I have redesigned our company website onto the Wordpress platform, and all blogs now appear over there. Go to www.creeksidepartners.com to read our latest thoughts.
Click here if you would like to receive our occasional (~monthly) commentary and quarterly newsletter by email. The email is on the Constant Contact platform, so you can unsubscribe whenever you like.
Best regards -- Rick
Tuesday, January 17, 2012
Wednesday, June 9, 2010
On Being Ready to Act
Our outlook over the next 5-7 years is for lower than average GDP growth and a slow grind back to normal employment levels. Over that same time horizon, we expect the nation to gradually come to grips with the fact that the federal government (in the form of Medicare) and state/local governments (in the form of pensions and health benefits) have promised more than they can afford to pay. Something’s gotta give and, whichever form that giving takes*, it will put downward pressure on consumption.
(*higher taxes, shrinking government, higher private savings, etc. "Austerity Measures" is the best catch-all phrase.)
Along with slow GDP growth comes slow earnings per share growth, the two being inexorably linked. During eras of slow earnings growth, stock investors must rely on dividends for much of their returns, and on P/E expansion for the rest. Unfortunately, P/Es are today rather expensive and don’t provide much room for rational investors to expect expansion. The market is today priced at a normalized P/E ratio of around 20; the historic average is around 15-16.
We like to think we are rational investors, and we too are looking to P/E expansion for decent returns. That means we are looking to buy stocks at cheaper prices than today. With the S&P500 at around 1075, we’re not quite there yet. With another 100 point drop…we’re going to buy some stocks. Another 50 more points and we’ll buy more. And so on. With one eye on the important dividend stream, we will focus our purchases on large global companies flush with cash and a demonstrated willingness to hand some of that cash over to shareholders on a regular basis.
As we are fond of saying, we’re not economic forecasters and we are certainly not currency forecasters. We don’t know what will happen among the world’s major currencies, and neither does anyone else. But we don’t have to get the timing right of all these macro events. All we have to get right is the purchase price of our investments. If we get the price right, time and macro cycles will do their thing and we will come out just fine.
We look at the California state budget crisis this way. We don’t know if the legislature will pass a good budget, a bad one or none at all. We don’t even know if the state will attempt to default on debt. We do know one thing however: If we buy the right type of bond at a fair price, we will get paid a fair return. The chance that the State of California (or any local government) defaults on voter-approved general obligation debt and stays in default is about the same as me pitching for the Giants this summer.
So, that’s where we are. We are waiting and we have trades that we are ready to make. If the next year or so is anything like the last couple of years, windows of opportunity will open and shut quickly. Stocks were overpriced for about a dozen years. They got cheap last winter for about a month and are now expensive again. Similarly, muni bonds got very cheap for about six weeks in late 2008. We bought bunches of them and are now waiting for the next panic attack.
In an environment where no conventional investment offers the prospect of satisfying returns, investors need to think ahead and have a plan of action. We have a plan in place, and we are patiently awaiting windows of opportunity.
(*higher taxes, shrinking government, higher private savings, etc. "Austerity Measures" is the best catch-all phrase.)
Along with slow GDP growth comes slow earnings per share growth, the two being inexorably linked. During eras of slow earnings growth, stock investors must rely on dividends for much of their returns, and on P/E expansion for the rest. Unfortunately, P/Es are today rather expensive and don’t provide much room for rational investors to expect expansion. The market is today priced at a normalized P/E ratio of around 20; the historic average is around 15-16.
We like to think we are rational investors, and we too are looking to P/E expansion for decent returns. That means we are looking to buy stocks at cheaper prices than today. With the S&P500 at around 1075, we’re not quite there yet. With another 100 point drop…we’re going to buy some stocks. Another 50 more points and we’ll buy more. And so on. With one eye on the important dividend stream, we will focus our purchases on large global companies flush with cash and a demonstrated willingness to hand some of that cash over to shareholders on a regular basis.
