Timeless Investing Advice

John Bogle's investing advice is timeless contains solid advice about how individuals should invest for the long term.

In brief, the article extols the virtues of non-professional investors buying low cost index funds such as the S&P 500, advice with which I agree.

I've taken the liberty to break the article down into seven simple steps. Here goes.

(1) ... "With relics of American investing history framing them, some respected icons of the nation’s financial system told investors that a secure future comes from following what has worked in the past.

Their message: Straightforward, long-term investments will turn out far better than the flavor-of-the-day/week/month."

(2) ... "While much of the (investing) event was spent talking about the need for the financial-services business to act in the best interests of customers — something it all too frequently fails to do — an underlying theme was that investing should be easier than most people make it.

Caught up in the 24-hour news cycle, with talking heads tweeting stock tips and blurting out their feelings about what is happening “now’ — as if they have special insight about the current moment — consumers are too involved in the day-to-day and not nearly focused enough on the right thing.

“Too many people spend their time trying to figure out the hot stock to buy rather than spending their time trying to get their asset allocation right,” said Gus Sauter, Vanguard’s chief investment officer. “Stocks, bonds and cash … take care of that decision and the rest should go right.”"

(3) ... "The problem is that consumers always want what’s new and hot and what promises the best results, and in the financial-services world, that typically means something that manages — for awhile, at least — to buck the odds and look great, justifying the higher costs."

(4) ... "'The investor gets what he doesn’t pay for,” meaning that every dollar that doesn’t go to pay for expenses winds up with the shareholder."

(5) ... "While they advocated that average investors keep it simple, low-cost and long-term, they failed to acknowledge that the industry is heading in the opposite direction — and most consumers are going with it. . . .

It’s why money gushes out of funds where a downturn in performance leads to a lower star rating from industry research firm Morningstar Inc., but floods into funds that have gained an extra star to get an above-average rating.

The move is based on past performance — there’s no denying which fund you would want to own if you could go back in time to build a portfolio — and supported by numbers, even if there is plenty of evidence to show that investors typically move into hot issues just before they cool and bail out of beaten-down securities just before they rebound.

(6) ... “The simple thing is to set up an asset allocation, rebalance regularly, revisit your allocation decision occasionally and stick with it.”

(7) ... "Chances are that approach will work in any long-term scenario the market dishes out, but it doesn’t mean that average investors or the financial-services companies they rely on won’t try to come up with something better that is mostly more complicated, more costly and less likely to work over a lifetime."

Now you have all the investing secrets you'll ever need. Just remember to heed them.

If you do, get ready for a successful, relatively stress free, low cost and easy way to achieve long term financial security.

Thanks. Bob.

Where Our Debt Addicted Nation Is Heading ... Kablooey!?

Americans are heavily in debt. No secret there.

Too much debt tends to get us into trouble. No secret there either.

Our government is perhaps the biggest debt enabler of all. Therein may lie a small secret. If so, let's get it out in the open.

And to do that, let's review a few situations, starting with what is never a good idea--when government loans to the private sector.

Notable & Quotable quotes from economist Henry Hazlitt's 1946 book "Economics in One Lesson." My, how things have changed since then:

"There is a strange idea abroad, held by all monetary cranks, that credit is something a banker gives to a man. Credit, on the contrary, is something a man already has. He has it, perhaps, because he already has marketable assets of a greater cash value than the loan for which he is asking. Or he has it because his character and past record have earned it. He brings it into the bank with him. That is why the banker makes him the loan. The banker is not giving something for nothing. He feels assured of repayment. He is merely exchanging a more liquid form of asset or credit for a less liquid form. . . .

Now it is to A, let us say, who has credit, that the banker would make his loan. But the government goes into the lending business in a charitable frame of mind because, as we saw, it is worried about B. B cannot get a mortgage or other loans from private lenders because he does not have credit with them. He has no savings; he has no impressive record as a good farmer; he is perhaps at the moment on relief. Why not, say the advocates of government credit, make him a useful and productive member of society by lending him enough for a farm and a mule or tractor and setting him up in business?

Perhaps in an individual case it may work out all right. But it is obvious that in general the people selected by these government standards will be poorer risks than the people selected by private standards. More money will be lost by loans to them. . . . [T]he recipients of government credit will get their farms and tractors at the expense of what otherwise would have been the recipients of private credit."

Thus, Mr. Hazlitt made the point in 1946 that government lending to private businesses is inappropriate. Charitable concerns or other good intentions are not sufficient reasons for government to loan taxpayers money to private sector participants. Along those lines, Solyndra and other recent poor government "investments" come to mind.

But that's not the end of the story. Not by a long shot.

Since Hazlitt's unheeded warning of more than a half century ago, government has become the major lender to many individuals and households. Consumers, in other words.

If it's not a good idea for government to loan to businesses, and it isn't, it's an even worse idea for government to extend credit to individuals, including home buyers and students.

Meanwhile, government has now taken over the student loan business and pretty much the entire home mortgage portfolio as well. Not even business related.

These are simply loans to individual consumers which are granted or guaranteed by government.

Let's hear what another writer says about the debt dilemma in America today, much of which is now backstopped by government.

Debt, the American Way is a review of the book "Borrow: The American Way of Debt" by Louis Hyman. In it Hyman asserts that Americans have an addiction to debt:

"Americans are maxing out their credit cards again. . . . Consumers have been more willing to use credit cards for shopping . . . . Banks are lending, consumers are borrowing and China is busy making us more stuff.

Who knew getting out of an unprecedented debt crisis was this easy? Print trillions of dollars for the banks, give Wall Street speculators zero-interest loans, and run up the national debt clock to $15 trillion. . . . Whip out your credit card, if you've still got one, and enjoy it while it lasts.

{According to Hyman}, "We all know it's going to happen . . . . Interest rates have to go up, and when they do—Kablooey!" . . . .

{The book} . . . points out that while borrowing has been around for millennia, it was used to finance production, not consumption, for most of that time.

This thing we take for granted, buying houses, cars and electronic gizmos on credit, is a relatively recent development. It created the middle class we know today, but it's also destroying it. Consumer debt has crowded out business debt. {Lenders} can make more money issuing credit cards to consumers than . . . loaning money to businesses.

Indeed, the interest rates charged for many consumer loans used to be prosecuted as criminal offenses."

Discussion and Analysis

In 1946 Hazlitt's book persuasively argued that government should stay out of lending to businesses.

In a similar vein today, Hyman concludes that our economic woes won't end until government policy changes and government gets out of the lending business entirely.

Unlike the old days, government loans today are often to consumers who represent poor credit risks.

Government needs to get out of the way and allow private sector lenders to get on with loaning responsibly to private sector business borrowers and consumers as well.

And private sector lenders shouldn't be rewarded or kept from losing money when they make consumer loans to those who later prove unable to service those loans.

As for government, it should refrain from making any loans at all, since it has no business expertise, no skin in the game and merely passes on the effects of bad lending to unsuspecting taxpayers.

The central point is simple and straightforward. If borrowed capital is invested in businesses that will use it to create good jobs, then people will require less credit to buy the things they consume.

"Debt, the American Way" summarizes its position on consumer credit cards as follows:

"Our grandparents would have never imagined taking out a loan for a bite to eat. Anyone who charges a pizza and doesn't pay off the balance at the end of the month eats debt for dinner.

Americans do not need to eat like this. They need jobs. But the great allocators of capital known as Wall Street would rather keep flipping debt-backed securities. And the great drivers of the U.S. economy known as consumers are increasingly stuck with low-paying jobs and high-interest credit cards."

Summing Up

Our collective financial illiteracy and tendency to borrow excessively and irresponsibly is truly destructive. Too many individuals, households and government entities fail to understand the risks they're undertaking at the time of borrowing.

As a result, too many of us assume the responsibility to service debts we should have avoided but didn't, and only because we weren't sufficiently knowledgeable about matters relating to debt.

For that matter, as a nation we need to get a grip about community and state finances as well, along with our country's debt service obligations as a whole.

Meanwhile, politicians through government programs such as cash for clunkers and rebates for home buying and such continue to encourage imprudent borrowing by individual households and government, too.

We the People need to internalize that government can't bail us out of our poor financial decisions, even if the politicians say otherwise.

Most borrowing is best left to the producers and should be used only sparingly by consumers.

And that's the plain and simple truth.

Thanks. Bob.

Structural Employment Issues ... The "Guy Rate" and What Looks Like a Long Slog Ahead

Fed Chairman Ben Bernanke believes our U.S. high unemployment issues are more cyclical in nature than structural.

He admits, however, that nobody knows for sure and that in any event, it's a close call. While I hope he's right, I think he's wrong.

First, let's review some facts contained in an article about the number of full time U.S. male workers in the age group 25-54. In What Does Bernanke Know?, a most interesting chart appears and sheds some light on the subject of cyclical versus structural:

"There are many reasons to distrust the unemployment figures. The most obvious is that those who give up looking for work no longer count among the official "unemployment." (Extraordinary, but true.)

But we know Ben Bernanke looks at the raw data.

What is he seeing? . . .

The chart focuses on just one simple number: The percentage of adult men, age between 25 and 54, who are in full-time work.

Let's call it "the Guy Rate."

It's not a perfect measure of the jobs market, but it's a key one and it cuts out a lot of noise. It ignores most kids in grad school, early retirees, and new mothers who choose to stay at home. It counts as unemployed a former $80,000 a year machinist who has given up looking for work. It also counts the one who is still stuck working one night shift a week at his local Shell station.

It focuses only on men of prime working age, it counts all of them, and then deducts only those who are in full-time work. . . ."

My take is straightforward. Based on only that one simple chart above, it's evident that our unemployment problem today may indeed be more structural than cyclical. And if that's the case, what's changed? Let's look closer.

In Fed Signals Resolve on Rates, Mr. Bernanke admits that while he still believes it's a cyclical problem, there's considerable room for debate:

"The Fed chairman took on some thorny economic issues in making his case for low rates. Among them is the question of whether the nation's still-high unemployment rate represented a so-called cyclical problem that can be resolved simply by encouraging economic growth with low interest rates, or a fundamental structural problem in the labor markets that growth itself and the Fed can't fix.

Mr. Bernanke came down on the side of those who argue the problem is predominantly cyclical and low interest-rate policies are helping to alleviate it. But many economists disagree with him, and he acknowledged the matter isn't settled.

The debate about cyclical and structural unemployment has been going on for a couple of years. Economists generally say cyclical unemployment is caused when weakness in the overall economy pushes down demand for goods and services and therefore the need for workers that provide them. Structural unemployment reflects deeper problems, such as a gap between the skills workers have and those that employers want. Structural problems don't necessarily disappear as the economic recovery gains traction.

Mr. Bernanke—in making his case for primarily cyclical unemployment—pointed out that newly unemployed workers and long-term unemployed workers all experienced diminished prospects of getting new jobs during and after the downturn. That suggests the job market hasn't punished one group of people disproportionately to others. Instead, he said, there weren't enough jobs for a wide range of workers in a wide range of industries. "The fact that labor demand appears weak in most industries and locations is suggestive of a general shortfall of aggregate demand, rather than a worsening mismatch of skills and jobs," he said.

But some economists disagree and the stakes are high. "You could be seeing a policy error in the making," said Wells Fargo economist John Silvia, who lists an array of factors that he says point to structural problems in the job market, which he says faster economic growth can't resolve.

Employment of college graduates is up 5.8% in this recovery, while employment of high school dropouts is down 3.9%, according to Labor Department data. This suggests that low-skill workers are having a harder time finding work."

Summing Up

Contrary to Fed Chairman Bernanke, I believe that our economy is undergoing fundamental structural change. And with respect to employment, both the manufacturing and construction sectors will employ relatively fewer U.S. workers in the future than they have in past decades, as will all levels of government.

Continuing improvements in information technology will lead to ongoing large productivity gains, and lower credit card and home mortgage related debt levels will restrict construction related activity

All these things will limit future employment gains, especially for the lower skilled. Finally, increasing low wage competition from an expanding global work force will make job gains and pay levels more difficult for lesser skilled workers as well.

In the end, of course, competition and markets for goods and services, as well as labor, will dictate who works in which sectors, how many work, and often where that work will be done, along with how much those workers will be paid.

Union leaders will do all they can to interfere with this fundamental and necessary adjustment process, and many politicians will come to the short term aid of organized labor officials. In the end, however, markets will set the prices and the acceptable productivity adjusted real cost of labor as well.

Knowledge workers will be much more important to U.S. employment levels than they have been in the past. However, unskilled and semi-skilled workers will have a tougher time finding employment. Education and knowledge will be the keys to future employment.

The longer we collectively take to recognize the simple fact that knowledge will be the key to the future, the longer it will take to get back what used to called "normal" rates of unemployment.

Simply put, knowledge workers will comprise the heart of the future American workforce.

As a result, we could well be in for several years of relatively high unemployment, even as the U.S. economy demonstrates more resilience and near term strength than the rest of the developed world.

We'll get there in the end, but first we have to get started.

Thanks. Bob.

More On Owning Stocks vs. Bonds ... Stay Away From Investment Advisors

The best way to keep more of what we earn is to spend less of those earnings.

Today's discussion topic concerns how much we waste needlessly on paying financial intermediaries, aka investment advisors, for what frequently are non-value added or even value subtracting services. Think OPM versus MOM and all that entails.

As an example, let's assume that we have $100 to invest and that the $100 investment is placed 50% in fixed income (cash and bonds) and 50% in stocks. We'll further assume that we have retained an investment advisor and agreed to pay that advisor annually 1% of the assets under management.

Since we have $100 in assets, we pay the advisor $1 annually. That doesn't seem like much, but let's look closer. Actually, it's a waste of money, and perhaps worse than that.

We'll further note that we could instead have elected to buy the bonds or keep the cash ourselves, so we're really paying the advisor 2% annually to manage the stock portion of our investment portfolio.

If our $50 invested in stocks earns an average 8% annually, we'll earn $4 on the stock portion of the portfolio. If we pay the advisor $1 annually, we're paying him a 25% commission on the stocks' earnings. And that $1 will represent 67% of the $1.50 in cash dividends received, assuming our stocks' average dividend yield is 3%. But it's even worse than that.

It's worse because most advisors simply don't add any market beating value to the portfolio's performance. The investment returns don't even keep pace with a random selection of stocks.

"A Random Walk Down Wall Street" is a famous book on investing by Burton Malkiel, economics professor at Princeton University. Therein Mr. Malkiel argues that a passive strategy of individual investing generally beats an active "professionally managed" investment approach.

Accordingly, Malkiel advocates not using investment advisors, since they generally add no value to returns for individual investors.

In other words, when we hire investment advisors, we end up paying approximately 25% of our earnings for no reason.

In essence, we're paying the financial "experts" to do nothing but take our money. Accordingly, the best way to improve a stock portfolio's performance would be to eliminate the costly "professional" advice.

But what to do? Here's what. Learn to manage your assets yourself, and you can always get started with the help of someone older and more experienced who has managed a self directed portfolio. If that person is trying to be helpful, he won't charge you a nickel for sharing his experiences and offering aid. By charging you zero, he'll prove he's in it just to help. Maybe there is such a thing as a free lunch.

In that regard, What Does The Prudent Investor Do Now? is a timely editorial by Burton Malkiel about the relative attractiveness of self investing in stocks, bonds and real estate today. Here's what he says:

"The economic news has certainly improved in recent weeks. . . .

In short, the chances of a self-sustaining recovery have improved—a "virtuous cycle" where increased employment leads to better consumer sentiment, stronger sales, and continued increases in employment.

But let's not uncork the champagne quite yet. . . . Rising gasoline prices will put increased pressure on consumers. And a number of strong economic headwinds still exist.

The economies of the euro zone are getting worse, not better. The housing sector has yet to make a convincing turn for the better, and the economic data, as a whole, suggest the economy is growing at a rate nearer to 2% rather than its previous trend rate of 3%-4%. The realistic conclusion for investors should be "Yes, things are better, but we still have a long way to go."

Given the present economic outlook, what is the best strategy for investors? Let's look at three asset classes in reverse order. I will rank them from worst to best.

Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.

Even if the overall inflation rate is only 2.25% over the next decade, an investor who holds a 10-year Treasury until maturity will realize a zero real (after-inflation) return. If the investor sells prior to maturity, it will likely be for less than the face value of the note if the inflation rate rises.

Even if the inflation rate remains moderate, interest rates are likely to rise to more normal levels as the economy continues to recover. Investors with long memories should recall that over the entire period from the 1940s until 1980, bonds were a horrible place to be. Given the likely trends, U.S. Treasurys and high quality bonds are likely to be extremely poor investments and are very risky.

Equities on the other hand are still attractively priced, despite their substantial rise from the October 2011 lows. A good way to estimate the likely long-run rate of return from common stocks is to add today's dividend yield (around 2%) to the long-run growth of nominal corporate earnings (around 5%).

This calculation would suggest that long-run equity returns will be about 7%—five percentage points more than the safest bonds. This five-percentage point equity risk premium is close to the historical average. . . .

Real estate is a particularly attractive asset class. Investors who are currently renting the place in which they live should strongly consider buying.

