It is said we stand in preparation to fight the last war. It never plays out as planned and the war of the prior generation is ultimately not the war of the present.

Economic crises are cut from the same cloth as war. We prepare for the prior economic calamity with significant resources. Then, when we least expect it, a new threat rises and brings the best laid plans of men to dust. 

We are presently experiencing a crisis like never before. A pandemic has swept the planet and threatens to keep circling the globe in waves of slightly different variations man has no natural immunity against. Knowing we have prepared for the last war, the pillars built after the financial crisis of 2008-9, is meaningless. Man has experienced pandemics before, even more deadly contagions than the current infection. But economically, we will have to venture further back in time for an equivalent.  And when you mix the two together it becomes a crisis unrecognizable.

President Herbert Hoover

Fearful we will make the mistake of preparing for the wrong confrontation, we quickly shift our focus from the prior economic crisis of a decade ago and focus on the pandemic of 1918-9 and The Great Depression of the 1930s. 

Except even that isn’t the same on virtually all levels. Never before has the stock market collapsed so fast from an all-time high to a bear market (a 20% or greater decline). The prior record from The Great Depression has fallen handily. 

The death toll is lower today than the pandemic of 1918-9. So far. It is fear that drives us. In a knee-jerk reaction we shutter large swaths of the economy, leaving only those industries we consider vital, functioning. The wheels of industry ground to a halt until the world stopped. All is quiet on the Western front, a front that covers the whole of mankind.

Fear controls decisions — and if you have control of your fear — others will manipulate your activities as if you acted on your personal fears. The disease is not the worst and modern medicine is containing the damage. It is worrisome, but it seems man will conquer the new scourge in a reasonable amount of time. Then, life can return to normal.

Or can it?

Healing the sick and preventing illness will prove the easy part of this theatrical presentation. The damage already done to the economy is massive. Many businesses, large and small, will not return. The question remains: Is the the next Great Depression?

It is dangerous to say this time is different. Fortunately it is already different so there is room for hope. 

And, before we point out why this is not the next Great Depression, we can thank the gods that be we had The Great Recession of 2008-9 as a dress rehearsal. For without that economic nightmare, we might never have had the courage to use the tools necessary to make this time different in a better way.

 

A History of Economic Collapse

It is acceptable banter in polite company to say this is the worst economy since The Great Depression or the economic consequences will be worse than The Great Depression. But the story starts before that great economic event, and Herbert Hoover was instrumental in the solution. 

During World War I, The War to End All Wars, Herbert Hoover earned the nickname “The Great Humanitarian.” As Europe descended into war, Hoover organized the largest relief effort in history. With tireless effort he secured funding for resources to feed the civilians on the Continent. Even after the war he worked to stabilize the destroyed nations on both sides of the battlefield.

President Wilson turned to Hoover to head his Food Administration. Hoover labored hard to bring 120,000 Americans home when they were caught unprepared in Europe as war broke out. Then he fed Belgium, a nation controlled by Germany, an enemy of the U.S. in that Great War. Hoover manged to feed millions while keeping America’s soldiers well fed at the same time. A delicate balancing act at best.

After the war Hoover headed the American Relief Administration, feeding 20 million in Central Europe. A devastating pandemic took hold during the later days of the war. As soldiers returned home they brought the deadly Spanish Flu with them. 

In 1918-9 the government closed businesses and churches to fight the pandemic. Face masks were required in many communities with harsh penalties for failure to comply. The shelter-in-place policies of today were not part of the strategy in fighting the Spanish Flu in the same blanket manner applied in early 2020. 

After the war the stock market enjoyed a relief rally. Businesses grew tepidly, if at all, as a war hangover recession loomed. The reduced war spending eventually affected economic activity. Though not spoken about often historically, the recession of 1920-21 is the result, in part, from the efforts to combat the pandemic of a few years earlier. 

President Harding tapped Hoover for his Secretary of Commerce. A recession that began in January of 1920 and ran until July of the following year was especially deep. Research conducted by Robert Barro and Jose Ursua indicated the Spanish Flu reduced worldwide economic activity by 6-8%. 

Herbert Hoover proved up to the task of defeating this deep economic decline of the early 1920s. His work led to the booming economy in the decade ahead. 

 

It has never been a good bet to bet against America.

 

The Great Depression

If ever there was a president up to the task of defeating an economic crisis it was Herbert Hoover. President Hoover was concerned over the wild speculation on Wall Street. A nasty tariff fight in Congress spooked the markets and caused sharp declines, but quickly recovered each time in early and mid-1929. Then the wheels came off. 

On September 3, 1929 the Dow Jones Industrial Average hit a high, a level it would not see again until November 23, 1954. What started slow turned into a steamroll. In October 1929 it was free fall.

But the economy seemed sound by many measures. The stock market was down much more than economic activity would dictate. This started a process of efforts by President Hoover that never seems to work.

One measure after another was tried. Fear the solutions (usually involving more government debt) would exacerbate the problem caused President Hoover to use only half measures. Tax cuts were on the table, but not too many so as not to sink the national debt into the unknown abyss. Increased government spending was also on the table, but once again, only in half measures as to at least pretend fiscal constraint was being applied.

Hoover’s ideas were exactly what the nation needed to exit The Great Depression early, if only the president could have seen clear to unleash the dogs 100% in battle against the economic disaster unfolding. FDR, once in office, used virtually all the programs proposed by Hoover. FDR used greater flare to describe his programs and gave them different names. FDR also did not hold back. The national debt ballooned like never before. It was different that time.

Yet, even President Roosevelt could not go all-in. FDR’s programs started the economy rolling again, but not to new heights. And after a period of growth he increased taxes to reduce the deficit, triggering the second phase of The Great Depression in 1937. A quick learner, FDR saw the economy stall and stepped on the gas again quickly. There seemed no end to the deficit spending.

It took another world war to open the spending gates wide enough to permanently end The Great Depression. In 1946 the federal budget deficit exceeded 26% of GDP. This may stand as the largest imbalance in the U.S. government’s history.

 

2020 Is Not the Next Great Depression

This time is different is the battle cry of the unenlightened. History may not repeat, but is tends to rhyme. My good buddy Samuel Clemens once told me something along those lines a long time ago. However, every once in a while, it is different. In short, there always has to be a first time for everything.

