I have updated my newsletter and website for 2018. See bonus comments below. Also please visit the new website http://www.the-wise-investor.com and let me know what you think. I am working with my web provider to have more up to date fund and model portfolio information available on a real time basis. It is still under construction...

Brother can you spare a "BIT-COIN?"
If you haven't heard about bit-coin, now is your chance. A bit-coin is a form of virtual internet currency which has gained attention in the news recently. Bit-coin is not actually a currency like dollars or pounds which are printed and controlled by their respective governments and stored (mostly) in regulated banks. Bit-coin is a virtal credit note which you can exchange on the internet. In theory what makes a bit-coin unique is that a transaction requires you to exchange a very long series of encrypted binary numbers which are tracked and logged on an unregulated set of computer-servers with redundant virtual ledgers in the cloud of the internet. The redundant ledgers keep track of who owns which "coin". The attraction, for some, is that there are only a finite set of these number combinations, ~21 million coins of which 11 million have been calculated or "mined". Mining a bit-coin takes a tremendous amount of computational power because the encryption algorithm to certify a coin as unique requires billions upon billions of calculations. This implies that they have value resulting from the energy it takes to calculate them (~$1200 of hardware and electricity per coin). It also implies that they cannot be counterfeited, diluted, or traced (more on that later). Although bit-coin sounds rather mystical and computer magical, using one for a transaction is not much different than a secure credit card transaction over the internet, where your bank and credit card company keep the ledger of your dollar credits, and both involve transaction fee's. In that regard they are not at all different. However, if you pull a dollar out of your pocket you will notice two things printed on it. First, it has a serial number identifying it as unique (just like a bit-coin), and second, the phrase "legal tender for all debt public or private." The bill makes a promise, by the US government, to enforce its legality as a medium of exchange. The U.S. government is us (you, me, et al.) and the force of our society and its laws. That makes the currency have value as a medium of exchange, but it does not imply that the bill has intrinsic value unto itself. The value of a dollar is taken on our faith in us. A bit-coin's value does not have the backing of the US government or any government to enforce its use as tender for all debts public or private. For bit-coin you must have faith in others who make transactions on the internet. There are a good number of thieves in the world and that is why we have banks and government sponsored currency. Bit-coins can be lost or stolen just like dollar bills. Despite what you may have heard they are also traceable by governments that have the resources and choose to do so. The important fact to remember is they do not have the enforceability of government sponsored currencies. Unlike buying the stock of a company for dividends and growth, investing in bit-coin is a zero-sum game. Someone will lose when someone gains in a transaction. Also, the IRS considers them a collectable for tax purposes, and gains made on their exchange are taxed as regular income. Lastly, there exists no proof that bit-coins are unique, there are likely many more of these algorithmically determined binary numbers sets, there will be copy cats and that will spell the end of bit-coin's meteoric rise. The block chain encryption technology behind the bit-coin ledger does have value, but it is not proprietary, so you can start your own block chain book keeping service just by learning how to program. How this story ends I cannot say for sure. I can say without doubt that some people will get hurt in the rush to make money out of the bit-coin euphoria. Some will wonder why they never saw it coming and be singing "brother can you spare a dime..."

Speaking of zero-sum

A zero-sum market is one where if someone takes a profit then someone else must take a loss. Bit-coin is zero-sum game. The stock market is not. Earnings growth and dividends change the math for stocks, bit-coins don't have those. Only short-term trading in the stock market results in zero-sum due to taxes and transaction costs. Most people only look at the short term, and that leads a fair number of them to the false impression that one man's gain is another man's loss. This misunderstanding historically has extended to our ruling class, and it has produced a lot of bad economic policy toward the markets. The good news is this has changed with a more modern understanding of how capital markets work (thank you speaker Paul Ryan). The US has a new tax policy and it will improve life for all its citizens. Regardless of your political belief it is good economic policy, and it helps make the stock market more of a positive sum game.

To see how the stock market is not a zero-sum game lets imagine at the beginning of a year you have $1010 to invest in stock. You go to your friendly broker and order 10 shares of XYZ corp. at $100/share trading at 20 times that coming years expected $5/share of net earnings. You pay your friendly broker a commission of $10 for the transaction, and at the end of the month your statement shows you own shares worth $1,000. Remember $20 dollar has left the market to pay your brokers salary (for our purposes we will assume he gets a commission on both sides of the trade), the market is $20 dollar poorer then it would have been had the transaction cost been nothing. That is less than zero sum. You paid $1010 and someone else collected $990. At the end of the year, after collecting $30 of dividend ($3/share) your statement shows that your wealth has increased by $24 of cash because you paid $6 of taxes on your $30 dividend, and much to your delight XYZ Corp. now trades at $102.10/share because it earned $5/share. It made a $7.14/share pretax profit and paid $2.14/share of corporate taxes (@30%, and after the $3 dividend it reinvested $2/share back into the company. As a result, the market bid up the price to reflect the increased earnings power. You are $45 dollars richer on paper. If you then sold the stock, paid the brokerage commission and $2 of long term capital gains tax you would net $32.80 for your efforts. The broker would net $24 because he gets commissions on both sides of the trade (totaling $40), but he has to pay 40% on his personal income. All in it works out to $82.43 of income generated on your $1010 investment. $32.8 to you, $24 to your broker, and $45.63 to the Federal government (who gets the lions share.) That is not zero, but it works out much better for the government then the investor who takes ALL the risk!

Now, let's see what happens when we lower the corporate tax from 30% to 20%. The company now pays only $1.43/ share in corporate taxes. They will earn $5.71 and because the board regularly pays out ~60% of its after-tax income to dividends you net $27.43 of cash after taxes. The stock now trades up to $116.69/share (20 x $5.71 on current earnings + $2.29 of additional earnings power + $0.11 of value for additional growth potential). You will be $194.29 richer! AND if you sell the stock, it's gone up 14.6%, you net $152.92, that is $120.12 more than at the higher corporate tax rate, and the government collects $22.03 more because net activity rises from $82.43 to $224.58! Magically, lowering taxes increases federal revenue, but now the risk taker gets the lion's share of the transaction. Did fake news make you believe otherwise? Because it got me wondering... Why would democrats vote against a bill that makes the nation wealthier? Discuss amongst yourselves.

A New Years Bonus

If history is any indication, there has been a seller's strike on stocks that are up dramatically because of the tax law changes. This is because lower taxes in future years produces lower write offs in future years. So, there is a tendency to take losses in the higher tax year and take gains in the lower tax year. That means stocks that have under performed for the year going into the end of 2017 should rise 2018, and stocks which have risen a in 2018 should trade down or taper in price action. Take advantage of this tendency, and do the opposite. Buy under performing asset classes like the Vanguard Large Cap Value ETF (ticker: VTV) before year end, and then buy the Large Cap Growth ETF (ticker: VUG) on a pull-back or tapering in early 2018.

Happy new year.

Douglas A. McClennen I.A.