Real-estate prices have fallen sharply, if not to their absolute lows, then certainly very near to them. Long-term mortgages are below 4% for those who can qualify. Housing affordability (a measure based on house prices and mortgage rates) has never been more attractive. Moreover, under present tax laws there are advantages to owning since mortgage interest is deductible and rent is not.

Too many people invest with a rearview mirror. Housing has been a dreadful investment since the housing bubble burst in 2007. I believe it will be one of the best investments over the next decade. . . .

In today's environment, the minimization of investment fees is more important than ever. A 1% investment management fee may appear to be very low when measured against assets. But when measured against a 7% equity return, that fee represents more than 14% of the return. Against a 2% dividend yield, the fee absorbs one half of the dividend income.

And measured against the mediocre return of the typical actively-managed equity fund compared to lower-cost, broad-based index funds and ETFs, management fees can be very high indeed. (During 2011, over 80% of actively-managed equity funds were outperformed by the broad-based S&P 1500 Stock Index.) Despite the considerable economies of scale that characterize the investment management business, the annual management fees charged to mutual-fund investors have not declined over time. Investors can't control returns offered by the U.S. and world financial markets. But the one thing they can control is fees paid to investment managers.

The only way to ensure that you can enjoy top quartile investment returns is to choose investment funds that have bottom quartile expense ratios. And, of course, the quintessential low-expense instruments are broad-based, indexed mutual funds and ETFs."

The Bottom Line

Makes sense to me. Increase your investment earnings by one third by reducing wasted expenses by 25%.

And gain some much needed knowledge about finance in the process of doing so.

And perhaps the best part of all is that the knowledge gained will come in helpful in countless other ways.

All at no cost.

Thanks. Bob.

Dividends Projected to Rise 15% in 2012 ... Still Room to Grow

Cash dividends historically have provided as much as 50% of a company's total return.

This year dividends are being increased substantially as companies have bounced back from the depths of the recent deep recession. Let's review why the outlook for further dividend growth is still quite strong.

Dividend Investors to Get 15% Raise is a hopeful look at what's ahead for increasing cash dividend payments to shareholders:

"The dollar amount of dividend payments underlying the S&P 500-stock index should increase 15% this year . . . .

That number might prove conservative.

It takes into account dividend boosts that have already been announced, as well as anticipated announcements from companies with a long history of raising payments. It also includes Apple’s newly announced payment, which will take effect beginning in the second half of 2012.

However, the estimate doesn’t include the possibility that other cash-stuffed technology firms will follow Apple’s (AAPL) lead and announce payments....

Banks could provide even more upside . . . . Historically large dividend payers, they slashed their dividends during the recent financial crisis but are gradually restoring them. Financial companies contribute 13% of S&P 500 dividends now, up from a low of 9% in 2009 and 2010 but well below the 29% they contributed in 2007. It’s difficult to predict when banks will restore their dividends, and (S&P analyst) isn’t counting on a normalization of bank dividends in his analysis.

Dividend increases hold several forms of appeal for investors. Some make stock prices jump right away; Apple rose 2.7% Monday. Rising dividends are also linked with share price increases over the long term, because they attract more attention from income investors.

Companies that raise their dividends are more likely than others to deliver greater-than-expected earnings in subsequent quarters . . . .

Three things bode well for long-term dividend growth . . . . First, companies are aware of increased investor demand for yield. . . . Second, despite a record 22 new dividends announced by S&P 500 companies last year, only 397 of the 500 now pay dividends, versus an average since 1980 of 413.

Third, dividend payments as a percentage of company profits now stand at about 30%, versus a historical average of 52%.

There are some wild cards to look out for, however. Safe-haven bonds have recently offered a pay raise of their own–because bond prices have fallen, pushing yields higher. The 10-year Treasury yield recently approached 2.4%, versus 1.9% at the start of 2012.

If that trend continues, it could lure investors away from dividend-paying stocks, and make companies less keen on boosting payments. That seems unlikely, if only because the Federal Reserve said in January it plans to keep core interest rates “extraordinarily low” through 2014.

A larger obstacle could be taxes. The dividend tax rate is currently capped at 15%, but the cap expires at the end of this year. Without action from Congress, the maximum dividend tax rate will revert to 39.6%. If that were to happen, it might cause more companies to favor share repurchases over dividends, because the former don’t trigger taxes for investors. Or, it might cause companies to continue holding onto their profits.

For now, a 15% increase in dividend spending is welcome news, especially among working investors who are finding it difficult to secure pay raises. Average hourly earnings for workers have increased just 1.9% over the past year, while inflation has raised the cost of living by 2.9%."

Discussion and Analysis

A one time 15% raise is pretty good. A 7% raise each year is perhaps even better. And being granted a one time catch-up raise is always a nice surprise.

Compared to fixed income investments today, companies that demonstrate solid earnings and are able to pay increasing cash dividends to their shareholders are great investments.

In other words, today the cash dividends of a company frequently make the case that owning an individual stock for the long haul is a great idea. Let me explain.

Dividends are paid from a company's earnings, as is the interest on bonds.

If earnings grow at a compound rate of 7% over time, the rule of 72 posits that earnings will double approximately every decade. As go earnings, so go dividends as well.

Currently cash dividends paid by many blue chip companies yield ~3% in relation to the company's share price.

Assuming a 30 year investing horizon, that 3% will become 24% in 30 years.

There's more.

Today companies are only paying 30% of company profits in dividends compared to a historical average of 52%.

And today earnings are below historical peaks in many companies as well.

Thus, our aforesaid 24% yield on cost in 30 years could easily be more than 50% as either (1) earnings revert to the mean, (2) cash dividends paid as a percentage of earnings revert to the mean or (3) earnings compound at a faster rate than 7% annually for specific companies.

But even if none of the above occurs, compared to bond yields, a 24% cash return on an initial investment is a whopper.

And we haven't even factored in the company's inflation adjusted share price appreciation.

Thus, why would anybody buy bonds?

Why not instead buy and hold shares of solid companies that have a track record of earnings and an ability to pay solid dividends as earnings increase?

Thanks. Bob.

ObamaCare and Medicaid ... The Real Story

This week the Supreme Court is hearing arguments about the constitutionality of the Affordable Care Act, aka ObamaCare. It is expected to render its decision in June.

Most of the attention has been centered around the individual mandate's constitutionality and the authority of government to in effect require younger people to buy health insurance.

But today let's discuss Medicaid and the broader implications of such costly federal-state "voluntary" programs.

My conclusion about the financial effects is the following: These participative federal-state programs, including Medicaid, always cost much more than initially projected, waste enormous amounts of taxpayer money and their stated voluntary nature is a sham. States realistically have no choice--they're in effect forced to participate on the terms dictated by the federal government.

ObamaCare's Flawed Economic Foundations says this about the law's "voluntary" program with respect to states expanding Medicaid eligibility and benefits:

"Consider also the health law's expansion of Medicaid. . . . an expenditure of federal funds is unconstitutional when it coerces states rather than encouraging them to participate in a federal policy. And coercion is the essence of ObamaCare's Medicaid provisions.

ObamaCare transforms Medicaid from a health-care program for impoverished and special-needs groups such as the disabled, into a mandatory federal entitlement—effectively obligatory on both the states and beneficiaries alike—that reaches even working adults whose incomes fall well above the poverty level.

The states are in no realistic position to say no. Consider what would happen if the states had declined to take federal Medicaid funds in 2009. Making up the difference to pay for their own Medicaid patients would mean increasing their budgets by 22.5%. Expressed another way, federal Medicaid spending represents an even more imposing 34.4% of taxes collected by the states nationwide. If states withdrew from Medicaid, the rise in uncompensated care would drive many providers out of business. . . .

The individual mandate and Medicaid expansions appear to many to be unconstitutional. They are certainly bad economic policy. . . . The administration built an intricate, balanced policy on a flawed economic foundation."

States Get Medicaid Rules is another timely article about the Medicaid issue:

"The Medicaid expansion . . . calls for adding 17 million or more additional people to the Medicaid program in the next decade. The plaintiffs, who include attorneys general and governors from 26 states, contend the federal government is forcing them to take on expensive new responsibilities that they can't afford. . . .

Medicaid allows states to set up their own systems to provide health care for the poor, under rules set by the federal government and supplemented by state laws. The federal government usually matches every dollar a state spends on the program with another dollar, and sometimes more. Most states currently only cover poor families with children.

Supporters of the health-care law point out that the federal government will pick up 100% of the costs of the Medicaid expansion for the first few years after 2014, and 90% after that. They also say states are free to leave the program if they choose, and that states can't take federal money for Medicaid and ignore rules for how it can be spent.

