Dow 12,000 – Who’d a Thunk It?

From the Desk of Joe Rollins

Last night’s financial news programs were focused on the Dow Industrial Average approaching 12,000. I’m not exactly sure whether the commentators were outraged, alarmed or indifferent regarding this prospect, but I certainly am not surprised that the Dow is moving higher.

In March of 2009, the Dow had dropped to 6,440. It appears that before the end of this month, the Dow will have almost doubled in the intervening 22 months. It’s unfortunate to see so many investors sitting on the sidelines watching the stock market double without jumping into the game, and it is equally frustrating advising investors to at least make their IRA contributions early in the year only for so many to never do so. Their answer is always “Soon.”

A client recently asked me when I thought the Dow would reach a new all-time high. While anyone can guesstimate when that might happen, performing a calculation based on the current data provides a more likely scenario. So many commentators in the financial press make outrageous predictions, but very few of them actually perform calculations based on economic data to determine the possibilities. The following is a good exercise in how to perform this calculation.

It’s easier to obtain information on the S&P 500 than the Dow Industrial Average. The S&P is also a better indicator since it includes 500 companies as compared to the Dow’s 30. Using the S&P’s information, I performed a calculation and extrapolated the outcome to include the Dow Industrial Average.

As I have written so many times in previous posts, the most important component to pricing stocks is earnings. The higher the earnings, the higher the potential stock prices. Of course interest rates play a part; the higher interest rates are, then the more likely that interest-bearing certificates would be competition for the stock market and would draw money away from stocks into fixed rate investments. However, we currently have the best combination for investing possible: extraordinarily low interest rates with CDs and government bonds paying very low rates, along with very high corporate earnings. This is the optimal time to be investing in stocks.

For 2011, most projections reflect that the S&P will return earnings of approximately $90 per share. If you use the standard, blended-rate multiple of 15.7, you get an index value at the end of 2011 of 1,413. It’s easy to pick a price/earnings ratio that would be highly volatile. As you are likely aware, the ratio is simply the average price of all the stocks in the S&P 500 divided by the average earnings of those same stocks. In other words, how many times earnings would the price be? P/E ratios historically go from a low of 14 to a high of 20, and the S&P 500 uses a conservative blended rate of 15.7.

Based on earnings of $90 earnings and a 15.7 multiple, the S&P would gain 9.7% for the year 2011 and end the year at 1,413. Given that interest rates are earning almost zero and a 10-year Treasury is earning 3.4%, a return of 9.7% would be spectacular performance for the year. The S&P earned 26.46% in 2009, 15.06% in 2010, and could potentially earn 9.7% in 2011, an extraordinary run of excellent performance.

For 2012, the so-called experts are forecasting earnings of roughly $100 for the S&P 500 companies. At a 15.7 multiple, the percentage increase for 2012 would be 11.1%. Therefore, if these numbers actually come to fruition, then the S&P 500 would have an annualized return from 2009 through 2012 of 15.39%. Given that inflation has been at virtually zero during this timeframe, then that return may very well be the highest rate of return in respect to inflation ever.

Extrapolating the same increases in values for the Dow Industrial Average at 12,000 now provides the following:

	S&P 500	DJIA	P/E	Earnings
January 25, 2011	1,288	12,000	15.7
December 31, 2011 - 9.7% gain	1,413	13,164	15.7	$90
December 31, 2012 - 11.1% gain	1,570	14,625	15.7	$100

The recorded all-time high closing for the DJIA occurred on October 9, 2007 at 14,165. Based upon my calculations above and good historic data, it appears that the next all-time high for the Dow that surpasses the high recorded in October of 2007 will occur in 2012. Obviously, investing is not as simple as forecasting, but given the current extraordinarily high earnings of the U.S. corporations, this should happen sometime next year should my forecast prove correct.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Q&A Series - State and Municipal Public Pension Obligations

This week's questions come from Dave, a client who would like a better understanding of the states’ public pension obligations .

