Stock Investment Tips Blog

I think all of us have a lot of respect for Warren Buffet, so whenever he gives us a tip on how he invests or gives an insight on how he invests, we listen. One point he made recently was to look at the total stock market capitalization compared to GDP. In recent years, market has done better when it’s in the 80% range than when stocks are valued above GDP. This, of course, rang true the most during the dot com bubble.

I’m not going to delve into checking up on this, since even if I did, I’d probably mess up somehow. But one point I would make is that whatever correlation there, we also need to factor in government’s percentage of GDP.

Since GDP is just calculated as Consumptions + Investment + Government + Net Exports, simply increasing government will increase GDP, but that won’t necessarily increase corporate profits. At the extreme example would be a completely communist country where there would be no corporate profits (no stock market in general) since they would all be seized by the state. Of course, the country still has GDP, since the government spends money. We would expect that countries with a higher percentage of GDP made up by government to have a lower stock market capitalization/GDP compared to more capitalist countries.

In short, all GDP isn’t created equal when it comes to corporate profits. An increase in GDP due to consumption/investment bodes well for stock profits, whereas one driven by government does not.

I assembled some data from the CIA world factbook comparing the total stock market capitalization/GDP. Since the data is at the end of 2007, valuations were obviously much higher then:

USA:  137%

Japan: 92%

France: 68%

UK: 143%

Germany: 55%

There’s a wide variation, but with the exception of the UK, the trend is clear. Out of these, our situation most resembles Japan, in terms of corporate taxes, debt/GDP, and the ultimate amount of government spending will be a part of GDP. Let’s make a rather bold assumption and assume that our market and Japan’s market was about equal in terms of accuracy of valuation at the time. Given that, we would ultimately expect the market’s capitalization/GDP to be about 33% less on average than it was during Reagen/Bush/Clinton years after Obama and Congress are through with their stimulus plans and tax hikes.

Newspapers in the UK are littered with reports of companies moving from the UK to Ireland to take advantage of the lower corporate tax rate. In the UK, the corporate tax rate is 30%, while it’s only 12.5% in Ireland. Many companies that are able to move to take advantage of the lower rate have moved, including Shire (SHPGY) and advertising giant WPP (WPPGY).

In the United States, we currently have the second highest statutory corporate income tax in the world (after Japan). Everyone knows that the effective rate is currently much lower due to corporate loopholes, the largest of which is that companies are not taxed on income from their foreign operations that is not repatriated.

The Democrats have long threatened to tax this income, citing increased government revenues as well as punishing companies for shipping jobs overseas. Conveniently ignoring data indicating that America is actually helped by these foreign divisions, the democrats have promised to kill this loophole. Obama mentioned closing this loophole in his speech last night, which was greeted by a standing ovation.

Almost every competent economist has stated that closing the loophole without a decrease in the corporate tax would be a disaster. Most of us have assumed that if Obama does in fact come through with his promise, it would include a sizeable reduction in the corporate tax. These changes, on the net, would not necessarily be terrible. They would disadvantage the multi-nationals but would be favorable for purely domestic companies.

I will fade Obama and the Democrats competence in this department any day though. I would not be one bit surprised if they decide to close this loophole and only reduce the corporate tax by a smidgen (perhaps 1-2%) if at all. They don’t need one Republican vote in the House to get this passed (as proven by the stimulus bill), and it is not too difficult to sway a couple of the weaker Senate republicans to prevent a filibuster. Obama certainly will not bring the corporate tax down to 20-25%, which when you factor in state corporate taxes, is what America would need to do to keep our corporate tax competitive.

While we are busy toying with socialism in America, Canada is going in the other direction. Their government has already enacted measures that would bring down the federal corporate tax to 15% and the provinces to have a max corporate tax of 10%, making the total tax burden 25% (compared to our 39%) by 2012. The government also has sizeable tax breaks for Canadian small corporations, with those making $500k or less a year generally paying less than 15% tax total.

Given the vast corporate tax disparity, a gradual corporate flight from the US to Canada could happen. Many industries, such as IT, are easily relocated. Those that move to Canada instead of staying in the US will be at a sizeable advantage. While politicans in the United States are attempting to bleed the last dollar from its companies and its people to pay for entitlements and stimulus programs, the companies that move to Canada are able to steal market share since their government leaves them alone. 

I run a small internet business that has about a dozen or so part-time employees and contractors. Almost all of the profits we make are reinvested back into the business (since it’s an LLC and those profits are above $250k a year, that means more money goes to the government instead of to expanding the business soon). I’m one of those entrepeneurs politicans say they love to help. I cannot think of an administation more hostile to both big business and entrepeneurs than Obama’s. Killing the corporate tax loophole and decreasing the corporate rate by 1-2% would technically favor companies like mine (if it were fully incorporated) over multi-nationals. Nonetheless,the clearest way for a company like mine to grow and prosper would be to just leave this country as well.

Disclaimer: Author does not own any shares in companies mentioned in this article

I’m one of the newest members of the ‘we are the next Japan’ community. The similarities are just too striking. A real estate bubble, followed by a financial crisis with no clear solution. Wasteful government spending, ballooning the countries debt/GDP ratio (Japan is at 170%, we’re projected to be at least 120% and our ’stimulus’ plans have just started). We share the highest corporate tax rates in the developed world. Midway through this mess, both countries raise taxes. Japan raised a consumption tax, and the Democrats are projected to let the Bush tax cuts expire for those making $250k or more (if any of those people are left).

My Democrat friends will quickly point out that Japan raised a consumption tax, whereas we will just raise income taxes on rich people (who just burn their money lighting their Cuban cigars while making an evil laugh). After all, it’s not like people making $250k or more would ever actually spend their money or put it towards expanding their own businesses (since that group is disproportianatly composed of successful small business owners).

There are some other differences as well. Japan’s asset bubble was seemingly worse in terms of overvaluation of assets, though at least their people had actual savings. Japan’s preferential method of wasting money was building bridges to nowhere, whereas we prefer to spend $10 million so some middle school can have a state-of-the-art drill team.

Even if we are the next Japan though, that does not necessarily mean stocks are a sell. Let’s look at how the Nikkei did. The Nikkei’s peak was about 38,915 in 1989. In 1990, it dropped to 23,848, a loss of 38.7%. The S&P 500 dropped 38.5% last year.

In 1991, the Nikkei closed just shy of 23,000, recording a small loss on the year. It ranged though from 21,456 to just over 27,000. Given the S&P 500 is already 50% off of its highs, it means our low is lower than their low in the second year of their great bear market, and we have a lot of temporary upside to go.

The Nikkei then cratered again in 1992, ending the year around 17000, a loss of about 26%. From 93-99, their market seesawed. It then boomed with the tech bubble and has now bust along with ours, with the Nikkei just above 7400 today.

This is a crude comparison, but it serves as a reminder that even if a decade of economic malaise is ahead of us, stocks aren’t necessarily a sell right now. If we’re on the same path of Japan, stocks are due for a short bull run before collapsing again. As bearish as I may be about US economic’s future, I won’t bring myself to short stocks right now.

But if we hit S&P 950 again, it’s time to sell, sell, sell.

Disclosures: Long stocks….for now.