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No Cuts, No Butts, No Coconuts

September 4, 2006

The markets have been forced to digest a plethora of events over the past several years, ranging from continuous geopolitical turmoil to a new Fed chairman, from blowups like the Refco scandal to an inflated housing market, each of these occurrences has raised considerable coverage from the financial press yet one cannot lose sight of the longer term trends (and threats) that still loom. The most obvious, and potentially most significant, is the coming generational aging of the boomer generation and the subsequent healthcare conundrum.

This week's "Outside the Box" will feature an article by the widely proclaimed "Bond King," Bill Gross, on the impact of boomer retirement and what that means for healthcare, the workforce and social security. Many of you will find some of his comments controversial. I do not agree with his analysis on tax cuts, as an example. But he is right about the issues which will face us as a generation attempts to retire without having saved enough assets to do so, either as individuals or as a country.

My long term readers are familiar with Bill as he is a Managing Director at PIMCO. During his tenure there, he has become regarded as the most prominent figure in the fixed income sector while at the helm of the largest bond fund in the world, the PIMCO Total Return Fund. PIMCO is one of the largest specialty fixed income managers in the world, with more than $617 billion in assets under management and more than 800 employees in offices in Newport Beach, New York, Singapore, Tokyo, London, Sydney, Munich, Toronto and Hong Kong.

May you find value in Bill's "outside the box" commentary and enjoy a safe and fun-filled Labor Day.

John Mauldin, Editor
Outside the Box

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No Cuts, No Butts, No Coconuts
Investment Outlook

Bathroom humor is always great fun to a fourth-grader and there's a little bit of that in the above that seems to have been passed down from generation to generation since...since...well ever since kids started standing in lines and needed to say something cool to maintain their place in them. I must confess that there have been lots of times when I have cut in line: at the movie theater with that "front two rows only" desperation; approaching the crowded freeway exit with that "I'm already 10 minutes late" rationale. Still, my biggest cut in line occurred on April 13th 1944, the day I was born, something for which I am completely innocent, of course, but because of which I have reaped substantial rewards. That was the day that I took cuts in front of tens of millions of American boomers - boomers yet to be born, but nonetheless waiting in a demographic "line" that would stretch from 1946 to 1965, and produce the largest lump of kids, teenagers, twenty-somethings and ultimately graying adults that this country has ever experienced. Being born several years in front of the first boomers has made life's game a little easier to play for me than for them. What good fortune to have applied to college when there were fewer applications to review but the same amount of empty dorms; to have found a job before the competition got really intense; to have bought a home for $30,000 in 1971 before the boomers wanted theirs five years later; and to have had kids who in turn benefited from similar demographic timing one generation forward. All my life I have been rather unconsciously cutting in line by purchasing stocks, mutual funds, and yes, bonds, just before my younger near-peers got the same idea. The early 1940s generation may not have been the greatest one but it could have been the luckiest - although to be honest, I would trade it in for a crack at being a X'er or a Y'er if I could take my wife Sue with me. Youth is a most precious commodity.

But to cut in front of a long line is to recognize the obvious - that there is a queue of people that want or need something. For the boomers, that something these past few decades has been "things," almost "anythings." Their voracious hunger for consumer goods and the high life has propelled our economy forward, indeed kept it afloat. Where would we or the world have been without them. They bought homes, then second homes. They bought two cars, then added a four-wheel drive off-roader to explore what turned out to be the suburbs. They bought big screens, then flat screens, and now with the advent of cellular technology - mini screens. If mankind's wants are insatiable, then the boomers are the greatest testament to that theory. Demand-side, not supply-side economics has been our guiding theorem ever since the first boomer was able to apply for a credit card and we are a richer country for it, I suppose. All hail the boomers, and as I've pointed out, you can add my name to the list of grateful beneficiaries.

But there are changes in the wind, or better yet, the seasons. The green leaves of this long boomer summer are turning now. Approaching 60, their focus is less on off-roading and more on off-loading - retirement, the transfer of responsibility and anxiety to a younger generation, as well as the assumption that they will be well cared for in those hospital rooms which are consciously visible but still subconsciously out of sight and mind, and up until now, intended for someone much older than themselves. Their intended off-loading, however, is a tricky proposition at best because the boomers are a lumpy demographic, a long line, that will require goods and services from a less densely populated younger generation. More of them, less of their successors.

It is a problem money or social security lock boxes, strangely enough, probably can't solve and that having more babies and stepped up legal or illegal immigration can. But the babies take 20+ years to grow into worker bees and we've long passed that point of no return. Immigration, as we all know, is a political hot topic and not likely to lead to rational conclusions or solutions anytime soon. So the boomers will be left it appears with a generational conundrum of gigantic proportions: who will take care of them?; who will still feed them - when they're 64? Fauna Kane, a Southern California boomer quoted by John Tierney in a recent article in The New York Times, says that people she knows aren't "thinking ahead, but nobody does...you think the good Lord's going to take care of you." Perhaps Mrs. Kane, but absent a miracle, it will be up to younger generations to do the Lord's work and there aren't enough of them to provide health care, a comfortable retirement, and to compete head-on with the Asian invasion at the same time. Something has to give way. In financial terms alone, Laurence Kotlikoff, a Boston University economist has estimated the unfunded liabilities of Americans associated with healthcare and retirement amount to $80 trillion, over seven times our annual GDP!

