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Newsletter
Newsletter – 2015 Predictions/Results
My name is Max Rudolph. I consult
with companies on enterprise risk management, asset-liability management and
strategic planning topics. I am a private investor focusing on individual
stock selection and value investing techniques. In addition to work for
companies, research and continuing education, I am also an adjunct professor
at Creighton University. I believe you can reduce risk and increase return
simultaneously. I live in Omaha, Nebraska, USA, am credentialed as an
actuary and hold a CFA charter. I write a monthly newsletter and each
January post my predictions for the year. Late in the year I review and
analyze what actually happened during the year. Some topics are written at a
high level, dealing with the general economy, and some are more detailed.
Most cover issues that I am stewing over and need to do a brain dump. I am a
lifelong learner so read a lot, and that impacts how my current thinking
evolves. The newsletters are educational in nature and do not constitute
investment advice. They are released publicly at
www.rudolph-financial.com with a delay after they are released to
subscribers.
For those interested in a 12-month subscription, and
having input on topics, corporations should send $1,000 and individuals $100
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
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You can also follow me on twitter @maxrudolph.
- Results: This document does not change anything
from what I wrote early in 2015 but adds sections that discuss the
results.
Predictions for 2015
Please remember that these predictions 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 investment and risk decisions,
consider your unique financial circumstances, and not hold others
(especially me) responsible for your own financial planning or lack thereof.
If you don’t accept these conditions you should stop reading now. For those
still with me, Enjoy!
General happenings
Over the past year a perceived stability has given way
to a currency war that is interacting with an oil glut to produce some
strange bedfellows. The United States was ahead of the curve here with its
quantitative easing programs so its exports and profits have grown, allowing
the dollar to continue as the world’s reserve currency. Debt levels are high
and growing, yet most of Europe sees negative interest rates on government
debt. Trust in the financial system is still intact, but it feels like we
are sitting at the bottom of an avalanche zone with snow continuing to fall.
It is unclear how it will play out, but somewhat surprisingly to me the US
seems to be in the best position. Unfortunately this often means that the
law of unintended consequences and surprises is about to dominate.
Geopolitical tensions have started to dominate, with Venezuela, Russia, Iran
and China about to lead their regions into a highly volatile period. Even
the United States and India have literally run to each other as everyone
else lines up against them. China has alliances with countries in South
America and Africa, and is doing business with Russia. More of this trade is
being done in currencies/commodities other than the dollar. The trigger will
be something unexpected. We should enjoy the calm before the storm. Climate
change and other sustainability issues will soon make water and other
resources the driving force behind regional conflicts. In other locations,
like Brazil and California, water needs to be priced appropriately to allow
market forces to adjust. Financially the signs continue to point toward both
deflation and inflation. The FOMC is dovish with Janet Yellen at its head,
with Mario Draghi her counterpart in Europe. We wait until the last minute
to deal with problems, and some day our luck will run out.
- Results: I’m pretty happy with this paragraph.
Some things have changed during the year but it was a pretty good
analysis of where we stood at that time.
At this point President Obama is a lame duck with two
years left to govern. Will Republicans work with him or maintain a freeze
until 2016? That looks likely to me, but I always hope somewhere moderates
will appear to make things right. Recent economic growth has been driven by
fracking, and at this point in time does not look sustainable. Hillary
Clinton is the Democratic frontrunner, and Jeb Bush is her likely opponent.
There is lots of time to screw up in the meantime, and if the economy is not
growing I expect Senator Clinton to bow out. Europe is a mess and dug itself
deeper with the Greek anti-austerity party taking power there. The new QE
Europe is a move toward allowing countries to leave. The Middle East is very
hard to read over the next 10 years. None of the countries there has
successfully diversified away from oil, so some say they will be living in
tents again within a generation. Iran is the wild card and has grown its
influence. China has financial, structural and political stresses pushing it
and will be challenged to generate a soft landing. I will be surprised if
Russia and South America do not have major problems in 2015. Australia will
struggle as commodity prices falter.
