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Newsletter – 2014 Predictions (Results)
My name is Max Rudolph. I consult
with companies on enterprise risk management, investment 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 and each
January I post my predictions for the year. Late in the year I review and
analyze what actually happened, including any tweets I got right during the
year. Coverage is mostly related to risk management and investments. Some
are written at a high level, dealing with the general economy, and some
cover specific topics. Most discuss issues that I am stewing over and need
to do a brain dump. I read a lot, and that impacts what I am thinking about.
The newsletters are educational in nature and do not constitute investment
advice. They are released publicly at
www.rudolph-financial.com about 6 months after they are released to
subscribers (predictions have a more timely release).
For those interested in a 12-month subscription, and
having input on topics, corporations should send $1,000 and individuals $100
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Predictions for 2014
Please remember that these predictions, and my
newsletters, are for fun and to encourage deeper thinking across topics and
a longer time horizon. If I really knew what was going to happen, I would
not share that information with you! You must make your own personal
decisions, considering your unique financial circumstances, and not hold
others (especially me) responsible for your own financial planning. If you
don’t accept these conditions you should stop reading now. For those still
with me, Enjoy!
stability is hiding a growing risk as debt levels remain high, which will
lead to currency wars and inflation. Sometime soon the calm will break. It
feels like geopolitical stability is building pressure in an earthquake
zone. Whether due to natural disasters or man-made wars/terrorism, we are
likely enjoying the calm before yet another storm. We are not ready for it.
It could be that the population/sustainability tipping point is getting
nearer, and more frequent extreme events make it harder to react until some
event takes us over the edge into a new regime. Financially there are
pressures leading toward inflation (debt, monetary policy) and deflation
(oil supply, demographics, costs of climate change). Janet Yellen becomes
Fed Chair in early 2014, replacing Ben Bernanke, and several other members
of the FOMC will also retire. Our strategy continues to be just-in-time
science, and concentration risk in everything we do makes our way of life
susceptible to one swinging strike.
- Result: Russia’s engagement with Ukraine
set in motion everything that followed.
of the world continue to evolve. Democrats are becoming the party of oil,
and maybe business, as they recognize where lobbyist money comes from.
Hillary Clinton has aligned herself with fracking interests, and has become
the sane candidate for President in 2016. Republicans retreat to the right,
a guarantee they won’t win national elections. Europe continues to be a
mess, and the US withdrawal from the Middle East combined with the impact of
fracking will reverse many positive events for that region, and especially
for women. Over the next decade we may see Iran rebuild its long-lost empire
and become a regional economic power. China will need resources, and it will
be interesting to see if they use negotiation or force to get it. Fresh
water access is becoming more important. Glaciers are melting and runoff
from snowfall is starting to come at the wrong time for crops. While I don’t
expect the world to collapse in 2014, event interactions and unintended
consequences are becoming more important. It’s time for the adults to enter
politics. People committed to a single direction and unwilling to negotiate
will only make the eventual results worse. Our critical path is becoming
are completely discounted by the public but have probabilities over the next
decade or more that are material. Extreme events happen every year. They are
very rarely specifically identified in advance. Hurricanes Sandy in 2012 and
Haiyan in 2013 were massive events in their regions, but extreme events
overall were limited in the US last year. The economy has so many variables
that short-term forecasts are unlikely to look like what actually happens.
In 2013 fracking provided oil supply that improved current account balances
in the US, made the Middle East less important politically, lowered
government spending and Chinese investment in Treasury bonds. Tensions are
building, and the US will need to decide how its role will evolve in each
region. While a stock market correction is overdue, the market will not have
a major correction without some external event to drive it. Bubbles are not
yet obvious, although some asset classes seem overvalued. How much is real
and how much due to bond yields manipulated lower by the Fed? Here are some
outlier scenarios that I think are more likely to happen in the next several
years (some may not happen for a decade or more). Due to the long-term
nature of these scenarios, in some years they might not change or only
slightly be tweaked.
