Stock Market at All time Highs! Are We In a Giant BUBBLE?

With the stock market hitting all-time highs, everybody wants to know if we are in a giant bubble.

You can’t trade and make money if you’re not in the market. If the fear that we are in a bubble is keeping you out, then you’re not making money.

The honey badger doesn’t care. The honey badger loves to climb walls of worry.

You can get an early read on which way the market is headed by tracking transports. Fedex is a bellwether stock in the transports industry.

The chart of FedEx just did a breakout above 180 and hit a new high. The rising Twiggs Money Flow shows FedEx is under heavy accumulation.

Remember folks, bull markets don’t die of old age, they are murdered by the Fed.

The chart below shows profit margins [blue] are falling as employee compensation [brown] rises.

Since 2015, employee compensation has started to recover as the labor market tightens and corporate earnings are falling (as a % of Net Value Added).

If you look back to the 1960s, you can see that when the labor market reaches capacity, profits fall as labor costs rise. The Federal Reserve intervenes to battle inflation from rising wages which will cause the next recession. The Fed does not usually intervene in a meaningful way until wages rise above 74% of corporate profits. In other words, we have a long way to go regarding rising wages before the Fed is going to hike rates so high that it causes the next recession.

Financial Education posted this video on if we are in a giant bubble. While I don’t agree with everything he says, he does make some good points IMO.

Trump Administration and Tariffs Versus Quotas

Protectionist policies in the form of tariffs and quotas are coming from a Trump Administration. It seems appropriate then that we examine tariffs and quotas from a macroeconomics perspective.

The two most common ways of restricting trade are with tariffs and quotas. From a political point of view and to prevent a trade war, a Trump Administration should consider the use of quotas over tariffs in some cases.

This figure illustrates the domestic market for food in Europe.

The equilibrium between supply and demand occurs at point A at a price of $8, and quantity of two hundred. Now, suppose that food is available in an unlimited amount from the rest of the world, at a price of $4 per unit and Europe doesn’t like this because it hurts their farmers.

The world supply curve is represented by the red horizontal line. In the absence of any transportation costs, the food price in Europe must be equal to the world price of $4. At the $4 price, you can see that European domestic production is measured by the line segment B, C and will be one hundred units, considerably less than before free trade.

American imports are measured by the line segment C, D and are equal to two hundred units, and revenues from the sale of these imports are equal to the shaded area C, D, E, F.

Now let’s say that European trade ministers impose a tariff of $2 per unit on food imports, where a tariff is a tax levied on imports. What happens now to domestic production and imports?

Clearly, domestic producers win because their production not only rises by fifty units, but their profits rise by the shaded area B, C, H, G.

European food consumers lose, not only because the price of food rises from $4 to $6, but also because they consume fifty fewer units of food. In fact, the total loss to consumers is measured by the area B, D, I, G.

The other big loser is the American food industry, which now exports one hundred fewer units and loses revenues equal to the shaded areas C, J, L, E and K, D, M, F.

The winner is the European governments that imposed the tariff. They collect tariff revenues, equal to the area H, I, J, K.

The Politics of Tariffs

From a political perspective, a relatively small handful of people in one domestic industry, farming, have gained a considerable profit at the expense of a much larger, but politically less powerful group, food consumers.

This protectionist tariff has also considerably harmed food producers in America, and this group is unlikely to remain silent on the tariff.

Why Quotas Trump Tariffs Politically

One likely result is that pressure will build politically in America to retaliate against European food tariffs with protectionist tariffs of its own, perhaps on European clothing imports. There is a way for Europe to avert this trade war and it’s with a quota which is an exact quantity limit on imports.

An equivalent quota, in this case, would be a one hundred unit limit on American food since that is the level of imports after the $2 per unit tariff.

Under a tariff, the shaded area H, I, K, J goes to the European governments in the form of tariff revenues. However, under a quota foreign exporters (American food producers) will be able to capture these revenues which will mostly offset their losses from selling fewer exports. The result in America will be far less political pressure from food producers for retaliatory tariffs.

Deadweight Loss

Whenever a government interferes in a free market, there is usually deadweight loss. There is deadweight loss associated with the imposition of a tariff or quota. In fact, the loss is the same regardless of whether a tariff or quota is used.

The shaded area C, H, J, represents the loss in producer surplus. In this case, too many European resources are being diverted into the inefficient production of food, at the expense of production in other sectors. At the same time the shaded area K, I, D represents the loss in consumer surplus and the loss in consumer satisfaction, from consuming fewer units of food. Together the two shaded triangles measure the total deadweight loss from tariffs or quotas.

