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Jubak's Journal
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• 5 stocks for the skeptical tech investor, 2/27/2004
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A recovery built on retirees' backs
Every time Washington juggles numbers to keep the recovery going and make deficits less shocking, your golden years get a little more difficult.
By Jim Jubak
The Greenspan squeeze is ready to put your retirement income in a vise.
The Greenspan squeeze is my name for a series of moves orchestrated by Federal Reserve Chairman Alan Greenspan and embraced by a spineless, budget-busting Congress that will reduce the cash flow that just about everyone will have in retirement. At its worst, the Greenspan squeeze has the potential to turn a modestly comfortable retirement in old age into poverty.
But if you start planning now -- and youre lucky -- youve got a chance to avoid having your retirement goals caught in the wringer.
In this column, Ill try to explain where the squeeze is coming from and which assets are going to get pressed hardest. In my next column, Ill look at which strategies are likely to work best against the squeeze and which stocks (and kinds of stocks) you should add to your portfolio to make the squeeze less painful.
Whats the Greenspan squeeze?
Part of the Greenspan squeeze -- the part that deals with actual cuts in Social Security benefits -- has been getting a lot of headlines lately thanks to the Fed chairman's Feb. 25 testimony before the House Budget Committee. Greenspan started off with some unpleasant facts: The country faces huge annual budget deficits as far as the eye can see and an even larger bill for retirement and health-care benefits for the soon-to-retire baby boom generation.
The Social Security Trust Fund, the pool of IOUs and current tax payments that funds monthly Social Security checks, is forecast to hit red ink in 2018 and be exhausted by 2042. Over the next 75 years, total unfunded Social Security benefit liabilities come to about $26 trillion, according to the Cato Institute. (The various Medicaid trust funds are also in deep trouble. For example, Medicares Hospitalization Trust Fund goes into the red in 2014, even sooner than Social Security.)
Of course, if Congress were to put money into the trust fund now, it would have to cough up a much smaller amount of cash, about $5 trillion. But the only way to do that, since the federal budget is already in deficit, would be to raise taxes. That, says Greenspan, would put the economy at risk and reduce future growth. (Which would, of course, make it even harder to balance the federal budget.)
So Greenspan urged Congress to cut benefits rather than raise taxes, a cynical ploy because we all know Congress has no appetite for increasing taxes, especially in an election year. Greenspan left the recipe for cutting benefits rather vague. He did talk about extending the retirement age again; its already set to rise to 67 for anyone born after 1960. And he spoke about the need to reduce cost-of-living increases in payments.
So whats the big deal? Theres really nothing particularly shocking about what Greenspan said: Its well-known that the trust fund will run out of money. His suggested benefit cuts resemble those in the 1983 Social Security reform package. Maybe he was cynical in even suggesting that Congress would consider raising taxes, but cynicism about Congress is an honorable tradition that goes back to the drafting of the Constitution.
Chaining the Consumer Price Index
Put Greenspans Social Security testimony together with the rest of the Feds overt policy and public lobbying, though, and you have a formula for significant reductions in cash flow for most Americans looking to retire in the next 20 years.
For example, connect Greenspans comments on lowering cost-of-living increases in Social Security payments to his longstanding preference for an inflation measure called the chained consumer price index. Unlike the version of the consumer price index used to measure inflation now, the chained index assumes that consumers spend less on things when their price goes up. The effect is to lower the measured rate of inflation. Inflation as measured by the Consumer Price Index has been 2.1% since 2001. Using the chained index, it was 1.8%.
Over time, that paltry 0.3% adds up. Over 10 years at 2.1%, a monthly Social Security payment of $1,600 rises to about $1,970; at 1.8% it climbs to just $1,912. Thats a difference of $58 a month or almost $700 a year. Over 20 years, the difference between the two inflation rates is $138 a month or $1,656 a year.
Chump change, you say? If it were a difference in the value of the assets in a retirement portfolio, Id agree. But its not.
This is a difference in cash flow. Income. And therefore this relatively modest annual difference represents a much bigger swing in the portfolio assets that an investor has to own to produce that cash flow.
In other words, to replace that $1,656 in annual income, youll need an extra $20,700 in your retirement fund. To get that number, Im assuming the portfolio yields 8%.
Of course, who can get an 8% yield these days? Which is where the other side of the Greenspan squeeze kicks in.
The 10-year Treasury note is paying just 4.01%. At that rate, you would need an additional $41,297 in your retirement fund to replace the lost Social Security income.
(And if youre afraid of the possibility that the Fed will raise interest rates at the end of 2004 or in 2005, which would cause a decline in bond prices, you wouldn't want to buy a 10-year note even for the extra yield. Instead youd decide to protect your capital and settle for the lower yield on, say, a two-year note.)
If the consensus projection on future equity returns is correct, forget about making up the difference by buying stocks. Stocks are likely to return only 8% over the next decade, the majority opinion now holds. (After that, who knows?) And if you follow financial planning advice, youll only cash out half that gain in any year so that you wont outlive your money. Or about 4% again.
The feds can play games with your income, too
See the squeeze? Wait, it gets worse.
The federal government, like any huge debtor, is interested in lowering its interest payments. But unlike any other debtor I can think of, the federal government keeps the numbers that control how much interest it pays out on inflation-linked obligations.
So, for example, the Bureau of Labor Statistics has begun a study to see if the true rate of inflation in health care is lower than current measures. The idea is that the Consumer Price Index doesnt subtract the improving quality of health care from any annual increase in the price of health care. Were getting an improved product each year: were living longer. Thus, to correctly calculate inflation, youd have to subtract that improvement in the health-care product from any annual increase in the price of health care.
The Bureau of Labor Statistics (BLS) has been using methods like this for years to measure inflation in the cost of things like cars and computers.
The BLS performs other interesting mathematical feats when it calculates inflation, as well. For instance, the bureau measures inflation in the cost of housing not by how much the price of a home goes up but by how much the cost of renting a similar house has increased or decreased. That worked until rents and housing prices began to diverge in the 1990s. Grants Interest Rate Observer has calculated the current inflation measured by the Consumer Price Index at 2.2% using rental rates would now be 3.6% if home prices were substituted in the inflation calculation. (For another view, see MSN Money columnist Bill Fleckensteins How the government manufactures low inflation.)
A huge incentive for lower inflation estimates
Alan Greenspan doesnt have anything to do with this kind of statistical legerdemain. But you dont need to be a conspiracy theorist to imagine that a government thats running huge deficits that require constant financing would favor measures that show inflation is low.
(And the Fed chairman has apparently decided that low inflation is what hed like to be remembered for, as well. In his Feb. 25 testimony, Greenspan said his inflation goal was between 0.5% and something under 1%.)
And heres how this inflation number affects the other side of the equation. With government-measured inflation low, interest rates can stay low, and that means investors looking to increase their cash flow are facing yields of 4% on 10-year Treasuries and 0.95% on 3-month Treasury bills for a long time to come.
Which assets are squeezed the hardest?
The retirement problems that Greenspans squeeze causes will extend to investors who arent counting on Social Security to provide anything for their retirement. Id argue that the squeeze has an effect on asset classes from bonds to equities.
For example, would you buy TIPS from this government? Treasury Inflation Protected Securities pay an interest rate that goes up with inflation as measured by the Consumer Price Index. The principal value of a TIPS is also adjusted to compensate for inflation, again measured by the CPI. The U.S. Treasury will issue $40 billion to $60 billion of TIPS in 2004, up from $25 billion in 2003 -- an increase of 60% to 140%.
Would you buy high-yield bonds, affectionately known as junk bonds, when investors are being squeezed to find extra income? Maybe not. On Oct. 12, 2002, the spread -- bond-market speak for the difference between the yield on higher-risk junk bonds and Treasurys with, theoretically, no default risk -- was 10.6 percentage points. By Jan. 26, 2004, that spread had shrunk to 3.4 percentage points. Now, I know that corporate profits have been getting better. With low interest rates, companies have been able to repair their balance sheets to a degree. Yet, the difference of 3.4 percentage points between the yield on a risky junk bond and on a U.S. government Treasury seems a rather skimpy return for assuming that extra risk.
According to the models run by Martin Fridson, editor of LeverageWorld, that Jan. 26 spread between riskless debt and junk was almost 2 percentage points less than it should have been to adequately compensate for risk.
Too much cash is chasing yield
Investors, Id argue, are taking on too much risk in their search for income. Theyre bidding the prices on some securities higher than what may be prudent. And thats likely to bring pain to at least some portfolios.
Finally, if the Fed is keeping interest rates at their current 40-year lows because of the way that the federal government calculates inflation, then isnt the stock markets high valuation more of a problem than it seems? (If inflation rates were higher, the Fed would, on past evidence, be more inclined to raise interest rates to head off an inflation problem.)
Low interest rates are the major justification on Wall Street for current stock prices. The argument we hear every day is: Dont worry about statistics that show the current stock market is overvalued by past measures such as price-to-earnings ratios. This is a period of extraordinarily low interest rates. Adjusted for low interest rates, the stock market is reasonably valued.
Hmmm. Theres that adjustment thing again
Any time interested parties, whether its the government or Wall Street, start arguing for adjusting the numbers, I start to worry.
Next column: Whats the best strategy for the Greenspan squeeze and some stocks for carrying it out.
New developments on past columns
8 great blue chips youve never heard of
Never mind: Wall Street had hammered Donaldson (DCI, news, msgs) shares after the companys Feb. 12 forecast of earnings growth of 20% to 25% for the quarter that ended in January instead of the 40% investors were hoping for. After the company delivered 24% growth on Feb. 26 in its second-quarter earnings report, the Street sent the shares back up more than 12%.
The difference? Wall Street had panicked on Feb. 12, fearing that the rise in costs that had produced lower-than-expected earnings growth were permanent. But the Feb. 26 report convinced Wall Street that the problem was a temporary blip in Japan and a step up in hiring to fill higher future demand. Sales at $332 million, up 17% year-to-year, came in above Wall Street estimates even after subtracting an 8% contribution from the weaker dollar. The companys 90-day backlog of orders increased by almost 40% year-to-year. That certainly suggests that the company should be able to absorb those higher hiring costs on a bigger sales base. As of March 2, Im keeping my July 2004 target price at $68. The shares are due to split 2-for-1 on March 19. (Full disclosure: I own shares of Donaldson.)
T. Rowe Price, Stryker make Clean Stocks list
It increasingly looks like Im way, way early on this one. I added Paychex (PAYX, news, msgs) to Jubaks Picks as a triple-barreled play on (1) the economic recovery finally beginning to add jobs, (2) the continued outsourcing of back-office tasks such as payroll as companies in the United States and Europe look for ways to cut costs and (3) a rise in interest rates that would increase the interest that Paychex collects on client balances.
Well, of these three, only No. 2 is delivering as I expected. This recovery continues to create jobs at a puzzlingly low rate. And the financial markets have concluded that any rise in interest rates wont begin until the end of 2004 at the earliest. Thats quite a change from forecasts that rates would begin to climb as early as May, and its that shift in expectations that has taken a bite out of the stock most recently. On Feb. 26, Prudential Securities cut its estimate of investment revenue at Paychex for the fiscal year that ends in May 2005 by almost 18%. I think its worth holding the shares until we see what the non-farm payrolls and unemployment report on February looks like. That report will come out on Friday. But if the trend remains weak, it will be time to cut my losses on this one. (Full disclosure: I own shares of Paychex.)
Ride consumer stocks into tax-refund season
Consumers kept on spending even though their personal incomes didnt rise much in January. Total personal income grew by just 0.2% in the month -- thats down from 0.3% in December and 0.4% in November -- but disposable income climbed by 0.8% thanks to lower taxes and lower mortgage payments. The biggest drop in consumption, 3.3%, came in durable goods -- reflecting lower auto sales. The consensus among economists is that this relatively weak beginning to the quarter will be followed by increasing strength as consumers start to see tax refunds (or take quick-refund loans in anticipation of those refunds).
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Donaldson and Paychex. He does not own short positions in any stock mentioned in this column.
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