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"The object of economics is to maximize happiness by purchasing pleasure, as it were, at the lowest cost of pain." - William Stanley Jevons, The Theory of Political Economy (1871)

When looking at the basic tenets of economics, it can be said that the purpose of the study is to seek efficiency in the everlasting quest of resource distribution. Businesses are created to profit from the quest, as the legal providers of goods and services. Governments are enacted to oversee the pursuit across a named boundary, while establishing law and order, which in theory is set to benefit their respective populations.

The political economy is the study of relationship between resource distribution (businesses) and government, as well as the relationship between the government and the people.

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An understanding in economics is essential in creating economic policy, which in theory is designed to maximize the profitability of business as well as the utility of the people.

In the United States alone, economic policy has created an evolving landscape that has proven to shape the business cycle in both the boom and the bust phases. The perfect implementation of economic policy designed to smooth the ups and downs of the business cycle has yet to occur. As such, an understanding of the current state of the U.S. political economy is a necessary requirement in determining current market valuation, the prospect of future market valuation and the risks of volatility.

To summarize, if businesses were ships, the political economy is the tide which rises and falls. As a rising tide lifts all boats, the astute investor may embark on a profitable journey by purchasing stakes throughout the fleet.

This article is part 3 of a 3-part series encompassing three important elements of market valuation in detail by utilizing insightful market data and analysis.

Here is the schedule of the entire series, published between September 23, 2013 and October 30, 2013.

Part I: Reviewing Investor Sentiment Conclusion

As noted in Part 1, the first and often most important element of market valuations are investor or market sentiment.

According to Howard Marks, who champions the bull market into three segments based on investor confidence, the current bull run is in stage two with room to run. Stage three does not occur until wild investor crazes shoot prices to unsustainable levels as "everyone's sure things will get better forever."

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The conclusion notes that while the economy is showcasing strength and the market has improved for four years running, not all investors are convinced that the market will continue to reach higher levels. There is no "tulip" craze or rush to buy houses that will keep going up forever.

Part II: Reviewing The Domestic Stock Market Analysis

As noted in Part 2, as there is no "official" way to determine fair market valuation, the investor can take a few measurements into consideration. There are many dated ways to determine value, however in today's market the price to earnings ratio, in combination with expected earnings growth, is the best method.

Another highlight was the momentum of liquidity, which showcases a higher demand for market securities. This in turn is a positive that should increase market valuation levels.

Using the October 25, 2013 S&P 500 close of 1759.77 and the S&P's most recent 2014 analyst earnings projections of $122.32, the S&P 500 earnings yield is 6.95% moving forward with a P/E of 14.39.

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The conclusion noted that the market was undervalued with the S&P 500 trading at 15.93 times 2013 earnings. It stated that a conservative 10% one-year total return for the S&P 500, using anticipated earnings with a TTM P/E of 15, was a clear upside. Since published, the market is up 4% (17 trading days).

The analysis concluded that while there are always uncertainties, the health of the market was deemed hospitable to the equity investor. Moving on from investor sentiment and general market valuation, this article will analyze the political and economic landscape facing the bull market today.

Part III: The State Of The Political Economy

As noted by the World Economic Forum, there are four key priorities for establishing growth. These priorities are each established and influenced through government policy. These priorities, which make the backbone of economic policy, are education, social stability, incentives for taking risk and global economic integration. A fifth priority of government spending and stability is also applicable to the domestic political economy and this discussion.

Economic Growth Priority #1: Education

On a domestic scale the United States is a leader in education. According to the Education Index, which is part of the United Nations Human Development Index and measures the mean years and expected of schooling in a country, the U.S. ranks well with a 96.1% score. Below is a sample of other nations, also, the scores ranged from 99.3% to 28.2% with developed countries all scoring above 80%.

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The United States is well-known for its advanced education system. In the 2011-2012 school year, over 760,000 international students attested to this by studying in America. Many global leaders, such as former Mexican President Ernest Zedillo, pursued an American education. Zedillo, now the director of the Center for the Study of Globalization at Yale University, received his master's and PhD from Yale.

While teachers may complain about pay and conservatives argue that professors are overwhelmingly focused on the liberal agenda, the fact remains that the U.S. has a highly-educated workforce and remains an internationally recognized leader in advanced education.

This heavy investment in human capital lends well to economic growth. This leads to innovation in the marketplace and the continued emergence of new businesses and technology that keep the U.S. economy at the top of the global list.

Like a racehorse that hasn't eaten in a day, the U.S. is set for the win but has gaps in human capital that are sustained by skilled immigration. By lowering the costs associated with allowing such immigration, the U.S. could fill these gaps quicker and thus strengthen the economy. Also, by allowing children of alien status citizenship, a new crop of legal immigrants would create a larger pool of talent that would lend well to economic growth as well.

Economic Growth Priority #2: Social Stability

The U.S. unemployment rate has dropped from 10% in October 2009 to 7.2% as of September 2013.

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By targeting unemployment as part of government public policy, the social stability of the population has increased while the economy has improved. While Wall Street and investors continue to fear a small change of economic policy known as the "taper," the low federal funds target rate is seen as more of a permanent short-term solution that will continue to support both an increase in economic expansion and a decrease in unemployment.

