Why Aren’t Companies Spending?

The bank books of corporations are ballooning.  According to the Wall Street journal, American companies have more money in their vaults than at any other time in the past 50 years.  Also, interest rates are near historic lows, making it easy to borrow and obtain funding.  So why don’t we see a lot of companies building new plants, hiring more staff, and generally expanding their business.

Once companies start spending again, we should expect the economy (and consequentially the stock market) to grow quickly.  The reasons why they are not are two-fold. 

The first reason is the uncertainty over the economy itself.  After seeing an economy that contracted quickly, companies are justifiably a little reluctant to risk putting capital on the line.   Looking at the numbers, this period was not as bad as the Great Depression (yet), as the news media was suggesting.  If it had been companies would have gone down by 80-90%, with the Dow perhaps falling to 3000 or so, instead of just down to the 8000 range.  Nevertheless, many companies are waiting for signs of life before making investments.  Lately we have seen some good earnings come out and some encouraging signs such as improvements in consumer sentiment, so we may be about to break out of this slump.  The Federal reserve’s easing of interest rates also tends to cause economic expansion.

The second reason is perhaps more worrisome.  That is the uncertainty caused by the unprecedented moves by the Federal Government and the Federal Reserve.  Specific examples include the huge bailout of the banks and autos, the dictates on CEO pay, the large number of new regulations that are expected, uncertainty over tax rates next year, the changing of terms for bond holders in GM, the large expanse into health care, and industry-killing legislation pending such as carbon taxes and card-check. 

In an environment where the government is choosing winners and losers, and changing the rules daily, it becomes very difficult for CEOs to determine where and how to spend money.  If you hire a group of workers and then their cost goes up substantially due to some new health care requirement, you would need to fire those same employees.  If you cannot fire them because of some new regulation, your whole company may go under.  In another example, if you expand aggressively to take market share from one of your competitors, and then the government comes in and provides low-cost funding to them, where is the advantage in trying to take market share.

This second form of uncertainty is more pernicious and may be with us for sometime to come.  Some would argue that the Great Depression dragged on so long because of the endless new regulations and laws passed during that period.  Hopefully we won’t see that again.

For the investor, as always if you have a long time window it is never a bad idea to buy up shares when prices are low. Just realize that nothing exciting may happen for a while and there may be some dips along the way.  Certainly those who bought in the 1930′s would have done very well by 1945 and have been rewarded for their patients.  For those who will need money soon, however, it would be wise to sell stocks and have cash available.  It is never a good idea to have money in the market that will be needed within the next 5-10 years.  One should not need to worry about the stock market when looking to buy a house or retire.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

It’s Rally Time

The market hates uncertainty.  Sometimes stocks will actually rally after bad news breaks – for example when a big lawsuit is settled or a new regulation is passed that will result in a decrease in sales.  While this may seem counterintuitive, the reason is that once the news comes out, the uncertainty is lifted.

 Today we saw evidence of this in the market rally.  The Dow Jones Industrials – a common measure of the health of the market – rallied more than 200 points.  Of course, a rally of 200 points with the index at 11000 doesn’t mean the same thing that it did when the index was at 2000, but it was still an impressive move.  This rally was caused by two factors: 1)the monetary policy of the Federal Reserve and 2) a resolution of uncertainty in the regulatory environment in general and cap-and-trade in particular with the election of a mostly Republican House.

On the first factor, the Federal reserve indicated that they will continue to buy long-term bonds in an effort to reduce long-term interest rates.  They are hoping that by lowering borrowing costs, more people will borrow money and do productive things with it that will stimulate the economy.   This can have the desired effect, but also has the effect of weakening the dollar, which can lead to inflation and currency wars with other countries  - neither of which is a good thing for the economy.  Like pouring gasoline on a fire, however, lowering interest rates does normally cause economic activity to increase at least initially, so moves by the Fed to lower interest rates will generally cause a stock market rally.  Hence the old Wall Street axiom, “Don’t fight the Fed.”

The second factor is a lifting of the uncertainty.  Before the Republican takeover of the House of Representatives, the Democratic party was able to pass many measures that affected corporate profits at will.  Health care reform, the pay czar, choosing of winners and losers in the auto and banking industry, and the new financial regulatory measures all caused uncertainty because they made it difficult to predict future earnings for companies.  The possible passage of cap-and-trade, which represented a huge new tax on productivity, also cast a cloud of uncertainty over the markets.

Under such regulatory environments, one may expect a company to do well, only to have the Government pass a new law that causes profits to fall.  Predicting whether a company succeeds or fails becomes less about the fundamentals and more about reading the political tea leaves correctly.  Because this makes it very difficult to predict future returns, and thereby determine fair price for a stock, investors are leery to put their money into the market.  They instead take a wait-and-see attitude which causes the market to falter, or demand a lower price for stocks to reduce their risk of paying too much.  Add the possible inflationary environment caused by the Fed, and you also get a big run-up in gold and other commodity prices (witness the record highs in gold prices).

With much of the uncertainty lifted, I would expect to see a rally in the market.  Conversely, the price of gold will likely fall, perhaps precipitously, as the current bubble bursts.  This will hold true unless the actions by the Feds do result in an increase in inflation.  I do not expect a rapid recovery in the real economy, however, since many of the factors affecting job growth (rises in health care costs, increases in regulation, laws increasing the cost of labor) remain in place.  This may keep inflation in check. 

As always, the strategy is to invest money that won’t be needed for several years in the stock market in long-term growth stocks and to move money that will be needed into short-term instruments such as CDs.  Also, proper diversification should be maintained with no more in any one investment than one would be willing to lose.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Watch out for State Debt Defaults

A little-watched issue that is starting to become a big problem is that of state debt.  States for years have acquiesced to public union demands for more lavish pensions.  For a politician this is an easy sell because he will be long gone before the bills are due.  Sure, you can retire after 20 years and draw a pension as large as your salary or higher.  Sure, you can spike your payout by working triple overtime during your last few years.

One effect of the financial crisis in the reduction in state revenues.  This, combined with the pension burdens which are causing greater and greater outlays of state funds to go to personnel costs, is causing many states to go to the brink of insolvency.  California, Illinois, and Nevada are already in dire straights and would have defaulted or faced serious cuts in services if it weren’t for Federal Assistance under the Build America Bonds program.   Many states are underfunding pension plans and issuing debt to meet daily expenses.

Eventually these states will run out of the ability to issue bonds and/or the requirement to fund public pension plans becomes too great, at which points defaults may become likely.  A federal bail-out may be necessary, but this won’t sit well with states that have been fiscally conservative.  This could be the next big financial crisis.  Be cautious around “safe” municipal bonds.

Market Analysis for October

This is a rather odd time for the market.  Technically, things are looking great, but fundamentally, things aren’t looking good.  is this a case of Mr. Market going wild, or is there something that is just not clear in the fundamentals.

All of the major indexes have started to make new highs.  October has been a great month for stocks.  Anyone just looking at the charts would think it was a great time to buy.  All of the trends have turned positive, and it looks like the Dow Jones Industrials could rally by 10% or more during the rest of the year.  Given that bonus season and end-of-year tax planning and investing is in the works, investing in October until January is usually a good bet.  It also looks like there is hope for a change in control of Congress, which could lead to less restrictive regulations and an end to the possibility of global warming taxes being legislated.

But the economy itself is not looking good.  Despite near zero interest rates, while the economy has come out of recession, firms are making due with less staff.  Restaurant and retail traffic has picked up, but people are certainly not spending like before and loans are difficult to get.  The housing market also continues to be dismal, with foreclosures reaching record highs and prices continuing to fall.

In looking for stocks to buy the other day, nothing looked particularly appealing.  There were a few decent choices, but most things had rallied back to their pre-slump highs, and therefore did not appear to be as much of a bargain.

The thing is therefore to invest, but tread lightly.  If you have quite a bit of cash, put some to work, but perhaps hold a little back to take advantage of any pullbacks that ensue.  You will miss a bit of the advance if things do rally after the elections, but it will help psychologically if stocks falter.  Remember also that markets price things in as soon as they can be predicted.  Because Republicans are expected to take control of Congress, the recent rally may have already priced that possibility in.  The market may actually slump a bit on the news.  It’s funny that way.

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

The Next Bubble – Bonds

In their recent Wall Street Journal Editorial, Jeremy Siegel and Jeremy Schwartz discuss the new bubble that is looming, corporate bonds:

http://online.wsj.com/article/SB10001424052748704407804575425384002846058.html

Add this to the list of recent bubbles, which includes the small stock/dot-com stock bubble and the more recent housing bubble.  The good news is that this newest bubble may actually be good news for stocks.

The current bond bubble is driven by two factors.  These are the extremely low interest rates set by the Federal reserve and the flight to safety by the general public.

The Federal Reserve drives down interest rates by lowering the rate it charges for banks to borrow money and by buying Treasuries on the open market to add cash to the system.  These actions affect the Fed Funds Rate the Discount Rate, the main tools of the Federal Reserve.  When this happens, bonds tend to go up in price since the higher returns of bonds are seen as more desirable, which lowers their interest rates.  Stocks also tend to go up since the rate of return offered by stocks is more valuable when the interest rate on bonds decreases (investors are willing to take more risk for a better return).  Because the Federal interest rates are near zero, the price of Treasuries has been bid up to the point where there is almost no yield at all (a scant 1%).

The second factor is that because people are so worried about losing money, they figure that 1% is better than a negative return.  Having been burned by stocks and real estate, along with foreign bonds and stocks, investors are looking for a safe haven.  Because one loses money when bond prices decline, however, the small 1% yield could easily be wiped out if interest rates rise.

So what does this mean?  Stay away from the crowd and out of bonds.  Remember that one never wants to follow the crowd, because wherever the crowd is, prices will be high and all of the money available is already invested.  When there is a bubble this rule is especially true. 

Use this current fear of stocks to buy up shares of good companies.  When the bond bubble bursts, as it will if inflation starts to pick up causing interest rates to rise, the money will come flooding back into stocks.  That is just where you want to be when it does. 

Remember that the high rates of returns from stocks are due mainly to a few brief periods where the market climbs rapidly.  If you are on the sidelines when one of these moves occurs, your rate of return will be far less and your retirement much more meager.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.