One has to expect that a certain level of fear among those holding short positions is also behind this rally – although something tells me, with the way the government is treating these stress tests, that the shorts will fight another day with regard to the financial sector, banks specifically – although this is certainly a contrarian view right now.
What’s more, with a historic mountain of cash on the sidelines, in a zero interest rates environment, the trigger was set to fire off a substantial rally. This was a key reason we explained in the March 10 letter that it did feel a powerful rally was in store
Yesterday’s economic reports on pending home sales and construction spending (both for March) easily beat expectations. We’ve seen this market move higher even in the face of bad news reports, so better-than-expected news from these data sets made it pretty easy for traders to push shares higher.
Tomorrow we get the ISM service-sector survey for April and it’s got a very good shot of beating a pretty weak estimate – if the number comes in at 45 or higher…wow, that could really provide a spark. Careful though, it’s important not to allow emotions to get the best of you here, we are no where close to being out of the woods. Every action the government has engaged in, and they many, must be viewed as having its own consequence that will have to be dealt with over the next couple of years.
Financials led the market higher, jumping 10.13%, as Warren Buffett says he doesn’t care what the stress test say he believes Wells Fargo is in fine shape – and simply because he is the top shareholder of Wells you can expect at least this bank won’t have an issue with private funds, for the rest it’s very suspect with the government as a partner.
Basic material stocks enjoyed another nice surge – these shares have soared 50% since touching their March 2 low. Investors are excited over the prospects of reflation (dispelling the thought that deflation is still a concern), although we would look for the CRB (commodity index) to hit 250 before it offers total conviction that the reflation trade is good to go without a major pullback.
All of the 10 major S&P 500 industry groups closed to the plus side.
Market Activity for May 4, 2009
An End Around on the Repatriated Income Tax
What’s known as the repatriated income tax is essentially the tax liability a company incurs when a U.S. corporation brings profits from an overseas subsidiary back home – that income is taxed at the 35% corporate income tax rate. Of course, the majority of this overseas income never comes back home as a result of the tax – the U.S. business pays the foreign country’s tax and then must pay this one if they bring it home, which puts our firms at a disadvantage since no other OECD country engages in such activity (only the foreign country’s tax rate is levied) – and thus we have less domestic capital than would otherwise be the case. When the company leaves that profit overseas, the U.S. corporate tax is not applied and that is known as the deferral on overseas profits – the deferral assumes that that money eventually comes home and the tax is then levied – hence why it is often referred to as the repatriated tax..
Well. What businesses do sometimes is borrow money from that overseas subsidiary and thus gain a tax deduction from the interest payments to that subsidiary. This appears to be what the administration is going after, that deduction – they wanted to completely repeal the deferral on overseas income, meaning firms would pay the tax of the foreign country in which they do business plus our own 35% rate, but ran into such a backlash that they have to do this end around. They will also end the tax-credit that firms are granted on the foreign tax paid – legislation that was put in place in the 1990s, I believe, as a way to make our firms more competitive as we have the second-highest corporate tax rate in the Western world.
They believe that by eliminating the deduction on interest paid to overseas subsidiaries and ending the tax credits U.S. firms will not have the incentive to have overseas operations and those jobs will come home. But this view is so benighted it not only pathetic it’s troubling they don’t understand the issues. Firms won’t bring these businesses home. Instead, many will choose to move their headquarters altogether to places that offer more attractive corporate tax regimes. This is nothing more than a corporate tax increase at the worst possible time, not that there is any time driving after-tax profits lower is a good time.
The correct way to go is to eliminate the tax on bringing profits back home, or at least slashing the tax from 35% to, say, 10% -- hundreds of billions in capital would come back home at exactly a time we need it most and the Treasury would see a very nice revenue gain as well. Or, better yet, eliminate deductions and credits completely and move to a very low corporate tax rate of 10%-15%. While this may cause some havoc in the short term, over the longer term it would not only benefit investors via the after-tax corporate profits boost (and thus send stock prices higher) the consumer would benefit as well -- firms don’t pay taxes, they are passed on through prices. Alas, there is no hope of this occurring at the current time – it will come though; we’ll get there after the current ideology, if left unchecked, proves economically damaging.
This proposal from the administration would also target individuals who choose to place their capital in tax-haven countries. According to Bloomberg News, a Treasury official says this will shift the burden of proof to the individual when the IRS alleges assets are being hidden in certain offshore bank accounts.
Again, there are two ways to make sure the U.S. is the place most desired place for capital to reside (the most desired place for investment dollars and businesses to reside) and both must work together. The first is by keeping tax rates on income and capital low. The second is sound monetary policy from the Fed that results in a stable currency value. By eliminating deductions, or raising tax rates, just the opposite occurs.
Pending Home Sales
The number of Americans signing contracts to buy previously owned homes rose for a second-straight month in March. Pending home sales increased 3.2% last month, according to the National Association of Realtors, which followed the 2% increase for February – although that February rise didn’t help actual sales for March as they were down 3%. We’ve seen contracts breakdown over the past several months prior to closing; existing home sales are obviously not counted until the contract is closed. Certainly job losses have played a role in signings failing to turn into closings.
Still, the rise in March pending home sales, which hopefully turn up in April sales, is a good sign. By region, the West and South saw the gains, as pending sales rose 3.8% in the West and jumped 8.5% in the South. The Midwest saw pending sales fall 1.0% and they fell a substantial 5.7% in the Northeast.
We should see some bounce in home sales with mortgage rates so low and prices down significantly. Still, one shouldn’t expect too much until job losses ease.
Construction Spending
U.S. construction spending rose 0.3% in March (a 1.6% decline was expected) as spending on private commercial and government projects offset the continued decline in residential building. This marked the first rise in six months.
Commercial construction spending (private non-residential) jumped 2.7% last month and government non-residential spending rose 1.2% -- both more than making up for the 4.1% decline in private residential construction spending (down 33.3% over the past 12 months) and the 2.3% decline in public residential spending.
I’m not sure where the rise in private commercial construction came from as vacancy rates are rising due to the economic contraction – maybe we’ll get a more clear reading when the number is revised next month, it doesn’t seem to add up.
The government side will be the driver of construction spending for a while as the infrastructure projects begin to take affect. Currently, public spending makes up 30% of the overall reading, that percentage will rise over the next year.
Have a great day!
Brent Vondera, Senior Analyst
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