Monday, December 10, 2007


Since I have been writing about the big turn that comes midway through the economic cycle, I have seen a lot of other turns or turn around situations. I think I starting to sound like John the Baptist who preached that the people should turn around or repent.


In the land of politics, it is beginning to look like the US will elect the first woman, the first black or the first preacher to be president. Maybe it will be the first Mormon or perhaps the first to have had three wives. Obama and Huckabee have surged ahead in the Iowa polls and Opra seems to be making a difference. I have heard that Obama will not say the pledge of allegiance to the flag because it has the word God in it. If true, a contest between the first black and the first preacher would be all the more interesting.


In biblical days, people were taxed based on what they had. Now a days, people are taxed on what they make. Huckabee wants to tax what people consume. I wonder what my old Sunday School Teacher, Howard Barnes, thinks about Huckabee. Howard, a history professor at Winston-Salem State University, used to admit to being politically slightly to the left of center. In return, I admitted to being slightly right of center. The only reason either of us could claim to be so close to center was that our political beliefs were somewhat tempered by our religious beliefs. Treating another person as you would like to be treated can certainly blow a hole in ones political inclinations.

Howard was as fiscally conservative as they come. He never owed any money on the small car that he drove for 20 years or more. He believed that the US is a nation of consumers and he understood that this constant consumption "made the money go 'round". A kindred spirit who taught in the class next door to ours, kept a bumper sticker on her car suggesting that we all live simply so that others can simply live.

The key that makes the consumption tax palatable is the PREBATE.

The way the prebate works is that the government would send a check to every citizen in America on the first day of the month. The check would be in an amount equal to the poverty level times the consumption tax rate. It would automatically be indexed for inflation as the poverty rate goes up each year. In 2005, the prebate would have been $183 per adult plus $63 per child. In other words, a couple with two children would have received a check from Uncle Sam for $492, assuming the consumption tax had been set at 23%. The key point of the prebate is that it eliminates the regressivity of the consumption tax. In fact, the poor family that lives cheaply, buying used goods and groceries in lieu of restaurant meals would actually receive a "tax bonus", their taxes owed would be less than the check they received.


The idea of changing the tax system causes high anxiety. People are adverse to change, even deep in their hearts they believe the change is good. This is the very reason that polls currently show that people have low confidence, we are living through a time of great change. The change is good but it upsets normal. It is the same phenomenon when cars starting replacing horse and buggies.

Last night, my wife and I drove past a horse farm. The air was filled with the stench of horse manure. It made me think of the days of horrible pollution. A hundred years ago, one could not walk the streets of a major city without smelling manure. Go back another hundred years or two and major cities had no infrastructure to accept human or animal waste. The streets and sidewalks were often the sources of insects and disease.

We are living during a time of change. Last quarter, productivity in America increased at the rate of 6.3%. People are working less to have more. At my Sunday School class party, a topic of discussion was the loss of writing skills in America. The premise given was that because "kids" are text messaging abbreviated words, they are not learning to write as they were required to in "the old days". I beg to differ. In the "old days", parents just about had to hog tie a kid to make him sit still long enough to write a thank you note. Writing a letter to a distant cousin was a battle to be fought. Now a days, kids voluntarily routinely communicate in writing to "friends" down the street and around the world. During our discussion, one parent told about his teenage daughters text message request. It confused him so his texted response was, where r u?. Her reply was down stairs. Last week at the Winston-Salem Children's Museum, my 20 month old sat at a "Little Tykes Computer Station" and clicked the mouse button to complete sentences in a story. Before long, she will be typing in words to complete the stories. The point is that the Information Age is going to continue to move in the direction of more people communicating about more stuff. This ability to communicate saves us time, energy and resources.

