The JP Morgan Effect; Eric Fry Points Out that Pension Funds are Selling Stocks
The Daily Reckoning Thursday, October 15, 2009
JP Morgan's profits point to a recovery - or do they? The amount of money people are being paid is taking a big hit... How did JPMorgan earn so much money in such a bad economy? Eric Fry points out that pension funds are selling stocks...
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The JP Morgan Effect by Bill Bonner London, England
What a marvelous flimflam! So obvious...and yet so effective! It's a pleasure to watch.
Yesterday, the Dow soared over they 10,000 mark. If it keeps going at this rate - up 144 points yesterday - it will soon equal the post-'29 bounce.. All we need is two more days and we're there.
Oil rose over $75. Gold closed the day at $1,064, after a big move to the upside over the last few days. And the dollar fell - to just $1.49 per euro.
The reason for yesterday's big move is announced on the front page of almost every financial rag this morning:
"JPMorgan profits lift the Dow."
JPMorgan, the Wall Street firm that was bailed out by the feds a year ago, reported income of $3.6 billion in the 3rd quarter. With that kind of profit in the financial sector, it won't be long before the whole economy is running red hot, right?
That's what the papers seem to think. The International Herald Tribune says the bank's profits are just another sign that a major recovery is underway. Investors seem to believe it, too. "Earnings optimism," is behind the buying, says a broker.
But is it true? Is the real economy growing, expanding, and making money? Let's look:
"Still on the job, at half the pay," is a headline in The New York Times. It tells the story of an airline pilot whose position has been downgraded and whose pay has been cut in half. The fellow is now earning $30,000 a year rather than $60,000. He is not counted in the unemployment statistics but he has much less spending power than he had a year ago. Practically all his discretionary spending power has been wiped out.
"The Bureau of Labor Statistics does not track pay cuts, but it suggests they are reflected in the steep decline of another statistic: total weekly pay for production workers, pilots among them, representing 80 percent of the work force. That index has fallen for nine consecutive months, an unprecedented string over the 44 years the bureau has calculated weekly pay, capturing the large number of people out of work, those working fewer hours and those whose wages have been cut.. The old record was a two-month decline, during the 1981-1982 recession..
"What this means," said Thomas J. Nardone, an assistant commissioner at the bureau, "is that the amount of money people are paid has taken a big hit; not just those who have lost their jobs, but those who are still employed."
All over the country incomes are falling. Officially, about 15 million people have no jobs. Many others have given up looking for jobs. And now, for the first time ever, more than half of those who lose their jobs run out of unemployment benefits before they find another one. Many others never get any benefits at all, because their jobs are not eliminated, they are merely cut back...either in the number of hours they can work or in the compensation itself.
Yesterday, we reported that Baby Boomers are actually working longer hours...but earning less. The boomers are in an especially tight spot. They've got only a few years to save money for their retirements...and it won't be easy in this slumpy economy.
And we reported the plight of the callow youths...whom BusinessWeek has called the "Lost Generation." Their unemployment rate is twice the national average. They're at the bottom of the labor pool, and unless the economy begins to expand they'll have a very hard time finding the bottom rung of the ladder.
Take all the people who are unemployed...who are working fewer hours...who have given up looking for work...whose positions have been downgraded...and add the family members who depend on them for their daily bread...and you have nearly a quarter of the population. How can companies expect to increase sales and profits with a quarter of the population forced to cut back severely?
They can't. The earnings numbers are misleading. Most of the earnings that we've seen come from cost cutting, not growing top-line sales. How do businesses cut costs? By trimming employees! In other words, the earnings figures we're seeing are contributing to the slump...not alleviating it.
You can see how, in the short run this can lead to increased profits. But it can't go on for long. The more businesses cut costs the more their sales go down, because consumers (who are also their employees) have less money to spend.
And according to a Wall Street Journal report, with too much capacity...and falling sales, businesses "are hesitant to reinvest such profits into their businesses."
That's why business investment, as we reported two days ago, is falling even faster than sales.. And it's why people who are looking for a job are going to have a hard time finding one.
