Reagan Tax Cuts

by Bruce Fenton

Opponents to of tax cuts cite numerous reasons why tax cuts won’t work. Too much, benefits the rich over the poor, will lead to deficit spending, will waste the surplus… all concerns expressed by the doubters. However, they are ignoring history.

Somehow they forgot the legacy of the Reagan presidency. So, on the anniversary of his 95th birthday, it seems fitting to comment on his legacy and vision.

Described by economist Art Laffer as the last “real President,” Reagan brought to the office a strong, singular focus to build a better country and to shut down world communism. Without a doubt, he did both.

Upon assuming office, he immediately embraced the supply side economic policies advanced by his economic advisor, Laffer. The Laffer Curve theory held that if taxes were cut, the resulting money left in the hands of the people and not the government, would stimulate the economy and the resulting growth would actually generate more tax revenue.

The broad-based income tax cuts that Reagan pushed through did exactly that, setting off an entrepreneurial boom that has propelled the growth of the economy for the past 20 years. Certainly the Clinton Presidency benefited from the tax cuts, and to Clinton’s credit, he even added his own cut by reducing the capital gains tax.

Reagan added to the economic well being of the country by facing down communism, and for all intents, shutting down its socialistic economic system around the world. This has opened up vast parts of the world as a marketplace for our goods and services. Today, one form or another of capitalism propels the economic environment of the world.

Reagan’s detractors, and to be sure there are many, point to his lack of sensitivity for social issues and the legacy of his deficit spending on defense and the infrastructure throughout the land.

In the case of the latter, we can draw a corollary by comparing his spending with what all of us do with our homes. We buy homes, and when home values and/or our income goes up, we remodel. By remodeling, we add value to our homes and increase the livability, or quality of life that comes with having a nicer home. The money for this remodeling usually comes from refinancing… adding to our family debt with additional long-term mortgage borrowing.

But, we do so with the mindset that we will have the income in future years to pay off this debt. Reagan envisioned leaving money in the hands of the people rather than the government, where it could be put to more productive uses than government spending would provide. He was right—our economy grew, and government income increased, eventually providing cash flow capability to pay for the “remodeling” that his Presidency did over his eight years in office.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Remember WIN?

If your consciousness level exceeded the decibel level of your favorite rock band of the 70s, you recognize WIN as President Gerald Ford’s exhortation to all to Whip Inflation Now.

Over the last few months, current but outgoing Federal Reserve Chairman Alan Greenspan has left no doubt that he will whip inflation now as his Federal Reserve cranked up interest rates. All this while telling us the economy was in fine shape, all things considered. Thus far, the underlying rate of inflation has yet to show many signs of being pushed higher by the surge in oil prices.

Mr. Greenspan and most other Fed officials tend to view higher energy prices as a one-time event, and pay much closer attention to the “core” rate of inflation that excludes energy and food prices. Despite the rise in gasoline prices, the core rate remains tolerable.

Government economic data suggests the economy has the strength necessary to absorb rising energy prices, a hurricane or two, and the interest rate hikes. In November, the government surprised many forecasters by estimating that the economy grew at a rapid clip of 3.8 percent in the third quarter, despite the impact of Hurricane Katrina and skyrocketing fuel prices.

No doubt about it, inflation remains the big gorilla in our economic forest. But the inflation of President Ford’s era, and the inflation Greenspan is jousting are two different inflations. Ford’s battle was with “cost-push” inflation … the type that occurs when companies’ costs go up leaving no alternatives other than raising prices. Hence, costs have “pushed” prices up.

This can happen when workers have wage pricing powers, such as occurs with strong labor unions, and equally strong cost of living benefits in union contracts. If commodity prices increase, companies are forced to raise prices to recover their costs. Businesses may be forced to “price in” interest rate increases, tax increases, along with excise duties on fuel and oil, and changes in currency exchange rates. These can all cause cost-push inflation.

The second type of inflation, “demand-pull,” is the current Fed’s enemy. This inflation results from too much money chasing too few goods. A sure sign of this inflation is a rising GDP and falling unemployment.

Today our economy is primarily service based. Our wage structure remains flexible and out of union control. To better understand the dwindling power of labor, one only has to look at the difficulties organized labor is having trying to organize Wal-Mart workers.

Thirty years ago this was not the case, as organized labor exerted significant leverage to force businesses to raise wages, which in turn exacerbated the impact of rising oil prices.

The recent successful efforts of airlines to cut wages, and Delphi to cut pension benefits signifies even more evidence that we have a flexible wage economy … one where inflation is not likely to be driven by a cost-push wage spiral.

The inflation we face today is more events related (the growing world demand for energy resources) than it is a secular inflation that is likely to increase over time. Fortunately our economy is resilient and flexible enough to adjust to higher energy costs. And, we are productive enough, thanks to the productivity gains brought about by technology, and a better educated and more skilled workforce made to produce the goods and services necessary to keep up with demand.

