THE SMELL OF FEAR

Suddenly there is the smell of fear in the market. The DOW dropped Friday and the Asian markets are following the path down this morning.

ROTATION, ROTATION, ROTATION

The rotation continues but it also continues to go forward a eighth of a turn only to back up a 16th or so before making its next move. The big drop Friday was in energy shares, with a 4.15% decline in the broad category and a 10% hit to SLB. A couple of years ago, congress was investigating for price gouging, again. Of course, the free market for oil is too big for anyone to get away with price gouging for very long. Today, the margins for refining oil have collapsed. The price of oil has been pushed up due to the fear of war, raising the cost of the raw material while the final demand has not increased.


Pundits all around the world take the sharp rise in oil and gold to be an inflation signal. They conveniently ignore the flight to quality in the bond market. The bond market agrees with the CPI reports. Inflation is falling. The best way to understand this situation is to remember what happened during the great depression. The price of gold and bonds went up as fear trumped reason. The flight to gold was not a fear of inflation but fear of the total collapse of the currency. Fear trumps ration during tough times. Fear can spread quickly. Should Turkey invade Kurdistan, which is doubtful, the amount of oil coming out of Iraq will be changed very little. The fact that the market has moved so sharply to a "non event" shows that traders nerves are on edge. Investors should remember the Warren Buffet adage to be greedy when others are fearful.

As I have written many times during the past several months, one of the last events before the prosperity phase kick in is a strong rally in the bond market. The big bond market move is currently in full swing. The fall in bond rates gives the FOMC the room to lower short rates again. The probability of another cut in the fed funds rate just jumped.

The fantastic strength in the world economy made it seem like further cuts might not be necessary. In particular, it seemed that the congress might be ready to make significant fiscal policy changes which would have stimulated the economy even more than a cut in the fed funds rate. When Charlie Rangel decided to give up on the "monster of all tax reforms" last week, he threw us all back into the "do nothing congress tar pit". With government receipts surging at the annual rate of better than 7% and government outlays growing at only 2.7%, THE GOVERNMENT IS TAKING IN TOO MUCH MONEY and it needs to respond. Unfortunately, it does not appear that a major compromise can be reached this session.

Over the past several days, the risk of recession has jumped. Whenever the US government starts to soak up such a huge amount of money, the risk to economic expansion is great. The good news is that the congress is still in a heck of a box and it might be forced into fiscal stimulus. Trying to pass even a one year patch to the AMT is going to be difficult. The congress will need to pass about $65 Billion of tax increases to patch the AMT. The congress will need 60 votes in the Senate to pass these offsets. I wish them lots of luck.

To pass even a one or two year patch, the congress might need to recognize that the AMT does not need to be offset. The truth is that the congress never expected to realize the extra taxes from the 19 million families that will be caught in the AMT trap for the first time next year. A few powerful Senate leaders on both sides of the isle are willing to pass an AMT tax without offsets. Wow, a sticky wicket indeed!

Bush and the republican congress have been lambasted for deficit spending. Can you believe that during the first term after the take over by the democrats that tons of earmarks will be passed and then not paid for according to the democratic "pay go rule"?

Even though the odds of comprehensive tax reform keeps dropping, it is still the best "way out". It is needed by the American people, it would stimulate the economy, solve the AMT problem once and for all and it would dramatically cut carbon emissions. The beautiful thing about the proposed reform is that conservatives would win energy independence while environmentalist would win the fight against global warming.

TRICKY SITUATION

The FOMC will most likely cut short term interest rates on October 31. Given that there is a high probability of a cut, you want to stay 100% invested in the market. However, the next 10 days might try your patience once again. Indeed, the congress is likely to pass a poor set of bills while knowing that they will be vetoed. They will continue to try to push through the SCHIP funding. The current deadline for congress is November 16.

Again, getting out of town in one piece is going to be tough. The option is to be a do nothing congress that failed to live by its own rules or to enact major reform. Either option is going to be tough.

