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Economic and Investment Outlook

Economic and Investment Outlook

Recently we had the pleasure of making a presentation at a local business association’s quarterly breakfast. The focus was the economy, contributing factors and the impact on small and mid-sized businesses – the owners of which comprised the bulk of the audience. Thereafter a Q&A was held with questions coming mostly from economic, investment and tax angles. Below is a transcript:

GOOD MORNING. I WANT TO THANK YOU FOR THIS MORNING’S PRESENTATION. I’VE BEEN TO THE LAST FEW. ALWAYS GOOD STUFF. I HAVE A QUESTION ABOUT INFLATION. THE FED INDICATED IT WILL KEEP RATES LOW THROUGH 2014. DO YOU THINK THEY’LL STICK TO THIS PLEDGE IF WE SEE A PICK UP IN INFLATION?
Well first I want to thank you for attending and finding value in our presentations. We enjoy being here and I guess the invitations for repeat performances if you will are a sign we’re bringing value to the membership so thanks again for coming out for our little spiel.

I like the word you used – pledge. The Fed told us they’ll keep rates low but they aren’t required to do so. A lot can change between now and 2014.

At Apollo we’re not too sure The Fed cares all that much about inflation right now. They have a dual mandate – price stability and full employment. The latter is getting most of the attention. Price stability was a concern when deflation was talked about. It never happened. Now we speak of inflation. Whether prices are headed up or down they remain relatively stable. Unless and until this changes in a major way the focus will be on the full employment part of the dual mandate.

That’s not to say inflation isn’t in our future. We have a heavy debt burden in our country. It needs to be repaid eventually. Doing so with a currency worth less in real terms is an interesting solution. Our creditors won’t like it all that much but that’s a concern only if they stop buying Treasuries. There’s no indication of lessened demand and, frankly, the Chinese and other creditors have few viable alternatives for parking cash.

YOU SAID PRICES REMAIN RELATIVELY STABLE YET GAS PRICES HAVE SPIKED IN RECENT WEEKS. WHY THE BIG MOVE IN PRICES AND WHAT’S THE IMPACT ON THE ECONOMY?
The East Coast has seen a spike in gas prices because of declining supply. ConocoPhillips shut its refinery in Trainer last year. Sunoco recently shut its Marcus Hook refinery and plans to close its Philadelphia refinery by July 1st if it can’t find a buyer. Total refining capacity lost over the past year is close to 50%. You cut East Coast supply by 50% and you’re going to see prices rise.

Refiners have little choice. There’s an oversupply of refining capacity even in the face of higher raw materials pricing – namely the price of imported oil. They’re not going to run their businesses at razor thin margins or a loss to supply us with gas. They’re not public utilities.

In a rather counterintuitive way the economic impact is negligible. People are starting to get use to the idea of $4 gasoline. The shock value isn’t what it was when prices spiked a few years ago.

Consumers are remarkably resilient. We find a way to adapt. I read that Apple sold something like 3 million iPads during its first week. If you tell me that 3 million people walked to the Apple store or took public transportation then I’ve got a bridge in Brooklyn to sell you. High gas prices make for great headlines but I just don’t see meaningful, long-term dislocations to the economy as a result. Now if we see $5 gas or $6 gas…

I THINK IT’S NEXT WEEK THAT THE SUPREME COURT IS GOING TO TAKE UP OBAMACARE. WHAT HAPPENS IF THE LAW IS UPHELD IN FULL, IN PART OR NOT AT ALL?
I’m guessing the question comes from an economic perspective but I want to touch on a different aspect first. For the sake of full disclosure I personally am a registered Libertarian. If the government can mandate that a citizen purchase health insurance then it’s the first step on a slippery slope. How long before I’m forced to buy a cell phone or some other product or service deemed critical? The compulsory provision of the law has the potential to fundamentally change the relationship between US citizens and our government. I personally find this very scary.

Economically the impact is mixed. There are so many competing provisions that there will be winners and losers under any scenario – far too many to cover in the time we have.

For the sake of example let’s focus on one possible outcome – that the law stands in part. Let’s say the individual mandate is adjudicated unconstitutional yet the provision that insurers cover pre-existing conditions holds. It’s a nightmare scenario for insurers. Premiums will skyrocket to compensate. Employers will find their benefit costs go up – way up. They’ll cut benefits and pass along cost increases to employees.

