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.