Why You Need an Investment Advisor Part I – Individuals Vastly Underperform the Market

Posted on November 19, 2012 by tomdoerflinger

Since 1929 U.S. stocks have provided a real return of 5.9% per year.  So if you sell a business and have a long time horizon, it makes sense to invest in stocks.  The cheapest and easiest way is to buy an index mutual fund or ETF.  But that is not the smartest thing to do.  It is better to find an experienced, trustworthy investment advisor to help manage your money.

Why?  Not because they will be such great stock pickers that they beat the stock market by a substantial margin.  I know a couple of talented professionals who can do that, but it is very difficult because the market is so efficient.  AIG’s Hank Greenberg once remarked, “All I want in life is an unfair advantage.”  Me too, but it is hard to find in the stock market, what with every trader, analyst, and broker having available on his desktop, via Bloomberg or FactSet, the income statement, balance sheet, cash flow statement, trading history, SEC filings, ownership data, conference call transcripts, relative valuation metrics, technical charts, event timelines etc. on thousands of companies.

And keep in mind that advisors who do have a lengthy record of beating the market may have done so by taking too much risk.  An example is Legg Mason’s Bill Miller, a talented fellow who beat the S&P 500 for ten years in a row.  He made concentrated, contrarian bets on unloved sectors – which after 2006 included housing stocks and financial stocks. Woops.  The fund dropped 55% in 2008; assets declined about 87% between 2007 and 2011 (partly due to withdrawals).

So why use an advisor if they are not too likely to beat the market significantly?  Because individuals, left to their own devices, tend to vastly underperform the stock market.  Consider:

  • Dalbar, a market research firm, “utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior…. Based on this behavior, it calculates an average investor return.”  Over the two decades ending 2008, the average investor return was +1.87% versus +8.35% for the S&P 500.
  • Former New York Times reporter Hedrick Smith’s book Who Stole the American Dream? (his answer: conservatives, even though the dream disappeared in the 1970s when liberal policies reigned) has an interesting chapter indicting 401(k) plans because typical investors vastly underperform the market. The State of Nebraska offered a 401(k) type pension plan to employees, but the legislature wondered whether it worked properly.  So they ran an experiment.  Employees were split into two groups; a group of workers who ran their own money and another pool of funds run by professionals. The professionals soundly beat the amateurs, 10.5% per year vs. 6.5%.
  • The reason for individuals’ poor performance is that they get in and out of stocks at the wrong time and chase performance by buying “hot” funds after they have become expensive.  A National Bureau of Economic Research study of mutual fund s found that “Fund flows are dumb money.  By reallocating across different mutual funds, retail investors reduce their wealth in the long run.”

As an aside, individuals’ terrible record as market timers is currently a very bullish signal. They have been net sellers of domestic stock mutual funds in 30 of the last 36 months, including each of the past 18 months.  Count on them to get back into stocks after they are up 50-100%.  In our next installment on this topic, we’ll explain why it is so difficult for individual investors to stay fully invested.

References:  Ben Inker, “Reports of the Death of Equities Have Been Greatly Exaggerated:  Explaining Equity Returns” GMO White Paper August 2012  (highly recommended);  Hedrick Smith, Who Stole the American Dream? (2012);  Andrea Frazzini, Owen A. Lamont,  “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns”  NBER Working Paper Series,  July 2005.

Copyright 2012 Thomas Doerflinger.  All Rights Reserved.

Posted in Uncategorized | Tagged , , | Leave a comment

Suburban Sun Stroke

Posted on November 11, 2012 by tomdoerflinger

Don’t it always seem to go
That you don’t know what you’ve got til it’s gone
They paved paradise
And put up a solar lot

with apologies to Joni Mitchell

In the booming 1830s Irish laborers used picks, shovels, wheel barrows and mule-powered carts to dig a 66-mile ditch connecting Pennsylvania with New York City.  In its heyday in the 1860s and 1870s the Delaware and Raritan Canal was used to ship millions of tons of anthracite coal across New Jersey, from the Delaware Valley to New York.  In the 20th century the Canal was repurposed as a splendid park and wildlife refuge.  In the borough of Princeton the Canal parallels Lake Carnegie, home of Princeton University’s crew teams. If you walk the tow path that runs along the Canal and Lake you will see plenty of ducks and hawks and an occasional blue heron.  Snapping turtles and painted turtles are common, and there are quite a few red-bellied cooters—large high-backed turtles, quite rare in New Jersey, that like to bask on rocks along the Canal.  Like Painted Turtles, they are skittish; come too close and they disappear into the water.

Natural areas like this are highly prized in New Jersey, the most urban state in the U.S.   Indeed, the state government spends millions of dollars annually on its Green Acres Program to buy acreage before it is gobbled up by developers of houses and office buildings.  Wealthy, environmentally correct communities like Princeton are particularly protective of their natural areas.  There is not much open space left in the prosperous burgh.

