Thinking Financial Planning

The Road to Zimbabwe Revisited

“Lenin was right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” [Keynes, 1919]

Inflation expectations appear to be on the rise, and there is increasing speculation from analysts about hyperinflation if the U.S. continues to pursue its current monetary policies to revive the economy. One such article appeared today, which I found thought provoking and deserving of a response: “The Road to Zimbabwe” by Robert Huebscher in the June 23 issue of AdvisorPerspectives.

There is no question that we are going down a path of greatly reduced purchasing power of the dollar. John Williams at Shadowstats provides a great service with more meaningful and factual data that can provide better insight into economic and market trends. However, the economics of inflation are far more complex than the relatively simple view he provides. I would also disagree that the facts he points to imply that we will see such rampant inflation in the next 12 months or less. There could be other facts that do, and we might well experience something extreme, but I don’t follow the conclusion from what’s presented here.

The point is, as Keynes says, that inflation is very complex and truly not one man in a million will be able to properly diagnose and/or predict the effect with any degree of certainty. Points that need to be considered:

• The government’s unfunded liabilities are astronomical, but that’s amortized over the next 75 years or so. How does that factor in to the next 12 months specifically? If we print only the money we need next year, what causes inflation to accelerate faster than it has in, say, the last year or so?
• I would argue all historical currency collapses that necessarily result in hyperinflation have been accompanied by speculative shorting of the currency in a targeted coordinated attack by well financed investors with access to large pools of capital relative to the targeted currency. The printing of currency by a sovereign government generally cannot result in what we would call hyperinflation in and of itself. Where is this speculative attack against a currency with the global volume of the US dollar going to come from? I don’t think it’s possible to leverage enough pools of capital to short the dollar with enough vigor to drive it down into hyperinflation the way Zimbabwe did, or the smaller Asian currencies were in the late 90’s, or Latin America currencies were in a number of examples, or Soros famously did with the British pound. There is no doubt that as reality sets in on the dollar, foreign dollar holders will divest themselves of bonds and dollars, reducing their long positions, but is this enough to hyperinflate the dollar in a way that US consumers experience the result? I don’t think it’s possible, even if we can divine the intentions of notoriously secretive sovereign wealth funds.
• As the dollar weakens, all other nations will inflate as well. They cannot afford to see their exports to the US collapse any more than we can tolerate a collapse of the dollar. So the question has to be asked, what does the dollar collapse relative to? Hyperinflation implies it collapses against the price of bread, gasoline, everything, if not other currencies as well. If it doesn’t collapse relative to other currencies, what does that look like? Will it collapse against all commodities and precious metals? Probably. Will it collapse relative to real estate? Maybe. Who knows? Inflation shows up in various asset classes at wildly different rates. What if gold skyrocketed in value to $5000/oz.? Could the US govt. exchange gold to sop up enough of the money supply to mitigate inflation. It might be able to if it wanted. The velocity of gold is much lower than currency. Devaluing the dollar against gold has been theorized as a mitigating mechanism to shore up the economy, as FDR did in the thirties. Again this is a complex scenario that is not out of the realm of possibility and which impact would be hard to predict.
• Inflation calculations necessarily must include the velocity of money. The higher the velocity, the faster and the greater the inflation. What if the money supply increases dramatically, but the velocity of money continues to decline? What if the vast majority of consumers continue to see their wealth decline and either hoard cash, or the increased money supply can’t find its way into the right hands to create demand in prices across the board? If the vast majority of consumers don’t see increasing dollars in their hands, either through increased unemployment, or declining real wages, it’s hard to say what the results will be. All it takes will be a single asset class to sop up the extra dollars (like gold above), the way foreigners have been sopping them up for the last decade or more in the form of US bonds for the apparent affects of inflation to be mitigated even with accelerated govt. spending. Could we have another asset bubble like Internet stocks that sops up excess cash so it does not flow into consumer prices or prices of imported goods? This is more likely if the increased money supply stays in the hands of only a relatively small number of parties with a low velocity of money. Will Ben drop it from a helicopter or will banks sit on it to bolster balance sheets? Who can predict?
• Which brings me to another point. The vast majority of the money supply comes not from govt. printing excess cash but from bank loans and free flowing credit. This is probably still in the process of contracting, although eventually inflation may overwhelm this effect. Since a dollar on deposit can eventually (maybe years later?) contribute to a 10x increase in the money supply, how are we going to increase the rate of bank loans from what we’ve already seen? Loans are getting tighter, Americans are trying to save more, businesses are taking on less risk. All factors that will continue to mitigate inflation in the near to mid-term.

I would be inclined to agree more with Marc Faber’s view of hyperinflation here on CNBC (below and at: http://www.cnbc.com/id/31450173). It’s probably coming, but it won’t come as fast as the dollar bears predict. It’s a much more complex situation with enormous contrary forces in place than any one person can accurately predict.

