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Making Sense of This
Economy and Stock Market
by Kenneth Coleman, editor
Investment Tracker
Both the long-term and short-term market trends remain bullish, while the intermediate-trend is bearish. It is too early to determine if the correction has run its course but the long-term trend dictates the continuation of the current bull market. So, why has there been so much confusion?
In the past, the economy was influenced by the rise and fall of interest rates. For example, the stock market became bullish and the economy would begin to improve as interest rates moved lower. The lower interest rates fell, the more bullish the economy grew. A bullish economy buoyed corporate profits, creating a bullish stock market.
Later, earnings would begin to decline late in the business cycle after interest rates continued to move higher. Stock prices would begin to move lower once corporate earnings began to tank. It used to be simple to determine what was going to happen next given the interest rate yield curve.
The current interest rate yield curve should portend an extremely bullish economy, and thus a very bullish stock market. However, until recently, this has not been the case.
Most prices, at all levels, should be skyrocketing after interest rates have been kept so low for so long. Some prices are skyrocketing, but only on the wholesale level. The consumer level of the economy has come dangerously close to being deflationary in many sectors. If interest rates are not the culprit, then what is responsible for the economy's slow and erratic growth?
There appears to be both inflationary and deflationary forces working behind the scenes in our economy. Since these are monetary functions, let's take a look at our nation's money supply.
Many people may be unaware of how the U.S. money supply operates. The Federal Reserve creates money when individuals and corporations borrow from the nation's banks. This is why the money supply is so sensitive to the fluctuation of interest rates.
Think of interest rates as the cost of borrowing (hence, creating) money. Everyone (individuals and corporations) borrows when money is cheap (low interest rates). Conversely, borrowing is curtailed when money is expensive (high interest rates). However, interest rates have been extremely low for quite some time. Even so, borrowing has slowed and the money supply continues to diminish. Why then is our monetary system not functioning in the usual manner?
There are two reasons. One, Americans alone are no longer buying U.S. Treasury securities, and two, foreigners are buying about 30% of U.S. Treasury securities.
Over the past two business cycles, the U.S. monetary system and the economy have been provided too much slack. This allowed too much monetary creation over the past two decades.
The purpose of a recession is to wipe clean the excess money creation, which requires the implementation of high interest rates for a sufficient time. It also requires either an extreme monetary disinflation. Either of the two would help take debt off the books.
Today, the U.S. economy seems to be immune to traditional economic stimuli. The culprit behind the economy's slow growth is the government's attempt to keep the economy going throughout the last two business cycles without allowing it a longer-term cooling-off period.
Between 1981 and 1991, the broad measure of the U.S. money supply (M3) grew from 2,441.9 billion to 4,094.0 billion. M3's growth between 1991 and 2002 grew to 8,332,0 billion. Compared to the years between 1974 and 1980, a period considered a major inflationary era, M3 grew from 1,070.4 billion to 1,987.5 billion.
There was very little variation of monetary growth between these three businesses cycles. As a result, there has been an enormous buildup of liquidity over the past 25 years. Now, the U.S. government must do everything possible to keep prices, interest rates, and all the harbingers of inflation lower than they usually are at this point in the business cycle.
When comparing money creation during the previous business cycles, the business cycle of the 1970s was a time when gold and silver climbed to $850 an ounce and $60 an ounce, respectively. Therefore, you could assume monetary growth would have been much faster in the inflationary years than during the years of slower growth.
The Federal Reserve raised key interest rates to 16% in 1979 in order to wring past excess from the business cycle of the 1970s. Interest rates never surpassed 7% during the last recession. The Federal Funds Rate was 5.5% in 1999, and 6.5% in 2000. It plunged to 1.75% (in normal terms) by the end of 2001 and fell much further in real terms (see chart).
The real Fed Funds Rate was a minus 2% in 2003 when adjusted for inflation, placing interest rates on a real value basis considerably lower than the listed +1.75%. Since 2004, the rate has gained 1% on a real rate basis.
Prices are still low because the Fed Funds Rate is so low and because cheap imports (principally from China) continue to flood our shores. Only recently have rising prices begun to push real rates higher.
I doubt anyone can make an argument based on the premise that several months of relatively high interest rates (6.5%) moderated the surplus of dollars accumulated during the 1990s stock market mania. Almost every dollar that was lost in the dotcom collapse has been regained by many investors through real estate investments. Those who already owned real estate made as much as 100% profit in the last several years.
