COUNTERINTUITIVE ECONOMICS

From the Desk of Joe Rollins

Congress, it seems, explains its economic actions by its inability to define whether their actions have actually done any good or not. The economy hasn’t really improved, but according to Congress, it probably would’ve been a lot worse if they hadn’t taken the actions they took. I’ll get to that point shortly, but in the meantime, I want to relay the financial results for the month of February 2013.

February was an excellent investing month, and while it certainly wasn’t as good as January, it was still quite satisfactory in almost every respect. The S&P 500 had a 1.4% return for February, and for the first two months of 2013, it is up 6.6%. The Dow Jones Industrial Average is even better, with a 1.7% gain for the month of February and a gain of 7.7% year-to-date. The tech-heavy NASDAQ Composite lagged, but it still had satisfactory returns of .7% for February and is up 4.8% year-to-date.

The NASDAQ is heavily weighted by a single stock – Apple. Due to the large valuation of Apple, the NASDAQ basically is connected to whichever way Apple moves. Since the beginning of 2013, Apple has declined approximately 15%, and therefore, the NASDAQ has struggled with it. While there’s nothing wrong with Apple’s outlook, it arguably got ahead of itself and needed to be adjusted. The NASDAQ’s year-to-date performance, however, is still quite excellent given that its largest participant has been a drag on the aggregate composite.

There are some other interesting trends that have developed during 2013. The small cap Russell 2000 has had an excellent run, and it was up 1.2% for the month of February and up 7.5% for the first two months of 2013. Additionally, the Barclays Capital Aggregate Bond Index is finally adjusting to the reality that bonds shouldn’t perform like stocks. Unfortunately, this bond index continues to be down for 2013 thus far. We are still seeing some strength in high yield bond funds, which are up a little over 1% for the year-to-date, but almost all other types of bond funds are recording losses. Almost every form of government bonds, investment grade bonds, international bonds and even emerging market bond funds are negative year-to-date.

When I report these results, I can’t help but be amused by the unbelievably low returns that many investors are receiving in money market accounts and CDs. I met with a client last week who indicated that he was getting ready to commit to a five-year CD paying a .9% annualized interest rate. If this weren’t so sad, I would have laughed.

The confirmed inflation rate is basically 2%, although many argue that it may increase to 2.5% in the new few years. Therefore, anyone entering into a 5-year CD paying less than the rate of inflation rate would have a guaranteed loss of purchasing power. Given that the S&P 500 was up 1.4% for February alone, stock returns would exceed in one month what CDs will earn in a single year. I only wish I could successfully emphasize to investors how futile it is to invest in these fixed-rate CDs at the current time.

As the 4th quarter reporting period for the S&P 500 earnings comes to a close, a new earnings record was established yet again. It appears that the total gain will only be 4% to 8% higher than the previous year, but the most important aspect is that it was a gain.

I continue to hear commentators exclaim dismay that the percentage increase in earnings has been decreasing over the last several years. I suppose these commentators have never heard the theory of big numbers. In the 1980s, it was believed that Wal-Mart would grow its earnings every year by 25%. In fact, there were many commentators who indicated that this growth in earnings would go on for 30 or 40 years since Wal-Mart was in an expansionary stage. The only problem with their exclamation was that due to Wal-Mart’s vast size, if it had grown at a 20% compounded rate then in a few years it would have every retail dollar sold in America, and shortly thereafter, it would have every retail dollar sold in the world. You cannot continue to compound numbers and expect that trend to not decline. The fact that the earnings increased this quarter – even after record earnings last quarter – should be enough comfort for most investors.

As for my comments regarding counterintuitive economics, I will provide you with a few examples: We were led to believe that if we greatly expanded the federal budget and provided virtually unlimited stimulus plans, the economy would explode upward and GDP growth would be impressive. Five years into the current administration, we see that none of that has happened. In fact, for the 4th quarter of 2012, the GDP growth was virtually zero.

However, the argument we continue to hear is that while the economy hasn’t grown, it would have been catastrophic if those stimulus actions hadn’t been taken. I am one of the few who believe that the vast expansion of federal debt in order to achieve whatever gains have occurred in the economy may not be worth the price paid. Over the last five years, the federal debt has increased by a mind-numbing $6 trillion. My point is that it’s time to try another alternative to increase growth since clearly this one hasn’t worked.

The other counterintuitive economic theory that continues to baffle me is proposing economic fixes that have been universally proven not to work. Recently, it was proposed that we increase the minimum wage to $9 per hour from its current basic minimum rate of $7.25 per hour. The theory is that if the minimum wage is increased, it would benefit the people being paid those low wage minimums.

While increasing the minimum wage may seem intuitive, decades of research has revealed this to be incorrect. An increase in minimum wage hurts employees rather than helps them. While those who work at minimum wage are helped in the immediate, the number of people employed actually decreases when the minimum wage is increased. Therefore, to argue that it helps employees is just incorrect. If you keep calling a cat a dog, it won’t make it come true. Unfortunately, in economics few things have not been tried before, and certainly the history of economic reality in this regard is well documented.

I’ve been asked by a number of clients if I believe that sequestration will hurt stocks. My only opinion regarding sequestration is that it’s good that spending is finally being cut. It appears that Congress is so inept that it can’t find a way to cut federal spending on its own. If a corporate executive was asked to cut 3% out of their annual budget, they would laugh at that ridiculously low budget cut. Certainly, 3% can be cut out of anything very quickly, but our Congress couldn’t even agree on this minor budget reduction. Therefore, sequestration may be positive for the stock market since it will finally demonstrate that there’s an attempt being made to control federal spending.

I do not see anything in the current economic environment that would lead to a massive decrease in prices. Earnings continue to be quite good, interest rates continue to be low, and while the economy is not growing, it’s not declining, either. All of those are extraordinarily positive attributes for higher stock prices going forward.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins