Playing the "STUPID" Card...

The tax on high-end employer provided health benefits (a.k.a. the Cadillac tax) is the same tax that is at the heart of the comments made by Jonathan Gruber that some are using to suggest that American's were lied to.  Yet, the discussion about changing the tax code to reflect the bias treatment of employment compensation has been debated many times before (see article link below).

There is often a big difference between who legally pays a tax (who the tax code imposes the tax on) and who "economically" pays the tax.  Hence, Gruber's newly surfaced comments at conferences and class lectures about how the tax would be shifted in part to everyone in the market is basic microeconomics albeit not that well understood.  I agree his choice of words was poor, but if the point about the economic incidence of the tax was made explicit, as Gruber stated, the bill wouldn't have passed and we would still have millions of uninsured people.

Based on the "current" conservative line of logic, all FICA taxes are a "lie" because taxes legally  levied on your employer for their Social Security and Medicare contribution of your behalf are actually born partially out of your wages depending on the wage sensitivity in the labor market.  The tax on cigarette manufacturers is a lie because the tax is economically born by smokers who are very insensitive to price (little decrease in consumption) when it goes up because of the tax.

The conservative media is turning this basic economic reality into a farce.  They appear to be very sensitive to being called stupid yet by making the whole argument about a "lie" appear to be, well, actually stupid.

Check out this article from the Houston Chronicle from 1/28/2007.  It is the very same tax, the "Cadillac Tax", being proposed by the Bush Administration in 2007.  This is not a new concept for conservative policy makers.  They know all about this tax and know this economic concept.  What they are really doing is playing the "stupid" card, literally and figuratively, on their conservative base.  So let me ask, who's really stupid here?

http://www.chron.com/opinion/editorials/article/Deduction-no-reduction-Bush-s-latest-health-care-1813934.php

The Inequality Trifecta by Mohamed A. El-Erian - Project Syndicate

The Inequality Trifecta by Mohamed A. El-Erian - Project Syndicate

What Markets Will... Krugman 10/16/14 NYT

http://nyti.ms/1qF02rP

From Economist's View: Thoughts on high priced textbooks

The article discusses the principle-agent problem and its application to the textbook market.  Knowing that many of my students are opting to not buy textbooks despite the potential that it might result in lower grades, I've been talking to publishers about price discounts and have been successful negotiating price discounts, especially for principles textbooks.

http://economistsview.typepad.com/economistsview/2014/10/thoughts-on-high-priced-textbooks.html

Root for a Correction

by Matt Malick and Ben Atwater
Root for a Correction

In market parlance, the textbook definition of a correction is a drop of greater than 10%, but less than 20%.  Any fall of 20% or more is considered a bear market.

Commentators often talk about a correction as a healthy phenomenon.  But, when one happens, it feels terrible – like it is never going to end.

It has been so long since we have had a correction - April 29, 2011 through October 3, 2011, when the market fell just over 19% on a closing basis - we almost forget how torturous they really are.

Presently, the Standard and Poor’s 500 has declined, as of yesterday’s close, 3.77% from its recent all-time closing high on September 18th.  This is far from a correction, but painful enough, especially given the dramatic underperformance of small-cap (Russell 2000) and international equities (ACWX) relative to the S&P 500.



However, a correction can be beneficial as long as investors don’t panic and make poor decisions.  If we are in the process of one, it would serve to make valuations more reasonable, dampen investor sentiment and provide a potential catalyst for a move to new highs following a successful earnings season.

As we approach earnings season, analysts are expecting S&P 500 companies to earn $29.69 per share in third quarter profits, which would leave the S&P 500 with trailing twelve month earnings of $108.27.  If the market were to correct in the meantime and fall 10% from its closing high to 1810.22, the price-to-earnings ratio on the market would fall to 16.71.  Although this valuation is not dirt cheap, it is close to the long-term average P/E and highly attractive when we compare bonds, real estate and various other asset classes to stocks.

Furthermore, when the market falls, investors almost universally get more pessimistic about the prospects for future returns.  And sentiment is a contrarian indicator.  If a correction shakes some of the fickle money from the market, then the market’s foundation is stronger when it begins to rise again.

As you well know, we believe excess valuations and sentiment are generally the preconditions for a bear market and corrections help dampen both.

Finally, if the market does continue to fall here, then a positive earnings season could be a catalyst to spur the market to new highs.  After all, if earnings meet or exceed estimates, we will then have back-to-back quarters of 9%-plus earnings growth, a seemingly bullish happening.

UPDATE: All-Time Highs

by Matt Malick and Ben Atwater

The stock market has been on a tear lately and the Standard & Poor’s 500 Index is approaching the two-thousand mark.  The current bull market, which began on March 9, 2009, is both the fourth strongest and the fourth longest, rising nearly 194% in over five years.




If it seems like stocks are cracking new all-time highs on a weekly basis, well, they basically are.  Since reaching a new all-time peak on March 28, 2013, the S&P 500 has hit a new record on 21.4% of trading days – more than once a week, on average.

