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Archive for January, 2009

Don’t Just Do Something — Stand There! Why the Stimulus Package Won’t Work

by David Sollars.

It appears that the U.S. Congress is set to pass a $850 billion dollar spending package designed to provide fiscal stimulus for the U.S. economy.  It is a mix of spending increases, transfers and tax cuts purportedly designed to pump up aggregate demand.  Both tax cuts and spending increases create budget deficits, and therefore the government must increase borrowing to finance its operations.  Add in the interest charges and this legislation easily surpasses a trillion dollars in total cost.

They idea of fiscal policy stimulus goes back to the Great Depression and the work of John Maynard Keynes.  The basic  idea is pretty simple — in times of weak aggregate demand, government could fill the void by spending more directly, or taxing less, thereby increasing consumer demand and business investment.  All policymakers would need to do is measure the needed stimulus (taking into account the multiplier effect, and then properly time the injection of stimulus in the economy. If the economy got overheated and inflation became a problem, then presto, the federal government could raise taxes or reduce spending to slow down the economy.

In theory, traveling to the moon is easy as well.  All you need was the right vehicle, pointed in the right direction, traveling at the right speed, etc.  But in practice, manned space flight turned out to be a little more complicated and costly. Unfortunately, economic theory and policy tools have not advanced to the point that we should have any confidence in the ability of this short run program to work as advertised. There are timing problems, scale issues and efficiency costs associated with discretionary fiscal policy that are well known (and discussed in any Econ Principles textbook) and will reduce the potential benefits and create unintended consequences. But the political need to do something will win the day, and Washington is all a-twitter with the single largest discretionary budget package ever devised.

Good politics is often bad economics.  Even a cursory look at the bill being rushed through the Congress reveals its Frankenstein-type nature.   It is a wish list for unrelated spending programs that, on their own, would not be considered reasonable.  Even the parts that make some sense, like the much-touted infrastructure spending, are small potatoes in the bill.  Instead we get millions for the National Endowment for the Arts.  The Department of Education gets $66 billion for  . . . well, we aren’t sure, but how can you oppose to education?  Amtrak gets a billion so that it can continue to lose money each year.  Congress even provides more millions to help those poor souls who will flounder from a lack of analog television transmission.  Some of the items are laughable – Speaker of the House Pelosi defending contraception subsidies as stimulus on the weekend new shows was a sure sign of some of the insanity behind this bill. Even traditional liberals can’t stand the stench.  Former CBO head and Clinton budget guru Alice Rivlin suggests separating the defendable stimulus pieces from the pork and the other things that have magically appeared without the usual substantive review.  According to some analysts only 5 to 10 percent of the total bill is actually related to stimulus spending.  Even worse, the “buy-American” requirements will likely result in WTO sanctions and encourage retaliation by our trading partners, hurting U.S. companies and workers in the export market – one of the few remaining shining lights in our current economy.  Just ask Caterpillar.

The little hard analysis that has been done reveals another serious flaw in the bill.  Much of the actual stimulative spending won’t occur this year, or the next year.  The recent CBO report suggest that most of the new spending that is part of the omnibus-bill won’t kick in until next year and the year after, long after our best estimates on when the  trough is reached  http://www.cbo.gov/ftpdocs/99xx/doc9968/hr1.pdf.  The levers of government  are slow and unwieldy even for someone as brilliant as Larry Summers!  Even Keynes later thought that public works and infrastructure projects were poor vehicles for short run stimulus given the realities of actual government expenditure — it takes time to build roads and bridges. 

My proposed solution: Take a deep breath and let’s consider what useful things might be in the bill.  The less controversial things like temporary transfers to the states to extend unemployment benefits, foodstamps or Medicaid make some sense in the interest of helping those who have lost their jobs in the recession.  But these aren’t job creators; they are more in the spirit of what we used to call public assistance.  Speeding up some public infrastructure spending might be useful, but it is limited.  If you really want to spur investment then include investment tax credits.  If you want to help working consumers, then halve the payroll tax for the next year.  Let the results show up in the end of February paychecks, and let actual taxpayers choose how to spend it.  The Senate version of the bill has the AMT fix for 2009, which is a good thing—but why don’t we just fix AMT now and forever instead of relying on one year fixes?  Any pretense of fiscal discipline is now officially shattered, so get on with it already.

Will any of this really work to stimulate the economy?  Probably not.  But it will impose fewer costs and not drive up the deficit as much as the current bill, which won’t work either.  We seem to forget we tried the lump-sum tax rebate trick last year. The emergency TARP bill that was passed year is starting to reveal its immense shortcomings.  Why do we expect this outcome to be different?  If we are going to go into debt for a trillion dollars, could we require some standard ROI analysis to demonstrate how this spending is going to stimulate the economy? At least that might actually create jobs for the thousands of financial analysts laid off in New York and around the country.

David Sollars is Dean of the Business School at Washburn University in Topeka, Kansas. You can reach him via email at david.sollars@washburn.edu.

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Categories: Market Commentary

The Case for Constructing New Coal and Nuclear Power Plants

by Jim Haines.

“That we are in the midst of crisis is now well understood. Our nation is at war, against a far-reaching network of violence and hatred. Our economy is badly weakened, a consequence of greed and irresponsibility on the part of some, but also our collective failure to make hard choices and prepare the nation for a new age. … and each day brings further evidence that the ways we use energy strengthen our adversaries and threaten our planet.”

President Obama is right. We are in a crisis. What, at best, he only alluded to in his inaugural address are the common threads that link our military, economic, and energy crises. Perhaps the dominant thread in that tapestry is energy. And energy policy surely presents many and immediate opportunities for president and citizens together to demonstrate their resolve to make hard choices.

