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Newsletter – 2018 Predictions: Results
My name is Max Rudolph. I consult
with institutional investors, advisors, and individuals about enterprise
risk management, asset-liability management and strategic planning topics. I
also do financial research projects and read quite a bit about financial and
historical topics. I try to find examples of history repeating itself
through approximate cycles. I am a private investor focused on individual
stock selection and value investing techniques. My background earning
credentials from the Society of Actuaries and CFA Institute, combined with
proximity to Warren Buffett and Charlie Munger through Omaha residence, has
paid dividends. I believe you can reduce risk and increase return
simultaneously using contrarian techniques. Recent interests include
complexity theory, behavioral economics, and emerging risks. These are also
the topics I occasionally tweet about @maxrudolph. In addition to client
work, I develop and present continuing education programs and am an adjunct
professor teaching online graduate level investment and ERM programs at
Creighton University. I live in Omaha, Nebraska, USA, am credentialed as an
actuary and hold a CFA charter. I have written a monthly newsletter since
2008 and each January post my predictions for the year. Late in the year I
review and compare against what actually happened. Some topics are written
at a high level, dealing with the general economy. Some are more detailed,
covering specific topics like incentives or modeling financial assets. Most
cover issues that I am stewing over and need to do a brain dump. In March I
update my intrinsic value calculation for Berkshire Hathaway and in the fall
I update the scenarios I think should be tested by financial institutions. I
am a lifelong learner, and that impacts how my current thinking evolves. My
newsletters are educational in nature and do not constitute investment
advice. They are released publicly at
www.rudolph-financial.com with a delay of several months after they are
released to subscribers.
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Predictions for 2018
These are not really predictions in the classic sense.
Treat them more like scenarios that you can build resilience against to
survive over the long term.
Disclosure - 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!
The financial markets continue to confuse me. I see
lots of warning signs; geopolitical risk, monetary policy tightening,
reduced covenants, higher leverage (especially margin debt). It feels like
all we are waiting for is a trigger for a crash. What could cause emotions
to turn against assets? A Presidential tweet, war in the Middle East, even
the retirement of Angela Merkel could be all it takes. Populism took a
breather and now is back in Eastern Europe. Venezuela has finally run out of
reasons not to implode, but I don’t think this will be more than an isolated
event unless it impacts the oil markets. Trump has his first year nearly
complete, and it has been very stressful. This makes it even harder to
understand how the economy continues to grow so quickly. Are we better off
on auto-pilot? Do human interactions reduce growth, so taking us away from
decision making means better decisions are made?
Results: Merkel has begun her path to retirement,
South America is a mess but so far isolated (leaving a path to the Americas
for China), the tax cut is finishing its first year, and Trump continues to
create havoc. The lack of business investment, with companies preferring to
pay out dividends or buy back shares, is a worrying development. It is a
good time to pay down debt.
The US tax plan will artificially boost asset values
and not hurt GDP, but adds to the imbalances in the system that needs so
desperately to clear. Reducing regulations makes sense in some instances,
but unwinding Dodd-Frank without discussion and shutting down the EPA and
DOE with no discussion is scary. Monetary policy will have to tighten
quicker than they want to, and this could be “the” event since QE and QT
(quantitative tightening) are uncharted territory so no one knows how to
take away the punch bowl, especially when fiscal policy is still
Result: One of Trump’s long-term “accomplishments”
is happening at the EPA and DOE, and it is not positive. Michael Lewis’ The
Fifth Risk deserves to be higher up on the list of important reads for 2018.
European and Japanese Central Banks have gone beyond
buying government assets and now are major players in the equity markets.
They will be challenged while unwinding those positions or getting in the
middle of a proxy fight.
I tend to think farther out on the time horizon than
most, and I can see a scenario that scares me very much. One where bullies
with guns take what they want with immunity, destroying the economy and
civilization as we know it. I read The Fourth Turning this year, and it
nearly predicts some sort of tribalism/populism every 80-100 years. We have
no moderates. We have far left zealots who think they know what’s best for
everyone, and far right zealots who profess to want to be left alone but
once in charge do everything they can to retain power and enact their
preferences on everyone.
Results: More articles are being written about the
lack of moderates, with Republicans moving farther to the right and
Democrats farther to the left. One possible solution to build a center would
be to change the primary system. Currently, to win a primary, you have to be
more extreme than your opponent. This makes it hard to beat the general
election candidate. Until we see independents run as moderates, and win,
this won’t change. The other option is the top-two primary, run as a
nonpartisan race and where the top two face a runoff in the general
Climate change will continue to be a major topic for as
long as I can see. Humans have created change at such a rapid pace that
plants and animals can’t keep up. Species are being eliminated so quickly
that we will have to carefully choose which ones to retain since we can’t
save them all.
