A Word on Price-Earnings Multiples

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An avid reader recently asked a two-part question: Why do investors put so much store in a stock’s P-E (price-earnings) multiple and is the ratio as reliable an indicator as many professionals suggest? The short answers are: 1) P-E ratios are extremely helpful in comparing investment choices.  2) They are reliable but only in context.  I will explain.

Why This Particular Ratio 

This indicator is a simple calculation that divides the stock’s current price per share by its annual earnings per share.  Because it tells the investor how much earnings he gets for a given investment, it’s extremely handy when comparing one stock to another, even if they are in very different businesses.

The ratio has its roots in an old investment rule-of-thumb that dates back into the mists of time.  Long before there were organized stock markets, merchants would assess the merits of a business opportunity by estimating how long it would take to earn back their original investment.  If someone offered them, say, one twentieth of their business for an investment of a certain amount, they would immediately ask how much the business earned during the last year.  With that information, they could calculate how many years it would take for them to earn back their initial investment, after which time the deal would be pure profit for them.  The shorter the earn back period, the more attractive the deal, all else being equal. The calculation also offered an easy metric for comparisons to other deals.  If another business owner offered them a share that would pay back in less time, it would (all else being equal) be more attractive.  The P-E ratio gives the same information.

Another way to look at the P-E multiple is to turn it on its head.  The upside down ratio, instead of telling you how many years’ earnings you must pay for a share, tells you the earnings as a rate of return on the initial investment. A P-E ratio of 20, for instance, pays you one twentieth of your investment every year or 5 percent. Expressing things as a percentage not only allows comparisons to other stocks, but it also enables the investor to compare a prospective stock investment to the yields on bonds and interest rates paid on deposits.

Kinds of Multiples

 Whether presented right side up or upside down, there are more than one kind of P-E multiple.  Some investors prefer to measure the price relative to the previous year’s earnings. They argue that those earnings are definite and involve no dubious estimations.  Others construct the ratio using the current year’s earnings, claiming that these are more up to date and only involve estimates for that part of the year not yet done.  Still other investors prefer to make the comparison with estimates for next year’s earning.  This approach has the drawback of being a pure estimate, but future earnings, after all, are what you are buying.

There is an additional consideration.  The number of shares in the market today may differ from the number going forward.  The company might buy back shares, holding them as what are called “treasury shares” and thereby reducing the number of shares available for purchase in the open market.  The company could also sell additional shares, and so increase the number available for purchase.  Buyers are seldom in the know of such plans. They can, however, know about options outstanding.  These enable others (often executives of the company) to buy newly created shares directly from the firm.  Such potential purchases can often significantly change P-E calculations, and it is something that any P-E calculation should take into consideration.  In cases where multiples appropriately account for the potential of conversions from options into shares, the calculation is said to be fully diluted.

Is the P-E Multiple Reliable? 

Yes, but only up to a point.  A company with rapid earnings growth will in time give shareholders claims on much more earnings than in the year they bought the stock.  Such stocks can remain attractive even though they have a much higher P-E multiple than companies with slower-growing earnings.  For example, an exciting technology company may look more attractive than a utility even if the stock on that technology company carries (to use financial jargon) a higher P-E multiple.  Similarly, a company dominating a secure industry offers greater security about future earnings than a small player in an uncertain industry, making it more attractive even if it carries a higher price-earnings ratio.  These assessments put price-earnings ratios into necessary context before the investor makes a decision.  To do justice to the information provided by these ratios, the investor must also add considerations of competition, the quality of management––indeed, the whole array of issues involved in securities analysis.

Is the Fed Going to Cut Interest Rates?

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Federal Reserve Board (Fed) Chairman Jerome H. Powell announced on June 4 that the central bank is prepared to sustain an economic expansion should the trade dispute with China weaken the economy.  Market participants read into his remarks an intention to cut interest rates, and enthusiasm over the prospect generated enough buying action to move the markets up smartly.  Of course the Fed never made such a promise, nor is it ever likely to do so.  Thus the market’s response, set against the Fed’s cautious words, raises two questions for any investor:

  1. What is the Fed actually planning?
  2. Over what time period will the policy change develop?

Question 1: If and when the Fed acts, it will do so with a rate cut, but otherwise, matters are far from definite.  Powell has not promised a rate cut, but neither has he taken one off the table.

Powell has been equivocal for good reason.  The Fed cannot forecast its policy moves: doing so would create major risk by inviting market participants to base their trading decisions entirely on that forecast.  As well, the Fed cannot forecast any better than anyone else, and Powell and his policy team know that.  If the Fed were to forecast one way and then see unanticipated conditions develop, it would have to change its plans, and even if it did so in a minor way, everyone in the market would have to adjust almost simultaneously.  The consequent disruption would be huge. It’s better that the Fed keeps its (always tentative) plans secret, so that market participants settle on a variety of positions.  Then, should the Fed have to shift policy, not everyone would have to change.

With this constraint in mind, a natural question would be: “Why say anything?”  And usually, the Fed refuses to speak.  But in the present environment, Chairman Powell probably had two reasons to make a statement.

First he could see that market participants were worried about the negative effects of the U.S.-China trade dispute.  Even if that dispute ends with a favorable trade deal, worries during the run-up to such a deal could itself do economic harm.  Not only has it depressed the stock market until recently, but if concerns become more widespread, they could dissuade consumers from spending and, more significantly, convince businesses to hold back on hiring and expansion plans.  The economy itself could falter from this negative psychology, creating a self-fulfilling prophecy of economic trouble.

The second reason is that Powell and his Fed team have no idea how long the trade dispute will drag on.  They, too, must share concern about the extent of the trade dispute’s economic ramifications.  They want the country to know they are not asleep at the switch, but at the same time they cannot know if, or when, they will have to respond.  This brings us to the second question –– over what period of time will a change in Fed policy occur?

Question 2:  Here, too, the answer is frustratingly vague.  The Fed cannot know if it will have to shift policy, or when it will have to do so: All will depend on the flow of economic data. Signs of economic weakness — whether caused by trade disputes or by worries over the trade disputes — will prompt a Fed reaction, one that would almost certainly involve an interest rate cut, probably of modest size, at least initially.  For now, the balance of economic data looks pretty good.  The first quarter’s real growth was strong, so even in the face of a sudden weakening, the Fed would likely hold off acting until it was convinced that the new, weaker picture was real and not just some quirk in the data. Indeed, if history is any guide, the Fed would likely wait for 2-3 months data before acting, because a premature policy move can cause far more harm than a delayed one.  This would mean that if suddenly in June the data turned weak, a rate cut would likely wait until the fourth quarter, and each month that shows signs of strength would delay such a cut accordingly.

