Posts tagged ‘taxes’

Fiscal Cliff: Will a 1937 Repeat = 2013 Dead Meat?

Source: StockCharts.com

The presidential election is upon us and markets around the globe are beginning to factor in the results. More importantly, in my view, will be the post-election results of the “fiscal cliff” discussions, which will determine whether $600 billion in automated spending cuts and tax increases will be triggered. Similar dynamics in 1937 existed when President FDR (Franklin Delano Roosevelt) felt pressure to balance the budget after his 1933 New Deal stimulus package began to rack up deficits and lose steam.

What’s Similar Today

Just as there is pressure to cut spending today by Republicans and “Tea-Party” Congressmen, so too there was pressure for FDR and the Federal Reserve in 1937 to unwind fiscal and monetary stimulus. At the time, FDR thought self-sustaining growth had been restored and there was a belief that the deficits would become a drag on expansion and a source of future inflation. What’s more, FDR’s Treasury Secretary, Henry Morgenthau, believed that continued economic growth was dependent on business confidence, which in turn was dependent on creating a balanced budget. History has a way of repeating itself, which explains why the issues faced in 1937 are eerily similar to today’s discussions.

The Results

FDR was successful in dramatically reducing spending and significantly increasing taxes. Specifically, federal spending was reduced by -17% over two years and FDR’s introduction of a Social Security payroll tax contributed to federal revenues increasing by a whopping +72% over a similar timeframe. The good news was the federal deficit fell from -5.5% of GDP to -0.5%. The bad news was the economy went into a tail-spinning recession; the Dow crashed approximately -50%; and the unemployment rate burst higher by about +3.3% to +12.5%.

Source: New York Times

Source: Blue Mass Group

What’s Different This Time?

For starters, one difference between 1937 and 2012 is the level of unemployment. In 1937, unemployment was +14.3%, and today it is +8.1%. Objectively, today there could be higher percentage of the population “under-employed,” but nonetheless the job market was in worse shape back then and labor unions had much more power.

Another major difference is the stance carried by the Fed. Today, Ben Bernanke and the Fed have made it crystal clear they are in no hurry to take away any of the monetary stimulus (see Hekicopter Ben QE3 article), until we have experienced a long-lasting, sustainable recovery. Back in early 1937, the Fed increased banks’ reserve requirements twice, doubling the requirement in less than a year, thereby contracting monetary supply drastically.

Furthermore, we live in a much more globalized world. Today, central banks and governments around the world are doing their part to keep growth alive. Emerging markets are large enough now to move the needle and impact the growth of developed markets. For example, China, the #2 global superpower, continues to cut interest rates and has recently implemented a $158 billion infrastructure spending program.

Net-Net

Whether you’re a Republican or Democrat, everyone generally agrees that job creation is an important common objective, which is consistent with growing our economy. The disagreement between parties stems from the differing opinions on what are the best ways of creating jobs. From my perch, the frame of the debate should be premised on what policies and incentives should be structured to increase competitiveness. Without competitiveness there are no jobs. At the end of the day, money and capital are agnostic. Cold hard cash migrates to the countries in which it is treated best. And where the money goes is where the jobs go.

There is no single silver bullet to solve the competiveness concerns of the United States. Like baseball (since playoffs are quickly approaching), winning is not based solely on hitting, pitching, defense, or base-running. All of these facets and others are required to win. The same principles apply to our country’s competitiveness.

In order to be a competitive leader in the 21st century, here are few necessary areas in which we must excel:

Education: Chicago school unions have been in the news, and I have no problems with unions, if accountability can be structured in. Unfortunately, however, it is clear to me that for now our system is broken (a must see: Waiting for Superman). We cannot compete in the 21st century with an illiterate, uneducated workforce. Our colleges and universities are still top-notch, but as Bill Gates has stated, our elementary schools and high schools are “obsolete”.

Entitlements: Social safety nets like Social Security and Medicare are critical, but unsustainable promises that explode our debt and deficits will not make us more competitive. Politicians may gain votes by making promises in the short-run, but when those promises can’t be delivered in the medium-run or long-run, then those votes will disappear quickly. The sworn guarantees made to the 76 million Baby Boomers now entering retirement are a disaster waiting to happen. Benefits need to be reduced and or criteria need to be adjusted (i.e., means-testing, increase age requirements). The problems are clear as day, so Americans cannot walk away from this sobering reality.

Strategic Government Investment: – Government played a role in building our country’s railways, highways, and our military – a few strategic areas of our economy that have made our nation great. Thoughtful investments into areas like energy infrastructure (e.g., smart grid), internet infrastructure (e.g., higher speed super highway), and healthcare (e.g., human genome research) are a few examples of how jobs can be created while simultaneously increasing our global competitiveness. The great thing about strategic government investments is that government does NOT have to do all the heavy lifting. Rather than write all the checks and do all the job creation from Washington, government can implement these investments and create these jobs by providing incentives for the private sector. Strategic public-private partnerships can generate win-win results for government, businesses, and job seekers. If, however, you’re convinced that our government is more efficient than the private sector, then I highly encourage you to go visit your local DMV, post office, or VA to better appreciate the growth-sucking bureaucracy and inefficiency.

