29 Jun 2001 Introducing Our Weekly Email
We are pleased to introduce our weekly email, the Friday Brief. It pulls together many of the numerous strands we’re following to try to make some sense of this unique time in history. The old economy, the new economy, the markets, the Federal Reserve, the politics, all interact to shape this economy of ours. Understanding their implications forms the art and science of investing. In the Friday Brief we will share some of the news and events that shape our investment decisions as well as the rationale for recent buy and sell decisions. This letter is unusually long because we catch you up on the entire quarter. We will try to organize the Brief in such a fashion to facilitate a quick and efficient read. For those who prefer more detail, we provide articles and links to articles we find particularly useful. PLEASE read the American Spectator article at the end of this brief as it makes an excellent case for just what we need from our congress right now. Write your senators and reps if you agree.
Fed Moves and Comments
Wednesday’s FOMC statement represented a compromise between a faction still nervous about the outlook for growth (those who wanted to go another 50bps) and a faction who think the economy is near a bottom (those who held the line at 25bps). The notable observations of their statement concern the items that were missing. Consistent with the less aggressive reduction in the funds rate, there was no reference to the need to monitor conditions closely or for a rapid and forceful response from monetary policy. In other words, the phase of FOMC aggression has given way to a phase of FOMC caution. Also missing from Wednesday’s statement was an explicit reference to the “wealth effect on consumption”, a feature of the three prior FOMC statements. That’s because evidence of a wealth effect is difficult to demonstrate in the data; any reasonable approximation of the wealth effect would have consumer spending contracting outright by now, and that is clearly not happening. The third thing missing from today’s statement is reference to the inventory cycle being well advanced. That’s because, having gotten off to a great start in Q1, de-stocking looks to have stalled in the early part of Q2. That poses a downside risk to economic growth over the summer. However, our advisors and we feel comfortable that the domestic economy is trying to turn the corner. The forthcoming tax cuts provide further support for that dynamic.
What concerns us most in the short-run is the impact of on-going deterioration in the global environment, especially on the export-intensive manufacturing sector. The manufacturing numbers over the next few weeks will have an important bearing on the outcome of the next FOMC meeting on August 21. The release of the National Association of Purchasing Managers on July 2nd will be our guide. Also worth watching are any signs of the impact of tax cuts on retail sales. The August 8th Beige Book will give the first, albeit preliminary, read on how much of the tax rebates the retailers are able to snag. We continue to expect the funds rate to fall another 25bps to 3.5% at the August 21st FOMC meeting. But if our forecasts are right, the October 2nd FOMC meeting will pass without any further action by the Fed.
We have been busier than usual this past quarter with our trading. The causes have ranged from major shifts in government policy, to global economics to recent evidence that our economic recovery will come more slowly than earlier expected, to individual company bombshells such as those of Lucent and Nortel.
Back in December and January, many were looking for an economic turn in the late first half of this year. It’s clear now that will not happen. The latest indications are for some sectors to begin turning this and next quarter while telecommunications is closer to a year from turning.
Jack Jeffords’ leaving the Republican side of the isle caused a sea change in the dynamics of federal legislation for the next year and a half. Some stocks were dramatically impacted by the change, particularly energy companies and to less an extent, the pharmaceutical companies. The new Democratic majority began immediately talking up price caps as a fix for California’s problems. The irony of a Republican Administration, a new FERC commissioner from Texas and California’s politicians destroying the ability and desire to raise capital to build electric generation infrastructure at a time it is clearly needed was not lost on investors. FERC, pandering to extreme anti-business, anti-free market interests won’t keep power on or prices reasonable with price caps. Fortunately, the price caps are variable and are based on the highest-cost, least efficient producers. Our companies, Calpine and El Paso Energy, are the lowest cost producers and most efficient. They will be able to make just as much money as they would without caps. Note: Our next investor update will examine in more detail our growing concern with the dangers of the anti-free market and anti-business attitudes growing in Washington and state capitals.
The rate cut lifted our stocks, but the market will not be on firm footing until liquidity is restored and business investment turns positive. There are signs, but they are too faint at present to provide meaningful fuel for the market.
From The American Spectator:
“Stock market crashes predict recessions rather than cause them. But when the driving force of the economy is exceptionally rapid innovation powered by risk capital, the disappearance in less than a year of $5 trillion worth of such capital, largely as a result of a Federal Reserve sucker punch, must be treated by the government as an emergency.
“Even in much of the financial press, the most common reaction to the NASDAQ collapse has been sniggering self-satisfaction that go-go investors have finally gotten theirs. All one needed to do to avoid disaster, high-risk investors are condescendingly told, was to be a sensible fellow and invest in the Real Economy, where they make important things, like Coke or perhaps aluminum-for the cans.
“But the ‘value’ investor snuggled safely on the sidelines is
comparatively useless to economic growth. Growth is primarily a function of innovation, and thus of risk. Investors in innovation, against all conventional wisdom, bet that they can beat the market, defying its relentless “efficiency” to seek out as yet unrecognized and undiscounted advance.
“This is at the best of times a hazardous undertaking. In the early 1970s, risk capital essentially disappeared, intimidated by a combination of inflation, high taxes and government hostility. The 20-year boom has largely been driven by the restoration of risk capital’s rewards.
“The Fed’s whipsawing of investors over the past 18 months shattered those rewards, discouraging and de-funding the nation’s most useful investors. The administration could hardly do anything more useful than create incentives to get them back in the game. It was the capital gains tax cuts of 1978, 1981 and 1997 that most powerfully drove the boom. For those obsessed with surpluses, capital gains cuts ALWAYS pay for themselves.
“Cutting the current 20 percent rate by five points and narrowing or ending the distinction between long- and short-term gains would do more to resurrect the NASDAQ than the Fed’s rate-cut water torture. And it would do more than all the one-sided bipartisanship and compassionate conservatism in the world to secure the administration’s increasingly tenuous political future.”
MIT’s Nobel Prize winning economist Robert Solow likes to crack (apparently un-ironically) that economic theory advances one academic funeral at a time. That goes triply for anything that smacks of, dare we say it?-the supply side. But hope, like growth,. springs eternal. In a new monograph titled “Personal Income Taxes and the Growth of Small Firms”, a team of unimpeachably mainstream economists headed by Princeton’s Harvey Rosen used tax return data to determine how reductions in marginal tax rates (in this case, the 1986 Tax Reform Act) affect small businesses. No prize for guessing what they found: “The greater the decrease in the sole proprietor’s marginal tax rates,” the report concludes, “the greater the increase in the size of his or her business.” Note that we’re talking revenue growth here, not just a post-tax earnings boost. And the results are startling, even after controlling for everything from the entrepreneurs’ personal profiles to the industries in which they operate: cutting the top marginal rate from 50 percent to 33 percent increased the size of the average business by 28 percent.
That’s not trivial in macro terms either. In 1985, non-farm sole proprietors accounted for roughly 20 percent of the $2.8 trillion in US domestic business income. Now maybe the same team can go back to the same data and look at the effects on tax receipts!