Is the US Stock market too high?

No, This Time is Different!

On October 14, 2013, two days before US Congress agreed to raise the debt ceiling, John Hussman wrote the following in his weekly newsletter, 


"[E]very market collapse ultimately comes as a surprise to investors, because something always convinces them that this time should have been different." 


For full article, please visit: http://www.hussman.net/wmc/wmc131014.htm

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How Wealthy are Politicians?

USA v.s. China

The 50 richest members of America's Congress are worth $1.6 Bn. In China, the wealthiest 50 delegates to the National People's Congress control $94.7 Bn.

The richest person in America's Congress is worth $355 Mn. The richest in China's Congress, $18.7 Bn.

The 5th richest person in America's Congress is worth $84 Mn. The 5th richest in China's Congress, $2.9 Bn.

The least wealthy person in America's Congress is worth $7 Mn. In China's Congress, $600 Mn.

The average wealth of an American Congressman is $31 Mn. In China's Congress, $1.9 Bn.

In America's Congress, the average age is 60, with the youngest and oldest being 32 and 80 years old. In China's Congress, the average age is 56, with the youngest and oldest being 40 and 71, respectively.

Reference: The Economist, September 28- October 4th, 2013, p.40.

Sources: Hurun Report, CQ Roll Call, The Economist

Baseline. Per capita income in the US was $52,000 in 2012, versus $6,000 in China, according to the International Monetary Fund, as reported in Wikipedia. 

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2013 US Federal Budget

 Interesting Facts & Implications

Wikipedia has an article on the 2013 US federal budget. Of particular interest are the last sections covering (a) 10-year projections and (b) total revenues and sending.

I will make some observations, ask some simple questions, and then proceed to answer them. The answers will be based on simple quantitative analysis. The observations and questions were originally posted in my previous blog.


Observations

Growth rates. The highest annual rate of increase among major tax revenue categories belongs to individual income taxes, at 8.4%. The highest annual rate of increase among major spending categories belongs to interest payments on Public Debt, at 14.2%.

Revenue composition. Corporations pay 12% of tax revenue while individuals pay 47%.

Expenditure composition. The top 5 spending categories in the federal budget account for 76% of spending and are, in descending order:

1. Medicare, Medicaid
2. Social Security
3. Defense
4. Interest payments on Public Debt
5. Agriculture

Questions

1. If interest payments on Public Debt are growing so fast, what does this mean in the long run? 
2. If corporations pay a smaller percentage of tax revenue than individuals, does this mean that individuals are disadvantaged?
3. How fast is the US federal budget growing relative to the general economy?

Answers

1. If interest payments on Public Debt are growing so fast, what does this mean in the long run? 

The intent of this question is to find out (a) what portion of the total federal budget is currently going toward interest payments and (b) how that portion is expected to change. If interest payments represent a large portion currently, then it means that less funds are available for other uses. If this portion is expected to increase, then it means that the squeeze on funds availability for other uses will only increase.

Answer: For 2013, interest payments on Public Debt represent 6.5% of the federal budget. By 2023, they are expected to represent 15% of the US federal budget. In relative terms, the interest payment burden is expected to more than double in 10 years.

Supporting calculations: (a) 2013 interest payments = $246 bn. 2013 federal budget = $3.803 tn. Ratio = $246 bn / 3.8 tn = 6.5%. (b) Interest payments' annual growth rate = 14.2%. Federal budget's annual growth rate = 5.0%. All figures from Wikipedia article cited at the top. Implied interest payments after 10 years = $246 x (1 + 14.2%)^10 = $928 bn. Implied federal budget after 10 years = $3.803 tn x (1 + 5%)^10 = $6.195 tn. Ratio = $928 bn / $6.195 tn = 15%.

Acronyms:
mn = million
bn = billion
tn = trillion

2. If corporations pay a smaller percentage of tax revenue than individuals, does this mean that individuals are disadvantaged?

This question is intended to provide insight into whether one category in society receives preferential treatment relative to another category.

Answer. It depends on one's perspective, and there are three perspectives.

1. From the tax recipient's perspective (i.e. the federal government), individuals represent a more significant contributor than corporations, and by a factor of 4 times: 47% of tax revenue comes from individuals vs. 12% from corporations.
2. From income earners' perspective, corporations pay a larger fraction of their income than individuals, and by a factor close to 2 times: 17% of corporate profits goes toward tax payments vs. 10% of individual income. 
3. From the perspective of foregone wealth in absolute terms, corporations pay less tax than individuals, and by a factor of more than 2 times: A shareholder (indirectly) pays $2,000 in corporate taxes vs. $5,000 paid in income taxes by an individual taxpayer, on average.

Long answer:

(Part 1) For the fraction of tax revenues paid by individuals vs. corporations, please see the Wikipedia article cited at the very top.

(Part 2) US individual income tax payments in aggregate represent 10% of aggregate individual income, as of 2012. On the other hand, US corporate income tax payments in aggregate represent 17% of aggregate corporate profits. From this viewpoint, the corporate income tax burden on beneficiaries is heavier than the individual income tax burden.

(Part 3) However, if a different metric is used and which is based on the number of individuals making tax payments, the picture flips. For those individuals who make an individual income tax payment, the average amount paid per individual is about $5,000. Similarly, for those individuals who benefit from corporate profits (by being shareholders), the average amount paid per shareholder is $,2000.

Supporting calculations: (Part 2) US aggregate individual income tax payments in 2012 = $1.359 tn (source: Wikipedia article cited at the very top), vs. US aggregate personal income in same year = $13.402 tn (source: BBER) Ratio = $1.359 tn / $13.402 tn = 10%. Aggregate corporate tax in 2012 = $348 bn (source: Wikipedia article cited at the very top, vs. US aggregate corporate profits in same year = $1.755 tn (source: St. Louis Fed). Ratio = $348 bn / ($348 bn + $1.755 tn) = 17%.

(Part 3) Regarding individual income tax, not all individuals make such payments. A good guess is that those below the poverty line don't make any individual income tax payments. If we adjust for this, out of a US population of 314 mn (as of 2012, source: US census), 14.3% are below the poverty level (same source, US census), leaving 269 mn as the number of individuals who pay individual income tax. Average individual income tax payment per person = $1.359 tn / 269 mn = $5,052, after rounding = $5,000.

Regarding corporate income tax, not all individuals are shareholders in corporations (and in businesses in general). The percentage of Americans who are corporate shareholders reached a 15-year low of 52% in May 2013 versus a peak of 65% in 2007 (source: Christian Science Monitor). Number of Us individuals who are corporate shareholders is therefore between 52% x 314 mn and 65% x 314 mn, or between 163 mn and 204 mn. Average corporate income tax payment per shareholder, higher value = $348 bn / 163 mn = $2,135. Lower value = $348 bn / 204 mn = $1,706. Average = $1,920. After rounding = $2,000.

Before moving on, I do acknowledge that the above analysis is simplistic. The next step would be to perform an analysis which first divides individuals by income level ...

3. How fast is the US federal budget growing relative to the general economy?

The intent here is to find out (a) the level of federal government activity relative to the entire economy and (b) how this relative level is expected to change.

Answer. The US federal budget in 2013 represents an amount equal to 23% of 2012 US nominal GDP. By 2023, this budget is expected to represent 26% - 32% of US nominal GDP.  If the US economy grows slowly, the actual figure will be closer to 32%, but if it grows quickly, the actual figure will be closer to 26%. It follows that the relative size of the federal budget is expected to increase by somewhere between 10% - 40% in 10 years, when measured relative to GDP.

Some takeaway nominal growth rates over the next 10 years:

• 7.6% p.a. tax revenues    -- p.a. = per annum
• 5.0% p.a. federal spending
• < 3.5% p.a. economic growth    -- my educated guess

Supporting calculations: (a) 2013 federal budget = $3.803 tn.2012 US GDP = $16.62 tn in nominal terms, i.e. in current dollars and without any adjustments for inflation (source: Wikipedia). $3.803 tn / $16.62 tn = 23%. (b) Implied federal budget after 10 years = $6.195 tn, as calculated for answer 1. We need to estimate nominal GDP growth rate for the next 10 years. Looking at various historical time horizons all ending with 2012, we see the following annualized growth rates for US nominal GDP: 10-years: 4.0%, 20-years: 4.6%, 30-years: 5.4%, 40-years: 6.5%, 50-years: 6.9% (source: multpl.com). For example, for the 10 year period ending with 2012, the 10-year historical growth rate of nominal GDP has been 4.0%. We observe that US GDP growth has been slowing down over the past 50 years, in nominal terms. (The real question is whether it has slowed down in real terms, but that's a suitable subject for a future blog.) 

For the next 10 years, I will assume that GDP growth rate will be between 1.5% and 3.5% per annum. We can now calculate US GDP after 10 years: $16.62 x (1 + 1.5%)^10 = $19.29 tn, lower bound. $16.62 x (1 + 3.5%)^10 = $23.44 tn, upper bound. We can now proceed to calculate the size of the US federal budget 10 years into the future relative to the general economy. Lower bound: $6.195 tn / $19.29 tn = 32%. Upper bound = $6.195 tn / $23.44 tn = 26%. Final comment. The federal budget is expected to grow at 5% p.a. (as per answer 1), whereas it is almost impossible for US nominal GDP to grow by as much as the same rate. The Wikipedia article cited at the very top also indicates that that tax revenues will grow at 7.6% p.a. over 2012-2022.


Final remarks. This kind of analysis -- all 3 questions -- can very well be performed for other countries and then be used to perform a cross-country comparison ....

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Is the US Tax System Efficient?

 (Including side comments about the US Federal Budget)

The following facts were excerpted from the July 13-19th, 2013 edition of The Economist.

1. The US tax code isn't simple. 90% of US taxpayers use an accountant or commercial software to file their returns.
2. Americans spend at least 6.1 billion hours each year complying with tax rules. This time could have been spent more productively. (See below for an interpretation.)
3. Interestingly, tax revenues would remain unchanged by getting rid of all loopholes and by allowing individual income-tax rates to fall a whopping 44%. (See below for an interpretation.)
4. Each year $1.1 trillion in tax revenues is foregone through countless deductions, exemptions, and credits. To put this in perspective, total federal tax revenues are only $2.8 trillion each year.
5. Corporate tax rates are the highest in the rich world: add state and local taxes to the 35% federal rate and they reach 39.2%.
6. The top individual tax rate is 39.6%.

Commentary on Fact #1

The US federal tax code is 73,954 regular 8-1/2" x 11" sheets of paper long. (source: Google search). This would be a stack of paper that's about 30 feet tall or as tall as a 3-story building.

Commentary on Facts #3 & 6

If the 39.6% top individual tax rate were to fall by 44%, it would become 21.4%.

Commentary on Fact #2

Assuming 115 million households in the US, the time spent on tax filing translates to 53 hours per household or 6.6 eight-hour work days per household. (Source: http://quickfacts.census.gov/qfd/states/00000.html)

If the time spent on tax filing were valued at $20 per hour, it would be worth $122 billion. Valued at $100 per hour, it would be $610 billion. To put this in perspective, the US defense budget for 2013 is $672 billion and is the largest discretionary line item in the federal budget. (Source: http://en.wikipedia.org/wiki/2013_United_States_federal_budget.)

Interesting facts about the 2013 US federal budget are (a) the annual rate of tax increases budgeted for the 2012-2022 period, (b) sources of US tax revenue, and (c) composition of US federal budget. Here are some excerpts.

Growth rates. The highest annual rate of increase among major tax revenue categories belongs to individual income taxes, at 8.4%. The highest annual rate of increase among major spending categories belongs to interest payments on Public Debt, at 14.2%.

Revenue composition. Corporations pay 12% of tax revenue while individuals pay 47%.

Expenditure composition. The top 5 spending categories in the federal budget account for 76% of spending and are, in descending order:

1. Medicare, Medicaid
2. Social Security
3. Defense
4. Interest payments on Public Debt
5. Agriculture

Some questions to think about: 

• If interest payments on Public Debt are growing so fast, what does this mean in the long run? 
• If corporations pay a smaller percentage of tax revenue than individuals, does this mean that individuals are disadvantaged?
• How fast is the US federal budget growing relative to the general economy?

For answers, please visit my next blog entry.

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Has QE Been Effective?

Former banker and author Satyajit Das answered this question in simple terms as follows.

"In the US, it now requires a government budget deficit of about $600 billion, augmented by injection of about $1 trillion in liquidity from the Federal Reserve, to create about $300 billion of growth."

In input / output terms, the government and the Fed are inputting $1.6 trillion into the economic system annually and in exchange, the economic system is outputting $300 billion of newly created economic value. The output-to-input ratio is under 19%.

Quantitative fund manager John Hussman argues that "the present course of Fed policy is destabilizing the global economy by contributing to a financial environment that encourages the allocation of scarce savings toward speculative activity, not productive investment." Source: http://www.hussman.net/wmc/wmc130527.htm.

Satyajit Das is a former banker and author of Extreme Money, and Traders, Guns, and Money. The above quote is from an article that appeared in the Financial Times on June 18, 2013, page 22.

QE stands for quantitative easing. It refers to the injection of liquidity into the financial system by the US Federal Reserve. Currently, the Fed has been injecting to the tune of $85 billion per month through the purchase of various assets. This translates into just over $1 trillion over the course of 12 months. To give a sense of how big this amount is, it's equal to $7,850 per household, assuming 130 million US households.


Afterthought 1:

History of QE. There have been three rounds of QE. QE1 started in Nov. 2008 at which time the yield on the 10-year US Treasuries was under 3.5%. QE2 started in Nov. 2010 at which time the same yield was under 3%. QE3 started in Sep. 2012 at which time the same yield was above 1.5%. Prior to any QE and right before the first signs of financial troubles emerged, which was in mid 2007, the same yield was it its highest at above 5%.

Today, June 21, two days after the Fed announced plans for tapering QE3, the same yield stands at 2.4%. The Fed indicated that QE tapering could start as early as in September of this year and that QE was likely to end by the middle of 2014. The Fed said it didn't plan to raise interest rates until the middle of 2015.

In the last couple of months, the 10 year US government bond yield hit a low of about 1.6%. The move from 1.6% to 2.4%, which is a rise of 80 basis points, translates into a price drop of about 6-8% (depending on the bond's actual coupon). The smaller the coupon, the higher the bond's duration, and therefore, the larger the price drop in relative terms.

The relationship between bond yield changes and bond price changes is captured by duration. See for example the Wikipedia article on bond duration. For example, the duration of a bond maturing in 10 years is somewhere around 5 to 7 years, depending on the coupon. The larger the duration, the more sensitive is the bond price to interest rate changes.

Question: What is the duration for stocks? Stocks have a much longer duration than bonds, perhaps 6 - 30 times larger. See for example the Wikipedia article on stock duration. This means that they are that much more sensitive to interest rate changes. All else being equal, a rise in interest rates due to Fed tightening could send the stock market down more than one would think.


Afterthought 2:

Question: How much liquidity have the developed world's central banks injected into the economy in aggregate?

Answer: G7 central banks have collectively put some $10 trillion of additional liquidity into the system since 2008, according to JP Morgan and Deutsche Bank estimates.

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3D Printing Accelerates Product Development

3D printers lay down particles of plastic, metal, or wood in thin layers to build up into solid objects. 3D printing is also called additive manufacturing.

German athletic shoemaker Adidas has said that 3D printers have reduced the time it needed to evaluate a new prototype by four to six weeks to one or two days. Before 3D printing, Adidas prototypes were handmade by 12 technicians. With the new technology, no more than two people are required to produce them.

American athletic shoemaker Nike seems to agree. Within six months, they were able to go through 12 rounds of prototype iterations for a boot for professional American football players.

The three biggest makers of 3D printers are:

1. EOS of Germany
2. 3D Systems of US
3. Stratasys, a US-Israeli company whose clients include Adidas, Nike, Reebok, New Balance, and Under Armour.

Mass shoe production via 3D printing has not arrived yet due to the slow speed at which printers produce items. Currently, it takes a Stratasys machine about two hours to produce a single shoe.

The above is an excerpt from an article that appeared in the Financial Times on June 10, 2013, page 15.

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Fund Manager's Career Risk,

 or Why the Stock Market Acts Irrationally Every so Often

The following is an excerpt from a September 2011 essay by Dylan Grice, formerly of Societe Generale.

Early in my career as an economist , I remember being taken around to see clients with a certain gloomy strategist known as Albert Edwards. It was early in the spring of 2000 and tech hysteria was fever pitched. Talk was of a “new paradigm” and madness masqueraded as wisdom. Albert had been going around, with me in tow, arguing that the madness was, well … mad … but most meetings were hostile and Albert’s views were felt to be too extreme. But one meeting stands out in my mind, making a deep impression on me ...

The fund manager who’d taken this breakfast meeting listened to Albert begin his argument but seemed agitated. Then, after only a few minutes he interrupted. “Look,” he gasped, “I know it’s all crazy, but what do you want me to do? If the bubble inflates like this for even one quarter and we don’t participate, we’ll lose half our assets. I’ll be out of a job!” [Highlight added after the fact.] Here was someone who could see the fraud all around him but felt powerless to resist. Bad fund management practice was driving out good.

Reference: http://www.scribd.com/fullscreen/123487201, pp. 157-158, January 2013.

[Side note: This time in history, i.e. May 2013, is a rare instance of a US equity market that is overvalued, overbought, and overbullish, according to quantitative fund manager John Hussman. Its cause, according to many, is QE (quantitative easing). Investors are being driven into risky assets because the yield on safer assets is so low because the yield on US treasuries is so low because the Fed is buying assets to the tune of $85 billion a month in order to encourage economic growth.]

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