Source: This lesson was made possible by the University of California Irvine and my favorite professor Dr. Peter Navarro, now economic advisor to the Trump Administration.

Pharmaceutical Drug Pricing

Pharmaceutical drug pricing is all over the mainstream financial media right now. Let’s examine the macroeconomics of what is happening.

The demand for pharmaceutical drugs is inelastic. People that need a pharmaceutical drug prescribed by their doctor will demand that drug regardless of price. As the price of the drug goes up, demand mostly stays the same.

Notice how steep the demand curve is. This steep drop-off represents the inelastic demand for pharmaceutical drugs. The increase in supply from S to S1 leads to a relatively large decline in the price, but not much of an increase in quantity demanded.

Companies like Valeant Pharmaceuticals and former CEO Michael Pearson abused the inelasticity of demand for pharmaceutical drugs for maximum profit. If demand for pharmaceutical drugs is hardly influenced at all by price changes, then raise the price of the drug to a level that maximizes shareholder profits. Sure the supply curve may shift up a little from a drop in demand from people on the margin, but most of the public with their large health insurance providers will pay the higher price.

Pharmaceutical Drug Price Ceiling

Some are pushing for a pharmaceutical drug price ceiling. As you learned from the macroeconomic analysis of rent control, price ceilings do not work.

The horizontal brown line on the supply and demand graph below represents a drug price ceiling.

The lower price of the drug shifts the demand curve up a little to point b. However, suppliers will rapidly stop supplying the drug when they are forced to sell it below market price at point a. The difference between the quantity of the drug demanded and the quantity of the drug supplied is a drug shortage as represented by the red shaded area. People will die from a drug shortage when there are no readily available substitutes, and so the government should not attempt to use price ceilings.

Make Pharmaceutical Drug Demand More Elastic

The way to control runaway drug prices is to make the demand for pharmaceutical drugs more elastic. If people have choices and substitute drugs they can use, the steepness of the demand curve will be flattened and represent a more healthy free market as illustrated below.

Notice that the demand curve is flatter and not so steep.

How do you change the shape of the demand curve so that demand is more elastic? You make it legal for generic versions of drugs to come to market sooner. Gov. Charlie Baker is trying to do that by reducing the time it takes for the FDA to approve generic drugs.

Pharmaceutical drug makers have been fighting to preserve their inelastic demand pricing power by colluding to fix generic drug prices.

Folks, until all this drama gets worked out, I recommend staying away from pharmaceutical drug stocks.

Macroeconomics Of Rent Control

California, New Jersey, and New York have the most cities with rent control. Sanctuary cities in California like San Francisco and Los Angeles have some of the toughest rent controls. Rent controls hurt the local economy and make rental unit availability worse. Aggregate deadweight loss from rent controls across the country negatively impacts the US economy and hence stock market. Let’s examine what happens with rent control from a macroeconomics perspective.

In a free, non-rent controlled market, the price of rent is established by the market where the supply and demand curves cross.

Look at what happens when rent control is introduced into a free market.

The red horizontal line represents rent control, or the maximum price landlords can charge for rent. The lower price of rent increases demand to “B.” However, since suppliers (owners) cannot charge the same rent that a free market would support, they choose to supply less rental units to the market at point “A.”

The gap between market demand and market supply is a shortage shown as a red shaded area. This shortage of rental units means that the competition for rental units becomes increasingly stiff and even well-qualified prospective tenants will find it difficult to find adequate housing in rent controlled cities. Worse, setting a price ceiling in cities like San Franciso and New York that have high property taxes and high maintenance costs means landlords would make hardly any profit and perhaps even lose money on rental properties. In other words, through rent control, the government has provided a strong disincentive for landlords to provide sufficient supply to meet a growing cities’ demand.

Rent control hurts local tax revenues as well because owners are bringing in less taxable income from their properties. Look at where the blue line intersects the demand curve at “D.” Point “D” represents the price renters would be willing to pay at the lower supply landlords provide under rent control. In other words, there are fewer rental units to tax (as supply contracts) and lower income tax paid by owners (because owners are making less). That’s a contraction in a local real estate market of both supply and lower tax revenues brought on by rent control. The local government must raise some other tax to offset what was lost from rent control, thereby increasing deadweight loss from taxation.

The blue shaded area represents a deadweight loss to a local economy from rent control. Deadweight loss is a loss of economic efficiency caused by rent control because more landlords could be leasing and thus more renters who could be renting (because of greater supply) if it were not for the price ceiling.

