THE DAILY RECKONING
No More Delaying this Decline
Paris, France
Thursday, September 11, 2008
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*** The fog of the ’flationary war is lifting...what does it mean when the world’s most free-market government nationalizes its largest finance industry?
*** No more delaying or disguising this decline...inflation may be in retreat – but that’s not good news...
*** The Paulson Doctrine...a scary story to keep a sleepy cabdriver awake...and more!
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The fog of war – that is, in the “war” between inflation and deflation – is lifting. We’re beginning to see more clearly which way the battle is going.
“America’s giant mortgage companies nationalized,” is how Le Monde treated Monday’s big story. “The biggest bailout in history...” it went on.
But what does it mean when the world’s most free-market government nationalizes its largest finance industry? It means a couple things:
First, that the days of “laissez-faire ”, even ersatz laissez-faire , are over. No more deregulation. No more tax cuts. No more free trade agreements.
Second, that the feds are running scared. They are in retreat. The battle between a natural market correction...and an unnatural, inflationary boom...is going against them.
We were right all along – or almost right; when the dot.com bubble burst it marked the beginning of the end – the end of the bull market on Wall Street...the end of the credit expansion that began in ’82...and the peak of American power and influence in the world.
The decline since then has been delayed and disguised – by a flood of new liquidity from the feds. But now, there’s no stopping it. And it’s much worse than it would have been eight years ago...since Americans became more and more used to spending money they didn’t have; they have more debt than ever. And because the Chinese and other foreigners became more and more used to selling things to people who couldn’t pay for them; now their new apartment buildings are empty and their new factories are quiet. And now, the downturn is global...and it will be longer, and harder, than practically anyone imagines.
This just in: “Top China developer’s sales fall sharply.” Maybe it was the distraction of the Olympics, but China’s biggest listed property developer, Vanke, said sales fell 35% last month.
And this too: Yesterday, gold fell more than $30 – to $757. The euro rose to $1.40. Oil is rising this morning, on fears of Hurricane Ike, but it closed yesterday at $102. Our guess is that it will sink to the $70 range.
*** And here’s Le Monde again:
“Good news, finally...almost everywhere, inflation remains under control and in retreat.”
Wrong. Wrong. Wrong. Inflation may be in retreat. But it’s not good news. It means the whole world is sinking into a slump – not just the United States and Britain.
And that’s what the feds are afraid of. Sec. Paulson justified the takeover of Mac and Mae on the grounds that the markets and the taxpayers needed “protection from a systemic risk.”
What was the risk? That both Freddie and Fannie would go broke, that houses would fall to what they were really worth, and that – when the federally-chartered agencies stopped paying their debt to foreign lenders – the whole world financial system would melt down. Driven by fear...Paulson took the bold action...
And now...for the next act:
The U.S. economy has grown during these last two decades. But it has grown only because consumers have been willing to go deeper into the debt. This was not good growth. It was not healthy growth. But at least it was growth.
You get growth by spending money. If the consumer spends – it is growth in retail, consumer items, services, and so forth. If business spends – you get more jobs, more capital equipment, more buildings, trucks, computer programs, etc.
But what if neither consumers nor business is willing to spend?
Sunday’s government takeover of the U.S. mortgage finance industry looked like a godsend to many investors – and to Le Monde . The government made it clear – if it weren’t already obvious – that it wasn’t going to abandon its two federally-sired mortgage twins, Fannie and Freddie. More importantly, it signaled that the feds were ready to spend.
Bill Gross’s PIMCO made $1.7 billion by betting on the bonds of Fannie, Freddie and other agencies. You could have made some money too. We explained the “Paulson Doctrine” in these pages – which guaranteed the bonds would eventually be saved – several weeks ago. The Paulson Doctrine maintains that the feds will let the shareholders take losses – but not the bondholders. Why? Because the largest bondholders are foreign countries – notably China. And America desperately needs more credit from these large, overseas financiers. Foreigners hold trillions of U.S. dollars and U.S. dollar-denominated debt. If they begin to fear the government is not behind it, they’ll dump it fast – which would be the end of the current dollar-based monetary system.
So, the move to bring Fannie and Freddie under direct government control was widely seen as a plus for everyone. Foreign lenders know the game is still rigged – so their money is safe. Homeowners think they’ll be able to continue living at someone else’s expense. And investors hallucinate that the government has “done something” to put this mess behind us.
But we have a question: Where do the federales get the money? The slump – though it has barely begun – has already clipped corporate and individual tax receipts. Plus, social welfare programs are becoming more expensive.
As unemployment increases – it was recently tallied at over 6%, the highest level in five years – the safety net catches more and more people. Make sure you never get trapped in that net. Even if you feel like you’re on steady ground now...it never hurts to be prepared. See how you can get the income of a second job – without the actual work – by clicking here .
*** “I’ll tell you how it works,” said a taxi driver. “You’re lucky you live overseas, cause this country is a mess...”
We had been taking a snooze in the back seat. Then, we noticed a jerky movement in the car. When we opened our eyes, we found the cab had drifted to the middle of the road. On the long drive from Charlottesville, VA, to Dulles Airport, our driver was falling asleep.
