I wrote a book.

It’s available today and is being published via Amazon.  Check it out, our press release even hit Yahoo!

It’s called The Trade of the Decade.  It’s about how to build an investment portfolio that can withstand all the challenges of the coming decade.

Investors have it tough right now.  The old rules and the old strategies no longer apply.  Those who can’t let go of the trends of the long the boom and pick out the new trends shaping the world will struggle.  They’ll find themselves in investments with too much risk relative to the return they provide.  I tried to write something to help people lower their risk while still providing a good rate of return.

If you have a Kindle, go buy it.  Chop chop!

If you don’t have a Kindle, go buy one of those too.  You’ll love it!  At the very least, download the free Kindle reader.  It’s available for all the major devices and cell phones.  You don’t even need to buy a Kindle to get in on all the Kindle awesomeness.

Then go buy the book.

Seriously, it only costs $3.99.  I know you spent more than that at Starbucks this morning.  If you don’t feel like you get ten times your value out of this book, then write me an email and tell me the book sucks.  I’ll buy the beers the next time you’re in Reno.  Or the Starbucks, if that’s your thing.  I priced it cheap for a reason.  I don’t want people hemming and hawing about, “ehhh I just don’t know if this will be worth it.”  Pretty much anything is worth a shot at $3.99, especially something that could make you a little bit of money or help you sleep better about the investments you have.

$3.99 is worth a better night’s sleep!

But wait, there’s more!  You can have the full color, more versatile PDF experience for a dollar extra.  $4.99 gets you a PDF that you can do whatever you want with.  I just opened up a new “Shop” section of our Draconian website.  Check it out.  You’ll get a PDF that you can read on any platform and that you can also send straight to your Kindle device or app.

Download that PDF right here.

OK, that’s enough of the hard sell.  If you don’t care about me or my book or how it came to be, scroll on down to the market recap section.  There are some important things to discuss like what the heck is going on with this debt-ceiling fiasco.

But if you do care about the world of book publishing, and want to take a peek inside the kimono, allow me to open it for you.

How I did it

Last quarter Amazon sold more eBooks than print books.  And nobody sells more print books than Amazon.  This year they’re selling 3x as many Kindle books as they did last year.  They’ve only been doing this for a couple of years.  12% of American households already have an e-reader and we haven’t even seen the sub-$100 reader yet.  The $99 price point is where technologies like this really take off.

This is happening, people.  You’re watching one of those most rapid paradigm shifts in the history of mankind.

It’s changing the game for publishing, too.  A while back I had a conversation with an old friend who has worked as a writer and in various jobs related to the publishing industry.  She said the print publishing world is pretty much freaked out and ill-equipped to adapt to the digital revolution.  The stodgy kingdom of traditional print is a notoriously slow-moving bunch.  How long before these dinosaurs are completely eaten by newer, faster, meaner monsters?  Will they carve out a new niche?

I could have gone the traditional route.  I have no doubt these publishers still offer some value in this world.  But that involves a lot of risk on both of our parts and today writers actually have a choice.

Amazon owns this company called CreateSpace.  For $190 they’ll do comprehensive copyediting.  For $299 they’ll design you a snazzy cover.  How much worse a job are they going to do than the starving editor or designer who’d take a chance on a guy like me?  How much more are those print dinosaurs going to charge?  What slice will they take out of my royalties?

If you want, CreateSpace will even print physical copies on demand and sell them through Amazon and other distribution channels.  They’ll do a press release for you, assign you an ISBN, and give you a bunch of other marketing material if you want.

It’s an amazing suite of services for an insanely reasonable price.  I used some of those options, and since I am fortunate to be surrounded by talented people, it left me the freedom to do the rest on my own.  I know some real writers with real publishing experience and they stomped out all my shoddy grammar and helped me structure my text so the message comes across.

I had an old friend, Katie Stapko, now of Stapko Design, make me a terrific cover.

You can see some of Katie’s body of work right here.  If your website looks stupid or your marketing materials and logo need an update, drop her an email.  She was a joy to work with and her rates are great.  Tell her you’re one of our readers and I’m sure she’ll probably give you special treatment, or at least special attention.

The old channels are dying

I could have gone the traditional route.  But it would have taken forever.  Usually it takes upwards of a year or more to get a book actually published once it’s been accepted.  And that’s assuming I could find a publisher to accept my book quickly in the first place!  We all know how much rejection new authors must endure.  I’m probably the least-sensitive guy I know when it comes to that sort of thing, but I don’t have a lot of patience when it comes to getting ideas developed and distributed.  This book was time sensitive.

I started writing this thing in February.  I was doing it totally on the side, too, since I have full-time job that occupies most of my day.

Had I focused my energy on the book project entirely, it could have gone from concept to actual publication in about a month.

Amazing.  Welcome to the world of digital publishing.

If you’re a writer who already has a readership and a platform, the money angle is compelling.  On the Kindle digital platform, so long as I price the book between $2.99 and $9.99 my royalties are 70%.  70%!!  I can set the price as high as I want and I get 35%.  That’s way more than the 10-15% you’d be lucky to get with a traditional publisher.  And that’s hardcover, too.  Paperback royalties are around half that.

Before you get too excited, know that writing books is a really bad way to make a living.  If I sell 1,000 copies of this book I think that would qualify as an overwhelming, ridiculously way-out-there runaway success.  In that scenario I would make a staggering $2,740.

Again, thank God I have a real job.

