Archive for December, 2012

Fiscal Cliff Questions

Wednesday, December 12th, 2012

Bloom County

I am getting a number of phone calls, emails, and drop bys from clients and others who want to know what they should do about the looming fiscal cliff. If only the anxieties today were as easy to understand/deal with (and the political discourse less toxic) as we saw in the 80’s and as demonstrated by the cartoon above (boy, do I miss Bloom County – it had a way of cutting to the chase on the issues of the day, in the day).

From moment to moment, the news everyone hears is conflicting – one moment the two sides are closing in on a compromise and the next they are dug into their positions and not giving an inch. It is no surprise that people are concerned about what is going to happen to their stock portfolios if no solution is reached.

This blog is not taking a political position on the situation, but rather I wanted to give you some thoughts on the financial impact of the proposals so you can make up your own mind what to do with the assets you manage yourself. I will also tell you what I am doing with client portfolios that I manage.

In my opinion, the numbers that they are discussing are WAY too small to make a positive impact on the long-term financial future of our country. The $800 billion in revenues that the Speaker is proposing from deduction limits is the same dollar amount as the President’s tax increase on individuals making over $200K and families making over $250K. That works out to $80 billion per year over the next decade, their agreed time frame for this discussion.

Our deficit this year will be $1.2 Trillion – an $80 billion increase in revenues still leaves us with $1.02 Trillion in deficits.

The Congressional Budget Office projects that on the current trajectory, our national debt will be $22 Trillion by 2016, up from the current $16 Trillion. If we are able to generate $80 billion per year for four years, that reduces the $22 Trillion to $21.6 Trillion.

If we look instead at the Simpson-Bowles proposed $4 Trillion (over 10 years) compromise – a number that is also being bantered about between the Speaker and President as being the “solution” to all our fiscal problems (they just differ on whether it comes from taxes or spending cuts) – you have $400 billion per year. That takes the deficit from $1.2 Trillion to $800 billion per year, and takes the national debt from $22 Trillion in 2016 to $20.4 Trillion.

In my opinion, the numbers we are talking about are still way too small to fix anything. On the current trajectory, our path seems to be mimicking that of Japan.

Japan raises too little revenue and spends too much on entitlement programs, funding the difference with debt. A scary statistic from Japan’s financials as reported in their Ministry of Finance’s 2012 budget (and detailed in the writings of Charles H Smith) is that interest on their debt plus their social security payments are 114% of their tax revenues. Their tax revenues do not even cover the interest they pay on their borrowed funds and the social security payments to their aging country. The 14% deficit plus all other government spending is funded by issuance of debt. For 2012, Japan borrows 51 cents of every dollar it spends.

Total US government revenue is expected to be $3.7 Trillion in 2016 while the total for interest on our debt ($0.5 Trillion), social security ($1.05 Trillion) and medicare ($1.2 Trillion) add up to 74% of revenues. This sounds pretty good in comparison to Japan, but if you look at 2013, interest on debt ($0.25 Trillion), social security ($0.81 Trillion) and medicare ($0.84 Trillion) compared to total US government revenue of $2.9 Trillion, you see that our expenses for the big three add up to 65% of revenue.

Each year, as our country ages and we add more debt to pay for the services that have been promised to people, we creep closer and closer to the situation that Japan is currently experiencing. Our percentage allocation to the big three is projected to increase 9% over four years. Each passing year, the increase gets larger – I don’t have an answer to how soon we will be at Japan’s 114% of revenues level, but it won’t be too many years into the future at current levels of spending and revenues.

The projected yield on our debt in 2016 is 2.5%. What happens to our financial picture if interest rates increase 1% because our lenders require a better return on their investment due to the added risk of continuing to loan to a country with $22 Trillion in national debt that is equal to 160% of its GDP? Our interest cost increases by $220 billion, taking our percentage from 74% of revenues to 80% of revenue to cover interest, social security, and medicare. For every 1% increase in the yield on our national debt at 2016 levels equates to 6% of 2016 revenues – this just isn’t sustainable.

So, what has Japan’s stock market done in recent years as their fiscal situation has been addressed with Keynesian stimulus policies?

Nikkei Past 20 Years

This is a chart of the Nikkei Index for the past 20 years. You can see that it has lost roughly 45% of its value over this period as Japan has added debt, didn’t increase its revenues and increased its entitlement programs. Its economy has stagnated with little growth in spite of significant levels of government stimulus, with its stock market in turn mirroring the economy.

