Taxes and the urge to merge

Tax reform, in whatever final shape it takes, is likely to put lots of money into corporate hands. While these companies already have lots of cash — a record $1.8 trillion in nonfinancial companies in the Standard & Poor’s 500 index — giving them more cash may give them an incentive to actually, you know, spend it. I talk about one likely option in my latest column, here. 

On another topic, the Baby Boom Generation spans the years 1946 to 1964. There’s a big difference between the early Boomers and their younger siblings: If you were born in 1946, you came of age with the Beatles, the Vietnam War, Lyndon Johnson and Richard Nixon. If you were born in 1964, you grew up with The Clash, gas lines, Jimmy Carter and Ronald Reagan. More importantly, older Boomers are more likely to have pensions and more likely to have taken a beating from the past two bear markets. Younger Boomers? They probably don’t have pensions, they face soaring college tuition costs for their children — and some will retire just as the Medicare Trust Fund runs out of money. You can read about it here.

By the sweat of your brow

“By the sweat of your brow
    you will eat your food
until you return to the ground,
    since from it you were taken.”

One of the enduring mysteries of the U.S. tax code is why the system is harder on those who earn their income by the sweat of their brow as opposed to those who get money from their investments.

The tax code’s main purpose, of course, is to fund the activities of the government, and Americans have been having a lively discussion about the proper scope of government activities and how to pay for them for more than 200 years.

Over the years, however, the tax code has been used to encourage certain behaviors and discourage others. In its current incarnation, for example, we give deductions for contributions to some retirement savings accounts, because that’s a good thing. We levy tax penalties on early withdrawals from retirement plans, because that’s often a bad thing.

There are plenty of things to argue about with these types of tax incentives. What is curious, however, is the favorable treatment of investment returns over ordinary income. Currently, for example, employment income is taxed at a maximum 39.6%, while long-term capital gains are taxed at a maximum 20%.

Ostensibly, the lower tax rate for capital gains – the difference between your purchase price and sales price on a winning investment – is to encourage investment. As such, it has some merit: Congress cut the capital gains rate from 28% to 20% in 1982, and the stock market took off. (On the other hand, Congress returned the capital gains rate to 28% in 1987, and the stock market generally rallied until 2000).

Nevertheless, we as a nation tend to encourage hard work and look down on those who work as little as possible. And here we come to a paradox between the admiration for hard work and the tax code. Consider this comparison of two people, each with $300,000 in income, presented by Ben Steverman of Bloomberg.

Our first taxpayer is an emergency room surgeon. The other plays video games all day, thanks to his inheritance.

twogus

Now, as with all things taxable, there are some important caveats here. One is that under current law, if the heir’s parents gave him his capital in their will, the estate is liable for taxes under estate tax law. (Heirs don’t pay estate taxes.) That said, it’s unlikely that the parents paid estate tax: It doesn’t kick in until $11.2 million for a couple and $5.6 million for a single individual. About 11,300 estate tax returns were filed for people who died in 2013, of which only 4,700 were taxable, fewer than 1 in 550 of the 2.6 million people who died in that year, according to the Tax Policy Center.

This is largely an investment blog, so it’s useful to point out that lower corporate taxes in the new tax bill means that companies are more likely to increase dividends, buy back stock, or increase merger and acquisitions. All told, it’s hard not for investors to like the bill, because it will help returns from the money you earn while you sleep. But we’re a country that admires hard work. In the end, however, even with a tax break, those who earn their living by the sweat of their brow still wind up paying more.

 

Lots of cash and animal spirits: What could possibly go wrong?

If you’ve ever been to a particularly raucous New Year’s party, you know that there’s a logical progression from the first awkward arrivals and introductions until you’re sleeping in a car full of raccoons and empty Cheetos bags.  And, at the time, each step makes wonderful sense.

Right now, the markets are at a spot where spirits are high and cash is flowing like liquor at your broker’s annual Christmas party. Let’s take a look at the animal spirits first.