Fiduciary Standards of Financial Advisors Part of Proposed Regulatory Reforms

This week, the U.S. Treasury unveiled their vision and recommendations for regulatory reform in the securities industry in a detailed whitepaper entitled, “Financial Regulatory Reform, a New Foundation: Rebuilding Financial Supervision and Regulation”. (Background: "Fiduciary Standard Part of Sweeping Regulatory Reforms", FA Magazine, June 18, 2009) The most pertinent changes for brokers and financial advisors is the sweeping reforms that make all investment advisors fiduciaries, including registered reps at broker-dealers and all CFP®s. The stated goal is to bring all classes of investment advisors under a common fiduciary standard (the strictest) to avoid confusion among consumers and to ensure the highest degree of integrity when dealing with clients for all professionals throughout the industry. While many brokers and advisors are still taking a wait and see attitude, and take an arms-length view of the whole regulatory alphabet soup, I think these changes will have profound impact on the industry and the way nearly all advisors run their practice, how they market themselves, and the services they offer. Understanding the big picture and preparing for what appears to be inevitable regulatory reform at this juncture is critical.

First, a bit of background: Today, the various certifications and designations of investment advisors are held to different sets of regulatory requirements and guidelines, particularly in the determination of whether the advisor is or is not held to a fiduciary standard. Registered Investment Advisors are held to a fiduciary standard, meaning that they are liable to provide appropriate investment advice for the needs and risks of the clients, but registered reps, insurance agents, and broker-dealer agents are not. CFP®s and financial planners are fiduciaries only if they are RIAs. Most descriptions of fiduciary responsibility focus on the requirement to further divulge how the advisor is compensated and any potential conflicts of interest that arise from the advisors compensation and the client’s needs. In general, a fiduciary needs to put a client’s needs first and foremost, and are held to strong ethical standards, much like a doctor or lawyer. OK, well, doctors anyway, “do no harm”, and all.

Divulging conflicts of interest and compensation schemes is all well and good, but where the fiduciary standard really matters is when the advisor gets sued. And, unfortunately, after down markets and investor losses, clients sue a lot. If the client has suffered losses that will affect their lifestyle or children’s college plans, there is a much greater liability on the part of fiduciary to prove that he considered all downside risks, and to show that the investment plan was clearly in line with the client’s risk tolerance and comprehensive investment needs. The onus falls on the fiduciary when material harm is done.

By comparison, nearly all broker-dealers require clients to agree to binding arbitration in the event of a dispute. They also make no warranties about keeping the client’s needs first and foremost, merely that a particular investment is “suitable”. The onus is on the client to show lack of suitability to the arbitrator, a much more challenging prospect for the uninitiated.

The National Association of Professional Financial Advisors (NAPFA) compares the approach of a fiduciary (which their members are), with that of broker-dealers who provide the following disclaimer in their client agreements:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. [My emphasis. – GK] Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest.”

Andy Gluck, CEO of Advisor Products, Inc. wrote an impressive blog about the regulatory changes and the impact of all registered reps becoming fiduciaries. He concludes that, “making all advisors say they will act as a fiduciary will water down the meaning of the term… I suspect that advisors who today are fiduciaries are going to have a tough time differentiating the way they give retail advice from the way brokers who are fiduciaries do it.”

Taking another perspective, I’m hopeful that the fiduciary standard will continue to maintain its inherent liability implications, as this is clearly the intent of the regulatory reform: to close loopholes that keep consumers from getting the best, most appropriate advice and standardizing ethical guidelines that alleviate confusion and clarify issues to the public. What I take all this to mean is less that RIAs will now face a marketing challenge, but that brokers won’t be pushing high flying Internet IPOs, and emerging market ETFs on quite so many unsuspecting investors. While they may never give up their binding arbitration clauses, broker-dealers are going to find themselves in court having to defend their investment advice with a whole new level of fervor where there will be much more of a presumption of guilt than innocence. Since there are many more registered reps at broker-dealers than RIAs, I think this reform will have much broader impact than many expect, particularly those that think that the fiduciary and ethical standards are going to be watered down to the least common denominator.

What is a broker-dealer, financial planner, registered rep, or variable annuity agent supposed to do? Well, I’m no lawyer, and I don’t even play one on T.V., but your goal should be that if you ever end up in court that you’ve got all the facts on your side. Have you taken a holistic view of your client’s financial situation in order to ensure that their risk tolerance was in line with your proposed investments? Have you taken into account all their lifestyle needs, goals and factored in an appropriate measure of downside risk commensurate with “doing no harm” according to historical precedents? Have you built an investment strategy that minimizes risk for the anticipated returns according to asset class correlations determined by historical data going back long enough to cover all reasonable market conditions? My guess is that if you are not doing financial planning, or at least are collecting enough data about your client to be in a position to do it, that the answer to most of these questions is “no”. Further, unless you are using asset allocation and portfolio management software to design efficient portfolios, the answer is probably “no”.

