Volume X, No. VIII

Labor Day approaches -- and so does Hurricane Earl. Summer may be "officially" ending, but the same doesn't hold for hurricane season. Let's hope Earl stays offshore. We were hoping for a nice, big family gathering, but some of us will be driving up the East coast. Fingers and toes are crossed.

Meanwhile, as we keep our eye on the approaching storm, we bring you three important items to keep your eye on the rest of 2010:

• How Long Will Food Prices Climb -- and How High?
• Why House Prices Will Continue to Fall
• What We Can Expect When the Bush Tax Cuts Expire

There. You didn't expect us to fret about oncoming storms all by ourselves did you? C'mon; join the club.

Wheat Prices just increased the most in 51 years. This isn't just a temporary spike. It's because of increasing demand as well as reduced supply.

China, India and other emerging markets are growing and demand for more and better food is on the rise on the part of the people living there. In addition, weather has not cooperated in many parts of the world, most especially in Russia and China. In fact, Russia has suspended exports of grain, because they are concerned they will soon need it to feed their own citizens. Their reduced crop production means supply may not meet domestic demand.

The biggest increase in demand comes from China. China has imported wheat before, but not to this degree. As their economy grows and they become more prosperous, their people want to eat better. Part of eating better means more meat. And grains are used to feed animals. So the pressure builds for more grains not only to directly feed the people, but also to feed more animals to provide the meat people desire.

As a result, on a trend basis, we're looking at long-term increasing demand; in the short to longer term, reduced supply.

Before we get too panicky, let's think back a couple of years to the last spike in agriculture prices. Food prices didn't go up as much as some people said they would a couple of years ago. Not that food doesn't cost more than it used to. It's just that what people perceive and what's really going on are sometimes two different things.

Do you remember when milk and eggs spiked up a couple of years ago? Everyone was howling. And they were right. In our part of the world, a dozen eggs (not the fancy organic, cage-free, etc types, just the regular stuff) shot up from about $1 to about $2.50 in the course of a few weeks. Ditto milk. It certainly did seem like eating was going to get a whole lot more expensive.

But guess what? Prices drifted down for some months until they settled down - not as low as they were, but not all that much more than they were.

Will we see prices shoot up, then fall back quickly? Well, because of the permanently increasing demand, `we may be looking at a serious and permanent rise in prices. How much prices rise depends on the ability of producers and distributors to keep up with the demand. Again, remember, wheat and other grains are used to make not only products like bread and cereal, but are also used for feeding animals. That covers a big part of our total food supply.

Now, food prices haven't significantly reacted to all this yet. It may take weeks, maybe months, assuming these skyrocketing wheat prices hold up.

But there is one worry here we need to keep our eyes on. The way prices work has as much to do with perception and anticipation as it does with the actual supply and demand. It's not just a matter of crunching numbers: so much supply/so much demand. If people begin to fear that wheat prices - and other grains - are going to continue to rise, possibly rise dramatically, then consumer food prices may soar.

So while logic tells us not to panic, it's important to remember that logic doesn't always rule people's emotions. And while logic ultimately should determine prices, it's equally true that people's emotions can drive prices far higher for far longer than seems rational.

If we base what's happening now on what happened a couple of years ago, we may face a shorter-term spike in prices driven by emotion. On the other hand, if emotions get carried away and supply really can't keep up with demand over the short term, we may have a more serious situation on our hands.

It is certainly possible that we could see a dramatic rise in prices for products made from wheat and other grains, as well as an increase in meat prices. But chances are that those dramatic increases will not sustain. Of course, longer-term there may be permanent increases in prices that won't return to old levels, just as we saw with some products the last time prices shot up.

As I said, we'll have to keep our eyes on this one.

At this moment, the United States remains the largest and one of the most efficient producers of grain. It is also the most efficient distributor. The result will be a windfall in profits for the American producers this year. (There's an investment opportunity there, of course.) But we may still find that demand stays a step ahead of supply, especially in light of the future growth of demand in China, India and other emerging markets.

Why this matters: Given the ongoing crisis that we've carefully outlined these past months, the economy will remain fragile. If the cost of basics like food rises, given current levels of unemployment and underemployment, people will have even less to spend. Since consumer spending continues to be weak, this will serve to dampen any sort of recovery. For how long? Keep your eye on food prices for one hint.

Are house prices stabilizing? We've been hearing and reading this for at least the last year. A quick survey of local values on Zillow.com shows that prices "wobbled" over the last year, and even seem to have picked up ever so slightly. But this may be misleading.

Reported increases in foreclosures tell us that the current inventory of houses on the market will only increase. Unless there is some significant up-tick in demand, this increase in supply should result in prices dropping further. It's just basic economics.

Of course, the counter to that might be that with mortgage rates at their lowest since the 1950's, buyers might be motivated to move in now. In fact, refinancing activity has increased. But, of course, refinancing just means someone stays in their current home and refinances to reduce their monthly mortgage payment. So far, there's no evidence of a surge in buying.

In addition we need to be aware of a kind of "hidden" reality lingering out there that may undermine today's seemingly stable house prices. The CEO of RealtyTrac, James Saccacio, recently said: "The roller coaster pattern of foreclosure activity over the past 12 months demonstrates that while the foreclosure problem is being managed on the surface, a massive number of distressed properties and underwater loans continues to sit just below the surface, threatening the fragile stability of the housing market."

Now you may want to take this comment with a grain of salt, since Realty Trac publishes the largest database of foreclosed properties in the country. The more people who believe there might be opportunities to buy a foreclosed property at a big discount, the more potential customers Mr. Saccacio might attract to his company's services.

Yet there's no denying that the processing of foreclosures remains slow and arduous. Banks don't really want to rush the process along. Once a foreclosed mortgage is processed, the bank needs to sell the property. And with a tight market, they certainly don't want to generate a growing inventory of homes to sell. After all, they're not in the real estate sales business, so it's really not an expertise of theirs to move house inventory.

The government's "HAMP" program (Home Affordable Modification Program) didn't work. That program was designed to let people "restructure" mortgages so that they could avoid foreclosure. The idea was to work with banks to reduce monthly payments so that people would be able to afford to continue paying their mortgages.

Unfortunately, what really happened is that, first of all, there was little interest in the program on the part of people defaulting on their mortgages. Secondly, people who do in fact restructure wind up defaulting again, about six months into the program.

So what we seem to have is an ever-increasing number of foreclosures, even with government emergency rescues efforts.

Now we can add to this increasing foreclosed property inventory the growing phenomenon of people who simply stop paying their mortgages, yet continue to live in their homes. You may have caught something about this in the news. What you may not have seen is that there are now law firms soliciting people whose mortgages are underwater (i.e., the value of the mortgage exceeds the value of the home). Their pitch is that they will keep defaulting homeowners in their homes for the maximum amount of time so that they can simply live mortgage/rent-free.

So in the end, what we have are people who can afford their monthly payments, but are now exploiting the housing disaster by not paying their mortgage - simply for profit.

And so it would seem that foreclosures, if anything, will increase, dumping even more inventory on the housing market. The pressure on house prices continues. It should not be surprising if we see further declines in the weeks and months to come.

Why this matters: Our economy simply will not improve significantly if houses continue to decline in value. Much of the economic growth prior to 2007 was caused by people extracting equity from their homes (using their homes as a kind of ATM machine) and spending it. Not only has that stopped, but if house values decline people will further reduce their spending as they will "feel" poorer. Keep your eye on house prices to get a better idea of whether the overall economy will pick up or start falling again.

With the Bush tax cuts scheduled to expire, let's just take a quick look at what we can expect to happen.

The administration says that the tax cuts favored the rich anyway, so it's just as well they expire. After all, the rich aren't paying "their fair share" now. They should pay more.

Some opponents of the administration are wringing their hands over the Bush tax cuts expiring. They're painting a scenario where the increase in taxes that results from the expiring tax cuts will be the next nail in the economy's coffin. Our recovery is weak, and tax increases will sink us.

Of course, to get somewhere near the truth, you've got to discount the fact that a lot of this sort of commentary is politically motivated noise that really doesn't help us understand things. It's just intended to get us potential voters to support Democrats or Republicans, liberals or conservatives.

Not that there's anything unusual about this game. That's what politicians do - politicians and the economists that support their positions. They try to manipulate the public - especially by emotional manipulation - to support their views.

But we were wondering whether there might be some useful information out there to give us a more objective way to evaluate what the expiration of the tax cuts might mean. And we found something useful - not only in evaluating what might happen if the Bush tax cuts expire, but also about tax cuts or increases in general and their effect on our economy.

