The Contrarian's View,
Vol. I, #1, July 5, 1986
- THE DARKER SIDE OF TAX "REFORM" -
People seem to be in love with the tax bill recently passed by the Senate,
as both bonds and stocks flirt with their recent highs. At the risk of be-
ing curmudgeonly in the face of a seemingly-imminent decline in the mar-
ginal tax rate from 50% to 27%, I'd like to point out why I think the Sen-
ate tax bill isn't as bullish for the economy as everybody else seems to
think it is.
The most obvious reason is: not everybody has a 50% marginal tax rate!
In fact, very few people do. Most of the country's disposable income....
from which new savings come.... is earned by middle- and upper-middle-in-
come families, whose marginal tax brackets range from the high 20s to the
low 40s. In the table below, I've shown several financial transactions,
along with the percent increase (or decrease) in pretax dollars needed
to yield the same after-tax result for a "typical middle-class" taxpayer,
presently in the 34% marginal tax bracket, who will be in the 27% tax
bracket under the bill:
Item % Increase
------------------------------------------------------- ----------
Wages, salaries or rental income ...................... ( 10% )
Interest income from bonds or bank deposits............ ( 10% )
First $200 ($100 for singles) of stock dividends....... 37%
Dividends, after the first $200 (or $100).............. ( 10% )
Short-term capital gain................................ ( 10% )
Long-term capital gain................................. 18%
Funding an IRA......................................... 37%
Earnings on funds you set aside in your child's name
for future college education...................... up to 37%
Interest expense on home mortgage...................... 0%
Interest expense for consumer purchases................ 37%
Depreciation (where still eligible).................... 10%
Purchase of equipment eligible for 10% investment tax
credit (repealed under bill)...................... 1%
"Tax-shelter" losses................................... 37%
Charitable contributions............................... 10%
Investment expenses (publications, etc.)............... 37%
If you were the above taxpayer, what would be your conclusions? Mine are
that it's slightly more advantageous to earn more money, and slightly
less advantageous to give it away to charity; and that it's horribly more
expensive to save for the long term, and considerably more expensive to
finance a car, or speedboat, or vacation. Note especially the increased
cost of saving for retirement or a child's education.
Generally, when the government raises taxes on an activity, you see less
of that activity; and when taxes are lowered, you see more. I would ex-
pect to see less borrowing for consumer purchases, less long-term saving,
and more in-and-out trading in the financial markets, but with less in-
terest overall in stocks, bonds and mutual funds. What's most profitable
under tax "reform"? Earn more, borrow less, save less, and pay off what
you presently owe.
Is this bullish for the economy? Over the very long term, I think so. I
have always felt we'd be much better off paying our own way than trying
to borrow our way to prosperity. For the short term, I think we have a
problem. An entire generation of Americans has been conditioned to tax-
deductible borrowing to finance current needs, while saving tax-deferred
(property and stocks, IRAs, insurance, pensions) for future needs. Consu-
mers lately seem reluctant to borrow more money, even at lower rates;
raising the cost of borrowing will likely curtail same, and might trigger
the next recession sooner than the "experts" predict, regardless of how
much money the Federal Reserve prints.
In short, if the Senate "reform" bill becomes law, expect a recession to
be underway by mid-1987 (caused by less saving and borrowing coupled with
a six-month delay of the tax cut for individuals, plus an immediate in-
crease in corporate taxes). The stock market will be heading south by
1987, as stock prices finally follow declining corporate earnings.
I can find only one period in our history similar to the present.... late
1928. Back then, the economy was softening, commodity prices were declin-
ing, the inflation rate had retreated from World War I levels, and the
money spigots were turned on full. "New money" must surface somewhere....
if there isn't opportunity to profitably invest it in the economy, it
squishes its way into the stock and bond markets, where it drives interest
rates lower and stock prices higher. In 1929, a wave of speculation and
the madness of the mob drove stocks to unreasonable highs; after the crash,
stocks quickly followed corporate earnings to depression levels.
This does not mean we must have a 1929-style blowoff to the current bull
market. Such a spectacle requires a kind of temporary insanity to grip the
public, and that isn't a predictable event. What we do know is that most
stocks presently are not cheap.... it costs $30 to buy $1 of DJI dividends,
and this is at the high end of the historical range ($10 to $35). The pru-
dent investor is now mostly in cash (see the portfolio review), waiting
for the lower prices which will inevitably come.
- STOCK MARKET OUTLOOK -
I am looking for lower prices throughout the summer. The odds are very
good - about 3 in 4 - that we are at or very near the final top in a four-
year (1982-1986) bull market. There is a chance, about 1 in 4, and espec-
ially if the Federal Reserve continues to create new money at a 15%-plus
annual rate, for a final, 1929- or 1968-style blowoff to the current bull
market. Remember that economic policy is shaped in Washington.... the
future health of the economy is determined by the taxing and spending
policies of Congress and by the Fed's monetary policy. My crystal ball
is prone to developing new images as the political tides of the Potomac
region ebb and flow. The present trend, however, is decidedly deflation-
ary EXCEPT for the green that's rolling off the printing presses.
- NOT IN REAL LIFE -
It's time again for Barron's stock-picking contest (which closed June 30),
and here is the paper portfolio I submitted to Barron's, along with the
closing prices on June 30: 14%- C.O.M.B. (34); 10%- Financial News Network
(15.75); 10%- Franklin Resources (49); 16%- Gap Stores (87.875); 16%- Home
Shopping Network (95.375); 11%- Limited Inc. (33.75); 12%- Tejon Ranch
(53.875); 11%- Toys R Us (34); all of these are short sales. The TV shop-
ping stocks especially are a fad right now, and are due for a tumble; the
others are "story stocks" at very high P/Es. The reason I say "not in real
life" is that I could be right about the general trend, but wrong with my
timing. All of these stocks are quite capable of soaring to even higher
levels before returning to this earthly sphere, completely wiping out a
real portfolio. On paper, the only risk is the cost of a postage stamp....
and who knows, I might be lucky.
- PORTFOLIO REVIEW -
A. "Hedger's Delight" - model portfolio, includes commissions:
25Jun86
Shrs Description Bought Sold On Sold At Cost Is Value
---- ------------------------------ ------- ------- ------- ------- -------
50 Apache Petroleum wt$18/30Sep86 21Dec84 41.25 12.50
100 Bally Manuf wt$40/4Jan88 SHORT 30Oct85 281.23 -375.00
1 Bally Manuf 15Sep98cvbd 60.00 2Oct85 795.00 925.00
10 BancTexas cvpf 1.46 (div susp) 21Apr86 44.00 50.00
50 Campbell Resrc wt$4.40/31Dec88 11Sep85 6.00 3.00
20 Computer Consoles SHORT 12Jun86 186.74 -200.00
1 Computer Con 15Feb98cvbd 77.50 24Sep85 685.00 770.00
200 Cosmopolitan Care SHORT 10Feb86 926.66 -1100.00
200 Cosmopolitan C wt$4.50/25May87 10Feb86 247.50 225.00
1 Eastern Air L 1Oct93cvbd 47.50 11Sep85 625.00 610.00
100 Energy Developmt wt$20/31Mar87 31Mar86 13.75 6.25
100 Golden Nugget SHORT 28Feb86 1390.67 -1375.00
100 Golden Nugget wt$18/1Jul88 28Feb86 357.50 300.00
50 Integrated Resources SHORT 16May85 913.10 -1212.50
15 Integrated Resources SHORT 11Jun85 296.50 -363.75
45 Integrated Resources cvpf 4.25 17Apr85 1560.51 1867.50
25 Integrated Resources cvpf 4.25 15May85 847.50 1037.50
30 Integrated Resources cvpf 4.25 11Jun85 1031.13 1245.00
200 Keystone Camera Products SHORT 12Jun86 1023.86 -850.00
300 Keystone Camra wt$8.25/20Mar90 11Jun86 330.00 225.00
50 Massy-Ferguson wt$3.60/31May91 31Mar86 24.07 37.50
20 McDermott Inter'l wt$25/1Apr90 31Mar86 41.25 52.50
200 McLean Industries SHORT 5Dec85 1777.90 -1500.00
200 McLean Industrs wt9.45/15Jul90 5Dec85 510.00 475.00
50 MSA Realty wt$9/1Apr89 7Feb85 89.38 143.75
110 Pier 1 Inc. SHORT 12Nov85 1663.24 -3492.50
55 Pier 1 Inc. SHORT 23Jan86 937.63 -1746.25
100 Pier 1 wt$22/15Jul88 12Nov85 585.00 3250.00
50 Public Service NH wt$5/15Oct91 22Jan85 96.25 300.00
12 Ridgewood Properties (A) SHORT 12Nov85 252.00 -312.00
100 Safeguard Scientifics SHORT 22Nov85 1010.47 -1450.00
20 Safeguard Scientifics SHORT 6Dec85 222.74 -290.00
100 Safeguard Scient wt$12/30Jun87 18Sep85 220.00 487.50
100 Spendthrift Farms SHORT 9Dec85 341.83 -275.00
100 Spendthrift Farms SHORT 10Dec85 341.83 -275.00
500 Spendthrift Farms wt$9/15Mar89 6Dec85 240.63 187.50
200 Wickes wt$4.43/26Jan92 SHORT 28Aug85 427.48 -675.00
50 Wickes wt$4.43/26Jan92 SHORT 6Feb86 104.06 -168.75
280 Wickes Companies (B) 28Aug85 1226.13 1680.00
CASH 36.30 36.30
(A) Pier 1 distribution; (B) 7:1 conversion ------- ------- --------
of $2.50 preferred. 12097.94 9653.15 -1733.95
SUMMARY - "Hedger's Delight":
Original cost: $ 9,616.85
Present value: $10,363.99
Increase (decrease): $ 747.14 [7.8%]
COMMENT on "Hedger's Delight": This portfolio is designed to counterbalance
excessively high or low stock prices. In spite of its present decidedly
bearish cast, it's been holding its own with a modest profit. The latest
entry is Keystone Camera Products - a neutral hedge I entered when the
$8.25 warrant was temporarily depressed because of an exchange offer for
it. Keystone is gearing up to manufacture blank videocassettes. Your guess
is as good as mine why they want to compete with the Japanese; but for
hedging's sake, let's hope they either succeed or fail spectacularly.
B. IRA 1 - real portfolio: Twentieth Century
2 Jul86
Shares Description Bought Sold On Sold At Cost Is Value
-------- ------------------------- ------- ------- ------- ------- -------
2.7410 VISTA 8Mar84 11.32 21.38
5.8240 VISTA 21Mar84 25.10 45.43
1.3680 VISTA 31Aug84 6.50 10.67
.0670 VISTA 12Jan85 .29D .52
1.6630 Cash Reserves 12Jun86 166.28 166.28
.0050 Cash Reserves 30Jun86 .50D .50
C: IRA 2 - real portfolio: Bull & Bear
905.8000 Dollar Reserves 16Jun86 905.80 905.80
---------
$ 1115.79
SUMMARY - IRA 1 and 2:
Original cost: $ 952.62
Present value: $ 1,150.58
Increase (decrease): $ 197.96 [20.7%]
NEXT ISSUE - will appear in mid-September.
/Nick Chase