Even though it didn't feel like it, the economy grew stronger than expected in the 3Q. The Commerce Department reported that GDP expanded at a 3.1% annual rate in the 3Q. This was largely due to sharply higher auto sales. Without auto sales, the economy would have only expanded at a 1.5% rate in the 3Q. It is widely believed that the economy has slowed down considerably in the 4Q. The Index of Leading Economic Indicators continues to fall; unemployment rose to 5.7% in October; and manufacturing output fell for the second month in a row. Consumer confidence and spending continue to fall, and retailers are bracing for a disappointing holiday shopping season.

The question is, are we headed for a recession? The Bank Credit Analyst expects the economy to remain in mildly positive territory for the next several quarters, but does not rule out a mild recession. Much depends on how much the Fed cuts interest rates. BCA predicts that the Fed will have to cut rates by 50 basis-points before year-end and probably more next year to head-off a recession and growing deflationary forces.

The stock markets continue to rally, with the S&P 500 Index up 16% from the October low. Meanwhile, bonds have moved sharply lower. Stocks were severely oversold and bonds were extremely overbought, so the latest moves may only be corrections before the major trends resume. I would expect stocks to retest their October lows at which time we will know if the market has really turned around. I continue to recommend that you have most of your equity investments in market-timing programs that can go to cash if need be. As for bonds, I will not be surprised if the October lows in interest rates were the top in the Treasury bond market.

In this issue, we look at the latest data from the IRS regarding who pays the most in income taxes. In the latest report for the year 2000, the IRS reveals that the top 50% of income earners paid 96% of all income taxes, while the bottom 50% paid only 4% of all income taxes. This trend is increasing year after year with the top income earners paying more and the bottom income earners (and those who don't earn any income) paying less. There are some obvious political implications for the future. See the details on pages 6-7.

Better Than Expected 3Q

The US economy surprised on the upside in the 3Q with GDP increasing at an annual rate of 3.1%. That followed an increase of 1.3% in the 2Q and 5.0% in the 1Q. As noted on page one, the 3Q number was highly impacted by record auto sales due to zero-interest financing during the quarter. If we take out auto sales, the economy grew at only a 1.5% annual rate in the 3Q. Auto sales, by the way, plummeted in October, down 27%, to their lowest level in four years.

There was other good news in the latest GDP report. The economic recovery has been plagued by low business investment spending. It has been strong consumer spending and rising home prices that have kept the economy out of recession to this point. As discussed below, the latest data suggest that consumer spending has begun to turn lower, and home prices may also be vulnerable. Yet the latest GDP report showed that business investment may finally be turning around. Business investment rose by an annual rate of 0.6% in the 3Q. This was the first increase in two years. While capital spending is still very tepid, the latest GDP report is encouraging.

The GDP price deflator, the indicator of domestic inflation, in the latest report came in at an annual rate of +1.4% in the 3Q following a 2.3% increase in the 2Q. While the 3Q figure was lower than the previous quarter, it does not suggest that deflation is unfolding in the US.

4Q Will Be Weaker

While the 3Q GDP report was stronger than expected, there is little doubt that the 4Q will show weaker results in the economy. Most of the economic reports released in October (for the month of September) were negative. The Index of Leading Economic Indicators fell once again in September as did durable goods orders (-6.9%) and retail sales ( -1.2%). Consumer confidence and spending fell in the latest reports as well. Unemployment increased from 5.6% to 5.7% in the latest report for October.

The question is not whether the economy has slowed down in the 4Q; it is only about how much and whether or not the economy will dip into recession by the end of the year and/or in the first half of 2003. No one definitively knows the answer to that question, but the latest survey of economists is encouraging. According the the Wall Street Journal (Nov. 1), the average economists' prediction is for growth of apprx. 2% in the 4Q.

The Bank Credit Analyst's View

With respect to the economy in the near-term, BCA seems to agree with the view of the mainstream economists. In their latest November issue, the BCA editors say the following:

"A renewed move back into recession is not the most likely scenario, but we expect that economic growth will be below potential (i.e. closer to 2% than 3%) during the next few quarters."

There is certainly no shortage of analysts who believe that the economy is headed back into recession in the months ahead, perhaps even in the 4Q. I get the sense that many of our clients feel that way also. But according to BCA and the latest WSJ survey of economists, the US economy may avoid a recession in the months ahead. Clearly, a recession can't be ruled out, but it can't be ruled in, either.

