A Break In The Action

I haven't been posting lately. I took on some new outside activities for myself in addition to my normal obligations. I'm going to see how those go before deciding whether to resume or not.

The Continuing Saga of Your House As An Investment

From the Report issued by CoreLogic:

CoreLogic reports that 11 million, or 23 percent, of all residential properties with mortgages were in negative equity at the end of the second quarter of 2010, down from 11.2 million and 24 percent from the first quarter of 2010. Foreclosures, rather than meaningful price appreciation, were the primary driver in the change in negative equity. An additional 2.4 million borrowers had less than five percent equity. Together, negative equity and near negative equity mortgages accounted for nearly 28 percent of all residential properties with a mortgage nationwide.

The Rising Tide: Taxation

This is not a political post per se but the theme of inexorably rising taxes has been a focus of this blog. For planning purposes.

We learn today that Cost of Government Day, a calendar date by which the average American is deemed to have paid for the cost of government falls on August 19th this year, the latest date ever recorded. The entire report of the Americans for Tax Reform Foundation is in the link above.

From the Report:

Cost of Government Day: Trends
Cost of Government Day (COGD) falls 8 days later in 2010 than last year’s revised date of August 11. In 2010, the average American will have to work an additional 51 days out of the year to pay off his or her share of the cost of government compared to 2000, when COGD was June 29.

In fact, between 1977 and 2008, COGD has never fallen later than July 20. 2010 marks only the second year that this has happened—2009 being the first. The difference between 2008 and 2009—from July 16 to August 11—was a full 26 days, spurred primarily by the Emergency Economic Stabilization Act (EESA) that created the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment
Act of 2009 (ARRA).

A look at methodology is below:

The Cost of Government is determined by adding the figures for government spending (federal, state and local expenditures) and an estimate of the cost of government regulations (both on the federal
and state level). The total cost of government is then divided by an estimated Net National Product to determine the percentage of national income consumed by government. This percentage is applied to the 365.25 weighted calendar year to determine the date of Cost of Government Day.

More Tax Planning Havoc: Coverdell Savings Accounts

As presently constructed, Coverdell college savings accounts are a great deal, even better than the more widely known 529 savings plans. We've discussed their features here. But the tax breaks that made Coverdells a favorite of so many planners and their clients are expiring at the end of 2010. Will Congress act on this one? We don't know.

You've got about five months to figure out what to do with your account. Here's what we said about Coverdells before:

1. Annual contributions are capped at $2,000 per beneficiary. They can come from any source but if the total exceeds $2,000, the IRS will slap a 6% tax on the excess.

2. Contributions are not tax-deductible. But any growth in the investment is tax-deferred, and money can be pulled out tax-free as long as it is used for qualified education expenses, which include items such as books, tuition, room and board and necessary equipment, such as a laptop computer.

3. Money can be withdrawn to cover approved expenses for kindergarten through 12th grade, as well as higher-education expenses. Approved expenses could include private-school tuition or an after-school tutor.

4. The money has to be used before the beneficiary turns 30. If the beneficiary reaches 30, or if the money is used for anything but education expenses, the IRS will levy a 10% penalty plus regular income taxes on the amount pulled out. One major exception: Special-needs beneficiaries can continue to draw from their accounts, tax-free, to cover approved expenses after the cutoff age. Contributions can also be made for a special-needs beneficiary after he or she turns 18.

Why use a Coverdell instead of a 529 Plan?

* Flexibility: Coverdell money can be spent on expenses for kindergarten through 12th grade; 529s are limited to higher-education expenses only.

* Wider investment choice: Coverdells must be held by a bank, a brokerage or some other institution approved by Federal law to handle them. Depending on the trustee chosen, investment choices in a Coverdell can be very broad, including stocks, bonds, mutual funds and nearly any other type of investment vehicle offered by the trustee. Most 529 plans limit their investors to only those options provided by their plans. Those choices are often as narrow as the limited selection of mutual funds offered by only one company. In a handful of states, 529 investors can opt instead for prepaid tuition plans.

So what should you do?

Well, if you like Coverdells there no reason to assume everything just goes away or that Congress will be punitive with how it handles them going forward.

You can always transfer the balance of your child's Coverdell account into a 529 plan for him or her. Wait to see what Congress decides to do with them and then make your own plan.

You could always pull money out for private school, if that's what you've been saving for. Use it know. There's always the risk that this distinction goes away and it's your last chance.

You could use up the account early by buying a buying a computer for your child or other supplies he/she will use at school.
You can just keep making contributions. I can't see a scenario where Congress doesn't allow you to convert the funds to a 529 plan.

Secular Bear Market Update

From planner Doug Short and his popular blog Financial Life Cycle Planning, a very revealing chart about how the secular bear market has affected a portfolio invested strictly in the S&P 500 index of stocks:


(Right click for a larger image.)

In a word: DEVASTATING.

Nearly 45% down in real terms after 10 years. That is why I talk about risk and absolute returns. Most investors can't stand a) the volatility much less b) the losses inherent in investing this way.

No Social Security Benefit Increase. Sorry!

The Bureau of Labor and Statistics reported yesterday morning that the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) was at 213.898 in July. What does this mean? Likely there will be no change to Social Security Benefits and the Maximum Contribution Base this year. (Hey it's Friday the 13th! You expected good news?)

There wasn't one last year either. Luckily they can't reduce the benefit should CPI start falling on a sustained basis. 0.25% on your savings (money market) and reduced SS benefits. That would really hurt retirees.

More Tax Planning Dilemmas

"If the present Congress errs in too much talking, how can it be otherwise in a body to which the people send one hundred and fifty lawyers, whose trade it is to question everything, yield nothing, and talk by the hour?"-Thomas Jefferson

Congress was a WEE bit distracted last year focusing on health care and financial reform (ahem). What did it forget? Oh, only to renew the estate tax which expired at the end of 2009.

Is this important? Well, if someone died last year, the portion of their estate that's over $3.5 million would be subject to a 45% tax. If someone dies in 2010, no matter how large their estate is, it all passes on estate-tax-free. According to some, that could add up to some $26 billion in lost revenue. Legislators have proposed a number of bills to rectify the situation ranging from reinstating the tax for the rest of 2010 to making the estate tax retroactive to Jan. 1, 2010.

A free pass this year may sound good but what does it do for planning purposes? How do you do estate plans if you don't know what the exemption amount is going to be? How do you divide marital and family trusts? It also happens to be that generation-skipping taxes got caught up in the snafu. They disappeared as well. Some states have tried to fix the mess by enacting their own laws but what then happens if Congress comes in and tries a retroactive fix?

Talk to your estate planning attorney or advisor. What a mess.

Lessons Learned

Two recent MetLife studies have shown that on one point financial advisers and baby boomer clients are remarkably aligned: It is more important to protect assets from losses than to achieve market gains.

As we have shown before losses really hurt investor's portfolios. Three years of 20% gains followed by a loss of 20% turns the total gain into a pedestrian 8 plus percent. A fifty percent gain followed by a 40% loss does not leave an extra 10% to the good. It's a LOSS (100 x 50= 150; 150 x (1-.40)= 90.

So what do advisers do about risk of loss? 74% recommend diversification according to MetLife. But apparently only 28% of baby boomers are taking that advice. Know what I say? I'm with the baby boomers! Diversification as practiced and preached is wrong-headed. Why? Because the only TRUE diversification is not among asset classes which show HISTORICAL non-correlation. That is looking in the rear view mirror and attempting to drive the car! As we have seen, in declining markets asset classes all tend to go toward a correlation of one. The only diversification occurs among asset classes that have DIFFERENT VALUATIONS. Asset classes that are valued richly decline rapidly. Asset classes that are undervalued decline less rapidly or even go up. As an example take small cap value stocks and REITs in 2000-2002. The market had shunned them for years. If you liked REITs during the tech bubble you were eating thin gruel for returns. But the bubble bursts and viola! happy days were here again. Most stocks went down. REITs and small cap value more than held their own. Why didn't this work in 2008-09? All asset classes except bonds were richly valued. Every one. REITs, utilities, commodities, international stocks. The explosion in cheap credit and money chasing whatever return it could find assured that. When the market started declining they all went down. The only exception was bonds! End of story (and benefits of diversification).

So if you want diversification, check the historical valuation of the asset class being suggested. Can it be done? Sure it can. An asset allocation shop like GMO (which we've written about before) does it all the time. Then, take a tip from Mark: If it's high, it won't diversify. (Apologies to Johnny Cochrane)

Savings Rate Increases

One of the themes we have been following on this blog is the public's reaction to the recession and market selloff. The selloff scared investors out of equities and into bonds. Really, anything with yield including real estate investment trusts and oil and gas master limited partnerships has been a beneficiary of the public's decreased risk appetite. It was also postulated that savings would necessarily increase, possibly into the 8-10% range annually. That range had been the long term trend.

