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Is the Rise of Margin Debt a Danger?

(February 22, 2007)

Dear Subscribers and Readers,

As of Wednesday evening, 2,800 freight train conductors and switchyard employees from the Canadian National Railway were still on strike – pending some kind of brokered agreement with the Canadian government.

In early March, the California Faculty Association's board of directors will vote whether to strike as a response to the breakdown of recent salary negotiation talks between the association and the California State University administration.  The association represents approximately “24,000 professors, librarians and counselors at 23 California State University campuses.”

14,000 workers at Goodyear Tire & Rubber went on strike on October 5, 2006 and did not return to work until January 2nd – a major reason why Goodyear lost $358 million during the fourth quarter of last year.

According to Statistics New Zealand, labor strikes in New Zealand increased from a loss of 13,255 days for the 12-month period ending September 30, 2005 to a loss of 26,198 days on a year-over-year basis.  36 of the 49 strikes in the country were over wage disputes.

Codelco, the world's biggest copper producer, just struck a wage agreement with a union representing over 500 workers at the Chuquicamata copper mine (the company's largest mine) – narrowing averting a strike. 

The reason why I am bringing up all these recent examples of labor disputes is simple: I believe one of the biggest risks to higher stock prices this year continues to be the threat of a more protectionist Congress and a labor backlash – given a widening distribution of both income and wealth in the U.S. economy in recent years, and given the perceived lack of dignity in which many Fortune 1000 employees have been treated – such as through:

  1. Mass layoffs (often with little or no warning) of said employees while the companies that are doing the layoffs are still hugely profitable;

  2. Stagnated real wages while executive management is making tens of millions of dollars.  If that was not enough, these executive managements also had to backdate stock option grants;

  3. A severe bear market in stocks during 2000 to 2002 – a bear market which had hit many retail investors disproportionally in their pocketbooks, while many folks in executive management had already cashed out beforehand.  In some cases, the implosion of various companies was directly linked to the actions of the CEO, such as Enron, Worldcom, Global Crossing, etc;

  4. Losing their jobs to workers in developing countries due to outsourcing or “offshoring”;

  5. Losing their jobs in private equity acquisitions while private equity investors and management of the new private companies “make off” with savings reaped from these layoffs.

As I have mentioned before in our previous commentaries, it is not our job to engage in any philosophical or detailed historical discussions about the concept of “capital vs. labor” since this is first and foremost a site dedicated to successful investing, and since many folks out there can do it better than we do.  Ultimately, however, it is not about philosophy or hard data/statistics – all this author knows is that many corporate workers are now getting tired and fed up with corporate management.  Ultimately, perception is reality.  Moreover, it is important to note that even in capitalistic societies, just like many things in life, labor/union power also goes through cycles – although trends in labor and union power tend to be very secular in nature and are definitely nowhere near as volatile as the movements in the stock market.  In our April 2, 2006 commentary (“Will Corporate Profits Continue to Outperform?”), I introduced the concept of the Gini Ratio in measuring the distribution of income in a particular society.  Quoting from our April 2, 2006 commentary: Readers who are interested in how this index is constructed can read the following page at Wikipedia, but in a nutshell, it is basically a crude and simple way to measure income inequality in a certain economy.  While it may be rather crude (for example, non-monetary welfare benefits such as food stamps is not taken into account into household income), the above chart showing the Gini Index over time definitely tells you one thing: Income inequality in the U.S. has generally increased since 1960.

In that commentary, we also published a chart showing that the level of real salaries and wages for workers in the United States have not increased very substantially over the last few decades. Courtesy of the latest “Flow of Funds” data published by the Federal Reserve, the following updated chart shows that as a percentage of GDP, wages and salaries paid to workers in the U.S. is still near a 40-year low:

Employees' Compensation & Employees' Compensaiton as a Percentage of GDP (1Q 1980 to 4Q 2006) - Except for a brief dip in 1997, employees' compensation (including supplemental income as well as wages) as a percentage of GDP is now at its lowest level since 1966 - even as employees' compensation continues to rise. The $64-billion question is: Will this stage a reversal in the coming months? Or will employees continue to be squeezed out of the picture? Part of the answer lies in the unemployment rate, but I have a feeling that government intervention will also play a role this time around. Stay tuned.

As I mentioned on the above chart, employees' compensation as a percentage of GDP – except for a brief period from 1993 to 1997 – is now at its lowest level since 1966.  More importantly, given the new Democratic-controlled Congress, and given the continuing “backlash” behind 1) China's currency policy, 2) excessive CEO pay (even President Bush is now joining the debate on the side of the workers), 3) Wal-Mart, 4) minimum wage laws, etc., there is a good chance that there may be various government legislations to be introduced this year that will seek to correct for this “inequality” in income.  As an important aside, subscribers should note that the above chart showing “employees' compensation” has already incorporated CEOs' pay into the mix!  That is, while the above chart shows the relative decline of the average U.S. worker's salaries and wages relative to profits either returned to shareholders or retained by the company, what it doesn't show is the relative decline of the median salary and wage level relative to the pay of executives in the Fortune 1000 companies.  While we are not in “uncharted territory,” so to speak, we are definitely in “territory” that has not been witnessed since the 1920s.