Taxes / Regulations / Laws: Taxes come from profits, and businesses create profits. In order to have a strong and competitive government, we need strong and competitive businesses. Higher taxes, excessive regulations, and burdensome laws will not create stronger and more competitive businesses. I acknowledge that reckless neglect and consumer exploitation will not work either, but reasonable protections for consumers and businesses can be instituted without multi-thousand page regulations. Reducing ridiculous subsidies and loopholes, while tightening tax collection processes and punishing tax dodgers makes perfect sense…so why not do it?

Politics are sharply polarized at both ends of the spectrum, but no matter who wins, our problems are not going away. We may or may not have a new president of the United States this November, but perhaps more important than the elections themselves will be the outcome of the “fiscal cliff” legislation (or lack thereof). If we want to maintain our economic power as the strongest in the world, solving this “fiscal cliff” is the key to improving our competiveness. Avoiding a messy 1937 (and 2011) political repeat will prevent us from becoming dead meat.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct positions in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

 

September 23, 2012 at 10:55 pm Leave a comment

The Fund Flows Paradox

How is it that the stock market has more than doubled over the last three years, when investors have been dumping stocks like they are going out of style? If you don’t believe me, and you think jovial investors are jacking stocks higher, then please explain to me why billions of dollars are hemorrhaging out of equity funds on a monthly basis over the last five years (see Fund Flow data chart below)?

Source: Calafia Beach Pundit

If by small chance you buy my argument that skeptical investors continue to doubt the sustainability of the three-year doubling in the stock market, then why is the Volatility Index (VIX) trading like investors are sunbathing at the beach while licking lollipops? For those not keeping score on the VIX (see also The VIX and the Rule of 16), typically a reading below 20 is interpreted as investor overconfidence and/or complacency. On the flip side, readings above 20 usually indicate pessimism or fear.

As you can see from the chart below, we have spent a good portion of the last few years on both sides of the 20 mph VIX speed limit, and currently at a reading of about 17, investors have slowed down to enjoy the scenery.

Source: Yahoo! Finance

So with massive selling and a cheery reading on the VIX, how can these bipolar data-points be reconciled? Therein lies the “Fund Flows Paradox.”

Take Me Out to the Ballgame

If you equate equity investors to fans at a baseball stadium, the fund flow data clearly shows investors are tired of losing money and have been leaving the game in droves. Instead of staying at the equity baseball stadium, those fatigued stock investors have decided to head over to the adjacent bond arena. The equity stadium will never completely be empty because financial markets always have speculative traders. In baseball terms you can think of these short-term traders as the emotionally volatile die-hard fanatics, who will stick around regardless of whether the home team wins or loses.

So while sentiment gauges like the VIX, or sentiment surveys conducted by AAII (American Association of Individual Investors) may be temporarily flashing contrarian bearish signals, one should be cognizant that these data points do not include the petrified opinions of investors who have raced out of the stadium. Eventually when the home team’s winning streak is long enough, investors will return back to the stadium from the bond arena. While there is no sign of individual investors coming back to the stock game anytime soon, in the meantime patient and disciplined investors have had plenty of opportunities to take advantage of. With massive numbers of individual investors and sellers sitting on the sidelines, the markets require relatively little buying to push prices higher.

Over the last few years, not only have equity valuations been broadly reasonable, volatility spikes during the last few summers have  also created amplified opportunities. With the wall of worries currently blanketing traditional and new media headlines (i.e., European crisis, U.S. election uncertainty, unsustainable and slowing profits, pending tax cut expirations, Mideast turmoil, etc.) there is no sense of urgency to pile back in to the equity markets.

The doubling in stock prices have occurred on low volumes, largely on the backs of a smaller institutional investor base, not to mention high frequency traders and speculators. While sentiment surveys may currently provide some insight into short-term equity trader attitudes, don’t let these volatile and unreliable data cloud the true underlying pessimism of the masses who have left the stock stadium in large numbers. Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.

Opinions are interesting, but actions speak louder than words. Spend more time looking at the actions of the fund flow data, rather than the opinions of various short-term sentiment surveys or short-term options trader statistics. Adjusting your focus to investor actions and behavior will provide a truer gauge of overall investor sentiment and assist you in solving the “Fund Flows Paradox.”

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

April 21, 2012 at 11:26 pm 15 comments

Investors Sit on Fence and Watch New Highs

Article includes excerpts from Sidoxia Capital Management’s 3/1/2012 newsletter. Subscribe on right side of page.

We’ve seen some things jump during this 2012 Leap Year (mainly stock prices), but investors have not been jumping – rather they have been doing a lot of fence sitting. Despite the NASDAQ index hitting 11+ year highs (+14% in 2012 excl. dividends), and the S&P 500 index approaching 4-year highs, investors have been pulling cash out in droves from equities. Just last month, Scott Grannis at Calafia Beach Pundit highlighted that $355 billion in equity outflows has occurred since September 2008, including $155 billion since April 2011 and $6 billion siphoned out at the beginning of 2012.

Once again, listening to the vast majority of TV talking heads has decimated investor portfolios. However, ignoring the dreadful, horrific news over the last three years would have made an equity investor 100%+ (yes, that’s right…double). Somehow, the facts have escaped the psyches of millions of average Americans as the train is leaving the station. Certainly in 2008, a generational decline in equity markets was accompanied by horrific headlines. Those who were positioned too aggressively suffered about 15 months of severe pain, but those who capitulated with knee-jerk reactions after the collapse did incredibly more damage by selling near the bottom and locking in losses. Only now, after the Dow has exploded from 6,500 to 13,000 over the last three years have investors begun to ask whether now is the time to buy stocks.

