Taxes – A Nation’s Tiller

Printing money is merely taxation in another form. – Peter Schiff

 

August 12, 2018

by Steve Stofka

The Federal government does not need taxes to fund its spending, so why does it impose them? Taxes act as a natural curb on the price pressures induced by Federal spending. Taxes can promote steady growth and allow the government to introduce more entropy into the economic system.

During World War 2, the Federal government ran deficits that were 25% of the entire economy (Note #1) and five times current deficit levels as a percent of the economy. Despite its monetary superpowers, the government imposes a wide range of taxes. Why?

Using the engine model I first introduced a few weeks ago (Note #2), taxes drain pressure from the economic system and act as a natural check on price inflation. During WW2, the government spent so much more than it taxed that it needed to impose wage and price controls to curb inflationary pressures. Does it matter how inflation is checked? Yes.

When price pressures are curbed by law, people turn to other currencies or barter. During WW2, the alternative was barter and do-it-yourself. Because neither of these is a recorded exchange of money, the government collected fewer taxes which further increased price pressure in the economic engine. After the war was over and price controls lifted, tax collections relieved the accumulated price pressures. As a percent of GDP, taxes collected were 50% more than current levels.

For the past fifty years, Federal tax collections have ranged from 10-12% of GDP, but they are not an isolated statistic. What matters is the difference between Federal spending and tax collections, or net Federal input. During the past two decades Federal input has become a growing share of GDP.

FedSpendLessTaxPctGDP

During the past sixty years, that net input has grown 8% per year. The growth rates have varied by decade but the strongest rates of input growth rates have occurred when the same party has held the Presidency and House. Neither party knows restraint. The lowest input growth has occurred when a Republican House restrains a Democratic President (Note #3).

FedNetInputGrowth

Let’s compare net Federal input to the growth of credit. As I wrote last week, the Federal government took a more dominant role in the economy in the late 1960s. By the year 2000, net Federal input grew at an annual rate of 10.3%, over one percent higher than credit growth. During all but six of those years, Democrats controlled the House and the purse. During those forty years, inequality grew.

FedNetInputCreditGrowth

During the 1990s and 2010s, government should have increased its net input to offset the lack of credit growth. To increase input, the government can increase spending, reduce taxes or a combination of both. When GDP growth is added to the chart, we can see why this decade’s GDP growth rate has been the lowest of the past six decades. It’s not rocket science; the inputs have been low.

FedNetInputCreditGrowthGDPGrowth

A universe with maximum entropy is a still universe because all the energy is uniformly distributed. At a minimum entropy, the universe exploded in the Big Bang. Too much clumping of money energy provokes rebellion. Too little clumping hampers investment and interest and condemns a nation to poverty. As an act of self-preservation, a government adopts redistributive tax policies. Among the developed nations, the U.S. is second only to France in the percent of disposable income it redistributes to its people (Note #4).

A nation can either tax its citizens directly, or add so much net input that it provokes higher inflation, which taxes people indirectly through the loss of purchasing power. Of the two alternatives, the former is the more desirable. In a democracy we can vote for those who spend our tax dollars. Inflation is both a tax and an unmanaged redistribution of money from the poor to the rich. How so? Credit is money. Higher inflation rates lead to higher interest rates which reduce access to credit for lower income households, and give households with greater assets a higher return on their savings.

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Notes:
1. Federal Income and Outlays at the Office Management and Budget, Historical Tables

2. The “engine” was first introduced in Hunt For Inflation, and continued in Hunt, Part 2 , Engine Flow , and Washington’s Role.

3. Federal spending less tax collections grew at a negative annual rate during the Clinton and Obama administrations. Both had to negotiate with a hostile Republican House in the last six years of their administrations.

4. “U.S. transfer payments constitute 28.5% of Americans’ disposable income—almost double the 15% reported by the Census Bureau. That’s a bigger share than in all large developed countries other than France, which redistributes 33.1% of its disposable income.” (WSJ – Paywall) The OECD’s computation of the GINI coefficient is based on disposable personal income, which is calculated differently in the U.S.

Miscellaneous:

Average GDP growth for the past sixty years has been 3.0%. The average inflation rate has been 3.3%. The 60-year median is 2.6%. The average inflation rate of the past two decades have been only 2.1%.

A good recap of the after effects of the financial crisis.

 

Washington’s Role

“The rich are much better placed to feed at the public trough. The poor get crumbs.” – Steve Hanke, American Economist, 1942 –

August 5, 2018

by Steve Stofka

In the past fifty years, the increasing role of the Federal government in the economy has been the chief contributor to inequality. In the last years of the Bush administration, America became a socialist economy. Credit growth under the Trump administration has not changed from the levels during the Obama administration. On this score, Trump is Obama II.

Since the Great Recession, the federal government has far surpassed the role of banks in net input into the economic engine. In the post WW2 period, the annual growth in credit outstanding (see Notes #1) to households, corporations, state and local government surpassed the net input of the federal government, its spending less the taxes it drained out of the engine. The blue line in the graph below is the growth in bank credit.

CreditGrowthvsFedInput1953-1970

The Great Society and the escalation of the Vietnam War in the 1960s marked a changing role for the Federal government. Bernie Sanders marked the early 1970s as the beginning of the increase in inequality. Bernie suggested that the Federal government should have a greater role in the economy to correct the problem. Bernie has it backwards, as I will show. It is the greater role of the Federal government in the economy that has contributed to inequality. The hand that feeds the poor becomes the hand that feeds the rich.

Under subsequent presidents after 1968, both Republican and Democratic, the Federal input into the economy dominated the net – loans minus payments – input of bank credit. When the Federal government spends more than it taxes, it becomes a proxy debtor for individuals, state and local governments who cannot borrow enough to meet their needs. As the net credit input into the economy sank in the last two years of the Bush administration, 2007-2008, the role of the Federal government approached the levels of western European socialist governments.

CreditGrowthVsFedInput

The Obama Administration and super-majority Democratic Congress of 2009-2010 simply held that input level established earlier by the Bush Administration and a Democratic House. When Republicans took control of the House in 2011, they fought with the Obama Administration to reduce the input level. From 2012 through 2015, the growth in credit eclipsed the net input of the Federal government. Since early 2016, the growth in Federal input has once again dominated the role of the banks in the private economy. After the tax cuts passed last year, the Federal government will drain less taxes out of the economy and further cement its dominant role as an input into the engine.

For the past 65 years, quarterly credit growth has averaged 1.9%. In the last ten years, it has averaged .4%. From April 2017, two months after Trump took office, through March 2018, quarterly net credit growth averaged the same .4% as it did during the Obama years. Banks may express confidence in the Trump presidency, but their credit policies indicate that they have as little confidence in Trump’s Washington as they had in Obama’s Washington. Unless Trump can turn that sentiment, his administration will suffer the same lackluster growth as the Obama administration. If the Federal government continues to dominate economic input, Trump’s pledge to drain the swamp will be broken. Federal economic power only feeds the K-Street crocodiles lurking in the swamp waters.

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Notes

  1. The growth of credit outstanding (net input) is a function of new credit issued (input), debtors’ payments on existing loans (drain) and the write-off of non-performing loans (drain).

K-Street in Washington is the location of many of the nation’s most powerful lobbying firms.

 

Engine Flow

July 29, 2018

by Steve Stofka

“Banking was conceived in inequity and born in sin” – Josiah Stamp

In the past two weeks, I’ve looked at the inputs and drains to the economic engine. This week I’ll look at the flow between bank credit, the largest input, and loan payments, the largest drain. Because bankers want to make a profit on the money they pump into the economy, they do a better job of managing the economy than government officials.  Banks manage access to the credit system better than governments and achieve less economic inequality. Whenever governments wrest control of credit creation away from the banks to promote greater equality, the country’s economy suffers.

Let’s begin with the first point; banks must protect their loan portfolios. To do that, they monitor the health of the economy. The Conference Board uses ten data series to construct its index of leading economic indicators to estimate the probability of recession. ECRI uses 50 data series to chart its weekly leading index. These indicators are sensitive and may give a false signal, indicating a coming recession which doesn’t occur. Watching these data series are the banks who form an emergent Artificial Intelligence machine that varies the amount of credit they input into the economic engine.

Let’s piggy back on the efforts and watchfulness of the banks. We can look for a change in the ratio of household credit, an input to the engine, to the unemployment rate, or the ability to drain the input. One quarter’s decline of 2% or greater in this ratio, or two quarters of a smaller decline has been a reliable indicator that a recession is approaching. Below is a graph of the Household Debt-Unemployment ratio during the past thirty years but this signal has been reliable since World War 2.

HouseholdDebtUnemploymentRate

Bank behavior has accurately predicted the start of every recession since WW2. Is this the holy grail for mid to long-term trading decisions? Not quite. The Federal Reserve does not release the total amount of household debt for each quarter until the end of the following quarter (see #1 at end). However, every month, the BLS releases the unemployment rate, the divisor in the Debt-Unemployment ratio. If the rate is lower than a year ago, no worries. If the year-over-year change in the rate is higher in two consecutive months, worry.