In America, a social security system is also in place to offer a financial safety net to the elderly and disabled. With the short-term unemployment declining and a stable domestic social security system, economic output will only increase.

Economic Growth Priority #3: The Risk Incentive

Taxes, taxes, taxes. While the U.S. is a giant pool of human capital and the rewards of innovation and risk are completely safe and legal financial gain, taxes threaten the incentive to take risk.

The U.S. tax policy is inefficient, as noted by several economists and leading authorities such as Steve Forbes and Art Laffer. According to both Forbes and Laffer, a flat-tax system would create more jobs, investment and tax revenue. The increase in government tax revenue is seen here in the Laffer Curve.

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In this regard, the government has an opportunity to increase revenues, investment and economic output at once. The current administration does not favor lowering corporate taxes or creating a flat tax system.

The country is able to hold with high levels of taxation due to several variables such as social stability and a lack of alternative nearby alternatives (as seen in Europe), however an efficient U.S. tax policy favors an increase in prosperity.

Economic Growth Priority #4: Global Economic Integration

As a leader of the global economy, the U.S. is completely integrated with the rest of the world. With safe and easy travel, expedient shipping and a world-class network of communication, resource distribution is becoming more efficient by the year.

With low international tariffs and legal trade legal between most countries, the U.S. is able to import and export on a massive scale and to utilize comparative advantage.

Regarding trade, the U.S. is able to further increase economic output by creating a new economic policy to abolish all international tariffs.

By ending such taxation, imported items will cost less and increase U.S. purchasing power. With negotiations of simultaneous tariff reductions for U.S. exports, economic output will increase. While there is a larger issue here, specifically an argument regarding American jobs, one must consent that the mercantilism never worked. In this understanding, job mercantilism via tariffs reduces global economic growth through an efficiency loss.

The chart below shows the gains and losses associated with a tariff between two countries. To learn more, read the article explaining the distortions that tariffs cause here. The net effects are negative, as the two triangles B and D below are the deadweight loss, which reduces resource distribution, consumption and aggregate utility.

In this regard, the global economic output can be increased by opting for a tariff-free world. Of course anti-dumping duties are to be understood as means of protection against predatory pricing, however in a total sense, international taxation can be rendered obsolete if the global economic goal is increased expansion and aggregate utility.

The Biggest Opportunity To Increase Growth Is Reaganomics

In terms of economic performance, several well-known conservative pundits point to Reaganomics as a definitive guideline regarding government economic policy leading to growth. The four tenets of Reaganomics are lower marginal tax rates, less regulation, reduced government spending and targeted low inflation.

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Above: Economist Arthur Laffer with President Ronald Reagan

It can be argued that Reagan's economic policies were a large variable of the massive 1990's bull market that occurred after he left office in 1988. In this sense, Reaganesque economic policy could be the greatest forward economic indicator of all-time.

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While lower taxes and inflation are already covered under the social security and risk incentive categories above, lower regulation and restrained government spending were not.

Economic Growth Priority #5: Government Spending & Stability

For a short-term, immediate fix to the global financial crisis, the U.S. government favored the Keynesian approach to increasing immediate economic output through government spending. Although it worked at what could arguably be the cost of an inefficient use of capital, the government spending has not been restrained. Under the current administration, it continues to grow to levels never seen in recorded history.

According to the Congressional Budget Office, Obama has spent the following each year (2103 in progress, budget amount supplied).

  • 2008: $2.98 trillion
  • 2009: $3.27 trillion
  • 2010: $3.46 trillion
  • 2011: $3.60 trillion
  • 2012: $3.65 trillion
  • 2013: $3.72 trillion

Now that the economy is showcasing signs of economic strength in both the jobs report and the S&P 500 earnings, the Keynesian hand is overplayed.

The U.S. economy has the potential to reign over unprecedented growth if Reaganesque policy, specifically lower government spending, lower regulation and lower taxes, were to accompany current low interest rates.

On the note of government stability, the recent federal government shutdown was an immature bluff that the global economy shrugged off. The government must remain stable to ensure future debt obligations are financeable and as such, financed at the lowest possible rates. Also, stability will ensure that a federal worker furlough does not happen again (if they get paid, the country loses productivity, if they don't get paid, the economic impact is negative).

Conclusion

In the five explored areas of what the government can do to establish growth, the United States is doing remarkably well. The country has room to run, however, as there are several areas that can influence economic growth in a positive way.

While the current administration is throwing spears at the bull market with a continued, unprecedented level of increase in federal spending, the positive merits of education, social stability, risk incentive and global economic integration are keeping the bull alive.

Without a shift in policy, the bull market will remain strong but will not operate at optimum levels. By outlining solutions based on economic efficiencies and growth, the U.S. may nurse this bull and lead the world into what may be the greatest bull-market of all time.

To conclude this series, it can be noted that the U.S. stock market is ripe for investment. Although the bull has run for the past four years, investor sentiment has not peaked. The pricing of the market is low while the short-term earnings outlook is very positive. Finally, the state of the political economy holds enough positives to keep the bull alive, albeit at the cost of inefficient government spending.

Source: Now Is The Time To Be Bullish (Part 3): The State Of The Political Economy