A thought experiment:  How would the good citizens of Princeton react if a developer proposed to build a 27-acre office complex on open fields located right next to the D&R Canal and Lake Carnegie?  The answer is obvious.  They would freak out—think of the risk to “environmentally sensitive” wetlands; the threat to wildlife; the traffic, noise, pollution, and congestion. The developer would try to meet these objections with detailed projections of new jobs created and tax revenue generated. He would commission an environmental impact assessment and promise that every effort would be made to preserve the natural character of the land–plenty of grass and trees and shrubs and maybe a pond.  But this would not placate Green Princetonians; a bitter fight would ensue.

But what if, instead of an office complex, those 27 acres were covered with 16,500 photo-voltaic panels?  No grass.  No shrubs.  No trees.  Just lots and lots of silicon pointed skyward to catch the sun’s rays 205 days a year (the other 140 are cloudy).

No grass, no shrubs, no trees? – NO PROBLEM!  This is solar power we are talking about, the savior of the planet, the ne plus ultra of the environmental gentry.  Princeton University, which did indeed build this “solar field” (which looks more like a sprawling space telescope than a “field”) bragged that the University “will become a leader in American higher education in solar energy when it installs a 5.3-megawatt solar collector field on 27 acres it owns in West Windsor Township. . . . The project eventually will reduce the University’s carbon footprint by decreasing its dependence on fossil fuels and should trim approximately 8 percent per year from its electric costs.” The true underlying economics are problematic at best.  Unlike an office project, this solar field requires government and consumer subsidies to be financially attractive to the University. Thus the State of New Jersey effectively operates two antithetical initiatives: “Green Acres” and “Solar Acres.”

Now, in the cramped confines of suburban New Jersey 27 acres is not a small piece of land.  In fact it is nearly as large as Princeton University’s beautiful main campus (from University Place to Washington Road, and from Nassau Street down to Dillon Gym).  Which raises the question: How much of the University’s electricity needs will actually be met by this big, ugly, intrusive, uneconomic, environmentally disruptive installation?  Only 5.8%!  The other 94.2% will still come from dreaded fossil fuels.

There are lessons to be drawn.  GEI (Green Energy Ideology) exerts a powerful grip on True Believers, such that they would destroy the environment in order to save it.  Except that they won’t save it, because trivial reductions in greenhouse gasses from this and similar projects will be overwhelmed by the increase in greenhouse gas emissions in emerging markets. (I have done the arithmetic but will not discuss it here.)  Another lesson is that, despite their frequent invocations of “science,” greenies’ standards for what is and is not environmentally correct are arbitrary, based as much on aesthetics as science.  Thus while this 27-acre monstrosity makes the cut, far smaller, less intrusive natural gas wells producing clean fuel, lower energy costs, and thousands of high-paying blue collar jobs are rejected.

All this has not been lost on average citizens in Barrack Obama’s vaunted “middle class.”  They are fighting back.  For details, see the website www.SmarterSolarNJ.com.

Posted in Uncategorized | Tagged , , , , | Leave a comment

No Reason for Optimism on the Fiscal Cliff

Posted on November 7, 2012 by tomdoerflinger

The standard view on Wall Street is that we will somehow avoid going over the “Fiscal Cliff.”  That may ultimately prove to be true, but investors should proceed on the assumption we could well go over the cliff and will at least come perilously close — close enough to damage the confidence of investors, businesses, and consumers.

Frankly, the main reason for Wall Street’s complacency about the cliff is that it (like a decline in housing prices in 2008!) is “too awful to contemplate” – a U.S. recession while the rest of the world is already in a slump. But if one considers how Washington actually handles these issues, there is little reason for optimism.  This is demonstrated by The Price of Politics, Bob Woodward’s excruciatingly detailed, meeting-by-meeting, phone call-by-phone call account of the 2011 fiscal negotiations between Congress and the White House.  Salient highlights:

  • Both sides are “dug in” on defining issues – no tax hikes for the Republicans, and no cuts in Medicare or Medicaid benefits for Democrats.  “Giving in” on them damages the political “brand.”  For example, Democrats feel that agreeing to Medicare benefit cuts would put them in the same boat with Paul Ryan.  One reason for this: the issues are so complex that it is hard to make concessions and then communicate to constituents that they are fairly minor.
  • For Republicans, the only acceptable way to get “more revenue” is tax reform lowering rates and broadening the base.  (Boehner’s comments today appear consistent with this position.) Obama has shown little interest in doing this; he considers higher rates on the affluent a moral issue.
  • Woodward, a liberal icon, portrays Obama as a clumsy negotiator who attends way too many meetings and tends to lecture people.
  • In the negotiations nothing was really settled until the very end. Bargaining positions on complex issues kept changing. Boehner likened it to “nailing jell-o to the wall.”
  • One reason for the extreme fluidity of negotiations is that there was a veritable four-ring circus:  the Simpson Bowles Committee, Republican Majority Leader Eric Cantor’s negotiations with Vice President Joe Biden, John Boehner’s secret negotiations with Obama, and the Senate’s “Gang of Six.”  The Gang of Six derailed Boenher-Obama by recommending $1.2 trillion in new revenue, more than the $800 billion Obama was asking for.  This prompted Obama to raise his revenue demand by $400 billion, which Boehner rejected, killing the deal.
  • Negotiations dragged on and on until the “last minute.”  Negotiators did not care much about developments on Wall Street or in the real economy.  In my experience investors exaggerate how much Washington worries about the stock market.
  • Keep in mind that these fevered negotiations that dominated Washington for well over a month did not actually solve any substantive issues – they merely handed fiscal problems over to a “supercommittee” which also could not resolve them, leading in turn to January’s fiscal cliff.

