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Building the Foundations for New Retirement Systems

(May 6, 2007)

Dear Subscribers and Readers,

I hope all our readers have had a good week.  The market certainly has, as the Dow Industrials closed higher by 143.68 points this week, adding to its 158.96-point rise from the previous week.  The Dow Industrials also closed higher each day from Tuesday to Friday.  More impressively, the Dow has now risen 23 sessions out of the last 26 – a winning streak which hasn't occurred since the summer of 1927.  Since the beginning of the streak (starting on March 28th), the Dow has risen 7.8% - an impressive feat – especially since the latest rally did not materialize out of a multi-month low (for comparison purposes, the rally from the March 11, 2003 low to March 21, 2003 resulted in a 13.3% rally in the Dow).  We will discuss more about this later, but for now, a few announcements:

As many of you may know, the Berkshire Hathaway annual shareholders' meeting took place over the weekend (please see the following link to see some of the things that were discussed at the “Woodstock for investors”).  A close friend and colleague of mine, Richard Faw, had front row seats for the occasion (he was already lined up at the Qwest Center at 4am on Saturday) and he will be offering his thoughts on what were discussed during the meeting in next weekend's commentary.  Richard is an actuary and CFA charter holder, and has actually written for us before as a guest commentator (please see his May 12, 2005 “Investor or Speculator?” commentary for a review of his prior work). 

Also, the May 2007 issue of “The Retirement Advisor” newsletter will be published over the next few days.  As I have mentioned before, each month, David Korn, Kirk Lindstrom, and I publish a monthly financial newsletter catered to folks who are near retirement or who are already retired.  This set of newsletters is more focused on long-term portfolio management issues as well as other financial management or planning issues.  For those who would like a sample copy, you can download our inaugural copy at no cost at the following link.

Speaking of retirement, there is no doubt that the private pension industry has been undergoing dramatic changes over the last 12 months – in light of the Pension Protection Act of 2006 and the imminent implementation of FAS 158 for pension accounting/disclosure purposes.  We first discussed this issue in our August 13, 2006 commentary (“The New Pension Legislation and a Challenging Market”) and while we did not follow up with more commentaries on the subject, I have continued to discuss this topic on and off in our discussion forum.  Make no mistake, pension reforms has and will continue to be an important subject – not only for our subscribers, but also for employers, the U.S. government, and for society alike.

Of course, the pension reforms is only the tip of the iceberg – and is in no way the main “culprit” for exposing the inherent flaws in the U.S. pension system today.  The “Achilles Heel” in our pension system today did not become obvious in the mainstream until the end of the great 1982 to 2000 secular bull market – when both defined benefits and defined contribution pension plans alike benefited from a near two-decade era of disinflation and rising stock prices.  Moreover, under the old ERISA funding rules, private defined benefits pension plans did not have to value their liabilities on a market basis (i.e. discounting their future benefit payments by some kind of market rate, such as the Moody's AA corporate bond yield or some kind of corporate bond yield curve).  Of course, the fact that rising stock prices was having a larger impact on pension assets than declining interest rates were having on liabilities (when interest rates go down, liabilities rise) did not hurt either.  By the end of the 1990s, many of the defined benefits pension plans within the Fortune 500 companies in the United States were contributing significantly to the bottom line of corporate profits, given higher-than-expected returns and the significant size of pension assets.

As we now know, the dramatic 2000 to 2002 bear market in stocks changed all that.  Not only did pension assets decline, but liabilities of defined benefits pension plans skyrocketed higher as interest rates continued to decline as deflation fears reigned during 2002 (culminating in the “dropping cash from helicopters” speech by current Fed Chairman, Ben Bernanke).  Many plan sponsors found out that their pension plans' liabilities were grossly “mismatched” with their assets (not unsimilar to what triggered the S&L crisis when the industry was blindsided by the dramatic rise in short-term interest rates while their assets were locked in fixed rate mortgages in the late 1970s).  Moreover, with the passing of the PPA of 2006 and imminent adoption of FAS 158, pension plans will be under greater scrutiny – as one of the primary goals of both the PPA and FAS 158 is to ensure “mark to market” accounting of both pension plan liabilities and assets.  Holding everything else equal, this strict “mark to market” accounting will mean greater pension income and expense volatility going forward – volatility that will directly impact the net income numbers of U.S. corporations that sponsor defined benefits pension plans.

