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is Max Rudolph. I am a credentialed actuary and CFA charter holder working
as a sole practitioner in Omaha, Nebraska, USA. I write a monthly
newsletter, covering a variety of topics. It has varied from 1 to 4 pages,
but most are less than 2 pages. Coverage is mostly related to risk
management and investments. Some are written at a high level, dealing with
the general economy, and some cover very specific topics. I try to write
something about the current financial environment, and there have been
plenty of topics to choose from. The newsletters are educational in nature
and do not constitute investment advice. The newsletters are released
www.rudolph-financial.com after 3-6 months.
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Financial Predictions for 2010 – How Did They Turn Out?
Each of these predictions
was made at the beginning of 2010. Now it is December 2010 and each one will
be reviewed for accuracy. Let’s find out how I did.
Please remember that these
predictions are for fun. If I knew what was going to happen, I certainly
would not share that information with others! You must make your own
decisions regarding your financial future and not hold others, including me,
responsible for your own results. Enjoy!
Here are some of the events
that occurred in 2010. Natural disasters will occur regularly and perhaps
- Haiti earthquake and cholera
- Iceland volcano and
- Chile earthquake
- New Zealand earthquake
- Indonesian volcano
- Gulf oil spill – story of the
- Auto safety issues – what
should we believe – good example of reputation risk
- Egg recall due to salmonella
- Floods in Central Europe
- Wildfires in Russia
- Flooding in Pakistan
- South/North Korea tensions
- European sovereign debt crisis
– Greece, Ireland, Portugal
Current likely bubbles
- Junk bonds
- Emerging markets
Emerging risks I became
aware of in 2010
- Wheat rust
- Wheat shortages due to
interaction with drought
- Dam maintenance shortfalls
- Monopoly manufacturing (e.g.,
- Dictators pushed into a corner
(e.g., Castro, Kim) – nuclear war for last bit of glory?
- What will the next war look
like? Technology has evolved a lot since the last major conflict.
- Cosmetic surgery in low cost
venues allows superbugs access to airplanes
- Municipal bond concentration in
These (mainly) economic
predictions were made in January 2010.
- Politics: every year I write
about the political cycle, and this year is no exception. Barack Obama
was a disappointment in his first year, working a strictly democratic
agenda rather than being a consensus President. His initiatives have
focused on political expediency rather than bringing Americans together.
In the 2010 elections he will surely lose his 60 seat filibuster proof
Senate and will lose some seats in the House while maintaining a
majority in both houses (this actually happened already as the democrats
lost Teddy Kennedy’s seat in Massachusetts, mainly because they took it
for granted). Once he loses the 60 seats he will become a lame duck
President unless there is a new armed conflict for US citizens to rally
around. Personal accountability has been ignored, with only the “rich”
expected to pay taxes. A better plan would be to have an income based
tax like FICA taxes but that is unlikely to happen anytime soon from
either political party. The lack of 60 Senate votes has cost the
democrats their big issue, health care reform, so now they will take on
reregulation of the financial sector. God help us all! Political
instability throughout the world will be a problem, driven by the
liquidity crisis, price of oil, and/or terrorism. Countries most at risk
are Iran, Venezuela, Pakistan, Mexico, and the Philippines. China could
see a negative surprise here.
Politics. The Republicans did even better than I
expected as the Tea Party subgroup, pulling the Republicans even further
to the right, continued to mobilize. The Democrats maintained their
majority in the Senate but actually lost their control of the House.
Assuming the Tea Party nominee for President does not win the Republican
nomination, the Democrats will be on the outside looking in after 2012.
Recent efforts (long overdue) by President Obama to work with the
Republicans may have isolated him from his own party but allowed needed
legislation regarding taxation to move forward. The countries listed
have had challenging years, with the uncertainty on the Korean Peninsula
dominating the recent news. The price of oil has delayed crises in
Venezuela and Russia (it has risen). Health care reform was pushed
through but much remains for it to be implemented. As it stands right
now it will lead to nationalized health care as insurers will not be
able to compete with government entities.
- Stocks: The stock market is
currently overvalued, having anticipated a quick recovery. The stock
market will be volatile in 2010 but end up within 10% of its starting
point. My gut feel is up slightly, but it is hard to get it right over
such a short period of time. Over the next 3 years I expect the market
to operate within trading ranges as increased productivity is offset by
higher valuation discount rates. Good companies to buy now are ones that
can pass on their inflationary cost increases to their customers like
those in the transportation and utilities sectors.