Unemploy

Here’s the same chart with the stock market’s reaction when the year-over-year change has been above zero for two months in a row. Insiders and market movers have lightened their exposure to equities.

UnemployStkMkt

Loans add money to the engine. Loan payments drain money from the engine. As unemployment rises, people reduce their loan payments. In managing their risk, the banks react to signs of economic weakness by reducing the amount of credit they issue. Because they are more responsive to evolving conditions than central banks and elected officials, banks manage the economy better than the government.

Access to credit is the key to understanding the disparity in fortunes among Americans. Let’s look at the flow of credit creation in a system where a bank can loan out ten times its deposits. Let’s say I borrow $10,000 from Bank A for a bath remodel. The contractor might have a gross profit of $2500 which he deposits in Bank B, who leverages that into a $25,000 loan to another customer, who remodels her basement. Her contractor’s gross profit of $5000 is deposited in Bank C, which leverages that into a $50,000 loan to another customer for a complete kitchen remodel. Only those people with good credit – the haves – can access this money machine. The machine is closed to the have-nots.

Governments have attempted to fix this inequality. The government borrows from the banks, acting as a substitute for the people who cannot borrow. The government then inputs the money into the economy, but this does not make the engine run because there is not enough being drained out in loan payments and taxes. The engine runs on flow – inputs and drains. One without the other damages the engine and makes the country vulnerable to a triggering event which causes collapse and the economic engine blows up. Yugoslavia (1994), Argentina (2000), Zimbabwe (2008) and Venezuela (2017) are the most recent examples.

Quoting an unnamed source, Winston Churchill said, “Democracy is the worst form of Government except for all those other forms that have been tried from time to time.”  Private bank management of credit creation is a terrible system, but far better than the other systems that have been tried.

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Notes:
1. With a month delay, the Fed releases a monthly estimate of household debt that excludes mortgages and HELOCs.

Ten years after the recession, the amount of household debt per employee is still above trend. A ratio of debt to disposable income is below trend.

According to the credit reporting agency Experian “Transactors” are 29% of card holders and pay off their balance each month. 43% carry a balance. The rest are dormant accounts. Experian ranks states by the average credit rating of its residents.

Fannie Mae reports that, as of the end of 2017, 37% of the mortgages modified during the housing crisis had defaulted again.

Bank of America clients with High Net Worth reported that their allocations were 55% stocks, 21% bonds, 15% cash, 10% other.

In May, consumer credit increased at a seasonally adjusted annual rate of 7-1/2 percent. Revolving credit increased at an annual rate of 11-1/2 percent, while nonrevolving credit increased at an annual rate of 6-1/4 percent (Federal Reserve)

 

The Hunt, Part 2

July 22, 2018

by Steve Stofka

Last week, I showed the inputs to the credit constrained economy as a percent of GDP. I’ll put that up again here.

CreditGrowthFedSpendPctGDP

This week I’ll add in the drains but first let me review one of the inputs, bank loans. Focus your attention on that period just after 9/11, the left gray recession bar,  and the end of 2006, just to the left of the red box outlining the Great Recession on the right.  For those five years after 9/11, the banks doubled their loans to state and local governments, a surge of $1.4 trillion. The banks increased their household and mortgage lending by $5.3 trillion, or 67%. Why did banks act so foolishly? Former Fed chairman Alan Greenspan couldn’t answer that. We have a partial clue.

For 4-1/2 years after 9/11 and the dot-com bust, there was no growth in credit to businesses, a phenomenon unseen before in the data history since WW2. The banks reached out to households, as well as state and local governments because they needed the $1 trillion in loan business missing on the corporate side (#1 below).

There are four drains in the economic engine – Federal taxes, payments on loans, bad debts and the change in bank capital. State and local government taxes are not a drain because those government entities can not create credit. The change in bank capital reflects the changes in the banks’ loan leverage and their confidence in the economy. During the 1990s and 2010s the sum of the inputs and the drains remained within a tight range of about 1/7th of GDP.

InputLessDrains

The results of bad policy during the 2000s are shown clearly in the graph. In addition to the surge in bank loans, the Federal government went on a spending spree after 9/11. There was too much input and not enough drain. The reduction in taxes in 2001 and 2003 exacerbated the problem. There was less being drained out. Asset prices absorb policy mistakes until they don’t – a life lesson for all investors.

Let’s add in a second line to the graph – inflation. The rise and fall of inflation approximates the flows of this economic engine model with a lag time of several months. I’ve shown the peaks and troughs in each series.

