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Tuesday, April 15, 2014

This Manic-Depressive Market Needs Earnings Season to Begin

By Louis Navellier

The stock market rallied strongly in the middle of last week, mostly on news of the “dovish” minutes from the last FOMC meeting, but then stocks fell sharply in the last two days of the week. NASDAQ fell 4.4% from Wednesday’s close to just below 4000 on Friday’s close. The S&P 500 fell 3% in the same two days. Although some “momentum” type stocks were hit with profit taking, some other stocks with strong sales and earnings momentum rebounded impressively in anticipation of positive first-quarter earnings announcements. The bottom line is that we believe this “manic-depressive” market environment should sort itself out during the upcoming earnings announcement season, which may fuel a strong rebound.

Meanwhile, today is tax-filing day, and my senior writer Gary Alexander has some encouraging news on how enlightened tax policies can spur economic and market growth. But first, Ivan Martchev will cover the latest excitement over Michael Lewis’ best-seller Flash Boys, plus the risks of investing in China now. Then, I’ll return with the latest economic statistics and outlook for sustainable global growth. It’s important to remember that markets tend to rise or fall based on economic fundamentals and the financial health of specific companies traded on major exchanges, so we try to tune out the “noise” and focus on the facts.

In This Issue

Income Mail:

Flash Boys is Still No. 1

by Ivan Martchev

My First Encounter with Lewis, in Liar’s Poker

Two Canaries for a Chinese Coal Mine

Growth Mail:

Tax Policies for Promoting Maximum Growth

by Gary Alexander

The Mellon/Coolidge Tax Cuts Fueled a Decade of Prosperity

Democrats did it too: The 1960s Kennedy-Johnson Tax Cuts

The Investment Payoff – Lower Rates Spur Economic and Market Growth

Stat of the Week:

High Inflation Returns in March

by Louis Navellier

Greek Bonds Fall Below 5% Yields as Europe Recovers

FOMC Minutes are “More Dovish” and “Less Hawkish”

Income Mail:

Flash Boys is Still No. 1

By Ivan Martchev

Ever since it came out 24 days ago, Flash Boys has been at the top of Amazon's best seller list. This is not a scientific survey, but the result of periodic checks every couple of days to see what is happening with the book as a real-life barometer of the understanding of high-frequency trading (HFT).

Perusing the top spots of Amazon's ranking of new releases, one gets a hint of the bipolar nature of U.S. society. There are a lot of books about new diets and quite a few on political issues. At one point in my non-scientific checkups of Flash Boys' demand, Rush Limbaugh's Rush Revere and the First Patriots was adjacent to Ariana Huffington's Thrive. Gladly for the fans on both sides, the two books are no longer situated next to each other on Amazon's ranking list. (At one point I was seriously concerned that my computer screen would emit electrical sparks between those two titles and become a fire hazard).

My First Encounter with Lewis, in Liar’s Poker

I read Lewis' best-seller Liar’s Poker maybe 20 years ago and thought it was a good book, but in retrospect I never really “got” it at the time. I worked in a related field to finance in the wild world of publishing in the suburbs around Washington, DC, and Liar’s Poker somehow did not relate to me.

Luckily, I had occasion to read it again. Back in 2008 while changing planes at the airport in Frankfurt, I had a couple of hours until my next flight and found a paperback edition of Liar’s Poker (in English) in a “duty free” shop.

I sat in front of the gate to wait for my flight, and I started reading. Since I read it the first time, I moved to New York and experienced first-hand the type of characters Lewis describes in Liar’s Poker, which gave me a whole different viewpoint on his book:

“Often as not, our chairman just hovered quietly for a bit, then left. You might never have seen him. The only trace I found of him on two of these occasions was a turd-like ash on the floor beside my chair, left, I suppose, as a calling card. Gutfreund's cigar droppings were longer and better formed than those of the average Salomon boss. I always assumed that he smoked a more expensive blend than the rest, purchased with a few of the $40 million he had cleared on the sale of Salomon Brothers in 1981 (or a few of the $3.1 million he paid himself in 1986, more than any other Wall Street CEO).”

