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Newsletter – 2012 Predictions (Results)
My name is Max
Rudolph. I consult with companies on enterprise risk management and
strategic planning topics. I live in Omaha, Nebraska, USA, am
credentialed as an actuary and hold a CFA charter. I write a monthly
newsletter, covering a variety of topics, and each January I post my
predictions for the year. Check back late in the year when I analyze what
actually happened. 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. Most cover issues that I am
stewing over and need to do a brain dump. The newsletters are educational in
nature and do not constitute investment advice. They are released publicly
www.rudolph-financial.com about 6 months after they are released to
subscribers (predictions are released soon after they are written).
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Financial Predictions for 2012 (and results)
Please remember that these
predictions are for fun. If I really knew what was going to happen, I would
not share that information with you! You must make personal decisions
regarding your unique financial circumstances and not hold others,
especially me, responsible for your own financial planning. Enjoy!
Politics, regional conflicts and sovereign economic
policies have a great impact on the worldwide economy, take years to play
out and have unintended consequences.
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. Bubbles
forming today are not as obvious to me as in some past years, so keep a look
out. Interactions between risks and correlations should be considered in
advance. How would these events impact you if they occurred in 2012?
Consider higher order impact as well as unintended consequences.
- Cyber-terrorism causes
ATMs to fail
- Space junk hits the
- An earthquake hits San
Francisco or Mount Rainier becomes active
- Fracking is declared
illegal due to environmental impact
- China erupts in civil
- Greece leaves Eurozone
- Venezuela erupts in
violence, shutting down their oil industry
- A disease (perhaps
tuberculosis or influenza) develops drug resistance and becomes
transmissible by air
Results: While none of these
specific events happened in 2012, many were in the news. Cyber-terrorism
continues to increase each year, with large financial corporations and
government agencies targeted. A meteor was identified that will pass closer
to the earth than the moon. Fracking made impressive gains this year in the
US but remains illegal in Europe for safety reasons. Barack Obama, green
President, could also be referred to as the fracking President. China
withstood natural disasters and its leadership transition seemed more
stressed than in the past, but their economy began to rebound. Greece
continues in limbo with no real solution in sight. Venezuela, with Chavez
dying from cancer and with unsustainable budgets, is entering a period of
instability that could spill over to neighboring countries (Argentina is
especially primed, with inflation underreported). Several novel viruses
appeared this year but are contained so far.
These predictions were made in
- Politics: Prediction –
Romney/Gingrich (need someone from the south who isn’t crazy) over
Obama/Clinton (Hillary). The economy will improve in 2012 but continues
to add jobs at a lackluster pace. Both parties will fight for
independent moderate votes during the fall. Perry and Santorum will
implode. Huntsman is running for 2016 and could be the next Romney type
candidate. He would be an interesting VP nominee but does not balance
the ticket with Romney. Health care reform can’t be implemented at the
same time as austerity programs, and Dodd-Frank is dead on arrival until
the next recession. If we follow the 1930s pattern and it is severe then
we would get far-reaching legislation and regulations. Watch for
tensions to increase in Venezuela and Russia, with North Korea another
obvious concern. Syria will fall to the Arab spring, Egypt will become
pro-Iran and Iraq becomes influenced by China. I continue to worry about
the mayhem unleashed when King Abdullah of Saudi Arabia dies. The Tea
Party lost their chance at national prominence but remains strong in
some far-right conservative areas. A third party candidacy (e.g., Ron
Paul) would give the election to the Democrats. Europe is likely to
finally make some decisions in 2012, and will kick out Greece but no one
else. Over the next several years Greece will be at risk of
colonialization-like efforts by China and others. The risk of unintended
consequences in Greece is high. The risk of China experiencing an
economic hard landing is increasing. This could have major consequences,
everything from an internal revolt to a selloff in US Treasuries to an
armed conflict. The next major wars will start in cyber-space, but the
Middle East remains tense and any ground troops would likely be used
More right than wrong. Later in the year I predicted that Obama
would win if the unemployment rate was below 8% (it was, mainly due to
workers dropping out of the potential workforce, but nevertheless Obama
was victorious), but in January my prediction did not anticipate all the
stupid things Romney would do to lose momentum. Ryan was a logical VP
choice but ignored the politics necessary to balance the ticket. He did
not even carry Wisconsin. I was right about the Perry and Santorum
implosions and Huntsman’s focus on 2016, along with the Tea Party’s
reduced significance. The economy did improve, and the job market is
more stable today. The uncertainty surrounding the fiscal cliff is
discouraging businesses from hiring. From a political standpoint it
seems to be posturing, but businesses will wait until there is a deal
struck before expanding. Regional tensions increased in the regions
suggested, but nothing has drawn in other countries yet. The growing
risks are South America and Korea, while the Middle East remains at a
high threshold. Greece continues to coast while other EU countries go
downhill (e.g., Spain and France). Some think having Germany leave the
Euro would be a better solution, leaving the rest of the union able to
devalue the Euro. A strong German currency would also provide the US
with currency flexibility. China remains at risk but enjoyed a
relatively calm year as they transitioned to a new leadership team.
