Unintended Consequences:  Iraq, Pensions and Index Funds

John Mauldin | Thoughts from the Frontline
March 15, 2003

Each week, I typically sit down at noon on Friday to write this letter. Quite often I stare at a blank screen pondering what to write about. Last week, and this week, my task has been to decide what NOT to write about. There is just so much that is worthy of our attention: pensions, indexing, Iraq, the drop in gold and the rise in stocks, international turmoil, the misleading headlines in the investment media and more. I have to leave the office without fail at 5:30 (kids come first), so let's see how much we get covered.

The context for this week's thoughts was provided to me by Art Cashin, head floor trader at UBS Warburg and also of CNBC fame. He writes a privately circulated and brilliant daily letter which is absolutely one of the most fun and informative tomes I read every day, without fail. His bosses need to allow him to circulate it to a wider audience. He wrote last Monday about unintended consequences, and provided the following story. My reading this week has brought to my attention a wide variety of unintended consequences. But first, Art's story:

"On this day (approximately) in 1349, in the midst of the infamous Black Plague epidemic, the forces of government, science and academia came together with a plan to save the people. As you recall from earlier episodes, the Black Plague had spread from the eastern Mediterranean throughout most of Europe killing millions over the preceding three years. People searched everywhere for the source of the plague...a heavenly curse; a burden of immigrants; the result of spices in the food. It was tough to figure, however, since whenever they held a conference either the host area caught the plague or the visitors did...so...not too many conferences.

"Then in the six months preceding this date the death rate leveled off...or seemed to. So in castles and universities and town halls across Europe, great minds pondered the cause of the plague. And they came pretty close. The collective governmental/academic wisdom was that the source of the Black Plague was fleas - (absolutely correct).

"So the word went out from town to town across Europe - to stop the plague - kill the fleas - by killing all the dogs. And immediately the slaughter of all dogs began.

"But like lots of well-intentioned governmental/academic ideas it was somewhat wide of the mark...and had unexpected consequences. The cause was fleas all right, but not dog fleas...it was rat fleas. And in the 1300's what was the most effective way to hold down the rat population? You guessed it - dogs. So by suggesting that townsfolk kill their dogs, the wise authorities had unwittingly allowed the rat population to flourish and thus a new vicious rash of Black Plague began. Before it was over, three years later, nearly 1 out of 3 people in the world had died of the plague.

"(Historic footnote...Published sources say that with so many people dying, millions of estates had to be settled - result...the fallout of the plague was a huge growth in....the number of lawyers.)"

The Unintended Consequences of Underfunded Pensions

I have written extensively about how corporations are misrepresenting their pension fund liabilities. Steven Kandarian, head of the US Pension Benefits Guarantee Agency which insures pensions and is financed by company-paid premiums, told the Senate Finance Committee that inadequate requirements have led to a $300-billion shortfall in the assets of company plans.

Typical is General Electric Co. which reported Friday that its pension plan contributed $806 million pretax to earnings in 2002. A footnote on page 27 in its annual report showed that it actually lost $5.25 billion, equal to 29% of the company's pretax earnings.

They can do that because they assume their pension plans, which invest in stocks and bonds, will grow at 9%. Since bonds are only paying 6% or so, this means they assume the stock market will grow at 10-12% a year. If that happens, they will not have to take from profits and fund the pension plans. Of course, if the market does not grow that much, then they will have to take a hit to profits.

If actual pension liabilities had been counted in financial statements, aggregate earnings for the S&P 500 would have been 69 percent lower than the companies reported for 2001, or $68.7 billion rather than $219 billion, Credit Suisse First Boston Corp. found in a research study on pension accounting published in September. Morgan Stanley says the S&P 500 companies have $220 billion dollars in unfunded pension liabilities as of the end of last year.

I could do a whole letter on public company pension fund problems. But for most of us, the problem is not one which affects us directly. We can simply sell the stocks of companies which have pension fund problems, and we don't have to buy S&P 500 index funds.

But there is a pension funding problem which dwarfs the public company problem, and which will directly affect your pocketbook. Let's look at government pension plans, which your tax dollars must fund.

Wilshire Associates does an annual review of state pension funds. They released the 2002 study this week. Ugly does not begin to describe this paper. Let me give you a few of the more salient findings.

Of the 123 state retirement systems covered in the study, 79% are now underfunded. In 2000 only 31% were underfunded. At least nine states have pension fund liabilities that exceed their annual budgets. Nevada would have to devote 267% of its annual state budget to make up its current shortfall. Illinois would need 144% of its current annual budget.