We know that the vast majority of RIAs, who have long been held to fiduciary standards, do make comprehensive financial planning an integral part of their practice. The reason is that they need to be in a position to answer “yes” to all the above questions when pressed. We also know that the vast majority of financial advisors at the large broker-dealers don’t do financial planning, or do it only as a marketing gimmick to show a need to sell products and services. Clearly, as these regulatory reforms move forward from the good intention/whitepaper stage to new legislation, this is going to change. Would you want to end up in court needing to prove that you have operated at the highest fiduciary standard possible without the documentation and planning details that justifies your decisions and the design of your portfolios according to the best historical asset correlation and risk management data available? Again, I think the answer is, “no”.

The last question is: will financial planning technology vendors be regulated through technical certifications of their products (sort of an FDA or UL approval for planning apps), with appropriate liabilities for their role in the delivery of advice? Well, AdviceAmerica welcomes being held to an equally high standard, but I wouldn’t expect any real legislation in this area until after they sort out the next great crash around 2050.

Yield Curve Update with Wolfram Alpha

Here's an interesting update to my earlier post on Wolfram|Alpha about two weeks ago. Since that time, long term treasury yields have increased considerably, so I thought I would rerun my query to display the yield curve and compare results.

First is the yield curve from today (June 11, about noon Pacific time):

Followed by the yield curve pulled from the earlier post on May 27:

Hard to see with the naked eye, but sure enough, we see a much steeper yield curve today with slightly lower yields at a year and under, while the yield on the 10-year is up from 3.17% to 3.71% (an increase of about 17%). I actually saw the 10-year yield today on CNBC at 3.96%, so I'm not sure how current even the Wolfram|Alpha data is. Bloomberg is showing 3.86% right now after trading hours as I type this.

The 30-year T-Bond yield has increased by about 10% according to the above charts (Bloomberg is showing the 30 year at 4.69 compared to Wolfram|Alpha's 4.59%, or an increase of 12.2%). Investors tend to panic when their stock portfolios drop 12-17% in just a couple of weeks, but we don't hear the same kind of high anxiety from bond investors now. I wonder why?

I retweeted an article last week that was titled "Fed Puzzled by Steepening Yield Curve". It's really not that puzzling. And it's not that the FED is easily puzzled, but part of their job is to feign indignation at the hints of inflation, when they are trying to push the deflation story in order to jawbone interest rates down. The fact is that investors are expecting greater inflation down the road, and a weaker dollar. Amidst the talk of Russia and China diversifying out of the dollar as their primary reserve currency (i.e., selling their treasury bonds), investors are looking for more yield to both offset inflation expectations and the fear of a glut of treasuries hitting the market sending prices down and yields up.

This is not good news for the housing market or the prospects of a recovery if the cost of borrowing is going up. If the recovery is going to continue, it's going to depend on an environment of low interest rates. Although the massive govt. spending and bailouts has increased the money supply to unheard of proportions, with the prospects of more and more of that to affect consumer prices over the coming years. These two forces (the need for both dollar creation and low interest rates) are definately at odds with each other, and will require investors to navigate difficult waters in the months and years ahead.

Financial Advice from Jim Rogers

I always enjoy the insights and perspective of legendary investor Jim Rogers, co-founder of the Quantum Fund along with George Soros. I found this short video recorded in the last day or so to be very compelling. Financial advisors should really take his prognosis to heart when thinking about current assett allocation strategies. His summary:

• Govt. economic figures, particularly employment numbers, are unbelievable
• He's not really "short" anything right now
• He's not long on equities, though, either, since business fundamentals continue to deteriorate
• The worst is not yet over and looks for a serious leg down later this year or next
• There is no other way to bail out the current financial mess than inflation. Bernanke is finally being honest about this, or more candidly realistic that this will cause future problems. Please invest accordingly.
• He's very bullish on commodities whether the market goes up or down

I have to admit I'm generally invested along these lines as well, in the interest of full disclosure. I have tentatively reintroduced some equity short positions lately, and I'm definately short longer term treasuries, which has been a nice trade recently, and I find hard to believe Jim Rogers isn't playing as well given his inflation bias.

Almost equally important, Jim Rogers has a new book out on fatherhood, offering wisdom to his young children since he became a father relatively late in life. He describes the new emotions you experience and great joy of fatherhood. Being a father is the greatest thing that's ever happened to me, so Amen to that Jim! Enjoy the full video: