Watching Sausage Being Made: The $3.5 Trillion Budget Reconciliation Package

Otto Von Bismarck, the man credited with uniting various fiefdoms into what is today Germany, once said there are two things the public must never see: one is sausage being made; the other is how legislation is passed into law. The $3.5 trillion reconciliation spending bill before Congress this week is already known for its size and breadth of recipients.  Programs as diverse as building veterans hospitals and providing hearing aids and dental care for seniors are on the agenda. Interestedly, the American Dental Association is against the proposal since Medicare pays relatively little.  Community colleges would become free to all who attend, while pre-school programs accommodating students as young as three and four years old would be offered, assuming matching state funds.  A program of this size will require significant funding.  While the plans are not yet finalized, below is a partial list of what to possibly expect. There is a pledge not to raise taxes on individuals making less than $400,000 per year or families earning less than $450,000.  Above that level, things get interesting. Incomes in excess of those amounts would see the marginal tax rate increase to 39.6% from the current 37%.  Families or individuals making over $5 million per year will be subject to an additional 3% surtax on the excess. The top corporate tax rate will be increased to 26.5% from 21% for companies making over $5 million under the proposal.  The top capital gains tax rate for individuals goes to 25% from 20%. There is a provision for taxing net investment income in excess of $400,000 ($500,000 joint).  This pertains to hedge fund operators, private equity organizers, and the like.  Previously they have used various tax avoidance strategies to pay no more than 15 percent tax on their investment income.  All these increases are to bring in a net $1 Trillion per year.  Add increasing the budget for IRS enforcement, taxing foreign earnings at 16.5% (up from the current 10.5%), and additional levies on those earning more than $5 million per year, and the estimated total income is $2.9 Trillion.  After estimating that the increase in economic activity will kick in another $600 Billion, the $3.5 Trillion funding package is financed. Two caveats:  the package has not been voted on, so anything can happen, both on the spending and tax side.  Second, getting spending of this magnitude off the ground will take more than a year.  It may take more than two.  Given the tightness of the current labor market, the programs will be collectively quite inflationary. It could be that the biggest impact on the economy will not be the taxes themselves but the competition for workers.  2022 was previously shaping up to be a year of decelerating revenues and higher input costs.  In other words, narrower profit margins.  Higher corporate income taxes will have an adverse effect on corporate profits, perhaps causing what was projected to be flat aggregate earnings year over year to go negative. If this is the case, companies will have even more incentive to raise prices sooner rather than later, and the Fed’s mantra about “transitory inflation” will go out the window. Most of the discussion thus far has less to do with the merits of the various proposed programs and more to do with whether we as a country can afford it.  There may be some pushback on parts of the tax proposals due to their costs.    Republicans would like to see the measure fail so as not to give the Democrats credit for the enactment.  They would also like to avoid the tax increases, which even some moderate Democrats see as a bit much. We will have to wait to see what happens.  In the meantime, talk of victory or defeat here is more one of the percentages.  Probably neither side will get all it wants.  The trick will be to see how much is signed into law and how it is financed. The Economy Economic activity is moderating. A combination of higher labor costs and transportation expenses has made advancing revenues and profits problematic.  An effort afoot to create more output in the US has run into problems of finding domestic expertise for products that have been almost exclusively imported for years.  The pending spending package will greatly increase the demand for labor. Whether it will provide a second wind to the economy could depend on how, for example, increasing funds for child care frees up women to re-enter the workforce in greater numbers than previously. Inflation Inflation is rising.  Import disruption, semiconductor chip shortages, and changing demographics are all working to push prices higher.  The party line at the Fed has been that the increase in prices is transitory, although no forecast sees a decline in labor costs this year or next. The Fed has not incorporated the spending bill before Congress on the rationale that it is not foreseeable until passed.  Look for forecast revisions once the dust settles on the size and shape of the spending packed adopted. Interest Rates Every time the Fed meets, the date for increasing interest rates seems to be pushed forward.  Three months ago, it was 2023.  Now it is early 2022.  Depending on the size of the spending bill to be passed this week, it may be late 2021. There is a school of thought that the stock market cannot afford an interest rate increase given its rich valuation.  While that may be true of some of the more generously valued shares, it does not appear to be true of the market overall.  The Stock Market Stocks overall seem to be a bit rich in terms of price.  Possible downward revisions in earnings estimates, a lack of clarity on what is going on in China, and the lingering effects of COVID have all made the estimation of revenues and profits for next year and beyond especially fraught.  Some retailers are talking of selling out their holiday inventory in November due to supply-chain complications.  They frankly cannot predict how and when they can stock their shelves for Christmas. Some industries are doing better than others.  Energy seems to be a bright spot for those who will still invest in the same.  Financial firms as a group are expected to benefit as interest rates rise.  Freight transportation is booming, passenger transportation less so.  The fourth calendar quarter is usually when research firms turn the page and focus on the subsequent year, in this case, 2022.  It will be interesting to see how estimates come out given all the cross-currents at the moment. Warren M. Barnett, CFA September 28, 2021 Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Bernie Madoff Redux: The Case Of Southport Capital

By now, most of the public has at least heard of the Ponzi scheme of John Woods, majority owner of Southport Capital, a Chattanooga, TN brokerage firm which has, in a complaint filed with the SEC, received $110 million from some 400 investors over the last ten years. These investors were told that their monies were invested in government debt and real estate projects that would produce a return of 6-7 percent per annum. Instead, the funds coming in were in part paying the interest to the earlier investors. Less than 20 percent of the monies raised went into any sort of investment, and the investments were not those which paid 6-7 percent right out of the gate, if ever. While the accounting is a bit murky at this point, it is assumed that John Woods and his co-conspirators were the principal beneficiaries of the fraud while it lasted. The vehicle for the fraud was a private equity fund called Horizon Investments. It was managed by Mr. Woods and a few close associates. The investment was sold through the brokers at Southport as a private placement. Southport is a “dual-listed” company that has both a brokerage arm and an advisor branch called Livingston Group Asset Management Company. The advisor part charges a fee for managing the Horizon Fund. The