Spending AND Taxes Got Us Into This Mess, And Only BOTH Can Get Us Out

Since we are right in the heat of the debt ceiling/budget deficit debate, I made a point to devote a section of my July quarterly client letter to the topic, but I also wanted to share some of that publicly as well. As old as these arguments back and forth in Washington are getting, they are important issues for our economic and financial futures. To try and boil it down to something (relatively) simple, below are two graphs I created to help people visualize exactly how we got into this deficit mess, and more importantly, the only way we can get out.

The first chart shows tax collections and government spending, as a percentage of GDP, in fiscal 2001 (the last year we had a balanced budget in the U.S.) compared with the projections for fiscal 2012 (which begins on October 1st of this year).

You can clearly see how we have gone from a surplus of 1% of GDP to a deficit of 7% of GDP; taxes went down by 4% of GDP and spending went up by 4% of GDP. If there was ever a question of whether the federal government has a spending problem or a taxation problem, this should end that debate. We have both, and each has contributed equally to our budget deficit woes over the course of the last decade.

To counter one of the most common rebuttals to this conclusion (that taxes are too high) consider that federal taxes (payroll taxes, income taxes, gift and estate taxes, etc) today are at their lowest point since 1950 (again, as a percentage of GDP). In order to balance the budget, we need to close an annual deficit of $1.4 trillion, the product of $3.6 trillion in spending versus just $2.2 trillion in tax collections. If we do not raise taxes at all, government spending would have to be cut by that $1.4 trillion figure, which would be a cut of 40% (and is impossible).

The second chart below shows the sources of our budget deficit, by comparing our finances in 2001 to those that the CBO projects for fiscal 2012. It shows in another way how increased spending and tax cuts are equally responsible for the fiscal problem we have, but it goes a step further by showing that nearly half of the increase on the spending side is due to huge increases in defense spending (which has more than doubled since 2001, from $300 billion in 2001 to $700 billion today).

So not only do we have to get taxes up and cut spending, but we have to cut defense spending meaningfully within that context. If we don’t increase taxes and we don’t cut defense spending, a balanced budget would require we cut the non-defense portion of the government’s budget by a whopping 50% (again, impossible).

If you weren’t ticked off at the childish crap going on now on Capitol Hill, you probably should be after reviewing these numbers. The solution to the problem is easy to identify if you want to be honest about it. But without even admitting to that in public, how will our politicians ever actually solve the problem? A depressing thought indeed.

Goldman Sachs Targeted Again, Entire Rebound Post-SEC Settlement Gone

So much for nailing that call on Goldman Sachs (GS) after the company settled with the SEC last year. The investment bank agreed to pay a $550 million fine last year on charges that the company engaged in fraud while selling mortgage-related investment products. The stock fell to around $130 per share at the height of the scare last July before rebounding nicely to the $175 area early in 2011. And yet here we are nearly a full year later and other lawyers are looking to get into the game. Unrelenting articles in the financial media from publications such as Rolling Stone don’t help either.

Unfortunately, I thought we had gotten past this issue, at least to the same magnitude as in 2010. Wishful thinking on my part. Most of the GS stock I bought for clients last year remains in their accounts, so this latest sell-off related to additional fraud investigations by the New York U.S. Attorney’s Office and the U.S. Justice Department has been painful. And with the 2012 election cycle ramping up, what better time to go after the big Wall Street banks yet again?

The interesting thing is, the issues haven’t changed much since last year. It is still fairly difficult to proof Goldman Sachs committed fraud because the clear evidence that they lied directly to those buying their mortgage-related products in 2007 and 2008 is scarce. People assume that since Goldman identified a bubble about to burst, while others didn’t, means that Goldman must have broken the law. And maybe they did, although the evidence I have seen is flimsy (even experts agreed that the SEC didn’t have a strong case). It could just be that Goldman Sachs is smarter than most of the other players in the marketplace (a theory that has been born out for years, by the way). Every transaction requires a willing buyer and a willing seller, which means there will be a winner and a loser in every trade. Just because Goldman was the winner does not mean that they defrauded the other party in the transaction.

As was repeated numerous times during the Congressional hearings prompted by the SEC investigation last year, Goldman Sachs acts as a market maker and a securities underwriter in these deals, not as a fiduciary. As a result, they are not required to put their customers’ interests ahead of their own when selling securities. All they must insure is that the investors know what they are getting and how much they are paying. Whether or not it is a good investment for them is up to the buyer to decide, not Goldman Sachs to advise them on. If there is evidence that Goldman lied to the buyers about what they were getting, then clearly the legal issue is only going to get worse for them, but again, there is hardly any evidence of that.

Even the SEC case, which resulted in Goldman agreeing to a large settlement,  revolved around Goldman omitting data pertaining to which people structured the deal. All of the details of the security, including what exactly the buyer was getting, were disclosed and known by all parties involved. There has to be personal responsibility, right? If you choose to buy something and are told exactly what it is ahead of time, it should be your responsibility to decide if it is a good investment or not, and if it turns out not to be, you should expect to lose money.

