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Some Musings On Income Distribution - Part 4

11. Investment Implications

I am not happy about the current distribution of income but I am not sure I have heard a cure which isn't worse than the disease. As an investor, it is important to focus on exactly what the evidence suggests in terms of actionable intelligence.

A. Low Inflation, Low Interest Rates

If a disproportionate amount of income is going to a small number of very wealthy people, it is almost inevitable that there will be less consumption and more saving than if income were more equitably distributed. Thus, demand pull inflation becomes less likely. Perhaps as importantly, the constant accumulation of savings will create a source of readily investible funds. To the extent that bottlenecks develop in the economy and lead prices to escalate, it is very likely that companies or entrepreneurial individuals will quickly marshall forces to satisfy demand and drive prices down. Thus, we are likely to have less inflation pressure than in the past and that, in turn, means that nominal interest rates will be kept lower both by market forces and by the Fed. I am not saying that we may not have inflationary spikes brought on by a disruption in oil supplies or an overly aggressive Fed. But the long term trend will be for inflation to be more subdued. As a result, reliable investments producing solid yield with some potential for appreciation are very attractive here. I think that equity REITs are oversold; my favorite name is Lexington Realty (NYSE:LXP).

B. Equity Valuations

We frequently see "backtested" rules of the thumb for equity valuation such as the CAPE or the Tobin Q and are told equities are now too expensive. I have written extensively on the topic of interest rates and equity multiples and I firmly believe that the assertion that interest rates are irrelevant to equity multiples is about as convincing as the assertion that a given object will have the same weight on the Moon as it has on Earth. I will not belabor the point here because there is another perhaps more important point I want to make. I believe that a convincing argument can be made that something very important happened in the years around 1980 which changed the effective rights and privileges of an owner of a piece of paper called a stock certificate. It involved LBOs, corporate raiders, activist shareholders, and the SEC safe harbor rule for share repurchases. All of a sudden, corporate management became increasingly aware that it was working for the shareholders. A failure to take shareholder interests to heart could lead to all sorts of nasty consequences. Of course, as an owner of a few thousand shares of a Dow company I cannot go up and browbeat the CEO. But I don't have to because I have Carl Icahn to do it for me. And I can be a "free rider" on his efforts so that the value of my shares goes up just as do his. There have been some ugly sides to this story and I, for one, would like to see some managements take a longer term view of shareholder interests. But the days of the corporation as a quasi-public entity balancing the interests of multiple stakeholders are effectively over. We are in an era in which, for better or worse, the shareholders may not be in the driver's seat, but they are certainly in the second row of taxicab seats telling the driver where to go and deciding how much to tip him. Of course, there are still abusive managements but they are called to task by activists and are usually responsive. And - you know what? - all of the "backtested" models show that equity multiples have been much higher since the mid-80's than in prior periods. For the first few years and up to 2000, it appeared to be (and was largely) a bubble; but more time has past and valuations have held up. In my view, higher multiples than those suggested by pre-1980 numbers are justified especially if interest rates stay low.

C. The Barbell Theory

This is easy to understand but is not invariably a good guide to investment. If income distribution has become regressive, then one would expect consumer goods manufacturers, service providers and retailers at the extremes of wealth markets to prosper and those aimed at middle class markets to suffer. Tiffany and the Dollar Store should thrive, while Sears should struggle. This theme has some legitimacy but it doesn't really explain the recent failure of Filene's, Syms (where I would drive and load up my BMW with dirt cheap clothing) and Loehman's. I would not take this theory to the bank just yet but it would seem to make sense and may explain certain developments as things unfold.

D. Counterparty Opportunities

Hundreds, maybe thousands, of years ago a couple of guys (or maybe women) sat down and thought up a clever way to make money. They would collect one shekel (or clam shell) from many people and ask each person to pick a 3 digit number. If they picked the right number (which would be announced the next day) they would receive a big pile of shekels or clam shells. One of the planners figured out that, over time, the game could not pay out 1000 shells or more and so they tried to sell people on a payoff of 500 shells. And after some market testing, they discovered that they could get lots of players if they reliably paid 600 shells. This meant that, over time, they would get to keep about 40% of the shells they collected. The numbers racket was born. People - at least Americans - are willing to pay $1 for a one in a million chance to win $600,000. And they are willing to pony up a few grand for a miniscule chance to become a successful multi-level marketing distributor. So the person or company willing to take the other side of some of these bets can do very, very well indeed. I am not suggesting the SA readers try to start a numbers game in the Hamptons or in retirement communities or investment clubs. But I am suggesting the public's "risk preference" may create extraordinary opportunities. The MLM guys seem to have capitalized on this, casinos are expanding, and on line gambling is taking off. None of this is good. If I could go back in time I would try to persuade, St. Paul to condemn this in one of his very articulate letters. But we are where we are. Are there or will there be opportunities in the options market, in penny stocks, or in other areas of investment to take advantage of this? I can't think of any right now, but it is such a striking example of dysfunctional economic behavior that attention should be devoted to the possible emergence of such opportunities.

Disclosure: I am long LXP.