It's actually worse, as the study was done on reports from the retirement systems that were mostly done in June or July of 2002. Since the average fund has 63% of their investments in equities (both domestic and international) and the markets are down by 20% since last summer, it is very possible total pension assets might be down another 10% or close to $200 billion in fiscal 2003 unless we see a substantial rise in the stock market in the next three months.

As of the report, state retirement systems only had 91% of the assets needed to fund liabilities. This is down from 115% only two years ago. It is not unrealistic to think that it might be as little as 80% by the middle of this year.

And, of course, I have to go on to note that it gets uglier. Wilshire assumes that these funds will get a 7.5% return per year on total assets, which is only 0.5% less than the 8% the average state plans assumes they will get.

How realistic is that? As noted above, the average fund has 63% of its assets dedicated to equities, down from 64% last year. Since the stock market had a large drop in 2001-2002, that means they were selling bonds and putting any new revenue into stocks to maintain their stock/bond ratios. The consultants tell the boards this is a smart thing to do, because you don't want to miss the next bull market. The boards buy into the logic, because the alternative is too hard to contemplate: lowering assumptions of future returns and thus requiring the states to ante up more money.

If you assume you can get 6% on your bond portfolio (which is aggressive, as most retirement funds are required to invest in high quality bonds which do not pay more than 6%), this means the average fund is assuming they are going to get returns of 10% per year on their stock market investments.

They basically assume that the market will double in the next seven years: Dow 15,000 here we come! An S&P 500 of 1700 is right around the corner.

I wrote a few weeks ago about the tables at www.decisionpoint.com which shows the current P/E ratio for the S&P 500 is 27.59. I can find no period in the history of the US markets in which 7 years after such a nosebleed level the stock market has averaged even 1%, let alone 10%. You can make an argument that from periods where P/E ratios hit their highs (generally in the area of 22-23), there were some periods where the markets averaged 3% the next seven years, but you can also find periods where the next 7 years showed actual losses.

But there are no examples of 10% from the P/E levels which we are at today. None. Nada. Zippo.

This week, the Financial Accounting Standards Board decided unanimously to review how options should be accounted for. As I predicted early last year, I believe they will decide to require companies to expense options. This will be a significant drag on earnings for many companies. Along with other stricter accounting requirements (see more below), the chances that earnings in corporate America are going to grow by 10% a year for the next seven years are remote.

There are those who will argue (and do so aggressively) that investors will ignore the new earnings and focus on pro forma earnings, and thus earnings could rise by 10-15% or more per year. I politely reply, "Nuts."

After the next recession, and even more earnings disappointments, investors are going to be even more conservative than they are today in how they view earnings. The standards will get stricter, and many companies will have to work to get back to what they reported only a few years ago.

Nightmare on Pension Fund Street

Let me start with a worst case scenario, and then see if we can find a way to paint a better picture.

Today, there is something north of $1 trillion dollars in equity assets in the 123 state pension funds covered in this study. My back of the napkin analysis shows that pension fund estimates assume that the equity portion of the pension fund assets will grow by 10% or around $100 billion per year.

That means in 7 years and at 10% compounding, they are assuming there will be approximately $1 trillion dollars in growth from the equity portion of their assets.

If the stock market is flat, they will be short $1 trillion in only 7 years, from a "mere" $180 billion shortfall today. If the market grows at 3%, the states will be down $750 billion from their estimates.

Can It Get Worse?

The Texas legislature is in session. In Texas, we regard large groups of politicians in one place as dangerous, so we only let the state legislature meet for five months every two years. I called one of the most knowledgeable long-time veterans in the legislature today and asked him how we are dealing with our Texas sized $19 billion dollar, public pension shortfall.

Bottom line: we aren't. It is not on the "leadership" radar screen. For the first time, Republicans finally control both houses of the legislature and statewide offices. They ran on a no new taxes platform. They are scrambling, as is almost every state, to balance a huge budget deficit without raising taxes. It is doubtful they will be able to do it. It they had to kick in another $3 billion a year, or close to 5% of the state budget, just to get us to balance within 10 years, there would be panic in Austin. There is no way they could find another $2-3 billion a year without substantial new taxes.

This is typical of states throughout the union. It is much easier to assume 10% equity growth, increase funding a little and hope the problem goes away.

If we see a sustained secular bear market, there is no way that state governments can meet the kind of pension shortfalls I am suggesting are possible, which is precisely what I think is going to happen.

What will happen? Will the public pension fund world come to an end? No, politicians will eventually step in, when things start to get grim. There will be declarations of crisis and emergency, and to "save the system," benefits are going to be cut or frozen. Future retirees will not be happy. It is probable in many states that defined benefit plans will be changed to defined contribution plans. Some states will honor current retirees, but younger employees will not be able to retire under the current system.

The longer this secular bear market goes, the worse things will get and the more money states will have to come up with in the future.

