Britannia Radio

The Daily Reckoning | Wednesday, March 3, 2010 Back in the US of A Sifting through the noise in the land of information Joel Bowman Markets in the US were up yesterday...the Dow by 2 points, the S&P 500 by 0.2%. Little victories are still victories, right? Depending on what paper you read, investors were “tepid”...“sidelined”...“taking profits”...“cautious”...“steadfast.” There are all kinds of post-mortems on the day’s trading, explanations for the miniscule moves, but really it’s all just noise. Your editor is back Stateside this week, having temporarily swapped his humble digs in Asia for the trappings of the developed world. The first difference we notice on returning to the west is the constant bombardment of information. Everywhere we look we see some brand of expert, armed with opinions, commentaries and sales pitches for absolutely everything...from ergonomic furniture to male impotence treatments...and their associated lists of possible side effects. They are on the radio, selling you life insurance and deals on auto parts...on the television, telling you what stocks to buy and sell, and why you should do so now. They smile down from billboards, advising the world on where to get the best burger...the brightest smile...the flashiest ride... With such an onslaught of information flying about, it’s a wonder anyone here has time to think at all. There’s information about everything you ever wanted to know, including all the things you didn’t even know you wanted to know. The same thing is true in Asia, of course – probably more so – but there your editor enjoys the luxury of not understanding the native language. He can tune the world out and think in peace. So, what critical information regarding the state of the world did we miss while on the flight over here? As near as we can tell, everything is pretty much the same as when we left it. Sure, the micro-term trends change minute to minute...but the longer-term fix is in. The economy is still deleveraging. Corporate growth is stunted. Lending is still largely on hold. Earnings increases derive from cost cutting, not from profit increases. And the battered and bruised American consumer is still hunkered down for what he surely senses are hard times to come. All this is not to say that there are no meaningful data points worthy of your attention. Only that they don’t usually appear on the front page of the LA Times. Addison Wiggin, our executive publisher, provided a couple examples of longer-term interest in yesterday’s edition of The 5-Minute Forecast... Here we go again. The Canadian dollar is rapidly approaching parity with the US variety. In the last five trading days, Canadians have collectively grown almost 4% richer compared with their slovenly southern neighbors. Over the last 12 months, the loonie is up 22% versus the greenback. At this rate, we won’t be able to tell people when we head off for Vancouver: “Canada, it’s just like the US...only less expensive.” Add in the hockey game on Sunday...then the following nugget... Canucks have earned some bragging rights this week. But they won’t. From our experience, they’re always so...friendly. “One of the most important lessons from stock market history is to not buy stocks trading at peak multiples of peak earnings,” Dan Amoss urges, “especially earnings that are driven by cost cutting, rather than revenue growth. Investors should pay high P/E multiples only for stocks that they’re highly confident can grow free cash flow at an impressive rate over the next few years. [Sounds like good advice for confidence in governments, too.] “Yet in case after case, in the fourth-quarter earnings reports I’ve reviewed, investors persist in awarding lofty multiples to earnings driven largely by cost cutting and temporary inventory rebuilding on the part of their customers. This is typical of market tops. Investors are focusing on what happened in 2009 – which offered an unsustainably good environment for corporate profits – and not worrying enough what earnings might look like three or five years down the road.” [Oh, cost cutting. That would never happen in government, never mind.] [Joel’s Note: Last week we announced that Addison is ready to roll out his new research service, tentatively titled Apogee Advisory. The project, Addison explains, is aimed at “providing investment research for individual investors that will not only cover the nexus between money and politics, between Wall Street and Washington, but would crush even the finest research published by the Wall Street houses, such as they are.” Addison will begin this new service with three “beta” issues, starting next month. Importantly, he’d like to test the idea to get your feedback. To that end, he’s offering these initial issues free of charge to a select group. If you’re interested in providing feedback, you can get the details here. The first issue is due out in early March and, as usual, positions are limited.] The Daily Reckoning Presents Dodge Taxes Legally... Become Treasury Secretary Ian Mathias If you don’t want to pay capital gains taxes, work for