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Unintended Consequences of Accelerated Depreciation (part II) 1
Economists vs. Job Creation: Why the disconnect?NASD Firm Margin
Special Report: Margin,September 17, 2003AugustSeptember 2 3122, 2004
Barry Ritholtz, Market Strategist
Unintended Consequences of Accelerated Depreciation (part II)Economists vs. Job Creation: Why the disconnect?NASD Firm Margin Spikes to Record Levels
Dismal Scientists seem to have forgotten the ‘Law of Unintended Consequences’ On Monday, the NASD publicized the dangers of Margin in a report titled “Investing with Borrowed Funds: No "Margin" for Error.” That warning was particularly timely: NASD member firms’ margin holdings hit record levels in July 2003 (see chart below). As of that date, clients of NASD Firms had a little under $26 Billion dollars in margined positions.
Prior to this peak, NASD margin had topped at $21.4 Billion in March 2000 (along with the Nasdaq peak). Margin in brokerage accounts fell during the Bear market, bottoming near $5 billion dollars in December 2002. It is not surprising that this 76.3% drop is very similar to the Nasdaq’s valuation loss of 78.41% over the same period. Similarly, NYSE member firms saw their margin levels drop 53.25%, close to the peak-to-trough loss in the S&P500 of 50.51%.
Data Source: NASD
The last time margin levels had been near $5 billion was January 1998. Previous margin lows were noted in August 1997, at $4.594B.
We have reviewed the public data regarding margin and have also spoken with the NASD officials behind the news release. We attribute several factors (some of which are in part conjecture) as the likely causes of to the spike in NASD margin:
1) Speculation came roaring back into fashion. Small investors feared missing the rally, and jumped in with both feet. Unlike the prior four rallies during the 2000 – 2003 bear market, this rally appeared to “have legs;”
2) A significant number of former high flyers – non-marginable when they became one-dollar wonders – are now trading back over $5. Trading over that threshold means these mostly small cap tech stocks can once again be bought on margin. These speculative favorites seem to have found their way into many hedge fund portfolios, as well as more aggressive individual investors;
3) Some consolidation in the clearing industry, with several former NYSE clearing firms being absorbed into large NASD clearing firms. That could account for some percentage of margined assets shifting from NYSE to NASD, as the general margin numbers climbed;
4) Smaller NASD firms have seen their style of speculation return to favor. The so called “stock jockey” firms have found surprisingly receptive public willing to roll the dice once again.
NYSE Firms Carry Much Less Margin
Despite the lack of finely differentiated details, several elements are clearly visible from the available data. NYSE clearing firms are bigger, and in many cases, much bigger, than their comparable NASD firms. The NYSE firms hold more asset classes.
Although (or perhaps because) they have significantly more assets under management than NASD firms, NYSE firms have not seen a similar increase in margin. In fact, NYSE firms have seen their margin debits rise only slightly from the September 2002 lows:
Data Source: NASD
Margined assets also peaked for NYSE member firms in March 2000, at $278.5 billion dollars. It reached a bear market bottom of $130.2 billion dollars in September 2002.
Conclusion
We do not read this uptick in margin as a warning sign for the broader market. Any comparison of the total outstanding margin at present with those of the March 2000 market highs simply does not warrant a correlation, in our view. The total amount of margin debt remains significantly below the bubble peaks, when considering the combined margin assets of both NYSE and NASD firms.
Data Source: NASD
Margined assets also peaked for NYSE member firms in March 2000, at $278.5 billion dollars. It reached a bear market bottom of $130.2 billion dollars in September 2002.
One noteworthy issue is the dearth of usable statistical data regarding margin details. We were surprised to learn how few margin statistics are kept by member clearing firms: There is no breakdown of margin data by assets, by type of holder, or by stock price. Excuse the quantitative junkie within, but I would have liked to be able to analyze:
1)Apportionment of margin between individuals versus institutions;
2)Nasdaq versus NYSE listed stock margin data;
3)Low priced stocks (under $10) versus all other;
4)Margined stock based upon pricing deciles ($10-20; $20-30, etc.).
Considering that this information is simply pulled off clearing firm databases, it is something that the exchanges should consider doing. More quantitative information about stock holdings, investor behavior, trading patterns, etc., can only inure to the benefit of all investors, in our opinion.undercurrents goings on beneath the surface smashingly --–perform below expectationsdisappointedhigh-end such as ’performance reported by numbers from CostCoCostco following several years of pent-up demand 20'performance, in our view, results from the retailers of higher end goods suggestsresults from the retailers of higher end goods suggest Bearing this out is This shows up in monthly and will ; They w
I’d gladly pay you tomorrow for a hamburger today.
-J. Wellington Wimpy, (Popeye)
Earlier this week, we discussed the importance of changes in tax rules governing Accelerated Depreciation of Capital Investment, the tax advantaged accounting change that is scheduled to expire on December 31, 2004.
From its inception, it was expected to be a temporary stimulus designed to assist industries hurting in the post-bubble environment.
