Today the S&P 500 stock index is up over 11% for 2012 and sits within 10% of its all time high,  although we are currently in a  relatively weak economic environment with high levels of uncertainty.  Much of this is catch-up is based on the strong corporate earnings performances over the last two years.  The current P/E of the index is 14, on projected earnings for 2012 and is not excessive by historical standards.  Upon further review we see that the current index performance for 2012 is concentrated in 30 stocks, which we will call the sturdy 30.  This performance is lead by Sears, Apple and a number of recovering national and regional banks.  The remainder of the 470 securities of the index are performing at less than 6% on average.  Looks a bit familar when compared to what transpired during the early 70′s.

Now we know that no two market periods are exactly alike and economic conditions vary from period to period.  Sometimes though market psychology and the herd mentality continue to persist and history does repeat itself.  Although the current P/E ratios of the sturdy 30 are not at the levels of the 40-70 times earnings of the nifty fifty, there is the concern that mutual and hedge fund managers concentration in relatively few stocks  can lead to major market declines as they move in tandum to exist a momentum strategy. 

If you review any major growth fund the percentage of Apple and Google in their portfolios can approach 8%-12%.  When everyone is holding the same security the earnings growth performance must be maintained.  If a quarter fails to meet expectations, due to business conditions or economic growth then these growth stocks and the stock averages are being set-up for major declines as everyone attempts to exit.  This is the major concern going forward.  I would hate to be a fund manager that is concentrated in these 30 stocks in this type of environment, especially with a potentially slowing economy in 2013.  We know what the result was in 1974 as the nifty fifty became victims of the recession with drops of 70%-90% in value as the general market was falling 50%

  With the expected slowdown in growth relating to tax policy that could lead to a recession next year we will see an impact on these widely held securities.  The lesson that can be learned from the 70′s and applied to the remainder of 2012 and next year is to remain diversified across all asset classes and do not rely on a concentration in relatively few stocks.  We are resisting the urge to overweight and continue to look instead for undervalued securities, especially in the energy and health care sectors.  We believe that these groups provide the best risk reward opportunity going forward and that the sturdy thirty are potentially built on a house of cards.

The real result of this debate is an attempt to modify the tax code to solve all perceived social evils and place more rules and regulations that increase the complexity and ability for the educated to take advantage of the code. This system also benefits  employment for professionals that do nothing but interpret the code and advise clients for compensation.

Why does the public rhetoric rarely match the legislative reality? With the amount of people in high paying influential positions with excessive lobbying power we will never see the truly simplified version of the code that could act as a stimulus to the economy and alleviate all the anxiety in the taxpaying public. There are approximately 115,000 IRS employees that administer the tax code. The government is proposing adding an additional 17,000. The registered lawyer community is approximately 1,143,000 and is increasing by 5% each year. Many of these lawyers are tax and estate planning attorneys that rely on their income interpreting the tax code. The tax preparer industry has a similar amount of people that thrive on the complexity of the code.

With all these people having a vested interest in code complexity and each having a significant lobby presence in Washington it is obvious why the code never gets modified to support incremental entrepreneurship and investment. Instead we get changes that attempt to support some social cause and raise revenues for additional transfer payments, raising the marginal tax rates to approach 50% in high tax states and additional rules and regulations.  This discourages work and creates no additional economic value added.

The fact is that many taxpayers already pay a version of the flat tax, called the alternative minimum tax. This is the tax that is charged after you have paid a preparer to develop your tax return through the tax code. This is after hours of work and a bill for $400-$1,000. Afterward the tax is modified by eliminating certain deductions, mostly that relate to state taxes and a flat 26% is levied on a portion of income and 28% on the rest. Truly a flat tax with minimal deductions. Why can’t this be expanded with lower tax rates to all taxpayers and eliminate the complexity that only benefits tax lawyers, tax accountants and IRS agents?

We must ask all candidates for congress where they stand on tax simplification. If they do not have a response or a specific proposal that reduces marginal tax rates and promotes fairness by reducing deductions and adjustments then they cannot possibly improve the current level of unemployment. They need to be replaced with someone that understands the economic benefit of tax simplification and lower marginal rates. We need leadership that will overcome the lobbyists and the people that promote only their self interest by maintaining the current tax system that discourage work and provides only administrative legal and accounting positions with minimal benefit to the economy.

The industries that are being impacted are home building, health care and education. At the latest review all three were ranked at the bottom in valuation and are currently 20%-30% undervalued. All three were at one time domestic growth industries and a recovery in all three will be required to move the economy forward and reduce unemployment. Unfortunately the current overhang of pending legislation and the recently passed health care reform are acting as a major constraint for future investment in these industries .

The first industry requiring attention is home building.  In good times homebuilding can represent 5% of GDP and with support industries the total impact can be up to 17% of GDP.  This industry is vital to a complete recovery of the economy.  Unfortunately it has been left in the hands of Fannie Mae and Freddie Mac that are currently approving 88% of all mortgages written.  These are the same people that caused the bubble in home building with loose lending standards and the support of the Congress.  Now they have put a strangle hold on mortgages that is slowing the recovery in housing and contributing to the current decline in home prices.  Removing the restrictions on banks to lend to this industry is mandatory to assist in the recovery.  I am not talking about going back to the sub prime era.  What is necessary are rules that make sense with proper down payment requirements and income verification.  Capital will not again flow into this industry until common sense rules are adopted and the current low approval rates  lifted.

The next industry is health care, currently 20% of the U.S. economy.  The uncertainty created by the imposed government health care reform is restricting capital flow to this key domestic industry.  Medicare reimbursements to home health care, nursing homes, hmo’s and hospitals are projected to decline 5% in both 2011 and 2012.  With the revenue uncertainty all these businesses, that will see demand increasing in the future, will be looking for additional capital infusions to increase capacity.  However, with the current government regulation and control on these business capital will seek other more profitable avenues.  Again we will have government regulations and controls impacting the growth and employment opportunities in a key domestic industry.

The third key industry for the future economic well being is secondary education.  The “for profit” education industry has played a major role over the last 15 years in advancing education in college and post graduate education.  When we have dropped as a nation from first in graduating the most college students annually to 8th in the world it would seem that we do not want to destroy any avenues for students to achieve success.  However, the government is now reviewing this industry and is in the process of evaluating the success of graduates from these programs.  The evaluation criteria will be based on attainment of employment by recent graduates.  If there is difficulty in finding employment in certain fields these “for profit” programs might not be reimbursed for loans that are being used to finance the students education.  Unfortunately the same rules will not apply for public institutions.  This in effect will reduce enrollment and create major uncertainty in this industry.  Capital has begun to flee with the stocks down 40% for the year as retraining avenues for our current workforce is at its greatest need.  I do not see why the government must come between the student and their selection of educational institution.  They should consistently apply student loan standards based on the students ability to pay and if necessary require cosigning to insure repayment.  All educational institutions should be under the same standard.

This is why I think in our domestic economy the government is picking the winners and losers.  This must change if capital is to flow into these key industries where their recovery is being held back by excessive regulation and uncertainty.  Without a change in policy we will see capital continue to flee to foreign markets and industries that rely on domestic demand will have to rely on government largess and inefficient borrowing to survive. This will allocate resources inefficiently and as with health care expand the deficit to unsustainable levels.  Until change occurs here I would avoid the stocks in these industries.

The first sign is the recent vote on the extension of unemployment benefits. At first there were not enough votes in the Senate but eventually political will cracked for controlling the deficit and the extension was passed. Now the house will pick up the vote where passage is a certainty. Coincidently the extension will terminate after the elections in November.

If the economy remains weak, especially retail sales with steady unemployment, there will be mounting pressure to apply further stimulus to the economy. Since the most recent $1 Trillion package has had minimal impact in providing permanent jobs the only hope is that the new package will focus on creating a more permanent demand by lifting consumer confidence and employment. My fear is that additional state government aid will be the centerpiece of “Son of Stimulus.” This will delay the inevitable state downsizing that is necessary to get most state budgets on track and will not provide any permanent jobs going forward.

What I would like to see is a restructuring of all outstanding mortgages to the current market interest rates, if the borrower is in good standing, regardless of the current home to mortgage value. For example if the existing mortgage rate on the borrower’s home is 5.5% and the market rate is 4.25% the borrower that is current on their payment would see an automatic refinance reduction in their mortgage payment. By applying to borrower’s in good standing there would be an incentive to stay in their house, even if it is currently underwater. This could stabilize the home market and provide income to people that have faithfully meet there obligations, regardless of the temporary situation. They have not tried to game the system and would be rewarded. Since most people are current on their house payment the reduction would be a significant boost to personal income. Some of this income would be spent on consumption and provide a natural stimulus to the economy.

People could respond, how about the bank’s income due to the reduction in interest charged? There would be a temporary reduction due to the refinance but the longer term benefit for the banks or whoever holds the mortgage paper would be increased stability in the market and less short sales and home foreclosures. Lets stimulate in a way that will create a lasting improvement in personal income and focus the effort on the one last great domestic industry, housing.

The implication for investors of the potential “Son of Stimulus” bill is to provide a floor under the market. We have just experienced a difficult 2nd quarter with market averages down double digits across the board. With the election approaching you can count on the incumbent party doing anything in its power to save the day before the elections.

The main issue surrounding the projected multi trillion deficit is the current spending in Washington. Federal employment has risen 17% since 2007. Costs keep escalating at a rate of 8% per year, when the inflation rate is less that 2%. This is a government that is clearly out of control. It is not a partisan issue. Both parties are to blame as the deficit has exploded over the last 10 years.

Why is this now such a concern? Just like a company that has excess borrowing as a % of its capital sees its growth options limited, the government will see that our future GDP growth rate has been compromised. Also, as a firm with excessive borrowing that will see its interest rates rise the Federal government with see higher interest rates in the future. State governments are already seeing a sharp increase in their debt loads and borrowing costs. This increase in debt cost will further limit spending options in the future and act as a constraint on the economy.

That is why the number one debate issue is spending. Unfortunately the congress would rather defer this painful discussion. We need leadership and decisive action. All departments should be reviewed to determine the need to maintain them.  There are currently 15 Federal departments.  All functions of each department should be reviewed for over lap and potential consolidation.  I appreciate the Presidents pay freeze but what is necessary is major personnel reductions to reduce cost over time. Just as a business that is bloated must reduce personnel and expense the Federal government must do the same.  Also Congressional and Judicial offices should be overhauled and reviewed for potential savings.  Until this exercise is performed entitlements and taxes should not be touched as a way to reduce the deficit.

The investment implications of the rising tide of debt are obviously rising borrowing costs.  Interest rates have already increased 1% from the low when the Fed announced QE-2.  All long term bond funds should be sold, as well as bonds with maturities greater than 7 years.  Instead concentrate on floating rate funds that will see rising interest rates.  Also convertible bonds offer some potential appreciation since they are linked to stock prices.  Foreign bonds may be a safe have but only in emerging markets.  Until Congress gets it’s act together government bond rates will be under pressure, along with the U.S. dollar.

This person’s current rate of interest was in excess of 7% and with an adjustment to the market rate of 4.25% he could have maintained his payments and stayed in the house. Instead this will be another situation of a foreclosure/short sale depressing property values and generating losses for the banking system.

When will congress address this issue? People that have maintained their payments in this adverse environment and can continue to occupy their houses with some interest rate relief should begin to receive priority on Capital Hill. I have discussed this issue in recent blogs and have heard some commentators present similar concepts but still there is nothing in legislation that is addressing the individual homeowner’s plight.  By reducing all current payers interest rates to the market, without closing costs, will reduce foreclosed and short sale properties on the market and help to stablize prices.  Also personal incomes will be enhanced raising consumption and GDP. 

Bank earnings hurt in the short term will be salvaged as the list of foreclosed properties, that they have to write-off and manage until sold at distressed prices, will be significantly reduced.  The Fed is attempting to expand the monetary base by purchasing $600 billion of federal securities.  The banks need to lend the money to consumers so there will  be a positive effect on the economy.  A reduction in interest rates would have this effect.   Please write your congressman or senator to have this issue addressed.  If not, the housing spiral continues.  Today it was reported that urban housing prices are beginning to fall again.  Stabilizing housing prices should be a key government objective.   This is could provide the base for increased personal consumption, reduced unemployment and future rising GDP.  Without some program we are destined for further stagnation and flat equity markets and the continued deflation that the Fed fears so much.

The problem is the people calling for increased controls are threatening the independence of the true body that can rescue the economy from the current slow growth and high unemployment, without regard for the short term political consequences.  The first round of quantitative easing was a rescue from the potential collapse of the banking system. Almost the entire increase in the monetary base was an infusion into bank reserves. Without this reserve increase banks would have to sell assets to raise capital further eroding the commercial and residential real estate markets and threatening solvency for all  banks. The Fed’s actions shored up the bank reserves and the purchase of mortgage backed securities lowered rates for people eligible for refinancing. This stabilized the banking system, but did little to increase the supply of money in the economy since the banks actual lending did not increase.

The new round of quantitive easing, labeled QE2, is an attempt by the Fed to increase the money supply and positively impact future economic growth. The expectation is that the intial injection through purchasing of $600 billion of government securities will maintain low levels of interest rates and provide a further stimulus to the economy. If necessary the Fed will dramatically increase this amount to maintain their position. Could these actions cause an increase in inflation and the erosion of the dollar?

The answer to that question is yes unless the congress acts aggressively to reduce the budget deficit.  The Fed’s action is providing air cover for the required action regarding excess spending in Washington.  If spending is reduced significantly, prior to any increases in taxes, the bond market will react by keeping interest rates low and the dollar will strengthen.  If decisive action is not taken the deficit will continue to balloon, the dollar will weaken, inflation will accelerate and interest rates will rise.  A significant increase in interest rates will increase the deficit by 5% or $200 billion and we will promote a new recession and a downward spiral in the US economy.  The Fed is providing an opportunity for the congress and President to show leadership and correct the current deficit problem now.  Its unfortunate that politicians are Fed bashing.  Maybe they realize that the ball is now in their court and its time for action.  This may be intimidating to some but hopefully an opportunity for others.

