Good to see someone appreciates the value we bring to society…
Author: tylerdynamist
Is the North rising again?
I think its getting safe to say its just about over. Barack Obama, barring some major surprise, will almost certainly be the next president of the United States. As a student of historical cycles, I’m trying to figure out what it means.
It’s been a weird election. For all the vitriol that has been thrown back and forth, these two candidates are actually not that far apart on policy. The are very different on taxes, but neither was likely to see his plan passed, anyway. They are different on health care, but both have interesting plans. On other issues, like foreign policy, global warming, energy, immigration, even social issues, they probably would have governed relatively similarly, even if their campaign rhetoric suggested otherwise. Remember, John Kerry asked John McCain to be his running mate, so he can’t be that far from the center.
It may be a groundbreaking election, and not just because Obama is an African-American. That’s nice, but I never really felt that was as much of as a barrier as other people thought. I actually believe that the average American has been ready to elect a black president for a while, it’s just that the right candidate hadn’t come along.
Instead, I think we should take note of the fact that Obama is from the North. He is likely to be the first president elected from the North since John Kennedy in 1960. Not only is he from the North, but he is from a big city in the North. In addition, he is likely to win with 51% or more of the vote, a feat accomplished by only two Democrats since the Civil War, FDR and LBJ.
And so I ask myself, could this be a watershed election that has ushered in a new Democratic, blue state era? Or is it a blip created by special circumstances, after which the south, plains and Rocky Mountain west will regain their dominance? I don’t know the answer, of course, and won’t until the 2016 election. Please indulge me as I think this through.
From 1800-1860, US presidential politics was dominated by the party of the South, the Democratic Party. The coalition was southern planters, yeomen farmers and northern Irish Catholics. During this period, the opposition party, the Whigs, only elected two presidents, for one term each. (Maybe you can throw John Quincy Adams in there as being a proto-Whig, too.)
From 1860-1932, US presidential politics was dominated by the party of the North, the Republican Party. The coalition was northern businessmen, northern protestants, and eventually, many northern industrial workers. During this period, the Democratic Party elected only two presidents, for two terms each.
From 1932-2008, US presidential politics has been dominated by the party of the South, but in a more complicated way than in the era before 1932. From 1932-1968, the Democrats, the party of the South, northern Catholics and northern academia, won every election but two. Two candidates, FDR and LBJ, were able to win national landslides in a way that hadn’t occured before 1932. It should be noted that the Democratic Party before 1968 was much different than it is today. It was a mix of Southern segregationists, northern union workers and progressive intellectuals. The Republican Party was much different then, too. It was a coalition of fiscal conservatives, social progressives and moderate midwesterners. It was more likely than the Democrats to oppose foreign interventionism and to promote desegregation.
Starting in 1964, the Republican Party saw an opening to exploit the inherent contradictions within the Democratic Party coalition and began to appeal to southern conservatives. While the GOP got crushed in 1964, Richard Nixon won narrowly in 1968. The GOP was then able to win large national landslides in 1972 and with Reagan in 1980 and 1984, and even with the first Bush in 1988. On the congressional side, the Democrats were able to maintain their dominance with southern conservatives and northern liberals in the same party until the GOP won a national landslide congressional election in 1994, sweeping out a huge number of southern Democrats.
The return to regionalism began under Bush in 2000. In that year, a bunch of northern conservative Senators from the class on ’94 were swept out of office, replaced by conventional liberals. Cultural issues became the primary dividing line, with states like West Virginia, Louisiana and Kentucky moving firmly into the GOP camp, but with the GOP losing any chance to win states like California, Illinois, Vermont and Maine that used to be classic Republican states.
When Bush won in 2004, it looked as if the GOP had built a realigned, dominant coalition of social, economic and defense conservatives dominating the south, plains and Rocky Mountain states. Just as Karl Rove had planned. And who knows, if the Iraq War and the economy had gone well, and if Bush had responded strongly to Hurricane Katrina, it might have been. With a moderate like McCain as the standard bearer, the GOP would have even stood a chance of expanding its reach into the upper midwest.
That said, it would make sense for a northern party to regain the upper hand. The first southern era was 60 years. The first northern era lasted 72 years. The second southern era has lasted 76 years now, so perhaps the blue states are due.