- Stocks: Although the
US will do better than other developed countries, stocks won’t explode.
We remain in a trader’s market, with regularly surging volatility. Small
caps will do as well as large caps in 2012. I would be surprised to see
below -5% or above 15% for the S&P500 but my best guess would be toward
the upper end of that range (this assumes that contagion from Europe is
contained). 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. It will take a few
years to develop before suddenly appearing. Why are utilities guaranteed
10% returns in today’s low interest rate environment? 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) and year-end prices:
Peabody Energy BTU 33.11, Xerox XRX 7.98, Walter Industries WLT 60.56,
Tidewater TDW 49.3, HanesBrands HBI 21.86, Cummins CMI 88.02 and Johnson
Controls JCI 31.26. The S&P500 closed 2011 at 1258. Full disclosure: my
family owns shares in each of these 7 companies. None are controlling
- Results: Right.
Large cap stocks are set to return low double digit returns while small
caps are up about 15% as Europe has deferred the endgame scenario for
now. The “fiscal cliff” has not spurred major sell-offs in the markets,
partly due to the low yields on alternatives like bonds. Specific
company names performed inconsistently, with those specifically tied to
energy doing poorly (BTU, WLT, TDW), XRX performing below expectations
and HBI, CMI and JCI doing well.
- Unemployment: The
world slows early in 2012 due to the end of the positive stimulus that
followed the Japanese tsunami, then picks back up with slightly below
normal growth (but still positive) in the US and lower elsewhere as the
sovereign debt crisis keeps uncertainty high. Private employers are
starting to hire in the US, but unemployment will remain sticky. If it
gets below 8.0% this will help the incumbent democrats. Structural
employment provides a floor of about 6% now, and public employers are
not done with their staff reductions. Older workers will continue to
struggle at the same time they know they have to work longer before
retiring. The municipal market is still at risk of perceptions that
drive spreads up, and some states and municipalities will default (I
could be early on the states but it will happen eventually). This could
have a positive impact on casualty insurers due to their concentrated
exposure to these bonds. 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 is more transparent. It also seems like companies have
a lot of cash on their balance sheets right now. If they go on a buying
spree for small and mid-sized corporations that would pay off the owners
who could then go about creating new firms. These are the entrepreneurs
that will eventually create jobs. The Washington uncertainty is keeping
this natural process from occurring.
- Results: Right.
The unemployment rate fell to 7.7% during 2012. At the time of the
November elections the rate was just below 8%, at 7.9%, driven by
unemployed workers suspending their job search. Several municipalities
defaulted and others remain on the brink. Others are bringing up the
idea that frictional unemployment has risen. I’m no longer the only one
with that on my radar.
- Residential home
market: we’re not completely through the housing bust, and foreclosures
will continue, but regional improvements will continue in 2012 for all
but the highest end homes. Apartments and home rentals will continue to
grow as economic reality takes hold. Not all markets will 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. Fannie and Freddie should
enter the Presidential debates, but with no good ideas the candidates
will try to avoid the subject. The trend of young and old moving in with
empty nesters will continue, much to their dismay.