After first experiencing a sharp rise after the crisis from negative savings levels, the savings rate dipped putting the whole thesis into question by some. My hypothesis had been that consumers were dis-saving again because falling wages. Well look at what has now happened. From the Bureau of Economic Analysis:

Personal income increased $3.0 billion, or less than 0.1 percent, and disposable personal income (DPI) increased $5.1 billion, or less than 0.1 percent, in June, according to the Bureau of Economic Analysis.
Personal consumption expenditures (PCE) decreased $2.9 billion, or less than 0.1 percent.
In May, personal income increased $40.5 billion, or 0.3 percent, DPI increased $36.9 billion, or 0.3 percent, and PCE increased $8.6 billion, or 0.1 percent, based on revised estimates.

Real disposable income increased 0.2 percent in June, compared with an increase of 0.4 percent in May. Real PCE increased 0.1 percent, compared with an increase of 0.2 percent.

Calculated Risk has the nice graphics and the money quote:

This graph shows the saving rate starting in 1959 (using a three month trailing average for smoothing) through the June Personal Income report. The saving rate increased to 6.4% in June (increased to 6.2% using a three month average).

Consumers are trying hard to rebuild their balance sheets. Increased savings means reduced consumption. Reduced consumption means less profits for consumer centric companies and less consumption taxes. The worry is that it also means a slower economy due to lower spending. If we are to restructure how the economy operates, that may nor be a bad thing.

Your host will be on vacation from July 10-17. (Note: The beaches where I will be don't look ANYTHING like this.) Posts, if any, will be sparse.

James Montier Compilation

James Montier is a member of GMO’s asset allocation team. Prior to that, he was the co-Head of Global Strategy at Société Générale. Montier is the author of four outstanding books:

• The Little Book of Behavioral Investing: How Not to be Your Own Worst Enemy (Little Book, Big Profits)

• Behavioral Finance: Insights into Irrational Minds and Markets

• Behavioral Investing: A Practitioners Guide to Applying Behavioral Finance

• Value Investing: Tools and Techniques for Intelligent Investment

Montier has been the top-rated strategist in the annual Thomson Extel survey for most of the last decade. He is also a Visiting Fellow at the University of Durham and a Fellow of the Royal Society of Arts.

Tim du Toit is the editor and founder of Eurosharelab and recently assembled some of Montier's published writings for a blog article. The assemblage was picked up by Barry Ritholtz of The Big Picture blog and can be found here. Montier is one of my favorite authors. I find his work to be a must-read.

Independence Day

Every American needs to read it. Again. Here's what it says.

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature's God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights,that among these are Life, Liberty and the pursuit of Happiness. That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.

Such has been the patient sufferance of these Colonies; and such is now the necessity which constrains them to alter their former Systems of Government. The history of the present King of Great Britain is a history of repeated injuries and usurpations, all having in direct object the establishment of an absolute Tyranny over these States. To prove this, let Facts be submitted to a candid world.

He has refused his Assent to Laws, the most wholesome and necessary for the public good.
He has forbidden his Governors to pass Laws of immediate and pressing importance, unless suspended in their operation till his Assent should be obtained; and when so suspended, he has utterly neglected to attend to them.
He has refused to pass other Laws for the accommodation of large districts of people, unless those people would relinquish the right of Representation in the Legislature, a right inestimable to them and formidable to tyrants only.
He has called together legislative bodies at places unusual, uncomfortable, and distant from the depository of their public Records, for the sole purpose of fatiguing them into compliance with his measures.
He has dissolved Representative Houses repeatedly, for opposing with manly firmness his invasions on the rights of the people.
He has refused for a long time, after such disolutions, to cause others to be elected; whereby the Legislative powers, incapable of Annihilation, have returned to the People at large for their exercise; the State remaining in the mean time exposed to all the dangers of invasion from without, and convulsions within.
He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither, and raising the conditions of new Appropriations of Lands.

He has obstructed the Administration of Justice, by refusing his Assent to Laws for establishing Judiciary powers.
He has made Judges dependent on his Will alone, for the tenure of their offices, and the amount and payment of their salaries.
He has erected a multitude of New Offices, and sent hither swarms of Officers to harrass our people, and eat out their substance.
He has kept among us, in times of peace, Standing Armies without the Consent of our legislatures.
He has affected to render the Military independent of and superior to the Civil power.
He has combined with others to subject us to a jurisdiction foreign to our constitution, and unacknowledged by our laws; giving his Assent to their Acts of pretended Legislation:

For Quartering large bodies of armed troops among us:
For protecting them, by a mock Trial, from punishment for any Murders which they should commit on the Inhabitants of these States:
For cutting off our Trade with all parts of the world:
For imposing Taxes on us without our Consent:
For depriving us in many cases, of the benefits of Trial by Jury:
For transporting us beyond Seas to be tried for pretended offences
For abolishing the free System of English Laws in a neighbouring Province, establishing therein an Arbitrary government, and enlarging its Boundaries so as to render it at once an example and fit instrument for introducing the same absolute rule into these Colonies:
For taking away our Charters, abolishing our most valuable Laws, and altering fundamentally the Forms of our Governments:
For suspending our own Legislatures, and declaring themselves invested with power to legislate for us in all cases whatsoever.

He has abdicated Government here, by declaring us out of his Protection and waging War against us.
He has plundered our seas, ravaged our Coasts, burnt our towns, and destroyed the lives of our people.
He is at this time transporting large Armies of foreign Mercenaries to compleat the works of death, desolation and tyranny, already begun with circumstances of Cruelty & perfidy scarcely paralleled in the most barbarous ages, and totally unworthy the Head of a civilized nation.
He has constrained our fellow Citizens taken Captive on the high Seas to bear Arms against their Country, to become the executioners of their friends and Brethren, or to fall themselves by their Hands.
He has excited domestic insurrections amongst us, and has endeavoured to bring on the inhabitants of our frontiers, the merciless Indian Savages, whose known rule of warfare, is an undistinguished destruction of all ages, sexes and conditions.

In every stage of these Oppressions We have Petitioned for Redress in the most humble terms: Our repeated Petitions have been answered only by repeated injury. A Prince whose character is thus marked by every act which may define a Tyrant, is unfit to be the ruler of a free people.


Nor have We been wanting in attentions to our British brethren. We have warned them from time to time of attempts by their legislature to extend an unwarrantable jurisdiction over us. We have reminded them of the circumstances of our emigration and settlement here. We have appealed to their native justice and magnanimity, and we have conjured them by the ties of our common kindred to disavow these usurpations, which, would inevitably interrupt our connections and correspondence. They too have been deaf to the voice of justice and of consanguinity. We must, therefore, acquiesce in the necessity, which denounces our Separation, and hold them, as we hold the rest of mankind, Enemies in War, in Peace Friends.

We, therefore, the Representatives of the united States of America, in General Congress, Assembled, appealing to the Supreme Judge of the world for the rectitude of our intentions, do, in the Name, and by Authority of the good People of these Colonies, solemnly publish and declare, That these United Colonies are, and of Right ought to be Free and Independent States; that they are Absolved from all Allegiance to the British Crown, and that all political connection between them and the State of Great Britain, is and ought to be totally dissolved; and that as Free and Independent States, they have full Power to levy War, conclude Peace, contract Alliances, establish Commerce, and to do all other Acts and Things which Independent States may of right do. And for the support of this Declaration, with a firm reliance on the protection of divine Providence, we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.

Source: Wikipedia

New Reads in Financial Planning

“You will be the same person tomorrow, next week, next month, next year and in 5, 10, 20 years except for two things – the people you meet and the books you read.” - Charlie "Tremendous" Jones


I read a lot. But maybe I should meet more people.

Here's what is catching my eye from the bookshelves at the moment:


Financial Planning Demystified by Paul Lim

Personal Financial Planning by Lawrence J. Gitman, Michael D. Joehnk, and Randy Billingsley

Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking by Laurence J. Kotlikoff

Are You a Stock or a Bond?: Create Your Own Pension Plan for a Secure Financial Future by Moshe Arye Milevsky

Wine Investment for Portfolio Diversification: How Collecting Fine Wines Can Yield Greater Returns Than Stocks and Bonds by Mahesh Kumar and Michael Broadbent

Value Investing: Tools and Techniques for Intelligent Investment by James Montier

The Little Book That Beats the Market (Little Books. Big Profits) by Joel Greenblatt

The Same Ol' Story: Active Versus Passive Management

This data gets repeated every year with little substantive change. Active managers that can consistently beat indexes are hard to come by.

