Margin Surplus – Or Why the US Ain’t Broke

In an article in the WSJ also available free on his blog, Andy Kessler – a very smart guy – offers an explanation of why the stock market keeps going up in the face of so many relentless negatives:

“Oil is over $70 a barrel, Iran's got nukes, and soon they'll price gas per ounce. The Fed has jacked short rates up 15 times… The yield curve is as flat as a subsidized Iowa corn field. There's $1 trillion of teaser rate Adjustable Rate Mortgages about to burst all over Southern California and 'burbs everywhere. Gold is over $600, commodities are roaring, the dollar is dropping again, there are trade deficits as far as the eye can see and GM is on life support. Drunken sailors in D.C. are running a sea of red ink…” says Andy.

Then he points out that Dow is near an all-time high, the NASDAQ has doubled in three years, and the S&P 500 is over 1300.  “The stock market knows something and is predicting some future the rest of us can only guess at,” he claims.

Andy says that what the stock market may know is that the US is in a transition from and industrial commodity to a design economy!

Andy’s getting back to the theme of “margin surplus” which he explains very well in his book Running Money.  There he used it to explain why the US currency and economy haven’t collapsed under the weight of huge trade deficits and foreign-funded government debt.  Now, of course, many people would say that the stock market is irrationally exuberant and that the collapse of the American economy is an accident about to happen; but I think Andy’s on to something.

To paraphrase him: think of a PC.  We all know that most of the components don’t come from here even if the nameplate says Dell.  The screen may come from Korea; the diskdrive from China; etc. etc.  Two critical components do come from the US, however: Windows (not to mention Office and other software that may be loaded on to the machine) and the design of the Intel chip.  Together, these may only constitute 10-20% of the total cost of the machine.  So, when we buy a machine, no question that it looks bad on the balance of payments – lots of money flows out of the US.

But what about margin?  The margin on the physical components, the screen, the keyboard, the diskdrive, even the RAM is paper thin.  The gross margin on Windows, on the other hand, is near 100% - Microsoft has no incremental cost of manufacture when a pre-installed version of Windows ships (maybe a back up CD-ROM or two).  And Intel’s margin on the chips, while not as high overall, is near 100% on the intellectual property part even though the chip itself may be manufactured off shore.

It may that half the total MARGIN on a PC shows up as profit in US companies even though a much smaller share of the component cost ends up here.  This makes these US companies good investments so the dollars that flowed out of the country to buy the low margin components come back to buy stock in US companies, to buy a share of that profit stream.  This makes the US as a whole a good investment so foreigners are also willing to hold our bonds.

When you think about it that way, all the places that make the cheap components are doing us a favor because the low price of the foreign-manufactured PC makes it a mass market product and enables huge sales and huge profits for Intel and Microsoft (and AMD).  Hmm…

The dollars which come back to buy shares in Intel and Microsoft (and AMD) don’t show up in the trade balance numbers.  But they are real.  And, according to Andy, they not only keep the US economy afloat but make it attractive.  We have a trade DEFICIT but we have a margin SURPLUS.  It’s the stock market which evens things out.

In yesterday’s article Andy explains how the design economy, which creates the margin surplus, works:

“You invent something here (chip, movie, iPod, medicine, financial instrument), email the design overseas for manufacture in $1-an-hour factories (OK, not financial stuff), and then ship it back for consumption. Sure, this runs up trade deficits, and our precious dollars leave the country, but that’s only half the story. Those dollars come back and invest in the U.S.”

Although Andy doesn’t point it out here, globalization is key to our success as a design economy.  If we didn’t have access to low-priced labor and overseas manufacturers working on paper-thin margins, we wouldn’t get the return from our high-priced designs because the resulting products would be too expensive to have a world-wide mass market.

Andy thinks the stock market is also sensing a future shrinking in the rate at which we create new government debt from a combination of increased fiscal discipline and the positive economic effects of lower marginal tax rates.  Less debt means less long bonds for foreigners to buy.  So, if they want to invest in the US, the stock market could get a greater share of the inflow.

Before you further hock the house, though, Andy does point out that the time to invest in this market may not be now: “The time to load up was three years ago. The stock market is notoriously schizophrenic. Remember, it thought you could sell pet food over the Internet. But it’s more often right than wrong, especially when proving pessimists wrong and optimists delusional.”