When Tax Simplification Can be a Bad Thing

According to a Bloomberg report, President Obama asked Paul Volcker and the Economic Recovery Advisory Board for a proposal by December 4 to overhaul the tax code.

I almost jumped for joy, but tempered my excitement when I read the details. An overhaul of the tax code is clearly needed, but we don't want one that makes matters worse. Spokesman Tom Gavin said the board has a mandate "to simplify the tax code, protect progressivity in the revenue base, close tax loopholes and find ways to reduce tax evasion and ... corporate welfare."

The tax code is unnecessarily complicated. I am all in favor of simplifying it. It takes the average taxpayer much too long to file a return. In fact, the code has become so complicated that more and more taxpayers have to turn to professionals for help. But simplification must be done in a fair way. Economists used to joke that Bill Clinton wanted to simplify the tax code when he was president. Under the fictitious Clinton plan a tax return would have only two lines: 1. How much money did you make? 2. Send it in. This is the kind of simplification we definitely do not need.

However, we do need to make paying taxes easy and painless. There is no reason why Americans should spend a full weekend or more filing a return. One quick fix is to eliminate all deductions in exchange for significantly lower tax rates. Take the mortgage interest deduction for instance. This deduction exists only because the home building industry has convinced Congress that using the tax code to promote home ownership is a good thing. Unfortunately, this tax subsidy contributed to the housing bubble. Consumers make choices. Whether they choose to buy a house, a car, or more clothing, the rest of us should not be subsidizing that decision.

Of course, I am also in favor of reducing tax evasion. Everyone should pay their "fair" share. However, it is not the stereotypical rich who are evading taxes. Tax evasion is most pervasive among those who work on a cash basis. It is not difficult for them to under report their income. And let us not forget about people engaged in the illegal drug trade. One study estimated that 10 years ago Americans spent $65 billion on illegal drugs. All of it went untaxed.

As for protecting progressivity of the tax code, this is a worrisome sign. While I agree that taxes are a necessity and that those who make more should pay more, a progressive tax code is specifically designed to punish people for doing well. It may be too much to hope that a Democratic administration would understand this, but a tax code that is too progressive reduces the incentive to work hard. At a time when we need to encourage the most productive members of our society to start businesses and employ more people, the last thing we should do is threaten to tax them at higher rates if they succeed.

Geithner's Stock Rises on PPIP

A government program has to have a catchy name. So it was that Treasury Secretary Timothy Geithner introduced the Public-Private Investment Program. This is the latest plan to save the banks and free up credit. According to this plan, the government will work in partnership with the private sector to buy up so-called toxic assets from the banks. The hope is that by removing these assets from the banks' balance sheets, banks will be more willing to lend.

The first thing you should notice is who gets top billing in the name of the plan. It is not called the Private-Public Investment Program for a reason. The government wants to make sure taxpayers come first.

The next thing you should ask is will the program work as planned? This program assumes that banks are not lending because of these toxic assets. It fails to consider the possibility that maybe businesses don't want to borrow. In general, businesses borrow money when they want to expand. When demand is strong and they are growing, they have to finance that growth. But when there is a recession and demand is weak, there is no point in expanding so there is no need for financing. Of course, this is a bit of a Catch-22. The recession won't end until businesses borrow and invest. But businesses won't invest until they are convinced the recession is coming to an end.

You should also ask if the banks even want to sell all those toxic assets in the first place. After all, they have already marked them down. They may prefer to wait until the markets improve so they can benefit by marking them back up. Of course, there is a price for everything and banks will sell at the right price. But the public-private partners will want to buy at as low a price as possible. A little arm-twisting by the government may be necessary to convince the banks to sell.

Nonetheless, Secretary Geithner's new plan is the best plan we have seen to date. The market certainly liked it and rallied strongly in response. Geithner has been criticized for talking in generalities and providing no specifics about how he will respond to the financial crisis. This time, he gave us specifics. Those who were shorting Geithner and calling for his resignation got a little burned. Today his stock went up at least a few points.

Is the U.S. a Developed or an Emerging Country?

