Obama and the Market: Now Through January

America has once again proved that it remains the world’s “shining city upon a hill”, as Ronald Reagan famously described this great country. Through the voluntary election process, two candidates with often clashing views allowed the citizens to speak and a peaceful transition of power is underway. Congratulations to Barack Obama on a well-executed campaign. We wish him nothing but success in leading our country to ongoing prosperity. Unfortunately, President-elect Obama will not have a wind at his back with the economy, unlike in 1992, when President Clinton took the reins and the country was exiting a recession. Today, it appears that we are entering what may be the worst recession since Reagan’s tenure.

In an article last month, we discussed how happy we were to have September behind us; little did we know what October would bring. I guess “out of the frying pan and into the fire” is the only way to summarize the transition from one month to the other. As expected, given such a tumultuous month, many events took place, and each has its own long narrative with many willing writers able to devote endless ink to tell their tales. As a result, we will not attempt much of a recap, but rather will try to tell the month’s story in a uniquely AFG manner, through value formation.

The foundations of AFG’s analytic insights are:

Measuring true unleveraged cash flows
Estimating current, not historic, cost of gross investment
Determining the right price for risk
Capturing the effects of competition on forecast cash flows

AFG transforms these inputs into: Economic Margins, Market Derived Discount Rates, size and leverage risk differentials, and company specific decay rate estimates. These are then combined to create company specific valuation estimates via the following pricing framework (For more details, see here):

Value = Sum of Future (Economic Margin * Capital) / (1 + Discount Rate)

We like to analyze changes in value as a result of expectation changes in either the numerator (cash flows) or the denominator (risk). Unfortunately, during the month of October, the major events worked against equity values on both the numerator and denominator of the pricing equation. Let’s examine what happened:

Credit Market Freeze

This by far dominated the news during the month, and tended to drive all events leading up to the Presidential election. This event negatively hit both aspects of the value equation at the same time. First, companies needing to access capital to grow lost their ability to do so, leading investors to reducing their expectations of future cash flows. Secondly, investors became more and more risk averse, which increased their required rates of return to tie up their capital, and subsequently drove the discount rate higher and higher. The effects of these working together likely led to the majority of carnage we experienced during the month.

TARP

The Treasury rescue plan seeks to increase liquidity in the market and recapitalize financial firms' balance sheets. Our last letter was critical of the plan, as we felt it put too much power in the hands of a single individual to set prices and essentially play god in the financial markets. In theory, this plan is to unfreeze credit markets, giving businesses access to capital by recapitalizing financial institutions and restoring investor confidence, thus reducing the cost of capital. So far, the plan seems to be applying a hair dryer to a 200-pound block of ice. Credit markets are thawing, as measured through the TED spread, but banks in the US seem to be holding on to their newly injected equity. Recent guidance by Cisco (CSCO) suggests that business spending will significantly slow in the year ahead and consumers seem to be very pressured, which bodes poorly for cash flows across the economic spectrum. The jury is still out on this program, but it has likely helped in the short run to stem continued panic selling in the equity market. However, TARP has not reversed the damage caused by the frozen credit markets on the economy and we are likely headed for further economic weakness.

Presidential Politics

Though each candidate’s policies have likely taken a back seat to the ongoing credit crisis, there were some clear differences between them that will also play out through our value equation. As Barack Obama is the winner, we will highlight some of his major policies to give us some ideas that may drive future market valuations. With all the attention resulting from the credit crisis, it is unlikely Obama’s policies have yet been fully digested by the market. We will examine what we consider to be Obama’s four major policy initiatives heading into his inauguration in January and their effect on equity prices through the value equation. It is important to note that while these were proposals or ideas he advocated during the campaign trail, President Elect Obama may change his view now that he is in office or change the timing under which he may put these policies in place.

Tax Policies: Obama campaigned on the promise to increase capital gains taxes. Our research indicates that investors seek a real after tax rate of return on their invested capital. Thus, as taxes and inflation increase so does an investor’s required rate of return. Think of the cost of capital having three basic components:

1. Base Real Rate of Return
2. Inflation Premium
3. Tax Premium

If capital gains taxes increase, it is likely that investors will require a higher rate of return, which in turn will lead to lower market multiples. For example, if a company is expected to generate $100 a year of cash flow, forever, and investors expect a 10% return with no taxes, the value of the company is $1,000. ($100/10%) However, if a new law is passed that makes taxes on capital gains 50%, now the investor has to earn twice as much in their investment to keep 10% after taxes, and must therefore price this asset with a 20% cost of capital, resulting in a value of $500 ($100/20%).