University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

 University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

As you can see, consumer sentiment has been rising since the dark days of 2009; it now stands at 98.2 — the chart is lagged by a month. Sentiment is now higher than it was in January 2015 (98.1), and the highest since February 2004.

Soptimism-graphmall business confidence is also up post-recession, but it jumped markedly after the election, presumably on the hopes of lower taxes and regulation by the new administration.

And that confidence — plus the 12% gain by the Standard & Poor’s 500 stock index this year — has sparked optimism among investors. The American Association of Individual Investors sentiment survey now stands at 45.6% bullish, vs. its 38.5% historical average. Similarly, just 25.7%  of those surveyed said they were bearish, vs. a historical average of 30.5%. Bullish sentiment is at a five-week high, and its third-highest level of 2016.

At the same time, there’s plenty of money on the sidelines, and some of it appears to be returning to stock funds. In the last week of 2016, investors poured an estimated $118 million into U.S. stock funds. But that’s a piker compared to the previous week, when an estimated $18.6 billion flooded — more than the previous 24 months combined, according to the Investment Company Institute, the funds’ trade group.

As of the end of November, there was $2.7 trillion in money market mutual funds, earning approximately zilch. A roaring stock market provides a great deal of temptation for at least some of that money.  Stock funds had about 3.2% of their assets in cash, which is not particularly high, and that figure’s usefulness has been eclipsed somewhat recently.

Another potential source of cash: Companies in the S&P 500 have a record $1.5 trillion in cash cooling its heels on their balance sheets. They can use this for buying back stocks, paying dividends, or — and this is crazy talk — reinvesting in plants, equipment and their own employees.

The bad news is that the stock market is already expensive. The S&P 500 sells at about 24 times earnings, as opposed to a historical norm of about 17 times earnings. S&P predicts that earnings will rise through 2017, bringing down the PE ratio to about 18. Bear in mind that forecasts are notoriously unreliable, particularly when they’re about the future.

Bear in mind, too, that the Federal Reserve is likely to continue to raise interest rates, and at a faster pace if the economy grows faster than expected.

Right now, it looks like animal spirits and plenty of cash will keep the market party going, and that can be good, clean fun. Enjoy the ride. Just remember that market rallies always last longer than a sober person would think. But remember that many things must go right for the rally to continue. It’s probably a good time to readjust your portfolio back to your original goals. No one ever went broke taking a bit of profits.

 

 

 

 

Neither far out nor in deep

There’s an old Turkish story about a village wise man who appealed to the Sultan to reduce the crushing taxes he had levied after conquering the province. “If you’ll reduce your taxes,” the wise man said, “I will teach this donkey to talk, and I’ll present him to you.”

The throne room in Topkapi Palace, Istanbul.
The throne room in Topkapi Palace, Istanbul.

The Sultan, amused, said, “How long will you need to teach the donkey to talk?”

The wise man considered, and said, “This is no easy thing. I’ll need five years.”

The Sultan said, “Fine. But if you don’t have this donkey talking in five years, I’ll have you skinned alive.”

Afterwards, the villagers crowded around the wise man and said, “How can you promise such a thing? The Sultan will skin you alive!” The wise man shrugged. “Many things could happen in five years. I could die, the Sultan could die, or the donkey could die.” As it turned out, the Sultan died three years later.

The moral of the story is that no one can promise that anything will happen in the reasonably far-off future. Everyone would like to know what the stock market will do in the next five years. But it’s more likely that someone will teach a donkey to talk than be able to predict the market accurately in five years.

And right now is a particularly difficult time to prognosticate. An old rule of thumb is that if you take the inflation rate and subtract it from 20, you’ll get the market’s fair value price to earnings ratio. (The PE ratio — price divided by earnings — is a measure of how expensive a stock or index is. The higher the PE, the more expensive the stock market is, and vice-versa.)