Of course, making decisions by reacting to news headlines is a horrible way to manage one’s money and will only lead to a puddle of tears in the long-run. Psychological studies have shown that losses are 2.5x’s as painful as the pleasure experienced from gains. The wounds from the 2000 technology bubble and 2008-2009 financial crisis are still too fresh in investors’ minds, and until the scars heal, millions of investors will remain on the sidelines. As usual, average investors unfortunately get more excited after much of the gains have already been garnered.

Investing should be treated like an extended game of chess that requires long-term thinking. As in investing, there are many strategies that can be used in chess. Shadowing your opponent’s every move generally is not a winning strategy. Rather than defensively reacting to an opponent’s every move, proactively planning for the future is a healthier strategy. Don’t be a pawn, but instead create a long-term, low-cost investment plan that accounts for your current balance sheet, future goals, and risk tolerance in order to achieve your retirement checkmate. But before you can do that, you must first get that rump off the fence and put a plan into action.

 

Hot News Bites

  Chili Pepper

How Do You Like Them Apples? Apple Inc. (AAPL) has become the most valuable company on the planet as it has surpassed a half-trillion dollars in market value at the end of February. Thanks to record sales of new iPhones, iPads, and Mac computers, Apple has managed to stuff away close to $100 billion in cash in its coffers. What’s next for Apple? Besides introducing new versions of existing products, Apple is expected to innovate its television platform later this year.

Greece Dips into Euro Purse Again: Euro-zone ministers approved a $172 billion rescue package for Greece to avoid default for the second time in less than two years. In addition to the Greek citizens, private bondholders are sharing in the pain. The deal calls for debt holders to write down their Greek debt by 74%; demands stark austerity measures (Debt/GDP ratio of 120.5% by 2020); and a continuous monitoring of Greece’s fiscal standing by a European task force.

Taxes-Schmaxes: There’s nothing more exciting in politics than the discussion of taxes. OK, maybe former Speaker Newt Gingrich’s moon colony proposal is a tad more interesting. Nonetheless, Congress voted to extend the payroll-tax cut through December, and both President Obama and presidential candidate Mitt Romney unveiled their new tax plans. Although Obama’s plan hopes to tax the rich, both politicians have plenty of tax-cuts embedded in their plans. In an election year, apparently debt and deficit amnesia have set in.

Investors “Like” Facebook: Although investors appear to be “Like”-ing Facebook in advance of its initial public offering (IPO), employees and owners seem to be even happier, considering the company is estimated to reach up to $100 billion in value once shares begin trading. I can’t wait to read CEO Mark Zuckerberg’s status update when he cashes in on a portion of his stake of $25 billion or so.

Gas Prices Empty Wallet: Improving global economic data is not the only reason behind escalating gasoline prices (currently averaging $3.73 per gallon for Regular). Iran reduced its sales of crude oil to Britain and France after those countries stopped importing Iranian oil, and Iran stated it has made progress on its nuclear-development program. Can’t we just all get along?!

Plan. Invest. Prosper.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, FB and AAPL, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 2, 2012 at 8:07 pm 1 comment

Invisible Costs of Trading

Source: Photobucket

You can feel them, but you can’t see them. I’m talking about invisible trading costs. Although some single transaction trading costs can run as high as hundreds of dollars at the large brokerage firms, investors are generally aware of the bottom-basement commissions paid on trades executed at discount brokerage firms like Scottrade, TD Ameritrade (AMTD), E-Trade (ETFC), and Charles Schwab (SCHW) – generally less than $10 per trade. Unfortunately, these commissions are estimated to only account for 20% of total trading costs1. What most investors are unaware of are the host of invisible trading costs and expenses associated with active trading.

Here are some of the invisible costs:

Bid-Ask Spread: Besides the explicit commissions charged, traders must incur the implicit costs of the bid-ask spread. Let’s suppose you have a stock trading at $12.50 per share (ask price) and $12.25 per share (bid price). If you were to immediately buy one share for $12.50 (ask) and sell immediately for $12.25 (ask), then you would be -2% in the hole instantly – more than double the $7.95 commission paid on a $1,000 investment. Effectively, the investor would already be down about -3% the instant the small investment was made.

Impact Costs: The issue of impact costs is a bigger problem for larger institutional investors, although thinly traded stocks (those securities with relatively small trading volume) can even become expensive for retail investors. Suppose the same stock mentioned previously initially traded at $12.50 per share before you transacted, but reached $13.00 per share upon completion (with an average $12.75 price paid). The $.25 cent increase (average price minus initial price) translates into another -2% increase in the costs.

Taxes: It’s not what you make that matters, but rather what you keep that makes the difference. If you make a decent amount of money actively trading, but end up giving Uncle Sam more than potentially 40% of the gains, then your bank account may grow less than expected.

While my examples may shed some light on the costs of trading, an in-depth study using data from Morningstar and NYSE was conducted by three astute professors (Roger Edelen [University of California, Davis], Richard Evans [University of Virginia], and Gregory Kadlec [Virginia Polytechnic Institute]) showing that an average fund’s annual trading costs were estimated to be 1.44%, higher than an average fund’s overall expense ratio of 1.21%.