Finally, given the historically high deficit of the Pension Benefit Guaranty Corp, the PPA of 2006 has also imposed relatively heavy penalties and restrictions for defined benefits pension plans that are not well-funded going forward (this is to take place starting on January 1, 2008).  This – coupled with heightened volatility of pension income/expense – has, to no-one's surprise, made employers more reluctant to sponsor defined benefits pension plans going forward.

To no-one's surprise as well, Wall Street has also been responding enthusiastically to these changes, as I discussed in our August 13, 2006 commentary:

Of course, there are always ways to mitigate volatility and uncertainty in pension plan contributions and pension expense (please email me at if you are a pension plan sponsor and want to find out more about this) – such as utilizing liability-driven investing strategies (e.g. immunization) or diversifying your asset strategies into “portable alpha,” hedge funds, private equity funds, or by utilizing a combination of derivative instruments. 

However, many of these products are relatively sophisticated in nature.  The fact is that most plan sponsors are still not educated within the world of derivatives – and even if they are, are not comfortable in utilizing them in their pension plans, to which they are regarded as a “fiduciary.”  Moreover, having all these “alternative asset” strategies still do not change a fundamental fact: that most companies are getting increasingly reluctant to sponsor and maintain defined benefits pension plans.  To some extent, this also reflects a change in attitudes – as companies no longer view themselves as being responsible for their employees' livelihood after they have retired.  This is especially true in today's world of globalization, a world where Fortune 500 companies have preferred to engage in a game of “global labor arbitrage” as opposed to hiring and nurturing their workers in the U.S.

The capitalists and the anti-globalization activists can argue about this all day, but the fact is that the current and the environment over the last five to ten years has brought great changes to the pension and retirement industry.  More importantly, many experts and commentators have argued that the shift to defined contribution plans (such as 401(k) or 403(b) plans) is also a cause for concern, as defined contribution plans have historically not been ideal vehicles to save for retirement either.

So what is the practitioner to do?  What if you are currently a pension actuary, or an investment manager that is thinking of creating an investment product revolving around liability driven investing (LDI)?  Or perhaps you may be an economist who is just worried about all the potential unfunded liabilities of both private and public defined benefits pension plans?  How about the “Average Joe” or “Jane” who is just plan worried about his or her chances to retire?  Will the mass retirement of baby boomers create a stranglehold on both physical and financial resources, and will this bring about mass societal change?

The Society of Actuaries (SOA) has decided to tackle these issues head-on.  Currently in the beginning stages, the SOA Pension Section Council came up with the “Retirement 20/20” initiative in late 2005 as a response to the secular decline in the popularity and adoption of defined benefit plans – not only within the U.S. but around the world as well.  A kick-off conference was held on September 28-29, 2006, with the subject entitled “Building the Foundations for New Retirement Systems.”  A quick description of the purpose of the initiative is as follows.  Quoting directly from the SOA:

[The] purpose [of the initiative] is to design a new system from the ground up. While defined contribution plans are an alternative to defined benefit plans, we believe that existing traditional plans (both defined benefit and defined contribution) are not ideal answers; and we believe there is a better way. Retirement 20/20 seeks to find solutions that meet the economic and demographic needs for the 21st century in North America. While we ultimately will deal with specific design ideas/risk sharing models and transition issues, that is not where we are starting. The first part of the process, including the September conference, focuses on fundamentals. The purpose of the Conference was to elucidate core ideas, rather than develop specific proposals for change or ideal plan designs. It sought to examine the stakeholders in the system, what the system must accomplish to meet their needs, what risks these stakeholders can take on and what role they can play in the system. It sought to determine what the system needed to accomplish, unconstrained by the structure of the existing retirement system and its regulatory structures. This report identifies key ideas that came out of the conference. The Pension Section Council will follow up and test the validity of these ideas.


The September conference brought together a diverse group of about 60 individuals with expertise in retirement issues, including actuaries, attorneys, economists, employers and public policy professionals. The focus was on what could be, on principles rather than specific solutions, on what we need to achieve, not how to achieve it. This conference included attendees from the United States and Canada. The conference was structured to consider three fundamental questions for each of the four basic stakeholder groups (society, individuals, markets and employers, discussed below). Panels for each stakeholder group considered the following three questions:

  • Who has what needs?

  • Who bears what risks?

  • Who should or could play what roles?