Finally, rent control shifts the aggregate supply curve inward or to the left which is not good for the economy as supply contracts.

As rental unit supply contracts, prices eventually rise. As William Tucker of the Cato Institute writes…

A look at the classified ads in rent-controlled cities reveals that very few moderately priced rental units are actually available. Most advertised units are priced well above the actual median rent. Yet in cities without controls, moderately priced units are universally available.

Microeconomics and Taxation

Most government revenue comes from the taxation of transactions and labor. Taxes impact both the supply and demand curves. Taxes cause a buyer to pay more for something and suppliers to receive less. The loss of value for both buyers and sellers is called the deadweight loss of taxation. Taxation has an enormous impact on the economy and thus stock market. Traders and investors need to understand the effects that taxation has on the economy and thus stock market. We will examine deadweight loss from a microeconomics perspective, ending with a macroeconomics viewpoint.

In a market without taxation, we will say that a package of socks will sell at a fair market price of $14. This $14 equilibrium price is set where the supply and demand curves cross.

When taxes hit the package of socks, the buyer pays a higher price of $15.40, and the seller receives a lower price of $11. Taxation lowers demand to d1 because buyers have to pay a higher price for socks. The seller is also taxed, and so he receives less profit for his package of socks. If there’s less profit, the supplier will supply fewer socks at a level of s1.

The amount that the government receives in taxes is equal to the buyer’s price minus the seller’s price, multiplied by the quantity of the transaction, whether for goods or services. The area of the light red rectangle is the tax revenue collected by the government. The area of the dark red triangle is equal to the economic value that is lost to taxation.

This loss of economic value consists of buyers who will either buy less or not at all because the price is higher than what they can afford so they decide to do without. Likewise, some suppliers will not produce the product because they are not receiving a high enough price to cover their costs. The benefit that these buyers and sellers would have added to the economy if it were not for taxation is called the deadweight loss of taxation. Because these buyers and sellers do not participate in the market, they do not contribute to the tax. Instead, the taxes are paid by the buyers and sellers who continue to participate in the market. The tax burden falls on the fewer buyers and sellers who continue to participate in the market. A vicious taxation loop can start where a government raises taxes more to offset lower tax revenues caused by rising deadweight loss.

Demand and Supply Elasticity

Demand elasticity is the change in quantity demanded at a particular price. If a large change in price results in little change in the quantity demanded, then demand is considered inelastic. If a small change in price results in large changes in the quantity demanded, then demand is considered elastic.

Products that have good substitutes have a high elasticity of demand, since if the price of one substitute increases, buyers can switch to another substitute. For example, if the price of beef increases, then people will buy more chicken, ham, pork, or some other meat. Beef is considered an elastic product.

Products that have fewer or no substitutes have a high inelasticity of demand since if the price increases, there are no substitute products buyers can switch to. For example, if gasoline and oil prices increase, buyers have to pay the higher price because there are no close substitutes.

Supply elasticity is the change in supply costs at a particular price. If the supply changes little with a change in price, then supplies are considered inelastic. Supply is elastic if there are large changes in supply for a small change in price.

For example, the supply of land is inelastic because no one is making any more of it. By contrast, the supply of software is fairly elastic since it costs very little to make and distribute copies of software over the internet.

Deadweight Loss Varies with Elasticity

The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is small, because the quantity bought or sold does not vary much with the price.

Demand Inelasticity and Deadweight Loss

Buyers need to have the product and so changing the price through taxation is not going to change that. For example, buyers need gasoline to operate their automobile. Gasoline is inelastic as there are no substitutes. Raising taxes on gasoline will result in a lower deadweight loss.

Supply Inelasticity and Deadweight Loss

Sellers want to sell land, and so the tax rate is not going to heavily influence the supply of land for sale. The supply of land is inelastic because, as Will Rogers once said, they’re not making any more of the stuff. Raising taxes on land sales will result in a lower deadweight loss.

Deadweight loss increases proportionately to the elasticity of either supply or demand.

Higher Taxes and Deadweight Loss

Balancing the tax rate which gives the most tax revenue with the least amount of deadweight loss is impossible. The tax rate that worked during the Bill Clinton Administration did not work during the Obama Administration. An endless amount of factors come into play when determining a moderate tax rate with the most yield versus minimal deadweight loss. What we do know is that when the tax rate is small, there is less deadweight loss and conversely, when the tax rate is high, there is more deadweight loss as illustrated in the two graphs below.