- Cyber-terrorism impacts the banking system or
shuts down power stations Result: getting closer. Cyber hacking
at Sony and several retail firms in the US is causing some to rethink
the benefits of the cloud.
- Space junk knocks out a satellite used for public
- Atmospheric river hits California and dumps rain
on San Francisco for a month Result: the Pineapple Express
visited California and reduced the state-wide drought.
- A severe earthquake (or volcanic eruption) hits
California, St. Louis or Seattle
- Super-volcano becomes active
- Fracking is declared illegal in the US or due to
environmental impact Result: heavy tar sands oil created safety
issues when it became obvious that it is much more volatile.
- China erupts in civil war or regional conflict
with a neighbor over resources Result: more reports of doctored
financial numbers seem to make China more at risk of a hard landing.
- Eurozone breaks apart – could be north/south, poor
countries/rich countries Result: at year-end 2014 Greece seems
ready to implode while imbalances between Germany and the south are
getting closer to detonation.
- Venezuela erupts in violence, shutting down their
oil industry – Argentina is at risk of making this a regional hot spot
Result: this is very close to happening.
- A virus develops drug resistance and becomes
transmissible by air Result: while transmission is difficult, the
Ebola scare is not over and provides a good reminder that pandemics
cover a broad range of viruses.
- Iran encourages regional conflict and becomes the
Middle East’s superpower Result: while ISIS has gotten most of
the headlines, it is likely that Iran is quietly forming coalitions.
These predictions were made in January 2014.
- Politics: Prediction – President Obama is now the
oil president. Democrats must abandon their environmental roots to get
funding nationally. Something will appear to happen this year on
immigration reform but, much like gun reform, the status quo will
remain. Economic woes have done more to slow immigration than any other
measure. Who will the Republicans run for president in 2016? It’s a wide
open race and the winner may not yet be a household name. Paul Ryan
seems the best early bet. Chris Christie and “trafficgate” may have
sealed his fate. If the Republicans go further to the right and there is
not a financial crisis they will lose. If the economy tanks Hillary
Clinton will drop out due to health issues, but otherwise she will give
it a go and be the favorite. It’s hard to say how she will balance the
ticket. The economy is evolving to a new state with a new (higher)
steady state unemployment rate. It will move forward more quickly if the
politicians can resolve budget issues. The taper will speed up but rates
won’t rise until at least 2015 under Yellen’s watch. Watch for major
problems in Venezuela in the short term with contagion throughout South
America. Syria and Iran continue as hotspots in the Middle East, but
problems may actually show up sooner in Turkey. Hosting the Winter
Olympics in Russia is a risk for them as it will highlight issues and
expose the region to terrorism. The Middle East is building a tension
that may erupt soon between Sunni and Shia regimes in a regional
conflict. Europe continues to kick the can down the road, but some
deflation in the region makes the inevitable day of reckoning sooner
than expected. So far Japan is winning its currency war, but it’s only a
matter of time before others join in. The risk of China experiencing an
economic hard landing and consolidating around nationalism 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, as all parties are probing
for weakness and hiding in the shadows. A lessened reliance on imported
oil by the US due to fracking increases the likelihood that China makes
a resource driven power grab.
- Results: while I feel my oil
predictions are fairly accurate, I did not expect the price to drop
so far as it did in 2014. Immigration is still hard to define
despite the president’s recent attempts to clarify. Senator Clinton
continues to be the Democratic favorite, but if the economy does not
improve she may feel it is not worth her while to run in 2018. No
clear Republican candidate has emerged, although Jeb Bush is the
undeclared front runner. A Clinton-Bush campaign would be
interesting. Rates have not been raised by a Fed chaired by Yellen.
The strong moves made by Japan have had the same impact as a rate
rise due to the stronger dollar. Tensions continue to rise but no
event was large enough to set them off. Putin’s power grab in
Ukraine ended a slow period for geopolitical stress and continues
today. South America is being hit hard by the low price of oil and
Africa by the Ebola outbreak. Brazil is now a net exporter, so it is
unclear where South America’s growth will come from.
