One of my favorite pastimes is thumbing through the financials of public companies. Hidden gems do exist, but they are rare with the myriad analysts using serious computing power to scrub large firms daily. This is one of the reasons investing in an index fund makes so much sense.
There are good investments in the large company world. As I write, Apple Inc. has around $50 per share in cash in the checkbook. When you subtract cash the enterprise value is in the low teens. This is a good value from most perspectives. However, there are risks associated with Apple. First, it’s hard to move the needle on such a large company. Second, they manufacture a large part of their product in China. A quick glance at recent news and it becomes clear the risk involved. Third, each product launch needs to keep growing larger at a rapid pace to stay on top the pack. The one thing Apple has going for it is a large margin of safety.
The Wide Open World or the Wild West (You Decide)
Large international public corporations aren’t the only game in town. There is another world fraught with many risks and the promise of undiscovered gems worth many multiples of its listed price.
These quasi-public companies are followed by virtually no one. Worse, audited financial data is hard to find if available at all. And the biggest problem of all: insider trading.
These companies are listed on what is called the Pink Sheets, a throwback to the days when their quotes were printed daily on pink sheets of paper. Quotes were hard to come by in the past. Today, most of these companies can be pulled up from most online trading platforms (E*Trade, et cetera). One thing to remember, pink sheets is a quotation service only. Online brokers get their quotes for these stocks from that source.
The reasons for listing on the pink sheets are varied. A large number are outright scams. Others are companies who have fallen on hard times. Large international firms outside the U.S. sometimes opt to list on the pink sheets so they don’t have as heavy a reporting burden. Nestle is a prime example.
The world of small stocks isn’t littered with pump-and-dump scams only. Many small banks also list on the pink sheets. A small, one-branch bank in a small town in rural America has no chance of selling shares on the broader exchanges. The reporting requirements alone would be disruptive to their business model. The small bank can instead opt to list on the pink sheets. They will still report to the banking regulators and provide some financial statements on which to make an investment decision. Find a small one-branch bank near where you live and pay them a visit. Ask if they have stock you can buy. You might be surprised. They sometimes pay an attractive dividend.
A Round of Golf, Anyone?
Your favorite accountant has some experience buying stocks from the pink sheets. It doesn’t happen often because there is far more garbage then gemstone in the detritus. The smell tends to get on your hands and it doesn’t wash off worth a darn.
Outside tax season I like to waste an afternoon several times a year scouring the pink sheets based on geographical location of the listed company. The screener I linked also has OTC listings in addition to the pink sheets. I’ll let you play around with it on your own.
For our discussion we will focus on one stock I did buy in the early 2000s. I set the screen to list U.S. companies only. I started scrolling down the list looking for all listings in Wisconsin, my home state. I made a note of each Wisconsin listing.
My hopes weren’t high I would find anything of value. Even if a gemstone rose to the surface I may never recognize it. Remember, information is hard to come by on many of the companies.
One name jumped out. A golf course less than a two hour drive from my home caught my eye. I was vaguely familiar with the establishment and didn’t know they were listed.
This is where it gets risky legally. The golf course on my radar was interesting so I started a pet project of researching the company. They hadn’t published any financial information in quite a while. Intrigued, I decided to go one step further.
My first reaction to any pink sheet listing is to stand clear. Our friendly golf course just hit me right. Wanting to know more I took a day trip. I can’t golf worth a crap, but I do get more value than the average golfer because I get to swing more often than they do. The trip was all in the name of research.
The golf course was well kept when I arrived. The parking lot was full; the golf course teaming with old guys wasting their day; and the clubhouse was doing brisk business. I was excited!
My research to his point was similar to analysts using satellite data of Wal-Mart parking lots during the Christmas shopping season. There is nothing illegal about visiting a company whose stock you are considering for purchase. Having a drink and playing a round of golf (I did) is also acceptable behavior. No security laws have been broken.
However, I had to be careful! Since financial reports were not published in a while I couldn’t jawbone with the golf course’s accountant to glean information. It would have been risky to even jawbone with bartenders or anyone connected to the club. Trading on non-public information is called insider trading a very illegal!
The stock of the golf course traded around $3. Based upon their location (close to my home) and how busy they were when I visited, I decided to buy. I bought all my shares from slightly under $3 up to $4. Because of the risk I would hear something I shouldn’t I never visited again. I bought $30,000 of their stock over several months and sat on it. There was no dividend so it was one of those things I collected on the back shelf and didn’t think about for a long time.
A few years later I checked on the stock to discover it started climbing at a slow and steady pace. My $30,000 was worth six figures. I was happy! I also knew if I tried to dump my shares I would probably not get the current listed price.
I tucked the stock on the back shelf again. Intrigued, I periodically checked the price. It kept slowly climbing. About six years after my purchase the stock was in the mid 20s when it disappeared. Oh-oh!
My dreams were shattered. There were still no financial reports and a quick drive to the golf course showed they were still open. Was it a scam?
Nope! A few weeks later a check came in the mail. They were bought by another golf course for cash. My reward for six years of holding the stock was a 14x gain.
Before you run out and try to replicate my experience, know lightening has only struck once in my field. I got lucky. My luck was weighted in my favor by verifying the company was really there and viable. (They had customers!) I bought with a lot of blind faith. Every other pink sheet investment (there have only been a few) produced less than respectable returns.
The golf course was my biggest venture into the pink sheets. It was also a bet (you decide if I invested or gambled) I was willing to take because it looked like a nice place. All public information legal to trade on.
My other investments from the pink sheets and OTC markets usually involved banks. Returns were less than spectacular. In some cases I even lost money. In my defense I never took a flyer buying a true penny stock.
Where is the Respect?
Penny stocks in rare cases can be a respectable investment as my experience has shown. I do NOT encourage such investments! They are very risky and only for those willing to do some extra legwork without crossing the boundary between legal and insider trading. You also must be willing to lose 100% of your investment.
For some reason a few penny stock journals follow this blog and republish articles from time to time (always with permission). I wanted to share my one positive example so these guys have an article that will resonate with their readers.
For regulars around here, I still recommend the bulk of your money finding a home in a broad-based index fund. This is the best place for most people to invest long-term. If you have an itch to scratch digging for buried treasure the pink sheets and OTC markets have possibilities.
One caveat. You will spend a lot of time digging before any morsel reveals itself. It’s just the nature of the game. The good news is that Wall Street isn’t watching. You don’t have to compete with large hedge funds and the super-wealthy. The value of all pink sheet companies combine is around $1 billion. Too small for mainstream investments bankers to waste their time on.
Now, if we’re done here, I know a clean golf course where we can knock a couple balls around.
Building wealth is simple when you understand the rules. Spending less than you earn provides seed capital for investments. Index funds provide the opportunity for superior growth with reduced risk due to diversification across the broad economic spectrum.
Once you have the basics it becomes clear you need additional cash management tools to serve your financial needs. Short-term cash for emergencies or living expenses are best held as bank deposits or in high-yield accounts like Capital One 360 or Discover Savings.
With long-term investments set in index funds and short-term needs covered by liquid money market type products it’s time to fill in the remaining gap. And there are some reasonable alternatives paying a respectable rate of return.
Business owners understand the need for liquid fund to cover seasonal fluctuations. In my office tax season fills the coffers used during the slow times of the year. November and December are traditionally slow in the tax industry while expenses tend to be high. Some year-end tax planning brings in some revenue, but the cost of mailing organizers, employee training and property taxes take an ax to the budget. This is the gap I refer to above.
Individuals face the same gap. Planning for a vacation or allocating funds for property taxes are an example. Individuals may also become uncomfortable with the level of the stock market. Selling index funds to store in a money market at a percent or two doesn’t make sense and becomes painful when the market continues climbing.
I never encourage market timing. However, there are times to take some chips off the table. Example: As you approach retirement (or if you are in retirement) I always recommend keeping about two years of living expenses in cash. If the market keeps climbing you can fund living expenses with dividends or small index fund sales. When the market has a temporary setback you can use the liquid funds to live. This assures you never have to sell at a market low! If the downturn becomes prolonged you can stop reinvesting dividends and capital gains to fund expenses. The goal is to never find yourself forced to sell in a down market.
Investing Gap Funds
Money market funds and online savings accounts at Capital One and Discover are good tools to store excess funds in retirement, for future investments or to pay large one-time expenses. The interest rate is low, but better than nothing.
For several years I used Lending Club and Prosper (notice I don’t include links because I no longer recommend these options) to serve as a high-yield investment for such funds. Then we had the Lending Club fiasco I was out the door. Where there is smoke there’s fire. I could be wrong, but I’d rather be a living coward than a dead hero.
Lending Club and Prosper issue unsecured loans you can invest as little as $25 in. The goal is to spread your investment over as many loans as possible to avoid one bad loan destroying your portfolio. There are lots of loans that default as borrowers have no skin in the game.
Peer Street offers loans in a similar fashion to the Lending Club/Prosper model with a few notable exceptions. Peer Street loans are backed by real estate with loan to value (LTV) typically below 75%. Borrowers have skin in the game!
The minimum investment is $1,000 per loan. This is still a micro loan, but not nearly as small as the $25 minimums at Lending Club or Proper. Since there is something backing the loan (real estate) the risk is likely much smaller. (Loans backed by assets default at lower rates than unsecured loan with rare exception.) You can still—and should—spread your investment funds over several loans to mitigate risk. (More below.)
Most Peer Street loans are short term (6-24 months) and generally yield 6-12% over 12 months. Peer Street periodically has very short loans (one month) that yield a lower rate, but more than Capital One or Discover currently. This can be a powerful cash management tool.
The short-term nature of the loans makes it easy to ladder your portfolio for consistent cash flow and liquidity. A small investment can provide a steady stream of available cash while earning a higher than average yield.
How I Use Peer Street
I don’t like to over-commit to any investment. My style is to dip my toe in the waters first and then stepping slow into the shallow end until I’m comfortable.
I started investing in Peer Street a few months back. Every loan I invested in is for the minimum: $1,000. So you understand my style, I currently have $6,000 invested with intentions of reaching $100,000 over the next year or two. As long as the wheels don’t fall off (remember the Lending Club issues) I’m happy. I’ll never put everything into Peer Street, but I will invest enough to move the needle eventually.
Every week or two I’ve been adding another $1,000 or so. Peer Street reports interest income and loan maturity funds on the 15th and last day of the month. The money appears in my account a few days later. I use this opportunity to add new funds to my account to bring the cash balance back to $1,000 so I can invest in another loan.
My slow approach is for two reasons. First, I can sample how Peer Street works before committing a level of funds that would hurt if I misstep. This allows me to acclimate to the investment. Second, the slow approach means I have loans spread out over a wide range. In a few months I will have loans maturing practically every month. Coupled with the interest stream I’m in a good position to benefit from the investment.
Investing in income properties can be a lot of work with plenty of risks. Peer Street makes real estate investing easier, smoothing the income ride along the way.
Interest income is taxable. Landlords have several tax advantages due to real estate ownership. Peer Street investments are loans and income is treated as ordinary income. If you are familiar with Lending Club or Prosper you will find reporting Peer Street income looks a lot the same. The main difference is loan losses. Lending Club/Prosper have a lot of loans that default. This can play havoc on your tax return in some instances. Peer Street has had a few loans default, but according to a conversation I had with a Peer Street consultant on the phone, investors lost no money. The LTV metric does offer a level of protection to investors. (Loan losses would be handled in a similar fashion to Lending Club should they occur.)
Time for a reality check. Most loans offered on Peer Street hover around 7%. Yes, the sales literature says you can pull up to 12%. Real world experience says you will have plenty of opportunity to invest with a 7% return. Some loans are lower, more are higher. Loans paying 8% or more require a strategy.
Peer Street allows for automatic investing of funds in your account. What I do is keep $1,000 in the account and set the parameters of the auto-investing feature at 8% or higher, LTV up to 75%, loan term up to 60 months (I don’t mind a longer term investment, but you may wish to tighten this parameter) and $1,000 max per loan.
Peer Street sends an email when they invest in a loan automatically. If you don’t like the look of the loan you have 24 hours to cancel from time of notification.
New loans are available most business days. The higher interest loans usually are filled with automatic funds. The 7% and 7 ½% loans are frequently available for manual investing.
There you have it, kind readers. No fancy stories today. This is an idea I’ve been working personally on a small scale for a bit and wanted to share it with you. As a reminder, the links in this post are affiliates. Peer Street graces your favorite accountant with $30 for every new account I send their way. I have affiliate links for Prosper and Lending Club, but do not include them because I no longer support their programs. I’d rather be safe than sorry.
I can’t make a real recommendation for you personally since I don’t know you personally, along with all the relevant facts. My only recommendation is to take it slow if you find Peer Street appropriate for your portfolio. No heroes; just another nice product to handle funds living in the gap.
Twin brothers walk into the Wealthy Accountant’s office. One brother is as smart as a whip with an IQ of 147 and a wiz with numbers. The other twin, while looking identical to his brother, is a bit short in the mental category. The less bright brother is hard working, but knows he can’t outthink his twin brother.
Which twin do you think has the greatest financial advantage? Which one is likely to become a millionaire?
Would you believe me if I told you the super-smart twin is orders of magnitude less likely to amass a financial fortune? Yet time and time again I see it in my office: smart people underperforming and average people hitting it out of the park.
Here’s the funny thing. Both brothers are probably equal in intelligence. Life experiences caused one brother to think of himself as average. Perhaps the less intelligent brother preferred working outside with his hands while the high IQ brother pursued a profession.
