The Grand Illusion
Right now, I’m getting the very strong feeling that the U.S. economic system is running on what amounts to faith in magic. Every statistic I look at seems to be unsustainable… and most of those indicators have been at what traditionally seem to have been unsustainable levels for several years, whether it’s the various stock market indices, the price/earnings ratios of the vast majority of American companies, the ratio of various capital reserves to the debt levels they support, the plummeting velocity of money, the amount of government securities purchased by the Federal Reserve [although the official end of quantitative easing is as much a suggestion that continuing the QE program was unsustainable as it was that the economy has “recovered” enough that QE is no longer necessary]. The fact that the federal funds interest rate remains essentially at zero has meant that various bank deposits pay next to nothing in interest, which is likely the primary reason why stocks are priced at levels that would seem unrealistically high in almost any other situation.
What many people overlook is that U.S. financial policies combined with the high price of crude oil several years ago and the lack of decent returns on investment to make available billions of dollars for investment in new oil extraction technology, i.e., the combination of fracking and horizontal drilling, which in turn resulted in a temporary oversupply of oil. That led inevitably to the decline in the price of crude oil, and an on-going slow-down in the development of new oil wells. Because production levels of fracked wells drop off swiftly, so will world oil supplies, initially at the margin, but in a year or two oil prices may well begin to creep back.
Associated with all these magic numbers is the fact that a significant percentage of new and emerging companies are technically overvalued businesses which often command a premium in the marketplace, but hire comparatively few, if often high-paid, people. Valuing companies primarily on popular appeal, limited product/services, and the need to keep innovating in order to maintain marketplace appeal is another form of “magic.”
But what will support those jobs and valuations if the appeal dims or vanishes?
In the meantime, governments at all levels, and companies in the “infrastructure” business tend to be delaying or minimizing investment in highways, bridges, power plants, water systems, air navigation systems, and the like, all of which result in more jobs and more permanent assets.
But the politicians, especially the Republicans, are all for the “new” economics because it promises something for nothing… like magic.
I guess they’ve all been reading too many of your Imager novels and now believe that imaging roads and bridges out of thin air is possible. See, it’s all your fault. 🙂
I wish there was a way to hold these people accountable for their long term business decisions. Its not fair that they can make poor decisions their entire career and do better for it when everyone knows they are making poor long term decisions.
All great points, but I’m a little puzzled by your reference to high P/E ratios. The figure I found today said (trailing 12 month) S & P 500 PER is 19.40, which is a bit high (historical average I believe is 15-16), but not amazingly so. I remember 2000; that was much more clearly a bubble, as (for example) long-time tech stock Intel had a P/E ratio of 60 at its top. I am far more concerned about what now (apparently) seems to be a flattening of revenues, where earnings are boosted by cutting (usually people) costs. Given the (guesstimated) ongoing 7% reduction in the folks searching for work or having it, it appears that the economy is growing briskly at a much lower level than it should, both in terms of employment and output. As for the Fed funds rate, A near-“liquidity trap” is sustainable for a very long time (Japan apparently did it for more than 20 years), but it’s a rotten economy.
You might be amused (or not) by the latest attempt by politicians (usually Republicans, as you note) to cover failed tax cuts with aggressive “dynamic scoring”, which uses the Laffer curve assumption that tax cuts spur investment by the rich and their companies that actually generate more revenues than the tax cuts withdraw from the government. I understand that the Kansas governor Brownback is trying this one.
You’re right about the S&P figure, but that’s a little misleading. I ran across a study that ranked all the NYSE stocks, and what’s truly frightening is that we now have the greatest percentage of stocks with high P/E ratios ever. The median U.S. stock began this bull market below 12 times earnings in 2009. In the last five years, however, the median P/E multiple has risen by about two-thirds to slightly more than 20 times earnings. In the past, there was a wide dispersion of P/E ratios. Especially in the last year, that has changed.
When I was an investment analyst (very many yeas ago) a P/E of 6 was thought high. Nowadays I wonder how people who need income assess the dividend streams they can buy against the interest on bonds or deposit accounts.
A P/E of 20 means you’re getting a 5% return on your investment, which is better than you’ll get anywhere else unless you accept even more risk. On the basis of prevailing interest rates on safer investments, a P/E of 25 or 30 might still look like a better idea, so long as you can fool yourself into thinking you’re a better stock picker than the market, and thus keep your risk beta down to a few percent.
This fallacy (of being better than average at spotting good investments) is widely held, and is the basis of some of the major financial industry failings of the last century or two – I was going to say ‘few years’ but realised that didn’t go back far enough. Amazingly, people still believe that the Black-Scholes-Merton equations protect you from putting your money into really stupid things, even though it’s long been known that they break down at the extreme edges of probability, such as if you look at the probability of really poor people defaulting on loans, or the probability of Russia becoming a safe place to invest (see LTCM).
