Juggling Dynamite

Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia, offers some cogent thoughts on Federal Reserve policy, the U.S. economy and the Federal budget. He also speaks about China. He has been a well known China bull for many years and offers his front line views from years on the ground there assessing the Chinese economy. That said, the utility of Chinese Permabulls has been nil from an equity investment perspective as Chinese stocks today are -7% ytd and a full -63% since 2007. Another case of a good story being a horrible investment if bought at too high a price. Here is a direct link.

Last week Detroit outlined its plan for necessary financial restructuring in bankruptcy. The emergency management team reviewed the cities public pension plans and found that the combined underfunding totaled $3.5 billion for the $2.77 billion Detroit General Retirement System and the $3.4 billion Detroit Police and Fire Retirement System, including the COPs and swaps liabilities. In particular the committee found that previous aggressive actuarial assumptions “substantially understated” funded status for each city pension plan.

“At this level of underfunding, the city would have to contribute approximately $200 (million) to $350 million annually to fully fund currently accrued, vested benefits. Such contributions will not be made under the plan…

“Because the amounts realized on the underfunding claims (the COPs and swaps unsecured debt) will be substantially less than the underfunding amount, there must be significant cuts in accrued, vested pension amounts for both active and currently retired persons.”

And finally the creditor committee articulated the painful truth about the high paid risk-sellers, fancy products and their aggressive return assumptions: “As discussed in the creditors’meeting today, if these pension funds’ assets had just been invested in a conservative way, instead of investing in risky development projects around the city and loans that will never be repaid, they probably would be fully funded now.“

These are timeless words admitting a truth that most financial ‘engineers’, investment firms, and their clients try to avoid at repeated peril. The answer to financial health and sustainable plans is not in subjecting capital to higher and higher risk but rather in higher contributions/savings and carefully controlled risk that focuses first on minimizing capital losses. Cat just leapt out of the bag in Detroit… See: Detroit Plan includes ‘significant cuts’ to pension benefits.

When the headlines are all about what the Federal Reserve will or won’t do this week, we can know for sure that today’s equity market is nothing to do with valuable investment opportunity and everything to do with unreasonable hype and hope. We continue to keep our eye on the foundation rather than the floral arrangements, and so far: global economy weakening, North American bond yields falling, commodities weaker, US dollar holding support, adviser sentiment supremely bullish, the most reckless behavior being touted as genius once more, margin (ab)use at all time high, S&P Shiller PE above 24, a near unanimous preponderance of buy and hold disciples — all confirming large downside destiny for over-valued stock prices.