From Standard & Poors, their index on the value of active management of asset classes for 2009:

* Over the last five years, the S&P 500 has outperformed 60.8% of actively managed
large-cap U.S. equity funds; the S&P MidCap 400 has outperformed 77.2% of mid-cap
funds; and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.

*The five-year data results are similar for actively managed fixed income funds. Acrossall categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

If you are interested in being "in the market", any decision to hire an active manager for the asset class has to be heavily scrutinized. What is his/her "edge". Over time, what makes you think the asset manager can maintain it? Does the risk of failure jeopardize you getting to your goal? If so, why take it?

Are You A Stock Or A Bond?

Moshe Milevsky wants you to be smarter about risk. Dr. Milevsky is the Executive Director of the Individual Finance and Insurance Decision (IFID) Centre and is an Associate Professor of Finance at York University in Toronto, Canada. He is the author of three books on investment management and retirement planning. Recently, he penned a short article for The Wall Street Journal on a topic where investing and retirement planning intersect, entitled "How to Think Smarter About Risk".That article is here.


Milevsky believes that too many investors may be taking big chances with their money because they aren't considering the most important asset of all: themselves. And he wonders if a large, sustained drop in the stock market would affect your personal finances. Most people would be devastated by a return to the stock market lows of 2009. But Milevsky thinks you should think more broadly. Most importantly, he believes you should think about how such a drop would affect your paycheck and your career. It depends upon the person:

Earnings in some professions are tightly linked to the stock market—an investment banker, say, or portfolio manager or financial adviser—while others, such as hospital nurses or tenured professors, are relatively immune to these zigs and zags. Most people will fall somewhere in between.

Consider this an exercise in personal risk management. It isn't intended to gauge whether you believe the stock market will test those levels again, and I'm not asking whether you are bullish or bearish. That is not what personal risk management is about, even if it is how most people practice it. The issue here is: If the bear returns for a prolonged visit, regardless of your subjective view of these odds, how would it affect your current and future earning power? And—more important—are you properly considering it when creating your investment portfolio?

Milevsky worries "that one of the problems plaguing both investors and their financial advisers is that asset-allocation decisions are based excessively on how people feel (risk-averse or risk-tolerant) and what they believe (bullish or bearish about the stock market) as opposed to how much risk their personal balance sheets can tolerate.To put it in even more-basic terms: As part of any asset-allocation strategy, you need to determine whether you are a stock, with earnings that can fluctuate wildly with the market, or a bond, with earnings that are less flashy but steady. You will likely find that the overall level of risk you are taking is much higher or lower than you think."

Milevsky goes on to discuss his concept of "a personal beta", your individual balance sheet and the role of insurance in changing some balance sheet items from "stocks into bonds". It's definitely worth a read.

Blackbaud Index: Charitable Giving Increases

Americans are generous people. Despite the economy, charitable giving appears to be back on the rise. The story is here.

The Blackbaud Index of Charitable Giving released today reported that overall revenue increased by 12.1 percent for the 3 months ending April 2010 as compared to the same period in 2009. A significant portion of this increase was related to the very generous outpouring of support to organizations helping with relief efforts in Haiti.

The Index was released today as an information element of The NonProfit Times' economic dashboard, a tool that is featured on the news outlet's homepage and provides an at-a-glance view of key indicators for the nonprofit sector. The dashboard will also include a specialty index from Blackbaud that provides further analysis and insight into key trends.

Along with the launch of the Blackbaud Index of Charitable Giving today, Blackbaud released additional data and analysis that reports on organizations by size. The Index found that three-month revenue for small organizations (prior year revenue of < $1 million) increased 12.3 percent in April, while revenue at medium organizations (prior year revenue of $1 -- 10 million) decreased 2.5 percent, and revenue at large organizations (prior year revenue > $10 million) increased 19.2 percent.

The data show that donations for the smaller organizations bottomed out in July of 2009, remained roughly flat throughout the second half of 2009, and turned upward starting in January 2010.

New q Valuation for SP 500: Smithers & Co.

History, history! We fools, what do we know or care.-
William Carlos Williams

Doug Short of Financial Life Cycle Planning (www.dshort.com) and I have been exchanging correspondence about the q ratio and its uses. He is generating a methodology to update this measure more frequently. I wrote an article here sharing a few of Smithers thoughts on q as a timing tool. Quite curiously, Smithers & Co., addresses the topic of updates by its readers in its commentary which accompanies the release of its quarterly chart. Let's take a look. Here is the latest chart:



And here is the related commentary:

With the publication of the Flow of Funds data up to 31st March 2010 (on 10th June 2010), we have updated our calculations for q and CAPE, which show very little change from our previous calculations.

Non-financial companies, including both quoted and unquoted, were 62% overvalued according to q at 31st March 2010, when the S&P 500 index was 1169. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen to 50%. Revisions to data had little impact on q, with downward revision to net worth for Q4 2009 of 2.9% being offset by a downward revision to the market value of non-financial equities of 2.1%. Net worth for Q1 2010 fell slightly as equity buy-backs exceeded profit retentions.

The listed companies in the S&P 500 index, which include financials, were 58% overvalued at 31st March 2010, according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen 46%. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

And what of more frequent revisions? This is what the commentary offered:

As net worth and cyclically adjusted earnings per share change little during a quarter, only changes in share prices are important for changes in the market value between our quarterly updates. The value of the market can thus be readily adjusted by viewers to this website. As the S&P 500 index changes, viewers can simply insert the new value and calculate the q and CAPE values, i.e:

With the S&P 500 at 1169 as at 31st March 2010, q was 1.6166 and CAPE was 1.5761.

To update as at 10th June 2010, when the S&P 500 was 1087, for q take 1.61 × 1087 ÷ 1169 = 1.50 and for CAPE take 1.58 × 1087 ÷ 1169 = 1.46.

Smithers and Wright have written two books on stock market valuation and the q ratio. The first was Valuing Wall Street. The second was Wall Street Revalued. Both are on my bookshelf and are HIGHLY recommended reads for an investor.

The stock market is overvalued. It's as overvalued as it was in 2007 despite never having reached the absolute price level of the SP 500 reached then (1565). That is because earnings are quite a bit lower and the price being paid for them are too high in relation. This overvaluation will resolve itself as it always does. We just don't know when. Long term investors have been warned.

The Rising Tide: State Tax Increases

The recession has hit states HARD. We now hear daily of layoff plans for state and municipal employees. Revenues have fallen dramatically. To counter this states have turned to tax increases to fund their deficits. A sampling of states that have raised taxes:

* California added 0.25% to each income tax bracket, effective January 1, 2009 and ending December 31, 2010. The state also increased paycheck withholding rates by 10% for each tax bracket, effective November 1, 2009.
* Connecticut added a third income tax bracket of 6.5% on income over $500,000 for single filers and $1 million for joint filers, effective January 1, 2009. The state also delayed increases to personal exemptions and credits for three years and added a 10% corporate tax surcharge for 2009-2011.
* Delaware added a new top bracket of 6.95% on income over $60,000, an increase from the former 5.55% top rate, effective January 1, 2009. Business gross receipts tax rates were also increased across the board.
* Hawaii added three new tax brackets effective January 1, 2009. The new rates are 9% on income over $150,000; 10% on income over $175,000; and 11% on income over $200,000. The state has also delayed sending out all 2009 refund checks until July 1, 2010 to help cover budget deficits.
* New Jersey created three new brackets for 2009: 8% on income over $400,000; 10.25% on income over $500,000; and 10.75% on income over $1 million.
* New York added two additional tax rates: 7.85% on income over $200,000 ($300,000 for joint filers) and 8.97% on income over $500,000. This is effective January 1, 2009 and is slated to end December 31, 2011. Beginning April 7, 2009, people who have adjusted gross income over $1 million cannot claim itemized deductions, except for 50% of their Federal charitable contributions deduction.
* North Carolina imposed a tax surcharge of 2% on people with income over $60,000 ($100,000 for joint filers) and 3% on people with income over $150,000 ($250,000 for joint filers), effective January 1, 2009 and ending December 31, 2010. The state also created a new 3% tax surcharge for corporations.
* Oregon voters approved the addition of two new tax brackets effective January 1, 2009, and ending December 31, 2011: 10.8% on income over $125,000 and 11% on income over $250,000. After 2011, the former bracket will be reduced to 9.9% and the top bracket will be eliminated. Oregon also increased corporate income taxes this year.
* Wisconsin added a new top rate: 7.75% on income over $225,000 ($300,000 for joint filers).