Now let's agree that the only reason that tax increases - specifically income tax increases - make sense (whether from allowing the Bush tax cuts to expire, or adding taxes outright) is if the increases add to the revenue of the federal government. And let's even put aside the whole question of whether increasing government revenue - in and of itself - represents some sort of net benefit to us (an interesting question, but we'll skip it for now). Let's just accept that increasing government revenue will somehow provide needed, important, even urgent benefits to all of us - or at least to those of us who aren't "rich" (since the rich don't deserve any sort of benefit, right?).

Now, according to the ever-insightful Caroline Baum (my favorite Bloomberg columnist), we have some facts we can use to draw some conclusions about whether tax increases or cuts have any long-term effects on government revenues. Ms. Baum states that we know empirically that, over time, federal revenue as a share of gross domestic product has stayed fairly consistent at 17.9%. That's been true if the marginal tax rate was 91% (in the 1950's), 50% (early 1980's) or 35% (early 2000s). The only exception is during recessions.

So, as a matter of normal policy, playing with the income tax rate doesn't seem to matter to government revenue.

Of course, we've just had (or are still in) a recession. In recessions, government revenue declines. You don't need an economist to explain this. If economic activity turns down, then business revenue and profits go down, and therefore taxes collected on business profits go down. And if unemployment goes up, people aren't making as much income, so personal income taxes go down.

So, what about the idea of at least raising government revenue by increasing taxes strictly on the rich. (Remember, we're allowing for the assertion that the increased government revenue would be used to benefit us - or at least some of us.) Well, it turns out that a fellow named Arthur Laffer has been writing about this for a long time, most recently in a number of editorials in the Wall Street Journal.

Laffer asserts something that strikes us as making sense. He says that raising taxes on the rich won't raise more money for the government. His reasoning is that the rich can counter the higher rates a number of ways. And having worked with some rich folks, what he says makes a lot of sense, based on our experience.

First, they can afford to pay accountants and lawyers to find loopholes. And, in spite of what you may think, or what you may read, there are always loopholes - even when every effort is made to close loopholes. In fact, closing some loopholes inevitably opens others. And the expensive hired help that the rich can afford to pay always find those loopholes one way or the other.

Second, the rich can decide to work less and take more leisure when income taxes go up. They can defer income from their businesses if that's to their advantage. (On the reverse side, they can decide to work more if tax rates go down.) The point is, they don't rely on a steady paycheck the way regular folks do.

(Note that if taxes wind up being increased on poor or middle class folks, that's bad news since those folks really can't do anything but suffer from a loss of income. They don't have the options the rich have.)

Really, this does ring a bell, based on our professional experience. So the question becomes what's the point of all the talk about taxing the rich and the rich needing to pay their "fair share." Is it anything more than a kind of playing on envy? Is there any practical purpose besides scoring political points with one group of people at the expense of others?

What do you think? Do you think letting the Bush tax cuts expire will really benefit us all? Or is this just a kind of political football being thrown back and forth to see who can take advantage of it most, or who will be able to use it to win the coming November elections?

Why this matters: As of today, there is a high probability the Bush tax cuts will expire. We don't think all the chatter you may hear about the impact on our economy will really be worth listening to. Republicans will claim the economy will take a hit. Democrats will assure us it won't and justice is being served -- maybe even that so much more tax revenue will flow to the government, there will be more money to funnel to some cause or entitlement that benefits you. But we think you'll want to keep your eye on this one mostly to see how exactly it will affect you in your particular tax bracket. Think: "How might this affect my planning?"…Period.

We'll continue keeping our eye on Hurricane Earl. But that'll be good for about a week. Those other three items will be worth watching the rest of this year. The first two should give us some idea as to which direction the economy's going. The third may have a significant impact on your tax and overall financial planning.

And as for summer, unless your one of those folks who just loves it hot and hotter, it's kind of overstayed it's welcome. In fact, this may be the hottest summer on record. Amazing!

Anyway, it's really not over until Wednesday, September 22nd. Then again, even if we get more beach weather, it's just not the same after Labor Day. So whatever you think of this hottest of summers, enjoy what's left of it.

Your looking-forward-to-Fall editor,

P.S. -- The expiration of the Bush tax cuts means that you've only got a few months to address some important planning and investment decisions that really need to be made before December 31st. If you would like some professional guidance before then (or know someone who might) please feel free to contact us. We may be able to help.

Meanwhile, with or without the Bush tax cuts, you can find out how we're all (poor and rich) subsidizing some rich folks in New York City. Just visit my blog today.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com