brokerage arm executes the trades for the advisor side and sells the packaged financial products assembled by the advisor (Livingston) for a commission. The conflicts should have been apparent instantly. Because it was an unregistered “private placement” and promoted as a non-marketable security, the conflicts were either not disclosed or not made obvious to the investor in the venture. This investment falls under the rubric “Alternative Investing.” As interest rates have fallen, investors needing income have become increasingly desperate for investments that have a steady return on the level of 12-15 years ago. Such investors were receptive to the blandishments of Southport brokers, some of whom may have been in the dark themselves and who touted the Horizon investments as ones that investors could retrieve their principal back in 30-90 days. This is the same promise made by Bernie Madoff, from whom Woods might have obtained his operating concept. Many will fault the Securities and Exchange Commission for this occurrence. However, Woods never registered Horizon Fund with the SEC, making it impossible for them to oversee until someone brought it to the SEC’s attention. Also, the SEC’s enforcement budget is a fraction of what it was a decade ago, thanks to Congress, while the proliferation of financial products has risen exponentially. Finally, investors of private placement products are usually required to sign a statement called a “big boy” letter saying that they are an “accredited investor.” Such a statement states that the investor has a net worth of at least $1 million (home excluded) or income of at least $200,000 per year in each of the two most recent years, the SEC-mandated minimum standards for purchasing a risky financial product. These amounts have not been changed in 39 years. The idea is that if an investment is risky, the investor must demonstrate that they can afford to lose the amount invested. The SEC spends more time going after those who are trying to fleece unsophisticated investors than in providing needed assistance to the investors themselves. Aside from a lack of inflation adjustment in the threshold amounts, the problem is that the investor’s financial information operates on a self-policing honor system. This data is notarized but never verified. It is assumed that the investor providing the information is presenting truthfully his or her financial status. Some people overstate their wealth in order to invest in a product that is supposedly only offered to those of means. They sometimes do this in order to obtain status since investing in such products is a subtle way to tell others of your presumed income or net worth. Some investors hope that investing like the “big shots” will enhance their own investment return. What people do not realize is that falsification of such information can impair their ability to sue for recovery. If you are this well off, you are more likely to be able to afford to lose your investment. At this time, it is not clear if the investors in the Horizon Private Placement were ever asked to sign such a statement validating their income or net worth. If not, the situation becomes even more criminal for the organizers. How can an investor protect himself or herself from situations such as this? The first thing is to demand a separation of functions. Those profiting from selling the investment should be different from those managing the same. In this case, the separation superficially existed, given the Livingston Group Asset Management Company appeared to be a separate entity from Southport Capital. The problem was that both were part of the same organization and shared common ownership. What looked like a separation, in fact, did not exist. An SEC database search would have revealed this. The sales brochures probably did not. The second thing is to insist on investments that can be converted to cash quickly and are valued by a third party. The lack of transparency of the Horizon Private investment gave the manipulators the ability to carry on a charade as to its worth for years. Many investors get vertigo following the stock market up and down. What they do not appreciate is that the fluctuation in prices is not the same thing as risk. Not all non-marketable investments have the soundness of a certificate of deposit, which is often the first experience most investors have with something that does not fluctuate in price. Third, submit a proposed investment to a reality test. A return of 6-7 percent a year on a US government investment does not currently exist. The return for a 30-year Treasury bond is less than 2 percent. If someone is promoting something too good to be true, it usually is. Finally, support more financial resources for the SEC. A tax of 0.1 cents per share transacted would greatly add to the budget of those who are mandated to protect the well-being of the investing public. States are hamstrung as well, for the same reasons. It is time to give those whom we entrust to safeguard our financial system the means to do so. The Economy The economy is getting ready to downshift due to the end of the federal stimulus program. While the program has been blamed for disincentivizing workers for low-wage jobs, the reality is that those states who had previously eliminated federal unemployment support are seeing a deceleration in economic activity relative to the states that have not, with no material uptick in numbers employed. Nationwide, the number of those not working roughly equals the number of jobs being listed as available. The problem is in the details. Many jobs are in areas where people do not want to move to due to family or community ties, the cost of living in the new locality (especially housing), a lack of complementary job skills, the cost and availability of daycare, a lack of social skills to secure service-type jobs, age of the jobless and the like. Interest Rates Internationally, interest rates have been slowly going up. Governments in other parts of the world (South Korea, Chile, Hungary) have already started raising rates. The question is how fast this trend will accelerate. The aggressiveness of interest rate increases will be a function of the ending of the Federal Reserve’s program of buying bonds. This provides liquidity and lowers interest rates by increasing the amount of currency in circulation. At present, the portfolio of bonds and other debt securities owned by the Federal Reserve is between $8 and $9 trillion. If the Fed were to simply stop buying bonds and let their portfolio mature, about $200 billion would be taken out of the money supply each quarter. Inflation The favorite word that is attached to inflation these days is “transitory”. People are trying to convince themselves that whatever inflation occurred this year will not be around going forward. This is being done because the alternative is perhaps too alarming to contemplate. Still, with labor shortages as prevalent as they are currently, it is somewhat wishful thinking to assume that inflation will go back to the level of pre-COVID. Expect inflation to be a more prominent topic of conversation going forward. The Stock Market Stocks seem to be grinding higher, supported by post-COVID profit increases that seem dramatic compared to 2020, less so when compared to 2019. The liquidity provided by the stimulus has helped greatly to keep the market on an upwards trajectory. Watch China. The current conduct of the country hardly reflects its self-interest. Its economy is slowing down. The issue is whether it will take other economies with it. Mark Hulbert recently quoted one of the fathers of contrarian investing, Humphrey O’Neill, saying “When everyone thinks alike, everyone is likely to be wrong.” There are still attractive stocks. The issue is whether there is an attractive stock market. Especially for those who invest in packaged products, the slope will soon get steeper. Index investing works when the broad sweep of the market propels it. Valuations would suggest that such tailwinds are going to slow down if not reverse. Warren M. Barnett, CFAAugust 30, 2021