Source: Tonya Moreno, "Significant State Tax Changes for 2009 and 2010"

The Rising Tide: New Health Care Taxes

We've been hammering this theme for months. Taxes are set to rise. It's a given. However, we weren't talking about taxes to pay for NEW programs but just paying for existing obligations. Then, in March, Congress passed the entirely new federal health care program. To help pay for the changes, the legislation contained two surprising new taxes: an extra 0.9% levy on wages for couples earning more than $250,000 ($200,000 for singles) and a new 3.8% tax on investment income on those same people (technically, people with "adjusted gross incomes" above those amounts).


As Laura Sanders of WSJOnline (www.wsjonline.com)writes:

Each tax signals a radical change in policy. For workers, the extra 0.9% levy puts a progressive element in what used to be a totally flat tax. The 3.8% tax on investment income also knocks down a longstanding wall by applying a "payroll" tax to unearned income. Until now, FICA taxes for Social Security and Medicare have applied only to wages, not investment income.

The article contains a question and answer of how the tax might work, given that the IRS hasn't had time to figure this out yet, and tax planning strategies for handling these new burdens, if you are affected. Well worth a read, the full story is here.

Market Valuation Measures: Improvement and Possible Use

For the past couple of weeks blogger and financial planning consultant Doug Short has been providing his readers with a series of posts which discuss and refine three measures of market valuation: his own measure of trendline valuation, Shiller's PE10 and one of my favorites, the q ratio of James Tobin as used by Andrew Smithers and others. The articles purpose is to demonstrate the benefit of their use by investors and, presumably, to make the measures more timely and useful. I applaud his work in this direction. The latest article is here and his excellent chart, showing these measures in the past and to date follows.



I wanted to chime in about the use of such indicators as a possible timing tool by investors. Can the q ratio be used in this manner? Here is what Smithers himself has said ("Wall Street Revalued", p. 77):

Selling equities when they are overvalued can be sensible, but only if the prospective returns from the sanctuary asset, in which the funds previously invested in equities are temporarily lodged, will exceed those on equities over the uncertain time period in question. The uncertainty about the time when the investor will wish to return to equities makes cash (or its equivalent, such as money on short-term deposit), the most likely and generally sensible choice as a sanctuary asset. Although real cash returns vary, the asset can at least be realized in the short term at its original nominal value. Bonds have an even greater exposure to inflation and even if that is stable the nominal value at any time prior to maturity is uncertain.

How true. The return on a "safe" asset is very low. The return on equities, even when shown to be overvalued, can still be relatively high. To switch from equities to cash requires a fine and bold calculation that the sanctuary asset return, plus any avoided losses, will exceed the return given from equities in the interim. THat is a judgment of three uncertainties: the length of time it takes for "fair value" to reassert itself in the equity space; the return on equities until that time; and the return on the "safe" asset class chosen.

Smithers continues:

Historically, there have only been five peaks in the market's overvaluation since 1900... . The average time between peaks has been 24 years but the average is far from regular and each of the last two swings has taken over 30 years from peak to peak.

...

If, for example, the real return on equities is normally 6%, Treasury bills can be expected to give at least a 1% real return and the stock market has an equal chance of being over- or under-valued in 15 years' time, then the limits of overvaluation given a limited number of rational investors will be just over twice. (Ed note: log terms).

...

A glance at Chart 15 shows that, during the period for which we have adequate data, only twice has the market become so overvalued that it was worth while (sic) selling on either of these assumptions: the first time being prior to its 1929 peak and the next prior to its peak in 2000.

Is the q ratio then largely ineffective as a timing tool? Apparently Smithers believes- given his assumptions- its use as such to be quite rare: twice in nearly 100 years. That's hardly the holding time-frame for the average investor. (Endowment investing is different.)But the rub (there's always one isn't there?) is in Smithers' assumptions regarding time elapsed from observed over-valuation to realize fair value, the prospective return from equities as an asset class, and the return from the sanctuary asset. If any one of these assumptions is altered, the calculus changes. And as we have written on this blog, not every market expert agrees with these values. I would only point the reader to my posts about John Hussman's models or Jeremy Grantham's forecasts to see how tweaking the assumptions might work a bit differently for the creative investor. What if bubbles were observed to burst more frequently than granted by Smithers? What if the sanctuary asset class is not cash but has some, though limited, volatility and a much higher expected return? What if the observed over-valuation shows that the expected return for equities over a given timeframe is not 6% but two percent, one percent or even ZER0? The possibilities for thoughtful substitution by an investor become great.

New Site Design

I thought the site could look "punchier". And maybe be a bit easier to read. So this is the re-design.

Same lousy content though. ;)

Hope you like it!

Switching Out of Bonds Isn't the Answer. Or Is it?

Christine Benz, Morningstar's director of personal finance, has written an article on the dilemma that faces bond investors today. The dilemma is the combination of historically low rates (present)and the threat of inflation (future). That formula is deadly for protection of principal. Her article is instructive for the purpose of seeing what knots we can tie ourselves in if we are not clear about what we are saying to our audience in this area. But it still manages to contain some good advice. It reads (in part):

Whether your guru is Jack Bogle, Bill Gross, or Roger Ibbotson, the smart money is on bonds posting disappointing returns during the next decade.

The logic is certainly sound. Bond returns are composed of two elements: whatever income they pay out and any price changes in the bonds themselves. And on both counts, the situation for bonds looks bleak. Current yields, historically a good proxy for bond returns in the future, remain ultra-low--about 1%-2% for shorter-term bonds and 3%-4% for intermediate-term bonds. And should interest rates head higher--and they really have only one way to go, following generally declining rates for more than two decades--prospects for declining bond prices are very real.

Given that dour outlook, it's tempting to downplay bonds as a portion of your portfolio. Some investors have suggested that you might as well hunker down in cash until worries about rates blow over. You'll have to settle for lower yields, but at least you won't face the principal losses you might confront in bonds.

Alternatively, if market watchers are right that bonds are in for a depressing decade, all the money we might see come sloshing out of bonds would have to go somewhere. From that standpoint, it might seem compelling to swap at least some of your fixed-income stake for stocks.

Mark here. We have ALREADY seen a mass exodus by retail investors from equities into bonds, bond funds and structured products. We've chronicaled that here. That flight has bid up prices to levels last seen in 2007 before the Lehman Brothers implosion. And equities have run 80% off their bear market bottom. Should we now reverse field? Benz writes that:

the bond market is a pretty efficient machine, and current bond prices factor in multitudinous bits of information about the economy and the prospect for interest rates. For you to take an antibond bet and, say, shorten up your fixed-income portfolio or move entirely to cash, you're essentially saying that you have better foresight of what bonds will do in the future compared with other market participants. You might, but you might not.

Mark again. The author appears to be saying "The market is likely smarter than you. All you are doing is guessing." Well, MAYBE. In Spring of 2000 with the market at 1550 plus on the SP500, did the market "have it right"? How about in Fall of 2007 at about the same levels? Good lord I had hoped that this canard that the market is some efficient discounting machine had gone the way of the dodo bird. It's a nice theory that runs aground on empirical observation. So if we don't possess The Crystal Ball we should do nothing? What we absolutely KNOW is that returns from bonds will be LOW. That's a given. Sure they could move lower. But that would be a temporary capital gain and likely quickly given back. If it is not that signals BIG TROUBLE for the economy and bonds returns will be your least worry.

And while it's hard to get excited about investing in an asset class with the threat of losses looming over it, it's also worthwhile to consider the likelihood and magnitude of losses one might face in bonds, especially if you have a time horizon of a few years or more. (If your time horizon for your money is shorter than that, you belong in cash.)

The Barclays Capital U.S. Aggregate Bond Index, a broad index tracking much of the domestic fixed-income market, hasn't posted a loss in any rolling three-year period since 1983. Granted, that was a very favorable period for bonds, marked by generally declining interest rates. But even an examination of a less forgiving bond-market environment shows that the threat of rising interest rates shouldn't prompt a wholesale panic.

A recent Fidelity study, looking back to the period of 1941-81, when yields rose from 0.5% to 16%, showed that investors in intermediate-term Treasury bonds actually lost money in just 1% of the rolling three-year periods during those 40 years. Yes, rising rates depressed bond prices during that period, but the higher yields that investors were able to pick up offset the price declines in most cases. Due to the ability to earn higher yields, intermediate-term Treasury investors actually made money during that inhospitable 40-year stretch. They averaged a 3.3% annualized gain during that period, well below bonds' average gains of 5.3% since 1926, but a positive gain all the same.

Additionally, the magnitude of losses that one might expect from bonds, even in a tough interest-rate environment, is also apt to be a lot lower than what you'd see from stocks. To use a recent example, long-term government bond funds, which tend to be extremely sensitive to changes in interest rates, lost 9% in 2009 amid concerns that rates would trend higher. Such a loss is never welcome, to be sure, but it pales in comparison to the 37% loss that S&P 500 investors faced in 2008.