Ian Bremmer and Sean West have an op-ed in today's Wall Street Journal called AIG and 'Political Risk.' I urge you to read it. While some people are upset that AIG employees got any bonuses at all, others are equally upset that the government has stepped in and threatened to take them away. The authors argue that the outrage by Congress and the Obama administration over the bonuses is a result of nothing more than political expendiency. It scores populist points. However, it also raises the risk for investors and does nothing to resolve the financial crisis.

Bremmer has been warning for several months now that Congressional actions represent the most important political risk investors face this year. I know Bremmer well so I sent him an email congratulating him on the article and expressing remorse that the U.S. suddenly seems hellbent on turning toward socialism. He replied by saying that what is going on is right up his alley because he has been studying emerging markets for twenty years. So there we have it. The world's most developed nation is behaving more like an emerging country.

Fed's Actions Induce Rally

Stocks surged immediately following the Fed's press release today. In perhaps its boldest action to date, the Fed said it would significantly increase the size of its balance sheet by buying up to $750 billion of mortgage-backed securities, up to $100 billion more of agency debt, and up to $300 billion of longer-term Treasury securities. In other words, it will flood the market with money.

The Fed has come under criticism is recent weeks for tightening the money supply. Steve Forbes, for example, recently pointed out that despite lowering short term interest rates, the Fed's balance sheet has actually shrunk by almost $400 billion since December. Today's decision reverses this trend.

Despite today's actions, investors know that the economy will not improve until housing prices stop falling. What the Fed announced today should support housing prices by reducing mortgage rates, but that may not be enough to generate sufficient demand. After all, housing inventories are still too high, and mortgage rates are just one component of the cost of buying. As I've discussed on this blog many times before, property taxes represent a major cost of owning a home and there is nothing being done to address this problem.

I continue to believe this is an excellent time for long-term investors to be buying equities. Those who are willing to wait five to ten years should not hesitate to get in now. Nonetheless, I also think there is a reasonable chance we will see another significant selloff in stocks in the near term. If we are lucky, the recession will be over by yearend. However, there is more bad news to come. With corporate profits falling and unemployment rising, we are still a long way from being out of the woods.

Leon Charney Report

I come across a lot of smart people. Leon Charney is one of them. Charney is a New York attorney who played a significant role in the Camp David Accords, which were signed during the Carter administration. Charney is also an astute investor who appears on the Forbes Billionaires list.

Unlike most other investors, Charney actually managed to hold on to his wealth this past year. He also has a popular PBS television show that airs in the New York City area. I have been a guest on his program a number of times. We filmed an episode on March 5, which aired on March 8. I am honored that an investor of his calibre even cares about my opinion. Click here to watch this episode of the Leon Charney Report.

Explaining Mark-to-Market Accounting

A good friend forwarded this humorous explanation of mark-to-market accounting. It was produced by John Carney and can be found at businessinsider.com:

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98. You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.

That is very entertaining, but here is a more realistic view of mark-to-market accounting:

Suppose it is not your cows that catch on fire and die, but your neighbor's cows. Your neighbor tries to sell his dead cows, but no one wants to buy them.

Since you own the same kind of cows, mark-to-market accounting forces you to value your cows at zero because no one is willing to buy your neighbor's cows.

Even though your cows are still alive, still producing milk, and still helping you generate positive cash flows, you have to pretend they are worthless.

This is why mark-to-market accounting needs to be fixed.

Cash is Trash

It is nice to see a violent rally in the stock market for a change. It is also nice to hear that Citigroup may not be as sick as everyone thought. At last look, the stock was up about 35% for the day. Of course, for a penny stock, that does not mean much in absolute terms. Nonetheless, it is encouraging to think that one of the most important financial institutions in the country is actually going to survive the recession.

FAS 157 (mark-to-market accounting) has made many of our financial institutions look sicker than they actually are. Even those that are cash-flow positive look like they are losing money on paper. This has scared investors and helped drive stock prices down. In fact, Warren Buffett recently said, "The investment world has gone from underpricing risk to overpricing it." In the end, those companies that manage to survive will come out stronger; and those investors brave enough to take advantage of the turmoil will come out richer.

