Archive for Economy

Third Quarter Review – Weekly Update October 9, 2017 Recommended by Paul Ferraresi

2016 Election and the Stock Market

People have been calling me and cornering me at social events asking:

“What will happen to the stock market after the election”? In the short run of a day or a week there may be a bit of an adjustment. The real issue is the next four years.

Avoiding any political statements I address this strictly from an economic stand point and as a business owner. Unfortunately, I find most Americans cannot connect the dots when economic policies are presented.

Let’s examine things in light of Economics 101. What moves stock prices? Answer: Earnings (or some call it profits). As a simple example lets say we want to buy a “pizza shop.” The present owner has been earning (making a profit) of $100,000 per year. Lets say the profit equates to “cash profit.” Assume there are 100,000 shares outstanding so the pizza shop’s earnings per share are $1 each ($100,000 profit divided by 100,000 shares). A general rule of thumb is that one would pay about 4 – 5 times earnings (or profits) for a small business like the pizza shop. This is known as the PE ratio or the price earnings ratio. In our case that would equate to a selling price of $400,000 – $500,000. Thus, without changing anything and earning the same $100,000 per year, we, as the next owners, could get a return on investment in 4 – 5 years, or, in other words we are demanding a 20% – 25% annual return (simply divide the selling price $400,000 – $500,000 by the $100,000 profit to get the return number). The present owner would be selling each of the 100,000 shares to us at $4 – $5 per share ($400,000 – $500,000 sale price divided by 100,000 shares).

Now let’s assume after we buy the pizza shop we institute some changes, i.e., getting discounts for buying in larger quantities, teaching employees to be more productive or adding technology so we are able to now earn $200,000 in profit after tax in the next year.

What are some of the outcomes of our changes and hard work: (1) With higher profits more in taxes now go to the government. We see the need to begin advertising since we can now handle more business so the advertising company hires more people (who pay income taxes) to handle our account. We also hire more people to handle the anticipated new business (and the new employees pay income taxes). We ask for more products from our vendors they do the same and so forth and so on. This is known as the multiplier effect. By the way I am not advocating a love of taxes but rather showing the outcome of a growing business and economy. So, with Adam Smith’s “Invisible Hand” principal more people are working, which means they are off the Government dole, more taxes are flowing into the Treasury and more of our new customers are happy.

As a side bar, since our business is now making $200,000 per year (or $2 per share on 100,000 shares) the next buyer would be willing to pay us between $800,000 and $1 million or $8 – $10 per share under the classic 4 – 5 times price earnings multiplier. If we decide to sell the business we would owe taxes on the difference between the selling price of $1 million and what we paid originally of $500,000. So, it is the INCREASE IN EARNINGS that push up the stock prices. By the way the P/E ratio for the S&P 500 has averaged around 12 – 13 times since large companies are more stable and you would demand lower rates of return. I am using a small business example to explain the concepts. Keep in mind the companies that make up the stock market act similarly in concept to this small pizza shop.

Here is a major input to help you understand companies and the stock market. If you took all the companies in the U.S. from the small pizza shops, to grocery stores to Apple computer and added up their profits, the average profit for all the companies in the U.S. comes out around 4.8% (before tax). Yes, it is not the gigantic number people think exists. Grocery stores work on 1% profit while the “sin” companies like alcohol, tobacco etc. have much higher profit margins.

As any business owner, just like any employee, I want to maintain my income (earnings) and lifestyle. Let’s say we are able to maintain the earnings or income of $200,000 per year (or $2 per share) as noted above.

Next, let’s say my expenses skyrocket overnight because the government imposes higher income taxes on our profits, imposes costly new regulations and forces me to buy expensive health care insurance for employees. So, without any change in sales, expenses have gone up and my profits drop back down to the original $100,000. Please keep in mind it is not just our pizza shop that is hit this way. The advertising agency and all of our vendors are hit the same way plus all the other companies in the U.S.

So to maintain our lifestyles we have 3 options: (1) Raise prices, which will make us uncompetitive and is purely inflationary. (2) Cut costs by laying off employees which will restore our profits and lifestyle and make our employees miserable, or, (3) shut down the business. In all 3 options the Government will lose tax revenue and many people lose their jobs who now become a burden on society again by going back on the Government dole. How about selling the business? Well at $100,000 in profits we might get our original money back of $400,000 to $500,000 but the new potential owner has looked at our books and seen profits dropping plus costs going up, so I doubt we can get our money back in a sale.

Who loses here: The Government, employees and entrepreneurs.

Remember small businesses produce 70% of all new jobs created in the U.S. In the past year, for the first time in U.S. history, more small business are shutting down each month than are opening. Tragic!!
Small businesses are just a reflection of large businesses that make up the stock market.

Are you connecting the dots yet?

I hope you have the answer after this long winded explanation of what will happen to your wealth in the stock market after the election.

One candidate wants to (1) lower taxes on business (we have the highest corporate tax rate in the world. That is why many companies are leaving the U.S. and we lose jobs). Every time the Government reduces tax rates more tax revenue is generated. (2) This same candidate wants to reduce costly regulations that stifle the ability to start and maintain a business. (3) This same candidate wants to revamp the out of control costs to business of Obamacare. If this candidate can do this, it will lead to an explosion upward in business growth, employment, tax revenue and the stock market going through the roof which means your wealth will skyrocket.

Who wins here: The Government, employees, entrepreneurs and society as a whole.

