At the time of this writing, US market indexes are near all-time highs in spite of falling profits for S&P 500 companies.  The only good news is that the fall has not been as precipitously fast as it was during the financial crisis of 2008-9.  Therefore, there can be only one reason why the US market indexes are so high.  That is, not only has the US Fed kept rates near zero, but other major economies are posturing to lower rates, or have already done so.

With rates being so low in the US for over 6 years, many US companies as well as whole industries have made great strides, or recovered due to the very cheap financing that has been available to them to prop up their finances.  This act alone, for so long, is highly unusual and should give all investors pause.  The Chinese government has taken notice, by lowering their own key lending rates a total of 6 times in the last year alone.  Europe has strongly hinted lately that they will do the same.

So by review of market data from a number of sources, it appears that without continuous stimulus by the US Fed, the US market should have dipped back into recession in 2011, followed by the longest recession ever seen.  This did not happen due mainly to the extraordinary moves by the Fed.  Other economies such as China by their actions are hoping to avoid a recession of their own, and Europe is also following suit.

The moves by the Fed to lower rates have also served to strengthen the US dollar vs. other currencies.  This was true even before other international governments began lowering their rates.  This in turn has had the effect of making US exports less profitable, due to the currency imbalance.  Since the current reality is that many large US companies derive most of their profits from overseas, this currency imbalance has limited their growth.  The US Fed would be foolish to begin raising rates when much of the rest of the world is lowering theirs.  Doing that would stifle growth further, which the Fed is hoping to avoid. It is clear that the US Fed will provide action by inaction, namely to continue to keep rates near zero for the foreseeable future.  Certainly, this will keep the market from crashing, but such unprecedented moves may be the only reason why the market has not crashed.

Unfortunately, the fact remains that healthy economies do not keep their interest rates near zero for over 6 years, or indefinitely.  It possible that economies such as China and Europe will also keep rates extraordinarily low for the next 6+ years.  No one knows how this will affect the world market, since the world has never seen this happen before.  We will explore more the difficulty that the Feds continue to face, ie why they each know that they cannot raise interest rates, in a future blog.

Google just announced that it will “reorganize” as a new corporate entity named “Alphabet”.  In a sense, this is Narcissus looking into a mirror and saying, “I am much more than a silly name meaning the number 1 with so many zeros after it.  No, look world, how Colorful I am!”, while creating a You Tube video for all the world to see.  No argument there.

However, there is much more to this reorganization than flash and a new name.

In reality, this is further definition of a financial experiment which may have little or no relevance outside the corporate walls of Google.  Certainly there is the possibility that by more formally separating the pieces, that there will be less infighting and less chaos as influencers within the company are less likely to cross boundaries into the parts of Google to which they do not belong.  It is also by no means clear that this reorganization will be of benefit to Google investors.  For example, 90% of sales is currently generated just by the “Ads” piece.  As economically sexy as all the other pieces are, there is no assurance that any of the other pieces will ever be profitable.

Having said that, it likely will only take one of the other pieces to take off for the all of the ad funding to pay off, depending on how successful that piece becomes.  Give credit to Google for attempting this financial experiment, as no company has ever attempted to do this on such a scale.  Only time will tell  whether Google will be better off attempting to create successful new businesses itself, or whether it would have been better off to go the conventional route of buying established companies with its $61 billion (and growing) cash hoard.

But these alternate realities would have played out the same whether Google reorganized or not.

The main benefit of this reorganization is not so much as a benefit to the current investor, but for the investor at some indeterminant time in the future if/when Alphabet is able to successfully spin off one or more successful companies from itself.  If this happens, it will create real reality (of $$$ in the bank) out of what is now just the virtual reality of ideas with potential.  Only time will tell.

About one year ago in a previous blog article, we commented on corporate “mergers by inversion”, which is the attempt by a US-based company to buy/merge with a UK-based company in order to reap significant tax benefits due to much lower corporate tax rates in the UK company. The biggest example given was the attempt by the US-based drug company Pfizer to buy/merge with UK-based AstraZeneca. This attempted merger has since been thwarted in part because of changes made in the US tax code.
However, the changes in the tax code do not affect US companies which had already completed their inversion before the changes in the tax code went into effect. In fact, it appears that most companies (the majority are pharmaceutical companies) that were interested in this form of tax-dodging were clever enough to make this change before the tax changes took place. For example, the formerly Pennsylvania-based Endo Health Solutions acquired Paladin Labs of Ireland in Q4, 2013 to become Endo International PLC. Since then, the Ireland-based company has boldly made or announced three acquisitions of US pharmaceutical companies totaling $8 billion. In total over less than 2 years time along with companies such as Actavis Pharmaceuticals and Valeant Pharmaceuticals, formerly US companies have acquired or have agreed to acquire over $125 BILLION of mostly US companies. This not only decreases the US tax-base, but also creates the feeling of loss for Americans who are aware of such shenanigans, sort of like being a Cleveland Cavaliers fan watching the talented but narcissistic LeBron James take his talents to South Beach, or a Miami Heat fan watching LeBron James take his talents to the beaches of Lake Erie.
While the US authorities were well-intentioned to finally change the tax code to make it less appealing for these inversions to be consummated in the future, the US IRS was clearly late to the party, forcing all remaining, law-abiding, tax-paying US companies and citizens to pick up their tabs.