America still number 1 – by a long shot
I’ve been getting tired of all the schadenfreude surrounding the United States’ financial crisis and all the articles pointing to America’s imminent abdication as world leader. While I’ve been writing articles pointing to the demise of the old Wall Street, I actually think that what is going to take its place is better and will cement America’s financial hegemony. Also, the New Economy is still dominated by American companies and American inventions.
Europe, Japan and Russia all suffer from declining populations and have financial problems of their own. Russia’s economic power is based on energy prices that could easily fall just as fast as they rose. China and India, while surely enjoying a long term rise, have per capita income below Samoa and lots of internal problems.
Even on world affairs, who is really challenging America’s preeminent position in naval, ground, air or space power? Europe? Japan? Iran? Russia? There is a big difference between bullying Georgia and truly challenging the US’s position as world hegemon. Japan and India have moved strongly towards the US in the last decade. Every Arab country save Syria and Sudan are either outright American allies or have at least decent relations. In Europe, the leader of every major country except Spain is friendly even to the Bush administration. China, while wary of US intentions as we surround them with allies, still has friendly relations with the US and deepening economic ties. In addition, the US spends more on its military than the next 20 countries combined and the last I checked, the UN is still located in New York.
Anyway, I’ve been meaning to write an essay about this, but thankfully, Marcus Gee at the (Canadian) Globe and Mail did it for me…check it out here.
It’s time to break out of our funk. So we’ll have a recession. So we’ll have to save more and export more. So we’ll have to prioritize in our foreign policy rather than try to tackle every problem ourselves. Big deal. We’ve been through a heck of alot worse than this in our history (the Civil War, Great Depression, World War II, the Vietnam era and 1970s). Let’s stand up and all remember that we’re blessed to live in this great country of ours, and if you don’t realize that, you’re not paying attention.
Maybe Ron Paul is on to Something
So the bailout bill fails, and everybody freaks out. There is pretty good reason to freak out. Our whole system is built upon a mountain of credit, much of it short-term credit, so when the mountain gives way, the whole edifce comes crashing down. Fair enough. The government needs to "do something".
Something else is bothering me though. What kind of system do we have, if that system is subject to collapse if it doesn’t receive a $700 billion injection from the federal government?
Maybe Ron Paul is right to bang on about our monetary policy that is designed to promote ever-increasing levels of leverage, currency inflation and trade deficits. Oh yeah, and our fiscal policy that perpetually runs big deficits and seems so manifestly corrupt. How did things get so unstable?
It’s not just the "anything goes", laissez-faire regulatory regime of the Bush Adminsitration that got us here. While the extremely loose financial market regulation of the last 7 years brought everything to a head, it was an endpoint we were destined to reach all along. This process didn’t start in 2000 and it didn’t start in 1980. It started back in the late 1800s and became the dominant system in the 1930s.
Our current economic system is based on three basic principles: (1) the promotion of inflation; (2) the promotion of consumption and homeownership and (3) relatively open immigration. This economic system has been traditionally promoted by southern and western states, first by the Democratic Party, then by both parties.
Much of the current government edifce is built to promote inflation, consumption and homeownership while discouraging deflation and savings. The federal reserve, the progressive income tax, Fannie Mae and Freddie Mac, Social Security, deficit spending, the abandonment of the gold standard, Medicare, the mortgage interest deduction, homestead laws, unionism, high estate tax rates, generous public pensions, low tariffs, loose bankruptcy laws, the interstate highway system, the earned income tax credit, etc.: all are designed to promote inflation, redistribute income to promote consumption and/or stimulate consumer borrowing for homeownership and consumption. Also, think about what happens every time we have an economic downturn…the Fed lowers rates to try to encourage people to borrow against their houses and/or the government sends out rebate checks for consumers to spend.
None of these things are bad, per se. They’ve just been building up over the past 70 years and have been taken as far as they can go. The American consumer is as leveraged as he or she can possibly get. The US government has some scope to borrow more, but not that much scope. Clearly the US financial system is overleveraged and needs to retrench. The US balance of payments has been running a deficit for most of the last 30 years, so it’s probably not advisable to increase our borrowing from abroad, either.
On the other hand, US businesses are actually in good shape and are the most competitive in the world. We should be actively encouraging more business and production to be conducted in the United States.
