Wednesday, May 16, 2018

"I have become my father!", "Taxes, tariffs, trade and tweets" and more...

From the Desk of Joe Rollins

Financially, the month of April was basically a flat month, but given the four T’s above (taxes, tariffs, trades and tweets), a flat month is actually encouraging. Every night before I go to sleep, I have to walk through the house turning off numerous lights, even in rooms that I am positive have not been used in weeks. It makes me feel like I have become my father in many respects. He would literally go out of his mind if he saw lights on in an unoccupied room. I guess you are beginning to wonder exactly how my father fits into this conversation of the stock market and the economy, but I promise to explain shortly.

Before I move onto these more interesting topics, I have to cover the performance of the stock market for April 2018. For the month of April, the Standard and Poor’s Index of 500 stocks was up .4%. Year-to-date, that index is down .4% and for the one-year period it is up 13.3%. For the month of April, the NASDAQ Composite edged out a small gain of .1%. The NASDAQ Composite is up 2.7% for 2018 and up 18.1% for the one-year period ended April 30, 2018. The Dow Jones Industrial Average was up .3% during April and is down 1.6% for 2018. Like the NASDAQ Composite, the Dow Jones is up a sterling 18.1% for the one-year period ended April 30, 2018. For basis of comparison, the Barclays Aggregate Bond Index was down a somewhat surprising .8% for the month of April and is down 2.3% for 2018. For the one-year period ended, the bond index was down .6%. As is easily reasoned from these numbers, of all the indexes mentioned above, the one that the public perceives as being the safest (the bond index) was down substantially more than any of the indexes deemed by the public as more speculative.

Josh graduated from Auburn last weekend with a Masters in Accountancy.
He is the cool one in the sunglasses!

I very rarely write about my father or exactly what his influence had on me and my financial thinking. For those of you that do not know, my father was a Methodist minister all of his adult life. Even though he graduated from the University of Tennessee with a Master’s Degree in electrical engineering, he was never really an engineer. Since he graduated in the mid-1930s during the Depression, there were no available jobs for his skill set. He taught high school math for a few years before entering into ministry on a full-time basis. Due to his educational background, he was offered many lucrative job opportunities over his lifetime, but he never left the ministry for his entire career, working in rural churches in Southwest Virginia and East Tennessee.

The most interesting thing about my father was his level of intelligence and ability to do virtually anything. I never really saw him undertake a task that he did not accomplish. At one rural church, he was actually a general contractor and built the sanctuary himself. He went through a lifetime of small, insignificant cities and churches, yet never lost his enthusiasm for his job. At the end of his career, he was relocated to East Ridge, Tennessee, which was essentially an all-white community at that time. As the churches in the area integrated, the outrage of the public took a toll on him and he died at the early age of 67 from the stress.

How all of this relates to my philosophy regarding economics and the economy is quite simple. My father was the most optimistic person that I have ever met. Even at the worst of times, he could see the positive around it. It wasn’t that he was Pollyanna about things that needed changing; he was the person who made the changes. He did not wait for the public to change, he changed it for them. He was definitely a leader.

It wasn’t that my father was a strict disciplinarian, he didn’t really need to be to get his point across. He was not around much when I was young since he had meetings at the church virtually every night of the week. In fact, he never saw me play basketball until college, when I played for the University of Tennessee. However, there was never any doubt that when he told you to do something, you did it. And there was never any doubt that he would take the most optimistic viewpoint on every subject.

As I sit around today and read the financial news with all the negative headlines, I often reflect back on my father’s attitude. Why on earth are these people electing to be so negative when in fact the economic news and the news on the financial markets could not possibly be better? There must be some underlying distrust of the facts when they could not be any clearer to being a positive framework for higher earnings and a higher stock market. During the month of April, we had a lot of conversation regarding the four T’s: taxes, tariffs, trade and tweets. Therefore, it became a roller coaster of large gains and large losses on the market but overwhelmingly the news was positive. Yet, somehow the financial press always made it seem negative.

