GOOD NEWS WAS BAD NEWS

As regular readers know, I wrote a couple of times in the past couple of days that the market was over bought and ripe for a pull back. Yesterday we got great news and a great turnaround during the day. The tech stocks in particular made a big turn and closed down. I also wrote that should a downturn happen, I did not believe one could time it well enough to sell out and get back in before the next upward move. At the current time, those who have significant sums not in the market are the ones who face the most risk. The game of wealth is a game of relativity, should you maintain your current wealth long enough, you will ultimately be a very poor person.

Yesterday's great news was about the declining trade imbalance. Over the past year, exports from the USA have grown by almost 12% while imports have grown by between 3 and 4 percent (exports of manufactured goods grew by better than 16%!). The jump in exports is growing our economy. The next GNP report should show growth of better than 3%. About 1% of this will be "stolen growth" from other nations. Actually it is kind of like we loaned the growth to others and are now taking it back. The hit to other economies will make the central bankers in those economies think twice before raising their interest rates.

Once again, all the carping about the weak dollar has missed its mark. The turn in the J-curve has been made and the US is climbing the steep staff of the J. At current dollar levels, exports will continue to expand. The time intensive capital goods orders produced by the USA will continue to feed into the export totals for several years (one irony is that the government numbers often exclude aircraft orders because of volatility while Boeing keeps adding a steady stream of "accounting exports" for orders already on the books). All next year, the presidential election year, the expansion of exports will add to the economic boom; all year long, the GNP numbers will be increased by 1% or so as a result of the boom in exports. Incumbent politicians on both sides of the isle will try to take credit for the economic boom; will congress pass major legislation before leaving for the campaign trail? The boom is already here but it is not getting the publicity that it will get as the election grows closer. Of course, the democratic nominee for president is not going to be real happy to see the boom numbers. As you may have noticed, Hillary is not running on the slogan, "It's the economy, stupid".

WHY, OH WHY?

Why did the stock market turn after the numbers were so strong? Yesterday, one pundit threw up his hands and said, "Only God knows!".

The economic reason is that the strength in the economy reduces the probability for another cut in short term interest rates. In the short run, the market saw this economic strength and pushed oil prices higher and bond prices lower. A strike in the Nigerian Oil Industry was also part of the reason for the higher oil prices. Keep in mind that if short term interest rates stay high, the cost of holding gold and oil inventories stays high. The key is that short rates are higher than the inflation rate. A two percent real interest rate compounded over a number of years makes holding gold painful. Oil and gold have a very high r square. If it is expensive to hold gold, it is expensive to hold oil. Over long periods of time, commodity prices fall in real terms. Stones were of great relative value during the stone age but that was before it was known how to forge metals. Man continues to find ways to replace expensive materials with cheap materials. Can you believe that cheaper materials are about to replace sand as a component of micro computer chips? Just in time because the production of computer chips is about to hit a whole new gear. Trillions of computer chips will be made in the coming years. One of many plant expansions is about to take place in Greensboro.; RFMD will build a new plant there.

THE TAXPAYER CHOICE ACT

Republican representative, Paul Ryan, the ranking republican on the house ways and means committee got tired of waiting for the Charlie Rangel tax bill. Rangel, as chair of the house ways and means committee, the one that is responsible for all new tax laws, holds a powerful spot. Rangel very much would like to repeal the AMT. His problem is in finding the revenues to replace the tax. So far, his committee has been bogged down in minutia. For example, much time was spent trying to come up with a way to eliminate the tax on the phantom income that is a result of foreclosure. Rangel "solved the problem" by adding new complications to the tax law in regard to second homes. The tax break on second homes was reduced, but we do not need to go into the details here; trying to make heads or tails out of the current maze of tax laws is a worthless pursuit.

It is anticipated that Rangel will propose a jump in tax brackets in order to eliminate the AMT. He will propose that the maximum rate be increased to 36%. Bush has pledged to veto an increase. Rangel has been dragging his feet to find the compromise that might work. In the mean time, democrats are working over time to try to over-ride the presidential veto of the SCHIP law. This "health care for poor children" is a test. When the test fails, the congress will be back at square one; what can Rangel to do? He does not want to pass another one year patch but the democrats certainly do not want to be responsible for forcing about 20 million Americans to pay an extra tax during an election year. Rangel wants to cut out the AMT but his party has said that it must play by "pay-go" rules; any cut in one area must be met with an increase elsewhere. This requirement will force many more complications to the tax law unless a sweeping reform bill can be passed.

