You can never get enough of what you don’t need to make you happy.

~ Eric Hoffer

Remember when you were a kid and you begged, pleaded with, and nagged your parents to buy you something for months on end? You wanted it so badly. It would solve all of your problems and provide you with endless happiness.

When your birthday came along and you finally received the desired treasure, it probably did give you the boost you predicted. But how long was it before that treasure ended up collecting dust somewhere and you moved on to the next desperately needed gadget, trinket, or toy?

For many of us, this cycle repeated over the course of our youth. For some of us, it continued well into our adult years. Indeed, the decades following World War II saw society as a whole adopt much the same pattern. Our homes gradually “needed” to be larger, even as the average family size decreased. One car, television, or garage was not enough. The age of consumerism was born. The line between wants and needs blurred until it all but disappeared. Did this increasing consumption lead to increasing satisfaction?

The Law of Diminishing Returns

In economics, the Law of Diminishing Returns states that if one factor of production is increased while other factors are held constant, the amount of resulting output increase will level off over time, and eventually start to decline. In layman’s terms, it basically means getting less bang for your buck over time, much like the child who is continually indulged but somehow less satisfied on each occasion. I’m going to refer to the Law of Diminishing Returns in the latter sense, so I’ll ask for some latitude from the economists out there.

The post war era has seen a dramatic increase in many factors. The returns on these have steadily increased as well – until recently. Let’s take a look at a few different types of factors, the relative returns they provide, and what some of the future trends might look like.

Corporate Factors

Corporations contributed to the economic success (and excess?) of the post war era in a couple of ways:

Mergers & Acquisitions

Many companies, particularly in the financial sector, grew by merging with or acquiring other businesses. This type of activity is stimulative to the economy and the stock market as it provides a lot of revenue for the bankers, lawyers and accountants necessary to facilitate these transactions. M&A activity took a break during the recent credit crisis, but has recently seen a resurgence with several large deals recently announced.

It seems, however, that investors are not viewing this activity quite so positively as they have in the past. The stock market was generally flat to down when these moves were announced. Some have speculated that the lack of enthusiasm might be due to the fact that corporate consolidation often leads to layoffs and hiring reductions. In a market craving jobs more than anything else, this is not a good thing. So M&A doesn’t seem to be providing as much bang for your buck as it did a few years ago because of reduced activity as well as reduced economic benefits.

Stock Buybacks

In the equity heyday, all it took was a rumour that some company was going to buy back its stock and you could count on a sizeable boost in its share price. Like M&A activity, stock buybacks have slowed and so has the enthusiasm with which they are greeted. Investors are generally less confident in equity price increases due to economic and financial market instability and flat to lower returns over the past decade. And in the end, wouldn’t you rather see the company you’re invested in putting cash into R&D or organic growth strategies rather than incestuous stock buybacks?

Government and Central Banking Factors

Global governments and central banks have done everything they can to incite consumers to spend and corporations to grow. The resulting outputs have been accelerated economic growth, an increased perception of prosperity, and a mountain of debt. Here are a few of the ways in which governments and central banks have contributed to economic growth:

Low Interest Rates & QE

Once Paul Volcker conquered inflation by raising interest rates in the early 1980s, a period of steadily declining rates began. The Greenspan era saw the Federal Reserve dramatically lower rates whenever the economy looked like it was ready to take a breather. Lower rates led to asset price increases and higher growth rates as consumers, corporations, and governments took advantage of the cheap borrowing costs to spend, spend, spend.

The result, as we know, was a series of financial bubbles and trillions of dollars of debt on household and sovereign balance sheets. With rates at or near zero, there’s no more bang to be had for your buck in this area – unless you believe further quantitative easing will be effective. Even if it does provide some temporary confidence boost, it seems apparent with each new round that the Law of Diminishing Returns is at work here as well.

Government Stimulus Programs

In the wake of the recent spending and debt-induced financial crisis, governments around the globe came to our rescue with more spending and debt. Cash for clunkers, various incentives and programs for underwater homeowners, and lots of borrowed taxpayer cash for stimulus programs were heralded as the reason for the economic and stock market bounce of 2009.

As recently as August 2nd of this year, U.S. Treasury Secretary Tim Geithner penned an Op-Ed in the New York Times entitled Welcome to the Recovery. Once again, the Law of Diminishing Returns was evident. The market saw a bit of a bump up following Secretary Geithner’s article, and then proceeded to sell off for the remainder of the month of August. The actual economic data painted a picture of sparse to declining activity compared to the lovely pastoral the Treasury Secretary tried to sell.

Consumer Factors

Consumers contributed to the post war boom by buying what the government and advertisers were selling – usually with no money down and easy monthly payments.

Spending on Stuff & Self

In an earlier article entitled How Did We Get Here? I wrote about the post war transition from austerity and selflessness to prosperity and mindfulness to temerity and selfishness. Gradually, we came to believe that we needed – no, deserved - more gadgets, bling and stuff in order to be happy. Did all of this stuff fill a void, distract us from that void, or create a new one?

We’re finally starting to see some signs that these socioeconomic bubbles may be ready to pop, or at least deflate a little. Somehow that Hummer isn’t bringing us the joy we thought it might. Neither is the 3-car garage, the coolest gadget, or the hottest fashion. In fact, dealing with the debt we incurred to buy all this stuff is starting to get downright stressful. Retail therapy just isn’t providing the same bang for your buck it did a few years ago.

Are you noticing any signs of the law of diminishing returns out there? Do you think that’s a good thing?

Related posts:

1. Variable Returns Can Work Against You in Retirement
2. Where Are Interest Rates Going?
3. 20 Cents from May 2010

. . . too many people are unwilling to do what’s necessary to get their financial house in order. . . . Everyone wins when we have our financial  affairs in order.

