Tuesday, July 26, 2011

The Real Math Behind Siegel's Mythical 3.5% Real Yields

As economic growth recovers and real rates rise, the price of Tips will fall leaving Tips investors with large losses in the face of accelerating inflation. - Jeremy Siegel, February 2, 2011

How are we doing on that economic growth recovery theory of his? I would argue not so good. I would also point out that his rising real rate theory isn't doing so well either. 30-year TIPS rates have fallen 0.5% (from 2.1% to 1.6%) since he said that.

US Debt Clock.org

US Total Debt: $55 Trillion (all forms)
US Income Taxpayers: 112 Million

If typical real yields permanently became 3.5% then the interest on the US total debt (all sources) would eventually become $1.9 trillion. Assuming we put that burden entirely on the US taxpayer's shoulders, that would work out to roughly $17,000 per year per US income taxpayer (in today's inflation adjusted dollars).

It doesn't end there though. These are inflation adjusted yields. If inflation averages 3.5% (3.6% over the last year) then the $17,000 would need to be doubled in nominal terms to $34,000.

Know many taxpayers that can afford to pay $34,000 per year just to service our debts? I don't. Assuming a miracle happened and the typical taxpayer could cough up $34,000 per year, then how do you suppose our many strip malls and restaurants would be doing?

Contrary to the opinion of Jeremy Siegel, clearly the era of 3.5% real yields is over. I have bet and continue to bet nearly all that I have that I am right on this and that he is wrong.

In my opinion, this can go only one of two ways from here and neither are rising real yield situations.

1. Since our economy can no longer support high real yields, low real yields are here to stay. Investors continually lower their expectations to adapt to the current reality. Think Japan.

2. Investors fear not getting paid back. Real yields appear to rise. It's a mirage though. Here's an example. You loan someone a dollar, they immediately pay you a 10% real yield on it, and then they skip town. What's your real yield once the dust settles? You started with a dollar and ended up with 10 cents. Your imaginary 10% yield turned into a 90% real loss.

Since the whole world is in this mess, I lean towards #1. In any event, I think it will become harder and harder to prosper off of our debt. It's just too big for that.

If we cannot prosper off of our debt any longer then we probably can't prosper off of our stock market any longer either. It's our debt that is propping it up. Too bad Jeremy Siegel can't see that. The prosperous
rear-view mirror has captivated him.

As I have said many times before, if I lose money in inflation protected securities then at least I won't be first. It is a strategy I often used when playing the
Game of Risk. This is also related to a quote I often use.

"If one must panic, at least panic first."

Few lost their nest egg being the first to panic out of an investment. I own TIPS. I intend to hold them until maturity. If I thought there was a good chance I'd panic in the future (and require an even greater fool), then I'd sell them right now. I do not consider them to be safe but I do consider them safer than most alternatives. Sometimes that's all that matters.

In sharp contrast, as of 2004 I do not own stocks nor do I intend to own them in the future. I think there will be many more opportunities to panic in the coming years.

I do not believe that the
"Mighty US can shake off the gloom." I've been bearish for nearly 7 years. It is my belief that our long-term financial condition continues to deteriorate. I'm more bearish now than when I started this blog in 2007. Name one macro condition that's better since then. I dare you. Here's a list to get you started. Sigh.

Stock prices?
Real estate prices?
Oil prices?
Pension fund solvency?
Real yields?


See Also:
More Dangerous Advice from Jeremy Siegel


Mr Slippery said...

Stocks look bad until debt, including private debt, is brought down. After that, if we find some new, cheap energy source, we may start real growth again.

The government will have no choice about devaluing the dollar at some point. The obligations are too far out of line. They can do that with inflation or going back on promises or likely both.

A long time friend of mine, who is also a VP at Dell, called me today in a panic about the debt ceiling. Apart from the debt ceiling, he is starting to put the bigger pieces together. It will sink for most people after the next official recession is called.

Oh, the humanity!

TJandTheBear said...

I'm with Slippery -- there's gotta be a major & quick devaluation in the cards. We are Japan in so many ways but the ones that really count... we don't have the internal savings to cover our own debt, and we can't monetize our debt without pushing energy through the roof.

nilys said...

When the borrower can't pay back his debt and sells himself to the lender into slavery, there is a bifurcation point: the lender is no longer a lender, he is a slave owner, and naturally the former freeman borrower becomes a slave. Is “money” in a slave-owning society the same as in a freeman society? I would argue that it is not. So, the question to me is: what would be the outline of the next society after the next bifurcation point, when this bifurcation point happens, and what do I do to not end up at the “wrong end” of the great divide.

Michael Hudson outlined an interesting cycle of societal change (see here http://www.nakedcapitalism.com/2011/07/michael-hudson-mr-obama%E2%80%99s-scare-tactics-to-get-democrats-to-vote-for-his-republican-wall-street-plan.html, paragraph 7), ascribing it to Plato. I personally don't remember reading anything like this in Plato, even through I read many of his dialogs, including The Regime (the republic). It seem to me that after Aristocracy comes dictatorship and a long decay, loss knowledge and technology, immersion into misery and fanatical religiosity, until the knowledge is rediscovered and the aristocracy and dictators are pushed aside or slaughtered by those who rediscovered the knowledge. At least that's what seems to have happened before.

The things to watch for the next decade are the loss of technological edge, decay of the military, “closing of the mind” and “brain drain”, not because we don't have money to pay for these things, but because we no longer have the willpower to and interest in things like these and we neglect and despoil human capital. Somehow, the idea is that if you throw money around, highly skilled people would just materialize out of thin ether. They will not. But what all the money in the world are worth if there is not a single artisan, a single master to make a thing of beauty. And so money is worth nothing but power. And it is also a very dangerous world out there. I can see how with our waining power, our enemies would want to take revenge for real and percieved misdeeds. We all – poor becoming peasants, and wealthy becoming vassals of another power – may be in for a very rude awakening in a generation or so.

Stagflationary Mark said...

Mr Slippery & tj and the bear,

The government will have no choice about devaluing the dollar at some point.

I'm with Slippery...

I'd say the government will have no choice about devaluing the dollar at EVERY point.

That's been the trend for many decades and I do not see what can reverse it.

I'm not in the quick devaluation camp though. I see a meat grinder tied to a perpetual motion machine. Right or wrong, that's why I like long-term TIPS. Sigh.

Stagflationary Mark said...


We all – poor becoming peasants, and wealthy becoming vassals of another power – may be in for a very rude awakening in a generation or so.

I hear that. Based on actuarial tables, I'm expected to live another 32 years (1.5 generations?). We've had a few rude awakenings in the last decade and I expect them to intensify.