As the play-acting drama of the "fiscal cliff" negotiations continue -- a drama that would be ridiculous and laughable were it not so detrimental to the ability of individuals and businesses to plan for their immediate future -- we would like to offer several related observations.
First, we point out that the entire "fiscal cliff" scenario is itself the product of the inability of the elected representatives in Washington DC to agree upon a budget. This inability is not new -- it has become a regular feature of political life over the past decade. In fact, although the Congress did pass what is often called a "budget" in 2009 (and has not passed one since), the 2009 measure was only a temporary "omnibus spending bill" and to find the actual date of the most-recent budget passed into law in the US, one needs to go back to 1997 (now over fifteen years ago).
This inability of Republicans and Democrats to reach an agreement is compounded by the fact that the two sides cannot even agree upon what the problem is, let alone which measures should be taken to solve the problem. In this case, some believe that government spending is the problem, while others believe that government spending is the solution, and some believe that low tax rates are the problem, while others believe that low tax rates are the solution.
But the problem is much deeper than that, as it is clear that even within the major political parties there are deep divisions over how to define the real problem. Within Republican ranks, for example, it has recently become clear that there are deep divisions between those who are arguing that the main focus should be on the "debt ceiling" while others argue that the debt ceiling is a red herring and that the real focus should be on pro-growth tax reforms and regulation reform (see for example this article).
The situation has become so divisive that an increased level of cynicism and pessimism among those who have to try to do business in a world that is impacted by the decisions of these "leaders" is entirely understandable. We believe that it is reasonable to conclude that an era of budget uncertainty is here to stay for the foreseeable future, and that the real questions investors should ask are how it will impact them, and what they should do about it?
But the problem is much deeper than that, as it is clear that even within the major political parties there are deep divisions over how to define the real problem. Within Republican ranks, for example, it has recently become clear that there are deep divisions between those who are arguing that the main focus should be on the "debt ceiling" while others argue that the debt ceiling is a red herring and that the real focus should be on pro-growth tax reforms and regulation reform (see for example this article).
The situation has become so divisive that an increased level of cynicism and pessimism among those who have to try to do business in a world that is impacted by the decisions of these "leaders" is entirely understandable. We believe that it is reasonable to conclude that an era of budget uncertainty is here to stay for the foreseeable future, and that the real questions investors should ask are how it will impact them, and what they should do about it?
We believe that this government-induced "budget uncertainty" acts as a drag on business, because it creates additional uncertainty about where tax rates will be from one month to the next, causes business leaders to be more cautious than they would otherwise need to be, and generally saps economic growth and productivity as energies and attention is diverted away from primary business concerns and into all sorts of political analysis and tax-planning activities. This drag on business activity caused by budgetary uncertainty is very similar to the drag on business activity that comes from misguided monetary policy that makes it more difficult for businesses to predict the future price of raw materials or the future strength of different currencies, and more difficult for lenders to provide capital to businesses that need it to expand (see here and here).
We might call the drag on business imposed by the budget follies of the past fifteen years a sort of a tax: the "Budget Uncertainty Tax." It is not an actual tax in that it doesn't represent business activity that is taxed after revenues are made and employees are paid -- instead, it is a tax that is taken in the form of revenues that are never made in the first place. In that sense, it is a "stealth tax" in much the same way that inflation can be a stealth tax.
We might call the drag on business imposed by the budget follies of the past fifteen years a sort of a tax: the "Budget Uncertainty Tax." It is not an actual tax in that it doesn't represent business activity that is taxed after revenues are made and employees are paid -- instead, it is a tax that is taken in the form of revenues that are never made in the first place. In that sense, it is a "stealth tax" in much the same way that inflation can be a stealth tax.
So what should investors do when they perceive that businesses are likely to be facing a "Budget Uncertainty Tax" for the next several years? Well, we don't believe that the answer is to run and hide, trying to escape the problem by not investing in businesses at all. We believe that almost all investors need the potential growth that comes from participating in the success of well-run businesses over the course of many years, and that investment in growing companies has historically been one of the very best defenses against the loss of purchasing power caused by inflation and other destroyers of wealth (see here and here for example).
However, during times when the obstacles to business success multiply -- obstacles such as the ones described above -- the need to become more discriminating in the businesses to which one commits capital increases dramatically. History appears to illustrate that during better business climates, the "rising tide lifts all boats" and investors can do fairly well by owning just about any group of well-run companies. During such periods, the advice to "just invest in an index" becomes popular (during the 1960s, an early version of large-cap "indexing" called the Nifty Fifty strategy was popular).
During uglier periods, however, investors need to be more like the prospector panning for gold, keeping only what are true nuggets and discarding companies that might be worth considering in better times (companies that might turn into diamonds if given the chance, but may never get that chance in the more uncertain climate).
However, during times when the obstacles to business success multiply -- obstacles such as the ones described above -- the need to become more discriminating in the businesses to which one commits capital increases dramatically. History appears to illustrate that during better business climates, the "rising tide lifts all boats" and investors can do fairly well by owning just about any group of well-run companies. During such periods, the advice to "just invest in an index" becomes popular (during the 1960s, an early version of large-cap "indexing" called the Nifty Fifty strategy was popular).
During uglier periods, however, investors need to be more like the prospector panning for gold, keeping only what are true nuggets and discarding companies that might be worth considering in better times (companies that might turn into diamonds if given the chance, but may never get that chance in the more uncertain climate).
We will continue to discuss this subject in future posts.