A Last Word

 Fed policy on raising or lowering interest rates is a frustratingly uncertain process, and many have expressed their disapproval of how those in charge proceed in such matters.  But the Fed’s process leads less to a decision based on its preferences than on a recognition of this reality: the Fed cannot forecast, and in this moment’s case either the direction of trade negotiations or their likely economic effects, and that a false move by the Fed would do more harm than a month or two of delay.  The Fed’s process is one of necessary prudence.

Facebook: “Breaking Up is Hard to Do” In Some Industries, But Not This One

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The fuss over Facebook offers lessons about the abuses of monopoly power and how best to avoid them.  The authorities have two options: (1) force breakups, thereby inviting competition to discipline bad behavior, or (2) regulate the monopolies and thus guard directly against abuses.  A third approach might use a combination of both, which is probably what is necessary for the monster that is Facebook.

Facebook clearly holds a monopoly position, or as close to one as a company can get.  It earns fully 80 percent of the world’s social network revenues.  Though it may have thus far avoided the historical associations of monopoly — price gouging and the abuse of employees – Facebook has certainly abused its customers’ trust and privacy, and that in itself should be enough for a call to action.  Recently the matter has come up dramatically when Chris Hughes, one of Facebook’s founders, characterized the firm’s power as “unprecedented and un-American,” and described Facebook CEO Mark Zuckerberg as all-powerful within the company.  According to Hughes, Zuckerberg and Facebook, are “unaccountable,” particularly on questions of “privacy and election interference.”  He wants Washington to impose regulations on the social network industry and break up Facebook.

Hughes has a point.  Unlike some businesses, competition would offer a lasting discipline with social media.  The crucial issue is the cost of entry into the business.  When it is reasonable, as with social media, competition can persist after a breakup.  Problems arise only when costs of entry are high.  In such cases, the industry itself has a persistent natural tendency toward monopoly.  Take electric utilities.  In that industry, firms must construct generating equipment, string wires, and connect to homes and businesses before they can ever earn a dime. Airlines are another example.  These firms have to buy planes, build maintenance facilities, and contract for terminal space in many cities before making money.  To spread these fixed, up-front costs over as many paying customers as possible the firms present in the industry will undercut each other ruthlessly and keep doing so until most of the competition is driven out of business.  The remaining firm (or firms) then has no difficulty raising prices and improving profitability.   If government were to impose a breakup on such “natural monopolies,” it would only invite another round of vicious price-cutting that would continue until a new monopoly forms.  In such cases, breaking up is indeed hard to do.

This fact of economic life is why government is best advised to count on regulation instead of the discipline of competition to keep such industries from engaging in abuse.  Rather than fight this natural tendency, government tolerates the presence of a single firm in the market, but insists on pricing guidelines and standards of service.  Just about all power and electric utilities work this way.

The problem has become clear since the breakup of AT&T in the 1980s.  Right after the breakup was ordered, the rump of the original monopoly and all the so-called “baby bells” would seem to have offered adequate competition.  But the undercutting stated almost immediately and over time the number of firms in the industry has shrunk from what it looked like right after the breakup.  The pattern will doubtless continue until there is only one or a handful of companies, what we call an oligopoly.  Then, in reaction, it is likely that more regulation will return.  Similarly, the competition unleashed among airlines when the industry was deregulated in the 1970s has in time reduced the number of firms in the industry to an oligopoly in which most cities in the country have only one carrier servicing them.  Because breakups in such industries naturally devolve into monopoly or oligopoly, regulation is required to maintain competitive discipline.

This is not the situation with social media and other Internet applications. Forcing break-ups to increase competition might offer a lasting way to alleviate today’s abuses.  The industry has none of the natural barriers to entry that exist in, say, the prodigious cost of constructing a utility network.  If people had more choices, customers who resent the abuse of privacy so apparent with Facebook could simply switch to a competitor’s platform.  Indeed, competitors could market themselves on their reputation for privacy protections. Given the ease with which customers could switch, the slightest hint of impropriety could destroy a firm.  This fear inspires firms like Facebook to gobble up clever new players before they turn into formidable competitors.

No doubt, Facebook CEO Zuckerberg realizes such dangers to his firm’s position, which is why he has made pleas for regulation instead of a break-up.  With regulation, he knows he will retain a measure of control –– which he would lose in a truly competitive environment.  Zuckerberg of course would prefer to go on as he has, peddling his Facebook’s clients’ information and gobbling up smaller firms.  But because that is no longer in the cards, he sees regulation less as a potential check on his behavior than as a way to maintain control of the process. He and his colleagues in the world of social networks know that the new regulators would have to work with those established in the industry to set the standards, because only the established players have the necessary expertise to write the new rules.  This kind of “consultation” has always been the case in the past when industries have come under regulation. Though not all those new rules would necessarily please Facebook, they would suit it better than if another firm pointed up Zuckerberg’s abuses and making the case that it would run a more respectful platform than Facebook.

Even more appealing to Zuckerberg is that new regulations imposed by Washington would make it more difficult for new social media companies to establish themselves; the new rules would in fact raise the cost of entry and help make the social network industry a natural monopoly, in which case Facebook would need trouble itself less about competitors than it would have in the past.  The regulators would effectively protect Facebook, if inadvertently.

But if more competition would do much to correct the abuses of Facebook and other Internet giants, regulation still may have a role to play.  So much in these companies happens behind what is for most of us an impenetrable curtain of technology.  A regulatory review, such as when the Securities Exchange Commission (SEC) or the Federal Reserve examines a financial firm, could presumably lift the technology curtain in ways even an investigative journalist could not.

So it seems that a combination of breakup and regulation would best serve to overcome these abuses.  Consumers could go where reputations are best. Regulators, by peering behind the technological curtain, would uncover abuses that might have remained disguised or hidden, or the regulators could scotch false rumors of abuse. The social media industry would still have its problems, but the dominance and the abuses that it invites and that Facebook seems to have engaged in, would, if not disappear, at least impose on us less.

