Fed Rate Cuts Are Near an End

While many investors are betting the Fed will continue cutting interest rates, I'm starting to believe we are very near the end of this rate-cutting cycle for several reasons.

First, the Fed has already been extremely aggressive with its recent rate cuts, slashing them 225 basis points since September. Because interest rate reductions spur economic activity with a lag, the rate cuts delivered so far are probably just starting to kick in. The Fed would prefer to wait and see if more monetary stimulus is really needed.

Second, the fiscal stimulus package recently signed into law by President Bush takes a lot of heat off the Fed. While tax rebates are not as effective as tax cuts, they do give the economy a bit of a boost. This makes it much easier for Ben Bernanke and the Fed to hold off on further cuts.

Third, the stock market appears to be stabilizing. This also makes it easier for the Fed to stand pat. Bernanke was strongly criticized for reacting more to the stock market than to economic data. He no doubt is hoping stable stock prices persist.

Fourth, recent economic weakness put inflation on the back burner. But inflation cannot be ignored anymore. Any further evidence that headline inflation is creeping into the core rate will make it very difficult for the Fed to keep cutting rates.

The FOMC's next meeting is almost a month away. A lot more economic data will be released between now and then. You can bet the Fed is hoping that more rate cuts will not be needed.

Baseball Takes Center Stage in Congress

CNBC has been airing the Congressional questioning of Roger Clemens and Brian McNamee all morning. This is about as interesting as Britney Spears' travails. I thought CNBC was a business channel.

This also explains why we are so turned off by our political leaders. After delivering a fiscal stimulus package, Congress has nothing better to worry about than steroid use in baseball? Is it just me, or does anybody else see a problem here?

Dow Becomes More Finance Heavy

Dow Jones & Co. announced changes to its prestigious Industrial Average today. Altria Group and Honeywell are being dropped. Bank of America and Chevron will be added.

Dropping Honeywell is a bit odd since the company has been doing well for a prolonged period. Honeywell's predecessor company, Allied Chemical, was added to the Dow average in 1925. Honeywell's comparatively small size was cited as the reason for removing it, yet there are three stocks that remain in the index that have even smaller market capitalizations. General Motors, a seriously troubled company, is one of them.

Chevron was previously in the Dow index. It was dropped in 1999 when both Microsoft and Intel were added, which marked the first time (and so far the only time) Nasdaq-listed stocks were added to the index. This raised expectations that more would follow. Some observers are disappointed that today's additions did not include a mega-cap technology company such as Google or Oracle.

Bank of America's inclusion increases the Dow's weighting in financials. The Dow also includes JPMorgan Chase, Citigroup, American International Group, and American Express. Is this the committee's way of signaling a bottom in this beaten up sector?

Bearish on Economy; Bullish on Stocks

The following commentary was released last week to subscribers of the Forbes Growth Investor:

Regular readers know that I have been bearish on both the economy and stocks for quite some time. While I certainly enjoyed the ride, I could not understand why stocks were rallying so strongly during the first half of 2007. Although the sell-off that began in mid-July did not surprise me, I was perplexed by the full and rapid recovery that immediately followed. Unfortunately, as we all know, those gains did not last very long. The S&P currently stands about 12% below its October peak.

It was obvious that economic conditions were deteriorating. There was much discussion about the housing bubble and the subprime mortgage crisis. Every rational investor had to be worried about the potential ramifications of these problems and the real possibility that they would spread to other sectors of our economy. Yet I found it incomprehensible how the eternal optimists kept downplaying these concerns. I don’t know how many times I was told that subprime mortgages represent just a tiny fraction of all mortgages, or that housing prices would never fall on a nationwide basis.

One prominent and perennial bull, who once chided the media for giving bears too much air time, recently argued there is “so little evidence of serious trouble” in the economy. Admittedly, this remark came before the 0.6% fourth-quarter Advance GDP figure was released, and before the Dept. of Labor said initial jobless claims jumped to 375,000, pushing up the four-week average by more than 10,000 to 325,750. Yet there has long been more than a little evidence that the economy was headed for trouble.

As for the argument that subprime mortgage problems would be contained, almost all financial institutions have already announced massive writedowns. This is no surprise. What is surprising, however, is a recent release from pharmaceuticals giant Bristol-Myers Squibb. Bristol said it took a $275 million impairment charge in the fourth quarter due to soured investments in auction rate securities (i.e., collateralized debt obligations backed by mortgages and credit card loans). Furthermore, Bristol no longer considers these investments liquid and has reclassified them from current to non-current assets. I suspect Bristol won’t be the only major non-financial company revealing these kinds of writedowns.

There is much debate about whether or not a recession is coming. In my view, it has already arrived. But whether or not it’s an “official” recession is largely irrelevant. The Federal Reserve is obviously so alarmed it has slashed interest rates at a record-breaking pace without regard to the inflationary consequences. Washington politicians are also alarmed. They are pushing through a fiscal stimulus package many observers thought would take months to reach the president’s desk. This combination of strong monetary and fiscal stimuli will prevent a recession from becoming too deep or prolonged. While I remain bearish on the economy for the time being, as I explained on my blog (http://janjigian.blogspot.com) on Jan. 21, I am turning more bullish on stocks. I believe stocks have fallen enough to be attractive to all investors except those with very short horizons. It’s time to allocate more money to this asset class. This month’s Citigroup recommendation conveys my conviction that some of the best opportunities for long-term gains will come from the oversold financial sector.

We Can Thank Buffett for the Microsoft/Yahoo Deal

Shares of Yahoo soared following today's announcement that Microsoft made a bid for the company. Microsoft is offering $31 per share for Yahoo, which represents a 62% premium over Yahoo's previous closing price.

Microsoft is obviously hoping a Yahoo acquisition will allow it to compete more effectively against Google. Analysts are already debating whether or not the deal makes sense. However, other than the timing, there is really nothing surprising about the deal. As I pointed out last June (Speculating on a Microsoft and Yahoo! Deal) Susan Decker's promotion to president of Yahoo made a deal between Microsoft and Yahoo all the more likely. This is because Decker had also been recently appointed to Berkshire Hathaway's board of directors. Not coincidentally, Bill Gates, Microsoft's founder, also sits on the Berkshire board.

When all is said and done, Yahoo sharesholders should thank Warren Buffett for today's offer from Microsoft. After all, Buffett was instrumental in bringing together the major players in this deal.

Only Tax Cuts Work in the Long Run

I was asked several times this past week about the presidential candidates and their plans to revive the economy. How the candidates would get us out of recession is largely irrelevant. After all, whoever wins the election will not actually enter the White House until a year from now. Hopefully, the recession will be over by then.

I know that not everyone believes we are actually in a recession, but whether we are or aren't is also largely irrelevant. The fact is that economic growth has slowed tremendously and some regions of the country are experiencing contraction. In any case, the situation is dire enough that something must be done to revive the economy.

I explained on MSNBC and on the Leon Charney Report, which airs in the New York City area, that an economic recession is a bit like a patient who is having a heart attack. First the doctor treats the heart attack--usually with surgery and medication--then once the patient has been stabilized, the doctor addresses the long-term health issues. He might prescribe a change in diet and an exercise program. The goal is to make the patient healthier in order to reduce the odds that he will suffer another heart attack in the future.

From what I've been hearing so far, the Democrats' proposals address the heart attack. They are looking for ways to immediately revive the economy. But they are ignoring the long-term health issues. I'm not seeing anything on their table that would keep the economy healthy over the long term and reduce the odds of another recession.

The Republican candidates, on the other hand, are focused on the long term. They all want to reduce tax rates on individuals and corporations. Mike Huckabee is even proposing to eliminate the income tax entirely and replace it with a national sales tax. Lower taxes will certainly go a long way to ensure the long-term health of the economy, but they don't do much to address the immediate problem.

