U.S. stocks ended a three-session slide on Friday to recovery about one-quarter of those losses thanks to a 1.5% surge in the final 20 minutes of trading.  It was another volatile session as the broad market swung 3%, down as much as 1.5% in early trading.  

Financials led the market higher, up 3.62%.  It was nearly a 5% daily swing for the group, which began the session lower but supposedly rallied on hopes the derivative-trading restriction provision will be struck from the financial regulation bill via the reconciliation process.  Basic material and consumer discretionary shares were among the top-performing groups.  Health-care and telecoms were the caboose, but all 10 major industry groups did gain ground for the session. 

Volume was strong, actually higher than Thursday’s big down day, which is the first time an up day has beat on volume in a long time.

For the week, the Dow slid 4.01%; the S&P 500 lost 4.22%; and the NASDAQ Composite fell 5.01%.  Mid cap stocks declined 4.98% and small caps were down 6.44%.  The broad market is off its 19-month high (hit on April 23) by 10.6%. 

Market Activity for May 21, 2010

Jobs Bill?  Only in Washington’s Wonderland

So here we go again, the House is planning a vote next week that would increase jobless benefits and send an additional $24 billion to the states – state and local government are in a world of hurt that will work as a drag on employment; state and local government employees account for about 12% of all U.S. jobs.  The irony here is that the federal government is adding to the states’ financial woes as health-care “reform” pushes more people into Medicaid – states fund roughly 50% of their Medicaid budget.  Politicians are calling this a “jobs” bill – calling it a “stimulus bill” only leads to voter outrage these days, but this is hardly a “jobs” bill. 

To pay for this, or what they believe will pay for this additional spending, is a proposal to jack up the tax rates on what’s known as “carried interest.” 

Carried interest is the share of profits paid to the managers of a partnership.  This tax increase will hit lawyers, the oil industry and private equity firms.  The hit to private equity is what I consider the most harmful as this is where the seed money for new innovation is delivered to markets. 

After the managers of a private equity firm return all capital contributions to the investors (a previously agreed upon rate of return) the managers of these investments are then paid.  Carried interest is currently taxed at the capital gains rate instead of the ordinary income tax rates because there is a lot if risk at state.  Many of these investments fall through, but when they are successful then one is rewarded via higher after-tax returns.  To engage in that risk, you must be compensated.  When that compensation is eroded by tax rates, less capital formation will occur, over time. 

Now, Washington is proposing raising tax rates on private equity by subjecting half of this pay to ordinary income (top tax rate will move to 39.6% in 2011) and half will be subject to the capital gains rate (which will increase to 20% in 2011 from the current 15%).  So tax rates on this income will effectively double.  Then in 2013, 75% of this income will be subject to ordinary income, the remaining 25% to the capital gains tax – an increase of 131% from the current rate. 

Eroding after-tax returns on firms that are the primary distribution channel for seed money will lead to less risk taking, which means less innovation and less business upstarts.  None of this leads to more jobs.

Somewhat unrelated, but since we’re on the topic of jobs, thought I’d post the following chart on state unemployment rates from Calculated Risk.

Borrowing from the Future

Housing has historically been a huge savings vehicle/wealth enhancer over long periods of time.  That is, one buys a home for basically the sole purpose of shelter and over two-three decades the price appreciation of the home combined with the pay down of the mortgage leaves one with a substantial build in household wealth.  The  appreciation leaves one with a return that is well in excess of principal and interest one has paid over the life of the mortgage. 

These days things a little different, however, as home-equity extraction over the past few years has sapped those savings -- pulling it from future savings and helping to drive spending today.  The graph below illustrates what has occurred and it will cause a hangover effect with regard to consumer activity.  Homeowners’ equity went nowhere even as home prices skyrocketed 2001-2006, which was also due to a lack of proper down payment restrictions.  Naturally equity collapsed as prices slid but there should have been a cushion built up during the period when prices were surging.

We saw this pullback in consumerism occur during 2009 as real personal consumption fell by one of the largest degrees in the postwar era, and retail sales slid the most since those records go back (which is 1992).  But consumer activity has bounced back of late, personal consumption accounted for 80% of first-quarter GDP (even greater than the outsized 70% of the past few years even as it needs to return to its long-term average of 65%).  Government transfer payments, home-buyers tax credits and the temporary free up of cash via strategic default have certainly helped to boost consumerism in the meantime.  But this too will encounter a payback effect.

There is no question that monetary policy, jacking interest rates lower earlier last decade, encouraged the home-equity extraction as borrowers could continually refinance – cash-out refis in many instances.  There is no question that government cash and the indecorous behavior of “walking away” from one’s mortgage obligations has fueled the latest round of consumer activity.  (Surely there is a large segment of the population by which demand was pent up, a consumer that has substantial resources, and they are also fueling retail activity, but I’m talking about on the margin, which counts a great deal.)

There will be other pay backs due to the monetary and fiscal policy decisions that helped to ease the damage of the worst credit event since the 1930s.  Those who understand this continue express a tone of caution. 

Today’s Data

We were without an economic release on Friday, but we get back to it today with existing home sales for April.  We should see a good number and it will be followed by strong sales figures when the May and June figures roll in – this data will reflect the contract signing that took place in April as the tax credit expired on April 30.  After that, sales will fall off even as the latest investor run for safety is flooring interest rates again.

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900