~ Scott Feher, Your Life & Your Money

If you’ve been reading this blog for any period of time at all, you know that I write a lot about imbalances in the global economy and in our society at large. Scott Feher, author of Your Life & Your Money, seems to have noticed some of the same trends. He writes:

“We live in an age of delusion. . . . Our biggest delusion is a sense of entitlement. . . . People delude themselves into believing everything is fine while engaging in behavior that’s definitely not fine. Then, when something goes wrong, they stand there blankly and do nothing about it, expecting somebody else to pick up after them!”

You may recognize some of these themes from a piece I wrote a while back that asked Have We Become a Society of Financial Adolescents? A lot of this type of sentiment can sound pretty negative, but the purpose is not to wave a finger at people. It is to incite them to take control of, and responsibility for their own destiny – financial and otherwise. But how? That’s the question that Mr. Feher aims to answer in this book.

Family CFO Basics

One of the key principles of the book is that, like any good corporation, every family needs a good Chief Financial Officer (CFO). The CFO needs to educate him/herself on financial matters and follow some basic rules in order to secure the family’s future prosperity. Here are just a few of the ideas discussed:

• Write a financial mission statement: This is just a written outline of goals and priorities the family will work toward according to specific timelines. Of course, it should remain flexible as life progresses and inevitably throws us the odd curveball.
• Don’t invest in any product or service that isn’t aligned with your mission statement: If a product doesn’t fit with your goal to limit spending, don’t buy it. If an investment doesn’t fit your risk profile, choose a different one.
  
• Know where your money goes: “Buying what you can’t pay for is called living beyond your means. It’s delusional, so don’t do it.”
• Master your expenses or you’re destined to fail: If you can’t say no to some expenses, you’re going to have a hard time living within your means.
• Don’t let financial mistakes become your permanent life story: We all make mistakes. The key is to learn from them, fix them, and move on.
• Keep apprised of economic issues that affect your finances: Taxes, risk, and inflation can have a big effect on how much of your money you get to keep. Understand the trends and how they could affect your money plans.
  
• Understand asset classes and how to use them: Mr. Feher offers a comprehensive review of the different types of asset classes and how to use them to plan your financial future.

Who Should Read This Book?

This book offers a concise review of the basics of personal finance and investing. The simple writing style is suitable for a novice, but also offers advice and perspectives that more seasoned family CFOs might appreciate as well. Scott Feher is a financial adviser himself, and he explores some ideas on whether you need an adviser and how to go about choosing one that’s right for you.

The book is written from an American perspective, and some portions deal with investment products that are unique to the U.S. market. There is a full chapter on the best ways to hold your assets that looks at pensions, annuities, and government programs, some of which would not apply to Canadians. Still, the basic financial principles espoused here are universal and the message is clear: You are responsible for your financial life and ultimately, only you can improve it.

I liked the way Mr. Feher put as much emphasis on personal finance basics as investing principles. He stresses learning about covering the basics before you move on to more advanced investing and planning techniques. It’s difficult to hear about folks trying to figure out which fund or stock to invest in when they are swimming in debt. Walk before you run.

Like many books on personal finance, Mr. Feher’s work ends with the idea that it’s not really about the money. Money is only a tool that we can use or misuse. If we use it wisely, we can enhance our life balance sheet as well as our financial balance sheet. If we misuse our money, we can do some real damage to both types of balance sheet.

With headlines becoming increasingly populated with stories about economic difficulties and household financial challenges, it seems that this book has come at the right time. As noted in the opening quote, fiscal responsibility at home is not only good for your personal balance sheet, it can help society at large. The more people who have a good handle on their finances, the fewer our over-indebted governments will need to bail out. In the end, that’s good for all of us.

Your Life & Your Money is straightforward and relatively short, making it very easy to digest. It’s only about 140 pages long, not including a couple of useful appendices which include an inventory of expenses and an investing questionnaire. If you’re ready to improve your balance sheet and you’re looking for some ideas on how to get started, this just might be the book for you.

Does this book sound interesting to you? What types of questions would you like answered in a book like this?

Related posts:

1. Book Review: Your Money or Your Life
2. Book Review: Your Money Ratios
3. Book Review: You’re Broke Because You Want to Be

As the summer winds down and the kids head back to school, it’s time to reflect on a few of my favourite articles from the web in the month of August. I always try to mix it up a bit, so you’ll find some insights from perennial favourites as well as a few from some new voices that I’ve discovered recently. Savour one last summer beverage and enjoy!

1. Bret at Hope to Prosper wrote about some important Economic Trends Affecting Americans. They’re just as relevant for Canadians, and I thought Bret’s thoughts on these issues were right on the money.

2. When will we ever learn? Big Cajun Man ponders this question in Lessons Learned Financially at Canadian Personal Finance Blog. Many of us make similar financial mistakes, sometimes repeatedly. This post looks at some of those, served up with a characteristic dose of “Canajun” humour.

3. BJ readers know that there’s a certain former Merrill Lynch chief economist (recently repatriated to Canada) who I usually agree with and quote regularly. How, then, could I resist including David Rosenberg Belongs in Your Inbox in today’s collection of articles? Thanks to Kevin from Today’s Economy Blog for sharing his thoughts.

4. If you’re not in the habit of reading Len Penzo’s weekly Black Coffee, you’re missing out. Whether you agree with Len’s point of view or not, you’re sure to find the information interesting and amusing. I’ve actually spit out my coffee on occasion when I come across a particularly hilarious line or two. For a tasty free sample, check out Black Coffee: Send in the Clowns (Never Mind, They’re Already Here.).