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Riding The Chinese Tiger: How Changes In Chinese Securities Laws Will Impact US Investing

There is an old maxim in China: “He who chooses to ride the tiger goes wherever the tiger goes.” This has gained relevance for investors after China decreed over the past weekend that private schools set up to tutor Chinese students will have to become non-profit in order to continue operating. One entrepreneur saw his firm’s $15 billion valuation shrink by 98 percent in a day. The attack on tutoring, which the Chinese government described as “injecting capitalism into education,” will probably not be the last effort to rein in entrepreneurs in China. It follows a pattern of attacking Chinese companies that have listed securities abroad to raise capital, such as Alibaba, Tencent, Didi Global, and others. The common thread is that these firms are innovative, collect data on their customers, and have created great wealth outside the Communist Party. Just as it is the nail that sticks up from the board that gets hammered back down, so it is the innovators that fall into the gun sights of the Chinese government. To better understand the dynamics at play, understand that the Chinese military and the Chinese Communist Party are one and the same. For years China followed the Soviet Union’s example of total government ownership. They also suffered from inefficient production due to overstaffing of government-owned factories due to cronyism. This was reversed under the tenure of Deng Xiaoping (1977-89), who understood that China could not move forward unless the entrepreneurial nature of its people was harnessed. During his term, factories were transferred to private ownership through public stock sales. Industries became more efficient, and living conditions were greatly improved. With economic opportunities so abundant in the cities, people flocked from the rural areas much in the same manner as Americans did a century earlier. Because economic advancement was shared more by the urban areas than the rural, tension began to mount between the two. Rural areas began to grumble about the lack of government focus and funding afforded them compared to the cities. Children visited their parents and discovered they had less and less in common. Of great interest to the military, there were fewer rural people to recruit into the armed forces. This was especially alarming because most of the soldiers come from the countryside, where local avenues for improvement are limited, education is more primitive, and enthusiasm for the government is less questioned. Finally, as the current leader Xi Jinping (2012-present) knows, revolutions are started in the countryside. They then spread to the cities. There were incidents of uprisings in the provinces. The military took note. With less of a surveillance system on its people in the country compared to the urban areas, the party decided to err on the side of conformity, this option being the first choice of totalitarian regimes everywhere. Things like private tutoring struck a chord among the rural populace. Most could not afford such things, nor was it accessible without the internet service, which many lack. As the party began to see a deepening divide between rural and urban populations, it opted to defer to the rural to keep solidarity within the party. In the same fashion, those who were perceived as ostentatious in their success were reminded of where they came from and where they live. In the west, with its emphasis on the individual, displays of wealth are considered optional. Sometimes such displays are considered distasteful by those who critique the nouveau riche, but this is usually as far as it goes. In China, such displays invite harsh rebukes from party officials who feel that those who choose to stand out due to their success must be made examples for others not to emulate. In some cases, rebukes can take the form of prison sentences for charges that would not hold up anywhere else. Occasionally wealthy people disappear from public view for weeks at a time to return far less extroverted. To the extent that this crackdown on private companies shares anything in common with the west, it is in the area of data. Both western and eastern governments are growing increasingly alarmed about the volume of information collected on people and its private use. It looks increasingly likely that antitrust laws will be used against large tech companies by US and European regulators. China, with no concept of antitrust, prefers to cut to the chase. The implication of this change in attitude towards both large technology firms and foreign investment is sobering. China has been the fastest-growing securities market in the world. For this reason, it has been a magnet for US investment funds. There may come a time when extracting one’s investments from China may be impossible. This is a cautionary tale of international investing. It will be interesting to see where the tiger chooses to go. The Economy After all the stimulus pumped into the economy during the COVID pandemic, it has now come time to see what the economy can do on its own. This is a topic of great interest. Growth rates for the second half of 2021 range from 2-6%. While this is still a positive number, it is a definite deceleration from earlier in the year. Employment continues to vex the expansion. While returning to work takes time, it may also take higher wages for entry-level jobs. Interest Rates Interest rates have declined in the past quarter against most forecasts that they would increase. This decline can best be explained by the almost $900 billion that has flowed into the US from foreign investors since the first of the year. As China and other areas look less stable, investing in the US becomes more attractive. The inflows have affected both bond yields and stock prices. How long the funds will stay in the US is anyone’s guess, but they provide yet another source of market elevation so long as they remain. Most bond forecasts call for increasing interest rates. Even $900 billion cannot offset a deficit of $3 trillion and counting. Inflation Inflation spiked in July to over five percent. While the rate is expected to moderate, there is no forecast of decline. As inflation stays elevated and is acknowledged by more of the investment public, there will be an insistence that investments earn a return in excess of inflation. By category, bonds are the most vulnerable in this scenario. The Stock Market Stocks appear to be setting records for overall price and valuations. The issue is whether this can go on. If it can’t, what will rein it in? With the concentration of large tech stocks in the conventional indexes, the owners of the associated funds may find their appreciation of 17.5 percent year to date to be illusory if congress does go after the companies on antitrust grounds. So too will a declining level of economic growth make valuations questionable, although such a declining level of growth will affect everyone, although not equally. With valuations not seen since the dot com era of 2000, it may be a good time to know what one owns. History may not repeat, but it can display facets of commonality. Warren M. Barnett, CFAJuly 27, 2021
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The Zombies Among Us: How COVID Has Affected Some Companies