 

 

 

 

On Calling the Next Recession

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Earlier this year, fears of an economic recession became widespread, largely driven by investor wariness of what is termed an “inversion”in the yield curve.  A long-standing Wall Street rule of thumb holds that when the yields offered by long-term bonds give up the typical premium they hold over interest rates on shorter-term instruments, a recession is on the way.  And that narrowing of the premium happened.  The spread between the yields on 10-year treasury notes and 1-year treasury paper shrank during that time from 75 basis points (that is, seventy-five hundredths of one percentage point) to only 15 basis points (fifteen hundredths of one percentage point).  But before simply accepting this common perception, it pays to have a look at how reliable this yield curve signal has been in the past.  The results are mixed.

Inversions have given false signals on a number of occasions.  In 1995 the yields on 10-year treasuries suddenly lost the premium they had over 1-year treasuries.  That was six years before the 2001-02 recession, so we cannot count it as an early warning, especially because spreads widened again during the intervening period.  In 1998, the yield curve inverted for a few months, and for some weeks the 10-year treasury yield fell below the 1-year yield.  But then the “normal” upward sloping curve returned in 1999.  A clear recession signal had to wait until 2000, when for a number of months the 10-year yield fell more than 50 basis points below the 1-year yield before the mild 2001-02 recession took hold.

The first hint of an inversion in this century came in early 2006, and some might consider it a very early warning of the Great Recession (as it is now remembered) of 2008-09.  But that would be a stretch.  For one thing, the yield curve by the middle of 2006 had returned to its normal upward slope.  It then reverted to an inversion later in 2006 and early 2007, only to resume its upward slope later in 2007, and it continued to get steeper into 2008, when the 10-year yield stood fully 100 basis points above the 1-year yield.  That can hardly be called consistent signaling.  Indeed, using those statistics, observers relying on the yield curve signal would have been calling an “all clear” just before the 2008-09 great recession began.  And, indeed, some did.

The yield curve offered far clearer signals during the last two decades of the twentieth century.  Strong and persistent inversions predated the 1990-91 recession as well as recessions in 1980 and 1981-82.  But if we look further back, the record again becomes spotty.  Inversions in 1969 and 1973 did signal the recessions of respectively 1970-71 and 1974-75, but an inversion in 1966 saw no following recession.  Even if one were to make the dubious claim that it was a very early indicator of the recession that did develop four years later, it still would not explain why the yield curve assumed its normal upward slope in those intervening four years.

While this uneven history may offer evidence that yield curve inversions provide a worthy signal, the record also suggests that the investor use such signals with care.  Helpful here may be research by the Federal Reserve Bank (Fed) of St. Louis, which has looked back at some 60 years of economic cycles.  The Bank found guidance in its research for interpreting the yield curve.  It also uncovered other indicators to improve forecasting by offering a verification of the yield curve signal. Regarding the yield curve itself, the Bank found that inversions must persist if they are to give a clear signal, and that even when they do, a recession takes, on average, 10-18 months to develop.  For verification, the Fed researchers recommend three checks:

First is the number of building permits for new houses.  It can confirm a recessionary signal from yield curve inversions with the same average 10-18 month lead-time.  In the current environment, these data (despite the first quarter’s overall economic strength) seem to suggest at least a tentative conformation of a recessionary signal. Permits for new construction rose a slight 0.6% from March to April, the most recent month for which data are available, but the April figure is 5.0% lower than April a year ago.  However, permit requests are also up almost 3.8% from the lows of last August, which might indicate that the dip was less a cyclical sign than simply the inevitable fluctuation of building permits from month to month and quarter to quarter.

Second, the Fed’s economists identified employment in construction as another verifier of the yield curve’s recessionary signal.  But at the moment, the reading is hardly recessionary.  For April, the Labor Department reported that the U.S. employed 7,486,000 people in construction, up 3.5% from April 2018, and a steady, if slow, rise for 2019 so far.  This picture, however, does not entirely contradict recessionary readings, because, on average, this indicator lags some months after the yield curve inverts before offering a confirmation of coming economic trouble.  This same lag also is true with the third confirming indicator uncovered by the Fed analysts: manufacturing employment.  The Labor Department indicates 12,838,000 people working in manufacturing in April, up about 1.6% from April 2018, and this too at a steady if slow pace so far in 2019.  Here as well it is hard to make a call for a recession but from a strict reading of the averages, it is also impossible to dismiss a recession out of hand.

On these bases, one cannot dismiss the recent spate of recession forecasts. They do, however, seem premature. And even if –– despite the tentative evidence available so far –– the flattened yield curve really is giving a signal for recession, the averages indicate that the slide in real economic activity would only begin to emerge by the turn of the year at the earliest and would likely not gain force until summer 2020.  Though only a fool would bet on such a forecast at this stage, there are enough straws in the wind to make it worthwhile to watch the indicators offered by the St. Louis Fed carefully for a confirming sign.

 

Ethical Investing

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This is, of course, an ambiguous phrase.  It could refer to how diligently professional investors do their duty to clients, in which case it would mean staying within the guidelines imposed by the client while using every legal means to obtain the highest return for the least risk.  But these days, as in other times in the past, “ethical investing” means choosing investments that further some social or moral purpose, possibly forgoing returns to promote certain corporate or national policies or to punish undesirable behavior.  For instance, investors who disapprove of Israeli policies might exclude investments in that country from their portfolio.  Others, concerned about the fate of human civilization, might emphasize investments deemed to benefit the environment while excluding those they feel would harm it.  Millennials, especially, seem to favor such approaches, though they are not the only ones pursuing social and ethical investing.

Approaches to ethical investing have grown in recent years.  I won’t go through them here, nor will I judge them from either a moral or an investment perspective.  However, there are two investment implications that deserve attention here: one concerns portfolio distortions; the other, fiduciary considerations.