Q: What is going on with state public pensions? Are the payouts sustainable, or are defaults among municipalities and states imminent?

A: Boy, has this topic been receiving a lot of press lately! While not all states are in dire financial conditions, California, Illinois, New York, New Jersey and several others have taken on obligations they simply cannot fund with their tax revenues. It is worthwhile for us all to understand the exact obligation these states are facing and why the problem is so severe.

I believe the root of the problem is public service unions. With public service unions, there is a direct conflict of interest between the unions and the elected officials since the unions can collectively raise funds from their membership and use their clout to get a particular political candidate elected. Then, if the candidate they support is ultimately elected, he or she is obligated to provide higher wages and more benefits to the union members. Unfortunately, this situation has grown worse over the years. Also, if that particular politician is voted out of office down the road, it then becomes someone else’s problem (i.e., the taxpayers’).

Using the most recent Presidential election as an example, Barack Obama indicated in his campaign that he would support public service union employees along with all other unions. Ironically, less than 9% of private sector U.S. workers are represented by unions, and as such, 91% of U.S. workers in the private sector have no union representation. However, the Obama Administration appears to be advocating mostly for the 9% minority represented by unions.

Almost immediately after President Obama was elected with almost universal support from union employees, he passed a failed stimulus bill that devoted approximately one-third of its amount back to state and local governments. This, in turn, paid many of the salaries of public service union employees. Even though it was clear from the beginning that this would not create employment, it was utilized to maintain state employees which everyone knew could not be maintained once the stimulus funds ended.

In the private sector, negotiations between labor unions and management are often adversarial. Therefore, the pensions and other benefits of workers covered by union contracts are negotiated in a manner that is typically fair for both the employees and for the companies. However, in the public sector, negotiations for pensions are much different.

In the U.S., roughly 36.8% of public sector employees are union members. Even though the total union representation for the private and public sectors in the U.S. is only 12.4%, they maintain substantial clout that has driven many states and local governments to the brink of bankruptcy. Government unions use their influence to elect those who candidates who accept their terms for higher wages and higher benefits.

In order to pay for the extravagant pension and other benefits of public service workers, the cities and states have no choice but to increase taxes. By virtue of increasing taxes, they run off local businesses. This is evident in the states in which these pension costs have become onerous. It is no coincidence that the states with the largest pension costs (California, New York, Illinois and New Jersey) are the very states that are facing massive unfunded pension costs and potential bankruptcy, and are also the states with the highest state income taxes.

The City of Atlanta currently has an unfunded pension cost of $1.5 billion. Given that there are only approximately 550,000 residents in the City of Atlanta, that works out to an unfunded pension cost of $3,000 for every man, woman and child that lives within the city limits. Since many of these residents are in the lower income bracket, they could not possibly pay this amount. As you can see, this cost could not possibly be raised through higher taxes, and therefore, these unfunded pension costs will have to be adjusted into the future.

Some states are even worse. New Jersey has grown their unfunded pension costs to close to $54 billion. Their problem is that the state is accruing the pension costs without funding the costs; they simply do not have the revenues to fund this cost. In 2010, the state did not pay its $3.5 billion accrued pension costs, and therefore, the obligation continues to worsen.

Part of the problem has been that the pension plans throughout many states have used unreasonable projected investment returns. For example, New Jersey projected annual returns at 8.25% when anyone who has been investing over the last few years knows that this rate is not attainable year-in and year-out. In fact, one calculation was completed assuming a more reasonable investment return of 3.5%, which made the state of New Jersey’s unfunded liability triple to over $173 billion. Ouch!

California, Illinois, New York and New Jersey all border on default at the current time. The low credit ratings on their debts will keep them from borrowing money without paying very high incremental costs. However, these situations are not similar to the private sector. States have a lot of flexibility in adjusting their pensions if they have the political will. Since state governments can change their own laws, they can easily change the law to reduce the pension benefits.

