Follow Max on Twitter
Articles and Presentations
My name is Max Rudolph. I am a credentialed actuary and CFA charter holder
working as a strategic planning consultant and private investor in Omaha,
Nebraska, USA. I write a monthly newsletter, covering a variety of topics.
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. The newsletters are educational in nature and do not
constitute investment advice. The newsletters are released publicly at
www.rudolph-financial.com 6 months after they are released to
For those interested in a 12-month subscription, please send $1,000 in US
currency payable to
Rudolph Financial Consulting, LLC
5002 S. 237th Circle
Elkhorn, NE 68022 USA
The newsletters are distributed via email, so please include an active email
Financial Predictions for 2011
Please remember that these predictions are for fun. If I knew what was going
to happen, I certainly would not share that information with you! You must
make your own decisions regarding your unique financial circumstances and
not hold others, especially me, responsible for your own results. Enjoy!
Politics, regional conflicts and sovereign economic policies have a great
impact on the worldwide economy, take years to play out and have unintended
Economic variables are mean reverting, cycling from low to high and back
again. Bubbles and their opposite occur regularly, although they are often
hard to identify until after the fact. Some of these can be recognized in
advance, and the risk manager who considers two for each one that occurs has
added value. Some of the potential bubbles likely to regress are
commodities, treasuries, municipals and emerging markets. Farmland is a
longer term bubble.
These predictions were made in January 2011.
Politics: The US political cycle lasts 4 years. The Democrats have lost
their supermajority in the Senate and President Obama is now trying to
reposition himself as a moderate prior to the next election. He will
struggle to implement health care reform and Dodd-Frank this year and
will be seen internationally more to position himself for the reelection
bid as a foreign policy expert. Tensions remain high on the Korean
Peninsula and in the Middle East. When King Abdullah of Saudi Arabia
dies that will spark a period of uncertainty that could lead to an
outbreak of hostilities in that region. The Tea Party won some races and
it will be interesting to see how well they “play with others”. If they
can this will help the Presidential aspirations of someone like Sarah
Palin. This would make re-election of President Obama more likely as the
Tea Party is so far to the right that the Democrats can position
themselves as the sane alternative. Driven by the price of oil and
terrorism, numerous countries have the possibility of social unrest.
Countries most at risk are Iran, Venezuela, Pakistan, Mexico, Saudi
Arabia and the Koreas. Sovereign debt issues in Europe could eventually
lead to the collapse of the Eurozone. This will be driven by Germany,
who will eventually get tired of supporting the other countries. When
they have had enough they will enter a path to world superpower along
with China. The risk of China experiencing an economic hard landing is
increasing. This could have major unintended consequences, everything
from an internal revolt to a selloff in US Treasuries to an armed
conflict. An interesting scenario with long term consequences would be a
joint US/China invasion of North Korea. In the short run it would ease
tensions but in the long run would provide the Chinese an opportunity to
size up how a potentially fading superpower would survive an attack that
could be direct or indirect, military or financial (many opponents have
underestimated the US in the past). The mismatch between males and
females due to the one child rule will have unintended consequences that
are hard to sort out (Gates Foundation efforts in the developing world
should also be watched). Unattached males make good soldiers, and mail
order brides from other parts of the world could cause immigration
Stocks: The stock market’s run-up in late 2010 has left it susceptible
to a correction, but overall I believe we will remain in a trader’s
market. It will continue to be volatile in 2011, with large caps
outperforming small caps. I would be surprised to see below -5% or above
15% for the S&P500. Over the next 10 years stocks will outperform both
cash and especially bonds. Bonds at low interest rates are hard to get
excited about as we prepare to enter an era of higher inflation. There
is a slight chance of hyperinflation in the United States, but it will
take a few years to develop before suddenly appearing. Good companies to
buy now are ones that can pass on their inflationary cost increases to
their customers like those in the transportation (e.g., railroads) and
energy sectors. Based on my filters here are a few companies that appear
to be undervalued based on publicly available information (not
recommendations, just ideas for further analysis): Whirlpool WHR, Tyco
Electronics TEL, HanesBrands HBI, Conoco Phillips COP, and Game Stop GME.
The S&P500 closed 2010 at 1257. Full disclosure: my family owns shares
in COP, TEL and HBI. None are controlling positions.
Unemployment: Fiscal stimulus continues to help bottom out unemployment,
but private employers have been slow to start hiring. I expect
unemployment to drop, but not below 8.5%. Structural employment provides
a floor of about 6% now, and many public employers will be forced to cut
back going forward. Do municipal employees have the skills and culture
necessary to succeed in the private sector? Some do but many do not.
Older workers will have a tough time adapting to their new reality.
