Fantasy Land Beliefs Move Markets in the Short-Term. Reality Moves Markets in the Long-Term

November 27th, 2006

November 27, 2006 - Yes, an increase in the minimum wage laws in the U.S., as is likely to occur given the new Democratic Congress, will benefit retailers in the short term because the beneficiaries of such an increase will believe that they have extra cash in their pockets even if they don’t. What do I mean by this? The Federal Minimum Wage in the U.S. has remained static at $5.15 an hour for the past 10 years. Since that time, inflation has not remained static. Senator Edward Kennedy has stated that he would like to enact legislation that would increase the minimum wage to $7.25 an hour over three years, a healthy 40% bump higher. In terms of inflation, an annual core rate of 3% that is often stated as a reasonable proxy for real inflation, is, as you know from reading my blog, nowhere near reality and is based on some fantasy-land projection.

To briefly discuss some of the more important factors that enables the government to produce a fantasy CPI every month, here are some of the more important changes to the calculation of the CPI that occurred in 1996. To discuss all the manipulation that occurs in the CPI calculation could probably fill ten pages, not to mention that it would most likely put most of you to sleep, so here are just a couple of what I deem to be the most important manipulations. The formula to calculate the cost of a basket of goods was changed from a fixed-weight basket to a basket of substitutes. In simple terms, the government assumes that when the costs of certain living costs increased, that EVERYONE will substitute cheaper inferior goods.

For example, if the costs of beef rose, then people would eat more chicken. If the costs of orange juice increased, then people would substitute cheaper apple juice. If movie theater prices rose, then the CPI index calculation assumes that people would stay at home and watch TV, and if car prices rose, the people would ride a horse and buggy or something to that effect. However to assume that all people engage in substitution behavior is ridiculous.

There are significant percentages of people whose real costs of living rise because they do not downgrade their quality of life and will continue to eat beef despite rising costs and continue to buy BMWs and not trade in their 7-series for a horse and buggy. In 1996, in order to further artificially depress the real CPI, the government switched from an arithmetic weighting in their basket of goods to a geometric weighting in which the goods that fell the most in price were given the greatest weights and the goods that rose the most were given the smallest weights in the calculation of the index.

And this is not to even mention the exclusion of food and energy from the core index that is most often cited (because it is the lower calculation that makes people think inflation is under control), and the other manipulations that allow CPI to be steady in the face of soaring rents and mortgages. When CPI was stated as being under control and default rates in mortgages in the state of California increased over 67% during one period earlier this year, I am sure that the residents of California that defaulted on their mortgages did not agree with the government’s official assessment of the CPI.

Thus, due to all the changes in the various measurements of the core inflation rate and the CPI over the years, the CPI has not come close to approximating the real rate of inflation for more than a decade now. The real rate of inflation in recent years most likely has been somewhere close to 5.5% a year, or possibly even higher. If we take 5.5% a year as our proxy, over 13 years, when the minimum wage may be increased to $7.25 an hour, real purchasing power over that same period will have decreased by more than 52% in the U.S., so the proposed increase in minimum wage would have to increase to about $7.85, not $7.25 an hour, just to get back to the same purchasing power in 1997.

Despite all the above arguments, the false belief that an increased minimum wage will create greater purchasing power will still benefit the retail sector that caters to this population segment (Wal-Mart, the 99 Cent Store, etc.). Ten years ago, many people could make ends meet at the minimum wage whereas today they cannot. The increase in the minimum wage will help people in this regard, and certain retailers will benefit, even if their relative purchasing parity power has not increased at all. However, even this benefit to the retail sector is likely to be short lived.

Why?

As I discussed already, due to the fact that there will always be other rising costs that cut into peoples’ disposable income that are not properly factored into the Consumer Price Index (CPI) such as rent, energy, and most likely rising taxes (under a Democratic Congress), much of the positive benefits of a higher minimum wage are sure to be quickly eroded by these factors.

Finally, if you’re wondering why I’m revisiting this topic, each time explaining it a little bit more in depth, in addition to the importance of understanding how domestic macro economic indicators drive stock markets, there’s a more important lesson here. And that involves the need to dig way below the surface to find critical economic trends that will allow you to build wealth. Building wealth is not just about uncovering asset classes and stocks that are severely undervalued (another topic that I discuss often here).

Both of these abilities are critical and necessary to building wealth. If you are able to uncover assets and stocks that are severely undervalued, the only thing that will drive their prices sky high is an underlying trend that will eventually drive their stories to the surface. Without eventual hype surrounding these assets or stocks, these investment opportunities will languish no matter how undervalued and solid these investments are.

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J.S. Kim is the Founder and Managing Director of SmartKnowledgeU™, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to return high double-digit and triple-digit returns.

Entry Filed under: The Biggest Investment Myths