What's the scariest investing story of 2008 so far?
It's not news that the median price of a new house is down 17% from its 2007 high --- and still falling.
Or that Miami has a 37-month supply of unsold condos, with 19,000 more new units set to hit the market this year.
Or even that losses at banks and investment banks in the debt-market meltdown could hit $400 billion.
Here's my nominee:
The Pension Benefit Guaranty Corp., the government agency that protects the pensions of 44 million workers in case their employers can't (or won't) pay promised benefits, has announced that to avoid going bust it will double the percentage of its portfolio -- to 45% -- that it puts into stocks. An additional 10% will go into alternative investments, including hedge funds.
In other words, facing a $14 billion deficit and even larger projected shortfalls, the Pension Benefit Guaranty Corp., or PBGC, decided not to save (by raising premiums) or to live within its means (by cutting benefits) but to gamble in the financial markets by taking on more risk. The PBGC was so proud of its new strategy that it announced it on Presidents Day, when the U.S. financial markets were closed and almost no one was paying attention.
So why is this so scary?
Because as a result of 10 years of booms and busts -- the Asian currency crisis, the Long Term Capital Management hedge fund disaster, the tech stock bear market of 2000-02, the housing smash-up, the debt market debacle -- I've increasingly come to believe that those of us who play by the rules (work hard, live within our paychecks, save) are chumps. The way to get ahead is to gamble big and then, if you lose, find someone to cover your losses.
Anger and fearI've been hearing the same thing in e-mails from some of you. There's sympathy for families that were defrauded in the housing boom and now face foreclosure. There's a willingness to fix the system so that buyers with a mortgage they can't afford don't lose everything. But there's also a deep anger from those of you who played by the rules and didn't buy more house than your paychecks would cover and are now paying the price in falling home values, a slowing economy, jobs lost and a sinking stock market.
Some of you are afraid -- for good reason -- that you'll be picking up the tab not just for honest mistakes but for greed and fraud as well.
Some of you have written to me saying that playing by the rules only makes you a loser. I've tried to argue you out of that conclusion despite my own doubts.
And now I've read a story about the PBGC's decision to roll the dice. And it scares me because it says that even the folks who are in charge of the game, the ones who should be models of prudence, are turning into gamblers willing to throw up their hands and say: "Roll seven. Come eleven. Baby needs a new beach house with an ocean view."
Here's the problem the pension agency faced and the fix it came up with:
How it's supposed to workThis agency, set up by Congress in 1974, is supposed to fund the pensions of workers when their employers go bust or get bought by someone who shuts down the plan. For a worker retiring at 65, payments from the PBGC currently max out at $51,750 for a pension plan set up by a single employer. If the plan promises benefits above that and goes belly up, sorry, but you're out of luck.
When Congress set up the PBGC, it didn't provide any taxpayer money to pay out these benefits. Instead, payouts are funded by premiums paid by companies that sponsor pension plans -- plus investment returns on the money the PBGC holds, pending future payouts, and any money it recovers from plans that go bust. In 2008, the premium is $9 per worker covered by a multicompany plan; for single-employer plans, it's $33 per worker plus $9 for each $1,000 of unfunded vested benefits.
Unfortunately, the premiums don't cover what the fund has to pay out in most years, and the odds are that the deficit will grow. The agency estimated that for fiscal 2006, the pension plans it covered were a total of $500 billion short. If any of these underfunded plans went bust, the assets that it turned over to the PBGC wouldn't cover the guaranteed payouts of retired workers, which would run the agency's deficit higher.
Several options for a solutionThe pension agency could have decided to fix its deficit problem by:
- Raising premiums, which would have required a politically unpopular vote by Congress.
- Lowering payouts, which would have required a politically unpopular vote by Congress.
- Tightening rules, so companies would stop underfunding their pensions, which would have required a politically unpopular vote by Congress.
- Purchasing a lottery ticket and announcing the problem was fixed.
Guess which solution the agency picked?
Here's how the PBGC described its solution: If the agency kept its current portfolio mix of 72% fixed income and 28% stocks, the odds that it would be solvent in 10 years were just 20%. If the PBGC put 45% of its portfolio into stocks and 10% into alternative investments such as hedge funds, and reduced its fixed-income allocation to 45%, the odds of being solvent in 10 years would go up to 60%.
That new asset mix would have worked out just fine for the PBGC in 2007, when its equity investments returned 16.5% and its fixed-income investments returned just 3.4%. On average, from December 1925 to the present, stocks as measured by the Standard & Poor's 500 Index ($INX) have returned better than 10% annually, while long-term government bonds returned just over 5%. So in changing its asset mix, the PBGC would seem to have history on its side.
