January 26, 2006
America's Auto-Immune Disorder
I wrote this piece for subscribers just after the London bombings last summer. With only small changes in the first line, it is as relevant today. As you know, I believe that changes in communication s technology are among the most important drivers in the world today. People from Colombia to Kenya and Buffalo to Bangalore can now watch each other wake up every day.
People in poor countries watch our TV shows. They have determined that 1) we are very rich, 2) it is probably not because we are smarter, work harder, or are better looking than us--it is access to capital. They have learned they are poor and they don't like it. We have to come to terms with the new communications and figure out how to grow together.
Viewers in rich countries can now see just how poor their neighbors are every day. Some choose to ignre it. Some are trying to do things to help poor people become rich. Some react by turning poor countries into demagogs, making them responsible for all our problems. Most of all, people become frightened they will lose their wealth and living standards. That's why this is such a politically contentious time, both in the US and around the world.
As the article below argues, I don't have time to be scared; there is too much to do. And I don't have much patience with people who use their energy being scared. Fortunately, throughout history, frightened people always adapt and go back to their normal activities. When they do, investors will pump the $2 trillion in cash they are sitting on back into the stock market and managers will plow their cash hoards back into capital spending. I want to be there when the price go up.
I hope you enjoy the piece.
JR
News stories from Iran, Venezuela, and other places have a lot of people crawling into their bunkers again. That's a big mistake.
Over the past 40 years I have traveled 15 million miles, wandered around South America, Eastern Europe, Northern Africa, and made more than 100 trips to the Middle East. I have good friends in all those places. I have been searched by 16 year old soldiers with machine guns, I have been detained by officials with stars on their shoulders but no brains in their heads. I have been in air raids and happened into food riots. I have been stopped by tanks. I am still here.
The world has never been safe; it never will be.
There are 300 million of us; whoever is mad at us can’t get all of us.
The big risk is not the risk of dying; it is the risk of not living.
It is not possible to spend enough money to protect people from other people who want to hurt them. The result would be man-on-man defense, just like in basketball. When I was 18 years old I lived for a time in West Berlin. The East German guards on the other side of the fence walked in pairs so they could keep an eye on each other. they were not having fun.
We should not pretend we can deliver total security. People should take more responsibility themselves for being alert to danger.
The real price of delivering excessive imaginary protection is not the money we pay the TSA employees at the airports, it is our loss of identity, which is a form of auto-immune disorder.
Biological Immune systems do not work by having a list of bad guys to look for. They work by being able to recognize “me”. When a healthy immune system encounters a cell, it is able to determine whether the cell is “self”, in which case it allows it to pass, or is “other” in which case it attacks, kills, or repels the invader.
Auto-immune disorders, such as AIDS, are situations in which the immune system loses the ability to identify itself and makes mistakes of both kinds, killing itself as a result. In that senses they are exactly loss of identity.
The most damaging long-term effect of terrorism is that we have become so focused on obtaining order that we are losing our identity.
In the case of America, our identity is to take risks, try things, and welcome strangers. Fear has driven us into our bunkers, behind our TSA guards, and into racism.
The good news is that we can fix this problem ourselves by remembering who we are.
We need to quit whining and get back to work.
JR
Posted by John Rutledge at 3:12 PM | Comments (5)
January 24, 2006
Why I Travel to China
About once each day someone asks me why I am willing to spend 14 hours on an airplane to get to China every month. This photo is my answer.
In December I visited Changsha, a small city (by Chinese standards) of only half a dozen million people in Hunan province, to give a lecture and visit with faculty members at the Hunan University School of Finance. I had a wonderful time with the students and faculty there.
During the afternoon I had a break between classes and decided to take a walk through a local residential neighborhood. While I was walking, these two little girls--maybe 7 years old--came up to me and said "Hello!" in perfect English. I was the only westerner on the street.
Between their English and my Chinese we decided to have our picture taken together.
The enthusiasm of young students in China is infectious. They believe in the American dream, that they can achieve anything through hard work. They are natural friends for Americans. We just have to make the effort to get to know them.
JR
Posted by John Rutledge at 9:22 PM | Comments (4)
WSJ Op-Ed on Dividend and Capital Gains Tax Rates
A number of subscribers have sent emails saying they had difficulty in accessing the op-ed I wrote in last Saturday's Wall Street Journal on why permanently low dividend and capital gains tax rates are important for keeping capital in America where our workers can use it to earn paychecks. The text below is an earlier draft. Hope you enjoy it.