One thing the troubled states could do almost immediately is change their pension plans so that the employees’ pension amounts are rolled into a defined contribution plan that acts going forward much like a 401(k) plan for the private sector. While I seriously doubt many states will elect that option because of the overwhelming number of state employees under union contracts, it is perfectly possible for the state to reduce benefits by extending the retirement age or reducing the benefits when retirement is attained.

I was in France this past fall when the national debate was going on regarding increasing the government retirement age from 60-years old to 62-years old. There were riots in the streets, and many of the mass transit systems were completely closed down due to public service union strikes. It is hard to believe that the average retirement age in the country of France is only 55-years old. As we discovered in the Greek financial crisis, most employees in that country retire at the approximate age of 50. There is just no way that taxpayers can continue to fund these incredible pensions for public service employees.

It’s now time for taxpayers to rise up against this abusive obligation created by states and cities. While we want good state employees, it’s unreasonable to assume that taxpayers can fund this type of cost. Therefore, all cities and states should adopt the same plan as the vast majority of Americans – a defined contribution plan such as a 401(k) plan. If the cities and states were to adopt these types of plans immediately, the entire unfunded pension obligation would go away. The real question is whether our elected officials will have the political will to make such difficult decisions.

Unlike the private sector, the states have the ultimate weapon to get this matter under control – sovereign immunity. Since states have the ability to assert sovereign immunity, they do not run the risk of being sued by the unions. In the private sector, massive long-term litigation would occur if the companies unilaterally changed the union pension benefits, but in the public sector, the states could simply claim sovereign immunity and move forward.

Additionally, there is no overall governmental safety net for public service pensions. Essentially, if the public service employees didn’t like the changes, there’s nothing they could do about it. At some point, the government needs to be responsive to the taxpayers, and if the public service employers do not like their benefits, then they need to find new jobs in the private sector.

As a side note, and on the topic of private sector unions, I recently read about a situation concerning the salaries of Carnegie Hall stagehands. Carnegie Hall stagehands benefit from a powerful union – the International Alliance of Theatrical Stage Employees – and the average base annual salary of the top five highest paid employees is $359,000. Interestingly, aside from famous soloists, most artists performing on Carnegie Hall’s stage earn far less.

Dave, I hope my explanation and my opinions regarding unions have given you some understanding of state public pension plans and the potential repercussions of these plans on the country as a whole. There are many avenues for cities and states to take to avoid these gigantic, unfunded pension costs. But whether California, Illinois, New York and New Jersey will make those decisions before they go bankrupt remains to be seen.

I believe that at some point, the politicians will recognize the problem and will either terminate the public service pension plans or convert them to defined contribution plans. Personally, I do not see any reason for state or local governments to go bankrupt over public pension issues. My opinion is that they will deal with them prior to an ultimate financial disaster.

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

Another Banner Year for Investing

From the Desk of Joe Rollins

The investment results for 2010 reflect that it was another fabulous year, although I doubt many people were anticipating those results from the way the year started. During the year, we went through tremendous political and economic changes: the stock market had already rallied close to 50% from its lows in March of 2009 before January of 2011, and we had a new Congress that was seemingly intent on overturning the capitalist system. It appeared that every headwind was fighting against a successful market.

Despite low interest rates, the real estate sector continued in doldrums; the government tried a stimulus plan that was a bona fide failure, and; the politicians in Washington could not spend money fast enough to repay political favors. From the beginning of 2010, the outlook was not very promising. With all of these negative items in the mix, who would forecast such positive results? Me!

The year 2010 is now in the books, and we all have to raise a glass of champagne to a very successful investment year. The Dow Jones Industrial Average finished 2010 with a 14.1% gain, the S&P 500 finished ahead by 15.1%, and the NASDAQ Composite finished at 18.1% higher. All three major indices had almost double-digit returns in the 4th quarter of 2010.