PROGRESS, PROGRESS, PROGRESS

The war in Iraq continues to go our way. The terrorist are being "fingered" by the citizens of Iraq. A year ago, 161 Iraqis were being murdered on the average week. The rate has recently fallen to about 5 murders per week. In the USA, about 42 of our people are murdered per week. With continued success, troops will be coming home or they will be redeployed to finish the job in Afghanistan. No American president can allow Iran to develop nuclear warheads for use against Israel. Israel has sent a delegation to China to lobby for the sanctions needed to "break the will" of Iran. Continued success in Iraq and Afghanistan will add to the pressure on Iran. Unfortunately, the situation is Pakistan is still volatile, however, there is a good chance that the new administration will be even more pro USA. A strong pro American administration in Pakistan could put the squeeze on the terrorist hiding in the mountains of Afghanistan and Pakistan.

GOOD NEWS, GOOD NEWS, GOOD NEWS

We are living through a "Ken Fisher moment". The majority of the people have a very low opinion of congress, the war, the president, the tax law and they simply have about negative attitudes. The result is opportunity. There is likely to be a strong sentiment shift as the election cycle progresses. Even without positive results from congress, the politicians will be able to brag on the nearly balanced federal budget. The success in Iraq will be reported time and again. One of the more accurate market indicators is that the market does well when the public opinion of the president and congress has been very poor but then rises to at least the 35% positive rating. The set up is here. BUY, BUY, BUY! When Fear turns to Greed, you want to be out in front!

TAX CUTS AND MORE TAX CUTS

Big tax cuts are needed and big tax cuts are being considered!

It is hard to imagine that a democratic congress is considering tax cuts. Maybe they really are and maybe they really are not.

Charlie Rangel appears to have given up on making the grand deal to eliminate the AMT. Perhaps even his "give up" is negotiating strategy. Has he thrown out a carrot or just campaign fodder?


Charlie just split his AMT bill and his tax bill into two parts. Next week there will be votes on each. The tax bill will go nowhere even though he will propose that the corporate rates be reduced from 40% to 25%. The devil is in how he would pay for the reductions.

For the last few weeks, Hank Paulson has been negotiating with Charlie. The attempt was to come up with a massive income tax reform simplification bill. The latest "give-up" indicates that instead of reaching a compromise, the democrats will put forth a bill with some goodies attached that cannot be passed, the republican president will veto the bill, a weak compromise bill will be passed and the two parties will run against each other on what could have been.

BIG TAX CUTS ARE NEEDED BADLY

Near the end of the JFK-LBJ reign, the ever escalating tax system had run its course. By 1969, personal income taxes reached a peak of 10.8% of GDP. Trouble was at hand. The USA experienced a double dip recession with the second one, the 1973-74 being a humdinger. The "tax simplification act" in this particular cycle was a small compromise tax reform in 1969 that was added too piece meal over the next several years.

Near the end of the Jimmy Carter years, personal income taxes had reached another big peak of 11% in 1981. Another huge recession followed in 1982. The early Reagan tax cuts turned the situation around and the market malaise that had lasted from 1969 until 1982 was over. The big, big bull market started its stampede in the fall of 1982. Reagan continued the progress on lower taxes when the Kemp-Roth bill made it through congress in 1986.

Near the end of the Bill Clinton era, personal income taxes reached the highest peak of all with personal income taxes reaching 13% of GNP in 2000. As usual, once the government gets its hands on too much of the national economy, the public protest is a change in party. Bush took over, just as Nixon and Reagan right at the start of a tough recession. Once again it was clear that tax cuts were needed and the congress went along with the Bush cuts. The result of the tax cuts, in all cases (I should have gone back one more cycle to include the JFK tax cuts because they worked as well, but then so did those of Grover Cleveland) was to stimulate the economy and to ultimately increase the total tax revenue even at the lower rates.

Here we go again! The federal government is once again taking too big a piece of the pie. This year, personal taxes are pushing up hard. The current level is 10.8% of GNP. Because the democrats plan to increase the top marginal rates, billions of dollars will be pulled out of IRA accounts for the next three years. All investors should take a look at their marginal brackets and consider withdrawing a portion of their IRAs early. In particular those who are over 59.5 years of age should take a look. Because 100% of withdrawals from retirement accounts is taxable at ordinary rates, the advantage of tax deferral will become a disadvantage if rates are going to climb.

Let me mention once again that the simple explanation for the great depression was that the federal government held too large a share of the GNP. Today it is common for the average man to rail against the federal deficit without remembering that each of the recessions mentioned above came as a result of sharp pay-downs of government debt. Democrats love to mention that Clinton balanced the budget, what they do not like to admit is that as a result of the excessive level of personal tax the economy was in a recession by the time Bill left office. Saying that the down turn in the economy was a result of the tech bubble bust is similar to what is done to show that carbon is causing the warming of the earth. The very gradual rise in the temperature of the earth started before the rise in carbon but a graph of recent history shows the two numbers going up together.

In any event, our banking system is a fractional system and we actually need small levels of inflation to avoid disruptive allocations of resources. Indeed, the FOMC needs the leverage of debt to be able to stimulate the economy at those critical times of need.

TAX CUTS PROPOSED

Charlie Rangel would raise a lot of taxes in order to patch the AMT and to lower the corporate income tax. It is widely recognized that America needs lower corporate rates to "bring businesses back home". If any one of you were CEO of a multinational company, you would have to choose a European subsidiary for a new project given that the tax of 24% would yield a higher profit than the US tax of 40%. If patriotism for the US caused you to make a different choice, the shareholders would remove you from office pretty quick.

SIGNS, SIGNS, EVERY WHERE THERE ARE SIGNS

One of the big signs posted by the market place has been the cancellation of 16 new coal fired electrical plants in recent weeks. The AP reports that there is a growing belief that either a cap and trade carbon tax system or a straight forward carbon tax will be passed. My estimate of the probability of passage by the current congress was on the rise again until Charlie announced his split of the AMT bill. It will now be much easier for a one year patch to be reached with the big compromise being done after a hard fought election.

This is a sad situation. Politicians need to do the peoples work. Instead we are going to hear endless advertisements about how bad President Bush is and about how bad the democratic congress is. We are going to hear a lot of that in any case but I had high hopes that the obvious compromise would be reached. A third grade student can tell you that the US needs to tax income less and dirty coal more.

BUT MAYBE, JUST MAYBE? I cannot imagine a bill going through that would retroactively tax power plants already constructed. There is still inconsistency among the signs. Games are being played to make the energy "crisis" seem worse than it really is. The bone thrown out by Rangel, of lower corporate rates, is surely at least a fishing hook.

Again, we all know that two bills will be vetoed. Anyone who has negotiated the purchase of a business or even a car knows that you have to be willing to "walk away" sometimes more than once before you can discover the best deal. Democrats could go a long way toward shedding their "tax and spend" label if they were to pass tax reductions that must eventually be passed anyway.

As regular readers know, I like the compromise of combining the Ryan bill with the Dingle bill. I do not like the Lieberman bill because the carbon cap and trade system is too easily gamed. Another "fishing hook" has been thrown out by republican negotiators. The original plan offered was acceptance of a 50 cent per gallon and $50 per tonne gas and carbon tax in exchange for a very simple, two bracket income tax; 10 percent on the first $100,000 of income and 25% on all over $100,000. The latest "hook" is acceptance of a 4% surcharge on all above $200,000. It was known from the beginning that democrats would not accept the 10/25 system, but republicans have reached out with the idea of a 4% surcharge in the same way that Rangel has reached out with the cut in the corporate rate. Please notice that Rangel's proffer is a 25% corporate rate which is in line with the 10/25 rate wanted by republicans. The idea is that real simplification can only happen if the corporate and the top personal rate is the same. This is key for the owners of farms and small businesses who might have the option of paying out more or less of the earnings as personal income.

