Saturday, October 23, 2010

Insurance and Healthcare, Surefire Stock Market Indicator

Insurance and Healthcare in the US

As with most controversial topics, the healthcare debate has lots of villains.  One of the favorite whipping boys seems to be insurance companies.  It’s easy right?  Big nasty insurance companies won’t insure someone because of their pre-existing condition.  Next thing you know, auto insurers will refuse to cover drivers with lots of speeding tickets and accidents.  Oh wait, they already do.

I don’t think insurance companies behaving badly is necessarily the problem.  I do wonder about all of us as insurance users. 

Healthcare is one of those things where the normal cost versus demand relationship doesn’t hold.  The amount of healthcare you buy is independent of the price.  When your kid is sick, you want to make sure they get well, and price is a secondary concern.  Economists have a cool phrase for this (they seem to have a cool phrase for just about everything) they call it a ‘price inelastic’ condition.  On top of the price inelasticity of healthcare, add health insurance which acts to insulate the buyer from the cost.  Think about it, you go to the doctor (where you rarely ask or know how much the visit really costs) and swipe your Visa card to cover the co-pay.  During the course of the visit, the doctor recommends a few tests.  Again, there’s no discussion of how much those tests costs and if they’re really needed.  A couple of weeks later, you get a piece of mail from your insurer that tells you the doctor visit and tests were $371. 

The normal economic forces that tend to keep the price of most things in check aren’t a part of the insured healthcare purchase process.  Contrast your trip to the doctor with your trip to the grocery store.  Most people pay attention to the prices of stuff in the grocery store.  “Hey, look at this”, you say to your wife, “the Alaskan salmon is 12.99 per pound, but this Atlantic salmon is on sale for 8.99 per pound.”  She replies, “Atlantic salmon it is.”  If we paid for our groceries the same way we pay for our healthcare, the conversation would be very different.  “Hey, we’ve paid the $20 co-pay, forget the Atlantic salmon, let’s get 4 pounds, no make that 5, of the Norwegian salmon.  It’s only $79 per pound, and the fish have all been hand raised by personal nannies and have been bathed every day in angel tears.”  Okay, the personal nannies and bathing in angel tears thing is over the top, but the point is that health insurance has spoiled us and made us very price insensitive.  It’s no wonder that prices grow faster than the overall inflation rate.

What’s the answer?  I think it’s helpful to go back to the origins of insurance.  Insurance was originally conceived as a way to spread risk to prevent the insured from being financially wiped out by an accident.  An early form of insurance was used by merchants who needed to ship their goods.  Instead of putting all their stuff on one ship, they would split up their shipment over 10 different ships.  That way, if one ship was lost (and shipping a long time ago was a dicey affair) the merchant would suffer a 10% loss vs. a 100% loss.  The point is, insurance didn’t make the merchant 100% whole, but it did prevent financial ruin in the event of an accident. 

So how is all of this applicable to today’s healthcare debate?  I think part of the answer is high deductible health insurance plans.  Health insurance with high deductibles (maybe $5000 per year) would mean that consumers would have to pay for the small to medium stuff, but the big, really expensive healthcare needs would be insured, i.e. you don’t get wiped out.  I think if healthcare purchases more resembled other purchases, people will put more thought into the buying process which will work to keep prices in check.  I don’t have a comprehensive plan to overhaul healthcare, but whatever we do, we have to reduce the cost insulation that sits between the consumer and the healthcare provider.  

Washington DC, in their great wisdom, has stepped in to the fray by creating health insurance for everyone.  So we’ve got a dynamic in place in healthcare where the normal pricing/supply/demand/substitute dynamic doesn’t hold.  Now let’s add 25 million additional insured consumers to the demand pool, but with a fixed amount of healthcare supply (it takes years to train nurses, doctors, and other healthcare workers).  Lots of new demand overnight, with a fairly fixed amount of supply.  Is it hard to figure out what will happen to prices?  

The problem is, with our new government healthcare plan, we’ve loaded ourselves up with another huge bottomless pit of a liability on top of the ones we already have and don’t manage well. (see note below)  At a high level, the solutions boil down to cutting benefits or raising taxes.  Washington doesn’t have the guts to cut benefits.  They only seem to know how to do two things…raise taxes or put things off for someone else to fix later.  I’m concerned that not taking action on these four beasts will slowly erode our finances to the point where we’ll have a very painful financial crisis.   The same public spending debate is currently unfolding in Europe.  The French are protesting their government’s plan to increase the retirement age from 60 to 62.  Two whole years?  How cruel!  Meanwhile the Brits are biting the bullet and making across the board spending cuts to get their financial house in order.  Let’s ignore the problem and hope it goes away v. let’s suck-it-up and fix it. 