By many economic measures the economy is taking it on the chin worse than any time in modern history. The stock market collapse is faster than 1929 or 1987. Thirty million are out of work in the first month of the pandemic and counting. Many businesses were forced to close and many never reopen due to the financial shock to their budget. 

There is another difference nobody wants to place front and center. Unlike the early days of The Great Depression, the government stepped up with all canons and fired fast and hard this time around. Even during the Great Recession of a decade ago Congress dragged its feet on how much stimulus should be provided the economy. 

This is the greatest time is history to be alive. What mankind is accomplishing was unthinkable a mere decade ago.

Unlike The Great Depression and with lessons learned from a half generation ago, the Fed dropped rates to zero instantly and reignited quantitative easing on a scale unthinkable a decade ago. Congress passed, and the president signed, stimulus bills at lightning speed. Trillions of dollars were pumped into the economy with fiscal policy (government spending) and trillions more with monetary policy (Federal Reserve activities).  

Never before have so many economic weapons been brought to bear, not even in a wartime situation. Some snickered when President Trump said he was a wartime president. Not a personal fan of the current president, I still agree with him on this issue. It will take a war time effort and war time powers to right the economic ship.

The Great Depression spiraled ever downward as elected leaders provided ineffective levels of economic stimulus 90 years ago and the reluctant efforts of a decade ago led to anemic economic growth as the economy left the Great Recession behind. The just finished economic expansion had one of the slowest, if not slowest, starts in U.S. history. 

The willingness of leaders in Washington to spend whatever is necessary, coupled with the Federal Reserve’s willingness to use unlimited resources to counter the economic dislocation, make it impossible for economic activity to descend into the chaos of the 1930s. Stimulus checks to individuals and forgivable loans to small businesses will limit the damage. Make no mistake, the damage will be acute and will linger. That lesson was taught us by The Great Depression. WWII spending proved the path necessary financially to beat the economic demon into submission. 

More proposals keep coming forward. Nearly $3 trillion in stimulus spending is already passed and working its way into the hands of individuals and businesses. It is not enough and will run short. Congress knows it and keeps pumping more stimulus measures at every whiff of a slowing economy. How much more stimulus spending will come is anyone’s guess. All I know is nobody seems to want to rein in the excesses at this time. And that is probably a good thing. The 26% of GDP deficit in 1943 is only the worst year of many with large fiscal deficits in the early 1940s. The spending was insane back then and America thrived afterwards. With the money going into the hands of Americans (back then and now) there is no doubt in this accountant’s mind the economy will pass this painful speed bump reasonably quickly with far fewer casualties than if belated measures similar to 2008-9 were used; or worse, the reluctant policies of 1929-1932.

The stock market has enjoyed a healthy bounce off the initial bottom. Nobody knows if this is a bear market rally or the first leg up in a V-shaped recovery. As always, follow the advice from another buddy of mine, Warren Buffett: It has never been a good bet to bet against America.

 

What Could Derail the Stimulus Measures

The Fed dropped rates to zero, opened the gates to unlimited quantitative easing bond purchases and has extended the purchases far beyond Treasuries. It seems the printing press (creation of more money/increasing the money supply) has not caused inflation to increase by any discernible amount over the past decade. In fact, inflation has been stepping lower and lower since the early 1980s. 

Printing more money, if you will allow my use of the term, has not ignited inflation in recent decades. What always seems to be an unbreakable law in times past does not seem to be an issue at present. Reason says at some point more money will force prices higher. Where that point is nobody knows. Many economists expected it to be an issue by now. Since inflation never seems to rear its ugly head anymore, economists as less frightened by it. 

Perhaps the lack of fear over inflation is low because most have never lived through it or it is a very distant memory. 

If inflation should make an appearance it could be game over. This whole fantasy of stimulus spending with the Federal Reserve buying all the newly issued bonds with fiat money only works if inflation does not attend the party. 

SpaceX is taking us to the future.

The national debt is likely to pass $25 trillion this calendar year with more red ink on the horizon. We could be paving the groundwork for one of the richest economic booms in the history of mankind or a worldwide inflationary disaster of Biblical proportions. I lay odds on the former.

Inflation may increase for a short time as demand is high and supply is artificially constrained. Once the pandemic passes completely in a year or two (the virus fades into the history books like the Spanish Flu or with the advent of a vaccine) supply and demand should find an equilibrium.

I know people are scared. Scared of getting sick and of losing loved ones. Scared of not having enough to feed themselves or their family, shelter and care for their family. Scared their business will fail. There are so many things that can befall us. I am an optimist and a realist. Businesses will fail. People will die. It will not be all roses. But we, as a people, will survive and even thrive. 

New businesses will be started; jobs will be created. Families will heal and new friendships forged. Warren Buffett is right, America’s best days are still ahead. The same can be said of the entire human race, all peoples, from all nations. 

This time is different. It is also the same. And like every time tragedy struck in the past, humanity has survived, thrived, grown and reached higher afterwards than ever before.

I for one am glad I am on this journey with you, kind readers. We should never be afraid of making the hard decisions. It will not be as bad as The Great Depression because this will not stretch out for a decade followed by a world war. This will last a year or so at most with the worst happening this year. And the other side will be glorious as the resources to build new businesses that will travel to the stars and beyond as being created as we speak. 

That is the hope you and I both need to live through this trial. There is no one more than you I would rather be on this journey with. Godspeed.

 

 

More Wealth Building Resources

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

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.

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.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Restarting the economy is going to be more difficult than it was stopping it. A vigorous discussion on the topic is desperately needed as many feel talking about opening the economy is akin to reigniting the infection rate when in reality the discussion is needed to formulate an appropriate and workable plan.

Talking about restarting the economy is good policy. Shutting down large swaths of economic activity was necessary for public health. And for the most part it was a fairly easy process: governors gave the order and their state ground to a halt as people sheltered in place, giving COVID-19 no viable path to propagate. The same happened around the world. It is The Day the World Stopped.

The spread of COVID-19 had slowed and in many countries has all but stopped. Concerns the virus is picking up steam where social distancing is relaxed is still a real risk. However, policies designed to slow the spread of the virus appear to be working. Multiple medical therapies hold promise and a massive effort to develop a vaccine are in progress. A vaccine would be a game changer, but realistically that is still as much as 1 ½ years away before it becomes available. The economic price would be too high, and the resulting harm to human health from lack of services, too damaging to wait over a year before reopening the closed parts of the economy.

