What Small Business Wants

 Following up on my recent post on business tax cuts, here is an Economist's View comment on an Economix article on what's holding small business back.  As we said below, it is sales, lack of customers, demand.  Jobs create demand. 

The Economix article also includes a link to the most recent National Federation of Independent Business small business survey.  The NFIB also has a new credit survey out.


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Wealthy Tax Cuts Slow Growth & Increase Deficit

As A follow-up to may last post, Econbrowser has an excellent graphic explanation of how the extension of the Bush Tax cuts for those making more than $200,000 and $250,000 would actually slow growth while increasing the deficit and keeping unemployment elevated.


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Do Business Tax Cuts Mean Less Food Stamps?

In recent proposals, President Obama has pushed a $50 billion infrastructure program for roads, railways, and runways as well as a $200 billion permanent extension of the research and development tax credit, allowing businesses to expense capital improvements in 2010 and 2011 rather than depreciate over several years.  He is pushing a Small Business Jobs Act which would provide $30 billion to community banks to lend to small businesses, $12 billion in tax incentives and tweaks to small businesses, and $1.5 billion for state small business programs.  Numerous attempts have been made to cut SNAP (food stamps) to make the small business tax cuts budget neutral.  He has also continued his push for an extension of the Bush tax cuts except for those making more than $200,000 (individuals) or $250,000 (families).

Unfortunately, Austan Goolsbee, the new chairman of the Council of Economic Advisers to the President, knows from his early published work that tax incentives do not work in stimulating an economy.  His "Investment Tax Incentives, Prices, and the Supply of Capital Goods" and other papers can be found here.  These tax cuts and incentives are political in nature, although they will achieve some longer term economic improvement.  But it will not create jobs now and cannot stimulate the economy into sustained recovery.  Real jobs creation requires government spending which creates jobs now and in the near future, but there is no political consensus in the U. S. Congress concerned about continued high unemployment which is growing and strangling the economy.  Families are saving and businesses are saving.  Tax credits and cuts do not create sales when the consumers have no jobs or fear losing a job or fear the uncertainty fostered and nurtured by both political parties in their maneuvering for the temporary bread and circus applause.  Sustainable economic recovery is directly dependent on job growth.  Without creating jobs as quickly as possible, the economy will go forward slowly at best with continued high employment, a general diminishment of the middle class, and even more rapid income inequality than has already occurred since 1960.

With respect to the Bush tax cuts extension, it has been well documented that lower income people are more likely to spend a tax cut, although this would be an extension of current taxes, and higher income people are more likely to save.  When there is so much effort to cut food stamps to budget neutral business tax cuts, why is it so important to extend the Bush tax cuts for those making more than $200,000/$250,000 when 55% of those tax cuts will go to .1% or 120,000 people for over $3,000,000 each over a ten year period?  Those who are liquidity constrained are more likely to spend and stimulate the economy.

Families cannot spend if they do not have jobs.  Families cannot spend is they are reducing debt in preparation for whatever may happen.  Businesses cannot spend if they do not have sales.  If businesses use tax incentives to purchase new equipment, how many jobs will be lost from the new equipment operation?  If new equipment and other capital expenditures increase the opportunity of increased productivity, of what use is that increased productivity in underutilized capacity economy?  Capital expenditures do not create sales.

Jobs create sales.  Jobs solve vacant housing inventories.  Jobs increases income for the wealthy.  Jobs stimulate an economy.  Jobs buy food and clothing and shelter and medical care.

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401(K) Auto Enrollment: Who Benefits"

In recent years 401(k) retirement plans, 403(b), and 457 plans) were allowed to adopt auto enrollment of employees.  As of June 30, 2010, approximately 38% of 401(k) plans have adopted auto enrollment; that number is even less if you consider 403(b) and 457 plans.  Large companies have been more likely to adopt auto enrollment than small companies and workers who had not previously saved for retirement increased by approximately 25% in large companies and 9% in small companies.  In that workers who had not been saving towards retirement now are, that is good; however, the default funds into which they must be placed are such that they will not be properly diversified and are unlikely to achieve enough money for a quality retirement during their retirement life time.   It does, however, create captive investors for the plan salespeople.

