Q2 Profits Look Weak; Strategists Will Cut S&P EPS

Posted on July 30, 2012 by tomdoerflinger

In our July 9 post, Second Quarter Earnings – How Bad Will they Be?, we answered:  Bad enough to compel strategists to eventually cut their 2012 S&P 500 EPS estimates from $103-$105 to $100. While $100 still seems reasonable, the tone of Q2 profits is even worse than we expected.

No Signs of Imminent U.S. Recession . . .

EPS results do highlight several pillars of strength that are sustaining U.S. economic growth despite weak employment and counterproductive fiscal and regulatory policy:

  • The major regional banks (WFC, BBT, USB, PNC, etc.) are reporting decent loan growth.
  • U.S. auto sales are healthy.  Ford’s North American business was solid, as were Eaton’s and Alcoa’s auto business.  This is not so much evidence of strong consumer confidence as the advanced age of the American auto fleet–it’s cheaper to replace than repair that gas-guzzling old jalopy.
  • The housing sector is growing again, which boosts activity in related areas of finance, retailing, law, advertising, etc.
  • Aerospace is healthy, judging from Boeing’s results and Alcoa’s commentary.

. . . but Some Ominous Signs of a Consumer Slowdown

Quite a few large, high-quality consumer companies have reported weakening demand, especially late in Q2, including McDonalds, Starbucks, Chipotle, and (earlier) Nike.  This weakness was not across-the board—VF Corp. and Six Flags were strong – but it is still worrying, particularly because it occurred while consumers were getting a small “tax cut” from lower gasoline and nat gas prices.

Here Come the Guidance Cuts

The strong dollar is a modest negative for U.S. firms, but the key driver of cuts is is slowing global growth, led by Europe.  The U.S. is not particularly strong; Europe is in a severe and worsening recession; China is slowing; and other BRICs such as Brazil and India are sluggish.  The situation in China is opaque and could improve, but Europe (which accounts for well over 40% of the foreign sales of the S&P 500) is in dire straits.   Consider that Spain, with 25% unemployment, just announced a new fiscal tightening package; soon France will follow suit.  The UK is in recession, and Germany is slowing along with its export markets.  European banks, whose balance sheets are loaded with dodgy sovereign bonds, are deleveraging by curbing lending. European companies will embark on another round of layoffs over the next few months.  A weaker Euro eventually will improve competitiveness, but this takes a long time—several quarters, not a couple of months.  And political unrest creates downside risk; even fairly innocuous street protests and strikes are enough to damage a key industry, tourism.  (Despite Europe’s problems, the continent has many fine firms serving global markets, which could be good investments.)

Guidance Cutters

Here are some of the major firms that cut guidance.  (Zacks confirms that many more firms are cutting guidance in Q2 earnings season than Q1.) Keep in mind that companies like to raise guidance during the course of a year,  which has been the norm since mid-2009. So this raft of cuts by big companies is extremely significant.

  • Cummins Engine, a high quality company with significant emerging market exposure, slashed 2012 revenue guidance about 12%.
  • Chip makers Intel and AMD both cut revenue guidance, and AMD had a big earnings miss.
  • Coca-Cola‘s unit growth was weak due to slowing demand in Japan, China and Brazil.
  • Johnson Controls (auto parts and building controls) had a big miss.
  • Dow Chemical, which has broad global exposure, missed estimates and slashed guidance.  (DuPont, by contrast, largely maintained guidance while warning about soft demand.)
  • Texas Instruments issued weak guidance because “the global economic environment is causing both [customers and distributors] to become increasingly cautious in placing new orders.”
  • Yum Brands, one of the most leveraged U.S. plays on Chinese consumers (they love the Colonel’s chicken), reported weak results.
  • UPS cut guidance as international business was flat-to-down on a unit basis, before currency.
  • ITW and Eaton, diversified industrial firms cut guidance, partly on weak foreign demand.
  • Ford cut guidance on weakness in South America, Europe and Asia.  The company said it needs to slash capacity in Europe.
  • Flextronics, a contract manufacturer that assembles electronic devices for other companies, said demand is soft and weakened late in the quarter.
  • Mettler Toledo, which makes scales and other instruments, cut guidance and thinks local currency revenue growth will be about 4% not  6.5%.
  • 3M, widely considered a global industrial bellwether, maintained earnings guidance but cut unit growth guidance.
  • Auto parts maker Borg Warner, with high exposure to Europe and Asia, cut guidance significantly.
  • United Technologies cut revenue guidance about 5%.
  • Starbucks cut guidance on weaker trends in the U.S. and overseas.
  • Las Vegas Sands, which operates gigantic casinos in Macau and Singapore, cut guidance.