For the first quarter of 2018, the GDP was first reported at 2.4%, which was considerably higher than it has been in recent first quarters and certainly higher than projected. Did you realize that more taxes have been collected by the U.S. government than during any time frame in history in April, even after the large tax cuts that were put into place in December 2017? Did you realize that for the first time ever it looks like the U.S. will be 100% energy independent and in fact, is beginning to export oil and natural gas to foreign economies? It looks like the first quarter earnings of the Fortune 500 largest companies will be up more than the projected 20%, closer to 30%. Corporate earnings projected for the rest of 2018 continue to look at 20% or better. Negative news – there is not much.

Recently, the congressional budget office has increased its GDP for the projected 2018 year. They have raised their projected GDP in the United States from 2% to 3.3% for 2018. They even increased GDP for 2019 to 2.4% from their previous projection of 1.5%. All of this can be attributed directly to the tax decrease in the United States. It did not get as much publicity as it should have, but yesterday North Korea released three long-term prisoners that they had used for political leverage. You do not need to be a rocket scientist to realize that North Korea is attempting to “make good” with the rest of the world so they can have the sanctions removed.

Last Friday, it was reported that the unemployment rate in the United States has fallen below 4%, which is the first time since 2000 that we have reached a sub four unemployment rate. It is also absolutely clear from the record that anyone who wants to work in America can get a job, there are just a lot of people who elect not to do so.

So, given all of the incredibly good news we see around us, I still stand by my year-end projection of a gain in the markets this year by double digits. Already in the month of May, markets have improved significantly and I would expect a bumpy ride, yet to end up positive by double digits at year-end.

No, I am not ignoring the negatives. As pointed out by one reader of my last financial blog posting, the congressional budget office is projecting a deficit next year of close to $984 billion. At the current time, the U.S. economy generates a GDP of roughly $22 trillion and the national debt is roughly $20 trillion. Therefore, if you have a few more years of huge U.S. deficits, then the amount of debt equal to the GDP would be roughly 100%.

There is no question that the Federal deficits are too high. Maybe there was a reason to run up a large deficit of $1.4 trillion in 2009 due to the financial collapse. However, the deficits continued to be high during the Obama administration. In 2010, 2011 and 2012, the deficits reached $1.3 trillion, $1.3 trillion and $1 trillion, respectively. In fact, during Obama’s entire presidency, the lowest that the deficit ever became was $438 billion. The only problem with the Obama deficits was that they were not increasing GDP (stuck at 2%) during the entire time. There could be an argument made that if you are increasing GDP, deficit spending may not be such a bad thing.

How is it that you can reduce tax rates yet increase revenues to the government? While it is not intuitive to think how that could even be possible, the Federal deficit is much more complex than your household budget. Increasing the number of people working and the number of people contributing to the tax base significantly increases the revenue to the government even though the tax rates are down. If you have not read it before, I will give you the analysis. Based on the CBO report itself, it forecasts that the GDP will increase by $6.1 trillion by the year 2027. This amount is all attributable to the tax cuts – make sure you understand that we are talking about a 30% increase in the current GDP due to the tax cuts alone. It also forecasts that due to the tax cuts, it will decrease revenue to the Treasury by $1.69 trillion in the same time frame, but also points out that GDP growth will increase by $1.1 trillion in new revenues over the same time frame. Even using the conservative analysis by the CBO, they are conceding that 65% of the tax cuts are already paid for by extra economic growth.

CiCi grows up!

I recall when Ronald Reagan came into office and made the bold statement that he could increase revenues to the Treasury by decreasing income tax rates, which would increase economic growth. At that time, virtually all trained economists portrayed Reagan as a senile old man. (Interestingly, Reagan and Trump were about the same age when they started their first term as President.) I am sure we have all heard of Reaganomics and the effect Reaganomics would have upon the U.S. economy. When Ronald Reagan came into the office in 1980, the Federal deficit was $74 billion. At its worst in 1986 during his years, the deficit rose to $221 billion. Please recall during the start of the Obama administration that Federal deficits exceeded $1 trillion for four straight years.