A wise old wag said that the only constant is change. We are living in a time of rapid change. It is up to each of us to find ways to use this technology for our own benefit and benefit we will. Even those who are slow to accept the changes are benefiting. Despite all the hype about Wal-Mart putting small retailers out of business and paying sweat shop wages the facts are that the price of manufactured goods has been falling off and on for the past 30 years. Those who want the government to have the power to decide who wins and who loses like to laugh at the idea of trickle-down economics. The words may have been chosen poorly but the world changes constantly at the margins. There is something called the Unifying Valuation Principle at work all the time. The following is a simplification of this process.

In simple terms, the growth of an economy, GDP, must roughly equal the rate of return available on investments. The return on investments is split into two parts, "fixed" rates available from credit instruments and variable rates available from equity instruments. The weighted return from these two sources must roughly equal the rate of growth in the economy. The complications come from population growth, productivity growth and inflation. In the absence of productivity growth, the real GDP would grow by average investment rate plus the population growth rate. Inflation is the big monkey wrench that confuses us all from time to time. Even the smartest and most educated get confused about inflation from time to time.


The FOMC's real job is to try to allow GNP to reach its maximum potential growth. There is frequently a gap between the GNP growth rate and its potential growth rate. In simple terms, the FOMC must raise short term interest rates above the inflation rate when the economy is suffering from over heating and the FOMC must lower short term interest rates below the inflation rate when the economy is suffering because productive resources are idle.

Wow! What is the FOMC to do when inflation is so low that it is difficult to lower interest rates enough to "push" the economy forward?

When most people look at inflation, they are like the 7 blind men describing an elephant after touching one part or another. It is easy to have a mioptic view of inflation. The better way to look at inflation is to look at it in terms of standard of living. I use a tired old example because it was a revelation to me in 1982. After I my first cell phone was installed, the most frequent call I got was from my wife. She typically called to ask me to stop at the grocery store on the way home to pick up a missing ingredient for dinner. My first emotions were anger and frustration. I had paid $2,200 for a cell phone and it was being used to send me to the grocery store. However, I soon realized that it was much better to stop on the way home than to go back to the store after arriving at home. My standard of living improved because I saved the extra time, energy and cost of stopping at the store versus going back to the store. In one form of another, that transaction has now occurred trillions of times. Now that the wirelessly connected pocket computer is ready to surge through the product life cycle, the savings are going to be multiplied many times over.


Before Greenspan retired as Chair of the FOMC, he expressed confusion as to how the long bond rate could remain so low. The answer is in the sentences I wrote above; the growth of an economy, GDP, must roughly equal the rate of return available on investments. The return on investments is split into two parts, "fixed" rates available from credit instruments and variable rates available from equity instruments. The weighted return from these two sources must roughly equal the rate of growth in the economy.

When productivity is high, inflation rates tend to be very low and businesses tend to make lots of money. If GNP is equal to the weighted average of the returns on bonds and the returns produced by business and if the returns achieved by business is very high then the rates on bonds must make up the slack. The math is simple, if A = B + C, if C goes up with no change in A then B must go down.


The divergence between bonds and stocks has not been bigger at any time in your life. Based on the earnings to price ratio, stocks are currently earning an average of better than 7.1% return but the 10 year bond keeps dipping down to 3.8% return. This is a huge spread. The simple average of the two comes out to 5.45%, which is not too far from the GNP growth rate of last quarter which was 4.8%. Most investors continue to make the mistake of owning a lot of 3.8% investments. They own these inside of retirement accounts which will not be touched for many years. These accounts should be of the longest duration and yet they are frequently filled with short term fixed rate investments.


Those of you who desire to improve your gas mileage might drive a little slower, inflate your tires a little more, avoid jack rabbit starts and change your oil and air filters more often. If all these moves are made to improve the mileage on a 6,000 pound SUV, the gains will pale in comparison to the change available by selling the SUV and replacing it with a 3,000 pound sedan. Even when driving the sedan, about 95% of the gasoline will be consumed to move the vehicle, the passenger only accounts for 5%.