As we are fond of saying, we’re not economic forecasters and we are certainly not currency forecasters. We don’t know what will happen among the world’s major currencies, and neither does anyone else. But we don’t have to get the timing right of all these macro events. All we have to get right is the purchase price of our investments. If we get the price right, time and macro cycles will do their thing and we will come out just fine.
We look at the California state budget crisis this way. We don’t know if the legislature will pass a good budget, a bad one or none at all. We don’t even know if the state will attempt to default on debt. We do know one thing however: If we buy the right type of bond at a fair price, we will get paid a fair return. The chance that the State of California (or any local government) defaults on voter-approved general obligation debt and stays in default is about the same as me pitching for the Giants this summer.
So, that’s where we are. We are waiting and we have trades that we are ready to make. If the next year or so is anything like the last couple of years, windows of opportunity will open and shut quickly. Stocks were overpriced for about a dozen years. They got cheap last winter for about a month and are now expensive again. Similarly, muni bonds got very cheap for about six weeks in late 2008. We bought bunches of them and are now waiting for the next panic attack.
In an environment where no conventional investment offers the prospect of satisfying returns, investors need to think ahead and have a plan of action. We have a plan in place, and we are patiently awaiting windows of opportunity.
Tuesday, May 4, 2010
GDP Report -- A Lesson in Messy Data
On Friday 4/30 the Commerce Dept. (more specifically, the Bureau of Economic Analysis, or BEA) released its first estimates of economic activity for the first quarter. The headline number was that GDP grew in the first quarter at an annual rate of 3.2%. OK...that's a number, but what does it mean?
First, you need to ask whether that is a figure that adjusts for inflation or not. News accounts didn't make the distinction, and the first few paragraphs of the official release don't say either. I had to dig pretty far into the news release to be sure that, yes, that figure is a post-inflation number.
The BEA estimates total economic output for the quarter and then "annualizes" it...which is a fancy way of saying, "multiply by four" (or, "add one; raise to the fourth power; subtract one"). But, it does little good to know that output went up by 2% if inflation was running at 2% -- the net growth is really zero in that case. So, the BEA wisely factors in the amount of inflation that it measured. Along with the economic output data, the staff comes up with a "price deflator." In Q1 2010, the BEA figured that total output grew by 1.02%. Annualizing that figure, we get 4.1%.
Now the question is...how much of that was eaten up by inflation? The BEA figured that prices rose at an annual rate of 0.9% in the quarter, which results in the net reported figure of 3.2%. With me so far...?
But, if I wander over to the website of the Bureau of Labor Statistics (part of the Department of Labor), I find that those folks figured that prices rose by an annual rate of 3.1%. Subtracting that from the 4.1% total growth rate reported back over at the BEA, and we get a net figure of only 1.0%, not the 3.2% reported by BEA!
So what's going on here? Is this some secret government conspiracy where the Commerce Department wants to say the economy is great and the Labor Department wants to say, no, it's not...? I don't subscribe to such theories. I think simpler and more mundane explanations are at work. The fact of the matter is that nobody knows for sure just what happened in a particular quarter until a year or so later. The Commerce Department has three scheduled revisions of the GDP figures yet to come. Frankly, I trust the Labor Department's inflation figures since they have far more resources dedicated to gathering the data and emply state of the art statistical methods and concepts in deriving a useful price index.
Whichever figure you want to use -- 3.2% or 1.0% -- the fact of the matter is that this growth rate is not sufficient to soak up unemployment. Productivity grows at 1.6% to 1.8% per year; the workforce grows by 1.0% or so. These combine to "use up" all of the growth we are experiencing at the moment, and don't provide much room to put everybody back to work.
The economy is still digging out of a hole and we've got a ways to go.
First, you need to ask whether that is a figure that adjusts for inflation or not. News accounts didn't make the distinction, and the first few paragraphs of the official release don't say either. I had to dig pretty far into the news release to be sure that, yes, that figure is a post-inflation number.