Reopening the economy can begin in as little as a few weeks to a month if handled properly. Germany has made signs they are ready to slowly restart economic activity. China, the first to suffer the scourge, has already reopened much of its shuttered economy. The real question now is: How well will it work? If the virus takes off again it will set us back. However, if enough people have built an immunity while social distancing is still practiced, many parts of the economy can reopen.

Turning economic activity back on will not be like flicking a light switch. There are several issues when restarting an economy after such a brutal and abrupt stoppage. We will now turn our discussion to an appropriate and safe way to reopen a shuttered economy. Even more important than opening closed businesses is how to get money flowing again. If nobody shows up for the party we are no better off.

 

A Plan for Reopening Shuttered Industries

While it is true the current economic downturn may be the most abrupt (fastest) and deepest decline in modern history, it isn’t the first time an economy had to plan on restarting after such a shock to the system. The situation (and rules) are different from rebuilding after the destruction from war; the rules, however, have many similarities, albeit on a much smaller scale. 

After World War II, Germany and Britain were in ruins, along with much of the rest of Europe and Japan and other areas of the Far East. While a contagious virus wasn’t running wild, a plan was developed for rebuilding the destroyed areas. Without the Marshall Plan, Europe would have suffered much longer as they worked to rebuild. A similar reconstruction plan was instituted in Japan. 

We don’t need anything as drastic as a Marshall Plan today. But the lessons can still be learned.  For example, you didn’t start rebuilding a war torn Britain by investing in industries that heavily rely on infrastructure before the infrastructure was funded and well on its way to becoming operational. In other words, there has to be an order to the reopening of an economy. 

It can happen fast. The Marshal Plan was a 4-year plan to fund investment in rebuilding cities and industries, and remove trade barriers between European nations and those nations and the United States. 

We do not need 4 years to reignite our economy! Still, it will take time and it will not always be a smooth process. Prior to a vaccine for COVID-19 there stands a strong chance there will be pockets of infection flareups. Fear will be the common enemy.

It would be unwise to open everything at once. A step-by-step process will allow for the fastest opening of the economy without undue risk to public health. The real question is: What gets opened first, second and so forth and to what degree?

Step 1 

Before any plan can work social distancing must be practiced by the public until an effective vaccine is found, effective and fast testing is available or most people are inoculated. If enough people develop a natural immunity (prior infection) the same result can be achieved, if only over a much longer time frame and higher number of dead.

A requirement everyone wear a mask in public would also go a long way, if not very fashionable. Social distancing and a mask would reduce the spread of COVID-19 to such an extent it might not remain viable for long as it can’t keep finding new hosts.

A cheap, fast and easy way to test for those currently contagious would also allow for a faster opening of economic activity.

Step 2

The first businesses to reopen should be retail establishments. It is easy to practice social distancing at a furniture mart and therefore, these businesses should be allowed to open soon.

Certain service businesses can be opened at this time as well. The law office, bank and public buildings and parks all allow for social distancing without much inconvenience to people.

Factories and other manufacturing facilities can reopen along with service businesses and retail outlets. Safety policies might mean some factories run at less than full capacity, but they would be open and should be able to find ways to slowly increase business activity until fully operational, or nearly so.

Churches and other places of worship would also be some of the first places to reopen. 

Step 3

After an adequate waiting period (say two or three weeks) to determine the virus is not spreading faster again, it will be time to open even larger swaths of economic activity. 

This is where it gets difficult. Bars and restaurants really could use a return to normalcy. Unfortunately, large groups of people gather at these establishments and social distancing is extremely difficult. Unless a natural immunity or vaccine reduces risk, large gatherings are a serious threat to reigniting the infection rate. 

Instead, it might be proper to open salons. Social distancing is impossible in these situations; by design the hair stylist has to be close to you to cut your hair. However, a mask might be enough to solve the problem. Yes, the hair stylist is close to the customer when cutting her hair, but the room isn’t crowded tight with people. A mask and hand washing between clients could do the trick. (This is more important than you think! Do you want to now what our world would look like after people go a year without any hair care? Yikes!)

An accurate and fast way to test for those currently contagious would also facilitate a quicker opening of these businesses.

Step 4

As serious as the matter is, certain businesses need to reopen as some point. Gyms are a high risk place, but social distancing, frequent hand washing and sanitizing equipment between use should make it a viable solution to reopening our exercise centers. A fast, accurate and low cost testing method to reveal who is contagious would certainly allow for these establishments to open sooner.

Restaurants are next. We might limit the number of people in the room and require masks for all employees. (Kind of hard for patrons to eat while wearing a mask.) The same for bars. A reasonable plan would be to allow a certain number of people per area and slowly raise the density of people allowed per gathering as long as infection rates remain low.

Step 5

The hardest hit is the last to reopen. Concerts and sporting events pack people in too tight for proper safety with a highly contagious virus on the loose. Yelling and cheering at a packed sporting event all but assures you will face a high risk of infection if an infected individual is present. Sporting events with empty stands is an option, but there is something about a full stadium that makes the event serious, real.

Travel will also be among the last to fully reopen. Packing a plane is not the best idea when a highly contagious virus is on the loose. Proper precautions could be taken to reduce risk. Disinfecting after each use and masks on public transportation would make sense. Testing, when available, would allow for a full opening of economic activity even if a vaccine is not yet ready.

 

These steps do not have to take place in a vacuum. Fully reopening the economy could happen in a few months with most business activity functioning at a high level within 30 days. Accurate, fast and low cost testing would also speed the reopening of the economy. A vaccine would be the best option, but the economy will still need time to reset as it opens after such a shock. Things will not pick up where they left off.

We have learned a lot about COVID-19 so far. Treatments are getting better and more equipment is available. That reduces the seriousness of the infection. Even without a vaccine there will be a growing number of people with a natural immunity. As we discover how effective an immunity infection provides, we can also focus on how many have been infected without serious symptoms. At some point we need to know how many people already are not at risk due to immunity. Reinfection issues will need to be addressed.

It is growing clearer each day we can reopen economic activity without undue risk to human health. There are measurable risks to locking people down to prevent the spread of disease. At some point it is a better choice to take precautions while letting the herd out in the pasture.

 

Velocity of Money

The velocity of money is the gorilla in the room nobody is talking about. Opening businesses is only the first step. My guess is there will be a surge in business activity as the wildlife gets a whiff of fresh air. Then the economic reality of the family budget will bear down. 