- Results: Right.
I pretty much nailed this one, although the candidates managed to
completely avoid the Fannie/Freddie discussion. This remains an issue
that needs to be solved.
- 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 but will continue to range from 15 to potentially as
high as 40 or 50 if Europe blows up. At year-end 2011 it was 23.
- Results: Right.
VIX expanded to over 20 late in 2012 as the fiscal cliff neared, but
spent much of the year between 15 and 20. Its lowest close during 2012
was 13.45 on August 17, and its high was 26.66 on June 1.
- Oil: Oil is currently
at $99.75, toward the middle 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.
As the technology to derive oil from shale increases supply, tensions in
the Middle East, Russia and South America pull prices up. Shale results
in a higher floor for the lowest prices but we could easily see a spike
this year due to uncertainty and posturing as the US reduces its
presence in the Middle East.
- Results: Mostly
right. The US is suddenly well on its way to energy independence due
to its sudden reliance on fracking, but this could quickly change if the
perception of environmental risks increases. The current price at the
end of 2012 is just over $90. Tensions in Iran over nuclear ambitions
caused brief spikes, but the price also fell below $80 to $75 for a few
days in 2012.
- Credit risk: there is
not enough transparency to know how close we are to yet another blow up,
but signs are abundant that credit risk is growing again. Liberal
covenants, personal loans, and insurance guarantees are increasing
credit risk. Municipal bonds, Fannie and Freddie could all have strong
impact in 2012. Valuation methods for defined benefit pension plans
allow off balance sheet liabilities to grow without transparency.
- Results: Early.
Default risk continues to grow but there were no major credit events in
2012. Pension plans continue to realize they have big problems and
several sold their risk to insurers at what is likely to be considered
in hindsight to be exactly the wrong time.
- Financial Services
Consolidation: Bank consolidation will continue, with mid-sized and
smaller banks merging to gain economies of scale and consumer trust.
Bank of America will implode at some point in the next few years. Fire
sale prices for their portfolio might add a lot of value for someone
with cash available. 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. In the long run I still expect to see a federal charter put
in place, at least as an option, but a research project I recently
completed showed the benefits of multiple regulators (regulatory
- Results: Early.
Bank mortgage divisions continue to hold their parent hostage, but many
large banks have started to build up their dividend payouts again.
Insurers have not consolidated, but the opportunity remains.
Currency trends will be driven by supply and demand for oil over the
next several years. The next great threat to dollar dominance is a
resurgent German led Europe or China, and both are several years away.
China could partner with Middle Eastern states and move toward a
regional or broader war, but that is not imminent. Resource shortages
(food, water) will drive regional conflicts. At YE2011 the Eur/USD
exchange rate was 1.28.
- Results: Right.
The exchange rate in late December is 1.32, similar to a year ago. The
dollar will not fall further until another currency shows itself strong
enough to support it, which could be a while, and there are signs it
could strengthen over the next several years.
- Fed policy: low rates
will continue through the election, encouraging leverage. While
consumers have trouble accessing it, private equity firms have no
concerns about borrowing. The US continues to be very susceptible to a
large catastrophe, financial disaster, or armed conflict.
- Results: Right.
While there has been no specific event, it all remains true and the Fed
anticipates low rates for several years.
Emerging Risks - Concerns
- Levees in California,
earthquakes/volcanos, water poisoning of NYC, cyber hackers – all
potential issues to develop contingent plans for. I am becoming more
aware of the cyber security threat and worry that the “cloud” may not be
as secure as users think. I am getting tired of receiving a new credit
card every few months because the old numbers have potentially become
public. Everyone should have a stash of cash they can easily gain access
to in case the retail banking sector goes down for a week.
- Results: The
“cloud” seems to become less secure every day.
- Infectious disease -
increased resistance to antibiotics (e.g., tuberculosis, staff
infections or pneumonia).