As can be seen from the graph below, as taxes are increased, the deadweight loss of the tax also increases, gradually at first, then steeply as the size of the tax approaches the market price of the product without the tax. Likewise, tax revenue increases at first but then starts to decline as a decrease in quantity more than offsets the increase in the tax rate.

Macroeconomics and Taxes

The Federal Reserve has been unable to get the meaningful shift from aggregate demand outward that they wanted to increase GDP. It’s no coincidence that under the Obama Administration, the US has the third highest corporate income tax rate in the world, at 38.92 percent. The U.S. rate is exceeded only by the United Arab Emirates and Puerto Rico. Higher taxes shift the aggregate demand curve inward from AD1 to AD2.

Conversely, lower taxes shift the aggregate demand curve outward.

Higher taxes also negatively impact the number of people willing to work as illustrated by the Laffer Curve.

The marginal tax rate is measured on the vertical axis, and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward-bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, “m” in the figure, an increase in the tax rate will cause overall tax revenues to fall. Note also, for a supply-side tax cut to increase tax revenues, the existing tax rate before the tax cut must be above “m,” perhaps at a rate associated with point “n” on the curve. The tax rate being above “m” is an important point because, in the early 1980s, the Reagan Administration’s economists believed that the economy was on the backward-bending portion of the Laffer curve (above “m”) and that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history.

The Reagan Administration also took actions to shift the supply curve outward such as cutting back sharply on the regulation of everything from monopoly and oligopoly to pollution and product safety, critical elements that shift the aggregate supply curve outward.

Policies which can successfully shift the economy’s supply curve out, do so with the twin advantages of both lower unemployment and lower inflation.

A Macroeconomic Analysis of ObamaCare

ObamaCare has created massive shortages within the healthcare sector. In cities, it is common to wait many hours before being seen as hospitals have a shortage of beds. Doctors have stopped taking new patients as they are overwhelmed by the numbers of people coming to see them. Let’s examine what happened from a macroeconomics perspective.

ObamaCare caused more than 35 million people to demand health services. The idea was that when demand for medical services increased, it would shift the demand curve to the right (D1). As more people demanded healthcare services, supply would increase to meet that demand.

The problem is that policymakers thought they could prevent price increases through non-free market price controls. That action of price controls prevented efficient movement of the demand curve along the supply curve. Instead, demand increased, but supply stayed the same.

Supply not increasing because of price controls is an absolutely logical market reaction and what many economists warned could happen. Health care providers do not have a profit incentive to increase supply because of price controls. If prices are going to be held lower at P1, then there are only enough profits in the industry for suppliers to produce at a quantity equal to demand at D2. ObamaCare increased consumer demand to D3, and so a health care services shortage has formed as indicated by the red shaded area.

Obama and Democrats focused too much on demand-side economics and not enough on supply-side economics. The failure of ObamaCare is that the supply curve did not shift downward (increase) to meet the new level of demand, at the lower price control level of P1 that the government established.

ObamaCare proponents claimed that top-down government operation was going to reap all kinds of cost savings for healthcare providers and thus would shift the supply curve down. That was wrong.

In an attempt to shift the supply curve down (to the right), the Obama Administration and Senate recently passed a medical reform bill to make it easier for someone to become a doctor.

The idea is to make it easier for people to become a doctor. I think this might be a case of too little, too late. Lowering requirements for doctors should have been done years ago.

Rising Wages Are What Will Cause The Next Recession

We all love rising wages, but it is rising wages that will cause the next recession and Bear market.

Below is a chart of labor costs (red) versus corporate profits (blue).

A clear pattern emerges from the chart above. Profits rise after a recession as labor costs fall. When the labor market reaches capacity, profits fall as labor costs rise. When labor costs rise, the Federal Reserve raises interest rates to tame inflation which causes the next recession. Around and around we go in an endless loop. Ecclesiastes 1:9 describes it like this, “What has been will be again, what has been done will be done again; there is nothing new under the sun.”

Since 2015 employee wages have been rising as the labor market tightens. We also have corporate earnings falling. It is no coincidence that in Q1 2015 earnings began falling. We now see that it was rising employee wages that caused this.

I warned about the microeconomics of minimum wage hikes back in 2015 on the weekly Saturday night show here:

Colin Twiggs makes the interesting observation that it may be possible for the Federal Reserve to avoid causing a recession if they react sooner with rate hikes before the labor market overheats. Mr. Twiggs thinks that the Federal Reserve must raise rates before labor costs reach 72% of net value added (left side of the chart above).

When the demand for higher wages takes corporate profits below 9% of net value added (right side of the chart above), the party is over, and it’s time to become a long-term bear and reduce exposure to stocks.