Distortions

These require a recognition of the biases such investing will build into a portfolio and consequently into its performance.  Most investing, especially when done by professionals, measures success relative to an investment index that includes the relevant universe of assets available to an investor for purchase –– what professionals refer to as a “benchmark,” or “bogy.”  With American stocks, that benchmark is often the S&P 500 Stock Index, which includes the 500 largest corporations in the country, with representatives in just about every industry.  There are broader indexes for American stocks that include smaller companies, global indexes, indexes for other countries, and indexes for regions, say Europe or Asia or emerging markets. Investors can say they have added value to their portfolio if they can produce for their clients a higher return than the relevant index, “outperform” it, to use financial jargon.  When, for ethical reasons, an investor excludes certain stocks that are otherwise in the index, or chooses to emphasize others, the portfolio’s performance will deviate from the benchmark for reasons that have nothing to do with the stock’s possible gain or risk.

Some years ago ethical investing excluded stocks of companies that did business in South Africa (as some investors do today with Israel), and the consequent distortions were huge.  These ethical portfolios could not buy any major oil company or any major auto manufacturer.  They could not own shares in most machinery or appliance producers, defense contractors, and many retailers –– the list was long.  Some portfolio managers bought smaller companies to maintain involvement with industries otherwise excluded, but investing in small companies to replace large ones introduced other distortions.  When some or all of these excluded stocks did well, the ethical portfolios trailed their respective benchmarks.  When these excluded stocks did poorly, the ethical portfolios outperformed their benchmarks.  But neither difference had anything to do with investment management abilities.  It was entirely an accident imposed by excluding South Africa.

Similar distortions are present in more contemporary ethical concerns.  For instance a preference for renewable energy or electric cars would render a portfolio extremely sensitive to fluctuations in oil prices –– perhaps even more so than one with an overweighting in major oil companies.  Though renewables and electric vehicles are an alternative to fossil fuels, their business prospects nonetheless rise when oil becomes more expensive and the public seeks alternatives, and fall just as dramatically when gasoline and fuel oil become more affordable.  Some investors, though eager to support renewables, feel uncomfortable with this exaggerated sensitivity to oil prices.  They might exclude oil companies from their holdings in order to blunt the volatility.  Such a decision might also fit with the ethical convictions built into the portfolio.  Whatever the individual tolerances for volatility or available investing offsets, investors wanting to pursue such ethical mandates need to know these implications.

Distortions can affect portfolios that exclude Israel or defense issues or timber production or any of a host of corporations that might bear, favorable or unfavorably, on ethical implications.  With each decision, investors must consider the potential effects on their portfolios and whether the proposed ethical stand is worth it to them.  The decision may involve soul searching about the extent of their conviction.  For those who invest on another’s behalf, especially professional investors, there is also a fiduciary consideration.

Fiduciary Concerns   

 Anyone who invests for others carries a measure of fiduciary responsibility to do the best they can at the least financial risk while also considering the preferences, tolerances, and objectives of those on whose behalf they are investing.  The law is explicit about who is a fiduciary, but the responsibility devolves to anyone thus involved.  This, too, involves ethics.  If you informally advise family and friends, your legal responsibility is limited, but your moral responsibility remains.  Your legal responsibility grows when you are paid for advice, and especially when arrangements empower you to buy and sell on another’s behalf.

If “clients” –– whether formal clients of a broker, or just friends and family to whom you’re giving advice –– have not brought up special ethical considerations, then it’s best to proceed without regard to your own personal convictions.  If they have expressed ethical considerations, have them state them as explicitly as possible:  Put them in writing.  This will protect you from blame or lawsuit if the “ethical portfolio” disappoints.  Having the client’s considerations in writing will also guide your professional investing decisions, keeping in mind that an ethical overlay on a portfolio is not in the professional investment manager’s area of expertise.  For example, if someone wants to punish Israel for its policies, find out if they want simply to avoid investing in Israel or if they want also to avoid corporations from other countries that do business in Israel.  If the client wants to buy “green” stocks, make sure the word “green” is well defined.  You don’t want to buy timber because it is a renewable energy source only to discover that your client wants nothing to do with any activity that cuts down trees. It would also be useful for you to brief the client on the possible distortions involved.  You should document that briefing as well.

A perfect example of the potential troubles surrounding ethical investing involves South Africa during its apartheid era, when the boycotts of that country in the 1980s led many U.S. foundations and municipalities to impose restrictions on their investment managers.  Because foundations usually have boards that are both in control of the foundations and responsible for their actions, the choice to boycott seldom caused trouble, except for managers who had failed to alert the foundations ahead of time of how the restrictions could affect their portfolios’ relative performance.

With the municipalities, however, matters were more complex.  The pools of money that municipal politicians and bureaucrats control are usually funds set up to support pensions obligations.  When those in control imposed the ethical restriction (whether from conviction or to get votes) they had neither an easy way (nor a desire) to consult the beneficiaries of the pension schemes.  If the ethically imposed distortions benefitted the portfolio and it performed well against its benchmark, there was seldom a complaint.  But when the portfolio underperformed its benchmark, participants in these pension schemes sued, sometimes individually but usually as a class.  In every case the courts found against the municipalities. However admirable the municipalities’ ethical commitment, it imposed a hardship on those who had no say in the decision but whom those decision-makers were legally bound to protect.  The courts ordered that the municipalities involved make up the difference.  Then, of course, the taxpayers suffered, though they could not sue for compensation.

A Last Word

 As is so often the case with investing, every move imposes a risk, a potential cost.  When such a move, in this case an ethical one, results in serendipitous advantages, no one complains.  But the story is almost always different when the decision imposes costs.  Those investing, for themselves or as agents for others, owe it to all involved, investors and their clients, to strive to become fully aware of the implications of their decisions.

So What Is This Recent Rally About?

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It is interesting, as media reports suggest, that markets have done so well this year even as concerns over a global economic slowdown have intensified. Even more interesting is that media discussion of the rally interprets it from an entirely different perspective than it employed when it interpreted the market retreat during the fourth quarter of 2018.  Then, the economy seemed to be doing reasonably well.  Media commentary took the decline in stock prices as a sign that an economic slowdown was coming.  But now, with stock prices up, the media says nothing about it as a sign of an economic pickup.  Rather, it expresses bewilderment about market strength in the face of economic weakness.  Could it be, as the media treatments seem to imply, that the market was forward-looking last year but this year has abandoned that practice?  That inconsistency seems unlikely.  The market is always forward looking.  Isn’t it more likely that, contrary to the media’s treatment, the market has maintained a consistent perspective and that this year’s rally is forecasting a pickup in economic fortunes later this year?