the President...or have lots and lots of kids. In the biggest stock sale of his life, former Treasury Secretary Hank Paulson didn’t pay one dollar of capital gains tax. Nearly $500 million worth of Goldman Sachs shares – a profit of hundreds of millions of dollars – and not a red cent went to the IRS. Paulson’s Treasury predecessors Robert Rubin and Paul O’Neil enjoyed a similar tax dodge themselves...as did many other familiar Washingtonians over the last 20 years, like Donald Rumsfeld and Donald Evans. You could enjoy the shade of this shelter too. All it takes is the President’s blessing. President George H. W. Bush is the originator of this refuge for the political elite. His Ethics and Reform Act of 1989 – ironically – was a soft-core crackdown on abuse of privilege in government...no more honoraria for federal employees (except Senators, of course), post-employment restrictions on Congressmen, increased financial disclosure and so on. But the Act also introduced Section 1043 of the Internal Revenue Code, a tax shelter available to those that need it the least. Under the guise of not wanting to “discourage able citizens from entering public service,” Section 1043 is an alteration of the government’s conflict of interest rules. Before 1043, executive appointees (mostly high-up cabinet members and judges) had to sell positions in certain companies to combat conflict of interest – like say, a former Goldman Sachs CEO-turned Treasury Secretary with millions of GS shares. After Sec. 1043, the appointee gets a one-time rollover. Upon their appointment, he or she can transfer their shares to a blind trust, a broad market fund or into treasury bonds. They’ll have to pay taxes on the position one day, but not immediately after the sale... like the rest of us. So if you were Hank Paulson, sitting on 3.23 million shares of Goldman Sachs in 2006, the chance to defer tens of millions of dollars of taxes was a pretty sweet deal. Paulson, along with almost every executive appointee (and their spouses and kids!), have been granted a tax shelter that is totally unattainable for the everyday investor. Section 1043 goes beyond leveling the playing field for public servants. In fact, it incentivizes service. It puts appointed officials on a higher playing field than their constituents. Many investors will, if they haven’t already, experience a moment where they’re desperate for a free pass out of one investment and into another. Imagine getting willed a million shares of Enron in 1999, or being on the verge of retirement in 2007. Your editor had shares of PNC passed down in his family for decades... Dad took a notable tax hit when he sold before the credit crisis. Too bad he wasn’t Secretary of the Treasury. He could have rolled those shares of PNC into a money market fund – largely what Hank Paulson did – and enjoyed income on subsequent gains BEFORE being taxed on the original investment. (All of this underscores the oddity of the US capital gains tax. It’s not a tax on gains, but a tax on transactions. What does an investor truly “gain” from moving out of one position and into another? The capital gains tax should only be exacted when an investor truly cashes out of a position. Otherwise, it’s tax on changing your mind. It’s a tax on diversification and rebalancing. In other words, the government is giving you incentive to “buy and hold,” a principle that has been just terrific for American mainstay stocks like GM, Bank of America or General Electric.) So what’s a humble investor to do? If you really feel like wasting your time, write your Congressman. Otherwise, maximize the potential of our absurdly complicated tax code. It’s damn hard, if not illegal, to get a pass on capital gains tax the way Hank Paulson did. But you can take the edge off. One of the most popular – and legal – ways is giving appreciated stock to your child. Each child can get a “gift” of up to $13,000 a year from each parent, tax free. Unless you’ve got a very entrepreneurial kid, he or she is probably in the lowest tax bracket. So you can give them the stock and they can sell it at a much lower tax rate. There are other, more complicated ways, too – some of which involve forming corporations or trusts. Charitable remainder trusts, for example, produce tax benefits, while also providing funds for charitable endeavors. Of course the money won’t belong to you anymore, but at least you would have the chance to finance the charities of your choosing, rather than the pork-barrel projects of the government’s choosing. Either way, don’t just sit back and assume that paying the full tax is the fair consequence of investment success. You’re in this mess to make money for you and the people you care about. Hank Paulson and his executive branch buddies found a shortcut – so should you. My understanding of American tax law is far from comprehensive. Think of it like skydiving... I’m comfortable explaining the basics, but you wouldn’t want me packing your parachute. If you want to minimize your capital gains taxes, find a good accountant. Regards, Ian Mathias for The Daily Reckoning