Durable Wealth

A Break In The Action

2010-09-15T11:16:00.002-04:00

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

2010-08-27T07:18:00.002-04:00

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

2010-08-25T05:00:00.001-04:00

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

2010-08-18T10:15:00.000-04:00

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

2010-08-16T05:00:00.000-04:00

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!

2010-08-14T15:00:00.000-04:00

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

2010-08-13T07:13:00.000-04:00

"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

2010-08-10T14:10:00.000-04:00

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

2010-08-03T10:18:00.010-04:00

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.

2010-07-10T07:05:00.004-04:00

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

2010-07-08T06:54:00.001-04:00

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

2010-07-04T05:00:00.002-04:00

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

2010-06-30T06:33:00.002-04:00

“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

2010-06-28T06:23:00.001-04:00

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?

2010-06-22T08:20:00.001-04:00

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

2010-06-18T05:00:00.001-04:00

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.

2010-06-17T06:47:00.006-04:00

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

2010-06-17T04:00:00.001-04:00

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

2010-06-16T05:00:00.002-04:00

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

2010-06-14T05:00:00.007-04:00

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

2010-06-12T13:37:00.003-04:00

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?

2010-06-11T07:46:00.006-04:00

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!

2010-06-09T07:41:00.005-04:00

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

2010-06-04T15:19:00.006-04:00

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

2010-05-30T05:00:00.003-04:00

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

2010-05-26T05:00:00.001-04:00

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

2010-05-24T17:41:00.004-04:00

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

2010-05-24T05:00:00.000-04:00

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!

2010-05-21T05:00:00.001-04:00

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

2010-05-18T09:08:00.001-04:00

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

2010-05-13T13:28:00.003-04:00

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

2010-05-11T10:06:00.004-04:00

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?

2010-05-03T07:06:00.003-04:00

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.

The Rush to Safety

2010-04-30T11:54:00.004-04:00

We have been talking about this dynamic for over a year now. The public usually rushes into an investment class at precisely the wrong time. For the tail end of 2008 and 2009, that asset class was fixed income.

Bond fund inflows reached record levels in 2009. The story is here.

Full-year inflows to bond funds in 2009, including traditional mutual funds and ETFs, reached a record high of $396 billion, according to a report by research firm Strategic Insight.

Long-term mutual funds, including stocks, bond funds and ETFs, experienced net inflows of $425 billion last year, according to the report.

Taxable bond funds had the highest net inflows in 2009, at $324 billion, followed by equity funds with $75 billion and U.S. equity funds with $6 billion.

Emerging markets saw net inflows of $55 billion; ETFs, $114 billion; and traditional index funds, $54 billion.

“There was a lot of demand for bond mutual funds last year,” Avi Nachmany, Strategic Insight director of research, said in a conference call, noting that the total return for bond funds averaged 17% in 2009.

Returns for the asset class were very good last year as the interest rate environment turned out to be very supportive. This year, not so much so. Rates are rising. I expect them to eventually rise much further. When? As soon as the deflationary forces abate. When will we see that? When credit contraction stops and an economic recovery unfolds. Does that exist now? No way.

Investors hated equities in 2008. They will hate bonds at some point too.

Of Two Disconnects: The Economy and Portfolio Performance

2010-04-23T14:54:00.001-04:00

I usually try to refrain from commentary strictly on economics and this post-- while close-- is no exception. There's a huge disconnect between Main Street and Wall Street that exists today and it isn't getting any better. For us to overcome this financial crisis these two sides must meet. We can't long exist in a dichotomous society. From Bloomberg:

Americans are down on the economy and the markets even as stocks and growth indicators are up.

By an almost 2-to-1 margin Americans believe the economy has worsened rather than improved during the past year, according to a Bloomberg National Poll conducted March 19-22. Among those who own stocks, bonds or mutual funds, only three of 10 people say the value of their portfolio has risen since a year ago.

During that period, a bull market has driven up the benchmark Standard & Poor’s 500 Index more than 73 percent since its low on March 9, 2009. The economy grew at a 5.9 percent annual pace during last year’s fourth quarter.

“It’s very difficult to turn perceptions around once you’ve been through the proverbial economic wringer,” says Mark Zandi, chief economist for Moody’s Economy.com. “Everything is colored by the fact that unemployment is near 10 percent. It doesn’t really matter what you ask, you’re going to get the same answer.”

Zandi says the poor performance people report on their investments “is very telling. It’s just a fact that everyone’s stock portfolio is up, or nearly everyone’s.”

Even among investors with annual incomes exceeding $100,000, and who might be expected to follow their financial holdings’ performance, more say they have lost money compared with a year ago than say they have made money.

J. Ann Selzer, president of Selzer & Co., a Des Moines, Iowa-based company that conducted the survey, says the disconnect is typical of the way Americans think about the economy.

‘Everyday Life’ Indicators

“Economists look at their indicators and the American people see indicators in their everyday life,” she says. “It is hard to argue with what people observe in their own communities.”

The poll also finds that Americans remain skeptical about the health-care overhaul even after the U.S. House passed the legislation March 21, with fewer than 40 percent of respondents saying they favor the plan. While most say the government should play a role in ensuring everyone has access to affordable care, a majority say health care is a private matter and consider the new rules approved by Congress to be a government takeover.

Wrong Track

A sense of despair pervades perceptions of the economy and nation. Barely one-in-three Americans say the country is on the right track. Fewer than one in 10 say they believe the economy will be strong again within a year. Just 4 percent of Americans who cut back on spending during the recession now say they are confident enough to open their wallets, according to the poll, which has a margin of error of plus or minus 3.1 percentage points.

Poll respondent Lynn Heath, 31, a Belleville, Illinois, stay-at-home mom with four children whose husband lost his job 18 months ago and since has only been able to find part-time work, says her family has nearly depleted its savings.

“We don’t have cable. We don’t have internet. I just learned how to make laundry soap. For $4, I can make two-and- half gallons,” Heath says.

The Obama Administration has made no progress over the past three months convincing the public that the $787 billion stimulus package passed last year either helped the economy or prevented greater deterioration. Only 37 percent of the public say they see positive effects, the same portion who said so in a December poll.

Economic Deterioration

Asked about a range of economic measures, people say they have seen deterioration over the past year: 54 percent say the condition of businesses in their community has worsened and 56 percent say the value of homes in their community dropped during the period.

Poll respondent Jim Buyer, 47, an electric utility lineman from Syracuse, Indiana, says that his impression of a worsening economy comes from cutbacks in overtime on his job and his observations as he drives to and from work along an industrial road that services home suppliers, toolmakers and recreational- vehicle manufacturers. Media reporting on the economy may be “slanted,” he says, and what he sees has greater credibility.

“We see the traffic in front of where we work,” Buyer says. “A couple of years ago it was hard to pull out at quitting time. Now you almost don’t even have to look because the traffic is so slim.”

Most Important Issue

Half of Americans say they believe the economy or unemployment is the most important issue facing the country. Health care was cited by 22 percent, followed by 20 percent who cite the federal deficit and government spending. Just 5 percent say the war in Afghanistan.

Unemployment in February was 9.7 percent. Payrolls in the U.S. have dropped every month except one since December 2007. Economists expect job growth to turn around in March, with a median forecast that payrolls will rise by 192,000.

Poll respondents rate persistently high unemployment the greatest threat to the economy over the next two years, with 75 percent calling it a high threat. Chronically high budget deficits are cited as a high threat by 70 percent, followed by homeowners who can’t pay their mortgages, which is cited by 58 percent. Higher taxes are deemed a high threat by 57 percent.

Nine of 10 Americans believe that cutting the deficit, which is projected to reach a record $1.5 trillion this year, will require sacrifices from middle-class Americans. Still, when asked about a range of potential tax increases and spending cuts to address the problem, the large majorities of Americans favor tax increases that only affect the wealthy.

More than three of four Americans say deficit-cutters should consider removing the cap on earnings covered by the Social Security tax, currently set at just under $107,000. More than two-thirds say repealing the tax cuts for wealthy Americans enacted by President George W. Bush should be considered.

Smaller majorities favor considering three other options: a reduction in annual cost of living increases for Social Security recipients, which 52 percent say should be considered; cuts in spending on public works, which 54 percent say should be considered; and a penny-an-ounce tax on sugar-sweetened drinks amounting to 12 cents on a 12-ounce can of soda, which 57 percent say should be considered.

Majorities say other options shouldn’t even be on the table. Among them are higher out-of-pocket payments for Medicare services beyond basic care, an increase in the eligibility age for Medicare, a 2 percent increase in income-tax rates on middle-class Americans, and elimination of the home-mortgage interest deduction.

What Hath the Rally Wrought?

2010-04-16T05:00:00.001-04:00

This rally in financial assets is relentless. Perhaps the non-professional doesn't appreciate just how extraordinary it has been but friend Barry Ritholtz of The Big Picture blog has ranked it in terms of return over time and it's in the upper 1% of rallies.

Everyone needs to assess their risk tolerance. This has been a risky market since the Lehman Brothers blowup (and really for some time before that) and it's a risky market now. The difference has been that this is a risky market that's rising at an incredible pace whereas in Fall of 2008 it was a risky market that was falling at an incredible pace. Nimble traders LOVE these kinds of markets.

I don't pen my thoughts in this area for traders. I do it for investors. Big difference. Traders can trade ANYTHING. Investors look at what is possible over their relevant timeframe and allocate capital or decide not to.

What is one of my favorite sources of long term valuation (Smithers & Co.) saying about this market? Take a look:

US CAPE and q chart

With the publication of the Flow of Funds data up to the end of 2009 (on 11th March 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 52% overvalued according to q at the end of 2009. Net worth is virtually unchanged from Q3 to Q4. Domestic net worth fell through dividends ($83 bn.) plus net equity buy-backs ($95 bn.) being greater than net domestic profits after tax ($164 bn.), but this was offset by some small upward revisions to asset values. There was a small increase in the value of US foreign investment abroad ($27bn.), but this was less than the amount of foreign earnings retained abroad, probably due to currency adjustments.

The listed companies in the S&P 500 index, which include financials, were 50% overvalued according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website.

Can you make money in overvalued markets? Absolutely. These conditions can persist for years just as they did in the period 1995-1999 and 2004-2007. Investors who were out of the market in those years due to overvaluation concerns missed some very nice returns. They also missed some horrendous subsequent declines. Those declines have the unfortunate effect of shaking a lot of investors out of their positions in the market. They then miss the subsequent gains. We have spoken of this before.

I am just sharing a valuable source of information. That being said, I am constructively long here with a good deal of risk management in place. It will be interesting to see how this resolves itself.

Happy Tax Day!

2010-04-15T06:52:00.003-04:00

"I'm proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money." -Arthur Godfrey

It's that blessed (blasted?) day again. Here's hoping your returns get filed early and the rest of the day is for, well, REST. I am heading to the tennis courts to have my brains beaten in by some young pro. Should be just as fulfilling as filing returns.

Tax Day Approaches!

2010-04-12T05:00:00.003-04:00

"The expenses of government, having for their object the interest of all, should be borne by everyone, and the more a man enjoys the advantages of society, the more he ought to hold himself honored in contributing to those expenses." -Anne Robert Jacques Turgot

I think Anne Robert Jacques Turgot needs to: a) seriously consider shortening that name, and b) have a gander at the modern tax system and reconsider her statement. Just my opinion.

Timely Reminders

As April 15th approaches, a few items to keep in mind. April 15th is the deadline for funding an individual retirement account, whether traditional or Roth. It's also the deadline for funding a health savings account for 2009. But what if you aren't certain if a Roth or Traditional IRA is right for you? Well, as long as you fund the IRA by April 15th and file an extension, the IRS will give you until October 15th to re-characterize the nature of your IRA contribution.

Some Relief

Choosing to file an extension provides you with additional time to file your actual 1040 and to fund a SEP-IRA. Note: You actually have to request an extension by sending Form 4868 to the IRS.

What Can You Expect?

2010-04-05T06:27:00.004-04:00

Regular readers know that I have very particular views about how and when to invest in the stock market. I don't rant or rave about them but try to get you, dear reader, to consider these views and to do your own research and to come up with your own views about probable returns and investment (not speculative) merit.

Pierre du Plessis of Investment Postcards from Capetown has recently written an excellent article on starting valuations and probable returns that I think is a must read for all investors. The entire article can be found here. But for a sneak peak as to what can be expected from investments in the S&P 500 at these levels, I give you this chart:

The chart gives the expected RANGE of returns given starting valuation of the market. Low starting valuations (low price to earnings ratios) are at the left. High valuations are at the right. The chart has a definite downward skew from left to right and shows that NEGATIVE RETURNS are quite possible some time ten years forward from any starting valuation over 12! What does du Plessis calculate as the present starting valuation? 20.3! Read the entire article. I leave you to conclude whether a buy and hold allocation to the general market makes sense at these levels FOR YOU. Yesterday's dyed eggs may be a more pleasant experience.

Happy Easter!

2010-04-04T07:07:00.002-04:00

We have small children in this family. For them, Easter is a lot about the above. Easter egg hunts, baskets and candy. It's also about family and friends and Easter dinners. We'll have all of that today and it will be a great one. Hope yours is too.

Give Me a Break!

2010-03-26T05:00:00.001-04:00

Taxes are going up. You can take that to the bank (or maybe you can't!). This and future administrations will need to pay for existing programs and deficits and new ones that are layered on. That is, of course, unless fiscal prudence comes back into vogue. Here's a tax break that every parent of a school aged child should know about and a way to take advantage of it even for high earners. Writer Bill Bischoff of SmartMoney gives us the refresher on the The American Opportunity credit for 2009.

If you earn a healthy income, then you probably don't qualify for the higher-education tax credits intended to help pay college-tuition bills. However, your college-age child just might.

Both the American Opportunity credit (maximum $2,500 for 2009) and the Lifetime Learning credit (maximum $2,000) help soften the cost of postsecondary education. The American Opportunity credit is available only for the first four years of college, while the Lifetime Learning credit can be used at any time and doesn't have a degree or workload requirement.

Unfortunately, you can't take both credits for the same student in the same year, and many parents earn too much to be eligible for either one. That's because in tax year 2009, the American Opportunity credit is phased out starting at an adjusted gross income, or AGI, of $160,000 for joint filers and $80,000 for unmarried individuals. At AGI levels of $180,000 and $90,000, respectively, the credit is completely phased out. The Lifetime Learning credit is phased out starting at AGI of $100,000 for joint filers and $50,000 for unmarried individuals.

At AGI levels of $120,000 and $60,000, respectively, you're completely ineligible.

As you might imagine, plenty of parents fall into the phased-out category. But even if you're among them, these valuable credits may not have to go to waste after all.

Here's how: Arrange things so your college-age child can claim one of these credits instead of you. To implement this strategy, you must forgo the dependency exemption deduction for your child ($3,650 for the 2009 tax year). Then the education tax credit becomes the property of your child, whose income is presumably well below the phase-out range.

The now-liberated education credit can cut your college-age child's tax bill by quite a bit. Remember, however, the credit is worthless to your child unless he or she has enough taxable income to actually owe the IRS. This income could be from summer jobs, work-study at school or income and gains from investments held in your child's name.

Also, keep in mind that this strategy makes the most sense when your AGI is quite high. Why? Because your dependency write-off for your college kid is itself partially phased out between an AGI of $250,200 and $372,700 for joint filers and between $208,500 and $331,000 for heads of households.

So giving up that dependency deduction on your 2009 tax return may not cost you all that much. (This strategy does not permit your child to claim an exemption on his or her return; the exemption belongs to you whether you choose to use it or not.)

As always, see your planning or tax professional for details and application.

Travelling

2010-03-24T07:30:00.000-04:00

A good friend's parent has passed after a short illness. I shall be back later this week.

Households Paring Debt (Slightly)

2010-03-11T18:33:00.004-05:00

The Fed’s Q4 2009 Flow of Funds statement is out. For those who aren't savvy to this report, it shows the balance sheet of the US, including households, companies and government. It reveals an improvement in the aggregate debt levels on an absolute basis but, shall we say, progress is slooow. Household debt (home mortgages and consumer credit) as a percentage of disposable income fell to 115% from 117% in Q3, vs 121% in ‘08, and versus the record high of 125% in 2007 and is back to the lowest level since 2004. However, it remains well above the level of 10 yrs ago (91%) and 1995 (83%).

It is my belief that we have to work back toward those 1995 levels in order to have the economy back on a sustainable path. Leverage does not produce wealth.

The Quest for Yield: Master Limited Partnerships

2010-03-09T13:00:00.001-05:00

Some financial planners are using master limited partnerships, or MLPs, to diversify retirees' portfolios, provide dividend income and try to hedge against inflation. No free lunch though. There are risks involved.

MLPs are typically limited partnerships that are publicly traded on a U.S. securities exchange. (I wouldn't touch the non-publicly traded ones.) Standard & Poor's has a report you can read explaining the market for them. You can read it online at www2.standardandpoors.com/spf/pdf/index/MLP_Primer_Nov2008.pdf.

Many MLPs are in the pipeline business. In essence, you get paid for the volume going through the pipe, so the cost of the gas doesn't affect you. Others have commodity price risk embedded in their models. I'd stay away from those.

The attraction to MPLs are their high yields. You can still find MLPs with yields of 8% or so. During the downturn these yields got REALLY rich.

When held in taxable accounts, MLPs provide some attractive tax advantages. Because of its structure, an MLP gets to pass its depreciation of assets and expenses through to investors, who may be able to use the pass-through expenses to reduce or eliminate the tax on the income received from that particular investment.

But you would lose that tax advantage by holding MLPs in a tax-deferred individual retirement account, and you have to pay ordinary income tax on any distributions you eventually take.

And if an MLP investment generates what is known as "unrelated business taxable income," which is likely, the IRA has to file a separate tax return and pay any tax involved from assets in the account.

How to fix this? First, you may want to consider converting your traditional IRA to a Roth so that you don't have to pay income tax on future earnings (subject to Roth holding rules). However, your account could still be subject to unrelated-business income tax.

Or you could make future investments in "closed-end" funds that invest in a number of publicly traded MLPs. Such funds aren't subject to the unrelated-business income tax, but still could benefit from potential returns. However, the returns from these funds tend to be slightly less as they absorb all the tax consequences.

All in all, an intriguing avenue for yield hungry investors. See your advisor for details.

