Two Bad Choices in Tax Debate

I found this article very informative and I think it is worth sharing.

 

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By Patrick Watson

Remember when everyone wanted to cut the federal deficit? Fiscal policy was much simpler back then: balanced budget good, deficits bad. Times change. Now the House and Senate are considering tax legislation that, according to their own numbers, will add $1.5 trillion to annual deficits over the next 10 years.

This is okay, we’re told, because the tax cuts will stoke economic growth, thereby delivering added tax revenue that offsets the rate reductions.Note the bigger point here. Republicans still say they don’t like deficits—but apparently, this particular plan lets them cut taxes without adding more debt. It’s a miracle.

Is their claim really true? Will the GOP tax plans boost economic growth?

That’s the 1.5-trillion-dollar question.

Theory vs. Reality

The Republican plan’s centerpiece is a reduction in corporate tax rates from a 35% top bracket to only 20%. That would put the US more in line with other countries.

What you seldom hear is that most other developed countries also have value-added tax (VAT), a kind of consumption tax. The US doesn’t. Our tax system will remain different, and not necessarily better, under the new proposal.

Anyway, the theory is that lower tax rates will entice businesses to bring back operations they currently conduct overseas. They will build new factories and hire more US workers. Those workers will spend their higher incomes on consumer goods, and we’ll all be better off.

Unfortunately, that thinking has several flaws.

For one, as we saw in the NFIB Small Business Economic Trends report that business owners say that finding qualified workers is their top challenge right now. Reducing corporate tax rates won’t make new workers magically appear, nor will it improve the skills of those already here.

What increasing labor demand might do is spark that inflation the Federal Reserve has wanted for years. There’s also a good chance it could spiral out of control, forcing the Fed to hike interest rates even faster than planned—which could offset any benefit from the tax cuts.

Fortunately, such added labor demand will appear only if businesses respond to the lower tax rates by expanding US production capacity.

Will they? Let’s ask.

“Why Aren’t the Other Hands Up?”

This month, in one of its regular business surveys, the Atlanta Federal Reserve Bank asked executives, “If passed in its current form, what would be the likely impact of the Tax Cuts and Jobs Act on your capital investment and hiring plans?”

Here are the results.

Image: Federal Reserve Bank of Atlanta

Only 8% of the executives surveyed said the bill would make them increase hiring plans “significantly.” Only 11% said they would significantly increase their capital investment plans. A solid majority answered either “no change” or “increase somewhat.”

Other surveys reached similar conclusions.

White House Economic Advisor Gary Cohn had an awkward moment last Tuesday at a Wall Street Journal CEO Council meeting. Sitting on stage to promote the tax cuts, Cohn watched as the moderator asked the roomful of executives whether their companies would expand more if the tax bill passed.

When only a few hands rose, Cohn looked surprised and said, “Why aren’t the other hands up?”

So maybe they were distracted or needed a minute to think. Fair enough. A few hours later, White House Economist Kevin Hassett appeared at the same event and asked the same audience the same question.

He got the same result: only a few raised hands.

Pocketing Profits

None of this should surprise us. Tax rates are only one factor businesses consider when deciding to expand. The far more important question is whether consumers will buy whatever the new capacity produces.

Think about it this way: if you’re a CEO and you have difficulty selling your products profitably now, why would lower taxes make you produce more? Even a 0% tax rate is no help if you lack customers.

Former Brightcove CEO David Mendels explained how big companies view this:

As a CEO and member of the Board of Directors at a public company, I can tell you that if we had an increase in profitability, we would have been delighted, but it would not lead in and of itself to more hiring or an increase in wages. Again, we would hire more people if we saw growing demand for our products and services. We would raise salaries if that is what it took to hire and retain great people. But if we had a tax cut that led to higher profits absent those factors, we would ‘pocket it’ for our investors.”

By “pocket it,” Mendels means executive bonuses, share buybacks, or higher dividends. That’s what 10 years of Federal Reserve stimulus produced. A corporate tax cut would likely have a similar effect.

Choose Wisely

As I’ve said for months, I don’t think the House and Senate can agree on any significant tax changes. The two chambers have different political incentives they probably can’t reconcile.

So I think we’ll be stuck with the current tax system. The economy will limp along like it has been and eventually go into recession. The hope-driven asset bubble will pop, hurting many investors.

If I’m wrong and the GOP plan passes in anything like the current form, we will get higher deficits but little additional growth. The tax cuts will flow to asset owners and shareholders, probably blowing the market bubble even bigger. That will make the inevitable breakdown even more painful.

 

Do you agree with Patrick?

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Robots have arrived on Wall Street

Last week marked the debut of an upstart fund called the AI Powered Equity ETF, an actively managed security that seeks to use artificial intelligence to beat the market. The exchange-traded fund officially launched last Wednesday so it is too early to measure how this fund will perform over the long term.

At its core, AIEQ ETF is powered by the big-data processing abilities of IBM’s Watson. It is responsible to develop a portfolio of stocks that will be able to offer results that are not only better than  human stock pickers  but also the overall market. Most ETFs are passively managed and follow indexes like the S&P 500, the Dow industrials or other sectors. In other words, your new portfolio manager is a computer program.

The fund currently is composed of 70 stocks, plus an allotment of cash, that are spread around sectors. Components are determined by “their probability of benefiting from current economic conditions, trends, and world- and company-specific events,” EquBot said in a news release.

The top five holdings by concentration are Penumbra 4.63%, Boyd Gaming 4.51%, Genworth Financial 4.45%, Mednax 3.8% and Triumph Group 3.52%, according to XTF.com. The turnover is expected to be high around 2% – 3% per day. The fund charges an expense ratio of 0.75%, which is slightly lower than the average expense ratio for actively managed ETFs.

The information explosion has made the jobs of portfolio managers, equity analysts, quantitative investors and even ETF builders more challenging. New technology in artificial intelligence could help solve those challenges. There’s still quite a range in AI models being used. There could be other quantitative groups that are looking at the same raw data but analyzing it in a different way, meaning the same input material can result in different insights and outcomes.

Another example of an unusual method for picking stocks is  Buzz US Sentiment Leaders ETF BUZ, an exchange-traded fund that selects its holdings based on positive chatter in social media and other online sources. The fund is up 17.2% in 2017, above the 13.9% rise of the S&P 500.

If the IBM’s Watson stock picking outperforms over the first quarter and money flows into the EFT, you’re going to see 20 competitors inside of six months.

This is a very gutsy structure, I am putting this ETF on my watch list. I am also going to monitor the top ten holdings of this ETF to get some stock picking ideas.

 

 

 

 

 

 

 

 

Investing ideas: I liked the product so much, I bought the company

Victor K. Kiam made a fortune as the President and CEO of Remington Products which he famously purchased in 1979 after his wife bought him his first electric shaver. Kiam became famous as the spokesman for the Remington shaver. His catchphrase, “I liked the shaver so much, I bought the company”, it made him a household name.

Your iPhone is your BFF and you can’t function without a Starbucks latte. You post something on your Facebook page every day, go home from work and chill out by watching Netflix. They’re all products you love and know well.

But does that mean the companies behind them are good investments?

The short answer: At least it’s a good starting point.

At first glance, it isn’t a terrible idea to own stocks if you have a good understanding of a company’s products and have a good feeling it will be successful. Yet knowing whether a business makes a good product and has excellent customer service are by no means the only measurements for investing.

For example: Snapchat (SNAP) and Twitter (TWTR) are both very popular but can they become sustainable businesses with positive earnings growth? So far, it isn’t looking very good for either of these companies. Before you invest, you have to determine whether the product or service is just a new fad or a money-making long-term trend.

One of my best investment ideas in 2016 came from going on vacation on a cruise line. Talking to other passengers I got very positive feedback on their cruise line experiences. Plus many of my boomer friends confirmed that they also loved taking a vacation on a cruise line.  The baby boom generation is getting older and I had dinner with many passengers in their eighties and even with one women in her nineties. (This could be a long-term trend)

Although I was on vacation on a Carnival ship, I bought shares in Royal Caribbean after extensive research.

Price / Earnings Earnings growth (5yr) Operating margin
Royal Caribbean 17.7 times 16.45% 19.95%
Carnival 18.5 times 8.95% 16.63%

It turns out that I could have beaten the returns of the S&P 500 index by owning either RCL or CCL as illustrated by the chart below.

Finding good, long-term investments is exceedingly difficult, there are only a few good ideas out there. When you find an extraordinary business and you have an understanding of what its future looks like, you should invest some money into it. Unfortunately, going that takes time, effort and know-how, often more than casual investors will do on their own “but it can be done”.

Ignoring investment rules to achieve income

 

A few months ago, I asked readers for advice regarding a $300,000 inheritance. The couple are in their late fifties, debt free with little savings. Although, they are very fugal, they live paycheck to paycheck due to lack of steady full time work. Few companies want to hire older workers when they can hire young people for a lot less.

Being very good friends, they came to me for some free advice. After a few meetings, I realized that traditional investment strategies just wouldn’t work this couple. They have been dipping into their retirement accounts to pay bills. I recommended putting $100,000 back into their retirement accounts. The $200,000 into a joint investment account with a discount broker in order to split the income and save on fees.

Disregarding Asset Allocation guidelines

Based on their age and proximity to retirement, a 60% equities and 40% bonds mix would have been appropriate. However, investing in bonds with low interest rates, inflation and taxation doesn’t give them very much income.

Disregarding Diversification guidelines

Being Canadian, foreign dividends are taxed like interest payments similar to Canadian bonds. Plus, foreign assets are subject to currency fluctuations. The increased value of the Canadian dollar has wiped out all U.S dividends and most of the capital gains from owning U.S. stocks.

Disregarding suitability guidelines

This couple’s investment knowledge is very limited, their only investments have been in mutual funds with high management fees. After explaining how high fees will reduce their income, they agreed to take more risk in owning some individual stocks and exchanged traded funds.

Constructing a portfolio to maximize income and minimize risk

  1. I invested $61,418 in four Canadian Reits that generates $418.16 per month or $5,017.92 per year. The Reits income will be a combination of interest and capital gains. Compared to investing $120,000 in bonds yielding 3% per year or $3,600.00
  2. I invested $63,329 in three Canadian dividend stocks that generates $330.00 per month or $3,960 per year. Due to the couple’s low income, these dividends will be tax free income.
  3. I invested the balance of $75,253 into four covered call ETFs that generates $392.00 per month or $4,704 per year. The covered calls will produced capital gain income and the ETFs also has some dividend income in their monthly distributions.

Grand income total works out to $1,140.16 per month. The average annualized return on the $200,000 portfolio is 6.85% with a minimum amount of risk.  

This is only a temporary solution to achieve some monthly income until their work situation changes. Sometimes investment guidelines have to be broken because one size doesn’t fit all.

Upcoming blockbusters could boost movie chain stocks

I have to admit that one of my guilty pleasures is watching movies on a big movie screen. My wife and I really enjoy science fiction and superhero type movies. We see anywhere from 10 to 15 movies every year. Sometimes we will even see the same movie more than once.

2017 has been a rough year for the film industry, with the North American box office suffering its lowest-grossing summer in 25 years. Ticket sales are down 10.8 percent this summer and have decreased by nearly 3 percent year to date. Box office flops such as “The Mummy” and “Baywatch” have hurt Hollywood but there will be some upcoming movies this year that could turn into blockbusters.

Release dates in November and December of 2017 include Thor: Ragnarok, Justice League and my personal favorite Star Wars: The Last Jedi.  Upcoming movies in 2018 appears to be very strong with:

  • Black Panther
  • X-Men: The New Mutants
  • Avengers: Infinity War
  • Han Solo,
  • Deadpool 2 
  • Ant-man & The Wasp.

However, investors have really punished the movie chain stocks. U.S. chains, Regal Entertainment (RGC) and Cinemark (CNK) are down 35% & 25% respectfully over the past 6 months. Cineplex (CGX) the largest Canadian chain is also down 25%, see chart below:

The vast majority of theaters in the U.S. keep a larger percentage of the ticket sales the longer the film is in the theater. For example: opening weekend they may get 10%, the 4th  week up to 25% and the 10th  week up to 50% or more. While concessions account for only about 20% of gross revenues, they represent about 40% of theaters’ profits. Profit margins on soda and popcorn average 85 percent.

All three of these stocks pay dividends, Regal has the highest yield of 5.7% followed by Cineplex at 4.35% and Cinemark with 3.43%. I expect that their 3rd quarter results could disappoint which would be a good buying opportunity. However, there is a risk that the price of these stocks could move up in anticipation of better future earnings.

Possible ways to trade a rebound in movie chain stocks

  1. Take a half position now and buy the other half after 3rd quarter earnings are released
  2. Buy a full position near the ex-dividend date, to get paid while you wait
  3. Buy half position, sell covered calls and sell cash secured puts for the other half.
  4. Buy some long calls near 4th quarter earnings release scheduled for Feb. 2018

Being an option trader, I am going to wait until Feb 2018 options are available. If the VIX which measures volatility stays low, I will probably buy a call option on one or two of these stocks.

 

Disclaimer: This post is for discussion purposes, do your own research.

A big disconnect between the Stock Market and the Canadian Economy

Canada’s economy is expanding at its fastest annualized rate in six years according to Statistics Canada. That’s a quarterly expansion rate of 4.5% which is the highest figure since the third quarter of 2011. It was led by the biggest binge in household spending since before the 2008-2009 global recession.

Economists had predicted Canada to grow around 3.7% and the Bank of Canada latest forecast was for GDP to expand at 3% in their July press release. When combined with the 3.7% expansion of the first quarter, it’s the strongest six month start in 15 years.

Why isn’t money pouring into the Toronto Stock Market?

Often times the equity market is moving well before the economy does and of course the Canadian equity market had a robust year in 2016. Investors may already have priced in all the good news last year, when Canada’s stock index gained 18 percent, one of the world’s best performances.

Part of the problem is that Canada’s stock market isn’t totally reflective of the economy, since it’s heavily reliant on energy and financials. Those two sectors account for 54 percent of the S&P/TSX Composite Index.

The outlook for oil is very subdued, it is still trading below $50 a barrel even with the shutdown of refineries due to hurricane Harvey. Global inventories continue to stay high and OPEC’s has lost its influence in cutting production. Crude oil prices in the future’s market are still below $50 a barrel for all of 2018 and part of 2019. Foreign investors are taking money out of the Alberta’s oil patch.

Continued growth in residential investments which was up an annualized 16 percent in the first quarter is also likely to fade as the impact of government measures to cool housing markets kick in. Although, bank earnings have beat expectations by a wide margin, loan growth going forward is expected to decline and loan losses are expected to increase. U.S. hedge funds are still shorting Canadian financials expecting the housing bubble to burst.

Investors believe that this robust growth will force the Bank of Canada to continue raising interest rates this year. It could add extra pressure to lowering consumer spending due to high indebtedness of Canadian households. It will also add a cooling effect to the hot housing prices in both the Vancouver and Toronto real estate markets. The rapid rise in the value of the Canadian dollar is added proof that currency traders are betting that a hike in interest rates is coming soon.