The stimulus money will certainly help, but that money helped people muddle through the abyss. Some jobs are not coming back. Some businesses will not survive the assault inflicted upon them. There is no amount of money that will put things back exactly as they were.

Will back rent need to be paid or will landlords suffer the loss? Will all employees be called back to work? What about businesses that close? If tenants are forced to pay a backlog of rent it will retard tenants’ spending on other goods and services. If the landlord swallows the loss the landlord will be forced to reduce spending. Either way money will not move as fast in the economy. The same applies to employees not called back to work as their employer closed permanently. 

The same applies to mortgage payments and other loans. Will payments be pushed to the back of the loan? Regardless, the family budget is worse off. Many questions still need answering for a smooth re-opening of economic activity.

And will jobs still pay the same with higher unemployment? 

 

 

Bars and restaurants might get an initial surge of business, but not all industries will enjoy such a bump. Travel and entertainment take time to set up. Planning a concert takes time. The day the switch is flipped is not the day people have airline tickets to get away. People will start closer to home before venturing further. Planning a vacation will not happen instantly.

And some industries are of the trickle-down type. For Boeing to sell more airplanes, airlines need to book more passengers. The money flows downhill and Boeing is not first in line for a check.

The above chart shows a damning detail about the American economy. From 1960 to 1990 the speed at which money exchanged hands in the economy was static. The accelerating economic growth of the 1990s bumped the velocity of money a bit higher before coming back down in the early 2000s.

But ever since the Great Recession the speed that money changes hands has been slowing. Part of the issue is the level of the money supply. The Federal Reserve has not been bashful about increasing the money supply over the last decade. If people don’t increase spending at the same pace the Fed increases the money supply we see the velocity of money come down. Each new dollar the Fed dumps into the economy has less effect than the one prior. This is a form of spin-down and it always comes to an end at some point.

That has been a problem for the last decade. More and more money gets pumped into the economy, but it has had a smaller and smaller effect. Money just does not move the way it used to, even when more is pumped into the system. 

The third major bear market in 20 years might drop the velocity of money even lower. A vibrant, healthy economy has a strong velocity of money as money is earned, spent, saved and invested. For a decade we have seen money pumped into the economy and mostly it arrived with a loud thump. Most of the past decade of economic gains is attributable to public spending on the national credit card. Without this so-called stimulus, we had no discernible economic gains. I will leave it to you, kind readers, to determine if this is a viable long-term solution.

The real challenge is not the reopening of businesses; it is the reinvigorating of the movement of money. If everyone has a million dollars, but they all sit on it — none of it moving — there is still no economic activity, at least as measured by Gross Domestic Product which tracks how much money has been put to work buying goods and services. If the velocity of money slows even more it could be a very anemic recovery, indeed! Or worse.

The economic expansion after the Great Recession was slow by historical standards. It is also a likely reason it lasted so long since the excesses of too rapid of growth were avoided.

But slow growth is like watching paint dry or suffering water torture if you need a job or are working to build a business. If money isn’t moving it means it isn’t going to wages or small businesses either. 

The challenge is starting a national dialog on reopening the economy as soon as safely possible and developing plans to avoid an incredibly slow recovery, even slower than the 2009-2019 expansion.

It seems during my entire adult life (from the early 1980s) each economic expansion has started slower and was harder to accelerate. Interest rates have dropped for 30 years until we are now at 0% yet again. If the Fed creates more money, only to see the velocity of money slow more, there will be little value gained by future Fed actions. 

Maybe a Keynesian style government infrastructure spending program might do the trick. However, China has tried to do this every time they want to spike growth and the benefits are not all they desired.

I guess the Fed could print money forever without consequences and give it away as a basic income. I also have a bridge I’d like to sell you if you believe there is such a free lunch without consequences. 

I certainly do not have all the answers. I think my plan for opening the economy is sound with some modest tweaks by the powers that be. The real problems start when the economy is back open and it isn’t what we remember when we last saw it.

And we better start tossing ideas around because I think time is running shorter than anyone wants to admit.

 

 

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?

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

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.

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.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

 

Square root employee?

The FIRE community has been educating the public in attaining financial independence and early retirement for a decade or so now. Whenever the topic arises it is sure to be followed by the exasperated rebuke, “We can’t all do this! Who will do the work if we all retire at 30? The economy will fail.”

The argument has a sort of logic on the surface. If everyone retired by their 30th birthday there could be a problem. A 50% savings rate could crush the economy! Right?

Or maybe not. A high national savings rate doesn’t harm the economy! The United States had a double digit savings rate in the 1950s and the economy roared. China and many other nations with vibrant economies have high savings rates. A low savings rate seems to be the real problem. In the U.S. we struggled more as our savings rate declined to its current low single digit home.

High savings rates don’t kill the economy; it provides a massive pool of ready capital to invest in infrastructure and future economic growth. No wonder our road, bridges, water and sewer works are subpar. The government decided it was good for the economy short-term to spike growth by encouraging excess consumption. As the savings rate kept declining less money was available for high speed rail and advanced internet services. And don’t even think of fully funding roads and upgrading the electric grid.

 

Price to the Rescue

Derek J. de Solla Price discovered an inverse relationship between how many people actually do most of the work in a given setting. Price discovered the square root of a group did half the work and the remaining members of the group did the other half. If you have a business with 10 employees, then 3 were doing half the work.

Here is where it gets scary. If you have 100 employees, 10 are doing half the work and 90 the other half! As an organization grows, incompetence grows exponentially while competence grows linearly! As the organization grows to 1000, thirty-two are doing half the work with 968 doing the remaining half! This is why it is so hard to grow a very large organization and keep it large.

Price’s law is visible in corporate America. In 1928 the Dow Jones Industrial Average expanded to 30 stocks. Of all the stocks on the original list, only one is still there: General Electric. The other 29 companies are either merged, bankrupt, dissolved or significantly smaller firms. Current financial difficulties at General Electric could soon remove the remaining holdout from the original Dow-Jones stocks. In less than 100 years every single one is off the list!

You don’t need as long a timescale to see Price’s law in action on the S&P 500. Of the ten largest stocks in the S&P 500, most were not on top a decade ago. Companies like Kodak, Sears, and Xerox are nowhere to be found at the top of the list, yet they were the crème de la crème at the height of the Nifty Fifty days of the early 1970s. A damning fact is the average stock in the S&P 500 spends an average of 30 years there. That’s it. Some make it longer, other less. But 30 years is all the leaders can manage on average to stay on top. This is why we buy index funds instead of individual stocks. Individual companies come and go, but as the economy keeps climbing, so does the size of the index.