Opponents of the law say that, with increasing pressure on state budgets, of which Medicaid is usually the largest share, even that 10% contribution could be too much to bear. They say states can't truly exit from the program entirely because they have come to depend on it. . . .

On average, the federal government contributes about 56% of the money for Medicaid, and the states pay the remaining 44%, experts say. All 50 states participate, with Arizona being the last to join, in 1982. None has left the program, though some have threatened to do so.

The states in the lawsuit, led by Florida, argue the federal government is intruding on states' autonomy by requiring them to cooperate with the new Medicaid expansion or risk losing all federal dollars for their existing programs. They say the federal government is using its spending powers to coerce them into implementing the overhaul.

Tim Jost, a professor of health law at Washington and Lee University, said a federal court had never struck down a statute on the grounds that it was illegally coercive, and noted that previous expansions of the Medicaid program had gone unchallenged by the states."

Discussion and Analysis

In my view, the Supreme Court may or may not overturn ObamaCare. It's too close to call.

That said, we'll continue to hope for the best while preparing for the worst. But now let's discuss the broader implications of federal "coercion" of states and what this means to taxpayers.

Medicaid financing is roughly a 50/50 spending split between the national and state governments. To receive the federal government's 50 cents, individual states have to accept the conditions stipulated by the federal government.

And if a state should ever choose not to agree to the federal conditions, that state won't get the 50 cents, even though in all likelihood it will continue to spend its own 50 cents to assist those in need. In addition, the state's citizens' tax bills won't change.

In other words, the feds will give the state 50 cents or nothing to assist that state financially in meeting the needs of its poor, including many nursing home patients as well. However, that state's taxpayers will have to continue to pay the same amount of federal taxes, no matter what the state "chooses" to do.

As a practical matter, this is pure and simple coercion. The state has no choice at all.

So the state proceeds to spend more money than it otherwise would, and its taxpayers get the bill. The bill to the state's taxpayers effectively totals $1, representing both state and federal spending on Medicaid, since the feds have no money of their own.

So are the Medicaid rules, both old and new, coercive? Of course they are.

Are they wasteful? Of course they are.

Will future costs be higher than estimated? Of course they will.

The newest Medicaid expansion under ObamaCare specifies that the federal government will pick up 100% of the costs the first few years and 90% thereafter. But the federal government has no money of its own. And when the actual costs end up being higher than predicted, we taxpayers will pay the bill. That's how the "system" works.

Will this expensive silliness ever end? Well, let's hope the Supreme Court surprises us and embraces again the idea of a federalist system of representative but limited government.

In any event, We the People will always have the last say. Through the ballot box, if nowhere else.

In America, the court of public opinion is the court that matters most.

Thanks. Bob.

ObamaCare's Constitutionality ... Does It Really Matter?

The Supreme Court will hear arguments about the constitutionality of the Affordable Care Act, aka ObamaCare, beginning tomorrow.

If you'd like to read about the legal arguments supporting a ruling on its unconstitutionality, please see The Supreme Court Weighs ObamaCare, an editorial written by the lawyers representing the 26 states challenging the legislation.

The critical part of the editorial is the following:

"ObamaCare mandates that every American, with a few narrow exceptions, have a congressionally defined minimum level of health-insurance coverage. Noncompliance brings a substantial monetary penalty. The ultimate purpose of this "individual mandate" is to force young and healthy middle-class workers to subsidize those who need more coverage.

Congress could have achieved this wealth transfer in perfectly constitutional ways. It could simply have imposed new taxes to pay for a national health system. But that would have come with a huge political price tag that neither Congress nor the President was prepared to pay.

Instead, Congress adopted the individual mandate, invoking its power to regulate interstate commerce. The uninsured, it reasoned, still use health services (for which some do not pay) and therefore have an impact on commerce, which Congress can regulate.

Congress's reliance on the Commerce Clause to support the individual mandate was politically expedient but constitutionally deficient. Congress's power to regulate interstate commerce is broad but not limitless."

In simple terms, had the Congress chosen to tax us in order to pass national health care legislation, it could have done so. But its members didn't do that, because they feared the reaction of We the People to new taxes. So they set out to achieve indirectly that which they couldn't accomplish directly. Now We the People have ObamaCare, and the Supreme Court has a most important issue to decide.

Simply because Congress elected not to use the taxing power of the government when passing ObamaCare, there's a serious constitutional question for the Court to decide. My point herein isn't to make a legal argument for or against ObamaCare.

Instead it's to call attention to the fact that although higher taxes are always unpopular, in the end We the People have to pay for the legislation enacted by Congress. There's no free lunch.

Congress knows that, so members chose to use a legalistic maneuver to get a national health care program passed. In other words, they opted to do indirectly that which wouldn't pass muster directly with We the People. And they sold it as one more free lunch. Nonsense.

Here's another related question. Since most people like Medicare, and it's supported by taxation, why wouldn't we be willing to pay a direct tax to get national health care? Here's my guesstimate about a possible answer.

Although it wasn't initially advertised as such, Medicare has turned out to be pretty much a 3-fer free lunch. For every three dollars in benefits received, seniors pay about one dollar. Hence, the tax to individuals is far below the program's cost.

So what should Congress have done when legislating ObamaCare? First, they should have asked working people to agree to triple Medicare "contributions." Second, they should have told us that we'd need to pay a sufficient amount in "contributions" to pay for the full costs of a new national health care program. {Government likes to call taxes contributions, as in "contributions" for our Social Security "insurance."} Back to the story.

Since members of Congress knew that higher taxes wouldn't fly, they decided that ObamaCare would be about regulating interstate commerce and not taxation. At the same time, they also made up a whopper about the ObamaCare program being self supporting financially. Of course, it's not.

An editorial by Republican Senator Johnson of Wisconsin makes the point about government's cost estimating ability with respect to ObamaCare's probable costs compared to projections in Obama Care's Costs Are Soaring:

"This would not be the first time a government program exceeded its projected cost. When Medicare was passed in 1965, for example, the federal government estimated it would cost $12 billion in 1990. Medicare actually cost $110 billion in 1990."

Yes, within 25 years Medicare's actual costs were almost ten times higher than predicted originally. And we haven't tackled them yet.

Who knows what ObamaCare will cost 25 years from now? Ten times its projected amount? And what will we then to do about it. Based on Medicare's history, not much.

Summing Up

And that's the main idea of this post. Whether ObamaCare is found to be constitutional or not, we have to face our very big problems with the cost of health care and other government entitlement programs. And we must address the runaway costs of Medicare and Medicaid as well.

Congress and the President are often seriously off base when predicting the costs and benefits associated with new legislation. They always miss to the downside. Are they lying? You decide.

Are We the People effectively monitoring the situation to make sure we're getting our money's worth and not burdening future generations with our mistakes? Not based on our Medicare experience.

Sadly, the following scenario has been the all too common experience of entitlement legislation.

(1) Even though costs may explode to the high side after a law's passage, by then the damage has been done and there's little chance of a reversal at the legislative level.

(2) So we hope the Supreme Court will bail us out, but generally they defer to the legislature and leave the issue of the legislation's repeal up to us.

(3) They reason that if We the People don't like the law or the legislators, we have the power to make the necessary changes to both.

(4) People don't like to have their taxes increased, so Congress tries to avoid tax hikes whenever possible.

(5) Debt and deficits grow.

Article I, Section 8 of the Constitution gives Congress the express power both to tax people and to regulate commerce between the states. A truth telling straight shooting Congress could have used its taxing power to enact ObamaCare. Then taxpayers could have decided whether it was a good idea or not.

Meanwhile, we know that taxpayers like Medicare when it costs us one third of its true costs. What we don't know is how much we'd like it if we had to pay for it in its entirety.

What happens to ObamaCare at the Supreme Court won't be nearly as important as what We the People do about facing up to these after-the fact huge and unplanned costs associated with government entitlement programs.

Thanks. Bob.

ObamaCare's Constitutionality and Federalism

Monday the Supreme Court begins three days of listening to opposing arguments about the constitutionality of what's commonly referred to as ObamaCare.

We'll also spend the next few days discussing the matter and what the decision may portend for the future of our unique American federalist system of government.

Although most pundits will declare the Court's ultimate decision in this case to be either the end of the world or its bright new beginning, we'll make a serious effort herein to keep both feet firmly planted on the ground and view all this in its proper perspective.

When these 'once in a lifetime' events occur every so often, it's appropriate to acknowledge an old aphorism: when things turn out great (meaning the way we want them to, of course), things really aren't all that great; and when things turn out bad (our team loses), things really aren't all bad either.

Thus, whatever the Supreme Court decides with respect to ObamaCare, the sun won't disappear forever and neither will our many problems go away overnight. So with that simple truism in mind, here goes with the guesstimating.