It has had that effect, in varying degrees, across many industries. The rule change has been stimulating capital purchases in a variety of sectors: In particular, Semiconductors, Industrial Manufacturing, Aircraft, Heavy Trucks, Telecom, and in particular, large Enterprise-wide Software applications.
The kicker to that stimulus is that Accelerated Depreciation is scheduled to sunset this year and the governing provision is that to qualify for the tax advantage, capital purchases must be “placed into service” by December 31. That creates a possibility of a Y2K-like run up in the late 3rd and early 4th Quarters, as companies scramble to catch the last of the tax benefit before the rule’s expiration.
up late 3rd and early sto catch the last of the tax benefit before the rule's
Unintended Consequences
Because there's no such thing as a free lunch this fact forces the question: What are the negative, unintended consequences of the changes in the accelerated depreciation rules? We know that many sectors have benefited from the rule – but what has been the cost? In what ways has the rule been harmful to the recovery?
There are two particular dangers: deferred hiring (macroeconomic) and future purchase pull through (microeconomic). Let’s briefly review each issue, to see if we can determine what, if any, the financial and/or economic impact the rule might have for the rest of this year and into 2005.
We know that many sectors have benefitted from the rule -- but what has been At what the cost? In what ways h it the ppt;DLet's briefly review each issue, to see if we can determine what, if any, the financial and/or economic impact of the rule might be for the rest of this year, and into 2005.
is looking forward
21) Future Purchase Tr
Given the tax advantaged status of purchases made in 2004 -- versus 2005, we would expect to see accelerated buying in the second half of thise the year. Anecdotally, we , As we have seen that. A, Iif there was any way any firm was planning omn nto makingeing a large that a you could make a capital purchase in buy Why would you buy in Q1 2005, it would greatly benefit from doing so behoove them to do so in 2004 instead,.
if there were
Our working assumption is that many of the buys being made now are coming at the expense of the first half of 2005. That's the "pull through" (or reverse channel stuffing) which is the result of this rule. Its kinda like -- 0only in
Consider an ousthe period: The following the run up to Y2K and the immediate aftermath int he . first half of 2000.
year end in 1999/2000, Leading up to and the widely feared Y2k problem, generated there ws lots and lots of activity was completed prior to the New Year.y. Some of it, like COBOLobalt programming and updating, were one- shot deals. We are unlikely that need will not to see another frenzy of COBOL activity again much more of that programming activity be worried about until the year 9,999.
lots of
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Other buys, like But we did see a flurry of PC purchases and software upgrades,did benefit from the activity prior to December31, 20001999 -- but at the expense of 2000 first half purchases..
And while the Nasdaq did screamed higher for the fiorst three months of 2000 the yea, thwe handwriting was laready on wall. Indeed, it can be s arguedable that if the Q1 March 2000 preannouncement period -- in of that year2000 -- was, at least in part, the a pin that helped helped prickeded the bubble. We all recall know what , leading to the market crash dated abouting to happened after March 21, 2000).
dating right around that time.
While our technical work does nnot suggest a similar crash is imminent, Wwe can and should can expect to see might see a similar phenomena in terms of pull through. Many of the second half 2004 purchases will come at the expense of first half of 2005 sales.
All of the the spark that
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1) Deferred Hiring
The rule has had an unambiguous macro-impact on the broader economy: Large capital purchases have come at the expense of hiring.
Unlike prior economic recoveries, the post-2001 recession period has seen very unusual dynamics in expansion hiring patterns. I attribute this atypical aberration to excess post-bubble capacity, large increases in worker productivity, and cost-effective overseas outsourcing.
Whjile pull thorugh is sector specific, thjetj
theAny scramble in the fourth quarter
While "pull thorough" -- discussed nbelow -- b is sector specific, we also observe nvery specific macro- impact within on the broader economy: large captial pruchases havse come at the expense , at in in no small expenseway, of hiring. on the r
\UnliekU prior economic recoveries, the the post-2000-01 recession, perido there has sbeen a very unusual dynamics in the delay aberration in the usual typical expansion hiring patterns. I attribbute theis a to a variety of factors: large increases in worker p, and in cost- effective o
outsourcing.
in
can be attribvuted
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there has also
Source: Chart of the Day, Federal ReserveNew York Federal Reserve
That was likely get
But we should not overlook the impact of a subtle structural another major change in Corporate Americathe economy: The widespread usage of business intelligence applications and enterprise resource planning wide software (ERP). These "“efficiency and productivity'’ apps It have s had a significant impact on the economic recovery.
It has long been a staple of economic belief that corporate capital spending boosts profits, adds to the gross domestic product, and puts people to work. This held true throughout most of the 20th century. When companies purchased oil-rigs, drill presses, or large trucks, someone had to manufacture those goods. Companies needed workers to meet the rising demand for this capital equipment. And once that widget was manufactured, someone else was hired to operate it, drive it, or work it.
Let's take a specifc look at exactly how.
a staple of economic belief Th, transport and install thema
In all likelihood that was the White House's intent in accelerating the depreciation schedule for capital improvements. If companies get a larger tax benefit for making bigger purchases, then jobs should be the natural net result.