If I had to summarize Liar’s Poker, it is about the disappointments of a young man that ended up on Wall Street after considerable effort and discovered that it is not as glorious as it sounded on the outside. Lewis undresses the elite in one of the biggest Wall Street firms and reduces it to its very substance—greed and fear. Early reviews of Flash Boys indicate Lewis will reveal more of the big questions about how Wall Street continues to evolve in complex ways beyond the experience of the average investor. Ultimately the message from his new book will turn out to be about the same two things that Liar’s Poker was about, greed and fear.

After all, it is a book about Wall Street.

Two Canaries for a Chinese Coal Mine

One of the traders from an institutional asset management firm situated in New York stopped by my office to chat about the recent correction. I told him we have not really seen a correction in the U.S. market in six quarters, save for a few two-week declines here and there that so far have always seen a new all-time high after they were over.

“I am not really worried about the U.S. market.” I said. “The Chinese export numbers in February were quite weak, down 18.1% from a year earlier. For March they are down 6.6%. There is weak demand for Chinese-made goods at a time when their own economy is decelerating. The forced lending that helped stabilize the economy in 2009 is beginning to come back and haunt them.”

“How so?” he asked.

Change In U.S. and Chinese Total Bank Assets Chart

Source: Bloomberg. Graphs are illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

“Well, Chinese bank assets are out of control. The Chinese financial system is producing credit that is generating ever smaller GDP growth rates, yet with more debt in the system. Chinese authorities tried to rein this in last year, but they stepped back, since it created a credit crunch in the economy. Many firms can't get normal loans from banks so they end up paying double the interest rate—or more in some cases—to get loans from unregulated subsidiaries of major banks or stand-alone finance companies that comprise the shadow banking sector. You see, the wealthy Chinese are the last source of financing for credit-starved corporate borrowers and real-estate developers that are building properties at an all-time low in affordability and at all-time highs in prices.”

“I have heard that before. This sounds like 2005 in the U.S.,” he told me.

“That's right. And I have two canary stocks for you to consider. Both companies caught in this mess. There are more in China, but these two have ADRs so you can see the filings.”

The two companies are SouFun Holdings* (SFUN) and Noah Holdings* (NOAH).

SouFun Holdings Ltd. Chart

Source: Graphs are illustrative and discussion purposes only. Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. Performance results presented herein do not necessarily indicate future performance. Please read important disclosures at the end of this commentary.

SouFun operates the largest real estate listing portal in China. A rising Chinese real estate market causes more turnover and more listings—this is good for SouFun. As it had a first mover advantage, it now controls the largest amount of eyeballs, so it is difficult to compete with the company. This is similar to eBay (EBAY) or Craigslist in the U.S. Yahoo* (YHOO) can't compete well with eBay in auctions in the U.S., and eBay itself has trouble competing with Craigslist as they had the first-mover advantage in classifieds. SouFun has had great operational performance, and it split 5:1 recently. It is a second derivative play on the Chinese real estate market. This recent action could very well be a necessary correction, but operational developments here are certainly to be monitored extra carefully.

Noah Holdings Ltd. Chart

Source: Graphs are illustrative and discussion purposes only. Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. Performance results presented herein do not necessarily indicate future performance. Please read important disclosures at the end of this commentary.

Next is Noah Holdings (NOAH). There is an item in the release of 2013 earnings in February that is rather peculiar: “Active clients for the full year 2013 were 6,445, a 55.2% increase from 2012. The aggregate value of wealth management products distributed by the Company for the full year 2013 was RMB44.5 billion (approximately US$7.2 billion), a 77.1% increase from 2012. Of this aggregate value, fixed income products accounted for 80.3%, private equity fund products accounted for 14.4%, and other products, including mutual fund products, private securities investment funds and insurance products, accounted for 5.3%. The average transaction value per client for the full year 2013 was RMB6.9 million (approximately US$1.1 million), a 14.1% increase from 2012, primarily because individual clients purchased more products distributed by us when their previously purchased products matured.”

So wealth management products saw a 77.1% year-over-year growth but 80.3% were fixed-income products, a.k.a. repackaged shadow banking loans.

Shadow banking as an idea is not bad. Neither are AAA-rated subprime CDOs that offer real-estate funding that otherwise would not be available. It is when shadow banking gets a disproportionately large share of the market compared to normal banking and ends up financing activities that otherwise would not get financing, or should not get financing based on their economic merits. That is when shadow banking becomes similar to an AAA-rated subprime CDO. I don't know if we are at that point in China yet, but I am perusing the economic data extra carefully as well as the press releases of those two canary companies.