Stocks. The S&P 500 index closed 2009 at 1,115.10 and
has mostly operated within a 100-point trading range on either side of
the open until a recent surge in the 4th quarter has taken
the index to roughly a 13% (pre dividend) gain for the year. The market
has done better than I expected, but until December I was right on my
prediction. I expect a correction early in 2011. Leaders in 2010
included emerging markets and small caps.
- Unemployment: Fiscal stimulus
has helped to bottom out unemployment, and I don’t expect it to get
worse than the current 10%. What worries me is the higher percentage of
government workers as a percentage of all workers. We can’t all work for
the government. That would wipe out the creative destruction process
that is capitalism and leave us with socialism. We have entered an era
where saving is more popular, but this will only be complete when some
who choose not to save are allowed to fail. There is enough money on the
sidelines that this should not cause a slowdown in growth. 2010 will be
a year when firms cut expenses so far (training, travel, new hires) that
it begins to impact their ability to profitably grow. The “survivors” at
big firms will no longer be the best and brightest, and these firms will
need to hire creative minds from outside to succeed. Budget imbalances
will eventually create inflation, but long term treasuries will increase
first. Taxes will not be impacted until unemployment returns to a more
normal level but will eventually need to rise.
Unemployment. A direct hit. Unemployment remains high
but did not rise above 10%. I still believe that the structural
unemployment rate is higher than it used to be (when I was in college I
remember it at about 5%). I still haven’t found anyone (except
individuals) who has been allowed to fail. The Bush tax cuts were
extended through the Presidential cycle, and FICA taxes lowered to boot
for additional stimulus.
- Securitization/Mortgages: The
securitization market will thaw a bit but capital requirements will
continue to be high for banks, discouraging loans. I don’t think we are
done with the bad news from home mortgages either. Some are saying that
the Fed will have major balance sheet issues if interest rates rise. Are
these unintended consequences or just a plan that was not thought
through? Probably some of both. I don’t understand why there are so many
governmental organizations designed to oversee residential mortgages.
One positive development would be for GSEs to eliminate their lobbying
arms. Higher interest rates will drive another round of foreclosures on
home mortgages as ARM contracts reset their rates.
Securitization/Mortgages. This prediction was pretty accurate but did
not have much impact. Basel III was just announced and the uncertainty
kept deals from happening. What I believe is a leading indicator of the
coming consolidation wave is the many mergers of HR and actuarial
consulting firms. Economies of scale and concentration will rule in that
market going forward. The home market is rebounding at the entry level,
and some regions are starting to come around, but higher entry point
homes will have slow turnover until the home mortgage deduction issue is
- Volatility has fallen all the
way back below 20, indicating to me that investors think the government
will bail them out no matter what and no matter when. This is clearly
wrong in the long term. A reasonable VIX seems to be about 25 for 2010
unless there is political instability.
Volatility. I missed this one again, as the VIX remains low (in my
opinion) at about 17 and has been monotonically falling since its high
of 45 in May after the BP oil spill. I don’t understand why it is so low
with what seems to be so many risks lurking just over the horizon.
- Oil: Oil is currently about
$80, at the bottom end of my long-term mean reversion rate of $80-110
range, but volatility continues to make short term predictions very
risky. If oil prices fall back below $50, political instability in
Russia and South America will quickly follow in the next couple of
years. With the recent devaluation of the Venezuelan currency this may
occur no matter what the price of oil is. As the world economy improves
the price of oil should increase. The interesting dynamic will be
whether natural gas takes market share as a green substitute as well or
if the world continues on as if nothing has happened. This will have
currency implications as well, with higher oil leading to a falling
Oil. I got this one pretty much right. Oil has traded in a range between
$70-95 in 2010 and is currently just over $90. It has started to rise as
the economy starts to rebound and winter storms are hitting the east
coast. Interestingly, natural gas has fallen to nearly $4. The dollar
has traded between $1.20 and $1.45 per Euro and currently is just over
$1.30. It continues in flight to safety mode but will eventually return
to its steady drop. Quantitative easing 2 has virtually guaranteed
inflation and currency devaluation, so don’t pay off your mortgages
early unless the rate floats.
- Credit risk: commercial
mortgages and junk bonds will especially impact smaller firms, while
CDOs and credit default swaps continue their negative cycle. Government
entities are at risk and a major state or municipality in the US is
likely to default on their bonds. These governments have always pointed
to their balanced budgets, but accruals have not been honestly assessed.
