Scapegoats for Inequality

Inequality clearly exists and is even pronounced compared to other periods. AOC, Bernie Sanders, Robert Reich and others from the left have challenged the legitimacy of the very existence of billionaires, though I wonder if this includes Taylor Swift, Oprah, Steven Spielberg, and Tiger Woods.

The assumption that the existence of billionaires is the cause of the problems of the poor and middle class is zero sum thinking. The high price of gasoline, beef, housing, medical care, and higher ed is not the fault of the rich; it is caused by the very government they herald as the solution to the problem. Further these problems are more pronounced in the blue states that have had one party control for decades.

Billionaires are not conspiring to drive up the costs. Billionaires and the very wealthy are not a monolithic group; there are liberals and conservatives among them. While the wealthy are able to influence government policy, they also have the ability to champion positive changes to it. Fighting this influence is one of government policy more than a commentary on the morality of wealth.

Nor are the answers radical changes to the constitutional structure. The problem is not the electoral college, the structure of the Supreme Court, or the need to add Puerto Rico and DC as new states. The answer is policy to relieve the problems of the working and middle class.

There are changes that have merit and should be considered, but the government has little credibility and trust. Many of the wealthy are willing to pay more taxes but have little faith it will be spent to address the problems. The inability to bridge partisan divisions and enact meaningful reform has instead fueled class warfare, political pandering, and the search for convenient scapegoats.

Why are Stock Buybacks Bad?

The Sinema negotiation on the Orwellian named Inflation Reduction Act levies a tax on stock buybacks.

As Tyler Cowen notes it is a tax on capital, a bad idea in neutral times and a worse idea in a recession or whatever you choose to call a multi period decline in GDP.

Historically buybacks were a good idea when a) the stock market price of a company is low and b) when the company has generated more cash than it can prudently deploy. Cash can be deployed either with dividends when it is a consistent and predictable flow or buybacks or special dividend when the surge in cash holdings is deemed less predictable. Buybacks compared to special dividends gives more discretion to the shareholders. The market is not tolerant of inconsistent dividend policy.

Some companies use excessive cash to buy unrelated businesses and often these have turned out bad. When a company buys back shares they buy it from shareholders who willingly sell their shares to deploy their capital elsewhere. When they sell their shares the gain is subject to taxes, so it is not like a buyback generates no tax revenues (unless the shares are sold by non taxable endowments or non profits).

Taxing buybacks is an incentive for large companies to get larger, hoarding cash or to make bad investments. It seems much more prudent to let shareholders keep their shares if they wish for longer term benefit and let those cash out if it suits their individual circumstances. Buybacks are just another form of free flowing capital which should be encouraged.

Buybacks are criticized as a tool executives use to boost their bonuses. Theoretically when executive bonuses are contingent on the stock price this can be true, but such decisions are rarely made by a single executives. Warren Buffett is critical of such bonus plans but they are common. I also oppose an executive reward based on stock price, but this concern is vastly outweighed by the benefits of free capital flows.

There are other means to address concerns of excess CEO compensation which Warren Buffett addressed here and here.

Sinema’s buyback tax only makes a terrible bill much worse.

The Covid Market

The sharp rebound of the stock market has been as surprising as the sharp selloff in March. Unemployment has reached levels unseen since the Great Depression of 1929; production has dropped 40% and M2 money creation is up 25%, all in the space of only a few months. There seems to be no limit to the size of the deficit we are willing to accept in the face of this crisis, and nobody seems capable of assessing the risk of these record deficits.

The huge drop in production coupled with the record monetary growth would seem an inevitable prelude to inflation, yet it is not yet visible. The common stimulative tools are unable to overcome the fear that is blocking consumer behavior.

Why is the stock market so resilient?

It is misleading to speak of the market as a single organic entity that moves in unity. The Covid market has diverged into the tech sector which is hitting new highs and the rest of the old economy which is struggling. It is common to see the tech laden NASDAQ go up on the same days that the Dow goes down. Tech is disproportionately represented in the S&P 500.

There are some special situations in the Covid economy that benefitted certain companies. Teledoc hits new highs as the regulatory roadblocks to telemedicine tumble. Dollar General hits new highs as its small markets attract consumers from larger more crowded venues. Chewy, the pet supply mail order, serves a growing market for shut-ins that want the company of pets. Animal shelters are emptying their pens. Papa John’s Pizza, already designed for home delivery, hit record sales. Clorox hit new highs in the midst of the selloff.

Energy, banks, travel, hospitality, insurance, and restaurants were all heavily hit, and remain below pre Covid levels.