 

Faulty Thinking

A quick reader might be thinking of how to game this information to her advantage. A few ground rules are in order before we get cute.

According to the U.S. Bureau of Labor Statistics, on January 1, 2016 the U.S population was 322,810,000 and 157,833,000 were in the Civilian Labor Force. You read that right. Forty-nine percent of the total population is in the labor force! As you can see, a very large number of people are not engaged in any kind of formalized labor. Children, the disabled, military personnel, incarcerated and the retired are not part of the labor force.

Running 157,833,000 through a square root calculator gives you around 12,500. At first blush we might be tempted to believe 12,500 people are doing half of all the formalized work in the U.S. with 157,820,500 doing the other half of all the work. Now you know why you’re so tired. You’re one of the 12,500!

Except it doesn’t work that way. As much as you may want to believe you’re carrying an unfair labor burden (and you might be), the truth is far more than 12,500 people are doing half the work of the country.

Price’s law works wherever there is creative productivity. It is certainly possible a mere 12,500 people are providing half the creative productivity as long as you narrowly define “creativity.” Elon Musk is a hyper productive individual. But you can’t discount the workers building the cars!

While Price’s law works wonderfully when applied to baskets scored or city sizes or a single business, it fails to adequately disclose who is productive nationally. If only 12,500 provide half the nation’s GDP there are not enough producers to have at least one productive employee per successful company.

No, the Civilian Labor Force is not “creative productivity” and therefore we should not apply Price’s law. Price’s law explains what happens within an organization. Again, if you have 10 employees, 3 are doing half the work. Thirty percent of employees are kicking out half of the company’s creative production. It could be tax returns or widgets. The percentage contributing to half the company’s production declines to 10% when staff increases to 100. The bigger the company grows the worse it gets.

The Pareto Principle appears more generous in stating 80% of results come from 20% of the inputs. In other words, 20% of employees are doing 80% of the work; 20% of clients are providing 80% of the profits; and so on. In the end Price’s law and the Pareto Principle are explaining a similar reality.

 

 

Price is Saving the FIRE Message

Back to where we started. The FIRE community message is you can save half or more of your gross income, invest in index funds and retire early, some as young as 30. And then the economy drops off a cliff and nobody is around to get the work done.

Except Price told us what we needed to know! If 30% of the people in a small business with 10 employees are doing half the work, 70% aren’t getting shit done! And business owners, tell me I didn’t just hit the nail on the head.

Square root kitty?

If so many people are unproductive it is easy to have fewer people in the work force and still get all the work done. What we need to do is train employees to be like the minority producers (the square root guys).

How can we do that? First we need to look back at our error in assuming you can apply the square root of the entire nation’s work force and conclude 12,500 people do half the work. A business can be just like the national work force. If you have one huge group within a company Price’s law is going to crush you.

But then explain companies that are large? How come some outperform for very long periods of time?

The solution is simple. By breaking a huge company into smaller groups you can increase the number of productive people. A major corporation can act and perform as nimbly as a smaller company by organizing human resources appropriately.

Of course another issue arises. If some schmuck in accounting can’t get off dead center, how will a smaller group make her more likely to increase productivity? And the answer is: it doesn’t. Merely cutting a larger group into smaller groups will not have a meaningful effect on overall productivity of the firm. Unless you organize the smaller groups to focus on specific tasks.

Large groups tend to get less done because they take on too much. By breaking tasks into smaller sizes handled by smaller groups you can unleash before unrealized creative powers. And there is an example that proves it.

 

The Richest Guy in the Room

Just as the largest companies don’t stay on top forever, neither do the wealthiest people stay on top of the Fortune 500 list of wealthiest people on the planet. The 1% churns. A lot!

Don’t get me wrong. Warren Buffett was the richest guy on the planet for a while. Now that Jeff Bezos jumped in front, Warren isn’t looking for gainful employment to put food on the table. Bill Gates was on top for a while. Back in the day Rockefeller was on top. What I’m saying is the list changes for people just like businesses.

The insight Price gave us and the understanding we have of the Pareto Principle allows us to better use our human capital. People are the most important resource. But an employee struggling in a large group is far more likely to excel in a smaller group.

You’ve experienced this yourself. You go to a conference and attend a breakout session where 10 people are in the audience. A significant percentage of the people participate by asking questions and adding additional information. If the room fills with 50 people a smaller percentage get involved. The bigger the group gets the more likely you are to keep quiet. A few step forward, but fewer than in smaller groups.

Also, productive people in one setting will be less productive in a different setting. Smaller groups only work if effort is applied into providing the right environment in the smaller group so more people become interactive producers. This is the solution to the problem presented by detractors of the FIRE community.

 

The FIRE Community was Right All Along

It is possible for people to save more and invest the difference without killing the economy. We can be just as productive as a nation, as a company, as an individual. Even more so if we apply only a small amount of effort.

Reaching financial independence at an early age does NOT harm the nation. Quite the opposite; it makes us tremendously stronger! A nation wallowing in debt loses vibrancy. So do companies and people!

Fewer people need to work when the ones who are working are more productive. The end of formalized work doesn’t mean the end of productivity. Early retirement frees times to explore new ideas. Some of those ideas are the Tesla’s of tomorrow.

Spending down household savings accounts for conspicuous consumption does provide short-term economic growth. Then again, snorting cocaine gives you a high that doesn’t last either.

FIRE is the only way.

 

 

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.

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 segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

#tariffs #tradewars #stagflation #economy | trade war | tariff | wages in a trade warTrade 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.

President Accountant

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.

Final Outcome

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.

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 segregation 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.

 

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.

This may seem strange to people living in a world of remarkable stable prices. But that could all change and rather fast.

Fixing Inflation

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.

Crying over spilled milk is an adage most of us first heard at a young age. Minor inconveniences are blown out of proportion when they happen. Eventually someone says you should stop crying over spilled milk

We’re living a spilled milk event as I write. The stock market and the economy have been growing steadily for about eight years now. Constant media covered convinced a large percentage of the population things were dire. We were scared shi+less and tucked our hard-earned money in the mattress. There was no way you would be tricked into investing in a bad economy.