My bet is the Court will decide by a 5 to 4 decision to either uphold or strike down the new law. Although I have no strong conviction about what looks like a very close call, if I had to bet, I'd bet for its consitutionality being affirmed. That said, I certainly won't be surprised if it's a 5 to 4 decision striking down the law. What would surprise me is a unanimous or near unanimous decision either way.

Using common sense, which admittedly isn't always employed these days, the law should be ruled unconstitutional as written. Congress should have used its taxing power instead. Of course, Congress and the President reasoned that We the People wouldn't have approved that taxation approach, so they instead pulled a fast one on us and used the Commerce Clause in justifying their actions. For that reason alone, the law should be rejected.

That said, The Court is always reluctant to overrule the legislature (separation of powers), and this time will be no exception. They may say it's a political question, and that We the People can get it changed at the ballot box or by pressuring our elected representatives if we so desire, and therefore don't need the help of the Supreme Court. Still, I hope the nine members of the Court, or at least five of them, gut up and do the right thing on their own initiative. We'll see.

The Commerce Clause (Article I, Section 8), upon which ObamaCare is justified, is all about interstate commerce, and much of the new health law has nothing to do with relations between the several states. However, it is true that the Commerce Clause has been used over the years to legitimize many things at the national level which on their face didn't involve interstate commerce.

In any event, one fundamental question before the Court concerns the 'individual mandate' and whether Congress can require a person to purchase health insurance pursuant to its powers enumerated in the Commerce Clause. Had it so chosen, Congress could have avoided that issue entirely and used its taxing power instead of the Commerce Clause. But it didn't do that. Why not?

To repeat, Congress could have chosen to justify its actions by using its taxing authority but didn't. That it chose not to do so is clear evidence, at least to me, that it knew citizens wouldn't approve of a national health care law.

Therefore, the very idea of Federalism is at stake, as is the power of the national government. If you're interested, Federalist papers #45 and #46 by James Madison speak directly to the powers of the national and state governments as intended by the Founding Fathers. He saw the the state powers as greater than those of the national government and argued that acting in the best interests of the people was all that really mattered. My, how things have changed in just a short 224 years!

Romney's Health-Care Duck is a good read for an understanding of how federalism works best. Here's a sampling:

"The more conservatives have been forced to think about health care, the more they've understood the merits of state experimentation. Jim Stergios, executive director of the Pioneer Institute—a free-market think tank in Boston that has published a book on ObamaCare and RomneyCare titled "The Great Experiment: The States, the Feds, and Your Health Care"—argued in a recent conversation that the fundamental mistake of ObamaCare was in imposing a giant, untested law on an unwilling nation.

He contrasts this to the 1990s welfare reform, which came only after 20 years of state experimentation. By the time the federal law was passed, politicians on both sides of the aisle, he says, had come to a sort of "settlement" as to what generally worked. "The Great Experiment" argues that the GOP "alternative" to ObamaCare needs to be federal steps that give states the maximum flexibility to innovate and experiment with free-market health care.

Mr. Romney's health-care proposals embrace some of this, in particular his Paul Ryan-like plan to send Medicaid funds back the states via block grants. What he has yet to do is embrace Massachusetts as a lesson for what other states ought not to do.

This needn't be an exercise in humiliation. Mr. Romney can take credit for being a Republican willing to talk about health care when most of his party wouldn't. He can argue the mistakes Massachusetts made were one consequence of it being early to experiment. He can note, as the Pioneer Institute book does, that several programs he had intended to improve choice and competition, were instead hijacked by his Democratic successor, Deval Patrick, for the opposite purpose.

Mostly, Mr. Romney can argue he is better qualified than most to say what doesn't work. He can note that several of his vetoes in the bill that his legislature overrode—an employer mandate, expanded option benefits for Medicaid recipients—have been proven costly and counterproductive. He can say that, best intentions aside, his state is now living proof that individual mandates, health subsidies for the middle class, and government control over insurance plans, medical services, and prices (all hallmarks of ObamaCare) raise prices and squelch choice.

Mr. Romney has admitted that "our experiment wasn't perfect—some things worked, some things didn't, and some things I'd change." Having acknowledged as much, he may as well embrace his duck, and use it to his advantage. If Mr. Romney is looking for a breakthrough with voters, this is the place to start."

Another worthwhile read is Liberty and ObamaCare, especially if you want a good overview of the Commerce Clause, its background and how it's been interpreted by the Supreme Court throughout history. It highlights the importance of the case before the Court in this way:

"Few legal cases in the modern era are as consequential, or as defining, as the challenges to the Patient Protection and Affordable Care Act that the Supreme Court hears beginning Monday. The powers that the Obama Administration is claiming change the structure of the American government as it has existed for 225 years. Thus has the health-care law provoked an unprecedented and unnecessary constitutional showdown that endangers individual liberty.

It is a remarkable moment. The High Court has scheduled the longest oral arguments in nearly a half-century: five and a half hours, spread over three days. Yet Democrats, the liberal legal establishment and the press corps spent most of 2010 and 2011 deriding the government of limited and enumerated powers of Article I as a quaint artifact of the 18th century. Now even President Obama and his staff seem to grasp their constitutional gamble."

Summing Up

Federalism indicates that the scientific method, aka trial and error, is an inherent part of our nation's DNA.

Having the freedom through experimentation to discover what works and what doesn't encourages both states and individuals to try various approaches and then adopt the best practices.

Learning by doing is a powerful way of acquiring knowledge and continually improving.

We seem to have lost that simple idea somewhere along the road to modernity.

Another thing we've lost is the humility within leadership to admit mistakes, learn from them, make adjustments and then try again.

And politics has become a game rather than a public service.

The vote on ObamaCare's constitutionality will likely be 5 to 4 one way or the other. That's not what's most important.

What is most important is what we do about our self governing society and how it works.

Whatever the ruling, health care has to become affordable.

And as a nation, we must accept the simple fact that we need to live within our means while providing opportunity for all.

Federalism was a wonderful gift from our Founding Fathers.

The interests and freedoms of We the People must always come first.

American federalism is an idea that has no equal. We should embrace it again.

Let's hope our Supreme Court, political leadership and We the People decide real soon to do just that.

Thanks. Bob.

Pension Investment Funding ... More Cash Contributions or More Stocks?

Interest rates are low. Thus, income on bonds will remain low as well.

That in turn presents an extremely difficult problem for many pension plan sponsors. First, some background.

If bonds earn 5%, that's a whole lot better for an investor than today's 2.5% rate. Twice as much.

And if stocks earn 4%/5% more than bonds, which they generally do, inflation adjusted stock returns will remain constant whether interest rates and inflation move up or down. But that's not the case with nominal returns.

Pension plan sponsors and their actuaries often assume that invested funds will earn a blended average of 8% over time. This includes an investment mix of stocks and bonds.

{NOTE: Frequently the model used by plans assumes an average annual return for bonds of ~5%, and ~10% for stocks. With 40% of the assets invested in bonds and 60% in stocks, that results in an overall return for the entire portfolio of 8%. On the other hand, if bonds earn ~3% and stocks earn ~8%, that same 40/60 mix yields a return of ~6%.}

Since inflation is quite low today, interest rates are low, too. Government policy has helped create low rates as well. Thus, bonds aren't earning anywhere close to 5% and, of course, stocks are having their problems as well. Hence, the 8% assumption is under heavy scrutiny.

To reiterate, stocks often return ~4%/5% more than the yield on bonds. That makes the 8% overall return assumption not credible today unless inflation and interest rates increase substantially. And the Federal Reserve certainly doesn't want higher interest rates as the economy stays weak. Thus, rates should remain well below their historical averages for at least several more years.

For pension plan sponsors, the difference in cash funding requirements between an assumed and actual 6% and 8% annual average investment return is dramatic. Let's look closer at exactly what this means.

Calpers Lowers Investment Target to 7.5% says this about the nation's biggest pension fund's investment dilemma:

"Calpers lowered a crucial investment target for the first time in nine years in a widely watched move that will add millions of dollars in retirement costs to the state of California, its schools and county agencies.

In a voice vote, the board overseeing the California Public Employees' Retirement System approved lowering the giant pension fund's assumed rate of return to 7.5% from 7.75%.

Wednesday's decision follows a recommendation by a key Calpers committee and the pension system's chief actuary to lower the rate to reflect lower inflation expectations.

Diminishing Returns

Compare assumed rates of return among some public pension plans.

View Interactive

The move, the first by Calpers since 2003, is likely to put pressure on pension officials in other states to lower their investment assumptions. Pension funds across the U.S. have been criticized for using unrealistic investment assumptions, which proved costly during the financial crisis.

Public pension funds such as Calpers use their assumed rates of return to calculate the present value of future retirement benefits and how much money participants need to contribute to pay for them.