A grim milestone was reached this week as this country recorded 600,000 deaths from COVID-19 and its offshoots. Still, the trend is decelerating rapidly, vaccinations are being accepted no matter how unevenly, and there is an air of, if not victory, at least hope in dealing with the pandemic. The effect of COVID on companies is less obvious. Firms show, for the most part, no outward strains from the pandemic save for those in the hospitality and retail industries. However, data shows that companies borrowed around $11 trillion to stay afloat during the time that revenues declined or disappeared. The repayment of this sum, along with the interest it generates, will impact profits and cash flows for years. Take Norwegian Cruise Lines Holdings as a case study. During 2020 and 2021 year-to-date the company has taken on $7.1 billion in financing. This figure includes a recent $1.6 billion from the issuance of 53 million in new shares. The number of shares outstanding has increased by 73 percent since December 2019. Pre-COVID, Norwegian earned about $1.2 billion pretax per year. Norwegian had and still has several ships on order. In assessing the company’s ability to deliver future earnings, it has a good deal of debt to work through. Norwegian also now has more shares and thus more dilution of future earnings. This hollowing out of balance sheets and potential dilution of future earnings due to COVID is, in fact, more common than is generally observed. Transportation and retail seemed to have been the most often hit by this erosion of financial health. Outside transportation, a key attribute seems to have been whether an industry or company was considered “essential” during the pandemic. If so, the firm may not have done badly. In some cases, the results were stellar. For firms that were not essential, there was a lot of downtime, lost revenues, and lost profits to absorb. Companies that carried large dollar amounts of assets per dollar of revenue were the most at risk for material declines in operating leverage. Some demand will be recaptured in the post-COVID era that in some ways seems upon us. Some demand is lost forever. The current stock market, at least prior to this past week, seemed not to make the distinction between companies that were on the cusp of earning money and those that would be able to keep it. Many investors are fixated on projected earnings per share. Their reason: if earnings are to go up, it must be good for shareholders. While eventually true, if earnings are to pay down the principal of debt, it helps shareholders only indirectly and over time. Additional shares are equally problematic. Once profits are restored, they must be divided by a greater number of shares outstanding. This last fact impedes earnings per share growth. What about share buybacks? Do they not increase share prices? Yes and no. Buybacks do shrink the number of shares outstanding, but do not help the balance sheet if funds financing the buyback are borrowed. Then there is the issue of whether the funds should be used to reduce debt instead. Debt reduction strengthens the company but does not goose the increase in earnings per share like buybacks do. Management has been lobbied by investment bankers to reduce shares outstanding by buying them back. This aids the industry analyst in making stock forecasts and makes the investment banker look good in the process. A second reason is it makes the stock options issued to management more valuable so long as no one complains about the debt remaining. This act of self-interest, along with the ego trip of not splitting stock to make its rise easier to compute, would seem to indicate that not always is management’s interest aligned with the owners – the shareholders. Europe takes the concept of stock as a proportionate interest in the business far more seriously than the US does. Here stock is acquired by a company through public transactions. In Europe, stock cannot be bought back unless there is an auction that all shareholders can participate in. Conversely, a company cannot be acquired for stock unless the shareholders vote to authorize the additional shares. Issuing stock to management on the scale allowed in this country is unheard of. The European tax treatment of stock options is more transparent as well. European stocks, in general, pay higher dividends than the typical American share. Such is their way to distribute surpluses to shareholders. Correcting these mindsets will take more reform than currently exists in terms of political will. The issue here is one of ownership and governance. In the long list of grievances, these matters are not at the forefront, as most do not understand the implications of reforming them. The EconomyBy most measures, the economy is off the charts. The charts themselves are distorted by the lockdown of the economy last year. Most economists are looking for economic growth in the neighborhood of 6 plus percent for this year and the early part of next year as well. After that, the pandemic will be gone from yearly comparisons, and it will be up to the long-term growth of the economy going forward. One statistic of interest is the so-called quit rate, which is how often employees voluntarily leave their jobs. It is usually related to the number of jobs available compared to the number being pursued. Employees are leaving in record numbers (about 2.7 percent) for other opportunities. The reasons range from demographic (more people retiring than entering the workforce) to opportunistic (better pay and benefits elsewhere). All this portends to a tighter labor market and higher inflation going forward, especially in service industries that are less prone to automation. The fastest way to take pressure off the labor pool is through some form of immigration, perhaps in the form of worker visas for a specific amount of time. This has been done in Europe for years. The usual form is for a five-year visa followed by another five-year visa if employed at the end of the first five years. After that, citizenship may be applied for, but oftentimes the immigrant is simply saving to go back to his or her home country. InflationInflation is gathering momentum, as the forced savings of the past year meets the limited supply of goods as well as supply chain snafus that drive up prices. Housing seems to be of special attention. Years of building fewer homes than supply required coupled with the shut down during the pandemic has created a demand that possibly will not be satisfied for years. Lumber prices are coming down relatively, but shortages of workers and zoned land for building are keeping demand from being satisfied. Starter homes are especially rare to build, as higher profits are delivered by building more expensive homes. Interest RatesHow long the Federal Reserve can keep its thumb on the scales of interest rates is anyone’s guess. Some predict 2 percent ten-year Treasury bonds by year-end, up from under 1.5 percent now. Savers in banks and money market funds will have to suffer a while longer. There is so much money flowing through the system it seems that it will have a judgment day, but there is as of now no financial John the Baptist to say when. Until then, investing in assets that have some return beats no return, so long as there is substance behind them and hopefully the potential to raise their dividend. The Stock MarketThe declines of this past week seem to be a harbinger of something, although what is up for debate. The greatest declines were by the stocks that have gone up the most, which would seem to indicate profit-taking by short-term traders. However, the larger theme of value over growth, and substance over lack of the same, seems to be intact. Of special note: Tesla’s former President Jerome Guillen, who left the company earlier this month after over ten years there, just sold all his stock in Tesla, pocketing proceeds of $274 million after cashing in his stock options. Also, the Chinese government is cracking down on the production of cryptocurrency in that country due to the amount of electricity required for its creation. Bitcoin prices are down almost 44 percent since the peak this year. Party on. Warren M. Barnett, CFAJune 21, 2021
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Inflation is Coming: Are You Ready? Are You Sure?

As of last Friday, the Standard & Poors Index, the basis for index funds under the same banner, had recorded a year-to-date appreciation of 11.29 percent. While this is a commendable number, it was attained entirely (and then some) on Price/Earnings multiple expansion. A year ago, the index had an average P/E ratio of 20.34. It is now 44.41. In a nutshell, stock prices went up while earnings went south. Covid played a huge part in this earnings decline, and the vaccination is expected to play an equally huge role in causing earnings to return. This begs the question: what are earnings expected to be going forward post-Covid? According to published pronouncements from Standards & Poors, earnings for 2021 are expected to be $178.08 for the 500 stock index. If this forecast is accurate, it would imply a P/E ratio based on 2021 estimated earnings of 23.22. In 2022, assuming we can see out that far, earnings are predicted to rise to $202.75, which puts the P/E ratio at that point (assuming no change in the overall value of the 500-stock index) at 20.39. Historically the P/E ratio has been about 16, although it has been subject to a great deal of fluctuation. As the name implies, the Standard & Poors 500 is a composite of 500 stocks of the largest firms in the country. The stocks are weighted by market capitalization, so a large firm like Amazon has more impact on the index than a smaller firm. Six firms make up 22.13 percent of the weight of the index: Apple, Amazon, Facebook, Netflix, Alphabet (parent of Google), and Microsoft. The Standard & Poors also maintains an index of the next 400 firms in terms of size. This index, called the Midcap 400, is up 19.04 percent year to date. A third index of the smallest 600 stocks is up 20.66 percent in this same time frame. Both these indexes are doing almost twice as well as the largest index. What does this imply? First, the S&P 500 index is having some issues relative to the larger market. It included the most favored stocks for so long that their valuations may now be called into question. Last week, Netflix disappointed in terms of subscriber growth, and this led to the stock correcting over ten percent. If companies like Netflix, Amazon, and the like were the chief beneficiaries of the lockdown associated with the pandemic, does it not follow they would be hurt relatively speaking when the economy recovered? In a similar vein, could it be that smaller firms, who bore the brunt of the lockdown, are now ready to take back the business lost to the larger firms? Time will tell as to how much consumers’ shopping habits have been altered by the pandemic. Initial reports are that consumers just want to get out and take their lives back. That could take the form of more socializing and less binge-watching television. It could also take the form of travel, at least within the US this year. Restaurants are scrambling to find staff, which may mean higher prices and slower service. In fact, with a high savings rate, it would seem that higher rates of inflation will be a foregone conclusion. A second advantage the mid-cap and small-cap indexes have over the flagship S&P 500 is a more reasonable valuation. A third advantage is that smaller companies are more likely to already be paying corporate taxes, as smaller firms lack the know-how to avoid paying taxes in the manner of larger enterprises. This means that smaller firms will not feel the impact of the proposed minimum corporate tax rate as much as larger firms, should it be enacted. While the rate at this point is largely undefined, it will be a jolt to the profits of large companies like Amazon, who have never paid taxes due to their heavy investment spending. Companies who play games with keeping their profits abroad to avoid US taxation will also be targeted. Putting all of this together, we may yet have a correction, or we may already have had one. The term to describe leaders falling back and being replaced by other firms is “sector rotation”. A historical example is 1974-82: in this time frame, the Standard & Poors index essentially went nowhere, while the smaller capitalization index tripled. We may be witnessing the same now, as the environment for large companies becomes increasingly hostile. Pressure on large-cap names comes from not just valuations and taxes but also from antitrust, foreign governments’ desire to tax earnings at a higher rate, political and social issues, and privacy concerns. In 2017, the S&P 500 went up 19.4 percent. The chief reason earnings went up that year was the decline in corporate taxes from 35 percent maximum to 21 percent. While we are entering a very strong and recovering economy, should the tax increase be enacted into law, it will impact valuations to the downside. The chief questions are whether the increases will be enacted and when, as well as in what form. The Economy With pent-up demand and a high savings rate, it would seem logical to assume the economy will do well as the lockdown becomes history. Estimates are all over the map, but all are positive. The chief concern at this point is the adequacy of labor relative to demand. Demographically the country has more people dying than being born, even before Covid put its thumb on the scales. Without some sort of controlled immigration, there is no easy way to fix this. European countries have addressed this with worker visas of three to five years. If there is no work, the foreign workers are sent home. Critics say the process is easy to circumvent. In Europe, stiff fines and jail time await an employer who tries to hire a worker with an expired visa or below the legal wage. In the US, the onus has been on the employee rather than the employer. Inflation It looks like America’s efforts to avoid inflation are about to run out of string. The record prices for housing are pressing the inflation rate, as is the shortage of semiconductor chips to build everything from appliances to automobiles. It is predicted that there will be fewer sales when supply is constrained. Right now, there are about thirty container ships outside the port of Los Angles and Long Beach waiting to unload. It is estimated that they hold collectively 45,000 containers of goods for everything from clothes to washing machine parts. Until the logjam is resolved, look for bare spaces on store shelves as a result. Interest Rates Efforts by the Federal Reserve to hold down interest rates may also be running out of options. The Fed continues to champion full employment. However, the combination of jobs being in areas where people cannot or will not commute or move to coupled with a denial by employers as to what is required in terms of compensation to hire, is leading to an impasse in stronger job growth. If wages rise faster than interest rates, the effect will be to cause people to acquire things that they think will appreciate in value faster than inflation overall. Should this mindset take hold, the Fed’s job will be greatlycomplicated. The Stock Market Floating on the liquidity furnished by the Federal Reserve, stocks continue to rise on the backs of higher earnings, low-interest rates, and high demand. Reports of higher taxes under consideration are spooking the market, although nothing has been proposed or voted on. Given the reaction to what has been proposed thus far, the passing of tax legislation may provide a buying opportunity for those that do not hold some of the highflyers which have more compelling valuations. Addition to the Firm Barnett & Company welcomes the addition of Katie Stuart to our staff. Katie comes to us from the banking industry, where she excelled at customer service. Katie is a native of Newport, Tennessee, and an MBA graduate of Carson-Newman University. Katie will be assisting Yvonne Hobbs with client needs as well as serving as the office manager. She has embarked on the CFP program and will be the resident expert on financial and retirement planning. We at Barnett & Company welcome her aboard. Warren M. Barnett, CFAApril 27, 2021
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How Indexes Mislead: Performance of the S&P 500 Relative to Other Benchmarks

As of last Friday, the Standard & Poors Index, the basis for index funds under the same banner, had recorded a year-to-date appreciation of 11.29 percent. While this is a commendable number, it was attained entirely (and then some) on Price/Earnings multiple expansion. A year ago, the index had an average P/E ratio of 20.34. It is now 44.41. In a nutshell, stock prices went up while earnings went south. Covid played a huge part in this earnings decline, and the vaccination is expected to play an equally huge role in causing earnings to return. This begs the question: what are earnings expected to be going forward post-Covid? According to published pronouncements from Standards & Poors, earnings for 2021 are expected to be $178.08 for the 500 stock index. If this forecast is accurate, it would imply a P/E ratio based on 2021 estimated earnings of 23.22. In 2022, assuming we can see out that far, earnings are predicted to rise to $202.75, which puts the P/E ratio at that point (assuming no change in the overall value of the 500-stock index) at 20.39. Historically the P/E ratio has been about 16, although it has been subject to a great deal of fluctuation. As the name implies, the Standard & Poors 500 is a composite of 500 stocks of the largest firms in the country. The stocks are weighted by market capitalization, so a large firm like Amazon has more impact on the index than a smaller firm. Six firms make up 22.13 percent of the weight of the index: Apple, Amazon, Facebook, Netflix, Alphabet (parent of Google), and Microsoft. The Standard & Poors also maintains an index of the next 400 firms in terms of size. This index, called the Midcap 400, is up 19.04 percent year to date. A third index of the smallest 600 stocks is up 20.66 percent in this same time frame. Both these indexes are doing almost twice as well as the largest index. What does this imply? First, the S&P 500 index is having some issues relative to the larger market. It included the most favored stocks for so long that their valuations may now be called into question. Last week, Netflix disappointed in terms of subscriber growth, and this led to the stock correcting over ten percent. If companies like Netflix, Amazon, and the like were the chief beneficiaries of the lockdown associated with the pandemic, does it not follow they would be hurt relatively speaking when the economy recovered? In a similar vein, could it be that smaller firms, who bore the brunt of the lockdown, are now ready to take back the business lost to the larger firms? Time will tell as to how much consumers’ shopping habits have been altered by the pandemic. Initial reports are that consumers just want to get out and take their lives back. That could take the form of more socializing and less binge-watching television. It could also take the form of travel, at least within the US this year. Restaurants are scrambling to find staff, which may mean higher prices and slower service. In fact, with a high savings rate, it would seem that higher rates of inflation will be a foregone conclusion. A second advantage the mid-cap and small-cap indexes have over the flagship S&P 500 is a more reasonable valuation. A third advantage is that smaller companies are more likely to already be paying corporate taxes, as smaller firms lack the know-how to avoid paying taxes in the manner of larger enterprises. This means that smaller firms will not feel the impact of the proposed minimum corporate tax rate as much as larger firms, should it be enacted. While the rate at this point is largely undefined, it will be a jolt to the profits of large companies like Amazon, who have never paid taxes due to their heavy investment spending. Companies who play games with keeping their profits abroad to avoid US taxation will also be targeted. Putting all of this together, we may yet have a correction, or we may already have had one. The term to describe leaders falling back and being replaced by other firms is “sector rotation”. A historical example is 1974-82: in this time frame, the Standard & Poors index essentially went nowhere, while the smaller capitalization index tripled. We may be witnessing the same now, as the environment for large companies becomes increasingly hostile. Pressure on large-cap names comes from not just valuations and taxes but also from antitrust, foreign governments’ desire to tax earnings at a higher rate, political and social issues, and privacy concerns. In 2017, the S&P 500 went up 19.4 percent. The chief reason earnings went up that year was the decline in corporate taxes from 35 percent maximum to 21 percent. While we are entering a very strong and recovering economy, should the tax increase be enacted into law, it will impact valuations to the downside. The chief questions are whether the increases will be enacted and when, as well as in what form. The Economy With pent-up demand and a high savings rate, it would seem logical to assume the economy will do well as the lockdown becomes history. Estimates are all over the map, but all are positive. The chief concern at this point is the adequacy of labor relative to demand. Demographically the country has more people dying than being born, even before Covid put its thumb on the scales. Without some sort of controlled immigration, there is no easy way to fix this. European countries have addressed this with worker visas of three to five years. If there is no work, the foreign workers are sent home. Critics say the process is easy to circumvent. In Europe, stiff fines and jail time await an employer who tries to hire a worker with an expired visa or below the legal wage. In the US, the onus has been on the employee rather than the employer. Inflation It looks like America’s efforts to avoid inflation are about to run out of string. The record prices for housing are pressing the inflation rate, as is the shortage of semiconductor chips to build everything from appliances to automobiles. It is predicted that there will be fewer sales when supply is constrained. Right now, there are about thirty container ships outside the port of Los Angles and Long Beach waiting to unload. It is estimated that they hold collectively 45,000 containers of goods for everything from clothes to washing machine parts. Until the logjam is resolved, look for bare spaces on store shelves as a result. Interest Rates Efforts by the Federal Reserve to hold down interest rates may also be running out of options. The Fed continues to champion full employment. However, the combination of jobs being in areas where people cannot or will not commute or move to coupled with a denial by employers as to what is required in terms of compensation to hire, is leading to an impasse in stronger job growth. If wages rise faster than interest rates, the effect will be to cause people to acquire things that they think will appreciate in value faster than inflation overall. Should this mindset take hold, the Fed’s job will be greatlycomplicated. The Stock Market Floating on the liquidity furnished by the Federal Reserve, stocks continue to rise on the backs of higher earnings, low-interest rates, and high demand. Reports of higher taxes under consideration are spooking the market, although nothing has been proposed or voted on. Given the reaction to what has been proposed thus far, the passing of tax legislation may provide a buying opportunity for those that do not hold some of the highflyers which have more compelling valuations. Addition to the Firm Barnett & Company welcomes the addition of Katie Stuart to our staff. Katie comes to us from the banking industry, where she excelled at customer service. Katie is a native of Newport, Tennessee, and an MBA graduate of Carson-Newman University. Katie will be assisting Yvonne Hobbs with client needs as well as serving as the office manager. She has embarked on the CFP program and will be the resident expert on financial and retirement planning. We at Barnett & Company welcome her aboard. Warren M. Barnett, CFAApril 27, 2021
