During the Applied Finance Group’s 6th annual Research Summit at the Encore in Las Vegas in mid-June, the mood was quite somber. Though the stock market had rallied from its March lows and turned positive for the year, the over arching feeling was one of worry that the rally would not last. In the weeks subsequent to our conference, economic news continued to worsen, as jobs were being lost at an increasing rate in June relative to May, which led to a new round of discussions regarding a 2nd stimulus package. Indeed there was and continues to be much to worry about, as inflation, growing national debt, and an overall weak economic environment made it difficult to enjoy the stock market gains achieved to date.
This sentiment is consistent with the results of AFG’s first Market Forecast Project conducted in mid July, which shows a significant amount of unease in the investment community regarding the economy and various fiscal and regulatory policies currently being proposed. For example, 90% of the respondents felt we should not have another federal stimulus, while 80% felt the currently proposed cap and trade legislation to curb carbon emissions was not a good idea for the economy.
On the topic of the stimulus program, we were early and loud skeptics of its potential effectiveness in our February and March letters. Sadly, the program’s results to date are making oracles of us. Unemployment has materially worsened since the stimulus program was rammed through congress without being properly debated, or made available for public review. It is likely that unemployment will surpass 10%, possibly hitting 11% next year, with the latest projection being the July unemployment rate has risen to 9.7% from 9.5% in June.
Further, while there are signs that the economy will register some growth in the 2nd half of the year, it may very well be a jobless recovery. All this makes us go back to the first principles regarding economics and human nature. In general people tend to want less of something as it gets more expensive, and people have no incentive to conserve something that is free and seemingly endlessly available. These two principles have led to the time tested result that government is very efficient at expropriating and redistributing wealth by force, but consistently incompetent as a wealth creator. Therefore it is no surprise that as the tax code will shift rates upward on labor and capital next year, the cost to invest and take personal risk increases and results in less economic activity. As a result we concur with the view that the coming economic expansion is likely to be less robust than exits from past recessions. Further, since the current fiscal strategy is to stimulate economic growth through government spending, the capital allocation process is likely to be less efficient than private sector actions.
Free markets allocate treasure to individuals or firms that can create customers by offering them goods and services that they voluntarily purchase. That voluntary exchange of value is the critical ingredient, which leads to wealth creation. It is the pursuit of such treasure that drives innovation and ultimately leads to the betterment of society. However, as the government can fund itself freely by inflating its way out of debt, and can create customers by decree, it does not face the discipline imposed by voluntary exchange. This critical missing component results in government having few incentives to innovate, either via new products or more efficient processes, to serve its customers fittingly.
Moreover, because government in the short run has unlimited access to capital, it has little discipline to make accurate cost forecasts or even utilize the public’s treasure efficiently - as recently evidenced by the Cash for Clunkers program running out of money 90% sooner than expected. Thus, it is not surprising that as the stimulus program continues to unfold, it will likely overspend and under deliver.
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* EM: Economic Margin (EM) is AFG's proprietary corporate performance measure. EM is defined as cash Economic Profit over
inflation adjusted Invested Capital while Economic Profit is the difference between Operation Based Cash Flow and Capital Charge.
* MVIC: Market Value over Net Invested Capital (MVIC) is the firm's current total equity, debt and other obligations divided by its net inflation adjusted invested capital.