Wealth and Income Inequality: What is to be Done?

This week, much will be written about the goings on and discussions that take place in Davos. This high powered gathering place serves as a platform for the ultra wealthy and not so ultra wealthy economists and professors to visit and discuss all manner of things economic. After years of stratospheric gains in global equities markets, the focus seems to have turned to what is to be done now that "we" are wealthier than ever, what can we do about the majority of world citizens that are being left behind? This is only a concern because obviously folks with no money or possibility of income struggle to consume the products that the "haves" produce. If the "have nots" don't consume it won't be long before the "haves" start to feel it. And what's worse is what happens when the "have nots" get really disgusted. It's called revolution and no one wants one of those. This is not hyperbole. The wealth gap is widening and the middle class is shrinking and at some point something's got to give. So what is to be done?

How Did We Get Here?

The Fed policies instituted since 2008 to combat the recession have contributed to the dilemma. By injecting massive and unprecedented liquidity in to the system to pick up the slack of reduced money velocity, the widening gap has been one unintended consequence of the Fed's actions. With the elimination of jobs to maintain profit margins, attrition due to technology, and the perceived lack of demand, US companies are not providing the jobs required to support a growing middle class. It is this growth that would mitigate some of the growing disparity between the wealthy and the rest of society. As a result, the injection of liquidity has found its way in to assets that are held mostly by the wealthy. This actually was intended. The desired result was a "wealth effect" that would stimulate the economy and start the "virtuous cycle" that would raise all boats. Unfortunately, this does not appear to have taken hold as of yet. There are certainly indications that economic activity has perked up and to no small part due to fatter stock portfolios and stronger balance sheets. However, this has not caused the uptick in hiring that is really needed to drive the economy higher.

Some Thoughts and Ideas to Combat the Gap

The easy answer and most widely discussed and applied approach is the tax approach. Tax higher income earners at a higher rate and apply those monies to social programs. There is no empirical evidence that shows higher earners will be dissuaded from earning more as they pay more in taxes. They simply earn what they earn and will keep as much of it as they can. Taxing passive income at higher rates is another tax approach that, in theory, hits the wealthy more as they own the majority of assets that produce passive income. Some example of these are rental properties, stocks and bonds, and other financial assets.
But taxing has proven to not be the best or most effective way to "spread the wealth" amongst the different groups in our social strata. There must be better ways to reallocate a portion of the wealth created in this country and around the globe, as this is truly a global issue. Bill Gates and George Soros can serve as examples of individuals who have taken a stand against social issues such as poverty, health care and education. We can use these folks as exemplar figures to be emulated. An organization like the Bill and Melinda Gates Foundation is a good example of something to be emulated and replicated on a global scale. The effort in this case could be to provide the education, training and hands-on experience that many citizens lack to achieve employment and become self reliant and productive members of a thriving economy. Employment agencies both public and private exist but are not sufficient or effective enough for one reason or another. The weakness of public run agencies is the overwhelming need and inadequate resources to provide help. The weakness of private agencies is the profit incentive creates an obstacle from all parties getting a "fair shake" when trying to get assistance. Directing philanthropic efforts towards employment in addition to the traditional philanthropic goals could help mitigate the growing gap.
On the other side of the equation are the corporations and companies doing the hiring. They need additional incentive to hire. Corporations cannot and will not hire just to hire from a  philanthropic perspective. They exist to make profits for their shareholders, they do not exist to create jobs for the sake of creating jobs. Labor is typically the largest cost component companies have. Some mechanism must exist to incentivize, or at least mitigate, the cost companies carry when confronted with the prospect of hiring additional staff. Economic uncertainty is a large obstacle companies face when considering when and how much additional staff to put on the payroll. Offering tax incentives for hiring domestically instead of overseas would help domestic economies and have the stimulative impact of improving the condition of consumers locally. The loss of these tax incentives for local governments could be offset by higher income taxes of the newly hired and creates a win-win solution.
The best, most productive and effective way to combat the growing income and wealth gap is to create more jobs and get the most important resource we have, the human resource, back to work. Simply taking money away from the wealthy and just giving it to the less prosperous is not the answer. There needs to exist a stimulative byproduct of the distribution of wealth.