It is not a hard choice to endorse more efficient uses of energy or conservation of energy or alternative sources of energy. No reasonable person, no energy company, no interest group is opposed to these as ideas or as manifested in actions that people take to accomplish them. To focus just on electricity, the first hard choice is to recognize two stubborn facts: Under any realistic assumptions about the potential success of efficiency and conservation, and assuming even modest economic recovery, 1) levels of electricity consumption (nationally and globally) will continue to increase over any forecast period, and 2) alternative sources of electricity generation, together with conservation and efficiency, will reduce but will not eliminate our need for new base load power plants fueled with uranium and/or coal. Currently, coal supplies about 50% of US electricity demand and uranium about 20%.

Those facts beg a crucial question: Can the earth sustain energy consumption at the rate necessary to assure global-wide availability of increasing supplies of electricity, if such supplies depend in large part on continued use of fossil fuels? Treatment of that question raises an intense and often emotional debate involving fundamental political, social, and ethical considerations – and that makes the heroic assumption of consensus on the science and responses to climate change.

At the root of it, we are embedded in the Middle East because of energy issues. As the Asian economies continue to grow and as third world economies develop, the pressure on US consumption of foreign sources of energy will only increase. Coal and uranium are our most secure and abundant sources of energy for electricity generation.

President Obama said with emphasis: We will not apologize for our way of life….” Trying to connect the dots, does that mean we will aggressively incorporate efficiency and conservation and alternative sources of electricity into our way of life while still pursuing that way of life – a way of life that even with efficiency and conservation and alternative sources will require increasing amounts of electricity? If that is what he meant and means, then he himself has a very hard choice and he must make it sooner rather than later.

At the same time that he aggressively leads us (as I believe he should) toward challenging goals for efficiency and conservation and alternatives sources, he must also aggressively lead us to continued construction of new coal plants (even as we await the as yet undemonstrated clean coal technology) and/or a resumption of construction of new nuclear plants. Both coal and nuclear plants have long licensing and construction periods. To the extent that climate change is a factor in this consideration (and it should be a substantial factor), then there should be greater emphasis, perhaps exclusive emphasis upon nuclear plants – at least until clean coal technology is proven. Waiting until the safety of a second term to launch such an effort would have catastrophic consequences for US energy security and sustained economic recovery and growth.

Jim Haines, retired CEO of Westar Energy, is holder of the Ned Eldon Clark Professorship in Business at Washburn University in Topeka, Kansas. You can reach Professor Haines via email at james.haines@washburn.edu.

Categories: Market Commentary

McDonald’s (MCD) Is Looking a Little Overvalued

by Rob Weigand

I’m thinking of a stock that’s beaten the S&P 500 by over 300% in the last 6 years and by 70% in the past 6 months (see charts below) . . . 

mcd-spx-6-yrs1

. . . and, it’s accomplished this heady feat with an average 5-year compound growth rate of 7%, an average return on capital of 12%, average operating margins of under 20%, and modest growth in free cash flow. Yes, that’s MCD I’m talking about, whose admirable run is starting to look a little tired.

mcd-spx-15-yrs

I modeled MCD’s value using the following assumptions: 1.) an average 5-year growth rate of 7% tapering to 5.5% over the following 5 years, and a long-term growth rate of 5.0%; 2.) a moderate reduction in its SG&A/Sales ratio from 10.7% (historical average) to 10.0%; 3.) slightly lower marginal tax rate of 30% (historical average 32%); 4.) long-term dividend growth of 6.0%; 5.) lower Cash/Sales of 8.0% (historical average 10.0%); 6.) and a gradual decline in its PPE/Sales ratio from 92% to 86% over the next 10 years (a generous assumption). At a weighted average cost of capital of 9.5%, MCD’s 2009 intrinsic value from a discounted cash flow model comes in right around $44 a share, vs. its January 12 closing price of $60. Re-running the model with 9.0% growth for 10 straight years and bringing down the PPE/Sales ratio several additional points, the intrinsic stock price perks up — but only to $53 a share. Additionally . . . 

Insiders love to sell this stock. Cumulative insider selling (data provided by Thomson/Reuters) for the past 4 years is shown below. Insiders have cashed out of their positions to the tune of over $160 million over this time frame. There’s no evidence of any insider accumulation in the past 4 years. The selling is broad-based as well; it’s not just one or two big sellers.

mcd-insider-selling

Short interest in MCD has eased off recently:

mcd-short-interest1

But short selling has been off all year; considering this year’s light market volume, MCD’s Days to Cover Ratio is higher than it’s been since 2004, suggesting this overvaluation story may be gaining some traction:

mcd-days-to-cover1

MCD also sells at a premium Price/Sales ratio vs. competitors such as Yum Brands:

mcd-p-s-vs-yum

Although their Price/Earnings ratios are comparable:

mcd-p-e-vs-yum1

One major caveat: This is not a short-sale recommendation. Given investors’ overall fearfulness these days, I have no compelling thesis suggesting MCD should fall sharply in value in the next few months. This is the type of stock investors have been crowding into, which is probably how it’s become modestly overvalued. For current shareholders, however, MCD seems like a prime candidate for writing covered calls. June 2009 calls with a strike price of $65 closed at an ask price of $3.20 today. Collecting that premium yields another 5% in the next 6 months — not bad in this market — plus another 8.3% return if your shares are called.

You can find Rob Weigand on the web or send him an email at profweigand@yahoo.com.

Categories: Market Commentary