While it is likely that we will have more rate increases even after Greenspan gives up the reigns of the Fed, I do not believe the inflation we face will be of the WIN variety. And with some attention to investing and saving strategies, our soon to retire Boomers will be able to look forward to more than flipping hamburgers in retirement.

Natural Gas & Technology

by Bruce Fenton

A looming natural gas shortage is beginning to look like the 500-pound monster in the forest of economic recovery. When oil prices spiked and gasoline rocketed far beyond $2 per gallon, it seemed that “winning the war” would add stability and lower costs to the energy picture. This may not be the case . . . and it has little to do with Iraqi oil.

Energy prices remain stubbornly high. Natural gas prices in particular remain inflated in comparison to historical standards. With natural gas accounting for nearly one-fourth of the nation’s energy consumption and gas imports on the rise, these higher prices, if sustained, will be an impediment to the much-anticipated economic rebound.

Higher prices for energy act as a tax on consumers and businesses. Unfortunately, it is the lower wage earners who will pay a disproportionately higher price for the energy they use.

President Bush has called for a renewed emphasis on gas exploration, but in a consumer friendly fashion. He stated, “We’re a technologically capable nation. We can explore for natural gas and protect our environment.”

Natural gas is a colorless, odorless fossil fuel that gives off a great deal of energy with few harmful by-products when burned. It is distributed from vast underground storage sites through a nationwide system of pipelines. Unfortunately, like all extractive resources, exploration for natural gas draws the attention and the ire of environmental activists.
But President Bush may have a point. The natural gas industry has made major strides in using technology to advance its exploration efforts. According to their website, www.naturalgas.org, new technology has allowed the industry to increase exploration and production to meet rising demand without materially increasing the stress on the environment.

Among the factoids on their website:

• 22,000 fewer wells are needed on an annual basis to develop the same amount of oil and gas reserves as in 1985.
• Drilling wastes have decreased by as much as 148 million barrels due to increasing well productivity and using fewer wells.
• The drilling footprint of well pads has decreased by as much as 70% due to advanced drilling technology, which is extremely useful for drilling in sensitive areas.
• By using modular drilling rigs and slim-hole drilling, the size and weight of drilling rigs can be reduced by up to 75% over traditional drilling rigs, reducing their surface impact.
• Had technology, and thus drilling footprints, remained at 1985 levels, today's drilling footprints would take up an additional 17,000 acres of land.

The importance of technological advances in this industry cannot be overstated. New technologies and applications are being developed constantly to improve the economics of producing natural gas, allow for the production of deposits formerly considered too unconventional or expensive to develop, and ensure that the supply of natural gas keeps up with steadily increasing demand.

Sufficient domestic natural gas resources exist to help fuel the U.S. for a significant period of time, and technology is playing a huge role in providing low-cost, environmentally sound methods of extracting these resources.

Hopefully, environmental activists and the industry will find some middle ground that will allow us to continue to develop natural gas resources as an alternative to the use of coal, oil and nuclear energy to provide the energy resources our growing nation needs.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Transportation and Our Economy

by Bruce Fenton

Recent attention given to the financial troubles of the airlines underscores the importance of transportation systems to our economy. Indeed, the so-called “Dow Theory” used by technical analysts to predict major market movement, uses the Dow Jones Transportation Index as an integral element for such predictions.

Charles Dow, father of the Wall Street Journal and developer of the Dow Jones Averages, theorized in his early financial reporting late in the 1880s that there was a relationship between industrial stocks and the railroads. (Keep in mind that there were only railroads at that time. It wasn’t until 1969 that the Dow Transportation average was broadened to include truckers and airlines.)

Dow was of the opinion that market movements could be categorized as three types. A primary trend takes place over the course of years. This trend can be either up (Bull) or down (Bear). Secondary trends may run counter to primary trends and are usually of much shorter duration, lasting several weeks or months. Finally, of lesser importance are the day-to-day fluctuations, which can move in either direction.

He theorized that in order for a reliable trend to signal the market’s direction, the railroad index and the industrial index should be moving in the same direction.

The relationship between the two indices was logical to Dow. In order for the industrials to get their products to market, they must use the railroads. He noted that when the industrials did well, so did the transportation companies. But, when one sector was doing much better than the other, a divergence was forming. If the other sector did not catch up, a major market reversal was coming.

During Dow’s time, railroads had a monopoly on industrial transportation. The invention of the automobile gradually diminished the strength of this monopoly.

Even though the automobile was invented in the 1880s, it was not until the 1920s that it became a factor in industrial transportation. The reason was simple—there were no roads.