Except that while the agency is indeed increasing the chances it will get where it needs to go, it's also increasing the odds it will take a big loss. The S&P 500's tendency to deviate from that average return is about twice as large as the tendency for long-term government bonds to do so, for example. Using data from 1997 through 2006, the odds are that 95% of the time the returns on stocks will be between 48% on the upside (yea) and -27% on the downside (yipes). Returns on government bonds range from 19% on the upside to -14% on the downside.
A shaky assumptionThat's all assuming, of course, that the financial markets won't be any more volatile over the next 10 years than they've been over the past 10. After living through the latter half of 2007 and the first two months of 2008, that feels like a pretty big assumption. (It's also an assumption that the PBGC didn't agree with in 2005 when, facing criticism that it was taking too many risks, it decided to rely more on bonds and less on stocks in its portfolio.)
But, hey, the PBGC is willing to roll the dice -- with the knowledge that if it gets this wrong, 1) the folks who made the mistake will be long gone and collecting six-figure salaries as Washington lobbyists, and 2) the taxpayers who have to pick up the tab, and the workers without pensions, will bear the pain.
So what can we do? What should be done?
- Individually, we keep the faith. I was an unpopular geek in high school, so I've got some experience living with the scorn of the popular kids. Stick to the principles of our founding fathers -- Franklin, Hamilton and Buffett -- and keep away from the gaming tables. Keep putting money aside in your 401(k) every month -- into cash when the market is dicey. Making saving a habit is not stupid. It's smart. You won't feel like a chump if you've got cash when it's time to pick up the pieces -- at bargain prices.
- Tell the folks who manage our personal money -- the mutual fund managers, personal financial advisers and the like -- that we want them to stay true to time-tested strategies and not to give in to the pressure to take shortcuts. Tell them we don't need that extra 0.25 percentage point of yield if it involves taking on 2.5 points of extra risk. And if they don't get the message, we take our business elsewhere.
- It's an election year, and the politicians might listen for the next few months. Let's tell them that we're fed up with regulators who don't enforce existing rules. The Federal Reserve could have cracked down on questionable mortgages originated by nonbank lenders. It has the authority. In Spain, bank regulators discouraged banks from creating off-balance-sheet funds. Here, regulators encouraged the practice. Who's sorry now? (And while we're at it, let's fix the rules that let the private buyers of companies increase their own profits by dumping underfunded pension plans on the PBGC.)
- Let's demand that the crooks -- the people who defrauded borrowers and investors in mortgage securities -- do jail time.
- Let's insist that every effort is made to let private "vulture" investors pick clean the carcasses of loan portfolios stuffed with rotten paper before there's even talk of taxpayer money being used for a bailout.
- Let's demand that our politicians and regulators stop talking solely about the need to fix the economy or the housing industry or the debt markets and start talking about this as a retirement crisis. We've just seen $2 trillion in home equity erased. That's a huge problem for Americans who rely on their homes as their primary retirement savings -- and that's a majority of us. I'll have more on this in my March 4 column.
- And above all, let's say to the Fed and to everyone in Congress and to whoever sits in the White House come January 2009 that we want an end to this bubble-and-bust cycle in the financial markets. Encouraging reckless gambling and then bailing out the worst -- and biggest -- gamblers is no way to run an economy.
Updates to Jubak's PicksBuy : As much as I've wanted to boost inflation protection in Jubak's Picks -- now that inflation is at 4.3% in the U.S. and 7.1% in China -- by buying another gold stock, I've said no because at almost $950 an ounce, the metal is at an all-time high (if you don't adjust for inflation). Who wants to buy a gold-mining stock now, only to watch the price retreat as traders take profits?
But I think I've found a way to hedge that risk, through a natural-gas shortage in Chile and Freeport McMoRan's exposure to copper. Supplies of natural gas to Chile from Argentina and Bolivia have dried up. Bolivia, for example, has contracts to supply 7.7 million cubic meters of gas a day to Argentina -- which is, in turn, the sole source for all of Chile's natural-gas imports. But Bolivia has been supplying less than 40% of that.
The shortfall throughout the southern cone of South America couldn't come at a worse time for Chile because a drought has cut into production at the country's hydropower plants. With the country headed toward winter, when demand for electricity peaks, the government is projecting energy shortages large enough to cut economic growth by 0.5 to 1 percentage point.
Chile's copper industry, which produces more than one-third of the world's copper, is especially vulnerable to energy shortages. Analysts estimate production will drop by 68,000 metric tons in the next four months. Though that's only about 1% of Chile's annual production, there's no reason to believe the energy shortage will end in the first half 2008.
