Economic and Political Outlook for 2012:

Hang Onto Your Hats!
Leon C. LaBrecque, JD, CPA, CFP™, CFA

Happy New Year, and welcome to 2012. Here are a few predictions and observations that provide you with our economic and political perspectives for the New Year. You may want to sit down with a favorite beverage or even an aspirin. In general, we’re certain this will not be a nice steady year:

1. We appear to be nearing the end of an oscillation period. Since 1903, the market has been behaving in 13-year oscillations, followed by upswings (1903-1915, 1929-1942, 1968-1981, 1999-2012?). Each oscillation is marked by technological growth, economic downturn then growth, and usually some ‘tipping point’ at the end. We could be at the end of an oscillation, given the right tipping point.
2. Europe is still messy. The EU still has an immense amount of work cut out for it. The ‘fixes’ of the ECB are still only symptomatic and don’t reflect the underlying problem: Greeks are different from Italians, and Irish are different from Germans. Unless the underlying economies have some governance, the EU will continue to suffer and will probably spend a part of 2012 in recession.
3. The market has room to run. The S&P 500 has a relatively low valuation (the Price to Earnings ratio is quite low by historical standards); interest rates are so low that bank deposits of CDs don’t offer much of an alternative. Money has been flowing out of stocks, it could very easily flow back in, but probably before late fall (can you guess why?).
4. The economy has room to grow. Despite all rumors to the contrary, the US economy has grown for nine straight quarters through the end of 2011 (since the 3rd Q of ’09). With low interest rates, we could see real estate start to move, car sales starting to pick up, and companies making more money. Don’t be surprised that our next threat is not recession but inflation.
5. We have met the enemy, and it is Washington. On November 6, there is a presidential election which we predict will be narrowly decided. Importantly, 33 seats of the Senate are up for grabs, including 22 Democratic Senate seats. It seems very unlikely that the two parties will get along before the election, and barring a Republican sweep (and a senate supermajority), it seems unlikely the two parties will get along after the election. More gridlock seems likely.
6. Unemployment will likely continue to slowly decline. Corporations have wrung almost every drop of productivity out of their workforce, and it seems likely that the only solution to expansion is to continue hiring. Note that the government workforce is shrinking and the private workforce is growing.
7. The Bush Tax Cuts Expire 12/31/12. This is a significant issue that no one seems to be taking seriously right now. Expiration of the cuts raises taxes on virtually every taxpayer, changes the rates on dividends to ordinary income, raises capital gain rates, brings back the marriage penalty, eliminates the child tax credit and raises the Alternative Minimum Tax (AMT). Roth conversion and municipal bond purchases will become more useful as the year-end deadline ticks away.
8. The Sequestration Cuts take place 01/01/13. The failure of the Super-Committee to act will cause an across-the-board cut in Federal spending. Following the normal mentality of bureaucracy, that will go to the employees first (fat chance Congress will cut their pay!). Job cuts by the Feds could lead to more unemployed people.
9. The Unearned Income Medicare Contribution (UIMC) starts in 2013. The UIMC adds a 3.8% additional tax on upper-income individuals (over $200K on single and $250K on married) on all unearned income, like dividends, interest, and capital gains.
10. The Debt ceiling expires again in 2013. Remember the fun we had in August of 2011? Well, it happens again, in early 2013.
11. Iran is a wild card. Iran is being very aggressive about its nuclear program, including trying to block shipping in the Persian Gulf. It is completely plausible that this could escalate into a military situation either with the US, NATO, or Israel (we bet on Israel).

Bottom Line: To say the least, 2012 doesn’t look boring. Be ready to take advantage of opportunities and avoid the downdrafts. And consider whether this combination of events might cause a ‘tip’ in the market that has had virtually no upward movement since 1999.

"Daddy, Are We There Yet???"