[It should also be noted that I acknowledge that the old Republican system of high tariffs, restricted immigration and the gold standard collapsed in the 1930s when it, too, was taken too far. These systems tend to have about 70 years in the sun before they collapse.]
What should a new system look like? It should promote savings, investment, technological innovation and exports.
- The tax code should be used to encouraged savings, perhaps moving to a progressive consumption tax
- Low corporate tax rates and generous deductions for capital expenditures to encourage production in the US
- Financial regulations that target the leverage of financial companies
- Remove the full employment mandate from monetary policy a set an inflation target or price rule
- Currency policy that targets a stable dollar relative to other currencies and limits big swings in international capital flows
- Federally-supported investment in internal improvements, particularly our transportation, communications and energy infrastructure
- Funding for high-tech, health, space and military research
- Encourage more defense spending by our allies and sell them high-tech military equipment
- Scale back on US defense spending, consider a more limited direct role for the US military
- Scale back the home mortgage interest deduction and/or eliminate Fannie Mae and Freddie Mac
- Bring the estate tax down to a non-confiscatory level
- Make Social Security needs-based and potentially cut the payroll tax
- Promote skills training and certification throughout a worker’s lifetime as part of the social security and/or unemployment insurance program
- Have a health system based on either consumer-purchased insurance or government-provided insurance and remove that burden from employers
So I’m basically saying we should have a progressive, more globalist version of Ron Paul’s program of sound money, less debt, and low taxes.
Long term opportunities abound
I am a believer in long cycles. As part of that framwork, I believe we are in the bottoming phase of the long cycle that arose out of the Great Depression. The changes that are happening today in the economy are not of the cyclical nature, they are of the secular nature. We are in the midst of the final collapse and restructuring of the old "mass market" economy. In its place, the "new economy", or what I call the "mass customization" economy, will take control.
As the tide of consumer credit that has been building since the New Deal in the 1930s washes away, so does consumer demand, leaving the industries that benefitted from that credit creation awash in excess capacity. There are additional old economy industries that are seeing consumer tastes or technological advances leave them behind. A list of industries with excess capacity is below:
Industries with excess capacity
Commercial and residential real estate, homebuilding, appliances, autos, retail, consumer lending, broker/dealers, airlines, media, land line telephony, pharmaceuticals, fast food
That said, there are several sectors that are dealing with capacity shortages:
Industries with capacity shortages
Data centers, developing market infrastructure, railroads, mass transit, electricity generation/transmission, oil production/refining, LNG transportation/storage, financial advisory, wireless network capacity, biotech, organic foods
Mostly, the list of industries with capacity shortages are those that require investment to complete the modernization of the old communications, energy and transportation networks.
Given the economic shift, there should be investment opportunities in the following sectors:
Long term investment opportunities
Electrical equipment, smart grid technology, mobile platform developers, capital goods manufacturers, steel and basic materials manufacturers, very light jets, carbon fiber manufacturers, ETF providers, private equity, retail financial advisors, financial services software, software-as-a-service, solar panel developers/manufacturers, organic food packagers/distributors, railroad equipment manufacturers, wireless towers, oil field services/equipment, LNG shipping, oil & gas pipelines, machine-to-machine communications, seafood farming, developing market consumer goods companies, next gen battery developers, home automation, biotechnology
I could keep going. The point is, there are a ton of sectors that have terrific long term prospects, and the United States is well positioned to lead in most of them. The current crisis will pass and yield to better times, as it always does.
Am I the prophet of doom?
Investing Watch: While my long term view is that the United States economy is actually in a much better competitive position than people give it credit for, I appear to be on a roll with my doomsday predictions. First Bear Stearns, then the "conservatorship" of Fannie Mae and Freddie Mac, I’ve referred several times to the eventual demise of Lehman Brothers, and I poked fun at the business model of Merrill Lynch. As of now it looks like Lehman Brothers will be liquidated and Merrill Lynch is getting swept up into the arms of Bank of America. The shrinking of capacity in the financial services industry continues and will continue, I’m sure. I had no idea, for example, that the venerable AIG was in trouble. We will also get to watch the drama of what happens to Washington Mutual. Perhaps even Morgan Stanley will lose its independence someday.