The unintended consequences of the current policy of benign neglect will mean either future tax increases, cuts in services or both. As medical costs rise, the state funded portion of those costs will rise as well. The pension benefits for younger workers will be cut, and they will be forced to either save more or face a less robust retirement.

Unless steps are taken soon, it is possible we could see shortfalls approaching $1 trillion dollars in state sponsored funds by the end of the decade. A deficit of this size on state levels can truly be called a crisis. A tax increase or other adjustments to fund this will be a large drag on the economy.

This does not take into account the many municipal (police, fire and employees) and county pension funds, which have the same underfunding issues. The problem, in reality, is much larger than the 123 state funded plans discussed above.

Index Funds Complicate the Markets

Wall Street loves index funds. They are the largest of mutual funds. They are sold as less volatile instruments than single stocks, and investors have flocked to them. Mutual funds use spiders and QQQ's and other exchange traded index funds to simulate markets. Longboat Global Advisors recently commented that an unintended consequence of the growth of index funds is "We believe that indexing via market capitalization is destroying whatever remains of pricing efficiency in the American market and is a primary reason for the bear's grip and the concurrent expansion of volatility, very simply put, every time a market cap index is bought, the fattest stocks receive sponsorship by the sole criteria of their inclusion in the index... [regardless of the actual prospects or value of the company]."

In April of 2002, Mr. Jean Claude Trichet, Governor of the Banque de France, in a presentation at the Federal Reserve Bank of Chicago, gave indexing as one of four reasons that markets appear less efficient. He stated that index management helps "to amplify market trends, buying more as the market rises and liquidating more as the market drops. It can be argued that index funds distort the price of the targeted indices and that, as a result, the indices end up creating rather than measuring performance."

In essence, buying a NASDAQ index fund supports the price of large NASDAQ stocks even as the prospects for profits of the individual companies decline.

There is no real solution, as you can't ban index funds. But it does affect the market. As an aside, the 15 companies which the S&P 500 dropped from the index lost an average of 73% in 2002 and were down 91% from their highs.

Why the Market Rallied

I must confess to getting apoplectic every time I hear that "the markets rallied because of news that the Iraq war might not happen." It is utter drivel, and only someone desperate for a headline could propose such. The markets and traders know there will be a war, and are driven to try and anticipate what the public reaction will be. The current betting by real traders is that there will be a war rally after the war is over, or very soon after it starts, assuming it is as successful as it now appears it will be. Since it appears it could start within days, no trader wants to be caught short overnight, or going into this weekend. As I have written, a short-covering rally of significant proportions, followed by a momentum rally is possible.

It is nice to get solid thinking from market veterans like Art Cashin or Dennis Gartman. I also receive a daily update from Ramsey King called the King Report, written for larger institutions and traders on world events and trading advice. This Thursday AM he wrote, long before the market opened:

"Stocks will try to rally after Wednesday's bounce off important technical levels. Also, since it's Thursday, beware of the usual late rally attempt. With a good deal of war liquidation complete, the expectations of a monster rally when war commences will now force short covering and induce bargain hunting in the believe the war could start on Tuesday, which coincides with an FOMC meeting at which the Fed is expected to cut rates. Plus next week is expiration week, and as we recount every month, upward expiry bias commences on either the Thursday or Friday of the week that precedes expiry week - that means today or tomorrow. Technicals are at extremely oversold levels and the just-mentioned factors augur for a short-term rally. Furthermore, Monday's 90% down day indicates a snap-back rally is imminent. And that's why thinking operators acted yesterday."

Art Cashin noted that the rally got momentum on the rumor that the CIA is negotiating with Iraqui generals for the surrender of whole divisions, which will in turn march on Baghdad. It was not the postponement of war, which no one believes is really possible, but the possibility of it being swift and painless that got the "animal spirits" of traders moving. If the war does go well, they expect a war rally a la 1991.

Of course, contrarians say we saw the war rally this week. Do you buy the rumor and sell the news?

It could go any of a dozen ways. Since we are in a secular bear market and the long term trend is still down, this is not the time to jump in for a long term investment. This is a trader's and stock picker's market. It is not time to buy and hold.

Finally, a few comments on the possibilities for unintended consequences resulting from the coming invasion of Iraq.

The French are openly dismissive of an American president, who does not understand how important it is to listen to world opinion, and especially that of France. They are determined to have their way, even though Americans have sacrificed much to support France in the past.

Bush in 2003? No, it was Woodrow Wilson after World War One. France (and Britain) were determined to punish Turkey (the Ottoman Empire) for supporting Germany and insisted on carving it up. They created whole new countries, like Iraq, that had never existed, lumping in tribes and regions with long histories of fighting. They split families and regions as they carved up the Middle East as they expanded the colonial empires, over the protests of Wilson.

