special dividends and (in)efficient markets

As I’ve already blogged about, many US companies are paying large special dividends to shareholders before December 31st. Either that or they’ve accelerated payouts planned for 2013, distributing them this year instead.  The idea is to avoid the presumably much higher taxes the IRS will be levying on dividends next year.  Some companies, like COST, appear even to be borrowing money to fund distributions.

The after-tax value of a dividend payment in 2012 to a taxable shareholder is likely greater than one made in 2013.  In addition, it may be possible to manufacture a tax loss from the transaction as well–something that would add another bit of extra value.  So it’s not surprising that stocks paying special dividends should be strong performers in advance of the day they start trading ex dividend.

I’ve been noticing another feature they seem to have, however, that I hadn’t anticipated.  The stocks appear to be “carrying” a large part–and in one case I’m aware of, all–the special dividend.  Here’s what I mean:

If a company’s stock is trading at $100 a share the day before it goes ex a $10/share dividend, then in a flat market you’d expect the stock to drop to $90 when ex trading commences the next day.  But the current crop of special dividend stocks aren’t acting true to form.  They’re trading at $93 or $95 or higher instead.

What could be causing this behavior?

I haven’t seen any cases where important news breaks on the day the stock goes ex.  The only thing that I can see is that a buyer is no longer entitled to the special dividend.

I have only one explanation, and a semi-crazy one at that.  I’ve concluded that buyers don’t know that the stock has paid out a large dividend.  Buyers think instead that the stock has just made a large downward random fluctuation that makes it an attractive purchase.

I have two thoughts:

–what I’ve just described could never happen in an efficient market, which tells you something about how much attention Wall Street is currently paying to stocks; and

–I wish I’d thought of this possibility before companies started paying special dividends, rather than when they’re finishing up.

more on the CPI–Laspeyres vs. Paasche

the current CPI

As I wrote yesterday, the CPI is a Laspeyres index.  That is, it takes a fixed basket of goods and services from a base year and calculates the changes in the total cost of that basket over time. A Laspeyres index always overstates the effect of inflation, however.  That’s because it doesn’t take into account the fact that people respond to price changes in some things by switching to less expensive substitutes that let them maintain the same lifestyle at lower cost.

The government thinks this overstatement has historically been about 0.2% per year.  The Social Security Administration estimates possible future overstatement to be about 0.3% annually.

Actually, the situation with the CPI is slightly more complicated.  Since 1998, the Bureau of Labor Statistics has been using a method that allows it to adjust the CPI if it sees, say, the price of Fuji apples rise and people switch to cheaper Honeycrisp instead (the government collects price data on over 80,000 items and includes regional price variations as well).  But it won’t adjust if people stop buying apples and switch to bananas.  So the practical effects of this index improvement have been small.

The BLS also computes a CPI for the elderly, using the same methodology but using a basket of goods and services that senior citizens surveyed say they use.  Those prices appear to be rising at 0.1% a year faster than the CPI itself.

a Paasche index is a non-starter

Paasche indices start with the current basket of goods and services that people use.  It works from the present back to construct an index of past price changes in the current basket of items.

A Paasche index tends to understate the effects of inflation because it assumes that on day one of the period being considered consumers instantaneously respond to all price changes that will occur over the period.  Hard to do if the price changes haven’t happened yet.  Also, not much practical usefulness, since the index data are only available after the fact.

a chain-weighted CPI

That’s what the current discussion in Washington is about.  It enables the BLS to adjust the CPI on the fly to shifts in consumer buying patterns based on price-driven substitutions.  The BLS has had a chain-weighted CPI up and running since 2002.  But until now the possible savings in Social Security payments hasn’t seemed to Washington worth taking on a powerful lobbying group like the AARP or the (misplaced, in my view) ire of senior citizens.

the role of the Consumer Price Index (CPI) in Social Security …and in a lot of other things

The CPI…

The CPI, produced by the Bureau of Labor Statistics of the Labor Department, is the government’s attempt to measure the change in the prices of goods and services paid by urban consumers, who make up 87% of the country’s population.

The CPI is the result of extensive data collection efforts, both from consumers to find out what items they buy and from retail outlets to determine how the prices of those items change.

The CPI is everywhere.  It’s used to determine the annual cost of living adjustment for Social Security, as well as for COLAs in government and private retirement plans.  It’s often used for the same purpose in labor contracts.  It’s also used by the IRS to adjust Federal income tax brackets for inflation and to set threshold levels for public assistance programs like food stamps.

The CPI is now in the spotlight as a bone of contention in the debate over reduction in entitlement benefits, as a way to close the large Federal budget deficit.

…is a Laspeyres index

This means it investigates what consumers buy during a base period (for the current CPI, it’s 2007-08) in order to arrive at a fixed basket of goods and services that it regards as typical. It calculates the total cost of the basket.

From that point on, it periodically checks with retailers to get current prices, using them to update the cost of the original basket.  The ratio of the total cost in today’s dollars of the basket, divided by the cost of the same basket back in 2007-08 is the current CPI value.

What’s wrong with that?

It depends on your perspective, I guess.   But as economists knew, even when the CPI was introduced as the COLA mechanism for Social Security in 1975, the Laspeyres method systematically overstates changes in the cost of living.

That’s because it ignores the fact that consumers constantly change their market basket of goods and services as the prices of items go up and down.  They react to higher prices by switching to less expensive substitutes that they may be perfectly happy with.  The result of this substitution is that the rise in the price of a given item in the original basket doesn’t necessarily mean a rise in consumer expenditure.  But the CPI acts as if it always does.


Suppose, for example, the BLS determines a family buys 10 pounds of chicken meat and 10 pounds of turkey.  Family members don’t really care which they eat.  If the price of chicken doubles and that of turkey remains unchanged, the family will stop buying chicken and buy 20 pounds of turkey instead.  So although the price of chicken has gone up the family’s food expense hasn’t.  Nevertheless, the CPI registers an increase.  The same for hamburger and turkey burger.

Or suppose the price of gasoline goes up and you join a carpool.  Or you buy a Hyundai instead of a Toyota.

Or you get fed up with cable and use Netflix and Hulu instead.

The CPI doesn’t pick up any of this.

a too-high COLA adds up

The Social Security Administration figures that using the current CPI upwardly biases cost of living adjustments by about 0.3 percentage points per year. Put another way, the 1.7% increase in benefits penciled in for 2013 should really only be 1.4%.  The rest is gravy for retirees.

Removing that upward bias from yearly Social Security COLAs would reduce total payments by an estimated $200 billion in the first decade.

the thin edge of the wedge?

Personally, I don’t consider this change in the way the cost of living adjustment for Social Security is calculated to be a big deal.  That’s because the use of the CPI has been the dirty little secret of legislators, Social Security recipients and labor negotiators for decades–although don’t try to tell that to a recipient.

Arguably, if a change to a more accurate cost of living measure for the Social Security COLA helps set the US back on a sounder fiscal footing, the subsequent rise of short-term interest rates to normal levels will benefit anyone with savings, especially seniors.

But once Social Security adopts another measure for COLAs, this sets the stage for replacement of the CPI elsewhere.  So the fight over Social Security may be more acrimonious than this program alone would warrant.

capital spending, robots and “reshoring” of manufacturing to advanced economies

Blogging for the New York Times, Nobel laureate Paul Krugman recently referred to a Times article on the possible return to the US of manufacturing once outsourced (or “offshored”) to Asia.  In “Rise of the Robots,” Mr. Krugman suggests that much (all?) “reshored” manufacturing will be highly capital-intensive.  Factories will be run by robots, with only a few, highly educated, highly paid human supervisors finding being employed.  Therefore, he concludes, reshoring isn’t the job creation panacea some might think.

I have several comments:

1.  This is not new news.

For over two decades, tech businesses like semiconductor manufacturing have been very highly automated.  Component assembly is increasingly so.  In  the semiconductor case, only a few process engineers watch over $3 billion installations that may generate billions in annual operating profit.  Units of output are tiny and weigh next to nothing, so transport costs aren’t that important.  As a result, tax incentives for building and the rate of tax on corporate profit are the two main determinants of where a plant will be located.

One reason there aren’t more fabs in the US is that income tax rates here are relatively high.

2.  At least some of the current reshoring is either in response to political pressure or to creating a more favorable corporate image in the media.  AAPL, an example cited by the Times, has pledged to invest $100 million to make Mac computers in the US.

Sounds good, doesn’t it?

But $100 million is less than 2% of the company’s annual capital spending budget.  So it’s just a drop in the bucket.  If we pluck a number out of the air and say the investment will generate $1 billion in annual sales, which I think would be an awful lot, that wouldn’t amount to even 1% of the $160 billion or so in sales that AAPL will ring up this year.  Plunk! (=the sound of a drop hitting the bucket)

3.  Stuff that’s very heavy, spoils easily or that faces strong protective barriers against imports, normally must be produced in the same country where it’s sold.

4.  For a brief time I owned shares of Osaka-based manufacturer Sanyo Electric in my portfolios.  I bought it despite its collection of ugly business lines because at the time it was by far the dominant global maker of cellphone batteries.  That business was growing like a weed.  It alone was, in my view, worth far more than the entire market capitalization of the company’s stock.

Because Japan was a high labor cost country, Sanyo had created a highly automated operation.  For each 20,000 units of annual battery production, it had installed machines worth $1 million, which were  watched over by six employees making $50,000 a year each (these are not the real numbers, but that’s not important  for my point).

Business was great–until Chinese competitor BYD emerged.  If the name sounds familiar, it became famous years later when Warren Buffett “discovered” it.  BYD didn’t have the highly educated workers available to it that Sanyo did.  So it couldn’t use the highly automated machinery that its Japanese rival employed.  Instead, it bought simpler, locally made machines that were manned by a larger number of less skilled workers.  To produce equivalent output to Sanyo’s, it installed $500,000 worth of its simpler machines, run by 20 people being paid $7,500 a year each (again not the real numbers–like the real Sanyo figures, those are in notes which remained the property of my employer when I left) .


The really stunning thing about this example is that:

–BYD made its batteries with both less input of capital cost and less input of labor than Sanyo.  In the textbooks that’s not supposed to happen.  You’re supposed to have to choose between capital-intensive or labor-intensive production methods.  And you’re supposed to be able to compete using either approach, depending on your local labor cost structure.  Not here, though.

A little arithmetic–

Assume that we write the cost of the machinery off in equal installments over ten years.  Then Sanyo’s costs are raw materials + electricity + water, etc. + $100,000 in depreciation + $300,000 in salary.  That’s $20 for each battery + materials…, maybe $25 for each in total.

For BYD, the figures are raw materials etc. + $50,000 +150,000.  That’s $10 + materials… for each battery.  That’s maybe $14 in total.

True, the BYD batteries were probably only 90% as good as the Sanyo ones.  But they cost only a little more than half as much to make.

Lots of medium-tech stuff is like these batteries.  Note, too, that the Chinese salary I quote is less than half the minimum wage in the US.  So the Chinese business model won’t fly here.

5.  As the NYT pointed out in a follow-up, wages in eastern China have more than doubled since I owned Sanyo Electric–meaning that, all other factors being equal, BYD’s labor cost advantage has almost completely eroded.  I presume, but don’t know, that, if so, BYD has shifted production into western China, where wages are still low.

If this business follows the pattern of other industries I’ve followed, like the textiles, at some point the battery industry will shift out of China in search of lower costs.  Machinery will be shipped to another low labor-cost country, India?  Bangladesh?, where production will be resumed.  In fact, BYD may enjoy considerable local tax breaks for doing so.

But wherever the machinery ends up, it’s almost certainly not going to end up in the US.  That would just recreate the company’s situation of too expensive low-skilled labor.  Also, its plants may not be particularly welcome in a country where the firm has no political clout.  More than that, it could be that being Chinese-owned would make it a target of adverse political action.

My take:

This is a big issue, one without a clear solution.  Contrary to Mr. Krugman’s suggestion, I don’t think we’re seeing a reprise of the 19th century, when holders of large amounts of capital had a gigantic (unfair?) edge over people born into families of modest means.  Rather, the 21st century reality is that the market price of unskilled labor in an increasingly global world is under $10,000 a year.