But consider this: what if you were someone like Stephen King (or, eek, Stephanie Meyer) with a website and legion of rabid fans and a real publicist and a real editor and real network of industry contacts?  A major author like that could write a book and sell a million copies tomorrow.  How long until some bestselling author realizes that they can sell five times fewer books and still make more money if they self-publish?  That’s how unbalanced the royalties are.  I have to believe that thought gives traditional publishers nightmares.  Does Scholastic Press really help J.K. Rowling sell five times more books?

Oddly enough, a traditional publisher and their established network would have the most value to a guy like me, yet I’m the type of writer that they are least interested in.

Let me tell you something I’ve learned about running a business: when your incentives and your customers’ incentives are as far out of alignment as that, it’s a baaad thing.

So long, old school publishers…

A Creative Commons license, what?!

Writing books and making stuff isn’t all fun and games.  When it comes to creating original works, lawyers often have to get involved. Ugh.

Fortunately, this is a world that’s evolving as well.

Rather than use a traditional and restrictive copyright, I published this book under a Creative Commons license.  This was the exact one I selected.  If you speak legalese, here is the full legal text.

You probably don’t care about Creative Commons, but you should.

Basically, I’ve arranged it so that you all have legal freedom to buy this book and share it with whomever you’d like for whatever purpose.  Download the PDF and e-mail it to your buddies at the club.  You can reprint an entire chapter on your website so long as you properly attribute the author.  Directly quote some of these ideas on your blog and have your readers comment on it.  The only catch is that you can’t use it for any commercial purposes.

I know this is an uncommon path for authors to take.  Once a work is published under this kind of license, there’s no going back.  It’s permanent once it’s in the hands of the public.

But I and my cohorts grew up in the age of piracy.  We spent our youths installing copies of friends’ video games on our computers.  We made tapes and burned CDs for each other and shared MP3s on Napster and Bit Torrent.  We downloaded illegal copies of Photoshop and made funny images of our roommates.  We didn’t do this with malicious intent, to steal others’ work for our own nefarious, money-grubbing purposes.  We just loved the media and wanted to share it with those we cared about.  We knew we were violating the moldy laws of yore.  But, like, the old world needed to catch up.

So, yes.  I’m encouraging you to pirate this book.

Buy a copy and pass it along to your friends or coworkers.  I see that Kindle has an option to support book lending now.  Sweet!  I totally enabled that feature.  Share the book directly with your other Kindle friends.

I needed a solid legal framework to allow for that sort of thing.  Creative Commons has done all the dirty work in this space and they’ve built a great toolkit that gives artists a lot of granularity and flexibility on how they want their work to be used.

Creative Commons has a lot of other licenses, too.  The academy award-winning musician Trent Reznor (which still sounds crazy to those of us who grew up listening to Nine Inch Nails) released one of his latest albums under a CC license.  He did it because the record company didn’t have the legal framework to let him do it the way he wanted and give his listeners freedom to download and remix.

All these tools are free, too.

Amazing.

I’m a terrible marketer

I know I probably should have spent this issue of the newsletter trying to tell you how awesome a book it is and what it’s all about.

I think the book is good.  I got good feedback from friends who aren’t afraid to speak honestly with me.  I think the investment thesis at the heart of the book is solid and feel pretty confident that it’ll be a good way to make money and keep your risk low in the next decade.  There is easily $5 worth of value in it.  At the very least, it’ll give you an insight into how the elite portfolio managers in this business structure their trades and express their investment ideas.  What I talk about in the book is what the tippy top of hedge funds do.  The big boys.  I think that a simple, easy-to-digest conversation about those topics is worth at least five bucks.

I guess I could have talked about that stuff — and maybe I will in a future newsletter — but I honestly thought that a behind-the-scenes look at the process might be more interesting for you today.  I’ve always been every bit as curious about why and how things get done as the things themselves.  It’s why I went to UCLA with dreams of entering film school and love those DVD commentary tracks.

If you want to continue this conversation about publishing, feel free to email me directly.

I’ll let you know how this process goes.  I’ll let you know how many copies I sell.

In the meantime, buy the book!  Kindle or PDF!

Debt Ceiling WTF

The market really took a dive this week on fears about the whole debt ceiling debate.

There are a couple of really important things to understand here that I’m not entirely sure the world is aware of.  I will make them as clear and concise as I can.  I’ve had a record number of people email me about this or ask me about it in person.  I can’t remember the last time so many people asked about the same single item.

1) A deal is going to get done.

Judging by some people’s Facebook posts and some of the questions I’ve been asked, I think there are people out there that are legitimately concerned that no deal will get done and everything is going to spiral out of control.

That isn’t going to happen.

There will be a deal.  I happen to think that partisan bickering and political games are childish and silly, but this is simply the way that it works in Washingon DC.  Behind the scenes, where they don’t have to worry about posturing and currying favor with their constituents, these guys are doing real work.

In fact, I think there’s an optimistic view that nobody is considering right now.  There’s a very good chance that this will be the most bipartisan piece of major legislation since the Clinton administration.  You know it’ll be bipartisan because both sides will hate it and compromise begrudgingly.  And I think it needs to be bipartisan in order to both pass the House and get Obama’s stamp of approval.

2) The bond market isn’t freaking out.

Some people have asked, “well how do you know that they’re going to get a deal done?”  I know this because the yield on the 10-year Treasury note is 2.98%.  If there was any chance, even a teensy one, that they couldn’t work out a debt deal, that yield would be way higher.  I saw a lot of CNBC headlines yesterday after the Dow lost 198 points.  A lot of people were saying to just get out of stocks and go to cash.

I’m not entirely convinced that’s the right perspective.  The economic backdrop right now is actually pretty good.  We’re getting slightly better numbers on employment and the recovery continues for major companies with a global footprints — it was a fantastic earnings season for the S&P 500 firms.

If the U.S. went into technical default or suffered a ratings downgrade — which would be the case if they couldn’t pass a deal — then that would lead to a cascade of selling in Treasuries.  Yields would spike.  The bond market clearly doesn’t think that’ll happen.

Nor do the credit markets.  The LIBOR-OIS spread, which our longtime readers will recognize as one of our favorite “fear gauges,” is at 0.13 and dropping.

3) It isn’t about the debt ceiling.

Raising the debt ceiling is trivial.  That’s easy to do.

But given the headlines around this story, it’s not clear that the real bickering and compromising is about something else entirely.  These Congressmen and Senators are using the need to raise the debt ceiling as an opportunity to pass a much broader piece of legislation.  The goal, as I’m sure you may have already surmised, is to reduce expenses and bring the budget into something more of a balance.  There’s even a chance there could be some major tax code changes too.  We’ll see.  There are a lot of legitimately interesting ideas in play that are being completely glossed over by the headlines.

Thanks for reading

I feel like it’s time to thank all you guys again.  You’ve been a fantastic readership and never in a million years would I have expected the response we’ve had.  I still can’t get over the bizarre novelty meeting total strangers who say, “Hey!  I read your newsletter!”  It’s a trip…

And thanks for buying the book.  Whether it’s on Kindle or PDF.

This whole thing is a big experiment and I promise I’ll keep you updated on how the process goes.  Who knows where it’ll lead.

Thanks for all the feedback on last week’s newsletter.  I got quite a few emails after that one, a couple of which were angry but all of which were civil.    

With 896 subscribers via email, 5,000 pageviews/month, and almost 500 followers over at SeekingAlpha, the reach of this newsletter has extended far beyond what I ever expected.  But in the grand scheme of the internet that’s hardly anything to brag about and we’re nowhere near so big that I can’t personally respond to those who take the time to write in.  I take a lot of pride in doing this, and I enjoy it when we touch a nerve that motivates people to send in some of their own thoughts.

Today we’re going to conclude our discussion on taxes and talk about why all this tax stuff matters.  It has investment implications.  Big ones.

Why it matters

In short, this is why: 

That chart doesn’t include every last drop of government revenue, but it contains most of it — personal income taxes, corporate taxes, FICA, and excise taxes.

You can see that once upon a time the U.S. Government ran the way your household does, matching expenditures with revenues.  But right about the time the gold standard went away, things changed.

The corollary to the above chart is this one:

The problem is that these two charts represent unsustainable equilibria.  I know I used that word last week and I know everybody nowadays is totally desensitized the word “unsustainable,” but it’s true.  This is a situation that cannot be sustained without some sort of change.

There are two ways to reconcile those charts.

• (1) The economy grows its way out i.e. taxes and expenditures stay fixed and as the economy grows, tax receipts rise relative to GDP while expenditures shrink.

I happen to think that’s problematic because it’s contingent on a few really important, low-probability events.  It’s contingent on holding expenses constant, which is pretty much impossible for politicians to do, and it’s contingent on this growth happening on a rapid timetable, also very difficult given the massive economic headwinds of the future.  So if nobody thinks there’s going to be a massive, speedy recovery in the next 5-10 years and nobody believes that the government can keep costs in line in a healthy environment, then something else has to be done.  Which brings us to:

• (2) The imbalance between receipts and expenditures are forced into balance manually i.e. tax rates go up and government spending goes down.

Now, the tricky part

Everybody understands the broad nature of the problem and the solution.  But the toughest part of all this is going to be the details of its execution.

Last week we talked about how good a very small segment of this country has gotten at making money.  The distribution of income in the U.S. is massively skewed, the highest in the developed world.

The top 15% of wage earners ($100k+) generate a massive amount of government revenue (half of it).  Those who make $10 million or more, a teensy percentage of returns, generate almost 10% of tax receipts.  10%!!  I have a really hard time envisioning any new tax policy where these people are not made worse off, particularly these latter folks way out there on the income spectrum.

Sorry, rich people.  I know you guys are already shouldering most of the load but you have it historically awesome right now and in the future that’s going to change.  You’re going to be asked to pay more in taxes and you’re not going to like it.  I hate it as much as you, but I’m a realist.

As I see it, there are really only two politically feasible ways to get this done.

Punish the rich

I’m a surprised we haven’t seen any political candidates emerge that are willing to run on a platform of “punitive” tax rates for the extremely wealthy.  I’m not necessarily advocating this kind of policy, but the super rich in this country are doing better than ever and this narrow demographic generates tons of revenue.  Forget the sunsetting of the 2001 tax cuts.  Why not impose a 50% tax on income of $1 million or more?  Why not 70%?

Again, I’m not really advocating a policy like this.  I’m just surprised that more people aren’t.  When given a choice between making sacrifices themselves or punishing the extremely rich, I’d have to believe that poor and middle class voters would choose to punish the rich.  Wouldn’t you?  It sounds like the sort of answer that would be really appealing to a large swath of the population.

But I guess it all comes down to dollars.  Politics is an expensive sport nowadays.  None of these guys can get elected without support from the wealthy and no individual, organization, or business with a lot of money is going to back a hyper-populist candidate like that.

By the same token, I don’t necessarily oppose a policy along these lines either.  I’m not a believer that a punitive tax structure on the rich would destroy the economy.  I don’t subscribe to that campaign of fear.  The world won’t fall apart if income of $10+ million is taxed at twice its current rate, though there will undoubtedly be some negative economic effect.  Given the composition of the economy, the effect would probably be less bad than if you targetted the poor or middle class to raise a similar amount of revenue.

Option 2: Blow the whole thing up.  Jerry Bruckheimer style.

This is the policy that I’d pursue if I was the director calling the shots.  Blow that shit up, Jerry!  I’d radically restructure the tax code in such a way to generate more revenue across the board and make it harder for people to manipulate.

The underlying philosophy with this type of reform is the increasingly-popular rallying cry of “broaden the base, lower the rates.”  That means doing away with all the wonky credits and deductions, broadening the total base of income that can be taxed.  Then it taxes that bigger base of income at a lower rate.  The result is a tax code that is much simpler, flatter, and more difficult to game.

Paul Ryan’s plan isn’t perfect, but it’s probably the most sensible and detailed one I’ve come across (and the least extreme).  He’s one of just a few people right now who are trying to have an adult conversation with the American people about this sort of thing.  You can read about that here.

On the other side of the political aisle, Erskine Bowles submitted some similarly brilliant ideas as part of his findings while serving in the debt commission.  His proposal would eliminate all credits and deductions and use three simple income rates (8, 14, and 23%) for all income.  Alice Rivlin, who served in Clinton’s cabinet and is also a member of Obama’s deficit-reduction commission, has advocated a national sales tax.

I’ve written in the past about how I think this is a terrific idea.  It will generate tons of revenue to pay for more and better government programs and it’s also regressive, which means it disproportionately affects people in lower income brackets.  As we saw last week, there are a staggering number of people out there who consume the services this country provides while contributing nothing to it.  This is the way to get them to contribute.  If you’re not going to tax any of their income, then tax them on the things they consume.

Tougher than it sounds

I understand that these sorts of things are really difficult to accomplish in such a hyper-partisan climate.  But there are sensible people on both sides of the aisle that are doing legitimate work here.  We should listen to these perspectives.

You’d think lower tax rates and a simpler structure would be an easy sell to the American people.  But there are a couple of major problems with this.  And I do mean MAJOR.

First, it makes it a whole lot tougher to use the tax code as a device for shaping social behavior.  As it stands, the tax code offers heavy duty incentives for some activities — buying a home, for example, or earning your income in the capital markets instead of a W-2.  And it contains some big disincentives, too.  It’s bad if you sell cigarettes or are in the oil & gas business.  The government likes things the way they are because it gives them more levers to pull if they want to specifically raise revenue from one pocket of the economy or stimulate another.

It also makes it very difficult to curry favor with your special interest.

Here’s how it works in this country:

I can’t run for office if I can’t finance a campaign.  I can’t finance a campaign unless I get major donors (corporations & trade associations) to back me.  They won’t back me unless I do something for them.  Quid pro quo, you know.  And what they want is special treatment from the government, usually via the tax code.  If I don’t push for some little line in the tax code that helps their corporate bottom line or if I don’t pursue broader policies favorable to them, they think about supporting somebody else in the next election.

The most egregious and downright-offensive exhibition of this was in the TARP legislation.  Version 1.0 was simple and gave Paulson & Bernanke the broad power they needed to stop the bleeding.  That got shot down.  The Dow dropped almost 800 points in response.  You’d think it would have been a wakeup call to Congress.  But no.  They dragged their feet, called the other party mean names, and made some threats.

Then they came back with TARP 2.0.  This was the one that was loaded up with a nauseatingly gigantic amount of pork.  These Congressmen took the crisis as an opportunity to fulfill their special interests’ fantasies, so long as it wasn’t too crazy.  For Oregon Senators Ron Wyden and Gordon Smith, it was a tax exemption for companies that manufactured toy wooden arrows.  I can just see those guys, feet up on their desk, saying “nuh-uh, I’m not voting for your bailout bill unless I get a little cheese in return.”

Sooo… you can see why politicians don’t run on platforms that upset the mechanisms that keep them in power and their backers happy.  A simplified tax code might be great in theory but I see it as nearly impossible to implement.  It’s a shame, too, because it could solve a lot of problems with one stroke of the pen.

Spending cuts

This is how the middle class is going to pay.  Any of these overhauled tax policies will likely be a push for those in the middle income brackets.  But these folks are going to have to sacrifice in the form on less-awesome government benefits and public programs.  Their future Social Security benefits won’t be as great, nor will the the quality of their Medicare-provided healthcare be as high.

It’s a lot easier to fine tune the composition of government spending than it is to tweak the revenue.  This is also where the biggest cuts will come, too.  I don’t agree with the Republican party’s unilateral and non-negotiable ideology when it comes to tax policy, but I understand that it’s the glue that holds their considerably more heterogeneous party together.  I agree with their pursuit to be particularly aggressive with spending cuts.

This stuff isn’t fun.  It involves sacrifices all around.  The U.S. has painted itself into a corner and the only way to get out brings substantial pain, certainly more than we got used to during the last few decades.

As you can imagine, this will have some pretty major implications when it comes to building an investment portfolio that can withstand the turbulence of the coming decade.

Investment Implications

If you didn’t already see it, I’d highly recommend reading Reinhart & Rogoff’s latest op-ed over at Bloomberg.  It’s a very elegant article and they explain the conceptual framework for why economies with large debt burdens don’t grow as much as less-encumbered ones.  The difference is big, too.  Economies with a debt burden greater than 90% of GDP tend to grow around 1% below median growth.  There are a lot of other reasons why the U.S. will exhibit below-trend growth in the decade to come, and our debt load could be the difference between a regular ol’ boring economy and Japan.

Reinhart & Rogoff also make another beautiful, intuitive point.  Historically, debt levels of more than 90% of GDP are extremely rare.  Have you ever thought about why?  Is it because nobody’s ever had the revolutionary idea that we could borrow prodigious amounts of money and spend it without risk or cost?  Doubtful.  More likely, the answer is that every economy hits a point where their rising borrowing costs force tax hikes and spending cuts to bring the budget into balance.  Tax hikes and spending cuts are bad for the economy, hence the sub-par GDP growth.

Ultimately, the stock market is dependent on the growth of the economy.  Over the long, long run the stock market grows at:

GDP + Dividends + Inflation

By definition, it has to.  All the other fluctuations are due to changes in appetite for risk.  Econ Geeks call that “multiple expansion”.  In the early 80′s, price as a multiple of earnings was very low.  By the 2000′s it was very high.  For twenty years investors became more and more comfortable taking risk and paying more for $1 of earnings.  The stock market went way up, beyond what was predicted by the growth equation.

So when you’re looking at an economy that’s now saddled with such a large and growing debt burden, it’s madness to think that it will grow at the rates we used to know.  The debt level — which is a somewhat abstract concept to most — really matters.  It’s an economic drag on its own and fixing it is a further drag on the economy.

This is a crucial dynamic when investing in the U.S. stock market for the long run.  The era of the passive index fund and the buy-and-hold strategy is over.  That’s a strategy for when price-multiples are low and the debt load is small.

If you want to grow your money in the market today (and don’t want to rely on an ever-expanding appetite for risk) then you have to be skilled at identifying the specific companies that will:

• Grow at a rate greater than GDP
• Pay above average dividends
• Benefit disproportionately from rising inflation

• Government expenses and revenues are extremely out of balance right now.  This condition is unsustainable.
• Fixing it means two things will happen in the years to come: higher effective tax rates and reduced government spending.
• Reinhart & Rogoff show us why countries with extremely high debt levels tend to grow at a slower rate.
• Successful investors will be those who can identify companies that will grow at a rate greater than GDP, pay above average dividends, and/or benefit from rising inflation.

A couple of weeks ago we did a newsletter about poetry.  Before that we did one on science fiction.  I didn’t think people would enjoy those but I got lots of feedback from people that did.  If this newsletter experience has taught me one thing it’s that I’m not very good at predicting what other people think and gauging their tastes & preferences.

Even while those seemed to go over well, I’m sure there are a lot of readers out there who listen to all our talk about stuff that isn’t related to finance and say “blah blah blah get to the point and show me some charts and data!”

Well, today is the newsletter for all of you guys.

Advance warning: this newsletter is going to upset a lot of you.  We’re talking taxes, and taxes are a touchy subject.  Some of that anger will be directed at the wealthy, some at the poor, and some of it will be directed at me.  If this were a perfect world I’d have you channel all that fury at your representatives in Congress and if this were a perfect world they’d actually do something about it.

But in the meantime we’ll settle for information, a foundation for further debate.

Marginal rates

My guess is that you’ve probably seen this first table before.  Or at the very least, you’ve heard the data point about how once upon a time in the U.S.A. the highest tax rate was over 90%.

This is a highly politicized data set.  Partisans on the right cry about how economically destructive a top rate of 70% is and partisans on the left cry about how 35% is way too low for the nation’s wealthiest to be paying.  As with pretty much everything else that’s highly politicized, this table doesn’t even begin to tell half of the story.

The marginal tax rate is meaningless.

What matters from a public policy and economic perspective are effective tax rates and average tax rates.

I know this statement isn’t going to rock your world or anything, but the tax code is pretty complex.  There are a million different deductions and loopholes that you can use to lower the amount of taxes that you pay.  It’s a fun little game, but I pay a CPA to play that game for me.  He’s better at it than I am.

You and I might each make $100,000 per year but what we each actually take home could be radically different.  I might have a simple life and rent an apartment and never contribute to an IRA and spend all my money on Isaac Asimov first editions.  You might have a wife and three kids and a big mortgage and max out all your retirement contributions.  Maybe you also installed energy efficient blinds and bought an electric car while I continue to roll around in my gas guzzling F350.  The point is that you’re going to give back a much smaller share of that $100k than I will because of all the deductions and exemptions in the tax code.  Who cares that we each live in the same marginal bracket.

Marginal rates may get all the headlines, particularly that top marginal rate, but the fact is that they don’t matter the way that effective rates do.  So that’s what you need to look at when you’re doing your own taxes or comparing the tax situation from one era of history to the next.

That’s where our discussion today is based.

Average rates for an average family

Here’s a better chart.  It makes some assumptions.  It tries to get at the heart of America, or rather, “America”.

This study assumes a family of four where most of the income is earned by one spouse and it assumes an average level of itemized deductions.  Because the tax code has changed so dramatically over the years, a broad generalization like is actually a pretty good way to compare two different windows of time.  It’s much better than just looking at the brackets.

Pretty crazy, huh?  When I first saw the raw data set, it blew my mind.  When I turned it into a chart, it’s even more remarkable.

I could go on and on, but allow me to touch on a few points:

The first thing that jumps out is the pronounced downtrend in the federal tax rate across the entire income spectrum.  This is a trend that goes back much further than the 2001 Bush tax cuts.  It goes all the way back to the early 1980′s, the birth of the Long Boom.

And it’s not just the wealthy that are paying lower and lower income taxes.  It’s the middle class and the poor.  In fact, especially the poor.

That’s probably the next thing that looks a little shocking.  What’s with the negative tax rate for low income families?!  It’s true, these families actually get a net payment from the government.  Things like the Earned Income Tax Credit and Child Tax Credit make this possible.

I know that gets a lot of Republicans fired up.  ”Welfare” is what we call a government-facilitated transmission of wealth from one segment of the population to another.  And it’s impossible to argue that the Federal Income Tax mechanism is acting as anything but.

Before all you feisty Ayn Randians send out any angry emails, keep in mind that these people aren’t necessarily such an obvious net drain on society.  These people actually do pay some taxes through their employer in the form of the payroll tax.

Fortunately, there’s data available as well for our same average American family.  What I did was combine the payroll tax data with the income tax data.  This provides a comprehensive overview of all the various taxes on individual incomes.

To recap, this chart does a lot of things:

• It totally ignores marginal tax rates and various brackets.
• It assumes an average level of deductions and an average family structure and measures the effective rate.  That’s the final tax rate at the bottom of your return once you’ve plugged all your stuff into TurboTax.
• It also includes payroll taxes that employers pay directly on behalf of their employees.  That’s FICA for Social Security and Medicare.
• The sources in this chart account for almost 90% of government revenue.

There’s really no other way to put it: Americans are paying the lowest rates in a generation.  The wealthy haven’t had it this good since the late 70′s and the middle class hasn’t had it this good since the early 70′s.  As for the poor, their total effective tax rate is not only historically low, but essentially zero!

We can get a little more granularity on this interesting segment from our friends at the CBO.

I bring these low-earners up specifically because it touches on another really important concept.  These folks are paying less and less in income tax (technically receiving more and more credits from the government) but they have been paying progressively more in the form of payroll tax.  While they may be paying higher and higher taxes for benefits that they will some day receive in the future — Social Security & Medicare — they are getting more and more money back in the now in the form of various tax credits.  That gives them more money to spend today, which grows the economy.  It’s a transfer of wealth from a future generation to the present.

If you peek behind the curtain of most of the fiscal and economic policy in recent history, you’ll find this a common denominator.  The “American Way” seems to be more and more about transferring wealth from the future to the present, and trading short-term acute pain for long-term chronic suffering.

Once you get past the emotion of it all, it truly is a fascinating dynamic.

Who pays what

There’s no real need to rehash what I wrote over a year ago.   Back then we talked specifically about where the revenue comes from and who shoulders the biggest share of the tax burden.  Everybody already knows the answer to that.  It’s the wealthy.  It’s always been that way and it always will be that way.

Despite the fact that the rich are being treated as favorably by the tax code as they have in a looong time, the top ten percent of wage earners still account for over half of total tax revenue.  The richest one percent account for over one fourth of total tax revenue.  Those figures are up from 40% of revenue and 14% of revenue respectively back in 1980.  See the full data set for yourself right here.

If you put the all these trends of that old newsletter with today’s you will arrive at the following conclusion:

The wealthy are paying relatively less and less of their incomes in taxes yet are accounting for more and more of total federal tax revenue.

The layman may be wondering how on earth that’s possible.  After all, the middle class and poor are paying less and less of their incomes in tax and, unsurprisingly, are accounting for less and less of total government tax revenue.  What gives?  How are all these sneaky rich people with generationally low tax rates accounting for such a large and increasing share of total tax revenue?

The answer is subtle.  These people have just become much better at making money.  The government might be collecting a smaller percentage of these folks’ incomes but it’s on a much larger base.

In other words, what we’ve got going on here in this country is a large and increasingly unequal distribution of income.

This is the sort of thing that I hear populists and liberal Democrats constantly raging about.  I have no idea if this is a good thing or a bad thing for society.  I just know that these people on the left have a legitimate reason on which to base their anger.  It’s data that cannot be refuted.

This is simply the way that things are.

In-Gini-ous

There’s actually a much less roundabout way to measure income inequality than breaking down a normalized composition of tax revenue across statistical quintiles.  It’s called the Gini Coefficient.  It was named after the Italian dude that came up with it.

Calculating the Gini Coeffcient involves some fairly hairy math.  But it’s easy to interpret: a value of 0 means that everybody has the same income and a value of 100 means that one guy has all the income.

The U.S. has a value of 45.  It’s the highest in the developed world.  In South Africa it’s 65 but who really knows what’s going on down there.  In Brazil the coefficient is 56.7, which certainly isn’t helped by Eike Batista and the Banco Safra guy.  Most of Europe ranges between 25 and 35.  In Sweden it’s 23, the lowest in the world!  Scandinavians always seem to score pretty high on all those global happiness surveys too.

But I’m sure that has less to do with their relative income equality than with their preternaturally good looking women.

(FULL DISCLOSURE: I have no idea who that is, I just went to Google, typed “Swedish models”, and that was the only one that was safe for work.  I’m as surprised as you are that it was a Tommy Hilfiger ad.  Google Swedish models at your own peril and discretion!)

Anyway, there are other ways to measure income inequality too.  But they all tell pretty much the same basic story.  It’s high in South America and Africa, where oligarchical government corruption has a lot to do with who gets to earn what.  It’s low throughout Europe.  Canada and Australia are somewhere in the middle as they seem to be with most things.

Pretty much every measure of income inequality is notably high in the United States.  And there’s a real irony here.

I hear a lot of passionate partisans complain these days about how the U.S. is becoming “socialist” in the sense that the government is shackling the wealthy in an effort to support the poor, an attempt to equalize incomes across the spectrum.  It’s sort of what we think of when we recall soviet Russia or the broader history of Marxist experiments around the world.

But when you look at the data, this simply isn’t true.

And that’s where the irony kicks in.  The U.S. actually resembles modern Russia, a society in which incomes are skewed to a rather large degree.  Russia has the biggest income skew in all of Europe and developed Asia (with the exception of China, a strange exception indeed).

Here’s a chart I caught a while back in a study from the Paris School of Economics.  It measures the share of total income that the highest earning 1% earn.

That chart blows me away.  I wonder how many people out there are aware of this condition.

There is a very small percentage of people in the U.S. that are making boatloads of money.  They’re earning 18% of all the income.  That’s the highest share since the 1920′s.

Income disparity in the U.S. is not only high relative to the rest of the world, but it’s also been increasing steadily since 1980.  If you think that incomes are reasonably well distributed in this country you’re deluding yourself.

Where’s the rage?

It sounds like a recipe for populist rage, doesn’t it?  A very small minority earning so, sooo much money, giving a smaller and smaller share of it back to the government while middle class incomes stagnate and the poor struggle to find any job at all.

I know that some people out there are upset about this situation, but I’m curious why the anger isn’t more passionate and more broadly-based.  It seems like the kind of platform that a politician unafraid of totally alienating a minority would want to run on.

My guess is that this is because Americans, more than any other citizens in the world, don’t begrudge the wealthy their wealth.  I think that’s one of the many facets of the American Dream.  We don’t hate the rich for being rich because, hey, that could be us someday.  And thanks to a very favorable tax structure, America is a pretty awesome place to be rich.

But America is also an awesome place to be poor.  These folks are contributing little, if anything, to society.  And this is a very large swath of people, too.  Somewhere around 20% of Americans contribute basically nothing in the form of taxes and another 10-20% beyond that contribute relatively little.

The talking point I hear Democrats repeatedly circle back to is that the rich “need to pay their fair share.”  I wonder if these people have really studied the data.  They must be using a different definition for the word “fair” than I’m accustomed to.  It can’t have anything to do with equality and can’t have anything to do with services consumed vs. services paid for.  It gets voters fired up, though, so I guess that’s why they use it.

As you can see there’s a lot to be angry about when you look at the current tax structure, regardless of your political persuasion.

I think that’s enough for today.  I’ve got several more things to add to this discussion — including why all this stuff matters — and some thoughts about how these conditions may shape the investing environment up ahead.

We’ll save that for next week.

• Americans are paying the lowest taxes in a generation.  It doesn’t matter where you fall on the income spectrum, it’s much for favorable for you now that it would have been at any point in the last 30 years.
• There is a very small minority of Americans who are earning a tremendous amount of income and are supporting a large portion of total tax revenue.
• There is a very large portion of the population who pay little or nothing in the form of taxes and this is a condition that never really existed prior to the 2001 tax cuts.
• Incomes in the U.S. are very unevenly distributed.  Americans have always seemed pretty cool with that, which is interesting given all the furor over the distribution of taxes.

It’s been a super quiet start to July so this will be a short newsletter.

But I have something really interesting for you guys next week.  And extremely controversial.  My early guess is that it will make every single one of you angry.  Some will be angry at me for simply talking about it and others will experience a more generalized, non-directed anger.  We like to focus on the data around here, so at the very least you can count on our perspective to be objective and rational.

I’ll give you a hint: it involves taxes.

Anyway, stay tuned.

Market Recap

Last week, stocks had their strongest week since 2008.  This week has been pretty good too.  We wrote about that oversold condition a couple of issues ago and it goes to show how powerfully stocks can snap back when  the selling is overdone.

For the most part, I’m a terrible market tactician.  I’m not in the business of making market calls or issuing buys & sells and I’m one of those investors who’s plain lousy at getting in and out of the market at the right time.  My approach is more strategic (just because that’s what suits my personality) and fortunately I happen to know a lot of people that are much better market timers than I am.

That being said, I think it’s really easy to identify the extremes when a market is oversold or overbought.  The problem is that those are always difficult times to actually step up and do something about it, to buy when it looks scary or to sell into hyper-enthusiasm.  The other problem is that sometimes the oversold/overbought condition gets even further extended.

But the market spends most of its time between extremes.  What then?

One answer is to just ride the trend.  The trend, right now, is up.  I’m not necessarily advocating that you have to ride that trend or buy the market because I think there are some important fundamental risks lurking up ahead.  The point is simply to illustrate something obvious which, depending on the filters you have all around you, may not actually appear obvious.

It’s actually not rocket science.  It’s poetry.  We talked about this very thing a couple of weeks ago.

What does the blackbird mean?  Is it symbolic?  A metaphor?  Opinions vary.

But at least the one thing we can all agree on is that the blackbird is a blackbird.

Sometimes that simple truth gets lost in all the analysis.

So acknowledge the cyclical trends.  The debate will rage and rage about what they mean and how long they will stay intact or what sorts of things may change them.  Make sure that any opinions you arrive at or conclusions you come to accept the trend as a base principle.

I’m not sure we’re quite there yet, but there will come a point in the cycle where it’ll be time to start thinking about how put together a portfolio that can make some money on the short side.  That’s the other subtle fact of the above chart.  Markets don’t move in the same direction forever and understanding the cycles of bull and bear trends is very important.

Another answer for environments like this is to just hang out and wait for something to come to you.  Despite the pressure that investors feel to always be invested — especially in this environment of negative real interest rates – it’s OK to have some cash.

I know it’s boring and I know it takes discipline, but it’s the kind of thing that can pay off over the long run in the form of better risk-adjusted returns.

Gasoline

This is the thing that I’m watching right now.  It sort of slipped off the radar when commodities cratered and the U.S. announced it would release some of the strategic petroleum reserve (another stimulus bullet!).  But I’ve got my eye on it.

With the economy projected to grow at just above the stall speed for the next year or so, something volatile like gas prices could move the needle.  It could be the difference between an economy that falls into true recession or stays a whisker above it.

I think the administration sees this too and I think it’s why they planned to release oil from the strategic reserve into an environment where prices were already falling.

It’s an important thing to pay attention to that most people and the markets have already sort of tuned out.

Lessons from a Junkie

Do you drink coffee?

If you don’t I’m sure you’ve got your reasons.  But if you do, my guess is that you do it pretty much the same way every day.  The ritual and the routine of the coffee experience are every bit as important as the beverage itself.

I’ve had coffee every which way.  I’ve had most everything on the menu at Starbucks and compared it with McDonald’s and Dunkin’ Donuts and even The Coffee Bean back when I was a city-guy.  I’ve had it at just about all the greasy spoon breakfast joints in town.  I’ve had it on cruise ships and fancy restaurants.  And I’ve brewed plenty of my own,  from various drip coffee pots and espresso machines.  I’ve used the Tassimo, the Senseo, and the Keurig.  I’ve even used those little filter thingees you put directly on top of your mug.  Apparently that’s what the urban hipsters are doing nowadays.

All this might make me sound like a junkie, but I’m really not.  The one rule I’ve never violated is drinking only one cup per day.  So I’m more of a disciplined dabbler.  I like to experiment and experiment until I find something that feels right and gets me optimal results.  Then I just stick with it.

For me that happened to be a French press.  I buy beans at the store and grind them fresh every morning.  It gives me exactly what I need: a morning ritual and a minor indulgence.  It’s one of the few luxuries I afford myself and I don’t mind that it costs a little more and takes a little longer.  I enjoy the process and feel like the result is a better cup than anywhere else around.

There’s a lesson here: investing is no different.  

There are a million ways to do it, and the confusing catch is that there are loud advocates for each.  Just turn on CNBC on any given day.  You are guaranteed to hear from guys that believe only in blue chip value stocks, guys that think junk bonds are most awesome thing ever, and guys that call you crazy if you have no exposure to commodities.  Then there are the short sellers and the hedgies and those private equity guys that, finally, are crawling out of the woodwork.  Each one of them firmly believe that their method is the best.

Listening to them can get a little overwhelming at times.

Mrs. Draconian still swears by her daily “Starbucks double short caramel macchiato with soy milk” which overwhelms me for a dozen reasons not least of which is that it’s an impossible order for me to remember when it’s my turn to go to the counter.  I’ve spent years – years! – trying to enlighten her about all the other cheaper, tastier ways to prepare coffee.  But she’ll have nothing of it.  Nothing else will stick.

And that’s OK.  Coffee isn’t a one-size-fits-all endeavor.  Nor is investing.

Since we launched this newsletter back in 2009 I have repeatedly circled back to this point.  So much of what we talk about on a week to week basis is transitory.  That’s just the way that this industry works.  Markets move up and they move down and a few days later we’ve forgotten all about it.

But this is a piece of timeless wisdom.  If, after two full years you have gleaned only one thing from our aimless weekly musings, I hope this is it: there aren’t any easy answers in this world.  There are only your answers.  If that sounds frustratingly post-modern, well, sorry about that.

Some of this stuff we talk about might work for you, some of it it might not.

A couple of weeks ago we talked about a really short-term strategy.  The week before that we talked about a super long-term strategy.  We’ve talked about stocks, bonds, commodities, real estate, hedge funds, and cash.

There is no right way to do this.  There is no one way to build a portfolio.  There is just your way.  And my way.  And his way.

My morning coffee ritual brings me a lot of comfort.  So does building an investment portfolio that’s tailored to my specific preferences.  It works and it gets me good results.

I like to preach a gospel of introspection and self-discovery.  The more you learn about what you like and why you like it, the better decisions you’ll make when faced with new challenges.  It’s every bit as important to focus on the process as it is the results.

When it’s super quiet out there, I’ve found that discussions like these and doing research like this can be quite profitable.  Before long — it could be tomorrow or it could be next month — it will be noisy.

You’ll be better prepared having already gone through exercises like these.