The Health Care Bill and Market Valuations

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Leading up to this weekend’s Health Care Regulation vote, we concluded our February 2010 Monthly Market Review with the following thoughts:

So where does the market go from here? Recently, the market has continued rewarding the speculative companies, lending credibility to the belief that a sustainable recovery is underway. While that may indeed be the case, there are many portents that say otherwise. First and foremost is the battle of wills taking place over the health care reform. While the public is clamoring for something, the majority of the polls indicate that the currently proposed legislation is not the change most desire. The outcome of this legislation in the coming weeks will be important, as it could very well dictate the momentum and tenor for Obama’s remaining term. Put very simply, we think a big driver for the market in the months ahead will be determined by the outcome of this last push for health care reform. Should it pass, we think tougher times are ahead for the market. Our logic is simple: if health care reform passes in its current form, taxes will increase on profits and capital gains beyond the expiration of the Bush tax cuts. Further, a win here by the Administration will likely embolden it to pursue its “Cap and Trade” bill which will create new energy taxes and further reduce corporate profits. Between the current health care reform and a new run at global warming legislation, corporate Economic Margins will be squeezed via lower cash flows and higher cost of capital. That double shock combined with what is currently a fairly priced to over-valued market will likely result in declining multiples and thus share prices.

Now the healthcare bill passed Congress Sunday, which will make the US one of the highest taxed regions in the world for a range of businesses and higher income individuals. This doesn’t bode well for the capital markets as tax rates are inversely related to market valuations. Let’s briefly explain why.

Assume a country exists with no taxes, and one security exists in that country with a risk-free annual cash flow of $10 a year, which lasts into perpetuity. If investors require a 10% rate of return, then this security will have a value of $100, (or $10 / .10). If tax rates on investment income increase to 10%, suddenly investors must earn 11.1% on a pre-tax basis to earn their required 10% return on this investment after paying taxes. Now the security will be priced at $90.1, (or $10 / .111). The reduction in the security value is directly related to the increase in returns required by investors to offset the additional taxes they must pay.

At the economy level, a few very bad things happen as a result of the decline in market value. First the economy is less wealthy, and psychologically will suffer a loss of confidence which historically has led to a reduction in economic activity. Second and more damaging, are that the ability and willingness of entrepreneurs to access capital and take risks to create value and innovate have been reduced. Making capital more expensive, chokes the entrepreneurs’ lifeblood, and leads to lower long-term economic growth, less economic dynamism, and ultimately a lower standard of living for everyone.

We expect the market to suffer in the intermediate term as the increased cost of investing settles into the investors’ psyche.