Beyond the specifics of who blows up, the important question is what it means for us regular folk. The process of deleveraging is called deflation. You can have deflation fast, like the great financial panics of the 1800s and early 1930s. You can have deflation slow, like Japan for the last 15 years. Or you can have hyperinflation, like Germany in the 1920s, where the government prints away the debt.
Given that the Treasury and Fed have been pretty adept at handling the crisis by engaging in the lender-of-last-resort role, it is unlikely that we will have deflation fast. And given the dollar’s key role in the financial system, the US government has too much to lose geopolitically to rapidly inflate away our debts. Thus, we will likely have deflation slow.
The gears of credit creation will have a hard time catching as the system goes through deleveraging, restructuring, and changing regulations. Overleveraged consumers and baby boomers facing dim retirement prospects will save more and work later in life. Consumption as a share of GDP will have to decline. The US may even start running persistent trade surpluses.
And so after the deluge, the mailaise. We’ll probably spend years griding sideways, with financial market participants dying of boredom and many drifting off the work in other sectors of the economy. The debt load of the American consumer will gradually abate. And sometime next decade, the US economy will be ready for rebirth and prosperity will return.
Just don’t hold your breath.
Both candidates are wrong about Afghanistan
Policy Watch: The election of Barack Obama vs. John McCain is ostensibly between two moderates, although on domestic policy I would define Obama as a classic liberal with a moderate temperament and McCain as more unorthodox than either moderate, liberal or conservative.
On foreign policy, however, McCain’s instincts come across as a belligerent Wilsonian, what used to be known as a "liberal hawk" but is now known as a "neoconservative". Obama pays lip service to the "realist" foreign policy of George HW Bush (from the traditonally conservative camp), talks tough about surging troops into Afghanistan and potentially invading nuclear-armed Pakistan, yet otherwise reminds me of Jimmy Carter.
In terms of the sweep of American history since World War II, it’s actually kind of a weird choice to have to make. The current president Bush, while generally viewed as a extremist warmonger due to the invasion of Iraq, is actually more of a moderate than either McCain or Obama appear to be, if you look at his administration’s foreign policy in toto (not their talk, but their actions).
This is not a political blog, and I certainly don’t want to get involved in a fight about the Bush administration. I do, however, care about geopolitics and its effect on our national interests and the world trading and security system. I feel compelled to point out that much of the Sturm und Drang surrounding the foreign policy debate in the 2008 election is divorced from reality. On the two big foreign policy issues of the election the two candidates will end up having the exact same policy.
The first is the War in Iraq. They will both end up with the same policy in Iraq because we have won the war. McCain won’t admit we’ve won, because he wants to use it to paint Obama as a wimp. Obama won’t admit we’ve won, because half his base wants us to lose to prove George Bush wrong. It’s example A of the classic baby boomer polarization that Obama deplores on the stump, and he’s right to, but on this one he won’t overcome it because opposition to the War in Iraq was the original thrust of his candidacy against Hillary Clinton. Either way, US troop levels in Iraq will come down dramatically over the next two years and both candidates will leave a remnant force like we have in South Korea.
The second is the War in Afghanistan. Both candidates want to surge more troops into Afghanistan to build up its democracy and fully defeat the remnants of the Taliban. On this point I think both candidates are wrong.
I am one of those strange ducks that supported the War in Iraq and is ho-hum about the "Good War" in Afghanistan. I looked at Iraq as important geopolitically, but fell more into the Joe Biden camp of overthrowing Saddam and then carving the country into three states. I was less concerned about building a democracy there, but felt that the best chance of doing so lay in creating three mostly ethnically homogeneous states. I understood the geopolitical logic of keeping the country intact to avoid the Shiite south becoming a vassal state of Iran, but felt that the risk/reward was less favorable than breaking the country up.
I am not a big believer in the viability of democracies in multi-ethnic nation states whose borders were drawn by european powers. If you look at most of the hotspots since the end of the Cold War (Yugoslavia, the Caucuses, Iraq, Lebanon, Afghanistan, Sudan, most African countries and, potentially soon, Pakistan) they all have borders drawn by western powers, usually designed to factionalize the internal population so their imperial masters could play them off one another.