When it comes to cliff-avoidance, this dreary record shows, there is no reason for optimism.  And even if we do avoid the cliff, another debt ceiling limit fight looms in January or February.  Obama will be very angry about having to deal with this again; in 2011 he claimed it was effectively unconstitutional because it undermined his authority as President.  And Obama can now afford to be an even tougher negotiator because, unlike in 2011, he does not need a strong economy to help him win reelection.  Some Democrats are willing to go over the cliff and blame the resulting economic damage on Republicans.  In July Senator Patty Murray said, “If we can’t get a good deal – a balanced deal that calls on the wealthy to pay their fair share – then I will absolutely continue this debate into 2013, rather than lock in a long-term deal this year that throws middle-class families under the bus.”

Keep in mind that, on top of all this “uncertainty,” fiscal policy very likely will tighten early next year at a time when Europe is in recession and emerging markets are sluggish.  The payroll tax cut will probably end and Obamacare taxes on high earners will kick in.  So profits, which slightly declined year/year in Q3, are not likely to rise much in 2013; S&P EPS of $106, representing a gain of 4-5% is a reasonable number.  But if we really go over the cliff and have a recession $95-100 is likely.  This risk will create extreme market volatility over the next few months.

 

Posted in Uncategorized | Leave a comment

It’s Time to Address Climate Change, Governor Cuomo

Posted on November 7, 2012 by tomdoerflinger

In an October 31 media briefing on Hurricane Sandy, New York Governor Andrew Cuomo linked the storm to climate change:  “For us to say this is once-in-a-generation, that it’s not going to happen again, as elected officials that would be short-sighted. This city, this region, is very susceptible to coastal flooding. Part of learning from this is learning that climate change is a reality.”  Cuomo proposes considering the type of storm barriers used in Europe – at the mouth of London’s Thames River, for example.

It would take years and years to build storm barriers around New York City.  But here is one thing the Governor could do right away to address climate change:  approve the use of fracking to drill for natural gas in the Marcellus and Utica shale formations in western New York. Natural gas produces far less greenhouse gas than coal, which is already being  supplanted by gas in many U.S. power plants. By all means let’s regulate drilling so it does not affect ground water and so the waste water is properly handled.  This can be done.  Thousands of wells have already been drilled around the country without significant environmental damage—including next door in Pennsylvania.

But is it acceptable to approve energy projects that involve any damage to the environment?   The reality is that all types of energy production have some impact – including noisy windmills that slice up birds and solar collector fields that blight hundreds of acres of open land.  Natural gas drilling sites, which temporarily cover a few acres, are actually far less less disruptive than either windmills or solar (or, for that matter, coal mines). And let’s remember that if Cuomo’s proposed storm barriers ever made the trip from rhetoric to reality, environmentalists would discover all sorts of risks to sensitive marine life.  Nothing is perfect.

Closing New York’s Income Gap

And, by the way, fracking in New York would address two of the biggest socioeconomic issues vexing liberals: wage stagnation and income inequality.  The median household income in three counties that would benefit from fracking (Broome, Chenango, and Cortland) is only $42,371, or just 55% of the level in Westchester County (home to many rich liberals, including professional fracking opponent Robert Kennedy Jr.).  By permitting fracking Cuomo would create thousands of relatively well-paid jobs for middle class families struggling in one of the more depressed rural economies in the United States.  And cheap natural would reduce fuel costs, thereby lifting real wages.

So will Cuomo actually step up and doing something concrete to address climate change while helping New Yorkers?  Or just talk?  We’ll find out.

Posted in Uncategorized | Tagged , , , | Leave a comment

Under the Limit – Obamacare is Creating a Part-Time Workforce

Posted on November 7, 2012 by tomdoerflinger

I talk a lot about how Obama’s new regulations are hurting employment and growth.  In my opinion economists tend to overlook the problem because A) it’s impossible to quantify and B) it doesn’t fit standard macro paradigms they studied in grad school.  Here is a compelling datapoint that shows why over-regulation matters and ends up hurting the purported beneficiaries.  The Wall Street Journal ran a story titled, Health Law Spurs Shift in Hours: Some Low-Wage Employers Seek to Avoid Overhaul’s Insurance Requirements With More Part-timers.