The introduction of Ryan's bill is reminiscent of the one introduced in 1986. The Kemp-Roth bill came out of the blue to become the law of the land. At the time, few people had even heard of Jack Kemp, but, like today, the complicated income tax law was ripe for reform.

The Ryan bill is simple. The tax on the first $100,000 worth of income would be 10% and the tax on all income above $100,000 would be 25%. In one fell swoop, scores of complicated rules would be abolished along with scores of itemized deductions. A $25,000 standard deduction, personal exemptions of close to $4,000 and head of household exemptions would all be allowed. A family of 4 would pay zero income taxes on the first $39,000 of income. The bill defeats the fairness question; what can be more fair than the jump from 10% to 25% on all high income money. The Bush capital gains tax cuts would be made permanent.

The name of the bill comes from the fact that tax payers will be given the choice of paying taxes according to the current law or under this new "flat tax system". About 5% of taxpayers, those who give the most to charity and have the highest deductions, might choose to file under the current system. A bill that simplifies taxes for 95% of the population is a good bill!


THE HOOK IS BAITED!

Because a number of key republicans are willing to trade a carbon tax for lower income tax rates, but are politically unable to propose such a tax, the hook has been baited. The Ryan bill makes no attempt to recover the trillion dollars of revenues to be generated by the AMT over the next 10 years. Since, there are several democratic versions of carbon tax bills already in circulation, "VICTORY" is at hand for the growing group of democrats who would "fix global warming and the energy crisis" by passing a carbon tax.

I believe the combination of Ryan's simple, two bracket tax and a tax on carbon would be well received by the public. There would be griping about the carbon tax at first, but most of the complaining would go away when it came time to fill out a postage card sized income tax form next April. The benefits would become more and more "apparent" during the economic boom of 2008. The politicians will speak proudly about their accomplishment and use the economic numbers and falling oil prices to show that they have done a great thing. The introduction of a carbon tax, combined with a cut in income taxes owed would give the auto industry a shot in the arm. A scramble to replace big trucks with fuel miser cars would take place. Because the carbon tax would be phased-in, with a 10 cents per gallon tax on gasoline being added each year for 5 years, the shock of the higher tax on gas would be less than the benefit from the lower income tax. The wisdom of those who have purchased smaller cars would be in evidence. More and more cars would be "up-graded".

PEPSI PROFITS

Pepsi just showed how a well managed company can survive and prosper under adverse conditions. Pepsi has faced higher corn prices and won. The sweetness of Pepsi beverages comes from corn syrup. Pepsi's Frito-Lay is a corn cooking company. Prices of finished products have been increased to keep profit margins sweet. At the same time, the public is growing tired of paying higher prices for food while corn farmers are being subsidized for converting corn into a poor substitute for gasoline in cars. The oil industry is clearly dragging its feet in regard to installing E-85 pumps. The oil industry understands the science of fueling cars better than the rest of us. The industry would prefer that the high octane good stuff be used, but the industry has gone along with adding a small quantity of ethanol to the mix. However, spending $200,000 per pump to install separate E-85 pumps makes no sense to these companies. The ongoing cost to maintain the extra pumps is considerable. The companies drag their feet in the hope that rational alternatives will be found.

My attraction to a carbon tax (as a replacement for other taxes) is all about adding market efficiency to resource allocation. We know that burning fossil fuels is detrimental to our health. The deal is the same as smoking in a restaurant; people should have the right to smoke if they must but they should not be allowed to smoke near my dinner table. I can not help but breathe the air polluted by the coal and oil; the pollution costs are not included in the price of coal or oil or other burning, but it should be.

