Download “I contend that for a nation to try to tax itself into prosperity is like a

QUA R TER LY RE V I E W OF T H E C A PITA L MA R KE TS | A PRI L 2014
“I contend that for a nation to try to tax
itself into prosperity is like a man
standing in a bucket and trying to lift
himself by the handle”
— Winston Spencer Churchill
As has been our custom each year, the April issue of
the Review & Outlook will include commentary on
the U.S. tax code. More on this subject later.
Against the backdrop of the past two years during
which domestic stocks posted strong double digit
gains, the results for the first quarter were more humble. After a brief and modest (-5%) sell-off in January, the domestic stock market recovered and the
bull market remained intact at quarter end. During
the first quarter, the S&P 500 gained 1.8% while the
MSCI-EAFE Index rose by 0.7%. If we can momentarily
dial back our expectations, these modest results can
actually be viewed as a positive to the extent that it
allows earnings to catch up to last year’s dramatic
increase in stock prices.
Investors continue to watch with interest the timing and magnitude of the Fed’s tapering process.
Thus far, Fed policy under Ms. Yellen does not appear
to differ materially from the course established by
former Chair Ben Bernanke. Moreover, higher rates
per se are not necessarily a bad thing. They are a
negative if they are due to higher inflation. They are
a positive if they reflect stronger economic growth
without concomitant inflation. Investors, and more
importantly, traditional savers will enjoy higher real
yields. Equity investors’ stock portfolios should benefit from the catalyst of stronger economic growth.
With the mid-term elections looming on the horizon,
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the state of the economy will be a major element of
the political rhetoric in the months ahead.
Due in part to 2013’s 32% advance in the S&P 500,
domestic equity valuations are somewhat less attractive than those available overseas. While profit margins
in the U.S. are near all-time highs, there is still room for
margin improvement in developed foreign markets.
At the same time, P/E ratios are lower in both foreign
developed and emerging markets. Reflecting the wide
disparity of performance during 2013, the P/E ratio of
just 12x in emerging markets reflects a 30% discount
to the same metric for the S&P 500. While quarterly
comparisons might sometimes disappoint, the valuation disparity between emerging market equities and
the S&P 500 warrant retention of the former for the
disciplined long-term investor.
While equity valuations could expand somewhat by
further increases in P/E ratios, the primary driver from
current levels needs to be higher earnings. With profit
margins currently at or near all-time highs, the prerequisite for higher earnings needs to be improvement in
top line revenues. Most of the companies within the
S&P 500 have reported their numbers for 2013, and results reflect profit gains averaging 10.7%. As has been
the case in recent years, most of the gain is the result
of improved margins, with revenue growth remaining
subdued at +0.7%.
Global Considerations
There are several macro factors that could make a positive contribution to both stronger domestic economic
growth, as well as improved earnings. The first is the
possibility of a more synchronous global recovery. In
recent years, global performance has been uneven and
there has been an imbalance between nations that
spend too much, and those that save too much.
Economic growth in Europe will once again be modest during 2014; however, this is currently reflected
by more modest valuations for European stocks.
While Europe continues to show gradual economic
improvement, inflation levels remain lower than
desired by the European Central Bank. Latest readings show Eurozone inflation running at 0.7 percent,
and there is increased concern that the Eurozone is
slipping into a deflationary environment similar to
that experienced by Japan in recent years. One area
where Europe could experience higher costs is energy.
Europe depends heavily on Russia for its energy needs,
with Russia providing Europe with 31% of its gas
imports. A milder than normal winter has resulted in
reserves currently being at high levels; however, if the
Russia-Ukraine crisis worsens, the “costs” threatened by
President Obama could end up being paid by Europe
in the form of higher gas and oil prices.
Current weakness in commodity prices, as well as
other negatives affecting emerging markets, have
been well-documented and in our view are more than
adequately discounted in current valuations. Last year,
with the S&P 500 and MSCI-EAFE index rising 32.4%
and 19.4% respectively, the MSCI-Emerging Markets
Index declined 4.3%. Key to improvement in the E.M.
space will be China’s ability to successfully decelerate its GDP growth from the recent level of 9% to a
more modest 7.5% target. As reviewed at the recently
convened National People’s Congress, the lower GDP
target is a key element in China’s desire to institute reforms, establish a more sophisticated financial system,
and lessen the risk of inflation. With China representing the world’s second largest economy, any problems
incurred implementing this strategy would have negative ramifications extending well beyond the confines
of the emerging market economies.
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Wall Street
A second positive surprise could develop if business
spending should increase above recent levels. In what
has all too often been a somewhat uncertain political and tax policy environment, capital spending by
businesses has been modest in recent years. Currently,
corporate balance sheets are in much better condition, and in the aggregate, companies are sitting on
a mountain of cash. Companies within the S&P 500
currently have cash and short-term investments in an
amount equal to 11% of total assets.