But let's return to JPMorgan...after the news:
"US foreclosures jumped to an all-time high of 937,840 in the third quarter," writes Ian Mathias in today's issue of The 5 Min. Forecast. "That's a 23% rise from the same time last year, says a report from RealtyTrac today. One in every 136 households received a filing - also a record. Once again Nevada takes the cake... An incredible one in every 23 households was in some form of foreclosure last quarter.
"And they tell us the economy is recovering?
"But here's the kicker - a theme that should be no surprise to 5 Min. loyalists: This isn't about subprime anymore. The most recent data from the Mortgage Banker's Association claims subprime mortgages currently account for hardly a third of foreclosure starts, down from 50% last year. Prime loans - the gold standard of the mortgage biz - now take up a 58% share.
"Even the foreclosure scene in terms of home prices has been turned on its head. Check it out:
"About 35% of home foreclosures occur in the bottom third of the housing market, says zillow.com, down from 55% in 2006. In June, the most recent data available, 30% of foreclosures were in the top tier - nearly double the rate from the year before.
"And the icing on this rotten cake: Option ARMs. This pending rate reset crisis - which just about everyone 'in the know' saw coming in early 2008 - looks like its really going to happen. 46% of option ARMs are currently 30 days past due, despite the fact that just 12% have reset to higher payments. Resets for the rest of those ARMs are right around the corner."
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And back to the House of Morgan:
How did JPMorgan earn so much money in such a bad economy?
We begin with a bit of skepticism. After all, we know consumers aren't borrowing. Consumer credit is going down. So they can't be making money there. And we know businesses aren't expanding, so they can't be making money by lending to corporations either.
Wait a minute. JPMorgan is a bank, right? Don't banks make money by lending money? Yes...that's what we thought. Then who is JPMorgan lending to?
The only net borrower is the government.
The Financial Times confirms that Morgan's "US consumer businesses continued to bleed, with its credit card unit losing $700 million in the quarter and its retail bank...barely breaking even." It wrote off $7 billion in uncollectible consumer loans - more than twice as much as last year.
Its mortgage group lost money too. And it surely didn't make any money helping US business build new factories and expand payrolls.
So what does that leave? All the components of the business that have to do with the real economy are losing money or barely breaking even. What's left?
The news reports attribute the huge profits to "trading." But trading is a broad category. And our guess is that if you look more closely you will find that JPMorgan made its money the old fashioned way - by ripping off the government.
'You mean, JPMorgan took the feds' money and now is showing huge profits because it is just lending money back to the people they got it from? '
Yes. But not only that. They're also probably speculating on gold, oil and stocks...along with everyone else. The feds' money has pushed all these speculative trades into profit.
'And now, they're going to pay themselves big bonuses, aren't they?'
Yes. The papers tell us, "bonuses explode on Wall Street to a new record."
'So, then...when the next crisis comes...they won't have any money in the banks, will they?'
'So they'll have to get bailed out again.'
'But maybe the next time the feds will wise up and just let them go broke.'
Not a chance. Wall Street has plenty of friends in the highest places in Washington. A report in today's media tells us that "Geithner Aides Reaped Millions Working for Banks, Hedge Funds." The aides earn about $150,000 for their government work. On the side, they advise the financial firms they're supposed to be regulating, and get paid millions.
Such a nice relationship. They make sure Wall Street prospers - even when it does stupid things. Wall Street makes sure they prosper - even when they advise the government to do stupid things. And when their gig is over in Washington they go back to Wall Street where they earn millions more. America's centers of political and financial power have a cozy little game going. It won't end any time soon. It's too profitable for both of them.
Bill Bonner The Daily Reckoning
P.S. This illustrates yet another reason this 'recovery' is a fraud...and why your money is at stake. Learn how to protect yourself with our free financial defense strategy, found here.
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The Daily Reckoning PRESENTS: Pension plans take a long time to reverse direction. And as Eric Fry points out below, once plan fiduciaries decide to proceed in a given direction - investment-wise - they typically continue down that path for years, if not decades. Read on...and stay tuned for more from Eric in the coming days.....
Pension Funds Learn to Say, "Sell!" by Eric J. Fry Laguna Beach, California
Pension plans are selling stocks. Headline or footnote?
Recent history suggests this little news item should be a headline. Pension plans - like supertankers, but unlike politicians - take a lot of time to reverse direction. But once plan fiduciaries decide to proceed in a given direction - investment-wise - they typically continue down that path for years, if not decades.