The causes are long term: runaway demand in Argentina, where the government has subsidized energy prices to maintain popular support, and underinvestment in Bolivia's natural-gas industry after it was nationalized 2006. Two big liquefied-natural-gas plants are set to open in Chile in 2009, and by 2010 the country will be in a position to export natural gas to Argentina.
In the meantime, production shortfalls will make tight global supplies of copper even tighter. From January to November 2007, global copper consumption exceeded production by 149,000 metric tons.
All of this means that Wall Street analysts who are projecting copper prices to fall from the current $3.80 a pound to average $3 a pound in 2008 are too low on their targets for copper stocks such as Freeport McMoRan. Desjardins Securities, for example, bases its $99.40-a-share target on an average copper price of $3 a pound in 2008 and 2009. Desjardins also calculates that every 10-cent-a-pound increase in the average price of copper adds 55 cents a share to Freeport McMoRan earnings. Rising copper prices on Chilean production shortfalls, in turn, make rising copper earnings into a floor that protects the buyer of Freeport McMoRan from any potential drop in gold prices. Copper makes up about 75% of the company's sales, but the company's reserves include 41.1 million ounces of gold and 128 million ounces of silver. (An additional 10% of sales come from molybdenum.)
All of this is a roundabout way of saying that as of Feb. 26 I'm adding shares of Freeport McMoRan to Jubak's Picks with a target price of $122 a share by December 2008. (Full disclosure: I will buy shares of Freeport McMoRan for my personal portfolio three days after this column is posted.)
Sell: If growth in Chile and neighboring countries is about to slow because of energy shortages, I don't especially want to hold shares of Chile's Lan Airlines in the economically sensitive airline industry. I'm going to take advantage of the rally that took the stock to $14.62 on Feb. 26 from $11.08 on Jan. 26 -- a gain of 32% -- to sell this stock out of Jubak's Picks.
I continue to like Lan Airlines for the long haul as a play on the developing economies of South America, but I don't care for short-term risk from the regional economy.
I'm selling these shares with an 11% loss since I added them to Jubak's Picks on May 8, 2007. (Full disclosure: I will sell my personal position in Lan Airlines three days after this column is posted.)
With the buy of Freeport McMoRan and the sell of Lan Airlines, Jubak's Picks remains roughly 44% in cash.
Developments on a past column"Natural gas? Play the Rocky Mountain high": On Feb. 20, announced fourth-quarter earnings that were 2 cents a share short of average analyst estimates. Revenue rose almost 8% from the fourth quarter of 2006 to $162 million, beating the analyst consensus of $156 million. More important than any of this, however, the company said it would raise production 18% to 21% in 2008 and then by 25% to 30% more in 2009.
I had added this stock to Jubak's Picks on Sept. 21, 2007, because the new Rocky Mountain Express natural-gas pipeline would enable gas producers in the Rocky Mountain region, the fastest-growing source of natural gas in the U.S., to finally get their product out of their relatively small local market and into the bigger markets of the eastern U.S.
That would gradually wipe out a discount that in 2007 saw natural gas selling for $3.37 per million cubic feet less in Wyoming than in Louisiana. Well, the Western stage of that pipeline, Rex-West, started delivery of natural gas to Kansas on Jan. 12. A second stage, expected to start partial service in December and full service in June 2009, will deliver gas to Ohio.
As of Feb. 26, I'm raising my target price for Ultra Petroleum to $88 a share from a prior $85 by October 2008. Please note: If you're following along at home with my fair-value calculations for Ultra Petroleum and four other natural-gas stocks, you should raise that fair-value price for the stock to $92 a share. (Full disclosure: I own shares of Ultra Petroleum in my personal portfolio.)
Meet Jubak at The Money ShowMSN Money's Jim Jubak will be among more than 100 investment experts on hand for The Money Show in Las Vegas, May 12-15. You can hear from the experts in more than 250 free workshops while sharing tips and tricks with other active investors. Admission is free for MSN Money readers. To sign up, call 1-800-970-4355 and mention priority code No. 009554, or register online.
Editor's note: Jim Jubak, the Web's most-read investing writer, normally posts a new Jubak's Journal every Tuesday and Friday. Due to a pressing book deadline, there will be no column on Feb. 29, however. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment, see Jubak's portfolio of Dividend Stocks for Income Investors. For picks with a truly long-term perspective, see Jubak's 50 Best Stocks in the World or Future Fantastic 50 Portfolio. E-mail Jubak at firstname.lastname@example.org.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Lan Airlines and Ultra Petroleum. He did not own short positions in any stock mentioned.