Inflation, the Biggest Sin Tax

Highlights: Sin Taxes, Lessons from the Cosmos, The Political Crutch,

The Enemy, How an Award Winning 401-K Invests During Inflation,

Other Currencies

Sin taxes

Governments have many problems but all have two in common. The first is that certain crimes appear to be endemic to their societies and don’t appear to be susceptible to inexpensive eradication. For example we know there are enormous social costs due to chronic losses from gambling, and there are others as well. Many governments take the attitude that they can not stamp out these sins; however they can hurt them by imposing taxes on them. There is a naïve belief that if they raise the cost to participate that eventually the public will not indulge. This brings us to the governments’ second need which is a source of growing tax revenue, not to pay for the social costs of the crime, but to meet general government expenditures. Just look at the incredibly sharp increase in taxes on cigarettes and alcohol in our lifetime. The victims of these sins are often labeled addicts. Strange, we do not label governments as addicts, though they are addicted to sin tax revenues. By the way I believe by far the largest sin tax in terms of impacts on our societies is inflation.

Lessons from the cosmos

We may believe that inflation is a relatively new phenomenon from the time of the birth of coins and currencies. Evidence just revealed this week proves that Albert Einstein^* was correct in suggesting that it was present in the original Big Bang Theory^* at the creation of our universe. This week according to James Bock, a Caltech^* physicist along with others using a telescope from the South Pole, found evidence of gravity (waves that Dr. Einstein, a century ago predicted would be found that were the direct result of the Big Bang that created our universe.) I will leave to others, more learned than me to explain the theory. For those of us that live in the world of numbers and taxes, the key to the discovery was the term used for the exponential growth of particles that became planets and other objects. That term was ‘inflation.’ Thus the term from the physical world describes a power that keeps growing.

^* When he came to the US Albert Einstein spent some time at the California Institute of Technology (Caltech). I have stayed in the room/suite that was prepared for him to stay in the faculty club on campus. Princeton lured him away to teach in New Jersey, where we now live. His Big Bang Theory is used as a title for a current television comedy about very bright scientists adjusting to functioning in the everyday world. I will admit my good wife is addicted to watching both the original and re-runs of these hilarious shows. Many believe that Caltech graduates are the models for these characters. There is much amusement about the success of the program at Caltech board meetings that I attend.

The political crutch

I have read a number of constitutions from around the world, and in none of them have I found that the sacred duty of the government is to create jobs for the governed. Yet any government that wants to stay in power, whether elected or not, is at risk when people are out of work and there is general lack of sufficient food. The leaders of the government, rather than to solely rely on the underlying economy to produce sufficient income and jobs, believe that they must do it. In general, governments have two sets of financial tools, fiscal and monetary policies. Fiscal policies are those that set the level of taxes raised from the population. As most people do not want to give up some of their hard earned money to the government, raising net effective tax rates is generally not favored.

The second set of policies is monetary policies. These deal with the levels of loans made by the financial community and in its essence the value of money. There is a long history of the latter. A monetarist would point out the Roman Empire, like all great empires, did not fall to the hordes of barbarians. Rome fell because for many years the government was literally shaving some of the metal from its coinage money. In effect it was devaluing. The public was not dumb and realized that the value of the money declined and so they raised the prices for their goods, services, and labor. Rome fell because it could no longer be protected by the best, most expensive, military in the world. In the Middle Ages shaving coins was punishable by death. A government which is not popular, and few are, can either publicly raise taxes or more quietly devalue which creates inflation. All too many of today’s leaders are unwilling to pay for current and future government services through tax revenues and so resort to forms of inflation that the public does not fully comprehend.

Central Banks which are titularly responsible for monetary matters and in theory independent of political forces are in fact beholden to them. Because the political leaders can not obtain sufficient taxes they have the central banks induce inflation into the economy that they hope will stimulate individual and corporate savers to spend and invest that will create new jobs and incidentally lower the value of their debt repayments.

The enemy

In a closed society that is not expanding, the need for increased spending and investment is high. By definition the people that have the necessary money are the savers. These people are those that are choosing not to spend in order to provide for the future spending needs of themselves, their families, and worthwhile charities. By lowering the value of their savings by inflation, central banks are in effect stealing from these savers. Thus, the savers become the target to generate the future growth. If they don’t readily provide the necessary funds they become the enemy. 