Unfortunately from an investor’s standpoint, as much as 30% of all trading costs can be attributed to money naturally pouring in and out of funds, due to fund share purchases and redemptions. Therefore, wildly popular or out-of-favor funds will have a detrimental impact on performance. I know firsthand the costs of managing a large fund, much like captaining a supertanker – you create a lot of waves and it can take a while to change directions. Smaller funds, however, can navigate trades more nimbly, much like a speedboat leaving behind smaller cost waves in its wake.

Style can also have an impact on trading costs. Value-based funds that sell into strength or buy into weakness can be considered liquidity providers, and therefore will experience lower trading costs. On the flip side, momentum strategies effectively pour gasoline on hot stocks purchases and pile on damaging sales to cratering losers.

Emotional Costs of Trading

More impactful, but more difficult to quantify, are the emotional trading costs of greed and fear (i.e., chasing extended winners out of greed and panicking out of losing positions due to fear). Constantly hounding winners and capitulating your losers may work in a few instances, but can lead to disastrous results in the long-run. Even if an investor is correct on the sale of a security, the investor must also be right on the subsequent buy transaction (no easy feat).

With that said, there are no hard and fast rules when buying/selling stocks. Buying a stock that has doubled or tripled in and of itself is not necessarily a bad idea, as long as you have credible assumptions and data to support adequate earnings/cash flow growth and/or multiple expansion. Consistent with that thought process, a plummeting stock is not reason enough to buy, and does not automatically mean the price will subsequently rebound. Reversion to the mean can be a powerful force in security selection, but you need a disciplined process to underpin those investment decisions.

Spiritual Savings

As I have stated in the past, investing is like a religion (read more Investing Religion). Most investors stubbornly believe their financial religion is the right way to make money. I personally believe there is more than one way to make money, just as I believe different religions can coexist to achieve their spiritual goals. Through academic research, and a lot of practical experience, my religion believes in the implementation of low-cost, tax efficient products and strategies used over longer-term time horizons. I use a blend of active and passive management that leverages my professional experience (see Sidoxia’s Fusion product), but I would fault nobody for pursuing a purely passive investment strategy. As John Bogle shows, and has proven with the financial success of his company Vanguard, passive investing by and large materially outperforms professional mutual fund managers (see Hammered Investors article).

Investing can be thrilling and exciting, but like a leaky faucet, the relatively small and apparently harmless list of trading costs have a way of collecting over the long-run before sinking long-term performance returns. Sure, there are some high-frequency traders that make a living by amassing a large sums of rebates for providing short-term liquidity, but for most investors, excessive exposure to invisible trading costs will lead to visible underperformance.

Read more about trading cost study here1

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Vanguard funds), but at the time of publishing SCM had no direct position in AMTD, ETFC, SCHW, Scottrade, MORN, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

December 15, 2010 at 12:05 am Leave a comment

California…This Bud’s for You

I guess it’s time for Californians to dust off their bongs and break out the rolling papers because Proposition 19, the proposal to legalize personal marijuana consumption for adults in the Golden State, is coming up for vote next month. Judging by recent polls, the proposition is gaining steam…or smoke. 

Results show that 52% of voters are backing the proposition versus 41% opposed and 7% undecided. In fact, the data shows Californians are supporting ganja more than they are backing the state Senatorial and Gubernatorial candidates (Barbara Boxer, Dianne Feinstein, Carly Fiorina, Jerry Brown and Meg Whitman).

Proponents are fiercely battling the opposition in the remaining weeks before the big vote. Given all the controversy, I wouldn’t be surprised if pro-pot advocacy groups enlisted renowned rapper Snoop Dogg as a paid spokesman to support the cause. I can hear Snoop now, “Vote yes on ‘pot,’ but remember friends don’t let friends drive doped.” Alternatively, I’m sure Altria Group (MO), maker of the famous Marlboro branded cigarettes, wouldn’t mind getting into the profitable cannabis business. They could even hire ex-President Clinton, who could admit he “inhaled…and enjoyed it,” while consuming some cannabis legally in California.

Would Snoop and Bill Say Yes to Legalized Marijuana?

The Budding of Prop. 19

What was the genesis of Proposition 19? Well, this isn’t the first time the wacky weed debate has actually been put to a vote in California. Almost four decades ago a similarly titled Proposition 19 initiative showed up on the ballot. Was it a coincidence the same number was used…perhaps? On the bright side, more mature protesters will not have to break the piggybank to buy new Proposition 19 buttons and T-shirts. This type of recycling gives new meaning to the word being “green.”

From a broader political policy perspective, marijuana consumption is no small problem. An estimated $113 billion of pot is sold each year nationally, with more than 10% of that attributed to California weed smokers. A whopping 15 million Americans have admitted to using pot within the last month, according to one survey. Of all the marijuana smoked, around fifty percent of the illegal bud is said to originate from foreign sources, most notably Mexico, which is dealing with deadly drug cartels that are killing innocent civilians by the thousands and threatening our borders. Proposition 19 cheerleaders are quick to point out that the legalization of cannabis would remove valuable money from foreign criminals’ pockets.

