Thursday, June 10, 2010

Weekends – A Time to Think Rather Than React?

From the Desk of Joe Rollins

This weekend, I found myself thinking about the inconsistencies that are prevalent in the news. When we are inundated with negative news, it is hard to find any positives. A client recently told me that I was completely wrong about stock market performance. She stated that the true indicator of stock market performance is confidence and morale, not profits. I respectfully beg to disagree.

I would describe investor confidence at the current time as moody. Investors seem to be grumpy for reasons I don’t totally understand. Inarguably, the month of May was rough, but realistically, the Standard & Poor’s Index of 500 Stocks is down only 3.9% for 2010. In fact, the average account under our management is down only about half that percentage due to the diversification of the assets. After the gigantic run-up in the stock market from March of 2009 through April of 2010, investors should have expected some type of correction. While the correction has undoubtedly been painful, to this point it has been shallow and almost totally meaningless to long-term investors like us.

People who are distrustful generally don’t have a good understanding of the facts. For example, the stock market sold off dramatically on Friday when May’s employment report was released, and the sell-off continued through Monday. On each of those days, the stock market decline was reported by the media to be due to the supposed failure of the economy to employ people in the private sector. While it’s true that the total employment report reflected a gain of 431,000 jobs, the vast majority of these jobs were temporary census jobs. In fact, there were only 20,000 non-census workers added to the employment base. While this may be a disappointing number, it’s a long way from the catastrophic reaction in the equity markets. Perhaps this is another good example of people selling without really thinking.

It didn’t take much research to confirm that the employment numbers weren’t really as bad as represented by the media. Specifically, non-farm payrolls posted a net gain during six of the last seven months. While these are not especially large gains, they have been a net positive which is light years away from where we were only one year ago.

In May of 2009, the economy lost 387,000 jobs. The following June, non-farm payrolls dropped by a stunning 500,000. It seems silly to argue that a move up of over 20,000 jobs in a month just one year later is not good news for the economy. Eighteen months ago, the economy was losing 600,000 to 800,000 jobs per month. The fact that we have had positive employment growth for six of the last seven months should not be thought of as anything but good news to our economy.

When reviewing other data, most of it is positive. For instance, when I reviewed the expected GDP growth for 2010, a survey of economists indicated that it would be 2.6%. Today the U.S.’s expected GDP growth has increased to 3.5%. Isn’t it interesting that GDP growth is increasing but the U.S. equity markets have sold off 13% in the last six weeks? Can you see the inconsistencies that are driving the public’s confusion?

Did you know that corporate profits in the United States could reach an all-time high during the third quarter of 2010? Not record profits over the last few years, but the highest profits of all time. Stock market profits are consistent with higher corporate profits, not lower profits. Free cash flow for non-financial American companies is now at its highest ever. U.S. corporations have accumulated cash on their balance sheets equal to 11% of total assets, which is the highest cash level in the last 60 years.

Productivity in the United States is growing at a record pace. Labor costs are dropping at the fastest pace in 40 years with technology driving higher productivity with each U.S. employee producing more in our history. All of this increase in productivity is due to U.S. corporations reacting to the financial crisis by reducing costs and replacing manpower with better technology. All of this will lead to higher profits in the coming months.

One of the competing forces for stock market performance is interest rates. The 10-year Treasury bond rate is within one-fourth of 1% of the lowest rate at which it has ever traded in this country. Money market rates continue to be at almost zero, and therefore, no interest products constitute any type of competition for equity investments. Extraordinarily low interest rates constitute a real danger to bonds in the coming months since, in all likelihood, the trend for interest rates will be higher, not lower, and bonds move inversely in value to higher interest rates. This is another extraordinarily bullish opportunity for U.S. equities.