5. There are a number of websites and anecdotes out there about people who have chosen to live extremely lean in order to retire early or just live a simpler life. Shawn over at Watson Inc. raises some interesting ideas, asking Is Extreme Frugality for You? I like my consumption to be calculated rather than conspicuous, but I’m not sure I’m ready to cut as close to the bone as some folks.

6. Even if you’re not prepared to go to extremes, B Simple offers a Cure for the Financially Overwhelmed at Simple Financial Lifestyle. Simple is always better, if you ask me. When things get too complex, trouble often follows.

7. Jim Yih writes that there’s Lots to Know about Canada Pension Plan at Canadian Finance Blog. He’s not kidding. You might not have realized how much there is to know until you read this article. It offers lots of links to information every Canadian should be aware of.

8. 50 and Broke? Early Retirement Planning Can Help. So says Canadian Dream: Free at 45. There are lots of retirement planning strategies that will work even if you’re a little late getting started.

9. Doctor Stock had a couple of posts on How Volume and Candlesticks Reveal Market Momentum over at Invest in the Markets. Part 1 looks at some examples of market bottoms and Part 2 examines market tops. I know some people think technical analysis is about as useful as a ouija board, but I couldn’t invest without it. A chart is like a Rorschach Test for the market, and volume is its lie detector.

10. I’ve got another “twofer” here in honour of the final holiday weekend of summer. This one comes from Boomer and Echo, a relatively new Canadian financial blog that features views from two authors of different generations. I’ve enjoyed their posts so far, and I think you might too. Check out Boomer’s Short Term Goals and then compare them to Echo’s Short Term Goals. It’s always informative to read about how others approach their financial planning.

I hope you enjoyed reading all of these as much as I did. Feel free to comment on your favourites below!

Related posts:

1. 20 Cents from May 2010
2. 20 Cents from February 2010
3. 20 Cents from March 2010

Numbing the pain for a while will make it worse when you finally feel it.

~Albus Dumbledore, Harry Potter and the Goblet of Fire

Is the Federal Reserve a hero or a villain? You can find plenty of Nobel Laureates, pundits, and civilians like myself on either side of that debate. Nassim Taleb, author of The Black Swan has been saying for quite some time that the Fed steered us into the ditch and that it’s shameful that the same group that got us here is still in the driver’s seat. Perpetual overspending and record low interest rates have not only failed to solve our problems, but are the major causes of them. It is therefore ridiculous to turn to them to solve our current challenges.

Paul Krugman is probably the most vocal Nobel Laureate who supports the Keynesian spend-till-you-drop/debt-levels-don’t-matter viewpoint. He has been a supporter of stimulative monetary and fiscal policy. His response to critics of higher spending, zero interest rates and quantitative easing is that central bankers and governments are not spending enough to rescue the economy. He says the stimulus would have worked if only it were bigger.

Thus, Alan Greenspan is either a messiah, evil incarnate, or simply incompetent, depending on who you ask. Ben Bernanke has mainly followed Greenspan’s approach to monetary policy, although he has been forced to become a lot more creative courtesy of the economic mess he inherited from Greenspan’s Fed, of which he was a member. Will continued quantitative easing work?

What on Earth Is Quantitative Easing?

Prior to, and following Fed Chairman Bernanke’s key speech at Jackson Hole on Friday, cyberspace, trading floors, and water coolers were abuzz with debates over what he might say in terms of future prospects for the economy and further quantitative easing. For those who aren’t familiar with the idea, QE, or quantitative easing is a way for the Fed to increase the money supply when traditional methods like lowering interest rates are no longer available, usually because rates are already at or near zero.

To implement QE, the central bank credits its own account “with money it has created ex nihilo (“out of nothing”).” It uses that money to buy assets like government bonds and mortgage-backed securities from financial institutions. The idea is to provide liquidity to the financial system in hopes that a) banks will lend that money out to consumers and businesses and b) that buying bonds will keep interest rates low.

As with any action taken to cure an illness, 4 main outcomes are possible: The remedy could work, it could actually make things worse, it could relieve the symptoms without curing the underlying illness, or it might just do nothing. We’ll take a look at each of these possibilities as they relate to the QE prescription.

QE:  Cure, Cause, Palliative or Placebo?

QE as Cure

Here are a few ways that quantitative easing might be able to keep the economy from slipping into a depression:

• Lower bond yields will force investors into other asset classes like stocks, commodities, and real estate, raising the prices of those assets and creating a wealth effect for investors. The hope is that consumers will see the value of their investments rise and feel confident enough to spend and invest more.
  
• Lower interest rates will improve housing affordability and make it easier for consumers, corporations and governments to service and roll over their considerable debt loads.
• Lower yields will weaken the U.S. dollar and help with the trade deficit.

QE as Cause

Many would argue that easy money policies created the asset and debt bubbles that are now plaguing us, so it doesn’t seem like more of the same would be helpful. Here are a few ways QE might hurt more than it helps:

• Continued low yields hurt savers, retirees, and pension plans who do not want to invest in riskier assets. In order to maintain an annual investment income of $40 000, you would need to have $2 million invested at a 2% rate of return. If yields were at 5%, you would only need to have $800 000 saved to achieve the same income level.
• Lower yields can lead to asset and debt bubbles as people begin to feel that low rates and rising asset prices can go on forever. If rates rise and/or asset prices fall, it can get pretty ugly, as we saw in 2008.
• Asset price and money supply increases are inflationary. If the Fed takes QE too far, we could end up with hyperinflation and extremely high interest rates. It goes without saying that higher rates in an over-leveraged financial system would be disastrous.

