“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures.  It’s liquidity that moves markets.”
– Stan Druckenmiller

 “As I look out over the coming years, I am convinced that we’ll see the blowing up of the biggest bubbles in history, including those of government debt and government promises, and not just in the U.S. but all over the world, leading to an eventual global crisis of biblical proportions – although it isn’t clear what the immediate cause of the crisis will be.  Right now I am looking at Italy with intense focus.”
– John Mauldin

“Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
– Sir John Templeton

I’ve fielded a large number of investor questions recently around tax cuts and earnings.  The idea is that tax cuts, for both corporations and individuals, will significantly improve corporate earnings and thus propel the market higher.

I attempt to answer that question inside today’s piece.  The Stan Druckenmiller quote, one of the world’s greatest performing hedge fund managers, tips my hand but do read on.  We’ll also look at what happens to equities in a rising rate environment and a fun chart you may like to share with your clients about an investor’s “emotional cycle.”  If bull markets die in “euphoria,” I argue we are just not quite there yet.

But before you dive into the heart of this week’s On My Radar, a risk we’ve been talking about for some time, underfunded pensions, just took a big step forward.

The California Public Employees Retirement System, better known as CalPERS, this week stated that a 7.5% annual return is no longer realistic.  Finally, amen, right on.  And as my kids would say when they were young, “duh.”

What is CalPERS?  It is an agency in the California executive branch that manages the pension and health benefits for more than 1.8 million California public employees, retirees, and their families.  At $300 billion, it is the largest pension fund in the U.S.

You probably have a close friend that will always tell it to you straight.  She or he will look you in the eye and tell it like it is.  Sometimes we like the advice, sometimes it is really “tough love” and it hits us hard.  But trust matters, honesty matters and we know that the toughest advice is often the best thing for us.  Dig deep, reflect, stand up straight and step forward on a better path.

Let’s cheer this week’s “tough love” announcement from CalPERS, as reported in the WSJ, America’s Largest Pension Fund: A 7.5% Annual Return Is No Longer Realistic.  Over coffee with Susan this morning, I explained (hopefully in plain English) what this means.  I’ll try to write this in a way that you may share with your clients.  This is big… really big.

Top officers of the largest U.S. pension fund want to lower their investment targets, a move that would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.

Think about this:  Promises were made to school teachers, fire fighters, police and other state employees.  Work for a certain number of years and receive a monthly pension check for the rest of your life.  Pension managers are considered experts at managing money and the largest plans, like CalPERS, attract the greatest talent.  They strive to achieve a certain return over long periods of time.  The lives of current retirees and future retirees are counting on the promises that have been made to them.

Money comes into the pension fund each month from current workers and money goes out of the fund to pay current retirees.  The smart guys in charge have to crunch the numbers and generate returns so that the right amount of money is available to take care of today’s retirees and grow the pool of money in a way that takes care of tomorrow’s retirees.  The state pays into the plan as well just as your employer or you, if you’re self-employed, might pay into a defined benefit plan or 401k (some percentage form of match).  If you have a defined benefit plan, your plan must be fully funded in a way that makes sure the obligations can be met.

Kind of standard stuff except when the plan falls way behind the actuarial numbers calculated to fulfill the obligation.  To meet those calculated numbers, an estimated return number is plugged into the spreadsheets and over many years that number was around 8%.  But 8% hasn’t worked over the last 16 years and with bonds yielding just 2%, as I’ve written about frequently, there is no way to hit those return bogies over the coming seven to 10 years.

See here and here for forward probable returns or I’ll cut to the chase and tell you it’s 3% to 4% for stocks and 2% for bonds (we’ll call it now 2.50% after the recent rate spikes).  Best case 4% not 7%, not 7.50%, not 8% as many plans are calculating today.

The problem is the “pig in the python.”  Those damn baby boomers (to which at age 55 I am on the younger side of that generation).  But we are many and the front end of the wave is hitting retirement age.  The math is going the wrong way.  Low returns, more retirees.  CalPERS finds itself just 68% funded versus where they need to be to meet the contractual promises they’ve made.  And 68%, while not good at all, is better than many.

If returns are weaker than the return assumptions suggested, then there is simply less money in the kitty available to meet the retirement payments.  Eventually, something has to give and we are getting closer to that tipping point.

More from the WSJ:

Chief Investment Officer Ted Eliopoulos and two other executives with the California Public Employees’ Retirement System plan to propose next Tuesday that their board abandon a long-held goal of 7.5% annually, according to system spokesman Brad Pacheco.  Reductions to 7.25% and 7% have been studied, according to new documents posted Tuesday.

California Governor Jerry Brown said in a statement to the Journal, “There’s no doubt CalPERS needs to start aligning its rate of return expectations with reality.”

A reduction in CalPERS’ return target to 7% or 7.25% would have real-life consequences for taxpayers and cities.  It would likely trigger a painful increase in yearly pension bills for the towns, counties and school districts that participate in California’s state pension plan.  Any loss in expected investment earnings must be made up with significantly higher annual contributions from public employers as well as the state.

If the assumed rate of return fell to 7%, the state and school districts participating in CalPERS would have to pay at least $15 billion more over the next 20 years, said spokeswoman Amy Morgan.  That number doesn’t include cities and local agencies.

Can you imagine how many people are going to be affected?  Here’s the bottom line.  The pension system, across our great nation, is underfunded and in trouble.  The choices will be to: