I am about to articulate an argument so contrary to popular wisdom that most of you will simply shake your head and proclaim, “Macrotourist that is the stupidest idea ever. You really outdid yourself this time (and that is saying a lot because you have some real doozies).”
This weekend I spent some time watching a great RealVisionTV interview with Danielle DiMartino Booth. Danielle is a former Federal Reserve staff member that now runs a private practice. It was an extremely interesting interview, and I can’t say I disagreed with much that she said.
Danielle spent a bunch of time outlining the underfunded pension plan problem. Too many plans do not have enough assets and unrealistically high return assumptions. This is a global phenomenon. It applies to private and public pensions plans alike. There is no disputing the fact this is a huge problem. It’s basic math.
She went on to talk about the reluctance of pension plan administrators to lower their return assumptions because there was no money to make up the needed deficit that would be created with the lower projected return. So far so good. Danielle’s insights regarding the head-in-the-sand mentality of most pension plan administrators were quite enlightening.
To add to her point, I would argue the majority of pension plans also exacerbated their problems by selling too many equities after the 2008 credit crisis. The dramatic increase in stock market volatility made many of these supposedly long term plans de-risk their asset mix. They clamoured for hedge funds in a hope to earn a steady return with less volatility. The trouble is that hedge funds… wait for it… hedge (and have fees that are too high, but that’s a story for another day). In an equity bull market, hedge funds will underperform the stock market. End of story. And that’s exactly what happened.
The other way pensions plans dealt with the 2008 credit crisis was to embrace risk parity. At its crux, risk parity is a style of investing that attempts to weight asset classes by their volatility. Since bonds are considerably less risky than stocks, you should own more bonds than equities. But the real genius of their marketing was that instead of just reducing the stock portion of the portfolio while increasing bonds, the risk parity crew convinced many investors that since bonds were considerably less risky than stocks, you should leverage up your portfolio with more bonds. Fixed income had the added benefit of being negatively correlated to equities in times of stress, so the extra leverage gave more positive carry along with reduced portfolio risk.
Yeah, I understand the theory. But I wonder if risk parity was simply a sophisticated way to leverage up the 35 year monster bull market in bonds.
The risk parity strategy has not been the same sort of disaster as hedge funds for the pension plans, but that’s because until a month ago, bonds were generating all sorts of positive return.
Let’s go back to Danielle and her insights about the looming pension fund problem. We have an underfunded global pension plan disaster-in-the-making. Combine that with the fact their returns have also dramatically underperformed because they de-risked at the wrong time, pension plans now find themselves with too many hedge funds, and with the recent ugly crash in fixed income, too many bonds.
Here is where I differ from Danielle. Both Danielle and her interviewer Grant Williams (who I have tremendous repsect for) concluded this pension fund problem was the next crash in the making. Yes, it will eventually be a complete shit show. But I contend they are thinking way too far down the line.
Imagine you are a pension plan administrator. You have already told the actuaries who want to lower your return projections that you can’t afford the increased capital requirements. Maybe you have agreed to a small cut, but it’s no where near a realistic number.
You desperately need your returns to match your projections, but the assets you bought in the aftermath of the 2008 credit crisis did not turn out nearly as well as you planned. Your hedge fund returns are crap, and their fees are insane. The money you sent to Bridgewater has performed all right, but the backup in yields has hurt that portion of the portfolio more than you would have guessed. What you really need is some sort of asset with a high expected long term return that will satisfy your outlandish return assumptions.
But wait, there is such an asset. And even though you sold too many equities after the 2008 credit crisis, increasing your allocation today will allow you to claim you will meet your long term return assumptions.
So although I completely agree pension funds are screwed beyond belief, I disagree about their response to their underfunded situation. I don’t buy that because they are offside, they will prudently lower their return assumptions and demand their plan members cough up more capital to meet the funding shortfall.
It’s human nature to put off taking the loss and instead play for the comeback. And when you are dealing with a group of individuals, the odds of that behaviour winning out for the majority of respondents goes through the roof.
Whereas most market pundits look at the underfunded pension problem and instinctively want to write a bunch of pink tickets on risk assets, I take the opposing view. I look at at this huge underperformance as the equivalent of a giant short squeeze. Probably the biggest short squeeze in the history of finance.
Although I have focused on pension plans, this is also happening on the individual level. An increasing number of people work for themselves and have no proper pension plan. Instead they save for retirement on their own. This is occurring at a time when life expectancy is dramatically increasing. These individuals find themselves with not enough savings, combined with an increasing retirement obligation due to their statistically probable longer life. This coincides with interest rates having declined to absurdly low levels of financial repression. This group of individuals also face a similar “short position.”
This monster “short position” is why every single dip over in the equity market over the past eight years has been bought. Of course we have had declines of 5% or even 10%, but there has been no meaningful correction. The stock market just keeps going up, much to everyone’s confusion. Valuations keep getting more and more absurd. Really smart investment guys have continually advocated going to cash before the next big crash. And yeah, I get it. It certainly seems scary as shit. Buying stocks in the hopes of selling it to the next greater fool is a terrible investment strategy.
Make no mistake - I am not advocating buying stocks in the hopes of riding this short squeeze wave. I will be happy if I simply avoid wasting money shorting in the hopes of catching the great next crash. And although I think there will be times when shorting stocks makes sense for a trade, I think we are much farther from a true meaningful correction than most market participants realize.
At this point you are probably saying to yourself, “great, all clear to get short now - when the MacroTourist writes pseudo bullish pieces like this, it is time for the rally to end.” And yeah, I agree, and it almost stopped me from writing it.
Yet too many people are confused by this mad scramble into risky assets. They look at the ferocity of the buying and say it has to end badly. They mistakenly think the buying is the result of thoughtful analysis about stock market valuations and therefore instinctively want to fade the move.
But nothing could be farther from the truth. The buyers are not buying because they like stocks. They are buying because they have no choice. There is nothing else for them to do. They are short an obligation that keeps growing. Meanwhile all other assets are repressed to absurd levels.
Stop and think about the European situation for a moment. Long term German yields are 40 basis points (up from negative levels). What is a proper forecasted return for a pension plan in Germany? What happens to their plans if they are forced to put in the proper rate?
The financial system has been distorted in such an ugly fashion, the outcomes are not nearly as obvious as everyone thinks.
Do I think stocks are stupidly overbought and due for a correction? Absolutely. This mad scramble into stocks is more outrageous than the infamous “Have you got a nickel?” twins-with-popsicles Gong Show episode that aired on the East Coast but was quickly pulled by network executives before the West Coast aired. A US stock market correction is coming, and it be ugly, quick and swift.
But here is the important thing to remember. It will not be the next great crash. Everyone is warning about the next 1987 style decline. I think there is more of a chance of an epic melt up than a crash. Sometimes the smart warnings are not nearly as smart as they seem…
Thanks for reading,