- Immigration reform: both political parties will
reach out to Hispanics through legislation to set up the 2016 election.
With jobs scarce in the US this becomes a less pressing issue and may be
punted to 2020.
- Results: President Obama decided to
tackle this issue without Congress and it will be interesting to see
if it withstands an expected court challenge. Both parties are
posturing to this demographic with eyes toward 2016.
- Stocks: As the taper begins the US will enter a
trader’s market, with more volatility in both directions. The market in
the US is certainly due for a correction but it is unlikely to be a
crash unless sparked by an event. I continue to avoid bonds, using
highly rated dividend stocks (not the highest rate but the most
consistent) for this type of exposure. The US consumer is delevering,
meaning there is less consuming. Single year results are very hard to
predict. I am more comfortable looking at specific companies. With that
said, plus or minus 10% seems a reasonable result for 2014. I still
believe that over the next 10 years stocks will outperform both cash and
especially bonds. Interest rates will either spike or remain low with
possible deflation over time. Slow and steady up, the Fed’s proverbial
soft landing, is unlikely. Higher rates will be equivalent to a currency
devaluation unless other countries make the same move. I understand why
variable annuities force investors into bond funds when their options
are in the money, but this reduced hedging cost seems to lock in the
likelihood that the goal will not be met. It seems like a mispricing is
in there somewhere. There is a slight chance of hyperinflation in the
United States, and it might only temporarily relieve us from a
demographics driven low interest rate scenario. It will take a few years
for inflation to develop before suddenly appearing. Good companies to
buy now are staples that can pass on inflationary cost increases to
their customers while remaining low cost producers. Avoid life insurers
until the regulators get serious about interest rate guarantee relief.
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:
Tidewater TDW 59.27, Hornbeck HOS 49.23, Seakor CKH 91.20 and Transocean
RIG 49.42 (long TDW HOS). The S&P500 closed 2013 at 1,448. For those
interested you can follow my portfolio at
www.tickerspy.com under maxrudolph.
- Results: while I was low on stock
returns (especially large caps), my specific stock recommendations
did not do well. The flight to safety continues and owes its
resurgence to actions by Russia (invading Ukraine with a very oil
concentrated economy) and Japan (Abenomics, leading a currency war).
My top returns in 2014 came from HBI and INTC. The tickerspy website
- Unemployment: Structural employment provides a
floor of about 6%, but this is confusing as the labor force
participation rate is not steady or consistent with prior data.
Additional municipal defaults may impact the job market. The temporary
drop of extended benefits immediately caused some workers to stop
- Results: unemployment remains low, and
many states increased their minimum wage in 2015.
- Residential home market: US regions will continue
to become less correlated with each other as regional economies improve
and inventory works its way lower. Fannie and Freddie continue as a
discontinuity waiting to happen. The trend of young and old moving in
with empty nesters will continue, much to the dismay of everyone
involved. Even if rates fall again, little refinancing will occur. That
ship has sailed. Watch for the Canadian housing bubble to pop over the
next couple of years.
- Results: Housing in the US continued to
rebound. Fannie and Freddie generate lots of Congressional sound
bites but no changes.
- Volatility: The VIX closed 2013 at 13.72, at the
lower end of its annual range. I have thought for several years that if
VIX was a predictor of the future it would be higher. Known risks
include heavy personal and government debt levels, and extremely loose
monetary policy that is about to tighten. I find it impossible to
predict VIX but I think a reasonable range would be 20-25. A single
digit VIX is definitely too low and above 35 is too high, but as usual I
see more possibilities for a higher result in 2014.
- Results: VIX remains too low and has
ranged from 10 to 30 (brief spikes) before ending in the 15 range
- Oil: WTI oil on December 31, 2013 was about $99,
toward the middle of my long-term mean reversion range of $80-120.
