F YOU DON'T LIKE THE WAY THE STOCK market or the economy's been treating you and you want someone (or something to blame) look no further than the venerable Phillips Curve. Oh sure, the Fed is the immediate cause of the problem, but if it wasn't for their reverence for the Phillips Curve, you might still be enjoying the profits from your triple-digit dot.com stocks.

OK, maybe that is overstating it just a little, but it does put the blame where it really belongs. It's hard to believe that such a simple, intuitive relationship can exert such an influence -- and such an incorrect influence at that.

Econ 101

Essentially, it's a graphical representation of the relationship between unemployment and inflation. While the two economic series may not seem related, it makes sense if you stop to think about how the two react in a changing economy.

First, think about an economy in recession. Typically unemployment hits its cyclical high after the economy has slowed and businesses that can't sell their products lay off workers. In order to get inventory out the door, companies have to cut prices, sending inflation to cyclical lows. So in a recession, you have peaking unemployment and falling inflation.

Next, consider an economy reaching its cyclical peak. At that point, companies are producing products as fast as they can since demand far outstrips supply. If anything, workers are being added to increase capacity, so unemployment is near its lows. In light of the strong demand for their products, businesses have no problem raising prices. In fact, they may have to in order to pass along their higher costs stemming from a tight labor market. So during a boom, you have rising inflation and minimal unemployment.

Finally, imagine an economy somewhere between a cyclical peak and recessionary low. Here both inflation and unemployment may be rising or falling, depending on the point in the economic cycle, but typically you'd expect them to be moving in opposite direction. Based on what you saw at the two extremes, in a recovering economy inflation would be on the rise while unemployment would be falling. In a weakening economy, unemployment would be poised to decline while inflation would be headed down.

So there you have it, intuitively you'd believe there's an inverse relationship between unemployment and inflation. When one rises, the other falls. When one peaks, the other hits bottom. If you graph the two, you'd expect to find a relation that looks like the nearby chart.

History 101

Of course the "stagflation" of the early '70s didn't quite fit the theory. A sluggish economy, high

If you didn't know better, you'd think this "fact" of the '70s went the way of facts from other periods such as the flat world and medieval witchcraft.

unemployment and high inflation couldn't be accommodated by the simple curve.

One might think that would indicate the theory was flawed, but like so many things, economic theory dies hard. Phillips Curve adherents acknowledged the simple curve couldn't explain the current conditions, but also postulated that the curve had moved. In other words, the relationship still held, the curve had just shifted upward.

Similarly, when the economy recovered in the '80s with both declining inflation and unemployment, the curve was said to have shifted back down. The problem was, with the curve shifting around so much, the inflation/unemployment relation never seemed to move along the curve.

Economists quietly realized the Phillips Curve emperor had no clothes. Talk of the relation slowly faded away and the infamous graph stopped appearing in introductory textbooks. If you didn't know better, you'd think this "fact" of the '70s went the way of facts from other periods such as the flat world and medieval witchcraft.

Fed 101

Three Strikes and You're Out

Source: Baseline Data No matter how you measure it, the nice C-shaped Phillips Curve relation just doesn't exist. Going back 20 years, Chart 1 is based on annual data, Chart 2 on quarterly, and Chart 3 on monthly. Have you seen anything that looks like this in your economics textbook?

Back in 1999 when the economy and market were moving ahead smartly, the Fed became worried that inflation was just around the corner. Their concern wasn't triggered by rising commodity prices or union contract pressure -- both were non-existent.

Instead, the focus of their alarm was the falling unemployment rate. The closer it got to 4%, the more concerned they got. Evidently they felt a tight labor market just had to imply inflation was ready to set in. The Phillips Curve was resurrected.

Over the next year, the Fed pushed up interest rates by 1-3/4% and the rest was history. Economic growth was choked off, the nation was teetering on the edge of recession, and inflation was nowhere to be seen.

Statistics 101

Before this flawed reasoning screws the economy up again, let's put the Phillips Curve to rest once and for all. You need no more incentive than the simple facts.

Despite it's intuitive simplicity, the Phillips Curve relation simply does not exist. Contrary to the nice C-shaped curves found in your old economics textbook, the unemployment/inflation relationship actually plots like the accompanying graphs.

To create them, we drew upon 20 years of data from Baseline. We looked at annual (chart 1), quarterly (chart 2), and monthly (chart 3) data. In each case, the data points looked like a shotgun blast, not a nice smooth C-shaped curve. In fact, when we did fit a curve, it always turned out to be a concave arc.

Rather than movements along or of a specifically shaped curve, the points appear to be fairly random. The low R² indicates almost no correlation. Despite its intuitive appeal, the evidence shows no significant relation between unemployment and inflation.