Yesterday, government officials announced agreement on a $150 billion economic stimulus package. They plan to mail checks to about 117 million families. They even proposed allowing Fannie Mae and Freddie Mac to temporarily purchase mortgages well above the current $417,000 limit. These proposals are well and good, but they merely treat the heart attack. They don't do anything to ensure the economy's long-term health. Hopefully, the Senate will add such measures before a final bill reaches the president's desk.

Too Late to Turn Bearish

It's funny how stock market bulls often turn bearish after prices have already fallen. I've been a bear for quite a while and found myself debating a number of bulls over the past year. One well-known bull even argued that by giving bears like me an equal amount of air time, the media was falsely creating the impression that economists were split on the issue of future growth.

Today there are no serious economists left who are predicting strong growth. The most bullish among them, including Fed Chairman Ben Bernanke, are predicting only weak growth. Many believe a recession is quite likely. Some, like myself, believe a recession has already arrived. Even non-farm payroll growth, perhaps the most encouraging economic measure all along, is starting to show serious signs of strain.

Today I had an interesting conversation with Professor Michael Goldstein of Babson College. He and I worked together over a decade ago when we were both on the faculty at Boston College. Michael was preparing for a television interview about the stock market. He reminded me that a year ago both of us were scratching our heads trying to understand why stocks were rising so rapidly. At that time, we were both concerned about falling house prices and their detrimental effects on consumer spending. Today we are just as concerned about rising credit card defaults.

Dow futures are currently indicating a very weak opening tomorrow morning. The Dow may immediately plunge 500 points or more. Michael and I think it could even dip below 11,000 soon--at least on an intra-day basis. However, we also agreed that significant declines below that level are unlikely.

Most long-term investors should take a contrarian view. At this time, they should be thinking more about buying than selling. It isn't yet time to jump in with both feet, but it is time to start thinking about taking advantage of serious dips. Some Special Situation stocks we continue to favor include SVU, RKT, and PERY. These also are stocks that I personally have been buying.

Bernanke Deserves Blame for Sell-Off in Stocks

Ben Bernanke testified in Congress today. Investors reacted by dumping stocks. Some insist that the sell-off had little to do with his remarks and more to do with other factors, such as Merrill Lynch's disappointing results. I doubt this is the case. After all, Merrill Lynch announced its results early this morning and the market was holding up well--at least until Bernanke's testimony got under way.

The Chairman's remarks made it clear that he is very worried about the economy. Although he said the Fed is still not forecasting recession, he clearly indicated that growth will be disappointing. He mentioned the troubled banks, mortgage-related problems in the residential market, signs of weakness extending into the commercial market, weakening employment figures, and an uptick in core inflation.

Bernanke strongly hinted that the Fed will cut interest rates once again. Some investors are disappointed that the Fed may not actually implement a cut until the Jan. 30 meeting. They want a cut right now.

Bernanke also asked Congress for fiscal stimulus. He apparently believes things are so bad that interest rate cuts alone are not enough to stimulate the economy. The mere fact that he was asking Congress for tax relief made investors nervous.

Cutting taxes is the best way to prevent recession. But Bernanke was not arguing for the kinds of tax cuts Republicans favor. Instead of cutting tax rates or making the Bush tax cuts permanent, he expressed a preference for something immediate but temporary. His comments were well-received by Democrats.

Alex Witt of MSNBC asked me about the political repercussions of all this. The bottom line is that things don't look good for the Republicans. Right or wrong, the party in power gets the credit if the economy does well. Likewise, voters blame the president and his party if a recession occurs. Voters demand change. At this point, an economic recession would improve the Democrats chances of taking the White House this fall. But with Democrats controlling both Congress and the White House, taxes are sure to go higher. Then we'll really know what a recession feels like.

Family-Owned Businesses Fear Higher Taxes

PricewaterhouseCoopers (PwC) invited me last night to dine with the CFOs of a dozen privately owned family businesses. These companies ranged in size from about $20 million per year in revenues to $2 billion. Executives from publicly traded companies have plenty of opportunities to meet with one another, but those from privately held family businesses often do not. Last night's dinner was put together to address this situation.