Results: Actions this year make it unclear that
politicians will choose to save the human species.
I continue to believe that the underlying world economy
never cleared the imbalances built up over the past 20 years (starting with
the Fed’s reaction to Y2K, and arguably earlier than that based on After
the Fall that goes back to Continental Illinois).
Proponents of the tax act say that investment by
companies will grow, but why is that true when rates are already low. It
would have happened already. Incentives have to become aligned with job
growth. The government needs to use its funds to build infrastructure rather
than blow things up. They need to balance the fiscal budget occasionally,
and become sustainable. Central banks need to push back on politicians who
act as if they can spend all they want because they want you to think that
the Fed drives the economy. Monetary policy only works when fiscal policy is
reasonable and debt/GDP is below 90% (per Reinhart/Rogoff This Time is
Results: I’m now waiting 10 years for infrastructure
spending to begin.
I see similarities to 1937 moving into 1938, when the
Great Depression was reenergized by the Fed and fascism gained momentum. War
soon followed. 1973 and the nifty fifty have many similarities with the
current environment, with guns and butter making a comeback in economic
analysis. Deficits cannot be allowed to continue without ramifications.
Results: I am hearing references to the 1840s and
need to read up on the era, filled with no-name Presidents and biding time
until the civil war.
Going forward Trump is starting to get people in place;
some are horribly unqualified. The ones named as judges that are lifetime
posts could do damage for 50 years. I have read several articles about parts
of the government that have not been restocked with senior leadership, and
this too will be a big deal over the long run. The EPA and DOE save lives if
allowed to do so.
I think the Fed will start off tightening quickly and
have to back off by late summer, mainly due to the combination of hikes and
reduced QE balance sheet items. Trump will be quick to blame the Fed for a
recession, but they are forced to react to the tax cuts.
Results: I’m pretty close on this one. I do think
the Fed will back off, but not until 2019. Quantitative tightening continues
to do its work at $50 billion a month.
I would not be surprised to see a European financial
crisis kick up again in 2018, but for now the discussion is focused on
populism and Brexit. Southern Europe would be better off out of the EU.
Germany would not.
In the US velocity of money may or may not have
bottomed, but certainly has not yet rebounded although the result shared for
4Q2017 may show inflation building. New places open to drill for oil will be
a problem for the high cost option, fracking.
Results: VM has bounced a little bit, but will be
tested as a recession looms. Fracking continues to reduce its costs, but
relies too much on Wall Street and low rates. Bethany McLean’s book, Saudi
America, is worth the time. Most interesting to me was that the Chesapeake
CEO’s brother-in-law was head of the committee with congressional oversight
of the industry (and related to Kate Upton and the Whirlpool fortune). A
total conflict of interest.
Beware of margin and reduced covenants. The US
continues to be in a good position relative to other countries, which isn’t
saying much, but this will give politicians an excuse to spend and blame the
fallout on others. Active investment strategies will do better over the next
few years than passive ones do, but only when value strategies are followed.
Those running after last year’s best performers will not do well. The FANG (Facebook,
Amazon, Netflix, Google) stocks will not all continue to explode upwards.
Results: FANG stocks are falling back to earth, and
half of all stocks are in bear territory (down 20% from their highs). Active
strategies have continued to come up short, and I think this will continue
until subsidies are removed from the system. Momentum strategies work until
Will passive strategies create their own form of
bubble? Yes, but it is not clear what it will look like. Many ETFs carry
basis risk by not investing in the entire group they represent. This is a
concern since a selloff won’t be evenly distributed across all assets, but
will be driven by those with the most leverage trying to sell their most
liquid positions. It’s a good time to reduce or eliminate any leverage
associated with trading.
Results: I wrote an essay on this (and posted it as
a newsletter in April 2018 titled Driverless Investing.
A lot of consultants will offer to solve your risk
appetite issues, but they all assume that it is a constant. Risk appetite is
not steady; it varies with volatility and the time we have been in a period
of growth. If someone is honest they will admit that they were scared to
death in 2008 and willing to accept the extra risk for return proposition in
2006. How did that work out?
When everyone is on board with culture, and everyone
agrees, is anyone really on board? If contrarian views are missing then a
period where risk is growing ensues.
