Friday, November 07, 2008

The Obama Market Slump

The stock market has fallen 12% in two days; a regular reader wants to know if this is "The Obama Slump".

In the short run, markets are driven by emotion; in the long run, markets are driven by math. Discerning what part of a market move is fear or greed and what part is math is virtually impossible, but people are certainly making irrational decisions right now. Last month, after huge declines in stock values, the public withdrew $56 Billion from equity mutual funds. Rational people add money when prices are low. Since the 12% decline in the past two days was only a retraction of most of the gains of the prior week, the public has sold at prices well below those of last year, when they were still adding money to equity investments.

A good friend has calculated that the combination of the bump in tax rates from 35 to 39.6 and the removal of the cap on social security will consume 45% of his net disposable income. Ouch! This fellow has performed a rational calculation in order to make an informed decision. By the law of rational expectations, we know that many people look ahead and make informed decisions based on planned "changes in the math". One of the important things to remember is that "changes to the math" often have different effects in the short and long term. If you are going to have to pay more taxes on gains next year, you want to sell winners to take gains this year. By selling and paying unnecessary taxes, the fearful are helping the government to raise extra revenue. The extra selling being done in the past couple of days just might be a function of the "Obama slump" but for every share that was sold, a share was bought!

Besides, Obama is not likely to attempt to push through the higher tax brackets this year or next. His first move will more likely be to pass the populist tax breaks he has proposed. Without taking any action, the Bush tax cuts will expire in 2010 and the tax brackets will go up automatically. This automatic tax increase raises will result in higher tax collections prior to the rate increase. The higher tax rates scheduled for 2010 raise big questions in regard to 401-K accounts.

With the exception of the company match, the 401-K account is a bad deal. The net tax benefit is to the US Government. Regular withdrawals from 401-K accounts are taxed at ordinary rates; the capital gains tax savings is given as a gift to the government. Therefore, while values are low, it may make much sense to withdraw funds. Of course, those who are retired and above the age of 59.5 benefit the most from early withdrawals as they do not pay a 10% penalty.

Suppose a retired investor withdraws $10,000, pays $3,500 in taxes and invests the $6,500 in a beach house. Had he waited until 2010, he would have owed $3,950 in taxes and would only have $6,050 to invest in a beach house. With beach houses currently available at deeply discounted prices, by waiting, he will have lost a lot more than the extra $450 in taxes. Lets say that this investor borrows most of the money for the beach house and uses the full $10,000 to pay the interest cost on the house. Since the interest cost is tax deductible, he will have withdrawn $10,000 from his 401-K and paid no net increase in taxes. He may ultimately pay the taxes when he sells the beach house but even Obama offers a tax break to those who convert ordinary income into capital gains.

For those who do not want to buy beach houses, they can take the money out of the 401-K and invest the balance in low priced stocks or mutual funds, save the initial $450 in taxes and save future taxes on the gains. Again, the gains on the stocks outside of the 401-K will get the benefit of capital gains tax treatment. Of course, Obama's plan for the government to take 45% of estates over 3.5 million creates another tax trap.

Still, if substantial numbers of people make the rational decision to withdraw money from 401-K accounts, before tax rates go up, the tax revenues to the government will soar over the next couple of years. Then, in the years after the tax laws go into effect, tax revenues will fall. The fall may be surprisingly large as the incentive to work is reduced by excessive tax rates.


One of the frequent talking points has been that the next stimulus package will include massive infrastructure spending. Even if the government passes a massive bill, we must remember that construction is taking a break after a multi-year run. For example, the Chinese consumed a massive percentage of the world's total consumption of concrete and steel in the 5 years leading up to the Olympics. The Chinese Interstate Highway Program made Eisenhower's program look like a game of tinker toys. Right now, the factory utilization rate is at a multi-year low and a number of firms are cutting back on office space leases. There have already been decisions not to build everything from coal mines to super tankers. The most massive of government programs will not replace the reductions in the private market place. In addition, the dramatic reduction in gasoline consumption has dramatically lowered the cash flow to the highway trust fund, many a planned project has already been delayed or stretched.

The US government, is monstrous but it is still only about 20% of our economy and most of that 20% is automatic stuff. The money flows in from taxes and flows back out to stuff like medicaid. Obama and the congress cannot possibly change most of the government policies in the short run. Indeed, even the loss of the Oregon Senate seat does not give democrats a filibuster proof majority. Obama supporters are in for great disappointments. Obama will not leave Iraq quickly, he will not increase taxes on the rich quickly and there are a few hundred thousand or maybe a few million who would like to grab one of the 14,000 government jobs he will fill.

