Why Selling Might Be Smart

This semester I am in a global economics class taught by a guy who works full-time at the Federal Reserve and teaches us on Saturdays. He gave a giant disclaimer on the first day of class, that his comments reflected only his own opinion, not that of the Federal Reserve, etc etc.

Well, I am about to do the same thing. My opinion is my opinion, and does not reflect a magical ability to see into the future. I am not a licensed security broker, do not have secret morning coffee meetings with Ben Bernake, nor hold inroads to congressional decisions. However, I am a rabid reader of the Wall Street Journal, a CPA working in the financial/private wealth industry, an EMBA student taking economics at Columbia, and a blogger – therefore, I cannot resist weighing in on what I see as an approaching fiscal cliff (as an aside, Alan Blinder makes his own Fiscal Cliff arguments in theWSJ yesterday).

Initially I was going to lay out all of my arguments here for why you might want to consider selling stocks in 2012. However, after penning just a few arguments, this post is getting long enough that I already feel readers’ eyes glazing over. Therefore, stay tuned for potential future posts ranting about other economic aspects. 

       1. Future Tax Rates

Congress has done a magnificent job of doing nothing to seriously address our impending fiscal crisis. The deficit was covered ad nauseam in the news during last quarter of 2011, but has been rarely mentioned recently due to (I suppose) being buried under ‘more important’ presidential election news. But the deficit issues haven’t gone away. If anything, due to the wonders of compounding interest, they are growing even more dangerous. Assuming that nothing drastic changes, which is a safe assumption given the lame duck concept and a miserable congressional track record for working together, on January 1, 2013 tax rates will be heading higher. Much higher. 

A particular target will be capital gains tax and income tax brackets. While current long-term capital gains are taxed at 0-15%, this rate is set to rise in 2013 to 10-20%, plus an additional 3.8% medicare tax to help fund ObamaCare. So if you have stocks or taxable-interest bonds with LTD (life-to-date) gains, consider selling this year to harvest the gains at the lower tax rates. If you want to then re-invest in the same year, that’s fine – you will then enjoy a higher basis for future cap gains calculations. Be careful of wash sales though; you must wait 30 days before buying an identical security, or else the IRS treats the sale as if it never happened for tax purposes.

       

       2. Potential Economic Shocks

As I write this, the Dow Jones (DJIA) is at a multi-year high of 13,224. This alone should give you pause. Most investors are psychologically biased towards buying stocks high (you see the market going up, then buy in when the run is often almost over) and holding on to losers. Baron Rothschild, an 18^th century British nobleman who made a fortune buying in the panic following the Battle of Waterloo, famously suggested that the time to buy is “when there’s blood in the streets, even if the blood is your own.” 

The issue I see in the market is that there should be blood in the streets – but the market is priced as if a rosy economic recovery is right around the corner.

Why do I envision blood in the streets when the news tells us that Greek’s debt crisis is resolved, 225,000 jobs were added in February 2012, and consumer confidence is rising? Just because the media isn’t discussing it doesn’t mean that there isn’t a problem. My thoughts:

Greece: Yes, Greece came to a deal on its debt. But much like taking Advil for a headache, the deal treats the symptoms of the Greek crisis by cutting bond face value and extending payment terms (the finance term for this is “extend and pretend.”) It ignores the underlying cause of the crisis: Greek’s spending addiction and inability to collect taxes. Thus, Greece will inevitably face recurring defaults until it a) curbs spending (unlikely) or b) is  eventually unable to convince international markets to lend it money (more likely over time), creating default and some degree of chaos.

Inflation: Much of the indicators signaling an improved economy have resulted from the Fed holding interest rates near 0%. This low interest rate makes investment more appealing to businesses. In finance geek speak, this means that more projects have “positive NPV,” i.e. that they appear profitable because obtaining the money is so inexpensive. However, the dark side to low interest rates is impending inflation, and it will be exacerbated by increases in the money supply (basically the government printing money).

Macro economists explain this relationship between inflation and the money supply as π = %∆P = %∆M - %∆Y . Translated to normal-people speak, this says Inflation (π) is equal to the % change in prices (“P”), which equals the % change in the money supply (“M”) minus the % change in GDP output growth (“Y”). The government’s spending policies have created the following increases in the US money supply (“M”):

3 Months from Nov 2011 to Feb 2012: 12%

 6 Months from Aug 2011 to Feb 2012: 11.1%

12 Months from Feb 2011 to Feb 2012: 18.3%

(data from Federal Reserve)

The US annual increase in GDP output (“Y”) has historically been ~1%. Therefore, while inflation is currently suppressed due to the recession, over the long-term we would expect inflation to be ~17% based upon the last year of money supply increases (i.e. inflation = 18.3%-1%). Raising interest rates is usually the Fed’s weapon against inflation, since higher rates slow down the economy, but this slower economic growth creates recessionary possibilities. Either way, current expansionary fiscal policy (in other words, increasing the money supply) will create future inflation, or future dampened economic growth. Both are bad.

Housing Prices: Much of the US economy is driven by US consumption, and consumption is based upon people’s perception of their wealth. Lower home prices mean people feel less wealthy and thus they save more and consume less. This inverse relationship between savings rates and home prices can be seen below (source: YCharts; blue line is US personal savings rate, orange line is US quarterly home price index):

Home prices have obviously taken an incredible beating since 2007. While the rate of foreclosures on homes is slowing, there is still an incredibly large back-inventory of repossessed homes. Additionally, stubbornly high unemployment means the foreclosure rate could remain fairly high.

Until the backlog of foreclosed home inventory is sold, excess supply will likely keep home prices depressed, creating an “L-shaped” recovery where prices stop dropping but remain at current lows. With low home prices meaning low consumption meaning low economic output, this doesn’t bode well for our economy. The below chart, courtesy of Deloitte, shows the current rate of foreclosures and relationship to unemployment:

Stay tuned for more economics in later posts…. (oh boy!)

PS: Sorry for such a depressing post. If you need cheering up, check out yesterday's post on apple bread .