Doctors and attorneys are awesome at playing financial offense. Many professionals share this quality. But high levels of intelligence don’t correlate well with high levels of financial wealth.
Big Hat, No Cattle
Thomas J Stanley argues in his 2001 book, The Millionaire Mind, that many professionals with a high income don’t have a corresponding level of net worth. Decamillionaires (people with a net worth north of ten million) have a term for people with high levels of income and little to show for it: big hat, no cattle.
These high earning professionals are also extremely intelligent. So intelligent, in fact, they start to believe they can outsmart the markets by timing them. They also have another weakness. Professionals need to maintain an outward appearance of affluence to convince other they are really good at what they do. Who would ever believe an accountant driving around in a bank reposed beater or attorney living in an 800 square foot home?
Average people in average income jobs are more suited to seven and eight figures of wealth! You read that right. The salvage yard owner is far more likely to have a serious level of net worth than a doctor, attorney or (gulp) accountant. Stock brokers and other financial advisors should have an inside track, but spending levels and a high level of understanding of how markets work causes many of these professionals to trade or time the market. The only traders with a snowball’s chance in hell of winning long-term are the market makers and financial newsletter publishers.
My Side of the Desk
Swing around, if you will, to my side of the desk. From my perspective you can see things clearer.
Every day people from all walks of life wander through my office. I have law firms, doctors and even accounting firms as clients. By and large this group enjoys a higher income than average. They also have a low level of net worth compared to what they earn. Worse, I’ve seen more than a few of these professionals pulling in upwards of a half million annually with only a low six figure net worth to show for it.
Before we continue, re-read the last sentence of the last paragraph. For some reason I find it vaguely important to our discussion.
There are plenty of excuses as to why these people are worth only slightly more than their last paycheck. None of them resonate with me.
Don’t leave my side of the desk yet. I have a few more clients to introduce you to.
Oh, here comes Sam. He worked in the mill his entire life. Not the smartest guy in the world, but a helluva family man. He goes to church every Sunday. His wife died a few years back. Worked in the paper mill his entire life before retiring with $4.7 million. By looking at him (or his car or his home or his . . . ) you would never guess he is rich. (Sam is a real client with a different name.)
Here comes another wonderful client. Jack has a landscaping company. He clips and maintains lawns for businesses and rich people, you know, the doctors, attorneys, financial advisors and accountants. Don’t say anything, but the guy maxes out his retirement accounts before adding more to his non-qualified accounts. Oh, and he is a millionaire too. Didn’t expect that considering the rust bucket he’s driving, did you?
The same pattern holds for farmers (they’re not all poor!), truckers, salvage yard dealers and guys laying concrete.
Don’t bite your tongue so hard. They aren’t all rich. Yes, I know guys in the military (or retired from) who are pretty darn rich. Many are pretty darn poor, too.
Not every doctor and attorney is net worth poor compared to their income. Many people in average jobs struggle. What I’m getting at is the people you expect to be rich are putting on a show. They have a big hat, but no cattle. They spend all their money putting on a façade. There’s nothing left to fund real wealth!
People with average incomes in jobs where there is little to no expectation of wealth have an easier time hiding their financial accumulations. A worn pair of jeans is more than fine to wear to work at the salvage yard or auction house. It’s expected!
When I first started investing in micro-loans on the Prosper platform I was able to see a few details on the borrower. Prosper provided a credit score and income range along with the borrower’s occupation. For some reason accountant’s needed loans in May. This blew me away for two reasons. First, an accountant should be flush with cash after tax season.
Second, some accountant’s work outside the tax field so they could need additional funds. Prosper also listed the reason for the loan request. When an accountant requests a loan to pay bills in May I’m dubious. Online lending platforms are not the cheapest way to borrow money! Any accountant worth his salt would never make such a poor financial decision. I say “his” because no woman would ever do something so foolish. (Yes, that was a joke.)
Prosper confirmed what I suspected from serving my clients. High income professionals frequently are poor handlers of money.
There is a lesson for the wise in this tale. You do NOT need a high income to be wealthy or financially independent! Average people in average jobs with average income can excel financially. The statistics are clear.
Sure, a high income can get you to seven figure net worth status faster if you can avoid the siren call of excessive spending to play the role. Even a below average income can grow into a tidy nest egg if handled properly. Minimum wage is a hard racket, for sure. But once your income climbs to a level even below the national average you have plenty of resources to fund an early retirement!
Excuses will show up in the comments. It goes with the territory on blog posts with this topic. They are still only excuses. Income level plays a role in your net worth. By age thirty you should have at least two years income invested. Once you reach 40 your net worth should exceed at least 10 times your annual income. If you are pulling down a $50,000 annual salary you should have a half mil tucked away in an index fund by your 40th birthday. As each decade passes the net worth report card should grow larger.
This is where the rubber touches the pavement. Really smart people want to trade stocks and bonds. They want to time the market because they did all the research. Of course the market makes a fool of the well educated.
There are only two ways to accumulate money in the market. The first is to drop the money into an index fund, or, if you are so inclined to engage an actively managed fund, a growth and income fund. Forget about aggressive funds and other crazy ideas. Your goal is to be rich!
The other way to get rich investing is to research listed companies for undiscovered value. Buy these gems and hold them for somewhere in the neighborhood of forever. Then go out and find another undervalued business to invest in.
Remember, you don’t want to be the smartest guy in the room. The smartest guy is often broke!
I want to be smart. Just not that smart.
It’s been a while since I showed you my working papers. Below are my unedited notes for this post. It should also be noted the working title of this post was Attributes of a Wealthy Individual; or The Smartest Guy in the Room isn’t the Richest was added at the last minute as a tribute to the Rocky and Bullwinkle cartoon. Hope the insight into my writing style helps you with your writing.
What characteristics are most common in the wealthy? High intelligence doesn’t guarantee wealth, it actually hurts! Smart people think they can outsmart the market and time it. Professionals have an appearance to keep. Doctors and sales people need to look the part. The massive spending required to “look good” reduces savings and all the profits those savings generate.
Average people have a much better chance. The salvage yard owner has nothing to prove so she socks away a massive percentage of her income and puts it into index funds because she know she can’t do better,.
I see it in my office all the time. A recent client picked up his return. He is retired with a serious seven figure retirement account before looking at non-qualified monies or other assets. He is an average guy from an average family retired from a mill job. And he’s rich.
Don’t be so smart to talk yourself into poverty. Intelligence can only dig you out of so deep a hole.
Today we have a special guest. My youngest daughter, Brooke, is 18 today. I have two daughters and I managed to keep them alive until adulthood. In my mind I’ve done my job. There is some trepidation, however, which will become clear in a moment. I raised my girls to the best of my ability. They’re fine young ladies. But their path to financial independence is a unique one.