In addition to these funds not earning anything in the
current low interest rate environment, this surfeit of
cash has attracted the attention of corporate raiders;
AKA “shareholder activists.” These individuals have
argued vociferously that companies should use their
cash to repurchase shares and/or increase dividends,
both of which are positive to shareholders in the
short-run. The repurchase of shares reduces shares
outstanding, which for a given level of profit, increases
earnings per share. It does not, however, do anything
to add jobs and/or increase the future productive capacity of the company in question. Share repurchases
during 2013 exceeded $470 billion.
To the extent that some of this cash is deployed on
plant and equipment and/or infrastructure spending, it should lead to improvement in what has been
a moribund job situation. As such, it helps to benefit
the overall economy and complements the benefits
of higher dividends, share repurchases and/or merger
and acquisition activity. Any combination of the aforementioned should prove positive for shareholders.
It is likely that the first quarter macroeconomic conditions will have been negatively affected by the unusually severe weather. Consensus economic forecasts
for the full year once again project real GDP growth
of less than 3%. If this is in fact the case, it will be the
ninth year in a row that the economy has failed to
attain this target level. This is the worst string of poor
results for the past 80 years.
Main Street
On a brighter note, the Federal Reserve recently announced that U.S. household net worth increased by
$9.8 trillion, and reached a new all-time high last year
at $80.7 trillion. Major contributors to this milestone
included improvement in home prices, continuation
of the consumer deleveraging process of reducing
debt, and a soaring stock market. The companies
within the S&P 500 alone increased in value by over
$4 trillion during 2013. Total household debt has
fallen by over $2 trillion during the past several years.
Unlike the federal government, the household sector
is doing a much better job of currently living within
its means.
History will measure the Fed’s quantitative easing
program by many different standards. Measured
solely by the objective of achieving growth via
benefits associated with “wealth effect,” the program was a success.
million Americans with jobs.
As a side note, and seldom included in the rhetoric
about inequality, much of the incremental wealth
realized during the past several years has accrued
to the benefit of older Americans. Demographically
they have less mortgage debt and are more likely to
save and invest. The 76 million strong “Baby Boomer”
cohort group represents 26% of our population. On
January 1, 2011, the oldest of that group turned 65
and according to the Pew Research Center 10,000
baby boomers will reach 65 each day for the next 16
years. By 2030, 18% of the U.S. population will be 65
or older. Hopefully, further advances in medicine will
further increase that percentage.
An unintended consequence of the Fed’s quantitative
easing program is the fact that very low interest rates
are a catalyst to substitute capital for labor. This has
contributed to both the intractable high unemployment rate and the broader topic of income inequality.
Hardest hit have been the young and minorities. If the
trend cannot be reversed, it will likely also have negative unintended social consequences.
If we enjoyed rap music, we might express the issue:
All of this is great news unless, of course, you do
not own stocks or a house, and worse, do not have
a job. Rather than excoriate those who are more
fortunate, we need to create a more business
friendly environment in Washington that will lead
to job formation. As we mentioned earlier, this has
been the weakest recovery from a recession since
the Great Depression. For the 40 year period ending in 2008, U.S. GDP growth has averaged 3.28%.
Final GDP growth for 2013 will not only fail to reach
3%, it will likely come in below 2%. Annual growth
during the past six years has never been above 3%.
Economists estimate that if the post 2008 recovery
had been equal in magnitude to the average of the
last 10 recoveries, there would be an additional 7
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It is my current impression,
that the Fed interest rate suppression,
is meant to avoid a depression.
But the labor force regression,
is hurting my progression,
unless it’s all a misimpression,
So, please stop the repression,
or else my oppression,
might lead to a transgression!
But, we don’t like rap music. (Please forgive the digression.)
Pennsylvania Avenue
As the mid-term election draws nearer, the topic of
income inequality will surely gain more attention. It
has been suggested that this is a clever attempt by
some to misdirect attention from the poor economic
growth and job loss of the past six years. Perhaps, but
we think the issues are actually very much related.
At the risk of sounding insensitive, we always assumed
that income inequality was an obvious by-product
of the system we know as Capitalism. As we recall,
the communist alternative as practiced by the former
Soviet Union did not work out that well. The issue is
complex. Perhaps it is akin to debt or alcohol, where
the question is not right or wrong, but how much is
enough and how much is too much? If Washington
policymakers wish to seek out those who have contributed to income inequality, the search will not take
them far. As alluded to earlier, the issue has been exacerbated by weak economic performance for much of
the new millennium.
As part of a solution, President Obama has proposed
raising the minimum wage by 40% to $10.10 an hour.
According to the Department of Labor, only 2.5% of
the American workers (3.6 million out of 143 million
workers) were earning the minimum wage at the
end of 2012. At the same time, many states now offer
unemployment benefits that equate to an hourly
wage rate that is 50% higher than the proposed
$10.10 minimum wage. Recently, these benefits have
been extended to up to 76 weeks. Therefore, it is not
surprising to find that there are three times as many
people receiving unemployment benefits than there
are working at the minimum wage.