This tendency provides the mother of all long-term indicators for the financial markets. Although pension plan fiduciaries tend to be VERY wrong at major, long-term turning points, they tend to be right - more or less - as markets transition from one extreme to the other.
The principal is actually very simple: pension plans behave like long- term momentum investors. So they tend to buy into rising markets...until after those markets have peaked and begun a major decline. Conversely, fiduciaries tend to sell into falling markets until after those markets have bottomed out and begun a decisive uptrend.
In aggregate, therefore, pension fund fiduciaries tend to behave like novice investors - buying high and selling low. But since their momentum investing unfolds over such long timeframes, this group of investors tends to be very right during the middle of a big move - up or down - in any particular asset class.
The world's fourth largest pension provides a classic case in point. The California Public Employees' System (CalPERS) with $181 billion of assets at last count, ranks fourth on the list of the world's largest pensions plans. But it might rank first on the list of worst market- timers. Between 1983 and 2000 the pension giant doubled its allocation to equities...just in time for one of the stock market's worst decades ever.
During the middle of this giant bull market, CalPERS was correct to up its allocation to stocks. But by continuously upping its exposure to a rising stock market, CalPERS eventually overdid it.
In September of 2000, as the US stock market was beginning its colossal collapse from the then-record highs set earlier that year, your editor highlighted the vulnerability of CalPERS' stock-heavy portfolio. In an article entitled "Golden State Bulls," he observed, "In 1983, with a moribund Dow Jones Industrial Average hovering around 1,200, the powers that be [at CalPERS] deemed 30% to be the optimal equity weighting for the fund. But 17 years and 10,000 Dow point later, the CalPERs...investment committee now allocates a whopping 67% of assets to equity investments.
"Although pension plan fiduciaries tend to be VERY wrong at major, long-term turning points, they tend to be right – more or less – as markets transition from one extreme to the other."
"Meanwhile," the article continued, "the fixed-income allocation has atrophied to but a shadow of its former self: from 67% back in 1983 to little more than 28% [today]...That's been a swell situation for the last few years. CalPERs - ominously referred to as the 'The System' in the fund's literature - earned a 10.5% return on its investments for the year ending June 30, 2000, marking the sixth straight year of double-digit returns."
Despite these pleasing investment results from the recent past, your editor wondered aloud about the immediate future: "If the bull market of a lifetime commenced when CalPERS was wading only ankle-deep in equities (some 30%), what does it mean that the pension giant now fairly bathes in them?"
Investors did not have to wait long for the answer: The stock market stunk up the place for the next nine years. Your editor highlighted this exact risk in his article.
"A back-of-the-envelope calculation shows that if the equity component [of the CalPERS portfolio] were to merely break even [during the next six years]," he warned, "the balance of the portfolio would need to generate a 25% return to meet the [fund's] actuarial assumption. And you know, that may not happen every year."
CalPERS did not welcome your editor's pro bono investment advice. In an October 8, 2000, story in the Sacramento Bee, CalPERS spokeswoman, Patricia Macht, countered, "That's (the magazine's) back-of-the- envelope calculation. We don't manage people's money on back-of-the- envelope calculations...We're not in stocks because we make a lot of money, we're in at the level that's prudent to be."
Your editor, defending his criticism in that same Sacramento Bee story, replied, "Just because [CalPERS' equity-heavy allocation] has worked doesn't mean that it's responsible."
CalPERS would have none of this criticism...and neither would any of the giant pension's many defenders and apologists. An influential money manager, who's name your editor will mercifully withhold, ended the Sacramento Bee by scorning your editor's concerns as "dead wrong."
As it turns out, of course, your editor's concerns were "dead right." (The S&P 500 Index has produced a total return of minus 12% from the end of September 2000 to the present). But anybody can get lucky once or twice.
More to the point, CalPERS "knew better"...or it should have. It should have known that stocks sometimes go down. So it should have also known that a fund that must dispense billions of dollars every year to retirees cannot prudently allocate 70% of its portfolio to such a volatile asset class. But the investment mavens at CalPERS could not bring themselves to worry about worst-case scenarios while best-case scenarios were delivering such delightful returns.