The BEA estimates total economic output for the quarter and then "annualizes" it...which is a fancy way of saying, "multiply by four" (or, "add one; raise to the fourth power; subtract one"). But, it does little good to know that output went up by 2% if inflation was running at 2% -- the net growth is really zero in that case. So, the BEA wisely factors in the amount of inflation that it measured. Along with the economic output data, the staff comes up with a "price deflator." In Q1 2010, the BEA figured that total output grew by 1.02%. Annualizing that figure, we get 4.1%.
Now the question is...how much of that was eaten up by inflation? The BEA figured that prices rose at an annual rate of 0.9% in the quarter, which results in the net reported figure of 3.2%. With me so far...?
But, if I wander over to the website of the Bureau of Labor Statistics (part of the Department of Labor), I find that those folks figured that prices rose by an annual rate of 3.1%. Subtracting that from the 4.1% total growth rate reported back over at the BEA, and we get a net figure of only 1.0%, not the 3.2% reported by BEA!
So what's going on here? Is this some secret government conspiracy where the Commerce Department wants to say the economy is great and the Labor Department wants to say, no, it's not...? I don't subscribe to such theories. I think simpler and more mundane explanations are at work. The fact of the matter is that nobody knows for sure just what happened in a particular quarter until a year or so later. The Commerce Department has three scheduled revisions of the GDP figures yet to come. Frankly, I trust the Labor Department's inflation figures since they have far more resources dedicated to gathering the data and emply state of the art statistical methods and concepts in deriving a useful price index.
Whichever figure you want to use -- 3.2% or 1.0% -- the fact of the matter is that this growth rate is not sufficient to soak up unemployment. Productivity grows at 1.6% to 1.8% per year; the workforce grows by 1.0% or so. These combine to "use up" all of the growth we are experiencing at the moment, and don't provide much room to put everybody back to work.
The economy is still digging out of a hole and we've got a ways to go.
Wednesday, April 14, 2010
Stocks Could Keep On Rollin'
Regular readers (and clients) know that we are underweight to equities at the moment. Meaning that, if a family has a long-term objective of 60% stocks, we only have about half that exposure to stocks and stock-like assets. We made this tactical change in late 2009 when stocks moved into mildly over-valued territory.
Our view is that a collection of stocks (say, the S&P500) is inherently worth some multiple of the ability of those companies to produce earnings. In the short run, earnings are affected by all sorts of things and will spike up and down. In the longer run, the earnings of a large group of companies grows on a relatively stable path, as all the short-term fluctuations (charge-offs, one-time gains, etc.) are smoothed out. If we further adjust for inflation, we find that real earnings growth moves like a battleship -- nice and steady and relatively predictable.
Using data available on Standard & Poor's website, we find that the trailing one-year earnings of the S&P500 companies peaked in June 2007 at $85 per share. As I write, the current trailing one-year earnings are reported at about $60 per share. This is up from the bottoming-out figure of only $7 per share a year ago, and reflects the ongoing and robust recovery. A key question for us now is whether earnings are headed back to their earlier level of $85, or if they will instead now oscillate around a different level. If earnings are headed back to a steady $85, then the S&P500 is worth about 20% more than today's price. If earnings are instead going to settle in the $60 range, then the index is overvalued by about 20%. This is a critical question that can't be answered with certainty, but can be analyzed a bit to understand the probabilities.
In the chart below, the red line shows the short-term variability of earnings (click on it for a bigger view). The blue line is the 10-year trailing average; the dotted line is the trendline of the blue line. As you can see, short-term earnings have recovered right back above the 10-year average.
So, again, our question is whether "it's different this time" and earnings will escalate back to their earlier highs -- and stay there. Or, will they settle nearer to their long-term potential, as shown by the blue and dotted lines? We cannot know for sure, but we need to make a decision about portfolios. To make that decision, we look to the individual investment policies and mandates of our actual clients. Unlike institutional managers and hedge funds, who typically deal with a small slice of a client's overall wealth, we manage most of the life savings of our clients. Our mandate is not, "just go make money," it is a mandate to balance opportunities with the very real fact that this is all the money our clients have, and we cannot risk losing it.