Growth Mail:

Tax Policies for Promoting Maximum Growth

By Gary Alexander

“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”

— Jean Baptiste Colbert (1619-1683), Minister of Finance to King Louis XIV of France

April 15 has suffered bad press for 150 years: In the early morning hours of April 15, 1865, President Abraham Lincoln died of a gunshot wound he suffered the night before at Ford’s Theater. Then, in 1912, the RMS Titanic sank at 2:27 am on April 15, losing two thirds (1,517 of 2,227) of its passengers and crew. On April 15, 1920, “anarchists” Sacco and Vanzetti allegedly killed two Massachusetts men in a controversial 1920s murder case. Then, on April 15, 1927, 15 inches of rain fell on New Orleans in just 18 hours, resulting in the Great Mississippi Flood, the worst river flood in American history, killing 246.

Something less dramatic happened on April 15, 1955. In Des Plaines, Illinois, Ray Kroc opened his first franchised McDonald’s outlet. On the same day, Americans filed their first IRS Form 1040 forms on the new due date that year, April 15, making today the 60th straight IRS tax deadline falling in mid-April.

April 15 wasn’t the first tax deadline. After the passage of the 16th Amendment authorizing income taxes, the first IRS filing date was March 1, 1913, less than a year after the Titanic disaster. In 1913, the top tax rate was just 7%, but few workers made enough money to pay that rate. In 1918, tax day was pushed up to March 15, giving new meaning to the warning, “Beware the Ides of March.” By 1918, however, the top federal income tax rate had already risen to 67%, in part to finance the heavy costs of World War I.

These super-high tax rates continued after World War I ended, pushing the U.S. into a sharp depression. Real GDP fell three consecutive years (1919, 1920, and 1921) by a total of 16%. Deflation reigned from 1920 to 1922, but then came a political master stroke in the art of taxation, a way of forcing more “geese” to pay more taxes with less “hissing.” It was the first of four major tax-rate cuts in the last 100 years.

The Mellon/Coolidge Tax Cuts Fueled a Decade of Prosperity

“Changes in marginal income tax rates cause individuals and businesses to change their behavior. As tax rates rise, taxpayers reduce taxable income by working less, retiring earlier, scaling back plans to start or expand businesses, moving activities to the underground economy, restructuring companies and spending more time and money on accountants to minimize taxes. Tax rate cuts reduce such distortions and cause the tax base to expand as tax avoidance falls and the economy grows.” – Veronique de Rugy, the CATO Institute: “1920s Income Tax Cuts Sparked Economic Growth and Raised Federal Revenues,” March 4, 2003.

A series of 1920s tax cuts, engineered by Secretary of the Treasury Andrew Mellon (serving Presidents Harding, Coolidge, and Hoover), reduced the top income tax rate from 60% to 25%, but amazingly the amount of taxes paid by the rich (earning over $100,000) grew from $321 million in 1920 to $714 million in 1928, while their share of total taxes paid grew from less than 30% to over 60%. Meanwhile, those earning under $5,000 paid barely 1% of all incomes taxes by 1928 vs. 15.4% of all taxes in 1920.

  -- Taxes Paid (mil. $) -- -- Share of Taxes Paid --
Source: CATO Institute, based on U.S. Department of Treasury annual “Statistics of Income,” 1920-28.
Income level 1920 1928 1920 1928
Under $5,000 $166 $13 15.4% 1.1%
$5,000 to $100,000 $588 $437 54.7% 37.5%
Over $100,000 $321 $714 29.9% 61.3%

These tax cuts fueled the Roaring 20s, a bonanza of prosperity. From 1922 to 1929, real GDP grew by 4.7% per year, and the unemployment rate fell from 6.7% to 3.2%. In a time of low inflation, the number of taxpayers in the highest income bracket (over $100,000) almost quadrupled, while the upper middle class earning $10,000 to $100,000 grew by 84% and taxpayers reporting less than $10,000 per year fell.

Marginal Tax Rate, Tax Paid, and Tax Share for Those with Income over $100,000.

Marginal Tax Rates, Etc. Chart

Source: U.S. Department of Treasury, "Statistics of Income," annual 1920 to 1929. The tax rate shown is for taxpayers at $100,000; for years before 1925, the top rate was even higher. — From the CATO Institute. Graphs are for discussion purposes only.