U.S. Department of Labor regulations are very specific as to what the default choices must be:

"(A) Subject to paragraph (e)(4)(v)(B) of this section, an
investment product or fund designed to preserve principal;
provide a rate of return generally consistent with that
earned on intermediate investment grade bonds; and provide
liquidity for withdrawals by participants and beneficiaries,
including transfers to other investment alternatives. Such
investment product or fund shall, for purposes of this
paragraph (e)(4)(v), meet the following requirements:
    (1) There are no fees or surrender charges imposed in
connection with withdrawals initiated by a participant or
beneficiary; and
    (2) Such investment product or fund invests primarily
in investment products that are backed by State or federally
regulated financial institutions."

These are usually a money market or stable value fund, a lifecycle or target date fund, a balanced fund, or a managed account such as a variable annuity.  Target date and lifecycle funds are under SEC scrutiny, because the same date funds from different companies are not similarly invested and disclosure to investors is less than desirable.  Stable value funds may have contractual problems that make them unacceptable or problematic in a qualified plan.  Money market funds are currently very low interest and have no principal guarantee like a money market at a bank.  A variable annuity can have internal costs and may or may not guarantee (for additional costs) principal or provide a lifetime income (however small).

The employee is sent an auto enrollment notice which specifically informs the employee they have the right to opt out, to actively choose their own investments within the retirement plan, or accept the default investment fund or funds which are specifically named in the notice.  The employee knows exactly in what funds the retirement contributions are invested.  The employer makes no choices for the employee; the plan administrator has chosen a default fund or funds meeting the regulations of the Department of Labor.  The employee may elect at a future date to change the investments within the plan or opt out.

Many employees do not want to make choices, lack investment knowledge, or face the choices of retirement and they ignore the notice.  The plan administrator's duty is to the company and cannot give fiduciary advice to participants.  Some companies make investment advice available, but it is from advisers who have conflicts of interest, although there are proposed regulations which would require participant advisers to be conflict free fiduciary advisers. Participants need impartial, conflict free, professional advice, but it is still very much a sales person's game.  The same employees who pay no attention to their auto enrollment notices and options also have no idea who is a fee only fiduciary advisor with no conflicts of interest as opposed to those who are not fiduciary duty bound and have conflicts of interest but can still legally call themselves fee only advisers, because the SEC makes it very difficult for even a knowledgeable investor to ferret out the distinctions.

Employees need to take responsibility for their retirement investments and seek out an affordable fee only, fiduciary duty to the client only, impartial professional advisor.  This requires they take action and ask questions.  How many do that?  How many employers provide conflict free help?  Not very many.

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How Risky Are Illinois Pension Funds?

On the 8/28/2010 Radio Show, we used the June 11th article in the Medill Reports by Alexandra Harris on the Illinois Teacher's Retirement System use of derivatives and investment diversification methodology which has made it the fourth riskiest pension fund in the Untied States.  We did not spend a lot of time on the subject given the amount of information we try to cover during the show and after we had researched the information earlier in the week, an article by Doug Finke was published in the State Journal-Register on the pension system and the fact they are selling $3 billion of assets to make pension payments and the State University Retirement System was selling $1.2 billion.  The Illinois Investment Board may also sell $840 million of assets to pay benefits for the state employee's, General Assembly, and Judge's retirement systems.  In the S J-R article, the Teacher's Retirement System spokesperson attributed the need to sell assets to the failure of the State to make its required contributions to the retirement system and the lost opportunity from not having the money to invest.


In the Medill Reports article, Alexandra Harris not only details the prior year losses in 2008 ($4.4 billion or 5%) and 2009 (22.3% loss) of which in 2009 the derivatives loss alone was $381, 367, 366.  Harris had a list of investments as of March 31, 2010, received under a Freedom of Information request and the Illinois Auditor General's audit report for Fiscal Year 2009 to obtain information on the investments and had them reviewed by professionals knowledgeable about derivatives and pension fund investing.  On page 52 of that audit report, you can see the projected allocations for investment for 2009 and what they were in 2008.  Harris indicates that the pension system has adopted a riskier investment allocation beginning in the 1990's, which would have been approximately the time the State adopted a ramped tier system of increasing payments by the State to reduce underfunding of State pension funds.  However, this funding formula has been delayed or suspended more than once in the intervening years and even the issuance of pension bonds in 2010 was denied by the General Assembly.  Consequently, the Teacher's Retirement System is 60.9% underfunded.

In the Medill Reports article, Teacher's Retirement System spokespeople indicated there would be a profit in 2010 from using derivatives, but the author's professional reviewers of the investment balance sheet and listing of investments were seeing a loss of approximately $515 million.