With that mandate in mind, we choose not to make a big bet that "it's different this time" -- even though it might be. After all, earnings moved above trend for most of the 1990's, and stocks went to the moon. As we know, they then fell back to earth. Rather than make that painful and disruptive round trip, we are placing our bets conservatively. We will have to be patient if and when earnings accelerate past a sustainable level, which will surely pull stocks up with them.
Read our quarterly newsletter here for some further commentary on our current positioning.
Our view is that a collection of stocks (say, the S&P500) is inherently worth some multiple of the ability of those companies to produce earnings. In the short run, earnings are affected by all sorts of things and will spike up and down. In the longer run, the earnings of a large group of companies grows on a relatively stable path, as all the short-term fluctuations (charge-offs, one-time gains, etc.) are smoothed out. If we further adjust for inflation, we find that real earnings growth moves like a battleship -- nice and steady and relatively predictable.
Using data available on Standard & Poor's website, we find that the trailing one-year earnings of the S&P500 companies peaked in June 2007 at $85 per share. As I write, the current trailing one-year earnings are reported at about $60 per share. This is up from the bottoming-out figure of only $7 per share a year ago, and reflects the ongoing and robust recovery. A key question for us now is whether earnings are headed back to their earlier level of $85, or if they will instead now oscillate around a different level. If earnings are headed back to a steady $85, then the S&P500 is worth about 20% more than today's price. If earnings are instead going to settle in the $60 range, then the index is overvalued by about 20%. This is a critical question that can't be answered with certainty, but can be analyzed a bit to understand the probabilities.
In the chart below, the red line shows the short-term variability of earnings (click on it for a bigger view). The blue line is the 10-year trailing average; the dotted line is the trendline of the blue line. As you can see, short-term earnings have recovered right back above the 10-year average.
So, again, our question is whether "it's different this time" and earnings will escalate back to their earlier highs -- and stay there. Or, will they settle nearer to their long-term potential, as shown by the blue and dotted lines? We cannot know for sure, but we need to make a decision about portfolios. To make that decision, we look to the individual investment policies and mandates of our actual clients. Unlike institutional managers and hedge funds, who typically deal with a small slice of a client's overall wealth, we manage most of the life savings of our clients. Our mandate is not, "just go make money," it is a mandate to balance opportunities with the very real fact that this is all the money our clients have, and we cannot risk losing it.
With that mandate in mind, we choose not to make a big bet that "it's different this time" -- even though it might be. After all, earnings moved above trend for most of the 1990's, and stocks went to the moon. As we know, they then fell back to earth. Rather than make that painful and disruptive round trip, we are placing our bets conservatively. We will have to be patient if and when earnings accelerate past a sustainable level, which will surely pull stocks up with them.
Read our quarterly newsletter here for some further commentary on our current positioning.
Thursday, February 25, 2010
Greece, Default and Insurable Interests
You'll be reading more in coming weeks about credit-default swaps on Greek debt. The Fed seems to be interested (finally) and the do-nothings on Capitol Hill might decide to pretend they're doing something.
I've been raging over the danger of credit default swaps for years. A credit default swap is an insurance contract, only it doesn't have the word "insurance" in it. Therefore, it's not regulated like insurance. You might enter into a credit default swap against, say, General Motors bonds. If GM defaults on those bonds, the swap pays you the notional amount of the contract. This is a sensible tool if you own $10 million of these bonds. You worry about default, but you don't want to sell the bonds. So, you buy insurance against loss. Same as you do for your house or your car.
However, a central and bedrock principle of the insurance world is that, in order to buy insurance against some calamity, you have to be at risk of that calamity. I can buy insurance against my own house burning down, but I can't buy insurance against yours. This would create a moral hazard, in that I sit around hoping your house burns down. Who knows...if I were a nefarious type, I might even devise sinister methods to increase the odds that your house burns down. I might figure out ways to impede the fire trucks from getting to your house quickly. I cannot buy insurance unless I have an insurable interest.