In 1919, the U.S. Army put together a cavalcade of military motor vehicles and set out to drive from Washington, D.C. to San Francisco. This epic continental journey took them across and through 3,250 miles of dirt, mud, rocks and sand. They averaged just less than 5 mph along the way.

The struggles of the journey left an indelible impression on a young Army officer, Dwight Eisenhower, who, four decades later when he became president, launched the building of the interstate highway system.

Author Pete Davies chronicles this adventure in his book American Road. He notes how important the development of a reliable transportation system was to the building of commerce across the lands.

Then, with very few exceptions, there were no paved roads. Few states were willing to fund the development and paving of roads. Much of the journey in the western states took place on wagon trails left over from the western migrations of 50 years earlier.

Today, our land arguably boasts the finest transportation system in the world. But Dow’s original theorizing retains remarkable relevance.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Gold

by Bruce Fenton

Gold was the supreme measure of value and the one common currency of commerce in the world’s financial system in the early development of our nation. The Bank of England went on the gold standard in 1821, agreeing to buy or sell unlimited amounts of gold at a set rate in pounds sterling. Since the Bank of England was the dominant bank for world trade, other nations (the U.S. included) had little choice but to adopt the same standards.

A plus for a gold standard was that it made inflation impossible. A government could not add to its money supply unless it had gold to back its currency. While U.S. banks did print bank notes denominated in gold, the notes tended to carry less value the further they were removed from the issuing bank.

In the beginning, the U.S. was not a major gold-producing nation—in 1847, the U.S. produced only 43,000 ounces. That changed dramatically with the discovery of gold in California the following year. By 1853, gold production reached 3,144,000 ounces, worth almost $65 million (Limbaugh and Fuller, Calaveras Gold).

The discovery of gold in California forever changed the face of the nation. It began the tipping of the population and center of commerce from the east to the west. It made millionaires out of some and bankrupted others. It brought railroads to the west and gave rise to towns and cities, forever blending ethnicities from all backgrounds. It basically laid the foundation for today’s economy.

The sudden influx of wealth from California gold was reflected on Wall Street.
Speculation in mining shares, many of dubious value, abounded. New corporations appeared, more stocks were issued and economic optimism grew. But despite the fact that the gold standard worked to minimize inflation, it did not allow the government the option of using monetary policy to help in times of national crisis.

When the stock market crashed in 1929 and the world economies fell into a deep recession, panicking investors eventually sought to redeem their bank notes for the gold of gold standard countries. Faced with decreasing gold reserves, the Bank of England suspended all gold payments. Their stock market rallied (as did the U.S. markets) when, in 1933, the U.S. announced it was suspending the gold standard.

The end of the gold standard came to the U.S. in 1971 when President Nixon stopped all foreign redemption of Federal Reserve Notes for gold. Again, the stock market responded with enthusiasm.

Today, gold remains an inflation hedge as well as a store of wealth in times of uncertainty. However, as a long-term investment, it has produced a negative return for the past two hundred years, when adjusted for inflation (Jeremy Siegel, Stocks for the Long Run).

Gold has also provided us with the endearing description of “bulls and bears.” For entertainment, the miners in California would chain a bull by one leg in a corral with a bear. They then bet on which would survive the encounter. The optimists bet on the bull and the pessimists bet on the bear. Not much has changed in that equation in the past 150 years!

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Ownership Society

by Bruce Fenton

The idea of “ownership society” did not originate somewhere on the plains of Texas or the back room of the White House. Matter of fact, if we look back to the birthplace of personal liberties (according to the French) it was Lafayette and friends who, in 1789, set forth in Article 2 of the Declaration of the Rights of Man that “The goal of any political association is the conservation of the natural and imprescriptible rights of the man. These rights are personal freedom, liberty, the ownership of property.”

The President’s concept of an “ownership society” puts the responsibility for an individual’s welfare on his shoulders and not the governments, essentially reversing 70 years of New Deal programs and policies. As owners we would become a nation of self-providers and self-funders for every economic need. We would own and fund our own pensions. We would own and fund our own health insurance. We would take responsibility for other government provided social services.

In his book Bullish on Bush: How George W. Bush’s Ownership Society Will Make America Stronger, author Stephen Moore adopts the view that through the miracle of compound interest, all Americans have the chance to become millionaires.

There are more than a few Democrats, and even a Republican or two, who have their doubts that the policies of the New Deal should be so hastily thrown out. With ownership comes the right to fail as well as to succeed.

Responsible public policy should take into account that not all men are created equal in the sense they have the ability to look after themselves. Not all families can automatically be turned into capitalists by making available tax favored saving accounts. For example on the lower end of the economic spectrum are families who need every penny to pay for basic survival and since these folks pay little or no tax anyway, they have zero incentive to become “owners” of social programs that used to provide them some social safety net for free.

