Some thoughts on Obamacare enrollments

Word is that only 49,100 folks have signed up for health insurance since 1-Oct.  This is both good and bad news, depending on your perspective.

First, the good news.  Meager enrollment figures means savings for taxpayers.  Most assuredly, those signing up qualify for tax rebates and subsidies, and with fewer people electing to purchase health insurance, costs should be lower than expected.  That's good news for taxpayers.

Now, the bad news.  Meager enrollment figures could hit insurers’ bottom lines.  Also most assuredly, those signing up intend on using their health insurance.  Insurance companies were counting on the young and healthy (low users) to subsidize the old and sick (high users).  But it appears the former group is largely sitting on the sidelines.  If this trend continues, insurers could suffer losses.

Perhaps I should short some health insurance stock.  Any ideas on which ones?

Public or private health

In what world is my personal diet a matter of public health?  Apparently government regulators at the FDA have concluded that in this present world, it is.  And in the name of public health they are banning “trans fat”. 

    

In no way is the ingestion of “trans fat” a public health issue.  If the FDA can argue that it is, then what aspect of my existence is explicitly private in nature?

Oklahoma seeks to bring down Obamacare

Oklahoma is shepherding a lawsuit that could wreak havoc on Obamacare.  With help from Michael Cannon (of the Cato Institute), the suit claims that the law’s tax credits and subsidies – fundamental to the law’s success and survival are available only in states that chose to create an exchange.  The IRS, which will administer the tax rebates and subsidies, has ruled that those subsidies will be available to everyone everywhere.

Cannon believes that this tweak in the law was deliberate.  He says Congress intentionally limited subsidies to state-created exchanges as an incentive for states to build their own exchange.  It was the carrot and stick approach.  You build the exchange, you get the subsidies.  If we build it, no subsidies.  Congress (mis)calculated that this financial incentive would entice nearly all states to succumb to Congress’s wishes.  They were wrong.

Thirty four states have refused to build their own exchange.  This means that a large swath of the American citizenry is susceptible to an adverse ruling.  Using population data from Wikipedia, I estimated that approximately 184 million people (58% of population) in those 34 states would not have access to the tax rebates and subsidies available to the 134 million citizens in the remaining states. 

 

What would be the fallout if citizens in Colorado can apply for and obtain tax credits and subsidies to offset the cost of insurance while citizens in neighboring New Mexico cannot?  Those against the law would most likely celebrate any ruling that nibbles away at the law itself.  However, supporters and those looking to get subsidized insurance would undoubtedly protest as they are now denied access to those tax rebates and subsidies, if only for living in a Red state. I know of no federal benefit or entitlement that is geographically limited. 

I’m neither arguing for or against the position.  Personally, I despise Obamacare on many fronts.  My purpose for this post was to think through the implications of an adverse ruling.  Denying lucrative subsides to half the population simply won’t fly.  I believe this would present an untenable situation, which is why I believe no judge will rule to strike down the nationwide tax rebates despite the strong indications this is what should happen.  The outcome would be profoundly divisive and unimaginably chaotic. 

Applying the Gordon Growth Model to the S&P 500

The Gordon Growth Model is a very old and very useful stock valuation model. It's based on the insight that the value of stock today is the present value of all future dividends the stock holder will receive. If one can argue the dividends will grow at a constant rate, then we can use the simple Gordon model:

where P is the value of the stock today, D is the dividend in one year (normally), r is the required return on the stock, and g is the expected growth rate of the dividend. Now, using the simple model takes a lot of care, and shouldn't be applied to every stock. But, it does make sense, as an initial approach, to apply this model to the S&P 500 so we can try to get a sense of the fair value of the S&P 500. 

Now, according to Prof. Shiller's data, the dividend you would receive if you held one share of the S&P 500 index (yes, it's not possible but this is a theoretical exercise), is 34.4. Note the current index level (which can be interpreted as the price of one share of the index) is 1776. 

I built a little table to see how reasonable the current level of the index is, given the dividend. The range of the required return (r) that I use is 5-8%, and the growth rate (g) range is 0-4%. The range of index values I generate is 430 (required return of 8%, growth rate of 0%) and 3444 (required return of 5%, and growth rate of 4%). In only three situations can I generate a value above the current index value: required return of 5% and growth of 3.5% or 4%, and required return of 5.5% and growth of 4%. 