The years kept rolling by as the economy ticked ever higher with the stock market in tow. You not only kept your powder dry, you spent a large portion of it (a 100% loss) and kept the rest in a 0%, or nearly so, bank deposit.

Now the media says everything is good news. The economy and stock market have bent heavy to the left as it heads for the stars.

Tax cuts will stimulate an economy at or near full employment. Things have got to be good. They have to be!

You missed the bitcoin craze, but you refuse to be left behind again. This is it! You’re going to do it. You’re going to jump into this high flying market for your share of the bounty even if you have to borrow to do it.

The Road Well Traveled

You might not believe it, but I’ve seen this storyline play out before. The last time we saw tax cuts of this size the DJIA was under 800 (that is NOT a typo). The year was 1981. Inflation and unemployment were both double digits and draconian measures were needed as the economy was heading into the back leg of a double recession.

By 1987 the party was in full swing before a sunny day in October refocused attention on reality. In a few years the market was at new highs again and all was good.

The dotcom bubble — like the Nifty Fifty of the early 1970s — promised a brave new world of ever increasing profits. Then the century turned and so did the market.

The beginning of the current run started in 2009 with people screaming the world was coming to an end and the sky was falling. The ugliness started a year or so earlier.

In each case the market found a bottom, the world went along just fine and the market eventually made new highs.

We had the Nifty Fifty of the 70s, the tax cuts of the 80s, the dotcom world of the late 90s, and the housing bust of 2008. Now we are back to tax cuts, low inflation, low unemployment and a market promising to rise every day as if the Lord promised it himself.

So now you’re ready to invest.

Reality Check

I’m the last guy to tell you to time the market. This thing could rock for longer than anyone expects. What is certain is the day will come when it will stop going up temporarily. That is the day greed turns to fear. And fear is a far more powerful emotion than greed.

If you stayed out the stock market the last ten years I have a suggestion. Don’t invest now! This is not a market timing call either!

The market direction or conditions should have a relatively small bearing on your decision to consistently invest.

After all these years of economic and market growth and only now you think it’s the right time to invest? If this is true you don’t have the temperament to invest in equities (stocks, mutual funds, index funds or ETFs). Buying because everyone is talking about it is insanity!

My granddad was a farmer who saved at an insane rate. The guy tucked away in the neighborhood of 70% of his income. When he hit retirement age his saved half or more of his Social Security check! (You read that right.) He even took a part-time job to fill his days when he was in his 70s and 80s and saved the entire take-home pay!

I always called granddad Doc because he always studied natural healing. Doc is a value lesson in today’s market.

Doc invested about 10% of his money at AAL, now Thrivent, the Lutheran investment house. The rest of his money sat in several banks. He had CDs, money markets, savings accounts and some land.

The 1929 stock market crash was etched into his young mind. He was born in 1922. The Great Depression colored his opinions on money.

Doc understood guaranteed money. Banks offered guarantees up to the FDIC limits. My dad convinced Doc to put at least something in the broad market. Only the investment house connected to the church could be trusted.

Better Safe than Sorry

Putting money in the bank is not a good way to build your net worth fast. Regardless, he managed a sizable (seven figures) of liquid net worth before the farming world collapsed and he lost most of his money trying to save the family farm.

Undeterred, Doc went back to what he knew worked. He started filling bank accounts again and had another seven figures liquid by the time he died.

To recap, Doc spent a lifetime building a seven figure liquid net worth, lost it in the farming crisis of the early 1980s, kept saving all he earned, put maybe 10% in a rip-roaring market, put the rest into bank deposits and had seven figures liquid again when he died ~ 10 years ago.

Not Cowardice

People are passionate about the market as I write. Netflix in the last month alone went from 187 to 272. From top to bottom this is a 45% gain. This is rare for any company to accomplish, but even more significant from a company slated to burn up to $4 billion in negative free cash flow this year!

Coupled with the recent bitcoin craze and people are primed for action. It has the feel of a casino! (As a reminder, the house always wins.)

There are only two mistakes that will kill you in the market. The first is getting enticed into buying when everything looks perfect and the market is parabolic. And second, getting scared out of the market when the market is suffering a gut wrenching decline.

Most people fail at investing because they trade the market. Emotions WILL get the best of you if you PLAY the market. Doc knew his emotional readiness and did what any smart man would: put his money in guaranteed bank deposits.

If you’ve been investing a portion of your income every month you have the emotional stability to weather the inevitable storm. (Or the intelligence not to look at your retirement account balance.)

Now is not the time to get brave and jump into the stock market. Even if you use index funds or ETFs. Odds are there will come a day soon when painful reality sets in temporarily. The last thing you want to do is buy now and find yourself waiting a few years for a new market high. Or worse, selling at the low due to fear.

Borrowing money to invest in stocks is the worst! You could find yourself forced to sell as the market declines if you buy with debt. DON’T DO IT!

Dos and Don’ts

Missing the current market rally is spilled milk. Chasing the market is a crazy idea. Here are a few dos and don’ts to consider in today’s investing environment:

DO —

  • Use index funds or ETFs
  • Keep investing in your work retirement plan at least to the matching level and to the maximum if you have the mental and financial will to do so
  • Keep calm
  • Stay the course. Stay invested and keep automated investing active. You and I both don’t know where the market will be over the short term so stay the course. The long game is higher

DON’T —

  • Panic
  • Borrow money to invest
  • Try to time the market by selling
  • Listen to the media hype. Wall Street loves the hype so they can sell to the greenhorns as the market weakens
  • Get too excited about your account balance. Those just hitting their FI (financial independence) goal might want to consider sticking around a while long as the FI number is built on a market spike higher with a real possibility these numbers could temporarily decline
  • Listen to your hairdresser, taxi driver, Uber driver, buddy at the bar, mailman, or even your accountant on hot stock tips
  • Look at your account daily

 

Young investors have it worst. They haven’t experienced one of these cycles before. The last real market decline was a decade ago!

This isn’t new either. Every 10 -15 years we rinse and repeat. Each cycle is slightly different while humming the same tune.

Investing, even in a hot market, isn’t necessarily a bad idea. Doing crazy stuff and getting greedy is!

No borrowed money for investments in the market! If you have a regular investment plan, keep it. Your investments will ride out the storm when it comes along. If you haven’t invested yet, now is not the time to be brave. Bravery is easy now because the feeling you have is really FEAR you’ll miss out.

