Why 2011 will be the year of the double dip

I have long said that without strong growth it will be impossible to overcome our looming sovereign debt hurdle.  Many are seeing signs of a strong recovery looking primarily at earnings.  I have been sceptical about the strength of the earnings as seen in the blue chip sector.  Banks have had strong trading profits in the last few quarters.  Even the perennial loser GMAC has finally reported a profit.  

Some economists, such as John Ryding, tend to think that strong growth is on the horizon with low P/E ratios. Right now consensus earnings estimates equates to a forward-looking P/E of 13.8. Of the five biggest U.S banks— J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley—all but Goldman trade at or below book value. Charles Rotblut of Forbes states that  "the economic data still shows signs of a continuing recovery. One respondent to the May ISM manufacturing survey went so far as to say that he was seeing “no signs of the ramp-up abating anytime soon.”

I tend to disbelieve that. The most obvious sign of the strength of the underlying recovery is Earnings.  Earnings in the P/E ratio is abnormally strong for this type of a recovery.  The reason is that companies are realizing profits now instead of waiting until 2011 when taxes (capital gains and income), estate taxes, and dividend taxes will increase.  Arthur Laffer explains this in his WSJ piece today
Consider corporate profits as a share of GDP. Today, corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011. These profits will tumble in 2011, preceded most likely by the stock market.
There is ample evidence that individuals and companies respond to incentives.  Ronald Reagan's tax cuts brought about flat earnings in the quarters that preceded them.  That was the market saying, I'll wait until taxes drop and then I will realize my earnings.

These current tax increases are just Ronald Reagan in reverse.  
...the prospect of rising prices, higher interest rates and more regulations next year will further entice demand and supply to be shifted from 2011 into 2010. In my view, this shift of income and demand is a major reason that the economy in 2010 has appeared as strong as it has. When we pass the tax boundary of Jan. 1, 2011, my best guess is that the train goes off the tracks and we get our worst nightmare of a severe "double dip" recession.
Just so we don't forget, the following are the many things that will happen on or about Jan 2011.  Federal, state and local tax rates are scheduled to rise quite sharply as Bush's tax cuts expire and go the way of the dodo.  That means that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Additionally, banks will be under new scrutiny and regulatory burden and many US states will remain the highest corporate tax jurisdiction surpassing even Japan.

So enjoy 2010.  As it is sandwiched between 2009 and 2011, we may come to regard it as the best of times.  

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