In attempt to revive him before it was too late, we made conversation.
“I’ll give you just one little thing I know from personal experience,” the cabbie went on, “I had a call to pick a woman up here in Charlottesville. She’s a Medicare customer. Do you know about that? Well, she had lost her car and she had come up here to the hospital. And then she was ready to go home. But she didn’t have a car. And I guess she didn’t have anyone to pick her up. She called a cab.
“So I drove her home...all the way down to North Carolina! The fare was $1,100 – which is a lot for a taxicab. But then, she didn’t have to pay it. She just signed one of these vouchers. (He showed us a simple white form...) And then I turned it into the government. So you see, you paid $1,100 to drive her down to North Carolina in a cab!”
The feds have dozens, maybe hundreds, of these absurd programs. When the sun shines, they grow like kudzu. Rain falls upon them like Miracle-Gro.
Fannie and Freddie, between them, have assets of $5.4 trillion and debt of $1.7 trillion. No one knows how much it will cost to keep them in business, but it is bound to be a big number. And the federal deficit is already as big as it has ever been – and growing. Where will the feds get the additional money to support U.S. housing?
We all know where – they have to borrow it. And now another question: We saw what happened when individuals borrowed too much; all of a sudden lenders didn’t want to extend them any further credit. Even Wall Street giants – such as Bear Stearns...and now, Lehman Bros. – can go bust if they borrow too much or speculate too wildly.
Can the U.S. government go bust too? Well...there is that printing press... The federal government can’t go broke, technically, because it can pay off its debts with money it prints up, just for the occasion. But in the event, the dollar itself would collapse in value. Foreign lenders would cease to extend credit. And then, the only choices open to the United States would be to cut back...or to print up even more money.
We’re a long way from the end of this show...but this takeover of Mae and Mac is a big step toward the final curtain. There are other land mines along the way...read about them in the free Financial Survival Library .
*** Our old friend, Michel, is writing a history of the United States.
“Does the U.S. Constitution authorize the federal government to finance mortgage loans?” he asks.
He might have asked a broader question: is there anything that the U.S. government cannot do? It can arrest people, put them in jail, and torture them – without even charging them with a crime. It can regulate any business. It can takeover any asset. It can tax and spend – as much as it can get away with.
“At the end of 1817,” Michel continues, “Congress passed a law authorizing the federal government to finance several canal routes, to which no one took exception. Monroe, who had just been elected for 1818, supported the law. But President Madison, ‘Father of the Constitution,’ decided that the law was contrary to the Constitution (or that an amendment was needed) so he vetoed it.
“My goal in this book is to show how, contrary to the intentions of the founding fathers, the Constitution has been interpreted, and twisted, in order to permit the federal government to do all it wanted to do, and that the doctrine of limited government, with powers exhaustively enumerated, has been undermined thanks to the use of two unfortunate expressions in the Constitution – ‘necessary and proper,’ and ‘general welfare,’ from which flows the statist doctrine of ‘implied powers.’
“It began with Hamilton (and a few texts of Madison in the ‘Federalist Papers’), who defended the interests of New England merchants, parenthetically, and it was developed by chief justice John Marshall who, although a Virginian, worked for 34 years at the Supreme Court to make it a very effective weapon against constitutional liberties (subject to some nuances).
“I continue my research, but I think it’s all there...that all the arguments for or against ‘implied powers’ were furnished during the period 1790-1800.”
Until tomorrow,
Bill Bonner
The Daily Reckoning
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The Daily Reckoning PRESENTS: Our colleague Alex Green has written a new book, called The Gone Fishin’ Portfolio . Right now, it’s sitting at the #2 spot on Amazon – and for good reason. See for yourself...we have an exclusive excerpt from the book, below...
HOW TO LEGALLY STIFF-ARM THE IRS
by Alex Green
“Be wary of strong drink. It can make you shoot at tax collectors – and miss.”
– Robert Heinlein
Arthur Godfrey once said, “I’m proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money.”
If you are an investor – paying taxes not just on your income but on dividends, interest and capital gains, as well – you could probably be just as proud for a whole lot less than that.
Fortunately, there is a simple way for investors to keep their annual tax bite to an absolute minimum – and legally stiff-arm the IRS.
You simply need to “tax-manage” your investments.
For example, mutual funds are required by law to distribute over 90% of their realized gains each year. You can get hit with a big tax bill even if you haven’t sold a share.
How? Inside the fund, the manager may be buying and selling like mad, turning over the entire portfolio in less than a year. While this doesn’t necessarily hurt his annual bonus, it can have a dramatic effect on your real-world returns. After all, you may owe taxes on all those short- and long-term capital gains, even if you haven’t sold a single share.
Lipper, a global leader in fund information and analytical tools, recently published a study, Taxes in the Mutual Fund Industry – 2007: Assessing the Impact of Taxes on Shareholder Returns.