To be sustainable, any retirement system must meet the core needs of all stakeholders (sometimes referred to as the “what's in it for me?” test). Stakeholders will have conflicting needs, so another principle of any retirement system should be that it doesn't violate the core needs of any stakeholder group. The conference used panelists representing various stakeholders to identify these tensions. Audience discussion also contributed to the understanding of needs, risks and roles.

Subscribers who are interested in reading further about this initiative should check out the Retirement 20/20 webpage that are featured on the SOA website.  There is also a report that has been published summarizing the issues that were discussed at the conference.  Going forward, this author will continue to keep track of this initiative by the SOA in continually reforming and bringing fresh ideas to our pension system today.  Suffice it to say, pension actuaries are very intelligent folks and have lots of clout and respect among the corporate sector – if any group can help bring reforms to our dysfunctional retirement system today, it is the SOA and its members.

Before we continue with our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,879.62 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,759.62 points

As discussed earlier, the Dow Industrials has now risen during 23 out of the last 26 trading sessions – extending a winning streak that had been unprecedented since the May 31, 1955 to July 6, 1955 winning streak.  From the March 28, 2007 close to last Friday's close, the Dow has risen 7.8%.  While this is short of the 10% rise during the streak in the summer of 1955, this is still impressive nonetheless.  More impressively, however, is the fact that the latest streak has now surpassed the streak in the summer of 1955 in terms of up closes – and is now in fact the longest winning streak since the July 1, 1927 to August 2, 1927 streak – when the Dow rose for 24 trading sessions out of the last 27 sessions.  In terms of magnitude, the Dow also managed to rise 11.6% during the summer 1927 streak.  Following is a daily chart of the Dow Industrials during the last such “winning streak” in the summer of 1927:

Daily Closes of the Dow Industrials (June 30, 1927 to September 15, 1927) - The last time that the Dow had just an impressive winning streak was during the period from July 1, 1927 to August 2, 1927, when the Dow closed up a record 24 sessions out of the last 27 sessions - rising a whooping 11.6% in the process. While the market would continue to see fresh highs in the weeks ahead, it was not immune to short-term weakness, as the Dow declined approximately 4.5% in the subsequent 9 trading sessions.

Because of the current overbought condition, it makes plenty of sense to trim down our 100% long position in our DJIA Timing System as a tactical measure – even though in the longer-run (over the next three to four months), the bull market in U.S. stocks still remains intact.  As we discussed in our latest mid-week commentary, this author will most likely trim our position if either of the following occurs:

  1. A one-day rally of over 200 points in the Dow Industrials either today or this Friday;

  2. A one-day reading of over 200 in the ISE Sentiment Index either today, this Friday, or anytime over the next week or so.

However, readers should note that I will retain the flexibility of trimming down our position even should NEITHER of the above two scenarios occur – so don't be surprised if you see a “special alert” informing you that we have trimmed down our position over the next week or so.  More details to come in this mid-week commentary, if we haven't already trimmed down our position by that time.

In terms of “liquidity,” it is to be noted that liquidity still remains relatively ample, given the huge cashflows generated by U.S. corporations as well as the record amount of cash sitting on the balance sheets of private equity firms.  However, liquidity – as based on one measure – the amount of assets in U.S. money market assets as a percentage of the market capitalization of the S&P 500, had just experienced a dramatic monthly drop during April.  Following is an update of that chart showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500 from January 1981 to April 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to April 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash.  2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio decreased from 17.44% to 16.79% during April - the lowest reading since November 2006 and the biggest decrease (0.65%) since November 2005. Over the longer run, a 16.79% reading is still relatively high and should be supportive for stock prices. However, the latest one-month decrease in the ratio is also overly high, and suggests weakness in the stock market over the short to intermediate term.

While the ratio between money market fund assets and the market cap of the S&P 500 is not a great timing indicator – what it does show is the amount of “cushion” that we have in order to insure against a significant market decline.  As of the end of April, this ratio dropped 0.65% - a decline that is most probably sufficient to induce a short-term correction sometime over the next few weeks.  However, while this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet.  Based on historical experience, this author will not be too concerned about the end of the current bull market until this ratio hits a reading of 15% or below.  Again, for the individual investor who is not leveraged and who is already long, a buy-and-hold strategy (instead of trading around the volatility) still makes the most sense.  But over the shorter-run, the chance of a correction remains high, and we will look to trim down our 100% long position in our DJIA Timing System at the earliest opportunity.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 1, 2004 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2004 to May 4, 2007) - Over the last week, the Dow Industrials rose another 143.68 points while the Dow Transports managed recover about half of its decline from the previous week - rising 48.70 points. While the Dow Industrials managed to climb to another all-time high, readers should note that the Dow Transports has again failed to confirm. In fact, the last time the Dow Transports managed to surpass its all-time high was two weeks ago. Given that both of these indices are now overbought both in the short and intermediate term, one should be careful in trading on the long side. However, the internals of the market and most of the world's stock markets continued to remain healthy, and thus the longer term trend remains up. For now, we will remain 100% long in our DJIA Timing System, although do not be surprised if we trim down our position even as early as sometime this week.