The Cuts Will Keep on Coming

In our experience when macro conditions deteriorate companies usually don’t cut guidance enough the first time.  (Financial psychologists call this “anchoring” – people tend to be “anchored” to their old estimates and change them slowly.)  So I expect estimates to keep coming down for the next couple of months.  Because much of the global economy takes August off, September comprises far more than 33% of Q3 business activity.  Therefore we expect many negative preannouncements in the second half of September and early October.  If this occurs, investors will start to worry about profits in 2013, the year of the fiscal cliff – will they be $110 or $100 or $90?

Weaker Profits Means Fewer Jobs

Companies will respond to “weak macro” by restraining capital spending, hiring fewer people, and trimming payrolls.  Europe, in particular, is in for a major round of layoffs.  The fiscal cliff is an extra reason for caution, particularly for defense contractors and their many suppliers in the industrial and technology sectors.

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Sylvia Didn’t Build Sylvia’s On Her Own

Posted on July 26, 2012 by tomdoerflinger

Sylvia Woods, the entrepreneur whose vision and decades of hard work turned her Harlem restaurant into a world renown culinary destination, died on July 19 after a courageous battle with Alzheimer’s.  She was born in South Carolina in 1926, and following the death of her father she was raised by her mother and grandmother.  At age eleven Sylvia met her future husband, Herbert, while they were working in a bean field; they married in 1944.

Sylvia got her beautician’s license in South Carolina and opened a farmhouse beauty parlor.  But her entrepreneurial instinct took her to Harlem, where she worked for several years in Johnson’s Luncheonette on Lenox Avenue and 127th Street.   Using her own savings and a mortgage on her mother’s house, she bought the restaurant in 1962 and built it into a successful business, Sylvia’s, while her husband supplemented the family income by driving taxis and trucks.  Her big break was a favorable 1979 review by New York Magazine critic Pauline Kael, who loved the ribs and hominy grits but allowed “the neighborhood, alas, is shabby and forlorn, perhaps a bit forbidding.”  Sylvia’s became a regular stop on European tourists’ Harlem circuit, along with the Apollo Theatre and the Savoy.  Over the years Sylvia and her sons developed ancillary businesses including a catering hall, a national line of Soul Food and two cookbooks.

Sylvia Doesn’t Get all the Credit for Sylvia’s; It Was a Collective Effort

We know from President Obama’s teachings that Sylvia didn’t build her business on her own.  She was smart, but lots of people in Harlem were smart.  She worked hard, but there were a whole bunch of hardworking people in Harlem.   Much of the credit for her success must go to the people who gave her help — her mother, her husband, the banker who gave her a loan, Mr. Johnson who sold her the restaurant, and Pauline Kael who gave her a favorable review.  So clearly Sylvia does not deserve all the credit for her success; it was a collective effort.

And don’t forget government.  Her restaurant was located at Lenox Avenue and 127th Street, which Sylvia didn’t build – the government did.  Suburbanites made their way to her restaurant via the George Washington Bridge, Brooklyn Bridge, Holland Tunnel, and Lincoln Tunnel—all government built.  Foreign tourists came via JFK and LaGuardia airports, which the government built.   Sylvia advertised on the Internet, which the government invented.   And many of her customers worked for the government.

So Sylvia should not get all that much credit for building a world famous restaurant in a tough uptown neighborhood; it was a collective effort.

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Mrs. Biggs’ Secret Stock Market Formula

Posted on July 23, 2012 by tomdoerflinger

Wall Street superstar Barton Biggs, who died last week, was  one of Morgan Stanley’s high-profile equity strategist, appearing regularly on CNBC and in Barron’s annual  investment roundtable.  Unlike many sell-side big shots, he actually invested in the stock market.   Biggs eventually migrated to the “buy side” (Morgan Stanley Asset Management) where he was a pioneer in emerging market investing.  After the tech bubble he left the brokerage business entirely and cofounded a hedge fund, Traxis Partners.