And besides, the stewards of the giant pension fund certainly understood that - come what may - they could always cite chapter and verse of the long-term bull case for equities. They could simply remind their would-be critics that equities had outperformed bonds by a large margin over almost any timeframe during the preceding 100 years. Between 1900 and 1999, for example, US stocks gained an average of 12.9 percent a year, while bonds returned only 4.7 percent annually, according to the data from the London Business School and Credit Suisse. Armed with such rear-looking data, and lots of pretty charts, the CalPERS pension fund charged into the new century loaded for bull.
This equity-heavy allocation seemed unassailably prudent to the stewards of CalPERS, who rarely missed an opportunity to congratulate themselves for a job well done. Not content to merely draw a paycheck, without also drawing attention to himself, Michael Flaherman, then- chairman of the CalPERs investment committee, crowed in mid-2000, "Our performance is the culmination of superior investment and risk management."
No sooner had Flaherman slapped himself high-fives than the stock market Fates began conspiring to punish his unabashed hubris. Since the end of the last millennium, stocks have produced an average annualized loss of 2.3 percent, compared to an annual gain of about 6.3 percent for bonds. Not surprisingly, therefore, CalPERS' equity-heavy fund has generated a meager 2.2% average annualized (gross) return since 1999. (For some mysterious reason, CalPERS discontinued reporting its investment returns net-of-fees in 2002. All of which means that the stated return of 2.2% would actually be a much smaller number).
But now that the bear market pony has frolicking outside the barn for several years, the CalPERS investment team is slamming the barn door shut. The team is drastically reducing its allocation to equities. As of last June, CalPERS reduced its equity target from 56% to 49% - the lowest such allocation since 1993. (Including "alternative" equity assets like hedge funds, the revised equity target would be 61.4%, down from 66%).
Net-net, CalPERS is now a seller of equities...or at least not a buyer. Most of the other pension plans in the US (and in the rest of the world) will likely follow CalPERS' lead.
"Equity assets in the U.K. fell to 41 percent of holdings at the end of 2008, according to data compiled by New York-based Citigroup," Bloomberg News reports. "The last time British pension funds held so little in equities was in 1974..."
Meanwhile, Bloomberg continues, "Four of the world's seven largest pension funds...have cut their equity target allocations..." It's probably safe to assume, therefore, that "caution" is the new buzzword in the halls of most pension fund managers. So it seems highly unlikely that they will exhibit their former exuberance for equities any time soon.
Demographic trends, as well as caution, will prohibit aggressive equity allocations. In California, for example, the baby boomer retirement wave is just beginning, which means that CalPERS must begin favoring capital preservation over "long-term growth." Ditto most other pension funds on the planet.
"The number of people worldwide 65 and older may jump to 1.3 billion by 2040 from 506 million last year," Bloomberg reports. "Their proportion of the total population will double to 14 percent in the same period, according to a June report from the US Census Bureau."
"[Since] the heavy equity weightings of public pension funds in this great land of ours comprise not only the mother of all sentiment indicators, but also a monstrous overhang of stocks, what if the funds sell?" your editor wondered in his mid-2000 article. "No sane fiduciary would choose to sell stocks of course - not if he or she wished to retain a comfortably feathered nest. But demographic trend may force the hand...Probably, the looming overhang is nothing to worry about - right now. But when the overhang threatens to break loose, remember: you heard it hear first."
That moment may have arrived.
Eric J. Fry for The Daily Reckoning
Editor's Note: Is your retirement safe? It may be time to turn to 'Plan B'. It's easier - and more profitable than regular retirement plans. Learn all about it here.
Eric J. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short- selling. Mr. Fry launched the sometimes-abrasive, mostly entertaining and always insightful Rude Awakening.
His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, BusinessWeek, USA Today, Los Angeles Times, San Francisco Chronicle and Money. He appears regularly on business news stations like CNBC and Fox.
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About The Daily Reckoning: Now in its 10th anniversary year, The Daily Reckoning is the flagship e-letter of Baltimore-based financial research firm and publishing group Agora Financial, a subsidiary of Agora Inc. The Daily Reckoning provides over half a million subscribers with literary economic perspective, global market analysis, and contrarian investment ideas. Published daily in six countries and three languages, each issue delivers a feature-length article by a senior member of our team and a guest essay from one of many leading thinkers and nationally acclaimed columnists.