Moore does make some interesting points with his concept of America as a society of savers and investors. With larger stakes in corporate America, we would be likely to identify with business and more likely to support policies, such as free trade, that “workers” have historically opposed. The additional emphasis on personal saving and investing would be beneficial to the economy and the stock market specifically.

This transition has already begun, if we look back to the decade of the 80s. IRAs became a part of the American savings scene. Corporations ditched defined benefit plans in favor of the 401k…leaving the worker the option, and responsible for, saving for their own retirement. More people than ever became stockholders either through retirement plan investing or personal savings.

The great boom of the 90s saw an expansion of numbers of American shareholder/investors. Unfortunately, while wide, the expansion was not deep according to the Federal Reserve survey that shows half of all households have financial assets that total less than $20,000.

The Bush concept of ownership has merit and will have broad appeal…providing policy makers don’t pull the rug out from under those who need societal assistance and a leg up in life. I like the idea of each of us accepting personal responsibility for our lives. But as the French Monarchy learned the hard way…too big a gulf between those who have and those who have not eventually leads to radical revolution!

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Social Security Dilemma

by Bruce Fenton

The “Yin and Yang” facing public policy makers was evident in a recent edition of USA Today® when the editors ran an article on the front page discussing how Social Security is being stretched by long retirements. In the next section, they presented the “yang” with a feature on how seniors live longer by taking care of their minds and bodies.

In a nutshell, the simple fix to the dilemma of potential future bankruptcy of the Social Security System is to not live as long. That’s not going to happen to our wave of self-actualizing Baby Boomers, each bound to hang on to eternal youth and outlive the actuarial tables!

According to the articles, people are collecting benefits an average of seven years longer than they did in 1960. President Bush is seeking to fill the gap created by larger outflows with his plan to allow workers to create private investment accounts from Social Security taxes to generate higher returns that will cover longer retirements.

When Social Security was established in 1935, the retirement age was set at 65…President Roosevelt’s mother raised no fool…the life expectancy was only 63 at the time! Today, the life expectancy for a male child is 77, and if he lives to 65 it is 83. In 1961 the Government lowered the early retirement age to 62. Today, the percentage of men still working at 63 has fallen from 78% in 1960 to 48%.

Longer retirements are stretching a Social Security System to pay more benefits than it was designed to handle. Earlier retirements hit the system with a double whammy, since a retired worker no longer contributes to the system, which essentially has become “pay as you go.”

Social Security administrators would like to see workers stay employed beyond age 62. For each additional year worked, worker retirement benefits go up about 7.5% annually. Today about 55% of workers start collecting benefits at 62, while less than one-fourth wait until 65 or later.

Federal Reserve Chairman Alan Greenspan has suggested raising the retirement age by one year. He projects that would equal a 7% benefit cut which would help eliminate about one-third of Social Security’s projected $3.7 trillion shortfall over the next 75 years.

We can help our struggling policy makers by staying healthy and working longer. And, as USA Today points out, there is plenty of evidence that we can thwart many debilitating effects of aging, both mentally as well as physically, by taking care of our mind and body.

Studies by the Albert Einstein College of Medicine and the Karolinska Institute in Stockholm, Sweden have found solid evidence that the most active seniors, mentally and physically, reduced their risk of developing dementia by 63% compared to the less active.

Their research indicates the activities that challenge the brain such as card playing, reading, even a good political debate with the spouse or friends now and then, help to stimulate brain cells. While such activity will not prevent Alzheimer’s, a disease partly caused by genetic factors, using the brain, especially in concert with a little physical activity such as a workout in the gym or walking, gives high-risk seniors a better chance of delaying the onset.

Like to dance? Researchers published an article in The New England Journal of Medicine in 2003 that showed ballroom dancing helped protect against Alzheimer’s, as did gardening, playing a musical instrument, and biking. Their findings suggested that physical activity might trigger the production of brain cells to replace those damaged by age.

“Use it or lose it” for our mind and body will help us live longer…and keep our public policy makers squirming over how to keep the checks coming.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Interest Rates Make Housing More Affordable

by Bruce Fenton

Little is more important to many people than their home… and few things are more important to the economy than homes and household formation.

The average American gets married around age 25-26. The first child comes along about two years later. This household buys its first home around age 33 and buys their largest, trade up home around age 43. During these years, our average family will spend more and do more for our economy than at any other time in their economic lives. (Data from Clayton E. Tucker-Ladd’s, Some Facts About Marriage and U.S. Dept of Labor Consumer Expenditure Surveys.)

The single largest cost to our average household is the mortgage interest they pay during their lifetimes. Low interest rates, offer an average family the opportunity to significantly reduce this cost and channel the monthly outlet saved into long-term savings or the opportunity to move up to a bigger home.