Related Reading

• Earlier: Calpers May Cut Target Return

By lowering the so-called discount rate, Calpers could ask the state to eventually contribute an additional $300 million annually. The pension board asked the staff to come up with a plan to phase in the increased contributions from state and other government agencies over the next two years to help soften the financial blow.

Concerns about the fallout from a lower investment target snarled discussions among pension officials in Minnesota on Tuesday night. The Minnesota Legislative Commission on Pensions & Retirement put off a decision for a week on whether to recommend lowering the state retirement system's 8.5% assumed rate of return. Minnesota's rate is among the highest in the nation."

Now let's see about Japan's similar dilemma. Tale of Trouble at Japan Pension Funds summarizes the Japanese pension funding issue:

"TOKYO—Most of the pension plans set up by groups of small businesses in Japan are under water, the latest data from the health ministry shows, even as the burden of future payouts grows in step with the aging of the country's population. . . .

About 75% of the nearly 600 pension funds in Japan set up by small businesses in sectors like transportation, construction and textiles didn't have enough assets to cover expected payouts in 2010, according to Japan's Ministry of Health, Labor and Welfare. That percentage shot up from just 7% in 2006, as markets reeled from the global financial crisis of 2008 and subsequent years of downturns. . . .

The problem, pension-industry trackers say, is that many of these funds are managing money their employees have paid into government pension plans that guarantee returns of 5.5%. Management of the money was transferred to the funds in the 1990s, when markets were booming, but the 5.5% guarantees remain in place.

Yet traditional investments like stocks and bonds now return much less than that. Between 2006 and 2010, the Nikkei 225 Stock Average fell 37%, and the yield on 10-year Japanese government bonds slid to 0.8% from more than 2%. The yield on 10-year government debt is now around 1.01%, and although the Nikkei has risen almost 19% so far this year, it declined 17% in 2011. . . .

The rapid aging of Japan's population, more than 25% of which is expected to be above retirement age by 2015, is compounding difficulties. In many Japanese funds, the number of people receiving pensions already exceeds those paying into funds, analysts say."

Summing Up

Pension plan benefits are guaranteed by the plan sponsor. Investment returns have been quite poor over the past decade. Now low interest rates are adding another difficulty to pension funds having enough money on hand to cover outflows. If investments earn less than what's assumed, less money will be available to pay the promised benefits. Then the taxpayers get the bill to make up for the shortfall.

Unless, of course, plan sponsors decide to increase their cash contributions, earn more on stocks, invest less in bonds or some other combination of the various alternatives.

My view is that more money should be invested in stocks. My further belief is that public plans shouldn't extend guaranteed benefits without taxpayers understanding exactly what they're being asked to do. Taxpayers should also know that a government's decision to stay with a pension plan for public sector workers would be the opposite of what plan sponsors in the private sector are doing.

It's a whole new ball game for investing by pension plans in bonds and stocks.

It's also a new game for plans deciding between guaranteed public sector pension benefits and 401(k) plans, as well as employee and employer contributions, and many other things as well.

Why more stocks and fewer bonds?

Low inflation means a lower nominal rate of return. That said, going to a higher mix of stocks suggests a higher overall rate of return. In addition, as interest rates increase during the next several years, it will even more difficult to earn an acceptable rate of return on bonds. Thus, I would argue for more stocks and fewer bonds, along with a switch in the public sector to 401(k) plans from pension plans.

That's the logical approach.

The logical approach may well not match the unions' and politicians' preferred approach, however.

But whatever is decided, it's time for a fresh look at all this.

In the U.S., Japan, Europe and elsewhere, too.

The taxpayers and affected employees deserve no less.

Thanks. Bob.

Goldman Sachs Agrees With Our Long Term Investing Call ... Stay Away From Bonds and Buy Stocks

How timely! Goldman Sachs must have seen our blog comments yesterday about preferring stocks over bonds and cash over bonds in the years ahead. See Goldman's Gigantic Bullish Call.

{Just kidding about Goldman following us and then adopting our point of view, of course. That said, it's nice to see them agree with our contrarian call, even if we both should later prove to be wrong. But we're confident about the call, and long ago put our money where our mouth is.}

To repeat what we said on the blog yesterday, the long term outlook for bonds looks bad. We'll try to expand on such a contrary point of view in coming weeks, realizing that this view of bonds as "unsafe" is not exactly mainstream thinking.

In fact, most people would say that we're out in left field. Oh well, what's wrong with playing left field?

While most financial advisors continue to recommend bonds as a fundamentally safe investment, we believe just the opposite will be the result. Even more important, a long term trend is developing which should make stocks a more compelling buy for years to come.

All we need to make this all work out well is to avoid a few really bad breaks and for no worldwide disasters to strike, such as war. And who can plan for that? Not us.

Assuming therefore that common sense prevails (admittedly no slam dunk), cash will outperform bonds in the next several years. And if common sense doesn't prevail, cash will still outperform bonds. Stocks will beat both.

In Goldman Sachs: We Prefer Stocks Over Bonds, Goldman asserts that it's time to say 'a long good bye to bonds.' They also conclude that stocks are a ' long good buy:' Nice play on words.

Here's part of what the article says about Goldman's investing advice:

"Goldman Sachs gave equities a ringing endorsement, saying the asset class is poised to deliver better returns over time than bonds.

Goldman on Wednesday said stocks are preferred over bonds, even though stocks around the world have posted substantial gains this year. Goldman’s call comes amid continued debate about stocks’ prospects, as economic growth wavers in developed nations and has shown recent signs of slowing in developing markets.

“Given current valuations, we think it is time to say a ‘long good bye’ to bonds, and embrace the ‘long good buy’ for equities as we expect them to embark on an upward trend over the next few years,” Goldman’s Peter Oppenheimer and Matthieu Walterspiler wrote in a “Global Strategy Paper” dated Wednesday."

Summing Up

Since it's aligned with the point of view we articulated yesterday as well as several times prior to then, we were pleased to see Goldman's call.

And in brief, here's the investment and economic scene we see unfolding over the next year or so.

Our scenario calls for lower U.S. gas prices over time due to a strengthening dollar along with increased global supply, including North America. The Saudis even seem to have gotten the message and are willing to drill, drill and then drill some more.

Soon our U.S. President, whoever he may be, will go along with the program, too. Why? Because it's the path to economic growth, low inflation and more jobs. In other words, it will absolutely become the right political thing to do, in addition to being the absolute right thing to do.

In addition, a stabilizing and strengthening U.S. economy will cause long term interest rates to rise, thus accelerating the dollar's strength. In turn, this will bring oil prices in dollar terms down more. That will aid U.S. consumers' purchasing power and give a further boost to the domestic economy. A virtuous circle.

Of course, we'll be hearing from the doomsayers and the alarmist inflationistas shortly, but while long rates will increase, they won't become worrisome for at least a few more years. And hopefully not then. So that's the economic picture we see unfolding.

In such an environment of rising rates, it's unsafe to own bonds and will be for at least several more years. But it won't be unsafe to own stocks. To the contrary, it will be the place to be.

More to come on this 30 year admittedly contrarian outlook in future posts. For now, that's my P.

And for those who may not be familiar with the acronym PEGIT, P stands for the reiterative planning process.

Stay tuned as the future reveals itself.

Thanks. Bob.

Individual Investing ... Stocks, Bonds and Cash ... A Contrarian's Approach

While working, people planning for their retirement years traditionally are encouraged to buy a blend of stocks and bonds, aka a balanced fund, to assure sufficient funds upon reaching retirement.

The standard mix is 60% stocks and 40% bonds, or something similar thereto. As they approach retirement, these same people are encouraged to own a higher percentage of bonds and a lower percentage of stocks.

Even though this investing methodology is pretty much universally recommended by financial advisors today, I think that's bad advice.

And what about those people who have already reached retirement age and have money to invest, including perhaps money in a 401(k) or IRA plan? What should their investment mix be?

As with all good questions, the correct answer is--that depends. In other words, how many assets does the person have, how much debt, how knowledgeable is the person about investing, and how much trouble does he have sleeping at night?

With those caveats, let's try to help the person, whatever age he may be, to understand the need for planning and knowing and acting.

Undoubtedly you have never heard of the acronym PEGIT. I know that because I made it up-- all by myself.

Using PEGIT helps me when I attempt to simplify something which otherwise can be quite complex. So here goes.

P stands for planning, E for education, G for gifting, I for investing and T for taxes.

The biggest benefit from planning (P) isn't the plan but the planning process itself. It should be iterative and kept up to date. After all, things change during a lifetime.

And the planning process should begin prior to graduation from high school. It should end only when we're no longer able to do the mental work. In other words, start early and keep going throughout life.