Legalizing and taxing cannabis has the potential of raising billions for the state of California. We all know about the sad state of fiscal affairs for California ($19 billion budget deficit) along with the dismal financial shape of neighboring states – an estimated $137 billion in deficits over fiscal 2011 and 2012  (see The Next Looming Bailout). Contributing to the deficits is the overcrowding of our jails and prisons.  Ever since the “Just Say No” to drugs campaign, which started in 1984, prison populations have quadrupled – many of the prisoners being non-violent pot smokers.  So, why not collect some cash from the millions that are already smoking pot illegally and help reduce our damaging deficits and free up space for more violent criminals?

Calling All Sin-Consuming Hypocrites

I understand the opposition to cannabis legalization, primarily based on concerns relating to public safety, workplace productivity, and potential losses in federal funding, but if certain people are opposed to Proposition 19, I sure hope they are up in arms over the numerous other legal (but sinful) products and services that permeate our daily lives. If pot is deemed harmful and illegal by society, then where are all the picketers protesting this long list of other sinfully legal products and services?

  • Casinos/Gambling
  • Cigarettes
  • Lotteries
  • Alcohol
  • Prostitution (Nevada)
  • Guns/Hunting
  • Ho Hos/Twinkies/Sodas (Fat Tax)

The potential safety issue surrounding an increase in stoned drivers is a real one. However, if we have managed to reduce drunk driving, with the help of severe penalties, over the last few decades, I’m fairly confident we can keep slothful, Domino’s pizza (DPZ) loving, pot-smokers under control.

There is no shortage of controversy surrounding this political hot-button issue, but drastic times call for drastic measures. You may be against the legalization of marijuana, but if Proposition 19 passes in California, you may want to go long Domino’s, and short Nike Inc. (NKE).

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in MO, DPZ, NKE, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 6, 2010 at 1:10 am 2 comments

The Next Looming Bailout…Muni Bonds

Source: Photobucket

Government politicians and voters have made it clear they do not want to bail out “fat-cat” bankers in the private sector, but what about bailing out “fat-cat” state pensioners in the public sector? States and cities across the country are increasingly under economic strain with deficits widening and debt-loads stacking up. California’s statewide budget problems have been well publicized, but you are now also hearing about more scandalous financial problems at the city level (read about the multi-million dollar malfeasance in the city of Bell).

Why Worry?

Well if a 2010 $1.3 trillion federal deficit is not enough to tickle your fancy, then how does another $137 billion in state deficits over fiscal 2011 and 2012 sound to you (National Governors Association)? Unfortunately, the states have made no meaningful structural improvements. If you layer on general economic “double dip” recession fears with excess pension liabilities, then you have a recipe for a major unresolved financial predicament.

Despite the dire financial state of the states, municipal bond prices have generally survived the 2008-2009 financial crisis unscathed. With unacceptably poor state budget risks, muni bond prices have continued to rise in 2010. The downside…new investors must accept a pitiful yield of 2.75% on 10-year municipal debt, according to Financial Advisor Magazine.

One investor who is not buying into the strength of the tax-free municipal bond market is famed investor and CEO of Berkshire Hathaway (BRKA/BRKB), Warren Buffett. Here is what he wrote about munis in his legendary annual shareholder letter last year:

“Insuring tax-exempts, therefore, has the look today of a dangerous business…Local governments are going to face far tougher fiscal problems in the future than they have to date.”

 

Buffett has this to say about rating muni bonds:

“I mean, if the federal government will step in to help them [municipalities], they’re triple-A. If the federal government won’t step in to help them, who knows what they are?”

 

Safety Net Disappears

Source: Photobucket

Like a high wire artist dangling high in the air without a safety net below, the states are currently borrowing money with little to no protection from the bond insurance providers. The shakeout of the subprime debt defaults has battered the insurers from many perspectives, leaving a much smaller market in the wake of the financial crisis. In 2007 about 50% of new municipal bonds were issued with bond insurance, while today only approximately 7% carry it (UBS Wealth Management Research). With decreased insurance coverage, the silver lining for muni investors is the necessity for them to perform more comprehensive research on their bond holdings.

Defaults on the Rise

On the whole, less insurance will result in more defaults. Although defaults are expected to decline in 2010, non-payments totaled $6.9 billion in 2009, up from $526 million in 2007 (Distressed Debt Securities). Even though the numbers sounds large, the recent default rate only represents a 0.25% default rate on the hefty $2.8 trillion market. That muni default rate compares to a more intimidating corporate bond default rate of 11% in 2009.

Bigger Bark Than Bite?

James T. Colby, senior municipal strategist at Van Eck Global, understands the severity of the states’ budget crisis but he believes a lot of the doomsday headlines are bogus. Riva Atlas, writer for Financial Advisor Magazine, summarizes Colby’s thoughts:

“Even those states in the worst straits like California and Illinois have provisions in their constitutions or statutes requiring them to pay their debts. In California, the state’s constitution says bondholders come second only to the school system, so the state would have to empty its jails before it stopped paying its teachers.”

 

Certainly municipalities could raise taxes to compensate for any budget shortfalls, but we all know most politicians are reluctant to raise taxes, because guess what? Tax increases may result in fewer votes – the main motivator driving most politicians.

If the states decide to not raise taxes, they still have other ways to weasel out of obligations. For starters, they can just stick it to the insurance company (if coverage exists). If that option is not available, the municipalities can look to the federal government for a bailout. Irresponsible actions have their consequences, and like consumers walking away from payments on their mortgages, municipalities will effectively be preventing themselves from future access to borrowing. Either way, the bark is less than the bite for investors since the insurance company or federal government will be making them whole.