Municipal bonds are a worry in this regard. Once one state or large city
defaults on their bonds the entire market will see spreads spike and
borrowing costs go through the roof. What will the impact be on casualty
insurers of this concentrated asset exposure? Certainly this is an
unintended consequence of tax policy. I’d like to see the state run
pension plans be consolidated either into Social Security (at least for
new employees) or into a bigger pool that can attract more sophisticated
The “survivors” at big
firms are not always the best and brightest, especially if layoffs were
influenced by seniority, 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, so watch for the yield curve
to steepen in 2011. Taxes will not be impacted until unemployment returns to
a more normal level but will eventually need to rise. This will not occur at
the federal level until after the Presidential election. (I’m reading an
article about Greece and they say that the tax collectors don’t work in
election years – and they wonder why Greece has problems!) States, on the
other hand, will look for stealth tax increases through consumer basics like
cell phone bills but will eventually need to increase income and/or gas
Securitization/Mortgages: The securitization markets will continue their
rebound. Capital requirement uncertainty will reduce and this will drive
consolidation of regional banks. Home mortgages will continue high
foreclosure rates, but all markets will not move together as regional
diversification returns to the marketplace and it begins to loosen.
Population will start to move to where the jobs are, for example away
from Illinois and toward the Dakotas. A decision needs to be made about
Fannie and Freddie in 2011 or it will enter the Presidential debates.
Volatility has itself been volatile over the past couple of years. Too
many investors are looking at VIX as a predictor of the future and there
are too many big risks, both known and unknown, that should increase
this statistic. Although I have not proven good at predicting VIX I
think it should be in the 20-25 range right now instead of the actual
Oil: Oil is currently about $90, toward the bottom end of my long-term
mean reversion rate of $80-120 range, but volatility continues to make
short term predictions very risky. If oil prices fall below $50,
political instability in Russia and South America will quickly follow.
As the world economy improves the price of oil should increase. Watch
Venezuela for problems.
Credit risk: the market is once again allowing liberal covenants, so I
am not sure what the market actually learned. 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. I don’t think the
federal government will take them over but some help will be made
available. 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 will widen.
Financial Services Consolidation: Bank consolidation will continue, with
mid-sized and smaller banks merging to gain economies of scale and
consumer trust. Expenses at insurance companies are too high and
industry overhead needs to be reduced. Insurance consolidation will
accelerate, with household names and smaller firms being merged out of
existence. 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”. In the long run I still expect
to see a federal charter put in place. Principles based approaches will
fade as regulatory tools but continue to be a competitive advantage for
those companies that recognize the shortcomings. Goldman Sachs will
fight a public relations battle and consider a return to the partnership
model. This will reduce transparency into their books. Why don’t people
require a fiduciary relationship when doing business with them? This
would better align their incentives with their customers.
Currency/Inflation: Eventually the dollar will revert to its trend and
fall based on imbalances in our trade and borrowing policies. This will
happen quicker if another currency takes leadership from, or at least
shares it with, the dollar. Europe needs to get its rogue nations under
control. If it doesn’t Germany could become that country. China is the
only other realistic option and that is unlikely for another few years.
They will be better served by a basket of currencies and we will see a
move in that direction with France as head of the G-7 and G-20. 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 to wind farms,
with unintended consequences following the well intentioned efforts of
politicians. Unless another economy steps up to provide a flight to
safety option the dollar will only be down moderately in 2011 and will
go up if Spain flounders. Food inflation internationally will be high
and lead to riots and potentially regional violence as countries that
import try to reduce their dependency by force. Inflation is tied
closely to currency, and importers of food and oil will struggle. The
law of comparative advantage will be challenged as countries with food
will tighten their borders and make sure their own people are fed first.
This could lead to high inflation and social unrest in some emerging
Energy subsidies: Who knows what technology is not being worked on
because of the focus on only certain types of green technology? We
can’t leave it to government to determine optimal supply/demand
balances. In the long run 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 and has already devalued his currency.
Venezuela has a really poor track record for paying their debts.
Global warming: Governments naturally design complex systems, while
simple solutions are not given a chance to work. We need to move
beyond a singular focus on carbon dioxide. Watch for asset bubbles
in farmland in the US short-term, and long-term opportunities in
northern countries like Canada and Russia (longer term add
Antarctica to this list) as tundra becomes accessible as farmland or
as a source of oil.
Fannie and Freddie reform will get a lot of hot wind in 2011. With
the 2012 election looming it’s unclear if Congress will deal with
them soon or ignore them. In the meantime they continue to add to
the government balance sheet.
Continued low interest rates by the Federal Reserve through the
election – this Fed is more political than I would like to see. The
US is very susceptible to a large catastrophe, financial disaster,
or armed conflict with a worthy foe. Look for copycat terrorism on
September 11 this year.
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. The
political tensions continue to increase as both sides posture. I
continue to be worried about unintended consequences of actions today,
with GSE liability still on the radar. The jobs recession will continue,
but investors and those already with jobs should be more secure once we
get past a flurry of layoffs early in the year. Inflation will remain
low while, longer term, Treasuries rise with anticipated future price
increases. The seeds of inflation are already planted. Government should
issue debt in longer term fixed instruments now while they can.