Am I saying that this is the exact path that we are on? No, there are major differences between the US and Japan demographically – we are not aging nearly as fast as Japan nor as Europe. Our spending, tax, and economic policies, though, do mirror Japan. We have undertaken the same Keynesian spending plan that Japan started years ago – they have had no success so I am not sure why our government thinks it can be successful with it.

What I am saying is that we should continue to see low levels of economic growth that will allow us to creep forward until at some point, unless we find a way to balance our revenues and spending as well as reduce our national debt, we will certainly hit the 114% of revenue level. Nothing good can come of that.

Take a look at the Nikkei Index from 1994 to 2000:


Now take a look at the S&P 500 from 2000 to today:


The patterns are eerily similar in the first few years of Japan’s Keynesian economic policy and our own. There is no way to know if the S&P 500 will follow the Nikkei’s path from 2000 to today – I’d doubt it since our demographics are better and we still have a chance to address our fiscal imbalance before we hit the point of no return – and I can’t allow myself to believe that our country won’t do something to fix the situation before it is too late.

However, if I am wrong, doing nothing to bring our revenues and expenses in line so that we can begin to pay down our debt will most certainly lead to lower stock prices. Stock prices are a function of corporate earnings (which are closely tied to economic growth) and investor enthusiasm to value those earnings higher. If we have a slow economy for several years into the future and we continue to add to the national debt, investors will be less and less willing to value earnings higher. P/E ratios will contract and even if earnings go up, the stock market will not perform satisfactorily.

If, on the other hand, we address our fiscal imbalance properly while we still have time, corporate earnings will likely increase with a stronger economy and investors will likely value earnings higher, providing us with a nicely higher stock market.

Right now, everything is in the hands of the politicians in Washington and we simply have to trust that they will act in the country’s best collective interest and make the right decisions that end the accumulation of debt. An initial 10-year $4 Trillion agreement would be a good start, but some serious work will need to be done to come up with a 10-year $12 Trillion agreement – my estimate of what it will take to balance revenues and expenses. That $12 Trillion will of necessity have to come from entitlement cuts, cuts to discretionary spending, cuts to defense, and increases in revenue – both from increased economic activity and from higher taxes for those not paying their fair share (determining who is not paying their fair share in and of itself will be a fight in DC that will mirror the current toxic level of discourse – but ultimately everyone will have to pay something and those already paying will have to pay more).

So what am I doing?

I have written here on the blog that we started raising cash in September when we felt the market had topped out. As we all know, the market dropped after the election but is now back to pre-election levels. The level of the S&P 500 we are at today is roughly fair value as I calculate it: 2013 estimated earnings per share of $107.73 X P/E of 13.5 (past five quarters average) = 1454.35 (today we are at 1433.94).

So, to me, the risk seems to outweigh the reward at the present time:

>we could get a situation where no resolution to the fiscal cliff is agreed upon and we have all the taxes imposed and spending cut as of January 1st, throwing the economy into a recession and the market sells off;

>we could get some resolution to the cliff that disappoints the investment community as either too onerous or too lenient, and the market sells off;

> we could get a perfectly acceptable resolution to the fiscal cliff but leads to a fight in six weeks to raise the debt ceiling, and the market sells off;

>we get a resolution to the fiscal cliff that is perfectly acceptable, and the market “sells the news” as people take profits from the recent strength; or

>we get a resolution and the market goes up.

It seems to me that the safest/smartest thing is to hold a level of cash in a money market fund that will fund the purchase of companies that can most successfully operate under whatever new tax and spending rules are set by agreement or by default of going over the fiscal cliff. We do not really know what the final agreement will look like or whether the default option of tax increases and spending sequester of going over the cliff will be the rule of the day.

Because of the risks and uncertainties, we will maintain an above average level of cash in client accounts so we can deploy it into companies at lower prices if the market pulls back. If the market does not pull back, we can use the cash to invest in whatever companies will best be able to operate under the as-yet unknown rules. In either scenario, it seems prudent to have liquidity. You, however, will need to do your own analysis and make a decision that is right for you for the money you manage for yourself.

I’ll leave you with this from Alan Simpson of the Simpson-Bowles Commission:

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