The current policies of many central banks including those in US, UK, Europe, and Japan is to raise inflation to 2% or more to drive their economies. The theft comes in by understanding the long-term effects of inflation. The collapse of the Weimar Republic in Germany brought Hitler into power when their money was practically worthless. Many would say that can’t happen here. If successive central banks meet their goals of 2% or more inflation in one or two generations the entire wealth of the savers can be wiped out. (The rule of 72 shows the number of years it takes to double your money by dividing the current or expected interest rate into 72. The same calculation can be used in reverse to see how long it would take to lose half. Two divided into 72 suggests 36 years. For those of us responsible for long-term investing for endowments or multiple generations of families, 36 years is a short term when century-100 year bonds are being eagerly sought.) 

How an award winning 401(k) invests during inflation

There is no complete answer to creating an investment portfolio that can meet the needs for reasonable returns that is aware of the risks of inflation. We have addressed these needs in a 401(k) that BrightScope labeled as the best in the country in terms of many attributes including low costs  As the participants can not withdraw their money from this plan for ten years, the ten year performance numbers are relevant as a guide for long-term oriented accounts. Below is the annualized performance for ten years through the end of February of the nine options offered to the participants and their rank within the nine alternatives:

Rank/Category=Total Reinvested Return

1.    Small-Cap Core=9.23%

2.    Small-Cap Value=8.23%

3.    Index fund=7.89%

4.    Growth=7.76%

5.    Value=7.07%

6.    Balanced=6.71%

7.    International=6.27%

8.    Bond=4.73%

9.    Stable Value=3.10%

Do not fixate on the actual numbers which were influenced by numerous special circumstances. During this last ten years I have been very concerned that after-inflation returns were going to be important for all of our accounts to meet their spending needs beyond the financial world. To me the best overall way to do this was to assume more volatility and liquidity concerns by investing in smaller companies. In any given ten year period the actual returns will almost certainly be different as will probably those ranked between 3^rd and 7^th. As the end of this period was February the ranking of International was hurt by currency movements.

Believing that the US will not adequately address its inflation issue, which should be zero based, I believe on a relative basis the long-term value of the dollar will decline upon the leaders. Thus, at this point in time for long-term accounts I would be increasing exposure overseas even with the economic and credit risks in China. The Bond return of 4.73% includes significant investments in TIPS to provide some real return benefits from owning bonds. Because I expect interest rates to rise the total reinvested return in bond funds in a cash flow account will enjoy higher rates that can offset some lower bond prices. Stable value returns over time should equate to the inflation rate.

Are there other long-term oriented 401(k)s with which we should be speaking?

Other currencies

The way we invest into non-US dollar currencies is through funds that have equity and debt positions in selected currencies. With the US dollar being the temporary safe currency it has appreciated against other currencies. This means that the other currencies have lost value relative to the greenback.  Liking to buy when things are down, I am attracted to investments in sound Canadian companies. The relatively newly appointed head of the Indian Reserve bank appears to me he could be making India’s securities more attractive by raising interest rates as some investors may want to diversify out of some of their direct holdings in China. Along the same line of thinking, the Taiwanese dollar could be of interest.

My question for all of us is: How are we going to hedge our inflation risk ahead of inflation manipulation replacing interest rate manipulation?

Please share your thoughts.  

___________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Thinking About Selling

Introduction

For the last several posts I have been dwelling on the coming peak in stock markets. I have not been predicting that the current record levels are the peaks before major declines; however I am suggesting that many of the characteristics of a classic top are showing up.

The difference between smart and loud people

We are experiencing the beginning of an enthusiasm epidemic. The clamor of some media pundits echoing comments by economists and a few real market movers is almost becoming deafening. (I wonder whether there are any quiet bulls!) When I parse what they are actually saying I discover that they are looking for another year of rising stock prices and they are willing to see declining bond prices. This was reinforced to me this morning, when leaving our local gym I ran into the director of research of one of the smart new research firms. He said he felt that there was another good year ahead before the size of the government sector’s debt including the central banks would create instability.  This is the equivalent of believing that he can safely dismount from the tiger of “the greater fool theory” that I have written about previously. I earnestly hope he can.

In our continuing discussions with portfolio managers of successful small market capitalization mutual funds, I find they are not waiting to begin their exiting strategies. Quite a number have taken the steps of restricting the amount of money coming into their portfolios by closing their funds and their separately managed accounts to new money. One fund has already started a program of reducing the size of its commitments to some winning positions. Another technique being followed by some is not to fully invest the latest surge of new money that has entered their shop. Their cash build-up already approximates 60% of their maximum cash positions.

What to Do?