In an earlier post, I explained the inherent pitfalls in how the media discusses economic and financial events.  This latest inconsistency should illustrate some of the points I made earlier.  Though I can’t know what will happen or even whether the rally will last (nor can anyone else), here are three interpretations that might explain recent events in a less mysterious manner than they have received in the media:

  1. The slowdown reported in the media is hardly the stuff to significantly sway investors’ perceptions of the future. The media referred to comments from the Federal Reserve (Fed) and the International Monetary Fund (IMF) about downgrading their forecasts for economic growth in the coming quarters.  The Fed relied mostly on language rather than on statistics and it made no mention of recession or abrupt economic developments. The IMF announced it had lowered its 2019 forecast of global economic growth to 3.3 percent from 3.5 percent that it made last January and from 3.7 percent it made last October.  These revised forecasts, while definitely on the downside, are well within the usual error attached to forecasts.
  2. The timing of these downgrades in global economic fortunes also seems significant. The Fed made its comments during the market retreat last year.  In fact, many media reports referenced the Fed’s more cautious outlook as reason for the market’s retreat.  The IMF made most of its downgraded revision during the month of December.  It is likely that the market –– always forward looking –– adjusted prices to a less robust 2019 in reaction to those forecasts made in 2018’s final quarter.  So, having already adjusted prices down to account for the economic slowdown, the market would hardly need to do so again as the outlook to which it had already adjusted itself became a reality.
  3. It is more likely the market has continued to look forward and now expects forecast upgrades. Indeed, recent weeks have brought news of upturns from areas as disparate as the American consumer and China’s industrial output, not a boom in either case, but an improvement over how the situation looked at the end of 2018. Japan remains stagnant and so does most of Europe, but this is hardly a change from the world to which market prices had already adjusted when they fell late last year.  Now that the market has priced valuations into reasonable ranges with last year’s adjustment, it has built on this limited positive news by pushing prices upward.

Though these explanations may not exhaust all interpretations of recent events, they do treat the retreat of late 2018 and the rally of early 2019 consistently, which is more than the media treatment has done. Keep in mind that because the rally has already responded to the news of some economic improvement, the ever-forward-looking market will need to see additional economic improvement to sustain its upward momentum.

 

 

Pertinent Questions

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I met recently with a group of business students.  Not surprisingly, we talked mostly about their careers and how they could best position themselves for the jobs they covet.  Four questions came up that belong in this blog.

  1. How does one secure a good track record managing equities?

There are a number of ways to manage stocks: some lean toward value, some toward growth, some are purely quantitative, some rely exclusively on human judgment, and some blend these elements.

For growth, the aim is to ferret out companies that are growing rapidly or, better yet, are about to experience a growth spurt. You buy their stock to enjoy the price increases that emerge from the growing market enthusiasm about the firm’s success.  You must always remain on top of the firm’s prospects and its stock price, because there will come a time when the market’s enthusiasm for the company outstrips reality, at which point, even if the company continues to do well, its stock price will languish or fall.  You must have the insight to recognize this moment and sell quickly –– boldly –– and put the money to work elsewhere before suffering the losses, absolute or relative to the other buys you could make.  Your insight must distinguish between a fundamental turn and the inevitable pauses that occur even as a stock climbs.  Therefore, growth management styles involve much trading –– turnover, in financial jargon.

Quantitative techniques have limited value for the growth approach.  You could devise a computer-based algorithm to identify fast-growing companies from a universe of stocks and perhaps even to assess whether the stock prices have kept up with that rapid growth.  Otherwise the effort involves a lot of research about why the company is growing fast and judgment about management, competition, and product offerings to determine whether that growth will last.  For those who have the skill and diligence, it can be very rewarding.

Quantitative techniques can have a larger role in the value approach.  The object here is to find stocks where the market has pegged the firm’s stock price beneath the company’s fundamental value.  The presumption is that at some point the market will wake up to its pricing mistake and price the stock upward accordingly.  This approach might lead to buying slow-growing, unexciting companies the market has neglected.  It might also involve a fast-growing firm for which the market has yet to wake up to its potential.  All sorts of computer-based algorithms can test for such valuation mistakes in the market. When I managed money professionally, I used one that assessed the earnings prospects of hundreds of companies, using what is called an earnings discount model to estimate the price they should sell at –– what in market jargon is called a fair value price.  That algorithm then compared the fair-value estimate to the actual market price and ranked stocks from those with the largest positive gap between fair value and the actual price –– the undervalued stocks –– to the smallest or negative gap (the over-valued stocks). In building a diversified portfolio, I would focus my research and analysis on those the algorithm identified as most attractively priced.

Whichever approach you take, you must stick with it over time.  The market can overlook value and fail to respond to growth for longer than you might feel comfortable with.  One is never always right, but if there is worth in the approach, it will only tell in the long run.  If you cannot stay the course for at least five years, you do not belong in stocks.  Choose bonds or bank deposits.

  1. If you were to become a professional portfolio manager and had a need to make your mark in less than a year, what approach would you use then?

The best approach then is to pray for luck. Luck is always a big part of investment success, but if you must make your mark in stocks in less than a year, luck is all you have.

  1. What about Bitcoin or some other cyber-currency? Do you think it would be good to have a global currency?

There was a time when the world did have one: gold. It worked for a long time, but it could not do so today for a number of reasons.  In theory, a substitute for traditional, nationally based currencies has appeal.  Bitcoin and other cyber-currencies have, however, failed in this regard.  They don’t have the stability that, among other things, is essential in a successful currency.  Cyber-currencies values have swung wildly relative to all major currencies (dollars, euros, yen, yuan etc.) and, most importantly, against goods and services in general. To take the place of dollars or any other currency, cyber-currencies must show more stability than these currencies do, not less.

  1. If you cannot buy a cyber-currency, what can you do if you expect dollar inflation?

You don’t need a global currency to protect yourself from dollar inflation, though a viable one would be convenient.  You can buy real estate, art –– things that hold real value when the dollar is losing value.  If you want an asset that gets priced every day, then buy gold or commodities.  Their prices swing up and down but they usually keep up with general prices levels, especially when inflation is a problem. Copper or zinc will work, too. They have in the past.

 

 

 

Pensions (Part Two)

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The last post describe the two basic sorts of pension plans, defined benefit (DB) and defined contribution (DC).  This second part digs down a bit into the DC area and the many different structures available there.  We start with the most widely used –– the 401(k) plan.

