The Baby Bust

"The point of our demographics is that we're not have as many children and the population is stagnant, if not declining.  So without immigration, we're not going to have the population." - Susan Oliver

"Social security is a plan that actually was designed in a much different time, in a different era, and with a different set of American demographics in mind." - Ginny B. Waite

It is relatively safe to say that the world is aging rapidly.  In 1970 the average woman on the planet gave birth to 4.7 children in her lifetime but by 2011 the trend had stalled and that number has fallen to 2.5.  Taking a deeper look it can be seen that not only is the world's population growth barely moving, but there are rapid shifts in demographic growth and this will have significant impact on investment allocations and opportunities.

Looking at the demographics of the developed nations of the world they capture roughly 1 billion people of a total estimated global population of 7 billion.  Furthermore the developing and under developed nations will provide 97 percent of global population growth in the coming years.  As an example, Spain with a population of roughly 46 million is projected to have a total population of 48 million by 2050.  In contrast Tanzania with an equivalent current population is expected to have a population of 138 million by that time.  The developed world has a population base that is barely growing while the developing world is growing gangbusters.

So as a global company like Wal-Mart your opportunity is outside of the United States.  There are billions of people out there that would love to have a Wal-Mart store in their village providing them with all the wonders of the world.  The problem is that a lot of these people have no way of paying for their purchases as they earn less than $2,000 a year however things are changing fast.  The graph below extracts data from the International Monetary Fund database and shows the Purchasing Power Parity of the global consumer.  Purchasing Power Parity is an economic theory used to level the playing field by adjusting a country’s exchange rate to reflect an equivalent dollar of purchasing power.  In other words a Russian that earns say 50,000 rubles a month may be able to live at the same economic level as an America who earns $5,000 a month even though the exchange rate would only give the Russian $1,700.  In this example they would be said to have Purchasing Power Parity.

Based on this theory the graph is very telling.  Global Purchasing Power Parity is accelerating meaning that wealth around the world is expanding.  More important is that the vast majority of this growth is being powered by the 6 billion people that live in developing and under developed nations.  As this trend continues more and more of the globes trade will move to these countries and away from the developed world transferring economic and commodity pricing power out of the hands of the incumbents and into the hands of the growth nations.  This demographic trend will shape the next hundred years and there is nothing that will turn the hands of this clock back. Multi-national companies know this and are expanding capacity, infrastructure and operations to the countries that are heading up the charge. These include Brazil, India, Russia and China, the so called BRIC nations. This is where the growth will come from, resources are required and opportunities abound.

Currently these countries make up just a fraction of the global trade.  In fact between them the BRIC countries make up only $9 trillion of an estimated $70 trillion total global market however it is estimated that by 2050 these four countries will produce and consume more than $130 trillion of goods and services making them far larger than any other sector in the world.  They will dwarf the United States which is expected to grow to $38 trillion by that time.  So demographics are on the side of the BRIC nations but the developed world will benefit as they are piling money and resources into these markets in an effort to win over consumers.  It is going to be a tough fight and I expect that by 2050 many new companies will emerge to take over from the current stalwarts.  For example less than a decade ago no-one in the United States knew of Hyundai, HTC or Foxconn and now they are stealing market share of the incumbents.

This is an incredibly important trend as it will have a huge impact on global markets.  Companies that are will positioned to benefit from this trend will skyrocket while others will be left in the dust.  In looking for investment opportunities always keep this slow moving tidal wave in the back of your mind as it will wash away those companies not on high ground.

The "Death Spiral State"

"Don't buy a house in a state where private sector workers are outnumbered by folks dependent on government." - William Baldwin writer for Forbes magazine and author of the article Do You Live In A Death Spiral State?

William Baldwin created quite a stir in the investment world with his article.  What Mr. Baldwin found was that there are eleven States where more people earn a living from the government than work in the private sector.  To be clear, most of these people work for the government but a large percentage of them are on welfare receiving support in the form of food stamps, pensions and other government hand outs. 

To qualify for this list not only did the State need to have a ratio of more than 1 (government paid / private sector) but they also needed to have large levels of debt, an uncompetitive business environment, weakness in home prices and poor unemployment trends.  His concern is that these States are on a Death Spiral as there is no way that this trend can continue so his advice is not to buy a house or a municipal bond in or issued by any of these States.

 

So let's take a detailed look into this advice and how it may affect these States going forward.  As I live in California I will concentrate my thoughts on that State but they should hold water in the others as well.

In order for these States to repair their budgets it is clear that they need to start to drive a surplus.  That will be near impossible with a workforce that is overwhelmed by State employees and beneficiaries.  In order to drive a surplus you need to bring in more tax revenue than you spend so it is pretty simple, either you raise taxes or cut spending or some combination of the two.  So let's look at raising taxes.  As you are already uncompetitive compared to the other States there is a high probability that business will move to another more business friendly State.  This moves the meter in the wrong direction but as we have seen in California taxes are being raised particularly on the wealthy and those are the people that are creating the jobs.  Force them out and things get ugly fast and based on the current round of tax increases I expect there will be decent sized migration out of California and this will have a negative impact on 2013 and beyond. 

The next place that you can raise taxes is on consumer items in the form of a sales tax or property taxes.  Each of these States has poor housing fundamentals so raising property taxes would hurt that sector even further however it is a way to tax the wealthy over the poor.  It seems clear to me that it is just a matter of time before property taxes are increased so if you are considering buying a house and you can only marginally afford the payment I would advise to continue renting as when these taxes are raised this could be the difference between losing or keeping your house.  Outside of this an increase in the rate of housing tax would put a lid on the housing price increase and would probably result in more short sales but only time will tell on this score.

Increasing sales tax is also hard to do when there are States that charge no sales tax, but this is possibly the least corrosive of all taxes as these are spread among all consumers including those on welfare.  In fact a thought would be to push property taxes down (maybe to zero) and increase sales taxes to cover the loss of revenue.  This should have a positive impact on housing prices pushing up demand and creating opportunities and employment but I am sure that this will never happen.  Furthermore sales tax moves with inflation and should increase year over year while property prices can move about wildly hurting government budgets just at the time when they need the revenue.  In addition property taxes benefit those that live in the same house for decades as their rates stay tied to the purchase price of the house.  This skews the burden onto the new home owner who is more often than not the most stretched in terms of making ends meet.  Not very equitable.

The next thing that has to happen is that these States need to cut spending and the size of the government sector.  I have to believe that there are thousands of workers in the government bureaucracies that are not needed, so cutting the pool of labor should not be that difficult outside of the fact that there will be massive political infighting.  If, for example, you ran the State like a private business I would imagine that tens of thousands of jobs would be eradicated.  In politics however large bureaucracies bring power so I see little in the way of change here unless the job is made to be unbearable which it is, except for the benefits.

Cutting spending is also not a difficult thing to do in theory, but once again practice is another thing completely.  For example cutting retirement benefits is an obvious one.  The vast majority if not all businesses gave up providing defined benefit retirement plans years ago.  It was simply too much of a burden to bear particularly when life expectancy increases every year.  They all switched to defined contribution plans where the onus is transferred to the employee who bears the risk.  Once again changing this would solve a lot of these States' budget issues but once again that is political suicide.  Until there is a major default by a State this will always be off the table but it is the quickest way to turn all of this around.  A side effect (benefit if you will) of this cut would be that States would struggle to find anyone who would sign up for the work.  This would actually be good as it would force the government to become more efficient and would reduce the number of workers - a double whammy!

So looking at the investments it is hard to think that renting is better than owning, particularly if you can afford it.  You do get the tax benefits and pride of ownership and even if the tax rates are raised, while there would put a lid put on the upward movement in the value of housing, as with all these types of changes it would be temporary.  More important to me in this equation is the population movement in and out of a State and I believe that most if not all of these States are growing in population size. While California's population is growing it has slowed to a trickle but every person that increases the population needs a place to live and this is what drives demand for housing.

As far as municipal bonds go there should be a fair amount of concern.  One thing to bear in mind is that no-one can force a State or a municipality to go into bankruptcy.  The State has to send itself into a reorganization and typically through this process the bond holders are restructured and over time paid out.  As a State has no equity that it can cram onto the holders of the notes and the good faith of the State's tax revenues are at stake as are future money raising requirements, in most reorganizations the bond holders retain their principle and what is re-structured are the terms of the note.  In other words, while your money may get tied up in a long drawn out negotiation, it still seems like a good bet as long as the yield is good.

One thing is for sure, each of these States needs a full overhaul and the leader who takes that on is going to be met with a tank full of opposition.  That said, the State that can mend itself will be rewarded with growth and prosperity and that would be a great time to own a house and those municipal bonds.

Tax Talk

"Elections should be held on April 16th - the day after we pay our income taxes.  That is one of the few things that might discourage politicians from being big spenders." - Thomas Sowell

"If anything, taxes for the lower and middle class and maybe even the upper middle class should even probably be cut further.  But I think that people at the high end - people like myself - should be paying a lot more in taxes.  We have it better than we've ever had it." - Warren Buffet

"We have a system that increasingly taxes work and subsidizes nonwork." - Milton Friedman

Talk about taxes always leads to a heated debate as the quotes above show.  I remember back to my university days when our economics professor had us perform a class project in which we were to put forth an equitable tax structure.  After a week of debating it was clear that this was an impossibility as there was always a group that received benefits at the expense of the others!  One thing was clear though, the higher the tax rate went the less the desire was to work, innovate and start a new businesses.  The headwinds were just too great increasing the risk of failure and thus putting a bullet to many a great idea.

With the tax rates in the United States at their highest effective level since The Tax Reform Act of 1986 and on par with the rates in 1937 a look back at history is of interest.  Back in the 30's as the economy was finally showing some signs of recovery the bullet that drove economic progress backwards sharply was the hike in the rate of taxes.  Admittedly there were other problems such as retaliatory currency devaluations and monetary policy mistakes - wait a minute, this all sounds familiar!  The result was that the Great Depression was prolonged for a few more years.

The hike in tax rates looks like it is perfectly timed to sideline the economy in 2013 and possibly 2014.  Worse than that with tax rates set to rise around the globe this could really spell trouble ahead.  In France there is a proposal to raise the top tax rate to 75%.  Think about that for a second - you earn $200,000 but you only take home $50,000!  The other $150,000 goes to pay down debt and finance worthless government spending!  How much incentive is there to work harder so that you can pay even more?  While this may not happen the French tax rate is still high at around 48%.  Britain has already hiked its tax rate and other countries facing budget deficits are planning to follow suit.  This global burden will affect global growth right at a time when growth is what the world desperately needs.

In an interesting twist taxes may be further increased due to better fuel consumption.  In the past it was thought a good idea to tax fuel purchases through a gasoline surcharge.  This tax money would then be used to service the roads and bridges.  The more that you drove, the more benefit you received from the roads so the more you would pay in tax to service the roads.  The problem now is that the tax received is not covering the required upkeep expenses due to the fact that cars are becoming more and more fuel efficient.  Less money spent at the pump means less revenue to repair the roads but the roads are getting more use as cars go further on less.  I don't know about you but it seems that there are potholes where ever I go these days.  Bring back the Hummer that will sort this out!

The solution many states are proposing is to switch the tax to a value added tax on goods and services.  This VAT tax would transfer the burden to repairing the roads onto the consumer rather than the driver.  Definitely not an equitable tax system but one that is being used to fill the shortfall in the road maintenance budget.  I personally think this a very poor idea as the purchase of a chocolate bar at the convenience store is not going to pay for the damage to the road.  Another idea is to charge a onetime tax on fuel efficient vehicles.  The reasoning behind the idea is that they use the road but by using less fuel do not contribute the same percentage to the road upkeep.  Now how is that for irony!  To me both of these ideas are absurd; why not just raise the fuel tax?  This in turn will raise the price of gasoline and would reduce the use of cars further, a win all around! 

The issue is that taxes, whether on income or fuel, have to go higher to support the massive debt burdens and budget deficits being run by governments the world over.  This will create another drag on global economic growth and, with the crowding out effect that large government debt levels are having, will take global growth down around the 2% level in 2013.  Considering that the IMF is expecting 3.5% growth and that the world grew by 3.2% in 2012 this level of global growth will be the equivalent of a global recession which is why I continue to expound the virtue of exiting the market.

Its All About How You Spin It

"Storytelling in general is a communal act. Throughout human history, people would gather around, whether by the fire or at a tavern, and tell stories. One person would chime in, then another, maybe someone would repeat a story they heard already but with a different spin. It's a collective process." - Joseph Gordon-Levitt

Today the market is rallying to levels not seen since 2007 on the back of some positive economic news.  If the market ends the week around these levels it will be the fifth week in a row that the stock market has posted a positive number.  Going back to December 24th the market has been on a tear and is up almost 8% during that period.  With the proverbial can that is the Fiscal Cliff being kicked out a few months and with unemployment edging up to 7.9% from 7.8% it is no wonder that the stock market is tearing higher!

Additional research from the World Bank shows that they have once again reduced their global growth expectations down to 2.5% from 3.0% for 2013.  GDP growth in the US is forecast at 2.5% in 2013 but that will never happen.  The tax burden on the US business owner and consumer has still to be felt and with the desire to become more fiscally responsible at the forefront of most budget negotiations the US will be lucky to grow at all in 2013.  Looking back at the final quarter of 2012 US GDP contracted by 0.1%.  This is the first time since the end of the Great Recession that GDP has contracted in any quarter but no worry we will burst out in 2013 with 2.5% growth!

So why is the market on such a tear?  Well let's take a look at some of the headlines that were printed today:

"US market rallies on jobs report"

 

"Wall Street rallies on upbeat data"

 

"Dow Tops 14,000"

But we have just seen that the actual numbers are terrible.  Also the forecast of GDP growth is wildly out of whack so there is something else going on here and that is the excess cash that is flooding the system is finding a home in stocks.  This stock frenzy is being pumped higher by the press and their cheer leading cohorts screaming from the sidelines with misleading headlines such as the above.  As long as the data is spun in a way that makes it look good the markets rally.  It is much like listening to a politician talk about all that he or she achieved during the past few years!

The market is now within spitting distance of its all time high and this frenzy is driving stocks ever higher.  As the market moves higher there is an ever greater disconnect between underlying fundamental value of the company and the stock price.  This is pushing the risk of the trade higher and higher. With every tick higher the chance of a severe meltdown increases and this is very concerning to me.

I would love to be all in riding the market higher but the issue is the risk is now totally skewed to a reversal and picking the "right" stock is incredibly tough.  Take as an example if you will of Apple.  The stock is down over $100 a share during the month of the S&P rise.  Another example is 3D Systems which was hammered from $70 to below $60 in a couple of days.  Both of these stocks were high fliers in 2012.  On the flip of this look at Salesforce which continues to bludgeon higher with a price to earnings ratio of 90.  Just as a refresher that means at the current level of earnings it would take 90 years to return you your investment!

With wild swings like these and amid the economic weakness that continues to haunt the globe, rising unemployment numbers and the prospect of higher taxes everywhere I find it incredible that the market is rocketing higher.  I certainly will not go so far as to call this a bubble but it is starting to have the look and feel of one and not a place I wish to risk my money.  To refute those of you who will cry out about my concern about the market run; if the economic fundamentals were there to support this rise I would find something to cheer about and would be invested but this market is being fictitiously driven higher by a false sense of security that is the Federal Reserve and their ability to create money out of thin air.  These are not solid fundamental conditions that warrant an investment and I advise you to remain on the sideline.