HELLO AND GOOD MORNING. LIKE THE FIRST PERSON WHO ASKED A QUESTION TODAY I’VE ENJOYED YOUR PRIOR PRESENTATIONS. THANKS AGAIN FOR ALL THE GREAT INFORMATION. I WAS MAKING SMALL TALK WITH ONE OF OUR SUPPLIERS. HER TAX RETURNS ARE BEING AUDITED. SHE SAID THE PROCESS IS A NIGHTMARE. IS THERE A WAY TO DECREASE THE RISK OF BEING AUDITED?
The IRS can make life easy or complicated. Audits are rare – in fact I believe it’s less than 1% of returns – yet the root canal-like feel can be very real. It’s a sad truth that the pain or lack thereof of an audit is rather arbitrary and greatly dependent upon how much of a pain the butt the auditor wants to be. Business owners make great audit targets because of how easy it is to run personal expenses through the business. Surely there’s some extra tax revenue to be found. High net worth folks are easy targets too because that’s where the money is. Why would the IRS audit someone making $20,000 a year when they can audit someone making $200,000 or $2 million? Who will end up paying more tax? So, in a way if you want an audit-proof return you shouldn’t earn money.

A better way to look at this isn’t to focus on being audit-proof but to set yourself up for surviving an audit should it happen. Do things by the book and you have nothing to worry about. Are there gray areas in the tax code? Sure. Can smart planning profitably exploit them? Sure. Just keep in mind there’s smartly aggressive and then there’s greedy.

HI. I WANT TO GET BACK TO GAS PRICES FOR A MOMENT. WITH ALL THE TALK OF THE ISRAELIS TAKING OUT IRAN’S NUCLEAR PROGRAM I HAVE TO THINK OIL PRICES ARE HEADED HIGHER. EVEN IF CONSUMERS ADJUST TO HIGHER GAS PRICES BUSINESSES CAN’T ADJUST TO HIGHER OIL PRICES.
Is that a question or a statement? Let’s look at this a couple of ways… Do the Israelis strike against Iran? Your guess is as good as mine. The US is pushing for a diplomatic solution. The moderate regime in Western-friendly Saudi Arabia wants a diplomatic solution. The only thing Europeans hate more than conflict is each other so surely they want a diplomatic solution.

We’re already looking at something like a $20 per barrel “terror premium” built into the price of oil. Surely we go higher if there’s conflict in the Middle East. Higher prices may choke off demand and, if so, will impact our economic recovery. That said any price increase is built in to a large extent and shouldn’t last long. Any temporary dislocation is just that.

I think what’s more important is the long-term trend in oil. If there was real recessionary risk we’d see falling oil prices in anticipation of lower demand. Oil prices are telling us just the opposite – the economy is strong and anticipation is for it to grow stronger.

As an aside keep in mind that while it’s logical to link oil and gas prices it’s not a one-to-one relationship. In your business there are times when your costs go up and you don’t pass them on to your customers, correct? Other times your costs are unchanged yet you raise prices, right? Refiners may pay more for oil but that doesn’t necessarily mean that an oil price increase of 10% will result in a 10% rise in gas prices. There are too many factors at play. If it was so simple than we’d open the spigot on the Strategic Petroleum Reserve.

WHAT’S YOUR TAKE ON THE NOVEMBER ELECTION? I THINK LIKE MOST PEOPLE I GET TIRED OF THE POLITICAL BICKERING AND AM JUST HOPEFUL FOR PROGRESS.
I too am tired of the bickering and all the self-interest nonsense. I could go on about my personal politics but you don’t care and, frankly, you shouldn’t so I won’t. Instead let’s look at this dispassionately.

You used an interesting word – hopeful. Hope was an Obama-ism during the 2008 election. While conceptually powerful hope doesn’t deliver results. Policies and incentives do that. Has Obama delivered results? The jury is out.

It’s been said Obama is anti-business. I don’t think he’s against business but he surely is no friend. Tax and regulatory hurdles faced by businesses are out of control. All of you see that on a daily basis when trying to run your respective businesses. Companies won’t hire workers or invest in plant and equipment when there’s uncertainty. There’s simply too much of that from health care to environmental policy to tax rates.

Obama has made himself an easy target. He’s beatable. Therein lies the rub. The Republicans should be ashamed of themselves for being unable to offer a viable candidate capable of beating a very beatable incumbent.

If Obama is re-elected expect more ad hoc, expenditure-driven policies aimed at consumers rather than investment-driven policies aimed at the larger economy. If presumptive Republican nominee Romney wins then the rhetoric will become friendlier to business. The question is can he push through business-friendly policies that remove uncertainty and, as a result, promote hiring and investment.