Brooke is finishing up her senior year of high school and has some pretty big plans. I asked her to share her story. She listened to me talk around the house for years. She can repeat my financial rules with perfection. I think you’ll hear a bit of dad in her voice. Enjoy.
Why I’m Retiring the Day I Graduate from High School
By: Brooke Schroeder
I’m different. I’ve always been different. I was born with a big disadvantage. Before I was a year old I had more surgeries than most people in a lifetime. At twelve I started taking over a dozen medications. Pill after pill is cut and placed in a dispenser like that of a 90 year old man.
Dad picks on me that all the pills I take are a meal in itself. My parents are supportive, but they have no idea how much of a pain it is to be sick all the time.
I’m also different from my family in other ways. My sister wants to travel the world and teach English (more on that later). My dad hates traveling past the mailbox at the end of the driveway. He says he wants to build a wall around the farm. When Trump came out with his wall on the Mexican border dad said he needs to talk to Trump and see if he could get a section built around the farm.
Everybody in the family reads a lot except me. It’s not that I don’t read, I just don’t want to do it twenty hours a day!
My mom stopped working a normal job when she was around 30. My dad is a workaholic. He gets crazy ideas and can’t help himself. He has the farm and his tax office. Then he writes his blog. He is always starting a business or doing something. And he reads more than my teachers at school. He reads everything. You would think it would get boring after a while.
There is one trait I share with my family: frugality. My dad is tight with money; I mean real tight. I’ve seen my dad pass on an ice cream cone just to say he didn’t touch the money in his pocket for the entire month. Like I said: tight.
I try not to spend too much money either. I certainly spend less than my friends. Every dime I earn goes into an index fund. My first money when I was a baby was invested. It wasn’t much, but it got the account opened.
While everyone else is reading I head outside. When not working with my hands I play with computers. I’m not 100% sure yet, but I might go to college someday to learn more about IT. Too be honest, I’m in no hurry to go to college. I like school and get good grades. My friends are there too. As graduation approaches I already miss them.
My friends all have plans. A few plan on getting married. Many are going to college. I guess some will buy a home and car and all the other stuff that messes with your happiness in life. The kids at school don’t share my frugal ways as much as I do.
I started working for my grandparents when I was like eight or nine. My dad has an accounting business and I help out over the holidays getting organizers ready to mail, but my heart is outside an office. My grandparents (dad’s parents) have a landscaping business. Digging in the dirt doesn’t bother me and once I learned a few tricks of the trade there can be real money in it.
When I was younger I worked summers and weekends landscaping. Winter was either a few hours at dad’s office or homework. The money was slow during the school year back then.
My dad was adamant I save most of my income. I stuffed my Roth IRA and regular Vanguard account every year. After all these years I have amassed $487,916.12. (My dad made me look it up because he says it’s impressive.) The stock market had a lot to do with it too.
The last few years my income exploded while my expenses stayed near zero. I use my dad’s old 2000 Honda Accord with duct tape holding on the spoiler in back. My plan is to milk that car until it dies. Dad picks on me he is kicking me out on my 18th birthday, but I’m staying. Free rent is good.
The income part has grown nicely over the years. I discovered I could find plants and supplies and sell them in projects for a lot more. We also have a 10 acre farm where I grow trees, flowers and other landscaping plants.
My sister is going to China this summer to teach English and is staying with a host family. I decided to not go to college, at least not right away. After graduation I plan on visiting my sister in China for two weeks. After that I have a few landscaping gigs I need to get back to.
When summer winds down here in Wisconsin I hope to live someplace warmer in the winter. (Dad keeps the house 60 so I have plenty of motivation.) I’ll probably travel the southern U.S. mostly this winter and the Mediterranean the next winter. It is hard finding people my age to travel with, however. They all have to work jobs.
So that is the plan my dad wanted me to share. I saved and invested. My investments are now big enough so that I don’t have to work after I graduate from high school. Like my sister, I like to travel and see stuff. I give my parents credit for teaching me how money works. I’ll probably always do some landscaping work on the side. If you know what you are doing you can make a year of income in a few summer months. Just finding one big rock a rich person wants in their yard can bring over a thousand dollars!
My dad isn’t kicking me out no matter what he says. If he does I’m still not leaving. My health is reasonably good right now, but with all the medical stuff I deal with it is no guarantee. People with my condition usually live to their 40s at most. Medical technology will probably let me live a long, normal life. But just in case, I saved so I didn’t have to waste time with a demanding career. There might not be enough time for me to do it the normal way so I’m making the most of the time I have.
This is where dad swallows hard. I’m so proud of my girls on one hand and sad they are living their own life of which some will be without Mrs. Accountant and me. Brooke is 18 today. She has a plan. I taught her all I know. I hope it is enough.
Bulls make money. Bears make money. Pigs get slaughtered! —Old Wall Street Adage
Back in the early days of my career the investment industry and the tax/accounting industry tried to merge. To be fair it was the investment industry’s idea. Tax offices were the perfect partner to sell securities (usually mutual funds with a respectable dose of insurance thrown in for good luck). Virtually every small accounting firm took the plunge.
Accounting offices are prime for solicitation. Tax professionals have a powerful relationship with their clients. Accountants also know a lot about their clients due to the data collected to file an accurate tax return.
Before someone got the idea to enlist the tax profession, it was common for insurance and securities salespeople to wine and dine the accountants in the area to build a relationship where the accountant fed ripe clients for plucking. (Did I say that?) Then H.D. Vest Financial Services changed the face of the accounting, tax and investment industry in one fell swoop. The world hasn’t been the same since.
As many firms did, I joined the herd of lemmings to the cliff. It wasn’t a bad choice. I learned a lot from my tenure in the field. I also discovered things I found revolting.
H.D. Vest Financial Services contacted me and I was a willing accomplice. The money was very nice, but I also had a massive interest in securities. If the opportunity in securities would have presented itself before taxes I’d probably be writing The Wealth Broker. (Sounds more like an oxymoron to me.)
H.D. Vest required we attend two major seminars around the country each year. (They had me with the traveling schedule.) Every December we met in Dallas (not far from the FinCon hotel last fall). The other event floated around the country.
A Story from the Brickyard
The keynote speakers at H.D. Vest events were influential members of the community. The one speaker who stuck out the most for me was Nick Murray.
Murray cut his teeth in an earlier age when hawking mutual funds took some effort. By the 1990s selling mutual funds in a roaring bull market was easier than taking candy from a baby. Murray’s advice and stories always stuck with me.
The age-old question was front and center: Where is the stock market headed? Clients are always nervous about investing. They’re afraid the market will tank the moment they buy. Murray had the perfect retort. He said he had no idea which direction the next 20% move in the market would be. He didn’t know the direction of the next 50% move, or 75% move or even 90% move. It could go either way. Up or down. But he guaranteed his clients the next 100% move in the stock market is up, not down. He ended by saying if he was wrong there wouldn’t be anyone around to sue him or complain.