To put this in perspective, consider that an 8%, 30-year mortgage will cost a consumer approximately $164,000 in interest per $100,000 borrowed. Reduce that interest rate to 6-½% and the interest cost falls to $127,000—a savings of $37,000 over the life of the loan. Take this a step further and invest the monthly payment difference of $101 into an investment earning 8% for the thirty year life of the mortgage, and the result is $150,000 of accumulate wealth at the end of the thirty year period. Or, if they prefer, they can accelerate the payment of their mortgage by putting those savings back into principal.

Our first Baby Boomer President, Bill Clinton, and Congress gave us additional tax incentives for home ownership. Prior to 1997, gain from one home sale could be rolled over, tax-free, into a home of equal or greater value. This worked fine for the older, Bob Hope Generation, who tended to stay put in the family home.

But the next generation, the Baby Boomers—more affluent, more mobile, and more inclined to lifestyle changes—is reaching the time in their lives when they will want to trade the smaller starter homes they bought a few years ago for that trade-up home. Ultimately, they will want to sell their larger home and move to an island in the sun, taking with them as much wealth as possible from the home ownership.

Clinton gave them the tax break they needed, when he signed tax law changes that allowed a married couple the opportunity to keep up to $500,000, tax-free, from the sale of their personal residence, provided they have lived in that residence two of the last five years.

By trading up, they can continue to grow their wealth in their real estate. By continually raising the cost basis in their home, when they finally sell and become equity refugees in the sun, they will take with them a large amount of wealth.

The sharply lower interest rates allow our average family the opportunity to reduce their monthly outlays for housing, increase their investments for future retirement, and/or move up to a larger home to accommodate their growing needs.

Run, don’t walk, to your mortgage broker or realtor… you may not see rates like these again for a long time!

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Economic Efficiency or Economic Justice?

by Bruce Fenton

Consumers are spending and business is beginning to ramp up its investment engines. Anything above a 4% growth rate is exhausting for business—capacity is exhausted, inventories are exhausted, more employees will be needed and old plant and equipment will have to be replaced.

An economic system that combines jobs for all with economic equality is the stuff of fairytales. An economy can be either efficient or just, but not both when taken to extremes.

An efficient economy operates within a free-market economic system that is blind to social justice. The economy cares only about the most efficient way to produce goods and services. It is an amoral system that, in order to be efficient, requires each of us to earn enough income to buy back what we produce.

A system driven by economic justice redistributes wealth through a tax system, giving the rewards of a few to the under-producing many. We tried this before and it didn’t work.
In the 1970s, our economic system worked somewhat the way I just described. Government policies that focused on stimulating aggregate demand had caused an economy that could not produce goods and services fast enough to keep up with demand; prices skyrocketed, interest rates were out of sight and productivity was low. Dividends were taxed at 70%, and the top earned income tax bracket stood at 50%. Accountants and lawyers devised tax shelters that had little or no economic value to allow the wealthy to avoid paying taxes. This process provided little incentive to work and produce efficiently.

By late 1980, it was such a mess that a bipartisan Joint Economic Committee of Congress recommended our entire system for managing the economy be changed. Instead of focusing on the demand side, as had been the case since the Great Depression, the focus would shift to unleashing the productive potential of the economy.

It was reasoned that by cutting taxes, but applying the tax bite in a different way, production of goods and services could be stimulated. Prices would come down, jobs would be created, and more importantly, tax revenues would increase. Investment was stimulated with investment tax credits and a lower tax on capital gains.

The Committee was right—as the history of the '80s and '90s tells us. When taxes were raised by the elder Bush and early Clinton, the economy stumbled. When taxes were cut by Clinton in 1996 and later by Bush II, we have seen our economy rebound.

Taxes provide economic justice, and for good cause. The time will come later in this expansion when the need for justice will trump the need for efficiency. When that happens, watch for the economy to come to a screeching halt. In the meantime, we need economic efficiency to put people back to work.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Economic Urban Myths

by Wendell Cayton

It’s urban myth time again—the rhetoric of a presidential campaign is upon us. TV market analyst Tobin Smith argues that all presidential candidates should have to pass Econ 101 before they can run for office, and I agree with him.

Last week, an email I received from supporters of one candidate noted that current economic policies would saddle each of our children with an additional $35,000 in debt.

So what? Any of us with children and a mortgage have exceeded that number many times. We pay it off by selling the home or making payments for 30 years. Instead of paying cash for homes, we borrow from the bank. This gives us the year over year cash flow we need to invest in our retirement accounts, pay for our children’s educations and improve the quality of our lives.

This is exactly the same thing our government does—the difference is that the government does not have the option of “selling the family home” to downsize and pay off the debt. It must support the debt with increasing tax revenues that can only come from a growing economy.
The bond market—the ultimate inflation barometer—has passed judgment on current policies by keeping the ten-year Treasury bond trading around 4%, an indication that bond traders do not see inflation as a threat.