JR
Why Dividend and Capital Gains Tax Rates are Important for Growth
When the Senate and House get back to work this week, the clamor for protectionism, in the wake of new numbers on our trade deficit with China, will drown out every other issue. But the key to U.S. growth and trade is not bashing the Chinese currency—it’s the Tax Reconciliation Bill that will emerge from Senate-House Conference in early February. At stake--tax rates on the capital that determines our productivity and workers’ paychecks.
America is not competing for jobs with China. We are competing for capital. Double-taxing dividend and capital gains income drives capital to China where it earns higher after-tax returns. When that happens, American workers are left behind with falling productivity and uncompetitive companies.
Reducing or eliminating dividend and capital gains tax rates keeps capital in America, where it makes workers productive and supports high incomes. Congress must act now to keep rates from increasing in 2008 by extending or eliminating dividend and capital gains taxes.
The 2003 cuts in both dividend and capital gains tax rates hit the stock market and corporate boardrooms like a bunker buster. The Dow Jones Industrial Average is up 32% since 12/31/02, one week before President Bush announced the dividend and capital gains tax rate cuts. The S&P 500 large-cap index is up 47%. Mid-cap are up 79%, and small caps up 81%.
Overall, the value of U.S. equities increased $6.0 trillion (+50%) since the dividend tax cut first appeared in the headlines, from $11.9 trillion on 12/31/02 to $17.9 trillion on 9/30/05, according to the most recent Federal Reserve Flow of Funds Report. Household net worth increased $12.1 trillion over the same period, from $39.0 trillion on 12/31/02 to $51.1 trillion, an increase of $40,631 for every person in America. These gains accrue to the 91 million Americans who own shares of stock directly or through mutual funds and to more than 80 million private and government workers through pension funds. Growth, profits, and investment spending also grew, and we have created 4.4 million jobs. Tax cuts were a major factor in producing these gains.
Dividend and capital gains tax cuts are not trickle-down economics as claimed by opponents. They work by jolting asset markets, stock prices, and capital spending and by altering business decisions about capital structure, dividend payout, and capital deployment.
In December, 2002, I prepared a report for a White House working group detailing how the dividend tax cut would impact the U.S. stock market and its major sectors through two different channels 1) recapitalizing the stock market and 2) restructuring corporate balance sheets. You can read the report by clicking on the link above.
Tax cuts initially impact asset prices by making investors recapitalize, or revalue, the equities of existing companies to reflect higher after-tax returns relative to interest-bearing securities like CDs, T-bills, bonds, and REITs, tangible assets like land and collectibles, and foreign assets. The return gap—more than 100 basis points for the 2003 tax cuts—makes investors sell relatively low-return assets, driving their prices down, and buy relatively high-return assets, driving their prices up, until after-tax returns have been driven together again. My estimates showed an initial impact of $560-938 billion, or 6-10%.
The restructuring impact of tax cuts on stock prices plays out over several years but is potentially several times larger than the initial price impact. The 2003 tax cuts were larger for dividend income (from 38.6% to 15%), than for capital gains income (20% to 15%); tax rates on interest income were unchanged. This made the impact on a stock’s value greater: the greater its profitability; the greater the percentage of equity, rather than debt, in its capital structure; the greater its payout rate; and the greater its duration (a stock with a greater duration is more sensitive to changes in cost of capital).
In 2003, U.S. companies were poorly structured to benefit from the changes. Decades of high dividend tax rates and deductible interest payments had encouraged managers to finance companies with debt instead of equity, which reduced profits and increased bankruptcy risk, and to reinvest profits and hoard cash for acquisitions rather than pay out dividends, regardless of the company’s prospects. According to the American Shareholders Association, the number of S&P 500 companies paying dividends fell from 469 in 1980 to 351 in 2002. By 2002 the S&P 900 (large and mid-cap) companies paid out just 53% of profits, and financed companies with only 27% equity and 73% debt.
Once tax rates were cut in 2003, managers quickly learned they could profit from lower tax rates by restructuring balance sheets (issuing equity to buy back debt, e.g., Nextel), initiating new dividends and cleaning out their cash hoards through one-time special dividends (e.g., Microsoft), and increasing dividend payout ratios. As a result, dividend payments received by shareholders have doubled since the tax cuts.
As companies, one by one, made these changes, their equity values increased. But changing capital structure takes time, one reason I believe equities will enjoy strong returns for many years if tax rates remain low.
We need permanent tax cuts, not temporary extensions, to fully realize these benefits. Managers do not make decisions about leverage and dividend payouts lightly; they will do so only if they believe tax rates will remain low. But Congress gives them temporary rate cuts and temporary extensions in order to comply with the bizarre Congressional budget scoring ritual.