Unions in general will have to deal with these unfunded benefits,
whether for legacy manufacturing firms, school districts, or
governments. Investigative reporters will find easy pickings and will
drive the market to make these balance sheets more transparent. Junk
bond spreads need to widen before investing in that market.
Credit risk. While CDS spreads have widened, so far
only small/mid sized banks have had a wave of defaults. The rest are
timing issues and will come. Corporations are ahead of the curve on this
one and will do better than cities and states. Junk bonds have not gone
bad as I expected, and liberal covenants are being written again. What
did we learn?
- Financial Services
Consolidation: Bank consolidation will continue, with mid-sized and
smaller banks merging to gain economies of scale and consumer trust.
Bank capitalization will get a lot of tough talk, and may drive a “tax”
on investment banks. Expenses at insurance companies are too high and
industry overhead will need to be reduced. Insurance consolidation will
accelerate, with household names as well as smaller firms being merged
into other firms. Larger, supposedly sophisticated, firms accepted the
investment and product risks knowingly, and many smaller firms were led
along with the crowd to the cliff by statements like “all the
sophisticated insurers are doing this”. AIG and its subsidiaries will
become known for setting market prices low and keeping industry
profitability down. Long term, AIG will be dismantled and the government
will take a loss. GM, GMAC, and Chrysler will never pay back the
government either and GM/Chrysler will eventually be merged into one
company. Despite a lot of bluster, GLB will stay on the books but with
some modifications that will be material only if unemployment stays
high. Capital requirements will drive risk out of banks. Insurers will
join this crusade once the federal charter is put in place and
principles based approaches are put in place, but this will not happen
in 2010. Goldman Sachs will return to the partnership model and
privatize. This will reduce transparency into their books as well as
monetize restricted options.
Financial Services Consolidation. I got the bank issues right but
somehow the government loans to corporations are being repaid in full.
It’s still not clear to me how these loans are being fully repaid but
that is what is being reported. It is interesting that the transparency
required by Dodd-Frank showed that GS borrowed billions of dollars to
invest at the bottom of the market at low rates funded by taxpayers. Why
does anyone do business with these guys? What’s good for me is all that
matters seems to be their mantra (although I know a number of people who
work there who seem quite nice).
- Currency: Eventually the dollar
will revert to its trend and fall based on imbalances in our trade and
borrowing policies. Other scenarios focus on countries heavily invested
in dollars, such as China, Japan, and the oil exporters, choosing to
dump them. US Treasuries would then spike and the US economy could find
itself in a vicious cycle resulting in stagflation. This would take
several years to play out. Various energy subsidies will play out here,
from ethanol subsidization to wind farms, with unintended consequences
following the well intentioned efforts of politicians (latest example is
forcing auto makers to make “green” autos). Watch for others to make
vehicles that people will buy, making it even tougher for the auto
industry to survive. Unless another economy steps up to provide a flight
to safety currency the dollar will only be down moderately in 2010.
Currency. I got this one right with the dollar
dropping about 10% in 2010 relative to the Euro. It hit its low for the
year in June.
- Unintended consequences
- Energy subsidies: Ethanol
subsidies caused regional food shortages. Now subsidies for things
like wind farms and green cars are creating unintended consequences.
Who knows what technology is not being worked on because of the
focus on wind power? Congress likes to tout that they are making
Detroit make green cars, but they are ignoring the supply/demand
balance that is so necessary for a profitable company. If they make
green companies but the price of oil stays low, people will go back
to buying SUVs and pick-ups. The market will determine who wins, not
the politicians. Sometime in the next 5 years Hugo Chavez will
either implode or try to cut OPEC production of oil. He continues to
nationalize firms which will lead to poor performers. My prediction
is that poorly designed energy subsidies will continue.
the Cash for Clunkers program had a nice unintended consequence that
was obviously going to happen. My 2002 SUV with 120,000 miles on it
is worth about twice what I expected since the CFC program forced
these types of vehicles to be destroyed. Those who can’t afford a
new car or truck are paying for that program now.
- Global warming: while Al
Gore has been winning the Nobel Prize and appearing on Saturday
Night Live, engineers have designed cheap potential solutions that
don’t see the light. Governments naturally design complex systems,
while often a simple solution will work. Is carbon dioxide the right
focus? I am reading material now that says no.
more international climate conferences and no results. Individuals
will need to tackle this problem. Maybe we can get Mr. Gates and Mr.
Buffett to save the world at low cost. I still remember Charlie
Munger making a comment about how rising seas should not be a big
deal because you have time to react. Watch for future implications
in Canada and Russia as tundra becomes accessible as farmland or as
a source of oil.