Since my focus is primarily on publicly-traded equities, I welcomed the opportunity to meet executives from the other side. Although I work for a privately-held family business, I rarely get a chance to meet executives from other such companies. The evening was a wonderful learning experience. In particular, PwC had compiled an interesting survey of privately-owned family businesses. Many of the findings were surprising to me. One was not. It turns out these executives worry a great deal about government regulation and taxation. In fact, two-thirds of respondents felt that tax simplification and/or tax reduction should be a priority for government over the next three to five years.

I have written often about the tax burden in the Forbes Growth Investor and elsewhere and wondered why the stock market had been doing so well even when it became increasingly apparent that the Democrats stood a good chance of taking the White House. A Democratic president combined with a Democratic majority in Congress spells higher taxes. Even if the Republicans manage to hold onto the White House, the Bush tax cuts are likely to expire--another way to spell higher taxes. It is difficult to argue that stocks can thrive in a high-tax environment--at least not until they first sustain a sizable sell-off. Perhaps that is what we are going through right now.

By How Much Will Citi Cut the Dividend?

Citigroup is scheduled to announce fourth quarter financial results on Tuesday morning. Analysts are projecting a loss of almost a dollar per share. Investors are keen to hear how much more mortgage-related writedowns there will be. As for the dividend, they are no longer wondering if it will be cut. The only question left is by how much.

The board of directors is reportedly meeting on Monday. You can bet the dividend will be a high-priority topic of discussion. Although company officials have said a number of times that the dividend is safe, no one believes this anymore. Cutting the dividend is the surest way to preserve capital. And you can bet the new investors from Abu-Dhabi will insist upon it.

Citigroup has a long history of consistent dividend increases. Yet management knows that the company can save almost $11 billion in one year alone by eliminating the dividend entirely. It can save $1 billion simply by taking back the 10% increase implemented just one year ago. Management also knows that investors are expecting a dividend cut, so it's an easy thing for them to do. The consensus is calling for a 50% reduction. If that turns out to be the case, the stock may stage a bit of a rally. However, a cut of less than 50% should cause the stock to surge.

Bremmer Warns of U.S. Decline

Ian Bremmer, president of the Eurasia Group, is one of the smartest guys I know. That's why I pay close attention to what he says. And what he is saying right now is not just surprising; it is scary.

He just released a report called the Top 9 Risks of 2008. Because the Eurasia Group is a political risk advisory and consulting firm, some of the items on the list are not at all surprising. What is surprising, however, is that he now considers the United States the #1 risk on his list. Bremmer argues that America's influence is on the wane. The risk is that the country will disengage from the world, erect barriers to trade, and make immigration more difficult. In short, the U.S. is losing both the political will and capital to lead the world. Go to Eurasia Group to learn more.

Oil Prices Likely to Drop as Recession Fears Grow

As shown in the graph above, both oil (blue line) and gasoline (red line) prices have surged over the past five years. However, oil prices have about tripled while gasoline prices have only done a little more than a double. The prices of these two commodities were tracking together quite closely until around June 2007. Since June, however, gasoline prices have remained relatively stable while oil prices have continued to rise.

Yesterday, oil broke above $100 per barrel. Speculators are getting much of the blame. The divergence between oil and gasoline prices gives some credence to this theory. After all, looking strictly at supply and demand considerations it is difficult to understand why oil prices have gone up so high. While it is certainly true that oil-producing regions of the world are not very stable, and that the world is consuming all it produces, there are no shortages.

As today's numbers show, the economy is no longer producing a sufficient number of jobs. The unemployment rate jumped to 5%. The U.S. economy is slowing and the probability of recession has risen significantly. While gasoline prices may go up in the short run, it is much more likely that an economic slowdown will cause oil prices to fall over the longer run. Look for oil to drop to $70 per barrel this year.