So let's purge the Phillips Curve from economic theory. The relation didn't exist in the past, it doesn't exist now, and there's no reason to think it will have any predictive power in the future.

Most bad theories are just wrong, but as long as the Fed continues to believe in the Phillips Curve, this one's actually dangerous.

Taxing Issues

"Because that's where the money is."

-- Willie Sutton when asked why he robbed banks

 

VER THE PAST YEAR, INVESTORS HAVE learned a painful lesson: Valuation matters. Those who were observant also learned that economics plays an important role in valuation. If the economy is expanding, P/Es and stock prices can easily rise. If the economy is contracting, well you know what that means for stocks.

There are two strains of economic policy that effect the overall economy: monetary policy and fiscal policy. The Fed controls monetary policy with Congress and the President running fiscal policy. Monetary policy focuses on the money supply and interest rates while fiscal policy employs tax and spending programs.

For the past decade, there really hasn't been any fiscal policy. Taxes were relatively steady, spending was contained, and the country purportedly built a surplus. With the Fed directing the economy through monetary policy, stocks rose and everyone was fairly happy.

But now with a slowing economy and falling earnings, everyone's hoping for a little economic stimulus and no one really cares where it comes from.

Let's Get Fiscal

Tax cuts boost the economy by putting cash back in the hand of the taxpayers. When they get it, they spend, save, or invest it. Any of these

With a capital gains cut, investors don't have to wait until they file their tax returns to feel the benefit.

alternatives are positive, increasing demand and adding capital to the markets.

But to be effective, tax cuts must be done properly. The sooner you give the taxpayers a break, the sooner they can spend, save, and invest. If you cut tax rates for businesses, they can reinvest, expand their markets, and put more people to work. If you cut capital gains taxes you free up funds that have been tied up for tax rather than investment reasons, stimulating new investment.

Unfortunately, politicians are doing everything they can to thwart the effectiveness of President Bush's tax cut. Some insist that capital gains reductions not be part of the legislation. This may make some political hay, but it also eliminates the most immediate and effective form of economic stimulus.

With a capital gains cut, investors don't have to wait until they file their tax returns to feel the benefit. Instead, they get an immediate

As luck would have it, the worst potential modification to the tax cut is the one with the greatest possibility of being incorporated.

incentive to restructure their portfolios and reinvest or spend the proceeds. Keeping this option off the table slows the effects of the legislation.

Other politicians insist the entire tax cut should be tied to specific "trigger" points in the surplus. This is purportedly an argument for fiscal prudence, requiring a certain level of surplus before the tax relief kicks in.

If nothing else, this provision would single-handedly eliminate any benefits of potential tax relief. If taxpayers are uncertain about the receipt of a tax cut, they won't act on it. If they have to wait until next year to be certain, the legislation won't affect the economy until even later. This isn't a provision you want for immediate impact.

Class Warfare

You've heard this in a number of different forms. Essentially it's an attack on the beneficiaries of tax relief, implying cuts should favor

The class warfare argument is based on the assumption that taxpayers will fail to distinguish between two distinct issues.

lower and middle-income taxpayers more than The Rich. Purported populists love this one since it allows them to appeal to the common man, rallying them against the affluent.

Certainly you've heard this class warfare argument leveled against President Bush's proposed tax cut. It started in the presidential debates and has persisted in the rhetoric coming out of Congress: The Rich will get giant cuts while everyone else will get a mere pittance.

That's good politics, but bad -- very bad -- logic. There's a reason the wealthy get the lion's share of an across the board tax cut: They're the ones that pay the vast majority of the taxes. If you cut tax rates, it only stands to reason that those who pay the most will get the greatest benefit. Just as Willie Sutton robbed banks because that's where the money is, the greatest tax breaks go to those who pay the most tax.

The class warfare argument is based on the assumption that taxpayers will fail to distinguish between two distinct issues. Tax relief is just what the name implies -- relief for taxpayers. The desire to direct more funds to the

…income redistribution is a government spending policy, not tax relief.

lower and middle-class is income redistribution, not tax relief. Essentially it's an attempt to redirect taxes paid by The Rich to those of lesser incomes.

Unquestionably, income redistribution is a noble cause, but it should be addressed as such, not confused with tax relief. The disingenuous politicians who rely on the class warfare argument realize that properly treated, income redistribution is a government spending policy, not tax relief. While the electorate is firmly behind a return of their hard-earned taxes, they aren't nearly as rabid about another government spending plan.

Bad economics is bad economics. It doesn't matter if it's the Fed raising interest rates in a slowing economy or politicians attacking a good policy for the wrong reason. Bad economic policy destabilizes the economy and the financial markets.

As distasteful as it is, as an investor you should be concerned. Valuation really does matter and the economic climate affects valuation.

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