- Airline cost saving on
maintenance will result in increased numbers of crashes worldwide.
- Education – many companies
are reacting in 2010 with restrictions on travel and continuing
education. This may look good in the short run on the income
statement but will lead to long term negative balance sheet
consequences. Watch for investment banks to offer to provide this
education for “free” and describe products they are selling. I see
this all the time at my local CFA chapter.
- Continued low interest
rates by the Federal Reserve – the US needs to reload the bullets in
its gun over the next couple of years to be ready when the next
disaster or catastrophe occurs. It would be hard today to react to a
major terrorist attack and its economic impact.
I expect this prediction to be unchanged in 2011.
Emerging Risks - Concerns
- There are many physical
disasters that could happen, and a really bad one could stimulate the
country to work together and build cohesion. I continue to be worried
about unintended consequences of actions today, with the FHA and FHLB on
the radar. I expect the economy to double dip into a second recession by
the end of 2010. It will be mild if the Obama administration pulls back
on stimulus early and deeper but occurring after the election if they do
not. The stock market will anticipate this and end up close to where it
starts with volatile swings in both directions this year. Inflation will
remain low while longer term Treasuries creep up, although the seeds of
inflation are already planted. This will cause a problem for ARMs at
reset as the higher rates will lead to higher defaults.
they did not pull back on stimulus so no double dip so far. Rates are
low and resets at higher rates have not occurred. These mortgages are
also being adjusted to help families stay in their homes.
- Levees in California,
earthquake in NYC/St. Louis/San Francisco, water poisoning of NYC,
hackers of Windows – all potential issues to develop contingent plans
- Can an internal CRO be strong
enough to stand up and be counted, or will fears for their job keep them
“in line”. Every firm needs a Chief Skeptical Officer. There is career
risk to doing your job as a Chief Risk Officer. Speaking out, even (or
especially) if you are accurate, does not lead to a long career. Perhaps
skeptics should be for hire and independent. Regulators and rating
agencies are not strong enough in this regard. NAIC risk focused exams
could be so much more than they are so far, and rating agencies have
perceived/real conflicts of interest since the company being rated pays
for the rating.
Companies are doing Enterprise Risk
Management for compliance purposes with external stakeholders rather
than to help make better decisions. This means that those who take that
next step have a competitive advantage over those who don’t.
- Tort reform needed – the world
continues to become more litigious at its peril
- Infectious disease - increased
resistance to antibiotics (e.g., tuberculosis, staff infections or
pneumonia). Watch for Nassim Taleb’s new book which is expected to
address issues such as these. It is getting more dangerous to visit a
- Global warming – unexpected
side effects like new viral/bacterial attacks, along with coastal
flooding and increased hurricane activity.
- Earthquakes and hurricanes –
the US is overdue for a major quake on the west coast and other areas
not normally expected for seismic activity are well into their cycle
(the Haiti earthquake occurred as this was being written). The US is
also due for a strong hurricane season.
- Principles-based capital in the
financial services industry will be abused by some and not always caught
initially by peer review. Currently it is doubtful that the US will have
a major influence on PBA worldwide due to the NAIC’s political games.
- Lots of games but nothing
has passed yet. The SOA research project will help companies better
understand the implications of implementation. The NAIC is moving
away from including multiple product types in the analysis. This
eliminates much of the real diversification that occurs.
- The games being played by
the NAIC regarding stochastic analysis and the interest rate
generator in particular are embarrassing to the institution. I
believe these types of politically based discussions with other
entities pulling strings in the background will lead in the next 5
years to a federal charter and the dissolution of the current form
of the NAIC. Just like all good ERM practices, the NAIC needs more
transparency and peer review.
the NAIC continues to ask
volunteers to spend lots of time to develop principles based approaches
but seems to be moving toward a Basel approach. This will be interesting
since a major difference between the banking and insurance methods is
whether to drive diversification benefits between risks through to
economic capital calculations. The NAIC, under Teri Vaughan, has started
to put together a solid national staff. This has been needed for years,
and adding Larry Bruning is a great addition. Larry is very
knowledgeable while recognizing that others have valuable opinions too.
- Home building sector will
finish bottoming and level or slightly improve over the next couple of
years depending on interest rates (up would be worse). It will take
longer for the upscale market to recover. It is probably time to buy
stocks in materials firms that serve this market and have low debt.
Discussion will start in the next couple of years about a tax overhaul
that could include a reduction of the mortgage deduction. Perhaps the
AMT will form the model tax law and many deductions will be eliminated.