The core inflation rate is 1.9%, meaning the market’s fair value is 18.1 times earnings. Standard and Poor’s says the estimate for the 2015 price-to-earnings ratio is 17.3 on an operating basis, which would make the market slightly undervalued. On an as-reported basis, which is probably less accurate, the estimate is 19.3 times earnings, which makes it slightly overvalued. We may as well split the difference and call the market fully valued.

Naturally, there are all sorts of ominous things on the horizon that could push prices lower. For example, manufacturing seems to be slowing down dramatically, partly because the global economy is so weak. Then there’s the Middle East. And Russia.

Less apocalyptic would be a slowdown in earnings, and there are signs of that already, Rather than pay employees more or invest more heavily in their own businesses, companies are electing to buy back shares — a useless exercise for anything except making your company’s earnings look better than they really are.

sentimentOn the other hand, housing prices are rising at a moderate and sustainable pace. The Case-Shiller 10-city composite home price index rose 4.7% the past 12 months ended August, and consumer sentiment is also fairly chipper. The unemployment rate is 5.1% (albeit still unstatisfying), interest rates are low, and the economy is growing modestly. We have no boom, but no bust, either.

But here’s the thing: If you’re investing for a goal in the next five years, you’re about as likely to forecast the stock market correctly as you are to find a talking donkey. Typically, stocks are a good investment for the long-term, patient investor. If you’re spending your days fretting over the next jobless report, you probably have too much money in the stock market.

Wall Street beauty contest: A tale of two funds

Let’s say a web site had a contest, and it worked like this. The site ran pictures of 100 people, and asked you to pick the most beautiful person. Whoever won the contest gets $1,000.

You picked the photo of someone you thought was exceptionally beautiful. And you lost, because that’s exactly the wrong strategy for this contest. You should have looked for the photo of someone you thought everyone else thought was the most beautiful.

by Unknown photographer, bromide print, 1933
by Unknown photographer, bromide print, 1933

John Maynard Keynes, economist and investor, used the analogy to describe how the stock market works. Your stock may be an exceptional value, with a fine dividend, low price-to-earnings ratio, and a CEO with a dazzling smile. But if that company, or that sector, is out of style, your stock will lag the broad market.

Let’s illustrate this by looking at two funds. The first is ProShares Dividend Aristocrats ETF (ticker: NOBL). The fund invests in stocks of companies that have raised their dividends every year for the past 25 years.

The second is PowerShares Dynamic Buyback Achievers (PKW). This fund invests in stocks that have shrunk their amount of outstanding stock by 5% or more.

For long-term investors, the Dividend Aristocrats should rule. A dividend is money in your pocket, and a company that raises its dividends regularly is clearly focused on its investors. Moreover, Wall Street normally shoots companies that cut their dividends, throws them out the window, and then shoots them again. A company that raises dividends has to be exceptionally confident that it has the financial wherewithal to keep paying the dividend.

Buybacks, however, may or may not affect stock price. And buyback programs tend to be ephemeral — here one year, gone the next. And companies that do buy their own stock may or may not be savvy buyers of their own stock. When stock prices were in the third parking level of historical norms in 2009, buybacks virtually ceased.

Which fund has done better? The buyback fund, of course. NOBL, the dividend fund, has gained 0.88% this year, vs. 3.2% for the Standard and Poor’s 500 stock index with dividends reinvested. PKW, the buyback fund, has gained 3.6%.

The reason, of course, is that buybacks have become the most popular strategy on the block the past 12 months. Companies bought back $148 billion of their own shares in the first quarter, topping the record set in the second quarter of 2007. (Quiz: What major market event started in the third quarter of 2007? Anyone?)

PKW is not without its beauties. It buys shares of companies that actually shrink their share count, rather than those that simply announce new buyback programs. (Companies often announce new programs, but don’t get around to actually buying all the shares they promise to.)

But the lesson of this story is that, at least for the moment, share buybacks are what other investors think is the most beautiful strategy on Wall Street. And for that reason, PKW is the winner.

beautyqueen1950s

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