Happy New Year - Where We Were and Where We're Headed in 2014?

First and foremost, Happy New Year to all. 2013 was a good year for equity markets and now it's time to briefly look back at what transpired in the economy and the markets and what may happen looking forward to 2014.

Where Did We End 2013?

The Dow Jones Industrial Average ended the year at 16,576.66, a rise of 26.50%, not including dividends, from the close in 2012. The Standard & Poor's 500 Index finished the year at 1,848.36, up 29.60%, not including dividends, from the close in 2012. The Nasdaq Composite closed the year at 4,176, up 38.3%, not including dividends, from the close in 2012. The Russell 2000 Small Cap Index closed the year at 1,163.64, up 37.0%, not including dividends, from the close in 2012. The 10-Year US Treasury Bond closed the year with a yield of 3.03%, up from a yield of 1.76% on December 31, 2012. The average 30-year fixed rate conventional mortgage was 4.18% in January 2012. Todays comparable rate is 4.69%. So 2014 is starting off with more expensive credit for homeowners and prospective homeowners. Real gross domestic product (GDP) growth in the fourth quarter of 2012 was 0.40%, GDP growth in the first quarter of 2013 was 1.80%, GDP growth in the second quarter of 2013 was 2.50% and GDP growth in the third quarter of 2013 was 4.10%. Fourth quarter and annual estimates for 2013 will be released January 30, 2014. Throughout 2013 the growth trend for GDP was upward. Inflation for the third quarter of 2013 was 1.80% after trending upwards through out 2013.

Where are Things Headed in 2014?

With the information above as a backdrop, where are the economy and markets headed in 2014? One of the biggest concerns expressed this time of year is can the market replicate the massive run it had over the course of the prior year? After such a strong 2013 for equities, is it realistic to expect additional powerful returns from the major indices? Most money managers will try to spin any positive they can from the momentum of the past. Further gains are certainly possible. Let's take a look at some trends that may guide us and some market milestones that may give us perspective and context for what may unfold going forward.
For context, it is important to note that in addition to gains of nearly 30% or more for each of the major equity indices, it is important to point out that all of these indices, with the exception of the Nasdaq, closed 2013 at record highs. This is important as it gives us some perspective on the resistance these indices might face moving forward and seeking further gains in the new year. I believe this is the singular reason many money managers are less sanguine entering 2014.
With many market experts attributing the gains in equities to easy money Fed policies, which we've touched on ad nauseam in this blog, the Fed's announcement to begin tapering its bond purchases at its December meeting was at least initially greeted exuberantly by markets. However, this reduction in monetary accommodation cannot be ignored for what it is: a subtle shift in stance away from accommodation and towards tightening. Most market pundits are not calling the Fed move  tightening. If it's not tightening, what is it? Less accommodation? Where does that lead? I believe the folks managing money in 2014 are quietly viewing this move as a tightening of sorts and their actions will speak volumes to this. Less liquidity will naturally lead to less exuberance  for gains in equities. With this tailwind reduced and ultimately eliminated, further gains in equities will require more solid underpinnings by market fundamentals such as earnings growth and more specifically, revenue growth. It will be corporate America's ability to produce this growth that will dictate how equities fare going forward.
The economic outlook is fairly optimistic. GDP has trended higher throughout 2013 and the latest GDP figures exceeded expectations pointing to upside surprises going forward. Corporations are broadly expected to make larger corporate expenditures in the new year. One line of thinking is that with less incentive to reinvest the existing corporate cash horde in corporation's own stock will mean more outside investment to grow business lines. Therefore the outlook for an improved labor market as a result of this investment is anticipated. Demand for goods and services should increase with a more robust labor market. This evolution can be thought of as the "virtuous cycle" that is often referenced in a healing economy. Equity markets lead the economy out of recession and this time around appears to be no different. The current economic improvement may be fully discounted by the markets and leave little to gain. This is a very real possibility and underpins concerns held by money managers hopeful for more gains this year. More than a few market pundits have suggested that markets have borrowed from future returns (the market's discounting mechanism at work).
One ironic concern of the market is that an improving economy can bring with it some unwanted consequences that may create headwinds for further equity gains. One of those consequences is rising rates. The 10-year Treasury yield climbed throughout 2013 and with it mortgage rates climbed as well. This is a natural result of an improving economy that, without the artificial hand of the Fed, would cause yields to rise. Rising rates can hold back some parts of the economy, specifically, the housing market. Rising mortgage rates may hinder homeowner's ability to refinance their higher rate loans and hurt the deleveraging process required for a healthy consumer. Will higher mortgage rates hold back further gains in real estate in 2014? This is a real possibility. A large component of a healthy consumer is their ability to leverage the value of their homes and access the capital markets. If real estate struggles for further gains in 2014 because of rising mortgage rates and banks do not relax their lending standards, homeowners will be challenged to maintain, let alone, increase their consumption habits. As consumer consumption makes up such a large component of the US economy, GDP and corporate revenues would suffer without a healthy consumer.