BABs and Taxes Add Fuel to the Fire

A glut of Build America Bonds (BABs) issued by municipalities, driven by demand from yield hungry pension funds, along with expected tax hikes for the wealthy have created a scarcity of tax-free munis.

In the first half of 2010 BABs accounted for more than 25% of municipal bonds issued, which was a significant contributing factor to the robust muni market. The BABs tailwinds aiding muni prices won’t last forever, as the bond issuance program is expected to expire at the end of 2010.

On the tax front, the wealthy are likely to see higher federal tax rates in the future – upwards of 36% – 40%. If you include the double tax-exempt benefits in states like New York and California, the relative attractiveness becomes even that much better. Combined, these factors have elevated muni prices.

Despite higher defaults, scarier headlines, and the lack of insurance, the municipal bond market remains robust. General interest rate declines caused by macroeconomic fears have caused investors to flock to the perceived “safe haven” status of Treasuries and Munis, but as we have all witnessed, the fickle pendulum of emotions never sits still for long.

Managing the Munis

As is evident from the municipal bond discussion, states and cities across the country have been plagued by the same deficit and debt issues as the country faces on a federal level. Tough structural expense issues, and revenue generating tax policies need to be scrutinized in order to prevent federal taxpayer bailouts of municipalities across the country.

From a municipal bond investor perspective, it’s best to focus on general obligation bonds (GOs) because those bonds are backed by the taxing authority of the municipal government. On the flip side, it’s best to stray away from revenue bonds or privately issued municipals because revenue streams from these bond channels are not guaranteed by the municipality, meaning the risk of default is larger.

While Congress sorts out financial regulatory reform with respect to banking bailouts and “too big to fail” corporations, our federal government should not lose sight of the widespread municipality problems our country faces today. If not, get ready to pull out the checkbook to pay for another taxpayer-led bailout… 

Read the Complete Financial Advisor Magazine Article: The Muni Minefield

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including CMF), but at the time of publishing SCM had no direct position in BRKA/B or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

September 27, 2010 at 12:47 am 1 comment

Sachs Prescribes Telescope Over Microscope

Jeffrey Sachs, Professor at Columbia University and one of Time magazine’s “100 most influential people” recommends that our country takes a longer-term view in handling our problems (read Sachs’s full bio). Instead of analyzing everything through a microscope, Sachs realizes that peering out over the horizon with a telescope may provide a clearer path to success versus getting sidetracked in the emotional daily battles of noise.

I do my fair share of media and politician bashing, but every once in a while it’s magnificent to discover and enjoy a breath of fresh common sense, like the advice coming from Sachs. Normally, I become suffocated with a wet blanket of incessant, hyper-sensitive blabbering that comes from Washington politicians and airwave commentators. With the advent of this thing we call the “internet,” the pace and volume of daily information (see TMI “Too Much Information” article) crossing our eyeballs has only snowballed faster. Rather than critically evaluate the fear-laced news, the average citizen reverts back to our Darwinian survival instincts, or to what Seth Godin calls the “Lizard Brain. ”

Sachs understands the lingering nature to our country’s problems, so in pulling out his long-term telescope, he created a  broad roadmap to recovery – many of the points to which I agree. Here is an abbreviated list of his quotes:

On Short-Termism:

“Despite the evident need for a rise in national saving after 2008, President Barack Obama tried to prolong the consumption binge by aggressively promoting home and car sales to already exhausted consumers, and by cutting taxes despite an unsustainable budget deficit. The approach has been hyper short-term, driven by America’s two-year election cycle. It has stalled because US consumers are taking a longer-term view than the politicians.”

On Differences between China and the U.S.:

“China saves and invests; the US talks, consumes, borrows, and talks some more.”

On Why Tax Cuts and Stimulus Alone Won’t Work:

 “Short-term tax cuts or transfers on top of America’s $1,500bn budget deficit are unlikely to do much to boost demand, while they would greatly increase anxieties over future fiscal retrenchment. Households are hunkering down, and many will regard an added transfer payment as a temporary windfall that is best used to pay down debt, not boost spending.”

On Malaise Hampering Businesses:

“Businesses, for their part, are distressed by the lack of direction….Uncertainty is a real killer.”

 

On 5-Point Plan to a U.S. Recovery:

1)      Increased Clean Energy Investments: The recovery needs “a significant boost in investments in clean energy and an upgraded national power grid.”

2)      Infrastructure Upgrade: “A decade-long program of infrastructure renovation, with projects such as high-speed inter-city rail, water and waste treatment facilities and highway upgrading, co-financed by the federal government, local governments and private capital.”

3)      Further Education: “More education spending at secondary, vocation and bachelor-degree levels, to recognize the reality that tens of millions of American workers lack the advanced skills needed to achieve full employment at the salaries that the workers expect.”

4)      Infrastructure Exports to the Poor: “Boost infrastructure exports to Africa and other low-income countries. China is running circles around the US and Europe in promoting such exports of infrastructure. The costs are modest – essentially just credit guarantees – but the benefits are huge, in increased exports, support for African development and a boost in geopolitical goodwill and stability.”

5)      Deficit Reduction Plan: “A medium-term fiscal framework that will credibly reduce the federal budget deficit to sustainable levels within five years. This can be achieved partly by cutting defense spending by two percentage points of gross domestic product.”

