenses. So I mean these are the realities, these are unfolding right now. And so that’s why I think that one of the additional mistakes I think people make in retirement is they fail to assess the economic and market environment of which they will spend the majority of their retirement years in.
And I told this story – I tell it every year, but I mean it made a lasting impression on me. When I got in this business – and that was towards the end of the 70s and I tell the story of this executive who worked at a Fortune 500 company and he was one of the top execs and he retired, had a paid-for home, 750,000 bond portfolio. And you go back to – I’m trying to remember if it was 1968 or 69 when he retired – when you had 3 and 4% interest rates. So he was in Treasuries and municipal bonds. He did have a company pension plan, he did have Social Security; his home was free and clear and he had a million dollar portfolio - $750,000 in fixed income and 250,000 roughly (a little over that) in a stock portfolio.
And I can remember to this day when he walked into our office, his bond portfolio had declined from 750,000 down 400,000 –and he would have never in his wildest dreams thought he would have seen that – because his pension never went up, his bond portfolio never went up in terms of income; and every year as interest rates went up with inflation he saw the value of those bonds drop, his income never changed and what turned out to be a very, very prosperous retirement was less so by the time he got to the end of the 70s. And so that’s another mistake I think people make. And John, you know, this idea that you put these cookie cutter formulas without any thought whatsoever to the macroeconomic environment I think is another mistake I think people make in retirement. [40:25]
JOHN: And just by way of reminder, we did a number of shows on dividend investing over the past 24 months – a lot of those are still archived so if you’d like information on that please go and visit that. But this is going to be a subject which will come up over and over again. And I think we’re going to have to adjust some of what we’re saying here to match unforeseen things too, you know, as the years go by here on the program because we’re always trying to respond to curve balls and actually to stay ahead of the curve to see things around the corner that most people aren’t spotting. So we’ll do that.
Next week, we’ll continue Part 4 of Planning for Retirement. You’re listening to the Financial Sense Newshour at www.financialsense.com. Coming up next, looking at Q-lines, time to take your calls and questions.