It found that taxable mutual fund investors surrendered at least $23.8 billion to Uncle Sam in 2006, just for buying and holding their funds! Taxes gobbled up 15% of the gross return of the average U.S. diversified equity fund. And the tax hit was even worse for the average U.S. taxable bond fund. Here 38% of the gross return was lost to taxes, nearly double the cost of operating expenses and loads combined.
If anything, this study may have actually understated the tax costs. Why? Because it included the 2000-2002 bear market in stocks, so tax-loss carry-forwards (and favorable changes in the tax code) actually mitigated the tax burden.
If you are voluntarily surrendering thousands of dollars to the IRS each year, you may feel like your investment portfolio is on a slow boat to China. Fortunately, you can tax-manage your portfolio to increase your real-world returns.
It’s not difficult. Here’s what you need to know...
Your annual tax liabilities will depend on both your tax bracket and how much of your portfolio is held outside of qualified retirement plans. I’m going to run through a few different scenarios, allowing you to easily adopt the strategy that is closest to your own personal situation.
Let’s start with the easiest scenario. If all your long-term money is in a tax-advantaged account like an IRA, Keogh, 401(k), 403 (b), private pension plan or annuity, you can stop sweating.
You’re safe from the taxman until you begin making withdrawals. So if all your long-term money is in a qualified retirement plan, you’re already home free.
But, if you’re like most investors, your personal situation is probably a little more complex. You likely have liquid assets both inside and outside of retirement accounts. In that case, you will need to tax manage your investment portfolio.
The first order of business is to place the right investments in the right accounts for maximum after-tax returns. You’ll need to put your most tax-inefficient holdings into your tax-deferred accounts and the remaining holdings in your taxable accounts.
For example, real estate investment trusts (REITs) are highly tax-inefficient. Most of your return will come in the form of dividends and these are taxable at your income tax rate, not the 15% rate for corporate dividends.
Another tax-inefficient asset is high-yield bonds. Here the majority of the return comes from interest income – and all of it is taxable. A junk bond fund will typically make capital gains distributions from time to time, as well. So you want to place these in your tax-deferred account, if possible.
Also highly tax-inefficient are inflation-protected securities (TIPS). The semi-annual interest payments on TIPS are taxable, the same as other Treasury securities. However, investors are also taxed on inflation adjustments to the principal, a situation that is commonly described as taxing “phantom income.” For these reasons, you should also hold your inflation-adjusted Treasuries in your tax-deferred account.
High-grade corporate bonds and ordinary Treasuries pay taxable income, too. They, too, should be held in your tax-deferred account.
On the other hand, individual stocks are highly tax-efficient. You control when you decide to take profits, so you can control your tax liability. And long-term capital gains are taxed at a maximum rate of 15%, regardless of your tax bracket. (Although Mr. Obama wants to change that.)
Stock index funds are fairly tax-efficient, with one exception: small-caps. If a small company is successful and keeps growing, it will reach the point where it is no longer a small-cap stock. At that point it will eventually be removed from the small-cap index. When a small-cap index fund sells a small-cap that has become a mid-cap, it will generate a realized capital gain. That gain, of course, will be distributed to shareholders.
So be careful where you place the assets you own.
Money managers and financial planners often talk about the importance of asset allocation. Tax-managing your portfolio is what I call your asset “location” strategy. It’s simply a matter of owning your least tax-efficient assets inside your retirement account and your most tax-efficient ones outside them.
Don’t think for a minute that this isn’t worth the trouble. Effective tax-management of your portfolio is critical – and can dramatically increase your real-world returns.
If you’re not doing everything possible to minimize your investment costs and taxes, you’re operating at a serious disadvantage.
As investment legend John Templeton famously said, “There is only one investment objective: maximum total return after taxes.”
As a financial writer, I write and speak about this topic all the time. Occasionally, this strategy provokes anxiety from some do-gooders who see tax-management strategies as some sort of abdication of civic responsibilities.
Nothing could be further from the truth. As a law-abiding U.S. citizen, you need to pay the taxes you are obligated to pay...and not one penny more. As Judge Learned Hand, who served for years as Chief Judge of the U.S. Court of Appeals for the Second Circuit, famously wrote:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again, the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike, and all do right, for nobody owes any public duty to pay more than the law demands.”
Amen, Judge.
As Vanguard founder John Bogle has said, “Fads come and go and styles of investing come and go. The only things that go on forever are costs and taxes.”
In short, taxes matter...a lot. Take the basic steps I’ve outlined here to tax-manage your portfolio and you’re assured of higher real-world, after-tax returns.
Regards,
Alex Green
for The Daily Reckoning
Editor’s Note: The above is an excerpt from Alex Green’s latest book, The Gone Fishin’ Portfolio . To purchase your copy, see here:
Alexander Green is the Investment Director of The Oxford Club and Chairman of InvestmentU, a free, internet-based research service with over 300,000 readers. (The Oxford Club’s Communique, whose portfolio he directs, is ranked third in the nation for risk-adjusted returns over the past five years by the independent Hulbert Financial Digest.) He has been featured on The O’Reilly Factor , and has been profiled by Forbes , Kiplinger’s Personal Finance , CNBC, and Marketwatch.com, among others.
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