The most negative unintended consequence was the removal of a central Islamic religious authority in the caliphate and the establishment of some Saudi tribal princes as leaders who were under they sway of the Wahhabi sect, a radical and militant group within Islam founded by Abdul Wahhab (1703-1792), known for its strict observance of the Koran and flourishing mainly in Arabia. With the finding of oil, Saudi princes have bought off this group by funding their schools and mosques, and their adherents have "grabbed the mike" in most mosques throughout the world. In 1920, they were a distinct minority and few, if any, Islamic scholars of the day were associated with them. Today, they are the principal sponsors of religious based terrorism.

Islam is not the enemy of the West. Wahhabis are a different matter. Those who listen to them are taught to hate us. They are an unintended consequence.

Let us make no mistake, for good or ill, Bush is going to remove Saddam. US polls (Fox News) show a growing 71% behind the war (this probably means that 71% of my U.S. readers are behind the war and 29% are not, with the reverse of these percentages for my European readers) with a growing percentage wanting it done now. Polls show Bush would lose a significant percentage of his support if he does not act soon. He will. The war may start before next weeks letter reaches your email box, or shortly thereafter.

For the record, this war is not about oil, despite the conspiracy theory buffs. It is not about America wanting an empire, despite George Soro's insipid accusations. It is not about the Carlyle Group wanting to rule the world.

I know George W. Bush somewhat, having dealt with him on occasion as I was involved in Texas politics when he was governor. I think I know somewhat of his character and personality. He is an impressive man, but more than that he is a genuine man. One of my minor regrets in my life is that I did not get to know him before he ran for governor. He is precisely the type of man you want to have as a friend.

This president was profoundly animated by 9/11. He does not want another event like that to happen on his watch, or because he left a problem to the next generation. It is as simple as that.

Conspiracy theories, oil cartels, empire and world domination and the like are a lot more fun to think about. But sometimes the real reason is the most simple. In this case it is.

What Will Go Wrong?

The things that concern me are not the ones most discussed in the media. I am not worried about a break in US European relationships. If you count countries, there is a clear majority of European countries supporting the US position, something like 15 to 5, with a few neutral countries. My friend Dennis Gartman, speaking at a conference in Portugal, writes of a very moving speech by the Portuguese president on why Portugal is supporting the US.

Since the actual people (and voters) of Europe are against the war by an overwhelming majority, are European politicians suicidal in their support for the US?

No, they are not. If you ask most Europeans in the countries which are supporting the US, they will say they are against the war. But there is more to the story.

In polls in the US, people overwhelmingly think the US education system is bad, but their schools are good. The medical system needs reform, but their doctor is just fine, thank you.

In Europe, the Iraq war is not something that will change the lives of most citizens. While the average voter is against the US war, they are far more concerned about how a French and German led Europe might force their nations to adhere to rules which would not be good for their countries, could hurt their opportunities for growth and limit their freedoms. A powerful US who would only like to do business is far less a personal threat than a French hegemony which would like everyone to conform to their work rules, tariffs and economic plans and lessen competition from other countries.

European politicians know that the Iraq war will be forgotten soon. The issue in the next round of elections will be who will run the European Union and how it will affect their country.

I can see the large dollar costs of the Iraq war. I can see a possible increase in terrorism. I can also see a possible growth in democracy in the region. I can see good outcomes and bad outcomes.

The things which worry me are the negative unintended consequences that we cannot even imagine. Churchill would not have created Iraq, and the French would not have installed the Saudi tribes, if they could have foreseen today.

It is the flea which worries me.

Christoph Amberger wrote an essay for the Daily Reckoning yesterday which was absolutely brilliant. Amberger was born in Berlin and remembers another cowboy American president coming to Germany, where there were protests from the same people who march today and oppose American power.

But Reagan persevered, and the Berlin Wall came down. Those who opposed America at that point were wrong. You can read his moving essay at http://www.dailyreckoning.com/sub/Mwave2.cfm. This link will also give you an opportunity to subscribe to the free Daily Reckoning e-letter. You can get to Christoph's essay by scrolling about halfway down.

It is approaching 5:30 and I must go. My sons are waiting. I have to fly for a quick meeting in DC on Monday but will return the next day. I will be in Austin on Monday of the following week speaking at the Texas Public Pension fund conference.

I leave you with this quote dug up by Bill Fleckenstein:

"It is very rare that you can be as unqualifiedly bullish as you can be right now." Alan Greenspan on January 7, 1973, two days after the market peaked on its way to declining 50% over two years as we endured the worst recession since the depression."

Your rushing out the door analyst,

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