A country can try to protect politically powerful but non-competitive industries, as Mr. Obama has recently done with tires, but that leads to disaster–enriching a small group of political favorites at the expense of everyone else (see my posts).

If all the good manufacturing jobs are robot-driven, then not all highly educated workers will find jobs there. That’s also not a great surprise, since the manufacturing sector in the US has been shrinking for decades.

But, of course, poorly educated workers will be excluded from manufacturing employment entirely.

In the service sector, where all the job growth has been in the US, the field seems to belong to highly educated, computer-savvy entrepreneurs.  Again, the poorly educated need not apply.

I don’t think that in the US a good education is a sufficient condition of personal economic prosperity, but it is a necessary one.

the latest Japanese election comes on Sunday

getting scared straight

Cable network A&E is now into its third season of Beyond Scared Straight. This is the latest iteration in the Scared Straight genre, created in the 1970s, in which budding criminals visit prisons and are supposedly frightened back onto the straight and narrow by Ghost of Christmas Yet to Come-like interaction with the inmates.  I’ve never had enough interest to try to figure out how much is real and how much is staged.

There is a real-life Scared Straight, though, for economics and public policy.  It’s called Japan.  Maybe we should send our elected officials in Washington for a visit.


The Japanese economy has been in neutral for almost a quarter-century, during which the standard of living for average Japanese citizens has steadily eroded. The workforce is aging (it’s actually been shrinking for about a decade) but Tokyo doesn’t allow immigration.  Weak management is slowly (sometimes, not so slowly) killing even iconic companies, but foreign turnaround specialists aren’t allowed to take control.

Worse, the government borrows heavily to spend on pork barrel “stimulus” projects that yield no economic return.  As a result, national debt now exceeds 2x annual GDP. That’s a Greece-like number. Perversely, because Japan is almost devoid of good new investment opportunities (small “counterculture” companies run by younger managers are an exception), citizens continue to plow their savings back into government bonds, even though they yield next to nothing–creating a continuing cycle of misery. The Diet has not been overwhelmed by the interest expense of its reckless borrowing, nor has it had trouble, so far, in raising fresh funds to squander.

There’s an election on Sunday, in which the hapless Democratic Party of Japan is likely to be replaced by the Liberal Democrats, who have been the dominant force in modern Japanese politics.  The DPJ was voted in a few years ago to change the patronage culture, but almost immediately lost its way in a frenzy of intra-party bloodletting.

why the election is interesting–and maybe important

Shinzo Abe, who will become the Prime Minister if the LDP wins, is running on a platform that includes dismantling the independent central bank.  If Mr. Abe gets his way, the bank will be forced to print money as fast as the presses can turn, until this action creates at least 2% annual inflation.


I guess the idea is to weaken the currency so that even arthritic export-oriented manufacturing companies will be able to make a profit.   There’s also the “advantage” that the currency markets, rather than the legislature, may take the blame for the immense loss of national wealth that would ensue.  At the same time, to the degree that the LDP is successful in creating inflation, it will also likely triple or quadruple the interest rate on new government debt–potentially making it impossible for Tokyo to service.  Scary.

Implosion isn’t imminent.  Mr. Abe hasn’t won yet.  Maybe he’ll change his tune after he’s in office.  Maybe the Bank of Japan won’t simply roll over and do what he says.  But, to mix metaphors a bit, that’s kind of like saying that the fuse to the dynamite that’s being lit is very long.  Japan could be an Asian version of Greece if a few years.

the really scary part for the US

In a nutshell, Japan’s basic problem is that since the early 1990s it has chosen to prop up the status quo, in the face of a changing world, no matter what the cost.  What’s really scary for an American is that Washington seems to be taking a turn down the same road.

the fiscal cliff: why not just raise income tax rates?

There are several arguments–some theoretical, some the fruit of bitter experience–against raising income tax rates beyond a certain level.

To be clear, personally I don’t think they apply in the present argument about how to close the current US annual $1 trillion+ Federal deficit.  After all, the country seemed to run perfectly fine in the 1990s, when rates were higher.   So I don’t see how turning the clock back to the status quo ante can be so bad.  (Following that logic would also imply rolling back the extra healthcare benefits enacted at the same time.)