QE as Palliative

Quantitative easing could make it look like things are getting better, when in reality they are staying the same or getting worse. If you had a bacterial infection, you could take something to alleviate the pain, but the infection would likely continue to worsen until you got an antibiotic that actually killed the bacteria. Some believe QE has already had this type of palliative effect and will continue to do so:

• Rising prices in assets like stocks, commodities and real estate can make us feel like the economy is recovering. But if debt levels continue to rise, they will eventually hurt the economy as consumer, corporate, and government entities are forced to use an increasing amount of their income to service debt rather than contribute to economic growth.
• If people get the idea that interest rates will be held artificially low forever, they may take on risks and obligations that they will not be able to honour later if interest rates rise and/or the economy turns down.
• If the U.S. dollar falls as a result of QE, commodity prices could spike as they are priced in U.S. dollars. Some may interpret the rise as a signal that the economy is improving.

QE as Placebo

You could easily argue that this one is the same as the palliative argument above, but I’ll make the following distinction: While neither the palliative nor the placebo treat the root cause of the problem, the palliative at least temporarily alleviates some of the symptoms. The placebo really does nothing but make us think we might feel better even if neither our symptoms nor disease are any better in reality. Here’s the placebo case:

• Every time the Fed announces new policy measures like QE, the shorts cover their positions and we see a huge snap-back rally in equities.
• Some investors and pundits feel better as they believe that the Fed is on the job, and they will cure what ails us.
• Some investors will follow the Fed into Treasuries, or whatever security they are buying as they see the Fed as providing a floor for prices in those securities.

My 2 Cents

I agree with the weekend article in the Washington Post that argued that the Fed’s Capacity to Stimulate the Economy Is Limited. I think QE might be a cause, a palliative, or a placebo, but I’m pretty sure it’s not a cure. The problems we face are structural, not cyclical. We need structural solutions at the legislative level, not at the monetary policy level.

What does this mean for our financial plans? Of course, each of us will answer differently. I’m worried the Fed is caught in a liquidity trap where they will not be able to stimulate the economy. Quantitative easing is based on money created out of nothing. That just sounds like cheating to me. We may see strength in commodities if the fall in the U.S dollar outpaces that of other currencies, but I will remain in cash until commodities rise on real economic prosperity rather than palliative measures rooted in nothing.

Further, it seems like much of the economic and stock market success of the 1980-2000 era was created ex nihilo as well. It was built on a foundation of debt. I can’t invest in that, so I’m not buying into Friday’s placebo rally.

What about you? Do you think QE will work?

Related posts:

1. Inflation or Deflation: Which Is It?
2. Where Are Interest Rates Going?
3. Get Your Inheritance Early – And Other Ways Your Parents Can Save Thousands in Taxes in Retirement

If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are.

~ Carmen Reinhart & Ken Rogoff, This Time Is Different

The subtitle of This Time Is Different indicates that the book covers “Eight Centuries of Financial Folly”, but its release date (September, 2009) makes it extremely relevant to our most recent and ongoing bout of financial folly. In fact, the authors devote the final four chapters of the book to what they call “The Second Great Contraction” (the first being The Great Depression) triggered by the U.S. subprime mortgage crisis. The authors do a great job of outlining the “huge regulatory mistakes” that lead to the current financial crisis, from the deregulation of the subprime mortgage market to the 2004 SEC decision to allow investment banks to triple their leverage ratios.

They describe 4 main types of financial crises (sovereign debt, currency, banking, and inflation) but concentrate quite a bit on the sovereign debt and banking varieties. They do note, however, that these crises tend to occur in clusters and one type can easily trigger another. In the run-up to the subprime crisis, they note that the U.S. exhibited “all the signs of a country on the edge of a financial crisis – indeed, a severe one.” Those signs were: “asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth”.

The This-Time-Is-Different Syndrome

Of course, the main tenet of the book is that the aforementioned financial follies are exacerbated by the “this-time-is-different syndrome”. It refers to ideas we often hear from financial professionals and government officials during boom times and is characterized by the following lines of thinking, which are eventually proven false:

• Old valuation rules no longer apply.
• We are smarter now. We’re doing things differently, and we have better systems in place.
  
• We have learned from past mistakes.
• The new boom is built on sound fundamentals, structural reforms, technological innovation, and good policy.

Does any of that ring a bell? It should. We heard all of the above right up to the point when the U.S. housing and mortgage markets imploded in 2007-2008. Too much debt eventually leads to problems and this incident was no different. The aftermath will likely follow the historical form Reinhart and Rogoff have noted as well:

• Asset market collapses are deep and prolonged.
• Profound declines in output and employment ensue.
• The amount of government debt explodes.
  

This Time Is Not Different . . . But It Sort of Is

There is a bit of an inherent contradiction in the this-time-is-different thesis. I once heard Ken Rogoff discuss it in an interview and it goes something like this: This time is not different in the sense that history shows that financial crises happen quite often. But there is also a tendency for financial and government leaders to fail to recognize that the economic trajectory after a crisis-induced recession is very different from the one we might see following a normal business cycle-induced recession. Therefore, “standard macroeconomic models calibrated to statistically “normal” growth periods may be of little use.”

In that sense, this time is different. It differs from normal cyclical economic activity, but not from what usually happens following a financial crisis. If you think of it that way, it seems like we shoot ourselves in the foot twice when afflicted by the this-time-is-different syndrome: once, when we fail to see the crisis coming, and again when we try to get ourselves out of it by using solutions that are effective for a different set of problems.

In the wake of the recent financial crisis, we have repeatedly witnessed governments and central banks attempting to treat the symptoms without really attacking the source of the disease: debt. Instead, they have tried to cure a debt hangover with another round of debt. Hair of the dog anyone?

“This Time” Is Worth Your Time

When I received my copy of the book, my first impression was “Gee, this is a lot longer than it looked online.” It’s a little over 460 pages, but the main text of the book ends around page 290. The remainder is a treasure trove of historical economic data aggregated for your convenience. There’s also an extensive notes section, plenty of references and two different index choices – one for names and one by subject.