Looking Forward and Making Wild Guesses

Few stock bull markets last beyond five years. The average bull market lasts 3.8 years. In March of 2014, the current bull market turns five. History is not a perfect forecasting tool for future performance but at least this statistic gives us some perspective. Armed with this knowledge we can attribute some probabilities to the likelihood of the current market run to continue. Here are the factors I am considering when I think of the likely performance of the stock market throughout 2014:
"Goodbye Mr Bernanke, it's been real" Whether you prescribe to the Fed's influence on the stock market's performance or not, what is undeniably true is that the Fed has been accommodative and supportive of this market for years. What the Fed has not done is get in the way in any shape or form to hold the market back. At the least the Fed was never a headwind to the market. Rates have not only been held at zero for years but the Fed has gone out of its way to assure the market that rates will stay low for an "extended" amount of time (read: forever). Whether the Fed is technically still accommodative doesn't matter any more. Once the Fed announced its taper at the December meeting everything changed. Market strategists will always tell you, "it's not the numbers, it's the trend". Well, you can't have it both ways, the trend from the Fed is "less" accommodation and that's all that matters. For all intents and purposes, the Fed is not the tailwind it once was.
Interest rates and bond vigilantes. It is likely that we have seen the low in interest rates. Could we get back to record lows some day down the road, yes. Is it likely? When you consider how bad things would have to be for us to get there, I think we have bigger problems than what the stock market is doing at that point. No hyperbole there. The Fed may think it can control interest rates for the time being, but it cannot control them forever. Forever is a long time. The elephant in the room is the Fed losing control of interest rates. If for some reason inflation becomes a legitimate problem in 2014, market forces will take control of interest rates and the Fed will lose control of rates. Regardless, rates will rise throughout 2014 as the economy improves. Rising rates will be a headwind in 2014 and until the economy acclimates to these higher rates, consumers will be restrained for the reasons mentioned above, and consumption will be muted.
NO ATM for you! Despite the surge in real estate prices since the dark days of the recession, homeowners cannot use their homes as ATMs as they did in the past.(Values are not quite there and banks are not quite there) I think people underestimate how critical this was to how well our economy performed in the past. It may be anecdotal, but I see fewer boats and RVs in driveways today. Despite what will likely be a healing labor market, the additions to the payrolls is not likely to add significantly to consumer consumption as thousands of the unemployed roll off unemployment benefits.
For these reasons alone I think market performance is muted in 2014. On a net basis, ignoring hims and haws throughout the year, at best the market will likely close flat for 2014. Specifically, the Dow will close 2014 at 16,500 and the S&P 500 will close at 1,850. The 10-year treasury will yield 3.75%.  GDP will be respectable for 2014 and labor markets will improve. In essence, my belief is that the market has borrowed from the future and will play catch up in 2014, taking a much needed breather. The fun part of guessing is we get to sit back and watch things unfold. Good luck in the new year!