This chart shows a daily plot of S&P500 Index prices. For each price, a letter marks the value for the date and you can see the page A1 main headline for that day from the Wall St. Journal in the legend. Since there are so may days shown not all the headlines are readable on this chart. But the most recent headlines, starting at bottom of legend, are visible.

Daily Wall St. Journal Headlines Tag S&P500

Now consider the same chart with the dates and headlines displayed only for the day on which the price changed from the previous day by a magnitude exceeding 3%. This graph  plots the changes. The headlines are labeled as before.

Wall St. Journal Headlines for +/- 3 % S&P 500 Daily price changes

The interesting result is that all the headlines are about government actions that could affect the markets, not economic/market action. It seems that judging politicians and central bankers is the primary investment skill needed now.

So are the Democrats just stupid as a group, unable to see reality or recklessly uncaring? I say they are not stupid, but they are so ideological as to be blind, and they suffer power lust. Even worse, as Charles Krauthammer writes, they are also deeply cynical. He says the Democrats want to pander to Americans and cut spending only minimally, in hopes such false largess will gain victory for The OBAMA! on 2012.

As Krauthammer writes below, The OBAMA! actually is denying there is any budget problem, hoping this Big Lie will help Him get re-elected!

“On Tuesday, Democratic Sen. Joe Manchin of West Virginia denounced Obama for lack of leadership on the debt. It’s worse than that. Obama is showing leadership. With Lew’s preposterous claim that Social Security is solvent for 26 years, Obama is preparing to lead the charge against entitlement reform as his ticket to reelection.”

Read the whole article here:

Charles Krauthammer: “Et Tu, Jack Lew?”

An extremely clear and concise tutorial on the situation is available here:

Tutorial: Will Municipal Bonds be the Next Disaster?

As the author says in his conclusion:

Finally: In recent years, there has been a change in our national understanding of the sacred nature of contracts. We have seen untold numbers of homeowners default on mortgages with the justification that the bank should never have lent them the money. We have seen the banks improvidently speculate with other people’s money and then justify it by saying that they were only doing what the customer wanted. This same mentality is evident in municipal government. Harrisburg, Pennsylvania councilwoman Susan Brown Wilson exemplified the ominous trend when she said recently, “By no means should the citizens of Harrisburg (alone) be strapped with the debt created eight years ago by a prior administration.” Are we not responsible for what past administrations have done? Isn’t that principle what secures any bond issuance? If Ms. Wilson’s is becoming the prevailing attitude, muni bonds are nothing more than colorful paper.

The number of muni bonds on dealer desks wanting bids is as large as at any time in history. Maybe this is dumb money getting out, creating a golden opportunity. But it could also be smart money running from a market that has a lot of the characteristics of the pre-2008 mortgage markets: lack of transparency, legal obscurity, inflated values and deteriorating economics. That’s a risk investors can no longer afford to ignore.

You can see in this quote a slice of the attitudes now prevailing in the muni markets. But these attitudes of entitlement and avoidance of responsibility appear in the popular press, too, as exemplified by the endless blame game played by politicians and consumer groups.

States face dramatically growing pension obligations they created to buy votes, and their cities have broken finances. The states cannot print money. The new Republican congress almost surely will not add to state bailouts. So the pain will be transmitted to directly to states and some will suffer much more than others. Like California.

But the form that pain will take is unknown now, but it cannot be avoided.

Budgeting skills are as important as what your portfolio is doing—probably, more important really, because budgeting is an everyday issue. If a person can scale back appropriately so that they can actually survive on a 4 percent withdrawal rate, they’re good. Any reasonably designed retirement portfolio will last with a 4 percent withdrawal rate. Eight percent? You’re going to have to get really lucky in your investments.

We love reading his work and he’s a very sharp, knowledgeable finance maven. But his claim about the 4 percent withdrawal rate seems a tad glib–there are many assumptions built-in to this claim that need explanation. Would you really like to bet on such a simple number for your retirement? We think not.

Intuitively, at 4% withdrawal rate,  if your return is 4%/YR and inflation is nil, then in fact you can simply withdraw the gain each year and never deplete the principal. But if, for example, inflation is 2%/YR and your return is 4%/YR, then we can show 4% withdrawal rate would last you 34 years. Not bad. But if your return is 3%/YR and inflation is 4%/YR, then this account will deplete after 22 years if withdrawals are at 4%/YR.  That’s probably a big difference. We show you how to handle all these “What Ifs”.

This post introduces the idea of the Safe Withdrawal Rate (SWR), a concept that has recently captured the attention of many investment advisors and publications. We introduce our own focus on this topic now. We announce two initiatives. First, we published a descriptive piece in Advisor Perspectives, a highly respected and popular website for investment professionals. This piece explains SWR ideas without math for the average investor. Second, we published our full research results in detail here, in our permanent pages (see Investing Tools drop-menu above, or click this link):

Investing Tools> Safe Withdrawal Rate

This page introduces our technical analysis and methodology to determinine your own, personal SWR. Our innovation: we capture each individual’s beliefs about his own future returns and inflation to find the expected value of his SWR, irrespective of market history. Ultimately, your personal beliefs about how future returns and inflation evolve is all that matters for your planning purposes.