Biggs lived most of his life in Greenwich Connecticut, epicenter of the hedge fund industry.  His 2006 book Hedge Hogging is an amusing and informative pastiche of fund manager profiles, as well as a savvy primer on investing in stocks, bonds, and art.  We learn about fibonacci numbers, the relative merits of growth stocks vs. value stocks, the perils of group think in investment committees, and the “violence of secular market cycles.”  Biggs captures the egomaniacal ethos of the hedge fund world through such characters as:

  • Ian, who started his fund with only $8 million in the 2001 bear market.  To get started he “sold his apartment and house in the Hamptons and moved the family into a grubby rental.”  Ian is so intense that he sleeps with his portfolio and grinds his teeth in his sleep.  Biggs liked that and gave him some money to run.
  • Grinning Gilbert, who after a couple of good years during the 1990s tech bubble bought a mansion on Round Hill Road in Greenwich.  Gilbert’s wife, “an aggressive, ambitious personality,” poured money into the house and “performed a full cannonball into the Greenwich social pool.”  They moved into the mansion in 2000, at the apex of the tech bubble.  But the fund withered over the next two years and a traumatized Gilbert retreated to his bedroom, subsisting on toast and soup for a week.  Eventually they decamped from Round Hill Road for parts unknown.
  • Vince, the “bearded profit of the apocalypse,” who opined to Biggs in 2005 that “Residential real estate is the next big disaster.  People are borrowing short to invest long, refinancing mostly with floating-rate mortgages.  When short rates go up, debt service payments will soar and house prices will decline.  Then the consumer collapses from the double whammy of the wealth effect and shrinking disposable income.”  Great call, Vince!
  • Fayez Sarofim, the famous mutual fund manager based in Houston.  Sarofim told Biggs that big pharma stocks such as Merck were cheap and attractive.  Bad call— they were cheap for a reason and would get cheaper because of the new product drought.

Mostly inadvertently, Biggs shows why hedge funds are a problematic asset class unless you are lucky enough to hook up with a genius such as George Soros, Steve Cohen, or Leon Cooperman.   Managers are under intense pressure to put up good performance sooner rather than later—before investors leave the fund.  This can lead to short-term thinking, over-trading, and herd following.  In bear markets some investors in a fund may panic and pull out, forcing the fund to sell stocks precisely when it should be buying.  Hedge funds’ fee structure—2% of funds under management plus 20% of profits—creates perverse asymmetric incentives for managers.  If a fund scores big the manager can get rich quick, which may prompt him to “swing for the fences” by taking excessive risk.  On the other hand, if the fund declines sharply the manager may close it (or his employees may leave) because he can’t have a big pay-day (a 20% cut of profits) until after it gets back to the “high water mark,” the level where the fund was started.  Yet another problem is tax inefficiency: most profits are short-term gains taxed as ordinary income rather than as long-term capital gains. Given these drawbacks – high fees, perverse incentives, tax inefficiency, and an unstable structure – hedge funds’ popularity is, frankly, rather surprising.

Mrs. Biggs’ Big Boring Score

Ironically, late in the book Barton Biggs gives us a fascinating example of a buy-and-hold strategy that looks a lot more boring and a lot more attractive than buying hedge funds.  In the early 1970s Barton’s father, who was the Chief Investment Officer of the Bank of New York,

“was worried about his health and inflation and suspected my mother would outlive him by a considerable number of years . . . So he constructed for my mother a portfolio of growth stocks (and cyclical growth stocks) such as Phillip Morris, Caterpillar, Exxon, Coca-Cola, AIG, IBM, Citicorp. Hewlett-Packard, Berkshire Hatheway, GE, Merck, Pfizer, and so on – nothing very imaginative, but solid, long-term companies you would want to sleep with.  When she died two years ago [circa 2003] at age 95, her cost on many of these positions was actually less than the current dividend.  My mother’s portfolio compounded over 32 years at 17% a year….I figure the purchasing power of her income stream compounded at roughly 12% per annum…..My brother Jeremy and I watched her list intently, and from time to time, we did weed out and replace a few companies that we thought were beginning to falter.”

Mrs. Biggs’ real, after-inflation purchasing power increased 3,658% over 32 years.  If she started with $10 million, she ended with $376 million.  And the fund was exceedingly tax efficient.