Labor-intensive service companies such as restaurant chains and hotel chains have to provide health insurance to “full time employees,” defined as those who work at least 30 hours a week.  And not just any health insurance – the expensive “soup-to-nuts” plan mandated by Obamacare.  Solution: limit employees to less than 30 hours per week.  This is terrible for workers; they don’t get health coverage and now will have to commute between two jobs to get enough hours of work.  This hurts U.S. productivity by wasting time and energy spent commuting between jobs.

This is a great way to keep the poor in poverty.  Many of these folks are in low-paid jobs but fairly stable jobs that, however, provide some upward mobility to mid-level managerial positions. The perverse effects of Obamacare will make it tougher for them to climb the occupational ladder.  We are talking about a big slice of the labor force; according to the BLS, “Retail Trade” plus “Accommodations and Food Service” equal 23.8% of the private labor force.

In addition to prompting large employers to cut the number of full-time workers, Obamacare encourages small businesses to stay small, because it only applies to companies with over fifty workers. So thousands of employers will figure out a way to stay “under the limit.”  A few years from now, there will be a lot more companies with 45-50 workers than 51-55 workers.  I understand this pattern already exists in Europe with similarly ill-conceived laws.

Posted in Uncategorized | Tagged , , | Leave a comment

“Policy Certainty” Sets Stage for Potential Romney Rally

Posted on October 29, 2012 by tomdoerflinger

Don’t get me wrong.  Some of my best friends are economists.  But their response to any and all problems is, “first, let’s create a time series, which we’ll regress against other time series until we find a relationship worth writing about.” This process has its place, but it can divert attention from obvious realities not lending themselves to quantification.

Consider “uncertainty,” which the media blames for high unemployment because it dissuades companies from hiring even though they have tons of cash.  To explore the relationship between “uncertainty” and economic growth, Stanford economists created an Index of Economic Uncertainty based on A) news articles mentioning certain key words such as—you guessed it—uncertainty,  B) tax code expiration data, and  C) the dispersion of economic forecasts for GDP growth, CPI, and government spending.  They find that:

The index spikes near consequential presidential elections and after major events such as the Gulf wars and the 9/11 attack.  Index values are very high in recent years with clear jumps around the Lehman bankruptcy and TARP legislation, the 2010 midterm elections, the Eurozone crisis and the U.S. debt-ceiling dispute.*

Paul Krugman, Jan Hatzius and others point out that the Index is highest when the economy is weak, which raises the usual “chicken and egg” problem that bedevils economists – does economic uncertainty create economic weakness, or vice versa?   Krugman wants to have it both ways.  With his usual analytical dispassion he labels uncertainty analysis a “scam” perpetrated by “right wing economists” who want to blame the weak economic recovery on Obama’s policies.  But he embraces this “scam” when it fits his politics, agreeing that GDP growth suffered in 2011 from uncertainty caused by Congressional Republicans’ refusal to automatically raise the debt ceiling.

Economic Uncertainty vs. Policy Certainty

This uncertainty debate is miscast at several levels. Critical distinctions need to be made:

In the first place, the very concept of “economic uncertainty” is dubious on its face because the future is always uncertain.  In fact, certainty creates its own uncertainty.  When things go well in the economy for an extended period, people tend to extrapolate the good times, which is called “complacency.”  Complacency tends to be self-limiting because it leads to over-investment, excess capacity and recessions (like the bursting of the 1990s tech bubble).

Secondly, it is true that sometimes genuine “exogenous events” unexpectedly ratchet up “uncertainty.”  Good examples are the 9/11 attacks and Saddam Hussein’s invasion of Kuwait in 1990; these events surprised everyone on Wall Street.  (The 2008 TARP vote and even the Eurozone crisis are NOT good examples because they are derivatives of the financial crisis.)

Finally, the “uncertainty” rubric that is applied to regulations emanating from Washington is obviously inappropriate.  Far from being “uncertain” these policies are in many cases already the law of the land, including healthcare reform, financial reform, and the EPA jihad against fossil fuels. There may be some “uncertainty” about how bureaucrats will interpret and apply the thousands of pages of legislation—for example, how the Volcker Rule will affect bond trading.  But, relatively speaking, this is Policy Certainty not Economic Uncertainty.  The policies hurt growth and employment not because they increase uncertainty but because they raise costs, limit revenues, increase risks, and hurt profits.

Economists’ Quantitative Blinders

Economists are ill-equipped to analyze Policy Certainty because they are not lawyers or accountants who understand the excruciating complexities of regulation.  Thousands of pages of legalese cannot be distilled into a statistic or time series.  In econoland, if it can’t be quantified, it doesn’t exist.

So economists have largely ignored the warnings of leading businessmen (who, whatever one thinks of them, actually make spending and hiring decisions) about the damage to economic growth wrought by Obama’s regulatory avalanche.  Wall Street economists have little to say about regulation.  Krugman dismisses it as the “you’re looking at me funny” argument.  You can read dozens and dozens of articles in The Financial Times diagnosing anemic growth without seeing mention of regulation – it’s all about deleveraging.