The steady hand will always win in the end. Warren Buffett tells us to be fearful when other are greedy and greedy when others are fearful. Greed is rampant now so a healthy dose of fear is warranted.

Steady, kind readers. Steady.

 

The latest tax cuts have sent the eight year old stock market rally on a steeper trajectory after 300% gains to date. Tax cuts and interest rate reductions have a habit of sparking market rallies, but only one has anything to do with value.

To understand why the market is rallying so hard you have to understand what people expect the corporate tax cuts to do. You also need to understand if these gains are based on real increases in value or only a mirage.

Tax Heaven

The corporate tax rate for regular corporations dropped from a top rate of 35% to a flat rate of 21%. For most corporations this means a 40% reduction in federal income taxes.

With all this extra money sticking around the corporate coffers there is ample reason to think this is really something to behold. The extra money can be used to retire debt, buy back stock, pay out dividends or invest for future growth.

But are these companies really worth more? Is there more value just because one expense will decrease for one year?

If a company is earning :

  • $10.00 per share

before the tax reduction and if everything remains exactly the same will see a:

  • $2.00 per share

increase in profits due to lower taxes, what value has been created?*

The company has $2 more per share in cash lying around and that does have value in a manner of speaking, but it’s not repeatable.

The corporation earns $10 per share in year one, $12 per share in year two and again $12 in year three even if the company is bloated and slow. Worse, incompetent management could spend the money on stupid stuff!

Our corporate illustration shows a company with 20% growth over a three year period, but only treaded water in reality. The tax cut makes it easier to hide problems for longer before it becomes apparent to shareholders they are getting screwed.

The Value of a Dollar

Shareholders might not care one iota as long as the money keeps rolling their way. The extra money the corporation enjoys from the tax cut can prop up the stock price if they buy back shares. Additional dividends also put a mischievous grin on the faces of shareholders.

Now think about this for a moment. How much is that $2 per share extra from tax savings worth?

TWO DOLLARS!

The value of the cash is $2. Period. How much will you pay for the $2 of cash? No more than $2, I hope.

By looking at the stock market it appears as if investors are paying more than $2 for the $2 per share tax benefit!

The tax cut isn’t repeatable either! People wrongly think the tax cuts help the next year. It doesn’t! Earnings are now stuck at $12 per share instead of $10 unless there is real growth. There is no growth in our example. How much would you pay for $12 per share if there is no growth with the risk management screws it up and ruins a bad game to start with?

The value of those earnings is based on interest rates. If the risk-free interest rate (U.S. Treasuries) is 3%, then the value of the $12 of stagnant earnings is no more than $396 per share ($396 x 3% = ~$12). If the risk-free rate rises then the value of the future earnings declines.

So why is the market rallying so hard? Because the extra $2 times the risk-free rate translates into $60 or so!

The Bad News

Unfortunately interest rates are not static. They are currently rising at a slow rate. It can only be guessed what inflation (the ultimate factor driving interest rates) and interest rates will do in the foreseeable future.

With an economy near full employment and stimulated with massive tax cuts, my guess is rates will go higher. This means those earning are worth less. And that assumes the extra $2 goes to the owners (investors)!

In the early 1980s the top brass in corporate America earned about 30 times the wage of an average worker. That number now stands well into the 200s. With more cash than ever, corporate America might be seduced into skimming a bit for themselves. I’m not suggesting anything, only making an observation.

Dividends are real cash you can count in your paw. Stock buy-backs are a bit more elusive. Stock buy-backs can mask stock grants and options to insiders.

It is safe to say only a portion of the extra $2 per share in profits due to the tax cuts will actually find its way into shareholders’ pockets. Depending on how you look at it, that could be a blessing.

Creating Real Value

If tax cuts don’t create real value, what does?

As stated before, the quality of future earnings is based on the risk-free interest rate. If you can’t earn more than that, why bother. Just drop your money into the risk-free asset and enjoy a few Mai Ties on the beach.

We discussed in April 2016 how companies create true value. Now is a good time to revisit the issue before your money gets a value lesson of its own.

Tax cuts provide the opportunity to create value; they don’t in and of themselves create anything! If tax cuts are not fully spent and the government lowers spending to offset the lost revenue, the economy will actually decline. If the government keeps spending while reducing taxes they do so with borrowed money. Knowing this, tax cuts have the same stimulus as the government just spending extra money themselves.

And tax cuts have historically not been 100% spent by those receiving the cut. Some people reduce debt or invest some of the newfound wealth. And since tax cuts are only good for one cycle their benefits are fleeting unless you keep cutting taxes every year.

This doesn’t mean we shouldn’t have tax cuts. Heck, no! I love keeping more of my money!

What I’m getting at is this: your income hasn’t increased solely because your tax bracket declined! And once you digest the reduced taxes into your budget you’re going to look for a pay increase to keep feeling warm and fuzzy inside.

So how do you get a raise? Well, inflation can mask any “real” wage increase if it doesn’t exceed the inflation rate. Or, you can increase your productivity so the company has more profits for your labor from which to pay you. (Now you need the corporation to part with a percentage of those additional gains you generated. That hasn’t happened much over the last 30 years.)

If tax cuts don’t create real value, what does?

Simple. Your return on invested capital (ROIC) in excess of the cost of capital (COC) is the textbook definition of value creation.

If the stock market rally is going to have real legs corporations will need to invest the tax savings in a productive way!

Corporate America has experienced record levels of profitability for some time now so the question begs to be asked: If they didn’t invest the extraordinary profits before, why will they be encouraged to do so now?

Good question. Wish I had an answer.

Personally, I don’t think corporations will increase investing anywhere near the levels of the tax break. We see headlines listing a token few major corporations granting a small 2% or so bonus to the rank and file for one year while announcing layoffs a few days later. (Kimberly-Clark announced 5,000 layoffs in their diaper division as I write. Tax cuts will not increase demand for things people don’t want. But automation, which the new tax bill encourages, will make human capital less necessary.)

Only businesses that invest the tax savings wisely will create real lasting value. By investing in increased production which yields more than the cost of capital, value is only realized.

The ROIC must exceed the COC or value is destroyed. Automation and technology make it easier than ever to do more with fewer people. This increases quality of life. But if the process is too quick it becomes a painful transition.

Now that most assets can be deducted currently versus being depreciating over a number of years or the life of the asset, businesses are incentivized more than ever to increase their use of technology and automation.

If these investments return more than the cost of capital, even capital derived from tax savings, real and lasting value is created.

