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Summary New legislation that may curtail unpaid overtime has been introduced. The P/E ratio of the market is at moderately high levels but the E (earnings) relative to GDP is extremely high. A shift to higher income for labor would be a negative short term catalyst but may be necessary for long term economic health. I’m preparing for the shift by buying less broad/total market funds and more equity REITs. While the turmoil in Greece has been capturing the headlines, there are other issues that may hit much closer to home. I’ve been a fan of indexing the market and riding out the bumps through dollar cost averaging. I believe American investors can be served well by using a diversified index like the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). Even as an analyst, I combine VTI with equity REIT ETFs as the major source of value in my portfolio. I believe in using the index as the main holding and attempting to build around it rather than attempting to individually pick every stock. While VTI is delivering an excellent expense ratio (.05) and excellent diversification (3827 holdings), it is still subject to market risk. I am concerned that we may be nearing a market top for the broad equity market and I am shifting my portfolio to a heavier concentration of equity REITs. Because I believe shorting the market is the game of fools, I would never recommend it. However, I do think the risk/return proposition favors equity REITs. The Middle Class There is a common refrain about the disappearing middle class. I must admit that I do believe over the next decade we may see a further increase in the gap between the “Haves” and the “Have Nots”. In my opinion, the market is far less attractive without consumers to buy the crap on the shelves. Background It helps to remember that the market can still be viewed by running numbers on the S&P 500 which makes up a very substantial portion of VTI. The following chart, built with data from multpl.com, shows the P/E ratios for the S&P 500 over a very long time frame. (click to enlarge) You might notice that we are currently right around the trend, but that is a very serious problem when we consider that earnings are exceptionally high as seen in the chart below: (click to enlarge) Corporate profits after taxes are hitting staggering values by historical measures. I believe a major factor in the high corporate profits is the introduction of more automation and a lack of intense competition in some sectors. One sign for weaker competition is buybacks. When companies are spending their cash on repurchasing shares there is an improvement in the P/E ratio and there is a fundamental increase in the shareholders ownership of the assets, but there is no increase in productivity capacity. A lack of new capacity leads to weaker competition which protects profit margins. If you need to see what high capacity and intense competition looks like, simply research companies in the mining sector. Earnings, ore prices, and share prices have fallen dramatically due to the intense competition. If corporate profits after tax were to revert to a more historically normal level as a percentage of GDP without enormous growth in GDP, it would lead to much lower earnings. Those lower earnings in turn would lead to lower share prices unless the P/E multiples increased significantly. The Headwind for Earnings The White House recently released a fact sheet on some proposed new legislation that would significantly expand the number of workers eligible for overtime pay. Nearly five million workers would be covered and this could set up quite a bit of political sparring. If nothing else changed and the companies simply paid the overtime that is currently avoided through “salaried” compensation, the simple result would be increases in labor expenses and compressed profit margins. At the same time, I would expect increased levels of sales as more money would go to middle class and lower class workers with a high propensity to consume . In short, the money would go into their pockets and then into the cash register at another establishment. Companies Won’t Agree I expect to see some fairly substantial lobbying efforts spend to fight or minimize this bill because the cost of purchasing congressmen and senators is cheaper than the cost of paying overtime to low-wage salaried employees. Was that too blunt? I’d rather get the point across clearly. The legislation is designed to raise the level of salary required to keep an employee exempt. The reason it is important for the long term health of the economy is that the current level is at less than $24,000 per year. By labeling employees as exempt, companies are able to work the employees for overtime that can drive their effective wage rate below minimum wage laws while claiming that the employees are “managers”. To the extent that this encourages companies to simply hire more employees for regular schedules, the change could be positive by improving employment rates and revitalizing a struggling middle class. However, it wouldn’t happen without pain. While the sales would be expected to increase, the weaker margins would compress earnings and I would expect share prices to fall. For VTI, that could mean share prices dropping as low as $90 in a bearish scenario (about a 15% pull back). Long Term I believe the long term implications would be very positive as it would improve employment prospects for many struggling families so a significant pull back would become a great buying opportunity. Without growth in the middle class, I think the growth in EPS from repurchasing shares may become unsustainable because earnings still depend on sales and sales still require consumers that can afford the products. In the short term, growth by repurchasing sales is fine. Over the long term, it fails to provide new productive (physical) assets that generate the wealth that we consume as humans. Seeing an end to unpaid overtime through the guise of “salaried” work would be a short term negative catalyst for stock prices, but it may be necessary for a healthy economy. I’m preparing by shifting more of my purchases into the REIT sector where I expect strong income to translate into higher average rents. I’m reducing my purchases of the broad U.S. market, to the acquisitions made by my dollar cost averaging in an automatic retirement account. How will you prepare? Disclosure: I am/we are long VTI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Scalper1 News
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