Despite today's good news, the recession is real and will continue for many more months. Credit spreads are still too high, consumers are still not spending, and corporations are still laying people off. Undoubtedly, stocks will remain volatile and we could see another selloff. Yet, I believe the risk of holding cash outweighs the risk of being long for anyone who has an investment horizon of five years or more.

Those who are interested can view these videos I taped for the MoneyShow on February 6:

Economy--No Progress Yet

Any Energy Plays?

Buffett Makes Mistakes, Too

President's Unemployment Forecast Much Too Rosy

In looking over President Obama's proposed budget for fiscal year 2010, I found Table S-8 Comparison of Economic Assumptions particularly interesting. As the name implies, this table compares economic assumptions under the proposed budget to the Congressional Budget Office's assumptions and to the Blue Chip forecasts. What really stuck out to me were the forecasts for the unemployment rate.

The Blue Chip consensus forecast is for the unemployment rate to peak at 8.7% in 2010. The Congressional Budget Office predicts it will peak at 9.0% in 2010. However, the president's budget predicts the unemployment rate will peak at 8.1% this year and then fall to 7.9% in 2010.

Admittedly, the Congressional Budget Office ignores the possibly beneficial impact of the American Recovery and Reinvestment Act. Even so, the president's forecast seems much too optimistic, especially since he is also proposing to raise taxes on the people who do most of the investing in this country.

The government cannot create jobs nearly as efficiently as businesses can. However, by raising taxes on the investment class, the president is virtually guaranteeing that more people will find themselves out of work.

The unemployment rate was 7.6% in January. Tomorrow morning, the Bureau of Labor Statistics will report the unemployment rate for February. The consensus estimate is 7.9%. I have been warning since last September that the unemployment rate would reach 8-9% by June. I think the average for 2009 could exceed 8.5%. This is considerably higher than the president's forecast. Unfortunately, I think it is also much more realistic.

Why Financial Education is Important

One of our equity analysts forwarded this multiple choice question he found on CNBC's website. It asks, "After breaking 7,000, where's the Dow headed next?" The three choices are 5,000, 6,000, and 8,000. Amazingly, about one-third of the respondents answered 5,000. Which brings up an interesting question. How can the Dow go to 5,000 next without going to 6,000 first? Perhaps this group of respondents are the same people who created mortgage-backed derivative securities.

The Oracle Speaks

Warren Buffett's annual letters to shareholders are legendary. We were treated to another one on Saturday morning. This year's letter and 10-K provided some interesting insights. Buffett, who is a fan of higher taxes on the rich, was surprisingly critical of government. He says government intervention in the financial crisis "will almost certainly bring on unwelcome aftereffects." He thinks inflation is a very likely outcome. He also predicts municipalities will soon be looking for federal bailouts of their own. The good news is that Buffett says "America's best days lie ahead."

Berkshire's book value per share fell 9.6% in 2008, its worse performance ever. Yet I think the biggest surprise is that the company did not do worse. Given the financial crisis and Berkshire's heavy exposure to the finance industry, I think the results were actually quite commendable. The company turned a profit and even troubled subsidiaries such as General Reinsurance showed marked improvement.

Still, Berkshire lost a lot of ground in 2008. Gross unrealized gains in equity securities fell $16.5 billion. Gross unrealized losses grew by $4.9 billion. There was a $25 billion decrease in the value of equity securities on the balance sheet. The company also wrote down $6.8 billion of derivatives on the income statement. It is important to understand, however, that the write down had no effect on cash flow. It is simply the result of the same mark-to-market accounting rule that is making our nation's banks look unprofitable. Even though it took a toll on Berkshire, Buffett says, "We endorse mark-to-market accounting." It would have been nice if he explained exactly why. Maybe he realizes that because of mark-to-market, Berkshire and other financial companies will report much larger earnings in future periods when market conditions improve.