In terms of stock positions, one should start to think about net selling slowly. I stress net selling. At all times I would urge investors to follow my late friend, Sir John Templeton’s advice to always seek out better bargains. While a switch may improve the long-term results of one’s equities, it does not reduce the overall market risk of the stock portfolio. What I am suggesting is to begin to plan to reduce the overall commitment to equities. (For me this is a nerve-racking move as I have been long stocks for the last 40 years.)

The One-year Timeframe Portfolio

As regular readers of my posts, you are aware of my concept of dividing one’s portfolio into separate time horizon-oriented sub portfolios, or “Timeframe Portfolios.” At the minimum one should have at least three sub portfolios with time horizons of one year, five years, and ten or more years. My immediate focus is on the one year which is both for the net cash generation to meet current needs and the result most amateurs focus on in their discussions in mixed investment committee meetings with non-professional investors. For this section of the portfolio a selling program is needed to meet cash and competitive needs. The object of the exercise, while enjoying the probable rising market prices, is to raise sufficient cash to meet funding requirements. My suggestions are first to decide how much cash is required at the end of the year and then plan to sell an amount each month or quarter.

The next approach is to set price levels for each position that is a reasonable one year goal. Whenever the price is reached, sell the position and include the proceeds in the required cash raised for the month or quarter. Finally, there will be events, some positive and some negative that will cause the stock price to gyrate. Either way it would be a good time to exit the one year position.

The Five-year Timeframe Portfolio

The middle sub portfolio or the five year portfolio has a different set of issues and therefore suggestions. What is absolutely clear to me is that sometime over the five years stock prices will take a nasty hit, most likely in the 25% range, but possibly as much as 50% before returning to an upward path. The critical question facing this portfolio is, “Who will see the results?” If the only reviewer of this portfolio is its owner, then a sound growth-oriented portfolio would make the most sense as stock markets tend to rise three out of four years. However, if the portfolio is likely to be reviewed by a critic, a significantly different strategy might be best. To be over-simplistic, owners want upsides, critics want to avoid declines. 

Most of the time the discipline of a value-oriented portfolio has had less chance of declines. The overall characteristic of a value portfolio is that the stocks are selling significantly below their perceived intrinsic value. (Not so far below that only a small minority of investors would perceive the same value. These portfolios are often labeled “deep value” and better left in the hands of keen professionals.) Most often to keep value stocks from declining at the same rate as more aggressive growth-oriented stocks, the value stocks pay a dividend and may have a practice of buying back their shares from their shareholders. The dividend yield on these stocks should attract some additional buyers if the stocks go down in price and their yields rise. Currently the ten worst performing stocks in the Dow Jones Industrial Average (DJIA), often known as the “Dogs of the Dow,” have dividend yields of between 3% and 5%. Many so-called value stocks have similar or somewhat smaller yields. And this is what makes them more vulnerable today. 

For months the general stock market has been discounting the beginning of the Federal Reserve’s tapering and bond yields have been rising.  Over long periods of time when bond yields go up, stock yields go up and stock prices weaken. When this happens the partial safety net from dividends become less strong for value stocks. In addition, many value stocks are from companies that require significant capacity expansions to produce the same or higher dividends in a period of rising costs. I am increasingly concerned about some of these in the energy business. Quite contrary to past beliefs there is a multiple year threat of over production of oil which will lead to lower prices. Nice for us as consumers, but it is not a favorable outlook for maintaining or growing dividends. Thus, my recommendation for value-focused portfolios is to reanalyze the intrinsic value calculations as well as the value of future dividends as a price support for the stock.

Bond prices are declining

Contrary to much of market history, we have until very recently enjoyed having bond and stock prices rising at the same time. In the past their price movements have been inverse to each other.  As mentioned the markets have already sensed the slow pullback of the manipulations by central banks to keep interest rates artificially low. In addition, while it is clear some of the most damaged European economies have stopped shrinking and may be rising a small bit, the rating agencies are slightly lowering a number of the sovereign bond ratings. They are showing appropriate concerns as to the willingness of political leaders to continue the various austerity policies that helped to give confidence to the funders of the turnarounds. Removing this discipline runs the risk of a 1937-38 Roosevelt Recession which may well have been a contributor to setting up WWII. With the high-quality bond markets showing signs of nervousness, the yield spread for high yield, if you will junk bonds, will widen.  If this were to happen it will make the current wall of refinancing more expensive, perhaps prohibitively. Without support from the fixed-income world many of the expected merger and acquisition deals are going to be delayed which could hurt the value stocks.

When one hears of transactions, one should make the judgment whether the buyer or seller is smarter. I am very selectively and for specific purposes slowly beginning to sell a little bit.

Please let me know what you are doing.   

_______________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.