Volatility continues to make short term predictions very risky as
fracking supplies come on line and Iranian supplies open back up. US
withdrawal of forces from Iraq/Afghanistan will also reduce demand. If
oil prices fall below $50, political instability in Russia and Venezuela
will quickly follow. Venezuela may not need that big a drop. As the
world economy improves the price of oil should increase with demand, but
so much supply is coming on line that increases have not occurred.
Either a geopolitical event or fracking concerns that drastically
reduce supply would be needed to have a spike in oil prices in 2014.
- Results: here my range of 80-120 needs
to be adjusted as the bottom fell out of the market in late 2014.
The driver seems to have been the Japanese move toward quantitative
easing while the US seemed close to raising rates. The dollar
strengthened, and since oil is priced in dollars this led to a fall
in oil. This causes problems for oil exporters, especially Russia
and Venezuela, and initially helps the US recovery.
- Credit risk: credit spreads continue to be tight
as assumptions abound in the market about too big to fail companies and
whether the government will ever allow large scale credit defaults. Junk
bonds are not a good deal, but some municipals may outperform if you do
- Results: high energy sector issuance
over the past few years is leading many to predict that junk bonds
will have a high default rate over the next few years. They
performed poorly in 2014.
- Financial Services Consolidation: Bank
consolidation will accelerate as the taper is discontinued. Hopefully a
consolidator of these banks will grow to a large size over the next few
years. Leverage ratios among large banks, especially Deutsche Bank, are
reaching stratospheric levels. Insurance company consolidation has
started, with private equity entering with unintended consequences for
the life insurance industry. Federal regulation is moving closer but
will take only baby steps in 2014.
- Results: too early on this one as
Japan’s currency moves kept rates low in the US. Foreign insurers
have started to buy US insurers (e.g., Protective).
- Currency/Inflation: Japan has started a currency
war. Who will be the next entrant? At YE2013 the Eur/USD exchange rate
was 1.38. The dollar should strengthen due to fracking in 2014,
especially against the yen.
- Results: the Euro is down to $1.21, the
yen has weakened to 120 from 105 a year ago, and the Russian ruble
has fallen by nearly 50%. Dollars are returning home to the United
States, with repercussions in emerging markets soon to follow. Will
this play out like 1994 (Mexico) or 1998 (Thailand, Russia, LTCM)?
- Fed policy: low rates continue through 2014 as the
mid-term election looms. Hopefully right after that they will be able to
tighten, or else it will wait another 2 years. The US continues to be
susceptible to a large catastrophe, financial disaster, or armed
- Results: thankfully there was no
catastrophe, and the Florida coast remained hurricane free yet
again. Japan’s strong currency moved has made it harder to move
interest rates up, although many think an initial move up will occur
in the first half of 2015.
Emerging Risks - Concerns
- Levees in California, earthquakes/volcanos, water
poisoning in big cities, cyber hackers, transportation of oil and oil
based products (e.g., downtown Chicago).
- Infectious disease - increased resistance to
antibiotics (e.g., tuberculosis, staff infections or pneumonia),
coronaviruses and new avian flu types that are transmissible by air.
- Results: Ebola remains the headlines
but other viruses remain worrisome.
- Global warming – unexpected side effects like new
viral/bacterial attacks, along with coastal flooding, increased
hurricane activity, stronger and more frequent tornados and convective
storms, and shifting weather patterns that impact farming through
changes to the jet stream.
- Results: unfortunately nothing to
change this view has occurred. 2014 was the warmest year on record.
- Earthquakes and hurricanes – the US is overdue for
a major quake on the west coast and 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. I’m
starting to worry more about at atmospheric river event in California.
The drought is strong enough that there is no longer a season when
wildfires are not common. Due to warmer air, more moisture is held in
the atmosphere, with unknown results (so far it looks like this breaks
up hurricanes and leads to stronger convective storms).
- Results: fracking appears to cause
small quakes but otherwise it was a quiet year.
- Malthus – too many people, not enough resources –
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? Are there unintended consequences
and systemic risk associated with the “giving pledge” by the rich? The
IPCC base year of 1998 turned out to be misleading as it was an
especially warm year for its era. Look at all the data graphically.