In a lengthy, portentous front page New York Times article on the supposedly mysterious slump in middle class incomes, David Leonhardt fingered all the usual suspects – globalization, automation, digitization, weak labor unions, low minimum wage, rising healthcare costs, a faulty education system – but never mentioned rising regulation.  Umm David, don’t you think the middle class outside the beltway might be doing better if regulation were not raising energy costs, killing high paying jobs on energy projects, penalizing small businesses that employ over fifty workers, and destroying thousands of good paying middle class jobs in the financial sector?  A compelling case in point is the state of Texas, whose business-friendly regulatory environment has led to much stronger job creation than in other large states – a point Dallas Fed President Richard Fisher makes in all his speeches.

The Great Suppression, Part Deux

Back on July 9 we deconstructed the “Great Suppression” of Keynesian “Animal Spirits” by Washington’s regulatory onslaught.  Suffice it to say that businesses are loath to hire and invest when they have to hack their way through an ever-expanding thicket of complex regulations.  And Obama’s disdain for capitalists who supposedly don’t “pay their fair share” of taxes is not exactly a confidence builder.

And no regulatory relief is in sight.  In a recent Barrons article Jim McTague detailed the next wave of rules and regs to hit the private sector, including ozone regulation costing $90 billion, regulation of “particulate matter” (aka soot), expansion of the Clean Water Act to cover millions of acres of land draining into rivers and lakes, etc. “The EPA,” McTague writes, “could end up regulating a huge swath of the economy, and the impact could be enormous.”

 A Romney Rally?

Most of this regulation could be reversed without ill consequences, and a President Romney will try to do that. The payoff would be big and quick. Business confidence would improve, hiring would pick up, the fracking boom would proceed, commodity prices would be restrained and middle class incomes would start rising again.  All this could happen fairly quickly because the private economy is remarkably healthy.  Corporations are well managed, well-capitalized, and highly efficient; the banking system is sound; the housing market has started to rebound; households have successfully deleveraged.  A Romney victory would have as big an impact as the Reagan victory in 1980, but the payoff would be faster because the private sector is stronger and we are not in the middle of a recession.  So a Romney victory would be very bullish for stocks, even if Barnanke departs and monetary policy becomes less accommodative.

*Scott R. Baker, Nicholas Bloom, and Steven J. Davis,  Measuring Economic Policy Uncertainty,   June 4, 2012

Posted in Uncategorized | Leave a comment

Q3 Earnings: Even Worse than Expected

Posted on October 22, 2012 by tomdoerflinger

On October 9 we issued a Complacency Alert, warning that, contra The Wall Street Journal, weak earnings did indeed matter to stock prices despite QE3 liquidity injections by the Fed.  The contours of third quarter earnings are about as expected, with Wall Street and other banks reasonably good relative to analyst forecasts while globally exposed cyclicals are reporting weak results.  Big healthcare companies are reporting in line earnings, and companies like PPG with exposure to housing (paints) are doing relatively well.  Housing exposed stock should continue to shine, relatively speaking.

However, both the overall tone of earnings and investor reaction to them are even more negative than we expected.  A large and diverse group of multinationals have posted results that are mediocre or worse, including IBM, INTC, MSFT, VFC, CAT, MCD, DOV, DHR, APD, PH and GE.  Look for similarly weak results from the industrial and chemical companies that report this week.  There is some indication that September orders were weaker than July and August, probably because companies are increasingly worried about the “fiscal cliff.” CNBC reports that 90% of companies are cutting Q4 earnings guidance, which is consistent with our October 9 statement that “forward estimates will continue to drop.”

These results once again illustrate that “S&P is not GDP” because, inter alia, S&P is global not just domestic and is far more leveraged to manufacturing and exports.  A modest improvement in U.S. GDP driven by stronger housing would not offset recession in Europe and weakness in emerging markets. So we see little reason to believe profits are now “troughing” and will soon strengthen:

  • Though arguably the U.S. economy is improving slightly, it will continue to be quite weak even if Washington avoids going over the “fiscal cliff.”  Recall that Republicans and Democrats agree that one significant tax cut, the reduction in the Social Security payroll tax, should end on January 1.  And on that day Obamacare taxes will start to hit Americans who make too much money.  If Obama wins business will worry about a renewed regulatory onslaught, which will discourage capital spending and hiring.
  • With Europe’s banks and governments deleveraging, we see little reason why Europe will quickly and decisively pull out of recession.  Decision makers continue to be reactive not proactive; it takes financial crises to scare them into moving forward on fiscal integration and banking reform.  For example, friendlier bond markets are allowing Spain to delay asking for a bailout from the ESM.  Whether in the Street or at the polls, citizens may revolt against the elite’s ruinous policy of recession cum fiscal austerity.
  • The situation in China and other emerging markets is opaque, but these economies are fairly dependent on exports to “developed markets” and on commodity prices—neither of which will be strong next year.  Even if effective policies are pursued, it will take quite a while to shift China from an export-oriented to domestic-demand footing.