Hmm. Are we saying invest because your losses, if any, are likely to be small as well as any gains, that is, over 40 years you see, so the whole thing would be "No Harm No Foul" if you do? And by the way, were those paltry returns real or nominal? I guess she is saying what I said above: Bonds could be the least of your worries. Let's move on.

What to Do?
Even though the prospect of rising rates shouldn't dictate a wholesale revision of your asset allocation, there are still steps to take to protect yourself.

For starters, consider downplaying long-term bonds as part of your portfolio, as Jack Bogle suggests in this video (Ed: Morningstar video link ommitted). Yes, long-term bonds have gained about a percentage point per year, which is more than intermediate-term bonds, on average, during the past decade, but their volatility as measured by standard deviation has been almost twice as high.

Second, consider delegating a big chunk of your portfolio's fixed-income position to a core fund whose manager isn't shy about factoring in the interest-rate environment into his or her outlook. A few that Morningstar analysts like include Metropolitan West Total Return (MWTRX), Harbor Bond (HABDX), and Dodge & Cox Income (DODIX).

Finally, if you're holding money you truly can't afford to lose, stick with true cash rather than short-term bonds or much higher-yielding (and higher-risk) substitutes such as bank-loan funds. Yes, yields on certificates of deposit and money market funds are low right now, but you're looking to this sleeve of your portfolio for stability rather than big return potential.

Okay, finally we get to the meat of the article. After much chasing of our tails while setting up the problem, we see she recommends a few bond funds that will do the heavy thinking and lifting for you. I have NO quibbles with the three she recommends. They are well managed and have good histories. If you want a bond fund or two in your portfolio you could do A LOT worse.

But do investors have to own funds that invest only in bonds for their income portfolios? Let's say you take the route of adding some equity exposure to your income portfolio. Where are those that will buy income generating equities (REITs, utilities, MLPs) as an example? Where is Berwyn Income Fund, which buys dividend stocks in up to 30% of its portfolio, (BERIX) in her list? Have you seen those 10 year returns? Or those that hedge the interest rate risk by alternative means? Have you heard of Hussman Strategic Total Return (HSTRX)? What about THOSE returns life of fund? Must an income investor eschew ALL volatility in this part of the portfolio (if they even still divide it up into the old bond/equity buckets)in order to get to their goal (the promised land)?

Giving it the benefit of the doubt, the article tries to be a balanced look at this difficult topic. It ends up I think falling short of where it needs to go. (I wanted to write "a bit of a hash" here but thought that a wee bit harsh.) It's difficult to give advice about bonds these days. It truly is. Deflationary pressures abound in the short term. Those auger for low rates for some time. The money sloshing around out there to fix our problems says the future holds just the opposite. That at some time inflation must return. Just not now.

The author's advice is to pick a manager who has shown flexibility in the past. Can't quibble with that. Which managers have protected principal through difficult environments? That says a long history here may be needed. Or was succesful navigation of the latest low interest rate period enough? The manager likely had to skillfully manage some additional risk in order to get ANY kind of returns.

Don't limit yourself to traditional bond funds or managers. Perhaps it's not a bond fund you need at all. Look around. I bet you can come up with some better alternatives than even I have. Write me if you do. And thanks Christine for letting me ask some hard questions around your article.

Good luck. It's a tough bond environment out there.

Check That Expiration Date!

As with bad cans of tuna, if you aren't aware of the danger of expired goods you could be in trouble. Here are some potential sources ofdifficulty for planners and their clients:

Tax Breaks that Expired at the End of 2009

* Deduction for classroom expenses for educators,
* Tuition and fees deduction for college,
* Additional standard deduction for property taxes,
* Additional standard deduction or itemized deduction for sales tax paid on a new vehicle,
* Itemized deduction for state and local sales taxes in lieu of state income taxes,
* Tax-free exclusion of the first $2,400 in unemployment benefits.
* Tax-free exclusion of IRA funds donated directly to charity,

Tax Breaks Expiring in 2010

The following provisions in the tax code will expire in the year 2010:

* Homebuyer tax credit for new or repeat home buyers expired on April 30, 2010. Military personnel can take advantage of this tax credit through April 2011.
* Tax credit for hybrid and alternative fuel vehicles expires for all makes and models at the end of 2010,
* Itemized deduction for mortgage insurance premiums,
* Qualified dividends taxed at capital gains rates,
* Reduced long term capital gains tax rates of 5% or 15% will revert to rates of 10% or 20%,
* All provisions part of the Economic Growth and Tax Relief Reconciliation Act of 2001. In particular, the current tax brackets of 10%, 15%, 25%, 28%, 33%, and 35% are scheduled to expire at the end of 2010. The marginal tax brackets will revert to their pre-2001 levels, which were five tax rates of 15%, 28%, 31%, 36%, and 39.6%.

These breaks are presently being debated in Congress. We've complained about the difficulty that advisers face in planning for their clients based on the late action on tax bills. Stay tuned.

High Quality Stocks vs. The SP500

GMO's theme that high quality companies are the only value in the US market gets a boost from none other than First Eagle Funds (11% returns life of fund) and their research director Bruce Greenwald. Video interview and transcript via Morningstar's Ryan Leggio. See here.

While high quality may outperform on a relative basis go-forward, you can see that on days like today, everything goes down. That being said, I also expect this subset of the market to outperform. Junky stocks (high debt, no franchise) have had their run off the lows, just like they did in the last Crash. Time for franchise companies to show what their franchise is worth.

Housing: The Temporary Reprieve

Let's see. A home-buying credit? Check. A second round of home-buying credits? Check. Tax write-offs of losses for builders? Check. State subsidies for builders? Check. Government "nationalization" of the mortgage origination market(Fannie, Freddie, FHA with 95% market share)? Check. What did all of this get us? Take a look! Here's the Case-Shiller Index of National Housing Prices for 1Q 2010. See the little bump in the graph for a few months? Is that all? Yep.



Sure looks like more declines ahead. Housing as an investment? Nah.

UPDATE 6/4/10: "Credits just shifted demand forward. Price gains not sustainable- Fannie Mae Economist." Story here.

Guess I'm not the only one who thinks so.

The Apprenticed Investor

One of the best investing and trading series ever written, by popular financial/trading/media blog host Barry Ritholtz (The Big Picture). Collected together from various publications, all for the first time.

Find it here.

Thanks, Barry!

The Good, The Bad and The Ugly: GMO Weighs In

In a nice article at Morningstar, the venerable Jeremy Grantham weighs in on valuations of markets and sectors. Long time readers know I really like Grantham's Quarterly Letters (www.gmo.com) and Monthly Outlooks. The link is here.

A few of the key takeaways provided by Morningstar's Ryan Leggio from his notes at a talk given by Grantham and Ben Inker, head of risk at GMO, to investment professionals last Wednesday:

Pension plans assume they can achieve an 8% nominal return with a 60/40 portfolio. Since bonds yield about 4%, this means they assume equities can return about 11% annualized going forward from today's valuations. By contrast, GMO thinks equities will return about 6%. With these assumptions, a 60/40 portfolio is more likely to return about 5% annually.

GMO thinks most equity categories are overvalued. This is because it forecasts the S&P's profit margin will return to its 6% historical level rather than rise to the 7%-plus level analysts are forecasting.

High-quality stocks are a free lunch in GMO's opinion. Since 1965 they have beat the S&P 500, but they should have a lower equity risk premium because they are better companies with better balance sheets than the average S&P 500 company.

Quality stocks are the cheapest they have ever been on a relative basis since 1965 compared to the S&P 500. The last time they came close to this level was in 2000 (tech bubble) and 1969 (right before Nifty-Fifty era).

Thanks Ryan!

Blog Note: Grantham said in his latest Quarterly Letter that a "run to the old highs" was possible. The crisis in Europe and the return of risk and fear in the markets seems to have tempered such optimism.

The Good, The Bad and The Ugly: Returns Going Forward

Morningstar has a good video of Rob Arnott discussing the returns environment for many major asset classes. If you don't know Rob, he is the chairman of Research Affiliates, and he's also the former editor of the Financial Analysts Journal. The link is here.

A highlight (or lowlight) from his video interview:

And yields on stocks--they've doubled in the last 10 years, because it was such a horrific decade. They're still half what they've been historically.

So the yields on stocks are low. The yields on bonds, and an array of other asset classes, are low. People need to ratchet down their return expectations. If you're expecting double-digit returns on your investments, then I'm a bear. I think you're not going to get there.