It is important to note that a reasonable range of required return for the S&P 500 is 6-8%. The historical (back to 1871) average growth rate of dividends is 3.5%. For those values, the range of index values I find is 765 - 1377. Note that, using the current dividend yield (34.4/1776) and growth rate, we can calculate the current total return as around 5.5%. That seems abnormally low to me.

According to my little exercise, the S&P 500 is currently above most reasonable values I can generate. I think that growth of 3.5% is rather high to expect right now. Most estimates I see are between 2-3%. That means the S&P 500 is going to drop down. I don't know when, so rather than shorting the index, put options are a better choice. 

Certainly we can "tech up" the situation, which will be my next exercise. Notably, we can include risk aversion measures, because if risk aversion is down, then it is conceivable that required return is lower than normal. That could justify higher stock valuations.

Stock Prices are High. So what?

Actually, according to the S&P 500, stock prices have never been higher, in nominal terms. In real terms (data from Prof. Shiller of Yale), the S&P 500 price level is at the 3rd highest point it's ever been. The first highest was at the height of the tech boom, and the second highest was at the height of the real estate boom. But the issue is not only the height of the price level, it's the relative height. In general, we prefer to look at normalized price measures, like price-to-earnings ratios (P/E). Earnings are defined as the trailing-twelve-months net income divided by shares outstanding. In real terms, P/E right now is 23.5 (again from Prof. Shiller's data), and the long-run average (going back to the late 19th century) is 16.5. The 60-month moving average of the P/E is 20.42. That means the P/E (and so price) is relatively high.

There are some reasonable arguments for a higher P/E. The first is that fundamentals (earnings, growth, dividends) are expected to be higher in the future. While this is possible, it is not normally the case empirically speaking. In the data, higher prices are followed by low returns, not by higher earnings/growth/dividends. Earnings are certainly doing well, as they recently reached one of their highest points (in real terms) since the late 19th century. But earnings aren't the whole story, growth is also important. There is good evidence that one source of higher earnings was reduced investment, which will compromise future growth. Now, investment has recovered, and earnings have turned downward, so we'll see what happens there.

Another factor that can drive up stock prices is a reduction in the required return. Required return is composed of the risk-free rate, plus risk factors. Required return can decrease because the risk-free rate goes down (we know this has happened, but is starting to increase again). It can also decrease because: risk decreases (not buying that story) or risk aversion decreases (meaning people require a lower risk premium for a given level of risk). Many people, me included, would argue the risk-free rate is abnormally low right now and that's driving at least some of the price increase. There is also evidence the equity risk premium is abnormally low right now, but that's usually estimated using price data, so it is rather mechanical and therefore I don't like to appeal to that argument.

In my view, stock prices are relatively high right now. What should we expect if that's the case? We should expect future long-term returns to be relatively low. That means, given dividends are stable, stock prices will drop. Now there are several moves one can make to take advantage a price drop. First, you can short specific stocks, or the whole market (SPDR S&P 500 tracking shares, for example). Second, you can buy put options on same (recognizing that puts expire!). Third, you can go long on commodities that tend to do well in market crashes, like gold & silver.

The problem with any short position is that you may lose money before you make money, since the timing of the market downturn is anything but certain. So when your options expire out-of-the-money, you'll lose the premium. A short position could get called, and you may have to buy back at a loss. At least long positions can be held for much longer than shorts, so those are less risky in that sense. Of course, if you think I'm wrong, the answer is simple: go long on stocks! But don't say I didn't warn you.

Walker shows 'em who's boss

Governor Walker has provided the exemplar way to deal with a federal shutdown.  The National Park Service apparently tried to shut down many of the parks in the Badger state that receive federal funding - even though a majority of dollars come from state and not federal coffers.

What did Governor Walker say when the NPS ordered the parks to close?  He said, nope!  They'll stay open.

We need more governors like Walker who correctly understand that the feds don't always call the shots.

Non-essential government? Then why do we have it?

"That the government could even have services it considers non-essential is ludicrous. It is a blatant display of an oversized government, with excessive programs." ~ Competitive Enterprise Institute.

If government is so essential to our lives, then the mere existence of non-essential government is by definition a fraud, waste, and abuse.

Now is also a perfect time to take inventory of the national government.  Any feelings of dismay over a federal shutdown should be dwarfed by feelings of contempt and disgust for an abominable federal bureaucracy.