What Is A Recession Anyway?

I say that because all of the sudden it appears the classic definition of a recession (two or more consecutive quarters of negative GDP growth) has been squashed. For the first time, it is becoming agreeable that a group of economists in Boston ultimately get to decide if and when a recession has occurred. As a result, we won't know until after it is over when it actually took place because they will be the official referees. And it appears they can use any metrics they want to make such a determination. How silly!

I'm not sure when it was decided that six months of negative economic growth was no longer a good barometer of recessions, but I could hazard a guess. You see, if you look at the final, revised numbers from the 2000-2002 economic downturn (widely asserted to be the last recession) you will see that there were never two consecutive quarters of negative GDP growth. Therefore, we can either say that period was merely a sector-specific, Internet bubble being burst, or we can change the definition of a recession and claim that it was indeed a recession because a group of economist say so. Clearly, the latter option has won out.

So here we find ourselves in a world where people take sides arguing that we will or will not have a recession, but we admit that we won't know for sure until it's over. All of this furthers my opinion that whether or not we have an official recession or not is largely irrelevant. Is the stock market really going to react meaningfully different if we have two consecutive quarters of negative growth, or simply one quarter down, one quarter up, and another quarter down after that? If economists get to have the final say after the fact, then we won't know about a recession for sure until it's over (when the market has already turned up again), so the official ruling won't matter to investors.

The bottom line is that the economy will always go through cycles. It's called a business cycle for a reason. The only thing that will solve the problems we face is time, so I think we should all just be patient, wait it out like all long term investors should do, and stop all this recession talk nonsense. Of course, that is extremely wishful thinking, but that's what I'm going to do regardless.

How Should Hedge Funds and Private Equity Be Taxed?

It seems like Congress goes into attack mode anytime somebody is making a lot of money. In some cases I agree with our elected officials and in other cases their arguments make little sense if you look at the big picture. Take the oil companies for instance. We all know the industry is swimming in money. If Congress aims to repeal subsidies these firms get from the federal government, I have a hard time opposing the idea. Our country does not need to subsidize our oil companies. However, if you propose some kind of excess profits tax simply because oil prices are high, that is ridiculous. We live in a market economy and markets are cyclical. You can't tax companies during boom times just because you feel like it.

Anyway, the topic du jour is the taxation of hedge funds and private equity funds. Again, we have a group of wealthy people who are making billions and paying the same (if not less) taxes as the average worker. To figure out where I fall on issues like these, I try not to bring politics into it at all. To me, it's logic-driven reasoning that should rule the day and help form an opinion.

I haven't been following the issue that closely, but the sticking point is the fact that hedge fund and private equity fund general partners split investment profits with their limited partners. The investment managers serve as general partners and collect 20% of the profits from the investments they make, which is often taxed as long-term capital gains, at a rate of 15%. The fact that someone can make $100 million and only pay 15% in taxes is evidently upsetting a lot of people in Washington.

At first blush it might seem like the 15% tax rate makes sense. If a hedge fund has $100 million in assets and earns 10%, there is $10 million in profit to be divided up. Assuming an 80/20 split, the manager makes $2 million and the limited partners share $8 million based on their ownership percentages. Since the $10 million in profit was the result of capital gains, then it is easy to see why some feel the 15% tax is fair.

There is one difference though, that seems very important. The whole point of having a low capital gains tax rate (relative to income tax rates) is to incentivize people to invest in businesses and put their capital at risk. Such actions are the life blood of our capitalist system. In return for risking your own money by investing in other ventures that need funding, you are rewarded with a lower tax rate on any profits you earn.

The problem is, hedge fund managers aren't risking their own capital a lot of the time. They are pooling money from their investors and managing it for them. Sure, they don't earn anything unless they produce positive returns, but if they lose money, they don't lose as much, if at all, because they typically have less capital at risk, if they invest in the fund at all. This seems like the most logical reason why one would be against the 15% tax rate for hedge fund managers.

Now, it's true that most fund managers have invested some of their own money in the funds they manage. Perhaps what the tax law needs to say is, when you have your own money at risk, you can claim profits as a capital gain, but when your investors are simply sharing a portion of the profit earned on their capital, in return for your management ability, then that income should be treated as a management fee, and therefore taxed at ordinary income tax rates.

It's a tough issue for sure. I just hope the law going forward reflects reality, meaning that if you get a tax break for capital gains, it better actually be your capital that was put at risk in order to produce the gains in the first place. A fair compromise in my eyes would be to allow managers to pay 15% on the portion that is their own capital at risk, and ordinary income tax rates on fees earned on limited partner's assets that are paid out to the general partner. That way, the whole point of the 15% capital gains tax rate (reward risk taking with lower taxes) is preserved.