Stocks Will Struggle in 2008

Following is my commentary from the January 2008 issue of the Forbes Growth Investor, which was released earlier to subscribers:

The stock market ended 2007 with a whimper. The closely followed S&P 500 Index managed to post only a 3.5% gain for the full year. Investors could have done about as well simply by holding cash and avoiding risk entirely. Although the other major indexes did somewhat better than the S&P 500 (see page 6 of newsletter for their full year returns), 2007 was a lackluster year overall.

Troubles in the housing market are largely to blame for weak stock returns. In fact, shares of home builders and financial companies were particularly hard hit during the year. As of now, prospects for stocks in 2008 do not look all that promising as the housing bubble has yet to fully deflate. According to the most recent reports, problems in housing are likely to get worse before they finally bottom. New home sales were down 34% year-over-year in November. Existing home sales were down 20%. If home sales continue at current rates, it will take more than nine months to clear the inventory of new homes on the market and more than 10 months to deplete the inventory of existing homes.

But it’s not just sales that are falling. Housing prices are collapsing as well. In October, the S&P/Case-Shiller 10-City Composite Home Price Index posted its biggest decline ever, falling 6.7% from a year ago and 1.4% from the previous month. This index is down 7.3% from its June peak. More worrisome, however, is that the rate of decline is accelerating.

All along, the more optimistic economists had been telling us not to worry. They said the sub-prime market was relatively small and its troubles would not spread to the rest of the housing market. They were wrong about this. What’s worse, it now appears that housing problems are spreading into nonhousing areas as well. Evidence is mounting that credit card delinquencies and defaults are rising. According to one study conducted by the Associated Press, outstanding balances on credit card accounts that are at least 30 days late jumped 26% from a year ago. Those that are 90 days late jumped 50%. The same study found an 18% increase in defaults. With the holiday shopping season having just ended, it’s a sure bet that these numbers will get worse.

Investors are just starting to realize that credit card problems are related to the housing and mortgage debacles. Because lending standards have been tightened, even otherwise creditworthy borrowers cannot easily tap the shrinking equity in their homes to pay off their credit card bills. And the so-called sophisticated institutional investors are less willing now than they once were to purchase securitized credit card loans.

Prospects for stocks in 2008 do not look good indeed. Housing and consumer spending are not the only things to worry about. Economic growth is slowing, yet persistently high energy prices and rising core inflation give the Fed little room to cut interest rates. Even the jobs market, which had long remained a bright spot in the economy, is starting to make investors nervous. Many economists now expect reduced growth in non-farm payrolls and an increase in the unemployment rate. The Dec. payroll figure and unemployment rate will be announced on Jan. 4. Anything out of the ordinary for either measure could create tremendous volatility for stocks.

Interest Rates v. Tax Rates

David Wessel wrote an excellent article in today's Wall Street Journal about the need to stimulate the economy. While everyone agrees that the economy is slowing and needs a boost, Wessel wonders if it is better for the Fed to continue cutting interest rates, or if a tax cut would be more effective. He pretty much rules out hope for a tax cut arguing that Congress is unlikely to agree to one.

That's too bad because the Fed cannot realistically cut rates anymore, and because tax cuts are indeed much more effective in stimulating economies. Even former Clinton-era Treasury Secretary Lawrence Summers is now pushing for tax cuts.

Why can't the Fed cut rates? Because inflation is rising. Since September, the Fed dropped both the discount rate and the fed funds rate by a hundred basis points each. Although it takes time for interest rate cuts to stimulate the economy, these recent cuts appear to be having little (if any) effect. They have, however, helped to trash the dollar. While U.S. exports have risen, which is certainly a good thing, so has the level of inflation. Higher inflation makes it very unlikely that the Fed will keep cutting rates.

Many economists are hoping that lower interest rates will soon revive the housing market. But the Fed's actions have not lowered mortgage rates. Furthermore, the housing market will remain in the doldrums for quite some time. There is simply too much inventory on the market. And no rational person would buy a house if he expects the price to keep falling--even if he could get a zero percent mortgage.

That brings us back to tax cuts, which of course are not popular with the liberal set. Liberals argue that tax cuts typically benefit only the wealthy. Yet if tax cuts must be implemented, liberals would rather see those in the lower income brackets get the cuts.