- Results: we
continue to move closer to a “Spillover” event, and several novel
viruses appeared this year. It appears that seasonal flu may be
especially strong this year but not overwhelming.
- Global warming –
unexpected side effects like new viral/bacterial attacks, along with
coastal flooding, increased hurricane activity and shifting weather
patterns that impact farming.
drought in the U.S. Midwest, regional wildfires, melting polar ice caps
and Hurricanes Sandy and Irene all created havoc. A very mild winter in
early 2012 led to early crops that stopped receiving moisture after May
and shriveled on the stalk. Hurricane Sandy could have been worse, but
citizens of New Jersey and NYC are glad it wasn’t. A false alarm with
Irene earlier in the year left many residents unprepared. If you live in
the path of hurricanes you should always assume the worst because
eventually a monster storm will appear. Recent evidence points to
increasing outlier weather events in all geographic locations.
- Earthquakes and
hurricanes – the US is overdue for a major quake on the west coast and
other areas not normally thought of for seismic activity due to long
dormant periods (e.g., Seattle, Yellowstone, St. Louis, New York City)
are well into their cycle. The US is also due for a strong hurricane
- Results: we got
the strong hurricanes but earthquakes were mild. Atmospheric rivers
feeding into California (and the west coast of other continents) have
now been “discovered”. Apparently every couple of centuries it rains in
San Francisco for a month or more. In 1861 it rained for 43 straight
days as the pineapple express created an extreme outlier event.
- Malthus – too many
people, not enough food – will good intentions of the rich to save lives
in the 3rd world lead to increased systemic risk for society
(mass starvation and unstable regions) in the longer term?
- Results: The
Gates Foundation seems to ignore the systemic risk it creates by
changing the historical way of life in a geographic region.
- 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. This should be a focus during strategic planning
- Results: In
late 2012 Nassim Taleb released Anti-Fragile: Things That Gain from
Disorder, detailing the downside of concentration risk and the stability
inherent in small random events.
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 an off balance sheet Ponzi scheme, relying on inflation
to reduce the value to the retiree and the expense to the employer. The
liabilities should balance every year economically. 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.
this all continues to be true. A defined benefit pension plan should be
valued using conservative assumptions until the plan is closed or the
parent firm is winding down. Perhaps a stochastic valuation with high
CTE levels in the early years of a plan would make sense. The ESG
(Economic Scenario Generator) recently approved by the NAIC (with the
original Mean Reversion Parameter formula and updated historical equity
results) should be used by pension actuaries to value these liabilities.
- Product design –
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
some good news was reported in December 2012, as some urban areas said
child obesity had been reduced.
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: grade 3% per year until you get to 12%
- Qualitatively consider
a 20% inflationary environment
- Flat equity markets
combined with higher inflation
- Falling dollar – could
combine with high interest rate scenario
- Global climate change
– how will this impact your business
- New for 2012 Liquidity
risk – consider your largest markets and what would happen if they dried
up. Have you accepted risks that you thought were mitigated?
- New for 2012 -
scenario where no diversification is allowed between risks
Results: I suggest including
a combination of several deterministic scenarios to consider realistic
exposure levels. Climate change scenarios should be considered by financial
Predictions from 2007
Since I started posting my annual
financial predictions in 2007, we now have 5 years of history to look at. In
the results letter each year I will look back 5 years and share any
interesting comments I made that seem accurate in hindsight.
- Credit risk will
increase – note especially junk bond spread widening and ARM/junk home
mortgages going into default
- Global warming –
unexpected side effects like new viral/bacterial attacks, along with
coastal flooding and increased hurricane activity
- Can an internal CRO be
strong enough to stand up and be counted, or will fears for their job
keep them “in line”
Hopefully these annual letters look
at things from a slightly different perspective than you see from others and
make you think. That is my goal.
Happy New Year!
Warning and disclaimer: The information provided in this newsletter is the
opinion of Max Rudolph and is provided for general information only. It
should not be considered investment advice. Information from a variety of
sources should be reviewed and considered before decisions are made by the
individual investor. My opinions may have already changed, so you don’t want
to rely on them. Have fun!