From our Chief Investment Officer, Brad Reynolds CFA

My rather precocious son JR goes to daycare every Tuesday and Thursday, and has been for a year now. I was driving him to daycare this AM, and despite having made this trip a hundred plus times the same way, five minutes into the drive I hear from the backseat, “Daddy, are we there yet?”

I realize that at three years old JR has an extremely short-term view of the world. He doesn’t see the whole trip and how it leads to our ultimate destination.  He is only concerned with what he sees out the window at any given second. So, I say to him, “No JR, we're not there yet, it takes time to drive to school.” “But why?” This is a question I have learned is best to pretend I don’t hear (parents know what I’m talking about). A little further along in our journey, we come to a stop light and my backseat bellows “I want to go that way” (motioning for a right turn). “No JR, that’s not the way we go.” ”But I want to” (another statement best to ignore). We finally get to daycare, and JR joyfully runs into the classroom for a day of play and envying his classmate’s Lightning McQueen flashy shoes (which I will of course now have to buy him, but that’s another story).

This got me thinking. Despite making the trip twice a week every week, JR (a very bright child) still doesn’t see the bigger picture. He only focuses on what’s right outside the window. I suppose that’s natural. I mean, he doesn’t drive and has never made the journey himself, I have. I know how to get there. Now granted the trip is not exactly the same every day, there are accidents, construction, weather conditions that delay us or even cause a minor detour. (I won’t mention the poor little squirrel that sadly met his end under my tires this morning). But I know how to drive the car, where I’m going, and different routes to get there despite any obstacles or bumps in the journey.

I suppose I could get JR a car and let him drive himself and figure it out, but I suspect there may be disastrous consequences, and he may not get there safely. I need to reassure him that I know where I’m going and despite any detours or delays I will get him there in time for the morning snack.

I can’t help but see the similarities with my professional life, safeguarding the financial wealth of our clients. It is easy to get caught up in the short-term, and focus on the ‘bad’ news of the day. It is our job to see the bigger, longer-term picture. We know the ultimate destination and the best way to get there despite how bumpy it may seem at times. I can assure you we are watching the road, not speeding, and navigating thru all the obstacles, both expected (traffic lights) and unexpected (squirrelly markets). We will do our best to get you to your destination safely and on time, all the while reducing your uncertainty.

Brad

Letter to the Members of the Super-Committee

The forgoing is an edited excerpt from an actual letter I am sending to members of the Super Committee.

Dear Members of the Super-Committee:

Congratulations on your being chosen for the task of helping to steer our nations’ fiscal ship in the right direction.  The task you face is of significant importance to all Americans, and to the world as well.  America stands as the bastion of economic and moral strength in the world.  Your recommendations will shape America’s present, and your actions will shape our future.  In that spirit, kindly consider my humble recommendations:

1.  Conduct yourselves with the respect and decorum expected from your position of leadership and honor.  The partisan bickering that surrounded the debt ceiling debate was destructive and divisive.  Genteel debate and conduct is a good starting point for reestablishing trust with the American people who are counting on you to lead them to a sustainable fiscal future.

2.  Please consider that all of you represent all of us, and that no one of you represents all of us.  You should put the country’s best interest foremost, and your Party’s, lobbyist, or contributor’s considerations secondary.  To wit, trying to balance a $1.6T deficit by cuts alone is unworkable, as is trying to fund it on the backs of 2% of the population.

3.  Please remember that there are two issues here:  (a) a short term problem (this very anemic recovery); and, (b) a long term problem (excess debt and deficit spending).  Delineating those issues is paramount:  Cutting jobs to cut spending in a weak recovery is a destructive feedback loop.  In other words, delay spending changes to make sure nothing harms the short term recovery.  Get the economy growing first.  Remember, the US debt-to-GDP ratio is still the lowest among our peers in the developed world.  Therefore, the first priority (short term) should be economic recovery, and the second priority (long term) should be reducing the deficit.  If done properly, we do not need to sacrifice one priority for the sake of the other.