But this 20th century economic concept runs into some decidedly 21st century issues. Namely, labor requirements are very different in the age of intellectual property and software.
The problem seems to be that a large percentage of the capital purchases have been made in the software sector: Enterprise-wide applications make companies more efficient, productive and competitive. So efficient in fact that it reduces (or even eliminates) the need for additional hiring.
Our channel checks confirmed that suspicion: CIOs and CTOs, especially at small and medium sized firms, have been aggressively purchasing these enterprise apps over the past 2 years. Firms that design these ERPs market them as "paying for themselves" in a few years – specifically, in labor savings. The tax advantage of accelerated depreciation provided management with an incentive to install these apps sooner rather than later.
The problem seems to be that a large percentage of the captial purchases has come in the software sector for ERP: Big applications which reduce or eliminate the need for additional hiring. in all likelihoodshould be the natural
Namely, labor requirements are very different in the age of intellectual property and IP and software.
haves been coming made in the software sectorEnterprise- wide make companies more efficient, productive and competitive.; So efficient Unfortunately, It that it also , seven s)
The danger is that
Our cAs this chart makes
economic hannel checks confirmed thate suspicion, -- sized , -- these over the past 2 yearsprovides with install these apps
The fFirms that design make these them as "paying for themselvesof accelrated depreciation vided
It is inevitable that Iin order to stay competitive in the global marketplace, most firms would have had to install these apps eventually anyway. There is a global "“efficiency arms race in Its like a efficiency,"” and if onme any firm garners an advantage using these tools, that makes these tools, than its inevitable that all t heir competitors will ; have to --– just to stay comeptecompetitive. y.
That's good news for the our the Unbited State's countriscountry' competitve stance vis-a-vis the rest of the world. We If we are uUp against cheap foreign labor, than som,e our technology had better provide a cost advabanatage to compensate.
That’s good news for the U.S.’s competitive stance vis-à-vis the rest of the world. Up against cheap foreign labor, technology had better provide a cost advantage to compensate.
The bad news is that the deferred hiring comes at an economically sensitive juncture during the recovery. We have already seen the impact in slowing GDP and anemic job creation, and with the exception of continued low interest rates, most of the stimulus is behind us. The present phase of recovery should be one of organic growth where increased hiring leads to more consumer spending.
Yet that has not been happening in any appreciable way.
That’s one of the unintended consequence of the ERP and business intelligence applications: a dampening of hiring needs. Even at software firms, one of the main beneficiaries of this capital spending spree, there has not been a huge increase in headcount. That’s one of the great ironies of accelerated depreciation: Intellectual property doesn't require many new hires in response to an uptick in demand: How many people are needed to make another installation disc? At best, software firms see a small increase of hires in sales and support staff – but it’s relatively tiny. Compare that to the 20th century equivalent: When a steel mill or an auto factory hired in response to rising demand, they would add tens of thousands of new employees.
that theis deferreed hiring comes at anduring . .
We have already seen see the impact inof anemic job creation. Now, With most of the stimulus is behind us.
The present next phase of recovery should be oneof organic growth -- increassed hiring leading to more consumer spending.
Yet that has's not been happening in any appreicable tion
T
atst one of ththese ERP and : -- spreenot been a huge one of the great ironiesmany new hires in response to anmake anotehr discsoftware firms see staff relatively
Thus, the unintended consequence of this 20th century solution to a 21st century problem: lackluster job growth.
corporate
"Slow Job Growth Puzzles Economists." That was the headline of a WSJ article in March of this year, on the economy's anemic job creation. "Many economists admit they are 'stumped' by the question of why the expanding U.S. economy isn't churning out lots of new jobs, as it did so faithfully in the 1990s," the Journal noted.
Since then, their forecasting record has gone from bad to worse. With the June shortfall now clearly not a “one-off” courtesy of July’s disappointment, one question remains: Why have so many Economists gotten it so wrong? Observers are hard pressed to recall the last time the Dismal Scientists have been so consistently inaccurate, by such a large margin, and for so long a period.
It is easy to surmise that a combination of factors is to blame for the unusually slow job growth: Productivity enhancements have delayed the need for new hires in many businesses. And, during this expansion, jobs have been outsourced overseas (which, for obvious reasons, do not show up in the Bureau of Labor Statistic’s data). Last, we cannot underestimate the impact the tech/telecom/internet crash had on suppressing end demand. So much excess capacity was created by over-investment during the bubble era, that an extended delay in job creation – “Slack in the labor market,” as Chairman Greenspan likes to call it – is the natural result.
Yet all these issues have been well known and documented long before Economists started serving up their stink bombs. Did the entire profession suddenly become unhinged – or is some other, unknown factor at work? Since most economists I know are only mildly delusional (at least, they appear that way to a non-economist) we should consider another possibility: A major factor –unaccounted for by mainstream economists -- has contributed to the present recovery cycle’s unprecedented long delay in job creation.