The other candidate wants to increase taxes, regulations and health care costs.

This simple article has only covered a few policies that are on the table that separate the candidates. My desire was to answer the question on what will happen to the stock market.

Well, I hope you now can calculate and understand where the stock market will be in the next 1 – 4 years based on who wins the election.

In the great words of Mayor Daly……

“Vote early and vote often.”

Progressive Policies

Most people do not connect the dots in life especially when it comes to economics. A politician with a “gift for gab” can convince people that the benefits of a new program can be helpful to them today. Few people actually think through the ramifications. Liberal “progressive” socialistic thinking has decimated every country in the world that communism ever touched. In the U.S. we have had over 50 years of liberal progressive policies slowly pushed into our lives which has created countless problems. The majority of people that view today’s problems just think that these problems were created out of thin air.

Martin Conrad wrote an insightful piece in the March 23, 2015 issue of Barron’s, 50 Years of “Progress”. I urge you to read this and reflect on what these policies have done in your life. The next time a “progressive” politician proposes a new “no cost to you but a life time benefit for you”, well you may vote differently. My favorite line is: “Be careful of the person who vows to take care of you, for soon your care taker will be your jailer”.

Gold Looking Forward

The halcyon days for gold in the late 1970s were distinguished by soaring inflation and double-digit interest rates, both of which are conspicuously absent. Geopolitical upheaval around the globe is an obvious analog to that period, but now it has had the effect of pushing the dollar higher-ironic, given the low esteem in which the U.S. is held in much of the world.

Massive Fed money printing has totally failed to produce the inflation that was widely predicted. In fact, Ed Yardeni Research, posits that QE ironically has had a deflationary, rather than inflationary, impact.

Much of the abundant, cheap Fed-created credit has gone to finance projects to expand supply, not just demand. For instance, expectations of booming demand for commodities, in part from China, spurred expansion of supplies. In addition, opportunities in U.S. oil production made possible by hydraulic fracturing and easily available financing in the junk-bond market, helped spur the shale boom. Along with globalization, these supply-side boosts have kept a cap on prices of tradable goods.

At the same time, the Fed’s simulative policies were supposed to mean an inevitable rise in interest rates. But nearly six years after the Bernanke Fed cut its key short-term rate to virtually zero, it’s still there. The near-universal prediction is that the liftoff will take place next year.

The Treasury securities market doesn’t see signs of inflation. Each time the Fed talks about raising short-term rates, the inflation premium in long-term government bond yields comes down.

Long-term bond yields should remain low as a result, which should underpin the stock market. Lower-risk stocks that act like bonds, such as utilities and health care, should do best, with lower bond yields, rather than market expectations of higher future earnings.
Based on our recent history, a period of low inflation, near-zero interest rates, and sluggish growth would seem an incongruous time for gold to shine. Gold, after all, is supposed to be an inflation hedge.

But there is a precedent for the metal to act well in a disinflationary or deflationary period: the 1930s, when countries devalued to gain global markets. So, with central banks printing money like never before, maybe it really isn’t so different this time.

Ring in the Old

This is an excerpt from an article in Barron’s, October 6, 2014, by Thomas Dolan.

Happy New Year? Cries of joy and good cheer did not ring out Wednesday, when the U.S. government closed out fiscal 2014 and opened the books on fiscal 2015. There was little to celebrate, except that it’s over.

If you wonder why the U.S. government cannot control its finances, you can use the Brookings Institution’s new Fiscal Barometer, a product of its Hutchins Center on Fiscal and Monetary Policy. In the past 12 months:

    • Individual and payroll tax collections were up 7.5%, to $2.394 trillion.
    • Corporate and other collections rose 13.1%, to $570 billion.
    • Defense spending shrank 4.9%, to $580 billion.
    • Social Security benefits grew 4.5%, to $836 billion.
    • Medicare benefits paid by the federal government rose 2.1%, to $487 billion.
    • Medicaid benefits paid by the federal government grew 11.4%, to $294 billion.
    • Interest on the public debit climbed 5.4%, to $271 billion.
    • Federal spending on everything else, from foreign aid to welfare to bureaucrats’ paper clips, advanced 0.6%, to $1.013 trillion.

Total receipts were up 8.5%, to $2.965 trillion, while total outlays rose 1.0%, to $3.481 trillion. In the same period, GDP was expanding at an annual clip of about 2.6%.

What this means is that the federal government can regain control of its fiscal affairs. In the three places where Congress and the president have chosen to fight deficit spending, they have succeeded. Thanks to the much-derided sequester, tax receipts are up, defense spending is down, and the discretionary cost of general government is rising much more slowly than the economy.

But in mandatory spending, or entitlements, the government has tied its own hands. These programs roll along upward without serious review. When all is said and done, a succession of Congresses and presidents of both parties have refused to make changes to spending programs that constitute more than half of the federal budget.

And American attitudes about the national debt are changing. As William Gale of Brookings recently observed, “It is interesting that many people who thought former U.S. President George W. Bush’s agenda was unaffordable back when the debt-to-GDP ratio was half as big as it is now, feel that a ratio of 74% is nothing to worry about even though the debt is predicted to rise further.

People who complain about the sluggish economic recovery are giving more power to the elected officials and popular economist who call for more spending, more borrowing, and more stimulus. Such policies actually produce the illusion of economic growth, just as a dead frog’s legs twitched when Luigi Galvani applied an electric current to its muscles.