The weather is much better in France, but give me Britain.

Note: The four riders of our fiscal apocalypse are the new nationalized healthcare program, Medicare, Medicaid, and Social Security. To be completely fair, Social Security currently runs a surplus, but it is a system that relies on new workers coming into the workforce to fund retired workers, and future demographic projections are not favorable.  The amounts paid in vs. the amounts paid out will flip the current surplus to deficit in the near future.

PE Ratios as a Predictor of Where the Market is Headed?

The PE ratio is a stock market metric that supposedly tells you how expensive (or inexpensive) stocks are.  If you’re able to buy stocks when they’re inexpensive, and sell them when they’re expensive, you make money. Gee, this stock market stuff is easy. 

The PE ratio is calculated for a stock by dividing the share price (the ‘P’) by the earnings per share (the ‘E’) for that stock.  PE ratios for stocks are analogous to the price per square foot of homes.  Anyone whose bought a house and read through the big wad of papers you get at closing has seen the appraiser’s work where they determine the value of your house.  They compare the house you’re buying to other houses in your neighborhood and calculate the price per square foot of the comparable homes or ‘comps’ to help figure out what your house is worth.  If you buy your house at a price per square foot that’s low relative to others in your neighborhood, you’ll probably do okay.  If the price per square foot is low because your house was built on an ancient Indian burial ground and your young daughter talks to spirits trapped in your TV, maybe not such a good investment.

Just as the PE ratio of a stock can be calculated to determine how expensive or inexpensive that stock is, the PE ratio of the stock market as a whole can be calculated.  The ‘market PE’ is cited by pundits as they talk about what a good buy the market is because stocks are undervalued (PE ratios are low) or how dangerous the market is because stocks are overvalued (PE ratios are high).

I’ve looked at a large sampling of stock market data going back to 1871.  I’ve compared PE ratios to stock market appreciation and have determined two things.  First, PE ratios are lousy indicators of future stock market direction, and second, you need to be in the market for the long haul to make any money. 

I plotted the PE ratios for the S&P 500 versus where the market stood 1, 3, 5, and 10 years later for all this data. On a couple of my charts below, I’ve highlighted the range of stock market appreciation that have occurred whenever the PE ratio on the S&P 500 was at 15 (a pretty typical PE for the market).  When the S&P 500’s PE was at 15, 1 year later the market was anywhere from 55% lower to 60% higher.  Not much predictive value there. Also at a PE of 15, the 10 year returns ranged anywhere from 60% lower to 350% higher.  Not a lot of predictive value there.  

PE Ratios and Market Appreciation 1, 3, 5, and 10 Years Later

The more valuable insight from these charts is that you need to be in the market for the long term to make money.  Look at the 1 year chart versus the 10 year chart.  On the one year chart, it looks like there are roughly the same number of dots above the line (I made money in the market) as there are dots below the line (I lost money in the market).  When you look at the 10 year chart, there are a lot more dots above the line (I made money in the market) and a lot fewer dots below the line (I lost money in the market).  I’m expecting a call from the Nobel people anytime now. 

If there is any predictive value in the PE charts, it is when the PE’s are at the extremes.  When PE’s are at or above the high 20’s, the market’s is almost always lower 10 years later. When PE’s are at or below 5, the market is always higher 10 years later.  The problem is that these extremes don’t happen very often.  An accurate predictor that gives you very infrequent 'buy' or 'sell' signals.

For those of you who are really in to this sort of thing, a couple of notes. 

First, in my look at the market, I deliberately use the phrase ‘market appreciation’ as the data making up the plots do not include dividends (that nice little check you get once a quarter with some stocks) which has historically made up a big chunk of the total return on stocks (total return = price appreciation + dividends).  When you consider the long term dividend yield averages something like 4.5% per year, the 10 year returns are understated by 55 percentage points which means the range of from 60% down to 350% up I cited above becomes a range of 5% down to 405% up. 

Second, the PE ratios I used in my calculations were based on 12 month trailing earnings which means I was relating the S&P 500 index at any given point in time to the earnings from the prior 12 months.  Sometimes PE ratios are figured based on 12 month forward looking earnings (seems too aggressive) while other folks look at 10 year trailing earnings (seems too conservative).

If you were nodding your head ‘yes’ as you read the above two notes, the Unrepentant Capitalist invites you to join him at the next Geeks Anonymous meeting.

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