Except the E refers to earnings, and those earnings aren’t necessarily passed on to the investor. While they’re supposed to be reflected in either a high stock price [capital gains] or dividends, it doesn’t work out that way all too often.
But we’re talking investor belief, not logic, here. At least some part, if not a large part, of Apple’s share price is the belief that at some point they’re going to find a way to pay out some of their earnings cash mountain in dividends. Earnings in principle should either be spent on investment for the future or on future dividends. The fact that in practice they’re either squirrelled away to no great purpose, invested in overpaying for some acquisition, or paid out in ginormous bonuses to managers in the mistaken belief that that makes any difference to their performance, doesn’t alter the belief that they’re going to end in the shareholder’s hands some sunny day.
I know that we’re moving a bit off topic here, but I’ve always felt that the notion that investors expect to get their payout eventually in dividends really needs to be revisited. It sounds great in theory, but doesn’t pan out in today’s tax and investment environment.
Suppose I have $20 million invested in an S&P 500 index fund. On average, I get 2.25% back in dividends per year, and the rest (8-8.5% iirc) in appreciated stock value. In the first year I take $240K from the portfolio per year for living expenses, and it’s covered by the dividends ($450K) minus taxes ($90K). I also pay capital gains, because the bottom 10 stocks or so in the S&P 500 exit and are replaced by new ones — but those are the smallest, so we have far less in capital gains to pay: say, 1/50 of the average index stock value times 1/20 of the stocks times perhaps 25% capital gains times 20% tax, or 1/20,000 times $20 million as a capital gains tax ($10K).
Now suppose my stocks yield no dividends at all (theoretically, and practically in the case of folks like Intel and Microsoft pre-2000). Then in my first year, I pay no dividends and I pay capital gains for the 10 stocks leaving the index plus about 10% in capital gains for the $240K, plus a little more to cover upcoming taxes — say, $260K. Then we have $10K capital gains tax for the stocks leaving, plus 20% times 10% times $260K for the stocks sold ($5K).
That’s quite a bit less tax. The difference lessens as the stocks in the index funds age, but unless they change the law not to reset the cost basis on death, your inheritor starts from year one. Btw, this is theoretical, but I know of real-world examples of the difference between dividend and capital gains taxes.
Now, I’m guessing you would argue that investors are irrational. In the short run, I grant you that — and Piketty’s work on wealth and ROI for the rich agrees. However, the fact that index funds have grown so rapidly that iirc they are now 1/3 of the stock market suggests that over the long run, on average, investors aren’t so irrational as to value stocks based on the belief they’re going to be paid out as dividends. Rather, I’d suggest that 2/3 of the market thinks it can time the market and 1/3 is investing for the long run and might actually prefer no dividends at all.
Wayne K touches on this above, but Kansas’ recent experience with ‘Laffer Curve economics’ should be placed dead in the sights for this discussion – not the least of which because Arthur Laffer was a paid consultant for Governor Brownback’s now-failed 2012 tax cutting experiment.[1]
Basically, the Laffer Curve is a graph with Tax Rate (X Axis) and Tax Revenue (Y Axis), which in its most basic form plots a D-shaped curve – As you raise the tax rate, tax revenue increases until a point where business is disincentivized and dries up along with tax revenue.[2] So, taxes should be set at the pareto optimal point where tax revenue is maximized.
Of course, Laffer Curve proponents (i.e., supply-siders/the GOP/etc.) presuppose that all tax rates are on the ‘top’ of the curve, and that lowering taxes will increase tax revenue. This basically describes every Paul Ryan federal budget – he cuts a bunch of taxes and the revenue magically appears.
However, in Kansas we are seeing something very different. Several years after Brownback’s Laffer tax cuts, the state faces literal billions in shortfalls – when they cut taxes, tax revenue plummeted. [3] Taking a look at the Laffer curve, if you cut taxes and revenue goes down, you are on the bottom of the curve – i.e., taxes were [b]too low[/b] and were never high enough in the first place.
But you will never hear Republican’s or Laffer say that. Laffer just claims it needs more time. [1, 3] Laffer, it should be noted, has never been able to produce a model of how Kansas’ tax revenue will increase, not even in 2012 when he was pitching the changes [3]. Of course, when I took a few economics courses, I was told economics “was a science and that if you didn’t have a model, you were just making [stuff] up,” or as LEM puts it here, doing magic.
[1] http://www.forbes.com/sites/taxanalysts/2014/07/16/what-went-wrong-in-kansas-maybe-nothing/
[2] http://en.wikipedia.org/wiki/Laffer_curve
[3] http://www.kansascity.com/opinion/opn-columns-blogs/steve-rose/article7024256.html