4.  Simplify the tax code.  As a CPA and former professor, I can assure you that our tax code and appurtenant laws are fraught with unnecessary inconsistencies and complexities.  In addition, vast tax incentives are an anathema to a free market society.  Hundreds of billions could be re-allocated by simplification of the tax code.

5.  Have courage in your decisions.  Our founding fathers stood with their reputations, fortunes and lives on the line to create this country.  Demonstrate a modicum of that courage to protect it, even if you have to inform the country that we need to simplify, spend less and pay a little more. 

6.  You can balance budgets by less spending, increasing revenue, or both.  I believe both are necessary.  Recognize revenue comes from rate and volume.  A growing economy pays more taxes.  Employed people pay more taxes.  Your plans should encourage business and job growth. 

7.  As to the current situation, we have a Fed balance sheet and money supply that should provide some significant stimulus, but for the cloud of uncertainty.   To that point, here are two ideas:

a.  Lower the Fed lending rate to zero.   Banks currently can keep functioning, protect massive store of cash, and moderately satisfy regulators and shareholders by sitting on their assets.  Lowering the fed lending rate to zero (only .005 less than the T-bill rate), will force more money out into the system for business and consumer lending.

b.  Have GNMA (or if desired, allow FNMA and FRMC) to provide mortgage lending for home purchases or refinancing under the following conditions:

i.      High credit score,

ii.     Current payment status,

iii.    Maximum Loan value equal to the greater of 80% of appraised value or current balance.

This might stop the downward slide of valuations, discourage strategic defaults, and again move money into the system.  In addition, it will provide a wealth effect in resetting the perceived value of the home higher to its current mortgage balance.

8.  On Social Security:

a.    Provide a graded increase on contribution rates, adding 0.3% to the rate each year for 5 years   starting in 2014.  Raise the wage base to $150,000;

b.    Index the Normal Retirement Age (NRA) for participants born after 1960 grading it eventually to age 70. My calculations indicate this reduces the liability by 8-10%;

c.     Modify the earned income limitation to incorporate the NRA earned income limitation until age 70. This encourages working semi affluent retirees to delay collecting benefits;

d.    Use linked CPI to add increases: it is a logical inflation measure.

9.  On Medicare:

a.    Link eligibility to Social Security NRA, e.g.  Instead of some folks being eligible for full Social Security at 66, but Medicare at 65, make the eligibility ages the same.

b.    Raise the Medicare tax rate to 1.5% in 2013, and raise it .15% a year for 5 years.

10.  Income Tax Rates:

a.    Either let all of the Bush cuts expire in 2012 (raising taxes on everyone), or modify the rates to broaden the base. 

b.    Consider that the UIMC in the Health Care bill is a strange and inconsistent tax on upper brackets.  In addition, it’s an unearned income tax paying for a payroll based program. Link your programs to your taxes (e.g. Social Security taxes pay for Social Security, Medicare taxes pay for Medicare, etc.).

c.     Eliminate the vast array of inconsistent and irrelevant individual tax rules.  AMT is an obvious example:  either use the regular formula or use the AMT formula.  Perhaps consider renaming the AMT (if you don’t eliminate it) to the more honest name of ‘Alternative Maximum Tax’.  Incidentally, force users of the Earned Income Credit (EIC) to actually support the dependents they claim on the return.  There is a level of fraud associated with EIC (I might even ask why we even have an EIC?).

d.    Eliminate the vast array of incentives and credits on the corporate income tax and simplify the corporate tax.

11.  VAT:  Deficit reduction excise tax:

a.    Consider a VAT of 3%, specifically earmarked to deficit reduction and not used for anything expect deficit reduction.  Link this to a freeze on discretionary spending to 2012 levels.

b.    Exempt necessities (food at grocery stores) from the VAT.