Of course, this performance is a lot harder than it looks.  Most people don’t have the CIO of the Bank of New York picking their stocks, or a shrewd Street strategist pruning the portfolio.  And–even more important–it is not easy to stay fully invested through the 13.5% inflation of 1980, the scary 1980-82 back-to-back recessions, the 1987 stock market crash, the 1991 real estate crash, the 1998 Asian financial crisis, and the tech bust of 2000-2003. That said, it is actually not that difficult for most investors, with the help of a knowledge advisor, to successfully follow a similar strategy.  The five keys to success are to steadfastly stick with sensible stocks, diversify across industry sectors, not go off on faddish tangents, sell your losers not your winners, and judiciously buy the leaders in dynamic new industries.

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Are Dividend Growth Stocks Overvalued?

Posted on July 11, 2012 by tomdoerflinger

Dividend growth stocks are so 2011.  Yesterday, a portfolio manager was interviewed on CNBC.

“What are you recommending?”

” We like high quality dividend growth stocks.”

“Everyone says that.”

Sometimes, “everyone” is not wrong.  Perhaps because equities are generally out of favor, with net outflows of money from domestic equity funds, this popular investment theme is still reasonably valued, more than three years after we started to write about it.  We took a list of 25 high-quality dividend growth stocks, with average dividend yields of 3.1%, and compared them with the S&P 500.  Their average PE on trailing twelve month EPS was 15.18x, or a 13% premium to the S&P 500 trading at 13.42x.  This is a very modest premium considering that these companies have above-average dividend yields, profitability, free cash flow and EPS growth, as well as superior stock price stability due to yield  support.  Furthermore, their PE premium has climbed only marginally since mid-February, from 10% to 13%.

So, yes, at this point dividend growth is an overaly familiar theme that puts the guys and gals on CNBC to sleep. But many dividend growth stocks are still reasonably valued and a good choice for investors who need yield as well as growth.  The high-yield equities that do look expensive are “bond substitutes” such as telecom, utilities, and tobaccos, although some of them may well continue to be good investments.

Of course, it is not easy to identify good dividend growth stocks, because many companies fail to grow as rapidly as Wall Street expects.  Many “growth stocks” turn out to be duds.  Consult your financial advisor, preferably one who is supported by a first-class equity research department.

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Second Quarter Earnings – How Bad Will They Be?

Posted on July 9, 2012 by tomdoerflinger

Wall Street strategists are forecasting 2012 S&P 500 EPS of $100-$105.  After fairly good first quarter results, their estimates edged up toward $105, but macro deterioration has brought numbers down to around $103.  My guess is that ultimately (i.e., next March) they end up at $100, driven lower by a severe recession in Europe, slowdowns in China and the U.S., hostile regulatory policy in the U.S., and a strong dollar.

According to the media, analysts expect a modest yr/yr gain in second quarter earnings, but many people have forgotten that the comparison is exceptionally easy because a year ago Bank of America had a huge write-down.  Adjusted for that, Q2 earnings could be flat or down slightly.  But the big issue is not the precise level of Q2 profits but how much analysts cut estimates forQ3.  Corporate CEO’s are no better at forecasting the economy than anyone else, but their Q3 guidance will reflect orders through the middle of July, so in a rapidly weakening global economy their comments will contain a lot of “new news.”  Is demand just softening, or is it collapsing?  We’ll find out.

You can’t tell the players without a scorecard.  Here’s what to focus on in Q2 results:

Negatives for Q2 Profits

Weak Wall Street results.  Profits in this industry are impossible to forecast, so surprises can be big and drive the quarterly S&P EPS number up or down quite a bit.  After decent Q1 2012 results, Wall Street’s profits were poor in Q2, and the Euro-crisis, the fiscal cliff, and slower U.S. growth  mean business won’t improve in Q3.  JPMorgan’s big (but how big?) trading loss is another negative.  Key EPS reports:  JP Morgan, Citigroup, Goldman Sachs,  Morgan Stanley.

Weak oil prices are negative for overall profits.  Oil service firms will be hurt by weak drilling activity in North America; key reports include Baker Hughes and Schlumberger.  Like Wall Street firms, Big Oil’s profits are hard to forecast because there are so many moving parts (upstream results, refining margins, chemical earnings, etc.)  Key reports:  Chevron, ExxonMobil, Occidental Petroleum.