- Results: Another pretty good analysis, despite not
anticipating Donald Trump’s bizarre presidential race to date. Jeb Bush
has fallen behind, perhaps so far that he should drop out. Clinton
remains the frontrunner for the Democrats, with Bernie Sanders likely to
fade by March 2016. The geopolitical issues were right, with Russia and
most of South America at a cross roads.
Some scenarios are completely discounted by the public
but have probabilities over the next decade or so that are material. Extreme
events happen every year. They are rarely identified in advance.
Geopolitical risks blew up in Ukraine in 2014 and Hurricane Haiyan in 2013
was a massive event, but extreme events overall were limited once again in
the US last year. One exception that should be watched for a recurrence is
the California drought. The economy has so many interconnected variables,
acting like a complex adaptive system, that forecasts are unlikely to be
accurate. In recent years fracking provided excess oil supplies that
improved current account balances in the US, made the Middle East less
important politically, lowered government spending and Chinese investment in
Treasury bonds. Then in late 2014 the Saudis elected not to support prices
and they crashed. There are multiple reasons, with frackers, Russia and Iran
likely in the bulls eye. What will the US role be in each region? Stocks
have risen for six consecutive years. Seven would be a record. Prices are
high, a long lasting correction is overdue, but it needs an external event
to drive it. The dollar remains the reserve currency despite loose
government policies. How much is real and how much due to bond yields
manipulated lower by the Fed? Here are some outlier scenarios I think are
more likely to happen than consensus 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.
- Results: many of these situations have proved to
be long lasting, such as the California drought (recently getting some
relief) and the oil saga. Late in the year the US allowed oil to be
exported, but it’s not clear why. My guess is that it helps frackers try
to avoid bankruptcy by opening up the spigots.
- Cyber-terrorism impacts the banking system or
shuts down power stations
- Results: cyber hacking hit retailers,
government and health insurers especially hard. Many boards think
insurance is the answer but should focus more on making it harder to
sustain a breach.
- Space junk knocks out a satellite used for public
communications
- Atmospheric river hits California and dumps rain
on San Francisco for a month
- Results: smaller atmospheric rivers have
appeared in California early in the year and in the northwest in
December.
- A severe earthquake (or volcanic eruption) hits
California, St. Louis or Seattle
- Results: Oklahoma continues to experience
fracking induced earthquakes but other regions were spared anything
resembling the “big one”.
- Super-volcano becomes active
- Fracking is declared illegal in the US or Canada
due to environmental impact
- China erupts in civil war or regional conflict
with a neighbor over resources
- Results: The hard landing in China is again an
increasingly likely event.
- Eurozone breaks apart – could be north/south, poor
countries/rich countries
- Results: this continues to be more likely,
with the British referendum likely to start discussions elsewhere.
- Venezuela erupts in violence, shutting down their
oil industry – contagion in Argentina and Brazil risk making this a
regional hot spot
- Results: all three of these countries have
major issues at year end 2015, but each have moved in different
directions.
- A virus develops drug resistance and becomes
transmissible by air
- Results: Ebola, MERS and influenza were mostly
quiet by the end of the year. Antibiotic resistance is nearing a
tipping point. This will be a big deal.
- Iran encourages regional conflict and becomes the
Middle East’s superpower
- Iran’s strategy is interesting in that it
signed an agreement with the west while continuing to support
conflict in Iraq and beyond.
- Water resources trigger a regional conflict
(likely Himalayas, or Europe)
I did not change any, and added only the last item for
2015, but several are much closer (e.g., Ebola, Venezuela, cyber risk,
China).
These predictions were made in January 2015.
