Cain's 9.9.9 Plan and the Trade War with China

What is the relationship here?

Hay. We don't have to start a trade war with China by snapping 15% tariff on imports. Guess what --- how about a 9% national sales tax and then cut payroll tax from over 13% to 9%, and corp income tax from 25% to 9%, just like what Herman says.

What is the net-effect here?

All imports will be 9% more expensive.

And tax on domestic goods will be subsidized by reduction on payroll tax and corporate income tax. Corporations will have less tax burden to hire in the USA and more incentive to repatriate money back to the USA to invest.

WTO can not argue a thing. Almost every other nation in the world levies VAT (value-added tax) or sales tax. China has it at over 20%. Europe too.

I say we need a VAT (though this may scare a lot people in this country), for the very reason why they are scared --- YES. To suppress consumption.

We are having structural economic problem and the recession will stay for long time unless we introduce structural change to the economy. We have been a consumer driven economy for 100 years and it has reached a point that the economy of high consumption and low investment can not sustain. We need to discourage consumption and encourage investment and hard working.

The end is unavoidable. Either we pro-actively change the economic structure or we will eventually be facing the day of reckoning --- when dollar loses reserve status and plunges and we won't afford consuming any more.

This slow motion train wreck started in 2000 --- when tech bubble reached its high. Since then real wage has not increased a bit in this country. What did we do to sustain the consumption economy? First, central bankers kept rate low for prolonged period to encourage reckless mortgage lending, so that citizens can keep borrowing against their houses to pay for luxury goods and dream vacations. Then housing bubble bursted. What our politicians do? Of course --- Government Handouts. Tax base is shrinking to under 50% of the population. Middle class is shrinking at an even faster rate. Without serious reform, we will either become a socialist country (if we are actually lucky) like Europe or a total anarchy, which means hell for this country as everybody is entitled to have a gun.

We have to consume less and invest more. We have to cut government spending, reform entitlements, and encourage private sector investment and risk taking by revolutionizing taxation. We have to encourage capital inflow to recapitalize this country by lowering corp tax and rationalizing immigration policy. We have to cut government handouts and encourage people to work to feed themselves. We have to do all those and race against time, which we borrowed against the reserve status of US dollars. Our high living standard will be all over if we fail to do those before one day US dollars lose reserve status.

Chinese Stock Market, Deflation and Inflation

The Chinese Social/Economical/ Political structure tends to respond well to deflationary pressure (much better than the rest of the world), which is the main problem in the current global recession.

The Chinese government is far more efficient in delivering economic stimulus than the US. The current growth has mostly been driven up by that stimulus, which hopefully will be a bridge to a more sustainable economic recovery when China's major trading partners recover. The one thing that the stimulus has not done is to steer the Chinese economy from export-driven to more domestic-consumption driven economy. The income disparity remains high and ratio of personal income to GDP remains low. Consumers in the near term will not be the driving force of the economy. Though China has been moving in the direction of liberating its consumers by raising labor protection, salary and social welfare. The goal won't be achieved in the short time.

China would be more concerned with inflation instead. As the economy is mostly driven by investment for lack of both domestic and foreign consumption at this time. The stock market is driven by excessive liquidity both injected by central bank recently and from accumulated monetary supply from high savings rate and the long term surplus from international trade and investment. In a deflationary environment, these would be great forces to offset it. But it will exacerbate the problem of inflation when it occurs. The Chinese stock market will peak and turn at any credible sign of inflation or even before that if enough speculation of inflation builds up. The risk appetite has been huge lately as the Chinese government is now having trouble selling its treasuries at current interest rate.

High-end House Market and US Treasuries

Now it is the turn for high-end houses and prime mortgages.

Today's Headline:

12 pct. are behind on mortgage or in foreclosure

Delinquencies and foreclosures set record in 1st quarter, driven by prime loan defaults

A couple of months ago, some suggested moving up by buying good school district and letting go their current homes (by foreclosure?). Those who followed this advice would be burned severely today. It would be as stupid as selling an asset at 30% discount to buy another in the same asset category at only 15% discount. It is no surprise that high-end market are catching up with the low-end to fall another 10%.

I did suggest to a friend to sell his small, old, but pricey Palo Alto house to buy a big house in San Jose or Fremont. It may be late now. Palo Alto house market is in stand-still though the price has not fallen dramatically from the peak.

Now the interesting question is:
Will Obama come to the rescue of troubled million-dollar-home owners on California coast? How many tax payers or mortgage bond holders or both have to be robbed to bail-out one such family? Washington has been breaking contract laws -- the very foundation of free market and capitalism to save the "debtors". It is not surprise that our government of democracy is on the side of debtors when our nation as a whole is a nation of debtors.

Just this week, creditors slapped the face of US government by saying "enough is enough" on long-term treasuries. The 10 year treasury rate is close to 4% now. "What goes around, comes around". It happens so fast, even before GDP in any major economy shows any signs of recovery.

When a nation's government public encourages its citizens to default on mortgage contracts (as in the loan modification conditions in the house rescue plan), will bond investors trust that government to honor its own debts by

(1) Repaying the debts on time, and
(2) Keeping denominating currency (US dollars) afloat.

Go figure!

Home Price to Rent Ratio

According to Case-Shiller data, the historical norm of home price to rent ratio is about 15 --- home price is about 15 times annual rent. I did some research and found that this ratio for high end homes and high income families with conventional mortgage is about 20 - 22 with tax savings and property tax factored in, at least in the first year.

The assumption is the following:
Home price range 800K to 1.2M
20% down payment
1.2% property tax rate
6% interest
Family at top tax bracket (Federal 35%)

I calculate the tax saving, and then subtract the tax saving from the mortgage interest payment and add the opportunity cost of down payment. The result is owner's effective annual cost. The home price is about 20 to 22 times this effective annual cost. Of course, any home maintainence cost or HOA, Home Insurance has not been counted for. And the assumption of 12 month rent may not be realistic either.

Owner's Effective Annual Cost =
Annual Mortgage Interest - Tax Saving + ( Down Payment * Savings Interest Rate)

Thus Price-rent ratio for high end homes can be as high as 20 to 22 instead of 15.

Some Observations:
This new Price-Rent ratio may justify some high prices in desired neighborhoods. But many neighborhoods in SF Bay area still seem too expensive even with this ratio, such as Palo Alto, Cupertino, Mission San Jose, Burlingame, Mountain View, etc. Even with the 20% price down from the peak, home prices in those areas are still over 25 times annual rent. On the other hand, some low-end neighborhoods in SF Bay area have seen the Price-Rent ratio come down to 15 to 20, such as most of Alameda County (excluding Mission San Jose of course).

Some conclusions:
Using price-rent ratio 15-18 for low-end houses and 20-22 for high-end houses in SF Bay area, the low-end seems much closer to a "fair" valuation than the high-end. Some low-end neighborhoods may have already reached the Case-Shiller's norm value of price-rent ratio. This is consistent with the comparison of price movement between the high-end and the low-end. The latter has come down by 30-40% from the peak due to large number of sub-prime foreclosures, while the former has only dropped 20% from the peak.

The downward pressure on prices still remains in the high-end real estate market. What can be even worse is that both interest rate and tax are going up (meaning less tax deduction from mortgage interest for high income earners). And rent in history never increases nearly as fast as interest rate during inflationary periods. And that will put downward pressure on the above calculated price-rent ratio for high end homes.

Inflation Hedge

The following is a list of stocks/ETFs for inflation hedge:

TIP
GLD
SLV
TBT
DBA
DBC
...

TBT is probably the most aggressive way to profit from inflation. It directly shorts 20-year US treasuries. It is a double play for both inflation and weak dollar.

GLD (gold) is a good play, but its value is artificial as gold has little usage in industries. Higher inflation with stagnant growth may drive off the demand for jewelries as people have to spend limited budget on common goods and staples with higher price. I believe SLV (silver) is probably a better play.

The safest bet is probably Agricultural Products (DBA). But I would wait for a pull-back to below $25 to get into DBA.

DBC provides the broadest coverage of Commdities. It should have a place in everybody's portfolio as long as you are concerned about inflation down the road.

Natural Gas vs. Oil

Natural Gas has been so cheap recently and its price remains down about 30% since the start of the year. It has not enjoyed the run-up of other commodities, like Oil and Agriculturals. Check out the comparison

UNG (natural gas ETF) vs. USL vs. DBA

There are still excess capacities in the Natural Gas industry, which also lacks co-ordination of pricing like the OPEC has. But the substitution relationship between Crude Oil and Natural Gas still remains, as they are both energy sources that are easy to tap on. Natural Gas is definitely a good long term play than Oil is.

After all, 80% of US electricity is from Natural Gas. This means that the peak usage may not only occur in Winter for heating, but also in Summer for A/C cooling.

I am moving money from USL to UNG and will keep buying if price dips again in the short term.