But how is that possible? After all, by definition tax cuts only benefit those who actually pay taxes. Because our income tax code is so progressive, those in the lower income brackets hardly pay any tax at all. How many Americans realize that the bottom 50% (by income) of our population pay only 3% of all individual income taxes? How could Congress possibly deliver a meaningful tax cut to this group? The only way to truly help those in lower income brackets is to implement policies that stimulate economic growth and create opportunities for all members of society.

For many working Americans, the tax burden is much too heavy. The combination of federal income taxes, state income taxes, property taxes, sales taxes, and all those other hidden taxes can easily eat up more than one-half of income. Property taxes, in particular, have literally gone through the roof in many parts of the country. If politicians really want to stimulate the housing market, the most effective way would be to immediately cut property taxes and limit how high they could go in the future.

Brain-Enhancing Drug Scandal

On the heels of Senator George Mitchell's report on the abuse of performance enhancing drugs in baseball, comes word that the phenomenon had been quite common outside the world of sports as well. New rumors have surfaced out of Sweden alleging that at least one-fourth of all Nobel laureates had at one time or another used brain-enhancing drugs to boost their intellectual capabilities. Critics claim their Nobel prizes were unearned and should be rescinded. One disgruntled scientist said, "These findings are truly unfair to all of us scientists with lower IQs who played by the rules. I think the world should immediately stop using whatever inventions those cheaters created!"

Ominous Warnings From the Fed

Today's Fed statement was filled with ominous warnings. It made references to slowing economic growth, the housing correction, softer business and consumer spending, strains in financial markets, elevated energy and commodity prices, inflation risks, and increased uncertainty. In other words, there is no good news to report.

Although the Fed cut the fed funds rate and the discount rate by a quarter point each, the market was strongly disappointed. Many investors were hoping for bolder action, perhaps a half-point cut in both rates. At the very least, investors were expecting more clarity from the statement. They exhibited their disappointment by selling stocks. Almost immediately, the Dow shed more than 200 points.

The Fed's comments make it clear that the probability of recession is much higher than many economists (including those at the Fed) had been forecasting. Yet with higher food prices, and with oil prices still flirting with the $90 per barrel level, the Fed knows it cannot focus solely on core inflation numbers anymore. The Fed knows that high food and energy prices will inevitably work their way into the core figures.

The Fed is truly between a rock and a hard place, officiating a game of tug-of-war between slowing growth and inflation. My view is that the Fed did the right thing by cutting the fed funds rate by just a quarter point. A steeper cut would have contributed to the dollar's weakness. However, I believe the Fed could have been a more aggressive with the discount rate. Given the slowing economy and the real potential for recession, there is no need to keep the discount rate a half-point above the fed funds rate.

Cruisn' For an Economic Bruisin'

Because I have been swamped, I haven't had an opportunity to post to my blog lately. I arrived home early this morning from the 12th Forbes Cruise for Investors, which went through the Panama Canal. A cruise, of course, is lots of fun. But it was also work for me and the other speakers. We started in Costa Rica on Nov. 30, went through the Canal, and stopped to visit St. Lucia. I disembarked in Antigua. The cruise is still proceeding on its was to Miami where it will end in a few days.

On my half of the cruise were Steve Forbes, Gary Shilling, Bob McTeer, Pete du Pont, and John Goodman. Rich Karlgaard served as the host. Gary, who has been right about the housing market all along, is still bearish on the economy and stocks. It was good to be around someone who is more bearish than myself. It made me feel like a good guy. The other speakers were more optimistic.

While on the ship, I learned about the Bush adminstration's plans to freeze certain subprime mortgage resets. Clearly, there are obvious moral hazard problems with doing something like this. It will be seen as a bailout of those who made imprudent decisions. Even so, I don't believe that even this measure will prevent housing prices from falling further. Freezing monthly payments may slow foreclosure rates modestly, but it won't solve the problem.