401(k) Plans

 Named for the 1980s law that established them, these plans take, for the purposes of investment, contributions from both employer and employee.  The law determines how  much can be put aside in this way.  Within limits, these plans also allow employees to add to them.  Some employers, in addition to their basic contribution, will match a portion of the additional savings that an employee elects to add.

One big appeal of these plans is their significant tax advantages.  The monies going into the plan on behalf of each employee do not count as taxable income.  What is more, the invested funds collect dividends, earn interest, and enjoy capital gains also free of tax.  When participants draw on the funds they will have to pay income tax on the withdrawals, but if they are already retired, the chances are they’ll have a lower tax rate then than when they were working.  These plans have a further tax advantage.  Normally, when a person sells a long-term holding, it has gained in price, creating a capital gains tax liability on the amount of that gain.  (For more on this subject, see this post.) But the monies in 401(k) plans are excused this tax when their contributors begin to liquidate their investments.

When employers set up such plans, they almost always do so with established investment firms where plan participants can choose from an array of investment products.  It is up to each participant to direct the investment of the funds, though many employers offer assistance in making these choices, as does this site. All plans give participants periodic opportunities to change their investment choices.

For all their advantages, 401(k) plans face a number of constraints. Participants must begin to draw down on the funds and pay taxes on those withdrawals no later than age 70½. Because they are meant for retirement, they impose a 10 percent tax penalty if the participant draws on the funds before age 59½.  There are, however, hardship exceptions to this rule.  The government will waive the 10 percent penalty if:

  • You have suffered a disability that makes it impossible for you to work;
  • You have significant medical expenses;
  • You face a court order to give the money to an ex-spouse or a dependent;
  • You take early retirement, but only after age 55;
  • You die and your beneficiaries collect the money.

Some plans will let you borrow against the value of what you have invested, but there are restrictions.  You can get help with specific questions from the 401(k) Help Center at www.401khelpcenter.com.

Individual Retirement Accounts (IRAs)

 If you are not in an employer-based retirement plan, you have the option of setting up a tax-advantaged individual retirement account for yourself.  (Actually, the law makes allowances for IRA contributions — though on a sliding scale –– even if you or your spouse participates in another pension plan.)  If you are married, you and your spouse can contribute to the same pool of investable money.  The law sets the maximum amount you and your spouse can put into the account.  These have the same benefits and restrictions as a 401(k) plan:

  • Every dollar put into the IRA reduces your taxable income.
  • You pay the taxes only when you begin to draw down on the funds in retirement, when, presumably, you will face a lower tax rate.
  • You pay no capital gains tax on your investments when you sell them.
  • You will pay a 10 percent tax penalty if you withdraw funds before age 59½ except under hardship conditions, as described earlier.
  • You must begin to draw down on the funds and pay taxes after age 70½.

Check with your accountant before setting up an IRA to find out exactly what restrictions apply to your particular circumstances.  The Internal Revenue Service offers help on its website, www.irs.gov.

You can open an IRA with any bank, broker, mutual fund company and many insurance firms.  The paperwork is simple and you have until April 15 (let’s say of 2020) to make the contribution for the previous year (that is, for 2019) –– although the IRA itself must be set up by Dec. 31 (of 2019).  Your investment choices are as wide as those offered to anyone doing business with the financial firm you choose.  If you were in a 401(k) plan at work and you lose your job or change employers, you can convert those 401(k) investments into an IRA, called an IRA rollover.  You set these up in the same way as a new IRA.

There is an alternative to these conventional IRA arrangements.  In 1997, Senator William Roth sponsored legislation establishing the Roth IRA.  Unlike a conventional IRA, a Roth offers no tax deduction for the funds you contribute.  To compensate, the Roth excuses tax on any monies you withdraw, including all investment income, interest, dividends, and capital gains.  As with a conventional IRA, there are limits on the amount you can set aside, but there is no 10 percent penalty if you withdraw funds early nor do you have to withdraw money after age 70½.  On the contrary, the law allows you to contribute to a Roth IRA forever and leave it there for your beneficiaries.

You can convert your conventional IRA to a Roth.  The firm handling your IRA can provide you with the necessary materials.  When you convert, you must pay tax on all the tax-deductible contributions you had previously made to the conventional IRA.  The same applies to IRA rollovers.  This tax liability can grow to significant size, especially if you have contributed to your conventional IRA for a long time.  See your accountant for how heavy this tax burden might be.

Simplified Employees Pension (SEP) Plans, Simple IRAs, and Keogh Plans

 There are three other options for tax-advantaged pension plans.  All are similar to 401(k)s and IRAs, but they are meant for the self-employed, for small firms, and for partnerships that otherwise might be unable to use a 401(k).  They are also much simpler to administer.

SEP arrangements are available to any self-employed person with a business that employs 25 people or less.  Unlike other plans, you can set up a SEP without setting up a corporation or LLC or any other corporate structure. If you qualify, you can contribute up to one-quarter of your salary, up to a stipulated amount, though the IRS might change these requirements from time to time.  These plans are similar to 401(k)s but have much lighter administration and reporting requirements.

The Simple IRA aims at firms with 100 employees or less.  Participants must earn a certain minimum salary, a figure that the IRS changes occasionally.  They can set aside a certain portion of their pay, which the IRS also reassesses these amounts from time to time.  This money is excused from taxable income.  Employers have two choices when setting up a simple IRA: (1) They can match the contributions made by participating employees up to 3 percent of their compensation, or (2) they can contribute for each employee, whether they agree to participate or not, up 2 percent of their compensation.  Otherwise, the rules are much like conventional 401(k) arrangements, except the penalty for early withdrawal is more onerous and presently stands at 25 percent.

Keogh arrangements aim at the self-employed and their business partners, whether part time or full time.  Even if you have a 401(k) for a salaried position elsewhere, you can establish a Keogh for that portion of your income that comes from self-employment.  A Keogh allows you to put aside up to a quarter of your income each year, up to a maximum that the IRS adjusts from time to time.  Generally, a Keogh allows larger contributions than either a conventional 401(k), an IRA, a simple IRA, or a SEP.  Otherwise, the rules are much like those of a conventional 401(k).