At the May 2017 Berkshire Hathaway meeting, where
Warren Buffett and Charlie Munger take questions for six hours, there were
two common themes. Both are reactions to existing companies and their
business plans. Amazon has gotten so big and so efficient that any mention
of their entry into a new sector (e.g., pharmaceuticals following the Whole
Foods acquisition) sends the firms in that sector down. Their ability to
scale up and add product quickly, and to try new things, make them a very
hard competitor to compete against. Perhaps only letting Chinese competitors
like Tencent and Alibaba into the US market will find Amazon susceptible
since their market price requires their limited profits to date to grow for
a long time and at a high rate. The other competitor is 3G Capital, and it
is their business practice of zero based budgeting that scares potential
acquisitions. For example, they have purchased Kraft and Heinz, reducing
costs to increase profits. Each expense needs to be defended before each
budget cycle. It remains to be seen whether they really want to run these
companies or will spin them off in an IPO or sell to their capital rich
partner, Warren Buffett and Berkshire. But the number of potential
acquisitions has been reduced dramatically since they first brought the
method to the US. Companies throughout retail and food in particular have
been gutting their own expenses, making it harder for 3G to gain entry but
also changing the culture of the firm. Some may find that the new culture is
not as family friendly and decide to sell anyway.
Results: The 3G effect is wearing off due to bad
publicity (layoffs, zero cost budgeting) and that potential targets have
adopted the practices themselves.
Here are a couple of items based on recent articles I
read. I have tried to keep the companies anonymous.
- If your risk manager’s goal is to focus on working
smoothly with the product team, the company will have problems during
the next crisis. While you have to work together, a certain amount of
tension is useful. This is why I always encourage companies to rotate
their outside risk consultants. Unfortunately I am the only one making
that suggestion so companies don’t return to me and I don’t get
crossover business. L
- I recently read an article where the insurance
company CRO, with an investment background, talked about the importance
of not being an actuary to be the CRO. I was astonished. As an actuary I
have had training in most of the parts of an insurance company,
including all the primary financial techniques that can get you in
trouble. (I have completed research on insurance insolvencies) Just as
most CROs need someone with investment background to be able to
challenge the CIO, someone without actuarial expertise likely has little
feel for the nuances of liability risk that are accepted. This strategy
can work if your risk team is responsible only for process, but that job
doesn’t pay much. This interviewee in particular seemed to think a lot
of their expertise, but it’s a company that I think has added a lot of
liability risk recently. I hope he is as right as he thinks he is. (this
might not bother me as much as it does if it wasn’t my third example of
hubris from this company over the years – it’s one of my favorite
leading indicator examples) Results: GE’s path during 2018 has shown
how management teams can become too big for their britches. The capital
unit quite obviously was taking risks they did not understand. I
attended a GARP conference once where the GE Capital CRO talked about
how their risk team had lots of experience and no new blood for years.
You need fresh faces, even if it is someone from outside to come in and
provide honest feedback. Companies don’t hire honest feedback in advance
of a crisis, and when they are forced to it is already obvious to
everyone so the contrarian hasn’t added anything. Timing is everything.
It’s a time for learning about unknown knowns. There
are many unique factors (leverage, monetary and fiscal policy) that make it
hard to look to history when making investment decisions. Once it calms down
you can implement what you learned.
Expenses are another factor in the individual’s
control. Our personal investment expenses were less than .5 bp in 2017,
based on 2% rollover, well below the 8-10 bp charged by index funds.
Results: a little higher in 2018, about .6 bp, due to some mergers and
education related sales. This includes only the assets not in a 401(k), and
has no mutual funds.
Russia and China continue to accumulate gold. The
dollar should continue to rise, making it very hard for exporters. The
investments to look for are companies with US monopolies once imports are
turned off. This should result in pure profit for them as prices can rise
with no increase in quality or volume. Warren Buffett’s Berkshire Hathaway
should do well, and the tax plan will help BRK as well. Look for them to
sell some long-term winners once they use some of their existing pile of
cash (over $100 billion). J
Results: Add India to the list of those accumulating gold. Beyond Venezuela
it will be interesting to where they are getting it from. I am surprised
that Berkshire Hathaway has not sold any of its long term holdings, but it
seems to not want over $100 billion in cash so is investing (mainly buying
AAPL) with the excess.
While geopolitical tensions seem highest in North
Korea, I worry more about the Middle East, China, and Europe right now. If
Trump keeps off twitter going forward I think North Korea starts to recede
into the background and China will address the situation quietly. An
Iran/Saudi Arabia confrontation is coming. We don’t need to be involved, but
we will get pulled in. Russia is selling as much oil as it can, and asking
for gold in return. Their central bank president seems to have a plan but
her cards are not strong unless the price of oil increases. They seem to be
betting on a Bretton Woods type negotiation and want a seat at the table
that gold assures them.
The South America issues will cause some problems in
the US, mainly in Florida and any groups helping individuals to stash money
in US$. Assets in China are trying to leave so quickly that the government
has imposed restrictions, recently outlawing bitcoin due to its anonymity.
Housing bubbles are growing everywhere, especially where airports have
direct flights to China (US, Canada, Australia especially). Venezuela
continues to implode, but other South American countries are stabilizing.