- Politics: Prediction – President Obama is trying
to play the oil card both ways, and will get caught. He threatens to
block the Keystone pipeline but economic growth during most of his two
terms has been driven by fracking. Now that he is a lame duck President
with a Republican Congress he will use executive orders like he did on
immigration to leave a legacy. It will be interesting to see if health
care reform is far enough along before he leaves to make it sustainable.
Who will the Republicans run for president in 2016? Jeb Bush is now the
frontrunner with Paul Ryan and Scott Walker strong candidates. Someone
may yet come out of the woodwork. Hillary Clinton remains the favorite
on the Democratic side, but I think she will drop out (leaving a free
for all). The taper, along with devaluations in other countries, has
strengthened the dollar. There won’t be any rate increases from the Fed
until at least 2016 as Europe will continue loose policy. Their loose
policy works as if we had raised rates. Venezuela will pull Argentina
down, leaving all of South America in turmoil. While Saudi Arabia seems
to have managed their transition well this time, Sunni and Shia tensions
are building. Europe will set up a structure so they can kick out some
members. Greece is first, but Italy and France will eventually follow.
Deflation and negative interest rates in the region makes the inevitable
day of reckoning sooner than expected. Japan has been the most
aggressive in its currency war, but eventually will implode as
demographics drive rates and economic growth lower. 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 a
regional armed conflict about resources. The next major wars will start
in cyber-space, as all parties are probing for weakness and hiding in
the shadows. The US and India as allies make for interesting bedfellows.
- Results: Hillary Clinton is the de facto
Democratic nominee, while mainstream Republicans pray for a sane
candidate. The Keystone pipeline was not approved and a Climate
Conference generated a weak mandate. The Fed nearly made it through
2015 without a rate increase, and the current 25 bp level is anemic.
Other countries continue their loose monetary policies,
strengthening the dollar. Oil continues to price below $40/barrel
and the US now allows oil to be exported. Europe remains strained
but did not lose any members. Oil has made for a challenging
environment in Saudi Arabia. Tensions are increasing everywhere but
did not go over the edge.
- Stocks: Now that tapering has ended and the market
did not implode, we are entering a trader’s market with limited value
stocks to buy. The US market remains 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 no longer
delevering, but I think this is due to student loans. While single year
predictions are unlikely to be right, plus 5% to minus 20% seems a
reasonable range for 2015. 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. Maybe
both, which is the disaster scenario. Slow and steady up, most modelers
and the Fed’s proverbial soft landing, is unlikely. Higher rates are
equivalent to a currency devaluation unless other countries make the
same move. There is a slight chance of hyperinflation in the United
States, but much higher elsewhere. 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,
although I expect more consolidation as foreign buyers seek
diversification (Protective/Dai-ichi) and US domiciled firms take
advantage of the strong dollar. 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: Gilead GILD 105, Winnebago WGO 20, Whirlpool WHR 200
and Terra Nitrogen TNH 121 (long GILD WGO WHR). The S&P500 closed 2014
at 2,059.
- Results: I had trouble finding stocks to buy
all year, and ended up converting a lot of energy stocks to cash
early in the year and left it mostly there. The S&P 500 total return
was +1.40%, at the high end of my range, and positive for the
seventh consecutive year. There were surges of volatility along the
way. The dollar strengthened and oil weakened throughout the year.
Many of the same companies make it through my filter at the end of
2016. I added to or established positions in GILD RCL WHR TRN BX KHC
CVS BRKB. I closed positions in WHR CHK PJT VMI and reduced HBI GME.
I do not have high hopes for 2016 absolute returns and believe that
Hillary Clinton would have an easier time running for President
representing the party that was out of power. The S&P500 closed 2015
at 2,044.
- Unemployment: Structural employment provides a
floor of about 6%, but this is confusing as the labor force
participation rate is still reducing so inconsistent with prior data.