The requirement of an insurable interest ensures that no more insurance is outstanding than the potential losses from the event. If a storm causes $1 million in damage, no more than $1 million will need to change hands. It would be profoundly destabilizing to have more money change hands than the losses from casualty events. We'd have the equivalent of people out in the streets stopping fire trucks from getting to fires simply so those people could realize a profit. We cannot have a system wherein certain participants hope that bad things happen to other people. Whenever a lot of (wealthy, influential) people hope that something happens, it generally tends to happen.
The existence of this moral hazard, and the need to outlaw it, was figured out hundreds of years ago. Lloyd's of London has had this policy in effect during its nearly 400 year existence. It is not a new notion that requires new concepts of regulation.
Credit default swaps are a end-run around the requirement that one have an insurable interest. Big banks, hedge funds and other speculators at one point ran the outstanding volume of credit default swaps into the trillions of dollars, against mere billions in potential losses. This is because the contracts can be bought by investors who don't even own any of the subject bonds. This no more a tenable outcome in the financial markets as it is in the casualty insurance market.
There is a very simple piece of regulation that will fix this problem: Credit default contracts need to be called what they are: insurance. And insurance can only be purchased by those at risk of the involved loss. It's really a rather simple concept that has served us well for hundreds of years. But, as usual, the lobbyists will fight back and true reform will probably remain elusive.
I've been raging over the danger of credit default swaps for years. A credit default swap is an insurance contract, only it doesn't have the word "insurance" in it. Therefore, it's not regulated like insurance. You might enter into a credit default swap against, say, General Motors bonds. If GM defaults on those bonds, the swap pays you the notional amount of the contract. This is a sensible tool if you own $10 million of these bonds. You worry about default, but you don't want to sell the bonds. So, you buy insurance against loss. Same as you do for your house or your car.
However, a central and bedrock principle of the insurance world is that, in order to buy insurance against some calamity, you have to be at risk of that calamity. I can buy insurance against my own house burning down, but I can't buy insurance against yours. This would create a moral hazard, in that I sit around hoping your house burns down. Who knows...if I were a nefarious type, I might even devise sinister methods to increase the odds that your house burns down. I might figure out ways to impede the fire trucks from getting to your house quickly. I cannot buy insurance unless I have an insurable interest.
The requirement of an insurable interest ensures that no more insurance is outstanding than the potential losses from the event. If a storm causes $1 million in damage, no more than $1 million will need to change hands. It would be profoundly destabilizing to have more money change hands than the losses from casualty events. We'd have the equivalent of people out in the streets stopping fire trucks from getting to fires simply so those people could realize a profit. We cannot have a system wherein certain participants hope that bad things happen to other people. Whenever a lot of (wealthy, influential) people hope that something happens, it generally tends to happen.
The existence of this moral hazard, and the need to outlaw it, was figured out hundreds of years ago. Lloyd's of London has had this policy in effect during its nearly 400 year existence. It is not a new notion that requires new concepts of regulation.
Credit default swaps are a end-run around the requirement that one have an insurable interest. Big banks, hedge funds and other speculators at one point ran the outstanding volume of credit default swaps into the trillions of dollars, against mere billions in potential losses. This is because the contracts can be bought by investors who don't even own any of the subject bonds. This no more a tenable outcome in the financial markets as it is in the casualty insurance market.
There is a very simple piece of regulation that will fix this problem: Credit default contracts need to be called what they are: insurance. And insurance can only be purchased by those at risk of the involved loss. It's really a rather simple concept that has served us well for hundreds of years. But, as usual, the lobbyists will fight back and true reform will probably remain elusive.
Thursday, February 18, 2010
A Long Hot Summer for Muni Bonds
It all seems too quiet right now...but it's going to heat up. The state and local government budgeting process is going to get rolling soon, and the picture is bleak. The sheer size of the budget gaps faced by cities, counties, school districts and the state itself is downright overwhelming. Articles are already appearing that hint at potential bankruptcy filings.