The same basic story was repeated during the Kennedy-Johnson tax cuts of the 1960s, the Reagan tax cuts of the 1980s, and the 2003 Bush tax cuts. Federal tax receipts rose rapidly when the top tax rates were cut.

Democrats did it too: The 1960s Kennedy-Johnson Tax Cuts

“It is a paradoxical truth that … the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out. This country’s own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.” – John F. Kennedy at a news conference, November 20, 1962.

President John F. Kennedy introduced the “Republican sounding” idea of lower tax rates on August 13, 1962, proposing an “across-the-board, top-to-bottom” tax cut in corporate and personal tax rates, to take effect in 1963. Kennedy repeated similar arguments to the press and the American public several times.

Kennedy wasn’t successful in passing his desired tax cuts before his life was cut short, but his successor, Lyndon Johnson, signed Kennedy’s idea into law in the Revenue Act of 1964, taking effect on February 26, 1964. This law cut the top rate from 91% to 70%, while reducing taxes in all the other brackets and adding a standard deduction. Prosperity erupted: The jobless rate fell from 5.2% in 1964 to 3.8% in 1966 and 3.5% in 1969. Tax revenues increased each year – so much so that the federal budget reached surplus in 1969, despite LBJ’s guns and butter spending, plus landing men on the moon and launching Medicare.

Alas, top tax rates at 70% depressed GDP growth in the 1970s until the Kemp-Roth tax bill (Economic Recovery Tax Act of 1981, or ERTA), passed into law August 4, 1981, reducing the top income tax rate from 70% to 50% while phasing in 25% cuts in most tax rates over the next three years – 1981 to 1983.

Income Tax Share of the Top 1 Percent and the Bottom 90 Percent Chart

Source: Tax Foundation. Graphs are for discussion purposes only.

During the Reagan years, the percentage of income taxes paid by the richest 1% rose from about 18% in 1981 to 28% in 1988, while the share paid by the bottom 90% shrank from about 52% to 42%. The lines crossed in the late Clinton years before retreating during the 2001 recession and 9/11. But since the Bush tax cuts of 2003, the top 1% of taxpayers have paid more federal income tax than all of the bottom 90%.

P.S. This pleasant but widely misunderstood outcome is still routinely libeled as a “tax cut for the rich.”

The “Jobs & Growth Tax Relief Reconciliation Act of 2003,” passed into law on May 28, 2003, reduced the top tax rate to 35%, while sharply cutting long-term capital gains and dividend taxes. The resulting prosperity engendered rising tax collections, causing the federal deficit to shrink each year, 2004-07:

Year Federal Deficit(billions) Unemployment Rate
Source: U.S. Office of Management and Budget (deficit); BLS (unemployment)
2004 $428.0 5.6%
2005 $318.3 5.1%
2006 $239.6 4.6%
2007 $151.1 4.6%

The Investment Payoff – Lower Rates Spur Economic and Market Growth

Now for the investment payoff: The stock market surged during each of these four tax-cutting decades:

Major Bull Markets Accompanying Major Tax-Cut Decades

Decade Low High Dow Gain
Source: Stock Traders’ Almanac 2010
1920s 1921 (August 21) 1929 (September 3) 496.5%
1960s 1962 (June 26) 1966 (February 9) 85.7%
1980s 1982 (August 13) 1987 (August 25) 250.4%
2000s 2002 (October 9) 2007 (October 10) 97.3%

Where do we stand today? Do we need another top tax rate cut? I’ll probably anger my libertarian and Republican friends by saying “no, not necessarily.” I’d welcome a tax cut, but I monitor how much the “geese are hissing,” and I don’t hear much resistance to current rates, so let’s leave income taxes alone.

What needs attention now is the corporate tax rate. Too much corporate money is sitting in overseas bank accounts, since corporate profits are punished here at home. The U.S. has the highest corporate income tax rate in the developed world, at 39.1%, well above the OECD overage of 25%. Ireland has staged a near-miraculous economic recovery by lowering its corporate tax rate to 12%, lowest in the OECD.

Top Statutory Corporate Tax Rate Chart

Source: Tax Foundation

The lesson? I believe Congress should cut U.S. corporate taxes to 25% or lower, to become more competitive in global markets and more states should lower personal and corporate tax rates to energize local business.