If you're expecting 5% return on your investments and you're well diversified and you're taking advantage of an array of alternative markets--yeah, that's not just achievable, but reasonably easily achievable. 6% or 8% is possible.

In my opinion, if you are successful timing in to and out of asset classes (this is really what Arnott is suggesting), 6-8% is possible. If you have the usual two-class equities and bond orientation and less than a ten year horizon, getting to 3-4% real returns is going to be a challenge. Not investment advice.

Right On Cue!

It must be something in the water. Or a conspiracy! The same week Bloomberg posts a nice article about the dangers of high yield, Fidelity chimes in with a look at how investors can earn more interest "without excessive risk". Let's see what they have to say. The story is here.

With the average checking account and three-month brokered certificate of deposit (CD) yielding a humble 0.25%,1 you may be yearning for a little more yield on your everyday cash and short-term investments.

Well, don't expect much help from the Federal Reserve, which continues to indicate that it plans to hold its benchmark Federal Funds rate low for an extended period. Still, there are ways that could help you eke out more yield on your cash and short-term investments—without taking on excessive risk.

"It can be done without committing either to long-term bonds or to the volatility that can come from dipping too far down in credit quality," says Richard Carter, vice president of fixed-income securities at Fidelity. "The recent steepness of the Treasury yield curve (see chart below) means that you may be able to get a little more yield for extending maturities a little further than you would have in a period like year-end 2006, when the curve was essentially flat."

What You Can Do

First determine how much of your short-term investments are for immediate needs and has to be easily accessible and liquid. This money should stay in a checking account, money market account or fund, or short-term FDIC insured CD, regardless of the low yield. Beyond that, however, there are a variety of strategies that can help you earn more on your cash and short-term investments. Consider these four:

1. Consider slightly longer maturities

For money you don't need right away, consider investments with slightly longer maturities, including Treasuries, which can provide higher yields. For instance, a 12-month Treasury is currently yielding close to 0.40%, a two-year Treasury close to 1.00%, and a three-year 1.50%. Other options: longer-term FDIC-insured CDs and short-term bonds from agencies or government sponsored enterprises (GSEs). The table below illustrates how slightly higher maturities can bring higher yields. Of course, it's important that your CDs stay within the FDIC protection limits,2 and remember that, while GSEs are strongly supported by the government, in most cases, they aren't explicitly government-guaranteed options.

2. Build a short-term ladder

You can also ladder these securities and invest equal amounts across several maturity buckets. For example, with a three-year ladder, it's now possible to earn annualized returns of roughly 0.8%-1% depending on the bond type chosen (see table below). The three-year ladder strategy won't have as high a yield as buying a three-year bond outright, but it will provide periodic "liquidity events" when your principal matures. That way, if rates rise within the next 6-12 months, you'll be able to reinvest the maturing principal at higher rates.

3. Consider short-term bond funds

Investing in short-term Treasury, government, or other investment-grade bond mutual funds—which is similar to investing in ladders of securities typically maturing in five years or less—may provide higher yields while reducing interest rate and credit risk. They may also provide diversification among issuers and are generally easier to sell than an individual bond.

"As a short-term bond fund manager, I have more opportunities to look at the market and look for attractive investments," says Rob Galusza, portfolio manager of Fidelity Short-Term Bond Fund (FSHBX). "This allows me to allocate assets into higher-yielding bonds more quickly, should rates rise."

4. A more aggressive choice: floating rate or leveraged loans

If you are more aggressive and comfortable with increased credit risk and potential for principal loss, consider mutual funds that invest in floating rate bank loans, which are primarily secured loans made by banks to non-investment-grade companies. Floating rate bank loans have coupons that reset periodically, or "float," based on a fixed premium over a market rate such as the London Interbank Offered Rate (LIBOR), which is the rate that banks charge each other for loans less than one year. And in case of bankruptcy, floating rate loans are senior in standing to bonds on the balance sheets of these companies. The average yield is currently 5.26% according to the S&P/LSTA Leveraged Performing Loan Index.

"The floating rate feature of these loans helps to reduce interest rate volatility, while the combination of seniority, security, and floating rates helps to limit the price volatility of the investment," says Christine McConnell, manager of Fidelity Floating Rate High Income Fund (FFRHX).

Keep in mind the risks of floating rate loans, however. These loans are often lower-quality debt securities, and generally are subject to restrictions on resale. Also, they may not be fully collateralized, which may cause the floating rate loan to decline significantly in value.

Next steps

Despite the low interest rate environment, there are still opportunities to earn more yield by diversifying your cash and short-term investments. Remember, however that because liquidity and risk are key, money for emergencies stills belongs in a checking account, money market account or fund, or short-term CD.

Okay, not much new here. My comments: The floating rate option is not for the faint of heart. At least the article describes it as "aggressive". The longer maturities give you additional interest rate risk. If you keep it short, you can always roll it over at higher rates should they increase. (If rates go lower here, that likely signals big trouble somewhere, either in the economy, the markets or both.) It's a very tough environment for those looking for yield.

The Reach for Yield

Investors are absolutely desperate for returns. Two market crashes and the resultant efforts by the Fed to cushion things by driving interest rates to near zero have investors clamoring for anything with a yield. High yield bonds are not the exception. In fact they may be the poster child for this phenomenon.

In a Bloomberg story appearing today the syndicator reports "Junk Bonds Sell With Weakest Creditor Protection Since 2007". The story is here. It's potentially a sad one. I see nothing but grief coming from this if the economy doesn't stabilize.

Two years after suffering $213.2 billion of losses when debt markets froze, investors in junk bonds are accepting what Moody’s Investors Service calls the weakest creditor protections since 2007.

Even with housing starts hovering at their lowest levels on record, Beazer Homes USA Inc. managed to sell bonds this month on terms that allow it to add more debt. The Atlanta-based builder couldn’t even do that when it issued debentures at the height of the housing bubble in 2006 and its credit rating was seven levels higher. In a report last week Moody’s singled out CF Industries Inc., Standard Pacific Corp., AK Steel Corp. as borrowers offering debt on terms historically available only to higher-rated companies.

“We got ourselves in trouble with that in the past and here it is again,” James Kochan, the chief fixed-income strategist at Wells Fargo Fund Management in Menomonee Falls, Wisconsin, said of the trend toward looser debt covenants. “It’s not that surprising, but it is disturbing,” said Kochan, who helps oversee $179 billion.

Lenders are letting down their guard just as worsening government finances raise doubts about the sustainability of the global economic recovery. Money managers say they have little choice but to go along. They need to find a home for the record $29.4 billion that has flowed into high-yield bond mutual funds the past 16 months from retail investors seeking to join in a rally that has produced an average 69 percent return since the market bottom in March 2009.

Weaker Safeguards

About 60 percent of high-yield borrowers this year offered weaker investor safeguards than on debt they issued previously, according to Covenant Review LLC, a New York-based research firm that analyzes bond offerings. Those include no limits on the amount of debt companies can have and few restrictions on using assets as collateral for future borrowing, reducing what’s available to satisfy creditor claims in a bankruptcy.

“This trend represents more than an episode of ‘back to the future,’” Moody’s analysts including Alex Dill, the firm’s senior covenant officer, wrote in their report. “It reflects a weakening in covenant protections even below those existing at the peak of the market, in 2006 and 2007.”

Beazer sold $300 million of 9.125 percent bonds due in 2018 on May 4 that carry lighter restrictions than its 2006 issue on the amount of debt the builder can add and how it can use money raised from selling assets. The terms also allow Beazer to double its capacity to pay dividends to shareholders even after a 90 percent drop in its stock, according to Covenant Review.

‘Poor Standing’

The company’s senior unsecured bonds are rated Caa2, which Moody’s defines as “judged to be of poor standing and are subject to very high credit risk.” Beazer was rated Ba1, one step below investment grade, in June 2006, when it issued $275 million of 8.125 percent 10-year notes.

Jeffrey Hoza, a vice president and treasurer of Beazer, and Chief Financial Officer Allan Merrill didn’t return calls seeking comment. Junk bonds are rated below Baa3 by Moody’s and less than BBB- by Standard & Poor’s.

Overseas Shipholding Group Inc., the largest U.S.-based oil-tanker owner, sold $300 million of bonds in March, its first offering in six years. Debtholders gave the company the leeway to sell assets, new secured debt and pay dividends to equity holders, according to Covenant Review. The bonds, due in 2018, are rated Ba3 by Moody’s and an equivalent BB- by S&P.

‘No Resistance’

“We were not going to do a deal if we were not able to get that kind of flexibility,” said Morten Arntzen, the chief executive officer of the New York-based company. “We had no resistance to it” from potential investors, he said. Proceeds from the sale were used to repay debt under a revolving credit facility, the company said in a March 29 statement.