The USA has abundant reserves of coal and we have the choice of building nuclear power plants. The moratorium on nuclear power plants has resulted in the burning of trillions of tonnes of additional coal over the past 20 years. Coal fired electrical plants are being added to the mix at a steady clip. I recall writing a year or so ago about the 14 coal fired plants that were under construction in the state of Illinois. The environmentalist make the evening news on earth day but they have failed to stop the construction of thousands of coal fired power plants. They are not powerful enough to stop the growth in US power consumption; a growing population requires energy for the production of food and heat for the home. More and more and more electricity is being produced. Our choice is how to produce it while maintaining the beauty and wonder of the good earth. Great strides have been made. Several hundred years ago, pollution had gotten so bad that the air in London was black and one could not walk down the street and keep ones feet out of human and animal excrement. More needs to be done and taxing the most dirty fuels the most is the way to allow the market to work its magic.

With a carbon tax in place, many a silly subsidy would not be renewed, yet there would be extra incentives to expand the research into plant based renewable fuels. When scientist are able to efficiently convert plants to high quality fuel, the oil industry will beat a path to their doors. Forcing consumers to put corn oil in gas tanks is the height of folly. There is no need to subsidize windmills, corn oil, solar panels, soy beans or anything else if the cost of burning fossil fuels includes the cost to the environment. The law of substitution is more powerful than any act of congress. No matter what the politicians do, the world will continue to find ways to make more stuff while using fewer resources per unit of stuff. A carbon tax would give all users of fuel extra incentive to use less. Since the tax would be highest on the dirtiest fuels, the usage of dirty fuels would be reduced the most.

As I mentioned before, one part of the good news would be that the price of gasoline would go up by less than the amount of the tax. In effect, Iran, Saudi Arabia and Canada would pay a portion of the tax for us. In the past quarter, the USA used about .6% less fuel than in the corresponding year ago quarter. A carbon tax, installed over the next 5 years, would cause consumption to decline. The result would be a tax cut for all Americans!

PUTIN AND RICE

Rice is in flight to meet with Putin. Russia has more to lose by allowing Iran to build a nuclear bomb than does most of the rest of the world. Crunch time is here. I believe Russia and China will go along with crushing sanctions on Iran if a deal is not made soon. Iran is going to come to terms or suffer. It is in the interest of the Iranians to enjoy peaceful use of nuclear power without developing a nuclear bomb.

International dominoes appear ready to fall. North Korea will dismantle its nuclear facilities soon and peace has broken out in a number of Iraqi areas. A proposal is being floated to reduce the total number of troops in Iraq and Afghanistan by around 26,000. The plan being considered is to move all the marines in Iraq to Afghanistan and to bring home about that many army personnel. With peace starting to poke its head up in Iraq, the idea of going back to "finish the job" in Afghanistan has political appeal. Guess what? Troops will be coming home during an election year.

Yes, peace in Iraq is hard to see because peace is still ducking behind senseless bombings. The thing that is different now is that the Iraqi people have turned against those who would continue the war. Radical Sunni and Shiite are being "fingered" by the masses. The task of finding and eliminating the "bad guys" has grown easier. The "enemy" is on the run. National unity is catching hold. There is a love of country developing. The success of the national soccer team has played a significant role. I love it.

INVESTORS SHOULD TAKE ADVANTAGE

Yes, I am beating the same old drum. No one knows exactly which stocks will do the best. It seems to me that a lot of prices are currently out of whack. For example, EMC owns 86% of the hottest stock around and yet the total market value of EMC is about the same as the value of the hot stock. If I were to buy into this situation, I would buy the EMC rather than the hot stock and get the EMC computer storage business for free. Most of you own shares in EMC through your ownership of QQQQ or QLD. You are participating in the dramatic run up of the speculative stock while holding the long term solid winner.

With prices jumping around in crazy patterns, investors should be careful. On the other hand, it is important to be in the market. Small mistakes will be easily forgiven by a surging market but crazy prices can turn in a hurry. This is one of those many times when one can throw darts at the stock page and make a lot more money than the average investor will make. The average investor will buy the hot stuff. He will achieve success when the momentum plays continue. The problem comes when it is time to sale but there is no economic rational to buy for even 10% of the trading price. My word of caution is that playing with fire is a good way to get burned.

Congress will not likely leave town for about a month. The pressure is no congress, Iran and Iraq to perform.

PLEASE, PLEASE, PLEASE do me the kind favor of forwarding this message to a friend or two. I put a lot of time into the creation of this document and would like for it to be shared freely.