Recession in Europe  has already lowered expectations for McDonalds, Nike, and Ford.  With demand collapsing in parts of Europe, corporate commentary will be very interesting.   Some important early results: Coca-Cola, Marriott, Intel, Google, Eaton, Honeywell, and United Technologies.  Alcoa’s comments on global demand for aluminum (used in autos, aircraft, and gas turbines) are always useful.

Slowdown in China.  Results of Alcoa, Coca-Cola, Intel, Yum Brands, Wynn, United  Technologies, and Caterpillar are key.

Strong Dollar.  The Fed’ s “trade-weighted” dollar index rose 5.6% yr/yr in Q2, much stronger than the 1.1% in Q1 and the most since Q3 2009. This is a negative for all multinational firms, because foreign revenue and profits translate into fewer dollar.  Currency effects will also have a fairly big impact on Q3 guidance.  Reports to watch: IBM, Johnson & Johnson, Coca-Cola, United Technologies and Mattel.  (A strong dollar eventually will hurt exporters, but not for many months.)  Foreign sales are about 32% of S&P 500 revenues, not 46% as The Wall Street Journal recently wrote, drawing on faulty research by Standard & Poor’s.

Positives in Q2 Profits

Domestic profits have good momentum (remember Q1 earnings season was good) and the U.S. economy continues to grow, albeit more slowly than we would like.  The difference between monthly job creation of 80,000 and 150,000 is a big deal politically but not for corporate results.  Companies have figured out how to prosper in a soft economy by keeping costs low, inventories lean, and capital spending in check.  Although Q2 domestic results should be okay, the big question is how much business has softened recently.  Key  reports:  Alcoa, Marriott, Harley Davidson, Grainger,  Darden Restaurants, PPG, Fastenal, and domestic  commercial banks (Wells Fargo, U.S. Bancorp, PNC).  Pay particular attention to what the banks have to say about loan growth and credit quality.

Apple typically delivers a big upside surprise.

Share buy-backs.  S&P says they have slowed recently, but with stock prices weak companies are getting a bigger bang for the buck.  So declining share counts will drive some upside surprises.  Analysts tend to be conservative on their share count assumptions, because they don’t want this hard-to-forecast variable to drive their models.

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Seven New Reasons not to Create Jobs in France

Posted on July 9, 2012 by tomdoerflinger

If you wonder what tax changes Barack Obama would have made in 2009 if the U.S. had a parliamentary form of government, take a look at what Francois Holland is doing in France.  According to the Financial Times:

  • E2.3 billion will be raised via a one-off increase in the “wealth tax” on those with wealth of more than E1.3 million.
  • 75% marginal tax rate on incomes over E1 million.
  • An increase in the inheritance and gift tax
  • A E2.9 billion rise in the tax on business, including higher taxes on oil companies and banks
  • 3% tax on company dividends
  • Higher tax on bonuses and stock options.
  • Rise in the transaction tax, from 0.1% to 0.2%, on French equities with market caps over $1 billion.

In France government spending claims 56% of GDP (second highest in Europe behind Denmark), and the unemployment rate is 10%.  Supposedly these tax hikes will ensure that France reaches its budget deficit target for this year of 4.5% of GDP.

Our prediction:  The tax hikes will not generate the expected revenue because  job  creators will decamp to more capitalistic climes (Switzerland, the UK,  the US and Canada).  Economic growth in France will be even slower than expected and the budget deficit larger.   Most of these tax hikes reduce the return on investment, so fewer investments will be made in France and fewer jobs will be created

Why it matters:    President Holland supposedly favors “growth” over “austerity,” but in reality he is pursing policies that will stifle growth.   The situation is similar in Spain, Italy, and Greece, which in various ways are failing to make the pro-growth, pro-market “structural” reforms needed to accelerate economic growth.  Employers are deeply demoralized—tangled in red tape and burdened by high taxes.  This reality tends to be overlooked because structural reforms are complex, incremental, and localized.  The media prefers to focus on high-profile, market-moving decisions  regarding monetary policy, bank recapitalization, fiscal policy and the like.

But in the end it’s all about growth, not financial engineering.  Nothing is more important than liberating the European private sector in order to reignite growth—the key to keeping banks solvent and reducing, or at least restraining, sovereign debt-to-GDP ratios.

