October 2009 Market Review

By Oct 30, according to Dow Jones news, of the 344 companies in the S&P 500 that have posted Q3 results, 80% reported earnings above analysts' expectations, 6% matched and 13% below. In a typical quarter, 61% of companies beat estimates, 18% match and 21% miss. Q309’s outperformance has surpassed the highest percentage of companies reporting earnings above expectations for a quarter, which are 73% in Q209 and Q104 respectively. However, the S&P 500 lost 0.84% in October, breaking its streak of 7 consecutive monthly gains in 2009. (By the way, 53% of our September MFP survey participants nailed it when they predicted the S&P500 would return –3% to 3% in October). The pause the market took in October is interesting, as the market seems to have finally responded to concerns that valuation is getting rich and uncertainty abounds regarding the growth prospects of the US economy.

November has a cheerful start so far with the stock market on the rise again, although we were just informed unemployment rate increased to 10.2%, the highest in more than two decades. Warren Buffett’s “all-in wager” on the US economy - his announcement to purchase railroad operator Burlington Northern Santa Fe (BNI) in a $44 billion deal certainly helped to inject optimism and produced the rally. We don’t intend to bet against our country, which has produced more wealth since its inception than what the rest of the Mankind has produced in thousands of years of history.

We, however, would like to explore two areas that will have a significant effect on markets in the months and years ahead: Government Fiscal Policy and Health Care Reform. In short, we believe the nation’s current paths on these fronts are intermediate to long term negatives for the market. Much like it was impossible to call the top during the tech boom, despite knowing prices were unrealistic, we believe the larger trends are likely to result in a less dynamic, more central planning driven market going forward. We expect the net effect of these policy changes will be reduced corporate profitability, less corporate growth, lower market price levels, a slower economic recovery, and an expansion less than the historical levels. The remainder of this letter explores the federal stimulus options and the health care bill just passed in the House.

Most of us at some time or another have had to make a forecast, and as with most forecasts it is usually safe to say the forecast will be wrong. President Obama made a very high profile forecast as his main pitch to sell his stimulus program back in January. He confidently predicted that without his program, unemployment would exceed 8.5%, while his program will keep unemployment under 8%. As Friday’s statistics showed, being in the forecasting business is tough as unemployment topped 10% for the first time in 26 years. Given the government stimulus program does not appear to be stimulating, it reminds us of a joke making the rounds before the elections in Washington.

Q: What is the fiscal policy difference between a Bush Republican and an Obama Democrat?

A: $650 Billion in Stimulus Spending. Before Bush left the White House, he carried out a $150 Billion stimulus program, among which $110 Billion was rushed tax rebates to individuals making $75,000 or less and families making $150,000 or less a year by the spring of 2008, hoping they would spend the money just as quickly. That stimulus didn’t work as we all know but effectively ended the debate in Washington as the best way to re-inflate a flagging economy. The Supply Side Economics concept of incenting tax breaks for people to produce more goods and services is dead. Long live Keynesian economics, which focuses on government planning. Obama has embraced this paradigm, adding his own $800 Billion stimulus. The goal behind the almost $1 trillion in stimulus spending, is to increase GDP and resume economic growth. The following equation displays the break- down of GDP and allows us to see the logic behind government spending based stimulus programs.

GDP = C + I + G + (E-I), where:

GDP = Gross Domestic Product

C = Consumption (Consumer)

I = Investment (Business Spending)

G = Government Spending

E-I = Net Exports

Holding all things equal, increasing G, will lead to an increase in GDP. Therefore it is not surprising that GDP increased 3.5% in Q309, largely attributable to government programs, with Durable Goods up 22.3% (Cash for Clunkers) and Residential Fixed Investments up 23.4% (First Time Home Buyer Tax Credit). By increasing government spending and running larger deficits, the logic behind the Keynes approach is that the government will juice the economy.

While the theory looks appealing in the equation form, it leaves much to be desired in practice. Most obviously, if the key to economic prosperity merely requires governments to spend money, every country should have a standard of living as high as the United States. In fact, an overwhelming body of empirical evidence says government spending is not a long term solution. While there are many reasons for this conclusion, ultimately the reason rests in the fact that government spending does not take place in a vacuum as every dollar of government spending either crowds out private spending or private investment. While in the short-run, the government can print money to finance its spending, in the long run it must raise the cash from higher taxes, or borrowing. Each of those activities directly competes with the private sector for funds and in turn “crowds out” private sector spending.

Secondly, the process by which government spending takes place has no market discipline to ensure the funds are put to the best and most efficient use on average. A simple example for that is the famous or notorious Cash for Clunkers program: Edmunds.com analysis says taxpayers' real cost of cash for clunkers is $24,000 a car, just $2,000 shy of the average amount paid for a new car by buyers in August, $26,915. The reason is of more than the 690,000 vehicles sold, only about 125,000 were entirely due to the government's added inducement. The rest of the buyers just got lucky by getting the government to kick cash into deals that they would have proceeded with anyhow. The market process is not omniscient, but fortunately when allowed to work is a swift jury deciding what works and what does not.

For instance, on a freeway near Fresno, there are hundreds of new bushes and a lovely sign proclaiming the landscaping was the result of the stimulus program. While the freeway median looks much nicer, is that really a good use of capital in the midst of a recession and corporate deleveraging? Everyone will apply their own utility function to such projects, but we would much prefer to see successful businesses access this capital for growth. How many government programs ever go bankrupt due to a lack of funds? Unlike private firms forced to bankruptcy if they fail to attract customers, government programs have an incentive to continue living well beyond their usefulness as special interests will be very vocal to keep such programs funded.

Since September of last year, the government has authorized over $800 billion in stimulus programs, various consumer refund programs, and the Fed has flooded the market with liquidity via a bloated balance sheet. From a GDP perspective, it is hard to imagine that government can continue along its path and not begin to significantly crowd out private investment directly, if it has not already. Assuming that the “G” portion of GDP will not likely increase meaningfully, and the President’s budget director argues it must shrink, how else can we grow the economy? The answer is to increase: consumer spending, investments, or net exports. Let us examine how future legislation is likely to affect the consumer and investment side of the equation and then reach some conclusions for the economy.

It is common knowledge that the consumers account for approximately 70% of the US GDP. Given record levels of unemployment, we should expect the economy to remain sluggish as consumers will be reluctant to spend until the employment landscape improves. Therefore, we must understand what will cause unemployment to decline. It is simple – companies must begin to hire again. This can be a result of companies adding new capacity, new companies starting up, or companies returning to prior employee levels. For most desirable things, the cheaper it is the more it will be demanded. In the context of a business, the concept of cheaper for purposes of expansion relates to:

a. Labor Costs

b. Input Cost

c. Capital Costs

d. Taxes

The logic behind each factor is fairly simple, but is worth repeating for completeness.

a. As labor costs decline, the profit margin per worker increases making it more attractive to add new workers.

b. As input costs such as raw materials, power, suppliers and other items decline, a firm’s profits expand making the value of existing workers efforts increase and/or creating the opportunity to grow the business to capture new, profitable opportunities, possibly leading to new hires.

c. As capital costs decline, additional investment opportunities become profitable making it attractive to grow the business and possibly add new workers.

d. As taxes decline, the profits created by a business increase, making the value of existing worker efforts increase and/or creating the opportunity to grow the business to capture newly profitable opportunities possibly leading to new hires.

However, it is easy to see how negative changes in these factors lead to firms reducing their work force or scale back future hiring plans. With this in mind, let us review the business environment our current congress and administration would like to create by the year 2011.

a. Labor Costs – The health care proposal that was passed by a smaller than expected 220 to 215 party line vote, will increase the costs of hiring for many firms. The new legislation imposes a tax that ultimately reaches 8% of a firm’s payroll for companies that do not provide insurance but have payrolls greater than $500,000. This will particularly be onerous for firms that hire unskilled workers, or rely on part-time workers. Much in the same way that increases in the minimum wage lead to higher unemployment among the unskilled, this legislation will result in higher layoffs or position eliminations among unskilled workers and part-time workers.

b. Input Costs – The proposed Cap & Trade legislation will impose a carbon tax on all fossil based energy, essentially all the energy in our economy. Virtually every business will have to cope with higher energy costs, requiring them to increase the sales price of their products or earn lower profits. Either scenario is likely to result in reduced employment. Compounding the effects of Cap & Trade, the proposed Health Care Reform will increase the cost of production for many businesses, resulting in them charging higher prices for goods/services. To the extent those goods/services are inputs for another firm, the buying firm will also need to raise prices and in the process reduce demand for its products. Some will argue that a carbon tax will drive the economy towards cheaper energy and greater innovation. Given that firms seek profits, if such activities are really profitable companies would already be pursuing them. Such arguments are just too Pollyannaish to be really taken seriously.

c. Capital Costs - There are numerous events affecting this input, so we will only examine a few of the more prominent ones.