GOOD NEWS TURNED TO BAD, NO NEWS TURNED TO HYPE, CAL, CAL, CAL AND GOOGLE, GOOGLE, GOOGLE.

CAL put out some great numbers but you would not know it by reading the news reports. For example, one article talked about a 2% rise in revenues and said that earnings dropped from $2.17 per share to $2.15 because the number of shares outstanding increased by 1.8%. The truth is that the $2.17 of 2006 included .86 of one time gains from the sale of securities and the $2.15 included a one time hit to the pension fund of 10 cents per share. Indeed, I suspect that earnings were further reduced by the massive amounts added to pension funds this quarter. The bottom line is that the 2 cent drop was really an increase in operating earnings from $1.31 to $2.25, at least. The year over year increase was 71%!

THE KEY POINT IS THAT THE MARKET IS GIVING US ALL A CAL BUYING OPPORTUNITY.

On the other hand, Google did about as well as expected but the news has been hyped and hyped some more. I am still in love with the company, with its products and with the direction I see its future products taking the world. Still, I do not plan to add to my holdings now. The stock has had a big run and it continues to trade at a very high price. It will take years of growth for this company to be "worth" its current valuation, however, because I expect it to grow for many years, it will continue to receive a premium even after it is "worth" the current price.

Over the next several years, Google will go head to head against the "big boys". The major telephone companies have been around for a long time and they are willing to play rough. The big media companies, such as Viacom, know how to play hardball. Microsoft is spending billions to be more like Google. The list goes on. Google will face stiff challenges.

Again, please do not get me wrong. For almost four years, I have strongly recommended Google. It was one of the first three stocks my 19 month old grand daughter purchased. I like it, I like it. However, the stock will probably continue to climb in a pattern similar to the last couple of years. After a good run, the stock will be in the news constantly. Then it will go sideways or fade back for a long stretch before the next run begins. It is impossible to catch these cycles accurately. The best policy is to buy and hold the stock. If the mobile phone becomes what I believe it will become, Google will help billions of people navigate life daily.

THE STEADY DRIP

Statistics show that those who invest regular amounts on a regular basis achieve higher returns than those who add money in chunks (when they feel good about the market). Last week I wrote that a pull back was likely because the sentiment had gotten too strong. This week, the sentiment is weakening. The talk about the 1987 crash and about $100 oil and war with the Turks is taking its toll. We need a little more fear to set up another great run. Congress will most likely finish its October 1 fiscal year budget before the Thanksgiving Holidays (Harry Reid says he is willing to call the folks back for a December session if necessary but I doubt it will happen). Chances are a weak budget will be passed by November 14. I still give a strong bill with great compromises a 20% chance.

CAL EARNINGS

CAL increased revenues per seat mile by 6% while cost per seat mile went up 3.1%. One never knows how the market will react (some folks are always disappointed with good numbers) but from my perspective the net yield gain was a home run.

The cost per mile was an especially good number given that fuel cost went up 4.3% and fuel use went up 4.9%. The company is clearly keeping a lid on non fuel costs. Even the 4.9% increase in fuel use was less than the traffic increase so once again the company is doing a great job to control costs.

The reported earnings, $2.15, were reduced by a 10 cents charge for pension contributions. Adjusting the number to $2.25 makes it 21% higher than the forecast of just two months ago and better than a 70% increase over the prior year quarter!

LONG BOND

Long term interest rates are falling. The 10 year bond is trading around 4.5%! What inflation? With the average wage up better than 8% over the past two years and with inflation dying, prosperity is breaking out. Consumers are paying down debt and buying more stuff all at the same time!

BUY, BUY, BUY!

FENCES, FENCES AND MORE FENCES

Today's news is that the earnings improvement in the airline business continues. Today's good report by AMR followed the prior good numbers delivered by DAL and NWA. AMR's profits are up from 6 cents per share last year to 74 cents this year. Projections are for continued improvement even though the company is projecting higher fuel costs.

AMR has decided not to prebook all the middle seats. The idea is to provide space for those who might be hit by canceled flights. In other words, AMR will voluntarily shrink its capacity. This action will lead to further price increases and an improvement in the travel experience of the passengers. In the meantime, purely domestic carriers, such as Southwest Airlines are getting hit especially hard by higher fuel prices. Thus, LUV will lead a series of fare increases. The average fare is still 11% below the 2000 peak. Adjusted for inflation, fares are 24% below the prior peak. With continued growth in demand, you can expect significant fare increases over the coming years. International carriers, such as CAL, have already raised ticket prices on long flights to offset higher fuel. International carriers have used contract carriers to go toe to toe with domestic carriers. They are able to match price while providing continuing service to other destinations and while offering better perks such as airport clubs and frequent flier programs. Last week, AMR lead a round of fare increases on non domestic flights and this week LUV is the leader on the next round of bumps.


Today, analysts have used the numbers reported by AMR, DAL and NWA to adjust their CAL estimates. The biggest adjustment came from the most positive analyst at Credit Suisse. The result is a penny lower consensus of $2.17 and a reduction for 2008 to just below $5. The reduction to next year is part of the "game" of letting this improving industry build on its track record of beating analyst estimates. In an earlier report I detailed the high average percentage "beat" by CAL.

Over at Legg Mason, Bill Miller continues to manage a few billion dollars well. One of his funds is better has an allocation of better than 7% in airline stocks. He owns all the majors with the exception of CAL. As you know, I believe getting the sector right is 90% of stock market performance. I am confident that Bill's fund will do well.

FENCES, FENCES AND MORE FENCES

The Great Wall of China was built to keep out the bad guys. The Berlin Wall was built to keep in the good guys. The proposed Mexican Wall will be to keep out the good guys. Only the Great Wall was constructed with common sense in mind but the world has changed just a little over the centuries. Thousands of daily airline flights "over the top of the wall" make today's fence the least wise of all.

TECHNOLOGY TO THE RESCUE

A mad rush is on to develop a new electronic fence. Boeing will report results in a few weeks. The push is to develop a new border security plan before the final compromise budget bills are passed by the congress. It is estimated that this electronic fence will cost about 8 billion bucks, double what has been budgeted for a standard fence that would not cover the entire border. I expect the final version to ultimately cost 6 or more times as much but what is a few billion to the federal government?

Mark my words, Congress knows that with public approval ratings hitting near or in the single digits, the pressure is on congress to pass all 12 of the appropriations bills. Because the must do something about the AMT, I expect that they will be willing to compromise with Bush to pass significant measures.

One of the potential "big wins" will be a last minute compromise on immigration reform. It seems like a long shot now but something big is coming down the pike. The fiscal year began on October 1 and even now Charlie Rangel, John Dingle and others are dragging their feet while the bureaucrats who report to Hank Paulson are engaged daily in negotiations with the staffs of congressional leaders.

FENCES MIGHT FALL! The Mexican Wall might be good news in the sense that we sometimes must swallow "silly pills" to get the good stuff done. As you know, the compromise I like is the joining the proposed 10/25% flat tax with a 50/50 cent carbon/gasoline tax.

Congress has the option of leaving town as a "do nothing congress" with their tails between their legs or as the congress that saved the world from global warming, the congress that save the middle class from the evil AMT and, perhaps even the congress that saved the nation from the horrors of Mexican workers and terrorist sneaking across the border.

No matter what the outcome in congress and no matter the current negative focus of the media, the world economy is on a roll that will pick up the pace in the coming year. IN CASE YOU HAVE NOT HEARD, WAGES HAVE GROWN AT BETTER THAN 8% OVER THE PAST TWO YEARS WHILE UNEMPLOYMENT IS RUNNING AT BELOW 5%.

When talk of Jimmy Carter days surfaced on Fox TV, Brit Hume dryly asked if Jimmy Carter was the President who left us with mortgage rates of 21%, inflation rates of 14% and unemployment rates of 9%? When the interviewer asked Mr. Carter what he would have done differently he said he would have sent another helicopter into Iran during the hostage crisis. Folks, by next summer, the majority of Americans will have begun to recognize that "times are good". The change in sentiment will give stock PE ratios a boost.

BUY, BUY, BUY!

BLOW OFF RALLIES -- HUGE PROFITS

The blow off rally in oil, gold and currencies has been blamed on every thing from hurricanes to a potential battle between the Turks and the Kurds. Blow off rallies come near the end of a major run. They can last a good while and exact tops are impossible to call; exact bottoms are easier but still impossible. :) In any event, huge projects are in the works; projects that will ultimately send the prices across the "spider web" curve. Over the past 5 years or so, the dollar has dropped to a clearing price level. Total US export growth in the past year was better than 12% and manufactured goods exports grew by better than 16%. Imports growth was in the 3% range! All the while, finished goods prices jumped by 4.5%! If you want to see a slew of earnings surprises, combine 16% export growth with price increases of 4.5%; a powerful combination for profits.



I read a few numbers late last night and did not write them down but the following are close approximations. In the last year, the dollar has dropped something like 12% against the Euro and 5.5% against the Chinese Yuan. It was not so long ago that Europeans had to spend 1.2 Euros to get on US dollar. Today, they spend a Euro and get back 42 pence in change! Those who worry over the trade imbalance are worried about a problem already solved.



CAL will hold its earnings web conference Thursday morning. Google and many others earnings reports will follow. The CAL estimates have been increased many times over the past couple of months. The low end of the range is now up to $1.87, the high end at $2.50 with the median at $2.17 (up from $2.14 a few days ago). I will not be surprised by $2.60.



Warning: should Congress reach a compromise carbon tax bill, one that would fund the FAA through an increase in the tax on jet fuel, the initial reaction of the market might be negative. Keep in mind that the higher the price of fuel the more sense to riding the bus or the air-bus. The average price of the average CAL ticket works out to less than 12 cents per mile as the crow flies. An increase in the fuel tax in combination with new anti congestion rules will clear a path for quicker landings. The higher price of fuel will make the "air-bus" savings per passenger larger.



By the way, I spent a great weekend at Table Rock, which is at the south end of Linville Gorge. It was a beautiful weekend. Our "Old Goats Patrol" made up of former scout masters enjoyed good times, great food, great views and a fun time at the "old liars campfire." I am behind on individual emails but following the market closely. The over bought enthusiasm is already at least halfway cured. This little correction should be over soon. BUY, BUY, BUY for the long term.

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.

RUN, RUN, RUN

I continue to have more to do than I can possibly get done. I will let individual email responses pile up for a few more days, until I can catch my breath. Just a few comments here to let you know the BIG BULL is still preparing for its next charge.

1) Yes, commodities are rolling over. A couple of readers continue to make the case that oil and gold are near record highs. All I can say is that these two very visible commodities simply do not tell the whole story. Take a look at a chart of Uranium prices. After running and running, all the way to about $140, the price has fallen to around $75 since the peak in June. Aluminum, lumber and others have fallen dramatically. Oil is still high but natural gas, which will be substituted for oil as much as possible this winter, is selling at about half the price of oil on a BTU basis. With warm winter weather, oil could easily trade at $50 per barrel by January.

2) The Democratic controlled congress continues to talk a big game while quietly backing away from confrontation. The latest quiet move was to remove the provision of increasing the tax on partnerships. John Rutledge noted that 15.5 million Americans would have been hit by the higher tax. The loud talk is mostly about SCHIP "poor children's health assistance". Republicans in tight races are being lobbied to vote to override the Bush veto. Democrats know that if they can't get the votes to help "poor children" then there is no hope of "winning" on "big" issues this year. Rope-a-dope seems to be the strategy of the day. The odds have increased that the congress will pass another one year patch to the AMT and leave big change to the tax system as a campaign issue.