It is fairytale fiction of course to think that in the face of a "worker" shortage which appears unsolvable, that any amount of government promises to pay will provide the answer. That is why social security "fixes" that involve accounting changes, or deposits of government "bonds" which in turn pay for future "bonds" are near laughable. A lack of workers can be solved only by producing more of them and that will almost assuredly be done only by extending Americans' retirement age into their late 60s and a scaling back of their benefits. More workers to help the boomers? The Lord, Mrs. Kane, helps those that help themselves, and there will be a lot more of that in the next decade. Either by deferring social security benefits or simply "incentivizing" sixty-somethings to stay on the job because their retirement nest eggs have come up short of expectations - we will begin to solve this new conundrum the old-fashioned way - we will have to work for it. Based on the following chart of potential new medical students, it appears that the Boomer's surgeons in the next few decades will have grayer hair and maybe less steady fingers in the operating room. Staying healthy is perhaps the only recourse.

Those that fictionalize a domestic "financial" solution to this demographic conundrum have loads of imagination, but little common sense. To think that all the boomers have to do is sell their homes to pay for retirement and healthcare begs the legitimate question of "to whom and at what price?" If there are fewer X'ers and Y'ers to unload even their second homes to, rudimentary supply/demand curve analysis suggests prices must adjust downward to facilitate the transfer, incorporating the ability of immigrants and future first time buyers to afford what now seem to be unaffordable starter homes. Similar logic applies to holdings of domestic stocks, bonds, or any other "asset" which boomers count on individually to fund their retirement needs, but which collectively must be unloaded to a smaller demographic of tentative buyers. It will be next to impossible to borrow or sell our way out of this one.

The mention of the word "borrow" in the preceding sentence turns on a light bulb that suggests that we might be able to at least employ a reverse Marshall plan over the next 30 years by extending the beggar's cup across the Pacific Ocean in hopes of continuing handouts. Boomer consumer needs and in some cases healthcare requirements can certainly be absorbed by parts of the world that are less "boomerish," and Asia and Latin America fit that description - Japan and China excepted. But a decade from now, Asia and the "Americas" south of the Rio Grande will likely have turned inward with a focus on internal demand as opposed to external, mercantilistic export-dominated policies. Boomer borrowing likely no longer will be subsidized as it is now and the prices of our imports will rise, not just because of the increase in financing costs, but because of a declining dollar as well.

Far better, like squirrels sniffing out an approaching winter, to have gathered and stored a harvest of nuts and seeds to carry us through the approaching December nights. While a "domestic" financial solution is a mirage, there's no doubt that had we saved and invested those savings outside our borders, that one day we would have been able to ring the "accounts receivable" doorbell and extend our standard of living. Instead, a President fixated on emulating a former Republican icon of a far different demographic era, chose to emphasize tax cuts for the rich and excessive consumption. With no more sense than our story's Mrs. Kane, he chose not to think ahead, but to look to the past; to emulate Reagan tax policies which were more than appropriate in the 80s, but which were increasingly less appropriate as the twenty-first century unfolded with its aging boomers serving as the proverbial pothole in the road ahead; to mnemonically recite like a schoolboy at a blackboard, "no new taxes" - the phrase that had condemned his father to a one-term presidency; and to have surrounded himself with advisers who had no less vision or courage than himself. The W presidency will go down in the ashes of history for more than just Iraq.

Too late to have babies, too politically sensitive to import more workers, too daft to recognize that the boomer winter is rapidly approaching and that our assets will not fund our liabilities. Too, too. Too, too. Too, too. What does a government do that is too absorbed in the moment and fails to alert its citizens to the perils ahead? Cut in line, I suppose. It devalues its currency, it reflates/inflates its economy, and because that doesn't create real wealth, it recites the mythology of a bygone era, of a "shining city on a hill," so that its citizens believe they've never had it so good. Well, as I acknowledged at the start of this Outlook, some of us never have had it so good, but the demographic season is changing and a rebalancing, more equitable distribution of our rather meager stockpile of nuts lies ahead. Corporate profits, nearing a record percentage of GDP will ultimately be taxed at higher levels in order to assuage a populist ballot-box revolt. And U.S. stocks, the present value of which represents the future value of private sector wealth creation, will stutter, perhaps stagger, as investors understand that much future wealth has been spoken for, if not already digested, by a boomer generation acting as consumers of first and last resort.

No coconuts indeed.


Your not planning to retire anyway analyst,

John Mauldin

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