Rational Investing: Tax-cut acceleration would stimulate U.S. economy

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.

Here's the 2003 Outlook in which I, ignoring my New Year's resolution, prognosticate about the economy and markets for 2003.

Bonds, interest rates: With no signs of inflation and a very slowly growing economy, interest rates are not expected to increase significantly over the near term; however, the appreciation in bonds of the past year is not likely to be repeated.

Bond maturities: The most attractive range for bonds remains in the seven- to 10-year area, with laddered maturities preferable.

Bond quality: As the economy improves, many corporations will benefit from strengthened balance sheets and better earnings, causing the rating agencies to raise the credit ratings of such companies. That should produce a total return in high-yield issues (junk bonds) that is significantly better than that of Treasury bonds. Credit analysis and diversification will prove very important in such a scenario.

Tax proposal: My guess, which I have written about in a previous column, is that President Bush will not get the full 100 percent elimination of double taxation on dividends that he has requested. Compromise with the liberals will probably result in a lesser break, possibly phased in over several years. (How about 50 percent exclusion from taxation now and an additional 5 percent or 10 percent a year until it's eliminated?)

Acceleration of the already-passed tax cuts and elimination of the marriage penalty retroactive to Jan. 1 would actually provide more widespread and immediate economic stimulus. If that occurs, the stock markets will improve quickly and the bond markets, anticipating inflation that has generally accompanied strong economic growth, will see an increase in rates and a decrease in values among high quality issues.

Stocks: If the double taxation of dividends is changed as discussed above, attention will be drawn to those companies that have the capability of not just paying a dividend, but of increasing it regularly. That is a metric that was pooh-poohed in the bubble days, but which could come into vogue very quickly. It forces companies to report cleaner earnings rather than cooking the books. Dividends are real earnings are what the accountants say they are. Big difference.

Some investors will jump into the wrong kind of dividend-paying investments. It is not simply a matter of scanning a stock guide or Web site for the highest yielding stocks. Only dividends paid out of earnings that have been taxed to the corporation will be eligible under the current proposal, effectively denying the exclusion to limited partnerships, real estate investment trusts and trust-preferred stocks treated as debt by the issuers.

Asset allocation: Depending on the bond and stock market reactions to the magnitude and expected duration of economic expansion, asset allocation portfolios may require rebalancing in the coming months. Should that be the case, amounts currently allocated to high-quality bonds (treasuries and investment grade corporates) should be lowered, with the proceeds redeployed into equities and high-yield bonds.

Expected range of returns: This one is anybody's guess; however, because the stock markets did not decline to a profits/earnings level as low as has occurred in past recessionary periods, it is difficult to conceive of it moving up at a pace similar to past recoveries. Think 5 percent or 6 percent appreciation, but that is for the broad market.

With good individual selection and attractive yields on many stocks, portfolios could exceed that level. It depends on how they are balanced, which in turn depends on the risk tolerance of each investor. Therefore, not all asset allocation portfolios will perform the same.

Do negatives bode well?

Worry, worry, worry. Iraq. North Korea. Inflation. Deflation. Terrorism. Corporate scandals. The list could be longer. Just check the front page of any newspaper or listen to the nightly news and add the worry du jour.

It's typical of what we have always heard during difficult economic times or periods of geopolitical instability. The media seem to thrive on giving us more to worry about. Forget any good news.

We have no special talent for calling what actions our government might take with fiscal policy or international diplomacy. Nor can we tell you where the bond and stock markets will be by year-end.

What we do know is that there is truth in the old saw, "A bull market climbs a wall of worry."

In good economic times, we all tend to be more positive, either ignoring or placing little importance on negative news. The opposite is true in less prosperous eras. Think back to the recessions we have lived through and how negative the news was. We were nearly inundated with it, to the point that many threw in their investment towels.

Ah, but had those investors not thrown in the towel