Overseas Shipholding’s covenants are “nearly useless,” according to Covenant Review. Investors bid up the debt anyway, pushing the 8.125 percent notes to as high as 102.25 cents on the dollar last month, according to Trace, the Financial Industry Regulatory Authority’s bond-price reporting system.

“They’re a high-yield issuer that’s getting away with investment-grade covenants,” said Adam Cohen, founder of Covenant Review. “You shouldn’t have a high-yield bond that gives you less protection than a lot of the high-grade bonds out there.”

Cash is flowing into mutual funds that specialize in high- yield debt at an accelerating pace. EPFR Global, a research firm in Cambridge, Massachusetts, estimates that before last week, investors put $8.57 billion into the funds, up from $7.33 billion in the same period of 2009.

Soaring Issuance

That money helped push down yields on speculative-grade bonds to 8.23 percent on April 27, the lowest since July 2007, from 21 percent in March 2009, Bank of America Merrill Lynch indexes show. Yields averaged 8.77 percent as of yesterday.

Borrowers are taking advantage of the demand, issuing $109.1 billion of debt this year, compared with the record $162.7 billion in all of 2009, data compiled by Bloomberg show.

Investors are also snapping up junk bonds as Federal Reserve policy makers pledge to hold interest rates near zero for an “extended period” to stoke the economy. Of the 460 companies in the S&P 500 that reported first-quarter results, 77 percent said earnings exceeded analysts’ estimates, Bloomberg data show.

Gross domestic product may expand 3.2 percent this year, after contracting 2.4 percent in 2009, according to the median estimate of 72 economists surveyed by Bloomberg. Housing starts climbed to an annual rate of 626,000 in March, up 1.6 percent from February’s 616,000 pace, though still half the level from October 2007, according to Commerce Department data.

....

No End

Martin Fridson, the chief executive officer of New York- based money manager Fridson Investment Advisors, said the loosening of covenants isn’t at a level yet that would signal the end of the bull market in junk bonds.

Covenants are typically strengthened following periods in which high-yield issuers are blocked from the market, “and at the end of that cycle, there’s an ‘anything goes’ mentality,” said Fridson, 57, who was Merrill Lynch’s head high-yield strategist before leaving to form his own firm in 2002. “We haven’t reached that final stage.”

Cracks in the junk bond rally are emerging on speculation that rising budget deficits in European countries such as Greece, Spain and Portugal may cause lawmakers to curb spending, slowing the global economy.

Bond Losses

High-yield bonds in the U.S. have lost 2 percent this month, according to Bank of America Merrill Lynch index data. This would be the first down month since February 2009, when they fell 3.47 percent.

....

‘Like a Meme’

“Once you get a structure into the market, it replicates itself like a meme and it survives because the investors keep buying it,” Dill said.

Rising demand for junk bonds has also allowed companies emerging from bankruptcy, including Houston-based Lyondell Chemical Co., which sold $2.75 billion of debt in dollars and euros on March 24 and Lear Corp. of Southfield, Michigan, which issued $700 million of notes on March 23, to borrow with few restrictions, Covenant Review’s Cohen said.

Lyondell’s covenants offer no clear limits on the amount of additional secured debt the company can sell and permit it to shift as much as $1.25 billion of assets to units that aren’t covered by the bonds’ limitations, reducing the collateral available to creditors, according to a Covenant Review report.

“In 2008, all the companies that we said would screw the bondholders did it,” said Cohen of Covenant Review. “Now, it feels like 2007 to me. We’re telling them they’re going to get screwed and they’re not paying attention.”

Hurling Rocks at Goliath: Fighting the IRS

Think having your 401k get halved and then sitting out the rally because you switched to bonds (they're safer!) isn't bad enough? Well some people think worse CAN happen: you could get audited by the IRS. This article from the Wall Street Journal (www.wsj.com)talks about this issue.

With Washington searching for ways to cut the budget deficit, IRS officials face intense pressure to collect more revenue. The agency plans more audits, especially of taxpayers in high brackets or those who are self-employed and deal in large amounts of cash. The IRS also has turned up the heat in such areas as offshore tax evasion, including undisclosed foreign bank accounts.

If you become an IRS target, what should you do? For many people, the answer may seem simple: Surrender as quickly as possible, no matter how good a case you have.

Even if you are sure you are right and have all the records to prove it, fighting the IRS, one of the most powerful government bureaucracies on the planet, can be the ultimate nightmare. Seemingly routine struggles can drag on for years, leading to endless frustration and sleepless nights. Even those who eventually triumph may wonder if the fight was worth all the time, effort and expense.

But if you're ready for the challenge, there are many smart ways to fight back—and win. Start by keeping comprehensive, well-organized documents. Always scour the IRS's claims for mistakes. Don't get discouraged when dealing with tax officials. If you are convinced you are correct, consider pushing your case up the chain of command. Try the IRS appeals division. You may also get valuable help from the IRS's taxpayer advocate service. Or go to court.

At the same time, there are some classically dumb mistakes to avoid—everything from simply ignoring the IRS to arguing that it somehow is voluntary to pay federal income tax.

Here are some combat tips from lawyers, accountants and "enrolled agents," who are federally licensed tax experts authorized to represent taxpayers at all levels of the IRS.

Dumb moves

Hire the wrong tax preparer: Beware of someone who asks you to sign a blank tax return. Or whose fee is based on a percentage of how much you save in taxes. Or who promises to get you a significantly higher refund than anyone else can. People like these are likely to prepare outrageous returns that will land you in deep trouble with the IRS.

The Ostrich approach: One of the biggest mistakes is to bury your head in the sand and ignore IRS notices and letters, hoping the tax collectors eventually will lose interest and go away. "When dealing with the IRS, the best thing someone can do is to maintain regular communication," says Charles P. Rettig, a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez P.C., in Beverly Hills, Calif. "Whether during an audit or in the tax-collection process, ignoring the IRS is simply a bad idea."

Act professionally throughout the process and reply to IRS correspondence on time. The IRS is very serious about deadlines. Also, "keep a record of all communications and correspondence with the IRS, including proof of delivery, and keep your records organized," says Caroline D. Ciraolo, a tax lawyer at Rosenberg Martin Greenberg LLP in Baltimore.

Frivolity: Some people tell the IRS and judges that it somehow is voluntary to file a federal income-tax return and pay taxes. Or that their wages, tips and other income for personal services aren't taxable. Or that they are residents of a state but not of the United States. Or variations of these themes.

Don't even think of making any of those claims. Tax Court judges routinely label these as "frivolous" arguments, delaying tactics or both. More important, judges often impose stiff monetary penalties on those foolish enough to persist.

Bribery: This is even dumber—and far more dangerous—than frivolity. In a case last year, for instance, a Houston-area resident was sentenced to prison for two years for trying to bribe an IRS agent, according to a report by the Treasury Inspector General for Tax Administration. The U.S. Attorney's office in the southern district of Texas said the man offered the agent $2,500 to reduce his tax liability to around $500 from $49,000. In addition, the man "repeatedly offered the agent pizza from his restaurant as part of the deal."

Automatic surrender: Just because the IRS says you owe money doesn't mean that's correct. The agency makes mistakes—plenty of them, even in computing penalties and interest. "I have had several clients receive notices regarding unreported securities sales," says Stephen W. DeFilippis, the owner of West Suburban Income Tax Service in Wheaton, Ill., and an enrolled agent. "In these cases, the clients exchanged mutual funds one for another and didn't realize that's a taxable event." The IRS, he says, sent a notice "including the gross proceeds in income and assessing tax on the additional income."

But the IRS missed a vital point, he says: "The clients brought me these notices, and in each case the mutual-fund exchanges resulted in a loss. So instead of owing a large sum to the IRS, the clients got a refund."

This story shows how foolish it can be to pay what the IRS says you owe without "thoroughly investigating" the subject, says Mr. DeFilippis.

But if the amount in question is relatively small and the issue is confusing, some may conclude it isn't worth the time, trouble and expense of challenging the IRS and may decide to pay in order to make the problem disappear. It depends on the details of each case, including how confident you are of victory and how much time and expense you are willing to devote to the battle.

But often the smartest move is to get someone involved on your side: either an accountant or a tax attorney. The IRS makes mistakes. Loads of them. But the presentation and proof of those mistakes can be critical. And even when the IRS is proving obstinate, having that expert on your side can give you enough gumption to fight on. The IRS is no longer the automatic winner in appeals. As it used to be. And an appeal may be your only avenue of relief.

Consult your planning or tax professional if you have questions.