I was very disappointed by the kinds of questions posed by shareholders at last year's meeting. Instead of asking good questions about the company's business operations, we got questions such as "What should I do with the rest of my life?" Apparently, Buffett was fed up with those questions, too. He says in his letter that at this year's meeting, he will "steer the discussion back to Berkshire's business." That is welcome news indeed.

Nationalization the "Atlas Shrugged" Way

I am posting this from Austin, Texas. I traveled here yesterday to participate in a panel discussion at the CFA Society of Austin. The panel was moderated by Vincent Catalano. Other panelists included former Fed governor Bob McTeer, David Abramson from BCA Research in Quebec, and Tim Hayes of NDR.

The discussion focused on the growing role of government in the private sector. The United States, which is supposed to be the model for free market capitalism, is taking a big step toward socialism. The budget put forth by our new president is a repudiation of the Reagan revolution. It seems our government is trying to outdo other governments in nationalizing some of our biggest companies. It's a good time to reread Atlas Shrugged by Ayn Rand.

So I guess it was fitting to awake this morning and find out that our government is about to hold a huge stake in Citigroup. If this is not evidence of nationalization, I don't know what is.

The latest GDP report was also disconcerting. The preliminary estimate for fourth quarter contraction was revised down to 6.2% from the 3.8% advance estimate. That's what I call a revision. This means the 8.1% unemployment rate projected for 2009 in President Obama's budget looks laughable. The employment situation will not improve until private sector investing improves. Don't hold your breath for that to happen now that Obama wants to raise taxes on the so-called rich. With higher taxes on the way, there is little chance the economy will revive enough to slow down the acceleration in the unemployment rate.

The Fat Tail

Last night I attended the book launch party for the
The Fat Tail, a new book co-authored by Ian Bremmer and Preston Keat. Bremmer is President and Keat is Director of Research at The Eurasia Group, a political risk research firm. Admittedly, I have known Bremmer for almost 10 years and my opinion may be biased, but I consider him to be the foremost expert on political risk. I have heard him deliver a number of speeches over the years. He is an excellent speaker who makes extremely cogent arguments.

The title of the book comes from the bell curve. In a normal distribution, there is a 67% probability that an outcome will fall within one standard deviation of the mean. Unlikely outcomes occur at the tails. In a distribution with fat tails, the probability of unlikely outcomes is higher. Bremmer and Keat are implying that investors often underestimate the probability that unlikely outcomes will occur. For example, they begin the book with the 1998 crisis in Russia and tell us how the leading experts assured investors that Russia would not default on its debt. Yet that's exactly what happened. The book is full of such examples.

Because I have just begun to read the book, I can't provide a complete analysis. So far, however, I find it interesting and timely. It also fits nicely with Bremmer's recent assertion that financial regulation and the U.S. Congress represent the greatest political risks of 2009.

More on the UAE

As my readers know, I traveled to Abu Dhabi and Dubai two weeks ago. I was invited by the CFA Institute to address investors at the Abu Dhabi Investment Authority (the world's largest sovereign wealth fund), Mubadala, and Hawkamah. Perhaps I am now more aware of events in that part of the world because of this trip. Maybe this is why I have noticed quite a bit of news about the United Arab Emirates since I returned home. For example, immediately following my return, Dubai made news by denying an Israeli athlete a visa to compete in a major tennis tournament. Soon after it made news again when it received a $10 billion bailout from the UAE central government. Dubai, which just a year ago was one of the world's greatest financial success stories, now seems plagued by poor decisions and economic turmoil.

Yet one of the best articles I have read in recent weeks was one written by Zvika Krieger in the Wall Street Journal. The title of his commentary says it all: "There's No Reason to Gloat Over Dubai's Fall." Mr. Krieger argues that the UAE is not perfect, but it is moving in the right direction. I agree. His op-ed inspired me to write a letter to the editor in support of his view.

