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A GLIMPSE OF THE CLIFF

Wall Street’s preoccupation with whether we’re beginning a new recession or whether there will be a resolution of the coming fiscal cliff is missing the point. The critical question facing investors is how to invest in a government controlled and manipulated environment. Let me explain…

The economic tea leaves are giving off mixed messages, with strength in housing, weakness in commodities, and sluggishness in capital goods. Autos are strong, while truck sales falter…what gives? How does one read these conflicting signs?

The recently announced Federal Reserve (Fed) policy (QE3) will feature the monthly purchase of $85 billion of mortgage paper and Treasurys. This infusion of newly “printed” money creates artificially low interest rates which stimulates the housing sector with low cost mortgages. Is it any wonder why the housing business has awakened, lifting the value of housing stocks along with buyer attitude? Why not a new car to go with the new house?

At the same time, capital intensive companies are reluctant to commit to an expansion because they understand the temporary and indefinite nature of this short-term stimulus. They have been given no assurance that there will be an adequate return on their expansion capital over the longer term. The very nature of their business requires long-term assurance that rates-of-return, taxes and regulation will not change. Current economic tax and financial policies offer no such assurance.

Investment professionals have always been taught that interest rates really represent the price of money which is determined through a normal supply and demand relationship. Furthermore, interest rates are used as a basis of valuation for various assets at any particular point in time. It is obviously confusing and disturbing to confront a world wherein the supply of money is unlimited, creating artificially low interest rates while throwing any supply and demand function to the wind. Through these tactics, the Fed has introduced new risk components into the investment equation and most investors have not yet recognized this when searching for relative value.

The Fed now purchases nearly two-thirds of all Treasury borrowing with this newly printed money. To make matters more interesting, our Treasury need not pay interest on these borrowings because the Fed returns all earnings to the Treasury each year. The problem arises if the Fed ever needs to withdraw money from the system through the sale of bonds. Interest payments would then be due and added to our already massive deficit. How long can we continue borrowing from ourselves by simply printing money?

Meanwhile, the stock market marches on, supported by investors seeking dividend-paying stocks along with stocks showing strong earnings. With bonds and savings paying virtually nothing, the Fed has caused investors to make different decisions to meet their income needs. This is what I mean by a manipulated and controlled environment. Any return to normalcy could have disastrous results for many.

On the surface things feel okay to most Americans. Unfortunately, there is little understanding by the electorate as how free market capitalism works. The complexity of this gradual manipulation and dismantling of our monetary and economic foundation is simply incomprehensible to the majority of Americans. We therefore expect no political change in November, and a continuance of current monetary, regulatory and tax policies.

Given that conclusion, we are left with the problem of timing the inevitable end of this controlled environment. This is a very difficult chore, made more complex by the fact that most countries around the world have chosen the same strategy: print and borrow more money. This timing issue now requires global perspective; however, to us, the United States monetary and fiscal conditions will be critical. In that regard, we are watching several indicators very closely.

The coming election will eliminate much uncertainty, allowing us to project fiscal and monetary policy. The election results could initiate a wave of selling as many investors “cash in” profits in order to pay taxes at this year’s lower tax rates. Sales to liquefy larger estates for gifting purposes are also expected, avoiding gift and estate taxes which will escalate dramatically in January.

Universal Healthcare (ObamaCare) taxes will certainly begin in January and have a dampening economic effect. Individuals and economic sectors to be affected are:

  1. Medical Device Tax ($20 billion) A 2.3% excise tax on gross revenue on medical device makers gross sales, regardless of whether it puts a company in the “red” or not. Expect the costs of pacemakers and prosthetics to increase to cover this tax. 409,000 people are employed in the sector.
  2. Special Needs Cap (13 billion) 30-35 million Americans use the “Flexible Spending Account” for special needs children expenses. These expenses will be “capped” at $2,500 per year beginning in January.
  3. Surtax on Investment Income (123 billion) Affecting all investment income and capital gains for those earning $200,000 per year ($250,000 married). Tax will be an additional 3.8%.
  4. Itemized Deduction Allowable (15.2 billion) The allowable deduction for medical expenses will commence at 10% of adjustable gross income instead of the current 7.5%.
  5. Medicare Payroll Tax Hike (86 billion) From 2.9% to 3.8% for all Americans earning $200,000 ($250,000 married). From 1.45% to 2.35% for employees.

These ObamaCare costs are scheduled to begin in January, and are a certainty due to the law recently upheld by the Supreme Court decision. As you can see, they represent a significant burden for our economy.

We expect a very heated negotiation as we approach the “fiscal cliff.” Planned tax increases and significant government cutbacks promise to over-burden the economy. Debt ceiling discussions will be part of these negotiations and the credit rating of our national debt will undergo close scrutiny as the talks continue.

All these converging negatives likely contain the answer to our timing question. By looking at your portfolio, you can see that we are conservatively structured as we enter this difficult time frame. Over the long haul, however, we believe that well-managed, self-financed companies, able to grow in a controlled, manipulated economy represent the best single opportunity for us, provided they are acquired at the right price. We have the cash to “pounce” on any such opportunity. Some gold and well-selected foreign bonds make sense as a hedge against an eroding currency.

As we head into the fourth quarter, I have every confidence in our ability to protect and grow your assets without taking unnecessary risk. All of us at Cadinha & Co. appreciate your continuing confidence and loyalty.

Best wishes for a happy holiday season…

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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