Let’s take on the urban myth of job creation. Our economy is structurally designed to destroy a certain number of jobs each year. It’s called innovation, progress, capitalism at its finest, or, to quote economist Joseph Schumpeter, the natural result of “gales of creative destruction.”

Only a fraction of destroyed U.S. jobs go overseas because of an economic principle called “the law of comparative advantage,” expressed centuries ago by David Ricardo. He theorized that economic gain will increase between two nations if each specializes completely in the production of goods it has a comparative cost advantage in producing.

Ricardo also held that foreign trade may promote further accumulation and growth if wage goods (not luxuries) are imported at a lower price than they cost domestically, thereby leading to an increase in real wages and profits. His ideas have proven right for centuries—overall income levels have risen in “specialist” nations as long as comparative advantage prevailed.

The U.S. job problem is not the result of manufacturing jobs leaving; according to Holman Jenkins writing in the WSJ, only about 10% of manufacturing costs are job-related. It’s the other overhead that kills profits: corporate taxes, litigation costs, federal mandates . . . all forms of “social overhead.”

For our economy to grow and our lives to improve, we will continue to be an exporter of technology and infrastructure, things we can produce at a comparative advantage. We will buy inexpensive manufactured goods from abroad, contributing to the growth and development of nations who ultimately will have the money to buy from us.

Enacting of proposed protectionist laws against off-shoring or many other urban myths being spread today can only lead to the unintended consequences of falling corporate profits and stock prices. If this were to come to pass, those counting on 401k plans to provide retirement income will be sadly disappointed when it comes time to collect.

Housing and Demographics

by Bruce Fenton

In his summary of the economic State of the Union last week, President Bush rightly focused on the strength of the housing industry, a pillar of growth that shows no signs of weakening after a boom that has lasted for years.

The Census Bureau reported that housing starts rose in December to their highest level since 1984, surprising analysts who had expected a decline. Permits issued for new construction also rose, suggesting that 2004 will be nearly as strong as 2003, a year that by some measures was the best ever for the industry.

There are a number of reasons why housing is important. Approximately 66% of our nation’s economy is driven by consumer spending. Housing is a key component of the consumer budget. For the vast majority of Americans, a house will be the biggest consumer purchase of their life. An expenditure of $200,000 or more for a newly constructed home will inject many times that amount of spending, or aggregate demand, into our economy as it is multiplied and re-spent many times. The purchase of a new home also leads to the purchase of such consumer durables as appliances and furniture.

One of the stimulants to the current housing boom is our historically low interest rates. Since home and furnishing purchases often require vast amounts of debt, low interest rates stimulate this boom. Conversely, rising interest rates will choke off the boom and have a negative impact on the overall economy and the stock market.

According to demographic spending studies done by Harry S. Dent for his book, The Great Boom Ahead, the average age of the head of household when the first or starter home is purchased is 33. This implies that the last of the baby boomers, born in the late 1960s, are now buying their first homes.

Immigration also plays an increasingly important role in the housing market and the economy in general. Dent notes that immigrants to this country are generally younger and are here to earn a piece of the American pie—the most important slice being homeownership.

According to a FannieMae report, the number of immigrant households is projected to grow dramatically in the 21st Century, representing more than 1/4 of overall household growth—the factor that accounts for most new residential construction in the United States. The longer these immigrants live in the U.S., the more likely they are to purchase homes.

The report also notes that about 12 million new households will be formed in the next decade. Minorities and immigrants will make up about 2/3 of this growth. Immigrants see homeownership as an integral part of becoming an American and frequently rank buying a home as their number one financial priority.

After looking at this data and the economic impact the housing market has on the overall economy, it is understandable why a rise in interest rates would trouble the stock market. Anything that might slow homebuilding and household formations is not good for the economy.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Barron’s Bear

by Bruce Fenton

I have to take my hat off to Barron’s columnist Alan Abelson, long-time writer of the column “Up and Down Wall Street.” If I lived in a bear den, as he must, I would probably be just as pessimistic; yet I find a certain perverse pleasure in reading his column and partaking of his acerbic comments.

I can rationalize reading Abelson with such relish as a way to keep my normally optimistic self grounded in the fact that there are others who see the glass half-empty against my half-full.
Each week, Abelson seems to find some facet of the financial world to skewer with his wit and cynicism. He also seems to find someone with a theory that calls into question anything approaching “irrational exuberance.” This past week’s column did both.

First, he took on President Bush for his lack of candor in dealing with economic matters. In this case, I agree with him. Instead of skirting the issues, Bush needs to make it clear that he and his administration did not cause the recession or the flabbiness of the economy. They inherited a bubble that was bursting from too much capital spending by business—something that will take a while to work its way through the system.