We expect Street analysts to slash their 2013 earnings estimates over the next six months, bringing the 2013 “bottom-up” S&P 500 EPS estimate down from $116 recently to around $106, which would only represent a 5% gain from $101 in 2012. According to Barrons data, in early September Wall Street strategists’ median “top-down”  2012/2013 EPS estimates were $102.25/$108.

Posted in Uncategorized | Tagged | Leave a comment

Off the Dividend Cliff?

Posted on October 17, 2012 by tomdoerflinger

Focus on the recession risk posed by the “Fiscal Cliff” has diverted attention from a the Dividend Cliff written into current law.  Prior to 2003 dividends were taxed as ordinary income at a taxpayer’s marginal income tax rate—far above the tax on long term capital gains.  In the tech bubble of the 1990s dividends were deemphasized as investors and corporations developed an unhealthy fixation on capital gains.  Companies favored share buy-backs over dividend increases, partly to boost near-term EPS, stock price, and the value of management’s stock options.   Buybacks conveniently obscured the magnitude of executive compensation via stock options.

Dividend Renaissance

But in 2003, after the economy was rocked by a series of accounting scandals (Enron, WorldCom,  Qwest,  Lucent, etc.), Washington decided to encourage dividends by cutting the tax on both  dividends and long-term capital gains to 15%. With the tax code no longer favoring capital gains and thus share buybacks, dividends increased rapidly—by an average of 10% per year, 2002-2012, excluding the year 2009 when banks slashed their dividends during the financial crisis.  With interest rates now hovering near zero, many individuals have turned to dividend paying stocks as a source of income.

This shift toward dividends is healthy from the point of view of both investors and corporate governance because:

  • Most large, mature companies can pay a decent dividend without penalizing EPS growth, so dividends enhance total return.
  • Dividends are far more transparent than share buy-backs, which may be announced but not done, or done merely to offset dilution from employee stock options.  Many companies brag about “returning capital to shareholders” via  buy-backs even though the share count does not actually decline.
  • Dividends impose more financial discipline on companies because they have to be paid regularly or the stock price will crater.
  • Dividends are convenient for investors, and a regular tangible payout is a salutary steadying influence on the behavior of investors.  Dividend paying stocks tend  to be less volatile.

The Dividend Renaissance is part of a broad improvement in corporate governance over the past decade.  Compared to several “go-go” periods in the past (1920s, 1960s, 1980s, 1990s), non-financial companies have behaved in a disciplined, rational manner since 2002.  Though overshadowed by the financial crisis, this is a positive trend  that should be encouraged.

Dividend Disaster Looms

But these healthy arrangements are about to end.  Under current law, on January 1, 2013:

  • The “Bush Tax Cuts” end, so dividends will again be taxed as ordinary income, or a top rate of 39.6%.
  • The tax rate on long-term capital gains rises from 15% to 20%.
  • Obamacare taxes kick in, so “high income” households pay an additional 3.8% on both capital gains and dividends.
  • Consequently the top tax rate on dividends will soar from 15% to 43.4% (39.6% + 3.8%), and the top rate on capital gains will be 23.8% (20% + 3.8%).  These huge hikes, of 189% and 59%, respectively, take us straight back to the “bad old days” when the tax code created a strong incentive for corporations to favor buy-backs over dividends.

President Obama supports these huge tax increases as a means of redistributing income.  Mitt Romney, by contrast, wants to keep the top tax rate at 15% for both dividends and capital gains, with even lower rates for middle class investors.

The Territorial Imperative

There is another big difference between Obama and Romney that will affect dividend growth.  Currently the U.S. has the highest corporate tax rate in the world (35%) which is imposed not only on domestic income, but also on foreign income.  So if IBM earns $1 billion in Europe and pays a 25% tax there, it will pay additional tax when it “repatriates” the income to the U.S.  As a result, companies do not readily repatriate foreign income, and $1-2 trillion in income is stranded overseas.  Well over half of the cash of many multinationals is stuck offshore.

The U.S. is one of the few countries to use this approach of taxing the global income of companies; most nations use a “territorial” system of only taxing the domestic income of multinationals.  Romney wants to cut the corporate tax rate from 35% to 25%, cut tax loopholes to broaden the tax base, and shift to a “territorial” tax system.  If this occurred companies would repatriate huge amounts of cash, much of which would be used for dividends and share buy-backs.  President Obama, on the other hand, wants to retain the current “worldwide” tax system and cut the corporate rate to 28%.

A Stark Choice on November 6

If Romney wins the tax on dividends likely will remain fairly low and equal to the capital gains rate, and corporate tax reform will encourage dividend hikes.  So the current pattern of fairly rapid dividend increases would continue, even if profit growth is not particularly rapid.  For example, if 2013 S&P 5000 EPS is $106 and grows only 5% per year until 2017, and if the dividend payout ratio is a moderate 36% by 2017, dividends will grow 9% annually, 2012-2017. If interest rates remain low, yield hungry investors will likely “pay up” for stocks (as they have already done for high yield stocks such as telecom and utilities), causing the PE of the S&P 500 to expand.  On the other hand if Obama wins and the tax on dividends soars we should see a sharp slowdown in dividends, with negative implications for corporate governance and stock prices.