Pension plans remain at risk, with funding levels 20% below that needed
even after 6 years of gains. Recent recommendations will do little to
save this market as valuation is the problem and it is not being
addressed. The life cycle of a DB plan lags that of a company so full
funding in the early years is critical. The rules continue to defer
funding, increasing the risk of failure. The latest “fix” is for an
insurance company to buy the liabilities, but for the participant this
is not a good deal as the PBGC has access to the federal printing press
so the guarantee is much stronger with them than with NAIC members.
- Results: generally correct. My former employer
moved my defined benefit plan from the parent to a subsidiary
insurance company and eliminated the PBGC premiums. It remains
incomprehensible to me how a fiduciary or government body would
allow this risk to so clearly increase to the employee with no
payment.
- Residential home market: US regions continue to
have lower correlation with each other. Fannie and Freddie are another
place we may see President Obama try to set a legacy. I’m still waiting
for the Canadian housing bubble to pop.
- Volatility: The VIX closed 2014 at 19.20, in the
middle 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 loose monetary policy. I
find it impossible to predict VIX but I think a reasonable “normal”
range when debt is high 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 2015.
- Results: VIX occasionally spiked but generally
remained lower than I think makes sense. It closed 2015 at 18.21.
- Oil: WTI oil on December 31, 2014 was about $59,
below my long-term mean reversion range of $80-120. As more fracking
comes on line and it becomes more efficient I need to adjust this range
down to $80-100. Once the Saudis have taken control of supply I believe
they will manage prices back up into this range. This commodity will
continue to be very volatile. Oil prices below $50 are creating
political instability in Russia and Venezuela and chaos could prevail in
those regions. A geopolitical event or fracking concerns that
drastically reduce supply are risks that could lead to a spike in oil
prices.
- Results: I got the geopolitical ramifications
right but continue to find oil to be too hard to predict. The Saudis
have lost control of the price, at least temporarily, and are having
trouble funding their internal spending.
- Credit risk: much of the junk bond issuance
recently has been to energy companies that are now at risk. Watch out
for defaults here and in emerging markets where the strong dollar is
causing problems for dollar denominated bonds.
- Results: this prediction is picking up speed
as 2015 comes to a close.
- Currency/Inflation: The US started the currency
war with QE (named by Brazilians after the dollar slumped in 2010). Now
Japan and Europe are taking a turn. At YE2014 the Eur/USD exchange rate
had dropped to 1.22 (and by the end of January was down to 1.13. The
dollar should continue to strengthen due to weak growth in Europe and
Japan. At some point there will be no buyers, and then it gets serious
with hyperinflation and defaults (watch VM).
- Results: by year end 2015 Eur/USD had fallen
to 109 and Japan rose to over 120 yen/dollar. This trend will
continue into 2016.
- Fed policy: low rates continue through 2015. A
pseudo tightening has occurred as everyone else has devalued their
currency. This will hurt exports from US firms but lead to a boom in
overseas travel as the dollar buys more than it used to. The US
continues to be susceptible to a large catastrophe, financial disaster,
or armed conflict.
- This tightening will be problematic for
Democrats as the economy and stock market both struggle in 2016.
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).
- Results: there were several non-terrorism
train derailments carrying oil, especially in Canada, but this seems
to be tapering off late in the year. Hackers are everywhere, and
scare me a lot.
- Infectious disease - increased resistance to
antibiotics (e.g., tuberculosis, staph infections or pneumonia),
coronaviruses, Ebola type and new avian flu types that are transmissible
by air.
- Results: the most recent Ebola and MERS events
are subdued, along with influenza. The Zika virus has infiltrated
Brazil and is moving north.
- Global warming – unexpected side effects like new
viral/bacterial attacks, along with coastal flooding, more concentrated
coastal storms, stronger and more frequent convective storms, and
shifting weather patterns that impact farming through changes to the jet
stream. It is going to be increasingly difficult to be a farmer over the
next 50 years as climate warms and modifies. Whether we like them or
not, genetically modified foods may be the only thing that adopts
quickly enough. In 2014 we saw extreme weather events in Boston and
Buffalo (snow), Detroit and Phoenix (rain).