 The loss of the U.S. tax base is one of the hidden culprits behind the slump in the U.S. economy. It is another reason many Americans feel so poor these days. It is also the cause of the wisp of disinflation. Many subsidies and government services have been cut with many more cuts to come. Many corporations have moved abroad or have sent thousands of jobs abroad because of tax subsidies. Who do you think pays for both the tax subsidies and the loss of tax revenue when corporations leave the U.S. economy? Corporations that retain their business exclusively in the U.S. and middle class taxpayers fill the tax void.
Today's massive loss of tax revenue (caused by corporations leaving the country) coupled with the loss of tax revenue between 2000 and 2002 (due to the stock market collapse) explains why states currently find themselves in ghastly financial straits, unable to maintain their infrastructure and provide essential services.
The stock loss tax deduction is another negative aspect of tax revenue loss. For example, an investor who lost $20,000 on several stocks in 2000 can now deduct those losses from stock earnings gained in 2003 and after. That investor could deduct $3,000 annually from stock losses if he or she decides to hold on to the stock. Tax deductions for these losses have been enormous because the stock losses that occurred between 2000 and 2003 were massive. This ultimately takes its toll on government tax revenues.
These tax revenue losses will not only impact the current tax base, they will encourage investors to sell profitable stocks in the future in order to take advantage of the tax break on part losses. Short-term recovery strategies such as these hurt sound companies that are presently making money, but were sold in exchange for a tax break.
In addition, companies in the process of refurbishing their infrastructure and replenishing their work force are now stymied by cuts in investment revenue. Many companies have had to hold off investing in both physical and human resources because of slowed growth. While some sectors in this economy struggle, others are thriving and unable to keep up with their growth. These sectors face shortages and bottlenecks in production. It would appear that tax revenue loss had created much of the incongruity in our economy.
This is not an attempt to bash corporate subsidies. The U.S. economy is a capitalist one. U.S. corporations need every penny they can squeeze to compete with multinational corporations. The problem is the lack of distinction between multinational corporations and domestic corporations with regard to government tax subsidies.
Multinational corporations are not restricted from collecting U.S. tax subsidies. A U.S. firm's taxes are deferred for ten years when it moves abroad. An investor is allowed to write off any future gains with any loss incurred through stock owned in a multinational corporation. The loss of tax revenues from domestic corporations leaving the country in order to gain tax subsidies shifts the tax burden to those companies remaining in the U.S. This loss of tax revenue hurts those domestic corporations trying to survive financially and support an employment-famished workforce.
However, not all tax action that occurred over the last few years has been bad. (See chart titled, "The Tax Rate Is Falling".) The 2003 tax cut package provided taxpayers $61 billion, much of which was returned to average taxpayers. Last summer, these funds began buoying GDP, helping push taxes as a percentage of income below 10-year lows.
Today, the big tax refunds are just beginning to kick in. Economists, interview in Business Week, estimate the tax cuts "will provide taxpayers 25% to 30% more refunds than last year." The depreciation tax allowance, set to expire by the end of the year, will help support the economy. Corporation will begin to invest in capital spending later this year once it is certain the depreciation tax allowance will not be renewed. The chances for an extension of the tax allowance during an election year are slim to none.
The capital gains, when followed correctly, provides investors with capital gains at a tax rate of 15%. This kind of leverage helps provide investors more disposable income. Consumer demand should continue to hum this year and next given the support of the lowered capital gains tax and stock loss deductions taken from current stock gains.
It is no wonder so many domestic U.S. corporations are forced to move abroad. The fact that there are still a great number of domestic corporations operating at a profit in the U.S. can be attributed to both the work ethic and ingenuity of corporate management and the average American worker.
Americans are survivors, and have managed to survive a similar situation before. For instance, during the mid-1980s, American alarmists had proclaimed victory for the Japanese system of economics over the U.S. The media described the Japanese system as number one. U.S. corporations felt compelled to employ Japanese managers in order to replicate the same success in the U.S. Alarmists, then, were worried Japan would eventually buy up America.
Today, we no longer hear the warnings concerning the Japanese threat to the U.S. Economy. Moreover, the shoe is now on the other foot. The Japanese have been forced reluctantly to replicate America's system of capitalism in order to regain the edge they lost during their economic collapse in the mid-1990s. They replaced their outmoded and cronyistic banking system with one that resembles our Federal Reserve.
Japan began taking action to remove a massive accumulation of bad debt from their banks within a short time following the change in control of their banking system. This placed both Japan's banking system and its economy on the road to recovery.
Editor's Note: Kenneth Coleman is editor of Kenneth Coleman's Investment Tracker, 4805 Courageous Ln., Carlsbad CA 92008, 1 year, 12 issues, $139. As of April 04, his published stock portfolio was up over 91 percent for the past 18 months. Mr. Coleman will be featured speaker at The Inner Circle Wealth Strategies Forum, September 20-22. See box on page 7 for more details.
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