Before the core of the book even gets started, there is both a Preface and a Preamble, both of which are worth your time. They set the tone for the information in the book and offer some succinct overall impressions. The first twelve chapters deal with the description and causes of various types of financial crises throughout history, including The Big One (the Great Depression). The remainder deal with the current crisis and how the information in the preceding chapters might apply today.

The first sentence of the Preface announces that “this book provides a quantitative history of financial crises in their various guises”. If you are not an economist or a big fan of mathematical or statistical analysis, you may find that the quantitative part of this text goes over your head a bit. In between the charts, tables and statistics, however, you will also find that some very compelling ideas emerge. The plethora of valuable information means this book deserves a spot in your personal library, both as a reliable reference and a reminder that human folly can and does regularly wreak havoc on our finances.

If you’ve read the book, I’d love to hear your impressions. If not, does it seem like something that might interest you?

Related posts:

1. Book Review: Juggling Dynamite
2. Book Review: Enough Bull
3. Book Review: Your Money Ratios

Accidents, and particularly street and highway accidents, do not happen – they are caused.

~Ernest Greenwood

Accidents in the financial markets do not just happen either. They often result from conditions that persist for quite some time before some seemingly insignificant bend in the road causes us to veer off course and wind up in a ditch. How long did a chorus of critics warn of a bubble in the U.S. housing and structured finance markets before it actually popped?

In traffic parlance, a rollover accident is one in which a vehicle ends up on its roof or side, usually as a result of one of these factors: excessive cornering speed, tripping, collision with another vehicle or object, or traversing a critical slope, such as when a vehicle crosses a ditch.

Rogoff and Reinhart, authors of the book This Time Is Differentobserve that “what one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble.” (I’ll have a full review of the book for you on Friday.)

Bonds Keep Rolling

When companies or governments issue bonds, they mature on a given date. Some are very short term, maturing in only 30, 60, or 90 days. Other maturities can range from 1 to 30 years. Once the bonds mature, the corporation or government must pay back the bondholders’ principal in full. Next, the borrower will usually look to “roll over” those bonds by issuing new ones in order to fund their continuing operations. It’s sort of like how you need to refinance your mortgage once your term is up.

This is the proverbial bend in the road. Accidents can happen here. One of the problems is that banks and governments will be vying for financing at the same time, and this could raise the cost of capital for everyone, including small businesses and consumers. If fewer investors want to buy those bonds for whatever reason, the price will fall and the yield will rise, raising the cost of capital. In extreme situations where buyers refuse to step up to the plate at all, we would have a full blown credit freeze on our hands. We’ve seen what that looks like already and I’ll go out on a limb and say that no one wants to go there again.

When the European sovereign debt crisis was coming to a boil a few months ago, many worried that European countries and their banks would not be able to roll over their significant debt issues. The New York Times reported: Crisis Awaits World’s Banks as Trillions Come Due. “Banks worldwide owe nearly $5 trillion to bondholders and other creditors that will come due through 2012, according to estimates by the Bank for International Settlements. About $2.6 trillion of the liabilities are in Europe.” U.S. banks will need to refinance about $1.3 trillion over the same period of time. That’s a lot of paper for the bond market to swallow.

China has traditionally been a huge buyer of U.S. debt, but they have recently sold some of their holdings. Some worry that this means there will be less demand for the massive quantities of debt the U.S. will need to issue. A recent article from The Daily Reckoning explains why that may not necessarily be the case.

Will Short-Term Gains Lead to Long-Term Pain?

One of the recent borrowing trends is for banks to borrow money for shorter periods of time. By accessing the next-to-free short term money made available by global central banks, many financial institutions have been able to work on improving their balance sheets. They borrow money at near 0% rates and lend it out to individuals and businesses for longer terms at higher rates. It’s a great racket, if you can get into it.

According to the New York Times article, “government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and the banks issued bonds to match.” What happens when those government guarantees expire? Governments can extend them, but what if the market loses confidence in the balance sheets of those governments? Many of the countries offering such guarantees aren’t exactly swimming in black ink themselves. That includes the U.S. and the U.K..

Why the Infatuation with Bonds?

The European stress test results seemed to defuse worries about a rollover accident, although many (myself included) felt that those tests were less than rigorous, to put it mildly. In the meantime, it seems that investors, both retail and institutional, can’t get enough bonds. Many reports point to rivers of capital flowing out of equity funds and into bond funds. As long as this continues, rolling over debt may not be a problem.

A recent Globe and Mail article inquired Whither the Bond Vigilantes? (The title was later revised to “Where Are the Bond Vigilantes?”, but I much prefer the original.) Bond vigilantes are supposed to hold governments accountable for their debt loads by demanding higher rates in return for putting their capital at risk. Not only have the bond vigilantes gone missing in action, but there seems to be a mob of bond groupies forming that just can’t buy enough debt to sate it’s appetite.

Jeremy Siegel recently warned that the bond market is a bubble. Wall St. Cheat Sheet begged to differ. Regardless of who’s right, bubbles can continue to inflate much longer than anyone thinks they can. This particular bubble is backed by the full faith and credit of the U.S. government. The Federal Reserve recently outlined its own rollover plans: it will use proceeds from maturing mortgage-backed securities that it holds to buy U.S. Treasuries.

It would be folly for any trader to fade the Fed. So with fixed income short sellers on a leash, the Fed providing the incentive for investors to continue to buy bonds, and most investors turned off by the stock market, it seems that the U.S. government will have no trouble issuing the trillions of dollars of debt it will require to finance itself – until it does have trouble. I’ll leave you with one last quote from Reinhart and Rogoff in which they explain “why financial crises tend to be both unpredictable and damaging“:

“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.”