The gasoline savings achieved by switching from a 15 MPG vehicle to a 23 MPG vehicle would be 53%. Those who spend lots of time trying to hit the right stock with a small portion of their assets are like the guy who pumps up his tires to save gas. After accounting for the extra time and effort, his savings will be small at best. The investor who moves a chunk of assets out of dead money home equity or slow moving credit money to stock market equity will experience a difference similar to the gasoline saved by switching from and SUV to a sedan.


I know I am repetitive and I know I ramble around all over the place but the economic world fits together like a jigsaw puzzle. As you should already know, Douglas R. Andrew is one of my favorite financial authors. His latest book, "The Last Chance Millionaire, It's not too late to become wealthy", tells the "dead money story" in detail. Americans are responding. A large percentage of Americans are paying off "dumb debt" such as credit card debt and taking on "smart debt" such as home mortgage debt. Last week, right in the middle of mountains of hype about the "housing crisis in American", the refi rate jumped again. Americans are once again being smart about tying up dollars in low return housing equity. The great irony is that the "gloom and doom crowd", which is a group of people that are always able to find the negative side of good, have used the explosion of "smart credit" to make the case that debt levels are so high that the world is going to fall apart. They conveniently ignore the huge decline in corporate and government debt and they erroneously imply that the housing debt is being used to support massive levels of consumer spending.


Have you noticed that the best of hype starts out with a dash of truth? Yes, a few people have used home equity to go on spending sprees. The great majority have not.


The use of a little truth to influence others is growing more common by the moment. Examples are all over the place. Yesterday, I read a Wall Street Journal article headlined with "Closed-End Funds Sale". The article talks about how many closed-end funds are currently selling at a discount to net asset value and that tax selling has caused a lot of stocks to be hit extra hard as the year comes to a close. The logical conclusion of this combination of events would be to buy shares of funds specializing in stocks that have been beaten down in value. Instead, after building a house built on truth, the article proposed the purchase of bond funds, total return funds, municipal bond funds, and international stock funds. "Buy at a discount but buy those assets that are at their highest values in years"!


Douglas Andrew and a long list of CPA's and tax advisors have convinced the American people to take full advantage of the gift given by Uncle Sam to those who borrow against their home. Do all good things come to an end? I say no. At the same time, I say the home mortgage deduction is dying. It no longer serves the purpose for which it was intended. Those who own a $500,000 fully paid for house are financial fools but on the other hand, it is foolish for government policy to be to send an annual check of about $11,000 to the fellow who chooses to borrow $500,000 against his home. It is even more foolish for the government to send this same fellow another check for $11,000 per year because he owns an ocean front home at the beach. The real irony drips when this fellow complains because a Hispanic kid who has lived in America all his life is granted in state tuition to go to college. In this "tax payers eyes" it is unfair for the Hispanic kid to pay the local cost of school tuition but fair for the wealthy to get paid $22,000 per year in housing subsidies.


One of my favorite historical characters is Doc Holiday. The story is told that after he tricked Wyatt Earp into believing he was too weak to "ride" and into giving him a deputy marshals badge, Doc killed Johnny Ringo in a the quick draw duel where Wyatt would have surely met his death. When Doc gave back the marshals badge to Wyatt, he said there are limits to my hypocrisy.

I like the fair tax (HR 25, s1025). It would abolish the IRS, help the poor and help us all. It would eliminate the home mortgage deduction. No longer would people buy three big houses just because the tax laws make them worth more. In my opinion, it is hard to find a "good subsidy". If a good is worth having the market will produce just about the right quantity of those goods. If a good is made only because the government mandates or subsidizes the good, too much of that good is produced. Those who buy the subsidized good are not the ones to be blamed.

Right now, the government subsidizes the home mortgage. The home mortgage sells at a 30% discount to value because the government pays 30% of the bill. Home mortgages are on sale. As a result, you should buy as much of this product as you can afford but, of course, you should only buy if the benefits exceed the costs. Keep in mind that each time you finance there are costs. This means that you should borrow the maximum you can when you borrow and then you should pay off as slow as you can. "Option loans" where one can pay only interest have gotten a lot of bad press because sub prime borrowers were encouraged to use them but to get the maximum check from Uncle Sam each year, one should closely consider interest only home mortgage loans.