A Story from the History Bin
Murray was on to something. Using the Dow Jones Industrial Average (DJIA) as a yardstick we can check how well Murray’s advice stood the test of time.
Charles Dow published his first index, a precursor to the DJIA, on February 16, 1885. The current industrial average was first published on May 26, 1896. We will use the May 26, 1896 start date for our history lesson as before that the average was more a transportation index and in fact is the basis of the current Dow Transportation Average. The DJIA started with fewer stocks, but by the late 1920s had the familiar 30.
One thing we are familiar with is the sound of the business news broadcasts saying, “Today the Dow Jones made a new high . . .” It happens a lot. There are certainly lulls between new highs periodically, but the upward pace almost seems to be persistent.
With so many “new highs” in the DJIA (and broader indexes) have you ever wondered when the last time was when a new low was made? Well, I have the answer if you’re interested. On August 8, 1896 the DJIA hit its all-time low of 28.48. We haven’t heard a new low in the Dow for over 100 years! The last time a “new low” was made was in the late 19th Century. 19th Century!
The chart in this post illustrates the relentless climb higher of equities. Notice the pimple about an inch from the left side of the chart. That’s the 1929 Crash and Great Depression. The scab about an inch to the left of the year 2000 is the 1987 market crash where we shaved 22.61% off the market in a day! It was a good day to buy stock in Fruit of the Loom. Now I know why Warren Buffet had to buy the company with guys wearing fruit costumes.
The most telling trait of the chart is the parabolic look the closer to the right you get. But if you pick any time in the past it usually has a similar look! In the 1980s it looked straight up. Same in the 1960s. Same in the 1990s. You get the drift. As the market ratchets higher the older areas of the chart look smaller and smaller until even major fluctuations (from the viewpoint of people living through the event) are pimples on the chart if they can be discerned at all.
Told by an Idiot, Full of Sound and Fury, Signifying Nothing
And so it goes, as Kurt Vonnegut would say. Once again we are enjoying market highs. The market has been up a very long time. We’re due for a correction, prognosticators say. Then we get a mild correction, but we still fear every shadow. We’re due for a bear market!
To top it off, your favorite accountant mentioned what he thought was an interesting fact. He moved to his highest cash position in his adult life at 52%. Half his, ah, my money went to cash in late January. How lucky can a guy get!
I got lucky because I wasn’t timing the market. Another significant business prospect (a non-public company) came my way. I don’t like borrowing money so I liquidated some serious positions. If all the money isn’t needed some will find its way back into the market. Regardless, my retirement money is still going into Vanguard index funds 100% as it peels off my paycheck. I also automatically deposit money into my non-qualified (non-retirement account for non tax people) Vanguard index funds every month on the 7th. It’s the law!
Now, with my idiotic profession of good luck earlier this year, we must focus on the only way to invest in the market. Like Nick Murray, I have no idea which direction the next 20% move will be. Same goes for the next 50% move, 75% move or even 90% move. But I guarantee you, as did Murray, the next 100% move will be up! The stock market has been doubling again and again from the beginning.
Is it any wonder the DJIA made an all-time low a bit over two years after the average began reporting without ever digging lower? Even the Great Depression couldn’t break to new lows! Yet again and again we hear news of a new high. Maybe this time is different, but I wouldn’t count on it. Business and the economy keep growing with minor hiccups along the way. Bear markets are scary from the inside because somebody is in the corner crying, upsetting all the nice people milling about.
Bear markets are temporary; bull markets are forever.
There is one final argument to stay invested in broad-based stock index funds no matter where the market is at. It involves the Cuban Missile Crisis of October 1962.
For 13 days (always a lucky number to make you feel comfy when playing with nuclear weapons) the United States and the Soviet Union came within a whisker of a full scale nuclear confrontation over imminent deployment of nuclear weapons in Cuba. President Kennedy went on television to inform the American people (and warn the Soviets watching) the U.S. had target 50 Soviet cities with nuclear weapons. It was assumed the Soviet Union had targeted an equal or greater number of U.S. cities.
The DJIA only lost a mere 1.2% during the nuclear crisis. That didn’t mean panic wasn’t under the hood. There is the story of a young stock broker who started screaming to sell when an older, more seasoned, broker in the office told the young broker to calm down. The young broker yelled the world could end at any moment and he had to sell. The old broker put a hand on the young broker’s shoulder and said, “Buy. If the nukes don’t fly the market will rally.” (The DJIA added over 10% by the end of 1962.) “If the nukes do fly the trades will never clear.”
The same is just as true today. Could President Trump really cause the end of the world? Maybe. But if the world doesn’t end you’re going to look mighty foolish.
Human history is marked by perpetual growth for many thousands of years. The growth trend has been marred by periodic declines, even extended ones. In the end it was always a losing bet to bet against humanity. Progress has been unrelenting for a very long time.
It always looks like a top. Always! But then we go higher. And if I’m wrong the trade will never clear. (Or at least nobody will be around to tell me how wrong I am.)
And for the record, bulls make money. Bears and pigs both get slaughtered.
Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning. —Winston Churchill
Trade policy can make for some strange bedfellows. Last week President Trump promised a 25% tariff on steel and 10% on aluminum. The GOP let out a collective gasp while Democrats had manure eating grins spread across their faces.
The stock market reacted negatively to the news. Clients (and a few readers) started asking me what is so bad about a tariff. I pointed them to a post I previously published on the consequences of trade wars, but there are still more questions. I’ll do my best to clear up the issues about why tariffs are a really, really bad idea we need to avoid.
What Really Happens When a New Tariff is Levied?
What is so bad about a tariff? It raises money to pay for the recent tax cuts. It promises to raise prices for steel and aluminum manufacturers. Some laborers stand to benefit from higher wages and with less competition, more job security. At face value it sounds like a good idea!
Of course, it only works if the tariff takes place within a vacuum. The tariffs Trump promises this week are blanket, meaning they hit steel and aluminum from every nation. When such a draconian ax is taken to the playing field there will be a response.
Normally tariffs take a long process to change. Treaties and trade agreements go through a long process of negotiations before each member nation to the agreement presents the details to their legislative branch for approval. Passage isn’t guaranteed. Several safety nets are in place to encourage each nation to honor the terms of all trade agreements.
The General Agreement on Tariffs and Trade (GATT) has been around since shortly after World War II (January 1, 1948). Over the decades there have been additional negotiations to expand and clarify the agreement. GATT has served the world economy well for 70 years.
Trade disputes can end up at the World Trade Organization (WTO). What makes WTO work is all member nations agree to the final decision of the WTO. In reality there is nothing to prevent a nation from thumbing its nose at the WTO, GATT or any other trade agreement or organization.
