Archive for April, 2011

Taxes and the Stock Market

Friday, April 22nd, 2011


[Credit for much of the following comes from the writings of hedge fund manager John Thomas.]

No matter what anyone promises you today, this week, or this year, your taxes are going up. At $1.6 trillion, the budget deficit is so enormous that bringing it into balance merely through spending cuts is a mathematical impossibility. Chopping funding for Planned Parenthood and National Public Radio just isn’t going to do it, in spite of the impact of the soundbite.

If you own your own home, have employer paid health care benefits, save for your retirement, earn money from capital gains or dividends, and put in a check when they pass the dish around at church every Sunday, you are the biggest beneficiary of the current tax system. You are about to take a big hit. Check out the hit list below that is floating around Congress, and the tax revenues that the termination of these tax breaks will raise:

$264 billion– Tax the health insurance premiums paid for by employers.

Washington Logic: Should those without employer provided health care subsidize those who receive it as an employee benefit?

This is the amount raised by taxing company provided health insurance as regular income. If this gets implemented, the impact will be felt across the Consumer Discretionary Sector as people will have less in their pockets for discretionary spending.

$100 billion– Eliminate the home mortgage interest deduction

Washington Logic: Should renters be subsidizing homeowners?

Kiss that home mortgage interest deduction on loans under $1 million goodbye. If this gets implemented, it will devalue homes and lead to another leg down in the real estate bear market.

$100 billion– End the tax deductibility of charitable contributions.

Washington Logic: Should those who don’t go to church subsidize those who do?

If this gets implemented, universities, churches, and the social safety net take a big hit, meaning there will be even more pressure to raise income tax rates at the State and Federal level to do even more wealth redistribution to pay for the drop in voluntary charitable contributions. Rising income taxes – not necessarily the absolute levels, but rather the rate of change – have a negative impact on almost all areas of the stock market

$52 billion– End the deduction for 401k contributions

Washington Logic: Should those without savings subsidize those who save money for retirement?

This is the argument that will be made to end tax deductibility of 401k contributions. If this is implemented, look for a major correction of 2007 proportions as the cash flow from 401k deferrals is a major input into Mutual Fund purchases in the stock market.

$39 billion– End the step-up in cost basis received on inherited assets

Washington Logic: It’s not their money, so why shouldn’t they pay more in taxes?

If this is implemented, it will incrementally cut down on trading volume as beneficiaries will hold the assets they inherit instead of selling them.

$36 billion– Tax capital gains as regular income.

Washington Logic: Only the rich have capital gains, so why shouldn’t they pay more?

When the 15% tax rate was implemented in 2003, it was a proximate cause of the rally in the stock market out of the NASDAQ Crash lows. Everyone’s 401(k) plan recovered from the crash, not just those of the rich – if that hadn’t happened, there would be even more strain on Social Security. If this is implemented, look for a significant correction in the market as the rising tax rate devalues the embedded profits in a portfolio.

$31 billion– Tax dividend income as regular income.

Washington Logic: The poor don’t have investment income, so why not raise this tax on the rich?

As with capital gains, when the 15% tax rate was implemented in 2003, it was a proximate cause of the rally in the stock market out of the NASDAQ Crash lows. Everyone’s 401(k) plan recovered from the crash, not just those of the rich – if that hadn’t happened, there would be even more strain on Social Security. If this is implemented, look for a significant correction in the market as the rising tax rate devalues the net earnings potential of the companies in a portfolio.

Please note that these measures only raise $586 billion a year, or just 45% of last year’s deficit. If we eliminated all deductions and credits, we could raise $1 trillion – at 76% of last year’s deficit we are still $300 billion short of closing the spending gap.

Without raising tax rates, the remaining money will have to come from cutting Medicare, Medicaid, Social Security, and Defense spending. Realistically, it will be politically impossible to get any of these changes implemented since the 2012 election campaign has already begun – neither side will want to appear to be giving in as they need to shore up their voting bases.

As an alternative, an energy tax (Cap and Trade) and a national value-added tax (a European-style VAT) are on the table and viewed as ways to fund the deficit without cutting entitlement benefits or raising income taxes.

The Cap and Trade tax will be described as impacting the excess profits of energy companies and the VAT hides the tax in the production process so it isn’t as readily visible to consumers. Both of these taxes, however, will be passed onto to consumers in the form of higher prices and the impact to the stock market will be similar to increases in income tax rates.

None of these hikes would be necessary if our economy grew at a 7% real rate instead of 2%. This is one of the reasons tax rates in emerging countries are so low – the economic vitality brings in ever-more tax receipts to fund government activities.

America’s long term growth rate is falling, not rising, and our budget problems are going to get worse, not better. What happens if interest rates rise for the world’s largest borrower? When the Fed stops buying Treasuries as QE2 ends this Summer (they have bought 70% of all Treasuries issued during QE2), will interest rates go up or will the Chinese step in and fund our deficit? Will they only agree to do so only if they are paid more to loan us the money? I’ll take the over on this one.

Obviously none of this is positive for equity investors but given the 2012 election, the government will do everything in its power to pump the stock market higher in the hope that the wealth effect generated by rising stock prices will make any future changes more palatable.

Are we pushing our problems onto the backs of future generations or will our kids be alright?

We’ll see.

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In The Time of Chimpanses, I am a Monkey

Thursday, April 21st, 2011


A couple weeks ago, I wrote a blog post that described why I was posting profits in our gold and commodity positions, selling 20% to 30% of our holdings. Clearly I was the monkey running the other way against the pack of chimps driving the price of gold ahead of its short-term fundamentals.