They admit that economic theory doesn’t provide very much insight into the exact timing or duration of such crises, but when all of the elements are there, it’s pretty likely a crisis will occur at some point. It’s doubtful whether even the Federal Reserve can hold off real market forces forever – if such forces have not yet been permanently been relegated to the realm of folklore and mythology.

Do you think the market is headed for a rollover accident?

Related posts:

1. Where Is the Stock Market Headed Next? Part II
2. Where Is the Stock Market Headed Next? Part I
3. Have You Lost Faith in the Market?

When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

~ John Mauldin

Update: This article was featured in the Canadian Personal Finance & Investing Carnival posted at Investing Thesis. Thank you!

I’m officially back from a 2-week vacation today, although I sort of cheated and put up a new post on Friday. It’s great to be back. I’d like to thank those who filled in for me with their thoughts and insights in my absence. In the meantime, however, the financial world went on without me while I caught up on some reading. I learned a lot as a result, and I’ll be sharing some of that with you over the coming weeks.

The inflation vs. deflation debate rages on, but for now, it looks like the deflationist camp has taken the lead. In the July 24th, 2010 edition of his Thoughts from the Frontline, John Mauldin listed a number of economic elements that can interact to create deflation. I thought we might look at how many of them are currently evident in the economy, or are showing signs they might pop some of the bubbles we’ve discussed recently.

Elements of Deflation

Hydrogen and oxygen combine to form water (H2O). According to Mr. Mauldin, the following economic elements can combine to to form deflation:

1.  Excess Production Capacity

Put simply, production capacity is the amount of resources available to produce the products and services we require. Right now, we have more capacity than we can use. Global capacity utilization has fallen off dramatically and has yet to recover.

2.  Massive Wealth Destruction

We have certainly seen a lot of wealth destruction in the form of falling home and stock prices. Deteriorating home prices mean that consumers can no longer tap the home equity ATM to fund their purchases. Declining stock markets mean that retirement savings have been depleted, forcing many to re-examine their financial plans.

3.  Decreased Final Demand

The asset side of the consumer’s balance sheet has taken a massive hit while the liability side has simultaneously multiplied. This has only recently begun to lead to Keynes’ Paradox of Thrift. Consumers are beginning to save more in an effort to right their lopsided balance sheets. That’s great, but it means they will spend less, which will be a drag on the economy. It also means that companies will have less pricing power. They can’t raise prices on products for which demand is falling.

4.  Massive Deleveraging

We have recently been (and arguably still are) in the throes of a major credit crisis. As a result, consumers and businesses are trying to reduce their debt levels and banks are pulling back on lending. According to Mr. Mauldin, bank losses are over $2 trillion and rising. Many banks still hold toxic assets which have not been marked to market and are therefore worth much less than the value implied on the banks’ balance sheets, if they show up there at all.

5.  Money Supply Falls While Velocity of Money Slows

The growth of the money supply globally is “close to zero”. In addition, the volume of money that central banks have pumped into the system is not moving. Banks and corporations are hoarding cash in fear of another credit crunch. As long as the velocity of money stagnates, the economy will too.

6.  Falling Home Prices

The housing markets in the U.S., Europe, and Japan have fallen considerably and remain weak. “Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.” Is it really so inconceivable to think that Western nations could be headed down the same path?

7.  Reduced Government Spending

We have yet to see this in many countries so far, but there certainly is a push from the austerity camp to cease and desist with ineffective stimulus programs and concentrate on paying down debt and balancing budgets. Many states in the U.S. have been forced to cut spending as they have completely run out of money and are not able to print it like the Federal government can. If the Feds ride to the rescue with aid to the states, that certainly won’t qualify them to sit in the “reduced government spending” section.

Having said that, if governments do decide, by choice or by necessity, to curb spending, that would indeed be deflationary. One could easily argue that global government spending programs are the single largest reason the financial system did not completely melt down in 2008 – 2009. Absent that boost, many global economies could easily slip back into recession.

8.  Chronic High Unemployment

This factor contributes to deflation by reducing final demand. Consumers without jobs consume less. That in turn erodes pricing power for producers and can lead to further increases in unemployment as businesses cut back on labour to match decreased demand. Chronic high unemployment is certainly evident in the U.S. and if deflation takes hold globally, it will rise in other locales as well.

So it seems that most, if not all, of these elements of deflation are either already present or showing signs of emerging in the near future. What should we do about it? According to the work of Rogoff and Reinhart, “economies are more fragile and volatile and . . . recessions are more frequent after a credit crisis. Further, spending cuts are better than tax increases at improving the health of an economy after a credit crisis.”

We have seen both fragility and volatility in the financial markets over the past couple of years. The elements of deflation are there. It remains to be seen whether or not they will meld to form a full-blown deflationary environment.

Are you seeing these elements of deflation where you live?

Related posts:

1. Inflation or Deflation: Which Is It?
2. Interest Rates: 2010 Mid-Year Review
3. 10 Reasons to Be Cautious Right Now

Torture numbers, and they’ll confess to anything.

~Gregg Easterbrook

Update: This article was featured in the Carnival of Financial Planning 08-27-2010 posted at The Intelligent Speculator. Thanks!

I hadn’t planned on posting today since I’m supposed to be on vacation. But I saw an article last week that I just had to comment on, so I decided to put up a little Friday Food for Thought today. The article in question claimed to explain Why the Economy is Not Relevant to Investing.

Some of you will read that title and immediately decide that the premise is ridiculous. Still, if you’re as curious as I am, it’s just ridiculous enough to make you want to read what the author has to say. I’ve written before that economic information is like a financial weather forecast and I’ve done my best to articulate Why You Should Care about Economics. This article didn’t change my opinion on any of these issues.