While this might be good incentive, it would hit the home market hard.
- US political environment – can
they say no to anyone requesting a bailout? Who is next?
- Malthus – too many people, not
enough food – will good intentions of the rich to save lives in the 3rd
world lead to mass starvation and unstable regions? Genetically modified
seeds will delay this into the future. Perhaps it will never happen, but
unstable regions will come from low economic activity and lots of
people, along with the Chinese high male population ratio. This will
drive internal unrest in China over the next 20 years.
- Economy – risk of stagflation
and the lack of an internal hedge for investors holding both equities
and bonds. There is currently a large interest rate risk in long bonds.
Make sure you are laddered so you grade to the current rates as they
- Pandemic influenza – 2009
provided a test that countries and businesses should learn from. Recent
signs show the opposite as Europeans claim it all was a hoax. What is
scary is the ability to create these superbugs in the lab. At some point
terrorists (or someone entrusted to guard the bugs) will create a
pandemic of some kind as Tom Clancy wrote about years ago (his example
- Counterparty risk – will losses
be allowed? AIG provided a great example of concentration risk. A
central clearing house is needed that keeps track of net exposures. How
Bernie Madoff survived all these years is a mystery to me. Where was the
due diligence? Much of the US economy continues to be concentrated in a
few parties, and now the American taxpayer is one of them. This is not a
positive consequence and will lead to more contagion in the system and
more correlation in the tails. Plus you will have stupid comments like
Nancy Pelosi saying that GM will eventually pay back the government
loans. It’s not going to happen. More qualitative analysis needs to be
done by financial experts rather than relying on models that aren’t
accurate in the tail or focus on top line rather than bottom line
growth. Relying on Black-Scholes models to both determine value and
confirm prices has been a disaster. If you can’t understand a risk
without complicated mathematics it should be avoided.
- Concentration risk – this will
be a hot topic over the next few years much as emerging risks have
become. Whether it is power at the top of an organization, geographic
focus or silo risk focus, too much concentration in too few entities or
people is a great risk. Eventually it will take you down.
- Risk combinations – some of my
research is showing that, even as risk managers, we tend to anchor based
on current events and have trouble getting our hands around how multiple
Top Actuarial Issues
- Defined benefit plan valuation
– needs to reflect marketplace economics, mean reversion and
conservatism. Actuaries from other disciplines should be welcomed, along
with those from outside the profession. Focus should be on cash flows
rather than regulatory requirements. An estimate of fair value of these
liabilities should be calculated and shared with stakeholders. Firms had
the opportunity to get out of DB schemes when the stock market was up
for 5 consecutive years after the bursting of the tech bubble. Why more
did not do so shows how little scenario planning was being done.
Municipal plans and teacher plans especially are going to default. This
may be the issue that causes unions to lose power, although that will
not happen until democrats are out of the White House. Whatever DB plans
are still active will shut down as soon as they become completely
funded. Another trend I expect is for companies to pre-fund this risk
and get it off their books, passing it to insurers or to the unions to
- Demographics – designing
products that are economically sound to both policy owner and company.
Variable annuity writers seem to have learned and adjusted with their
new products, but will anyone sell or buy them? Have UL with secondary
guarantee writers learned anything? What role will AIG subs play in
supply/demand? Will they price at a lower rate given the government
guarantees? Will the government walk away at some point and let them
default (my prediction)?
- Obesity – how will the various
drivers of mortality and morbidity interact (some good, some bad)
- Lack of rudimentary knowledge
of assets and how to value them – need teaching sessions that are short
of stochastically based financial economics. Focus on transparency and
- Peer review – how to make it
extend beyond a regulatory requirement to help manage the business by
identifying and exploiting advantages as part of a strategic planning
- National health care – we
continue to need actuarial solutions with transparency. Tort reform is
not happening but is necessary for cost reductions.
- Systemic risk – this is another
topic where actuaries can help but are not being engaged. I personally
don’t think it can be done due to the political pressure surrounding the
In one of my 2009
newsletters I promised a base set of scenarios that companies/individuals
could use to plan for the next few years. Some analysis will reflect
quantitative tools but all should look at the risks on a qualitative basis
- Higher interest rates and
inflation: either deterministic scenarios grading 3% per year until you
get to 12% or a mean reversion process that does the same would provide
some eye-opening results.
- Flat equity markets combined
with higher inflation: defined benefit plans are especially vulnerable
to this risk.
- Health care – assume a national
plan takes over. How would that impact your business? What should you do
at that time?
- Falling dollar
- Global climate change – how
will this impact your business