I’ve circled a couple of other times in the past couple of years when gold got similarly extended, running up along the top band at two standard deviations of price beyond the moving average. From a statistical standpoint, that just does not continue forever. As we’ve seen though, it can continue for awhile as investors get giddy chasing the price higher.

Something always happens to throw water on the party and bring the price down to two standard deviations below the moving average. I think it will be the prospect of the end of the Fed’s policy of purchasing treasuries to fund our budget deficit. They’ve announced that June 30th will be the end, and sometime soon, I think the market will react and drive up the price of the dollar as it believes interest rates on treasuries will have to rise to attract another buyer.

A rising dollar will be the proximate cause of a short-term correction in the price of gold, and to me it looks like the blue line at $1400 per ounce seems like a likely place for it to correct toward.

So, for now, I am happy to have booked profits on the part of our positions that we did, and we will wait to see what happens next. If we get up toward my 2011 target of $1650 per ounce, I’ll probably sell even more.

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S&P Sits It Out

Thursday, April 14th, 2011

S&P 500 Incex

The S&P 500 is sitting right on the 50-day moving average as you can see in the chart above. The market has increased a huge amount over the past two years, so its not unusual if it wants to sit on its laurels for a bit, particularly given the economic news today.

> Jobless claims were 412,000 vs. expectations of 385,000
> Producer Price Index came in at 0.7% vs. expectations of 1.1%
> Core PPI came in at 0.3% vs. expectations of 0.2%.

its all a bit confusing and conflicting – we’d been told that unemployment was getting better, but jobless claims rose, previous PPI’s showed significant inflation was bubbling under the surface but last month was less than expected, yet the core (ex-food and energy) came in higher than believed. The news is all backwards, so its no wonder that the market was basically flat on the day and sat on the 50-day moving average like the goose that is nesting on the bank’s roof sits on its eggs.

However, the precious metals keep rallying in spite of the miners lagging severely. Gold and silver were up big today reaching an all-time record for gold and a multi-decade high for silver – but the miners have severely lagged the metals, not even reaching their December highs.

Generally these types of differences between the commodity and the commodity producer mean that we will either see a big pullback in the commodity or a big rally in the producers. Divergences are scary, so I’m glad we took some money off the table last week – long-term, its the place to be, but near-term anything can happen as the price can head to the mountain top or the wasteland.

Remember, bulls and bears make money but pigs get slaughtered.


Gold and Commodities Get Ahead of Themselves

Wednesday, April 6th, 2011


We hit a new high on the price of Gold today, and in examining the charts of gold, the gold miners, and the basic commodities, they have all gotten ahead of themselves.

As a risk management measure, we are booking some profits on these holdings – selling 20% to 33% of the position, depending on what it is – and locking in the gains we’ve experienced with the plan to buy back when the market is right.

In the chart of gold above, you can see that it is trading outside the upper blue band called a Bollinger Band. This band represents two standard deviations of price and volatility away from the 20 day moving average. Statistically, 90% of all price movement should be inside the two bands, and when prices move to or outside one of the bands, it is getting ahead of itself.


This chart is of the Gold Miners Index ETF. You can see that it is similarly ahead of itself.

When using the bands, I like to confirm it with a couple of other indicators. The the chart above you can see that the Relative Strength Indicator at the top of the chart (called RSI 7) is showing a reading above 70. RSI is a momentum measure of price movement. Statistically, readings above 70 and below 30 point out short-term highs and lows in price movement. A reading above 70 confirms in my mind the reading on the Bollinger Band that the gold and commodity related investments have gotten ahead of themselves.

DB Commodity Index ETF

The chart above is of the DB Commodity Index ETF. On it you can see the third indicator that I like for situations like this, the Stochastics. It is a momentum indicator and as a rule it changes direction before the price of the underlying security. A reading over 80 indicates that statistically the closing prices each trading day over the previous two weeks has been at the high end of the daily range for an unsustainably long period of time. In other words, the way I like to look at it is that most of the buyer have already made their buys and the sellers are waiting to enter the market.

Based upon the confirming nature of all three of these indicators, we have booked profits in a certain percentage of the gold and commodity investments indicated above along with others (like Fidelity Gold Fund, Prudential Jennison Natural Resources Fund, PIMCO Commodity Real Return Fund, Junior Gold Miners ETF, DB Precious Metals Index ETF which have similar charts to those shown above).

You can’t read the minds of other investors, but these indicators give me a feel for the psychology behind the price movements that runs independent from the fundamentals. And short term, their is just too much hype about owning hard assets as an inflation hedge and the indicators show that prices have moved ahead of their fundamentals.

Our plan is to let the current situation play out – it may continue to move higher before it pulls back. That’s OK since we still have 2/3 to 4/5 of the positions on the books. But when the over-extended situation corrects itself, we will move that money back into those investments.

One question I get is why don’t we sell the entire position instead of just the 1/5 to 1/3 of it. The answer is that sometimes the indicators can be wrong. Over-extended situations can correct themselves in two ways, either by time or by price. With the three indicators in confirmation, it seems likely that a price correction is in the cards, but nothing is 100% certain.

Investment management is a process and not a zero-sum game. Gambling is a zero-sum game with winner take all results. In a process, you manage the situation based upon what you see happening in the market and you don’t make bets on outcomes.

You always read here that you should invest what you see and not what you believe. What I see is a segment of the market that has seen a lot of enthusiasm from investors who have gotten in late and pushed prices up significantly. The intermediate term fundamentals for investing in gold and commodities remains positive, but I see an opportunity to simultaneously manage investment risk and take advantage of a short term phenomenon that should allow us to book some profits now and reinvest that money at a lower price at some point after the over-extended situation resolves itself.

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