Bird flu has returned to Europe. Other viruses will
also return over time. China is very fragile right now as politics are
driving economics. The US needs a backup plan if Saudi Arabia falls. Africa
is the next migration problem, leaving some to question the efforts of
philanthropists there. Climate change and other sustainability issues are
making water and other resources the driving force behind regional
conflicts. This will only get worse, and an isolationist US is not going to
help. Is a Pence presidency more worrisome than what we have now? A Trump
resignation prior to the 2018 or 2020 election could lose much Democratic
momentum. Who will run for the dems? Realistically I hate to say it but 2020
might be better fought by a white male to avoid firing up the Republican
base. The Democratic leadership needs to turn over for them to win
(especially Nancy Pelosi). Results: I still believe Pelosi needs to go
before 2020, but she has not wilted in front of the President as she takes
over. In fact, if Pence is drawn into the impeachment proceedings don’t
forget that she is next in line. Beto O’Rourke will get comparisons with
Lincoln due to his losing the Texas Senate race, but I don’t really know his
positions (much like Ben Sasse, who seems like a nice guy but the more I
know about his positions the less I want him as my senator).
I learn more about climate change every year. It is
fascinating how little we really know, and how often when something new is
learned that it makes things worse. The shrinking Arctic ice sheet’s impact
on the jet stream, the sinking of the ocean floor due to the heavier weight
on top of it as glaciers melt and water expands, and the important role of
methane (cow belches, not farts) in global warming. Unfortunately, many in
the media (I notice it most in the WSJ) feel it is their duty to balance pro
and con articles and the articles that argue against climate change should
be challenged prior to publication (but aren’t). An emerging risk that I
hope is far off is a shifting (swap) of the magnetic poles. This happens
occasionally but little is known about how it would interact with humans or
Results: lots happening but nothing changing.
Trump’s cabinet is making it worse.
The White House has spent the year trying to cleanse
government servers of the words “climate change.” It’s nuts. I just wrote a
5,000 word essay for the Society of Actuaries on climate change so won’t go
into it here, but I believe it is real and should be addressed. In fact I
think it may be too late for a carbon tax to work and wish we were spending
money and resources to scrub carbon from the air and oceans. The problem is
that the rate of change is destroying biodiversity (plants and animals can’t
evolve quickly enough to survive). I am very pleased that I don’t live on
the coasts, and would be buying up Great Lakes land if I was Ted Turner or
John Malone rather than Montana due to the fresh water.
Results: I published my award winning essay as a
newsletter in June 2018 – Was Malthus Right, but Early?
I am still in search of moderates, and based on votes
on taxes, immigration, gun control, and climate I plan to vote against each
incumbent in the 2018 national election.
Results: I spoke on campus at the University of
Nebraska just after the election, and an actuarial student asked me if I had
followed through with this plan. I did.
When the European Union breaks apart it will be a
problem for both those in the south and those in the north. Germany’s
exports are nearly half of its GDP. When they lose the Euro as a common
currency their economy will implode as their currency strengthens. It will
be easier for those in the south like Greece to devalue and regroup. I still
think Brexit will end up a good thing for England due to the timing, getting
out before the big problems. The politics, most recently in Poland, is in
addition to these issues. The Middle East is setting up as a battle between
Iran and Saudi Arabia, with Turkey a wild card that likely determines the
winner. There is little reason for the US to participate, but Israel and
Europe are likely to pull us in due to reliance on Middle Eastern oil. I
think North Korea would calm down if allowed to keep a single nuclear
The China risk is rising, especially if the rest of the
world goes into recession as they are so reliant on exports. Climate change
has a huge impact on this area due to cyclones, but the biggest risk is
still that China has little in the way of resources and will eventually need
to partner with or conquer other countries that do.
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. Weather
based events were dominant in 2017, with multiple hurricanes/cyclones, wild
fires, flooding, drought, etc. etc. etc. Drought and atmospheric rivers
recently showed the devastation a combination of events can cause in
Results: broken record, and due for an earthquake on
the west coast.
Much like any other ecosystem, the economy is a complex
adaptive system, so short-term forecasts are unlikely to be accurate. Stocks
have now risen for nine consecutive years, a record. The recent tax bill
increases the value of firms, but most of the recent rise has been due to
P/E multiple expansion. Markets need to pause and catch their breath as most
companies are overpriced. I still think winners are companies with domestic
monopolies and small caps where exports are not key to their value.
Berkshire is well positioned for a correction, with over $100 billion in
mostly Treasury bills. More companies are following the European model of
private ownership of businesses, making it difficult to find undervalued yet
publicly traded firms. Those are being bought out by private equity firms.