If Obama moves to increase capital gains taxes, that will be a negative for the market over the intermediate term. Currently, with the large capital losses facing investors, increasing capital gains will not have a significant effect as if the market were at positive gain levels. What is likely to happen is that a return to pre-credit crisis levels will take longer with a more punitive capital gains tax regime.

Trade Policies: President Clinton recognized the importance of free trade and boldly broke with labor unions to support NAFTA. In addition, he put the country on a trade path, continued by G.W. Bush, that has emphasized opening markets around the world. Obama’s stance on trade appears to break from this tradition, as he had some controversies regarding his support of NAFTA during his debate with Senator Clinton, and recently during a debate with Senator McCain said he would not support a deal with Columbia even though all neutral observers say the deal would lead to net US exports from our current status with the country. While analyzing trade policies is not straightforward as there will be some winners and losers depending on particular industry groups, adding frictions to markets tends to reduce cash flows in aggregate. This lesson was painfully driven home as President Hoover signed the Smoot-Hawley tariff act in 1930, which increased tariffs on over 20,000 goods imported to the United States. This set off a round of global trade retaliation, which led to a 66% decline in world trade. For example, US exports to Europe fell from $2.3 Billion in 1929 to just $.78 Billion in 1932.

A hostile set of trade policies will likely depress the numerator of the value equation leading to depressed market prices.

Regulation: Obama’s major regulatory agenda seems to include projects related to carbon emissions. The most likely scenario appears to be a "Cap and Trade” on carbon emission policies. This essentially puts limits on the amount of carbon emissions companies can generate, and provides incentives to become more efficient, by allowing firms with excess carbon credits to “sell” this capacity to firms that require more than their current allocations. This is essentially an energy tax, and as a result will tend to increase costs. In terms of the value equation, higher costs lead to lower economic profits and thus lower future cash flows. While businesses may pass on some of these additional costs to consumers, higher costs will result in lower demand again resulting in lower cash flows.

The likely effect of a “Cap and Trade” tax will be lower corporate profits across the business spectrum, reducing the numerator of the value equation and driving valuations lower.

Obama has also stated that he intends to invest in new research to expand alternative energy. If such results are cost effective these programs may very well eliminate the tax burdens imposed by “Cap and Trade”. However those discoveries are likely to take time and the immediate effect of this policy will be higher business taxes and lower profits.

Health Care Reform: These policies require additional information to fully determine how much of a “cost based” versus “profit based” system Obama proposes. As we learn more, we will expand on this topic in the future.

What does all of this mean from an investing perspective? Because equity values depend on the power of compounding, changes in the discount rate or expected cash flows tend to have a magnified effect on growth stocks relative to value stocks, as they have a longer duration of cash flows. As most of these policy initiatives tend to either depress the numerator (cash flow) or increase the denominator (cost of capital) in the value equation, growth stocks are more likely to suffer in the months ahead than value stocks. We will be researching these ideas through some additional special reports that look at the expectations embedded in growth versus value stocks and the performance of these groups of stocks to help you better determine when these policies are fully priced into these respective stock groups.

Recently we issued a report titled “Then and Now” that discussed the expectations embedded in stock prices today relative to March 2000. While emotionally it was much easier to invest in 2000 when the economy was strong, financially it was a disaster as the performance expectations built into the S&P 500 were fairly absurd. Today, the environment is much more difficult emotionally as GDP is shrinking, unemployment is rising, and the markets continue to search for a bottom. But today, the financial rewards are potentially much greater as the S&P is priced to shrink its sales by over 15% during the next 5 years. Our belief is that the market is laying attractive odds over the mid to long-term for investors to add to their holdings. Much like President Clinton adjusted many of his policies as the markets did not react favorably to them during his first two years of office, we hope President Obama will also keep an eye on the market to provide him valuable non-partisan feedback to help guide him over time.

Comments

[Prudent Man...:]

Predicting economic growth and human nature with mathematical formula results in Long Term Capital Management.

As Ludwig Von Mises stated decades ago, econometrics is only useful in helping one see where we were and is counter-productive because it gives false security and interferes with sound analysis. In other words it is voodoo science.

2008 Nov 12 09:22 AM