Rather than succumb to the nanosecond, fear-induced headlines that rattle off like rapid fire bullets, Sachs supplies thoughtful long-term oriented solutions and ideas. The fact that Sachs mentions the word “decade” three times in his Op-ed highlights the lasting nature of these serious problems our country faces. To better see and deal with these challenges more clearly, I suggest you borrow Sachs’s telescope, and leave the microscope in the lab.

Read Full Financial Times Article by Jeffrey Sachs

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

July 30, 2010 at 2:18 am 3 comments

Dividends: From Sapling to Abundant Fruit Tree

Dividends are like fruit and an investment in stock is much like purchasing a sapling. When purchasing a stock (sapling) the goal is two-fold: 1) Buy a sapling (tree) that is expected to bear a lot of fruit; and 2) Pay a cheap or fair price. If the right saplings are purchased at the right prices, then investors can enjoy a steady diet of fruit that has the potential of producing more fruit each year. Fruit can come in the form of future profits, but as we will see, the sweetness of a profitable company also paying dividends can prove much more fruitful over the long-term.

Investing in growth equities at reasonable prices seems like a pretty intelligent strategy, but of late the vast majority of fresh investor capital has been piling into bonds. This is not a flawed plan for retirees (and certain wealthy individuals) and should be a staple in all investment portfolios, to a degree (some of my client portfolios contain more than 80%+ in fixed income-like securities), but for many investors this overly narrow bond focus can lead to suboptimal outcomes. Right now, I like to think of bonds like a reliable bag of dried fruit, selling for a costly price. However, unlike stocks, bonds do not have the potential of raising periodic payments like a sapling with strong growth prospects. “Double-dippers” who are expecting the economy to spiral into a tailspin, along with nervous snakebit equity investors, prefer the reliability of the bagged dry fruit (bonds)… no matter how high the price.                     

How Sweet is the Fruit? How Does a +2,300% Yield Sound?

Not only do equities offer the potential of capital appreciation, but they also present the prospect of dividend hikes in the future – important characteristics, especially in inflationary environments. Bonds, on the other hand, offer static fixed payments (no hope of interest rate hikes) with declining purchasing power during periods of escalating general prices.  

Given the possibility of a “double-dip” recession, one would expect corporate executives to be guarding their cash with extreme stinginess. On the contrary, so far in 2010, companies have shown their confidence in the recovery by increasing or initiating dividends at a +55% higher clip versus the same period last year. Underpinning these announcements, beyond a belief in an economic recovery, are large piles of cash growing on the balance sheets of nonfinancial companies. According to Standard & Poor’s (S&P), cash hit a record $837 billion at the end of March, up from $665 billion last year.

The S&P 500 dividend yield at 2.06% may not sound overwhelmingly high, but with CDs and money markets paying next to nothing, the Federal Funds rate at effectively 0%, and the 10-Year Treasury Note yielding an uninspiring 3.11%, the S&P yield looks a little more respectable in that light.

 If the stock market yield doesn’t enthuse you, how does a +2,300% yield sound to you? That’s roughly what a $.05 (split adjusted) purchase of Wal-Mart (WMT) stock in 1972 would be earning you today based on the current $1.21 dividend per share paid today. That return alone is mind-blowing, but this analysis doesn’t even account for the near 1,000-fold increase in the stock price over the similar timeframe. That’s what happens if you can find a company that increases its dividend for 37 consecutive years.

Procter & Gamble (PG) is another example. After PG increased its dividend for 54 consecutive years, from a split-adjusted $.01 per share in 1970 to a $1.93 payout today, original shareholders are earning an approximate 245% yield on their initial investment (excluding again the massive capital appreciation over 40 years). There’s a reason investment greats like Warren Buffett have invested in great dividend franchises like WMT, PG, KO, BUD, WFC, and AXP.

Bad Apples do Exist

Dividend payment is not guaranteed by any means, as evidenced by the dividend cuts by financial institutions during the 2008-2009 crisis (e.g., BAC, WFC, C) or the discontinuation of BP PLC’s (BP) dividend after the Gulf of Mexico oil spill disaster. Bonds are not immune either. Although bonds are perceived as “safe” investments, the interest and principal payment streams are not fully insured – just ask bondholders of bankrupt companies like Lehman Brothers, Visteon, Tribune, or the countless other companies that have defaulted on their debt promises.

This is where doing your homework by analyzing a company’s competitive positioning, financial wherewithal, and corporate management team can lead you to those companies that have a durable competitive advantage with a corporate culture of returning excess capital to shareholders (see Investing Caffeine’s “Education” section). Certainly finding a WMT and/or PG that will increase dividends consistently for decades is no easy chore, but there are dozens of budding possibilities that S&P has identified as “Dividend Aristocrats” – companies with a multi-year track record of increasing dividends. And although there is uncertainty revolving around dividend taxation going into 2011, I believe it is fair to assume dividend payment treatment will be more favorable than bond income.

Apple Allocation

Growth companies that reinvest profits into new value-expanding projects and/or hoard cash on the balance sheet may make sense conceptually, but dividend paying cultures instill a self-disciplining credo that can better ensure proper capital stewardship by corporate boards. All too often excess capital is treated as funny money, only to be flushed away by overpaying for some high-profile acquisition, or meaningless share buybacks that merely offset generous equity grants to employees.

