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Tuesday, August 21, 2007

Dunk's Commentaries

Bill Dunkelberg--who is a Commonwealth Foundation Board Member, Temple economics professor, and chief economist for the NFIB--provides these regular commentaries on today's issues. Here's his latest installment...

With three months left in the government’s fiscal year, it appears that the federal deficit will be much smaller than expected, not 400 billion, not 300, not even 200 billion. This is good news on the surface, but it masks the fact that it is the growth in tax revenues that is reducing the deficit, not a lot of spending discipline. Tax revenues are growing twice as fast as government spending due to a good economy.

To its credit, government spending has slowed from last years torrid pace, but with the economy at full employment, the budget should be in surplus, not clawing its way out of a large deficit.

Except for the surprise surpluses in the late dot com years, again due to your sending in a lot of your money in tax receipts, the last surplus was 1969. Republican or democrat, congress just likes to spend more than it takes in, doling out your hard earned money to get re-elected. We still haven’t fixed that problem.

If you like thrills and spills, then you have enjoyed the roller coaster rides in the stock market. In one week in July, the market lost five percent of its value. That’s the bad news. The good news was that even with a five percent loss, the market was up six percent for the year.

Large firms, especially the Dow Jones Industrials or the S&P 500 are globally diversified. Consequently, a slower U.S. economy has not impacted profits as much as some expected. These large companies make more than half their profits overseas. When these profits, say in euros, are converted back to dollars with a weak dollar, profits get an extra boost. This has kept the major stock averages moving to record levels this year.

If you want to diversify your stock holdings globally, you don’t need to buy stocks whose names you can’t pronounce. Major U.S. companies are diversified for you. Or, new exchange traded funds that reflect the entire market of a country can also give you a safer and easier way to globalize your investment portfolio.

The government released its first guess about economic growth in the second quarter and, much to our relief, it was a solid performance. With first quarter growth an anemic seven tenths of one percent, some were concerned that the economy was on the edge of slipping into recession. However, the economy grew 3.4%, a respectable number.

Now, I have trouble thinking of a 13 trillion dollar economy actually increasing its growth rate by 500% in just 90 days, so let’s average the first and second quarter numbers and agree that the economy is growing a little better than 2%. That’s below what most observers think is long run potential, but sufficient to move the economy along and keep employment growing.

In general, profits can’t grow faster than GDP– unless you have globalized companies. Overseas profits are growing well and when translated back to dollars with a weak dollar, profits get an extra boost. This is why slow u.s. growth didn’t have much impact on stock prices. As you invest, keep in mind that the rest of the world will grow faster than the u.s. for the foreseeable future.

For you Baby Boomers and youngsters, consider this. $1000 invested in Berkshire Hathaway in 1956, the equivalent of $8000 today, would be worth $27 million today. A track record that good for that long is not luck. But it wasn’t based on fancy schmancy models either.

According to an interview with U.S. news, the principles to follow are simple. Rule 1 is don’t lose money, rule 2 is don’t forget rule 1. If you lose 50 percent of your money, it takes a 100 percent return to get even, hard to find.

Cut your losses, invest based on return on equity, not earnings per share, and, the hardest part, peer into the future – figure out what’s going to work in the longer run, invest in diamonds, not rhinestones that sparkle in the light but don’t perform. My guesses? Energy, health care, food and water and transportation. Biggies. And instead of picking companies, use exchange traded funds with the right focus. Or copy warren. Few of us can beat Warren Buffet, but just a fraction of his success will leave you sitting well.

The teaser on my AOL screen reads “Countrywide, 4 out of 5 approved, refi to combine mortgage and debt! Bad credit?” Well, they invited bad credits and they got them. With the huge boom in house values, lenders like countrywide forgot about lending standards and counted on the appreciation of homes to cover their mistakes. Sorry, it didn’t work that way. The housing boom produced too many houses and prices fell.

Now, the number of homes in some stage of foreclosure is up 60 percent from the first half of last year, numbering nearly 600,000. Companies like countrywide financial and American home mortgage are indeed in financial trouble as are hedge funds such as those at bear sterns who bought these assets using lots of

Fortunately, the risk has been spread around the world. Unfortunately, the risk has been magnified by using lots of debt in the deals as mortgages changed hands. Overall, it will not cause catastrophic problems, but it has created some interesting trading days on Wall Street.

One major reason the levees failed in New Orleans was that local politicians diverted funds earmarked for levee maintenance into other politically more attractive projects. Fast forward to Minnesota. A bridge collapses and politicians immediately call for more spending on roads and bridges, financed of course by an increase in your taxes.

But Minnesota spends 1.6 billion a year on transportation, enough to build 4 newbridges a year. But $1 billion, or 60 percent of the money is diverted from roads and bridges to the states light rail network that carries virtually none of the states traffic but is a great political showpiece. Only 3 percent of the states commuters ride the rail or buses to work, but their transportation soaks up 25 percent of the budget.

Are higher taxes needed? The state has a budget surplus of over $2 billion, more than the entire transportation budget. The money went to art centers, sports stadiums and welfare benefits, projects more likely to earn votes than road repair.

Minnesota has the seventh highest income tax rate, the third highest corporate tax rate and the tenth highest tax on workers. State spending has doubled in the last ten years, but not on roads and bridges! 12 million in federal transportation funding was diverted to the light rail line that nobody uses and the Isanti bike/walk trail and bus service in Duluth and the Mesabi Academy of Kidspeace in Buhl.

What Minnesota needs is not more taxes, it's better leadership.

We lost the S&L industry because Congress created these institutions to make and hold mortgages. Washington produced high inflation which raised interest rates which then bankrupted virtually all of our

Today, mortgages are the hot potatoes of the financial world. Nobody wanted to hold them and they were passed around the entire world, subjected to financial surgery at each pass to change their shape. At each stage of the game, the acquirer used debt to make the purchase, piling leverage upon leverage upon leverage. So, the good news is that the pain is widely shared, not concentrated as it was for the S&Ls.

The bad news is that the underlying assets, the mortgages, were really sub prime in many cases. Lenders assumed that rapidly rising home prices were their insurance against losses from defaults that arose from lax underwriting standards. Lenders didn’t, for example, check to see if the income you put on your application was in fact the truth.

But, it’s not banks that are in trouble, it’s hedge funds and those who lent money to hedge funds. Let’s let the market sort this one out under the watchful eye of the central banks.

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