Equities are a long-term investment. Based on our estimates, the duration of the S&P 500 is over 22 years. Each of the first 5 future years of expected free cash flow contributes only about 5% of the stock market’s intrinsic value. That means 90% of the value of the stock market depends on expected after-tax profits after year 2, the date when tax cuts are currently scheduled to expire. We need to make tax cuts permanent so investors can fully reflect them in stock prices.
Congress can adopt the 2 year extension in the house bill and keep the recovery strong and net worth growing. Better still, they could make current tax rates permanent, which would encourage managers to speed up restructuring activities, accelerate stock market gains, reduce cost of capital, and increase capital spending. Best, they should end double taxation by making both dividend and capital gains rates permanently zero.
America enjoys the highest living standards in the world because American workers enjoy the use of the largest and most advanced stock of tools in the world. But tools are mobile, workers are not. While America continues to double-tax capital income through dividend and capital gains taxes, China, India, and other countries are aggressively competing for American capital with increasingly investor-friendly policies.
When the capital leaves, the paycheck goes with it. We can’t afford to let that happen.
JR
Posted by John Rutledge at 12:32 AM
January 23, 2006
My Op-Ed in Saturday's Wall Street Journal on the Importance of Making Dividend and Capital Gains Tax Cuts Permanent
I wrote an op-ed, Capital Offense, which ran in the Saturday (1/21) Weekend Edition of the Wall Street Journal. You can read the article by clicking on the link, above.
In early February, the Senate and House will meet in Conference to hammer out the details of the tax bill. My spies on the Hill tell me Congress is likely to extend current dividend and capital gains tax rates for 2 additional years until 2010. Better would be to make both tax rates permanently zero.
This op-ed explains how dividend and capital gains tax rates impact equity values and corporate capital structure decisions. There is intense global competition for capital today. China and India realize that attracting US capital is a key to their high growth rates. This is especially true for advanced communications technology--the only way to keep growing without using more oil.
The US needs to understand that we are not competing for jobs. We are competing for capital. Making the tax rate cuts permament will help keep capital in America where it can support higher productivity and paychecks.
JR
Posted by John Rutledge at 12:14 AM
January 1, 2006
Teaching English in China
I received a wonderful email from a reader named Jane, asking for help in identifying an opportunity to teach English in China. Here is an edited version of her note and my response FYI:
Dear JR,
I want to teach English in China in February 2006.
Received Ed.D. 12/05. Years teaching high school business courses in Canada, USA, Zambia. Specialist in Accountancy, Data Processing, ESL. The headhunters I have contacted are working slowly. Is it because there are no positions?
Jane
Dear Dr. Jane,
First, hats off to you. Most people I know are content to sit at home and complain about the world's problems; few are willing to rise from their Barcaloungers to do anything about it. In my book you are a real hero.
I think the single most important issue for our childrens' welfare during their lifetimes is how the English and Chinese speaking peoples learn to get along together over the next 20 years. That will only happen if we get to know each other very well by spending time with each other and by learning each other's language, history, and culture.
There are many opportunities in China to teach English for people with much less experience and expertise than yourself. You won't make a lot of money there, but I guarantee it will be an unforgettable experience. And no, you do not have to be a Chinese speaker to make a contribution.
I am travelling to China next week and will ask my friends there in the Universities and in the Education Ministry how best to connect you and any others who have the same interest with the people in China who can make this happen. I will write about this as soon as I have an answer.
I will be happy to pass along any names and resumes people send me to the appropriate people in China. I am also interested in learning about situations in the US where schools are interested in hosting a Chinese student or teacher who would like to teach Chinese and learn about America.
More to come.
JR
Posted by John Rutledge at 3:30 PM
Forbes on Fox Topic: The Hot New Investment Trends for 2006
Hot sectors happen when a policy or technology event materially raises after-tax returns on capital there relative to other assets. Investors move money from low to high return assets which creates capital gains for the guy who got there first. This is precisely the same thermodynamic process as a storm system (a gap between high and low pressures or temperatures) in physics. People can best understand it by looking at a weather map of these storms. (See the weather map on my website for several of these storms.) The reason I like the weather map metaphor is everyone already understandds it, and everyone also knows that a storm is TEMPORARY. The same is true for hot investments, i.e., you also have to know when to SELL them when the party is over.