Life Changes, Withholding and Your W-4

2010-03-03T19:53:00.005-05:00

When you are through changing, you are through. -Bruce Barton

As you know if you are a regular reader, my family has moved due to a recent job change by my wife. Goodbye Northeast. Hello (again) Midwest. This has brought huge changes to our lives. She travels much more. Mark is seeing a LOT of the kids and little of the outdoors and, since we have a much bigger house thanks to the happy coincidence of geography, we are making a local furniture store very happy.

When you make significant changes like this you need to step back and see how they effect your financial planning. Some changes are obvious; some more subtle. One obvious effect is that state taxes are different. New state, new returns to file. More subtle: State laws govern wills and trusts. Better have a quick chat with my estate planning attorney to see if we need to do anything.

With the new job has come a new paycheck. How should we think about IT for planning purposes? Well, if you work for an employer that automatically withholds taxes from each paycheck, then you have the ability to adjust how much is withheld by adjusting the exemptions on IRS Form W-4. This is a thinking process you should undertake for many significant changes such as:

* Having a child
* Getting married or divorced
* Buying or selling a home
* Number of "claimable" dependents changes
* Changes in retirement
* Changes in college savings contributions
* Change in employment

So look at last year's return. Did you receive a sizable tax refund last year? You just gave an interest-free loan to Uncle Sam. Or did you owe the IRS money? You didn’t withhold enough and you may even owe (arrgh!) a penalty. Your goal should be to strike a balance so that you receive little or no refund.

The W-4 form has instructions and a worksheet that can walk you through the exemptions, but, frankly, that can be a bit intimidating. You can find those here. Unbelievably, the IRS has a very useful tool that can help you estimate what you should claim on your W-4 so that you don’t have to guess: IRS Withholding Calculator. I've tried it and it's pretty darn useful!

Finally, the W-4 will take care of your federal tax withholding, but you should check with your employer or your HR department to see if any changes need to be made to your state withholding.

Lessons

2010-02-27T05:00:00.003-05:00

The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changes and yet everything is completely different.- Aldous Huxley

I like Jeffrey Saut of Raymond James. I think his market analyses are some of the best around. He tends to be a bit too bullish for me but then again he comes from the sell side where that bias is expected and encouraged. You just have to know who you are reading. That thought is evident from my prior post on Jeremy Grantham.

Saut penned a great January piece called "Lessons" that I intended to get up in, well, JANUARY, but it somehow slipped through the cracks. Sometimes when that happens (me forgetting not Saut writing something good) I confine the piece "to the dustbin of history". Not this one. It's good enough to revive. Here it is:

Lessons
January 4, 2009

Year-end letters are always hard to write because there is a tendency to talk about the year gone by, or worse, attempt to predict the year ahead. Therefore, we are titling this year’s letter “Lessons” in an attempt to share some of the lessons that should have been learned over the past year. We begin with this quote from an Allstate commercial featuring Dennis Haysbert:

“Over the past year, we’ve learned a lot. We’ve learned that meatloaf and Jenga can actually be more fun than reservations and box seats. That who’s around your TV is more important than how big it is. That the most memorable vacations can happen ten feet from your front door. That cars aren’t for showing how far we’ve come, but for taking us where we want to go. We’ve learned that the best things in life don’t cost much at all.”

Charles Dickens’ classic novel A Tale of Two Cities begins with the quote, “It was the best of times, it was the worst of times.” That quote is certainly reflective of the stock market in the year gone by as 2009 should go down in the books with that moniker. To be sure, 1Q09 was ugly with the S&P 500 (SPX/1115.11) surrendering nearly 30%. From those March “lows,” however, the SPX has gained some 69%. For those that targeted the “lows” it has been a great year. For those that didn’t, it has truly been “the worst of times,” for after losing ~58% in the SPX from the intra-day highs of October 2007 into the intra-day lows of March 2009, they have not come close to recouping the monies lost in that downdraft. The lesson that should have been gleaned is that if participants would have managed the risk (read: not allow positions to go too far against them before taking some kind of action; i.e., hedge, sell, etc.), they would have missed much of the SPX’s 2008/2009 downside debacle and in turn done pretty well over the past two years. As often referenced in these missives, investors need to manage the risk, for as Benjamin Graham espoused in his book The Intelligent Investor, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”

Investors should keep that quote on their walls so they don’t forget the major lesson of 2008/2009. Yet, there are other lessons to be remembered. To that point, Merrill Lynch lost two of its best and brightest in 2009 as Richard Bernstein and David Rosenberg left for less constrained environments. During their final weeks at Merrill they wrote about lessons they have learned. To wit:
Richard Bernstein’s Lessons

1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important than are capital gains.
2. Most stock market indicators have never actually been tested. Most don’t work.
3. Most investors’ time horizons are much too short. Statistics indicate that day trading is largely based on luck.
4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.
5. Diversification doesn’t depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.
6. Balance sheets are generally more important than are income or cash flow statements.
7. Investors should focus strongly on GAAP accounting, and should pay little attention to “pro forma” or “unaudited” financial statements.
8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.
9. Investors should research financial history as much as possible.
10. Leverage gives the illusion of wealth. Saving is wealth.

David Rosenberg’s Lessons

1. In order for an economic forecast to be relevant, it must be combined with a market call.
2. Never be a slave to the data – they are no substitutes for astute observation of the big picture.
3. The consensus rarely gets it right and almost always errs on the side of optimism – except at the bottom.
4. Fall in love with your partner, not your forecast.
5. No two cycles are ever the same.
6. Never hide behind your model.
7. Always seek out corroborating evidence
8. Have respect for what the markets are telling you.

There was another sage that left Merrill Lynch, but that was 18 years ago. At the time Bob Farrell was considered the best strategist on Wall Street, and while he still pens a stock market letter, his “lessons learned,” written back then, are as timeless today as they were in 1992.

1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras – excesses are never permanent.
4. Exponential rising and falling markets usually go further than you think.
5. The public buys the most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chips.
8. Bear markets have three stages.
9. When all the experts and forecasts agree – something else is going to happen.
10. Bull markets are more fun than bear markets.

With these lessons in mind, we wish you good investing in the New Year.

Grantham’s ‘Horrifically Early’ Forecasts

2010-02-25T05:45:00.000-05:00

It seems that others are "discovering" just how prescient Jeremy Grantham can be with his views on stock market valuations. The twist? He is often too early, "costing his clients money". You can read the full Bloomberg story here.

Jeremy Grantham warned in January 2000 that U.S. equities were “more overpriced than at any time in the last 70 years due to the massive overpricing of technology and especially dot-com stocks.”

By the end of 2002, the Standard & Poor’s 500 Index had fallen 40 percent and technology shares were down 73 percent. The forecast didn’t help his firm, Grantham Mayo Van Otterloo Co., because he’d been bearish since 1997. Assets declined 45 percent in the late 1990s as customers sought out better- performing mutual funds that liked the technology stocks Grantham disdained.

Grantham said in an interview that his negative calls are often so early that investors who acted on them gave up gains before prices peaked. He recommended avoiding Japanese stocks more than two years before they started falling at the end of 1989. While his timing doesn’t deter fans like former Harvard University endowment manager Jack Meyer, it requires a delicate balancing act by GMO, which oversees $107 billion.

“We lost business like it was going out of style,” the 71-year-old Grantham said of his dot-com prediction at a Jan. 28 speech to investment advisers in Boston, the home of GMO, which he co-founded in 1977.

GMO’s funds usually don’t fully adopt his recommendations, or hedge their bets, underscoring the difference between being a star strategist and successful money manager. That’s true for the fund Grantham works most closely with, GMO Global Balanced Asset Allocation, which oversees $3.1 billion.

Setting Off Alarms

The tension between acting on a long-term vision and keeping clients happy in the short run is a fact of life for all money managers, said Charles Lieberman, chief investment officer at Advisors Capital Management LLC in Hasbrouck Heights, New Jersey, which oversees about $190 million. “The issue is: Are you willing to stick your neck out and how far?” he said in a telephone interview.

The tension is heightened at GMO, where Grantham’s warnings of investment bubbles have at times sent customers packing for firms with a more upbeat view of the markets.

“If we are too aggressive, and we don’t get it right, we run the risk of being fired,” Ben Inker, GMO’s head of asset allocation, said in a telephone interview.

Two of Grantham’s most recent forecasts were right -- and timely.

Emerging Markets

In 2007, he wrote in his newsletter that all asset classes were overvalued and it was time to sell high-risk securities. GMO’s $2 billion Emerging Country Debt Fund, which held high- yielding securities from countries such as Venezuela and Argentina, decided to stick with those investments in 2008.

“Every bet we made turned out to be wrong,” Thomas Cooper, the fund’s co-manager, recalled in an August interview, pointing out that investors sought out safer securities during the financial crisis. The fund lost 33 percent in 2008, and the following April GMO was fired by the Massachusetts state pension system as manager of $230 million in emerging-market debt.

The fund bounced back, returning 50 percent in 2009. Its 14 percent annual return over the past 10 years made it the best performing bond fund, according to Chicago-based Morningstar Inc.

“Jeremy has been a great long-term investor,” said Meyer, who ran Harvard’s endowment for 15 years until 2006, when he left the Cambridge, Massachusetts, university, to start Convexity Capital Management LP, a Boston-based fund manager. Grantham was ahead of the pack in the 1990s identifying the value of emerging-market stocks, inflation-adjusted securities and timber, Meyer said in a telephone interview.

‘No Justice’

In March 2009, when the S&P 500 index bottomed out at 676, Grantham wrote that fair value for the benchmark of the largest U.S. stocks was 900, or 33 percent higher. By July, with the index above that mark, Grantham concluded U.S. stocks had become too expensive again.

“After 20 years of more or less permanent overpricing, we get five months of underpricing,” he told newsletter readers. “There is no justice in life.”

The fair value of the S&P 500 today is 850, 23 percent below yesterday’s close of 1103.94, said Grantham. He arrives at that valuation by assuming a long-term average price-to-earnings ratio of about 15 for U.S. stocks and applying it to a long-term average for profit margins.

Grantham is chief investment strategist at GMO, whose assets have risen almost fivefold since 2000. Its more than 40 mutual funds usually require a minimum investment of $10 million and are aimed mainly at institutions such as pension funds and endowments, according to the firm’s Web site. The firm also acts as a sub-adviser on several retail mutual funds.

.....

Current Outlook

Grantham’s favorite asset class today is high-quality U.S. stocks, companies defined by high, stable returns and low debt. The allocation fund had 31 percent of its money in that category at year-end, sometimes called blue chips, according to the GMO Web site. In the interview, he said he expects such stocks to return an average of 6.8 percent a year over the next seven years, compared with 1.3 percent for all large-cap U.S. stocks.

Emerging-market stocks may rise about 4 percent annually in the next seven years, as investor enthusiasm for economic growth in developing countries carries the stocks to unsustainable levels, Grantham said.

“Why not go along for the ride?” he said. The MSCI Emerging Markets Index returned an average of 22 percent in the past seven years, compared with a gain of 5.5 percent by the S&P 500 index.

U.S. government bonds will return 1.1 percent a year over the seven-year period, according to the latest GMO forecast. The Bank of America Merrill Lynch U.S. Treasury Master Index rose 4.3 percent from 2003 through 2009.

Grantham said he expects a difficult, not disastrous, period for the economy and investments.

“It will feel like the 1970s,” he said. “One step forward, one step back.”

.....

No ‘Permabear’

Grantham dismisses his “permabear’” label, saying that in 2000 he was bullish on emerging-market stocks, real estate investment trusts and inflation-adjusted bonds. GMO data show that the three asset classes returned between 4.9 percent and 8.1 percent a year in the 10 years ended Dec. 31. The S&P 500 lost 1 percent a year over the same stretch.

Looking back on more than 40 years in the investment business, Grantham summed up his career this way: “We win all the bets but we are horrifically early,” he said.

I have benefited immensely by reading Grantham's writings and, to an extent, following his calls. My personal IRA accounts are much the better for it.

The man knows his "weaknesses". You can chart his calls against the market (as I have done) and discover that he is sometimes as much as three years (!) early with his calls. An investor would give up a portion of those gains if he switched equity exposure to bonds but -- and here is the important point-- he would sidestep large declines. This strategy isn't for everybody but it works for me.

As always, consult with your advisor if you wish to take this further.

Winter Break

2010-02-19T20:53:00.004-05:00

Okay, so I won't be playing PineHills this weekend but a man's gotta dream! Back on Wednesday.

Annuities in 401k Plans?

2010-02-17T05:00:00.001-05:00

Insurers and mutual-fund companies are have become aware that the decade's poor stock market performance and low fixed income yields means there's an acute danger that Americans will outlive their savings.They've responded by selling annuities as holdings for 401k plans.What's an anuuity you say? Rather than go into the details of straight annuities ad all their permutations I will point you to the explanation given by Investopedia:

Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Annuities can be structured to provide fixed periodic payments to the annuitant or variable payments. The intent of variable annuities is to allow the annuitant to receive greater payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.

That's an annuity. Picking up the story, written by Bloomberg's reporter Martha Collins:

The different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their needs. President Barack Obama on Feb. 1 called for a change in government rules to allow adding annuities to 401(k) retirement plans. While the annuities offer a steady stream of income in exchange for upfront payments, the price for peace of mind may be higher fees and less access to cash.

“You’re paying for a benefit that you may or may not use,” said Glenn Daily, a fee-only insurance consultant, referring to annuities. “These things are so complicated I doubt many people will understand what they’re buying.”

MetLife Inc. and Prudential Financial Inc., the two largest U.S. life insurers, are aiming to tap into what may become a $1 trillion market by blending annuities with target-date 401(k) funds, which shift to more conservative assets such as bonds as an investor nears retirement. The funds were used as the default investment by 87 percent of retirement plans in 2008 with automatic enrollment, according to Vanguard Group Inc.

Insurers are working with mutual-fund companies to build the guarantees into 401(k) funds because state laws require an insurance charter to sell annuities.

The income guarantee that insurers and mutual-fund companies are developing lets workers pay for an annuity in installments using their regular contributions to retirement accounts, said Garth Bernard, chief executive officer of the Boston-based Sharper Financial Group, which specializes in retirement income solutions for financial companies.

Fund Scrutiny

Legislators have scrutinized target-date funds because some lost as much as 41 percent in 2008. The funds attracted $45 billion last year, up from $28.7 billion in 2006, according to Chicago-based Morningstar Inc.

“It’s a huge market,” said Tom Johnson, senior vice president in New York Life Insurance Co.’s retirement income security business, of the potential for annuity/retirement accounts. Americans held $6.8 trillion in 401(k) plans and IRAs as of September 2009, according to the Investment Company Institute, a Washington-based mutual fund trade group. If 15 percent of those assets went to guarantees, it could mean more than $1 trillion for insurers, Johnson said.

“We believe guaranteed income is important because it locks in a level of retirement income,” said Jamie Kalamarides, senior vice president of retirement solutions for Prudential, based in Newark, New Jersey. “Most Americans aren’t saving enough.”

Prudential, MetLife

Prudential and MetLife have already introduced income guarantees designed for target-date funds. Investment-management firm BlackRock Inc. is offering to employers a target-date fund with a MetLife annuity as the fixed-income component, said Kristi Mitchem, head of New York-based BlackRock’s U.S. defined contribution.

Asset manager AllianceBernstein Holding LP is working on a similar product with multiple insurers including Axa SA, while Putnam Investments LLC expects to announce a lifetime income benefit for its 401(k) funds this year, the companies said.

Fidelity Investments, the largest target-date fund provider, offers employers a 401(k) fund with an annuity through insurer Genworth Financial Inc., said Michael Doshier, vice president of the Boston-based company’s workplace investing group. Vanguard is also exploring income stream options within its retirement plans, said spokeswoman Linda Wolohan.

Two Forms

The types of guarantees being developed vary and have trade-offs, said Bernard of Sharper Financial. One type has relatively high fees and another prevents retirees from liquidating their savings once they start receiving monthly income, he said.

Annuities and guaranteed income benefits in retirement plans can be an important safeguard against outliving savings as more Americans fund their own retirement, said Moshe Milevsky, a finance professor at York University in Toronto. Combining them with target-date funds is a concern, he said.

“Let’s not get carried away,” said Milevsky, who specializes in insurance. “To say that we are going to lever these guarantees on top of target-date funds that have not been fully tested yet, I’d be wary.” The Department of Labor endorsed target-date funds as a default investment option for employers in 2007.

The Treasury and Labor departments started reviewing public comments this month on how to make it easier to convert savings into lifetime income streams.

Government Guidance

“Many plan sponsors would like explicit guidance from regulators,” said Tom Idzorek, chief investment officer at Ibbotson Associates, a unit of Morningstar. A government endorsement would create “a rush of sponsors trying to add these to plans,” he said.

Last year, 4 percent of employers offered a plan that allowed participants to allocate a portion of contributions to an income guarantee, according to Callan Associates Inc., which surveyed 90 plan sponsors with more than $100 million in assets. The previous year, the total was 3 percent. Employers are concerned about cost, portability and how to pick an insurance provider, said Lori Lucas, defined contribution practice leader for the San Francisco-based investment-consulting firm.

Annual fees for guarantees in 401(k)s can be 95 basis points or more above the retirement plan’s investment-management fees, she said. A basis point is 0.01 percentage point.

“Those fees may reduce account values by 7 percent to 9 percent over 10 years,” said Drew Denning, vice president of retirement and investor services at Principal Financial Group Inc. The Des Moines-based firm, the fourth-largest provider of target-date funds, recommends investors wait until retirement, when they know their financial circumstances, before deciding to shift a portion of their savings to an annuity, Denning said.

Switching Insurers

Employers also are concerned that guarantees will prevent employees from exiting their retirement plans if they transfer jobs, said John Carl, president of the New York-based Retirement Learning Center, which consults plan sponsors.

“The portability of these contracts at this juncture is minimal between insurers,” Carl said. “You’re essentially locked into the program you choose -- or are defaulted into.”

That’s because an insurer calculates its annuity payments based in part on the life expectancy of a pool of individuals holding such contracts, which makes it harder to switch from one insurer to another, Carl said.

Solvency of the offering company is another impediment, said Robert Toth, an attorney who specializes in retirement plan products and services.

“How do you make a decision that the insurance company will still be here 30 years from now?” said Toth, who is based in Fort Wayne, Indiana. “Employers fear making that choice and being responsible.”