The problem during the Reagan administration was while they were able to increase revenue to the Treasury they were never able to control the expenditure side. Due to the massive increase in military installations and other programs during the Reagan administration, expenses climbed a great deal faster than revenues. Even though he proved his point in increased revenues, it was not much consolation because the deficits continued to grow. But what was the effect on the stock market when these tax rates were significantly reduced? From 1982 to 1989, the S&P 500 had the following returns: 1982: 22%, 1983:23%, 1984:6%, 1985:32%, 1986:19%, 1987:5% (year of the first major crash), 1988:17% and 1989:32%. If you do not see a direct link to lower taxes and a higher stock market then you are clearly missing the forest for the trees.

Therefore, there is no question that the deficits at some point will need to be controlled. However, the Obama administration tried to improve the economy by spending more money. The theory was that if the government pumped money into the economy, the economy would grow, and therefore revenues would be raised – clearly that did not happen. So, the question remains as to whether the Trump administration will be correct. Can they in fact decrease tax rates and increase the economy, as Ronald Reagan did in the 1980s? If in fact the GDP grows as much as anticipated, there is a high likelihood that the tax cuts would pay for themselves; and if we could freeze the deficits at the end of this eight-year cycle as a percentage of GDP, debt would have actually decreased. The problem with analyzing the deficit is that we often get bogged down in the absolute numbers. The only number that is consistently correct would be a percentage of the national debt divided by the GDP.

Realistically, there is absolutely no chance in the world that the Federal budget would ever be balanced by increasing revenues to the Treasury through higher rates. At the current time, when revenues are less than expenditures by $1 trillion, it is unrealistic to assume that you could drag another $1 trillion in revenues from the general public without creating severe economic effects. While it may be perfectly possible that we could stop the deficit from growing, there is little chance that we would ever raise enough money to pay this off.

Some may say that is a fairly negative statement, but it is true. The only way to get the overall deficit program under control would be to control government expenses. It is interesting that you hear politicians give long-winded and hollow speeches regarding the deficit, but almost never do they mention cutting expenditures. Until there is some control over Medicare, Social Security and discretionary expenses at the Federal government level, there will never be a solution to the deficits created in prior years.

There are many economists that indicate that the deficit should never be a problem in the U.S. economy. I guess they have a point because at any time the Federal government could print more money and use this newly minted money for purposes of retiring the deficit. However, those actions would be so draconic that hyperinflation would clearly be created. If you are ever interested in learning exactly what might happen if they tried this, read about what Germany did leading up to WWII, leaving them with an essentially worthless currency.

Neither of the solutions above are the answer to the deficit problem; the deficits must be stopped on an annualized basis by growing the economy to a point where future tax revenues will overwhelm the Federal expenditures, thus controlling the long-term deficit. In reality, if we could stop the growth of the deficit as a percentage of GDP, the economic rewards would be well worth the sacrifice.

In summary, it is clearly true at the current time that there are more positives than negatives for stock market investing. You cannot pick up the financial news without seeing some significant person forecasting a stock market decline of major proportions. Is it possible that the market could go down tomorrow? Of course, it is. In fact, you could have a 10% correction in the market at any time without warning. We have already had two 10% declines in the market since the beginning of 2018, yet we are up in line with my forecast as I write this posting.

I often hear that you should hedge against stock market declines and therefore protect the downside. There is absolutely no question that hedging can be an effective deterrent if you have some reason to fear a major decline. I often recall the famous saying by Peter Lynch when it comes to those matters, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves.” And he followed that up with an even greater observation, “I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”

Of course, I have to close with one more famous quote, but this one is by Warren Buffett, “…the only value of stock forecasters is to make fortune tellers look good.” My analysis of the economy, earnings and the overall market is good and I see nothing that has changed my forecast of double digit returns in 2018. Of course, everything we do can change on a daily basis given economic events, but at the current time I do not foresee that happening.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins

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