Given the above issue, it is again essential to ask: Are you basically a capitalist or a wage-earner?  Would you like to see a 10% rise in your salary as opposed to a 10% rise in your 401(k) portfolio?  Do you have sympathy for the workers at Delphi or GM?  How happy are you when housing prices in your neighborhood appreciate by 15%?  Can you even afford to buy a house in your neighborhood and pay off your mortgage in 30 years?  Or do you see yourself as being a virtual slave to your local bank or credit union?  It is also interesting to see that there tend to be many more capitalists near the peak of the stock or housing market than at the bottom – when everyone is having a grand old time and when one is more concerned with rising asset prices than income levels.  While many workers have been oblivious to layoffs in the auto industry, for example, it is still difficult to tell whether the increase in capitalistic thinking in recent years is cyclical or secular in nature (GaveKal seems to think that it is secular).  This question is even more important in places like Los Angeles (where the median price of a home is over $500,000) and in Hong Kong, Tokyo, New York, and London.  A 20% increase in the S&P 500 is great, but not when your 401(k) account only has $50,000 (and half of it is in bonds or cash) – and when it comes at the expense of your neighbor's job and future salary increases.  At this point, I am still not convinced that most Americans have turned capitalistic in nature.

Okay Henry, I am in business for myself.  While I am definitely interested in the potential of a “labor backlash” hurting the stock market, that is probably only something to be watched over the long-run.  What about any indicators you are currently watching that may have a more immediate impact?

Well, maybe.  NYSE margin debt data outstanding as of the end of January 2007 was just released a couple of days ago – and many bears are already “celebrating” this number simply because it has overtaken its March 2000 peak.  As I discussed in our December 21, 2006 commentary (“Margin Debt Approaching Record Highs”), since under normal circumstances, this is usually not a problem, as the amount of margin debt has historically hit higher highs during successive cyclical bull markets – even during the cyclical bull markets within the secular bear market of 1966 to 1974 (see the first chart in our December 21, 2006 commentary).  Nonetheless, this increase in margin debt still poses a red flag – as the rate of ascent in the margin debt outstanding has been nothing short of phenomenal over the last few months – as shown on the following chart showing the Wilshire 5000 vs. the 3, 6, and 12-month changes in margin debt from January 1998 to January 2007:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to January 2007) - As shown on this chart, the rate of increase in margin debt experienced the greatest three-month increase since March 2000, while the 12-month increase in margin debt is now at its highest since April 2000!

The total amount of margin debt outstanding on both the NYSE and the NASD increased $10.2 billion (assuming that NASD margin debt remained the same, as January NASD data isn't released until the end of this month) to $313.5 billion – a new record high.  As mentioned on the above chart, the 3-month change in margin debt ($45.8 billion) is now at its highest since March 2000 while the 6-month change in margin debt ($57.5 billion) is now at its highest since April 2000!

That being said – for those that are already long and are in stocks that have good fundamentals and earning power – I would not consider selling here.  Records are meant to be broken, especially during a bull market.  Moreover, many things I have read suggest that most of the increase in margin debt has been due to speculation in foreign stocks and ETFs – as opposed to the concentration in domestic technology stocks back in late 1999 and early 2000.  In past times, I would have slapped an emphatic “sell” on international stocks and on emerging markets – but given the much cleaner balance sheets and economic/earnings growth in emerging markets in recent years, I now believe margin debt can continue to increase from current levels before we see any kind of significant correction.  Readers please stay tuned.

More on Taiwan: For those who are still skeptical of investing in Taiwan (mostly because of the latest corruption scandal involving the current opposition leader and a leading 2008 Presidential candidate), I urge you to read the following take on Taiwan by the Heritage Foundation.  Quoting the Heritage Foundation:

Taiwan's economy is 71.1 percent free, according to our 2007 assessment, which makes it the world's 26th freest economy. Its overall score is 0.5 percentage point higher than last year, partially reflecting new methodological detail. Taiwan is ranked 6th out of 30 countries in the Asia–Pacific region, and its overall score is much higher than the regional average.

Taiwan has high levels of investment freedom, trade freedom, property rights, fiscal freedom, freedom from corruption, and freedom from government. The average tariff rate, inflation rate, and level of corruption are all low. Although Taiwan's personal income tax is high, the corporate tax rate is moderate, and overall tax revenue is low as a percentage of GDP. Government spending is similarly low. Taiwan's investment climate is healthy, and 100 percent foreign ownership is permitted in most sectors. Property rights are protected by the judiciary, although there are minor problems with case delays and corruption associated with organized crime.

The only “fly in the ointment”: Taiwan is relatively weak in labor freedom and business freedom. The country's labor market is not as flexible as it could be, and dismissing a redundant worker is costly. Starting a business takes as long as the global average, but commercial licensing can be difficult.

While Taiwan is still grasping with a corruption culture – subscribers should know that by regional and global standards, it is still quite satisfactory from an investment standpoint, ranking 32nd out of a total of 158 countries as compiled by the Heritage Foundation – coming ahead of countries such as South Korea (40th), Italy (also 40th), and Malaysia (39th).

As always, please email me with any suggestions and/or questions.

Signing off,

Henry To, CFA

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