Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part III. Picking Winners

Chapter 15. The Big Economic and Political Picture

IN THIS CHAPTER

Looking at the effects of politics and government on stocks

Checking out a few handy economic and political resources

Politics can be infuriating, disruptive, meddlesome, corrupting, and harmful. Don’t let that fool you — it has its bad side, too! Even if politics doesn’t amuse or interest you, you can’t ignore it. If you aren’t careful, it can wreak great havoc on your portfolio. Politics wields great influence on the economic and social environments, which in turn affects how companies succeed or fail. This success or failure in turn either helps or hurts your stock’s price. Politics (manifested in taxes, regulations, price controls, capital controls, and other government actions) can make or break a company, industry, or sector quicker than any other external force.

remember What people must understand (especially government policymakers) is that a new tax, law, regulation, or government action has a macro effect on a stock, an industry, a sector, or even an entire economic system, whereas a company has a micro effect on an economy. The following gives you a simple snapshot of these effects:

Politics → policy → economy → sector → industry → company → stock → stock investor

Now, this chapter doesn’t moralize about politics or advocate a political point of view; after all, this book is about stock investing. In general, policies can be good or bad regardless of their effect on the economy — some policies are enacted to achieve greater purposes even if they kick you in the wallet. However, in the context of this chapter, politics is covered from a cause-and-effect perspective: How does politics affect prosperity in general and stock investing in particular?

remember A proficient stock investor can’t — must not — look at stocks as though they exist in a vacuum. My favorite example of this rule is the idea of fish in a lake. You can have a great fish (your stock) among a whole school of fish (the stock market) in a wonderful lake (the economy). But what if the lake gets polluted (bad policy)? What happens to the fish? Politics controls the lake and can make it hospitable — or dangerous — for the participants. You get the point. The example may sound too simple, yet it isn’t. So many people — political committees, corporate managers, bureaucrats, and politicians — still get this picture so wrong time and time again, to the detriment of the economy and stock investors. Heck, I don’t mind if they get it wrong with their money, but their actions make it tough for your money.

Although the two inexorably get intertwined, I do what I can to treat politics and economics as separate issues.

Tying Together Politics and Stocks

The campaigns heat up. Democrats, Republicans, and smaller parties vie for your attention and subsequent votes. Conservatives, liberals, socialists, moderates, and libertarians joust in the battlefield of ideas. But after all is said and done, voters make their decisions. Election Day brings a new slate of politicians into office, and they in turn joust and debate on new rules and programs in the legislative halls of power. Before and after election time, investors must keep a watchful eye on the proceedings. In the following sections, I explain some basic political concepts that relate to stock investing.

Seeing the general effects of politics on stock investing

For stock investors, politics manifests itself as a major factor in investment-making decisions in the ways shown in Table 15-1.

Table 15-1 Politics and Investing

Possible Legislation

Effect on Investing

Taxes

Will a new tax affect a particular stock (industry, sector, or economy)? Generally, more or higher taxes ultimately have a negative impact on stock investing. Income taxes and capital gains taxes are good examples.

Laws

Will Congress (or, in some instances, state legislatures) pass a law that will have a negative impact on a stock, the industry, the sector, or the economy? Price controls — laws that set the price of a product, service, or commodity — are examples of negative laws. I discuss price controls in more detail later in this chapter.

Regulations

Will a new (or existing) regulation have a negative (or positive) effect on the stock of your choice? Generally, more or tougher regulations have a negative impact on stocks.

Government spending and debt

If government agencies spend too much or misallocate resources, they may create greater burdens on society, which in turn will be bearish for the economy and the stock market.

Money supply

The U.S. money supply — the dollars you use — is controlled by the Federal Reserve. It’s basically a governmental agency that serves as America’s central bank. How can it affect stocks? Increasing or decreasing the money supply results in either an inflationary or a deflationary environment, which can help or hurt the economy, specific sectors and industries, and your stock picks. When the money supply flows into goods and services, you get higher consumer prices. When it flows into assets (such as stocks), you get asset inflation, which precedes an asset bubble.

Interest rates

The Federal Reserve has crucial influence here. It can raise or lower key interest rates that in turn can have an effect on the entire economy and the stock market. When interest rates go up, it makes credit more expensive for companies. When interest rates go down, companies can get cheaper credit, which can be better for profits.

Government bailouts

bailout is when the government intervenes directly in the marketplace and uses either tax money or borrowed money to bail out a troubled enterprise. This is generally a negative because funds are diverted by force from the healthier private economy to an ailing enterprise.

remember When many of the factors in Table 15-1 work in tandem, they can have a magnified effect that can have tremendous consequences for your stock portfolio. Alert investors keep a constant vigil when the legislature is open for business, and they adjust their portfolios accordingly.