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How Avoiding Risk Can Create Risk: A Primer on False Risk Avoidance

Students of finance become acquainted with what is taught to be the “risk-free rate.” This is the return that can be obtained by investing in securities of the United States Treasury. Usually, the five-or ten-year treasury yield is counted as the benchmark rate, with potential returns taken as some increment of this rate. What makes the treasury rate chosen risk-free is the assumption that the US Treasury can never default on its obligations. Since the government prints money, there is the potential for it to simply print more as their bonds become due. So long as Treasury bonds are accepted and interest rates stay stable, everyone is fine. Since the first of the year, everything has not been fine. The ten-year Treasury yields have gone up only about 7/10 of a percent, but this was enough to cause the treasury bond to decline over 6.9 percent in value. The longer 30-year bond went down over 16.3 percent in the same time frame. While people who should know better remind us that the bonds will be worth face value at maturity, inflation ensures that the nominal worth at that time will not buy what it did when the bonds were issued. Thus, avoiding the risk of default creates a risk of depreciation of wealth- a case study in how avoiding one risk creates another. Investors, especially as they get older, crave stability. In doing so, they sometimes make the fatal mistake of assuming that the volatility of prices is the same as risk. From this mistake, a premium is paid for assets that do not fluctuate in value. Usually, an asset does not fluctuate in value because it cannot be easily priced or sold. Some investors prefer the ownership of a non-traded partnership interest, even when publicly traded real estate offers more liquidity (ease of sale). Most of the investing public considers the stock market to be the epitome of risk, given how much it fluctuates in value. As Peter Lynch, one of the early success stories of investing in the past 40 years, pointed out, the market goes down 20 percent or more at least one year out of three and two years out of five. In spite of this, stocks have a compounded annual return in excess of the categories of cash, bonds, or inflation. Part of the success of stocks at beating other asset classes is that of the potential for rising dividends. As inflation increases sales and profits, often dividends are increased as well. The income from bonds is fixed, and most of the time, cash returns less than the inflation rate, especially if taxes are deducted. The bond market has done well for almost 41 years. After Paul Volcker raised the yields on US Treasury bonds to 15 percent in 1980, interest rates have trended down to the level of close to zero late last year. Higher rates sustained the losses by bonds since. It is safe to say that the long decline in interest rates is over, and as yields increase, bond prices of longer-dated issues will continue to decline. As we enter this new era of rising prices and interest rates, it would seem that assets that retain their value and/or increase their payouts would become ascendant. They will not walk a straight line, but they have a better chance of maintaining purchasing power than investments that get run over by higher rates of interest. All this puts the risk-averse investor in an awkward position. They can either accept volatility and ride it out or seek investments that are not volatile and hope they maintain their purchasing power. Risk-aversion is almost a universal human trait. The problem is that, sometimes, aversion can carry as much cost as risk, if not more so. Even in stocks, risk can be measured best after the fact. In general, the less a stock has in terms of a dividend, and the higher its price relative to its earnings, the greater the potential for gain and risk of loss. In terms of the overall market, data would tend to support the idea that stocks, in general, are generously valued. The problem is, no one knows how long this can last. The Economy The signing of the $1.9 trillion stimulus bill seemed to have thrown a switch on the US economy. Forecasts now call for accelerating economic growth for the balance of the year. Fourth-quarter numbers are for as much as a 6-8 percent gain year over year. While revenues are expected to be up across the board, the cost of borrowing to stay afloat will hit some companies hard. There are some firms that were forced to sell additional stock to keep their doors open.They will find earnings progress especially painful, depending on the number of additional shares sold. Interest Rates Interest rates, which have gone up since the first of the year, will go up more. The increase is the first of any size in the memory of many investors and has been an unwelcome jolt on the stock market. Many investors in the stock market are not there by their own choosing, but because returns on cash and Certificates of Deposit are so low. As interest rates move to be over two percent for the ten-year treasury yield, look for money to move back into short-term cash investment from stocks. Also, look for the spread between non-investment debt and investment-grade to widen. Finally, muni debt at some point will also be impacted by the rise, although talk of higher taxes somewhat curtails the adverse impact for this category. Inflation Inflation predictions are for sharply higher rates. The debate seems to be whether the increase in the inflation rate will be temporary or ongoing. At this time, the predicted tightness in the labor market would argue for ongoing. This will change the complexion of investing going forward. The Stock Market Stocks have had quite the roller coaster ride to date. The Dow-Jones average is up 6.7 percent, while the Standard and Poors 500 is up 4.6 percent. The index for the over-the-counter market, the NASDAQ, is up only 3.4 percent, reflecting its technology dominance, while the Russell 2000 index, which has more small and fewer technology companies, is up 14.6 percent. Going forward, there is a high expectation that smaller stocks will do well with the stimulus and stronger economy. Should this not be the case, a reaction will be swift. A Note from the Founder I have been informed that certain members of the firm will be leaving shortly to start their own venture. It has been described to me as focusing on financial planning and exchange trader products. You will be no doubt notified of this decision in short order. As of now, your contract is for the services of Barnett & Company. While we welcome your patronage, this is your money. If you decide to transition to the new firm, you will need to fill out paperwork for that purpose. If you do not fill out such forms, your investments will stay with your current provider managed by us. Please call me or Yvonne Hobbs should you have any questions. 423-756-0125. Warren M. Barnett, CFAMarch 22, 2021
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GameStopped: Revenge Of The Internet On The Hedge Funds