The Medill Reports article also attributes the risky investing style to a methodology of the Yale Endowment, which got itself in trouble in 2008 with its illiquid style of investing.  However, if you look at the allocation in 2009 of the Yale Endowment on page 7, you will see that the Illinois Teacher's Retirement System allocation of investments is quite divergent from the Yale Endowment and far riskier, even without considering its dependence on derivatives.  The Teacher's Retirement System has eight (8) pages of derivative investments, far more U.S. and international equities and far less Absolute Return, Real Return (only 6 investments), and Real Assets.  They are not comparable.  What is clear is that the Teacher's Retirement System is engaged, and has been engaged, for several years in risky catch-up investing that paid off through 2007 and is now clearly dangerous.

Derivatives were a primarily cause of the current financial crisis.  The use of derivatives and the type of derivatives being used by the Teacher's Retirement Fund are not marginal hedging of other investments.  They are substantial bets of inflation in regional parts of the world, long term Treasury yields, and CDS on corporate and sovereign debt of foreign nations.  This is more appropriate for a major bank trading desk and we have seen the destruction that can bring and the cost to society.  It is not appropriate for a pension fund.

To see how the other pension funds are invested and doing, go to the Illinois Auditor General and look at the audit reports under Retirement Systems.
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How Far Is Too Low?

On Wednesday, we saw the stock market surge moderately on Increased Chinese PMI, Australian Q2 GDP growth, and ISM better than expected numbers.

Today, Bloomberg tells us the U. S. has avoided recession because the economic data cannot get much worse.  When you read commentary like this, you need to fall back on your macroeconimic framework and deal with the data in analytical terms.

Chinese PMI was up only one-half percent, but there had been speculation it might fall .  Consequently, the Western commentators saw this as meaning increased future exports to China.  The Chinese stock market fell despite the Chinese PMI going up.  China was been taking steps to moderate inflation and a real estate bubble.  It has been taking steps to promote the use of the yuan in trade and equity markets to decrease the use of foreign currencies.  It has been emphasizing and growing internal production for internal consumption.  Too much is being made of a modest increase with mixed data, which surprised analyst expectations.  Of eleven categories, ten fell: new export orders, imports, output, backlogs of orders, stocks of finished goods, stocks of purchases were all down.  Four of the categories were below the expansionary level of 50.

Australian Q2 GDP was up 1.2% beating the expectation of .9%.  This was hailed as proof that exports, of which Australia is heavily dependent on China, would expand, because this GDP number included a 5.6% increase in export volume.  Unfortunately, the trade effects which have encouraged exports will not last much longer and the Australian economy is being driven by increased personal consumption in which private debt is increasing and savings decreasing.  Additionally, the Australian political scene is very uncertain as the recent election was, for all practical purposes, was a tie and any coalition government will dependent on obtaining at least 3-4 of five independent members of parliament, none of whom have any close affinity with either choice of government.  It is doubtful any coalition will last for any significant length of time.

U.S. Institute of Supply Management Manufacturing Index was up eight tenths to 56.3, while expectations had been a possible decline of 2.5.  However, new orders declined and inventory increased.  One should reasonably expect this index to decline going forward.

Just as economists can get lost in models which do not listen to the streets and limit data or the analysis of data and information, the public commentators often fail to utilize a macroeconomic framework to provide consistency and methodology.

The above reports and the reactions to them at this time could well be the anxious grasping for hope.  The reality is that lagging economic indicators will catch up with current indicators starting at the end of September and particularly in October and November.  There is every reason to believe unemployment will increase, housing prices will decrease and housing inventory increase, earnings reports will start to confirm and second half slow down as will GDP reports from countries around the world.  As an example, Spain was up two tenths on sales tax increases (VAT) and Germany is acknowledged to have lower (perhaps significantly) Q3 growth than its export driven 2.2% Q2.

Do not just read the news reports; dig into the data and the information and context behind it.




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Beware Earnings as F.O.E.

Earnings reports and earnings season every quarter are times when the market responds to impressions rather than researched information.  Too a large extent the public cannot be entirely blamed, because they are relying on news reports and financial information from the companies.  In as much as these do not reflect the underlying tax accounting manipulations, real cash flow, the types of cash, and other legal legerdemain that constitute forward operating earnings (FOE), the information being publicly passed and digested does not give a reliable value of the security or the market as a whole.