Greenspan Was Right in 1996

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Alan Greenspan, Dec. 5, 1996


On the day Alan Greenspan spoke those now famous words warning that stock prices might be too high, the Dow Jones Industrial Average closed at 6437.10. Yesterday, more than 12 years later, the Dow closed 16% higher at 7465.95, which comes out to about 1.2% on an annualized basis. Of course, the Dow peaked at more than 14,000 before falling back to current levels. If anything, this should cause investors to question the wisdom of long-term, buy-and-hold investing. That approach is akin to simply sticking your head in the sand and ignoring signs of trouble. A strategy of active asset allocation, i.e., taking money off the table after rallies and buying more after selloffs, produces much better results over the long term.

Dubai May Be Struggling, but Abu Dhabi Looks Strong

I'm back from Abu Dhabi and Dubai. I'm still a little jet-lagged, but I got a good night's sleep for the first time in a week. Here are some more thoughts about my trip.

The United Arab Emirates consists of seven emirates. The best known are Dubai and Abu Dhabi. When it comes to economic development, Dubai is considered the more aggressive one. Dubai embarked on a plan to quickly become the major financial center in the Middle East and one of the most important in the world. There was a tremendous amount of money spent on infrastructure. (Reminds me of the Obama stimulus plan.) Beautiful buildings and roads were planned and constructed. As I said in an earlier post, Dubai is at the cutting edge of architecture and construction.

While I was in the U.A.E., The New York Times published an article warning that the economic boom in Dubai has come to an end. (I thank Vitaliy Katsenelson and Todd Weintz for bringing this article to my attention.) I had already heard rumors of many of the things discussed in that article. Because I spent less than 24 hours in Dubai, I did not get a complete picture of the economy. I had to wonder, however, how there could possibly be enough demand to justify all of the construction going on. To my eyes, Dubai certainly seemed like a busy place. There was plenty of traffic on the streets and the Al Bustan Rotana Hotel where I stayed was busy enough, but I do not have a personal point of reference to make any comparisons.

I was told by some individuals that business activity is way down. Construction has apparently been suspended on some buildings. Most workers in Dubai--from laborers to executives--are from someplace else. One young finance executive told me he was concerned his company would be laying people off soon. A driver told me things were getting bad and many people were going back home or looking for jobs elsewhere. (Sounds a bit like the situation in the U.S.). Given a new law that imposes a heavy fine for disparaging the economy, I wondered if they were being cautious with their comments.

I spent about six days in Abu Dhabi and things there seemed perfectly fine. Abu Dhabi has been more conservative with its economic development plans. There is plenty of construction going on, but there are no obvious signs of overbuilding. People in Abu Dhabi appeared more confident about the local economy. Those in the finance industry were extremely concerned about the global economic slowdown, but not so much about the situation in Abu Dhabi.

Abu Dhabi also has one major advantage over Dubai. It has plenty of oil. While the plunge in oil prices has delivered a blow, this emirate can still generate tremendous cash flow from oil production. Yet those managing the Abu Dhabi economy understand the importance of diversification. Abu Dhabi appears to have struck just the right balance between relying on oil and seeking other sources of income. In fact, Abu Dhabi has the potential to become a major tourist spot. The Emirates Palace Hotel is right on the beach and has several swimming pools. The weather is almost always sunny. It is a perfect spot for a family vacation. The Sheikh Zayed Mosque is magnificent and open to the public for visits. Indeed, during my stay I noticed that Abu Dhabi was full of tourists, many of them German speaking. Abu Dhabi also has a world class golf course. The Abu Dhabi Golf Championship is on the European tour and offers $2 million in prize money.

There may be some friendly competition going on between Dubai and Abu Dhabi, yet at the end of the day, these emirates are a part of the same nation. If things get bad enough for Dubai, Abu Dhabi will likely come to its aid, especially if oil prices rise as global economies emerge from their collective recession.

Impressions of Dubai

I am back in Abu Dhabi after a short trip to Dubai. Before going there, I had heard a lot about all the construction going on in Dubai. Yet it was still a surprise to see it with my own eyes. With all the skyscrapers, Dubai reminded me a little of New York City except that everything is brand new and sparkling clean. There are so many buildings, and perhaps even more that are still under construction. It is hard to believe there is enough demand for all that space. In fact, I heard some projects have actually been stopped midway through. Given the global recession, it seems funding is drying up and some of the projects may not be completed at all. I've also been hearing that many foreign workers are losing their jobs. Some are returning home, others are trying to find jobs in Abu Dhabi where the economy is still good.