I suspect that the biggest stumbling block is that patronage politicians know very well how to divide up shares in an ever-expanding economic pie (who wouldn’t?) but are incapable of agreeing on how to apportion mutual sacrifice.  It doesn’t help matters that, in my view, Republicans have an antediluvian economic philosophy and Democrats have none.

Nevertheless, there’s a limit to how high rates can be pushed.

how can higher tax rates be bad?

When rates reach a certain point:

1.  people start to work less.  I had an eccentric uncle (one of my favorites) who quit his brokerage house back-office job (the only position Irish Catholics would be hired for) and supported himself for the rest of his life investing his own portfolio–turning $400 into $1 million+.  Why leave?  …he was so incensed at the income tax he was paying on overtime.  Uncle Harry wasn’t your typical worker.  But if you’re losing, say, 70% of your incremental income to the tax man, what’s the point of doing extra work?

2.  people spend increasing amounts of time on gaming the tax code, diverting economic energy from more productive uses. Behavior can get crazy.  In the UK in the early 1980s, companies were buying suits and renting them to their executives rather than giving pay raises, because the tax on incremental individual income was so high.  If history runs true, the loophole-ridden US tax system would spawn huge amounts of new tax shelters–very profitable for promoters, disastrous for the purchasers.

3.  tax avoidance accelerates.  I was sitting next to the Spanish finance minister at a lunch early in my career.  I naively suggested that his country would have to raise income taxes in order to close a troublesome budget deficit.  The minister looked at me like I had dropped from the moon.  He explained that income tax rates in Spain were already as high as they could go.  Experience showed that pushing them higher resulted in lower tax receipts.  Very many people would begin to hide substantial amounts of their income from official eyes through off-the-books transactions.

4.  people leave the country.  In the US, we can see this behavior on the state level, in the steady migration from high-tax areas like New York, New Jersey or California.  France, which has recently raised the top income tax rate on high earners to 75%, is now seeing the wealthy starting to renounce their French citizenship and move elsewhere in the EU, like the UK or Belgium.

won’t closing the Federal budget deficit be bad for stocks?

…after all, the only way the US will achieve budget balance will be through some combination of higher taxes and lower government spending.  The former will mean less income available for consumption; the latter will mean less stimulus from Washington for the economy.  On the surface, at least, both imply slower economic growth for some years–something that should be bad for stocks.

Yes, that’s right.  But it’s not the whole story.

For one thing, half the profits of the S&P 500 come from operations outside the US.  Their growth shouldn’t be negatively affected to any great degree, if at all.  Professional will tilt their portfolios toward foreign earners.

There’s also the question of the price earnings multiple applied to corporate profits, which in the case of the S&P 500 is currently relatively low.  Arguably, there are two reasons for this–both based on the idea that ordinary investors are much more savvy than pundits think.

1.  The current situation with government spending and taxation is economically unhealthy and ultimately unsustainable.  If deficit spending proceeds unchecked, some point lenders will lose confidence in the ability of the US to repay its obligations and demand, at a minimum, higher interest rates on new loans.  A two percentage point rise on $14 trillion in debt–which would come only slowly, as existing debt matured–would add about a quarter-trillion dollars to government debt servicing expense! And that’s by no means the ugliest thing that could happen (look back to the government bond buyers strike in 1987, for example).

Maybe the market PE would be 10% higher if the US weren’t slowly headed down this road.

2.  In investors’  imaginations fiscal contraction is almost certainly worse than the reality will be.  It’s even possible that more highly taxed citizens will demand better service from Washington than we get at present–maybe immigration reform to allow highly skilled foreign students to remain in the US, maybe shrinking the military so it’s not Washington’s largest expense, maybe finding out why Americans pay 2x what the rest of the world does for the same healthcare.  Who knows?  In any event, the elimination of uncertainty may be worth another point–or more–on the PE multiple.

In essence, I’m arguing that a reversal of bad fiscal policy won’t be a Wall Street disaster because the assumption of a continuation of that slow-motion train wreck is already depressing equity prices.  I don’t think, on the other hand, that prices will explode upward if Washington changes stripes.  A mild uptrend, with growth stocks outperforming?  Maybe Generations X and Y will begin to invest to fund their retirements…