My aim is not to discredit the author here. In fact, he is a CFP (Certified Financial Planner) and CFA (Certified Financial Accountant) and is therefore theoretically much more qualified than I to discuss these matters. I just want to point out the other side of the debate. After that, it is (as always) up to you to decide where you stand.

It’s the Economy, Stupid

This catch phrase from U.S. President Bill Clinton’s 1992 campaign has bubbled up in the headlines again as elections approach south of the border. Many believe that the state of the economy will determine which party is more successful this November. But does the economy have anything to do with stock market performance?

I’ll quote some of the arguments presented in the article in question and offer a brief rebuttal for each:

• “most investors buy and sell investments at the wrong times . . . because they base their decision on a mainly irrelevant factor – their outlook for the economy.”: I actually agree that many investors buy and sell at the wrong times, but I don’t think it’s because they’re using the economy as a guide. It’s usually because they are not following a robust trading system that includes a disciplined exit strategy – or because they are listening to people who tell them that buy and hold is the only intelligent investment strategy.
  
• Next, the author explains that “there are 2 main reasons why the economy is not really relevant to investing”:

1. “The stock market is the head and the economy is the tail.” The idea here is that “the stock market forecasts the economy, not the other way around.” On the contrary, history is replete with examples where the markets have gotten it wrong. Markets rallied hard from 2003 to 2007 even as the U.S. housing market was beginning to implode. Perhaps it could be argued that the bond market got it right, but the stock market was way off the mark. It didn’t correct until the financial system became crippled under the weight of loans supported by fantasies and fraud.

2. “Expectations of how the economy will perform are already built into the price of stocks.” Again, that may or may not be the case at any given moment, but it is not always, or even often, true. Further, “expectations” and reality often diverge quite radically as we have seen repeatedly over the course of history. Was the 2007 stock market pricing in the calamity that befell the economy in 2008?

• ‘A “double-dip recession” probably won’t happen this year. How do I know? Because the stock market went up last year!’ Setting aside the potential conflicts presented by someone who claims the economy is irrelevant making economic predictions, I can offer another reason why a double-dip recession won’t happen this year: The first recession never ended. The “recovery” that we’ve seen over the past year or two was the result of unprecedented government interventions whose effects are now fizzling. The stock market went up in 2007 too. The economy sank into a near-depression in 2008.
• “You can predict the stock market more accurately by simply always predicting it will go up!” Seriously? Here’s where the number torture comes in. The author says that “in the last 25 years, the Canadian and global stock markets have been up 76% of calendar years and the U.S. market has been up 72% of years.” The key here is to realize that he’s talking about the performance of calendar years in isolation. So any given up year may have been preceded by a year that was down enough that the market still does not recover its losses in the up year. That’s how the market can have very large moves over a decade and still end up nowhere at the end of it. (That’s called a secular bear market and that’s what we’ve got on our hands right now.)

David Rosenberg recently pointed out some of the reasons this type of thinking won’t work in today’s investing environment:

“What the bulls still refuse to see is that we are in an entirely new paradigm and that the old rules of thumb are rarely, or ever, going to be able to be relied upon, as was the case in the credit-expansion days of yore. There is simply too much debt overhanging the U.S. household balance sheet, the largest balance sheet on the planet. Despite the deleveraging efforts to date, the process of balance-sheet repair is still in its infancy”

I will grant that the stock market and the economy rarely move in lockstep. Economic information is definitely not the only information investors need to be successful, but to exclude it altogether is just foolhardy. I’ll leave it up to you to decide whether you want to trust your money to a professional adviser who tells you to ignore the economy based on arguments that are specious at best.

What’s your view? Is the economy irrelevant to your investing plans?

Related posts:

1. Do You Understand the Difference Between Investing and the Business of Investing?
2. Online Investing: How to Get Started
3. Passive Investing and the Ostrich Effect

1. First Post: Balance Junkie started out on December 1st, 2009 with a not-so-creatively titled post called Introduction to Balance Junkie.

2. A Post I Enjoyed Writing: I’m not sure if you would say I enjoyed writing Ignorance Makes You a Better Investor and Other Money-Losing Fallacies, but I definitely found it cathartic.

3. A Post with a Great Discussion: A more recent article that generated a fascinating discussion with lots of great information and commentary was 5 Financial Bubbles: Are We Facing a Bubble of Bubbles?

4. A Post on Another Blog I Wish I Had Written: Zero Hedge posted a July 4th essay from a reader On Why America’s 234th Birthday May Not Have Many More To Follow. I’m not American, but I think many members of the Western world face similar issues and challenges.

5. The Most Helpful Post: I could have chosen a few articles for this one, but I guess I would have to say that TFSA vs. RRSP Duel: Who Wins? might have been one of the more helpful posts if you’re a Canadian reader. It includes a detailed chart that compares TFSAs to RRSPs.

6. The Post with the Title I’m Most Proud of: Financial Spilled Milk: Macbeth Meets Ponzi was an article that probably had the most creative title. As for the post itself, I think I may have gone a little over the top with metaphors and references that might have been lost on some readers. I can get carried away sometimes.

7. A Post I Wish More People Had Read: I received some positive feedback from those who did read Capitalism: The Missing Links, but it didn’t receive a whole lot of page views. Take a look and see what you think!

(This will be the last of my “vacation posts”. I was supposed to take the remainder of this week off as well, but I will actually have some Friday Food for Thought for you this week. I’ll return to regular posting on Monday.)

Let me know what you think of these 7 choices. If you have a post that you think fits for any of these categories, go ahead and point it out in the comments section.

