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Market Commentary Second Quarter 2014

July 10, 2014

U.S. STOCK AND BOND MARKETS

During the second quarter of 2014, the major U.S. stock market indices climbed higher. The S&P 500, Dow Jones Industrial and NASDAQ Composite averages posted gains of 5.2%, 2.8% and 5.5%, respectively. Those indices have now posted respective year-to-date gains of 7.1%, 2.7% and 7.7%. However, smaller company stocks as a group experienced a 10% decline during the quarter, another sign that the bull market, now five years past the 2009 lows, might be losing energy. Coupled with the unusual, bearish stock market decline in January, smaller stock weakness is another sign to keep us alert for possibly broader weakness later this year.

The stock market is bullish, but it looks like a tired bull.   Contrary to the fears of most investors, interest rates on U. S. Treasury issues declined again in the second quarter, pulling yields lower on corporate bonds and other fixed income such as preferred stocks. Longer-term fixed income investments, including preferred stocks, have been strong performers thus far this year after sustaining sharp declines in 2013.  We do not forecast any further decline in longer-term interest rates, but neither do we see any economic catalyst to drive interest rates higher. Similar to our attitude concerning stocks, we are watching for changes in the bond market that might foretell higher rates and lower prices.

TODAY’S GREAT DEBATE (or one of them): INCOME INEQUALITY

Last quarter, we examined one of the hot issues for political debate, that being the cause or causes of the economic recovery’s historic weakness.  This quarter, we examine another issue dear to many in Washington:  widening income inequality among U.S. workers. Many Democrats charge Republicans with promoting policies that “unfairly” entrench the wealth of our richest citizens, the fortunate “one percent.”  Republicans defend with an assault on Democrat policies that stifle economic growth and suppress income and wage growth.

In October 2011, the Congressional Budget Office (CBO) released a study dividing U.S. household incomes into quintiles and showing changes in the proportion of total national income earned by each quintile during the period spanning 1979 through 2007.   For the nation as a whole, average household income adjusted for inflation and government transfers grew 62%. However, the earnings of the top one percent grew 275%, while the earnings of the remainder of the top quintile grew only 65%. Meanwhile, the “middle class” (percentiles 21-80) experienced household income growth of only 40%, and earnings within the lowest quintile grew just 18%. Thus, the share of national income earned by the top quintile rose from 43% to 53%, even after factoring in higher taxes, and the proportion of national income earned by the bottom 80% shrank, even after government transfers. (The CBO reports that four-fifths of the increase in upper class income during the later years of the study period resulted from capital gains, although the very long-term driver of income inequality is differing growth rates of wages.)

THE EFFECT OF GOVERNMENT POLICIES

Government policies to tax incomes progressively and to assist the poor have had only a modest effect in addressing income inequality. Based upon before-tax incomes, the top one percent earns 21% of the nation’s income, and the bottom quintile earns only 2%. After accounting for income taxes on the wealthy and government transfers to the poor, the top one percent still earns 17% of the nation’s income, while the bottom 20% earns 4%. Income taxes and government transfer programs have had almost no effect in shifting the proportion of income received by households between the 41st and 95th percentiles.

REASONS FOR INCOME INEQUALITY

So why is inequality increasing? The CBO reported that “the precise reasons for the rapid growth in income at the top are not well understood,” although they might include “technical innovations that have changed the labor market for superstars…., changes in the governance and structure of executive compensation…and the increasing scale of financial-sector activities.” We have no data and thus no comment concerning “technical innovations that have changed the market for superstars” and “the increasing scale of financial-sector activities”. We do note, however, that several hedge fund managers are now billionaires, and that the average 2012 compensation for Goldman Sachs employees was $400,000, according to the Wall Street Journal.

THE INFLUENCE OF EXECUTIVE AND DIRECTOR COMPENSATION

However, we have data concerning “changes in the governance and structure of executive compensation”. A 2013 research study published by Lawrence Mishel and Natalie Sabadish reported that, between the years 1979 and 2012, annual CEO compensation including the exercise of stock options increased 875%, more than double the gain in the stock market and much more than the total annual compensation growth of only 5% for private sector “production/nonsupervisory workers.” (According to the study, average private sector non-supervisory worker compensation has only increased from $48,600 per annum to $51,200 per annum during this 34-year period.)  The study reports that “measured with options granted, CEOs earned 18.3 times more than typical workers in 1965 (and) the ratio peaked at 441.3-to-1 in 2000.”