Although I am forcing myself to make a purchase each month, based mostly on
stories driven by demographics and defense (oil firms are now defense stocks
– the next war will still be fought with oil), but few firms make it through
my stock filter and we continue to have larger than normal cash positions.
Despite January’s gains, it would not surprise me to see stock prices down
20% or more this year, with a small chance for 50% drops over the next
couple of years (I made this same prediction for 2017). This may be delayed
due to the tax cut, but will make the recession/correction stronger when it
does occur. The dollar remains the reserve currency, mainly due to a lack of
acceptable substitutes. I expect rates to rise in the short run, but
eventually demographics and slow growth could easily take them lower again.
This is a big deal for savers, especially pension plans and insurers who
each are required to guarantee positive nominal returns. The dollar has
weakened and the renminbi has become the “hot potato” currency that no one
wants. China recently outlawed bitcoin as its citizens tried to use it to
get money out of the country. China’s next recession will cause them to sell
US Treasuries and buy yuan, so yields will go up in the US and the yuan will
strengthen when their export market needs it to weaken.
Results: China is likely selling US Treasuries and
gold to support their currency, the opposite of what politicians are
accusing them of. In 2018 I bought defense stocks, tech, and a few large
caps. Going into 2019 more companies pass my filter, but the trend is still
down. Many stocks are down 20% from their peak, but the markets are not down
anywhere near that much for the calendar year.
Outlier (Qualitative) Scenarios
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.
- Cyber-terrorism impacts the banking system or
shuts down the power grid
- Space junk knocks out a satellite used for public
- Atmospheric river hits California and dumps rain
on the west coast for a month – seems more likely as jet stream weakens
- A severe earthquake (or volcanic eruption) hits
California, St. Louis or Seattle
- Super-volcano becomes active somewhere in the
world (US option is Yellowstone): longer time horizon
- Magnetic poles will switch between north and
south: longer time horizon
- 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 – most likely fresh water or sea-going
- Eurozone breaks apart – could be north/south, poor
countries/rich countries or just kicking out individual members
- Venezuela erupts in violence, shutting down their
oil industry and leaving South America a regional hot spot – this has
- A severe virus develops drug resistance and
becomes transmissible by air
- Antibiotics fail to work against a common
- Iran encourages regional conflict and becomes the
Middle East’s consolidating superpower against Saudi Arabia (you may
have sub-scenarios with alternative conclusions about how the
Russia/US/Iran/Turkey relationships qualitatively play out)
- Water resources trigger a regional conflict
(likely Himalayas, Middle East, or Europe)
- S&P500 down 30% from high point, combined with
double recent bond defaults and real estate collapse in the largest
US/Canadian coastal cities. ( increase until it becomes a solvency event
so you can strategically determine hedging strategy)
- GDP down for 3 consecutive years.
- Climate change leads south Florida to become
unlivable and becomes a leading indicator for other changes (reduced
biodiversity, sea level rise, increased strength of convective storms):
slow, painful, and so far unimagined by the market
While I tweaked some of these, there were no major
additions. I added magnetic poles as it is another long-term event that has
not happened for a long time.
These predictions were made in January 2018.
- Politics and currency wars: Prediction – Donald
Trump is a geopolitical disrupter. The 2018 mid-term elections in the US
could be a major swing to the left (especially if Pelosi is replaced and
Obama campaigns). Europe is a separate story, with eastern regions
moving right. I expect the dollar to strengthen as Quantitative
Tightening continues. The velocity of money will pause before continuing
to drop. There is a lot of uncertainty about this, but I expect the Fed
to increase rates a couple of times and continue QT to offset the new
tax law. They may need to back off late in 2018 if a recession has
started. Iran and Saudi Arabia will start to provoke each other, but it
will take several years before war breaks out. The UK Brexit timing will
turn out to be fortuitous. China is my big worry, with currency and
regional tensions being a problem. Cyber wars are coming. All should
have cash reserves on hand. It may be an accident rather than
intentional. An attack on the electrical grid has become increasingly
realistic. Preparation for network shutoffs, whether intentional or
accidental, will pay off. Something will go wrong. Results: pretty
- Political sidebar: (from 2017 predictions) a fun
game has been to wager how long before Trump is impeached, or how long
before his advisors are sent to jail. Both are impossible to predict,
and I don’t bet, but my money is still on Jared Kushner. He’s involved
in too many things and not high enough in the structure to stay clean
(unlike Ivanka). Most likely is he gets caught selling influence.
Update: money laundering now seems likely as well. Results: too many
probes ongoing to accurately see which direction this goes, but the
discussion should pivot to Pence’s involvement.