Related posts:

1. Balance Junkie Joins Seeking Alpha
2. Balance Junkie Summer Update
3. Balance Junkie on Twitter

I want to start off by saying that I am not advocating anything that could get you put away! What I am recommending is that you speak with your parents about saving them thousands in taxes throughout retirement. Those who are in retirement may be paying too much in taxes on money they will never use!

The big question most people in retirement have is “Will I run out of money?” There is a great calculator on the home page of my website at www.frankwiginton.ca that will tell you whether you will run out of money, and if not, how much you will still have left as an estate. It will also tell you approximately what your lifetime tax bill will be. You will likely be surprised by the numbers – many are!

So now that you know your parents won’t run out of money and they are likely to be leaving a sizable estate and paying a hefty tax bill what should they do with the money?

Watch a video of Frank discussing some of these idea’s on BNN!

Spend It!

Once your parents have done proper comprehensive financial planning and they can conservatively estimate that they will have lots on money left over, start spending it! The problem with this very simple solution is that many who have saved during their entire life struggle to flip the switch from saver to spender! There is a great article from the National Post a few years back where Ted Rechtshaffen, CEO of TriDelta Financial discusses this issue.

I say go out and live your life! Do the things you want to do while you can! Too many times have I met people who have saved all their lives putting trips and time with family and buying a dream cottage or car on hold; just to be stricken with an illness at a time when they are ready to start doing and enjoying these things.

Shelter It!

TFSA – If they have excess assets that they really aren’t going to use, maximizing the use of the new Tax Free Savings Accounts (TFSA) is a good place to start. Naming a beneficiary on these accounts will also ensure this money passes to the beneficiary tax and probate free. If they eventually plan for this money to go to you, their children, through their estate, it may make sense for them to deposit money into TFSA accounts and shelter more of their assets! Technically the assets will legally become yours and you could withdraw them at any time.

Insurance Policies – Rather than hold investment assets that go up and down with the market and increase your parents annual tax liability through capital gains, interest, and dividend income – they could purchase a life insurance policy. Example: Let’s say Mom is 64 years old and in fairly good health. She could purchase a permanent life policy for $11,500 a year which upon her death will pay out $500,000 tax free to her beneficiary! So instead of having that $11,500 generate investment tax liabilities every year for the rest of their life it will be sheltered (in the form of premium on an insurance policy) with a principal guarantee and guaranteed to generate a return (the return will depend on how long they live). Now this won’t work for everyone as there are several factors and qualifiers. Here is a great article talking about this concept!

Personal Real Estate – Your parents may have already paid off their mortgage and can only claim one personal residence for tax exemption purposes. So how can they use real estate to shelter assets? Again – if they plan to leave money to their children, they can start paying off the children’s mortgage! Right now with interest rates so low there is little benefit to do this. But, rather than sticking money that won’t be used into a five year GIC at between 2-3% and having that income taxed – why not pay down the kids mortgage that is running at 4%+! When mortgage rates do eventually start to rise they will have a lot less mortgage to renew at the higher rates!

Give It Away!

A simple idea is for your parents to give money now to the people they want to have it. They not only get to see them enjoy the money while they are alive they also save the tax on the future growth. If your parents are giving it to minor (under 18) they need to be aware of the potential income attribution rules of the taxation. My recommendation is to give it to the parent with direction that it is for the minor. That way the growth is taxed in the parent’s hands and not the grandparents’. NOTE: when you are gifting securities you can choose to gift the asset at the book value (what you paid for it) or the current market value or some value in between. If you gift it to the child at the market value you will have deemed to have disposed of the asset and if the value is higher than the book value you will end up with a capital gain and have to pay tax.

Consider contributing to the grandchildren’s RESP to help pay for college. This sheltering will also qualify them for the Canada Education Savings Grant (20% bonus up to $500 a year).

Donate It!

This is a whole article in of itself! Donating assets to a favourite charity has many tax benefits. The 40% tax credit is a great start with cash donations but this can easily climb to 60 or 80% depending how you donate other assets to the charity! Donate securities and you avoid the capital gains tax. Donate insurance policies and you could claim the annual premiums as charitable donations. There are many other ways to donate to charity depending on your overall financial situation.

To learn how much you could afford to donate to charity every year try the TriDelta Financial Donation Planner. It is a very simple tool that will show you how much you might be able to afford to donate!

In order to do tax planning in retirement properly and effectively you need to start with a comprehensive financial plan. From this you will substantially reduce your investment risk and develop a clear picture of the different factors that influence your taxable income. From understanding the taxation of various investment assets, to drawing down registered assets early, to income splitting, and tax sheltering; you can start to truly plan an effective tax reduction strategy. Without the comprehensive financial plan you will end up paying tens of thousands of dollars more in taxes throughout your life.

Frank Wiginton is a highly sought after personal finance speaker and a Certified Financial Planner with TriDelta Financial. Over the past eleven years Frank has made it his mission to improve the lives of others by providing independent, unbiased, financial advice. He works with clients to prepare comprehensive financial plans that give them a better quality of life.

Frank is routinely asked by the media to comment on personal finance issues. Appearing on Business News Network (BNN), CITYTV, Global TV, and heard on CBC radio and quoted in the Globe and Mail, National Post, Toronto Star, MACLEANS, Canadian Business, Chatelaine, and Money Sense Magazine.

He is a Certified Financial Planner (CFP), Financial Management Advisor (FMA), Canadian Investment Manager (CIM), and a Fellow of the Canadian Securities Institute (FCSI).

A passionate sailor, traveler, photographer, and outdoorsman, Frank lives and works in the Toronto area with his wife and daughter.

frank@wiginton.ca www.frankwiginton.ca Twitter: @1frankthought

Related posts:

1. 10 Ways to Save on Insurance
2. Variable Returns Can Work Against You in Retirement
3. Taxes: The Missing Step