SINCE WE’RE DISCUSSING WASHINGTON WHAT ARE THE CHANCES WE GET A TAX INCREASE NEXT YEAR?
To be fair no one is proposing a tax increase. We’re simply facing the expiration of prior cuts in marginal rates as well as other favorable provisions.

Surely the timing couldn’t be any worse. Our recovering economy is strong but not bulletproof. There’s no need to fly right into a headwind if we don’t need to.

I think we see favorable rates on capital gains and dividends disappear along with a hike in marginal brackets to the extent there’s a strengthening of Democratic control in Congress.

I’m not sure the focus should be on do we or don’t we see nominal changes to tax policy. We need structural reform a la Ronald Regan in 1986. We’re on an unsustainable path. We can’t continue to spend more than we take in. We must reform fiscal policy so that we cut spending and increase revenue. The latter needs to come not by raising marginal rates but by cutting rates and expanding the base. Unless and until politicians embrace the obvious even in the face of its unpopularity with voters we’re going to have to deal with manufactured crisis after manufactured crisis. Anyone up for another “debt ceiling” discussion? That was fun, right?

IF DIVIDENDS ARE TAXED AT A HIGHER RATE DO CORPORATIONS START CUTTING THEIR PAYOUTS? DO DIVIDEND-PAYING STOCKS UNDERPERFORM THE OVERALL MARKET?
Ah, a counter-1990s question. When Bill Clinton cut capital gains rates corporations argued their best use of cash from the perspective of returning it to shareholders was not paying dividends but stock repurchases. Today corporations try to reward shareholders with dividends.

We love dividends. They’re great. Historically they represent something like a third of total equity market returns dating back to 1926. Paying a favorable tax rate is merely icing on the cake.

We don’t expect to see companies cutting dividends. Too often such a move is interpreted as a sign of balance sheet weakness. If however equity markets sell off and the timing coincides with a tax rate increase I’m sure one of the talking heads on CNBC or Fox Business will draw the erroneous conclusion in an attempt to show erudition they don’t have.

WHAT’S THE OUTLOOK FOR CONSUMER AND CORPORATE CREDIT AVAILABILITY?
Consumers are beginning to see easier terms. The days of easy credit are gone – possibly forever. The pendulum swung too far in the other direction, however, as just about everyone was shut out of credit unless Jesus Christ co-signed the application. There’s normalization in the market for borrowers with strong credit profiles, cash flow and collateral.

Corporations ironically are being hurt by low rates. If loans are priced based upon risk yet market rates are artificially low banks won’t lend if they believe they aren’t being sufficiently compensated. Larger corporations can tap credit markets but small and mid-sized companies will continue to be pressured by the banking system.

YOU SPOKE EARLIER ABOUT DIVIDENDS. IN A LOW RATE ENVIRONMENT WHERE SAVERS CAN’T FIND A DECENT CD I’VE BEEN USING DIVIDEND-PAYING STOCKS AS A SUBSTITUTE. ARE THERE OTHER OPTIONS?
Dividend-paying stocks have that nice cash flow component but they are stocks. They are not bonds or CDs or savings accounts. We would caution anyone buying a stock purely for the dividend.

Other options? Sure. How about corporate bonds? Strong balance sheets and access to low-cost capital markets make them attractive. You can even dip down into the higher rungs of junk credits. Keep in mind that these fixed income options come with the same risk as all other fixed income options – namely a rising rate or inflationary environment will erode the real value of the cash flows. That scenario would make dividend-paying stocks more attractive. It’s a catch-22.

Typical disclosures are in order. These are not recommendations of Apollo Wealth Management, they are not an offer of advice, investments can lose money, past performance is not an indicator of future performance, consult your financial advisor…yada yada yada.

IS NOW A GOOD TIME TO PUT CASH INTO EQUITIES?
More recommendations, huh?

The standard line holds true. Every person should own a solid, long-term, diversified portfolio comprised of a variety of asset classes that’s consistent with his or her cash flow, time horizon and risk tolerance. Short-term, adequate cash reserves are important for day-to-day expenditures and for being opportunistic when market circumstances warrant since prices don’t necessarily reflect actual worth or value. That said the answer is yes yes yes.

Pessimism, panic and fear are good indicators that it’s time to put capital to work. There’s lots of worry out there and the public is such a wonderfully accurate contrarian indicator.

The S&P is up 11% year-to-date. Too far too fast, right? I don’t know. The S&P was pretty much flat last year so couldn’t we say it’s up 11% over the past 15 months? Would that make some folks feel better?

