Thursday, April 9, 2009

The Debts of the Spenders: Inflationary Impact on P/E, Corporate Taxes, And Asset Values

While bears continue to moan about the fundamentals the administration is setting the grounds for an economic recovery and higher interest rates. To be fair, I am as bearish as anyone on the bullish prospects but it's suicide to fight the tape. Go w/the flow.

A 3 day holiday weekend, light volume, and technical selling in the forex markets are all indications of the MM's pushing the tape to the bull side [EDIT: also Vix <40]. Just like they did in Thanksgiving and Christmas.

Meanwhile, here is an excellent piece of analysis that I came across:

The Obama administration and the US Congress are laying the foundations for high inflation when the economy eventually recovers from the recession.

US equity investors should be ready for the effect that a rapidly devaluating currency may have on earnings-per-shares and price-earnings ratios.

How inflation increases corporate taxes

Companies with fixed assets are usually allowed to deduct the depreciation of these assets based on historical cost.

For example, if a company buys a machine for $10 million with an expected life of 10 years and no residual value, it may be able to deduct $1 million a year from income, thereby effectively reducing its tax burden.

When inflation is three percent a year, the tax benefit from depreciation will be reduced by about 15% over a ten year period, compared to the real value of the deduction that would have accrued in a non-inflationary environment.

However, if inflation were to run 25% over a ten year period — as has occurred in developing economies that can’t get government spending under control, the tax benefit from depreciation will be reduced by 76%.

For companies with substantial fixed assets and the need to replace depreciating equipment, high inflation, combined with declining deductions for deprecation, in real terms, will effectively increase their corporate tax burden, reducing cash reserves, and threatening continued operations.

Since, under inflation, government spending is out of control, the authorities are not amenable to lowering taxes, forcing corporations to increase prices faster than current inflation to stay in business.

This leads to even higher inflation.



matt said...

Any guesses on how far off this inflation may be?

Do you think commodities or short treasuries would be a better play?

(say, TBT or GLD)

In Debt We Trust said...

I am not a fan of gold. But I also believe that there is a place for PM's in every portfolio as an investment - not as a trade.

Several markets are already starting to see inflationary effects - namely the grains (wheat, soy, corn, rice).

We are in planting season and the USDA just issued a very bullish forecast.

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