InputLessDrainsVsPCE

Look at that critical period from 2006 through 2007. The Fed kept raising rates in response to rising inflation (the red line), driven primarily by increases in the price of oil.  The Fed Funds rate peaked out at 5-1/4% in the summer of 2006 and stayed at that level for a year. The Fed misread the longer term inflation trend and contributed to the onset of the recession in late 2007. The net flows in the engine model (blue line) indicated that the long term trend of inflation was down, not up.

Where will inflation go next? Using last week’s theme, follow the hounds! Who are the hounds? The banks. The inflow of credit from the banks is the primary driver of inflation. Why has inflation in the past decade been low? Because credit growth has been low. Where will inflation go next? A gentle increase – see the slight incline of the blue line at the right of the graph. Contributing to that increase were last year’s tax cuts. Less money is being drained out of the engine.

Too much flow into the economic engine or an improper setting of interest rates – these mistakes are absorbed by assets, which are the reservoirs of the engine. Stocks, bonds and homes are the most commonly held assets and most likely to be mispriced. During the early to mid 2000s, the mistakes in input were so drastic that the financial crisis seems inevitable when we look in the rear view mirror. During the past eight years, the inputs and drains have remained steady, but interest rates have been set at an inappropriate level. Again, we can anticipate that asset prices have been absorbing the mistakes in policy.

 

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1. In the last quarter of 2001, loans to non-financial corporate business totaled $2.9 trillion and had averaged 6%+ growth for the past decade. Anticipating that same growth would have implied a credit balance of $3.9 trillion by the end of 2006. The actual balance was $3.1 trillion.

Hunt For Inflation

July 15, 2018

by Steve Stofka

Saddle up your horses, readers, because we are going on the Hunt for Inflation. I promise you’ll be home for afternoon tea. During this recovery, Inflation has been a wily fox, a real dodger. It has not behaved according to a model of fox behavior. Has Inflation evolved a consciousness?

Inflation often behaves quite predictably. The central bank lowers interest rates and pumps money into the economy. Too much money and credit chasing too few goods and Inflation begins running amuck. Tally-ho! Unleash the bloodhounds! The central bank raises interest rates which curbs the lending enthusiasm of its member banks through monetary policy. Inflation is caught, or tamed; the bloodhounds get bored and take a nap.

Not this time. Every time we think we see the tail of Inflation wagging, it turns out to be an illusion. Knowing that Inflation must be out there, the central bank has cautiously bumped up interest rates in the past two years. Every few months another bump, as though unleashing one more bloodhound ready to pounce as soon as Inflation shows itself.

Yes, Inflation has evolved a consciousness – the composite actions of the players in the Hunt. These players come in three varieties. One variety is the private sector – you and me and the business down the street. The second variety is the federal government and its authorized money agent, the Federal Reserve, the country’s central bank. Finally, there is a player who is a hybrid of the two – banks. They are private but have super powers conferred on them by the federal government. The private sector is the economic engine. The federal government and banks have inputs, drains and reservoirs that control the running of the economy.

The three money inputs into the constrained (see end) economy are 1) Federal spending, 2) Credit growth, and 3) net exports. In the graph below, the blue line includes 1, 2, and 3. The red line includes only 1. The graph shows the dramatic collapse of credit growth in this country. Federal spending accounted for all the new money flows into the economy.

CreditNXFedSpendvsFedSpend

Before the financial crisis, money flows into the economy were just over 30% of GDP. In less than a year, those inputs collapsed by almost 25%.

CreditGrowthFedSpendPctGDP

When inflation is lower than target, as it has been for the past decade, too much money flow is being drained out for the amount that is flowing in. In the case of too high or out of control inflation, as in the case of Venezuela, the opposite is true. Too much is being pumped in and not enough is being drained out. That’s the short story that gets you back to the lodge in time for a cup-pa or a pint. Next week – the inputs, drains and reservoirs of the economy.

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  1. Constrained – the private economy, state and local governments who cannot create new credit.
  2. Net exports are the sum of imports (minus) and exports (plus).

The Line of the Idle

July 8, 2018

by Steve Stofka

It used to be easy for a horse to get a job. This week I’ll look at the workers who have been idled by a century of automation. As a counterpoint to the daily rhythms of being busy, a casual idleness helps us recharge our batteries. In an America whose moral foundations are the Protestant work ethic, a constant idleness taints a person’s character. Those who have retired after a lifetime of work are expected to stay active. Leisure time is a resource not be squandered.