• In 2011, Capital Gains tax rates will increase by 33% to 20%. It is interesting to note how different this administration views capital gains tax rates relative to President Clinton. Clinton presided over one of the biggest tax cuts in American history, as he signed into law the reduction in capital gains taxes from 30% to 20%. A historical footnote to this action is that during his first two years in office unemployment for Clinton was higher than during the last two years of Bush 1. While capital gains taxes will return to Clinton levels, Obama’s change in rates will hinder business expansion, while Clinton benefited from a move friendly to business expansion.
• The price of gold, the ever falling dollar, and a bloated Fed balance sheet indicate inflation is more likely than deflation in the coming year. This view is also shared by a 2 to 1 margin in our latest Market Forecast Project. The falling dollar is particularly problematic, as the US has reaped enormous benefits from the dollar being the world’s reserve currency. Should this status end, inflation will accelerate as the dollars sitting in bank vaults around the world freely circulate in search of real assets. Those excess dollars will put significant price pressure on all goods and services for American people.
• As capital gains rates and inflation increase, so must the equity cost of capital. Suddenly, companies looking to expand must pay more to source the funds required for such expansion, and fewer projects will make economic sense to pursue. Bottom line, an increasing cost of capital results in less business expansion, and may even reduce existing business lines as some of them may also fail to earn an adequate rate of return. This results in either reduced future employment, or laid off/terminated existing workers.

d. Taxes – Small businesses have been the main employment driver in the economy for the past 20 years. The majority of those firms are S-Corporations, which are taxed at the owner’s individual tax rate. In 2011, the highest marginal federal individual income tax rate will increase from 34% to 39%. In addition, the proposed health care reform legislation will add a 5.4% surcharge to individuals making more than $500,000 and couples making more than $1,000,000. These actions together reduce the incentives to grow existing profitable businesses. Further, as no one starts a business with the expectation of failure, these tax increases effectively serve as a deterrent to starting a new business as the profits one keeps will decrease.

The trends in the factors facing companies today are essentially the opposite of the past 30 years. Further, many of these issues are interactive. Higher taxes lead to lower expansion, which leads to lower employment and lower consumer spending. This becomes a vicious circle of sorts, with the exact cost being hard to determine as no one tracks the jobs lost or not created due to anti market policies. Just take note of the troubles the White House has in counting the jobs its stimulus program has created or saved.

The end result to these various polices, regardless of how noble they may be in spirit, will be to slow economic growth, and reduce employment throughout the economy. While these effects will not be immediate, we believe they will serve as a long to intermediate term drag on the economy. If indeed, these policies become law and the economy continues to be depressed in 2010, it is highly likely a dramatic change will take place during the Congressional elections. Alternatively, should these policies not become law, and the current administration and Congress look to enact true pro-growth policies as Clinton did, all bets regarding the above analysis are off and we will look to identify how to exploit a growth oriented economy.

The last alternative is what seems to be emerging currently, a sort of high propaganda, low impact series of legislative initiatives that ultimately do not change existing laws, but result in more stimulus programs to pursue various political objectives without the formality of making law. While short term negative, such actions will likely not have significant long terms effects and can be reversed by future fiscally responsible administrations and/or Congress. Bottom line, we applaud Buffett’s concept of investing in America but would not let irrational exuberance guide our actions with the recent market strength, as the economy is still finding its way out of the wilderness of an unprecedented federal deficit, decades-high unemployment, a disastrous dollar policy, the severe ramifications of looming legislative changes to corporate America, and the ongoing ideological struggle between a big vs. small federal government.

We believe now is a great time to practice the Chinese saying – “Hope for the best, but prepare for the worst”. In the context of an equity portfolio – focus on high quality, well managed, and attractively priced businesses. While the last few months haven’t been a bad time to own higher beta, lower quality firms, we caution that such a strategy may fail gravely in the months ahead. Also, as we recommended during our annual Research Summit last June, look for companies with significant overseas operations, especially in Asia. Not only will those economies likely register stronger growth in the years ahead, but those currencies will likely continue to appreciate against the dollar making sales in those currencies especially valuable.

For those of you that have not become a part of our Market Forecast Project, please enroll and participate in this month’s survey. For the month of October (September 30 to October 30, 2009), the returns are the following:

AFG Portfolio Performance