Since its inception in 1950, the S&P 500 has struck new all-time highs on just 6.8% of trading days. But, this long-term average includes weak markets where new highs are rarely eclipsed, such as the period from 2000 to 2013.

The roaring 90s offer an interesting point of comparison.  After attaining a new all-time peak on Valentine’s Day in 1995, the S&P 500 made new highs on 19.1% of trading days up until the tech bubble began to burst in March of 2000.  This frequency is in the ballpark of the current environment.  But, keep in mind, that equities hit new highs on almost a weekly basis for over five years, whereas the current run has lasted less than 16 months.

As the market continues its ascent, we are keeping a close eye on sentiment and valuations.  Thus far, even minor upticks in volatility have led to spikes in bearish sentiment, as measured by various survey data.  From an anecdotal perspective, the financial media, the investment industry and even clients still seem to view this market with a great deal of skepticism.  Not until investors begin to shrug off bad news and view pullbacks as “buying opportunities” have bull markets usually run their course.

And from a valuation standpoint, the S&P 500 trades for about 18 times trailing earnings per share.  While loftier than the historical average, the ninth innings of bull market runs accompany even higher multiples.

While we believe this bull market still has legs, all good things must eventually come to an end.  Therefore, to be prudent, we are continuing to rebalance client portfolios where appropriate.  This involves trimming outsized positions, adding to underperformers and realigning the mix between equities and fixed income.

UPDATE: Bonds as a Hedge

www.atwatermalick.com

The market has been more volatile in 2014 than last year.  When markets get rocky, many investors look for fancy products to “hedge” their risk.  The reality though is that high-quality bonds are the cheapest and most effective hedge available.

Since the start of the year, the Barclays Aggregate Bond Index (blue line) has been relatively stable and has proved a nice diversifier to the Standard and Poor’s 500 Stock Index (green line).



Over a longer time period, for example the ten years from 2004 through 2013, both stocks and bonds performed well.  Equities (blue line) and fixed income (orange line) returned 7.4% and 6.1%, respectively, compounded annually.  However, as the chart below demonstrates, when stocks did well, bonds tended to lag and vice versa.  And in this example from Morningstar, systematic rebalancing caused a portfolio of half stocks and half bonds (gray line) to actually outperform either individual asset class with less volatility.



Because interest rates are so low, some investors think bonds are a lousy investment.  But while bonds may have limited long-term return potential, they are still a terrific hedge against market volatility.

Fidelity Investments studied a rising interest rate environment from 1941 to 1981 and found that by adding 20% bonds to an all-equity portfolio, volatility dropped by over 20% (standard deviation went from 14% to 11%), while returns fell by less than 10% (annualized total return went from 11% to 10%).

In other words, even when bonds seem like a poor investment on a standalone basis, they can be a smart holding in a portfolio context.  For this reason, it pays to be disciplined about rebalancing.

UPDATE: An Emerging Emergency?

By Matt Malick and Ben Atwater


Stocks were pummeled last week.  Or at least it felt that way.  Given the low volatility and high returns we saw in 2013, this week felt particularly grave.  The S&P 500 fell 2.6%, while the Dow Jones Industrial Average lost approximately 3.5%, its biggest drop since 2012.

The crisis du jour lies in emerging markets.  A Bloomberg gauge tracking 20 emerging market currencies hit its lowest level since April 2009; the index has tumbled almost 10% in the past year, the biggest annual decline since 2008.

More specifically, South Africa’s rand is at its lowest level since 2008, Brazil’s real fell to a five month low and has lost 28% in two years, the Argentine peso is at levels unseen since 2002, the Turkish lira set a record low and Ukraine’s hryvnia is the weakest it has been since 2009 amid violent protests.

After logging a relatively rotten year in 2013, emerging market equities are showing signs of a complete breakdown, losing more than 5% so far in 2014.  As you know, we do not have direct exposure to emerging market stocks, a conscious and, so far, wise decision.

More than $940 billion has been erased from the value of emerging market stocks since the United States Federal Reserve signaled in May the potential to curb its easing policy.  Fund tracker EPFR estimates emerging equity and bond funds have seen outflows of $5 billion this year and nearly $60 billion since the beginning of 2013.  Presently, there is a significant flight of capital from emerging market assets.

Whether or not U.S. equities can continue to withstand a meaningful correction in emerging markets remains to be seen.  Another question on our minds is when we might see a buying opportunity in emerging markets.

For now, the benchmark Standard and Poor’s 500 Index has fallen below its 50-day moving average, which is a poor technical indicator going forward.  Interestingly, though, the S&P is still just 3% below its record closing high.

One bit of good news, of the 122 S&P 500 constituents that have released earnings so far this season, 74% have beaten earnings estimates, while 67% have exceeded sales projections, according to Bloomberg.  The reason we own individual stocks is because the fundamental health of the underlying businesses is the only thing that ultimately matters in the long-term.  The current emerging markets “crisis” is merely a noisy short-term problem.