- Geopolitical: as the US becomes more protectionist
and less willing to guarantee the peace around the world, this means
there will be more regional conflicts. Some will escalate and we may get
pulled in anyway. Although I prefer to be proactive, an inward thinking
US in the 1930s was able to quickly ramp up using the latest technology
once we entered WW2 rather than having to scrap earlier preparations
(although since it was struggling to exit a depression that might not
have been a big deal). After being in the spotlight throughout the last
presidential election, Mexico has stayed in the shadows. Hopefully they
are building infrastructure to be a place where immigrants are welcome.
Many from further south would love to move to a safer location with job
security. There is an opportunity if a free economy can be maintained.
Results: Mexico has turned to the right. Unlikely a good sign for
- Stocks and general economic conditions: I keep
waiting for equities to have a correction that sticks. US markets are
overdue, and the Fed increases may be the catalyst for a 30-40% drop. I
suggest avoiding businesses that rely on retail exports from the US as
the dollar eventually strengthens with monetary tightening. Global
volatility will resume soon, with emerging markets the losers. Contagion
may follow. I continue to avoid bonds. My preference is to use highly
rated dividend stocks for this type of exposure, with yields about 2%. I
see the economy performing okay initially in 2018, with a recession (or
more, depending on how it is handled) later in the year as monetary
tightening kicks in. The tax cuts may make the Fed move faster than they
would have otherwise. The heavy turnover on the Fed makes their actions
uncertain. I expect consolidation in the insurance industry as foreign
buyers seek diversification and US domiciled firms take advantage of the
strong dollar. The S&P 500 closed 2017 at 2,674, up 22% (total return)
for the year. I wrote an essay titled The Risks of Driverless
Investing that will be released publicly in 2018. It considers the
downsides of passive investing. Results: money market funds are now
at 2% as an inversion gets closer to reality. Bonds at 3% may not be a
bad investment going into a recession. The index is down for the year,
but not materially.
- Unemployment: Structural unemployment has risen in
the last decade as it becomes harder to go between jobs or move to the
gig economy (locked into mortgage or health insurance, last in first out
mentality for layoffs). Pension plans are doomed for failure, with
funding levels at companies 30% below that needed and multi-employers
practically wiped out, even after 9 years of gains. I expect the
unemployment level to rise by the end of the year from just above 4% in
2017. The next generation must become lifelong learners as artificial
intelligence replaces jobs and lifespans extend. Results: wrong – the
unemployment rate has hovered about 3.7% for the second half of the
year. I wonder if we have the right metric for unemployment. With the
rise in the gig economy would underemployment be a better metric to
measure the economy with?
- Residential home market: US regions continue to
have lower correlations with each other, but coastal cities with direct
flights to China and South America are heating up. Bubbles are forming
as Asian currency seeks an outlet (e.g., Vancouver, Toronto, Seattle).
Miami seems to be a home for South American money seeking safety. This
will interact with climate change in a bad way for real estate in south
Florida. Results: markets in Australia and Canada seem to be popping.
- Volatility: The VIX closed 2017 at 11.04. 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 this high would be
at least 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
going forward, especially if we experience both a recession and 20% drop
in the stock market. I am not an options expert but wonder if this
assumption has undervalued the cost of volatility in those markets.
There must be a better metric to reflect risk. Results: late in 2018
the VIX is near 30 and has recently been higher.
- Oil: WTI oil at the end of 2017 was about $60 per
barrel. I have no ability to predict the price of oil, but the
combination of OPEC limits and frackers close to or below breakeven
makes it likely that the next spike will be due to a geopolitical event.
Currency wars also play havoc with the oil price. Energy is about as
complex as financial markets get. I have recently taken a position in
Chevron as a proxy for the defense sector, making a bet that the next
war will be fought with legacy fossil fuels. Results: late in 2018
WTI is under $45. Early in the year it looked like oil would rise, but
manipulation to increase supply when Iran was set to have sanctions.
Then they softened the sanctions and supply went through the roof.
- Credit risk: I am still worried that much of the
junk bond issuance recently has been to fracking companies that struggle
due to the price of oil. Watch out for defaults here and in emerging
markets where the strong dollar causes problems for dollar denominated
bonds. These issues will cause spillover in other markets and industries
as hedge funds sell “safe” assets to cover losses. US junk bond spreads
will widen soon as their cycle continues. Results: so much of BBB
issuance goes to insurers that I worry about a “near junk” implosion.
Junk bond spreads have risen.
- Currency/Inflation/Interest rates: The dollar
should be strengthening due to monetary tightening but is not. There is
a variable I (and others) am missing. I am currently working on a
research project with Mark Alberts that focuses on a low growth scenario
and how it would impact the insurance industry. Results: our research
project will be out in the spring. The $ continues to be weaker than I
expect. 110-115 against yen, 1.1-1.15 against Euro.