While an increase in the minimum wage would be
beneficial to this very small group of workers, the
impact on the economy and nation as a whole is far
less positive. According to the non-partisan Congres-
sional Budget Office, implementing the President’s
proposal will cost the private sector $15 billion and
increase the deficit by $5 billion over the next 10
years. More troubling is the CBO’s estimate that such
an increase would also result in the elimination of
between 500,000 to 1,000,000 jobs.
The President used his executive privilege in February and issued an order raising the minimum for
federal workers. This was largely symbolic as the CBO
estimates that fewer than 4,000 federal workers make
less than $10.00 an hour. We would be more impressed if the policy makers in Washington focused
more on education and job training than further
expanding our entitlement system. As seen by the
following charts, the correlation between higher
education and better job opportunity and higher
wages is irrefutable.
Unemployment Rate by Education Level
18%
Less than High School Degree
High School No College
Some College
College or Greater
16%
14%
Nov. 2013:
10.8%
12%
10%
Nov.
2013:
7.3%
7
3%
8%
6%
Nov. 2013:
6.4%
%
4%
Nov. 2013:
3.4%
2%
0%
'92
'94
'96
'98
'00
'02
'04
'06
'08
'10
'12
Source: BLS, FactSet, J.P. Morgan Asset Management.
Unemployment rates shown are for civilians aged 25 and older.
Guide to the Markets – U.S.
Data are as of 12/31/13.
Average Annual Earnings by Highest Degree Earned
Full-time workers aged 18 and older, 2011, USD
$90,000
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$80,000
$87,981
'92
'94
'96
'98
'00
'02
'04
'06
'08
'10
'12
Source: BLS, FactSet, J.P. Morgan Asset Management.
Unemployment rates shown are for civilians aged 25 and older.
Guide to the Markets – U.S.
Data are as of 12/31/13.
Federal & Ohio Effective Rates
Average Annual Earnings by Highest Degree Earned
Full-time workers aged 18 and older, 2011, USD
Federal &
ACA Tax*
$87,981
$90,000
2012
2014
2012
2014
Short-term
Gain & Ordinary
35%
43.4%
38.9%
46.5%
Long-term
Gain & Dividends
15%
23.8%
18.9%
26.9%
$80,000
+29K
$70,000
$59,415
$60,000
Federal, Ohio &
ACA Tax*
*Affordable Care Act Tax Rate = 3.8% (new in 2013)
$50,000
+27K
Few readers will be surprised to learn that we are very
much in the camp that prefers that we have more new
millionaires to tax, rather than tax current millionaires
more. With that in mind, and as April 15th nears, we
will close with the following “tax facts”:
$40,000
$32,493
$30,000
$20 ,000
$10,000
$0
•
High School Graduate
Bachelor's Degree
Advanced Degree
Source: Census Bureau, J.P. Morgan Asset Management.
•
As reflected later in the report, income inequality is
by no means the exclusive purview of what some
want to pejoratively label the “1 percent.” Some have
even gone to the extreme of suggesting that this
group is a budding oligarchy akin to the 11 Russians
who control much of Russian industry. Since there
are 143 million American workers, the top 1% of
workers must by definition have 1,430,000 members.
Some oligarchy! Paul Krugman’s aspersions notwithstanding, they can’t all be bad people.
If we more equitably divide the issue into the top
and bottom 50% of all taxpayers, we find that there
still exist radical differences in who receives most of
the income, as well as who pays most of the taxes:
Income
Category
5
Percent of
All Income
Percent of
All Taxes Paid
Top 50%
88.5%
97.1%
Bottom 50%
11.5%
2.9%
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To rank on top 1% of Net Worth, requires net
worth of $6.8 million.
To rank on top 1% of Income, requires income of
$389,000.
Source: Federal Reserve
•
The total number of pages of Federal Tax rules has
increased by 34,108 pages to (74,608) since 1995.
Source: IRS
•
An average high income American couple who
retired in 2010 paid $765,000 lifetime Social
Security taxes, but will receive only $693,000 in
benefits.
Source: Urban Institute
•
In 1980, the top 10% of U.S. taxpayers paid 49% of
all federal income tax paid.
In 2011, the top 10% of U.S. taxpayers paid 68% of
all federal income tax paid.
Source: IRS
•
•
In 2011, 46,100,000 tax payers paid NO federal
income tax.
Source: IRS
Breakdown of Income and Taxes Paid by Category
Income Category
2011 AGI
Percent of All Income
Percent of Income Taxes Paid
Top 1%
Over $388,905
18.7%
35.1%
Top 5%
Over $167,728
33.9%
56.5%
Top 10%
Over $120,136
45.4%
68.3%
Top 25%
Over $70,492
67.8%
85.6%
Top 50%
Over $34,823
88.5%
97.1%
Bottom 50%
Under $34,823
11.5%
2.9%
Source: IRS
We hope you find all of these tax facts of interest as we approach the 15th.
Richard C. Hyde
Director, Wellspring Financial Advisors
Wellspring Financial Advisors, LLC is an independent
personal wealth management and multi-family o ce. We
5885 LANDERBROOK DRIVE, SUITE 205
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216.367.0680
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