But what if you're over 18 and less than 90, but haven't begun the habit of planning? Start now.

Educating (E) ourselves about financial affairs is essential. The more money we earn, the more "experts" will want to "help" us invest or spend that money. Self help is preceded by knowledge.

Get to know at least the basics about this financial stuff. You'll be glad you did. Besides, investing is both interesting and fulfilling.

Gifting (G) means how much we're able to, as well as the amount we want to, give to others, whether that be cash, the church, tuition, a car, investment funds, charity or a bequest at the end of the road.

Investing (I) decisions are something we need to take very seriously throughout life. Getting an education is investing, buying a house is investing, taking out a student loan is investing, setting aside funds for retirement is investing and so forth.

Taxation (T) is something to be avoided but not evaded. We should pay what we owe and no more than that. Unless, of course, we wish to make a "gift" to government, which we always have the right to do.

Let's review I today.

With respect to investing, most financial advisors are quick to tell us to invest in a mix of stocks and bonds. They also advise that cash is trash when interest rates are low, as is the case today.

Let's focus on a 65 year old with 25 years to live. He has $100 and plans to spend $4 of that $100 annually. And if possible, he'd like to leave all, or at least most, of that $100 in inflation adjusted terms to his heirs when his time is up. That's his plan.

Here's what I would do financially if it were me with respect to the mix between bonds, stocks and cash.

I'd invest zero in bonds. If rates stay low, bonds won't earn enough to provide any real inflation adjusted income over time. If rates rise, bonds will become worth even less than they are today. Either way, with bonds I lose if rates stay the same or rise.

Let's keep enough cash to assure ourselves that we can pay $4 annually from the $100 starting point. And a sufficient amount to sleep well at night, too. Of course, that brings us back to E. The more we know about investing and markets, the better we'll sleep.

For now we'll keep $8 in cash or two years' worth of spending. That leaves $92 for stocks.

{Here's a similar but more belt-and-suspenders investing and spending approach. If you're a light sleeper, then keep between $20 and $30 in cash, representing about 5 to 7.5 years of spending needs.

With the $80 or $70 invested in stocks, you should realize ~$2.40 or ~$2.10 in dividends annually, which in turn can be used to replenish part of the cash used each year. At some point in the not distant future, the $80 or $70 will grow back to the original total amount of $100. Then, or even before then, you can always rack up and shoot over, as you hopefully will have already been doing. The big and basic idea is to avoid bonds and the outsized risks associated therewith.}

Back to the main story. Stocks and some cash are the best approach over time. Not bonds.

We'll invest by buying stocks in blue chip companies that have a solid track record of paying dividends and increasing those dividend payments over time. Companies like Pfizer, Merck, McDonald's, Wal-Mart, GE, Boeing, Microsoft, Intel, Pepsi, Coke, Whirlpool, Exxon, JP Morgan and Wells Fargo are a few that come to mind.

We'll plan to earn cash dividends of 3%-4% on those initial investments. Thus, the $92 will initially pay us more than $3 annually. We'll also plan for that annual amount of dividends to grow to at least $4 within eight years.

Hence, we'll use $1 from the $8 original cash stash and $3 from the dividends to pay ourselves at least $4 in each of the first eight years. Thereafter we'll have dividends sufficient to meet our cash needs.

Even more important, our $92 will likely have grown to more than $150 and perhaps as much as doubled by then. And we'll thereby have some considerable remaining assets left at the end of our line, whenever that may be.

But why no bonds? Because bonds become less valuable as rates rise. And rates will be higher ten years from now than they are today. They'll even be higher in one year.

Here's an example. If we buy a bond which pays 2% with our $100, then we receive $2 annually. If rates increase to a more normal 4% within a few short years, a bond purchased then for $50 would yield that same $2. What was worth $100 now becomes worth only $50.

That's what happens when interest rates rise over time. And it's just the opposite of what happened the past 30 years. Thus, since rates won't be lower ten years from now, I'd rather stay in cash and take advantage of the increase in rates over the coming years.

Summing Up

Here's the point of this common sense contrarian approach. Bonds will be riskier than stocks during the coming decades. And at best bond returns will have trouble matching inflation. Cash can do that, so why bother with bonds? They're too risky for me.

Besides, there's no real reward to be had by owning bonds because in a period of increasing interest rates, holding cash is preferable to bonds.

Rates will be rising in the future, even though during the past 30 years they declined. As a result, today too many (almost all) investment advisors are living in that conventional but dangerous past world of investing advice.

In 1980 rates were as high as 15% and inflation was high as well. Now they're as low as 3% and inflation is low, too. That's quite a drop. So it's obvious that in the future, rates will be higher than today, barring deflation.

And even if we have deflation ahead of us, which I don't expect, cash will be king.

But if we have higher inflation, which I do expect, at least cash will keep its purchasing power compared to bonds.

This may seem confusing. That's why E is so important to each of us as we pursue PEGIT continuously. And it's an 18 to 90 exercise, so there's plenty of time to get that E, whenever we begin.

We'll keep trying to achieve clarity on stocks, bonds and cash in future posts.

Getting to a basic level of knowledge of I is well worth the effort, especially since the financial 'experts' are advising just the opposite approach these days.

As the old saying foes, with all thy getting, get understanding.

Thanks. Bob.

Government Doesn't Have The Money To Pay Retirement Promises ... And The Household Sector Isn't Setting Enough Aside

There is at least an implicit myth about government and money. The myth is that government has money.

There is a related myth about government's ability to meet its financial obligations. The myth is that government can meet its obligations.

Government promises are only as good as the willingness of future taxpayers to make good on those promises. Since that's in the future, we can only guess what will happen. And guessing is not an appropriate substitute for proper planning.

{Of course, a future government can always print more money, but that doesn't represent real purchasing power. Today we're using the word money to represent something of value.}

On a related note, city governments often are granted money from their state governments, which are provided money by the national government. But none of these governments has any money of its own. It first must take that money from its citizens or borrow it from others. If it borrows, its citizens are required to repay the loans. Hence, it's always on the taxpayers, regardless of which government spends the money or where it gets the money which it spends.

To make the point crystal clear, all governments simply are the collectors and spenders of taxpayer generated money. Hence, all claims, aka debts, on the government are the ultimate responsibility of citizen taxpayers.

So how good a credit risk are these various governments? Well, to be blunt, they're as good as, and only as good as, their future taxpayers' financial capability and willingness to pay. It's as simple as that.

Accordingly, taxpayers have a right as well as a need to know what the various and cumulative future obligations of government represent.

Taxpayers have that right and need to know, because the taxpayers will get the bill for payment.

Thus, if government has acted or currently acts irresponsibly, both current and future taxpayers are on the hook. And the bigger the obligations, the greater the likelihood that the bill will go to future taxpayers instead of the current ones.

Will future taxpayers accept the bill when it's presented? Well, that's up to them.

After noting that most businesses within the private sector have cleaned up their financial situation in recent years, Rearview Stress Tests asks the relevant question, "When do taxpayers get to stress-test the government?" Here's some of what it says:

"With the exception of housing, which is still subject to political attempts to prop up prices, the rest of the private economy is also doing well. Corporate balance sheets are as healthy as they've been in many years. The bond market and private hiring are coming back. Even consumers have shed much of their debt and are doing better, save for the raid on their real incomes from rising food and energy prices. Absent stupid policy, the next economic or financial crisis isn't likely to start with banks or another business bubble."

Then it moves to the federal government:

"The balance sheet to worry about belongs to the U.S. government, which in the name of trying to restore growth threw the party of the century. The Treasury is still rolling out $1.3 trillion deficits, three years into a recovery, and the Federal Reserve is still holding interest rates at near-zero and has tripled its own balance sheet.

Neither institution—much less the White House or Congress—seems to have an exit strategy worth the name. The White House says a big tax increase next year will solve any fiscal woes, and Fed Chairman Ben Bernanke says, well, trust him. . . .

What we don't know, but would like to, is what would happen to the Fed's balance sheet if interest rates rose rapidly, say, to their historic modern norm of about 5%? What really needs a stress test is the government."

Discussion and Analysis

To the above suggested government stress test, I would add the unfunded entitlements, including those of the various cities and states. We'd find that most governments are broke and have made promises that simply can't be kept without a wholesale change in taxes and across the board government spending reductions. We have far too many indebted governments with no current plan or known capability to make good on the future promises they have made on the taxpayers' behalf.

But it's even worse than that. We aren't even articulating a serious intent to get our financial house in order. If you doubt this, just listen to the politicians running for office this year. Who has a plan?

And unfortunately, most taxpayers and households have made no credible plans of their own either.

It's a reasonable estimate that more than $100 trillion in unfunded retirement promises have been made.

And it's also known that individuals and households aren't saving anywhere close to enough to provide for their retirement needs, leaving aside what we will need to set aside to backstop the unfunded government promises.

Summing Up

Of course, nobody knows for certain what will happen with respect to future investment returns. However, we do know that promises have been made to future retirees for which insufficient money has been set aside.

We also know that most pension plans are assuming that future returns will approximate historical results.

And we know that households continue to rely far too much on Social Security promises.

Meanwhile, we know that interest rates are low, debts are high and worldwide economic growth is likely to be subdued for many years.

And what are the politicians saying about all this? Not much.

Meanwhile, We the People close our eyes and hold out hope that the money will be there as promised.

And that brings us--where else--to the workers of tomorrow. Future generations.

My prediction is straightforward; there's a likely train wreck ahead. But when is the question, and that remains to be seen.

That's about all any of us can say with a high level of confidence. Isn't that a shame?

Thanks. Bob.

Student Loans and Government as Lender ... the Joke's on Taxpayers

The Bill for ObamaLoans describes the all too predictable developing student loan fiasco.

Today about one of every four student borrowers has past due balances. That already horribly high number will only grow now that the federal government is in charge:

"A recent report from the Federal Reserve Bank of New York has the disturbing details for taxpayers.

Thanks to President Obama, the government now stands behind almost the entire student-loan market. That debt pile is expanding fast and it turns out the borrowers are less reliable than advertised.

Here's how New York Fed economists describe them: "Of the 37 million borrowers who have outstanding student loan balances as of third-quarter 2011, 14.4 percent, or about 5.4 million borrowers, have at least one past due student loan account." That adds up to past-due balances of about $85 billion, or roughly 10% of total student loans, which is about the same past-due rate for other types of household debt such as mortgages, credit cards and auto loans.

Not bad, taxpayers might conclude, considering the government is handing out student loans regardless of credit history or ability to repay. But the researchers dug deeper.

"Does this mean that the prospects for student loan delinquencies are similar to those for the household debt in general, and thus no special attention is warranted?" asks the New York Fed. "Unfortunately, this is not the case—some special accounting used for student loans, not applicable to other types of consumer debt, makes it likely that the delinquency rates for student loans are understated."

Are they ever. After correcting for this "special accounting," says the Fed study, "We find that 27 percent of the borrowers have past due balances, while the adjusted proportion of outstanding student loan balances that is delinquent is 21 percent—much higher than the unadjusted rates of 14.4 percent and 10 percent, respectively."

So student loan borrowers are roughly twice as likely to fall behind on their payments as borrowers for other types of consumer credit. And, thanks to decades of bipartisan support for taxpayer-backed student loans—and a recent acceleration in federal subsidies driven by Mr. Obama—this is a rare category of consumer debt that continues to grow. Total student-loan debt has grown to almost $870 billion and is now larger than the total of U.S. consumer credit-card balances ($693 billion) or auto loans ($730 billion).

The Fed economists acknowledge that they may not have a precise handle on the scale of student delinquencies, given the idiosyncracies of this government-controlled market. For example, Washington's increasingly popular "income-based repayment" options, which allow people to defer payments without being categorized as delinquent, make it difficult to get an accurate count of the deadbeats.

Also unclear is the impact of an expanded debt-forgiveness program for student loans enacted along with ObamaCare that was scheduled to begin in 2014. But last year Mr. Obama told a cheering crowd of students in Denver that he plans to make the forgiveness provisions available this year.

On Tuesday, the Congressional Budget Office disclosed that the gross cost of ObamaCare over a decade is $1.762 trillion, up from $930 billion when it passed. Just wait until we discover the true cost of ObamaLoans."

Summing Up

Why would we anticipate anything other than a fiasco with student loans? Government programs have a way of wasting taxpayer money.

But when loans are granted to students with no credit history or track record of borrowing and repaying, loaning is little more than a crapshoot.

To my knowledge, the government lending criteria are minimal, if that, to secure a student loan. It's like spending OPM on steroids.

Besides, the college sits in the spectator's position of not having to vet the borrower's ability to achieve success in college.

And for sure, nobody considers the likelihood that the borrower upon graduation will secure a job with sufficient earnings to pay off his loan as stipulated in the loan agreement.

Government loans to students very often will turn out to be a joke, and the joke will be on both students and taxpayers.

At that later time taxpayers will be asked to pay some more, and government officials will say it's only fair that they do so.

But it's not fair. Not even close.

Thanks. Bob.

Oil Companies and Taxes Paid ... Who's Subsidizing Whom?

When is enough enough? President Obama wants the oil companies to pay their "fair share."

But oil companies already pay more of their earnings in taxes than their owners get to keep for themselves. To my knowledge, no other industries or individuals are being asked to do that. Is that fair?

So let's quit kicking the oil companies around for political reasons. Besides, when did running a successful business become Un-American?

Since it's an election year, it's a pretty safe bet that the contents of Big Oil, Bigger Taxes won't be highlighted in a speech by President Obama anytime soon.

That's because the article points out some very uncomfortable facts for the President. For example, that oil companies are the ones doing the subsidizing of the government rather than the other way around.

Therefore, let's quote extensively from the above referenced article:

"President Obama says he wants to end subsidies for what he calls "the fuel of the past," but lucky for him oil and gas will be the fuels of the future too. His budget-deficit blowout would be so much worse without Big Oil, because the truth is that this industry is subsidizing the government.

Much, much worse, actually. The federal Energy Information Administration reports that the industry paid some $35.7 billion in corporate income taxes in 2009, the latest year for which data are available. That alone is about 10% of non-defense discretionary spending—and it would cover a lot of Solyndras. That figure also doesn't count excise taxes, state taxes and rents, royalties, fees and bonus payments. All told, the government rakes in $86 million from oil and gas every day—far more than from any other business.

Not paying their "fair share"? Here's a staggering fact: The Tax Foundation estimates that, between 1981 and 2008, oil and gas companies sent more dollars to Washington and the state capitols than they earned in profits for shareholders.

Exxon Mobil, the world's largest oil and gas company, says that in the five years prior to 2010 it paid about $59 billion in total U.S. taxes, while it earned . . . $40.5 billion domestically. Another way of putting it is that for every dollar of net U.S. profits between 2006 and 2010, the company incurred $1.45 in taxes. Exxon's 2010 tax bill was three times larger than its domestic profits. The company can stay in business because it operates globally and earned a total net income after tax of $30.5 billion in 2010 on revenues of $370.1 billion.

Meanwhile, Mr. Obama's 2013 budget—like its 2012, 2011 and 2010 vintages—includes a dozen-odd tax increases that would raise the industry's liability by $44 billion over the next decade, according to the White House, and by $85 billion, according to the trade group the American Petroleum Institute (API). At any rate, the President's economists ought to be weeping for joy for the revenue windfall from an industry that grew 4.5% in 2011, compared to overall GDP growth of 1.7%.

Crunching Compustat North America numbers, API estimates that the average effective tax rate for oil and gas companies is 41.1% for 2010—i.e., taxes as a share of net income. That is broadly in line with the Energy Information Administration's estimates for "major energy producers." By the same measure, other manufacturers on the S&P Industrial index pay an effective rate of 26.5%. . . .

For comparison, nuclear power comes in at minus-99.5%, wind at minus-163.8% and solar thermal at minus-244.7%—and that's before the 2009 Obama-Pelosi stimulus. In other words, the taxpayer loses more the more each of these power sources produces.

As for the "subsidies" that Mr. Obama says the oil industry receives, these aren't direct cash handouts like those that go to the green lobby. They're deductions from taxes that cover the cost of doing business and earning income to tax in the first place. Most of them are available to other manufacturers.

What Mr. Obama really means is that he wants to put the risky and capital-intensive process of finding, extracting and producing oil and gas at a competitive disadvantage against other businesses. He does so because he ultimately wants to make them more expensive than his favorites in the wind, solar and ethanol industries.

Why he would still want to do this amid the political panic over $4 per gallon gasoline is a mystery. Even Mr. Obama now claims to want lower gas prices, commenting recently that "Do you think the President of the United States going into re-election wants gas prices to go up higher?" Too bad his every policy choice, and especially his tax agenda, would lead to higher prices."

Summing Up

I can't add anything to what's already been said. Let's hope public pressure helps the President see the energy light. And real soon, too.

The political season is silly, but this attack on energy by the Obama administration is beyond silly--it's completely ridiculous. And besides that, it's quite harmful to our economy, budget, jobs and national security as well.

At times like this, I'm reminded of the aphorism that if something can't go on forever, it won't.

So let's hope that the President soon gets serious about energy.

It can't happen soon enough.

Thanks. Bob.