What do you think?

Why A Negative Savings Rate Isn't All That Worrisome

From the AP: Personal Savings Rate for 2006 Drops to Negative 1 Percent, the Lowest Level in 74 Years

"The Commerce Department reported Thursday that the savings rate for all of 2006 was a negative 1 percent, meaning that not only did people spend all the money they earned but they also dipped into savings or increased borrowing to finance purchases. The 2006 figure was lower than a negative 0.4 percent in 2005 and was the poorest showing since a negative 1.5 percent savings rate in 1933 during the Great Depression.

The savings rate has been negative for an entire year only four times in history -- in 2005 and 2006 and in 1933 and 1932. For December, the savings rate edged down to a negative 1.2 percent, compared to a negative 1 percent in November. The savings rate has been in negative territory for 21 consecutive months."

You can definitely put me in the camp that claims the U.S. economy is nowhere near as good as the stock market is telling us, but at least one statistic used by the pessimists out there is really not a big deal; the personal savings rate.

We keep hearing how the rate has been negative and what that tells us about the American consumer's balance sheet. However, the statistic is very misleading. One would think that calculating a savings rate would include accounting for what most people consider to be "savings." That is, money that is put away for future use and not spent.

Unfortunately, the personal savings rate simply takes one's disposable income (income after taxes are paid) and subtracts spending. Actual savings, most notably retirement savings in 401(k) plans and IRA's, is not actually counted as savings in this statistic. So, you can see that we really can't conclude that people aren't saving nowadays. We just don't know how much people are saving from this number alone.

What we do know is that debt levels are rising in the American household, but we already knew that. We know the average American has thousands of credit card debt, and with historical low interest rates and very easy credit, it's no surprise people are accessing it. However, without including monies earmarked specifically for savings by consumers, the personal savings rate really doesn't tell us as much as some would like you to believe.

Fed Meeting Preview

As we head into the FOMC meeting today, I wish I was a bit more optimistic. The market has priced in a pause in rate increases and a definitively more "dovish" policy statement. The last time I saw the Fed Futures it was around 18% for a rate hike today at 2:15 ET.

Even if we get what the market expects, will the market make a nice run to the upside? I doubt it. We could get an immediate pop, but I don't think it would hold up. There will be plenty of sellers looking to slim down positions if we get something like +100 on the Dow this afternoon.

The other alternatives suggest we might see reasonable selling pressure. I've said here lately that I think we could very well get a 25 basis point hike today. I think the 18% chance that the futures markets have priced in is too optimistic. That said, the hike itself isn't catastrophic, so long as the Fed makes it clear in their statement that it is the last one for a while.

This is where the problem comes in. I don't think the Fed will want to say anything that makes them look "dovish" on inflation. Their policy statement, whether they raise rates today or not, might very well talk tough on inflation and indicate that while they are pausing for now, if they continue to see inflation pressures they won't hesitate to raise rates later in the year.

Such a development would likely cause a market sell-off, making today's highly anticipated Fed meeting fairly disappointing for those of us who own stocks. I sure hope I'm wrong and we see stock price advances from here over the near term. But if that happens, I would be tempted to take some money off the table. If others feel the same way, any rally will likely be short-lived.

*Update*

Full Disclosure: With the Dow +43 this morning, I have initiated a short trading position in the Spiders (SPY) for my personal account in anticipation of the gains fading after the Fed decision is released. 

Analysts and the Fed

Two completely separate points I'd like to make this morning.

The first is regarding an analyst call on Garmin (GRMN) yesterday, one day before the company was slated to report second quarter results. As many of you know, GRMN is the leading maker of global positioning systems (GPS). American Technology Research decided that it was a good idea to initiate coverage of the stock yesterday, ahead of earnings, with a "sell" rating and a $75 price target, with the shares trading at $95 per share.

These types of calls are always intriguing to me. First, Garmin has blown away numbers for the past couple of quarters. The company is taking market share and the GPS business is growing rapidly. If anything, the company would have better odds of having a great quarter than a poor one. It's true that Garmin's competitors posted bad quarters already, but that is likely due to Garmin kicking their butts.

Second, why would you want to make a call without any information on Q2 or the outlook for the rest of 2006? With Reg FD in effect, there is no way a company is going to leak to anybody how the quarter went. Essentially, the analyst is completely in the dark about current fundamentals at Garmin and yet still is sticking his/her neck out to recommend investors sell.