Financial institutions that work with conventional 401(k)s can make arrangements for any of these other plans.  The employer and the participants benefit if the employer sponsoring the Keogh pays the fees involved separately from the plan.  That way the plan avoids the burden and the cost counts as a tax-deductible business expense to the employer.

The 529 Funds for Education

 Though not strictly a pension, the 529 shares similar characteristics with other plans discussed here.  Named for the section of the tax code that covers the matter, the 529 allows for a tax-advantaged saving/investment plan for educational expenses.

529s are governed by each state, so rules and benefits may vary quite a bit. In general, you can set up a 529 with any financial firm, probably a mutual fund.  It will have custody of the funds and administer them together with the investments when the money is put to work.  Unlike most retirement schemes, the money put into 529s is not tax deductible when it comes to federal taxes, because the IRS treats the proceeds from a 529 as a gift.  Some states, however, allow a deduction of contributions on their (state) income taxes. However, investment earnings and capital gains are excused from all federal and state taxes.

To secure these advantages, the funds must be used for what the IRS calls “qualified” educational expenses.  These include tuition, room and board, books, fees, supplies, computer software and hardware.  Though established under state auspices, few states, if any, have strictures against using the funds for out-of-state schools.  Nor do they make distinctions between public and private institutions.  You should compare all plans available to you because their differences may suit one person more than another.  Make sure that the school chosen qualifies as a recipient of these funds.

If you start a 529 for your child at birth, invest mostly, or entirely, in stocks. The 18 or so years until the child will draw on the money is ample time for the assets to recover from the inevitable, though temporary, setbacks that stocks suffer.  As your child approaches within five years of college age, your investment focus should change.  Because short time spans constrain the period for stock values to recover from a setback, shift the fund’s investments to bonds and more stable stocks.  (See this post for more detail.)

 

Pension Plans

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Pension plans offer investors great advantages.  The plans collect funds, invest them, and administer the payments to participants when they retire.  They almost always possess tax advantages.  Pension funds fall into two distinct types: defined benefit (DB) arrangements, those that promise participants specific benefits in retirement, and  defined contribution (DC) arrangements, those that make no such promise but allow participants advantageous ways to accumulate funds and invest them for retirement.  Within these two basic structures, funds can vary greatly.

Because there is much to say, I will use this post and the next to examine the topic.  In this post I take up DB plans and the generalities of DC plans.  The next post will go through the complexities of DC plans, which will include 401(k) plans and IRAs.

Defined Benefit Plans

 DB plans are what most people think of as pensions.  Social Security is a DB plan.  In a DB, an employer or government entity promises to pay retirees a certain amount until they die.  Plans might include cost-of-living escalators, and they might also include medical and death benefits and/or provisions for continued payments to a surviving spouse or partner. Provisions vary from plan to plan.

The “sponsor,” who sets up the plan, pools employee contributions into a fund, and invests those monies prudently to fulfill the plan’s promises. Sometimes the sponsor makes contributions from its own resources, sometimes it collects them from participants, and sometimes it relies on contributions from both sources. The administration and investment decisions are entirely the sponsor’s — participants have no say, because it is the sponsor, not the participants who has the obligation to pay.  If the fund falls short, the sponsor must make good its obligations.  If the sponsor is a corporation, that burden then falls on the shareholders.  If the sponsor is a government entity, the burden falls on the taxpayer.

All these plans are exempt from investment taxes, though participants pay income taxes on the distributions made when they have retired.

Here are the three best-known examples of defined benefit plans:

  1. Social Securityis funded from the payroll taxes paid equally by employers and employees. Its payments include an escalator tied to the rate of inflation and benefits paid to surviving spouses, referred to as “spousal benefits.”  To some extent Social Security is interwoven with disability and Medicare, both of which are supported from the same sources that fund Social Security.  When these funds are invested, it is solely in U.S. Treasury bonds.
  2. State and Local Government Plans include a variety of retirement plans for government employees. All are funded in varying degrees by the sponsoring government entity –– that is, by taxpayers.  Some plans also rely on contributions from participants during their employment.  Many have escalators to accommodate rising living costs, and many offer medical benefits, though the specifics vary greatly.  All count on investments in stocks, bonds, and other assets to sustain the funds necessary to meet the plan’s obligations.
  3. Corporate Plans are usually offered by larger, well-established companies. All get most of their funding from the corporate sponsor –– that is, from the shareholders.  Many also rely on contributions from employee-participants. Most include cost-of-living escalators and survivor benefits. Here too, some offer medical benefits.  All invest in stocks, bonds, and other assets to sustain and grow the funds.

Defined Contribution Plans

 Though these so-called DC plans make none of the promises of DB plans, they have one great appeal over the DB variety: participants in DC plans own the assets accumulated with the contributions made in their name, and they can direct them as they see fit.  All DC plans rely on fixed contributions made by the sponsor on behalf of the participants.  The firms and government entities that establish them also make contributions on behalf of individual participants.  All also accept additional contributions from individual participants. Some firms, states, and local governments rely on defined contribution plans to supplement their defined benefit offerings.  Some only offer DC plans.

Because the DC assets belong to the individual participant, they follow the employee into the next job, into retirement, and should participants die before the participant’s assets are exhausted, to their designated beneficiaries.  In financial jargon, these assets are said to be portable. The funds available for retirement depend entirely on the contributions and their relative investment success over the years. More on these varied structures in the next post, including their tax advantages.

 

Taxes

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As February has now rolled into March and we begin to focus on the April 15 tax deadline, it’s a good time to look into the role of taxes in investing.  Though only your accountant or lawyer can properly assess the tax consequences of your financial decisions, still, every investor should have a general understanding of how the government taxes investments and should also be aware of which investment strategies have tax advantages beyond those provided by pension funds.  Here are some basic considerations.

Income Tax

 Generally, all income generated from investments –– dividends and interest –– are taxed.  The tax rate, however, can differ considerably from what you pay on ordinary income from wages.  Here are how these rates vary and why:

Interest Payments 

You pay standard income tax rates on almost all interest received from investments, including interest on deposits at banks and other financial institutions and on interest from short-term bills bought and sold on financial markets.  Taxable as well are payments you receive from corporate bonds and from bonds issued by foreign entities (corporations and governments), including interest paid on U.S. Treasury bonds.  Interest paid on Treasury savings bonds is, however, free of state and local income tax.