Trump’s unilateral tariff on steel and aluminum is certain to end up at the WTO. However, in the current political climate the U.S. can send some return international sign language involving the middle finger if it deems the tariffs a matter of national security. Section 232 of the 1962 Trade Expansion Act allows a president to unilaterally, without input or approval from Congress, set a tariff deemed necessary for the sake of national security.
Now that we’ve concluded the president can set a restrictive tariff if it is to protect national security, we can turn to the consequences of such action.
It’s impossible to know if the president will follow through on his threat, but there is nothing to indicate he’ll back down. What we do know is that there will be a serious response from nations around the world. The EU promised to increase tariffs on select U.S. products, including Harley Davidson motorcycles made right in the authors home state of Wisconsin. The gains the steel industry should experience will be felt in job losses in the Milwaukee area where Harley Davidson motorcycles are produced.
Is it Just a Shift, a Gain or are Real Economic Losses Possible?
The next question I get asked involves the ultimate economic gains or losses. Many people mistakenly believe it ends up a zero sum game. It isn’t!
The losses are best illustrated with a simple example. If steel tariffs on imports to the U.S. happen, the cost of steel to all U.S manufacturers increases. The wage gains in one industry pressure wages in other industries purchasing steel. The U.S doesn’t benefit much from the perceived benefit of closing our borders to free trade. However, nations feeling the pain of the tariff will not stand idle while they are gutted economically. These other nations levy tariffs against U.S goods so their domestic producers have an advantage over U.S. producers. And U.S. manufacturers of steel based products have higher input costs and are uncompetitive internationally.
This is where the problems begin. Economic theory is clear about price and demand. If prices increase relative to wages demand will fall. Steel prices will go up so instead of gaining all the benefits of a tariff there is a loss from the higher price. Other nations lose sales of steel to the U.S. while consumers now choose substitute products whenever possible. Regardless, the finite financial resources of consumer’s means they can only buy fewer goods since prices are now higher compared to wages in their industry.
Here is where a good idea gets ugly. Retaliatory tariffs now decrease demand for selected U.S. products. China can buy soybeans elsewhere and goods exclusive to the U.S. (Harley Davidson motorcycles) can be prices out of international markets due to prohibitive retaliatory tariffs. Even Canada could fight back by disrupting the supply chain of auto manufacturers.
By now it’s easy to see all the expected benefits of a unilateral tariff regresses to lower economic activity, fewer jobs, lower corporate profits and a difficult stock market. This is why President Reagan was a free trade guy. It’s also why the GOP is so against the tariff. It leads to the nemesis of the 1970s: stagflation, where prices rise while economic activity declines.
But what about the Democrats? Are they idiots thinking the tariff will benefit them? Well, the Democrats aren’t idiots. They’re protecting the interests of their constituents. Unions love the tariff because it helps them (in the short run) even if other industries suffer the ripple effect of the tariff. Many Democratic representatives are from areas with heave steel or aluminum production. They also have major union support. Democrats are engaging survival instincts even at the risk of eventual calamity.
A History Lesson
Tariffs have been with this country since its inception. Tariffs were a major source of federal government revenue before the income tax was instituted. In part, the income tax was needed to provide for an expanded government role in national security (fighting wars) and to allow more open trade between nations, fostering economic growth on both side of the agreement.
The threat of tariffs is also devastating! The real risk President Trump takes by announcing the tariffs is that virtually every nation on the planet will gear up to increase tariffs on exclusive U.S. goods in retaliation. The consequences could be catastrophic!
We can see from a famous real life example how the possibility of increased U.S. tariffs can slow an economy for a decade or more. In 1929, freshly elected President Hoover called a special session of Congress to review tariffs shortly after taking office. Hoover’s idea was to get modest adjustments to tariffs to better manage the economy.
Special interests soon got involved. The special session of Congress dragged on. The vibrant economy of the 1920 started to slow and then decline by the late summer of 1929. The stock market crashed in October of the same year with the economy chasing quick behind.
There is a lot more to the 1929 stock market crash. The economy of 1929 was extended and gold started to leave the country. When money is specie (backed by gold or silver) it’s important to keep enough gold around to back the local currency. Today we have fiat money (issued by decree of the government) so they can print to their heart’s content.
What people often forget is the Tariff Act of 1930 slowed the economy and crashed the stock market before it became law! The blowback was already in force and industries already started adjusting to the advantages or disadvantages. In the end the losers always outnumber the winners. Increased prices always lower demand as consumer’s resources buy less. Less demand means fewer jobs and down you go until the cycle of stupidity is broken.
The Game Plan
Only days into the announcement by the president and its clear there will be retaliatory tariffs if the U.S. carries out the threatened tariff increases on steel and aluminum. The economic ramifications should be felt quickly. The stock market will struggle under the potential for lower earnings. The steel and aluminum tariffs alone could undo all the benefits of the recent tax cuts. It’s that serious.
You can’t predict the future any better than I can. Therefore, a steady as she goes approach is advised. Timing the stock market based on tariffs and counter-tariffs is ill advised.
But you must be ready for some pain! The damage done by the threat alone is meaningful. If the tariffs go into effect and the EU and other trading blocks and nations institute their own tariffs against U.S. goods, it will be a painful time to be fully invested.
An appropriate plan is based upon where you are in your life. If you are young and starting out you need to max out your work retirement program (401(k), 403(b), 457, et cetera). Filling your health savings account and IRAs are also a good idea if you are allowed by the tax code.
Older readers and those near or in retirement should always have a few years of liquid net worth in cash (money market and similar accounts). Any market decline then requires only a modest adjustment to lifestyle as you will have plenty of reserves in cash to draw from, plus dividends.
Something this important and potentially nation-altering requires me to engage in my favorite pastime: predicting the future. It’s all in good fun, understand.
I predict (yes, I am the new Nostradamus!) the next economic savior to ascend to the presidency will kill inflation and spark economic growth by embracing free trade. Reagan’s ideas of supply-side economics have been played out to the nth degree so this time will require different medicine. Once the pain sets in free trade will be the perfect medicine to lower inflation and spark economic growth. Anyone ready to vote for President Accountant?
Remember to vote early and vote often.
More Wealth Building Resources
Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?
Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.
PeerSteet is an alternative way to invest in the real estate market without the hassle of management. Investing in mortgages has never been easier. 7-12% historical APRs. Here is my review of PeerStreet.
QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. Quickbooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.
A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.
Amazon is a good way to control costs by comparison shopping. The cost of a product includes travel to the store. When you start a shopping trip to Amazon here it also supports this blog. Thank you.
It was an exciting week in the Wealthy Accountant’s world. Facebook decided they didn’t want me to use the name Keith Taxguy. Now if I were a Russian meddling in the election I would’ve had no problems at all. It all ended well (so far).