And that will keep the stock market riding high, providing us with the warm and fuzzy feeling inside.

 

* I took liberty with the math for easier reading. A company at the top tax bracket of 35% under the old tax law would pay about $3.50 per share on $10 of profits before tax.  Cutting their tax by 40% would not be $2 per share. (40% of $3.50 is $1.40.) In reality it would take ~ $16.67 of profits to pay ~ $6.67 in tax to arrive at $10 of reportable gains to shareholders. Rather than get bogged down in the math I kept it clean, as a family-oriented blog should be.

Normally I don’t like to comment on a tax bill before it becomes law, hence the reason I’ve only commented once on the current bill as it wound its way through the halls and committees of Congress. Now that the bill is sitting on the President’s desk awaiting his signature I’m comfortable opening a dialog on some of the issues I see the regular press has missed.

Since the beginning I’ve called this a Swiss cheese tax bill because it has so many holes in it I can drive a truck through with my eyes closed without a worry I’ll hit a wall. I suspect many of these holes will be closed in time. Until then, fuel up the truck fellas. We’re going for a ride.

The Missing Link

Pass-through entities don’t pay taxes at the corporate rate, instead, passing certain items, including profits, to the owners to be reported on their personal tax return. Income is generally taxed at ordinary rates.

The current bill reduces the tax rate for regular corporations (C corps) to 21% while individual tax rates top out at 37% for individuals. To level the playing field between regular corporations and pass-through entities (S corps) the bill included a 20% deduction on pass-through business income.

The deduction is limited to $315,000 of eligible income for married couples and $157,500 for single filers. However, a last minute change greatly enhanced the advantage!

A formula was inserted which will allow the 20% deduction of income on amounts greater than the income limits. The formula for the deduction is the greater of: 1.) 50% of wages, or 2.) 25% of wages, plus 2.5% of the value of qualified property at purchase.

Real estate is the target of this formula. It will allow for massive deductions for certain real estate investors at rates tremendously higher than many other small business owners will get.

But that isn’t what I want to talk about today.

A Load of Swiss Cheese

Traditional news outlets will give you the basics of the tax bill. I’ll touch on the same issues in the near future. For now there is a pressing issue we need to discuss instead.

The above business deduction for pass-through entities makes current year (2017) business deductions more valuable than if taken next year if you are under the income limit! This includes real estate investors where the deduction can be much higher.

As I read the bill, my interpretation is the deduction extends to sole proprietors and small landlords. When the IRS provides regulations on how the new deduction is handled I may have to give updated advice later. It’s unclear if small landlords and sole proprietors get the deduction without creating a pass-through entity. As I read the bill it is allowed without the extra paperwork. But the IRS may disagree and it might be necessary to hold real estate in a partnership, or if there is only one owner, an S corp. (Gulp! Did I say that?) I’ll keep you up to date. As soon as I have more clarity I’ll pass it along. Either way, there should be a way for owners of income property and sole proprietors to take advantage of the new deduction.

There are two reasons for business owners/landlords to accelerate expenses before year-end: 1.) Tax rates are declining slightly for many individual taxpayers, and 2.) A deduction is worth less next year.

This might seem counter-intuitive, but Congress may have passed a tax bill that discourages pay increases and capital expenditures by small businesses and investors of investment property.

Deducting as much as possible this year makes sense with rates going down in 2018. Buying an asset and expensing it, if possible, is worth more now than it will be in a  week and a half after publication of this post due to the lower rates AND the business income deduction!

An example illustrates the disincentive to invest in more capital expenditures and payroll next year. Suppose we have a small business with $200,000 of profits. If the business is planning an investment in a new piece of equipment costing $50,000, the owner’s tax benefit is reduced by 20% in 2018 and after! It looks like this under the new tax bill:

Without equipment purchase:

Income: $200,000

20% business deduction: $40,000

Income reported on personal tax return by owner: $160,000

With equipment purchase:

Income: $200,000

Deduction for expensed equipment purchase: $50,000

Income after equipment deduction: $150,000

20% business deduction: $30,000

Income reported on personal return by owner: $120,000

The equipment cost $50,000, but the reduction in income is only $40,000! The business owner saw a reduction in tax benefits from the increased expense by 20%.

We can debate the method used to deduct the property (expense versus depreciate), but the premise is the same: every business expense is worth 20% less starting January 1, 2018!

Look at it this way. If a small business owner increases wages, as Congress says they are incentivized to do, they will suffer the cost of the higher wages AND a reduction in the new business credit! The business owner will cough up the added payroll expense, plus payroll taxes, and face a decline in the business credit.

If the small business owner REDUCES wages, they are rewarded under the new tax bill! If a business owner cuts payroll by $100,000, she will save payroll taxes AND have a higher income of which 20% is deducted. The $100,000 increase in business income will only have $80,000 subjected to tax.

One last example: Prior to January 1, 2018 it is illegal to deduct 20% of a business’s profits for fake business miles or other non-cash deduction. Starting January 1, 2018 you don’t have to cheat to get the benefit; it’s codified!

Final Thoughts

Congress has sold this massive tax bill as a job creator. Instead of taking time to get a solid piece of legislation written, they rushed it and it shows.

The incentive to small businesses is clear: CUT PAYROLL! This will have the opposite effect of what was intended.

Sure, businesses will need to spend on updating equipment eventually. But the longer they can hold off the better they will fare; they get a 20% deduction off the top before they spend a penny. A smart small business owner will have more incentive than ever to CUT wages and capital expenditures. And for the altruistic business owner, a tax penalty applies in the form of a reduction in the new business deduction if they do increase wages.

Real estate investors tend to hire fewer people so the effect is less. Even still, spending on improvements entail up to a 20% penalty for each outlay as the business deduction is reduced.

My favorite deductions have always been of the non-cash nature; I get a deduction and keep the money, too.

I hope y’all love Swiss cheese because there will be plenty to go around until they change the tax law.

 

Note: This is self-serving as all get-out, but this is one simple example of how this tax bill will harm the economy and the workforce, the backbone, of America. If you can see past my self-promotion, spread this post everywhere: social media, email and links. Don’t forget your elected officials in Washington. Don’t be afraid to expand on the consequences of this tax bill. There is plenty to spur the economy. But there is also plenty to slow the economy as well. With small business employing so many people in this country it is imperative to get the word out so the people who can facilitate appropriate change can take action with this new knowledge.