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Over the Limit: How Romney Should Tie Obamacare to High Unemployment

Posted on July 9, 2012 by tomdoerflinger

The political genius in Obamacare is that it is such an immense and immensely complex piece of legislation that no one knows what’s in it.  Nancy Pelosi notoriously said, “So we have to pass the bill so you can find out what is in it.”  But only a few stalwart specialists in the media and pundocracy, including Betsy McCaughey, Cato’s Michael Cannon, and the WSJ’s Joseph Rago, have invested the hundreds of hours needed to comprehend Obamacare’s infinite intricacies and baffling befuddlements (which have been further multiplied by the Supreme Court ruling).  After a cross-country tour Time Magazine’s Joe Klein, a friend of the law, claimed only 2% of the American public knows what is in the law; he should move the decimal point two or three places to the left.

It’s tough for Romney to attack this faceless legislative blob.  He needs something specific to aim at – something that specifically and simply illustrates how Obamacare kills jobs.  He needs a factoid that substantiates, amplifies and illustrates the phrase “job-killing Obamacare.”

Here it is: Obamacare imposes heavy fines on companies that go “over the limit.”  What limit?  The limit of 50 employees.  Under the law, if a company does not provide insurance to its workers and has more than 50 employees, it must pay a fine of $2000 per employee for the number of full-time employees less 30.  So if Acme Corp. has 48 employees, it need not provide insurance.  But if it makes the mistake of hiring another 3 workers and still does not provide insurance, it must pay a tax of $42,000 [$2000 X (51-30)]. It gets worse, and far far more complex, but the whole point is to keep it simple.

Mitt Romney is very smart and has the right instincts on the issue, but he needs to put some meat on the bones of “job-killing Obamacare.”  This is the way to do it.  Employers pay a big fine if they go “over the limit” and hire too many employees.  No wonder job growth is so anemic.

(The “Over the Limit Syndrome” is finally receiving the attention it deserves, a year and a half after we started to highlight it in research reports.  Senator John Kyle mentioned in on Larry Kudlow’s show a week ago, and Mort Zuckerman mentioned it on ABC’s This Week show on Sunday.)

 

 

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The Other Keynesian Paradigm

Posted on July 9, 2012 by tomdoerflinger

Employment growth has been terrible for the last few years, and Keynesian economists think they know why – companies aren’t hiring because demand for their products is weak in a debt-burdened economy.  The problem with this notion is that corporate performance has actually been quite good.  On a rolling four-quarter basis S&P 500 earnings have doubled from the 2009 trough and are 8% above their 2007 highs.  Doctrinaire Keynesians claim there is nothing wrong with the labor market that another $1 trillion in government spending – or is it $2 trillion? – wouldn’t fix.

They would do better to consider another Keynesian insight having to do not with aggregate demand but, rather, with the “animal spirits” of businesses.  Unlike his more doctrinaire disciples, at Princeton and elsewhere, Keynes had a nuanced appreciation of the contingent nature of human behavior.  In the General Theory he wrote:

. . . a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic.  Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.  (emphasis mine)

President Obama has done a great job of snuffing out “spontaneous optimism” and “animal spirits” in the business community.  Much of the economic weakness Keynesians blame on lack of demand is actually caused by over-regulation and hostility to business.  Call it the Great Suppression, which has several dimensions, including health care reform, financial reform, the war on fossil fuels, and anti-capitalism.  Start with:

Healthcare Reform

We often hear it affects “one sixth of the U.S. economy,” but that is a gross understatement because it makes it far more costly and complex for all small businesses to hire workers.  Figuring out healthcare rules has become as daunting as calculating your taxes, maybe more so.  Consider this small section of the law – a tiny slice of a 2700 page monstrosity which itself requires further elaboration by HHS and other agencies:

SEC. 45r.  EMPLOYEE HEALTH INSURANCE EXPENSES OF SMALL EMPLOYERS.

“(a) GENERAL RULE.—For purposes of section 38, in the case of an eligible small employer, the small employer health insurance credit determined under this section for any taxable year in the credit period is the amount determined under subsection (b).

(b)  HEALTH INSURANCE CREDIT AMOUNT. – Subject to subsection (c), the amount determined under this subsection with respect to any eligible small employer is equal to 50 percent (35 percent in the case of a tax-exempt eligible small employer) of the lesser of –

(1) the aggregate amount of nonelective contributions the employer made on behalf of its employees during the taxable year under the arrangement described in subsection (d)(4) for premiums for qualified health plans offered by the employer to its employees through an Exchange, or

(2) the aggregate amount of nonelective contributions which the employer would have made during the taxable year under the arrangement if each employee taken into account under paragraph (a) had enrolled in a qualified health plan which had a premium equal to the average premium (as determined by the Secretary of Health and Human Services) for the small group market in the rating area in which the employee enrolls for coverage.”