John Hussman has written about the problem of forward operating earnings on many occasions in his weekly commentaries.  On July 19, he discussed how dividends are not properly taxed and this leads to companies to report earnings and then waste the "...retained earnings on speculative acquisitions and incentive compensation to insiders...".  He then went on to discuss how he warns investors to be skeptical of valuation metrics built on forward operating earnings as they are estimates of next year earnings but omit a whole range of charges such as bad investments, loan losses, restructuring charges, etc.  This generates statistically distorted and overly optimistic projections as substantiated by historical data.  He then illustrates how Tobin's q ratio, which is based on comparing market value to replacement cost, as advocated by Andrew Smithers and Schiller's CAPE, which is based on the ten year average of actual net (not operating) earnings provide consistently comparable valuations.  "Ultimately, the value of any security is the properly discounted stream of cash flows that the security will deliver into the hands of the investor over time."  Net earnings not operating earnings are the important and more accurate information.  "...net earnings represent the only amounts that investors can hope to obtain, and then only if the net earnings are distributed as dividends or invested in productive activities that don't get written off later."

On August 2, 2010, Hussman continued his concern with the increasingly careless use of operating earnings as a misleading measure of stock valuation.  "The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation."  Analysts tend to treat these hypothetical operating earnings to create forecasts "... as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business. Meanwhile, operating earnings often include a benefit from those very same "extraordinary" sources - provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses)."

On August 9th, Hussman repeated the importance to the investor of being able to properly assess stock valuations.  He then continues with warning investors to not believe that cash on the balance sheet could "... suddenly be used, in aggregate, for new investments and capital spending." Often, this cash is in the form of loans to the government or private companies in the form of T bills and commercial paper.  Consequently, these investment savings are not available to spend.  These marketable securities are someone's liabilities.  Often, cash is the result of the issuance of corporate debt.  You cannot look at cash assets and ignore liabilities in national and global balance sheet of all assets and liabilities; what affects one side of the balance sheet effects the other side of the economic balance sheet of all corporations, individuals, and government.

When you look at market valuation and the value of a security, you need to dig into the actual detailed financial information and historical data and use that data in a rigorous model that yields information and not forecasts.  Too many market pundits will cry earnings and pronounce them as positive or negative based on summaries and estimates of forward operating earnings when they should be focused on net earnings, in what form cash is held, liabilities, and the use of earnings.  Too often market talk about earnings is the shot used to stampede the herd.  Often, market commentators have vested positions in how the market moves or, worse, political motives in forming public opinion.







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Revisionist GDP Numbers

On July 31st we reported the 2010 Q2 GDP numbers of 2.4%, of which 1.05% was from increase or rebuild of inventory and only 1.3% actual demand growth.  Of more concern, Q1 2010 was revised from 2.7% to 3.7%, which included a substantially revised inventory rebuild of 2.64%.  At the same time each quarter of 2007, 2008, and 2009 were also revised indicating the recession was worse then we were led to believe.

What Q2 2010 showed was spending needs to pick up, which is unlikely, and too much consumer and business spending go to imports.  Personal consumption expenditures (PCE) of 1.6% in Q2 slowed from 1.9% in Q1.

Q3 2010 will need to grow 3.4% to get to pre-recession levels.  With the economy slowing, unemployment growing, and housing prices (new existing home sales will be out August 24th) and inventory trending down that is not going to happen.  The July 30 Consumer Metrics Commentary on the GDP numbers shows the problem of the inventory rebuild number in the GDP going forward.  It should be noted that the GDP methodology used in the United States is completely different from that used by any other country, because the United States since 1980 has used a hedonic price index to adjust GDP numbers for a subjective value attempting to determine the economic growth from innovation, such as the economic growth from computers being replaced by more powerful computers.

With economic data for the last several months being mixed and beginning to show not only a slow down but the possibilities of contraction, analysts from various sources have been pouring over how the Q2 2010 GDP number might be revised on Friday, August 27th, and opining that it will be revised down to 1.9%, 1.4%, or even an extreme 1.0%.  With eyes around the world, particularly Europe, watching the United States for signs of recovery or slowing growth portending a possible near future contraction, the revision could have fear-confidence repercussions globally.  October Q3 GDP reports could begin to show contraction again in some European countries which have been expanding on tax increases, like Spain.  Will the fear-confidence factor grow into a sharp market correction?