Nonetheless, Dubai is an architect's dream. Imagine having a client ask you to design the most outrageous building you could think of without regard to the expense. The Bourj al-Arab Hotel looks like a sailboat (dhow). Another building looks like a jet airplane. Some buildings are straight; others are curved. Some look like they could be fitted together like Lego pieces. The building that houses the indoor ski slope looks like it could tip over. They are really at the cutting edge of what can be done with construction.

While in Dubai, we made presentations to members of Hawkamah, the institute for corporate governance. This was also sponsored by Mudara at the Dubai International Financial Center. There was intense interest in our presentations and we were peppered with questions. There is keen interest in promoting good corporate governance practices in this part of world.

I finally got a chance to relax and catch up on some sleep. Unfortunately, I am returning home just as my body has adjusted to local time. I'm sure there will be more sleepless nights to come.

First Impressions of Abu Dhabi

As the Obama team gets ready to stimulate the U.S. economy, I flew off to Abu Dhabi to see how things are on the other side of the world. I will be giving a talk tomorrow to the Abu Dhabi Investment Authority (ADIA), then I'm off to Dubai.

So far I am very impressed. I flew over on Etihad Airways, the national airline company. It is a very long flight. Fortunately, I was in business class. Both the service and food were great and the time went by rather quickly. After clearing customs, we took a drive through the city. There is a lot of construction taking place and there are cranes everywhere. Although I hear the economy has taken a hit from the fall in oil prices, that is not readily noticeable.

I am staying at the Emirates Palace Hotel, which without a doubt is one of the finest hotels in the world. It really does look like a palace inside and out. The hotel is located right on the beach on the Persian Gulf. The architecture is beautiful. Everything is very geometric. The inside of the hotel has marble everywhere. I am going to catch up on some sleep, then it's off to dinner. There are several interesting restaurants in the hotel. More later.

January Roundup From Forbes Growth Investor

The following is from the February issue of the Forbes Growth Investor.

Despite staging a bit of a rally toward the end of 2008, stocks plunged again to kick off the start of a new year. According to data from Ibbotson Associates, last month’s selloff in large-cap stocks was the worst ever for a January. An old Wall Street adage says,“As goes January, so goes the year.” This is not an encouraging sign for investors who are long. Those who believe in adages and indicators should at least take some solace from the Super Bowl, since it pitted two teams from the old NFL against each other; a good omen for stocks.

Unfortunately, the news continues to be bad on the economic front. Most economists were expecting a large retreat in fourth quarter GDP. Yet the Advance estimate, a decline of 3.8%, was better than the consensus expectation. Investors seemed relieved at first. However, they quickly changed their minds once they realized that increased government spending, a $6.2 billion build in inventories, and an $80 billion decline in imports largely explained why the GDP report was not worse than it was. This was the first build in private inventories in at least two years. Companies were producing more than they could sell. During the current (first) quarter, however, businesses have been laying off workers at an accelerating rate so production should slow. As for international trade, it too is slowing appreciably. And it wasn’t just imports that declined. Exports were off $83 billion.

There is a real lack of demand on the part of consumers. Other than necessities, people are not buying anything. This is not simply due to a lack of available credit. There has been a real change in the mindset of American consumers. We are rapidly transforming from a nation of spenders into a nation of savers at precisely the wrong moment. No one wants to spend money—even those who are relatively well off and gainfully employed—when coworkers and neighbors are losing their jobs. Large numbers of clothing stores, electronics stores, and automobile dealerships are simply shutting down for good.

Lack of demand is also plaguing the housing market. New home sales have fallen off a cliff. Just a few years ago, home builders were selling 1.2 million new houses a year at an average price of almost $300,000 each. These days they are selling only one-fourth as many houses at an average price that is almost 20% less. At the current rate of sales, it will take 16 months to clear the inventory of new houses. It is inevitable that at least a few of the publicly traded home builders will not survive this crisis as independent entities.