The phrase “pull your weight” meant to act like a horse and contribute to the team effort. From the Revolutionary War for Independence to World War 1, horses fought bravely and earned a place of respect in American history. Many a statue portrays a general atop his brave steed. Horses helped turn America into the bread basket of the world. Then the gas engines came after their jobs. Motors took over the jobs of pulling horse drawn carriages, plows and work wagons. Thousands of horses joined the line of the idle.

Then the engines came for the jobs of the agricultural workers. In the first half of the 20th century, farm employment fell from 40% of the labor force to 20% in 1950, and is 2% today.

Then the robots came for the jobs of manufacturing workers. A 1987 BLS report found that “relatively few employees have been laid off because of technological change.” Thirty years later, the National Council on Compensation (NCCI) summarized data from several sources. “In 2016 the United States produced almost 72% more goods than in 1990, but with only about 70% of the workers.” This two-part report is a bit lengthy but a quick glance at the graphs on the first page tell the story of the decline in agricultural and manufacturing jobs. (Part 1 and Part 2) . As a percent of the labor force, agricultural jobs peaked in the late 1800s. Manufacturing employment peaked just after World War 2.

Robots help assemble the horseless carriages in the car factories. In businesses across the land, the robots now weld and lift, pick and sort, box and ship – jobs that humans had a monopoly on. The robots are now learning how to drive and to think. Almost 40% of adults, and 20% of adults in the prime of their lives now sit idle, joining the horses in pasture.

Electric motors, long chained by a cord to a wall, have broken free and are now taking the jobs of gas engines. Robots built by workers in other countries compete for the jobs of American-built robots. Now the machines are making other machines obsolete.

Forged by the Protestant work ethic, the retired generation of Boomers pursue their leisure in earnest. RV sales are at record levels and last year’s visits to national parks almost matched the record numbers of 2016. Each year there are more visits than there are people in the country (Nat’l Park Service link). This growth in recreation occurs at a time when continuing drought in the western states has put extraordinary pressure on plants and wildlife. Summer in the west is now the season of fire.

In 1900, people welcomed their idleness as a byproduct and hallmark of progress and prosperity. The idleness of prosperity looks very different from the idleness of poverty visible in many troubled countries around the world, including parts of America. Which line is longer and which line are we on?

Stocks and Tax Receipts

July 1, 2018

by Steve Stofka

There is a close correlation (see end) between the trend in equity prices and Federal tax receipts, as we can see in the chart below. Occasionally, the market gets too optimistic or pessimistic. When it does it inevitably corrects back to the trend in tax collections.

SP500VsTaxReceipts

Note the strong divergence between stock prices (blue line) and tax collections (red line) since the 2016 election. Tax collections grew modestly in the first year of the Trump administration; from $2.133 trillion in the first quarter of 2017 to $2.178 trillion in the fourth quarter of last year. Following the tax cuts passed at the end of last year, tax revenues in the first quarter of 2018 fell $150 billion to $2.033 trillion. In fifteen months, the trend is negative for tax collections. In that same time frame, the SP500 rose 20% on the hope – or for some, the faith – that Trump policy will spur economic activity. That greater growth should lead to greater tax collections. It hasn’t.

Some say that the taxes during the previous administrations were too high. “Lowering the rates will raise the revenue,” is the prayer of supply-siders and tax cutters. “Just wait, revenues will rise as strong economic growth kicks in,” they promise. But this correlation of equity prices and tax revenues transcends administrations: the Obama years, and the Bush years and the Clinton years and into the H.W. Bush presidency. We could go even further back. When equity prices mis-estimate future growth, they correct back to the hard trend of tax revenues. It doesn’t happen overnight. The market had been correcting for more than a year before September ‘s implosion of Lehman Brothers in 2008.

George Soros became one of the most successful traders by constructing a story in advance of his trades. The story is a prediction of what he thinks will result if event A happens. When event A doesn’t happen within a set time, or when event A does not lead to B result, he gets out of the trade. He doesn’t fall in love with his story as so many of us do. Economists and politicians fall in love with their theories and stories the way fans do a baseball or football team. This year we’re going to go all the way!

For the long-term investor, the important thing is an allocation commensurate with one’s risk tolerance, time horizon and income needs. Secondly, have patience.

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Since 1990, the correlation is .96. Since 1997, it is .91. Since 2008, it is .94. Since the 2016 election, it is -.45.

Who Owes and Who Owns

June 24, 2018

by Steve Stofka

Total debt levels are high relative to income, but the payments on that debt, the Debt to Income ratio, are at historic lows. Why? The absurdly low interest rates of the past decade play a significant role. What could happen as interest rates rise?