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SEC Comment on the Fiduciary Problem

In the United States the financial services industry and the many associations which represent its salespeople, such as the CFP Board, have been pressing for an amorphous financial standard which would apply to all advisors without respect to how many conflicts of interest they have.  An actual discussion of true fiduciary duty is not allowed on the table, because fiduciary duty does not allow any conflicts of interest.  Even with the financial standard smoke screen, the salespeople protest they cannot understand what it is and how it could be applied and the public needs to practice caveat emptor.  Present securities law, rules, and regulations favor salespeople over fiduciary advisors and purposefully confuse the public as to who is who and what they do.

The new financial reform legislation which passed Congress kicked the fiduciary question down the street and required the SEC to study what, if any, fiduciary requirements should be placed on salespeople, advisors who sale, and advisors who do not sale (this later category is not a popular subject on Wall Street or in insurance companies).  Comment on this subject ends August 30 and you can read comments on file here.  The transparency of designations which clearly communicate to the public who is who and the level of fiduciary responsibility or actual fiduciary duty are long overdue.  Even the associations confuse the issue.  For instance, NAPFA holds itself out as an association of fee only advisors, but the majority of its members are salespeople who appear to provide the bulk of the association's revenue.  Besides an initial and annual membership fee, the requirement to become a fee only advisor member includes submitting a fictional financial plan consistent with the example plan sent to prospective members.  How hard can that be?  Yet, many lazy news organizations and writers fail to do the research and think this is the source for fee only advisors, when it actually has a very small percentage of actual fee only advisors as members.  A clear SEC designation would clear this mess up and make a lot of these self-serving associations redundant.

I have previously written on the need for a two years master's degree program for fiduciary advisors and have been working on a curriculum program.

Here is the comment I sent the SEC:

SEC

Comments on File 4-606

In the United Kingdom, Canada, and Australia it is now illegal to give financial advice and sell products and the regulations being phased in, because the two activities are ethically incompatible.

In the United States, the discussion of true fiduciary duty in which there are no conflicts of interest, as above, has not been publicly allowed, as salespeople and the organizations and associations which represent them are committed to the existence of "unavoidable" conflicts of interest and the promotion of a "fiduciary standard" which would put wolves in sheep’s clothing and continue the confusion of the public as to who is who as a commissioned advisor, fee-based, or fee-only. In fact current SEC law and rules and regulations allow financial advisors, with Broker-Dealer relationships, and advisors who accept fees from sources other than clients and/or soft money or services from a Broker-Dealer to legally call themselves fee only advisors. This confusion is purposeful and serves the best interests of salespeople.

I have previously published, prior to the passage of the new financial reform bill, a criticism of the current regulatory process and need for clear designations under the title of "Fiduciary Responsibility vs. Fiduciary Duty" which was published nationally by Advisor Perspectives

and also here.  It is time for public transparency, clearly delineated advisor definitions, and appropriate fiduciary responsibility salesmen and conflicted advisers distinguished from the fiduciary duty of a true fee only advisor with no conflicts of interest.

That article reads as follows:

     

I included the text of the "Fiduciary Responsibility vs Fiduciary Duty" article above as the SEC comments page recognizes no links in my comment.

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Yves Smith Interview

On the 7/31/2010 Radio Show, we had the opportunity to have Yves Smith as a guest.  Yves Smith is the author of ECONNED, which is one of the best books on the financial crisis, because it covers the economic thinking which led up to the financial crisis as well as how Wall Street greed proceeded at high speed towards the crisis and how government failed in its regulatory duties before and after.  Yves Smith is also the creator of the blog naked capitalism.

Here is the link to the RSS feed for The Pursuit of Financial Happiness which you can past into your preferred reader:

http://www.stationcaster.com/stations/wmay/rss/?c=336


 Here is the actual podcast of the Yves Smith guest appearance.

The Pursuit of Financial Happiness radio show podcasts are also available free on iTunes, but you need to go to the Advanced tab at the top of  iTunes and then select Add Subscription and past the above RSS feed in order to get a current list of shows, because iTunes takes its time adding shows from the RSS feed and just subscribing to the show itself in iTunes' Podcasts will not get you a current list of podcasts.

UPDATE: 1 June 2015
The radio station link is no longer any good.  Here is a good link:


http://www.mjscpaplan.com/podcasts/Interview_w_Yves_Smith.mp3



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