Longevity Insurance

Longevity insurance, another type of income guarantee, may be a better, cheaper option for protecting against outliving savings, said Daily, the New York-based insurance consultant. Longevity insurance guarantees future monthly income typically around age 80 and may be less expensive because “you’re only buying the tail end” of the benefit, Daily said.

“Why should you take the plunge now instead of waiting?” said Daily. “Some of these guarantees are so hard to value that you have to be an economist to figure it out.”

That's a balanced article and I compliment Ms. Collins for presenting it that way.

Reading Is Fundamental

2010-02-10T05:00:00.002-05:00

Barry Ritholtz of the Big Picture blog is both a friend and constant read for me. I think some of his best writing is on the fundamentals of investing. See here. But today's post is about his reading list for beginning investors. It's not exhaustive. It's kind of eclectic. But it's a very good list and I can't really quibble with what he includes. Here's his list and his comments on each selection:

Introduction to Investing

Any one of these books will give you insight into investing and the markets. All three will make an essential base for future studies:

Jack D. Schwager: Stock Market Wizards : Interviews with America's Top Stock Traders

Schwager interviewed market legends at the height of their success. What makes the book so worthwhile are the consistent themes that evolve from currency traders, mutual fund managers, commodities traders, hedge fund managers. Regardless of what is being traded, there are related motifs that run throughout.

What results is not a “How to trade” book; instead, it is a book about “How to think about trading.”

This has become a seminal book on trading and investing. I actually re-read Market Wizards every five years — it is that good. Wizards was so well received by the financial community that the same author put out The New Market Wizards. Whether you read one or both of these books, you will have knowledge of the market from both the trader’s and the investor’s perspectives.

Charles D. Ellis: The Investor's Anthology: Original Ideas from the Industry's Greatest Minds

Instead of interviewing famed investors, Ellis gathered their best writings into one collection. He ends up with a series of short chapters by luminaries of days gone by. There is something worthwhile on just about every page. This is another favorite worth rereading every few years.

Maggie Mahar: Bull: A History of the Boom and Bust, 1982-2004

The best book about the past 20 years of the market, bar none. Mahar does a terrific job weaving the long tale of how things eventually reached their penultimate top in 2000. She spares no one — the government, the Fed, Wall Street, her colleagues in the financial press — all are subject to a scathing critique for their complicity in inflating the bubble.

Bull! reads like a historical work, despite the recentness of its subject. There are a surprising number of lessons buried in these pages that will reward the careful reader. I found it both fascinating and informative.

Historical Perspectives

It’s astounding how little things have changed over the past century. Yes, information moves more quickly, and computing power has allowed for a more quantitative analysis of stocks — but human nature remains immutable. (Mark's note: I thoroughly enjoyed this book.)

How I Trade and Invest in Stocks and Bonds by Richard Wycoff

Quite simply, this is one of my favorite books on the markets and investing. The fact that it is from 1923 is totally irrelevant. If I could reprint the book with each mention of “coal” replaced with “oil,” and if I substituted “Internet” for any time the word “railroads” appeared, you would have no idea when this was written. Indeed, you would think it was a current work.

There is probably more market intelligence and trading wisdom in this book per word than any other I have ever read. I strongly recommend this one.

Reminiscences of a Stock Operator by Edwin Lefevre

By now, you have probably heard the story of Jesse Livermore. If you have ever said, “The trend is your friend” or “Let your winners run and cut your losses quickly,” then you were quoting Livermore — even if you didn’t know it.

This is an absolutely exhilarating read. In fact, it is so much fun, it shouldn’t count as homework or research.Coincidentally, this was also published in 1923 — apparently a good year for market-related books. (Mark: This reads like a thriller. Couldn't put it down.)

Psychology

As a species, we are notoriously bad at understanding our own thinking and emotions. We are even worse at predicting our own behavior. Understanding your own mind and those of your fellow investors is crucial to successful investing. These books will go a long way to helping you understand your hardwired weaknesses and blind spots.

Thomas Gilovich: How We Know What Isn't So

This is one of the most influential investing books you will ever read. So many of our own foibles are detailed here that it is almost embarrassing. Everything from unsuspected biases to how we engage in critical reasoning comes under scrutiny. What it reveals isn’t pretty. Despite the genius that is human achievement, it turns out that we are all very poor at comprehending complex data and analyzing risk.

This book will help you understand how your brain: processes randomness; overlooks evidence that is inapposite to prior beliefs; selectively perceives and reinterprets data; and engages in selective recall. It’s how we all create an artificial story line to help make sense of otherwise incomprehensible data.

Once you finish this book, you will never look at investing the same way.

Note: This is purely psychology writing; If you prefer a more specific investing-related analysis, consider Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics by the same author (with Gary Belsky).

Gary Belsky: Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics

Hard-core fans of cognitive biases and economic anomalies (and other similar type of analyses) will also appreciate Richard H. Thaler’s The Winner’s Curse. Thaler is one of the most influential researchers in the field of behavioral economics.

Richard H. Thaler: The Winner's Curse

If you want to see how cognitive and reasoning deficits manifest themselves, then the seminal book on the subject is Extraordinary Popular Delusions & the Madness of Crowds by Charles Mackay. There have been a lot more booms and busts then you imagine. This book details how they came about and their impact throughout history. Fascinating and instructive stuff.

Charles Mackay: Extraordinary Popular Delusions & the Madness of Crowds

Once you understand how our brains fool us into occasionally doing idiotic things — funny, but it seemed perfectly reasonable at the time — then you can start looking for ways to avoid making those gaffes. Humphrey Neill’s Art of Contrary Thinking will show you the way. He explains why “When everyone thinks alike, everyone is wrong.” This intriguing thesis applies not only to markets, but to politics, academia, even sports.

Humphrey B. Neill: Art of Contrary Thinking

What if human nature can never learn from its mistakes? What if we are doomed to repeat the aforementioned cognitive, reasoning and behavioral defects over and again? That provocative thesis is put forth by Robert R. Prechter Jr.: Prechter’s Perspective. This is the book that explains why our own nature leads to history repeating so often.

Robert R. Prechter Jr.: Prechter's Perspective

A few caveats: I am not a devotee of Elliot Wave theory (Prechter’s school of choice). Further, I hasten to add that many of Prechter’s market calls have left much to be desired. However, his overarching perspective of human nature, and of history’s cyclical tendencies, makes for utterly fascinating reading. Even though I found myself arguing with many of the premises in the book, I enjoyed this thoroughly. The cycle geeks out there will too.

A great beginner's list!

Roth Conversion Strategies

2010-02-08T05:00:00.000-05:00

2010 is The Year of the Roth. This has been a constant theme of mine in this blog as I attempt to highlight the opportunity and point out some of its dangers and pitfalls.

As with most strategies there is an "offensive" way to play it as well as a "defensive" way. The following article is definitely an offensive-minded strategy, involving account-splitting and characterization reversals. I hadn't thought of this. Here's what was written:

U.S. investors who convert a traditional Individual Retirement Account into two or more Roth accounts to make a bet on the market rising can save on taxes if it doesn’t.

The multiple Roth IRAs should be split among different investments, according to Joseph Spada, managing director of Summit Financial Resources in Parsippany, New Jersey, whose average client has $25 million in net worth. A conversion can be reversed if some of the assets lose value, saving $140,000 in income taxes, for example, on an account worth $1.2 million.

“The IRS is giving you a bucket of mulligans with your IRA,” said John Bledsoe, a Dallas-based estate planner, referring to the term used in golf for a do-over. Investors who convert to a Roth IRA have until Oct. 17, 2011, to undo their decisions and recoup taxes paid, said Bledsoe, author of “The Gospel of Roth,” whose average client has $100 million or more in assets.

The Internal Revenue Service lifted income restrictions this year on converting a traditional IRA to a Roth IRA, meaning U.S. taxpayers making more than $100,000 a year in adjusted income can make the transfer. There’s no limit on conversions if an investor has multiple IRAs or a cap on the amount that can be converted.

Those who switch from a traditional IRA, where taxes are paid only on withdrawals, to a Roth IRA, must pay income taxes upfront in exchange for tax-free withdrawals during retirement. A taxpayer in the top income bracket with an IRA worth $1.2 million would pay 35 percent or $420,000 in federal taxes when converting the account into a Roth IRA this year.

Three-Way Divide

A $1.2 million account could be divided into three Roth IRAs worth $400,000 each, Spada said. The first account may be invested in fixed income, the second in equities and the third in high-yield bonds. If one fund lost value, the investor would save the 35 percent tax paid on the $400,000 account, or $140,000, by recharacterizing that Roth IRA into a traditional one, Spada said.

“You don’t want to pay the tax on an account that actually went down in value,” Spada said. Undoing the conversion doesn’t change the fact you lost money on your investments, which is why investors shouldn’t take more risk than they normally would when converting to multiple Roth IRAs, he said.

Free Look

Theodore Lustig converted his family’s IRA into three Roth accounts with different asset types on Jan. 4. The 55-year-old attorney put the first account in fixed income, the second in oil stocks and the third in U.S. bank stocks.

“You have a free look,” said Lustig, who’s based in Dallas. “You have until October 2011 to see how your investments have performed.”

Lustig said he could reverse the conversion on accounts that decline or, “if everything works out,” pay a lower tax on income from accounts converted in January that rise in value.

“Even if it turns out that I will save taxes by converting, the conversion may still be undone if I just get cold feet or have unforeseen expenses and no longer want to pay the taxes on the income,” he said.

Wow. Combine a complicated law with a monetary incentive and all sorts of things can happen. Sort of like derivatives. Or securitization.

I don't have an opinion on these strategies. They purport to give a free lunch, something I don't believe exists in this world. I guess I would want to have a LONG conversation about them before I even considered them. As every tax attorney can tell you, "recharacterization"-- when used by the IRS-- is painful. So can be updated guidance, revenue rulings and tax cases. As with everything on this blog, do your own due diligence.

Focus On What You Can Control

2010-02-04T06:37:00.007-05:00

Elsewhere I have pooh-poohed the annual ritual engaged in by pundits, investment houses and their economists, bloggers and newsletter writers of forecasting the direction of the markets over the coming twelve months. I don't think it can be done. It's financial porn. It may be entertaining to read but destructive in the long term. (Note: Readers know that I believe you CAN estimate long term returns from asset classes once you know starting valuations.)

As Larry Swedroe, investment manager and author of "The Only Guide to Alternative Investments You'll Ever Need" has said:

There seems to be some great human need for us to believe that there is someone who can tell us where the economy and the market is going. The best thing for people to do is recognize that there are no forecasters [who can do this].

What to do then? Well, in my opinion (and Swedroe agrees) you should focus on the things you can control. What are they?

(1) You can control how much you save.
(2) You can control how much you pay in taxes via tax efficient investment vehicles and strategies.
(3) You can control how much risk is embedded in your portfolio.
(4) You can control how much you pay in costs for your portfolio (advisor fees, trading costs).
(5) You can control how much volatility the portfolio is designed for.

Can readers suggest other things you can control?

ADDENDUM (2/6/10, 6:10AM)

Fidelity has now introduced a no trading fee program in 50 exchange traded funds (ETFs). Charles Schwab has done something similar. For asset allocators this is big news. Portfolios can be bought and rebalanced without costs. Since costs are a large part of the drag on individual investor portfolios, removing this drag has immediate benefits to performance. What is the downside? Temptation into frequent trading. What is in this for Fidelity and Schwab? Attraction/retention of customers.

Planning Basics: Fiscal Fitness Day

2010-02-01T05:00:00.003-05:00

Here's an idea I think should catch on. Instead of taking a "mental health day" or a "stay-cation", why not try a "financial wellness day" (okay, two days) to get your financial life in order? That's exactly what Ron Lieber of the New York Times suggested in this July 2009 article. It's an idea that has gotten some attention. Here's what Lieber wrote:

Like many of you, I suspect, I have a never-ending, ever-multiplying list of undone money tasks. There are always a few accounts that charge too much or pay too little interest, service providers to haggle with and opaque insurance forms that beg questions. Who has time for all but the most essential items on this list on any given day? Or in any given month, for that matter?

So I decided to spend 10 or 12 hours trying to cross off every single item on my list. The goal wasn’t merely completion. I also hoped to actually gain back the money I had lost to the pay cut, either through savings or increased earnings in bank and credit card accounts.

By the strictest definition, I failed on the first count.

The list was too long to even start certain items on it, and many of the money tasks require multiple steps. The new jewelry insurance requires an appraisal. The nanny tax company needs a pile of information to get started. The will-writing lawyers don’t call back right away. At least I got these tasks started.

Financially, the total of my savings and new earnings will net out to about $2,000 annually after taxes, thanks mostly to a better savings account rate.

That doesn’t quite replace the lost income, but it’s a lot more money than I had before.

The real gain here, however, was in establishing a new ritual. I got enough done that I now plan to take a fiscal health day at least once a year, 10 hours on a weekday when all phone lines and financial institutions are open, with no interruptions except for e-mail.

Here’s a list of some of the things I knocked off or got started. Or, if you prefer movies to articles, watch the mini-documentary of my day.

HIGH-YIELD SAVINGS ACCOUNT Though Internet savings accounts that pay above-average rates have been around for some time, I haven’t needed one. Now that we’re keeping more cash around in case we want to buy a new place to live, however, it makes sense to enroll.

I put our money in an account via SmartyPig, a Web-based savings program. It pays an industry-beating 2.75 percent, though it comes with certain restrictions, like the requirement that you put at least $10 in your account each month.

CASH-BACK CREDIT CARD The new Charles Schwab Bank Invest First Visa pays a straight 2 percent back into our Schwab brokerage account. That’s 0.75 percentage points better than we were earning with our Capital One card. The Schwab card also levies no foreign exchange fees for use outside the United States.

JEWELRY INSURANCE We are paying nearly $400 annually to insure our wedding and engagement rings. Jewelers Mutual, which I’d been meaning to call for more than two years, can do it for about $250, as long as we produce an appraisal.

PHONE SERVICE We stripped our landline bare of any long distance or special features and got rid of our DSL service, which we had been using as a backup for our cable Internet connection. That will save about $500 annually, though that savings will be partly offset once we find another backup plan.

Not surprisingly, given that we’re talking about the phone company here, this task ate a bigger part of the day than any other. I had to talk to the landline people, the DSL people and the billing people to confirm a switch on the auto-payment system to our American Express card (now that Verizon finally accepts it). Of course, I waited on hold, ended up in the wrong call center and had one call dropped. But hopefully, I won’t have to talk to them again for years.

NANNY TAX SERVICE I signed up with the Nanny Tax Company in Chicago to deal with the quarterly and annual tax filings related to paying our baby sitter on the books. While this costs $425 annually plus a one-time $100 registration fee, the time savings makes this a wash, if not a net gain in money.

A representative with our bank at Schwab also explained that it would allow us to make free, regular direct deposits into our baby sitter’s account at a different bank. That means we can create a free, basic payroll service, since we’ll get help calculating withholding amounts from the Nanny Tax Company.

WILL We still don’t have one, even though we’ve been parents for three and a half years now. Pathetic and inexcusable. But it won’t be that way for long. We’re considering hiring a lawyer from New York State who is far from our Brooklyn home to save money, and I called three lawyers on fiscal health day looking to price the possibilities. Local lawyers who think this approach is foolish should sound off in the comments on this story. We will finish this task before summer’s end.

INSURANCE PAPERWORK If you’re lucky enough to have health insurance, you’re probably constantly adrift in a sea of forms that make no sense. We’re no different, but a major snafu caused us to have to switch plans a few months into 2009, throwing everything into utter disarray.

On fiscal health day, I got all of the paperwork divided into about a dozen piles to begin our assault on the benefits office and the various insurance companies involved.

WHAT TO DO IF WE’RE DEAD Merrill Lynch gives away a terrific form titled “Organizing your financial life. Critical information at your fingertips.” It’s basically a road map to sorting your financial affairs in case you fall off a large cliff, though Mother Merrill doesn’t quite market it that way. After several years of putting this off, I finally filled out the form on fiscal health day and will send copies to our families soon. There’s a link to the form from the version of this story online.

NONPROFIT AUTOPILOT In less than 10 minutes, I put a bunch of our charitable giving on autopilot. We signed up with Networkforgood.org and then asked it to charge our credit card each month and pass along the money to the nonprofit groups. No more end-of-the-year scramble to get donations out, and the institutions will receive more regular income.

Network for Good does charge a fee for its service, and it may be possible to set up recurring donations free with individual nonprofit organizations.

SHOPPING SPREE Yes, you get to have fun on fiscal health day. Gather up all of your gift cards and spend the money that’s left on them. The longer they sit, the more interest Apple or Borders or the department store will earn from your money and bigger the chance you’ll misplace the card.

We had $68.63 that had been on a Barneys card for a while, and I used it to add to my collection of colorful socks. This being Barneys, I needed an extra $15 or so to add a second pair. Still, the beautiful hosiery was a great reward for having finished a bunch of longstanding financial chores.

What a great idea! Here are some "refinements" I would make to it.

Balance pain and pleasure. Why not unplug from distractions while you do this by staying at a B&B, a nice hotel or in that cabin you've been eyeing for vacation? (Make sure all have phone and internet access. You're going to be using these heavily as you get organized.)Or at least set some time in the evening for a movie, dinner or your favorite activity as a reward to yourself. This will be hard work!

Set priorities.The night before, make a list of what you need to get done. Break it into groups. Your "A-list" should be done NO MATTER WHAT. Your B-list after your A, etc.

If you need help, get it. Some of what you may need to do could involve visits to professionals. Do you need to see your accountant? Your tax attorney or estate planning attorney? Do you have a financial advisor? How about that meeting with HR to discuss plan or benefit changes?

Do nothing else. This is going to require total commitment and focus. It's the "other things getting in the way" that has prevented you from doing this before, right? So turn off the TV, the iPhone, leave email to another day.

Good luck!

Haitian Charitable Deduction Benefit

2010-01-27T05:00:00.001-05:00

I had just posted an article on the changes in tax laws for 2009 when "Pop!" here comes another one courtesy of Congress: Haitian Relief Donations.

Individuals and businesses will be allowed to take a deduction for donations given to charities providing relief to the victims of the earthquake in Haiti. Any donations contributed through February 28th can be deducted either on your 2009 or on your 2010 return.

See your trusted advisor or tax professional for guidance.

Grantham's Latest "Call"

2010-01-26T09:20:00.009-05:00

Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co., said U.S. President Barack Obama’s bid to ban proprietary trading by banks is “good stuff” because it serves to rein in unethical behavior.

“Prop trading was indeed the rot at the heart of our financial problems,” Grantham, wrote in an investor letter posted yesterday on the firm’s Web site. “Watching traders take home their $28 million bonus sent a powerful message to lowly salesmen and packagers of asset-backed securities, for example, to get out there and really take some risk.”
.....

Grantham reiterated his forecast for “seven lean years” for the economy. The Standard & Poor’s 500 Index, which closed yesterday at 1096.78, is above what Grantham believes to be its fair value, of around 850.

“The real trap here, and a very old one at that, is to be seduced into buying equities because cash is so painful,” Grantham wrote in his letter. “Equity markets almost always peak when rates are low.”

Grantham's Quarterly Letter can be read here (registration required).

Why do I post this? Well, of all the market pundits I read-- and there are dozens that I do-- Grantham gets the big picture right, doesn't take extreme positions based on his forecasts, only makes forecasts based on the long term, AND HAS BEEN STUNNINGLY ACCURATE. See here. And here.

Can his methods fail? Of course. But who would you rather listen to (if listen you must)? Someone who never saw the crisis coming and failed to act or someone who was clearly warning of the excesses and made prudent changes? Grantham is an example of the latter.

Charitable Giving: Donor Advised Funds

2010-01-21T10:00:00.001-05:00

"Charity sees the need, not the cause."- German Proverb

I haven't written much about the topic of charitable giving yet but it's an important one to me and to the blog. 2009 was a year "for the books" and the blog's message track last year was dominated by the markets and, peripherally, by taxes. Let's try to remedy that.

Donor-advised funds are charitable giving accounts offered by a sponsoring organization. Designed to be an accessible, simple, and less expensive alternative to private foundations, they are often provided by community foundations and by for-profit financial services companies.

You, as donor, contribute tax-deductible assets to an account, advise the sponsoring charity on how it should invest the assets and recommend grants from the account to charitable organizations of their choice over time.

The sponsoring organization does the record-keeping and due diligence. The account can even be made anonymous. There's even a website touting their advantages.

In an article in the Wall Street Journal, the shift toward donor advised funds and away from private foundations was discussed. The article read:

Raymond P. Kurlak established a private foundation in 2000 to fund education and literacy programs, joining a growing wave of philanthropy in the U.S. In the wake of the recent turmoil in financial markets, he became part of another trend: He closed the Raymond Foundation about a year ago and rolled the assets into a donor-advised fund.

Mr. Kurlak opened an account with the Schwab Charitable Fund, an independent, nonprofit organization founded by Charles Schwab Corp. Other funds founded by big financial-services firms include the Fidelity Charitable Gift Fund and the Vanguard Charitable Endowment Program, and there are many other choices as well. As the names suggest, these funds distribute money to charitable causes as recommended by the donors. One of their advantages is that they relieve philanthropists of some of the costs of running a foundation.

Mr. Kurlak estimates that he saves about 10% by using Schwab to administer his account instead of paying for his own lawyers, accountants and office supplies, as he did when he ran his foundation. Those savings are particularly important because of the losses his foundation suffered when stock prices dropped. Cutting back on costs makes his depleted assets go further. "I'm very pleased," he says. "It takes much less time and money" to direct the distributions from his Schwab account than it did to run his foundation.
Privacy and Tax Savings

Cost-cutting is one of the factors driving an increase in conversions from private foundations to donor-advised funds. But there are others that aren't so closely tied to the direction of stock prices. Funds also relieve philanthropists of many of the hassles of running a foundation, like filing paperwork, checking out potential recipients or, for larger foundations, managing a staff. Mr. Kurlak says he spends about two weeks a year on his account's business now, down from two months a year on his foundation in the past. And the funds offer tax advantages and greater privacy for donors, among other advantages.

Making the switch from foundation to fund isn't for everyone. Some individuals may prefer the cachet of running a foundation, or the opportunity it gives them to teach family members about philanthropy. Perhaps most important, foundations give donors total control over their contributions, which can be crucial for those who support causes that are out of the mainstream.

Still, the number of accounts at donor-advised funds climbed 11% last year, to 148,588, following a 13% increase the previous year, according to the National Philanthropic Trust, a charity in Jenkintown, Pa. Conversion isn't difficult, and many of the funds have expanded staff to assist donors with the process.

The Schwab Charitable Fund was fielding so many inquiries about converting that it recently devoted additional staff to conversions and developed a questionnaire to help individuals decide whether to make the move, says Kim Wright-Violich, the fund's president.

"As assets have gotten beaten up, people have gotten really frustrated about not being able to do the same level of gifting," says Ms. Wright-Violich. More philanthropists are realizing, she says, that the money that donor-advised funds can save them in administrative and other costs can go toward the causes they support. In some cases, she says, such funds can cut donors' costs by as much as 50%.

Besides cutting administrative costs, funds can reduce donors' investment fees. Small foundations, because of their limited assets, often pay relatively high fees to the firms that handle their investments. But donor funds, working with a much bigger pool of money from all the accounts they administer, often pay much lower fees to invest donors' money.

Donor-advised funds also have certain tax advantages over foundations. Donors get an immediate tax deduction when they make a contribution to a fund, as they would with donations to their own foundation. But the deductions are more generous: Donors can deduct cash contributions to a fund totaling up to half of their adjusted gross income each year; the limit for donations to a private foundation is 30%. Donors can also deduct up to 30% of their adjusted gross income for donations to a fund of securities that have appreciated in value since the donor bought them; for a private foundation, the limit for such donations is 20%.

In addition, investment gains in an account at a donor-advised fund generally are tax-free, unlike a foundation's investment gains, which are subject to a small excise tax.

The funds also handle all the paperwork and due diligence involved in making donations and investments. That may be particularly reassuring to some givers in the wake of the Madoff scandal, which heightened concerns about investment scams.

Donor-advised funds also offer account holders some additional flexibility and help protect their privacy.

There is no requirement for annual distributions from an account at a fund, while foundations are required to distribute at least 5% of their assets each year. That can be especially important when financial markets are tumbling, because many philanthropists may want to hold on to more of their money so that they have a bigger asset base to rebuild from when the markets rebound.

The privacy issue is one that catches some philanthropists by surprise. Many are unaware when they set up a foundation that its tax forms will be made public, exposing details of the foundation's operations and even some personal information. No such information is available for accounts at donor-advised funds. And all donations to a fund can be made anonymously, a strong incentive for many donors to convert, says Sarah C. Libbey, president of the Fidelity Charitable Gift Fund.

James Barnes, chief relationship officer for the Vanguard Charitable Endowment Program, says another reason some foundations are converting is that the founder has died and family members disagree on the direction the foundation should take. Some people in that situation are splitting up a foundation's assets among several accounts at donor-advised funds, and those accounts can then be used for different purposes.

Families also often decide to convert simply because they've grown tired of the time and cost of meeting and of managing a foundation. The economic turmoil of the past couple of years may have helped fuel conversions because philanthropists are having to spend more time tending to their businesses, leaving less time to devote to foundation work.

Of course, there are some potential drawbacks to consider before switching from a foundation to a donor-advised fund.

One of the biggest is that with a fund, "you no longer have the independence and the total control" that you have with your own foundation, says Steve Gunderson, president and chief executive of the Council on Foundations, a nonprofit association of about 2,000 grant-making foundations and corporations, based in Arlington, Va.

That may not be an issue for most philanthropists, because it's rare for a fund to refuse to make a donation as desired by an account holder. But Mr. Barnes at the Vanguard Charitable Endowment Program notes that the funds can only write checks to charities. That means they don't allow donors to provide direct support for individuals or for groups that don't qualify as charitable organizations.

Another possible drawback is that contributions to the funds are irrevocable. So while a fund allows for more flexibility in the timing of donations because it doesn't require distributions of at least 5% annually, it limits flexibility in a different way by not allowing a donor to react to circumstances by putting the money to other use.

For those who choose to make the switch, the first step is to contact the state authorities that regulate charities, says Ms. Wright-Violich of Schwab. Each state has different requirements for terminating a foundation. The foundation must also file a final federal tax form. More detailed guidance is available from donor-advised funds.

So costs, tax advantages, privacy versus some degree of flexibility. Except for the rare individual or family, I believe the shift toward donor-advised giving is going to continue. Here are some of the nation's leading funds where you can find out more:

* Schwab Charitable
* Calvert Foundation
* Fidelity Charitable Gift Fund
* Vanguard Charitable Endowment Program

As always, see your planning professional or tax advisor to see if this is right for you.

Why Many Investors Keep Fooling Themselves

2010-01-19T09:22:00.004-05:00

I had intended this next post to be on charitable giving. It's an important topic and relates to the mission of this blog regarding transfer of wealth.I'll get it up next. But I came across this article and it's so good I am putting it up in full. This relates to our previous post. It's written by Jason Zweig of the Wall Street Journal and bolsters my case that when it comes to investing, we don't know what the heck we are doing. Zweig writes:

What are we smoking, and when will we stop?

A nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years.

Robert Veres, editor of the Inside Information financial-planning newsletter, recently asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes, what I call a "net-net-net" return. Several dozen leading financial advisers responded. Although some didn't subtract taxes, the average answer was 6%. A few went as high as 9%.

We all should be so lucky. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. All told, those costs reduce annual returns by five to seven points.

So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

The faith in fancifully high returns isn't just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that can't last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

Even the biggest investors are too optimistic. David Salem is president of the Investment Fund for Foundations, which manages $8 billion for more than 700 nonprofits. Mr. Salem periodically asks trustees and investment officers of these charities to imagine they can swap all their assets in exchange for a contract that guarantees them a risk-free return for the next 50 years, while also satisfying their current spending needs. Then he asks them what minimal rate of return, after inflation and all fees, they would accept in such a swap.

In Mr. Salem's latest survey, the average response was 7.4%. One-sixth of his participants refused to swap for any return lower than 10%.

The first time Mr. Salem surveyed his group, in the fall of 2007, one person wanted 22%, a return that, over 50 years, would turn $100,000 into $2.1 billion.

Does that investor really think he can get 22% on his own? Apparently so, or he would have agreed to the swap at a lower rate.

I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.

Meanwhile, I asked Mr. Salem, who says he would swap at 5%, to see if he could get anyone on Wall Street to call his bluff. In exchange for a basket of 51% global stocks, 26% bonds, 13% cash and 5% each in commodities and real estate—much like a portfolio Mr. Salem oversees—the institutional trading desk at one major investment bank was willing to offer a guaranteed rate, after fees and inflation, of 1%.

All this suggests a useful reality check. If your financial planner says he can earn you 6% annually, net-net-net, tell him you will take it, right now, upfront. In fact, tell him you will take 5% and he can keep the difference. In exchange, you will sell him your entire portfolio at its current market value. You have just offered him the functional equivalent of what Wall Street calls a total-return swap.

Unless he is a fool or a crook, he probably will decline your offer. If he is honest, he should admit that he can't get sufficient returns to honor the swap.

So make him explain what rate he would be willing to pay if he actually had to execute a total return swap with you. That is the number you both should use to estimate the returns on your portfolio.

Absolutely awesome.

Fund Returns vs. Investor Returns

2010-01-18T06:53:00.005-05:00

We have written on this phenomenon before. The individual investor does not achieve the same returns from a mutual fund as is indicated by the fund's performance. Is the manager skimming fees? Are investors being cheated? No! Investors simply have the tendency to pile into funds when they are riding high and abandon them when their performance lags. They buy high and sell low.

From the Wall Street Journal:

Meet the decade's best-performing U.S. diversified stock mutual fund: Ken Heebner's $3.7 billion CGM Focus Fund, which rose more than 18% annually and outpaced its closest rival by more than three percentage points.

Too bad investors weren't around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30, according to investment research firm Morningstar Inc.

These investor returns, also known as dollar-weighted returns, incorporate the effect of cash flowing in and out of the fund as shareholders buy and sell. Investor returns can be lower than mutual-fund total returns because shareholders often buy a fund after it has had a strong run and sell as it hits bottom.

At the close of a dismal decade for stocks, the CGM Focus results show how even strategies that work well don't always pay off for investors. The fund, a highly concentrated portfolio typically holding fewer than 25 large-company stocks, offers "a really potent investment style, but it's really hard for investors to use well," says Christopher Davis, senior fund analyst at Morningstar.

The gap between CGM Focus's 10-year investor returns and total returns is among the worst of any fund tracked by Morningstar. The fund's hot-and-cold performance likely widened that gap. The fund surged 80% in 2007. Investors poured $2.6 billion into CGM Focus the following year, only to see the fund sink 48%. Investors then yanked more than $750 million from the fund in the first eleven months of 2009, though it is up about 11% for the year through Tuesday.

"A huge amount of money came in right when the performance of the fund was at a peak," says Mr. Heebner, the fund's manager since its 1997 launch. "I don't know what to say about that. We don't have any control over what investors do."

Well, I know what to say about that. Most people aren't wired to play the investment game successfully. Those that are head to Wall Street. You and I suffer disproportionately when we lose as opposed to when we win. Hence our tendency to stop the "pain" by taking losses, never to recover them. These tendencies are well known.

Ken Heebner has had great returns for a decade. It doesn't mean he is about to repeat them. The tendency of hot funds to cool off is well known also. His may or may not. He had a so-so 2009.

What I am saying is that for most people diversification among strategies and asset classes likely holds the key to an investor sticking with the program. Every effort should be made to smooth returns. The less bumpy the ride, the less desire to panic at bottoms. How that is done- for you- is up to your advisor. I believe it CAN be done. Sometimes you will lag in bull markets. In bear markets you will make that back and probably then some. Since the bull part of market cycles tend to be twice as long as bear portions it can be uncomfortable at times. It's not for everyone. It takes away some of the thrills. It also takes away a lot of the pain. See your advisor for a full discussion.

2010 Tax Planning

2010-01-14T06:31:00.005-05:00

It's that time of the year! We all wait anxiously beside the mail box to see if the new year's tax forms have arrived. (Sarcasm warning.)

So when should your mail-person bring those welcome missives? Well, W-2 Forms reporting your wages and tax withholding normally arrive January through mid-February. Employers can either mail out or deliver the Form W-2 by January 31st. If you haven't received your W-2 by mid-February, I'd call and ask for a replacement.

Documents reporting bank interest, student loan interest, mortgage interest, dividends, and other types of income or deductions also get mailed out at end of January. One exception, however, is Form 1099-B, the reporting of proceeds from stocks, bonds or mutual funds that you sold. It isn't mailed out until February 16th. Last year brokers were sending out two Forms 1099-B, the first to meet the IRS-imposed deadline, and a corrected 1099-B about a month later. A declaration of the fact that it could be corrected was included in the first mailing, thereby necessitating a wait before you filed. Irritating but necessary.

For a 2010 Tax Calendar of important dates, see here.

Now That We Have Rallied, Where Do We Stand?

2010-01-10T10:46:00.005-05:00

"Those who cannot learn from history are doomed to repeat it." - George Satayana

I have certain beliefs about the markets. Every investor does despite frequent proclamations by the wizened to "remain agnostic" or better yet "let the markets tell you what to do." I believe that markets cycle between overvaluation and undervaluation. Periods of strong returns are followed by periods of weak ones. We have gone through such a decade of weak returns in the S&P 500, the large cap index of stocks.

At its March 9, 2009 nadir the S&P 500 had declined 57% from its peak. It has rallied 67% since then to finish Friday at a new interim high of 1145. Now what?

Well I won't join the list of prognosticators who attempt to tell you at this time of what the market will do in the next twelve months. This is the wrong forum for that. We are interested in the topic of investing in the context of FINANCIAL PLANNING. Earning "Top Forecaster" status is for someone else.

So other than the raw numbers I cited above, where do we stand? I am going to point you to the work of economist Andrew Smithers again of Smithers & Co. He has published two fine works on the markets "Valuing Wall Street" and "Wall Street Revalued" both of which I urge you to read. You can't get a better dissection of much of the nonsense that Wall Street and analysts peddle in the hopes of selling you stock. Here is what Smithers thinks:

Forty-eight percent overvalued.

If you need help in figuring out what to do with this information (if anything) please re-read my piece on "^The Duration of Stocks".

And, as always, see your trusted advisor or tax professional for advice.

ADDENDUM:

Reader "Sleepless" submitted a comment containing a link to a great interview with Andrew Smithers performed by Jim Puplava of Financial Sense Online. Have a listen. The link is here. Look for the entry in the January 9th program for Guest Expert and choose your media player of preference.

Planning Basics: The Time Value of Money

2010-01-07T08:26:00.004-05:00

"Money is better than poverty, if only for financial reasons." - Woody Allen

It approaches hyperbole to state that the most fundamental concept in finance and hence of financial planning is that money has a “time value.” Money in hand today is worth more than money that is expected to be received in the future. “A bird in the hand…” and all that. Why is that so? Well, a dollar that you receive today can be invested such that you will have more than a dollar at some future time. If only our Congressmen knew this, but I digress.

First an example to show what we mean. Let’s say you have 100 dollars of money today and you invest it for one year and earning 5 percent interest. It will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient assuming 5 percent interest.

But the method is robust enough that it also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are “discounted” and then added together, thus providing a lump-sum "present value" of the entire income stream.

All of the standard calculations for time value of money derive from a basic algebraic expression for the present value of a future sum, discounted to the present by an amount equal to the time value of money. For example, the future value FV to be received in one year is discounted (at the rate of interest r) to give the present value PV thusly : PV = FV − r•PV = FV/(1+r).

Some standard calculations based on the time value of money are:

Present Value

The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.

Present Value of an Annuity.

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due.

Present Value of a Perpetuity

An annuity with an infinite and constant stream of identical cash flows

Future Value

Future Value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.

Future Value of an Annuity

The future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

Basic Equations, Identities and Combining Equations

Several basic equations that represent the equalities listed above. The solutions may be found using these formulas or, since we are in the twenty-first century, a financial calculator or a spreadsheet using Microsoft Excel for example. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT).

The equations are identities. For any of the equations below, the formula may be rearranged to determine one of the other unknowns. (Note: In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate although financial calculators and spreadsheet programs can “force” the solution through rapid trial and error algorithms).

These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond.
An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate.

The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless. I can't stress this enough.

For calculations involving annuities, you must decide whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation.