New policies instituted in the office this year are paying off. For the first time since I showed up in the blogosphere people are surprised how fast I’m getting work done. After tax season I’ll spill the beans on my experience so other tax firms can experiment with the same tools. It should help other business owners and those with a side gig formulate ideas to increase their efficiency. This means less work and more profit. Isn’t the modern world awesome!
I found a gapping problem in the new tax law this week that will cause serious issues next tax season. I stumbled upon it by accident (asking clients questions). Monday I’ll have a full write-up. This issue is for more than accountants. Anyone who files a tax return is affected. I estimate 70% of taxpayers will need to adjust for the error or will have a nasty surprise when they file their return next year.
A few reminders before we head into the entertainment part of the weekend. Do-it-yourselfers should consider 1040.com through this blog. I like the program and use the commercial grade program in my office. Since this blog’s profits go to charity (increasingly supporting agencies helping abuse survivors) it’s for a good cause.
We have another nifty drawing to give money away again in the upcoming week. Don’t miss your chance.
Looking to manage your growing stash better? Personal Capital is a resource many are using to visualize all their investments in one spot. Best of all it’s free!
In the near future I will share my experience using PeerStreet. I think it is an excellent addition to many portfolios. Over the last year or so I’ve wound down my Prosper and Lending Club investments for a variety reasons I’ll outline in the future post. I’ve added PeerStreet to my investment mix and so far have been very happy. I also like the added protection of real estate backing the loans I’m investing in.
And now for some weekend entertainment.
What I’m Reading
Tax season limits my reading time. (Notice my sad face.) I’m working on a really good book I hope to report on next week. I also have been catching up on some neglected issues of National Geographic. The short articles fit the schedule easier this time of year for me.
What I’m Watching
Tax season quickly turns into a real life edition of Groundhog Day. Each day melts into the next, only to repeat again and again until we get it right. With this in mind, I’ve never seen the movie Groundhog Day. I know, I know. Everybody has seen the darn movie except me, until now.
This weekend I went to the library to checkout Groundhog Day. (I actually sent Mrs. Accountant.) Now we can officially declare every living human has seen Groundhog Day. So much for my reputation as an early adaptor.
For the record, I actually watched the movie; something I rarely do. Normally TV is background noise or a sleep inducer. Bill Murray earned his keep. I watched, yes watched, the entire movie. Of course they had me when the groundhog was driving.
Here is a YouTube video everyone MUST see. Elon Musk hits the nail square.
What I’m Listening To
I worked in silence most of the week as I was on a mission from God. The work was peeling off at a rapid clip. Here is one soundtrack I noticed in my YouTube queue from earlier in the week.
Be good, kind readers. One month of tax season is nearly in the books. See y’all Monday.
(Now I’m off to read a book. I am taking the whole weekend off! All of it.)
Recent volatility and decline in the broad markets in the U.S has people wondering if the correction returned the market to typical valuations. There are several tools used to measure the market’s value. One of the most widely used is the price/earnings (P/E) ratio, derived by dividing a stock’s price by its trailing twelve months (TTM) earnings.
The P/E ratio on the S&P 500 stands at 24.46 as I write (February 11, 2018). The ratio has been above 20 since early 2015.
When you take long periods of market data and shake them together you end up with an average P/E somewhere in the mid-teens. There is no hard and fast rule stating what a fair or reasonable P/E should be though plenty of opinions exist.
Another way to look at the P/E ratio is to flip it upside down where you divide the earnings by the price. This is called the earnings yield.
The earnings yield is an easier way to understand if your investment is paying enough to justify the risk and lost opportunity cost of investing elsewhere. The S&P 500 earning yield is 4.09% as I write. This means if all the companies in the S&P 500 paid all their earning out as a dividend you would have a 4.09% yield.
Again, there is no hard and fast rule on what an appropriate earnings yield should be. However, if Treasuries are considered a risk-free investment and yield more than 4.09% you might want to reconsider your strategy.
History of the P/E Ratio
The P/E ratio has been all over the map. We sit near record highs in the ratio currently, but have been above 20 for several years. This in and of itself is a bit unusual.
The other side of the spectrum had the ratio in the single digits with the earnings yield double digits. (If the P/E is 10 then the earning yield is also 10%. If the P/E is 5 then the earning yield is 20%. Example: A $100 stock has a $10 per share profit. If they paid all the profit as a dividend it would equate to a 10% yield. If the $100 stock earned $20/share the P/E (100/20) would be 5 and if the $20 were all paid out it would equate to a 20% yield.)
The actual dividend is almost always less than the profits of the underlying company as a higher dividend would require borrowed money or liquidation of assets to pay. The earnings yield is the highest amount a company could consistently pay out. Realistically, most companies can’t pay more than 80% of profits in dividends so resources are available to invest for future growth.
The P/E ratio has climbed above 20 many times in the past. Concerns over high valuations based solely on the P/E is short-sighted and a poor investing barometer.
Up until the early 1990s when the P/E climbed above 20 either earning grew bringing the ratio back below 20 or stocks declined in price or some combination of both. Since the early 1990s the ratio has been above 20 more often than not. During the dotcom craze the ratio exceeded 40 and during the Great Recession (2008-9) the ratio briefly pierced 70 as earnings declined (especially in the energy sector) faster than the market declined.
In both cases the excessive P/E ratios returned to the upper teens in a short period of time. Earnings rebounded even as stocks advanced. The faster growth rate in profits reduced the ratio. The excessive losses due to falling oil prices eventually ended and the ratio declined.
Why is this Time Different?
Why have stock prices stayed so high for so long? Except for brief periods the P/E has been above 20 for twenty-five years! This has never happened before in U.S. markets.
‘This time is different’ is the battle cry just prior to bloodlettings. History doesn’t repeat itself, but it does rhyme. Each era of stock market history has different events moving prices. If you dig down you will find the differences are only cosmetic.
What drove stock prices in the past drive them today.
The P/E chart shows the ratio climbing steadily from the early 1980s until shortly after the turn of the millennium where it made traumatic moves as it settled into the lower 20s zone.
What caused this steady ratio increase? First, the increasing ratio means the stock market has been climbing faster than earnings for a long time. People are paying more and more every year for the same dollar of earnings. At first blush this seems insane. But there is a valid reason for the activity.
Inflation was rampant (double-digits) in the late 1970s. Interest rates were increased repeatedly by the Fed until borrowing costs reached well into the double-digits.
After years of high interest rates to fight inflation, the price of goods and services stopped the rapid climb. The back of inflation was broken. Price increases moderated. Each economic hiccup reduced price pressures further until the 2008 recession when deflation (declining prices) made an appearance.
With each step lower, interest rates dropped in tandem with inflation pressures. It’s been so long since we felt the sting of inflation most people investing today don’t remember what it was like. A certain accountant in the room does, though.
Inflation and Stock Prices
Many factors drive stock prices. Earning top the list. But what is the value of those earnings?