In the face of this, muni bonds are still trading at very high prices -- meaning very low yields. We were offered some 1-year bonds yesterday at a yield of 0.40%.
As regular readers know, we are tactical investors. That means that we spend a lot of time waiting for opportunities -- opportunities to move into cheap assets or to move out of expensive ones. Right now, muni bonds are expensive...and we are waiting. While we are quite reluctant to get into the predicting game, we do sometimes play the expecting game. And we expect that the mid-summer budget distaster will reach a crescendo at some point and investors will flee muni bonds the way they fled Fannie Mae and Greek bonds.
If that fleeing occurs, we will buy bonds by the fistfull. As we have written before, some muni bonds are genuinely at some risk of default. But, many types of bonds are "money-good" even under a bankruptcy proceeding. Municipal bankruptcies aren't like corporate proceedings...courts don't dissolve the entity, sell the pieces, and distribute the cash to bondholders. School districts, cities and the like can't "go out of business." They don't have "equity" to give to creditors upon a default.
I read a recent rating agency report that confirmed the AAA credit rating on the general obligation bonds of my favorite California small town. This high credit rating is much deserved, and the report touted at some length our town's prudent fiscal management. But, here's the catch: The credit quality of those bonds has almost nothing to do with the town's prudent fiscal management.
The City Council doesn't "appropriate" the bond payments -- fitting them into a budget of many choices. No -- the bond payments come directly off the property tax bills that are printed, mailed and collected by the county tax collector. Should, heaven forbid, our dear town find itself in bankruptcy, the bonds payments will continue to flow from property owners, right on past city hall, and straight to the county's money pool, from where it will be sent to the paying agent for the bonds.
These are the types of bonds that would get beaten down along with other, more risky, types of muni bonds. And we will be standing by in the heat of July ready to fill our portfolios with misunderstood and high-yielding bonds. We saw the same opportunity in late 2008 and we took advantage of it then.
In the face of this, muni bonds are still trading at very high prices -- meaning very low yields. We were offered some 1-year bonds yesterday at a yield of 0.40%.
As regular readers know, we are tactical investors. That means that we spend a lot of time waiting for opportunities -- opportunities to move into cheap assets or to move out of expensive ones. Right now, muni bonds are expensive...and we are waiting. While we are quite reluctant to get into the predicting game, we do sometimes play the expecting game. And we expect that the mid-summer budget distaster will reach a crescendo at some point and investors will flee muni bonds the way they fled Fannie Mae and Greek bonds.
If that fleeing occurs, we will buy bonds by the fistfull. As we have written before, some muni bonds are genuinely at some risk of default. But, many types of bonds are "money-good" even under a bankruptcy proceeding. Municipal bankruptcies aren't like corporate proceedings...courts don't dissolve the entity, sell the pieces, and distribute the cash to bondholders. School districts, cities and the like can't "go out of business." They don't have "equity" to give to creditors upon a default.
I read a recent rating agency report that confirmed the AAA credit rating on the general obligation bonds of my favorite California small town. This high credit rating is much deserved, and the report touted at some length our town's prudent fiscal management. But, here's the catch: The credit quality of those bonds has almost nothing to do with the town's prudent fiscal management.
The City Council doesn't "appropriate" the bond payments -- fitting them into a budget of many choices. No -- the bond payments come directly off the property tax bills that are printed, mailed and collected by the county tax collector. Should, heaven forbid, our dear town find itself in bankruptcy, the bonds payments will continue to flow from property owners, right on past city hall, and straight to the county's money pool, from where it will be sent to the paying agent for the bonds.
These are the types of bonds that would get beaten down along with other, more risky, types of muni bonds. And we will be standing by in the heat of July ready to fill our portfolios with misunderstood and high-yielding bonds. We saw the same opportunity in late 2008 and we took advantage of it then.