Given the continuing troubles in the housing market, I am posting below my comments from the December issue of the Forbes Growth Investor. This commentary was released to our subscribers several days ago:

It is not a pleasant topic, but the time has come to talk about recession. Although the probability of recession has obviously risen by a significant amount in recent months, most economists, including those at the Federal Reserve, are still betting the U.S. will be able to avoid one. Yet almost all economists, even those at the Fed, have lowered their projections for growth.

Minutes from the Fed’s Oct. 30-31 meeting reveal the new thinking. Most notably, the Fed is now projecting that economic growth will range from 1.6% to 2.6% for 2008, down from the 2.5% to 3% projection made just four months earlier. It is important to realize that the Fed is predicting anemic growth, but not recession. This, however, does not provide much comfort.

Not long ago, the so-called real estate experts claimed that housing prices never fall on a national basis. Those who said things were different this time were ridiculed. That argument is now settled. Not only have prices fallen; they are still plunging. The quarterly S&P/Case-Shiller U.S. National Home Price Index fell 1.7% sequentially in the third quarter, the biggest drop in its 21-year history. This index is down 4.5% year-over-year, and the rate of decrease has accelerated. This means that more than $11,000 of value has been erased from a home that was worth $250,000 a year ago. Of course, in some parts of the country, the story is much worse. In Tampa, you can now fetch just $222,250 for a house that was worth $250,000 a year ago.

Given losses of this magnitude, it is no surprise that foreclosures are up. Particularly hard hit have been homes financed with subprime adjustable-rate mortgages. The Fed estimates that monthly payments on more than two million such mortgages will be reset by the end of 2008. We will see many more foreclosures between now and then.

The real estate market is in a downward spiral. Falling property values contribute to foreclosures, and rising foreclosures contribute to falling property values. When a house is foreclosed, all the houses in that neighborhood lose value. In fact, Global Insight, an economic consultancy, recently estimated that property values will fall by $1.2 trillion in 2008. Foreclosures are being blamed for about half that amount.

In recent years, local governments have reaped a windfall in revenues by taxing all those inflated properties. That game will come to an end as homeowners demand that assessments be brought down to more realistic levels. Financial institutions are just starting to write down the values of their securitized subprime mortgage portfolios. Citigroup provides just one example of how devastating this can be for stockholders. The stock started the year at $55 per share. It is currently the biggest loser in the Dow Jones Industrial Average year-to-date.

Given the extent of the housing debacle, and a stock market that could potentially go much lower, why wouldn’t the economy go into recession? The Fed’s lowered growth projections are still too rosy. Perhaps the Fed is betting that the shrinking dollar will cause a huge boost in exports. We are certainly seeing some of that already. While it is true that a weak dollar can help prop up the economy in the short run, over the long run the U.S. is better off having a currency that everyone wants to hold. It's time for Treasury officials to do more than just give lip service to a strong dollar policy.

Shorting Starbucks Paid Off Big. Time to Cover?

Regular readers of this blog know that I have been bearish on Starbucks (SBUX) for quite some time. Here is what I said in August 2006:

Perhaps the latest Starbucks report is a harbinger of things to come. Starbucks reported disappointing growth and the stock took a big hit. Management blamed it on too much demand for blended drinks that take a long time to prepare. That's unique. Growth slowed because demand was too strong. With gasoline prices pushing north of $3 per gallon, I suspect the real story is that consumers are wondering how much sense it makes to pay $16 a gallon or more for coffee.

In October of that year I said:

Starbucks is another stock that appears overvalued. It is selling for 51 times expected earnings, almost 4 times sales, and 11 times book value. That seems like a lot to pay for what amounts to a chain of restaurants. Of course, Starbucks has tremendous growth prospects, but that doesn't warrant buying the stock at any price.

In May 2007 when gasoline prices broke above $3.20 per gallon, I said:

Companies like Starbucks and Whole Foods that sell overpriced and unnecessary goods might find that growth will slow. These two stocks have already fallen well off their highs. Chances are they will go lower still.