Population growth continues to exacerbate the problem. Some estimate the
earth already holds three times as many people as is sustainable in the
long run. I believe this makes us more susceptible to war, famine and
- Results: this is a topic I would like
to research in 2015: why has Malthus been wrong so far? How should
Japan look at their economy as demographics age and reduce the
population. Why isn’t it okay for GDP to reduce along with it? Are
we looking at the right metrics?
- 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 efforts. I have found that those who
have strong investing abilities choose to avoid leverage. Unfortunately,
margin debt is revisiting levels not seen since 2008. Not a good sign,
especially when combined with other types of concentration risk.
- Terrorism – the Sochi Olympics will be very
stressful even if no events occur. In the US, political extremists may
become active leading into the election cycle.
- Results: with the Middle East active the US
heated up over racial issues in Ferguson, Missouri as well as NYC
and other locations.
Top Actuarial Issues
- Defined benefit plan valuation – valuation methods
need to be revamped to front end funding levels for both private and
- Results: political rather than long
lasting solutions continue to persist
- ORSA implementation – regulators will likely try
to shoehorn this into existing processes and not use holistic thinkers
who can think across risks and product lines. This is an even more
important characteristic for reviewers. Capital requirements continue to
move forward but no one really knows what they are doing. Groups that
have worked on this issue for years are not part of the decision making
process. When the C-3 Phase I interest generator model, which has not
been updated in 20 years, replaces the mean reversion parameter all hell
will break loose at companies primarily selling deferred annuities.
Required capital will increase as models reflect today’s recent rates.
This will be a preview of the ramifications of a long lasting low
interest rate scenario.
- Results: ORSA implementation is slow
going, but the NAIC is moving toward a checklist approach to
everyone’s detriment. A research project this year compared the
new/old generators and surprisingly showed minimal differences as
rates are not allowed to be negative and tend to rise through mean
reversion. Using premium as the sole ORSA filing criteria shows the
regulators need to accept input from outside sources.
- Product design – be sure to look at exposures in
case hedges are not available.
- Results: as I learn more about indexed
products they worry me more and more
- Obesity/smoking – how will the various drivers of
mortality and morbidity interact (some good, some bad)?
Strategic Scenario Planning
Look at stress scenarios qualitatively and graphically
in addition to quantitative focus. Consider a combination of several
deterministic scenarios, including one where the Wall Street tool kit is not
- Higher interest rates and inflation: grade 3% per
year until you get to 12%
- Qualitatively consider 20% inflation environment
(if you have annuities you should be testing the VM scenario generator –
the mean reversion rate will update going forward so you have 20 years
of historical data that was not included in the C-3 Phase I generator
- Low interest rates – Japan scenario
- Flat equity markets combined with higher inflation
- Falling dollar – combine with high interest rate
- Global climate change – how will this impact your
business and suppliers (look out 20 years to consider new agents or a
mortgage in southern Florida, where over $100 billion of property value
is at risk from a 3 foot rise in sea levels)
- Liquidity risk – consider your largest markets and
what would happen if they dried up or were regulated out of business.
Have you accepted risks that you thought were mitigated? A core line of
business should not be at risk here. If it is then it should be a
- No diversification is allowed between risks
- If you are ambitious run a scenario with equity
markets down 35% and 10 years’ worth of deflation
Predictions from January 2008
Since posting my first annual financial predictions in
2007, there are 7 years of history to look at. Each year I will look back 5
years and share interesting comments I made that seem accurate in hindsight.
- “Economy: there is not much positive to look
forward to in the United States.”
- “Credit risk will increase with unintended
consequences as the sub-prime crisis plays itself out”
- “Counterparty risk – it is currently so
concentrated that one misstep could have major repercussions. Watch the
credit default swap market. Much of the economy is now concentrated in a
few parties. This leads to more contagion in the system and more
correlation in the tails.”
From the 2008 results document
- “Defined benefit plan valuation…Making assumptions
above about 5% for future asset growth is irresponsible.”
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.