Wednesday, December 30, 2009
My Two Cents
I've been writing newspaper columns, blogs and essays fairly regularly for about the past 8 years. In all that time, I have stayed away from the other half of the "friendly gathering taboo" duo: politics, or at least, political policy. It's said to never discuss money or politics in polite company. I violate the former all the time, but I generally shut my trap on the latter. Why? Because people pretty much hold their opinions strongly, and are only interested in mine to the extent that they can then berate me for my foolishness. Given that I am an avowed political eccentric -- simultaneously holding both left- and right-handed views -- everybody I meet is always ready to disagree with me about something. And, since I am as stubborn as they are...I don't really want to hear it. So, we talk about sports or the appetizers instead.
But, just this once -- I've got an opinion to share and it's about taxes. First, I will establish that I'm not a harsh anti-tax table-pounder. We want stuff; we have to pay for it. Taxes pay for the stuff we like getting -- roads, schools, courts, jails, firemen, police, parks, beaches, cash-f0r-clunkers rebates, etc. Don't get me wrong -- I don't favor tax increases. We pay plenty here in Cali, and the state is going to have to figure out how to cut expenses. Ditto the feds.
My problem with the tax code is its bass-ackwards investment incentive structure. As currently written, the capital gains tax rate only makes one distinction: how long did you hold the investment asset? If you held it a year or longer before sale, you profits are taxed at a 15% rate. The intent here is to move away from short-sighted trading strategies into more stable long-term outlooks.
Let's take a sidetrack for moment so that I can make a distinction between investments that add to economic productivity and those that are merely transfers of money from one pocket to another. If a plumber spends $25k to expand his business (buying tools or training apprentices), that investment of $25k was productive. If instead he buys $25k worth of Google stock, that investment was not productive and will have zero effect on job creation or GDP growth. Remember, when we buy stock, we buy it from someone else. Google doesn't actually get any of that money.
In the tallying up of the National Income and Product Accounts, stock purchases are not "investments." Purchases of commercial equipment are "investments." Productive investments are those that put money directly to work in profit-making enterprises. If you buy a condo that already exists simply to flip it to the next sucker, you are making a non-productive investment. If you build or significantly remodel a condo, and then manage it over time for income, you are making a productive investment. You have to understand that the VAST majority of money that flows into and around Wall Street has nothing to do with actual productive investment. Most money spent on productive investments in the U.S. comes from retained earnings. The plumber, and Google for that matter, expand their businesses by deploying money they earned in the past. Wall Street provides only a tiny fraction of actual productive investment capital. Our national obsession with "saving Wall Street" is based on the myth that, without Wall Street, businesses will have no access to investment capital. The reality is far different.
Yet, the tax code provides an equal treatment of productive and non-productive investment profits. The long-term capital gains tax rate of 15% applies equally to hedge funds trading currency swaps and to the plumber who one day sells his business to retire. This is, in my view, absurd and destructive. Your Congress has swallowed this story whole-hog from hedge fund managers:
I am paraphrasing here an actual bit of testimony before Congress the last time it considered requiring that hedge fund managers pay income taxes instead of capital gains taxes.
Our business tax policy should create incentives to make actual, productive investments instead of encouraging the non-productive and speculative practices of simply moving money and assets from one account to another, while skimming off the crumbs as they go by. These trading practices should be taxed at ordinary income rates, since they are returns not based on real additions to GDP, but are instead returns to the labor and skill of the traders. In all other professions, income earned for labor and skill is taxed at ordinary rates. Only on Wall Street are such skills taxed at artificially low rates under the lie that the income is based on "investment returns."
So, here's my rough proposal as we move into what should prove to be an interesting year as Congress is forced to re-consider the Bush tax structure:
But, just this once -- I've got an opinion to share and it's about taxes. First, I will establish that I'm not a harsh anti-tax table-pounder. We want stuff; we have to pay for it. Taxes pay for the stuff we like getting -- roads, schools, courts, jails, firemen, police, parks, beaches, cash-f0r-clunkers rebates, etc. Don't get me wrong -- I don't favor tax increases. We pay plenty here in Cali, and the state is going to have to figure out how to cut expenses. Ditto the feds.