An explanation of terms first. The Debt to Income ratio (CFPB  page) measures the monthly flow of debt service payments to the flow of monthly income. Lenders use this ratio to judge the capacity of a borrower to repay a loan. Let’s call this ratio DTI.

The aggregate household debt to income ratio measures the pool of total debt to the flow of yearly income. Lenders and economists use this measure to assess the leverage of income, i.e. how much debt can the average income buy? Let’s call this ADTI.

As the DTI rose to historic highs before the recession, the average household was paying more than 13% of their disposable income to service their debt.  7.2% of that was mortgage payments. After the recession, the DTI has fallen to historic lows just above 10%. 4.4% of that was mortgage payments, which are near historic lows. Rock bottom interest rates have been the chief factor in that reduction. The percentage of disposable income going to non-mortgage debt payments have remained stable at 6%.

The ADTI shows the leverage of income to debt. Before the recession, each household had debt to income ratio of 1.2:1 (1.2 to 1), as shown in the chart below. (Federal Reserve paper).  The aggregate debt to income ratio is now 1:1. During and following the recession, some households reduced their debt voluntarily; some had their debt reduced involuntarily through home foreclosure and credit card debt write-offs. Although the current ADTI level is just about 1:1, this is far above the debt levels of the 1980s and 1990s when the ratio fell as low as .6:1. Households have transitioned from overleveraged before the recession to fully leveraged after the recession.

DebtToIncomeAgg

Households with higher incomes are more leveraged and raise the aggregate ratio of debt to income. Those with lower incomes have less credit available to them and less debt. They lower the aggregate ratio. Lower income households may not qualify for a mortgage, the greatest source of most household debt and a point of high leverage. The current mortgage leverage is more than 3-1; a $77K income is needed for a $260K mortgage at 4.5% for thirty years (calculator).

To reach the average 1:1 ratio of debt to income using the example above, there must be $183K of income with no debt. For one $77K household to get overleveraged to get that mortgage, there must be fifteen households with $50K incomes who are underleveraged (.25:1 debt to income). Where are those people? Many of them are in rural areas, particularly in the vertical middle of the country and several mountain states. See the 2006 county map of aggregate debt to income in the Federal Reserve paper linked above.

“It’s the economy, stupid!” read the banner that James Carville posted in Bill Clinton’s campaign office during the 1992 election race. In a series of articles published in 2004, journalist Bill Bishop coined the term “the big sort” and published a book by that name in 2009. This is one more example of the sorting that is taking place in this country.

Many people in rural areas live a penny-wise life because they don’t like to be in debt. Some are living frugally because credit is not available to them. In either case, their low levels of debt relative to income are enabling those in urban and suburban areas to maximize their debt leverage. Those living in urban areas may complain – quite rightly – that they must borrow more than they would like because the cost of living in some cities is so high. Regardless, people in one set of circumstances and making do with less are effectively enabling the income to debt leverage of another set of people who are enjoying more. That dissonance adds to the cacophony of the current debate in this country.

Less Bang For The Buck

June 17, 20918

by Steve Stofka

There are two types of inputs into production, human and non-human. Over a hundred years ago, Henry Ford realized that he had to invest in his human inputs as well as his equipment, land and factories. Once he started paying his employees a decent wage, they were able to buy the very cars they were producing on Ford’s assembly line.

The total return on our stock investments depends on two inputs: dividends and capital gains, which is the increase in the stock price. Both are dependent on profits. Dividends are a share of the profits that a company returns to its shareholders. Capital gains arise from the profits/savings of other investors who are willing to buy the shares we own (see end for explanation of mutual funds).

In the past three decades, a growing share of total return has come from capital gains. Because of that shift from dividend income to capital gains, market corrections are harsh and swift.

In the 1970s, stocks paid twice the dividend rate that they do today. It took an oil embargo and escalating oil prices, a continuing war in Vietnam, the impeachment of President Nixon, a long recession and growing inflation to sink the market by 50% beginning in early 1973 to the middle of 1974.

In 2000, the dividend rate or yield was a third of what it was in 1973. Total return was much more dependent on the willingness of other investors to buy stocks. In 2-1/2 years, the market lost 45% because of a lack of investor confidence in the new internet industry, a mild recession and 9-11. Dividends act as a safety net for falling stock prices and dividends were weak.

In 2008, the dividend yield was about the same as in 2000. In 1-1/2 years, the market again lost 45% of its value because of a lack of confidence brought on by a financial crisis and a long and deep recession.