By defensively talking around the real issues of the economy, Bush begins to invoke an aversion to truth and reality—not a good trait for a President soon to seek reelection! Personally, I would like him to plainly confront the deficit issue: just say we’re going to be printing money for awhile, so we should get used to it. We can also stand the truth when it comes to the price tag for fixing the economy and, while we are at it, Iraq.

Just so the rising stock market doesn’t get everyone too excited, Abelson interviewed analyst Andrew Smithers of the London firm of Smithers & Co. Smithers and partner Stephen Wright just published a report with the catchy title, The Real Bear Market Hasn’t Happened Yet. Smithers is fond of using the Q ratio theories developed by the late James Tobin, a Nobel laureate from Yale. Tobin’s Q ratio is the total value of the stock market divided by corporate net assets at replacement cost. If the market is overvalued, the Q ratio will be greater than one, with the reverse being true for an undervalued market.

Smithers and Young are not ready to call an end to this bear market. They believe that bear markets end when prospective returns are significantly above their historic average. According to their analysis, despite the slide of the past three years, market returns are still overvalued.
Part of the overvaluation was caused by massive corporate share repurchases. This was simply a transfer of corporate assets to shareholders. Applying that to the Q ratio, the resulting reduction in corporate replacement values reduces the denominator in the ratio, and increases the ratio—or overvaluation assumptions.

Our friends from London argue that at its peak, the market was three times overvalued. Despite the fact that the market drop from the high has wiped away one-third of that overvaluation, we still have another third to go before fair value levels are reached. And, if that isn’t enough to get your attention, they point out that for the market to get back to “cheap as it was in 1974,” we would need to knock 60% off the current value.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Social Security Benefits

by Bruce Fenton

In 1935, President Franklin Roosevelt signed the Social Security Act, which provided a nationwide retirement and social welfare program for the first time. Since then, Social Security has grown to become an essential part of modern life and has been modified to provide for widows, orphans, the disabled and divorced spouses.

Today, about 98% of all workers are in jobs covered by Social Security. One in six Americans receives a Social Security benefit, and nearly one in three beneficiaries is not a retiree. According to the Social Security website, www.ssa.gov , Social Security benefits comprise about 5% of the nation’s total economic output.

To be eligible for benefits, a worker needs to be employed and subject to Social Security taxes for 40 quarters. A fully insured status enables the worker to receive unrestricted retirement, disability and survivor payments. To be eligible in any quarter, a worker must earn at least $870.

Benefits payable are determined using a formula for the average indexed monthly earnings (AIME) that takes into account the worker’s top 35 earning years since 1950.
The retirement benefit amount may be equal to, less than, or greater than the AIME. If the worker chooses to retire early, say at 62, the earliest age for retirement, the amount is reduced by approximately .56% for each month before normal retirement age (generally 65). If the worker elects to delay receiving benefits beyond the normal retirement age, but prior to age 70, the benefits are increased by 8% a year up to 140% of the normal benefit.

A retired worker’s spouse may elect to receive the greater of one-half of the worker’s benefit or his or her own benefit. It does not matter if the primary worker is still working and has not begun to draw benefits—the spouse may draw at his or her eligible age.

A divorced spouse who has been married for ten years or more to an insured worker and who has not remarried may draw under the same rules as a married spouse. This does not impact the benefits available to the insured worker. As a matter of fact, the insured worker could have several divorced spouses drawing upon his or her benefit, and could also be currently married to a spouse drawing benefits.

The minor children and spouse caring for minor children of a retired worker may be eligible for benefits. For those of you who became parents when you were older, your children under the age of 18 (or 19 if not graduated from high school) will receive a check equal to one-half of your benefit. The same goes for your spouse if he or she is caring for a minor under age 16. The total payable to a family is limited by a family maximum benefit calculation.

Finally, if an insured worker passes on, his family is entitled to certain benefits. Children under age 18 (or 19 if not out of school) receive a benefit, as does a spouse caring for a minor child under age 16. The amount is subject to family maximums and is dependent upon the worker’s AIME. A surviving spouse may elect to draw a widow’s benefit at age sixty, whether or not he or she was married to the worker at his/her time of death.

The Social Security website contains a wealth of information on benefits and rules as well as a useful retirement planning calculator. The latter will help you estimate your benefit based upon different scenarios for retirement, earnings and family situation.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

We Can Learn A Lot From History

by Bruce Fenton

There was a time when a technology boom swept across the land. Entrepreneurs touted a new, improved life for everyone. The stock market marched up and up, with no limit in sight. Life was good…then came the crash.

The leading technology stock of the day lost 75% of it value. The Dow Jones Industrial Average (DJIA) plunged. Investors panicked, a depression swept across the land. Suddenly, the new technology did not matter.

A few years later, Americans expressed their revulsion against corporations across the land and cried out for an end to corporate greed and corruption. The President and Congress acted, and a host of new regulations sprang forth.