If one goes back to the beginning, it can be surmised that the main reason for the creation of what became Wall Street was to raise capital for business and government. From the early brokers who gathered under the Buttonwood Tree in Lower Manhattan in 1792, the chief rationale of the stock market was to finance the future of the country. For most of the first 125 years, stocks were considered a riskier but potentially more rewarding version of a bond. Common stocks were sold with a capital value of as much as $100 per share, which was their capital contribution. Common stocks were sold with a stated or implied dividend. If business was good, stockholders received an increase in their dividend, something other securities did not do. While corporations were under no legal obligation to pay the dividend (unlike some preferred stocks and all bonds), missing a payment would usually set off a crash of the stock and a denial of access to the capital markets to the company. Stock manipulators like Jay Gould and Elliot Fisk tried to take over companies with stock that had been issued but not paid for. This was known as “watering down” the stock, as the corporation’s capital account did not receive a monetary benefit from the shares issued. This was illegal, but prior to the invention of the Securities and Exchange Commission (SEC), it was caveat emptor. After World War I, stocks were bought less for their dividend income and more for their earnings prospects. The 1920s ushered in the automobile, electrification, the telephone and radio, motion pictures, all of which enticed people to invest in the limitless future of these emerging and disruptive technologies. Often, if stocks paid a dividend, that was an afterthought. The investment idea was to capitalize on the trends. All of which led up to 1929. So many people had used borrowed funds to invest that when the market turned down, they were forced to sell out of their holdings. This created a cascading effect, which resulted in the market’s fall in 1929 and 1930. Once again, stock yields exceeded those of bonds in the 1930s and would remain so until after World War II. Today, we are witnessing another transition. Through the internet, hundreds of thousands of unversed speculators are being harnessed to focus on a few stocks. As this is being written, the stock of GameStop (a game retailer that was previously destined to go the way of Blockbuster in the video rental industry) has suddenly become a hot stock, having doubled in value just yesterday. This is the result of two things: a cabal of short-sellers who thought the company was going bankrupt and a legion of internet investors who wanted to make life miserable for the short-sellers. Think of it as populism meets capitalism. Short sellers focus on stocks that they think are going down in value, ideally to zero. They borrow shares from a brokerage firm and sell them, promising to buy them back later. As the stock declines in value, the account of the short-sellers increases. Sometimes, short-sellers publish “research” on the internet to support the idea that the stock being shorted is toast. In the case of GameStop, the effort backfired. Online brokerage firms like Robinhood aspires, on their clients’ cell phones, to promote endless trading of which they receive a fee (forget the deception of “no commissions”). Investor platforms like Reddit discovered through public information that GameStop stock was 105 percent short. This means that the brokers who sold the stock short did not collectively have enough stock to cover their positions. In the ensuing melee, GameStop’s stock oscillated between $10-500 per share before the SEC and brokerage firms stepped in to “maintain order” by making the stock more difficult to trade. By so doing, they were trying to drive down the price supposedly to protect the speculators but really aiding the short-sellers, who were at this point out billions of dollars. The brokers who sold them the shares short were facing ruin at the run-up prices if the hedge funds could not cover by buying back. While some may see this as a victory for the little guy against the hedge funds who orchestrated the shorts (at least until the brokerage firms and SEC jumped in), it is also a commentary on how much the stock market has, in places, become a casino, and certain stocks no more than casino chips. A second lesson to be learned is the ability of this short-squeeze trading to spill over into other parts of the stock market. If people buy GameStop at $500 a share, only to watch it go to $100, will such an investor have to sell other holdings to meet their own margin calls? This is how the events of 1929 cascaded out of control. We have gone far beyond the Buttonwood Tree. If the market is to provide a place for investors to set aside funds for their retirement, it will need to address those who want to make it a casino. Brokers and speculators love trading, but investors need positive returns over time. There may be a way to accommodate both; if not, investors need to come first. Recall the original purpose. The Economy Not surprisingly, economic data is now viewed with political overtones. With a $1.9 trillion COVID relief bill pending, such is to be expected. The reality is that the economy is still hurting. People are still being laid off in higher numbers than pre-COVID, especially in the service sector that disproportionately employs women. One in 20 homes cannot stay current on their rent or mortgage. On the other hand, vaccination progress is material. COVID cases are going down. Depending on who is being quoted, some semblance of normality is 3-9 months off, assuming no significant mutations that current vaccines cannot handle. What seems to be forgotten is that the funds being legislated can only be spent if people qualify for the same. If the economy were to recover quickly, the money would not be spent. Those who worry that the stimulus will go to those not needing it should consider surtaxing it. Someone of a higher income will repay the government more than someone in a lower tax bracket. Embedded in the bill at this time is not only an increase in the minimum wage to $15 per hour, but an expansion of who is covered by the minimum wage laws. In the restaurant industry, hourly wages can be as little as $2 per hour if tip income makes up the difference to $7.65, the current base. If restaurants, hotels, and others who hire those who rely on tip income need to pony up the difference to $15 per hour, the effect on prices could be substantial. Interest Rates Interest rates are going up. The combination of the sheer volume of government bond issuances and higher perceived returns in non-interest investments like stocks, Special Purpose Acquisition Companies (SPACs), and private equity are all eroding support for bond values. Depending on the decline, this could be a major theme of the next few years. The ten-year Treasury yield is currently 1.40 percent, and the thirty-year is 2.25 percent. Both are up from the first of the year. Inflation Inflation is becoming harder to explain away. The falling dollar and international economic revival are stoking commodity prices to their highest level since the last expansion. Even computer chips, once considered almost a commodity, are in short supply. Add to this the inflationary implications of the higher minimum wage, and the stage is set for the first round of sustained inflation in a generation. What happens next is a matter of credit availability and mindset. There are those who believe that consumers, having been denied the ability to spend money on services during COVID, bought goods instead. They may be shocked at how much more the earlier services now cost. The Stock Market Since last fall, there has been a shift away from high valuation growth stocks to lower-valued value names. Depending on how high interest rates rise, this may be a trend with some duration. Higher interest expenses will affect companies in proportion to their leverage. For the most part, the effect will not be felt all at once but rather over time as debt is reissued at higher rates. An offset may be the stimulus spending and higher minimum wage, depending on how it is structured. Studies show that those on the lowest income levels tend to spend income increases disproportionate to those receiving at higher income levels. The ability of the economy to sustain itself is key to the market’s performance in 2021. Warren Barnett, CFA
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