Things are a little rosier for existing homes. Sales climbed 6.5% in December thanks largely to falling prices and growing interest in foreclosed properties. Inventory fell almost 12% in just one month. It is possible that we are finally approaching a bottom in existing home prices. I’m still calling for that to happen by late spring. While stable housing prices are key to restoring confidence in the economy, the days of thinking about residential housing as an asset class are probably gone for a long time. It is good to get rid of the speculation in this sector.

Dow 36,000 Is Nothing But A Book Title Now

The Dow Jones Industrial Average is currently at about the same level it was in early 1998. This means that, ignoring dividends, investors have earned nothing in 10 years.

In March 1999, immediately after the Dow broke above 10,000 for the first time, James Glassman and Kevin Hassett published their now infamous op-ed in the Wall Street Journal called Stock Prices Are Still Far Too Low. They argued that investors were overestimating the risks associated with investing in stocks. They argued that stocks were no more risky than a government bond.

Perhaps to demonstrate just how bullish they were on stocks, they also published a book that same year titled, Dow 36,000. They weren't trying to imply that the Dow should reach 36,000 some day. No, they were insisting that the Dow should be at 36,000 right now (i.e., in 1999).

Their point was that investors were wrong to think that stocks were risky simply because stocks were volatile. Because history showed that stocks outperformed bonds over the long term, the authors argued that stocks were really no more risky than bonds. In fact, they argued that the appropriate risk premium for stocks is zero.

This reminded me of a debate I had many years earlier about mortgages. My opponent at the time was arguing that the best mortgage is always the one with the lower interest rate. My point, however, is that cash flow must also be considered. A one-year interest free mortgage is clearly cheaper than a 30-year mortgage at 6%, yet there aren't many borrowers who have the kind of cash flow needed to service that one-year mortgage.

Likewise, stocks have outperformed bonds over the long term and may continue to do so in the future. But not all investors can stomach the volatility. Investors have cash flow needs. They can foresee some of those needs, but they can't foresee them all. This is why investment advisors never tell their clients to put all their money in stocks even though they believe stocks will do well over the long run.

Stocks are not risk free, but from a long-term perspective, they are probably less risky today than they were when the Dow was at 14,000. Yet at 14,000, investors were happy to buy stocks--many using lots of margin. But now, most investors are simply too scared to buy. Who knows when (if ever) the Dow will hit 36,000, but it's a good bet that it will hit 10,000 again--perhaps sooner than we think.

Beware the U.S. Congress

There are plenty of conflicts and problems going on around the world, each vying for the attention of global investors. The war between Israel and the Palestinians is currently on the front burner. It's a conflict that threatens to pull in Iran, which continues in its race toward a nuclear weapon. The wars in Iraq and Afghanistan are still going on. Terror attacks in Mumbai threaten to break the shaky peace between Pakistan and India. And Russia is flexing its muscles by threatening former Soviet republics and restricting the flow of natural gas to Ukraine and Western Europe.

Given all these seemingly intractable problems, which poses the biggest risk for investors? According to Ian Bremmer of the Eurasia Group, the top risk of 2009 is financial regulation in the United States and the rising power of Congress.

Bremmer reminds us that following our last financial crisis, Congress gave us the Sarbanes-Oxley act. We are likely to get something much more onerous this time. The bottom line is that there will be considerably more regulation. Congress will try to regulate everything from the rating agencies to complex financial securities. It will also reform the regulatory agencies. The risk is that Congress may make things worse by delivering bad regulation or simply going overboard in a manner that prevents innovation.

Bremmer also worries that government is getting involved in the actual management of private enterprises. It already holds large stakes in publicly-traded companies, and there is talk of a car czar to oversee the automobile industry.

Finally, Bremmer is concerned that fiscal policies meant to spur the economy may fail. Infrastructure spending, for example, may end up doling dollars to favored pork barrel projects instead of targeting the most worthy programs.

The Eurasia Group is perhaps the best political risk consultancy in the world. It certainly is an ominous sign that this highly-respected firm thinks the U.S. Congress poses the greatest risk to investors in 2009.