Hit Job on Megan McArdle

I like the Atlantic Monthly and sometimes read Megan McArdle's blog. So imagine my surprise when I saw this article, which is basically an all-out attack against Ms. McArdle and her family. I hope she responds.

Steven Lagerfeld: We've Made a Bad Bet on Taxes

The WQ's Steven Lagerfeld opened my eyes to the risky, two-way bet of tax cuts:

In another way, today's red vistas of debt recall the era of tax cutting under Ronald Reagan. The Reagan Revolution was in part a gamble: Cut taxes, and an alarmed public will demand budget cuts in order to avoid red ink. Now we may be witnessing a kind of reverse Reaganism: Increase the size of government and gamble that an alarmed public will eventually authorize the taxes to pay for it. [From Wilson Quarterly, Summer 2009, Vol. 33, No. 3, page 4]

Mr. Lagerfeld is absolutely correct--by refusing to cut government spending, we failed to uphold our end of the tax bargain. It seems that voters will always demand the same level of services or increased services; as a result, cutting taxes--which reduces revenue available for government services--might actually be a slow suicide pact. Californians just don't seem to have the stomach to cut spending, even when the money isn't there to provide the same level of services. Perhaps some kind of counterproductive but ingrained psychology is involved--after all, once you've tasted gourmet food on a regular basis, it's almost impossible to go back to the frozen microwave dinner--even if you have less money to spend and should be cutting back.

If Mr. Lagerfeld and I are both correct--that the bet on lower taxes failed, and once spending is increased, it's almost impossible to cut services--then cutting taxes should not be the main focus of any government policy. Instead, we ought to be focusing on the following areas: first, having a consistent tax policy to attract business and minimize inflation; second, requiring all new government programs to terminate at the end of the following fiscal year if sufficient revenue to fund the program does not exist; and third, to pass a balanced budget amendment to each state's constitution.

Marriage, Dating, Housing, and the Tax Code

A. Men and Women Approach Marriage Differently

Housing investors and fans of Robert Shiller's MacroShares Major Metro Housing Up ETF (UMM) should pay attention to the dating scene. The WSJ recently had an article on Japanese dating trends. The following sentence from the article caused me to examine a link between modern marriage and housing prices:

Experts say that in tough times, single women feel an urgency to get married for financial stability, while men tend to put off marriage until they feel they can afford it.

I agree with the sentiment expressed above. If my thinking is typical, then pro-marriage advocates should promote low inflation. If a person has steady wages, s/he will probably want to buy a house. Once s/he buys a house and has steady wages, then marriage and children become the next natural step.

Of course, people may marry and have children without owning a home, but most women want a stable place to raise their children. This is sometimes called the "nesting instinct." This nesting instinct is one reason housing prices and marriage are inter-related, especially because first-time homebuyers heavily impact housing demand and sales. If you still don't see the connection between marriage, children, and housing prices, listen to Barry Ritholtz:

A newlywed couple buys a starter home from a family (with another child on the way), who are moving to a bigger home, and whose seller is moving to an even nicer part of town, and so on. It is a long chain, not of mere lateral moves, but increases in size, cost (and property taxes). If any of those sales fall through, the entire chain collapses...Can they [the newlywed couple] afford that starter house? If not, then the entire real estate chain is frozen.

In his example, Mr. Ritholtz uses a married couple expecting children. But if houses are too expensive, then the typical younger person will delay marriage because s/he will not overpay for a house and/or will be concerned about taking on too much debt. Also, if a typical younger person's net worth is low, then s/he will not have a financial safety net and will be disinclined to purchase a house due to the fear of missing monthly mortgage payments. It takes time to build a financial safety net, so we may assume it will take several years before a typical younger person will be able to purchase a home. Thus, in an area with expensive homes, the typical person in his or her 20's and 30's is likely to delay getting married and having children. These seem like reasonable assumptions. The question is whether such assumptions rationally lead to the following conclusions:

1. If the government removes the home capital gains exemption and the mortgage interest deduction, then homes will become more affordable;

2. People are more likely to marry and have children if they can afford a home;

3. Therefore, to promote marriage, the government should not subsidize home purchases and sales.

B. America's Tax Code Encourages Perpetual Housing Inflation

The more I think about it, the more I believe our taxation system is anti-marriage because it encourages housing inflation. So many people complain about Greenspan and derivatives when discussing the housing bubble, but what about the tax code itself? Our tax code almost guarantees steadily increasing housing prices because of the mortgage tax deduction and the $250K exemption on capital gains when selling a primary residence. No other investment receives such generous tax treatment.

The higher the price of a house, the longer a person has to save up to buy one. If single family houses become really expensive--like 500K+, which is still typical in the Bay Area--then the idea of saving a 10% to 20% down payment before the age of 35 becomes almost impossible. This is common sense, but if you're not convinced, just look at the Federal Reserve's numbers. According to the Fed (PDF file: February 2009 report, page A11), in 2007, the median net worth of an under-35 years old person in America was only $11,800--down from an astounding $80,700 in 2004. The median net worth of someone 35-45 was a much more respectable $86,600. Based on these numbers, and assuming banks will require at least a 10% down payment for a mortgage, it is safe to say that the typical metropolitan resident has to wait until around 35 years old to buy a single-family home (not a condo or townhouse). Again, assuming a link between homeownership, marriage and children, the longer it takes for couples to afford a home, the more couples will delay marriage and children.

However, many people get married before they turn 35 years old, and they want to buy a house, prices be damned. How does a bank accommodate a young newlywed's desire to own a home? We've already seen what happens--banks would issue a loan and then pass on the risks to Fannie Mae and Freddie Mac. They did this because the tax code encouraged and continues to encourage homeownership. Thus, subsidizing/inflating housing prices when wages do not also increase across the board results in funny accounting (e.g., Alt-A mortgages, NINJA mortgages, "liars' loans," etc.), a steadily increasing marriage age (for those who decide to wait), or both.

C. Banks Benefit from the Current Tax Code, Not the Average American Family

If we are truly concerned about marriage and birthrates, isn't it time to re-examine the mortgage tax deduction and the government's plan to re-inflate housing prices? After all, the current tax system benefits banks and mortgage lenders more than the typical American family. By subsidizing houses so heavily, the American government is inflating the value of an essential asset and giving money lenders tremendous power over our lives. Our parents didn't have such high levels of mortgage debt, and they managed just fine. Heck, our grandparents would probably start a revolution if they were under our current system. If you think I'm overstating my case, research American history, especially the Great Depression. One of my favorite sepia pictures shows about fifteen Americans protecting a house from foreclosure. Anticipating the local sheriff, the resident and his neighbors had placed a very visible noose on the front door's awning and stood in the front yard, armed with rifles. I'm willing to bet the sheriff skipped that particular house and the bank wrote off the mortgage.

You don't have go too far back to see how tax incentives have inflated housing prices. For example, there's no question that tax incentives have created housing size inflation. Just look at the size of houses built in the 1950's--they were small, decent houses. American parents did a good job raising kids in those smaller, more affordable houses. Why do we need such large houses today? Who benefits from these larger homes? The developer and bank, which charge prices based on square footage, or the typical homebuyer? Is it really worth delaying marriage and having fewer children so we can pay the bank an extra ten years' worth of mortgage interest and principal?

I'm really getting off-topic now, but there is also an interesting sociological issue with allowing the tax code to inflate housing values. More specifically, couples on the coasts and in metro areas need two incomes to own a decent single-family home. This two-income requirement skews the dating game in favor of both high-earning men and high-earning women; as such, it devalues hopeful stay-at-home parents. If a man or woman is an excellent homemaker but does not earn much money, s/he may be at a disadvantage when "competing" for a long-term relationship. As a result, a woman might be an excellent secretary, waitress, and/or mother, but her "value" will be less in an area where two incomes are necessary for homeownership. By using the tax code to inflate housing values, one could argue our government has placed women who are interested in having and raising children at a competitive disadvantage.

My conclusion: if you want to fix the marriage problem and avoid another housing bubble, re-examine our tax incentives. Encouraging inflated housing prices isn't the best way to keep a nation growing, and it doesn't encourage upward mobility. (It sure does help the banks, though.)

Bonus: from USC College Magazine, Spring/Summer 2009, page 30, Laurie Hartzell's interview of Simon Wilkie:

He adds that the relationship between median income and the median price of a home is an indication of the state of the economy. "If the average person can't afford the average mortgage, then the housing market is in trouble, and the prices are going to come down. It turns out this is a really good rule of thumb." [Despite this rule of thumb, the government is trying to increase the cost of mortgages through inflation.] Although no one will admit it, Wilkie stated, a large portion of the stimulus package will be inflationary. "One way to get people out from being under water on their houses is to inflate the value of houses back up." A massive program of inflation would solve the foreclosure problem, but the fix would only be temporary.

Bonus: added on March 30, 2015: from MIT grad Matthew Rognlie:

"Land/housing is really one of the only investments that give wealthy people a long-term leg up. "

"It might be wiser to redirect anger towards those who get in the way of new housing, rather than rely on taxes to solve our problems."

"Just 14% of homes are affordable to middle-class families. In the once diverse Mission District, where many young tech workers are now relocating, it's hard to find a new home for less than $1.5 million."

"The government should focus more on housing policy and less on taxing the wealthy, if it wants to properly deal with the inequality problem."

Bonus: added January 2017: see link HERE and HERE for more on this topic.

Bonus: added March 2017: more HERE on how the mortgage tax deduction leads to excessive reliance on the financial sector.  

Sell Before It's Too Late?

Yesterday, I sold almost all my equity-based positions. I also called my sister and suggested she sell all of her stocks and mutual funds. Of course, you should do your own due diligence, but as of August 3, 2009, the S&P 500 closed at 1002.63, an annual high. The potential for further upside does not seem to justify the risk of holding equities. My remaining major positions--held in a retirement account--include only an inflation-protected bond fund; a GNMA fund; and a corporate bond fund.

My earlier prediction that the S&P would rise to a range between 920 to 950 proved accurate. I made my prediction on April 1, 2009, when the S&P was only 811.08.

More recently, on July 2, 2009, I bought commodities, especially natural gas commodities. Within a month, some of these positions increased almost 20%.

Any economic "recovery" without rising employment will be short-lived. Right now, I see unemployment staying at 7 to 9%, which will suppress wages and disposable income. We will know more on August 7, 2009, when the BLS releases the unemployment numbers.

At some point, it will make sense to jump back in the stock market. Right now, though, I agree with Hilary Kramer's analysis, which can be found here.

Update on June 11, 2010: the S&P 500 was 1002.63 when I made this post. The S&P did go down to 979, but then rose to 1086.84 over the next ten months or so--an 8.4% gain. Although I was wrong about the stock market's direction, the other investments I mentioned--GNMA and TIPs--also had decent gains when including dividend/interest payments. Also, I correctly predicted the unemployment numbers. Where will the stock market go next? I have no idea, but my personal tolerance for risk has gone up. When people start talking about the disintegration of the EU and the collapse of the Euro, maybe it's time to go contrarian--as long as you have 20 to 25 years to wait.

Disclaimer: The information on this site is provided for discussion purposes only. Under no circumstances do any statements here represent a recommendation to buy or sell securities or make any kind of an investment. You are responsible for your own due diligence. To summarize, I do not provide investment advice, nor do I make any claims or promises that any information here will lead to a profit, loss, or any other result.

Public Sector Pensions and Politics

The SJ Mercury points out that public sector pensions are based on unrealistic actuarial projections. See here:

The current level of benefits is built on an assumption of an 8.25 percent annual gain on investments after expenses for Federated, and 8 percent for safety workers. These unrealistically high assumptions leave taxpayers solely on the hook when returns come up short, as they have — drastically — the past two years...

City Council members are reluctant to confront unions on bread-and-butter issues and, with term limits, have little incentive to tackle long-term problems. But if nobody faces up to this, a taxpayer revolt is inevitable. And waiting will only make things worse.

Find me an investment advisor who can guarantee 8.25% annual gains in perpetuity, and I will show you a Brooklyn bridge for sale. (For the record, Madoff doesn't count.)

Gates-gate is about Police Power, Not Race

From Above the Law:

As Radley Balko argues in Reason, "[t]he conversation we ought to be having in response to [Gatesgate] isn't about race, it's about police arrest powers, and the right to criticize armed agents of the government."

More on Gates-Crowley here.

Sigma Designs Inc's (SIGM) Shareholder Meeting (2009)

I attended Sigma Designs Inc.’s (SIGM) shareholder meeting yesterday, July 30, 2009. About eleven people attended, mostly company employees. The company offered shareholders juice, soda, mineral water, cookies, and cherries. CFO Thomas Gay handled the formal portion of the meeting and then turned the meeting over to Kenneth Lowe, VP of Business Development and Strategic Marketing. Founder, CEO and Chairman Thinh Q. Tran played a more reserved role in the meeting, helping Mr. Gay and Mr. Lowe answer some of the more technical questions.

Sigma Designs provides system-on-chip solutions (SoCs) for third parties, primarily in the home entertainment area. It dominates in the area of IPTV set-top boxes, where, according to Mr. Gay, it controls approximately 80% of the market. Its main competitors are STMicroelectronics NV (STM) and Broadcom (BRCM).

Here are the highlights from Mr. Lowe’s presentation.

1. Internet Protocol Television, otherwise known as IPTV, is a technology by which video is delivered to the home. It relies on broadband rather than more traditional formats.

2. Some of Sigma’s customers include Motorola, Cisco, Samsung, Sony, Celrun, Dasan, WD/Cowin, UT Starcom, and Netgem.

3. Sigma provides its SoCs to numerous telecommunication service companies, including the major players in the home broadband market.

4. For fiscal year 2009, Sigma had $209 million in revenue, with a net income of $26.4 million.

I asked several questions, and Mr. Lowe, Mr. Gay, and Mr. Tran answered all of my questions thoroughly.

I mentioned that 94% of Sigma’s revenue was from outside the United States, and asked why they did not hedge their currency risk. [10K: pages 18-19]. Mr. Gay said it was unnecessary to hedge any currency risk because all billings/prices were in U.S. dollars. Billing in American dollars may help Sigma compete with Swiss-based ST Micro (STM), which currently reports earnings based on the stronger Swiss franc. (Mr. Gay said he believed the company was French, but Yahoo Finance lists STM as headquartered in Geneva, Switzerland.)

I mentioned Sigma’s relatively small net income and asked Sigma whether it would be better served if it went private. As a private company, it would not have to comply with regulations imposed on public-traded companies and could better focus on its core business. Mr. Gay said that having publicly available stock allowed the company to “compete for talent”--in Silicon Valley, where companies have to compete for talent, employees will favor companies with publicly-traded shares. Mr. Gay also explained that Sigma’s publicly available stock could be used for acquisitions (which would allow Sigma to conserve its cash).

I asked what gave Sigma’s products an advantage in the marketplace, i.e., what constituted Sigma’s “wide moat.” Mr. Lowe told me that Sigma provided “full solutions” in the IPTV streaming business and Sigma’s technology was more “resilient” than competitors’ products. He indicated that Sigma’s products minimize data “packet loss” and disturbances (more so than the competition). He also told me that Sigma had “deeper roots” in the hi-def area than any other competitor. For example, he said, Sigma adopted the Windows Media Standard before anyone else.

I asked a question about Sigma’s financial restatements. Mr. Gay told me “those issues are behind us” and the last time the SEC had contacted Sigma about its financial restatements was in 2006.

Another shareholder criticized the smaller board of directors and the presence of the same three board members on three different committees. The shareholder also asked why insiders were selling shares. Mr. Gay said that insiders were selling shares primarily because of option expiration dates, and Sigma would be using more restricted stock grants to encourage long-term investing. Mr. Gay also said he regretted the company’s stock buyback plan, which was now completed and which caused the company to buy its own shares at the relatively high price of $20.50 per share (SIGM now trades at around $16/share).

The same shareholder pointed out that Sigma was focused on discretionary consumer products, which are being affected most severely in the current recession. Mr. Gay responded that telecommunications companies have not suffered as much as other companies, and despite the recession, some studies projected 30% growth in IPTV sales.

After the meeting, Mary Miller, Director of Marketing, treated shareholders to a product demonstration. It was fascinating to see the technology come alive. Basically, Sigma partners with other companies like Schlage to provide home control products. Sigma supplies the chips in the set top boxes and other devices, which allow third parties to offer unique consumer products. For example, for under $500 (not including the television), you can set up a home that Bill Gates would be proud to own. When we walked into the demonstration room, Ms. Miller adjusted the light, blinds, and temperature using just a few buttons on a remote control. Within seconds, the room went from regular lighting to the perfect movie and TV-watching environment. I had only seen such home entertainment options in movies like Iron Man, so it was fun seeing everything in person.

But Ms. Miller wasn’t done. Using Schlage’s software and gateway (which used Sigma’s Z-Wave chip), she also demonstrated how you could open the door to your home from anywhere in the world, as long as you had internet access. For example, let’s say you left something at home and you wanted your friend to get it for you. With Schlage’s program, you could open your house’s door using a laptop. (Perhaps if Harvard University had invested in this technology, the situation involving Professor Gates and Officer Crowley would have never occurred.)

You can also activate home cameras from your iPhone or your laptop and check on your teenage children or other residents. Ms. Miller joked that from anywhere in the world, parents could have firsthand knowledge about whether their kids were at home and doing their homework. When I asked how much all this would cost, I received price estimates of $12.99/mo for Schlage’s software and about $500 for the lock, gateway and cameras. In terms of home control options, the future is here, and it’s surprisingly affordable.

With Sigma’s strong balance sheet and connections with established companies, it may become a potential takeover target. Right now, however, its revenues need to increase in order to boost its stock price and market exposure. Even so, in this economy, Sigma should be lauded for making a profit while its competitors posted losses.

Disclosure: I own fewer than ten shares of Sigma (SIGM).