If you recall, 2010 was quite a rollercoaster ride. We got out of the box quickly in 2010 only to suffer through the Dow Jones “Flash Crash” on May 6, 2010. The indexes continued to deteriorate into negative territory through the summer months. In November of 2010, however, Fed Chairman Ben Bernanke announced a second round of quantitative easing (QE2) by central banks, in which the Federal Reserve would buy $600 billion of government securities to hold in their own inventory through the middle of 2011. That seemed to be the catapult that got the market going, and after that time, the S&P 500 generated a positive return of approximately 20% from mid-August through the end of the year.

We certainly endured a lot of ups and downs in the market during 2010, but if you are a regular reader of my posts, you know that I remained positive that the markets would have positive results for the year (see my “Best Investing Environment in a Decade?” post.)

As we enter 2011, I am reminded that the markets do not go up endlessly. However, there may be an opportunity in the first half of 2011 for the market to continue to appreciate. Two of my clients contacted me this morning regarding my outlook for the market in 2011. It’s a sure sign that investors are nervous when I am contacted before 9:00 a.m. on the first working day of the New Year.

One client indicated that he felt it was unlikely for the markets to continue to go up given their strong gains in 2009 and 2010 along with the extension of the low capital gains rates. Even though the changes in the tax law were not approved until late 2010, there is no question that it will benefit investors for the next two years.

The other client indicated that Congress and President Obama would unquestionably be at odds as soon as the G.O.P. newcomers convene on Wednesday. I can’t argue with that, but I do know a few things that make the prospects for investing this year better. First, it’s unusual to see interest rates remain so incredibly low. Therefore, there is a mass exodus from cash that is earning essentially zero to opportunities for higher-earning investments.

During the 4th quarter of 2010, most bond funds had a marginal or negative return. In December of 2010, the municipal bond market took it on the chin with most of the funds losing half of their year’s gains in one month. For the first time in over four years, most bond funds have experienced a negative outflow of funds, which most commentators are assuming will eventually end up in stock funds.

The fact that we are expecting gridlock in Washington is nothing but good news for investors. Some of the best financial markets we have ever had are when Congress and the President cannot come to a consensus. If you are skeptical, just look back at the years 1994 through 1999 when Bill Clinton was completely crosswise with the Republican Congress. Governmental gridlock resulted in some of the finest equity markets in recent memory. Investors should welcome and cheer for additional gridlock in Washington.

It’s difficult to forecast anything in the financial world beyond four or five months, but I currently anticipate that the financial markets will be good through the first half of 2011. It’s highly likely that by the second half of 2011, GDP growth will accelerate. If interest rates stay moderately low and there are no major world or political events, I anticipate that the financial markets will have a positive double-digits net return in 2011. That may be a bold call for the coming year, but it’s one I truly believe given the information available today. So, the sooner you contribute to your IRA, the faster you will be rewarded.

On another matter, we would like to thank all of our clients who participated in the client survey we sent out with the portfolio performance reports for the third quarter of 2010. Many survey respondents commented that our quarterly reports contain too much superfluous information. Therefore, beginning with the 4th quarter, 2010 quarterly performance reports, we will simply provide you with a summary of your net assets and remove all extraneous paper from the reports that are duplicates of what Charles Schwab & Company and Fidelity Investments are already sending on a monthly basis. If you would prefer to continue receiving this information from us, it is always available at any time on request. You will also continue receiving your monthly account statements from Charles Schwab & Company and/or Fidelity Investments in their present form.

As many of you know, 2010 marked Rollins Financial’s 20th anniversary since our firm opened in 1990. We are fortunate to have many of the same clients we had when our firm opened, and to show our appreciation, we recently sent our 20-year clients a special gift to help them ring in the New Year. We look forward to reaching the 20-year milestone anniversary with all of our clients in the years ahead, and sending a special “Cheers to the New Year” your way as a small token of our gratitude for your loyalty and trust in Rollins Financial’s services.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins