Today's Hot Topics   ▲  |  ▼

The signs of 'recovery' so far have not been nearly convincing, argues Kelley Wright of Investment Quality Trends, who explains what he thinks investors need to see to really believe in the economy.

What is clear (from the recent GDP report) is that consumers, investors, and companies do not behave in a vacuum. There are dynamic reactions in anticipation of events as much as there are dynamic reactions as a result of events.

By example, a significant amount of income was pulled from 2013 into 2012, which has taken place in every instance where tax increases were announced in advance.

More than a few companies borrowed billions of dollars to pay special dividends to shareholders at the then-lower tax rates. Others paid dividends in the fourth quarter of 2012 instead of Q1 2013. Moreover, many large corporations and financial institutions paid 2012 bonuses in 2012 instead of in early 2013, which is the common practice.

Consumer confidence has soured considerably. At the risk of appearing exceptionally obtuse, we can only surmise that the new tax increases in the American Taxpayer Relief Act—coupled with those in the Affordable Care Act—has begun to seep into the national consciousness.

In case you missed some or all of these items, the following is a brief synopsis:

• a 4.6% increase in the top marginal tax rate to 39.6%
• a phase-out of itemized deductions (mortgage interest expense, various state income, property, and sales taxes, and charitable gifts) for high-earners
• a phase-out and elimination of personal exemptions for high-earners
• an increase in the capital gains and dividend taxes from 15% to 20% for high-earners
• a 3.8% surtax on capital gains, dividends, and other investment-type incomes for high-earners
• a 0.9% surtax added to the Medicare tax for high-earners
• a 2.3% excise tax on medical device manufacturers

In total, it's a 2.7% hit to real household income, not including the increase of Social Security taxes back to the pre-meltdown level. This raises the top marginal tax rate for 2013 to 46.3%, the highest effective tax rate since the Tax Reform Act of 1986. No wonder consumer confidence has taken a hit.

The markets have largely chosen to ignore anything except the prevailing meme: The fiscal cliff has been avoided; housing is showing signs of recovery; investors are shifting from bonds to stocks. As for the long-term structural problems with the US deficit and spending, however, nothing has been fixed.

With the full impact of the tax increases still to be realized, I don’t see that the Fed is anywhere close to taking its foot off the liquidity pedal. I anticipate that the ballyhooed rotation from bonds into stocks will turn out to be nothing but a short-term trade, and that interest rates will decline again as investors seek the shelter of “risk-free” returns. Obviously, that will not be good for stocks, in the short term anyway.

How will we know when the economy is really getting healthy? First, when the Fed can stop coming to the rescue, and asset prices continue to climb. Secondly, there must be real increases in both employment and wages. Lastly, it would be comforting to see consecutive quarters of GDP increases in excess of 4%. Show me those and then I will get excited.

My thought is these signs of true recovery will come in stages. The good news for value investors is that the inevitable ebb and flow of investor psychology will provide several opportunities to acquire excellent companies at good value.

The key is to be patient and not to get caught up in periodic bouts of irrational exuberance. Buy right—when good value is presented—and the returns will come.

Subscribe to Investment Quality Trends here...

Related Articles:

The Market, Whether Up or Down, Is the Safest Place for Money!

Should You Fear the Black Water Snake?

Secrets of the Latest GDP Report