So, when looking at new and existing investments, consider the importance of dividend payments and dividend growth potential. Investing in an attractively priced sapling with appealing growth prospects can lead to incredibly fruitful returns.

Read the Whole WSJ Article on Dividends

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct positions in BAC, WFC, C, BP, PG, KO, BUD, WFC, AXP, Lehman Brothers, Visteon, Tribune, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

June 27, 2010 at 10:55 pm 2 comments

EBITDA: Sniffing Out the Truth

Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric. 

The Genesis of EBITDA

The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying interest expense could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.  

The Advantages of EBITDA

Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:

  • Operational Comparability:  As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice. 
  • Cash Flow Proxy: Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
  • Debt Coverage Ratios:  In many lender contracts certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.

The Disadvantages of EBITDA

While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.

  • Overstates Income:  To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTER all expenses, including interest expense, depreciation expense, and  income tax expense.
  • Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
  • Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).

Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

April 6, 2010 at 11:00 pm 1 comment

Short-Termism & Extremism: The Death Knell of our Future

In recent times, American society has been built on a foundation of instant gratification and immediate attacks, whether we are talking about politics or economics. Often, important issues are simply presented as black or white in a way that distorts the truth and rarely reflects reality, which in most cases is actually a shade of grey. President Obama is discovering the challenges of governing a global superpower in the wake of high unemployment, a fragile economy, and extremist rhetoric from both sides of the political aisle.  Rather than instituting a promise of change, President Obama has left the natives restless, wondering whether a “change for worse” is actually what should be expected in the future.

Massachusetts voters made a bold and brash statement when they elected Republican Senator Scott Brown to replace the vacated Massachusetts Senate seat of late, iconic Democratic Senator Edward Kennedy – a position he held as a Democrat for almost 47 years. Obama’s response to this Democratic body blow and his fledging healthcare reform was to go on a populist rampage against the banks with a tax and break-up proposal. Undoubtedly, financial reform is needed, but the timing and tone of these misguided proposals unfortunately does not attack the heart of the financial crisis causes – excessive leverage, lack of oversight, and irresponsible real estate loans (see also, Investing Caffeine article on the subject).

With that said, I would not write President Obama’s obituary quite yet. President Reagan was left for dead in 1982 before his policies gained traction and he earned a landslide reelection victory two years later. In order for President Obama to reverse his plummeting approval ratings and garner back some of his election campaign mojo, he needs to lead more from the center. Don’t take my word for it, review Pew Research’s data that shows Independents passing up both Republicans and Democrats. The overall sour mood is largely driven by the economic malaise experienced by all in some fashion, and unfortunately has contributed to short-termism and extremism.

Technology has flattened the world and accelerated the exchange of information globally at the speed of light. Any action, recommendation, or gaffe that deviates from the approved script immediately becomes a permanent fixture on someone’s lifetime resume. Our comments and decisions become instant fodder for the worldly court of opinion, thanks to 24/7 news cycles and millions of passionate opinions blasted immediately through cyberspace and around the globe.

Short-termism and extremism can be just as poisonous in the economic world as in the political world. This dynamic became evident in the global financial crisis. Short-termism is just another phrase for short-term profit focus, so when more and more leverage led to more and more profits and higher asset prices, the financial industry became blinded to the long-term consequences of their short-term decisions.

Solutions:

  • Small Bites First: Rather than trying to ram through half-baked, massive proposals laced with endless numbers of wasteful pork barrel projects, why not focus on targeted and surgical legislation first? If education, deficit-reduction, and job creation are areas of common interest for Republicans and Democrats, then start with small legislation in these areas first. More ambitious agendas can be sought out later.
  • Embrace Globalization: Based on the “law of large numbers” and the scale of the United States economy, our slice of the global economic pie is inevitably going to shrink over time. How does the $14 trillion U.S economy manage to grow if its share is declining? Simple. By eschewing protectionist policies, and embracing globalization. Developing country populations are joining modern society on a daily basis as they integrate productivity-enhancing innovations used by developed worlds for decades. In a flat world, the narrowing of the productivity gap is only going to accelerate. The question then becomes, does the U.S. want to participate in this accelerating growth of developing markets or sit idly on the sideline watching our competitors eat our lunch? 
  • Hail Long-Termism and Centrism:  Regulations and incentives need to be instituted in such a fashion that irresponsible behavior occurring in the name of instant short-term profits is replaced with rules that induce sustainable profits and competitive advantages over our economic neighbors. Much of the financial industry is scratching and screaming in the face of any regulatory reform suggestions. The bankers’ usual response to reform is to throw out scare tactics about the inevitable damage caused by reform to the global competitiveness of our banking industry. No doubt, the case of “anti-competiveness” is a valid argument and any reforms passed could have immediate negative impacts on short-term profits. Like the bitter taste of many medicines, I can accept regulatory remedies now, if the long-term improvements outweigh the immediate detrimental aspects.

The focus on short-termism and extremism has created an acidic culture in both Washington and on “Main Street,” making government changes virtually impossible. If President Obama wants to implement the change he campaigned on, then he needs to take a more centrist view that concentrates on enduring benefits – not immediate political gains.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

Article first submitted to Alrroya.com before being published on Investing Caffeine.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but at the time of publishing had no direct positions in securities mentioned in the article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

February 3, 2010 at 12:01 am Leave a comment

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