Ascertaining the political climate

The bottom line is that you ignore political realities at your own (economic) risk. To be and stay aware, ask yourself the following questions about the stock of each company in which you invest:

·        What laws will directly affect my stock investment adversely?

·        Will any laws affect the company’s industry and/or sector?

·        Will any current or prospective laws affect the company’s sources of revenue?

·        Will any current or prospective laws affect the company’s expenses or supplies?

·        Am I staying informed about political and economic issues that may possibly have a negative impact on my investment?

·        Will such things as excessive regulations, price controls, or new taxes have a negative impact on my stock’s industry?

Regardless of the merits (or demerits) of the situation, investors must view it through the lens of economic causes and effects, which in turn leads to their decisions on which companies (and their stocks) are impacted positively or negatively.

Distinguishing between nonsystemic and systemic effects

Politics can affect your investments in two basic ways: nonsystemic and systemic.

·        Nonsystemic means that the system isn’t affected but a particular participant is affected.

·        Systemic means that all the players in the system are affected. Laws typically affect more than just one company or group of companies; rather, they affect an entire industry, sector, or the entire economy — more “players” in the economic system.

In this case, the largest system is the economy at large; to a lesser extent, an entire industry or sector can be the system that’s affected. Politics imposes itself (through taxes, laws, regulations, and so on) and can have an undue influence on all (or most) of the members of that system.

Nonsystemic effects

Say that you decide to buy stock in a company called Golf Carts Unlimited, Inc. (GCU). You believe that the market for golf carts has great potential and that GCU stands to grow substantially. How can politics affect GCU?

What if politicians believe that GCU is too big and that it controls too much of the golf cart industry? Maybe they view GCU as a monopolistic entity and want the federal government to step in to shrink GCU’s reach and influence for the sake of competition and for the ultimate benefit of consumers. Maybe the government believes that GCU engages in unfair or predatory business practices and that it’s in violation of antitrust (or antimonopoly) laws. If the government acts against GCU, the action is a nonsystemic issue: The action is directed toward the participant (in this case, GCU) and not the golf cart industry in general.

What happens if you’re an investor in GCU? Does your stock investment suffer as a result of government action directed against the company? Let’s just say that the stock price will “hook left” and could end up “in the sand trap.”

Systemic effects

Say that politicians want to target the golf industry for intervention because they maintain that golf should be free or close to free for all to participate in and that a law must be passed to make it accessible to all, especially those people who can’t afford to play. So to remedy the situation, the following law is enacted: “Law #67590305598002 declares that from this day forward, all golf courses must charge only one dollar for any golfer who chooses to participate.”

That law sounds great to any golfer. But what are the unintended effects when such a law becomes reality? Many people may agree with the sentiment of the law, but what about the actual cause-and-effect aspects of it? Obviously, all things being equal, golf courses will be forced to close. Staying in business is uneconomical if their costs are higher than their income. If they can’t charge any more than a dollar, how can they possibly stay open? Ultimately (and ironically), no one can play golf. The law would be a “triple bogey” for sure!

What happens to investors of Golf Carts Unlimited, Inc.? If the world of golf shrinks, demand for golf carts shrinks as well. The value of GCU’s stock will certainly be stuck in a sand trap.

remember Examples of politics creating systemic problems are endless, but you get the point. Companies are ultimately part of a system, and those that control or maintain the rules overseeing that system can have far-reaching effects. All investors are advised to be vigilant about systemic effects on their stocks.

Understanding price controls

Stock investors should be very wary of price controls, which are a great example of regulation. A price control is a fixed price on a particular product, commodity, or service mandated by the government.

warning Price controls have been tried continuously throughout history, and they’ve continuously been removed because they ultimately do more harm than good. It’s easy to see why (unless, of course, you’re an overzealous politician or bureaucrat eager to apply them). Imagine that you run a business that sells chairs, and a law is passed that states, “From this point onward, chairs can only be sold for $10.” If all your costs stay constant at $9 or less, the regulation wouldn’t be harmful at that point. However, price controls put two dynamics in motion:

·        First, the artificially lower price encourages consumption — more people buy chairs.

·        Second, production is discouraged. What company wants to make chairs if it can’t sell them for a decent profit (or at the very least cover its costs)?

What happens to the company with a fixed sales price (in this example, $10) coupled with rising costs? Profits shrink, and depending on how long the price controls are in effect, the company eventually experiences losses. The chair producer is eventually driven out of business. The chair-building industry shrinks, and the result is a chair shortage. Profits (and jobs) soon vanish. So what happens if you own stock in a company that builds chairs? I’ll just say that if I tell you how badly the stock price is pummeled, you’d better be sitting down (if, of course, you have a chair).