And in July 2007, after Starbucks announced a price increase that came out to nine cents per cup on average, I warned:

There seems to be little skepticism on Wall Street about Starbucks' recently announced price increase. The company admitted again that higher costs are pinching profits. It is struggling with higher dairy prices, higher fuel prices, and higher energy prices.

Well last week Starbucks announced earnings and the stock got hammered. Although the company continues to make good money, growth is slowing. Worse, store traffic actually fell. It seems that even Starbucks addicts are not able to cope with the latest price increase.

This company is caught between a rock and a hard place. Does it raise prices to protect margins at the risk of lower volumes? Or does it hold the line, absorb higher costs, and watch margins shrink? Of course, if dairy or energy prices were to start falling, Starbucks would become a buy once again. But it's not yet time to start buying the stock. However, if you shorted Starbucks at much higher levels, you may want to start thinking about covering at least part of your position.

The Pro-Tax Buffett

The Pro-Tax Buffett is the title of the ninth chapter of my new book, Even Buffett Isn't Perfect, which is due for release in May 2008. Warren Buffett's Congressional testimony delivered today convinces me that the title of the chapter is apropros.

Buffett favors higher taxes on the so-called rich. He favors both higher income taxes and higher death taxes. Estate taxes take their biggest toll on those whose estates are not very liquid. This group includes small farmers, ranchers, and business owners. These individuals typically oppose the estate tax because it often means that heirs must kill the business to pay the tax. Yet many of the mega-rich including Buffett favor this tax. Perhaps it is because they feel a little guilty about being so rich. Perhaps it is because they are convinced that charities would suffer if there was no estate tax and no loophole available to escape it. Yet, as a number of conservative commentators have pointed out, even if there is no tax, anyone who feels strongly about leaving his money to the government is free to do so. However, they should not force others to do the same thing. Furthermore, if they really believe this tax is a good thing, they should not take advantage of loopholes to escape it.

Prior to the Bush tax reforms, estates that were valued above $675,000 were taxed. The federal tax rate reached as high as 60% on large estates. Under the current law, this non-taxable limitation escalates to $3.5 million by 2009. Estates above $3.5 million will be taxed at 45% in that year. In 2010 the estate tax will be completely repealed. There will be no estate tax in 2010. However, in 2011 it comes back with a vengeance, hitting estates worth more than $1 million.

Just imagine the kinds of discussions that are underway in law offices across the country as wealthy clients try to plan their futures. Pity the old and sick. Their heirs are praying they hang on until 2010, but they may also be hoping they kick the bucket before 2011.

Chances are good that Congress will once again tinker with estate taxes sometime in the near future. Most Americans would not object to an estate tax that was reasonable and fair. However, taxing estates above $1 million at rates approaching 50% hardly seems reasonable. Some have suggested a 15% tax on estates above $10 million. Liberals think this is inadequate. Conservatives think even this is too much. Regardless of which party controls Congress and who sits in the White House, we can only hope that our politicians reach some sort of reasonable compromise on this issue before too long.

Today's Rally May Be Short-Lived

The Dow rallied 320 points today. Most analysts are crediting the rally to Wal-Mart's better-than-expected earnings, and comments out of Goldman Sachs saying it won't be posting any significant writedowns. Other analysts are saying the market rallied simply because it was short-term oversold. In other words, stocks went up today because they had gone down in previous days.

I am happy to see today's rally in Wal-Mart because the stock is on my recommeded list in the Special Situation Survey. I'm also happy to see the nice rebound in Citigroup because I started buying it just a few days ago (see Can Citi Maintain the Dividend). Yet I remain cautious on stocks overall. We will be seeing more mortgage-related writedowns. Yestereday's announcement from E*Trade won't be the last. Furthermore, problems could soon arise with securitized credit card obligations.

Although oil prices backed off more than $3 per barrel today, they remain extraordinarily high. This means gasoline prices will be going up significantly from current levels--just in time for the holiday shopping season. With consumer spending likely to slow, the weak dollar may be the only thing keeping our economy out of recession.

I would use strong rallies like today's to hedge positions. The UltraShort ProShares ETFs are a good way to accomplish this.