- Fed policy: Due to lack of proactive planning,
made worse by the current administration, the US is susceptible to a
large catastrophe, financial disaster, or armed conflict. Puerto Rico
needs funding to rebuild, and infrastructure spending should have been
prioritized over tax cuts for the wealthy. I’m still waiting for carried
interest to be taxed as income. Results: every day I feel closer to a
new armed conflict. Supposedly we are leaving Syria and Afghanistan, but
what is the value if we have to reestablish footholds later?
- Tax policy: The recent tax bill lowers revenue so
will be expansionary. This makes it harder for monetary policy to do its
job. The repatriation of overseas profits will provide a temporary
offset, and some corporations who hold securities in their portfolio can
now sell some of the gains. Berkshire Hathaway, where I focus in my
March newsletters, will likely sell some of their long held positions
this year (perhaps American Express). Results: a year out from the
tax cut and the administration does not seem to realize that cuts are
temporary stimulus. It must reset soon, and every manipulation to delay
that time will increase the pain of the reset. I have been surprised
that BRK did not sell some of their long term positions in 2018. This
may have been impacted by their already large cash position.
Emerging Risks - Concerns
- Infectious disease - increased resistance to
antibiotics (e.g., tuberculosis, staph infections or pneumonia),
coronaviruses, Ebola (and similar), avian flu types that are
transmissible by air. Mosquito borne diseases are making a comeback led
by Zika and Dengue, moving north. Results: Ebola in Congo continues
to spread. Avian flu has been quiet in the US. Has something changed?
- Global warming – unexpected side effects like new
viral/bacterial attacks, along with coastal flooding, wildfire/flooding
combinations, more concentrated coastal storms at unusual times of year,
stronger and more frequent convective storms, and shifting weather
patterns that impact farming through changes to the jet stream due to
the shrinking Arctic ice flow. 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 adapts quickly enough. We’ll continue to see extinctions as
conditions change too quickly for most species to adapt and biodiversity
shrinks. Record high temperatures for the planet persisted post el Nino
– this is a very bad sign (previously the 1997 el Nino results had been
used by deniers as a reason why the earth was cooling – look how high
this data point is relative to today). Look at a graph of all data
points rather than comparing single year data points to avoid cherry
picking. It makes it too easy for climate deniers to lie with
statistics. Statisticians need to police the use of statistics to align
incentives. The solar cycle has been argued to be the driver of this
warmth, but the current cycle has been weak and would be cooling the
planet. The real estate market in Miami should blow up in the near
future, but to date shows no signs of doing so. I recently wrote an
essay titled Was Malthus Right, just Early? that will be released
publicly in 2018. Results: a year after writing the Malthus essay,
the lasting memory is the role of Ben Franklin. He wrote of how any
agricultural gains would be gobbled up by early marriage and children,
with population growing to meet the food supply.
- 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, St. Louis,
New York City) are well into their cycle. The weaker jet stream is
leading to more atmospheric rivers, and combined with the wild fires
will create havoc. (so far they have lasted only a few days but
historically could last a month) The drought is strong enough that there
is no longer a season when wildfires are not common in California and
Australia, and other regions in the US are also at risk due to the pine
beetle infestation combined with drought. Due to warmer air, more
moisture is held by the atmosphere, with unknown results (so far it
looks like this breaks up hurricanes but leads to stronger convective
storms and nor’easters). The additional weight causes breaks in the
earth’s crust under the ocean, adding another risk to fracking beyond
the earthquakes caused in areas such as Oklahoma and the Netherlands.
Results: the wild fire season is now never ending, with the Camp Fire
(Paradise CA) one that will be remembered for a long time. Florence
created another heavy rain hurricane.
- Levees in California, water poisoning in big
cities, cyber hackers, transportation of oil and oil based products via
rail through urban centers (e.g., downtown Chicago) are all regional
- Malthus – too many people, not enough resources –
will good intentions of the rich to save lives in Africa lead to
increased systemic risk for society (mass starvation, unstable regions,
forced migration, even genocide) in the longer term? Are there
unintended consequences associated with the “giving pledge” by the rich?
How do these complex systems interact based on changing and fast moving
inputs? Is it really so bad to have aging demographics, changing
immigration trends, and shrinking populations? Demographics are destiny.
Should we look at GDP growth by splitting it between population growth
and productivity growth? In the long run we are more susceptible to war,
famine and disease through population growth, and this interacts with
climate change issues. What happened to the Zuckerberg foundation model
to rebuild infrastructure? Results: in our low growth research
project it is important to split up growth between population growth,
per capita GDP growth and productivity growth, especially as population
hits a maximum.
- Student loans – not only will millennials default
due to student loans, there are many instances where their parents
co-signed for them. These retirees are seeing their Social Security
checks garnished. This situation will have much more impact on the
economy in the future than we have seen previously (negative).