The Stakes Are High

David Bianco, Deutsche Bank’s highly regarded U.S. Equity Strategist, reckons that under the optimal Romney Wins scenario (15% rate on dividends and capital gains and Territorial System of Corporate Tax) the fair value of the S&P 500 is 1600, versus 1400 under an Obama Wins scenario.   So an Obama victory would offset some of the beneficial impact on stock prices of the Fed’s QE3.  The negative wealth effect, the hit to corporate confidence, and the reduced after-tax dividend income of retirees would all hurt economic growth.  With dividends once again far less tax-efficient, companies would shift toward share buy-backs,  reducing companies’ financial discipline and transparency.  All this is obviously negative for retirees needing investment income.

Posted in Uncategorized | Tagged , , , | Leave a comment

What to Expect in Q3 Profits

Posted on October 9, 2012 by tomdoerflinger

Uh oh.  COMPLACENCY ALERT   COMPLACENCY ALERT 

The Wall Street Journal just ran an article saying Q3 earnings will be poor but it doesn’t matter because the Fed is pumping in liquidity.  Unfortunately weak earnings most definitely do matter because Fed pump priming won’t boost GDP much if we continue to pursue anti-growth regulatory and fiscal policy (which makes the presidential election critical for investors).  And the widespread notion that stocks simply floated higher over  the last three and a half years on a sea of liquidity is false; stocks only climbed about as much as earnings increased.  So the PE, in fact, did not expand much.  The bull market was an earnings story, not a liquidity story.

The talk of the Street is that Q3 S&P profits are expected to decline slightly year-on-year, which is surprising to some because the U.S. is not in recession.  But it is not surprising to us; more than a year ago we were forecasting 2012 S&P EPS of $102, which is about where strategists are now.  (We later went as low as $99, which hopefully was a bit too bearish).  S&P is not GDP.  When net margins are at record levels and global GDP growth slows, it is not at all surprising that a combination of weak revenue (driven partly by declining commodity prices) and margin pressure would cause profits to decline slightly even though GDP growth is still positive.   This is roughly what happened in the Asian financial crisis of 1998 – despite much more robust U.S. GDP growth than we have now.

Themes for third quarter earnings:

  • Q3 earnings will indeed be weak, but not much weaker than investors now expect.  The quarterly “profit wild cards” such as currency, oil prices, and Wall Street results are relatively benign this quarter.  Investors are already braced for poor earnings, and our read of the “early reporters” (companies with a quarter ending in August) is that earnings were soft but not terrible.  We had strong reports out of homebuilders, certain tech companies (ORCL, Accenture), and a financial (Discover).  But stocks leveraged to global growth (FDX, NKE) fared poorly.  The domestic consumer is weak but not a disaster (AZO, BBBY, GIS, CAG, MAR).
  • Where we expect the weakest results and the biggest estimate cuts are globally exposed cyclical  companies.  Europe is in a severe recession that is getting worse.   ECB bond buying will not save the real economy, but fiscal austerity will hurt it (Krugman is not always wrong).  Meanwhile the BRICs continue to crumble.  The situation in China is opaque but clearly worse than expected, with weakness extending well beyond public investment to the consumer sector.
  • Therefore many global industrials will have poor earnings, as illustrated by recent news out of UTX, EMR, and CAT.
  • One of the stronger sectors will be housing related stocks, including banks leveraged to housing.  This is a good investment theme but is not big enough to drive overall S&P earnings.
  • We don’t love their underlying fundamentals, but consumer staples’ earnings will be helped by weaker commodity prices (apart from corn and meat) and a weaker than expected dollar.  The broad Fed dollar was 2.9% weaker in September than June, so Q3 guidance was based on too-bearish currency assumptions.  Big pharma will also benefit significantly from a weaker greenback.
  • Corporations (but not governments) have extra money to spend on improving efficiency, and the results of Oracle and Accenture suggest they are spending it.  That’s broadly positive for enterprise technology companies, such as IBM and Cisco.  But PC demand is weak for both secular and product cycle reasons, a negative for some chip stocks.

Bottom line:  After all the hype about “first down earnings since 2009,” we expect the media to conclude that Q3 results were not as bad as feared.  However, forward estimates will continue to drop.  The 2013 bottom-up estimate is $116; $106 looks more plausible, and if we go over the dreaded  fiscal cliff $100 is a distinct possibility.

It is not really “typical” for companies to provide forward guidance for the coming year when they report Q3 results in October and early November.  But we expect fewer companies than usual to provide 2013 guidance when they report Q3 results, for two reasons.  The global macro picture is exceptionally  opaque and potentially even worse than it appears (particularly China), and, secondly, the U.S. election and fiscal cliff create extreme policy uncertainty in the U.S.