A Taxing Dilemma

You know in your heart that tax rates are going to rise. In fact you plan on it. You advise clients so and in your personal accounts you are positioned that way. They HAVE to, right? How else to fund the massive bailouts and stimulus programs.

But in the past, unlike this year, the IRS gave you some inkling by now of what it intended for the next year. Congress too. But they haven't and that is causing some stress among financial advisers.

As an example. advisers have been waiting to see what the tax rates on dividends will be for next year. This conundrum, and what investors want to know, were examined in a recent Wall Street Journal article:

Next year, what will the top tax rate on dividends be?

Investors like Clint Myers, an investment actuary in Georgetown, S.C., want to know. Some experts cite a 20% figure, while others say 39.6%, and still others talk about a tripling of the current 15% rate. "Lately I have seen figures citing almost any rate you can imagine," Mr. Myers says.

The short answer is that the 2011 nominal rate on dividends could be either 20% or 39.6%. Or something else—it is impossible to say given the legislative mood these days.

This is a big issue. Dividends provide approximately 40% of the total return to investors. How you tax them directly affects the allocations an adviser suggests for his/her clients. When will Congress act? We simply don't know but the present structure expires soon.

Next Jan. 1, a package of tax changes enacted under President George W. Bush expires. These provisions contained a historic change for dividends: For the first time, most were taxed at the same low rate as capital gains. Until then dividends had been grouped with interest, with both taxed at the higher rates levied on wages. In 2003 the nominal top rate on qualified dividends (usually, on stocks held longer than two months) dropped to 15%, where it has been ever since.

If Congress doesn't act, this reclassification will lapse at the end of 2010, and next year the top dividend rate would automatically revert to 39.6%.

The upshot is that next year the after-tax value of a 4% dividend yield on $100,000 of stock could be anything from $3,400 to less than $2,500 (before state taxes), and higher tax rates could lower the value of the underlying holding. Hardest hit, says Robert Gordon of Twenty-First Securities, could be utility stocks and fixed-rate preferreds with no way to adjust upward. He suggests a portfolio review to check for vulnerable spots.

Good advice.

An Annuity Bubble?

In an article entitled "Annuities: Their Surprising Comeback" Elizabeth O'Brien of SmartMoney chronicled the "surprising" explosion of annuity purchases, especially by boomers. It seems that boomers, having been twice burned by the stock market in their peak investing years, are now twice shy. We have talked about this phenomenon before. My take? The push for yield continues and investors expectations for this asset need to be moderate at best. Maybe something on the order of 6-7% per annum, barring further financial distress.

The link is found here.

When Karin Kuder retired in 2007 from her career as an occupational nurse, she hardly imagined she’d wind up writing a six-figure check to an insurance company and signing away control of her nest egg. But after she lost tens of thousands of dollars in one scary swoop in 2008, she found herself enduring sleepless nights. So Kuder, who’s 62, put more than $150,000 in a fixed annuity, where it grows at a steady rate and can’t shrink if the market drops. “I don’t worry about that money,” Kuder says. “It’s safe.”

They can be a nightmare to understand, even harder to shop for. And yet the inscrutable annuity, a product that’s been around for centuries, is fast becoming the country’s most tempting retirement investment, offering the kind of security that financial advisers say aging baby boomers are grasping for. For years, of course, annuities have been picked apart by critics, and even by some advisers who sell them, for their high fees and bewildering rules. (The number of pages in a typical prospectus for one kind of annuity: 700.) But as economic insecurity lingers, some experts are seeing annuities as a product that can deliver the kind of guaranteed monthly paycheck—in good times and bad—that our parents enjoyed in the age of the company pension.

In a twist that fits a cautious era, it’s the least sexy of these investments that have fared the best. In 2009 so-called fixed annuities attracted $108 billion in assets, 48 percent more than they did two years prior, according to Limra, an insurance trade organization. Although sales slacked off somewhat as the stock market recovered, Americans have still sunk their money into these investments at a rate of about $300 million a day, and the insurers that sell them are pouncing. Major annuity sellers have stepped up their efforts to get employers and mutual fund companies to include annuities in workers’ 401(k) plans. And advisers who’ve backed annuities all along are saying they told us so. Jean Fullerton, a planner in Manchester, N.H., says the number of her clients buying annuities has surged in the past year. “Now that we’ve had the market crash,” she says, “they’ve finally caught up to my thinking.”

The industry certainly has momentum on its side. Most investors haven’t recouped the savings they lost in the crash. In a recent survey by the Employee Benefit Research Institute, roughly one in four people said they might postpone retirement for financial reasons. Annuity providers say they’re prepared to cover that gap; they often cite a study by Wharton School professor David Babbel, who concluded that a retiree who didn’t annuitize some savings would need a nest egg 25 to 40 percent larger than someone with annuities in his portfolio. That study was financed by the insurance industry, but it has swayed some skeptics—even the Obama administration has since given annuities an implicit endorsement.

Still, annuities haven’t gotten any less complicated, and there’s no easy way to compare investments whose features and costs vary depending on who’s selling them and whose prospectuses can rival War and Peace. With these issues in mind, we put together our first-ever ranking of the top annuities. We combed through more than 100 annuity offerings from two dozen major insurers, ferreting out details about their prices and features; we also turned to researchers at Morningstar and A.M. Best to help us gauge their financial strength and uncover hidden fees.
Making the “mortality” wager

For many years, basic annuities were an afterthought: They were briefly in vogue after the tech bust, but as stocks heated up mid-decade, their popularity receded. The latest crash, of course, changed investors’ attitudes—and prompted an unexpected shout-out from the White House. In January the president’s Middle Class Task Force, charged with helping average Joes repair their bank accounts, said that fixed annuities could reduce the “risks that retirees will outlive their savings, or that their living standards will be eroded by investment losses or inflation.” Today the Labor and Treasury departments are mulling over proposals for bringing annuities into the retirement-savings mainstream.

Fixed annuities play a security-blanket role by setting up a slightly creepy wager: The customer gives the insurer a chunk of money, the insurer bets that the customer will die before she gets her money back, and the customer bets she’ll outlive her money and then some. The older the customer is, the more likely it is the insurer will win. That calculus gets converted into a payout through “mortality credits,” explains Chris Blunt, executive vice president of annuity giant New York Life. So a man who buys an annuity at age 70 might get paid 8 percent a year, while a man who buys at 50 would earn less than 6 percent.

What troubles some investors is that fixed really means fixed—as in set in stone, like Medusa’s victims. If the stock market goes up 50 percent, an annuity owner’s annual 8 percent can feel measly by comparison. That’s why for most of the past decade, variable annuities, which invest the customer’s money in mutual funds and potentially pay more, were the hotter investment. Though still an option, those annuities got into some hot water during the crash, inflicting losses on companies that sold them. Today many advisers look more carefully at an insurance company’s financial strength. These ratings are issued by third-party companies; advisers and insurers will disclose them to customers who ask. Grade inflation is rampant in this world, however: B or B+ is the lowest score that most insurers post, and there can be a big difference between a single-A-rated company and a top-rated, A++ company, says Clifford Michaels, a financial adviser in New York City.

Experts also say that fixed annuities aren’t always quite as restrictive as they sound. More companies now allow the buyer’s heirs to keep receiving payments if the buyer dies earlier than expected. Investors can also get payments that rise to adjust for inflation. These features come at a price, in the form of lower monthly income, notes Judith Alexander, director of sales and marketing at annuity consultants Beacon Research. But annuity companies, including New York Life and Nationwide Financial, say they’re doing more to make those features more flexible and, potentially, cheaper.

Still, even financial planners who love annuities don’t sell them to all their customers. They seldom make sense for people in poor health. And for younger buyers, the meager payouts aren’t usually worth the loss of control. The sweet spot for investors begins when they’re in their early 60s. But advisers stress that even then most investors should stash, at most, 40 percent of their assets in annuities, with the remainder in other investments—they need to keep their portfolios growing and have cash on hand for emergencies. Indeed, for a long time, advisers and investors thought of annuities and other investments as an either-or proposition, says Eric Henderson, senior vice president for individual investments at Nationwide: “More and more, people are saying it’s ‘this-and.’”

Here's the takeaway. Annuities become very popular after crises like the tech bust and 2008. They have a role in a portfolio but it's limited. When an advisor legitimatelt believes that his client may outlive his money, AND A PRODUCT IS AVAILABLE, AFFORDABLE AND SUITABLE, then an annuity my be introduced into the investment mix to maximize the probability of funding retirement. (Nothing in life is guaranteed, folks.) Otherwise, annuities are an insurance policy that most can't afford at a time when least desirable, i.e. right when the asset class you were frightened out of (stocks) have the highest return probabilities.