- Concentration risk – this will be a hot topic over
the next few years. Whether it is power at the top of an organization
(moron/hubris risk), 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 at record levels, not a good sign. Identifying
concentrated exposures should be a focus during strategic planning
efforts at companies. Concentration risk also increases contagion risk.
Less focus should be put on fancy econometric models and more on simple
exposures and their downside impacts. Results: at the end of 2018
several hedge funds have shut down and the December correction is likely
to identify some who were swimming naked due to margin.
- Terrorism – in the US, political extremists may
become active leading into the next election cycle. It amazes me that we
have not had more attempts to injure politicians, especially with the
lack of gun controls. So far it is mostly white males doing the damage
to random victims. Results: Parkland High School (February), Thousand
Oaks CA country bar (November), Pittsburgh synagogue (October), Santa Fe
High School (May) each reported at least 10 deaths. A gun violence
database shows 10 pages of incidents.
Top Actuarial Issues
- Defined benefit plan valuation – valuation methods
need to be revamped to front end funding levels for both private and
public plans. Assumed returns remain orders of magnitude too high. I
would suggest using nothing higher than 5%, with a cap using the most
recent 10-year geometric mean, and that might need to be lowered.
Fiduciary standards should require conservatism in pension assumptions.
Results: General Electric proves the point. At a time when its
survival is not guaranteed, there is nearly $30 billion of unfunded
pension liability. Why are bonuses being paid to anyone at the company?
Where are the senior managers who have fiduciary responsibility?
- ORSA/PBR implementation – regulators have moved
toward checklists with ORSA, but can still make it worthwhile if they
outsource review of the reports to experts who understand how risks
aggregate and diversify. PBR has baked in conservatism (percentile) on
top of conservatism (margins). When a complex system includes margins
the results embed unintended consequences. Results: this expert is
rarely asked to peer review a company’s risks. Hopefully they are asking
someone else who will give them an honest opinion.
- Product design – be sure to look at exposures in
case hedges are not available. The gross exposure is more important
during a crisis, while the net exposure drives results in most
circumstances. A concern I am seeing is that companies are adding the
NAIC 1000 scenarios from the ESG (Economic Scenario Generator) to their
cash flow testing because of the mean reversion feature. Results are
better than from the NY7. As I’ve shown in my research papers, in this
environment the ESG provides best case results.
- Obesity/smoking/biomed technology – how will the
various drivers of mortality and morbidity interact (some good, some
bad)? Results: an SOA study shows that mortality for ages 15-44 and
55-64 are higher than previous studies due to opioids and suicide. Not
good. Likely tied to under-educated and their trouble finding work. Not
just a white problem, despite some reporting.
- Health care – the Republicans touted that they
destroyed ObamaCare, and there is more truth in that than they
understand. By taking out the individual mandate it will destroy the
market as insurers drop their product. I worry that we are moving toward
antibiotic resistant bacteria as research is discouraged, and we are
definitely not prepared for an influenza pandemic. Results: by
discouraging use of cheap proactive measures instead of desperation
measures, we will increase health care costs while also decreasing life
- Systemic risk – too many insurers rely on FHLB for
capital infusions during a crisis – it has not been tested and may not
play out as expected. I believe there is systemic risk in insurers, but
only when they all play “follow the leader” with sales, investment, or
product design practices. Many are currently adding longevity risks by
accepting payout annuities. A cancer breakthrough could be solvency
threatening. Results: …or a low growth scenario.
- Over-reliance on the normal distribution – I would
like to see life actuaries train with their casualty brethren and learn
more about power laws that appear to represent the tail distributions
better than bell-shaped, normal, distributions.
Predictions from January 2012
I posted my first annual financial predictions in 2007.
Each year I will look back and share interesting comments I made that seem
accurate in hindsight. I have deleted sections but not changed the wording
in what remains.
These (mainly) economic predictions were made in
January 2012. Recall that this year featured a presidential election where
Obama/Biden defeated Romney/Paul Ryan.
- 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. 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
- Stocks: Over the next 10 years stocks will
outperform both cash and especially bonds. 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
- Unemployment: 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.
- 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.
- 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.
- Oil: If oil prices fall below $50, political
instability in Russia and South America will quickly follow. 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.
- 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.
- Financial Services Consolidation: 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.
- Currency/Inflation: The next great threat to
dollar dominance is a resurgent German led Europe or China, and both are
several years away. Resource shortages (food, water) will drive regional
- 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.
Top Actuarial Issues
- Defined benefit plan valuation – Valuation methods
have led defined benefit plans to be little more than an off balance
sheet Ponzi scheme. Focus should be on cash flows rather than regulatory
- Product design – 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)?
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!