Otherwise the debt burden will grow so quickly with floating rate and
roll over debt that it will be hard to grow out of it. Foreclosures need
to occur for the housing supply to clear. It will be hard to move
forward until that happens.
Levees in California, earthquakes/volcanos, 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 independent skeptics should be
hired by regulators and rating agencies to get contrarian opinions. NAIC
risk focused exams could be so much more useful than they are so far,
and rating agencies have perceived/real conflicts of interest since the
company being rated pays for the rating. I am usually a big fan of
Berkshire Hathaway, but Moody’s should not issue ratings for them. They
are a major shareholder and it is a huge conflict of interest. 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
Infectious disease - increased resistance to antibiotics (e.g.,
tuberculosis, staff infections or pneumonia). It is getting more
dangerous to visit a hospital.
Global warming – unexpected side effects like new viral/bacterial
attacks, along with coastal flooding and increased hurricane activity.
Changing climate will alter weather patterns, making areas more or less
prone to moisture and cold.
Terrorism – so far external terrorists have shown themselves not to be
very smart, but they are very determined. A greater risk in the US is
that the political rhetoric creates followers who will “fight” for their
Earthquakes and hurricanes – the US is overdue for a major quake on the
west coast and other areas not normally suspected of seismic activity
(e.g., Seattle, Yellowstone, St. Louis, New York City) are well into
their cycle. The US is also due for a strong hurricane season.
Principles-based capital in the financial services industry appears to
be dead in the water as Basel becomes the standard (no diversification
benefits, silo risk management). 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. They should go
outside their team for contrarian opinions.
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
time to buy stocks in materials firms that serve this market and have
low debt. A tax overhaul when it occurs will cap the mortgage deduction.
US political environment – can they say no to anyone requesting a
bailout? Who is next? Will the Fed allow a state to default on its debt?
Illinois and California are trying to tax their way out of a problem but
that will send jobs elsewhere and have unintended consequences that have
not been thought through.
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 in the longer term? Genetically modified seeds will
delay this into the future. Perhaps it will never happen, but unstable
regions develop where there is low economic activity and lots of people.
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 rise. Borrowing firms and governments
with a high percentage in short duration bonds will default when the
debt coverage spikes.
Pandemic influenza – 2009 provided a test that countries and businesses
should learn from. 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 was Ebola).
Counterparty risk – will losses be allowed? AIG provided a great example
of concentration risk, although I wish someone would show me where the
money went and how it was repaid. A central clearing house is needed
that keeps track of net exposures. How do we keep a clearinghouse from
increasing systemic risk itself? How Bernie Madoff survived all these
years is a mystery to me. Where was the investor 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 systemic risk and higher correlation in the tails.
More qualitative analysis needs to be done by financial experts rather
than relying on models that aren’t accurate in the tail. Relying on
Black-Scholes models to determine both value and prices has been a
disaster. If you can’t understand a risk without complicated mathematics
it should be avoided. We need to spend more time learning from history.
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, short term liquidity, 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 – risk managers tend to anchor based on current events
and have trouble getting their hands around how multiple risks interact.
Top Actuarial Issues
Defined benefit plan valuation – needs to reflect marketplace economics,
mean reversion and conservatism. Valuation methods have led defined
benefit plans to be little more than a Ponzi scheme, relying on
inflation to reduce the value to the retiree and the expense to the
employer. Everyone needs to save for their own future. Actuaries and
investment professionals 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.
Municipal plans and teacher plans are especially likely to default. This
may be the issue that causes unions to lose power.
Demographics – designing products that are economically sound to both
policy owner and company. Variable annuity writers seemed to have
learned and adjusted with their new products, but have reverted back to
features that make no sense to me. Why is it conservative to force asset
allocations toward bonds in a low interest rate environment? Have
insurers considered a hyperinflation scenario? They should.
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. An actuary’s primary
skill is discounting contingent events. This skill set is valued outside
insurance and pensions too if you are a strategic thinker.
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 process. Making someone accountable does
not preclude the need for outside opinions and skepticism.
National health care – we continue to need actuarial solutions with
transparency. Tort reform is not happening but is necessary for cost
reductions. Will health care reform be repealed? No. The votes aren’t
there. The Republicans will attack it through funding mechanisms and
making the legislation difficult to implement.
Systemic risk – this is another topic where actuaries can help but are
not being engaged. I personally don’t think systemic risk can be managed
effectively due to the political pressure surrounding the topic.
What follows are 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 first. When
models are used for extreme scenarios they do not perform very well.
Higher interest rates and inflation: use 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.
NEW FOR 2011 – qualitatively consider a 20% inflationary environment
Flat equity markets combined with higher inflation
Health care reform – qualitatively how would that impact your business?
Falling dollar – could combine with high interest rate scenario
Global climate change – how will this impact your business