Now, I am not going to pretend to know exactly what evidence will lead to what legal outcomes over the next year regarding these mortgage-backed security transactions. All I can say is that Goldman stock is now all the way back to where it was during the height of the SEC worries last year. It has given back the entire 40-point gain that was recouped after that case was closed. The company continues to have the smartest people in the investment banking universe and be the premiere firm to do business with. Their profits remain strong and the stock trades near tangible book value after the recent correction. Goldman Sachs since their IPO in 1999 has proven again and again they can create shareholder value in all market cycles. Consider the chart below, which shows GS’s book value per share growth since the company went public more than a decade ago. As you can see, the company is run superbly well, which usually warrants a sizable premium to book value.

For long term investors it appears to be a great buying opportunity, the same conclusion I made at about this time last year. Of course, if the stock should rebound 40 points again after more lawsuits are resolved, perhaps it would be wise to take some more money off the table, as this issue doesn’t seem like it will be going away anytime soon.

Full Disclosure: Clients of Peridot Capital were long shares of GS at the time of writing, but positions may change at any time

If Conservatives Succeed in Phasing Out Medicare, HMO Bull Market Will Continue Unabated

Contrary to what opponents of the Obama Administration’s healthcare reform law argued originally (that the “government takeover” of healthcare would drive private insurance companies out of business), HMO stocks have been on fire over the last two years, as this chart of the Morgan Stanley Healthcare Payor index shows:

The reason, of course, is that the new law was about as far from a “government takeover” as one could get. Instead, Americans are being required to buy insurance from the private sector, which not surprisingly, is a huge boon to the HMO companies (hence the stocks are soaring).

With healthcare costs rising far faster than inflation, and the long term costs of Medicare serving as the single biggest problem for our federal government’s long term budget issues, Republicans led by Rep. Paul Ryan are unveiling a new budget proposal. At the heart of the plan is a phase-out of Medicare for Americans who today are under the age of 55. In its place, the government would subsidize the cost of private insurance plans that retirees would purchase on their own. Think of it as the same employer-based system you have now at work, except that the government would pay some of the cost of the plan after you retire, and you would be responsible for the rest.

This concept is sure to face a ton of backlash, as it shifts the burden of surging healthcare costs from the government directly into the pockets of the middle class America. However, imagine how great it would be for the insurance industry and the HMO stocks. Not only would the HMO companies operate in an environment where people were required to buy a plan from them, but all of the country’s retirees would become their customers, whereas today they don’t sell plans to any retirees who qualify for Medicare.

This is surely a development to watch, not only from the standpoint of future retirement planning, but also in terms of how you analyze potential healthcare investments in the future. The U.S. healthcare system is already run based on how much profit can be generated (not how to give the best care for the lowest price) and this new plan would transfer even more wealth from the pockets of Americans to the coffers of the insurance industry. Not good for us, but great for the HMO stocks!

GE is the Poster Child for Why the U.S. Must Revamp Its Income Tax System

News that General Electric (GE) earned more than $5 billion from its U.S. operations last year and yet paid absolutely zero in corporate taxes should disturb everyone who is concerned with the federal government’s budget deficit, or even just fairness more generally. Yesterday’s New York Times story entitled “GE’s Strategies Let It Avoid Taxes Altogether” sheds light on yet another way the lack of common sense in Congress is costing us financially. Here is one of the more astonishing facts from the article:

“While the financial crisis led G.E. to post a loss in the United States in 2009, regulatory filings show that in the last five years, G.E. has accumulated $26 billion in American profits, and received a net tax benefit from the I.R.S. of $4.1 billion.”

And yes, many people are complaining that the U.S. corporate tax rate of 35% is too high and must be lowered for us to be more competitive with the rest of the world. And if every firm paid that rate, I would certainly agree, but we need to change the system so that everyone pays their fair share and the number of tax lawyers you can afford to hire does not determine how much income tax your company forks over. If that is accomplished by closing loopholes and simultaneously reducing the corporate tax rate (provided firms actually pay that rate), then we should be all for it. There is absolutely no excuse for one of the country’s largest and most profitable companies to not pay a dime in corporate taxes.

Deficit? What’s Another $1 Trillion Among Friends?

So much for having any optimism on the budget front after a bipartisan majority voted for a sweeping plan that would cut the deficit to 3% of GDP by 2015 and balance the federal government’s books by 2025. Democrats and Republicans are gearing up to vote early next week on a nearly $1 trillion tax cut package. What’s worse is that not a dime of it is paid for, so the entire cost (initially estimated by the Congressional Budget Office to be more than $850 billion over 10 years).

Given these developments it is not hard to understand why treasury bond rates are surging, despite the Fed’s massive $600 billion asset purchase plan. Even with the drop in bond prices, U.S. government debt continues to be the most overvalued asset class out there (maybe with the exception of cloud computing stocks). Selecting solid corporate bonds and holding them until maturity appears to be the far better investment today, even after the strong performance we have seen from them over the last couple of years. Bond buyers better tread carefully.

Finally, A Concrete Income Tax Simplification & Reform Plan That Makes Sense!

Continuing the post from yesterday about the ideas put forth by the co-chairmen of the Obama Administration’s deficit reduction commission, I skimmed through the 50-page presentation (you can do the same here if you would like to) and there is a lot to like in it. One of my favorites is a real, well thought out plan to simplify the U.S. income tax code. I mentioned in my last post why I think the mortgage interest deduction is ridiculous, but the whole code is too complicated with so many brackets, schedules, and deductions.

One of the things that bothers me the most is that income is taxed differently depending on how you earn it. Shouldn’t a dollar of income be considered a dollar of income, regardless of whether you are an employee earning a fixed salary, a CEO who cashes out stock options, a retiree who lives off of dividend payments, or a hedge fund manager who trades stocks for a living? Our current tax code essentially tells us that certain ways of earning a living are better than others by rewarding them with lower tax rates. It doesn’t make sense that George Soros or Warren Buffett should ever be in a lower tax bracket than their secretaries, but today they are.

But maybe there is hope. The co-chairs of the commission put forth three options for fundamental simplification of the tax code and one of them really stands out to me. They propose eliminating all tax deductions, treating all income as ordinary income (rather than having dividend income and capital gains income be taxed at lower rates), reducing the total number of tax brackets from six to three, and best of all, dramatically reducing income tax rates for everyone to make up for the loss of deductions.

Here is the slide in the presentation that summaries this option:

As you can see, we are left with three individual income tax brackets (8%, 14%, and 23%) along with a reduction in the corporate rate (which will serve to boost stock prices and declared dividends).

Does anyone else think that treating all income the same and taxing it at 8, 14 or 23% makes a lot of sense? I know people will have to give up their standard deduction or several itemized deductions (such as mortgage interest and charitable donations) but look at those rates! Not only would it be hard to argue that the government was taxing us too aggressively, but without deductions you can bet that your tax return will be confined to a single page and take a lot less time to prepare. And most importantly, this recommendation is included in a comprehensive plan that reduces the deficit to 2.2% of GDP by 2015 and eventually balances the budget.

I know it will never fly with the politicians but I am going to hold out hope anyway as it is exactly the kind of plan that I would create if given the power to do so.

Bipartisan Deficit Reduction Commission Brings Some Sanity to Budget Debate

According to a story from the Associated Press, it appears that President Obama’s bipartisan deficit reduction commission is ready to bring some realism and logic to Washington on ways to reduce the federal budget deficit. Of course, the odds that politicians will support these ideas are low since they have proven lately that they believe in magic (on one hand calling for deficit reduction while on the other refusing to support entitlement spending cuts or tax increases — both of which are needed to balance the budget).

Not all is lost though, according to this AP story. I say that because the recommendations being put forth by the two leaders of the commission (one from each party) are exactly the kinds of budget cuts that we should be talking about. Social security and defense spending together account for about 40% of government spending, making it imperative not to deem those areas “untouchable.” I was also happy to see that they mentioned farm subsidies and the mortgage interest deduction as other areas of focus.

While the mortgage interest deduction is a tough sell politically (if eliminated it would hit the middle class), it costs the United States about $100 billion per year and makes little sense from a policy perspective. In a day and age when many Americans believe that Washington, DC is spending money unnecessarily, why should the federal government help us out with our mortgage payments? Really, that is all the mortgage interest deduction is, the federal government reimbursing you for a portion of your mortgage. There is no reason whatsoever for a government running annual deficits of over $1 trillion to be paying some of people’s mortgages.

Let’s cross our fingers that the new Congress, filled with people who got elected by campaigning on deficit reduction, actually deliver on their promises and support some of the commission’s recommendations, because if they don’t real cuts will be impossible.

Political Gridlock Good for Markets? Another Common Theory Debunked

Stock markets love gridlock. This is what one would think after listening to investment pundits in the media. The thinking goes that markets hate uncertainty and with gridlock in Washington very little actually gets done, eliminating fears of new, unexpected legislation. However, a quick look at the numbers show that this theory is completely wrong.

Sam Stovall of Standard and Poor’s looked at historical U.S. stock market returns under three political scenarios, “unity” (one party controlling the presidency and both houses of Congress), “partial gridlock” (one party holding the presidency and another controlling Congress), and “total gridlock” (a split Congress). The results since 1900 show that the stock market actually hates gridlock. How this stuff gets repeated so often in the financial and political media is beyond me.

Annual Stock Market Returns Under Three Political Scenarios (Source: S&P)

Since 1900:     Unity +7.6%       Partial Gridlock +6.8%     Total Gridlock +2.0%

Since 1945:     Unity +10.7%     Partial Gridlock +7.6%     Total Gridlock +3.5%