“Investing and speculating are widely confused. Investing is “to allocate capital into productive activities with the anticipation of operating profit.” Speculation is “to allocate capital in order to profit from politically caused distortions in the market place.”

If you can think of any counter-examples, please let us know!

She says

The Fed’s asymmetrical thinking extends as well to its treatment of financial assets—such as equity and debt instruments—en route to a bubble. As prices surge and markets soar, the Fed is reluctant to raise interest rates lest it be accused of hindering growth. But when the bubble bursts and asset prices begin to tumble, the Fed quickly steps in with dramatic interest rate reductions to “restore investor confidence” in hopes of avoiding a meltdown.

and concludes with

Now here’s the scary part: Even though more than half of all American households now own equities directly or through mutual funds, an increase in equity prices does not figure into the Fed’s calculation of inflation. So while measures of core inflation (which exclude food and energy) carefully register minute gains in the price of a fixed basket of goods and services meant to reflect what a typical family buys to achieve a minimum standard of living, they ignore massive price surges in what has effectively become a widely held consumer good: stocks.

Read the full article here

Not really. Consider this excerpt from the article:

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.

Remember the 1970s-era price ceiling on gasoline? By causing prices at the pump to lie about the scarcity of oil, that price ceiling led Americans to waste untold hours waiting in lines to fuel their cars. Similar wastes occur when corporate assets are mispriced.

Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme’s managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme’s share price will be too high. Investors will buy Acme shares at prices that conceal the company’s imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme’s employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

Eventually, of course, those misled investors, creditors and workers will suffer financial losses. But the economy as a whole loses, too. Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme’s deceitfully high share price, those better-run firms don’t enhance their efficiencies as much. They don’t expand their operations as much. They don’t create as many good jobs. Consumers don’t enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

In short, overall economic efficiency is reduced.

You can read the whole article here.

{ See our last post on Medicare dwarfing all other economic problems }

Let’s take a look at the over-arching debt and obligations owed by the US. We can get get a meaningful overview from the few numbers below.

US Assets and Obligations

The source for these numbers is the US Treasury and National Center for Policy Analysis (NCPA). They were conveniently pulled together here. The last line in the table is taken from our post above, and the source is Kent Smetters, Wharton School insurance and risk management professor.

Let’s get some perspective. According to the US Treasury, the average interest rate paid by Treasury is 3.36%/YR. Thus, the interest paid on the debt is about $400B/YR, which is a fraction of the annual revenues to the Treasury. On the other hand, if we applied the entire revenue stream to the US government to interest, we could pay down only $2.2T/.036=$65.5T . Thus, the enormity of the amounts of debt and obligation are loosely bounded.

Even more striking: if the US literally sold itself for the amount estimated by Prof. Smetters, the revenue still would be dwarfed by the outstanding obligations. The US cannot even hope for a hostile takeover to save itself!

So what will the end game from this situation be? Here are the possibilities, as summarized by Sprott, and the very likely outcomes:

• Default on Medicare promises. (Unlikely given the current debate in Washington to expand medical coverage.)
• Default on Social Security promises. (Unlikely given the increasing average age of the voting public.)
• Put forward a credible plan to balance the budget. (Unlikely given the most recent budget projections.)
• Default on outstanding debt. (Unthinkable)

The only remaining solution is to inflate the obligations and debt. QED.

As the magazine says in the article:

In selecting this year’s winners, Global Finance’s editorial team considered objective and subjective factors. Objective criteria included growth in assets, profitability, geographic reach, strategic relationships, new business development and product innovation. Subjective criteria included the opinions of equity and credit-rating analysts, banking consultants and others in the industry, as well as corporate financial executives. The winners are not always the biggest banks but, rather, the best banks – those with the qualities that corporations should look for when choosing a ban

You can read the article and the winners  here.

The new assumptions present a far different picture of risk. Consider the 60% stock, 40% bond portfolio that fell about 20% last year. Under the fat-tailed distribution now used in Ibbotson’s tool, that should occur once every 40 years, not once every 111 years as assumed under a bell-curve-type distribution. (The last year as bad as 2008 was 1931.)

Insulation from extreme market events doesn’t come cheap. Allianz SE’s Pacific Investment Management Co., or Pimco, which systematically hedges against extreme market events in several mutual funds launched last year, says the hedges may cost investors 0.5% to 1% of fund assets a year. Pimco uses a variety of derivatives and other strategies to hedge the funds.

You can read the whole article here: ( “Some Funds Stop Grading on the Curve”, 8 SEPT 09 ).

In many ways, this new approach to portfolio optimization incorporates the barkings of Nassim Taleb, of Black Swan fame, who has been incessantly warning of the dangers of designing portfolios assuming the “thin” tails of the Gaussian probability density, rather than using a more realistic “fat tail” model. Fat tails more accurately, and usefully, account for extreme bad outcomes, such as we recently experienced in the credit and real estate markets.

We expect in one to two years the large investment and broker-dealer firms will routinely offer Fat Tail-based portfolio design as well as special mutual funds incorporating these ideas.

Finally,  as we noted in our post of 15 JULY 09, this knowledge has been available for 20 years. So it is quite stunning that the financial industry, which usually is amazingly fast to adopt good ideas, has avoided the fat tail approach until now.