Tax-Free Bonds

I posted earlier that taxes are excused on payments from municipal bonds (also called muni bonds).  But there are exceptions: income from bonds that support private, profit-making activities is taxed.  This should be clear in the bond’s prospectus and any broker/dealer should so inform you.

Because of their tax advantages, municipal bonds pay a lower yield than equivalent taxable bonds.  In recent years, about a 28 percent personal income tax rate is where the lower yield paid by the average municipal bond balances the advantages of the tax savings on the bond.  Professionals call this the break-even point.  If your income tax rate is higher, the muni bond becomes attractive, because your tax savings will be more than the bond’s lower interest yield. If your personal tax rate is lower than 28 percent, muni bonds become unattractive, because you would be giving up more in yield than what you save in taxes.

Dividend Income

Most dividend income qualifies for a reduced tax rate. This lower rate is usually the same as capital gains tax rates (of which more below).   As of this writing, the top tax rate on capital gains and qualified dividends is roughly half the top rate on ordinary income. To get this tax break, you must have held the stock for at least 60 days and the dividends must be issued from either a U.S. corporation, a company incorporated in the United States or one of its possessions, or a foreign corporation whose stock readily trades on a major U.S. exchange.  Even when dividends meet these criteria, they do not qualify when, among other things, they reflect dividend distributions connected with capital gains realized by the corporation itself, are paid on bank deposits, or are paid by tax-exempt corporations.

The reasoning behind giving dividends a reduced tax rate, as well as for the exceptions to it, is that corporations already pay a separate income tax before paying dividends.  Because that expense counts against –– that is, it’s paid before –– shareholder income, the argument goes, a tax rate on dividend income equal to the tax rate on ordinary income would effectively tax shareholders twice.  Applying a lower rate on dividends tops up the rate already paid at the corporate level to the full individual rate on ordinary income.

Capital Gains Tax

Generally, you are taxed when you realize any gains, the difference between the price you received when you sold the investment and the price you paid when you first bought it.  The tax rate on capital gains is usually lower than the rate on ordinary income. However, the lower rate only applies when you have held the asset for a year or more. Such profits are designated as long-term gains; if less than a year, the gains are considered short-term and are taxed at the rate applied to ordinary income.

Here is a useful strategy to help you minimize your capital gains taxes. Because the law allows taxpayers to write capital losses against capital gains before calculating your tax bill, review all your holdings for securities that have lost value each time you sell one for a profit.  By selling both, you can subtract the realized losses from the gains and pay tax only on the net figure.  This strategy works for both short-term and long-term gains and losses.

If, for sound investment reasons, you want to continue holding the securities sold at a loss, simply buy them back, though IRS rules dictate that you must wait 30 days before repurchasing the securities.  Keep in mind that the clock determining long- and short-term gains on those repurchased assets then resets to the new purchase date.  If these securities then gain in value and you want to sell, you would have to wait a full year for them to qualify for the long-term capital tax gains rate.  Though this strategy increases transactions costs, usually the tax savings more than justify this expense.

Note 1: Never take losses this way that are greater than the gains.  For tax purposes, wait from realizing the losses until you have gains elsewhere to counterbalance with the tax losses.

Note 2: When executing this strategy, be careful to match short-term losses against short-term gains and long-term losses against long-term gains.  To realize the tax advantages, never use short-term losses to offset long-term gains, though it sometimes pays to use long-term losses to offset short-term gains.

Recent Tax Proposals

Periodically, Washington or various state capitals float ideas about new taxes on investments and investment income.  A perennial favorite is the financial transactions tax.  Another, just introduced by Senator and presidential hopeful Elizabeth Warren of Massachusetts, is a federal wealth tax. I offer a word or two on each, taking the most recent proposal first.

The wealth tax would seem to have a dubious future.  It would burden in particular the many who hold wealth that does not produce ready income, and they especially would resist it.  It is also problematic because it would conflict with real estate taxes, which are a form of wealth tax relied on for revenue by states and particularly towns and cities.  It also poses constitutional questions.  Note that the country had to pass a constitutional amendment to enable the federal government to levy income taxes.  (It used such taxes during the emergency of the Civil War, but by the early twentieth century it became apparent that Washington would need, permanently, additional sources of income; thus the Sixteenth amendment, passed in 1913.)  But the amendment’s text speaks only in terms of income, not wealth.  If it took an amendment to enable the federal government to levy income tax, a wealth tax may well require the high hurdle of another amendment.

The idea of a financial transactions tax has arisen periodically in Washington and, obviously, in New York City–home to Wall Street.  Transaction taxes come in all flavors, but generally they are taxes investors pay whenever they buy or sell a stock or bond (usually a small percentage of the value of the transaction).

Transactions taxes have come and gone.  In the United States, the Revenue Act of 1914 imposed a 0.2 percent tax on stock trading.  Washington doubled it to 0.4 percent in 1932 during the Great Depression and kept it there until it was repealed in 1966.  At present thee are no transaction taxes in the U.S., except for a very small percentage on large futures trades. (More on these in this post.  At last count, some 40 countries have transaction taxes, including Belgium, Finland, France, Greece, India, Italy, Japan, Singapore, Sweden, Switzerland, Taiwan, and the United Kingdom.  Their rationale for these taxes — and for when such taxes are proposed in the U.S . –– includes:

  • The taxes supposedly dampen market volatility by discouraging trading.
  • They curb speculation for the same reason.
  • They offer a fairer and more equitable way to collect taxes.
  • They have little susceptibility to evasion.

Seldom mentioned but nonetheless prominent is that transactions taxes would offer a great source of revenue to government.

Attempts to re-impose the tax in the U.S, whether locally or nationally, have foundered on fears that it could prompt trading to move away from the jurisdiction imposing the tax.  The stock exchange has threatened to leave New York City, for instance, whenever the mayor or the governor in Albany has proposed such a tax.  It would take many jobs and much income with it.  Especially in an electronic age, such a move would face little difficulty.  The same argument has forestalled efforts to impose such a tax at the federal level. So much business has already gone offshore in the so-called inversions in which American firms to secure lower tax rates have incorporated in Ireland and other low-tax jurisdictionsthe politicians fear the same for securities dealing and trading. Still, the proposals return from time to time and every investor should keep informed on the issue..