Can you imagine how much more difficult this isolation would be without Amazon, social medial, and conferencing apps like ZOOM? We are ever more dependent on our digital connections and the stock prices in that market responded accordingly?

We are forced to recognize efficiencies that will remain when the virus passes. Media personalities broadcast from home, telecommuting is more acceptable, and online classes have moved to the default position.

When the vast amount of money from the Fed is dropped on the economy it does not matter where it is directed, much of it will find its way to the service providers and producers where the money will be spent. When trillions of dollars are pulled from thin air and dropped on the economy it is inevitable that much of it will find its way into the stock market.

In the short run the market is a voting machine, but in the long run it is a weighing machine. The prices for shares are ultimately dependent on the value the underlying companies can produce, but it is also dependent on the alternatives available. This tallest midget scenario has driven this market for the last ten years. Interest rates on short term and long-term securities are at record lows, real estate will be very regional dependent, and other alternatives have limited liquidity and lack the critical mass of the stock market. In such uncertain times the liquidity premium makes stocks more attractive; with a click shares can be turned into cash commonly without any commission or fee.

This does not reduce the risk in equities. There is little understanding from the most credentialled, and even less agreement on how the dramatic actions from the Fed and the Congress will unwind. Investors can tolerate known unknowns much more than unknown unknowns. Fear drives the equities market just as it is affecting the underlying economy. For a lot of investors low returns on cash is still preferable to the potential losses in a market that few understand.

Covid Thoughts 2020 04 18

Human progress seems to come in waves of euphoria and depression, and each is in many ways a reaction to the other. At our pinnacles we delude ourselves into thinking we have overcome our fragility; in the abyss we underestimate our inner strengths and resiliencies. This is amplified by a media fueled by partisanship and outrage, and social media where everyone gets a big microphone unfiltered by professional standards, objectivity or reason. (This is not to suggest that the professional media has universally adhered to respectable standards.) As Peggy Noonan observed in Patriotic Grace, we now read for confirmation, not information.

The decision to shelter in place and to place the economy on pause is a first for this country and was greeted with reluctance and skepticism, and eventually fear. Based on projections we expected the mortality to be much higher than the flu, and we were told we were unprepared with enough supplies and thus we needed to flatten the curve; intentionally lengthening the duration of the outbreak in order to reduce peak loads on certain hospitals.

Shuttering large swaths of the economy is a huge unquantifiable cost we would only consider in such a dire health care scenario. It appears that new information reflects a significant overestimation of the mortality. When we referred to the mortality, we compared the number of deaths to the number of DIAGNOSED cases and compared that rate to the last flu which measures the number of deaths to the number of ESTIMATED cases, understanding that many who have the flu never see a doctor. As new studies estimate the number of cases that are never diagnosed the mortality rate drops significantly – more in line with the seasonal flu. How Many People Already Have COVID-19? These studies are small samples and may be regionally biased, but the comparisons should at least be based on the same criteria.

Secondly the shortage of respirators also seems over estimated. From National Review, The Ventilator Shortage that Wasn’t:

Now New York appears to have passed the apex. Deaths, a lagging indicator, crested at 799 on April 9 and hit 606 on April 16, the lowest figure since April 6. Hospitalizations are also declining, and on April 16 also hit their lowest level since April 6. Cuomo today has so many ventilators he is giving them away: On April 15, he said he was sending 100 of them to Michigan and 50 to Maryland. On April 16, he announced he was sending 100 to New Jersey.

If we were better informed on mortality and supplies would we have decided to pause the economy with its huge costs?

We will never know how effective the shelter in place orders were, but they likely saved lives and the heightened hygiene being practiced would likely have saved lives with any flu and will continue to benefit for years to come. Without a vaccine available and with treatments rushed through normal processes we still do not know how it will end. There is still a case to make for quarantines for the most vulnerable, and new measures to consider for large crowds and public spaces.

We cannot undo the decision made but the new data should help us design an appropriate reopening strategy. Better and faster testing would make us all more comfortable with steps back to normal.

In a Remnant Podcast (Episode 194) with Jonah Goldberg, guest James Pethokoukis suggested the importance of getting the back to work strategy correct; it would be insufferable to lead to a second surge in critical patients. He recommended that panel be bipartisan, professional and different from teams handling other issues.

The Opposite of Stock Repurchases

Generally, corporations avoid excess cash especially when it is low yielding. Their job is to generate cash and deploy it to generate a return on assets which with leverage becomes a return on equity. Using cash to buy back stock makes sense when you think your stock is undervalued and you do not have a better use for the cash in your existing operation or in an appropriate acquisition.