Why did investors pay less than 8 times earnings in 1980 and now pay close to 25 times? Investors today pay three times what they did in 1980 for a dollar of earning!
In 1980 inflation was high; today inflation is low, almost nonexistent, and has been for a decade.
Inflation drives interest rates. The higher inflation the higher interest rates will climb.
If prices are steady (no inflation or zero inflation) and a company grows earning 10% the future value of those earnings are worth their full value.
If the same company were operating in a 5% inflation environment the discounted value of those future earnings are reduced by half. (This is an over-simplification to keep our story moving. Each successive year earnings are reduced by the risk-free rate of return. It has a compounding effect.) That means investors will pay less for those earnings. This is why investors pay three times what 1980 investors did for the same dollar of profits.
Future Growth Problems
When inflation climbs, interest rates follow and hence the risk-free rate of return.
As interest rates climb on the risk-free alternative (Treasuries for U.S. business and investors) it gets harder to justify many projects considered for future growth.
Value is created when the return on invested capital exceed the cost of capital. The cost of capital on excess cash held by businesses is the risk-free rate. When Treasuries pay almost nothing virtually every project projected to show any return is viable. Increase the risk-free rate to 5% or higher and many projects no longer make sense.
Of course, a margin of safety will be added by the company. In a zero rate environment a company will not accept a project with a projected rate of return of 1% just because it exceeds the risk-free rate. They will need a margin of safety to account for errors in calculated returns and to compensate investors for the risk taken.
As rates rise and fewer projects are approved, the number of goods and services eventually declines along with the number of jobs until equilibrium is found.
What Could Cause Inflation and Lower Stock Returns?
For 35 years investors have watched stocks climb faster than earnings. Deflationary pressures were more common in the 19th Century as prices swung wildly with the economy’s ups and downs. Over long periods prices were stable with the exception of the wild internal fluctuations.
Refer back to the P/E ratio chart. You will notice three times in the last 150 years the ratio dropped below 10 for an extended period: after WWI, after WWII and during the late 1970s. The starting point of the chart showing a low ratio came right after the U.S. Civil War.
At first glance you might think war was the cause of low P/Es, but you’d be wrong. Then you might wonder why the most pronounced period of low P/Es was the only one not following a war.
Well, the 1970s low P/E ratios followed a long war in Vietnam. War seems once again the cause of a low market ratio.
War does funny things to an economy. Both World Wars had price controls as the U.S. dealt with the economic stresses of fighting the war. Pent up demand and a higher savings rate allowed people to chase goods and services they were denied for a period of time. Business ramped up production and prices stabilized. With prices under control investors calculated the future value of earning at a higher rate causing the P/E ratio to climb.
The 1970s had additional issues pushing prices higher. Spending to fight the Vietnam War primed the pump for price increases. The first oil embargo in 1973 sent energy prices rapidly higher. President Nixon took the U.S off the gold standard further unleashing prices as the Federal Reserve had no real limit other than self control on how much money they could pump into the system.
Stubborn inflation was pushed even higher with a second OPEC oil embargo in the late 70s.
Now inflation became entrenched. Killing the beast wasn’t going to be easy. People expected wages and prices to climb. It felt normal so the tendency was to push prices higher.
Stagflation was a new animal for economists in the 1970s. A stagnant economy still generated large price increases. It made no sense.
The newly elected President Reagan had an idea. He built a tax cut around combating stagflation problems with supply-side economic theory.
Supply-side economics has received a bad rap at times, but it was the perfect medicine for low economic growth and high inflation.
What the 1981 tax cuts did was lower rates for business and individuals. This could cause inflation to flare higher. Buuuuuut . . .
For businesses some expenses are depreciated. Back then small businesses had to depreciate assets expecting to last more than a year and costing more than $100. This kept businesses from increasing production as costs came 100% out-of-pocket (or from borrowed money) while it took years to depreciate the entire asset.
What Reagan did was genius! Before the two big tax changes of the 1980’s small businesses could elect to expense assets (IRC Section 179) up to $10,000 with certain limitations instead of depreciating. The tax law was changed to increase this to $20,000.
Small business owners could now write-off more of their investments immediately. Businesses responded. Capital investments increased requiring more employees. The extra supply brought down pricing pressures.
Over the next decades Section 179 asset expensing was constantly increased until it was well into the six figures. Bonus depreciation is similar to Section 179, allowing for additional current deductions for asset purchases. Section 179 and bonus depreciation are so high now any further increases have no real effect at sparking additional economic growth.
Primed for Inflation
The medicine needed to kill inflation worked. Unfortunately, the same medicine was used again and again driving down inflation until deflation was the issue.
Supply-side economics has run its course until the next round of inflation appears. Supply-side tax bills don’t have the desired effect to the chagrin of politicians. Might I suggest to the elected officials in Washington to think of something new once in a while.
Back in 2008 the Fed’s balance sheet was under $1 trillion. It now stands at $4.5 trillion! This is one of the biggest, if the not the biggest, percentage increase in the nation’s money supply in such a short period. Even major wars didn’t create so much additional money.
Once again, this time was different in the details. All the excess money creation was sopped up by central banks around the world and the Fed. (Yes, the Fed holds much of its own money! The offsetting entry in the ledgers is held by the balance sheets of money-center banks to make them look solvent when they had lots of bad loans.)
Lots of new money didn’t cause inflation because it never hit the economy; it’s like it didn’t exist. Money in bank vaults might be a neat gimmick to make banks look sound during an economic crisis, but it does nothing to spur economic growth.
All the money in bank vaults didn’t disappear. It was waiting for a spark to be release it. That spark came late last year with the Tax Cuts and Jobs Act. Gas was thrown on the flames with an additional $400+ billion in new spending in a bill meant to keep the government open.
To Infinity and Beyond
The money is printed and the match lit. It is of vital interest to investors what happens next.
When the P/E ratio climbs as it has over the last 35 years the stock market advances at a rate faster than earning growth. The opposite happens when the ratio declines!
I have no crystal ball. Predicting where the stock market goes next is a fool’s errand.
With the facts listed above there is ample concern for an underperforming stock market for an extended period. Those most at risk are those in retirement, just entering retirement or retiring in the near future.
History is clear. Inflation causes higher interest rates and lower market multiples. Higher earnings can keep the market ratcheting higher, albeit at a slower rate as investors pay less and less for each dollar of earnings as inflation increases.
Excess money thrust into an economy has a high probability of affecting prices. The current economic experiment is gargantuan. The pile of new money waiting for freedom has a green light. As money flows through the economy at normal velocity, the effects of the new money are magnified.
It could be self-feeding; it could be an old accountant reading the tea leaves wrong.
Ah, who am I kidding? My cup of hot tea is just fine! Massive new spending by the government means the balance sheets at banks look better so they can now lend out all that money they’ve been dying to earn a profit on.
I don’t know the future, but I bet it’s going to be one helluva ride.