Last year’s storms were:
1. Oil and commodity prices, both implications of China strong growth;
2. Small cap U.S. stocks caused by the gusher of liquidity for small companies that happened when the banks opened their doors to business loans again 18 months ago; and
3. The turnaround of Japan caused by the end of their 13 year deflation.
In 2006, the most interesting storms will be:
1. Communications technology. Congress will pass a new telecom law next year that will dramatically increase capital spending on new high-speed networks. At the same time, China, Korea, India and others are making massive investments in IT as a strategy for growing their economies without using more oil and gas. This is great for capital owners altogether, but it's especially great for telecom equipment makers and software writers. Best way to play that is EWY,the Korean ETF. (Korea is an important R&D provider for China.) Another is IWZ (the US technology sector).
2. The inflation monster will pull its scary head back into its cave next year and the Fed will back away from tightening (especially if we have a bad event at GM or Ford to prod them into providing liquidity). Investors will realize that inflation and interest rates will stay low so it is safe to buy the companies whose profits are growing more than 10% per year. The market will boom, especially for the small companies who rely on bank liquidity for working capital. Best way to play this is the Microcap stocks (IWC; the Russell microcap ETF) or the small cap ETFs (IWM and IJR).
3. We will get an extension on the dividend and cap gains tax cuts in January. Great for the overall market, but especially great for companies paying dividends (you can use DVY for this), or companies with big cash positions and huge free cash flow (maturing tech stocks like MSFT who can initiate dividends or pay special dividends.)
4. I also have sizable bets still in place on the China Growth stom system (EWY (Korea), EPP (Australia, New Zealand, Singapore, Hong Kong), on coal (BTU), and on Japan (EWJ).
As always, I own all of the stocks I mentioned above. (How could I tell readers I like a stock if I don't put my own money into it?)
JR
Posted by John Rutledge at 12:51 PM | Comments (4)
Forbes on Fox Topic: Cutting Corporate Tax Rates to Boost the Economy
Another topic on we discussed on Forbes on Fox Saturday (12/31/05): The U.S. has the highest corporate tax rate of industrialized nations. Do we need to cut corporate taxes now to attract more investments and help boost the economy, job market and stock market?
My answer? Absolutely! Cutting corporate tax rates (not corporate taxes) is important for the economy, especially for the worker who owns no capital but has to rely on using the capital of other people to earn a paycheck. And while we are at it we should keep income tax rates low as well. More than 80% of tax revenues collected at the top tax rate is paid by small business owners, who account for 70% of all jobs.
Capital is what makes workers productive and able to command a big paycheck. Capital has become almost completely mobile over the past 20 years due to fast communications and low transaction costs in financial markets. The owner of capital can now move assets from anywhere, to anywhere, at virtually no cost. But the worker cannot move so easily. The key for the worker, and the economy, is to keep American capital here in America.
We are not competing for jobs with China, India, or anyone else. (Cavemen all had jobs; they all hunted dinosaurs.) We are competing for capital. High corporate tax rates and nonsensical regulations drive capital out of America to other places. (US companies carry an overhead cost burden of 22% relative to other countries due to tax and regulatory policies.) The workers paycheck goes with the capital when it leaves.
JR
Posted by John Rutledge at 12:47 PM | Comments (3)
Forbes on Fox Topic: Does Iraq Hold the Key to the Markets in 2006?
"Does Iraq Hold the Key to the Markets in 2006?" was one of the Forbes on Fox topics Saturday morning (12/31/05). Here is a summary of my remarks:
Iraq developments are very important for the U.S. markets next year. My view is that the investment fundamentals (growth, profits, interest rates, and maybe even lower dividend and cap gains tax rates) are very, very strong, and that investors should be committed to equities for next year. The only thing keeping the market from reflecting the strong fundamentals is people's fears. Investors are sitting on $2 trillion in uninvested cash today.
Bad events in Iraq could keep investors in their bunkers for a little longer. If that happens, I will buy more stock.
Iraq, by the way, is not going to bloom flowers overnight. There is too much strategic power and wealth there (under the sand), and not enough strength to defend it. Somebody's army (ours, the UN, China’s?) is going to camp out there for a long, long time. But the real positives are showing up in gulf region stock and property markets; oth bup 200%-300% in the past 3 years. (My friends at Global Investment House in Kuwait are a great source of data and analysis about these markets. I get them delivered to my desktop every night to read each morning.)
In the U.S., it’s all about fundamentals versus fear. Fear is temporary; fundamentals always win. The fundamentals are great for profit growth and low long term interest rates. It's only a question of when that shows up in the market as rising prices. Stay invested.
JR
Posted by John Rutledge at 12:43 PM | Comments (1)