Then there are the folks infatuated with the NASDAQ. That index is up over 20% year-to-date. OK, but more than a third of that return is due to Apple. Unless your portfolio is 33% Apple stock then it’s a horrible comparison.

To put it simply there is no competition for stocks. The Fed has rates at ridiculously artificial lows. Who wants to earn 2% on a Treasury?

The end of the quarter is close at hand. We’ll likely see some window dressing as fund managers add “winners” to their portfolios to show off in quarterly reports. The retail investor has not participated in the bull market that began in March of 2009. Trading volumes have been light. They’re scared and have been sitting on the sidelines far too long in their typical “buy when it feels safe” way. Sadly they have a long history of buying high and selling low. The point being when the retail investor jumps in there’s going to be further support under stock prices.

Surely I’m not saying stocks can’t go lower. They can and probably will at some point. There’s always a risk of buying “early” but timing is a trading mentality – not a friend of the investor. The idea isn’t to call tops and bottoms.

All said as long as rates remain low and corporations are flush with cash the longterm trend for stocks remains up. As the saying goes, “Don’t fight The Fed.”

IN A PRIOR PRESENTATION YOU TALKED ABOUT VOLATILITY AND THE RE-PRICING OF RISK. DOES THE CURRENT LOW LEVEL OF THE VIX MEAN WE’RE HEADED FOR GREATER VOLATILITY?
Interesting question. One would think greater volatility is in the cards because when you’re at such a low level there’s nowhere to go but up.

For those of you who aren’t familiar the VIX is an index measuring volatility. It’s informally called the fear index or fear indicator. I’ve often likened it to air travel. Low volatility is like a smooth flight. High levels in the VIX are like being on a turbulent redeye from the West Coast.

The VIX is a funny thing. When it’s low we’re lulled into a false sense of security. The relationship between risk and reward is decoupled. Investors believe they can earn “excess returns” in “risky assets” without assuming meaningful risk. Then we get a spike in volatility. Investors panic, clutch the armrests a bit tighter and clamor for oxygen masks to fall from the ceiling. The fundamental truth is whether it’s a smooth or turbulent flight the plane still makes it to its final destination. The lesson is not so much where is volatility headed but how does one handle it.

THE NEW YORK TIMES HAD A PIECE NOT TOO LONG AGO ABOUT MUTUAL FUND RETURNS – ABOUT HOW TRACK RECORDS WILL START TO LOOK BETTER WHEN 2008 IS REMOVED FROM THE ROLLING THREE YEAR MEASUREMENT PERIOD. CAN YOU COMMENT ON THAT?
Well, that’s certainly true. The marketing departments of the mutual fund companies often tout one, three, five and ten year returns. Removing the disaster that was 2008 and starting the three year measurement period over in 2009 when the markets hit their lows in early March will make historical performance look pretty good.

Therein lies one of the many problems with benchmarking. We’ve never been a fan of benchmarking at Apollo. It’s simply too arbitrary and imperfect.

I’ll paraphrase Marty Whitman: To be an investor means to accept that you’re not aiming to track a benchmark or your peers over the short-term. By definition you will lag every now and then. Long-term investors have to put up with short-term pain to capture long-term gains.

Tweedy, Browne has an interesting take too. I’ll paraphrase them as well. The goal is not to beat an unthinking, statistical listing of a broad group of companies which we know can be a daunting competitor over time but to use business-like thinking and analysis in acting as a steward of client funds.

And to really beat this into the ground – you can tell how much disdain we have for benchmarking, right? – look no further than Warren Buffett. The Oracle of Omaha as we’ve come to call him is considered the world’s greatest investor. Have a look at the Berkshire annual report and it’s easy to find some back-to-back years where he’s done terribly compared to the S&P.

I’m digressing. Yes, three year returns are going to look good once 2008 is removed.

IS THE NONSENSE WITH EUROPE OVER OR JUST POSTPONED?
Both. It’s over in the sense that there are too many governments and global banks with too much exposure. No one wins if there’s chaos. There’s little political will for another round of bailouts or whatever we want to call them. Headlines are going to appear and fear will rise from time to time but expect to see a managed, dare I say massaged, outcome.

It’s postponed in the sense that these short-term managed outcomes are not a final solution but a proverbial kicking of the can down the road. It’s what we do in the US and is equally as ineffective.

I’m getting the look that we’re out of time so I just want to say thanks again for your hospitality and the opportunity to be with you once more. Best of luck to everyone for a prosperous rest of 2012.

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