Afghanistan, in fact, is only a country because it is the area that couldn’t be conquered by the British or Russians during the "Great Game" era of the 1800s. Within its borders are Pashtuns (the largest ethnic group), Hazeris, Tajiks, Uzbeks, Balochis and Turkmens, among others. There are no actual "Afghans", other than in a we-get-to-send-a-delegation-to-the-United Nations sense. The Taliban came from the Pashtuns in the south of the country. Our allies in the overthrow of the Taliban, the Northern Alliance, consisted of non-Pashtuns in the north.
No offense to the citizens of Afghanistan, but it is also one of the most backward countries in the world. I can’t quite understand why people think it is a waste of time to nation-build in Iraq, a relatively advanced country with the potential to be quite weathy, but are excited to do so in Afghanistan, a mountainous and rugged country that resisted the British, czarist Russia and the Soviet Union, all of which tried alot harder to subdue the country than NATO ever would.
Our national interest in Afghanistan lies only with keeping the remaining al Qaeda terrorists in the region off-balance enough that they can’t operate with impunity and plan attacks. Right now, even though some of them are alive, the old al Qaeda hierarchy in Afghanistan and Pakistan has been heavily degraded. It would be easier to plot and execute an attack on the US from Germany than from Afghanistan, and neither would be very easy. If the goal is to co-opt the Pashtun into politcs, then perhaps carve out a separate Pashtunistan in the south with its capital in Kandahar, and leave the remaining grab bag as "Afghanistan" in the north, with its capital in Kabul. Sure, the Taliban might come back to power, but if they are forced to actually govern and don’t have the excuse of needing to fight the Northern Alliance, they are far more likely to be internally-focused rather than wasting their time thinking about plotting attacks on the US, halfway around the world. Besides, the Bush Doctrine would remain operative…start allowing terrorists sanctuary again, and you will get punished.
Anyway, it appears as if we are going to spend more blood and treasure in this quest and there is going to be little debate about it. The Democrats want to prove that Bush was wrong to divert the War on Terror into Iraq, and McCain just seems to always be itching for a fight. By defining the mission up, we are decreasing the odds of success while diverting spare resources from potentially more important uses.
Like positioning to prevent Russia from retaking Georgia and the Ukraine, for example. Or a tax cut.
Two good recent essays on the subject:
Bartle Breese Bull writing an opinion piece in the New York Times; and
How to value the stock market
I’m still on summer vacation, but figured I’d post an analysis I did earlier this month on how to value the stock market relative to bond rates. While some of the prices may have changed a bit, the point is for this to be a long term analytical framework. I welcome comments challenging or adding to the theory, as I’m always searching for the right answers…
HISTORICAL RETURNS
From 1926 to 2001, stocks, bonds and t-bills produced the following returns:
|
Nominal |
Real |
Real After-tax |
Inflation |
|
|
Stocks |
10.68% |
7.41% |
5.57% |
3.05% |
|
Bonds |
5.33 |
2.21 |
0.66 |
3.05 |
|
Cash |
3.81 |
0.73 |
-0.39 |
3.05 |
Source: Ibbotson Associates
It is from Ibbotson’s older studies that market participants have settled in on an equity risk premium of 5-6%. This analysis would imply an equity risk premium of as high as 7%. Since the market has basically moved sideways since 2001, with relatively low dividends and a rally in bonds, I would suspect that a more recent run of Ibbotson’s analysis would have the spread come down to around the historical average of 5-6%.
The purpose of this paper is not to determine whether 5-6% is the right number. Instead I am seeking to provide a method of calculating what the priced-in return of the market is today, and then to use a "disequilibrium analysis" to determine how the market may have it wrong.
COMPONENTS OF EQUITY RETURNS
On a basic level, equity returns are driven by two things: the beginning dividend yield and the long term growth rate of dividends.
Using the Gordon growth model
P=D/(r-g)
Where P= stock price, D=dividend, r= expected rate of return and g=dividend growth rate
Rearranged to
D/P + g = r
So that the dividend yield plus the long term dividend growth rate equals the expected rate of return.
Dividend yield and payout ratio. Ok, easy enough. The problem with the dividend yield is that the payout ratio has fluctuated over time, due both to changes in management optimism and to changes in the tax code and options compensation that encourage stock buybacks. Stock buybacks are a form of dividend in that they are not reinvested in the business.
