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Email ArticleWhile every year has many dramas, 2008 can certainly be ranked as one of the most eventful years in the contemporary US history. During the year, the S&P500 index lost approximately 40% of its value and the US was in recession for 12 months, marking the current recession one of the longest and worst in history. The financial crisis that spearheaded the economic recession has resulted in the disappearance of multiple well-revered financial institutions, leaving the future of the once miraculous Wall Street in debate and a state of confusion. In addition, 2008 culminated in one of the longest, and most participated presidential elections, which will send the first African American to the white house on Jan 20. With all the fears, doubts, and hopes, we welcomed and got our first taste of 2009.
The first week of 2009 has been by no means easy or peaceful. Israel has been engaged in air strikes and a ground war with Hamas throughout Gaza, in retaliation of heavy rocket fire from the area. The world is awaiting a clear policy for Israel from president elect Obama who has remained largely silent on what is likely to be his first international test. Domestically, the US stock market had a cheerful 1st day trading, gaining approximately 3%, but is now down for the year on a bad payroll report. Investors continue to digest negative news including tumbling home prices, a deteriorating labor market and downbeat news from bellwether companies from across all economic sectors. Investors are rightly asking whether all the bad news is priced in or whether we are heading for additional declines.
One positive sign is that after a chaotic October and November, the US stock market was slightly positive in December 2008, with the CBOE Volatility index dropping nearly 30%. This may be a sign that investors are tired of living in panic and start to incorporate less emotion and more logic into their view of the future. After all, the intrinsic value of an asset is determined by its discounted future cash flows, and for most businesses, this future will not reach an abrupt end in the midst of this slow down, but rather continue and eventually experience an economic rebound. Another positive indicator has been the relative winners and losers over the past month. We recently studied the behavior of major market sell-offs, (This report can be found at Analyzing Market Troughs and Rebounds.), and a key indicator of a trough was the strong performance of value stocks relative to momentum stocks. Over the past 24 months, momentum stocks have outperformed value stocks. However, since Mid-November, selecting stocks on the basis of their intrinsic value has resulted in superior performance relative to price and earnings momentum strategies. We view this as a positive development if the market is returning to its long-term tradition of recognizing undervalued companies and rewarding investors that invest in those firms. Ultimately, this is not to say that undervalued stocks cannot go lower, but for value conscious, long term oriented investors the market is currently offering great companies at prices that make them great investments.
How will 2009 impact the value of stocks? As we discussed before, the foundations of AFG’s analytic insights are:
• Measuring true unleveraged cash flows
• Estimating current, not historic, cost of gross investment
• Determining the right price for risk
• Capturing the effects of competition on forecast cash flows
AFG transforms these inputs into: Economic Margins, Market Derived Discount Rates, size and leverage risk differentials, and company specific decay rate estimates. These are then combined to create company specific valuation estimates via the following pricing framework:
Value = Sum of Future (Economic Margin * Capital) / (1 + Discount Rate)
We like to analyze changes in value as a result of expectation changes in either the numerator (cash flows) or the denominator (risk). Therefore, lets examine what might happen in 2009 and how those events will impact the value equation.
Credit Market to Thaw? The credit market freeze that has dominated the story for 2008 will likely ease as consensus predicts the massive money supply the Fed made available to the system will find its way to the market. This will simultaneously and positively affect both aspects of the value equation. First, companies needing access to capital for growth will regain their ability to do so, leading investors to increase their expectations of future cash flows. Secondly, a more growth friendly lending environment as a result of the thawing credit market will lead to a more promising prospect for corporate America. Consequently, investors will likely become less risk averse, which decreases their required rates of return to invest, and subsequently drives down the discount rate for asset valuation. These phenomena working together will likely lead to reignited interest in investing rather than hoarding cash.
Stimulus Package, Is It Necessary? President elect Obama appears determined to implement a stimulus package that could reach $775 billion over two years, despite a projected $1.2 trillion US budget deficit for fiscal 2009 excluding the stimuli. Obama pledges to follow through on his campaign promise to deliver a $1,000 tax cut and government grants to 95% of working families. Additionally, among various new and enhanced tax credits offered to businesses, Obama would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. These “tax cuts” are expected to reach $300 billion or nearly 40% of the total stimulus package. In theory albeit in much doubt, these stimuli will increase consumer spending, therefore increasing cash flows to businesses, and in turn improve asset values. We have grave doubts of the merit of those “tax cuts” to individuals that do not pay taxes. In fact, by making payments to individuals such policies could work to discourage individual initiative. The Wall Street Journal analyzed Obama’s proposal and estimated that under his plan, the marginal tax rates for some taxpayers earning less than $45,000 would increase to nearly 35% from the currently levels of approximately 20%. This results from those people losing the benefits of the $1,000 tax rebate while beginning to earn additonal income. This provides a great incentive against low income individuals who try to improve themseleves, work harder, or become more productive. (The article can be found at Obama’s 95% Illusion.) We will have to see the final proposal, but that aspect of the proposed policy is disturbing given the world is becoming more and more competitive. Thus our economic policies should encourage individuals to add greater value to their employers and in turn earn higher wages. One of President Clinton’s great accomplishments was welfare reform and this seems to be a movement away from that achievement.
Another aspect of Obama’s proposals we find troubling is his celebration of failure rather than success. His provision for retroactive tax credits for business losses helps losers rather than helping the successful to further flourish, discouraging creativity and competition. In addition, it does nothing to change future behavior. Much more interesting from our perspective would have been a short term reduction in captial gains rates. This would at least stimulate additional entrepeneurship and risk taking, something sadly missing in today’s economy. With all the negative ramifications of the proposed stimulus package , we hope these policies will not have long term negative effects on the American spirit, as this country is built on rewarding success and innovation, and increasing productivity is the most effective way to improve the economy and living standard for everyone.
We do applaud Obama’s decision for not actively seeking to raise capital gains taxes or tax rates on the highest earners, at least at this moment. While he has not campaigned to extend the scheduled repeal of those tax increaes in 2010, he at least has backed away from his campaign promises to actively change those rates. We think this is very important. Much is often made of the Clinton economy and prosperity that resulted from his policies to raise taxes on the wealthiest Americans. But such a broad sweeping generalization is misleading. As Clinton entered office, the economy was recovering from the recession that sunk Bush 1. Among Clinton’s first acts was to raise taxes on the highest earning Americans. Not surprisingly, the economy under Clinton’s first two years of office was weaker than under Bush 1. Unemployment during the first two Clinton years on average was higher than under the last two years of the Bush 1 presidency. After the dismal performance of the Clinton economy during these years, Democrats lost their majority in Congress. This led to the anticipation that capital gains taxes would fall significantly due to the campaign promises made by many Republicans campaigning under the Contract with America platform. Clinton and Congressional Republicans did eventually reach an agreement on reducing capital gains and dividend taxes by 33%, one of the largest cuts in American history. As capital began to flow freely into the market and new buisness ventures, unemployment began a consistent 6 year decline. That tax cut was the catalyst that ultimately sparked the strong Clinton economy starting in 1994 that Americans fondly remember. We hope president elect Obama understands this, and has a plan to confront his party in the near future to prevent capital gains taxes from increasing in 2010.
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