- Results: 2015 ended with flooding events in
the US and UK. Several strong cyclones hit the Asian Pacific coast.
The weather at the North Pole was warmer than Omaha on December 31.
2015 was the warmest earth has recorded.
- 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 but leads to stronger convective storms and nor’easters).
- Results: landslides in Washington state
occurred and were determined to be historically common occurrences.
Cyclones were strong in the Pacific but weak in the Atlantic. The
jet stream continues to stall out, leaving flooded areas next to dry
ones.
- 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
associated with the “giving pledge” by the rich? Is it really so bad to
have aging demographics and a shrinking population? In the long run we
are more susceptible to war, famine and disease.
- Student loans – not only will millennials default
due to student loans, there are many instances where their parents
co-signed for them.
- 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, especially if
leverage is involved. Margin debt is currently high, not a good sign.
Identifying concentrated exposures should be a focus during strategic
planning efforts at companies.
- Results: Bubbles driven by leverage and
central bank manipulation continue to grow. Emerging market debt has
started to pop.
- Terrorism – in the US, political extremists may
become active leading into the election cycle. Anyone named Clinton or
Bush may be targeted.
- Results: terrorist activities in the United
States became entangled with the gun rights activists and those they
support in the US. Large scale events occurred elsewhere, but
multiple death shootings in the US are now common. Our political
leaders know there are basic steps they can take, but the political
ramifications for saving lives through background checks and
eliminating high capacity magazines and assault weapons are high.
This is the voters fault.
Top Actuarial Issues
- Defined benefit plan valuation – valuation methods
need to be revamped to front end funding levels for both private and
public plans.
- ORSA implementation – regulators have moved toward
checklists, but can make it worthwhile if they outsource review of the
reports to experts who understand how risks aggregate and diversify.
- Product design – be sure to look at exposures in
case hedges are not available.
- 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
available.
Pick some of these to do every year, some
qualitatively, some rotate every 3 or 5 years. Total stress scenarios should
be 10 or fewer.
- Negative interest rates
- Spike interest rates over 10%
- Level
- High credit risk – double default rate for BIG
assets
- Equities – down 35% and options market dries up
- Mortality – pandemic .6% excess mortality
- For companies writing indexed products –
model/report separately – test product if derivatives market dries up
- 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 1,000 scenarios from the VM
scenario generator)
- Low interest rates – Japan scenario
- Flat equity markets combined with higher inflation
- Falling dollar – combine with high interest rate
scenario
- Global climate change – how will this impact your
business and suppliers (e.g., 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
satellite line. What would you do if no one offered a derivative
position for you to hedge against? Are there protections written into
liabilities?
- No diversification is allowed between risks. Do
you have enough capital to survive?
- If you are ambitious run a scenario with equity
markets down 35% and 10 years’ worth of deflation
Predictions from January 2009
Since posting my first annual financial predictions in
2007, there are 8 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: …with Barack Obama about to be
inaugurated as President of the United States…volatility and tough times
will continue for a while. Obama will need to make some tough decisions,
and the tone he sets regarding personal accountability versus political
expedience will last for years. While the US has had many financial
missteps lately, there do not appear to be other countries doing better.
- Oil will rise above the current range of $40 per
barrel. I believe its long-term mean reversion rate is in the $80-110
range, but recent volatility has made any predictions very risky. The
Arab Spring was an indirect result of oil prices, ethanol subsidies and
crop shortages and could recur in several regions.
- Hospitals are at risk in 2009, along with
municipalities who have offered more than they can pay in benefits
(especially defined benefit pension schemes and post-retirement medical
benefits).
- Political instability throughout the world will be
a problem, driven by the liquidity crisis, price of oil, and/or
terrorism.
Here are some risks I was worried about over a longer
time horizon.
- 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.
- US political environment – can they say no to
anyone requesting a bailout?
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!
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