Dividend growth. We will focus on the market as a whole to determine the general valuation level of the market. Over the long term corporate profits will grow in line with Nominal GDP. There are some periods when profits’ share of GDP goes up, like the late 1990s and 2000s, and period when it goes down, like the 1970s and early 1980s, but over the long term they will grow in line with GDP. S&P 500 profits, however, grow at a rate that is about 1% slower than GDP, as that index consists of larger, more mature companies.
GDP Growth. Nominal GDP growth consists of three components: growth in the workforce, growth in worker productivity and inflation. Long term real GDP growth has traditionally been 2.5% to 3%, with workforce growth at about 1% and productivity at 1.5% to 2%. Workforce growth has slowed recently and will likely move toward 0% for a while as the baby boomers retire, and then pick back up to its historical pace in the latter part of next decade. Productivity growth, on the other hand, has been running above trend recently.
Real earnings growth. If I strip out inflation, real S&P earnings have grown at a rate of 1.74% a year since 1960, which makes sense relative to real GDP growth of 2.5-3.0%.
Inflation. Inflation has been volatile since the 1920s. It was negative in the 1930s, regulated and then high in the 1940s, moderate in the 1950s, rising in the 1960s, very high in the 1970s, falling then rising in the 1980s, stable in the 1990s, and rising in the 2000s. As of August 7, 2008, the 30-year treasury bond was yielding 4.55% and the 30-year TIPS (Treasury Inflation Protected Security) was yielding 2.05%, meaning the market expects long term inflation of 2.5%.
Below I plot out today’s yield curve relative to my "equilibrium" yield curve. As interest rates, earnings and inflation are volatile, yet mean-reverting, I need to anchor the values in reasonable, long term assumptions.
|
Current vs. Equilibrium Yield Curves |
||||
|
Fed Funds |
5-year |
10-year |
30-year |
|
|
August 7, 2008 |
2.0% |
3.15% |
3.93% |
4.55% |
|
TIPS Rate |
1.03 |
1.65 |
2.05 |
|
|
Assumed Inflation |
2.12 |
2.28 |
2.50 |
|
|
Equilibrium Treasuries: |
||||
|
Midpoint |
3.0% |
3.5% |
4.0% |
4.5% |
|
Range |
2.5-3.5 |
3.0-4.0 |
3.5-4.5 |
4.0-5.0 |
Source: PIMCO, author’s analysis
Trend real earnings. To determine whether today’s market is over- or under-valued, I calculated long term real trend earnings for the S&P. I use inflation-adjusted trend earnings to smooth out the effect of business and inflation cycles. A graph of annual S&P real earnings is shown below.
Source: Damodoran, S&P, author’s calculations
Trend earnings for 2008 are estimated to be $58.65. The S&P is currently trading at 1,266.07, which results in a PE to trend earnings of 21.6. The long term average payout ratio of S&P companies is 50%, so the implied dividend yield to trend is about 2.3%, which is about what the actual dividend yield is today, if we include stock buybacks. Focusing on dividend yield is a better way to value the market than focusing on current year PEs, because dividends are far less volatile than earnings. Corporate managers tend to only pay dividends relative to their long term earnings power, because they don’t like to have to cut dividends at a later date.
Expected S&P Return. We now have all of the pieces to calculate what return is priced into today’s S&P.
|
Dividend yield |
2.32% |
|
Real trend earnings growth |
1.74% |
|
Real return |
4.06% |
|
Inflation |
2.50% |
|
Total return |
6.56% |
|
Tax Rate |
20% |
|
After Tax return |
5.25% |
Fixed Income Alternatives. No compare this to current fixed income alternatives.
|
Alternatives |
Today |
After tax (40%) |
Equilibrium (pre tax) |
|
Vanguard Long Term Investment Grade |
6.44% |
3.86% |
5.75% |
|
Vanguard Long Term Treasury |
4.38% |
2.63% |
4.25% |
|
Vanguard Short Term Treasury |
2.55% |
1.53% |
3.25% |
The equity risk premium is currently only 3.56% relative to the equilibrium risk-free rate. The best deal looks like investing in long term investment grade bonds, particularly if you own them in a tax deferred account. On an after-tax basis, the spread is 3.72%.