Looking at the role of central banks

Central banks are the governmental entities that are charged with the responsibility of managing the supply of currency that’s used in the economy. The problem with this is the tendency of central banks to overproduce the supply of currency. This overproduction leads to the condition of having too much currency, which leads to the problematic condition of inflation. If too many units of currency (such as dollars or yen, for example) are chasing a limited supply of goods and services, consumers end up paying more money for goods and services (ugh!), but this is the reality that occurs when central banks (in the case of the United States, the Federal Reserve) create too much of the currency.

Poking into Political Resources

Ignoring what’s going on in the world of politics is like sleepwalking near the Grand Canyon — a bad idea! You have to be aware of what’s going on. Governmental data, reports, and political rumblings are important clues to the kind of environment that’s unfolding for the economy and financial markets. Do your research with the following resources so you can stay a step ahead in your stock-picking strategies.

tip I know that this section is laden with economic terms and the like, but fear not! Take your time with the terms and concepts, and don’t forget that plenty of good sites provide easy-to-understand definitions and explanations. Look up any term in this chapter (or book) and do a search at venues such as Investopedia (www.investopedia.com) and Investor Words (www.investorwords.com). More sources are in Appendix A.

Government and other reports to watch out for

The best analysts look at economic reports from both private and government sources. The following sections list some reports/statistics to watch out for. For additional private reports and commentaries on the economy, investors can turn to sources such as Mish’s Global Economic Trend Analysis (globaleconomicanalysis.blogspot.com), the Mises Institute (www.mises.org), and Moody’s (www.economy.com). General sources, such as MarketWatch (www.marketwatch.com), Bloomberg (www.bloomberg.com), and Yahoo! Finance (http://yahoo.com/finance), are good as well.

warning Alas, government reports aren’t totally reliable because errors and/or purposeful fudging happen and usually have a political component to them. Take the gross domestic product (GDP), for instance. In the second quarter of 2008, the GDP was reported at a surprisingly robust 3.3 percent — a very healthy number given the fact that the economy was struggling at the time. A closer examination revealed that the GDP was calculated using a very low inflation rate of just 1.2 percent, a 10-year low. Yet in a separate report for the same quarter, the same agency (the Bureau of Labor Statistics, or BLS) reported that inflation was at 5.6 percent, a 17-year high! Had the BLS used this more believable inflation rate, the GDP would have actually been at 1.1 percent. I doubt that the fact that 2008 was an election year is a coincidence because games like this have been played by administrations of all stripes dating back to Franklin Roosevelt’s day. A good way to round out your economic analysis is to compare government data from other sources that scrutinize the same data. One that I like is Shadow Government Statistics (www.shadowstats.com).

Gross domestic product

Gross domestic product (GDP), which measures a nation’s total output of goods and services for the quarter, is considered the broadest measure of economic activity. Although the U.S. GDP is measured in dollars (as of 2015, annual GDP is in the ballpark of $18 trillion), it’s usually quoted as a percentage. You typically hear a news report that says something like, “The economy grew by 2.5 percent last quarter.” Because the GDP is an important overall barometer of the economy, the number should be a positive one. The report on the GDP is released quarterly by the U.S. Department of Commerce (www.commerce.gov).

remember You should regularly monitor the GDP along with economic data that relates directly to your stock portfolio. The following list gives some general guidelines for evaluating the GDP:

·        More than 3 percent: This number indicates strong growth and bodes well for stocks. At 5 percent or higher, the economy is sizzling!

·        1 to 3 percent: This figure indicates moderate growth and can occur either as the economy is rebounding from a recession or as it’s slowing down from a previously strong period.

·        0 percent or negative (as low as –3 percent): This number isn’t good and indicates that the economy either isn’t growing or is actually shrinking a bit. A negative GDP is considered recessionary (meaning that the economy’s growth is receding).

·        Less than –3 percent: A GDP this low indicates a very difficult period for the economy. A GDP less than –3 percent, especially for two or more quarters, indicates a serious recession or possibly a depression.

tip Looking at a single quarter isn’t that useful. Track the GDP over many consecutive quarters to see which way the general economy is trending. When you look at the GDP for a particular quarter of a year, ask yourself whether it’s better (or worse) than the quarter before. If it’s better (or worse), then ask yourself to what extent it has changed. Is it dramatically better (or worse) than the quarter before? Is the economy showing steady growth or is it slowing? If several quarters show solid growth, the overall economy is generally bullish.

Higher economic growth typically translates into better sales and profits for companies, which in turn bodes well for their stocks (and, of course, the investors that hold those stocks).