This command and control legalese goes on for hundreds of impenetrable pages.  Obamacare increases not only the cost of employing workers but the legal risks of the employer.  A firm with fewer than 50 workers is not obliged to provide coverage, but if a firm goes “over the limit” it must provide coverage or pay a steep fine for all of its workers.

Financial Reform . . . or . . .  Jamie Dimon’s “Great Fear” Is Realized

Washington also threw a big wet bureaucratic blanket, Dodd Frank, on the financial sector, which employs nearly eight million workers.  Here, too, small business is hurt most because unlike large corporations they cannot afford platoons of lawyers and lobbyists and usually are not self-financing.  In June 2011 JPMorgan’s Jamie Dimon got to the nub of the matter in a prescient exchange with Fed Chairman Bernanke.  Dimon started with a lengthy litany of reforms:

“I have this great fear someone is going to write a book in ten or twenty years and the book is going to talk about all the things we did in the middle of the crisis to actually slow down recovery…..I made a list of all  the things already done and a few things to be done.  Already done:  Most of the bad actors are gone, thrifts, all the mortgage brokers and obviously some banks.  Off-balance sheet businesses are virtually obliterated, some are gone – SIVs.  A lot of the insurers used to guarantee them are gone.  CDOs are gone.  Money market funds are far more transparent.  Most very exotic derivates are gone. There is far more transparency in any remaining off-balance sheet thing.  Fannie Mae and Freddie Mac are in the government hospital.  Higher capital and liquidity are already in the marketplace—we estimate more than double what it was before.  There are tougher requirements, boards are tougher, risk committees tougher.  There is an oversight committee.  Regulators I can assure you are much much tougher in every way, shape possible.  One of the core problems was mortgage underwriting, which has gone back to what it was 30 years ago.  I think it’s a good thing. But no more sub-prime, no more alt-A, no more mortgages being packaged.    The CMBS market has been completely transformed, there is far more transparent accounting.  We’ve been through two stress tests, one at Treasury and one at the Fed. I believe most of the banks passed the recent ones with flying colors, partially for the reasons I just said.  Now we are told there are even higher capital requirements, the so-called siffie charges et cetera and we know there are 300 rules coming.” (Emphasis mine)

Then Dimon asked:   “Has anyone bothered to study the cumulative effect of all these things?  And do you have a fear like I do that when we will look back and look at them all, they will be the reason it took so long that our banks, our credit, and our businesses – and most importantly, job creation start going again.  Is this holding us back at this point?”  (Emphasis mine.)

Bernanke’s admirably candid response:   “….Has anybody done a comprehensive analysis of the impact on credit?  I can’t pretend that anybody really has.  You know, it’s just too complicated.  We don’t really have the quantitative tools to do that.”  (Emphasis mine)

Judging from recent jobs data, a year later it appears Dimon’s “great fear” was well-founded.  The Financial Times reports that in May nine investment banks met in Boston with big buy-side shops including Fidelity, Columbia Management, and Wellington.  The buy-siders complained bitterly about the lack of liquidity in the corporate bond market; tougher capital standards and the Volcker Rule make banks less willing to hold large inventories of bonds to facilitate market making.  Lower liquidity raises capital costs, especially for smaller companies.

“Transforming” the Energy Sector

Remember “climate change”?   Obama’s energy policy attacks fossil fuels while subsidizing green energy projects that were expected to create “720,000 job years by the end of 2012.”  A chapter in the 2010 Economic Report of the President was titled “Transforming the Energy Sector and Addressing Climate Change,” even as the Energy Department was forecasting that in 2035 renewable energy, excluding biofuels, would account for only 3% of U.S. production while fossil fuels would still account for over 70%.  Obama’s hostility to fossil fuels hurts not only energy producers (which directly employ 279,000 people) but their customers struggling with unnecessarily high energy costs.