Stat of the Week:

High Inflation Returns in March

By Louis Navellier

TLast Friday, the Labor Department announced that the Producer Price Index (PPI) rose 0.5% (a 6% annual rate) in March, due largely to a 1.1% rise in food costs and a 0.7% rise in wholesale services, offsetting energy price declines of 1.2%. Excluding food and energy, the core PPI rose 0.6%.

We’ll see if there’s a similar surge in Consumer Price Inflation, released later today. In the meantime, there was some good news in business sentiment and hiring. Last Tuesday, the National Federation of Independent Business announced that its small business optimism index rose to 93.4 in March vs. 91.4 in February. Six of 10 components rose, led by the anticipation of strong capital outlays and sales growth. Also on Tuesday, MarketWatch reported 4.17 million job openings in February, up 4% in the past year.

Last Friday, the University of Michigan/Reuters announced that its preliminary consumer sentiment for April rose to 82.6, up from a final reading of 80 in March. As a result, consumer sentiment is now at the highest level since July, which bodes well for April retail sales and second quarter GDP growth.

Greek Bonds Fall Below 5% Yields as Europe Recovers

A serious candidate for my “stat of the week” was the low bond yield rate in Greece, which successfully issued $4.14 billion in new five-year bonds last Thursday at a yield of just 4.95%. In 2012, Greek 10-year bond yields peaked at over 30%. Greek 10-year bonds fell well below 6% last week. The strong euro has helped make Greece’s debt attractive to potential bond buyers. Clearly, the European Central Bank (ECB) and the International Monetary Fund (IMF) have successfully helped get Greece back on its feet.

Speaking of the IMF, on Tuesday the IMF issued its revised outlook for global growth this year and next year. For this year, the IMF is estimating 2.8% GDP growth for the U.S., 1.2% for the euro-zone, 1.4% for Japan, 1.8% for Brazil, 3% for Mexico, 5.4% for India, and 7.5% for China. The overall global economy is expected to grow 3.6% this year and 3.9% in 2015, with emerging markets and developing economies growing even faster, at a composite growth rate of 4.9% this year and 5.3% next year.

New IMF Projected GDP Growth Rates, 2014 and 2015

Country 2014 2015
Source: : International Monetary Fund (IMF) World Economic Outlook, released April 8, 2014
China 7.5% 7.3%
India 5.4% 6.4%
United States 2.8% 3.0%
Brazil 1.8% 2.7%
Japan 1.4% 1.0%
Russia 1.3% 2.3%
Eurozone 1.2% 1.5%
Global Growth 3.6% 3.9%
Emerging Markets 4.9% 5.3%

FOMC Minutes are “More Dovish” and “Less Hawkish”

What got Wall Street most excited last week was Wednesday’s revelation of the minutes of March’s Federal Open Market Committee (FOMC) meeting. The FOMC minutes were more “dovish” than expected. Many FOMC members thought the Fed’s forecasted interest rates were too high. The fact that many FOMC members questioned the Fed’s interest rate guidance reassured Wall Street that interest rates may remain low for much longer than Yellen implied in her post-meeting press conference.

After reviewing the FOMC minutes, Ian Shepherdson, chief economist at Pantheon Macroeconomics, said, “There is nothing hawkish in here.” In the FOMC minutes, the Fed said it will “take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments” before deciding to raise short-term rates. Translated from Fedspeak, interest rates are likely to continue to remain low for a lot longer than Yellen previously implied, and the Fed’s official interest rate forecasts are likely too high.

There’s one more piece of good news out of Washington. As we prepare our tax filings (or file an extension) today, it’s great to hear that the U.S. budget deficit has fallen 31% in the first six months of fiscal 2014. Last Thursday, the Treasury Department reported that the March 2014 federal government deficit was only $37 billion, down 65% vs. the $107 billion in March 2013. For the first six months of fiscal 2014, federal spending has fallen 4% to $1.734 trillion, while tax receipts have risen 10% to $1.321 trillion. Since the Treasury Department is borrowing less money, there is a better chance that interest rates might stay low, which takes pressure off the Fed. Higher tax receipts are a reflection that the U.S. economy is steadily improving. The best way to balance a budget is through growth, not higher tax rates.

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