Traditionally, if two or more consecutive quarters show negative growth (an indication that economic output is shrinking), the economy is considered to be in a recession. A recession can be a painful necessity; it usually occurs when the economy can’t absorb the total amount of goods being produced because of too much excess production. A bear market in stocks usually accompanies a recession.

remember The GDP is just a rough estimate at best. It can’t possibly calculate all the factors that go into economic growth. For example, crime has a negative effect on economic growth, but it’s not reflected in the GDP. Still, most economists agree that the GDP provides an adequate ballpark snapshot of the overall economy’s progress.

Unemployment

The National Unemployment Report is provided by the Bureau of Labor Statistics (www.bls.gov). It gives investors a snapshot of the health and productivity of the economy. If the level of jobs (especially full-time jobs) meets or exceeds the number of jobs needed to keep able-bodied adults employed, the economy is growing, and that is a positive for both the economy and the stock market.

In recent years, the unemployment rate has been a subpar statistic in terms of giving people an accurate picture of unemployment in the economy because it has been changed to be overly optimistic. For example, the rate was 5 percent in December 2015, which seems to be a good (low) unemployment rate, but it counts part-time jobs and full-time jobs with equal weight and ceases to count someone as unemployed if he or she ceases looking for a job.

This is why analysts look at other unemployment measures such as the BLS’s U-6 unemployment rate, which is a more comprehensive rate that’s adjusted for part-time jobs and for those still unemployed but have ceased to look for work. In December 2015, that rate was about 10 percent (yikes!).

Yet another measure of unemployment is a stat called the Labor Force Participation Rate, which counts all working-age adults who are participating in the workforce. As of December 2015, the number of adults in the workforce was approximately 62 percent, which is nearly a 40-year low (in other words, 38 percent of adults were not working — not good!).

The Consumer Price Index

The Consumer Price Index (CPI) is a statistic that tracks the prices of a representative basket of goods and services monthly. This statistic, which is also computed by the Bureau of Labor Statistics, is meant to track price inflation. Inflation is the expansion of the money supply. This is referred to as monetary inflation, and it usually leads to price inflation, which means that the price of goods and services rises. Inflation, therefore, is not the price of goods and services going up; it’s actually the price or value of money going down. Investors should pay attention to the CPI because a low-inflation environment is generally good for stocks (and bonds, too), whereas high inflation is generally more favorable for sectors such as commodities and precious metals.

Leading Economic Indicators

The full title is the “Composite Index of Leading Indicators.” Leading Economic Indicators (LEI) is one of the most widely tracked economic statistics because it’s made up of ten economic components whose changes typically precede changes in the economy at large. Investors and analysts watch this carefully so they can spot a major trend unfolding in the economy and determine whether that trend is positive or negative. The index is published by the Conference Board (www.conference-board.org).

There are also “lagging indicators” and “coincident indicators” that the Conference Board publishes, but investors are more concerned about the future, so the LEI is more closely watched.

The Producer Price Index

The Producer Price Index (PPI) tracks the prices that are paid at the wholesale level by manufacturers and other producers. Investors watch this because if producers are paying more for commodities and other materials, then higher prices will subsequently occur for consumers. The PPI is calculated monthly by the Bureau of Labor Statistics.

The Consumer Confidence Index

The Consumer Confidence Index (CCI) is published by the Conference Board and is a survey of 5,000 consumers and businesspeople about the economy. Consumer confidence being up is generally seen as a positive for investors because it indicates that people are more upbeat, and that leads to a tendency to either spend more or be more apt to make big-ticket purchases. This expected consumer activity bodes well for the economy and stocks in general.

Websites to surf

To find out about new laws being passed or proposed, check out Congress and what’s going on at its primary websites: the U.S. House of Representatives (www.house.gov) and the U.S. Senate (www.senate.gov). For presidential information and proposals, check the White House’s website at www.whitehouse.gov.

tip You also may want to check out THOMAS, the service provided by the Library of Congress, at http://thomas.loc.gov. THOMAS is a search engine that helps you find any piece of legislation, either by bill number or keyword. This search engine is an excellent way to find out whether an industry is being targeted for increased regulation or deregulation. In the late 1980s, real estate was hit hard when the government passed new regulations and tax rules (related stocks went down). When the telecom industry was deregulated in the mid-1990s, the industry grew dramatically (related stocks went up).

Turn to the following sources for economic data:

·        Bureau of Labor Statistics (investors’ information page): http://www.bls.gov/audience/investors.htm

·        Census Bureau’s Economic Indicators page: http://www.census.gov/economic-indicators/

·        Conference Board: www.conference-board.org

·        Free Lunch: www.freelunch.com

·        Grandfather Economic Report: www.grandfather-economic-report.com

·        Investing.com: www.investing.com

·        The Federal Reserve: www.federalreserve.gov

·        U.S. Department of Commerce: www.doc.gov

tip You can find more resources in Appendix A. The more knowledge you pick up about how politics and government actions can help (or harm) an investment, the better you’ll be at growing (and protecting) your wealth.