The US economy grew about 2.6% in the last quarter of 2014. This is reflective of the growth in consumer spending (which represents about 70% of the US economy) of more than 4%, and less than 2.6% for the rest of the economy, including manufacturing and exports. In fact when the US economy is humming along at a healthy clip as it is beginning to do now, improving consumer confidence results. This is a natural consequence of a healing and healthy economy.
Looking closer at consumer confidence (ie, the Thompson Reuters University of Michigan survey), it recently hit an 11 year high of 98.1. This slow but continuing improvement is due to a variety of factors, including low inflation, an improving employment situation, and still low gas prices at the pump. Even more important than this 98.1 figure is the rate of change of this figure. For example, the 6 month change of consumer confidence is one of the largest improvements ever. This recipe is generally a good combination for stock markets. In fact, one of the few improvements similar in magnitude occurred in the early 1980’s, which was the start of one of the biggest bull markets in history. Even though markets are currently near all-time highs, could we be in the middle of another large bull market today?

Overall inflation in the US is currently running at about 1.5%, still less than the 2.0% target that the Federal Reserve shoots for. Fairly or not, many equate a decrease in inflation enough to cause deflation, with a recessionary environment or economy. While low inflation is not in and of itself bad, when it gets too low it provides less room to avoid a spiraling effect towards deflation in the event some sort of macroeconomic shock occurs. The problem becomes more complicated as the US economy becomes more dependent on the world economy. True, while slow and plodding, it is generally agreed that the US economy is on the mend. However, the specialized calculus as determined by different economists can sometimes result in confusing results when different estimates of the relevant factors are used in the equation. This is why the stock market has been behaving in a more volatile way recently, with large swings in valuation even within a 1 day period.

More directly, what situation would we be in if inflation dropped a mere 0.5%, due to multiple threats overseas such as a possible slide back into recession by Europe, coupled with a decreasingly inflationary environment in China, the so called “manufacturer to the world”.

It is also unclear, given the different strategies employed by the Fed by multiple attempts to stabilize the economy over the last 6 years, what the Fed can effectively do if called-upon to act once again. Our lives in some ways have never been more complicated, to the extent that the macroeconomic forces impact each of our microeconomic lives.

Many corporations (and all corporations set up under Subchapter S of Chapter 1 of the IRS code) are not taxed.  And for those that are taxed, many pay much lower than the maximum 40% tax rate.  In fact in 2011, the 10 most profitable companies paid an average tax of just 9%

US law disallows taxation of US company profits overseas.  In the 1990’s several US companies moved to tax havens such as Bermuda and the Cayman Islands, a maneuver called “self-inversion”, to reduce their tax burden.  Since 2004, tighter US regulations have done away with this practice.

Since 2004, US companies have looked for other ways to reduce the taxes that they pay, typically with the approval of shareholders.  One of the most popular ways is through a process of “inversion by merger”, whereby for example, a US corporation merges with a corporation which resides in a foreign country that has lower taxes than the US, followed by moving the newly created holding company to the foreign country.  This has been done several times over the past several years, which effectively moves dollars previously taxed and collected by the US to remain in the pockets of the foreign company and it’s shareholders.  The most recent example of an attempted “merger by inversion” in the news is the attempt by US-based drug company Pfizer to buy/merge with UK-based AstraZeneca.

Inversion activity is a symptom of problems in the international tax system that needs to be addressed.  At the very least, vague or nonspecific language in the current regulations such as requiring the company to perform “substantial business activities” in the foreign country, should be clarified in order to create a level playing field and to improve fairness to all countries in international tax reform.  However, the news is not all bad for the US IRS.  For example, there are still instances where it is advantageous for a US-based company to repatriate funds from overseas to the US, such as for reinvestment in the US.  A recent example is the US e-commerce company EBay, which recently said it will bring as much as $9 billion back into the US, which will create an additional $3 billion tax charge.