Warren Buffet as head of Berkshire Hathaway holds over $100 billion in cash. Shareholder activists have criticized this hoard as unfair to shareholders. Buffet is a long-time thinker and has used his cash to acquire other companies such as the $32 billion purchase of Precision Castparts, Inc in 2015- his largest. He is patient and willing to sits on his cash until a true value comes along. I assume he is getting ready to deploy much of the cash soon.

This huge cash position of Berkshire means they do not need a bailout. Others such as the airlines used their improved position from the corporate tax cut and the robust economy before Covid to buy back shares and now seek a bailout. I am not critical of stock repurchases; it is prudent and frees up capital for other shareholder investments, but if they retained that cash would the bailout be as necessary?

What about the opposite? If you can buy back your shares can’t you float more shares to raise money? When your share price is in the tank it is a terrible time to raise capital, but a bailout could come with stock options allowing the federal government to recover some of their aid when the market recovers. The government recovered much of its bank bailout in 2008 with similar conditions. The government took an equity stake in GM during the 2008 and sold the shares years later when it recovered. It did not recoup all of its investment, but it was much less costly than just an unencumbered bailout.

Few are more skeptical of this involvement in corporate governance and control than I am, but this is a different market. Care should be coded in the bailout to avoid long term ownership and taking more than this tiny step toward nationalization. While the businesses are suffering this shock, the government is as well. Our refusal to control our deficit and debt has left us with fewer means to address this crisis.

Warren Buffet’s investment in Goldman Sachs in 2008 was in preferred shared and warrants to buy additional shares in the future. This gave him a generous return in exchange for providing Goldman with essential liquidity at the proper time. While we need to be concerned about the financial condition of essential industries, we should not lose sight of the need to be concerned with the financial condition of the nation they want to bail them out.

Thoughts on Buybacks

Apparently, many people think buybacks are an inappropriate use of corporate funds and should be banned when receiving a bailout, which is part of the passed Covid Bill. I do not have a problem with that portion of the bill; buybacks are appropriate when you have no better use of the money or when they make economic sense. If you need a bailout then now is not the time to buy back stock.

Yet the ideal time to buy back stock is when the price of your stock is low and grossly oversold, and the interest rates are at record lows; precisely the conditions we now experience. It supports the price of the stock which is good for the market and it provides cash to investors who can redeploy in other investments or consumption which has a much-needed stimulus effect. Buybacks are a way to keep money flowing to better needs and opportunities.

The problem with buybacks is a common bonus system for CEOs that aligns their bonus with the share price rather than improvements in market share, return on assets, efficiency or other metrics that are more conducive to long term success. If CEOs can persuade their board to use cash or cheap credit for buybacks, they have an incentive to do so to boost their bonuses. The problem is not the buybacks, it is the perversion of the incentive systems. Executives should just own shares like the other shareholders to be aligned with their interests. If the politicos wish to restrict abuses of the bailout funds the better avenue is to restrict executive compensation; a move I would normally highly object to, but these are challenging times.

During the Clinton years executive pay deductibility was restricted. The response from the corporate world increased executive compensation. The problem with regulations is that they create the need for more regulations. Simple solutions to complex problems are fraught with unforeseen and counterproductive consequences.

From The Washington Post:

“In 1993, Bill Clinton signed into law his first budget, which created section 162(m) of the Internal Revenue Code. The provision stated that companies could only deduct the first $1 million of compensation for their top five (later top four after changes by Bush’s SEC) executives from their corporate taxes. The idea was to discourage companies from paying in excess of $1 million, as any additional compensation would be taxed. So why didn’t it work?”

“According to a new paper from Temple University’s Steven Balsam published by the Economic Policy Institute, the big flaw in 162(m) was its broad exemption of “performance-based” pay. The $1 million cap only applied to traditional salaries, bonuses and grants of company stock. Stock options (that is, stock grants that take time to vest and are meant to provide a performance incentive to workers) and other performance incentives are considered performance-based pay and are deductible even in excess of $1 million. So, unsurprisingly, businesses started paying executives more in the form of stock options, such that fully 55 percent of deductible executive pay was “performance pay” between 2007 and 2010.”

When CEO bonuses were paid in 2008 after the bailouts America was justifiably outraged and it is reasonable to include conditions to avoid this outcome again. It is equally outrageous and irresponsible to load this bill with unrelated political swag and enforce long term changes in corporate governance and other purely political agendas in order to address a very short-term set of problems.