There has been much in the news regarding the failures of the finances of Greece, Italy, Spain and Hungary. How is all of this affecting the U.S.’s ability to compete in international commerce? Fifteen years ago, the U.S. accounted for 25% of the global GDP. Interestingly, today the U.S. has not declined at all and still constitutes 25%. The emerging markets of Brazil, Russia, India and China have advanced their share of GDP growth to 15% from a lowly 7% in 1995. However, this increase has not been at the expense of the United States. The entire reduction of GDP growth captured by the emerging markets was at the expense of Europe and, principally, Japan. All of this is very positive for U.S. equity investing.

Undoubtedly, there are problems in the United States, but the U.S. economy has always adjusted for those uncertainties. Our Congress in Washington has given no indication that they have any intention of trying to do anything to solve the out of control deficits of our country. In fact, they’ve gone the other direction as of late and decided to spend even more money. In 2011, the U.S. will be facing one of the largest tax increases ever in our history. This clearly is not a good omen for our economy or for investing.

In 2011, the highest individual federal income tax rate will increase from 35% to 39.6%. It may be hard to believe, but the highest federal dividend rate increases from 15% to 39.6%, and the capital gains rate will increase from 15% to 20%. These are large income tax rate increases. In a few years, we will add on additional rates of 3.9% to get the highest effective tax rate from 39.6% to 43.5%. We will also face the boondoggle of Obamacare, which will bring much higher taxes and much larger deficits.

It is hard to argue that out of control deficits and rapidly accelerating tax rates are a good thing. However, the ineptness of our current Congress will almost assuredly lead to a more moderate Congress in the next term, which will hopefully bring us real change rather than bigger deficits and higher taxes. With over 50% of the U.S. population paying no income taxes at all, it should be self-evident even to the bozos in Washington that it will be totally impossible to balance the federal budget by tax increases alone.

Another client of mine has been critical of my posts wherein I opine that socialism is inferior to capitalism economically speaking. He has provided Scandinavian countries as an example of a successful socialist economy and has asked me to research the concept and discuss it in a blog.

Using Denmark as an example, the government provides for most of its population’s needs. For example, education and health services are practically free in Denmark. Obviously, the Danish government could not provide for those services without extraordinarily high income tax rates.

Accordingly, Denmark has the reputation for having one of the highest tax burdens of any country in the world. The tax rates for individuals range from 42.9% to 63% along with a 25% value added tax (VAT). Therefore, 44% of all full-time employees in Denmark pay taxes at a marginal rate of 63% and a combined marginal tax rate of 70.9%. Wow! Aren’t those rates unbelievable? This means that for every $100 the average Dane earns, the government takes $71. They don’t have the choice to receive the government services or not – everyone gets them, and everyone pays the taxes.

Nonetheless, there is little revolt in Denmark regarding the high tax rates, because the people understand and expect that they are getting something in return. Denmark’s population is highly paid and it has been placed high on international barometers of quality of life. But, to have anything to spend after paying such a large tax burden, one would have to be well paid.

In my opinion, the disadvantage of the government providing for these social services by virtue of its high tax burden is that it is more attractive for Danish entrepreneurs to seek work abroad. In the United States, if we increased taxes to support free social services, it is likely that entrepreneurs would go to a country with a lower tax structure. If they have a choice, they will choose to do business in countries with lower taxes.

In the early 1970’s, I recall there being outrage over the Beatles becoming tax exiles from Britain. It wasn’t so much that they disliked living in England as much as they disliked paying such high taxes. When they moved away from England to the U.S., their tax rates were cut in half. Like the situation with the Beatles and other famous musicians leaving Britain to avoid paying such high taxes, I cannot imagine that the U.S. would have many entrepreneurs or higher earning citizens if the tax rate in the United States doubled to a combined tax rate of over 70%. Less commerce is not good for an economy since entrepreneurs are the very people that employ other Americans.

So, yes, a socialist society can be financially prudent and solvent if the people are willing to pay for it. Are Americans willing to pay for those services? I don’t think so. In short, with 50% of the U.S. population paying no taxes now, major structural changes in our government will be required. My guess is that will be less government rather than more, which I believe to be a good thing.

As always, the foregoing comments are my opinions, thoughts and personal biases (which are based on facts, not myths). In all cases, I could be wrong.