Still Concerned About Deflation

While the BCA editors feel that we may avoid a recession and grow at a rate of around 2% for the next several quarters, they continue to be very concerned about the risk of deflation spreading to the US sometime next year. Here are some direct quotes:

"It would be reassuring to think that the authorities are aware of the dangers, but we fear that complacency reigns. Deflation is regarded as an outlier risk, rather than a clear and present danger. Most policymakers appear to believe that policy is already easy enough to guarantee a sustained economic recovery - all that is needed is patience. We do not share their confidence.

As we discussed in last month's Special Feature, the odds are high that the U.S. economy will slip into at least a mild deflation during the coming year. The economy-wide inflation rate is only 1% (based on the GDP deflator), [actually, 1.4% based on latest report] and it will tend to drift down given that the economy will continue to operate below its potential level at least through the end of 2003.

Deflation poses particular risks for a highly leveraged economy, such as the U.S, although a full-fledged debt deflation should be avoided as long as the housing sector does not implode.

Many commentators have pointed out that the core consumer price inflation rate is currently above 2%, and deflation is extremely unlikely given the stickiness of services prices. However, this ignores the fact that many of the areas where inflation is sticky are out-side of the corporate sector (e.g. education, medical care). To the extent that deflation has important implications for profits, it is corporate sector prices that matter. The corporate sector is already in deflation, with prices 0.6% below year-ago levels in the second quarter. This deflation will intensify during the coming year.

When all is said and done, we expect that the disaster scenario will be avoided. The corporate sector is healing, albeit very slowly, and business spending should pick up next year [actually, it already has based on latest GDP report discussed earlier]. Until then, easier policy will help keep the consumer and housing afloat. Growth will not be fast enough to prevent deflation, but it should not degenerate into a destructive debt deflation. However, fears of a Japan-style slump could linger against a background of continued volatility in financial markets and sluggish economic growth."

BCA Calls For 50 Basis Point Rate Cut

It should be clear from the quotes above that BCA is serious in its concerns about deflation in the US. The editors once again called on the Fed to cut interest rates by 50 basis-points at its November 6 FOMC meeting. They go on to say:

"We have been expecting them to ease by 50 basispoints in order to protect against the risk of both deflation and a slide back into recession. An easing is also warranted by the increasing risk of a financial accident. Our Financial Stress Index has spiked to its highest level since the 1990/91 banking crisis.

It is possible that the rebound in equity prices will encourage the Fed to remain in a "wait-and-see" mode. If that occurs, then the equity rebound may not last very long. The Fed's failure to cut rates in August or September helped to short-circuit the equity rally that began in late July. If the Fed does not move this month, then the odds are good that the markets will rebel anew, forcing the Fed to cut at its December meeting. The Fed will cut further in 2003 if economic growth remains below trend."

BCA Conclusions

The editors believe the most likely economic scenario is that we avoid a recession with the economy growing at somewhere around a 2% annual rate for the next several quarters. Obviously, this could change if any negative (or positive) surprises occur. The BCA editors remain very concerned that the global deflationary trend could spread to the US. In following, they believe the Fed needs to act more decisively to head-off the deflationary threat. While they are concerned that the Fed might be a bit complacent, especially with the latest stock market rebound, they believe the Fed will act in time so that a major deflationary rout is avoided.

BCA maintains its "below average" recommendation on stocks, but they believe that equity risks will diminish as it becomes clearer that the economy is not going into a recession. They expect to recommend "average" or "above average" equity positions soon. They believe that long-term rates probably bottomed out in October and expect to recommend "below average" holdings of Treasury bonds very soon. They expect the US dollar to hold firm in the near-term, due to the weak global economy, but move lower over the long-term.

Larry Kudlow is an economist, a syndicated columnist and a frequent guest on financial talk shows. I enjoy reading his work, although I don't always agree with him. In his latest column which follows (reprinted in full), he makes some interesting points about the economy.

"America's resilient, durable, flexible, market-driven economy - which features the lowest central-planning influence of any of the 30 major world economies - continues to surprise the pessimists.

With numbers now in for third-quarter gross domestic product, the U.S. economy has maintained a solid, if unspectacular, recovery over the past year. It has grown at a 3 percent rate, with 3.6 percent growth in the domestic economy (real gross domestic purchases), since the end of the recession a year ago. That's solid. The unspectacular part is that first-year recoveries have typically run in the 5 percent to 7 percent range. But let's be thankful the American economic machine is in fact growing at all.

We can't forget that the onset of war a little more than a year ago, in the wake of the terrible bombings of the World Trade Center and the Pentagon, virtually closed down U.S. commerce and financial operations for a time. So, in producing 3 percent growth, America has performed admirably.

This should shutter partisan arguments that President Bush has failed on the economy.

Of course, the Democratic Party, in full-campaign stride, is out painting a picture of an ever-present and terrible recession. But a combination of modest tax cuts and a monetary nudge from the Fed has helped generate economic recovery instead of a widely forecast and prolonged downturn. The consensus of economists who made that recession forecast following the terrorist attacks gave new meaning to the term dismal science. And they were dead wrong.

The pessimists also missed on the technology sector. While tech stocks have taken a lot of the heat for the worst stock-market correction in decades, rapid productivity gains from the application of technological advances continue to work inside our $10.5 trillion gross domestic product (GDP). Share prices for tech-based companies have faltered, but this sector is now sending out signs of recovery.

In the new GDP report, business investment in equipment and software increased 6.5 percent at an annual rate in the third quarter - its best performance in 2½ years. Business spending on durable goods increased 23 percent annually. Computer sales are up, rising at a 75 percent annual rate in the most recent quarter. Wireless is doing well, with top-line sales and profits at Nextel, Verizon and AT&T coming in surprisingly robust. And customer demands for cable and broadband are spiking, if Comcast is any measure of performance. In short, the tech sector is waking from its long sleep.

And so is the stock market. With overall corporate profits rising roughly 20 percent in the third quarter, backed by a 3 percent growth-trend in the overall economy, the U.S. stock market has now established a firm base from which future increases can no longer be in doubt. The only thing in doubt is the speed at which we are capable of growing. And to figure that out, we may have to look to Washington.

If Congress and the White House return growth-minded from next week's election, they can get right to work by eliminating the double and triple taxation of dividends and other forms of investment. Such a policy action could put profits from the sale of stocks and homes on an equal footing where they belong. Next, new business start-ups, which are the engine of employment, should be made tax-exempt in their early money-making years, and then taxed at half the normal rate for a few years thereafter.

Growth-minded policymakers should also speed the arrival of the Bush income-tax cuts passed in 2001. More, they should make permanent the across-the-board tax-rate-reduction program and the 30 percent cash-expensing bonus for business write-offs of new equipment. Finally, the Federal Reserve should be encouraged to inject more cash into the economy. This would stabilize business prices, finance growth, and improve our potential to expand.

On the other hand, there's always a risk that policymakers might embrace the Great Society leftover plans now being suggested by numerous Democrats on the campaign trail. This would be a stupid step backward in history toward liberal Keynesianism. But the likeliest voters - those who are shareholders and business owners - can be counted on to reject the antigrowth consequences of increased spending and higher taxes.

Surely the prosperity of the past two decades has proven that business investment is the key to growth. It is our businesses that create jobs and the income that sustains consumer spending. But capital formation is essential to those businesses. We must strive to make the tax cost of business capital in the U.S. the lowest in the world.

And let's not forget, a vibrant economy at home is necessary to produce the military and national-security resources that are so essential to the spread of freedom and democracy to the darkest corners of the world."

Again, I don't agree with everything Larry Kudlow has to say. Certainly, his case that the stock market has nowhere to go but up is questionable. But with regard to the economy, he makes some excellent points. Who would have thought a year ago that it would have grown by 3% over the last 12 months? But it has. Still, the Democrats would have us believe the economy is horrible, and that it's all George W. Bush's fault!

Over the last month, just about everything I have read and heard has been negative. While there is a lot of gloom-and-doom out there, and while, yes, there are some serious risks in the near-term, there is also a good chance this economy will muddle through over the next few quarters without a recession. Even BCA, with its concerns about deflation, believes that is the most likely scenario.

The Bottom Line On The Economy

If we assume there are no new negative shocks, such as more terrorist attacks, then the future of the economy really boils down to this: Can consumer spending and home prices hold up until business investment spending kicks in? It may be that simple.

We all know that stronger than expected consumer spending has made this economy stronger than just about anyone imagined after 911. Likewise, the strong rise in housing prices served to offset stock market losses. So, the economy grew despite 911 and despite the bear market in equities. Now, however, we know that consumer confidence has turned down along with consumer spending. This is why the tone turned so negative in the last month. But as noted earlier, business investment and capital spending are the other keys to economic strength or weakness.

On page 2, I noted that the latest government report showed business investment spending rose 0.6% in the 3Q. That number needs a little more analysis. Since 911, spending on civilian aircraft (commercial airliners) has plummeted. If we exclude the effect of low aircraft spending, the investment spending number increases from 0.6% to 5% overall in the 3Q. Spending on equipment alone rose by 12%, again with aircraft spending excluded.

While most analysts are pessimistic on an increase in business investment spending, the latest figures look encouraging with a lot more room for improvement. Should the Republicans gain control of both houses of Congress, we could also see some new incentives for capital spending to increase even more. In any event, the Fed is expected to cut interest rates at least a couple more times, so the environment for more business investment spending should only improve.

If capital spending can increase by as much or more than the decrease in consumer spending, this would also suggest that a recession can be avoided. These are two areas we need to watch closely, along with the trend in home prices. Home prices need to remain fairly steady. In any event, the next few months should tell the story.

Latest IRS Data On Taxpayers

The following data is from the Internal Revenue Service (IRS) on the various income groups for the tax year 2000 (the latest data available) regarding who paid what percent of federal income taxes based on adjusted gross income (AGI). The following figures from the IRS represent who paid the most in taxes based on their incomes:

The top 1% (AGI $313,469+) paid 37.4% of
total income taxes collected for 2000.

The top 5% (AGI $128,336+) paid 56.7%.

The top 10% (AGI $92,144+) paid 67.3%.

The top 25% (AGI $55,225+) paid 84.0%.

The top 50% (AGI $27,682+) paid 96.1%.

What this tells us is that, based on 2000 figures, 50% of the country paid less than 4% of all income taxes, versus 6.46% in 1986.

The trend in these figures is not new, except in that the percentage of total income taxes continues to be borne by the highest income earners. The proportion of taxes paid by the top half increases with each year, and will continue to do so.

We could soon be in the situation where 50% of the voters pay no income tax at all, yet can vote for higher taxes to be paid by the top half. It could happen in a few years.

Even if we were to adopt the idea of a less graduated "flat tax," the above would still be true. Even with some adjustment within the various brackets, the simple fact is that the rich make more money and thus pay higher taxes. No flat tax proponent has put forth the idea of adding lower income groups (the bottom 50%) to the tax rolls. Tax policy and political rhetoric revolves around shifting the burden within the top 50%.

What did come as a surprise were the levels of income at each successive level. To be in the top 10% of all taxpayers, an AGI of only $92,144 or more is required. This struck me as being somewhat low to be in the top 10%. Even more surprising was the level of AGI to be in the top 50% of taxpayers. How can it be that to be in the top 50% of all taxpayers, you only have to earn an income of little more than $27,000?

One reason is that many taxpayers who earn less than this amount are not taxpayers at all, they actually receive refunds in excess of the taxes withheld from their pay. With earned income credit, child care credits and other special provisions for low-income workers, many in the lower 50% actually have a negative income tax percentage.

I do not disagree with these credits or think the working poor should not receive some special considerations, I'm just trying to help explain the data from the IRS.

Class Warfare?

The IRS data also goes back to the 1986 tax year, thus allowing us to do some research on trends in light of tax law changes. In 1997, the long-term capital gains tax rate was reduced from 28% to 20% for high income taxpayers. At the time, I recall this was criticized as a tax bill that would only "benefit the rich," allowing them to pay less in taxes. However, if you look at the IRS data, the exact opposite has happened.

The average tax rate percentage for the top 1% of taxpayers was 28.87 in 1996, the year before the new capital gains tax rate took effect. In 2000, the average tax rate percentage paid by the top 1% had decreased by more than one full percentage point to 27.45%, a reduction of 5%. This would seem to indicate that the critics were right and the richest of the rich were getting a free ride.

However, if you look at the share of total income taxes paid by the top 1% of taxpayers, you find that this percentage was 32.31% in 1996 and 37.42% in 2000, an increase of over 15%. So, for a 5% reduction in the average tax rate percentage, the rich get to pay over 15% more of the total tax bill. Hmmmm... Doesn't sound like that great of a deal to me.

As I stated above, we will soon be in a situation where the top 50% of taxpayers will be paying virtually all of the income taxes. What reason will there be, then, for someone in the bottom 50% to vote against a political candidate who promises even bigger government, more handouts, with the "rich" paying for it all? Can you say TAX INCREASES?

A Tax Cut, But The Rich Still Paid More

You may look at the IRS data and comment that the share of total income earned by the top 1% also increased since the passage of the 1997 tax law. This is true. You might wonder how, given the capital gains tax cut, that the rich ended-up paying even more in taxes. A natural reaction to the tax rate reduction was to sell older capital assets, pay the tax, and then reinvest in newer ventures. This resulted in the rich paying more total taxes.

This is how capital formation works in the United States. You want to make it easier for those with money to invest to get that money into the capital markets. Favorable tax rates do just that. Healthy capital markets mean more jobs and opportunity for everyone. After all, we can't ALL work for the government.

In 1995, the CATO Institute published a policy analysis covering the capital gains tax. It contained two quotes that I think encapsulate the reason to have favorable tax policy for capital gains. The first one is by John F. Kennedy who, in 1963 said:

"The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital . . . the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy."

The other quote is by a New Jersey painting contractor, one of the "poor" that the liberals typically try to enlist in their class warfare battle. He said:

"You're looking at a poor man who thinks the capital gains tax [cut] is the best thing that could happen to this country, because that's when the work will come back. People say capital gains are for the rich, but I've never been hired by a poor man."

Conclusions

You may be wondering how and why I jumped from stale IRS statistics to a discussion about capital gains tax rates. The simple reason is because the liberal view that espouses class warfare preys on the ignorance of their constituency. The New Jersey painting contractor had it right - jobs come from capital being put to work, and the "rich" are those with the capital to do so.

Tax cuts get the same reaction from the liberals. "Tax cuts only help the rich," they cry. Well, that's true I guess, since the top 10% of taxpayers pay over two-thirds of all taxes paid in this country. However, these are also the same people who, given a tax cut, will go out and spend that money for goods and services that put other people to work.

The alternative is to tax the rich more oppressively and allow the government to provide this redistribution of wealth. This is the liberal solution, but a poor one indeed. When was the last time you felt the government was efficient at doing anything? That's what I thought.

(You can find the IRS info referred to in this article on the Internet at www.irs.ustreas.gov/taxstats/index.html.)

Investment Conclusions: Where Do We Go From Here?

With all of the uncertainty in the economy, it is hard to decide what the best investment alternatives are for the current environment. It is still too early to say that the bear market in stocks is over, in my opinion. I have pointed out in the previous pages that there are reasons to be optimistic that a recession will be avoided, especially if the Fed cuts interest rates further as we expect. Even so, stocks are likely to continue to be very volatile in both directions, so I certainly would not recommend buying stocks or funds at today's levels. I will be very surprised if we don't see at least a retest of the October lows. That may be the next chance for a reasonably low-risk entry point.

As for bonds, I tend to think that BCA is right, that Treasury yields hit their low in October when 10-year bond rates dipped briefly below 4%. Even if that is correct, it does not necessarily mean that bond yields are going to trend significantly higher, especially with the economic weakness we expect to see from now until year-end. This suggests that bonds will be in a trading range for some time, until the economy gets stronger and rates begin to trend higher.

So, what is an investor to do? My answer continues to be that you have most of your money in market-timing programs offered by professional money managers that have the capability of moving into and out of the market based on proven systems. Market-timing programs have historically been good places to be when there is a desire to participate in market gains while limiting losses. The last 2 ½ years have thrown a curve to many market-timing Advisors, but the good news is that we now have that period of time covered in the track records we review. We are able to see which programs have navigated the choppy stock and bond markets of 2000 - 2002 without incurring severe losses.

As a result, we have several market-timing programs that have positive year-to-date performance as this is written. I have discussed one of these programs, Hallman & McQuinn Capital Management (H&M), several times in these newsletters. As of November 5, H&M's program is in positive territory for the year.

Having a positive performance during 2002 is impressive enough, but H&M posted a gain of 2.26% during the 3rd quarter of 2002, the worst three months for the markets since the last quarter of 1987. H&M's ability to move into and out of the market quickly helps H&M meets its primary objective of protecting capital even in difficult markets, while also growing account balances over time.

I suggest that you consider H&M during these extremely volatile market conditions. I am currently increasing my position with H&M, so I am putting my money where my mouth is. To obtain complete information on Hallman & McQuinn, give one of our Investor Representatives a call at 800-348-3601 . You can also request the information by e-mailing us at mail@profutures.com or by visiting our website and going to the "Contact Us" section.

As for bonds, I continue to highly recommend Capital Management Group (CMG) (formerly Capital Growth Management). They recently changed their name because they were being confused with CGM Funds, with which they are not associated. CMG's market-timing system should be ideal for the conditions we expect in the bond market over the next year or longer. CMG is also profitable this year. Call or send us an e-mail or go to the website for more complete information.

ProFutures will be closed on Thanksgiving Day and the Friday thereafter. We are very thankful for our many clients across America and wish you a very Happy Thanksgiving!