12.  Spending:

a.    Freeze discretionary spending to an acceptable level.  Allow increases only by the percentage linked to overall deficit reduction (e.g. discretionary spending can only go up when the deficit goes down, and then only by linked CPI).

b.    As a token of good faith, cut Congressional office budgets (except security) by 3%.  Freeze them for your terms.  Don’t give yourselves a raise until you balance the budget.

c.     Thoroughly evaluate each aspect of the budget, but start with the big one that should be easier:  the defense budget.  The waste in military spending in Iraq and Afghanistan are enough alone to probably cut $50-$100B.  I feel you should avoid cutting costs to soldiers, or soldiers’ families.  Waste on support programs is another thing.

In short, the budget of the United States is not entirely different than any other budget:  Spend money on essentials, get enough revenue to cover expenses, don’t hurt anything, or anyone too much, and spread the pain.  My best wishes and thoughts are with all of you.  Please recognize that we, the people of America, need you to serve as the advocates of all Americans not just limited groups. Have courage, and stand up for what is right, fair and good for the country.

Leon C. LaBrecque, JD, CPA, CFP^®, CFA

LJPR, LLC

My Friend the Manic-Depressive

Caveat:  I make no claims of the political correctness of my foregoing statements (nor have I ever, in any way, so this disclaimer is irrelevant).

I have a friend, Mark, who is manic depressive, which is more currently called ‘bipolar disorder’.  In bipolar disorder, a person undergoes mood swings from euphoria to depression.  These swings can be very rapid.  There are three basic forms of bipolar disorder, of which poor Mark is type I, which is at least one episode of full mania and one of severe depression.  Mark has had multiple episodes of both, and it’s getting worse.

In the manic phase, a person is easily distracted, tends to have a very elevated mood, gets very involved and can engage in ‘binge’ activities.  In the depressed phase, the person is depressed, has difficulty concentrating, loss of self-esteem, and even thoughts of suicide.

Take earlier this year:  Mark and I were talking about all the wild things that had happened in the first quarter.  The protests in Wisconsin and Lansing, the Arab Spring and Libya, Oil topping $115, and the earthquake and tsunami  in Japan.  Me, I thought those sounded like bad things.  Not Mark; he was in a full euphoria and nothing could get him down.

Then the news came that Osama bin Laden had been killed.  Oil prices went down and the prospects for reductions in the costs of Iraq and Afghanistan looked good.  But by now, Mark’s mood had shifted, and he got depressed in the face of good news.

So I thought around June, with the debt ceiling coming up, Mark would be depressed.  But his mood shifted again, and he was happy, almost giddy.  Even though the debacle in Washington had me concerned and more than a little embarrassed, Mark didn’t care.  And then the debt deal was made.  Then as the deal closed at the wire, Mark abruptly shifted his mood and became more depressed than I have seen him since 2008.  Mark ran around his place, and started selling everything, from his dad’s gold watch to all the stocks in his 401(k).  He calmed down for a day, and then S&P downgraded the government debt, and Mark went crazy.  Now he wanted government bonds (even though they were downgraded), sold more stocks and in a reversal from his previous mood, bought gold under the idea that ‘the sky was falling’.

I thought that Tuesday might help him, since he’d been so despondent.  And it did.  In fact when the Fed announced they would hold interest rates low for two years, which I felt was good news, Mark felt better and bought back in.  I gave a sigh of relief and hoped my friend was better.  Until Wednesday, when he went crazy again, although this time he bought oil and gold and sold everything he bought yesterday.

Of course, Mark is wearing me out.  One day he likes gold, the next he doesn’t. One day he likes stocks, the next he doesn’t.  One day he’s afraid of Treasuries, and the next day, that’s all he buys.  I called his doctor and asked what to do when a type I bipolar person is on a severe swing.  His advice:  “Be very careful until they go back on their meds, they can be dangerous.”  Poor old Mark(et).

Leon

PS:  My apologies to Warren Buffet, who originated this idea of Mr. Market being Manic Depressive.  Clever ideas are worth stealing.