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.