This is yet another example of why investors shouldn't worry if an analyst issues a negative report on a stock they own. If you have done your homework and believe in your investment thesis, use the weakness generated by these analysts (Garmin was down $5 per share yesterday to close at $90) to buy the stock at a cheaper price.

Garmin's Q2 report this morning was another blowout. Earnings per share came in at $1.10 versus estimates of $0.94 and the company raised guidance for all of 2006. The stock has traded up as much as $15 per share in pre-market trading this morning.

On a completely unrelated note, the Fed Funds futures market is now indicating that traders are pricing in a 34% chance that Bernanke will raise interest rates on Tuesday. I am afraid that this assumption is highly optimistic. I would take the "over."

Will Bernanke Throw Investors a Bone?

We know that interest rates hikes work with a lag, so it takes 6-12 months for the effects to ripple through the economy. We know that we've had 16 straight rate hikes that has taken the Fed Funds rate from 1% to 5%. Shouldn't Chairman Bernanke and the FOMC take a break, and see how the two-year long rate-raising campaign affects everything?

That's the case for the Fed to quit. I'm in that camp, personally. It's not like the Fed can't raise rates whenever they want to anyway. If they pause for a month or two and regret it, you can always go back and raise some more. Would such a plan have any drastic repercussions? I doubt it. And let's not forget, even though the market gets on a regular timeline with the FOMC meetings, Bernanke and Co. can move between meetings if they need to.

The way I see it, the stock market has stabilized after getting down to S&P 1,225, 8% below the highs. It has a little room to rebound, given the chance. If we get more of the same later this week from the Fed, and by that I mean a 25 bp hike and a similar statement to recent ones, equities will have a tough time to hold current levels. Uncertainty is always bad for stocks. If we get a signal that this hike is the last one for a while, I think can get a brief rally that might get us to back close to 1,300 on the S&P 500. At that point, I'd probably do some selling.

Another less likely option, but a good one nonetheless, would be to move 50 bp this week and signal a pause. This would satisfy both those looking for a hawkish stance on inflation, as well as a pause to observe the ultimate effects of all of these hikes. I think the market would rise in this scenario as well. I hope Bernanke decides to take a wait and see approach, but we'll just have to, well, wait and see.

Bernanke Era Begins

Just how different will today's Fed meeting be compared with those of former FOMC Chairman Alan Greenspan? Will the Fed's all important statement be a lot more clear and straightforward, or will it be only slightly tweaked from those used over the course of the last several years? These are the questions investors and economists are eagerly anticipating getting answers to as we await the outcome of Ben Bernanke's first meeting as head of the FOMC.

I think the wording might be slightly different under Bernanke, but those looking for bold shifts in policy wordings might be disappointed. We will get a 25 bp hike today, but where do we go after that? Will 4.75% be the end, or are we going to 5.00% or 5.25%? I think the case can be made that 4.75% is enough. Surely anything above 5%, given the current economic climate, will spook many investors.

Most importantly, what does this mean for the stock market? The market has been acting very well lately, and in my mind that signals we are pricing in the end of the rate hike cycle. If that's the case, those expecting a huge rally when the Fed does get around to stopping will likely be met with sellers looking to book the gains earned in recent months.

Bernanke Reign Begins

The markets really aren't reacting much, if at all, after newly appointed FOMC Chairman Ben Bernake answered questions on Capitol Hill today. Aside from Bernanke's preference to avoid partisanship, his answers and views on the economy were very similar to Greenspan's. As far as interest rates go, I continue to think we'll see 5% Fed Funds this year.

Implications for the stock market aren't very bullish in such a scenario. Stocks tend to be flat to slightly down after the last hike of a rate tightening cycle, and any move above 5% Fed Funds would indicate inflation is fierce enough to further crimp corporate profit growth. All in all, there are many excellent investment opportunities out there, but index funds won't fall into that category in the short-to-intermediate term, in my view.

Different Year, Same Old Story

It was postulated here earlier in the year that 2005 could very well turn out a lot like 1994, the last time the Fed went on autopilot and raised interest rates consistently for an extended period of time. The result was a flat-to-down market that ended up a mere 1% for the year (only after a substantial rally late in the year). As some of us expected, 2005 has indeed played out the markets tend to do when the Fed is increasing the cost of money.

To see exactly how similar it has been I decided to construct a year-to-date chart of the S&P 500 and compare it to the same nine-month period in 1994. Below you will find both charts, 1994 first, followed by 2005.

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