For the week ending May 4, 2007, the Dow Industrials rose 143.68 points while the Dow Transports rose 48.70.  While the latest weekly rise in the Dow Transports is encouraging for the bulls, subscribers should note that the Dow Transports non-confirmation on the upside with the Dow Industrials is still in force, as the Dow Transports' all-time high occurred over two weeks ago – on April 20, 2007.  In the short-run, this is a signal that the market is now getting weaker (this is consistent with the divergences being seen in the NYSE McClellan Oscillator and in NYSE and NASD new highs vs. new lows).  Even should the Dow Transports confirm on the upside by rising to an all-time high tomorrow, we will still strive to trim down our 100% long position in our DJIA Timing System as soon as we can – especially since the tailwind of quarterly contributions from calendar-year DB pension plans is all but over.  Moreover – in about a week – many of the insiders which had been prevented from dumping shares onto the stock market because of restrictions during earnings season will be able to start selling.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators decreased from last week's 24.4% to 23.3% for the week ending May 4, 2007.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending May 4, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased from 24.4% to 23.3%. While the four-week MA is not very overbought, it is certainly not oversold either - and thus we will most probably trim down our 100% long position in our DJIA Timing System over the next couple of weeks or so should the stock market continue to move higher. For now, however, the longer term trend remains up.

With the latest non-confirmation of the Dow Industrials on the upside by the Dow Transports, I am now skeptical of any further rallies in the market this week – and I will continue to look for a correction as long as our sentiment indicators are not at least moderately oversold – such as the readings that we experienced during April 2005 and October 2005.  Again, while U.S. internals suggest that a significant top is most probably at least three to four months away, this author would not hesitate trimming down our 100% long position in our DJIA Timing System in the short-run – especially if we see a quick upside spike in the stock market over the next few days.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA of the ISE Sentiment bottomed at a reading of 98.5 on March 21st (representing the lowest reading since the 97.6 reading on October 30, 2002) and has since bounced back to a reading of 127.8 as of last Friday. Meanwhile, the 50 DMA also perked up slightly, but has again declined in the latest week, from a reading of 113.9 to 113.7. Again, this author currently do not see a significant top in the stock market until July/August at the earliest - but given the latest run-up in the 20 DMA, the market is definitely not immune from a short-term correction here - especially if the S&P 500 manages to rally by a quick 1% to 3% over the next few days.

While the 20-day moving average of the ISE Sentiment (at a current reading of 127.8) is nowhere near overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) is getting “long in the tooth” in the short-run.  Should we see a spike in the ISE Sentiment readings or a quick 1% to 3% rally in the stock market sometime this week– then we will not hesitate trimming down our 100% long position in our DJIA Timing System.  In the longer-run, however, the oversold condition of the 50 DMA suggests that the bull market is not over yet.

Conclusion: For those who are worried about the state of our retirement system – you have every reason to do so – but rest assured, there are many folks out there who are smarter than we are who are genuinely striving to reform our pension system.  Moreover, you can continue to keep track of their progress and email them with questions at the Retirement 20/20 webpage created and maintained by the Society of Actuaries.

As for the U.S. stock market, we will continue to remain 100% invested in our DJIA Timing System for now, but the latest non-confirmation in the popular Dow indices and the April decline in money market assets vs. the market capitalization of the S&P 500 is definitely a red flag, especially given the current overbought condition in the Dow Industrials.  Should the Dow Industrials or the S&P 500 spike higher by 1% to 3% over the next five trading days (preferably accompanied by a spike in our sentiment indicators or the ISE Sentiment Index) – then we definitely trim down our 100% long position in our DJIA Timing System, although we reserve the right to do so anyway even if this scenario does not pan out.  Subscribers please stay tuned.  As always, we will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System.

Signing off,

Henry To, CFA

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