June 12. 2014
Now what? Maybe it’s time to cut some of the asparagus?
Stocks have reached levels that carry warning signs. They are at historical peaks relative to GDP, with the only exception being the tech bubble era. US stocks continue to rise even as inflows to mutual funds weaken. Foreign investors have been relatively inactive in our US stock markets. That may change if they see US growth improving. So, maybe foreign inflows can still carry this bull market higher.
With the exception of the first quarter of this year, the profit share of the GDP has been at half-century record highs. Last quarter’s plunge is explained by many as being due to changes in accounting rules. And there was weakness in the first quarter, when US GDP was a negative number. We expect another downward revision of Q1. Was this lackluster performance due only to weather? As readers will see at the end of this commentary, weather can be very important.
A second-quarter rebound in GDP will reveal a second-quarter rebound in the profit share. How big will it be? This is a very critical issue now. If profits fully recover and climb toward new highs, you want to remain fully invested for another stock market leg up. If profit growth has peaked, you want to alter your investment mix. Today we cannot know. When confidence is low, a little cash reserve is a good cushion to have.
We still have to contend with accounting differentials in Q1 and with foreign-sourced profits. So will we know anything in July and August, when the estimates of second-quarter GDP are sequentially revealed, starting with the preliminary estimate and going through the revisions process? Maybe. Maybe not.
Why is the profit share of GDP so important? It’s simple. The earnings of US corporations, whether privately owned or publicly traded, come from the profit share. But there is a problem in comparing those earnings to GDP, since some of the profit share is sourced outside the US economy.
Over the last few decades, following the World War II years, the ratio of stock prices to GDP has been in an upward trend contemporaneously with the rise of foreign-sourced profits. They add to earnings and hence to stock prices, but they do not show up in US GDP.
The profits of American multinational companies remain abroad, and taxes on them are accrued but not paid since the profits are not repatriated. Those unrepatriated profits are now approaching two trillion dollars.
This US corporate income tax structure has been tested only once, in the early part of the last decade, when the Bush Administration signed a bill after the Congress passed a one-year repatriation tax cut. The original estimates were for about $25 billion to be repatriated. The final numbers were in the many hundreds of billions. I remember well that Johnson & Johnson was the first major company to announce its repatriation plan after President Bush signed the law at the end of 2004. They announced nearly $11 billion. Markets went crazy, and analysts scrambled to revise their estimates. I remember talking with JNJ officials about their rationale. They were presented with an opportunity to bring home billions at a low tax rate, and they seized it.
Why the Washington idiots don’t do it again is beyond comprehension. But that is why we call them names. We elect fools to govern us. Thus we get what we deserve. We may get a change now since a tax surge on repatriated profits will fund some spending on highways or other unfunded needs. A repatriation bill would be a reason to stay invested for another upward leg in this bull market.
American tax policy discourages the redeployment of funds for domestic investment. And then we wonder why job creation in the US is slow. There are very good reasons when companies are incented to keep their profits overseas. The US economy creates a lot of jobs overseas. It is finally starting to create over 200,000 a month here. Not because of our politicians but IN SPITE of them.
Tell that to the political geniuses who govern us. Try to tell that to the newly elected Tea Party member who has displaced Eric Cantor and see how far it gets you. A nation built on immigrants is moving to the extreme. The same nation that welcomed generations of newcomers at Ellis Island takes children and locks them up on our borders while they are only trying to get to the United States just as our ancestors did. Not one member of my family would be an American citizen if present day policy were enforced when the original immigrants arrived. Try that one yourself and see how it fits. Then tell your Congressman.
But I digress. No apologies. America is a system. Voters elect. Those who don’t vote get no say in the outcome. We all have to live with the consequences.
Back to markets. What now? What about asparagus?
We have raised a cash reserve. We may deploy it at any time. We may hold it for a while. Things are now very fluid.
It has been a marvelous year and a half. The harvest has been a bumper crop. Broad-based ETF portfolios structured over the last 18 months are about 35% to 40% higher in value than they were at the start of the period. That is truly a remarkable outcome and was fully unpredictable.
Now it seems there is a need for a rest. A correction? A pause? Are we going to see it? Yes. Will it be steep or shallow? Nobody knows. Remember, the interest rate is at zero, which means the discounted value of a long-term income stream is infinite. Stocks do not rise to infinity. Interest rates do not remain at zero forever. That is the tension in the market.
But rates are at zero right now, and they will remain zero for the rest of this year and into 2015. That is true for the US, the UK, the Eurozone, and Japan and many other smaller economies. We may get some insight from this coming Fed meeting on the timing of policy change. My guess is it will only be a nuance in words and that the assumption of tapering continues to be the main theme for the entire year.
We are moving bond accounts to more defensive positions because interest rates cannot stay very low forever. It has been a terrific run in bond land. Now we must seize the opportunities that still exist. A recent cushion bond offering above 4% to the call is an example. They are out there. One has to work hard to find them.
We are altering the mix in equity accounts with our ETF strategies. It is time to change the mix. Our new book on ETFs will be out in a few weeks and will describe the process in some detail.
Now to a final thought.
When I was a young boy, I lived on a farm in South Jersey. My grandfather’s best cash crop was asparagus. He had about 20 acres. Asparagus is not an annual type of planting. You must plant and then allow the plants to mature. That takes a few years. If you are a patient investor-farmer, you are then able to cut and sell asparagus each and every year for a long time.
I cut asparagus before I was ten years old. I paid attention, and I saw that in good years asparagus was a very successful crop for my grandfather. Weather was important. Best was a hot summer with lots of thunderstorms and humidity. When it is hot and humid, an asparagus shoot grows rapidly. Some times it can grow 5 or 6 inches in a single night. I have sat in the middle of an asparagus field on a hot, humid July night and listened to the little crackling sounds of growing asparagus. It is a remarkable experience.
My grandfather taught me that his process with asparagus required experience and patience. One had to accept the process and allow it to work. He also taught me that some years are better than others. And when there are good years, it is often wise to take some profits and put them aside.
We have had some very good years. We now have a little cash reserve. The S&P asparagus index is at 1940. We expect that a correction and hence some buying opportunities may await us. And we are not sure whether the weather will be ideal this summer.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland