The Capital Gains Tax Paradox

The Obama Administration is now considering nearly doubling the tax rate on capital gains when it should be seriously considering reducing or eliminating those taxes. Many economists assert that a reduction in capital gains tax rates will spur private investment in the stock market and ultimately help our economy recover and grow. The Obama Administration loathes the idea of cutting those rates for fear it will be criticized for offering tax cuts to the wealthiest strata of our society.

First, in these difficult times, every measure to spur recovery should be seriously considered as everyone will benefit from a strong economic recovery. Second, even though a reduced capital gains tax favors the wealthy who collect more capital gains, the centroid of securities ownership in this country is squarely in the middle class, not the wealthy. Half of all households, more than 100 million Americans, own securities. These owners typically have more than half their household financial assets in stocks and earn a median household income of $65,000. In today’s economy, these are not rich folks. The Obama Administration needs to acknowledge these facts. While it’s true that many owners hold securities in their tax-deferred IRA and 401K accounts that won’t benefit directly from a reduction of capital gains taxes, it’s also true that more than three-quarters of securities owners own some outside their retirement accounts. Also, if a reduction in capital gains taxes helps push up securities prices, all owners will benefit from the increase in wealth.

Third, given the fact that nearly half of global stock market wealth vanished within the past year, most capital gains have already been realized, taxed and ultimately lost by investors. Going forward, there will be few capital gains to be subjected to tax. In fact, on average at current index levels only investments made more than a decade ago will register any meaningful capital appreciation.

Last and most significant, it’s possible and ironic that the only way to stem the decline and reverse the stock market trend might be to eliminate capital gains taxes, thereby causing the impetus for new investment. Incremental new investments would push the market higher and lead to capital appreciation, i.e., eliminating the tax on gains may be necessary to produce capital gains going forward.

In view of these facts, a reduction or elimination of capital gains taxes could be a powerful stimulus for many middle class Americans, would cost taxpayers nothing in the short run, and minimally until both the economy and stock markets recover significantly. It would also be a no-risk proposition. If it doesn’t work, it doesn’t cost taxpayers anything.

Mark-to-Market Accounting May Be Chinese Handcuffs

The financial crisis seems to be once again causing a market meltdown. The solutions offered to date, such as bank nationalization or some permutation of TARP, all would entail a massive writedown of bank assets according to the rules of mark-to-market accounting. That would render many of the nation’s leading banks, such as Citigroup and Bank of America, insolvent. Consequently and somewhat ironically, our efforts to free ourselves of this crisis could actually make a bad situation worse. The obvious if taboo course of action should be to reconsider the merits of mark-to-market accounting rules and examine their role in contributing to our financial mess.

Dissenters say that tinkering with the rules would be conveniently covering up fundamentally flawed bank business models and that it would be distorting reality to say that assets are worth more than indicated by those rules. However, the rules may be at the root of the problem. Experienced bankers know intuitively that a distressed market under duress does not function properly and does not produce true market values. Banks strapped for cash have dumped loan portfolios current in their payment obligations and collateralized by real assets for mere pennies on the dollar, as private investors line up and raise billions in capital to buy those assets. Mark-to-market accounting rules are forcing low-ball values today just as plainly as they over-inflated those same values a few years ago. Is that the reality we should be seeking?

Changing the rules for the sake of expediency makes no sense, but, by ignoring market conditions, the rules have dictated extreme short-term asset prices that bear no resemblance to their longer term and more realistic values. Also, changing the rules now may help us recover from the current crisis and as important prevent it from recurring in the future. Our goal should be to put in place a process that encourages willing buyers and sellers to freely trade assets. So long as mark-to-market rules provide private investors the possibility of “stealing” assets from banks at fire sale prices they will have no incentive to bid up those prices. Relaxing the accounting rules to take a longer view of asset values may enable banks and investors to trade assets at prices that both can live with, which will lead to true value, and ultimately free our financial system from its Chinese handcuffs.

The Obama Speculative Bubble

Barack Obama’s Presidency represents the latest in a series of speculative bubbles in recent memory to challenge our way of life, like the Tech Bubble that popped at the turn of the millennium and the recent Housing Bubble, which has been belching air for the past couple of years. The “Obama Bubble” has been inflated by the worst economic and stock market downturn since the Great Depression, virtually one-sided media coverage in his favor during the Presidential primary and general election, and more money than has ever been spent by a Presidential candidate in our history.

Speculative bubbles occur when the public becomes so excited and enamored with some commodity that it abandons traditional and common sense approaches to analyzing its value, claiming that somehow a new relationship among variables has occurred and old analytic methods no longer apply. Somehow “it’s different this time.” During the Tech Bubble, tech stock prices exceeded levels normally dictated by company revenue and profitability. During our current Housing Bubble, home prices increased well beyond family incomes’ ability to finance and buy homes. Obama’s “stock” is now trading well above what a fundamental analysis of his candidacy would indicate. Obama lacks executive experience, possesses a limited professional track record and even some key members of his own party stated publicly during his candidacy that he lacked the experience necessary to be President.

Mainstream-media political analysts following presidential campaigns have historically given more consideration to candidates’ past deeds and personal associations than to what they say. Everyone knows that talk is cheap especially from politicians who will say almost anything to get elected. Yet many analysts were willing to take the Democratic candidate at his word, despite the fact that few of Obama’s words could be substantiated by past deeds. Media pundits were so captivated by Obama’s rhetoric and oratory performances that they readily gave him the benefit of every doubt on his positions and failed to critically review the viability and practicality of his policy proposals.

More curious was the complete lack of regard by analysts that an Obama administration would have extraordinary influence and power to push a one-sided liberal agenda, due to meaningful Democratic majorities in both the House and Senate. The current Stimulus Bill is a preview of how our national political system is likely to work at least for the next couple of years.

At one of the most critical times in our history, America elected one of the least prepared Presidential candidates in history, and circumstances gave him more power and influence than any President has held in recent memory. Barely one month into his Presidency, the euphoria of his election triumph is giving way to some serious cold hard reality and almost daily you can feel the air escaping the bubble. If the Obama Presidency were a stock, now would be a good time to sell!

A Stimulus Bill or President Obama's New Clothes?

President Obama’s Stimulus Bill (the "Bill") should make any thoughtful person quake in his/her boots. Its current $787 billion price tag grows to more than one trillion dollars with interest over the next ten years or about $3,200 for each man, woman and child in America. It also represents more money borrowed in a lump sum than our Government has collectively borrowed here and there over most of its 233-year history.

The Bill was initially conceived as emergency legislation designed to soften the landing of an economy headed toward its worst recession since the 1970s. It has strayed considerably from that original intent. A recent commentary by Charles Krauthammer described it as an "abomination," which may be an inadvertent pun on Jerome Corsi’s book: The Obama Nation. Liberal Democrats, whose social policy agenda has been thwarted since the 1960s, loaded the Bill with new policy directives and spending programs inconsistent with and in some ways detrimental to its immediate need and purpose. The President admits the Bill’s emphasis is on spending, although he would also have us believe spending and stimulus are synonymous. As it stands, the Bill adds a measly 2-3 million jobs to the economy over the next couple of years, which translates into an outrageous price tag of $350,000-500,000 per job!

Acknowledging the inherent shortcomings of his Bill and to justify abandoning his commitment to post-partisanship, the President’s major endorsement of his Bill is that "it’s better than doing nothing," implying that Republicans are predisposed to inaction. The Republican response has been to first direct capital to address the housing/mortgage/banking problem at the root of our financial/economic crisis and then to emphasize proven tax-cutting measures to stimulate private spending by consumers instead of the Government. History and most economists side with the Republican strategy. The President’s other major endorsement is that "we need to act now." Temporarily eliminating payroll taxes for everyone could have been done overnight. Some Republicans claim they had a plan to create twice as many jobs at half the cost of the President’s Bill. Don’t we owe it to ourselves to hear them out? If our Government is going to blow a trillion dollars, prudence dictates it should make every attempt to get it right!

Even more disturbing than the President’s abandonment of his campaign pledge to work across the aisle with Republicans (only 3 in the entire Congress approved the Bill), is his apparent disregard for the advice of his own hand-picked economic experts. Key economic advisor and former Treasury Secretary Larry Summers stated clearly and early on that an appropriate and effective stimulus should be timely, temporary and targeted. The stimulus should create new jobs as quickly as possible, disappear when the economy recovers, and emphasize economic sectors likely to offer the biggest bang per stimulus buck. This Bill will likely fall short on those criteria. Furthermore, university economics professor and Obama advisor Christina Romer researched the issue and concluded that fiscal policy, whether it be in the form of government spending or tax cuts, does not provide an effective stimulus for economies in recession. Ms Romer also determined that apart from recession and in general a 1% tax cut produces a 3% increase in GDP, which most economists agree is far more effective than government spending in stimulating the economy. In light of all that, why does the President's stimulus strategy focus on fiscal policy and why does it emphasize government spending over tax cuts by a margin of 2 to 1?

The President claims to recognize the importance of our economic crisis and knows it will probably define his Presidency, yet curiously relinquished control of the stimulus legislation and delegated it to House Democrats who (he had to know) would seize the opportunity to draft a wish list of politically charged pork projects and social programs. After many iterations in the House and Senate, the result is a nearly 1,100 page document thrown together in a couple of weeks and revised copiously mere hours before its ultimate passage by the Senate. What happened to the President’s promise of transparency in the legislative process? Shouldn’t the President want to hear from a decidedly disapproving American public, if not congressional dissenters, before finalizing such a significant and transformational piece of legislation?

The President’s inspirational oratory about the need for and quality of his Bill rings hollow knowing that his White House played a minor role in its conception and no one, including members of Congress, read the complete document before voting to approve it. As responsible citizens and especially as lawmakers, they should know better and be ashamed of themselves. It would appear Democrats and the President have aggressively and hastily convinced themselves this Bill makes good sense and have done their best to bring Americans on board too. One has to wonder if this legislation in hindsight will be remembered as a Stimulus Bill or President Obama’s new clothes.

Bank Nationalization and/or Failure are Bad Ideas

The stock market has spoken loud and clear. If we nationalize our banks or let them fail, we can forget about private capital as a source of bank sustenance, probably for a long time. When Congress initially voted down the Troubled Asset Relief Program (TARP) last Fall the market tanked further and faster than ever before in its history, and recent bank nationalizations in England and our own discussions about nationalizing banks here have produced a similar if less violent market sell-off. TARP’s original version of government purchasing toxic bank assets and selling them at auction still offers the best possibility of attracting private capital back into our financial system and probably at ultimately no cost to taxpayers.

Since mid-2007 we have witnessed unprecedented price volatility in our global stock, bond, real estate and commodity markets, which has shaken our understanding of how they work as a group and how they interact with each other. Even our heretofore absolute faith in U.S. Treasuries as the planet’s sole example of a risk-free financial instrument—one upon which all global investments are based-- has been called into question along with the overall credit-worthiness of the U.S. Government. In one year we lost or temporarily saved many venerable financial institutions some of which date back to our nation’s founding, such as Citigroup and Lehman. Investors have lost faith in corporate and political leaders and with good reason. All of these factors have permanently and dramatically increased the perceived if not actual risk of making investments. Americans lost an estimated $11 Trillion in wealth in less than two years. Many will consider long and hard before they make new investments going forward, which will raise the cost of capital and reduce its availability to our financial system.

Wiping out more private shareholder and bondholder wealth by allowing major bank failures and/or bank nationalizations could cause investors to flee the capital markets for years to come. Some version of TARP is probably the answer. It should be perfected and implemented. For those who think bailing out Wall Street and not Main Street is a bad idea, know that there will be not much of a Wall Street or Main Street without the private capital needed to form and grow new businesses that employ our citizens. For those who think bank failures are the necessary cost of capitalism, know that free markets and private entrepreneurship will suffocate without investment capital from our private citizens.

Bear Market Likely to Continue

The odds are mounting against a return to DOW 14,000 anytime soon. There will be short-term bull rallies, but it seems likely that the bear that gripped the market in 2007 will hold on for many years. The conceptual if rudimentary explanation for my market pessimism, especially over the long term, is illustrated by the simple formula: Price = Earnings x Multiple. Stock market prices (Price) are the result of a complex and dynamic relationship between actual after-tax corporate earnings (Earnings) and the extent to which those earnings are expected to grow over time, which is reflected by a stock’s price/earnings multiple (Multiple). Obviously, stock investors would like to see all their stocks’ earnings and multiples expand steadily over time.

No one is predicting corporate earnings will rise in the next couple of years. The consensus view is that the current recession will last at least as long, which means GNP could fall and unemployment could rise well into 2010. Falling home prices and exorbitant consumer debt levels will curtail consumption and earnings levels accordingly. The Government’s Stimulus Plan may reduce corporate taxes and thereby modestly lift after-tax earnings in the short-to-medium term, but eventually tax rates will need to rise to pay for the currently exploding Government deficit already exceeding $1 Trillion.

Multiple expansion seems unlikely too. Although both macroeconomic and company-specific factors dictate their magnitude, multiples generally rise when inflation and interest rates are low or falling and overall economic and political risks are perceived to be minimal or contained. Inflation is low right now because of worldwide recession and deflation in global real estate values. Interest rates are artificially low because of the concerted efforts of the world’s central banks to pump unprecedented liquidity into global capital markets. Many observers expect those conditions to abate once the financial crisis and recession subside. Also, as the BRIC (Brazil, Russia, India, China) economies and others catch their breath and resume their heady economic growth and concomitant demand for resources, their growth will once again place significant price pressure on world commodity markets, especially oil, industrial metals and food. Consequently, accelerating worldwide inflation is reasonable to assume for many years to come. Inflation and growing government deficits around the world will inexorably push up global interest rates. Geo-political risks are already high and can be expected to continue from on-going turmoil around the world.

While resumed growth may be good news for the earnings side of the equation, high inflation, high interest rates and heightened geo-political risks are bad news for and likely to depress stock multiples in the future. Also, it should be noted that most of the upside in the stock market in recent decades has come from multiple expansion, not earnings growth.

The gloomy short-to-medium term outlook is likely to eventually work itself out, but no one seems to be considering the potential short and long-term negative effect that market shenanigans of past couple of years may have on investors’ attitude and appetite for risking new capital.

Unprecedented recent price volatility in our global capital markets has shaken our understanding of how they work and interact with each other. Americans lost $11 Trillion in wealth in less than two years. Even our heretofore absolute faith in U.S. Treasuries as the planet’s sole example of a risk-free financial instrument, and the basis of comparison for all global investments, has been called into question along with the overall credit-worthiness of the U.S. Government. It boggles the mind that in one year more than a dozen venerable financial institutions were lost or temporarily saved, some of which date back to our nation’s founding and early history, such as Citigroup and Lehman Brothers. These dramatic events occurred quickly and without warning and have caused many to lose faith, with good reason, in corporate and political leaders. All of these factors have materially and perhaps permanently increased the perceived if not actual risk of making investments. Reluctant investors demanding better risk-adjusted returns could reduce the availability of capital and raise its cost in the future. The end result: future stock multiples may be permanently reduced.

Based on the foregoing, and barring some unforeseen positive catalyst that dramatically increases economic productivity, or excites investors or changes the perception of market risk, such as the widespread use of the Internet in the 1990s, it is difficult to imagine a significant upside surprise in the stock market for a long time.