Uncertainty over NATFA  renegotiation

Global political developments aren’t helping, with renegotiation of the North American Free Trade Agreement which started in August, created a new spat with the U.S. erupting over aerospace manufacturing.

Already, data suggest investment into the country is cooling. Foreign direct investment in Canada dropped 25 percent to C$8.68 billion in the first quarter, according to separate data released Tuesday. The country relies heavily on foreign funding to finance spending — totaling C$130 billion over the past two years, according to balance of payment data.

Canada has benefited from a convergence of developments that include a coordinated global recovery and rising trade volumes. The bottoming of the oil shock in western Canada, along with federal deficit spending, rising industrial production in developed economies. Canadian consumers have benefited from a buoyant jobs market and rising home values, resulting in a surge in consumer spending.

Is this Sustainable? I think not!

Economists had been predicting a slowdown in growth to about 2 percent in the second half of this year, but are revising numbers up after the GDP report. I believe this surge in economic growth is temporary. The higher value of the Canadian dollar and higher interest rates will dampen economic growth.

The Toronto stock market returns for all of 2017 are flat which could indicate that foreign investors also believe the future going forward isn’t so rosy!

 

 

 

Why you should look under the ETF’s hood

A fund’s name might seem like a good starting point for gaining an initial understanding of how it is constructed. Unfortunately, names turn out to offer little help for evaluating funds. There is simply no universally accepted system in use by ETF providers and research to classify funds. For example “Infrastructure” would seem to have something to do with the amenities, roads and power supplies needed to operate society.

Names can be deceiving! To illustrate, I went to one of my favorite ETF provider’s web site to look under the hood. I was looking to find some discrepancies. It took some time but the geographic allocation in the fact sheet on the BMO Global Infrastructure Index ETF (ZGI) wasn’t global at all but had the majority of their holdings in North America.

  • 66.02% United States
  • 25.16% Canada
  • 6.71% United Kingdom
  • 1.56% Mexico
  • 0.56% Brazil

The top ten holdings also have a lot of pipeline companies who pay construction companies to build the actual  infrastructure.

  • Enbridge 10.07%
  • American Tower Corp 8.82%
  • National Grid Plc 6.71%
  • TransCanada Corp 6.68%
  • Crown Castle Intl Corp 6.07%
  • Kinder Morgan 5.87%
  • P G & E Corp 5.17%
  • Sempra Energy 4.25%
  • Williams Cos 96%
  • Edison International 3.82%

It takes years for pipeline companies to benefit from any new capacity to come on line. On the other hand, companies who specialize in construction & engineering like SNC-Lavalin or Aecon would see immediate revenue growth. I would recommend looking for another infrastructure ETF that had more global exposure with holdings of construction & engineering type companies.

Another example is the BMO S&P/TSX Equal Weight Industrials Index ETF (ZIN) which has a small discrepancy. The fact sheet says it has 26 industrial holdings but two of those holdings include airlines. (Air Canada 5.46% & Westjet 4.13%)  Now both of these companies buy industrial products but they specialize in transportation.

Here are some key steps all investors should take when evaluating ETFs:

  1. First, decide if you are going to be a do-it-yourself investor or work with an advisor. As their name suggests, ETFs are traded on exchanges, so they can be bought and sold like stocks through a discount brokerage.
  2. Make sure you understand the index underlying the ETF you are considering. Focus on how the index is constructed, what it tracks and how long it has been around. A longer record will reveal how the index responded to different market conditions.
  3. Check the fund’s fact sheet, are the underlying holdings and geographic allocation accurate? How does the exchanged traded fund compare with similar funds from other providers?
  4. Avoid ultra-short and leveraged ETFs, leave those to professional traders.

Ultimately, the proper implementation of ETFs in a portfolio requires, like all investment decisions, due diligence, caution and persistence. ETFs can offer many attractive features but their long-term value depends on how well they fit into an individual’s portfolio.

To evaluate an appropriate fit, investors have to be prepared to look under the hood.