3) Jobs, jobs, jobs for the illegals. For a number of months, a large number of workers have been expecting lay offs. These workers social security numbers are either 000-00-0000 or numbers that do not match the names of the workers. In many cases the numbers match the names of dead people. After the latest attempt at immigration reform failed, the Bush administration warned employers to "cleanse their payrolls". A month or so ago, a court suspended the plan and, yesterday, it ruled the plan to be out of bounds. The bottom line is that immigration reform is still needed. Piece meal attempts to "fix" the problem will not work. The ruling of the court pretty much puts us back at square one. The good news is that millions of jobs will continue to be filled by "illegal immigrants" and great pain to the US economy will be delayed to a future time.

So, for the next year, you can count on hearing a lot about tax reform, energy reform and immigration reform. Tax reform will be defined by democrats as raising taxes on capital gains, corporations and "the rich" in order to give $1,000 checks and such to the rest of us. Tax reform for the Republicans will be defined as simplifying the tax code while reducing the tax on capital in order to restore the competitive position of the US in world markets.

In the area of energy, constant calls for increases in the government mandate for ethanol use have started falling on deaf ears. Poor people in some countries are literally starving as a result of higher food prices. Commons sense says that forcing the burning of food products in vehicles is not the best solution.

Democrats will talk about energy in terms of global warming. Republicans will push for energy independence as a national security measure. Democrats will propose a "Manhattan Energy Project" in order to create jobs and solve the global warming crisis. The reason for the push does not matter. The pressure will grow to use the abundant resources available, including coal and nuclear power. The push by democrats to tax carbon fuels could turn the price of uranium around one more time. The huge drop in the price since June is an indication by the market that the current congress will not be able to reach a cap and trade system or a carbon tax compromise. An increase in the tax on carbon will make the nuclear power numbers all the more compelling.

ROLL, ROLL, ROLL

The bottom line for investors is that the business cycle is clearly moving into the prosperity phase. In this phase, as the price of commodities rolls down, headline inflation rates roll down, giving an automatic boost to real incomes (the simple case is of the consumer who fills his gas tank for less). Full employment brought on partly by commercial construction will provide another boost to real incomes. Spending increases by some will become the income of others and the multiplier effect will kick-in. BOOM, BOOM, BOOM; economic prosperity is at hand!

Those who say that Hillary has a lock on the Presidency ignore history and the economic cycle. We know that neither Bill Clinton or George Bush won a majority of votes. With the exception of Goldwater's run, presidential elections tend to be very close. The economic times will not ever be much better than they will be by next summer and fall and voters do tend to "vote their pocket books". Investors should take advantage of the situation and make money now. While the down turn will not be immediately after the election, do not wait until all the numbers say we are in a boom, boom, boom before you go 100% into the market. It is my opinion that the biggest mistake made by the average investor is wait until near the top to be fully invested. One needs to get in early and get out "too early". Keep in mind that most folk find it most difficult to start scaling out when "everyone" is making big money. Our "hard wiring" makes us want to enjoy the party with all the other guests, once everyone has joined the party it is time to leave. This BIG BULL began with a roar 5 years ago. The big money made during the first half of the cycle was made from October 2002 to June of 2004. The second half is under way. The cycle has two to four more years to run. It is similar to a baseball game with each inning representing a year but 9 years is an average game not the required length. Don't wait for the last year or two before you try to start hitting home runs. This baseball game is more than half over.

A number of indicators suggest the market is over bought in the short run. A pullback would not be a surprise, but the risk of being out of the market is greater than the risk of being in the market.

I have overstayed my allotted time. Got to run, run, run. Have a great day!