The Obama slump of the past two days was really just a continuation of the housing slump. The best way to think of the current situation is that banks are under water on billions of dollars worth of home mortgages. These banks are trying to keep their heads above water just like the many individuals who "own these houses jointly" with the banks.

The USA is much closer to the big economic up-turn than are many nations. Even so, after a long pause, the FOMC is once again lowering US short rates. By the time the latest cut was made, the market had gotten even further ahead of the FOMC. Market rates suggest that the Fed Funds Rate should be at .25%! This is consistent with market forecast of inflation. The best news in this area is that rates for loans between banks are dropping quickly. Frozen credit markets are thawing quickly.

Other good news is that the government does not appear ready to pass another silly rebate law. The irony is that the idea behind the last $600 check scheme was from Keynesian Economics, but Keynes was well aware of the "savings paradox". Based on consumer spending reports, it appears that many scared consumers saved their rebates or used it to pay down debt. Thus, we ended up with new debt on the government books and a negative stimulus to the economy. The savings paradox is that it takes savings to produce long term growth but savings in the short run is the same as stealing the punch bowl from the party.

What we need is gridlock. If we are lucky, Pelosi and Reid will over-reach and even moderates will refuse to go along. Since our economic problems will be largely solved when the rebound in the real estate market becomes clear, the main thing we need is for natural rules to work. Here again, the irony is thick. Of all the most recent economic numbers, the housing numbers are among the few that are in the positive column. New home sales rose from 460,000 in September to 464,000 in October and existing home sales rose from 491,000 in September to 518,000 in October. The fact that housing prices fell was emphasized by the media but the consistent pattern at turns is for sales to rise first and then for prices to follow.

There have been other signs of strength: short interest fell by 4 Billion Dollars, the US Dollar gained ground and productivity rose 1.1%. The 1.1% was down but it is a great number to hit during a tough recession, a rebound of industrial production will cause productivity to rise sharply. The wholesale of gasoline is down to $1.33, implying an average retail of $1.93 within weeks.

Obama is to be admired for running a great campaign. He did not cloud the uninformed with unnecessary knowledge. A Rasmussen poll of democratic voters suggest that 30% do not even know who Harry Reid is! Democrats and republicans tend to agree that Clinton was a better president than Carter. The reality is that Clinton was elected just after a tough real estate recession when the economy was likely to grow no matter what and that Carter was elected just after price controls had artificially held down prices. Not to diminish the good deeds done by Reagan but to some extent Regan was simply lucky to come to power after Paul Volcker did a job on inflation that Arthur Miller had been unwilling to do.

We have been and are in a real estate induced slump. The primary thing that will turn this slump around will be naturally lower interest rates, in the US and in other parts of the world. One can take away currency distortions by computing 30 year T-Bond and other rates in terms of SDR's (special drawing rights). Using SDR's, US Bond rates hit 3% in June of 2003, when rates hit their long term low in terms of US Dollars. The SDR rate is currently at a 70 year low of 2.7%! Low interest rates stimulate economies.

The way to look at this is that the world rate to buy US real estate is based on a 2.7% base. In other words, the US Dollar is still cheap. It makes sense for citizens of other countries to diversify their investments and to buy real estate in the USA.

If I am wrong and Pelosi and Reid get all the stuff passed they want, then union wages will rise, inflation will jump and long rates will soar. But, everyone but Pelosi and Reid realize that the country cannot afford everything Pelosi and Reid want. Again, what we need is a stalemate or a good compromise between republican senators and Obama. If Obama governs as the moderate that ran in the general election (he won 21% of the voters who describe themselves as moderates compared to 9% by Kerry), then the compromise will be somewhat reasonable.

Mike Huckabee made the excellent point tonight that Obama needs to adopt policies that fit the reality of a global economy. The staffs of legislators and the staff of the new president will understand that we cannot afford to raise taxes on businesses or people who can take their assets elsewhere. Americans are loyal when only a few bucks are involved, but they buy Toyota's when the price is right. Toyota, the largest car maker in the world, can move production to where ever it wants as loyalty to the US is not the question.

As an American, I support my President. He is our commander in chief. We want and need him to succeed. Tomorrow, he will hold his first news conference. The US congress will hold a lame duck session starting in 10 days. Moderate and encouraging words tomorrow should serve to ease the fears of many. It would only take a small boost in confidence to get the market headed in the right direction.