We can learn a lot from the way the crash occurred in 1920-21. The government regulatory efforts happened in 1932 when President Franklin D. Roosevelt and a newly elected Democratic Congress took control of the country.

The fact that much of this mirrors our situation today is important…we’ve “been there, done that.” But what is equally important today is understanding what happened between the crash and the government intervention 10 years later.

The Henry Ford generation was a generation of innovators and entrepreneurs. Born in the latter half of the 1800s, they invented the car, the airplane, the telephone, and harnessed electricity. Their numbers were greatly increased by a huge wave of immigrants who hit our shores in the latter part of the 19th century and the early part of the 20th Century.

They worked hard, bought houses, bought cars, educated their children, and spent money through the first two decades of the 20th century. They also benefited from a booming stock market. This generation was mirrored 80 years later by the baby boomers… innovators, entrepreneurs, and spenders.

The crash that occurred was caused by an overabundance of new technology coming to market. There were not enough buyers. The shakeout that ensued created a mini-depression as stock prices plummeted. But it only lasted for a few short years. From 1922 to 1929 the stock market resumed its march up and to the right.

The high tech companies of the time, such as General Motors and General Electric used their cash and muscle to gain market share and develop dominant positions within their industry. The strongest not only survived this shakeout, but they were able to consolidate their positions within their industry and became dominant forces on Wall Street and in the heartland.

During this period the Dow increased at a six-time multiple. General Motors saw its stock drop 75% before rebounding to a 22 times multiple before the crash of ’29.

That crash was the result of too much technology coming to market at one time…just like we are living with today. The crash did not kill technology…just allowed the strongest to survive and carry the technology of the day to into the mature industry stages.

The government intervention was not dissimilar to what we will see as a result of accounting scandals. It did not kill business, as business has thrived for 70 years in its wake. To say it needs some modernizing goes without question.

As investors, we can learn from the experiences of our parents and grandparents. History has a habit of repeating itself. If so, we may yet have our Roaring 2000s.

Bruce Fenton is a financial consultant, a writer, and the president and founder of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Estate Tax Changes

by Bruce Fenton

An oxymoron—politics and principle—will clash when the Congress begins the full debate over President Bush’s proposal to eliminate the estate tax. Certain staunch, card-carrying Republicans who never met a tax cut they didn’t like are standing in line to fight this one.

President Bush has made repealing gift and estate taxes a centerpiece of his tax cut plan. Proponents and opponents of the repeal agree that, as proposed, it would save the wealthiest 2 percent of Americans about $236 billion over the next decade.

Estate tax lawyers and other experts are concerned that unless Congress writes conditions into the legislation, taxpayers will not realize the savings advertised, and certain government treasuries will be adversely affected

Not just the federal Treasury, but also the District of Columbia and the 43 states with their own income taxes, would lose far more revenue than they might anticipate, these experts said. They also said charities could feel the effects, since certain tax incentives for gifting would be eliminated.

The Unified Gift and Estate Tax codes assess taxes on transfers of property that exceed a one-time amount of $675,000, whether the transfers occur during a lifetime or upon death. Amounts above this threshold are taxed at rates that begin at 37 percent and rise to 55 percent on amounts greater than $3 million.

According to a report recently in the NY Times, nearly 48,000 Americans, or 2 percent of all the Americans who die each year—ranging from small business owners and professionals to multibillionaire executives—pay estate taxes. Just 4,000 people who die each year leaving more than $5 million dollars or more pay nearly half the estate tax.

Last year President Bill Clinton vetoed a bill that also would have repealed the estate tax, but it would have limited the income-tax avoidance strategies that are possible under the Bush proposal.

The proposed Bush plan will allow property to be gifted and transferred at death, escaping all capital gains and transfer taxes. This will not only impact federal taxation, but will deny the many state treasuries of their share of transfer taxes collected under current law. (State transfer taxes are deductible from federal transfer taxes and therefore appear transparent on a tax return.)

Charitable giving will be adversely impacted since transfer from an estate to a charity is also tax deductible.

Finally, a clever spouse could transfer property into a trust, without triggering a gift tax, and effectively deny their spouse access to the property after dissolution of the marriage.

Those who will be vocal in pointing out the shortcomings of the Bush plan will be none other than the life insurance industry and many estate-planning attorneys. The Bush proposal will eliminate the need for large, expensive life insurance policies that are currently used to provide tax-free funds to an estate at death which eventually are used to satisfy tax obligations.

Estate planning attorneys who specialize in arranging property ownership to avoid transfer taxation will have to find another way to use their talents.

Both of these groups will go to great lengths to point out the shortfall of revenue that will impact state coffers. Both will point to the negative impact on charitable giving this bill would have. Both have much to lose if the tax cut as proposed becomes law.

Bruce Fenton is a financial consultant, a writer, and the president and founder of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.