Other bedrock shifts have occurred in the past three decades. Corporate debt is an input to production. In the post-WW2 period until 1980, corporate debt as a percent of GDP was a stable 10-15%. $1 of debt generated $7 to $10 of GDP. Following the back-to-back recessions of the early 1980s until the height of the dot-com boom in 2000, that percentage almost doubled to 27%. Each $1 of corporate debt generated less than $4 of GDP.

CorpDebtPctGDP

Today $1 of corporate debt generates just $3 of GDP. Debt is a liability pool. GDP is a flow. That pool of debt is generating less flow. It is less efficient. In 1973, $1 of corporate debt generated 46 cents in profit. Now it generates just 30 cents.

To hide that inefficiency and make their stocks appealing to investors, companies have used some of that debt to buy back their own stock. This reduces the P/E ratio many investors use to gauge value, and it increases the leverage of profit flows.

Here’s a simple example to show how a stock buyback influences the P/E ratio. If a company makes a $10 profit and has 10 shares of stock outstanding, the profit per share is $1. If the company’s stock is priced at $20, then Price-Earnings (P/E) ratio is $20/$1 or 20. If that company borrows money and buys back a share of stock, then a $10 profit is divided among 9 shares for a per-share profit of $1.11. The P/E ratio has declined to 18. When the company buys stock back from existing shareholders, that often drives up the price, and thus lowers the P/E ratio further.

The P/E ratio values a company based on the flow of annual profits. A company’s Price to Book (P/B) ratio values the company based on a pool of value, the equity or liquidation value of the firm. If we divide one by the other, we get an estimate of how much profit is generated by each $1 of a company’s equity, or Return On Equity (ROE).

1982 was the worst recession since the Great Depression. Stocks were out of favor with investors and were at a 13 year low. In 1983, $8.70 of equity generated $1 of profit for companies in the SP500. Seventeen years later, at the height of the dot-com boom in 2000, companies had become more efficient at generating profits. $6 of equity generated $1 in profit. In the last quarter of 2017, companies have become less efficient. $7.30 of equity generated $1 of profit.

Let’s look at another flow ratio, one based on the flow of dividends. It’s called the dividend yield, and the current yield is 1.80, about the same as a money market account. I can put my $100 in a money market account or savings account and earn $1.80. If I need that $100 a year from now, it will still be there. I could use that same $100 and buy a fraction of a share of SPY, an ETF that represents the SP500. I could earn the same $1.80. However, if I wanted my $100 back in a year, it might be worth $120 or $50. A stock’s value can be very volatile over a short time like a year, and the current dividend rate does not compensate me for that extra risk.

Why don’t investors demand more dividends? After the early 1980s, economists at the Minneapolis Federal Reserve noted (PDF) that, on a global scale, companies’ profits grew at a faster rate than the dividends they paid to shareholders. The dividend yield of the SP500 companies fell from 6% in the early 1980s to 1% in 2000 (chart).

Those extra profits are counted as corporate savings. The same paper showed that global corporate savings as a percent of global GDP increased from 10% in the early 1980s to 15% this decade. Each year companies were adding on debt at a faster pace than during the post-war decades, but undistributed profits were growing even faster. The net result was an increase of 5% in the rate of corporate saving. Companies around the world were able to shift dividends from the savings accounts of shareholders to the savings of the companies themselves.

From the early 1980s to the height of the dot-com boom, stock prices increased more than ten-fold. Investors that had depended on company dividends for income in previous decades now depended on other investors to keep buying stocks and driving up the price. The source of an investor’s income shifted slightly from the pocketbooks of corporations to the pocketbooks of other investors. Investors adopted a shorter time horizon and now look to other investors to read the mood of the market.

The bottom line? If investors rely on each other for a greater part of their total return, price corrections will be dramatic.

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Notes: Price to Book (P/B) ratio was 1.5 in 1983 (article).
P/B graph since 2000
When mutual funds sell some of their holdings, they assign any capital gains earned to their fund holders. This amount appears on the mutual fund statements and the yearly 1099-DIV tax form.

A November 2017 article on share buybacks at the accounting firm DeLoitte

 

Study Dollars

June 10, 2018

by Steve Stofka

In the past forty years, inflation-adjusted per student spending on higher education has increased by 40%. Despite this, the number of tenured professors has fallen by half. Two-thirds of instruction is now carried out by adjunct faculty with no job security and few benefits. State and federal dollars subsidize workers training for the banking and insurance industries, but not those entering the construction and manufacturing industries. No wonder people express their grievances at government for a lack of funding (Alternet article) . Where is the money going? Maybe the question is: who is the money going to?