Disequilibrium Analysis. Looking at the above numbers, one could make the argument that the assumed inflation rate is below the long term trend of 3.0%. If inflation was 0.5% higher, that would accrue to stock returns (to 7%) and eat in to real bond returns. Either way, it appears the spread between stock returns and investment grade bond returns is too low. Treasury rates are either in line with, or slightly below equilibrium. Real earnings growth has more risk of surprising to the down side after the big rise over the past two decades. Taxes are likely to rise near term, with the difference between taxes on equities and bonds narrowing.
Tax-free alternatives. The above after tax rates should be compared to municipal bonds when investing in taxable accounts. The equilibrium rates are compared to treasuries on an after-tax basis. You would probably want to add a few basis points to compensate for the fact that muni bonds carry a little more risk than treasuries. And to make sure that the equilibrium rate is at least above inflation.
|
Tax Free Alternatives |
Today |
After tax (5%) |
Equilibrium (pre tax vs. Treasuries) |
|
Vanguard Long Term Tax Free |
4.15% |
3.94% |
2.76% |
|
Vanguard Int. Term Tax Free |
3.65% |
3.47% |
2.44% |
|
Vanguard Short Term Tax Free |
2.37% |
2.25% |
2.11% |
Here I’m assuming you are not investing in triple tax-free bonds and are paying state tax of 5%. It would appear that municipal bonds offer terrific value on an after-tax basis and are well above their equilibrium yields and are even above investment grade corporates on an after-tax basis. In addition, with tax rates more likely to rise than fall, the attractiveness of muni bonds only increases.
Sadly, it’s tough to beat inflation on an after tax basis by investing in bonds. The key is to hold bonds in your tax deferred accounts and stocks and muni bonds in your taxable accounts. I know it sounds counter-intuitive to put fixed income in your long term retirement accounts, but if you run the math, you’ll save a lot on taxes versus holding taxable bonds in a taxable account and stocks in a tax deferred account.
S&P Values at different Expected Returns. I personally believe that the current earnings yield is too low and that the stock market is overvalued. The reason the long term return of the market is 8-10% is that in starting point year 1926 the dividend yield was higher than 5%, which together with 3% inflation and 2% real earnings growth gives you a 10% return. The great returns in the market since that time have come from multiple expansion, aka yield compression. With the implied dividend yield of only 2.5% today, the potential for continued multiple expansion is diminished, and the potential for multiple contraction (a process that has been playing out since 2000, by the way) is increased.
Here is how the S&P would need to be valued to provide a range of expected returns.
Source: author’s calculations
In other words, to target a long term 8% return that provides a 5% equity risk premium to the average risk-free rate, the market would need to fall 38% from today’s levels. If long term inflation ends up being 3% instead of the 2.5% that the treasury market predicts, then the market only needs to fall 29%.
Buy bonds.
New York tax revenues go “poof”
Due to large losses at financial firms in the past two years, New York City and State face a huge revenue shortfall as banks stop paying taxes and in many cases are filing for refunds, Bloomberg News reports. Many large institutions will be able to carry forward their losses to offset cash taxes for 5 or 6 years. We are starting to see just how geared the New York tax base is to the fortunes Wall Street firms and their employees. This is particularly tough given how geared the earnings of those insitutions are in the first place.
If, as I believe, Wall Street is about to go through a permanant downsizing and restructuring, New York will be in for a long reckoning indeed. As someone of the generally anti-tax persuasion, I hope New York is able to navigate this crisis by downsizing and restructuring its preposterously bloated government bureaucracy. Alas, knowing New York’s politics and history, I suspect it will be the private citizenry that will end up getting milked instead.
UBS to jettison its investment bank?
UBS has decided to separate its investment bank from its asset management arm. This step could presage UBS’ jettisoning of its investment bank. As I said in a previous post, Merrill Lynch should do the same thing. Apparently 247WallStreet agrees with me and throws in Citibank and Wachovia to boot.
Asset management is in inherent conflict with investment banking in that an asset management client can never be sure that he isn’t being put into an investment because its the right investment for his portfolo or because it makes money for the investment bank. The whole auction rate security debacle is case in point. So is the collapse and bailout of the internal Bear Stearns, Citigroup and UBS hedge funds, and the near death of Goldman’s Global Alpha hedge fund.
An investor is better off trusting a pure-play asset manager (like say a Northern Trust) than an investment bank or universal bank.
The Dynamist 