My problem with the tax code is its bass-ackwards investment incentive structure. As currently written, the capital gains tax rate only makes one distinction: how long did you hold the investment asset? If you held it a year or longer before sale, you profits are taxed at a 15% rate. The intent here is to move away from short-sighted trading strategies into more stable long-term outlooks.
Let's take a sidetrack for moment so that I can make a distinction between investments that add to economic productivity and those that are merely transfers of money from one pocket to another. If a plumber spends $25k to expand his business (buying tools or training apprentices), that investment of $25k was productive. If instead he buys $25k worth of Google stock, that investment was not productive and will have zero effect on job creation or GDP growth. Remember, when we buy stock, we buy it from someone else. Google doesn't actually get any of that money.
In the tallying up of the National Income and Product Accounts, stock purchases are not "investments." Purchases of commercial equipment are "investments." Productive investments are those that put money directly to work in profit-making enterprises. If you buy a condo that already exists simply to flip it to the next sucker, you are making a non-productive investment. If you build or significantly remodel a condo, and then manage it over time for income, you are making a productive investment. You have to understand that the VAST majority of money that flows into and around Wall Street has nothing to do with actual productive investment. Most money spent on productive investments in the U.S. comes from retained earnings. The plumber, and Google for that matter, expand their businesses by deploying money they earned in the past. Wall Street provides only a tiny fraction of actual productive investment capital. Our national obsession with "saving Wall Street" is based on the myth that, without Wall Street, businesses will have no access to investment capital. The reality is far different.
Yet, the tax code provides an equal treatment of productive and non-productive investment profits. The long-term capital gains tax rate of 15% applies equally to hedge funds trading currency swaps and to the plumber who one day sells his business to retire. This is, in my view, absurd and destructive. Your Congress has swallowed this story whole-hog from hedge fund managers:
"If you are going to ask me to be in the same tax bracket as a plumber, I cannot be bothered to get out of bed in the morning. I will be forced to close my business. I can get by on $10 million a year. If you tax me to the point where I can only make $9 million a year, then I will have no choice but to stop working and go on welfare. Tax the plumber and leave me alone."
I am paraphrasing here an actual bit of testimony before Congress the last time it considered requiring that hedge fund managers pay income taxes instead of capital gains taxes.
Our business tax policy should create incentives to make actual, productive investments instead of encouraging the non-productive and speculative practices of simply moving money and assets from one account to another, while skimming off the crumbs as they go by. These trading practices should be taxed at ordinary income rates, since they are returns not based on real additions to GDP, but are instead returns to the labor and skill of the traders. In all other professions, income earned for labor and skill is taxed at ordinary rates. Only on Wall Street are such skills taxed at artificially low rates under the lie that the income is based on "investment returns."
So, here's my rough proposal as we move into what should prove to be an interesting year as Congress is forced to re-consider the Bush tax structure:
- Capital gains realized from the sale of productive investments will be taxed at 15%. This will include pretty much all small businesses since their cost basis is entirely productive investments. Buying a condo and flipping it a year later is not productive -- it's trading income and should be taxed at ordinary rates. If you construct a building, rent it out and sell it later, you can have the 15% rate.
- Corporations should get a full expense deduction for dividends paid out to shareholders, to the extent they are less than or equal to taxable earnings. Corporations should not pay a punitive double-tax for returning cash to shareholders.
- Capital gains taxes on ordinary stocks, bonds and mutual funds should depend on who you are. If you're a household taxpayer (or a trust benefitting a household), you qualify for the current long-term capital gains rate of 15%. If you're a hedge fund, investment bank or other entity that is in the business of making such profits, your profits are taxed at ordinary income tax rates.
My frustration with the tax code is that it rewards non-productive "investment" behavior the same way as it rewards productive investments. Our long-term economic growth depends entirely on productivity growth. Productivity growth arises from productive investments in equipment, research and education. It does not arise from condo-flipping, day trading and CDO-packaging.
Subscribe to:
Posts (Atom)
Posts