In 1940, just 5% of Americans had a four-year college degree (NCES, Dept. of Ed).  In 2015, 75 years later, a third of Americans reported having a college degree.

CollegeDegreePct

A few years after WW2 and the enactment of the GI Bill’s education benefits, 2.7 million were enrolled in a two or four-year degree granting institution. By 1959, enrollment had grown 33% to 3.6 million students (NCES). About 60% were enrolled in a public institution. According to the Bureau of Economic Analysis (BEA), total Federal, State and Local spending in 1959 was $12.4B, about $3400 per student in 2016 dollars.

In 2016, there were 20.2 million students enrolled in college, a third of them in two-year programs. They were sharing a pot of $241B federal and state dollars, about $12,000 per student. That’s inflation-adjusted dollars: apples to apples. Here is a chart covering the past 50 years.

EdSpendPerStudentReal

Confronted by escalating Medicaid costs and uncooperative taxpayers, the state portion of higher education spending has fallen over the past two decades.

StateLocalEdSpendPerStudent2016$

In Colorado, the taxpayer rebellion started in the 1990s when the Denver Post reported that a University of Colorado (UC) faculty member was retiring with an annual pension almost eight times the average yearly income in Colorado. The abuse has not stopped. Last year, the L.A. Times reported that UC continued to hand out generous pensions to faculty members.

In the 1990s, UC and other public and private universities planned that the future annual investment returns on their endowment funds would continue to be generous. They stopped making contributions to meet the future obligations of the equally generous pensions they promised to faculty. “Our accountants told us we would be all right,” was the lament of one city official in California. After a decade of rock bottom interest rates and single digit returns for college endowments, students, parents and taxpayers must now pick up the tab for the Polyanna thinking of politicians and college administrators.

In 1959, state and local governments spent 98% of higher education funding. In 2016, they spent less than 60%. Because public and private institutions are tax-exempt, state and local governments provide billions in forgone tax revenue that is not counted.

StateLocalPctEdSpend

About 9% of total spending goes to private for-profit institutions (NCES). Because the for-profit institutions grab headlines, some might think that they receive a greater percentage of education dollars than they do. I did.

Inflation-adjusted per student spending has risen 27% in the past twenty years. Where is all that money going? Not to today’s instructors. Less than a third of spending goes to instruction (NCES). About 40% goes to administration and student support.

Public and private non-profit institutions do not detail the expenses for maintenance and operation of their buildings and grounds, nor their interest and depreciation expenses. This gap is about 28-30% of spending, so we can conservatively estimate that they spend at least 25% of their budget on these items. As buildings continue to age, operations expenses will grow faster than the rate of inflation and eat up more education dollars. Each year, colleges and universities spend more time and dollars in their outreach to a growing cohort of “non-traditional” students.

An educational system designed for the children of the landed elite in the 19th century is trying to catch up to the needs of a diverse student population in the 21st century. That earlier system wasn’t much good to start with. That’s a topic for another time.  Entrenched political and financial interests now hinder any substantive changes in these institutions as they prepare the students of today for the world of tomorrow.

About 3 million students are graduating high school this year. Two thirds of those graduates are enrolled in a two or four-year college (BLS), and the majority are female. Out of every 100 college students, 56 are female (NCES). There are not enough state or federal educational programs to meet the skills training for the million students who will not go on to college this year, or the million who may drop out before getting a degree.

Discrimination – Education policy in this country subsidizes the training of workers employed by a large bank like J.P. Morgan Chase, but has little support for the workers in the construction and manufacturing industries. The subsidized workers at Chase are more likely to lose their jobs to automation than the unsubsidized workers at a large homebuilder like Pulte.

Fifteen percent of all employees are in the BLS category of Professional and Business Services. This percentage has grown from 8% of the work force in 1980. Employees work for private companies and government, enjoy lower unemployment rates and much higher incomes. (BLS profile ) The great majority have college degrees. College enrollees are attracted by these numbers, but the numbers are changing. The growth of this category in the 1990s lessened during the 2000s and has lessened again since the Great Recession. I’ve highlighted the trend changes in the graph above.

ProfBusSvcPctPayems

In the past year growth is relatively flat. The number of institutions with job growth has offset those with declining job growth.

ProfBusSvcEstablish
The world is changing rapidly, and for some the changes are too much and too quick. That reaction against change underlies the support for Donald Trump in the rust belt states.

Current college enrollees and graduates may find that they have prepared for a world that existed a decade ago, and will be materially changed a decade hence. The college debt is permanent but not the state of the job market. Be versatile, be flexible, be prepared.