Anti-capitalism

Businesses under attack from their own government are disinclined to hire domestically.  Just ask the CEO’s of Emerson Electric, Intel, 3M, Loews, Boston Properties and Wynn Resorts, who in various ways have all made this point, even though CEO’s generally do not like to criticize one of their biggest customers, Uncle Sam.  A year ago David Farr, Emerson Electric’s CEO, said on an earnings conference call:

There is a flood of regulations coming at us from the U.S.  The incentive to invest in the U.S. is negative. And from my perspective I have all the clarity I need. They’re spending. They’re taxing. Our tax rate in the US will be over 36% in the US this year. We pay, actually pay, the U.S. government over $500 million in taxes this year, and they say they want to raise it even more.  I run a company.  I have a lot of money to invest, but I’m not going to invest it here.

Obama blames our economic woes on the Bush tax cuts and the recklessness of capitalists – never mind Fannie, Freddie, and the Community Reinvestment Act.  Average Americans who “played by the rules” supposedly did not benefit from “the most expensive tax cuts for the wealthy in history” while affluent Americans have failed to “pay their fair share.”  (In fact the top 10% pay 71% of income taxes while the bottom 50% pays 2%.)  High earners have been anticipating an imminent tax hike ever since Obama became President – in addition to Obamacare’s tax hikes on the affluent (which start in six months).

Beware Simplistic Equations

Some economists live in an abstract, simplistic, ahistorical world where the behavior of millions of people supposedly can be modeled in a single chart or a few equations.  In the real world policy, attitudes, ideology, and “animal spirits” matter.  Lord Keynes recognized this even if some disciples do not. Obama’s heavy-handed regulation has had predictable results.  We first suggested in the summer of 2009 that we were headed for a third consecutive “jobless recovery” made worse than the first two by over-regulation.

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Quadruple Whammy for Younger Adults

Posted on June 29, 2012 by tomdoerflinger

When it comes to social engineering, you can usually depend on Washington to do the wrong thing.  If it is not overturned, Obamacare will increase income inequality by imposing a new tax on younger workers.  Older Americans are growing richer while younger Americans are getting poorer, as shown by the Federal Reserve’s Survey of Consumer Finances, for the period 2001-2010.  Households headed by a person under age 44 saw their median income decline more than 14%; those headed by someone age 65-74 enjoyed a 25% rise in median income.

This long-term trend has been exacerbated by the sluggish economic recovery, which has kept unemployment rates extremely high for younger workers.  The unemployment rate is 8.2% for those aged 25-34 versus 6.4% for those over the age of 44.

The financial problems of young adults are compounded by educational debt.  Two thirds of college students graduate with college loans, which averaged $25,500 in 2010.

What has President Obama done for these young adults struggling with declining incomes, high unemployment, and heavy education debts?  He is hitting them with a big new tax, Obamacare’s individual mandate.  It requires citizens without healthcare coverage to pay a penalty, which is the greater of $695 per year up to a maximum of $2085 per family, or 2.5% of household income.  The tax will be phased in over three years starting in 2014; after 2016 it is indexed to inflation.  So in 2016 a household earning $50,000 pays 2.5% or $1,250, which is worse than it sounds because $1,250 is a much larger share of after-tax income.  This tax will hit younger adults the hardest, because they are more likely to lack health insurance.  According to the Census, 28% of people age 25 to 34 do not have Health Insurance Coverage vs. 16% for those age 45-64 and 2% for those over 65.

Given these multiple burdens on younger workers, it is no wonder the economy is weak.  Where are the outraged Keynesians bemoaning Obama’s destimulative fiscal policy?

Sources:  Federal Reserve, Survey of Consumer Finance; BLS; U.S. Census

 

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“The private sector is doing fine. Where we are seeing weaknesses in our economy have to do with state and local government . . .”

Posted on June 29, 2012 by tomdoerflinger

Let’s put President Obama’s notorious observation in some historical context. The table below shows the level of employment in the total economy, the private sector, and the government sector, all indexed to 2007 = 100.  Between 2007 and 2010 private employment plunged 6.5% while government employment increased 1.2%. Private employment is starting to recover but is still 3.76% below the 2007 level while government employment is only 1.12% below 2007.  These days the private sector is in permanent restructuring mode, but it takes a severe financial crisis to reduce government employment, which increased every year between 2000 and 2009. Since 1999, private employment has climbed just 2.2% while government employment soared 8.2%.  While no one likes to see teachers and firemen laid off, local governments are now being pulled through a restructuring wringer that operates full-time in the private sector.

 

 

 

Source: Bureau of Labor Statistics

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