Bush Tax Cuts: How to Profit From the Compromise Tax Deal In 2011

With a compromise agreement that extends the Bush tax cuts for two more years, the Obama administration has given investors what they wanted - but not what they needed.

The compromise tax deal was signed into law by U.S. President Barack Obama on Friday, and continues to draw fire from critics on both sides of the political aisle. The $858 billion tax package isn't paid for. In fact, it actually costs more than the controversial Obama stimulus plan that has been criticized for having little measurable impact - even as it caused the budget deficit and the U.S. debt burden to explode.

And yet, investors have been cheered by the deal.

Near term, that's an acceptable perception. But in the long run, some very real problems loom. Investors who ignore those problems will take a real beating - and it will be self-inflicted. But investors who prepare for the inevitable will actually improve their positions: They'll not only protect themselves, they will profit.

Details of the Deal

By extending the Bush tax cuts, President Obama and the U.S. Congress have effectively given U.S. taxpayers ice cream, when what they really needed was spinach.

True enough, in the near-term, there probably are some bright spots. Further out, however, some real problems loom. That means some very tough decisions will have to be made starting next year - and for years to come.

The tax deal signed into law Friday extends the entire Bush-tax-cuts package for two more years, introduces a one-year 2% payroll tax cut and prolongs the 99-week extended unemployment benefits for another year.

Due to these measures, the U.S. budget deficit is increased over the next two years by about $900 billion over its expected figure, adding to America's debt problem and possibly "crowding out" small businesses from the bond markets even more than they already are.

! In the near term, however, the tax cut is stimulative, much more so than the similarly sized "stimulus" package of 2009. Despite their similar sizes, the tax-cut and Obama-stimulus packages are very different animals.

The tax-cut package actually puts money directly into taxpayers' pockets (except for the ethanol subsidies Congress is adding to the package - an unfortunate move that's a topic of discussion for another time).

On the other hand, the Obama stimulus diverts capital resources away from taxpayers to the most inefficient bits of government (at the federal, state and local levels). Since taxpayers know what they want, that money is spent efficiently, adding to the efficiency of the economy as a whole.

To the extent the tax cuts get saved or invested, they help U.S. capital formation, which is much too low for long-term growth. So the market is right in regarding this "stimulus" as bullish in the short term.

Indeed, economic growth in 2011 should be 0.5% to 1.0% higher than it would have been without it. So if you must expand the federal deficit to provide short-term stimulus to the economy, tax cuts are a much more effective way of doing so than government spending, because they don't sap the economy's economic efficiency.

We all know how inefficient the federal government can be, when it comes to spending. But there's now mounting evidence of a budgetary disaster blossoming at the state level, too. (Readers interested in hearing more about this should check out CBS News' excellent story, "State Budgets: The Day of Reckoning," which appeared in Sunday's edition of that network's "60 Minutes" TV news magazine.)

And Now, the Bad News ...

We've demonstrated how tax cuts can be better than a stimulus. But there's a "bad news" element to the tax cuts, too. And just how "bad" this bad news ends up being hinges on what Congress chooses to do in the New Year.

If Congres! s ignore s the need to do something about the deficit, long-term interest rates will rise, damaging the housing market and crimping capital investment. What's more, the outlook for 2012 and later, when the boost from stimulus has gone, would then be for a return of 1970s style "stagflation" - with gold and other commodities prices rising to record levels.

In other words: the possibility of $5,000-an-ounce gold - which we've told you about many times here in the pages of Money Morning - is becoming very real.

If, on the other hand, Congress gets serious about making cuts in public spending in 2011 - and by "serious" I mean annual reductions of at least $150 billion (about 1% of gross domestic product, or GDP) - then the initial economic boost will be followed by a gradual restoration of the economy to full health, as purchasing power is restored to the private sector.

That's the way to navigate this portion of the financial-crisis rebound.

If U.S. Federal Reserve Chairman Ben S. Bernanke were to increase savings by raising interest rates, the U.S, economy could over a few years return to full health.

Unfortunately, that's probably too much to ask. Without Bernanke increasing rates, inflation and inadequate savings are likely to remain problems, but the system would nevertheless be stable with no chance of a Greece-style blowout. In my estimation, the probability of either of these outcomes is more than 20%.

Most of the elements in the tax-cut-plan - like the continuation of the Bush tax cuts and the 99 weeks of unemployment insurance - represent "business as usual" as far as Washington and the U.S. economy are concerned.

The 2% payroll tax cut is new, but I must confess that I'm stumped when it comes to thinking of a way to invest in it. So we'll have to invest instead in the likely macroeconomic effects of the entire package. You'll find the strategy in the "actions-to-take"! section that follows.

Before we talk about those recommendations, however, permit one final comment. When I look back over the route that we've traveled as we made our escape from the depths of the financial crisis - and then look at the journey to come, I can offer one piece of advice with a lot of confidence.

Enjoy the tax reductions in 2011. For they will be the last ones we'll see for a long time to come.

Actions to Take: Given that the extension of the Bush-tax-cuts package is likely to increase the deficit, we can expect an increase in long-term interest rates.

To play that, the best vehicle is the ProShares Ultrashort Barclays/Lehman 20-year Treasury Bond Index Exchange-Traded Fund (NYSE: TBT). This invests in a U.S. Treasury bond futures short position. In theory, for every 1% the prices of long-dated Treasuries decline, the ETF's share price would increase 2%.

Like all leveraged short funds, it has a problem with rebalancing - its hedge ratio goes askew as the underlying futures bounce up and down. Thus, over the past two years, while interest rates have remained approximately constant, it has lost about 15% of its value. However, for short-term holdings - to take advantage of possibly rapid increases in interest rates - it is perfectly adequate. A 7.5% annual "tracking error" is by no means excessive for these funds.

The other way to play this is to expect inflation, and buy commodities. You can do this directly on the Big Board (the New York Stock Exchange) by purchasing shares of the ETFs linked to commodities.

The main gold ETF [the SPDR Gold Trust (NYSE: GLD)] and its counterpart for silver [the iShares Silver Trust (NYSE: SLV)] are well known. And as those two precious metals have zoomed in price - silver prices have doubled in the last 18 months - they have treated their investors quite! well.
But don't end your search there. There are ETFs for palladium [the ETFS Physical Palladium Fund (NYSE: PALL)] and for platinum [the ETFS Physical Platinum Shares (NYSE: PPLT) ETF]. Platinum, by the way, is a metal whose potential I happen to like a lot.

A new copper ETF [the ETFS Physical Copper Fund (LON: PHCU)] has debuted in London, though it doesn't trade in New York.

The best way to play copper is probably one of the copper mine ETFs - for example, the First Trust ISE Global Copper Index ETF (NASDAQ: CU).

This fund would provide investors with a play on inflation, on rapid economic growth in emerging markets, and on the serious physical supply situation in copper, where several large mines are drying up and new major capacity is not due until 2015.

That's a winner all the way around.