Please notice that I did not say that this is the time to try to take advantage of deeply discounted homes and second homes. If you are about to buy a home or second home, you should certainly borrow the maximum allowed, however, you only increase your safety, and long term wealth by "investing the difference". As far as buying the "big house" now, I really do believe the home mortgage deduction is dying. No matter if Huckabee is elected or not, passing the full blown version of the fair tax is iffy at best. I believe a more likely event will be a dramatic simplification of the income tax combined with an extra tax on carbon (an energy consumption tax). Each time income tax simplifications are passed, like in 1969 or in 1986, real estate takes a hit. There are powerful economic forces at work here. With more and more millions of Americans taking full advantage of the interest rate deduction, the more and more likely it is that the government must adjust the tax system. Even if the congress does nothing, current law and inflation eventually kills the mortgage deduction. The maximum deduction is set on individual loan totals of $1.1 million. Only a few years ago, this limit seemed large but today it is not unusual for a individual to owe more than the sum of $1.1 million on his home and second home. If you do not owe $1.1 million dollars against a home and second home then there are lots of people making more than you who are paying less taxes than you pay.


Many of those who are most concerned about inequality are all for more government subsidy. Once a society starts down the subsidy road there is no end to the regulations required to reach "fairness". If the decision is made to subsidize home mortgages, what should be the maximum subsidy and should it cover second homes? If we decide to subsidize corn fuel, should the subsidy end once a farmer gets $200,000 from the government? If the corn fuel is so good, then why should we not subsidize all the corn we can grow?

Look at what has happened in China and in Venezuela. Both countries have been going through a dramatic change in government. In the case of Venezuela, the government keeps taking over more and more of the economy. More and more industry and more and more decisions are being dictated by the government. The good news is that the country has been making great strides toward "fairness", inequality is being stamped out. The bad news is that the country is on its way to the poor house. The people are going to all end up being equally poor. It is no accident that Chavez admires Castro and that the people of Cuba are equally poor.

China is on the same path but going in the opposite direction. More and more economic freedom is being given. For the first time, the people are being allowed to buy shares in companies. The country is enjoying a boom like no other in history. The bad news is that inequality of wealth is going in the opposite direction of Venezuela. The number of multimillionaires in China is growing by leaps and bounds. The rich are becoming very rich. The good news is that the dramatic growth in country wealth is filtering down to the masses. Hundreds of millions of people who were extremely poor just a few years ago are seeing huge percentage jumps in their income.


A time of change is a time of turn, turn around and repentance.

The mid cycle turn being upon us means that the prosperity phase of the business cycle is upon America.

This time of technological innovation and of free international trade means that the average cost of all things is actually going down. We often miss this because we fail to consider that the cost of a trip to the grocery store and trillions of other similar events has been reduced to the cost of at phone call, text message or click of a mouse.

This time at the end of the real estate cycle means that tax laws are due for over haul. To make the 1986 law palatable, certain investment advantages were grandfathered. If you believe the tax advantage for home mortgages will not be changed, you should start taking maximum advantage as soon as possible. If you believe the tax advantage will be eliminated but grandfathered, you should set your self up now for maximum advantage. In all of this, you should remember that tax reform tends to temporarily kill the value of homes, in particular the value of resort homes (in the real estate recessions after the 1969 and 1986 tax reforms banks and savings and loans went bankrupt as a resort of countless homes being worth less than mortgage balances).

Liquid home equity is often the key component to financial security. The person who owns a house but has no money is not as secure as a person who owns a house and also has $100,000 in liquid investments, even though he owes $100,000 against his home.

If you do not have liquid assets, it is time to turn your assets around. There is no good reason not to do so!