CEOs still earned 202.3 times more than “typical workers” in 2012. Advocates of stock option grants argue that stock options, exercisable over a period of years, help retain key employees and focus their efforts on corporate performance more acutely. Critics of large executive stock option grants, including Warren Buffett, point out that incentive packages would be better focused on internal measures such as a company’s return on invested capital, not on its stock price that is arbitrarily influenced—sometimes dramatically—by the actions of outside investors.

Buffett has been quoted as calling stock option grants “equitable only by accident” and “free lottery tickets.” We think Buffett has a valid point. Consider the case of a hypothetical company whose management team makes strategic errors, driving down the stock price from $30 to $15 per share. Assume that a friendly board of directors retains the management team and grants more options exercisable at $15. If the company simply stabilizes and the stock price recovers to $30 over time, outside shareholders will have realized no gain during this period, but the management team will be holding riskless options that now are worth $15 per share.

According to Bloomberg News, corporate directors’ compensation has also become more lucrative, averaging $251,000 in 2012. With so much money in board fees on the line, a board could easily lose its focus on protecting outside shareholders from the errors of a poor management team.

In the last quarterly letter, we noted that corporate managements are increasingly using their company’s cash flows to repurchase and reduce their own shares outstanding rather than increase capital spending and thereby sales. In essence, they are increasing earnings per share by shrinking shares rather than growing gross earnings. This form of capital allocation can boost the rate of earnings per share growth for years, usually beneficial for shareholders. However, it also explains why corporate capital spending is near 50-year lows while net share repurchases are near historic highs. Rationally, large stock option grants may have influenced this strategic shift.

INCOME MOBILITY AS AN ECONOMIC COUNTERMEASURE

If “income mobility” rather than income inequality is the most important measure of a “fair” economy, then the U.S. economy should receive high marks. The Treasury Department has conducted two 10-year studies on “income mobility” in the U.S., the latest one covering the decade 1996 through 2005. In these studies, Treasury reviewed 84 million federal income tax returns covering 120 million taxpayers, analyzing changes in their declared income over time. What the latest study found is that 56% of taxpayers in the lowest quintile in 1996 had moved higher, with 29% of the lowest quintile members making it into the second highest quintile and 5% into the highest. Half of middle income taxpayers in 1996 moved into a higher quintile by 2005, while only 21% fell into a lower quintile. Finally, 31% of members of the highest income quintile in 1996 fell to a lower quintile by 2005, and 3% fell all the way to the bottom.

Rather than viewing inequality as a problem to be fixed, perhaps it is a positive sign of an increasingly dynamic U. S. economy that offers skilled workers the opportunity to build immense wealth. Consider the remarkable story of Ukrainian immigrant Jan Koum. In 1992, Koum’s mother immigrated with her teenage son Jan from Kiev to Mountain View, California, where Koum attended high school and later San Jose State. Koum worked at a grocery store, his mother took babysitting jobs and they received food stamps to make ends meet in the early years. Several years later, Koum terminated a nine-year career at Yahoo and went on to co-found WhatsApp, a company that provides messaging software used on smartphones. Early in 2014, Koum and co-founder Brian Acton sold WhatsApp to Facebook for $19 billion, and the formerly indigent Koum now sports a net worth estimated at $6.3 billion. Koum’s move from poverty to immense wealth took only 22 years. Speaking of Facebook, it produced ten billionaires with its 2012 public stock offering, less than ten years after its 2004 founding. Facebook also enriched the four founders of Oculus VR, which was founded in October 2012 and sold to Facebook earlier this year for $2 billion. History shows that wealth (and poverty) can be created rapidly during times of transformational change, such as the present.

OUR OUTLOOK

Our outlook for stocks, bonds and cash reserves remains unchanged. Stocks are priced at abnormally high levels, but we do not see any catalyst to create a decline.  Bonds yield less than normal in relation to history and to inflation, but we also see no catalyst to change this status quo. Recognizing that markets are unpredictable, conservative investors are not foolish to hold some cash reserves with the belief that higher than normal stock and bond prices will adjust lower at some point.

As always, we welcome your thoughts and comments.

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