Unfortunately the facts do not support the general hoopla of the media. The stock market in the US generally rises after all mid-term elections, averaging gains of 23%. In fact the gains are slightly higher when Democrats are in the majority, but not statistically significant. How about gridlock? Well the market average is also an increase of 23% indicating that the composition of Congress is not what matters its the policies that support economic growth that make a difference. 

Therefore the real important group decision is left with the Federal Reserve, only to be supported by Congress.   Will they attempt to expand the money supply providing a quick infusion of funds to reduce interest rates and increase borrowing capability for small business and consumers?  The last fund expansion of over $1 trillion only increased the bank reserves.  Loan demand and expansion of the money supply did not occur.  Without some changes in lending practices regarding the housing market and small business the latest expansion will also be a flop.  Also the unintended consequence will be the continued fall of the dollar and potential future inflation as imports become more expensive.

The economy grew over 2% in the last quarter a slow but sustainable pace.  A recovery in consumer spending and demand for housing are necessary to grow the economy faster.  All the money supply expansion in the world will not increase demand for funds without a change in policy.  I have discussed what is necessary to increase loan demand for housing.  Small business could also use some support.  The problem is that information about what funds are available and at what price is not clearly understood by small business owners.  Both Federal and state government must go on an education campaign to increase awareness of what loans are available through the banking system.  Also, a shot in the arm for homeowner refinancing, regardless of home value, is necessary to spur demand.  This is the only support the economy needs from Congress, whether Republican, Democratic or gridlock.  With it the economy continues to grow, without it the economy stagnates.

 We do not know the total depth of the foreclosure cycle. This leads to the uncertainty of home pricing going forward. Banks are currently under investigation for forged documentation relating to foreclosures. Until the overhang of all the pending foreclosures is cleared there is little hope of seeing existing home price increases. Foreclosures beget drops in market prices and subsequent additional homes that could be foreclosed or short sold, as of the third quarter over 20% of all homes are underwater. Many homeowners have delayed the short sale process based on incomes being supported by unemployment compensation.  When this is exhausted and payments cannot be met the urge to short sale your home is very impelling. This will put further pressure on housing prices and the bank then has the option to short sale the home or foreclose.  These two pressures will continue to haunt the markets until the majority of existing inventory is cleared. When housing prices do begin to rise additional inventory that was taken off the market will now reappear, further limiting the rise in prices for a number of years.

What can be done to break the cycle? A number of government agencies at the Federal and state level have attempted to slow the rate of foreclosures and keep existing homeowners from defaulting. This policy has been marginal at best.  What is needed is a policy that attempts to keep people that have faithfully made their house payment in their homes, while generating more income to assist consumer spending going forward.  Current market interest rates are low but many people that have faithfully paid their mortgage cannot refinance.  I again call for the government to set a policy for people that are current on their mortgages to be able to refinance their home at the current interest rates, regardless of the value of the home.  This would allow most people that are underwater to refinance lowering there payment and allow them to stay in the home and generate additional income.  This will go a long way to stabilizing housing prices and will not reward people that have gamed the system.

People will say that the banks will suffer an earnings loss due to the adjustments of mortgage interest rates.  The banks currently are being subsidized by the Federal Reserve and savers with historically low interest rates.  Why not pass that savings on to people in the form of lower mortgage rates.  In the long run the banks will see less foreclosures and short sales that will shore up the banks portfolio of mortgages and reduce losses on foreclosed homes.  Everyone will be a winner and maybe we can finally find the bottom of the housing market!

Let us instead focus on the facts:

1. Emerging markets are leading all equities higher. This trend began in September and will continue to be the theme through year-end. This is the primary reason for the dollar and euro declining relative to the stronger growth economies.

2. Oil is trending higher. Contrary to popular belief as oil moves up this signals a positive trend for global growth and a future uptrend for the stock market. If oil declines or crashes this is negative.

3. U.S. dollar is lower. This is positive in the short term since our ability to export will be enhanced with a weaker currency. However, if this trend continues it could signal inflation in the long term. The dollar has fluctuated over the past twelve months but is virtually unchanged from a year ago.

4. A significant technical indicator of market direction, the S&P 50 day moving average breaking the 200 day moving average on the upside, will be reached next week.  Many people that follow this indicator will be buying the markets before the election.

5. The potential election results could provide further fuel to the rally based on anticipation of tax cut extensions and reduced regulation.  This hopeful trend may not be realized but it will still provide optimism in the short run.

6. Finally the trend in corporate earnings remain positive for the remainder of the year and into 2011.  We are on pace to record double digit increases for both years.

These are the reasons why I believe we will continue to see stock market advances in the U.S. and emerging markets through year end.  I would expect the S&P to close the year  up 10% in the range of 1200 to 1225.  That is why we need to ignore the headlines and embrace the facts.