Posted in Uncategorized | Leave a comment

The Pulse of Prosperity: 1964

Posted on October 4, 2012 by tomdoerflinger

America was at the high tide of prosperity by the mid-1960s.  The gold year was 1964—three years into the expansion but before Vietnam and rising inflation cast a pall.  Scanning the pages of Time Magazine, one finds signs of confidence and optimism everywhere.  America’s major steel makers, facing little foreign competition, were announcing ambitious plant expansions.  Detroit enjoyed record auto sales and controlled all but 5% of the U.S. auto market; Chrysler and GM were building major new assembly plants.

Corporations were coming out with a raft of exciting new products – the Boeing 727, the IBM System 360, a “peculiar and promising product called Teflon,” and an inexpensive sports car from Ford Motor called the Mustang.  The brainchild of 39-year-old executive Lido Anthony Iacocca, the Mustang cost just $2,368.  Firms that made electronic gear for the Pentagon had just developed something called “micro-circuits.”  Time reported that, “At Texas Instruments, which shares leadership in the micro-circuitry field with Motorola and Fairchild Camera, engineers have developed a piece of silicon the size of a split pea into which they have fused the equivalent of 38 transistors, five capacitors and 26 resistors.”  The first heart transplant, from a chimpanzee to a human, was performed (it didn’t work).  The Wall Street Journal reported that “in a few years” something we now know as the VCR would be on the market.  (It was more like 20 years.)

The U.S. was also in a building boom in 1964.  The Port Authority of New York and New Jersey announced plans to build not one but two towers that would be the tallest buildings in the world.  On college campuses, new buildings were springing up like mushrooms.  The Smithsonian Institution built a huge new Museum of History & Technology while the Museum of Modern Art built a new wing and enlarged sculpture garden that doubled the number of works of art on exhibit.

At the top of the best seller list was the late President Kennedy’s Profiles in Courage.  The sexual revolution was in progress, but Nelson Rockefeller’s recent divorce was still considered a liability to his Presidential ambitions.  At the movies Peter Sellers played three separate roles in “Dr. Strangelove, or How I Learned to Stop Worrying and Love the Bomb,” which contained such memorable lines as “You can’t fight in here, this is the War Room.”  In sports, the NFL Championship—there was not yet a Super Bowl—was won by George Halas’ tough but colorless Chicago Bears, who shut down the flashy offense of the New York Giants, spearheaded by quarterback Y.A. Tittle and his three ace receivers Del Shofner, Frank Gifford, and Aaron Thomas.  The baseball season kicked off with Willie Mays (the highest paid player in the sport at $105,000—per season, not per game) hitting seven homers in nine games.

Living standards were rising rapidly.  The color TV was becoming a standard luxury; RCA and Zenith could not make them fast enough.  J.C. Penney started to sell a $5 shirt.  High rollers in New York were buying $100 suits.  Chevrolet reported that 75% of its Corvair sales now were the top-of-the-line Monza model.  Central air conditioning, once a luxury, was fast becoming commonplace; 25% of new homes had it.

The press still loved President Lyndon Johnson, whom they would be tearing to pieces in a couple of years.  Time said his State of the Union message, pressing for a tax cut in the midst of this boom, “had oratorical flourish without sounding strident.”  A reporter marveled how in just a single week LBJ “…made nearly two dozen speeches, traveled 2,983 miles, held three press conferences, appeared on national television three times, was seen in person by almost a quarter of a million people, [and] shook so many hands that by week’s end his right hand was puffed and bleeding.”  LBJ’s boundless energy would soon land his presidency hip-deep in the rice paddies of the Mekong Delta, dodging the bullets of both the Vietcong and the corrupt, ineffectual South Vietnamese forces.  But Vietnam was still a worry, not a crisis, in 1964.

The apotheosis of 1960s overconfidence was the 1964 New York World’s Fair, built by Robert Moses in Flushing Meadows.  The fair was, as Time noted, a “boast” of American prosperity, “a showcase of entertainment mounted by America’s most sophisticated and free-spending entertainers—its captains of industry.”  U.S. Steel donated a giant stainless steel globe called the Unisphere, which you can still admire while stuck in traffic on the Long Island Expressway.  AT&T’s exhibit featured 1400 novel devices called “touch-tone phones” with push buttons instead of dials.  General Electric offered a “carousel of Progress,” General Motors built a “futurama,” and floating over the World’s Fair assembly hall was one of Buckminster Fuller’s geodesic domes.

The World’s Fair expressed an expansive, exuberant, free-spending confidence in the future—a confidence shared by Washington, Wall Street, and corporate America alike.  It was diametrically opposed to the fretful, fearful spirit of 2012, when Europe is foundering, China is slowing, the Mideast is seething, the U.S. economy is stuck in first gear, Washington is paralyzed by partisanship, and investors feel trapped between a fiscal cliff and a mountain of Federal debt.  But extreme confidence was not justified in 1964; stock prices rose only 40% over the next eight years and then went nowhere from 1972 to 1982.  Perhaps today’s uber-pessimism is misplaced as well.

Posted in Uncategorized | Tagged , | Leave a comment