Finding the Formulae

Here is where I would naturally present all the formula regarding each of the concepts listed above and explain what each of the abbreviations ( i for interest rate, PV for present value, etc) meant. But I am not going to waste the pixels. You can find this in any finance textbook or in numerous sources on the Web. Instead I am going to give you a few links where you can find all of the relevant formulas and even examples.

From Investopedia

From StudyFinance.com

From GetObjects.com

I know some critics who have claimed that "this is all there is to" financial planning. I don't agree but even some practicioners have claimed as much. This knowledge IS however extremely valuable and study of it and its application is invaluable. That is why I have started the New Year with this post.

Good reading.

Out With the Old

2010-01-01T06:42:00.005-05:00

HAPPY NEW YEAR TO ALL!

This is not a blog for these kind of ruminations, but I tend to think the ground shifted beneath us in 2009. I believe that the 2010s will be a decade of great change, but not in the manner that most people once expected. We have some serious issues to work through as a nation. At the same time, the changes occurring around us will affect our ability to control our own destiny.

There is a tremendous amount of hard work to do and our leaders are faced with many, many difficult decisions. You must take control at the individual level and your personal financial plan is one aspect of that. Let's work on that together in 2010.

Lost Decade for Stocks

2009-12-28T06:47:00.009-05:00

Okay folks, I really, REALLY meant to restart blog posting with another article in the series entitled "Planning Basics" but I found this article at Econobrowser by Jim Hamilton such a good read I had to share it with you. In it Hamilton presents two superb graphs: one of total non-farm payrolls over the decade and the other of corporate (S&P 500 as proxy)earnings. Wonder why stocks have gone nowhere over that time period? The article contends these are highly suggestive of the answer. Here's a peek.

Pure carnage. Now for S&P 500 earnings:

(Click on either image for a larger view.)

The same. Of particular concern is the increase in earnings variability as the economy has become more geared to the financial sector (30% at one point). Since the sector profits through various types of "transactional taxes" if you will, I believe it would be a very good thing if we substantially decreased our reliance on this mechanism of "growth".

Merry Christmas

2009-12-25T05:00:00.000-05:00

Peace on Earth and Good Will Toward All Men. Merry Christmas All!

Arrival

2009-12-23T15:40:00.003-05:00

And a wintry white arrival it was.

Amid boxes, papers and general disarray, my family and I are "settled" in our new house in Wisconsin and occasionally venturing out to brave the colder winters here.

A Hiatus

2009-12-11T04:00:00.001-05:00

I am moving my family back to the Midwest. I grew up there, as did my wife, and we have much family there. It will be nice to have family close.

We have enjoyed our time in New England. It was too short. I made some good friends here. All my family did. These friends will be missed.

I am taking a hiatus to coordinate the move. For about a week I will not have access to my usual tools. (I know, you CAN blog remotely, but that's not for me.) Then the holidays will be upon us. I'll pick this up again on the other end. Posting will be even lighter than normal.

Mark

Brighten Your Holiday Spirits with End of Year Tax Planning

2009-12-10T04:38:00.005-05:00

If you didn't catch my earlier post on this when the topic was, well, a WEE BIT MORE TIMELY, it is here.

Speaking of timely, hopefully you are farther along in your gift shopping than I am.

Economist John Hussman: Stocks' Discounting Mechanism Broken

2009-12-09T05:46:00.002-05:00

I have been a long time fan of the economist and money manager John Hussman's writings. In fact I own both of his mutual funds. A recent post of his in his Weekly Comment drew my particular attention because it hit upon a question that has been nagging me for years now. It goes like this: What if the change in the composition of the stock markets has affected them in some manner? What if the fact that hedge funds and proprietary trading desks now dominate the daily volumes on the exchanges means something for the individual investor other than it making it ever harder to "win" the investment game? What if the markets no longer function as a long term arbiter of value? Hussman has the same concern. Read it here.

Another Credit On Its Way: Cash for Appliances!

2009-12-07T05:00:00.001-05:00

More stimulus is on its way from Washington:

In the coming months you may be eligible to receive rebates from your state or territory for the purchase of new ENERGY STAR-qualified appliances.

These rebates are being funded with $300 million from the American Recovery and Reinvestment Act of 2009. Under this program, eligible consumers can receive rebates to purchase new energy-efficient appliances when they replace used appliances.

......

Each state and U.S. territory was allowed to design its own rebate program, and all 56 have submitted plans to the U.S. Department of Energy (DOE).

The link to the Department of Energy's website announcing the program is here. A PDF of states with programs that have already been approved is here.

UPDATE (December 8, 2009):

And now "Cash for Caulkers"? Will this never end?

Planning Basics: A Philosophy of Financial Planning

2009-12-04T05:00:00.002-05:00

"Personal financial planning, or financial planning, denotes the process of determining whether and how an individual can meet life goals through the proper management of financial resources."--
Certified Financial Planner Board of Standards, Code of Ethics and Professional Responsibility

AUTHOR'S NOTE: I want to start a series of posts about financial planning basics for my readers. My intention is that one post a week will concern these basics and a second weekly post will discuss a more advanced planning concept, a bit of timely news or a particular strategy of interest. The posts relating to basics will be denoted "Planning Basics". That way, if you are an advanced reader you can just skip them or tag them for perusal on a slow rainy day.

Once you read the above statement by the CFP Board, it is blindingly obvious (at least to me) that the emphasis in financial planning should not be the sale of products (such as life insurance, annuities and mutual funds) but the process for helping people meet their financial goals, either through the development of comprehensive plans (preferred) or through the use of a segmented approach for solving discrete problems (if appropriate and practicable). Why all the qualifications in that sentence? Well, sometimes what a potential client asks you to do can be neither appropriate or practicable and it is your job to say "No" even if it means that you won't be earning a fee. These don't have to be illegal (tax fraud) or immoral (abusive financial relationship) but can simply be mistakenly applied concepts or strategies. Or it may be that a client asks for something simple whereupon investigation you discover that the "simple fix" brings too many other moving parts into play. Instead of a fixing a flat tire you find the client needs struts, rotors and ball joints.

So what is that process we are talking about? Well, I don't believe we can talk about that without touching upon the areas of a client's financial well being impacted by the relationship nor of the planner's role in coordinating services for the client in these areas. Here are the key planning areas:

Risk Management Planning
Education Planning
Cash Management, Savings, Debt and Credit Planning
Estate Planning
Retirement Planning
Investment Planning
Tax Planning
Planning for Financial Independence

That's a lot! And that's a lot for one person (your financial planner)to have skills in. Even though a financial planner may understand how all of these areas interact, his/her expertise may only be in one/two or more but fewer than all eight of these critical areas. Hence the need to coordinate the activities of others such as a life insurance agent, tax attorney, estate planning attorney, broker, mortgage specialist, etc. (The act of coordination requires superior organization and communication skills.) As stated, some of these functions and activities can be performed by the financial planner. I would say that it is very desirable that the planner do so. But the more sophisticated planners recognize that in order to best serve their client, many circumstances warrant seeking the professional advice of others. Let's talk about three of them: attorney, accountant and portfolio manager.

Attorney

It's now a given that the legal community casts a rather suspicious eye toward the financial planning community. This is for two reasons. One, the legal community questions the credentials for such a complicated task as outlined above. Two, the legal community believes that the practice of financial planning "encroaches on its turf". Its suspicions are only heightened by statements such as this one, from Practicing Financial Planning (for Professionals) by Mittra, Sahu and Crane (2007) : "In the context of financial planning, an attorney's key function is to certify the legality of a proposal developed by a financial planner and to prepare the associated legal documents." What?! The attorney is someone who merely "certifies" and "prepares" what a financial planner has drafted? The whole notion is mistakenly naive and a violation of an attorney's Code of Ethics and Professional Responsibility. The authors go on to decry these "turf Battles" and "acrimony" between the two professions and then assert that "in [the] role [described]the attorney operates not as an adversary but an integral part of the team of professionals". No, the role described is 1) order taking and 2) ministerial as well as insulting.

Yes, your attorney has a vital and important role in the financial planning process. It is not as described in the above best-selling planning manual, but to provide sound and professional legal judgment through fact assembly and assessment, research, drafting, document preparation and client counseling in those areas of the financial plan that are affected by the law.

Accountant

Accountants and CPAs have traditionally performed two principal functions for the client: maintenance of records and preparation of taxes. However, the profession is often asked to do much more, namely, advice on the tax effects of certain financial transactions including investment purchases or sales or those of business entities. The CPA or accountant often coordinates with the client's tax lawyer in these regards, especially where the act of giving counsel may be interpreted as the giving of legal advice.

Portfolio Manager

A portfolio manager helps design the vehicle that preserves or enhances a client's estate. An attorney may prepare documents that preserve the estate and a CPA may advise as to the existence of Tax Code provisions or strategies that also do so, but the portfolio manager uniquely constructs through use of investment vehicles and products (stocks, bonds, funds, annuities, limited partnerships, real assets, alternative financial products, etc) a portfolio designed to achieve the client's financial goals.

Insurance Counselor and Other Professionals

One important dimension of the overall financial plan is that of asset protection through the purchase of life, disability, property, casualty, professional liability, long-term health care, and other insurances. Aside from the insurance counselor, a planner may need to work with trust officers, real estate brokers,and investment bankers. In working with each the objective of the planning professional is to get sound objective advice in outside areas of expertise such that the financial plan is enhanced by its inclusion.

Summary

We are starting a series on financial planning basics. This is meant as a sort of "30,000 foot view". Today's article touches upon the philosophy of financial planning, and continues with a look at the planner's areas of impact and his/her role as provider and coordinator of services in those areas.

Mainstream Media Discovers Long Term Stock Value Measures

2009-12-02T06:07:00.000-05:00

Readers know that I place strong reliance upon long term measures of stock values. Planners are usually not traders and there is a BIG distinction between trading and investing. I find that most mainstream media outlets (WSJ, CNBC, etc) are nearly universally focused on the former and not the latter. How refreshing therefore to find an article in the NY Times (Economix) that discusses a favorite measure of mine: Shiller's PE10, "Stocks Start Looking Dear Again" by David Leonhardt. What does it say?

Corporate profits may rise or fall in any given year depending on the state of the economy, but a share of stock is a claim on a company’s long-term earnings and should be evaluated as such. And over the past century or so, there has been a pretty strong correlation between the 10-year p-e ratio and future returns. When the ratio shot above 20, as it did in the 1920s, 1960s and recent years, stocks were headed for a fall. When the ratio dropped well below its 100-year average of 16, as in the 1930s and the early 1980s, a bull market typically followed. (The average of the past 60 years is about 18.5)

What does the ratio say today? That perhaps the recent rally has gone a bit too far.

The article gives links to history of the indicator and its development. It's short and worth a read. My usual cautionary note: These long term indicators say NOTHING about the direction stocks will take in the short term. Enjoy.

Reversing Last Year's Trade or Booking GAINS for Once

2009-12-01T11:59:00.005-05:00

As part of my usual end of the year pontificating about tax strategies, I'm going to discuss capital losses and gains first. Why? Because the topsy-turvy nature of our capital markets from 2007-2008 to 2009 may give some opportunities for some unique strategies.

About this time last year I would have been advising you to offset capital gains with capital losses. In other words if you had sold profitable investments (lucky you!), I would have suggested you try to find some losing investments you could sell to minimize or eliminate your capital gains tax. In that environment it wasn't hard. However, a lot of investors now have significant losses in 2008 being carried over, and may have additional losses in 2009. Capital losses offset capital gains, and any excess losses are deductible up to $3,000 per year, which, given the degree of the carnage in the markets the past few years, may seem like a pittance to some. For example, if you suffered $100,000 of total capital losses in your portfolio but only $50,000 in capital gains, then your net capital loss is $50,000, but your total capital loss deduction for the tax year is merely $3,000. The remaining $47,000 in losses are carried over to next year. If this is you and, as a result of this you decided to stop investing and therefore never had another capital transaction, it would take you about 17 years(!) to fully utilize your carry-forwards.

What to do? Well, we might need to reverse the traditional advice and try to sell off investments with gains to offset losses.You could sell off profitable investments and repurchase them immediately. This books a capital gain for tax purposes, uses up some losses, and gives you a new cost basis position in the investment. You might be thinking, isn't this tactic prohibited by the wash sale rule? No, the wash sale rule only applies when you sell an investment at a loss and repurchase the same investment within thirty days. If you're selling an investment at a profit, the wash sale rule doesn't apply.

A little used tactic is to give appreciated stocks and other investments to someone with significant capital losses. Taxpayers can give up to $13,000 per year per person tax-free as part of the annual gift-tax exclusion. Under the scenario put forth above, a family member could give this individual stock or mutual funds or other investments that have appreciated in value with a cost basis of $13,000. The gains will be offset by the losses, and thus eliminating any capital gains tax.

One other note. You may want to think about the TIMING of the use of your losses. (I talked about this in my article on tax shifting.) President Obama has proposed increasing the tax rate on long-term capital gains to 20%. Perhaps you may want to keep carrying over some capital losses to offset future capital gains.

See your trusted tax advisor or planning professional about any of this.

The Woodshed

2009-11-30T05:00:00.000-05:00

Reader's of Bill Cara's blog -- and of Leisa's-- know the meaning behind this. When I stray from civil discourse with fellow commenters or blog hosts, your author, upon reflection, will self impose a trip to the woodshed for penitent rumination. The one at Leisa's site is much nicer. Luckily, I haven't had to visit for a while.

Happy Thanksgiving Everyone!

2009-11-26T08:37:00.003-05:00

Your humble blog host will be attacking that tableful in about 5 hours. Have a great one, all! I'll be back next week.

That Great "Investment": Housing

2009-11-25T04:24:00.005-05:00

Ah, a blast from the past. The cover from the National Association of Realtors chief economist David Lereah's book.

Readers know that I am on a bit of a rant here. Too many people were sucked into the "housing is always a great investment" shtick at the worst of all times. We've already shown what the 100+ year returns from housing have been. The low natural returns didn't prevent one of the biggest bubbles EVER from being blown or its natural aftermath. (You do know that all bubbles collapse, don't you?)

Well, here's the latest data point. The number of "underwater" mortgages continues to climb. "Underwater" is another way of saying that you owe more on the property than it is worth in the marketplace. From the Wall Street Journal:

The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23%, threatening prospects for a sustained housing recovery.

Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic, a real-estate information company based in Santa Ana, Calif.

These so-called underwater mortgages pose a roadblock to a housing recovery because the properties are more likely to fall into bank foreclosure and get dumped into an already saturated market. Economists from J.P. Morgan Chase & Co. said Monday they didn't expect U.S. home prices to hit bottom until early 2011, citing the prospect of oversupply.

Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home's value, the First American report said. More than 520,000 of these borrowers have received a notice of default, according to First American.

Negative equity "is an outstanding risk hanging over the mortgage market," said Mark Fleming, chief economist of First American Core Logic. "It lowers homeowners' mobility because they can't sell, even if they want to move to get a new job." Borrowers who owe more than 120% of their home's value, he said, were more likely to default.

Mortgage troubles are not limited to the unemployed. About 588,000 borrowers defaulted on mortgages last year even though they could afford to pay -- more than double the number in 2007, according to a study by Experian and consulting firm Oliver Wyman. "The American consumer has had a long-held taboo against walking away from the home, and this crisis seems to be eroding that," the study said.

Even recent bargain hunters have been hit: 11% of borrowers who took out mortgages in 2009 already owe more than their home's value.

Many borrowers are so deeply under water that they can't take advantage of lower rates and refinance their mortgage. "We're declining hundreds of loans each month," said Steve Walsh, a mortgage broker in Scottsdale, Ariz. "The only way we will make headway is if we allow for a streamlined refinance where the appraisal is irrelevant."

Did everyone catch that? Eleven percent of owners who bought IN 2009 are already underwater. The housing bust is not over. On a national level more declines are coming, a view shared by Ivy Zelman, one of the more prescient experts on the housing crisis. If you are lucky enough to live in selected areas, house prices may be stable to slightly increasing. But for the rest of the country great care must be taken in purchasing a home.

The government is throwing ALL KINDS of stimulus at this. From artificially lowering the cost of mortgages to goosing demand through tax credits for first time (and now long time) buyers. It has had the effect of TEMPORARILY stabilizing the rate of descent. That is all. We are likely to see very poor data come out in this area from now until the spring 2010 selling season.

"Invest" at your own risk.

More Stimulus: The New Homebuyer Tax Credit

2009-11-20T05:15:00.001-05:00

When George Washington threw the dollar across the Rappahannock River, he didn't realize he was establishing a precedent for government spending.

-Harold Coffin, "The San Francisco Examiner"

Quick Summary of the First-Time Homebuyer Credit

For 2008: up to $7,500, the credit is paid back over 15 years.

For Jan - Nov 2009: up to $8,000, the credit does not need to be paid back.

For Dec 2009 - April 2010: up to $8,000 for first-time buyers, the credit does not need to be paid back.

For Nov 7, 2009 - April 2010: up to $6,500 for "long-term residents" buying a new home, the credit does not need to be paid back.

Until April 30, 2011: homebuyer credit continues to be available for qualified members of the U.S. uniformed services.

Dollar Amounts of the Homebuyer Tax Credit

The tax credit is worth 10% of the purchase price of the home. For 2008, the maximum credit is $7,500 ($3,750 for married couples filing separate returns). The credit is also limited to the same $7,500 maximum for unmarried persons who purchase a residence together.

For 2009 and 2010, the maximum credit is $8,000 (or $4,000 for married couples filing separately).

Long-term residents purchasing a new home have a lower maximum credit of $6,500, or $3,250 for married couples filing separate returns.

Limit based on Maximum Purchase Price

No tax credit is allowed if the purchase price of the home exceeds $800,000. There's no phase-out or gradual reduction of the credit.

Qualifying as a First-Time Homebuyer

For the purpose of this tax credit, a first-time homebuyer is defined as someone who has not owned a primary residence in the three-year period ending on the date of purchasing the home. Married couples are considered first-time buyers if neither spouse has owned a residence in the previous three years.

Qualifying as a Long-Term Resident Homebuyer

People who already own a home can qualify for the tax credit if they buy another home. The qualify, individuals needs to have owned and lived in their residence for at least five consecutive years in the eight-year period that ends on the purchase date of the new property.

Limited Time Period for Purchasing a Residence

The credit has a very limited life-span. Individuals will need to purchase a residence after April 9, 2008, and before May 1, 2010. Qualified service-members must purchase a residence before May 1, 2011.

Income Phase-out Range

The credit is phased out for individuals with modified adjusted gross income between $75,000 and $95,000. For married couples filing a joint return, the phase out range is $150,000 to $170,000. Effective Nov 6, 2009, the phase out ranges start at $125,000, or $225,000 for married couples.

Modified AGI for the First-Time Homebuyer Credit

To determine if the tax credit is reduced or eliminated by the income phase-out range, individuals will need to determine their modified adjusted gross income.(Excerpted from About.com)

There's more. (Isn't there always?) The IRS announcement of the expanded credit can be found here.

Form 5405, the tax form to claim the first-time homebuyer credit can be found here.

Income Replacement Rate Fallacy

2009-11-19T05:28:00.007-05:00

"Rules of thumb are, quite simply, rules of dumb."--

Larry Kotlikoff, BU Professor and co-author of "The Coming Generational Storm" and "Spend Til the End"

When we use "rules of thumb" we are making an approximation instead of a precise measurement. That's what rules of thumb mean, literally, using your thumb as a measuring stick or ruler. Then why are we surprised when those measurements don't add up?

Robert Powell has written an article about a new study by two University of Wisconsin-Madison professors showing just how badly use of a common rule of thumb regarding income replacement rates in retirement turned out to be. Their findings were about what you would expect:

The rule of thumb is that you'll need to replace 70% of your pre-retirement income on average once you retire, but evidence continues to mount that this assumption by many professionals and retirement savers is way off base.

Now, a new study by two professors casts further doubt on the idea that the widely used replacement-rate figure is a sound basis for building a retirement plan.

"The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed," wrote John Karl Scholz and Ananth Seshadri, two University of Wisconsin-Madison professors, in their paper "What Replace Rates Should Households Use?"

In fact, no more than 15% of the population Scholz and Seshadri studied need to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.

In short, the authors said: More refined guidance is needed to serve households well.
Target replacement rates are less than 100% for three main reasons, according to the study published by the Michigan Retirement Research Center.

"First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement."

Still, that ignores a whole host of issues related to coming up with the right replacement rate.

For instance, consider what effect children likely have on your expenses prior to and in retirement, the authors wrote. Most calculators use the same replacement rate regardless of the number of children in a household, the authors said. But the number of children you have matters when it comes to calculating your replacement rate. In fact, all things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working. (Of course, the kids' ages at the time of retirement will affect that calculation.)

What is needed for your real number is not back-of-the-napkin calculations but something the authors refer to as the life-cycle model. To be fair, the author's study did note that replacement rates -- even when using the life-cycle model -- did confirm some commonly held beliefs. Specifically, "replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families."

But even then you still need to take into account the effect of federal taxes, medical expenses, education, and what the authors call earnings shocks or -- in laymen's terms -- layoffs and big salary increases.

When all is said and done, the authors suggest that optimal replacement rates could range anywhere from 23% (for single parents with several children and a negative late-in-career earnings shock) to 240% (for low-income, married households with a few children and a substantial positive late-in-career earnings shock).

In other words, "conventional advice may overstate optimal targets by a factor of two, or understate retirement consumption needs by a factor of three depending on the idiosyncratic experiences of households," Scholz and Seshadri said in their study. See the study (PDF).

That's especially the case when it comes to online calculators, the authors said. With the life-cycle model, the replacement rate depends on factors often ignored by online calculators. "The savings requirements of two households with the same earnings profile, retirement age and life expectancy would be given an equivalent target by the online planning tools regardless of whether one household raised five children and other had none," the authors said. They said the optimal replacement rate for married couples is 75%, but just 55% for singles.

Put another way, if you're using an online calculator to plan your retirement, you might be under-saving or over-saving by a wide margin, though the consequence of over-saving might not be as bad as under-saving.
'Rules of dumb'

Experts, meanwhile, seemed to agree with the conclusions reached by Scholz and Seshadri.

"The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard," said Larry Kotlikoff, a Boston University professor.

"Rules of thumb are, quite simply, rules of dumb," he said. "Their use violates the financial planner's Hippocratic oath: First do no harm."

Kotlikoff also said the model used in Scholz and Seshadri's study is not without its warts. "But it's fine for its purpose, which is comparing conventional financial planning with economics-based planning."

Rick Miller, a certified financial planner with Sensible Financial Planning, cautioned against using any rules of thumb. "Using rules of thumb can be very dangerous, if they significantly understate the requirement, or can risk significant regret, if they overstate the requirement."

The summary for this article (and indeed the whole study) is simple: When you need to determine numbers regarding things far out in the future you can't use rules of thumb! You actually have to crunch the numbers!

See your trusted tax advisor or financial planning professional for advice in this area.

For One Year Only (So Far)

2009-11-18T04:29:00.006-05:00

When I first started this blog I didn't expect that I would talk so much about taxes. But the trend in taxes these days seems one directional: UP. It is becoming more and more important that each of us have a handle on how we are taxed and how we can reduce our tax burdens.

Today I just want to point out the new tax benefits for 2009. If you haven't been paying close attention, these appear to be one-time events related to government stimulus efforts for the financial crisis.

Unemployment Benefits are Partially Non-Taxable
The first $2,400 of unemployment benefits received in 2009 are tax-exempt. The remainder of the benefits are taxable. This temporary tax break has not been extended to 2010.

American Opportunity Credit for Undergraduates
A new tax credit for students attending the first four-years of college. The credit is worth up to $2,500, 40% of which is refundable (meaning it can increase your tax refund even if you have zero tax liability). This new credit is more generous than the Hope Credit (which it temporarily replaces for 2009 and 2010) and the Lifetime Learning Credit (which remains available for postgraduates).

Car Sales Tax Deduction for 2009 Only
People who buy a new car, motorcycle, truck or other vehicle can deduct the entire amount of sales tax paid (up to the first $49,500 of purchase price) either as an itemized deduction or as an addition to their standard deduction. (Source: About Taxes.com)

As an aside, here's an interesting chart about tax incidence that has been making the rounds on the Web. No political statement is intended by re-publication here. I just find it interesting. (I apologize for it being a little grainy. It is in the original article as well.) From mint.com:

As always, see your financial planner or trusted tax advisor regarding these.

The Skinny on Roth IRA Conversions

2009-11-12T00:01:00.001-05:00

I have been highlighting the opportunity that is coming up for CERTAIN investors to take advantage of new provisions allowing conversion of regular IRAs to Roth IRAs. It's not for everyone, but for those for whom it IS appropriate, I believe the savings will be substantial.

As a reminder, here are some Roth IRA basics:

* Contributions to a Roth still carry
income limits ($176,000 for married;
$120,000 if you’re single in 2009).
It’s just conversions that have no
income restrictions.
* Until the end of 2009, conversions
from an IRA to a Roth are limited to
anyone with income of less than
$100,000.
* Contributions to a Roth IRA are
made with after-tax money. In other
words, the contribution is not
deductible. That’s why investors
owe income tax when converting
deductible contributions made to a
traditional IRA to a Roth IRA.
* Contributions can be withdrawn any
time without tax or penalty – this
includes any amount converted.
* Once your money is in a Roth -
whether from annual contributions or
a larger converted amount - it grows
tax-free.
* All profits can be withdrawn tax-free
provided the account holder is at least
59 ½ and the account has been open
at least five years.

Fidelity Investments, as part of its improved "investor-friendly" interface, has a nice article complete with examples,entitled "Conversion Confusion" demonstrating the opportunity. You can find it here.

Pay now or pay later? That is the question if you're weighing the pros and cons of converting your traditional individual retirement accounts to a Roth. The benefit of a Roth is simple: Once you're in, you don't have to worry about paying taxes on that account, ever. Tax-free income down the road, though, comes with a price. And that price can be hefty: In the eyes of Uncle Sam, what you convert is taxed as ordinary income.

A bigger tax bill is probably the last thing you need right now. But ironically, this tough economic environment may make it an ideal time to convert to a Roth. Those smaller IRA balances means you’ll owe less tax. (Talk about a silver lining.) Think your income disqualifies you? As of 2010 the $100,000 adjusted-gross-income cap on Roth conversions will disappear. And, next year — and next year only — investors will have the option of spreading their tax liability over two years.

Despite all of the excitement surrounding the Roth, converting doesn't make sense for everyone. At a minimum, says Chris McDermott, a certified financial planner and senior vice president of investor education at Fidelity Investments, investors should be able to answer “yes” to three key questions: Do you expect to pay a higher tax rate when you retire? Do you plan to hold the account for at least 10 years? Can you pay the taxes owed without tapping a tax-sheltered account?

Even if you do answer yes to all three, there are other considerations, notes Barbara Steinmetz, a certified financial planner in San Mateo, Calif. Among them, how will the conversion affect your overall tax situation? “Just a small amount could make the difference to bump you from one bracket to another,” she says. “My advice is to always run the numbers.”

The Fidelity conversion analysis tool appears to be for subscriber-investors only. Here's one that Wells Fargo makes available to all. I haven't vetted it but these tools should only be used to initially evaluate whether conversion MAY make sense for you. Then, as always, you should discuss your options with your trusted financial advisor or tax professional.

Boomers in Denial

2009-11-09T05:02:00.006-05:00

Two things are infinite: the universe and human stupidity; and I'm not sure about the universe.

- Albert Einstein

Think that the savings rate isn't set to increase in the next few years? It will. Why? It HAS TO or an entire generation is going to badly underfund their retirement. Why do I say that? Well, Wells Fargo just released their Retirement Fitness Survey, and had a few pointed things to say about the investment habits of pre-retirees ages 50 to 59.:

“There is a sense of denial among the pre-retirees,” said Lynne Ford, head of Wells Fargo Retail Retirement.

Even after suffering significant losses last year, many remain overly optimistic about their investment returns and the ability of their savings to fund their expenses after they stop working.

Only 23 percent of pre-retirees are saving more for their retirement than they were a year ago, the survey found. Most, some 57 percent, are saving the same amount, and 20 percent are saving less.

Perhaps even more startling is the extent to which their savings are falling short of their goals. On average, these pre-retirees expected they would need $800,000 to fund their retirement. However, most had only saved about $300,000.

Despite their inadequate savings, nearly two-thirds of the group lack any formal plans for retirement savings or spending strategies.

Of the 35 percent of those who had a written plan for retirement, only slightly more than half — about 52% percent — say they had updated it in the past year during the market downturn.

Okay folks, this is just plain silly. If you have a car crash, don't you think it might be wise to step out of the vehicle and assess the damage? You don't just blithely drive on! There's more:

Among the biggest mistakes people are making is over-estimating their investment returns and the amount of money that can safely be withdrawn each year in retirement.

In the survey, both those who were about to retire and those who already had said they expected their savings to grow by 8.7 percent each year, on average. However, the compound annual growth rate of the S&P 500 from 1958 through 2008 was only 6.6 percent.

People also under-estimate how long they will live in retirement, she said. A healthy person in their mid-sixties can easily expect to live into their eighties or even nineties. However, few people are prepared to support themselves in retirement for more than twenty years.

Okay, Mark here. Now we are turning a negligent activity into the criminal. It's not just denial any longer, it's willful ignorance. This continues our theme of people being their own worst enemies when it comes to investing. See this post. We continue our foibles while strolling through the land of planning as well, it seems.

Like Wile E. Coyote, we stepped over the cliff last year. Shouldn't we have said to ourselves that cliff and no parachute are a bad combination? But, according to Wells Fargo, it seems we just dusted ourselves off and continue to chase Roadrunner for the next episode.

Let the Tax-Shifting Begin!

2009-11-06T05:00:00.001-05:00

"We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle”

Winston Churchill

In a Bloomberg News story appearing November 5th, the dots are finally being connected between spending programs on one hand and the need for additional federal revenues on the other. See here.

The U.S. government is spending $787 billion to stimulate the economy, the deficit is $1.4 trillion and Congress is debating costly changes to health care. The taxpayers’ bill to pay for it isn’t far behind.

“Something is going to have to be done to raise revenue unless entitlement spending is cut,” said Gerald Prante, senior economist for the Washington-based Tax Foundation.

While the final resolution of the competing aims is being debated, what is under discussion has pundits opining that Federal tax rates may rise in 2011 to as high as 39.6 percent, up from 35 percent (for those earning more than $373,650). The House version of the health reform bill sets an additional 5.4 percent surtax on adjusted gross income for high- income individuals. Long-term capital gains rates may reach 28 percent, from 15 percent today, Prante said.

Tax advisers intend advising clients to take advantage of lower rates and expiring tax breaks on 2009 and 2010 returns, a tactic that could save millions for clients in the top brackets. Strategies range from investing in film production, deferring large-scale expenses into future years, investing in energy credits, to exercising non-qualified stock options.

“For many of our clients, particularly those who run their own businesses, there may be an opportunity to accelerate significant amounts of income -- even as much as $50 million to $100 million of taxable income,” said Mark Nash, a Dallas partner at New York-based PricewaterhouseCoopers Private Company Services, whose average client has assets of $150 million or more. The tax savings from moving income into 2009 or 2010 would be 4.6 percent of that amount, he said.

To me this just says "It's coming". The whole article is worth a read.

Another Measure of Long Term Value of the U.S. Market

2009-11-02T08:46:00.005-05:00

From Smithers & Co., their informative visualization of long term value of the U.S stock market:

From their website, an explanation of their methodology and results:

US CAPE and q chart

The US Flow of Funds data (“Z1”) have just been published (17th September, 2009) for Q2 2009. We also have 99% of the EPS on the S&P 500 for Q2 2009. On the basis of these data, and allowing for the 16% rise in the stock market since 30th June, 2009, US non-financials on 17th September, with the S&P 500 @ 1069.45, were 40.6% overvalued (using q) and the total market including financials was 36.5% overvalued (using the cyclically adjusted PE “CAPE”).

From being around fair value at the end of March, the US stock market has become significantly overvalued again. In the case of q this is largely because of the rise in the market, aided to a small extent by falling asset values, largely of real estate, and rising liabilities.

In the case of CAPE the increase in the overvaluation of the market is also largely due to the change in share prices but, as current EPS, measured at constant prices, are around half those recorded 10 years ago, the cyclically adjusted EPS is also on a downward path, which is likely to continue for some time.

What is q you say? "q" is the ratio between the value of companies according to the stock market and their net worth measured at replacement cost.What is CAPE? CAPE is the cyclically adjusted PE ratio as formulated by Robert Shiller. Both of these measures (CAPE and q) have been statistically determined to be significantly correlated to LONG TERM returns.

But did you catch what Smithers & Co. was saying about long term returns going forward? "From being around fair value at the end of March...". That would be after a 29% rally off the March 9 lows to about the 810 level on the SP500. We now sit (November 3rd) at 1045.

Have people telling you the market is cheap? Not that it can't rally from here, but cheap it's NOT.

Year-End Tax Planning

2009-10-30T06:43:00.004-04:00

Taxation *with* representation ain't so hot either. ~Gerald Barzan

Here's some basic tax strategies to consider implementing before the end of the year to keep your income taxes as low as possible.

Review the New Tax Credits and Deductions
There's some new tax credits and deductions available for 2009. First, if you purchased a new car or truck you can write off sales tax even if you didn't itemize as part of the new vehicle sales tax deduction. If you are a homebuyer, you should review if you are eligible for the $8,000 tax credit for first-time home buyers. Homeowners should also review whether it would be advantageous to take the additional standard deduction for property tax in lieu of itemizing.

Individuals who have two jobs and Social Security recipients who are working should review their eligibility for the Making Work Pay tax credit.

Boost Tax Deductible Expenses
Every year you should look at strategies for increasing your deductible expenses versus those that are not. Make an extra mortgage payment. The extra interest you pay will be added to this year's mortgage interest by your lender, boosting your itemized deductions. (But confirm with your lender that your payment will be credited as paid in the current year!)

Pay your property taxes.
If your property tax bill is due early next year, you might want to pay it now and take the deduction.

Donate to charity.

Pay Deductible Medical Expenses.
Pay doctor bills, insurance premiums, buy eyeglasses, or stock up on prescription medications. You can take a deduction for medical expenses exceeding 7.5% of your adjusted gross income.

Boost business expenses.

Business owners and independent contractors can buy office supplies, invest in new equipment, or pay bonuses to their employees. They should also review their retirement plans or decide about setting up a retirement plan. Many retirement plans need to be established by the end of the year if owners want to make tax-deductible contributions for the year. You will want to review what constitutes a legitimate business expense just to make sure it will be tax-deductible.

Manage Your Investments to Take Deductible Losses
Sell losing investments to offset capital gains. Investors can lower their capital gains taxes by selling securities that have lost money. Losses offset gains dollar for dollar, and losses in excess of your gains can be deducted, up to $3,000 per year.

Max out your retirement savings. Contributions to a retirement plan reduce your taxable income.

Tax Strategies Beyond Form 1040
Check your:

* Tax-free gifts for education through Section 529 plans
* Maximizing Your Flexible Spending Accounts
* Lowering Estate Taxes Through Gifts

Questions? See your tax attorney and/or your financial advisor!

The "Stretch" IRA

2009-10-19T05:40:00.001-04:00

In your late night studies on retirement investing vehicles, you may have come across the term 'stretch IRA'. This is actually not a category of IRA, such as a Traditional, Roth, SEP or SIMPLE IRA. It is more like a financial-planning or wealth-management strategy imbedded in the product (IRA) provisions.

The "stretch" provision is one you might be interested in if you are using your IRA primarily to provide for your beneficiaries. That is, if your retirement needs will be funded by other assets (lucky you!. Then, you may want to take advantage of this provision in order to structure flows to persons other than yourself.

Identifying the Concept

Does your IRA allows the beneficiary to distribute the assets over a life-expectancy period and also allow him or her to designate a second-generation beneficiary of the inherited IRA? If so, it is this provision that allows a beneficiary to designate a second-generation beneficiary (and even a third, fourth and so on)that determines whether the IRA has the "stretch" provision. It allows the IRA to be passed on from generation to generation, thereby stretching the life of the vehicle.

How It Works

The beneficiary must follow certain rules to ensure he or she doesn't owe the IRS excess-accumulation penalties, which are caused by failing to withdraw the minimum amount each year. How so?

Let's use an example:

Huey's designated beneficiary is his son Dewey. Huey dies in 2008, when he is age 70 and Dewey is age 40. Dewey's life expectancy is 42.7 (determined in the year following the year Huey died, when DDewey is age 41). This means that Dewey is able to stretch distributions over a period of 42.7 years. Dewey elects to stretch distributions over his life expectancy, and he must take his first distribution by Dec 31, 2009, the year-end following the year Tom died.

To determine the minimum amount that must be distributed, Dewey must divide the balance on Dec 31, 2008, by 42.7. If Dewey withdraws less than the minimum amount, the shortfall will be subject to the excess-accumulation penalty. To determine the minimum amount he must distribute for each subsequent year, Dewey must subtract 1 from his life expectancy of the previous year. He must then use that new life-expectancy factor as a divisor of the previous year-end balance.

Now, remember our assumptions. The IRA plan document allowed Dewey to designate a second-generation beneficiary, and he designated his son Louie. If Dewey were to die in 2013, when his remaining life expectancy is 38.7 (42.7 - 4), Louie could continue distributions for Dewey's remaining life expectancy. It is important to note that only the first-generation beneficiary's life expectancy is factored into the distribution equation; therefore, Louie's age is not relevant.

In this example, Huey could have chosen to designate Louie as his own beneficiary, resulting in a longer stretch period. In such a case, Louie would be the first-generation beneficiary, and his life expectancy instead of Dewey's would be factored into the equation.

Primary Benefits of the Stretch Concept

Tax Deferral

The primary benefit of the stretch provision is that it allows the beneficiaries to defer paying taxes on the account balance and to continue enjoying tax-deferred and/or tax-free growth as long as possible. Without the stretch provision, beneficiaries may be required to distribute the full account balance in a period much shorter than the beneficiary's life expectancy, possibly causing them to be in a higher tax bracket and/or resulting in significant taxes on the withdrawn amount.

Flexibility

Usually, the stretch option is not a binding provision, which means the beneficiary may choose to discontinue it at anytime by distributing the entire balance of the inherited IRA. This allows the beneficiary some flexibility should he or she need to distribute more than the minimum required amount, say in the case of a financial emergency.

Benefits for Spouses

Remember, a spouse beneficiary is allowed to treat an inherited IRA as his or her own. When the spouse elects to do this, the spouse beneficiary is given the same status and options as the original IRA owner and the stretch concept is not even in play. However, should the spouse choose to treat the IRA as an inherited IRA, then the stretch rule may apply.

Conclusion

Consult your current IRA provider or financial institution if this concept is of interest to you. IRAs can be transferred if this provision is not present in your provider's IRA plan documents. Finally, be sure to consult with your tax and financial professional for assistance. This concept must mesh with your financial profile and your wealth-management goals.

Inflation vs. Deflation

2009-10-15T08:40:00.005-04:00

We have been discussing what I call the most important choice that planners must make in fashioning their clients' portfolios: Will we have inflation or deflation? Over what term? Now comes a bit of evidence from the Social Security Administration on what environment presently prevails. For the first time in 50 years, no cost of living adjustment for seniors. Why? Read on.

From the Associated Press:

There will be no cost of living increase for more than 50 million Social Security recipients next year, the first year without a raise since automatic adjustments were adopted in 1975, the government announced Thursday.

Blame falling consumer prices. By law, cost of living adjustments are pegged to inflation, which is negative this year because of lower energy costs. Social Security payments, however, cannot go down.

But if Social Security payments aren't rising and rates that savers receive are paltry, what to do? Provide artificial increase through "one-time" stimulus, of course.

Thursday's announcement comes a day after President Barack Obama called for a second round of $250 stimulus payments for seniors, veterans, retired railroad workers and people with disabilities.

The payments would match the ones issued to seniors earlier this year as part of the government's economic recovery package. The payments would be equal to about a 2 percent increase for the average Social Security recipient.

Problem solved!

Gentle Reminders- Taxes

2009-10-10T06:15:00.005-04:00

Taxes: Of life's two certainties, the only one for which you CAN get an automatic extension. ~Author Unknown

Thursday October 15th is the last day to file your 2008 tax return without penalty. It's also the last day for self-employed persons to fund a SEP-IRA for 2008. Wait! There's more! It's also the deadline for submitting any late or corrected foreign bank account reports to the Treasury.

I'll have some year-end tax planning tips for you in a few days. Yes, it's that time of year. Sigh.

Overvalued Markets and Average Ten Year Forward Real Returns

2009-10-05T05:36:00.001-04:00

So a reader asks about my comment about staying out of overvalued markets. How does one DO that? The answer is that there are several measures that I personally use to gauge value but I am going to show you a simple analysis as to how this might be done. Remember that I will be talking about AVERAGE RETURNS. This is an important point. We are trying to control for risk. Sometimes our risk control measures will be well rewarded. Sometimes not. And sometimes the stock market presents you with a hand to be played that ON AVERAGE you should just toss back. Here goes.

In this analysis we are going to assume that the broader stock market represented by the S&P 500 Index is the proper benchmark for comparing stock market returns. And we are also going to assume that, on average, that what investors are concerned about is returns ten years out. I know, that 's a lifetime for some and if investor behavior during the recent crash is any indication, many have hair trigger fingers.

In the first analysis the price to earnings or PE ratios and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals).

The cheapest quintile had an average PE of 8.5 (you paid 8 and 1/2 times earnings for the shares)with an average ten-year forward real return of 11.0% per annum, whereas the most expensive quintile had an average PE of 22.6 with an average ten-year forward real return of only 3.1% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham's GMO, (an investment advisory having billions of dollars under management and having splendid risk-adjusted returns over its lifetime) it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams below and, as can be expected, are very similar to those based on PEs.

So where does the market sit based on these measures? The fourth most expensive quintile based upon PEs and the most expensive quintile based upon current dividend yields. Does that mean the market is about to fall tomorrow? No, research shows that in the short term market performance bears little relationship if any to these valuation measures. But for an investor who needs the money in 2019 for a child's education and also needs a 10% return in order to fully fund it, these analyses should give reason for pause. COULD expectations be met with an investment here? Sure, outliers exist in life and what we are presenting here is a RANGE of performances. But, as we began his analysis, ON AVERAGE, investments here are not well rewarded.

A Break In The Action

2009-09-29T05:00:00.002-04:00

My family and I are moving some 1200 miles from the Northeast and back to our roots (and family) in the Midwest. Packing, house-hunting and the wind up of various activities and commitments leaves little time for blogging this week. We are sad to leave our friends but excited about the new community that we will build there!

See you next with a post about the value (long term of course!) of the stock market!

Millionaires on Budgets

2009-09-22T05:37:00.003-04:00

The financial and economic experts that I regularly follow are all talking about a secular change in attitudes toward debt and spending. The obvious shift is downward, with Americans trying to rectify declining balance sheets with debt that was taken on in the last few years. Apparently, even millionaires have gotten the message. From the NY Times:

SOMEONE with $100 million has nothing to fear, not even fear itself.

But not long ago, a client with such assets called and asked Bruce Bickel, her wealth adviser at PNC Wealth Management, to put her on a budget.

“She said we’ve never done this before, and we think we should,” said Mr. Bickel, managing director of private foundation management services at PNC. “It’s all relative. Their loss has put them in a fear response.”

Doesn't sound like fear to me, despite what her counselor may claim. Sounds like rationality. The stock market is not a one-way bet. It has larger risks to the downside than many people realize, especially when it gets overvalued and disconnected from fundamentals.

Her response is being mirrored all over the country, and for good reason:

The Boston Consulting Group predicted this week that worldwide wealth would not return to 2007 precrisis levels until 2013. It also said it found that the number of millionaires was down 18 percent and that, across the board, clients of wealth management firms had lost trust in their advisers.

The lack of faith doesn't seem misplaced. For all the crowing going on about returns these days, the collective record of preserving assets by fund managers in 2008 was abysmal.

More from the article:

Even though stock markets have rebounded from their lows this year, wealthy investors have not rushed back in.

Nancy Rooney, head of the Northeast investment business for J.P. Morgan private wealth management, which serves clients with $1 million to $25 million, said she has seen two types of investors become cautious in their investing.

The first have new money and had not experienced serious market swings before. They had been focused on their quarterly gains and largely ignored the risks. Having lost a lot more money than they thought possible, they are struggling with the shock of it.

Or, as Mr. Cochran put it, “Many people thought they were gunslingers.” Now, he said, “They’re not gunslingers any more.” Mr. Holley described the sentiment as a return to “meat and potatoes” investing.

Now, that group is focused more on the risk of an investment than its possible return. One result is they are poring through all the disclosures before investing, and they are not as worried about missing out if they are pressured to invest too quickly.

The second group is older and held wealth longer. They exhibited almost a knee-jerk reaction to the crisis and put a lot of money into cash early on. They continued to stand on the sidelines through the initial rebound. Only now are they looking to invest in safe assets, like preferred bonds secured by United States government obligations.

“We are very gradually working with them,” Ms. Rooney said. “For many of them, it was a loss of confidence in themselves as well as in the markets.”

The advisors talk about this as if it is a bad thing or as if their clients need counseling. It is not. It is RATIONAL. If any segment of the population should stay out of overvalued markets it is retirees and near retirees. Likewise, newbies to stock market investing should stare long and hard at ten year average return tables-- especially those linked to starting valuations (PE ratios) before investing a dime. If they don't conclude that the chances of low or no returns is significant the advisor should show them the door. Ignorance is not a defense to losses.

Read the whole article.

Money Market Fund Guarantee Expires

2009-09-18T10:04:00.003-04:00

Besides carrying lousy interest rates, some of the safety that has been imbedded in money market mutual fund accounts for a year-- a government guarantee-- is set to expire today.

One of the many casualties of the financial crisis, these funds were the quick recipient of Uncle Sam's backstopping of all things financial when the Reserve Fund "broke the buck" meaning its value fell below even a one for one dollar return of a customer's money. The subsequent run on money market mutual funds pulled billions away from them and presumably into safer investments such as straight Treasuries in September of 2008. Government was quick to step in. No more:

The Treasury is allowing its year-old guarantee of money fund assets to expire, in one of the first big reversals of the government’s involvement to stem the financial crisis.

The unprecedented backstop was put in place a year ago after one of the nation’s biggest money funds, the Reserve Fund, suffered a run on assets because of losses tied to Lehman Bros. IOUs that it owned.

The government’s blanket guarantee of fund accounts had the desired effect: After a record outflow of $120 billion in the week ended Sept. 23, fund assets quickly stabilized. Confident investors soon began adding more cash to the funds -- even though the Treasury’s guarantee only covered industry assets as of Sept. 18.

After hitting a record high of $3.85 trillion in January money fund assets have been gradually declining, reaching $3.45 trillion this week. But the slide more likely is the result of investors pulling cash to invest in riskier assets (i.e., stocks and bonds) than because they’re worried about the U.S. guarantee expiring.

With the Federal Reserve committed to holding short-term interest rates near zero indefinitely, the funds are earning little on the short-term corporate and government debt they buy. Their investors, in turn, are earning next to nothing, even though most funds are waiving all or most of their management fees: The average taxable money fund pays an annualized yield of just 0.06%, according to IMoneyNet Inc.

I doubt that expiry will cause investors to seek riskier assets. Buy into a 55%+ rally? More likely, the monies will stay put.

Deducting Losses in 529 College Savings Plans

2009-09-17T05:24:00.008-04:00

I have to confess that I had not thought about how losses incurred inside a 529 College Savings Plan could be deducted until I read this article in the Wall Street Journal. It's not a perfect solution (capital losses would be) but it does offer a measure of relief.

Here's how it works. From the article:

Imagine a couple that put $120,000 into a 529 tax shelter for a grandchild a year ago. If the market had continued to boom, that money would have grown tax-free. As long as it was eventually spent on qualified tuition expenses, no tax would have been paid on withdrawals. These 529 plans are terrific tax shelters for middle-class couples with children or grandchildren.

Obviously, though, investing has been a hazardous occupation of late. Imagine that same couple now looks at the 529 and realizes those investments have plunged to just $70,000 in value.

Yikes. That's a $50,000 loss.

The couple can close the account and withdraw the money. At that point, they may be able to deduct nearly all of that loss from their taxable income. That wouldn't restore all the money lost, but could at least soften the blow.

Many Americans may be missing out on this deduction. Most 529 plans are sold through financial advisors, but comparatively few know about this rule. (For those seeking more details, they can be found in IRS Publication 970, Tax Benefits for Education, page 51, and in the Federal Register, Vol. 73, No. 13, page 3445.)

There are lots of caveats. This is one of those things you don't want to try on your own with consulting your tax accountant.

I agree with that last statement. This is a tricky one and must be carefully thought through. But anything that helps in these times should be looked into.

As I previously wrote, I think the recent market lows were an opportunity to ADD to these accounts. But circumstances vary, and frank discussion with and advice from your financial advisor is necessary to establish what is right for YOU and your family.

A Decade of No Wage Gains

2009-09-14T05:07:00.000-04:00

In a decade in which we have experienced not one, not two but three market bubbles and collapses (stocks and houses) we now find that the entire period has left us with stagnant wages. An entire decade with ZERO wage gains! Shocked? Surprised? Not me. From this viewer's chair the entire period was characterized by malinvestment-- first in telecom, media and internet-related businesses and then in financial services punctuated by "financial innovation" (if there is such a thing). The NY Times article is here.

The typical American household made less money last year than the typical household made a full decade ago.

To me, that’s the big news from the Census Bureau’s annual report on income, poverty and health insurance, which was released this morning. Median household fell to $50,303 last year, from $52,163 in 2007. In 1998, median income was $51,295. All these numbers are adjusted for inflation.

In the four decades that the Census Bureau has been tracking household income, there has never before been a full decade in which median income failed to rise. (The previous record was seven years, ending in 1985.) Other Census data suggest that it also never happened between the late 1940s and the late 1960s. So it doesn’t seem to have happened since at least the 1930s.

And the streak probably won’t end in 2009, either. Unemployment has been rising all year, which is a strong sign income will fall.

What’s going on here? It’s a combination of two trends. One, economic growth in the current decade has been slower than in any decade since before World War II. Two, inequality has risen sharply, so much of the bounty from our growth has gone to a relatively small slice of the population.

Well, the early betting line from here is that 2010 sees flat to declining wages as well. It's hard to imagine wages rising with such slack in the labor market (9.7% at last look). Can anyone imagine employers bidding up the cost of labor when your neighbor and mine is collecting extended unemployment benefits? Who is betting on a vigorous "V" shaped recovery other than Wall Street?

Anyway, another data point that structural changes are needed to right this economy. So far, we seem little interested as a country in that bit of hard work.

Debit Card Danger

2009-09-10T09:07:00.003-04:00

I usually refrain from topics relating to debt management, general personal finance and the like but I found an article at Naked Capitalism so surprising and so useful that I am linking it here. I hadn't realized the dangers of debit card loss and high checking balances until I read this. It really is a toxic combination and it caused me to review my own policies for cash management. The gist is that debit card security is not as strong as that associated with an ATM card even. What happens if a thief gets hold of it and tries to drain your checking account bit by bit? The entire article is well worth your time. It follows nearly in its entirety.

Why does anyone have a debit card? I am deadly serious about this question. Not long ago, I switched banks, going from one end of the spectrum to the other. I had been with US Trust, which has great service if you are doing anything complicated and can live with their 9-5 schedule, but costly if your needs are more plain vanilla. They were bought by Bank of America, the good people all left, and I figured if I was going to be with a regular retail bank, I might as well go with one that was cheap, had 24/7 service and good branch hours, and I wound up at Commerce Bank, now TD Bank.

Commerce tried foisting a debit card on me. It took some doing to get an ATM card instead. I do not know why people use debit cards, so perhaps readers can explain this mystery to me.

If your wallet is stolen, someone can pretty quickly drain your account and even go into overdraft. Unlike credit cards, where your losses are limited, you have no recourse. Having had my wallet taken more often than I care to recount and having had the perps run up truly impressive credit charges charges in a mere 10 minutes the last instance (they seem to be getting more savvy over time), the last thing I would want to carry is a debit card. The ATM pin affords you some protection; you have none with a debit card.

Now that would seem to be a sufficient reason not to carry a debit card. Then we have the fact that banks charge particularly aggressive over-limit fees on debit cards. From the New York Times:

When Peter Means returned to graduate school after a career as a civil servant, he turned to a debit card to help him spend his money more carefully.

Peter Means’s bank charged him seven $34 fees to cover seven purchases when there was not enough cash in his account, notifying him only afterward.

So he was stunned when his bank charged him seven $34 fees to cover seven purchases when there was not enough cash in his account, notifying him only afterward. He paid $4.14 for a coffee at Starbucks — and a $34 fee. He got the $6.50 student discount at the movie theater — but no discount on the $34 fee. He paid $6.76 at Lowe’s for screws — and yet another $34 fee. All told, he owed $238 in extra charges for just a day’s worth of activity.

Mr. Means, who is 59 and lives in Colorado, figured employees at his bank, Wells Fargo, would show some mercy since each purchase was less than $12. In addition, a deposit from a few days earlier would have covered everything had it not taken days to clear. But they would not budge…

This year alone, banks are expected to bring in $27 billion by covering overdrafts on checking accounts, typically on debit card purchases or checks that exceed a customer’s balance.

In fact, banks now make more covering overdrafts than they do on penalty fees from credit cards.

I don’t get it. Debit cards are inferior to ATM cards (less security) and in some cases, higher fees (at my bank, if you have a line of credit established, you do not incur an overdraft charge if you go into the credit line). So why does anyone have a debit card? Is this a perverse example of behavioral economics, where the bank offers the worst “opt in” alternative (debit card) and consumers have to take the energy to opt out and get the better products?

And these debit cards, which ten years ago were deemed to be losers for the industry, have been redesigned into cash cows:

Debit has essentially changed into a stealth form of credit, according to critics like him, and three quarters of the nation’s largest banks, except for a few like Citigroup and INGDirect, automatically cover debit and A.T.M. overdrafts.

Although regulators have warned of abuses since at least 2001, they have done little to curb the explosive growth of overdraft fees. But as a consumer outcry grows, the practice is under attack, and regulators plan to introduce new protections before year’s end. The proposals do not seek to ban overdraft fees altogether. Rather, regulators and lawmakers say they hope to curb abuses and make the fees more fair.

Yves here. But we are already getting the usual defenses:

Bankers say they are merely charging a fee for a convenience that protects consumers from embarrassment, like having a debit card rejected on a dinner date. Ultimately, they add, consumers have responsibility for their own finances.

“Everyone should know how much they have in their account and manage their funds well to avoid those fees,” said Scott Talbott, chief lobbyist at the Financial Services Roundtable, an advocacy group for large financial institutions.

Yves here. I bet you he does not keep a running balance on his checking account. Back to the story:

Some experts warn that a sharp reduction in overdraft fees could put weakened financial institutions out of business.

Michael Moebs, an economist who advises banks and credit unions, said Ms. Maloney’s legislation would effectively kill overdraft services, causing an estimated 1,000 banks and 2,000 credit unions to fold within two years. That is because 45 percent of the nation’s banks and credit unions collect more from overdraft services than they make in profits, he said.

Yves here. Garbage in, garbage out. Does not distinguish between debit card overdrafts and check overdrafts. The two are mingled. Back to the story:

For years, banks had covered good customers who bounced occasional checks, and for a while they did so with debit cards, too. William H. Strunk, a banking consultant, devised a program in 1994 that would let banks and credit unions provide overdraft coverage for every customer — and charge consumers for each transgression.

“You are doing them a favor here,” said Mr. Strunk, adding that overdraft services saved consumers from paying merchant fees on bounced checks.

Yves here. Favor? Banks are not in the favor business. This is an insult to the reader’s intelligence. Here is a key bit:

But many of the nation’s banks have found that overdraft fees are easy money. According to a 2008 F.D.I.C. study, 41 percent of United States banks have automated overdraft programs; among large banks, the figure was 77 percent. Banks now cover two overdrafts for every one they reject…

Most of the overdraft fees are drawn from a small pool of consumers. Ninety-three percent of all overdraft charges come from 14 percent of bank customers who exceeded their balances five times or more in a year, the F.D.I.C. found in its survey. Recurrent overdrafts are also more common among lower-income consumers, the study said.

Just wait. The next argument in defense of these practices will be that it is cheaper than payday lending.

Apparently Planners Search for Direction Too

2009-09-01T05:38:00.002-04:00

In an article entitled "Planners Hunt for Help on Portfolio Construction", the recent crisis caused examination (or re-examination) of portfolio construction practices among the nation's planners, which 2007 report authors Cerulli Associates call "a hot button issue".

"As many advisers have looked to expand their practices, they have realized that their highest value activity is spending more time with their existing clients and acquiring new clients," according to CA, which produced an analysis of its survey for FPA Insight, a research newsletter for institutional members. "As they search for ways to better focus their activities, they have looked for the things that were essential to their practice and those that they could outsource. For many advisers, this meant looking to the outside for help with portfolio construction."

What follows is an excerpt from CA's report in FPA Insight (Volume 1, Issue 1):

Portfolio construction is a part of an adviser's practice that has only grown in complexity. During the bear market of 2000-2002, many advisers were forced to accept that their core talent was not managing client assets. In addition, there are more products available than ever before for financial advisers.

The mutual fund universe alone boasts more than 8,000 choices before taking into account a growing selection of separate accounts, exchange-traded funds (ETFs), and alternative investments. Added up, it presents a dizzying array of choices for the financial adviser.

Our survey results confirm advisers' feelings on this topic. More than 75 percent of advisers agree that portfolio construction has grown more complex.

In addition, more than 70 percent of advisers report using a wider range of products, changing their product allocations, and using more complex products. One can see how an ever-widening product universe would affect the complexity and volume of products used by advisers. In fact, the most common reason given by advisers about why portfolio construction has grown more difficult is that it has grown so time consuming.

Outsourcing this task, however, is not a widespread trend. Just over half of the advisers responding to this quarter's survey stated that they never outsource any portion of the portfolio construction process. There are a number of reasons advisers have resisted making this move. Despite an industry move to more holistic planning and deeper client relationships, many advisers are offering many of the newer products in an effort to distinguish themselves. In addition, clients are more sophisticated and, in some cases, are demanding these new products. Finally, many advisers come from a deep investment management heritage and may have begun their career recommending individual stocks.

Although the reasons may differ from adviser to adviser, the net effect is the same-this is not a task over which many advisers are willing to completely give up control.

Although advisers have a stated objection to fully outsourcing this task, a different picture emerges when examining their daily activities. More than half of advisers report using third-party tools to help determine asset allocation. For those advisers associated with a Broker-Dealer (B-D), exactly half report using platform tools to determine asset allocation.

These same advisers report getting help from their B-D in the form of model portfolios, research and due diligence, training and education, and integrated product platforms. Although these advisers might not consider themselves outsourcers of portfolio construction, many of these are activities that leverage outside expertise in order to help save them time.

CA believes these shifting product trends will only continue. When asked what products they use in constructing a core satellite portfolio, ETFs ranked as a popular option for both the core and the satellite portions of the portfolio. This reflects the flexibility of this emerging product. Advisers can deploy the product as a low cost, indexed option at the core of a client portfolio.

However, as product development accelerates, many advisers are seeing the advantage of using more narrow offerings or taking advantage of intraday trading. Not surprisingly, more than half of the advisers surveyed reported that they plan to increase their allocation to ETFs in the coming year.

Folks, the ETF revolution has been going on for some time now. To say that advisors are starting to embrace it doesn't give much comfort. I suppose one had to see how they performed versus index funds but that case has been successfully made for quite some time. ETFs perform just as well with less cost. As a pure source of market exposre they are the lowest cost vehicle around.

Advsiors don't want to give up control over portfolio construction for two reasons in my opinion: 1) it offers a source of fees in an industry where business models almost demand it, and 2) it offers the opportunity to differentiate services. The latter is key to marketing. If your product is like any other (a commodity) how can you premium price it?

Does that mean, Mark, that all of this offers no value? No, that is not what I am saying. It offers the opportunity for value creation. Very few can provide it though.

Sentiment in the Investing Cycle

2009-08-25T07:57:00.002-04:00

The below sentiment cycle chart was first published in 1991 by technical analyst Justin Mamis in a book titled, The Nature of Risk.

I haven't found any better explanation or synopsis of this cycle than that provided by Teresa Lo of InvivoAnalytics. What follows is an excerpt from her book on trading entitled The Ultimate Trading Course. Teresa writes:

What we have (in Chart 14 of The Nature of Risk) is essentially a graphical representation of the manic depressive moods typically experienced by market participants as a function of time and price in one complete sentiment loop. There are two areas in a typical loop where the market does something that traders describe as "churn" or "chop", and two areas where directional trends are found.

RETURNING CONFIDENCE
On the upside, the area where churning takes place is in between the Returning Confidence phase and the Subtle Warning phase, after a significant advance has already taken place. This often appears in the form of a head and shoulders top on weekly or monthly charts. By the time confidence returns, the market has already been going up for ages while the retracement patterns become ever larger, each one scarier than the last.

To technical traders, this type of price action tells us that the market is getting tired. Perceived bull market volatility excites investors. They waited forever on the sidelines for fundamentals to confirm that the move up was "real". The coast is finally clear and they jump in with both feet. This phase typically ends with a failure on test of top, and the big, super scary "buy the dips" pullback begins.

BUY THE BIG DIP
The public continues to pour money in, lured by glowing good news and economic data. After the long move up, finding attractive stocks becomes difficult for technical traders and market veterans. Traders chase momentum where they find it. Investors believe that the game is back on, and they are willing to take big risk and buy big dips. This Big Dip usually comes after a failed test of top in the Returning Confidence phase. The Big Dip typically takes price below the 50-day simple moving average and quite often, to the 200-day moving average. This is where ABC Corrections are typically found.

ENTHUSIASM
Once it is widely accepted that economic and corporate fundamentals are supporting higher prices, a bell goes off. The bull survived The Big Dip. Those who had previously been afraid now have plenty of reasons and "proof" that it is safe to go back into the market and buy again.

At this point, we detect a subtle change in psychology, a shift from the fear of loss to the fear of missing out, and the appetite for risk becomes evident. Investors buy on faith, bolstered by analyst and media reports projecting the trend to continue. As price rises to new highs, they all scream, "It's a breakout!". They are supremely confident that the best is yet to come.

The high made in the Returning Confidence phase typically marks the "point of breakout" and becomes an important psychological number. We know this high is where sellers showed up before, and if price should sink below this area, traders and investors might come to the conclusion that the breakout failed, and therefore, begin selling in case the uptrend is approaching the point where it starts to bend.

At some point, all the buyers who want to be in the market have bought, and they stop buying. Smart money begins to take some off the table. The net result is rotation of buying and selling from sector to sector, causing the major stock indexes to stop going up in any meaningful way and price charts to churn and chop. In the old days, they called this "distribution", marking the transfer of stock from smart to dumb money, from strong to weak hands. This area is where a buildup of participants in position to write sell tickets takes place. If price fails to move up or it comes back under the point of breakout, selling begins.

DISBELIEF
The market fails to go higher, and indeed many of the early leaders have broken down under the 50-day moving average, giving technicians the Subtle Warning. This marks the beginning of the "something is not right" gut feeling, but in the absence of bad news, investors hold on to hope. Not only are they heavily invested in the market, they are psychologically invested in being right and they ignore anything that does not go with their worldview. Indeed, they even wonder aloud why their beloved stocks cannot go up amidst good news, higher earnings guidance and analyst upgrades.

OVERT WARNING TO PANIC
The area of sustained directional trending price action to the downside takes place is between the Overt Warning and Panic phases. There will be some sort of catalyst. Perhaps it is an earnings warning or some point of economic data that leads the crowd to finally clue in that the nagging negative price action they have been watching is the beginning of something big and bad.

The 200-day moving average is broken, and CNBC alerts investors. Everyone knows that the ship is sinking. Those who bought in the churning top realize they are holding the bag and stop buying the dips. Smart money shorts each failing bounce. Stop losses are hit, and margin calls force liquidation. Supply simply overwhelms demand and price action becomes a one-way street.

DISCOURAGEMENT AND AVERSION
After a long price slide, the area where churning takes place is between the Discouragement and the Aversion phase, after a significant decline has already taken place. Often, this appears as a head and shoulders bottom, a cup and handle or a saucer dish pattern. As the public continues to dump stocks, short sellers become bold and bearish. Their views are supported by bad news and poor economic data. Prognostication of lower prices to come is undoubted. This is when everyone knows that the market cannot ever go up again, and that anything, even cash, is preferable to owning stocks.

WALL OF WORRY
While the broad indices are still going down, certain sectors will have bottomed. At some point, everyone who wants to sell has done so, and the selling stops. Low prices and relative value returns, and early buyers with deep pockets begin to nibble at the market. The net effect is that the major stock indexes stop plunging and begins to dribble or moves sideways.

This area is where we find a buildup of participants in position to write buy tickets, producing potential buy pressure. With sellers gone, the market even goes up on bad news. Rallies are labeled as "technical bounces" or are written off as "short covering" Short positions add more on every bounce, confident that lower prices are around the corner. When good news trickles in, it is summarily dismissed as aberrations, subject to revision next month.

AVERSION TO DENIAL
Sustained directional trending action to the upside begins between the Aversion phase and the Denial phase. As the market slowly creeps up, the shorts start to sweat while those who don’t own a piece of the action vow to themselves that they will get in on the next dip that they believe is sure to come. The market continues higher and does not let them in.

More and more bids materialize as buyers show up again while shorts begin to cover. Since there are not many sellers overhead, the move up can be big and fast, and on low volume. If it keeps going, eventually those left behind in the dust have to get in again, and the loop continues.

What, Mark, does this have to do with investing, you say? It turns out that Mamis Sentiment Cycle dovetails nicely with Warren Buffet's maxim to "Be fearful when others are greedy and greedy when others are fearful", doesn't it? The best returns are not made from high valuations on stocks (after lengthy bull markets or strong upward moves in bear markets) but when shares are being thrown away by others. You don't buy chicken at $5 a pound when you know the store will have a sale that weekend for $2 a pound do you? Why are stocks any different?

In any event, Grantham and Hussman (two investors I highly respect) both said in March that stocks had become UNDERVALUED. For about the first time in 20 years. THAT was the time to buy. Now stocks are slightly overvalued by most measures. It's time to be patient and wait for the next opportunity.

Coverdell Education Savings Accounts: Part Deux

2009-08-19T05:00:00.001-04:00

Many readers said they appreciated the heads-up on Coverdell ESAs, saying they had never heard of them! This despite the fact that most had children who had attended college, were in college or nearly were!

So I think it's time these ESAs were explained a little further.

Contributions to a Coverdale ESA are made with after-tax dollars, so you are not permitted to claim an income tax deduction for your contributions. This means that any portion of future withdrawals that represent your contributions will come out tax-free even if the earnings portion is taxable. You only pay the piper once.

Your child can receive tax-free withdrawals in any year, but only to the extent that he or she incurs qualified higher education expenses (QHEE). If your child withdraws more than the amount of QHEE, then the earnings portion of that excess is subject to income tax and an additional 10% penalty tax.

If you also take withdrawals from a 529 plan in the same year for the same student, you will need to allocate the available QHEE between the accounts. Through 2010, tax-free withdrawals can also be taken from an ESA to pay for certain elementary and secondary school expenses. This includes tuition, fees, tutoring, books, supplies, and equipment incurred in connection with school (grades K through 12). It also includes any room and board, uniforms, transportation and supplementary items which are required or provided by the school. You can even use it for the purchase of computer technology or equipment, or Internet access.

Here's a "watch-out" though. Qualified higher education expenses must be reduced by any other tax-free benefits received, such as scholarships and benefits under a qualifying employer-provided educational assistance program.

Eligible institutions are almost any college, university, vocational school, or other post secondary educational institution eligible to participate in student aid programs administered by the Department of Education.

In any year in which a withdrawal is taken from the ESA (assuming it is not the correction of an excess contribution), your child will receive a Form 1099-Q and will need to determine how much, if any, of the withdrawal is included in taxable income. The instructions for making this computation are contained in IRS Publication 970.

The ESA must be fully withdrawn by the time the beneficiary reaches age 30. If it is not, the remaining amount will be paid out within 30 days subject to tax on the earnings and the additional 10% penalty tax.

The additional 10% tax will not apply to withdrawals made due to the beneficiary’s death or disability, or to the extent that the beneficiary receives a tax-free scholarship. Also, it will not apply if the withdrawal is taxable only because qualified expenses were adjusted with the Hope or Lifetime Learning credit, nor will it apply to a withdrawal that is a return of an excess contribution.

Your contribution is treated as a gift from you to the beneficiary. It qualifies for the annual $13,000 gift tax exclusion.

You can even change the beneficiary on the account to another family member if your child decides not to attend college. The "responsible individual" on the account can change the beneficiary at any time to another "qualifying family member" who has not yet attained the age of 30. A qualifying family member is the beneficiary’s child, grandchild, stepchild, brother, sister, stepbrother, stepsister, nephew, niece, father, mother, grandfather, grandmother, stepfather, stepmother, uncles, aunt, first cousin, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. The spouse of any of these relations (except for a cousin) is also a qualifying family member. The beneficiary’s interest can also be transferred tax-free to a spouse or former spouse because of divorce. The new beneficiary must be under age 30 at the time of rollover.

All in all, a wonderful tool for college savings! Again, see your advisor or tax professional for more details on this program.

Converting Roths: Part Two

2009-08-12T06:57:00.003-04:00

Some additional thoughts on Roth IRA conversions....

With a Roth IRA you get to withdraw your investment and earnings tax-free if you've owned the account for five years and you're 59 1/2. But when you do a Roth IRA conversion, there's a separate five-year clock that applies to "conversion basis amounts. If you are under age 59 1/2 at the time of a Roth IRA conversion, the amount you convert is subject to income taxes, but not the 10% early withdrawal penalty that typically applies to taxable distributions taken prior to age 59 1/2.What the government didn't intend was for you to use the IRA conversion option as a work-around for avoiding the 10% early withdrawal penalty.

To avoid this potential abuse, conversion basis removed from a Roth IRA within five years of conversion is potentially subject to a recuperative 10% penalty assuming you are still under age 591/2 at the time of Roth distribution, a point that often causes confusion.

Traditional IRA owners can do Roth conversions. That group includes individuals with SEP IRAs and SIMPLE IRAs, though you have to watch out for the early distribution penalty from a SIMPLE IRA.

But plan participants in 401(k)s, 403(b)s and 457 plans also can do Roth conversions as long as they are eligible to take a distribution from their plan and the funds are eligible for rollover to an IRA. You should check whether your plan will allow in-service distributions so that those funds can be converted now instead of waiting until you stop working.

Things get really complicated if you have a non-deductible traditional IRA! You have to consider the total value of all your IRAs when converting all or a portion and use a pro-rate rule. So, if by chance you have $100,000 in four IRAs, one of which has $50,000 in after-tax contributions, then Uncle Sam will only tax you on 50% of the amount converted. You can't only convert the non-deductible IRA.

More questions abound on whether you can use some of the IRA funds to pay the tax bill due or whether you should use outside funds, whether you can convert to multiple IRAs or not, etc. Consult with a tax or planning professioal on all of these matters.

The Roth IRA Conversion Opportunity

2009-08-12T05:00:00.001-04:00

In addition to providing information regarding planning topics, it is our mission to make it ACTIONABLE. That is why this next article may be one of the most important we pen this year. (We think our other may have been regarding the timing opportunity for 529 plans.) What is up, you say? Well, under the Tax Increase Prevention and Reconciliation Act of 2005, all taxpayers will be able to convert all or some of their traditional IRAs into a Roth IRA, REGARDLESS OF INCOME.

Now, instead of being faced with an "unhelpful" income cap on who could avail themselves of the chance to pay taxes now as a way to avoid paying more taxes later, anyone can do so, and that is big, big news. So much so that the entire financial planning industry is gearing up for this opportunity. For you out there with significant IRA assets, and a connection to a financial advisor or planner, steel yourself to the fact that many phone calls and letters will be coming to advise you of the opportunity and how it relates to your savings and retirement goals as well as legacy planning. Just watch.

Do we think the information deluge to come is misplaced? Absolutely not! As we said, we think this will be one of the most important pieces we write this year. But we also think you'd be well served with answers to some of the most frequently asked questions about Roth IRA conversions before the storm hits. Just imagine this as a pre-emptive strikeof sorts.

Prior to 2010, the amount converted would be reported as income on that year's tax return. Under TIPRA, however, conversions done in 2010 don't have to be reported on your 2010 tax return. Instead, you get to report the income on your 2011 and 2012 tax returns.

Thus, if you converted a $100,000 IRA in 2010, you would report $50,000 in ordinary income in 2011 and $50,000 in 2012, i.e. you get to split your income, thereby potentially reducing your tax burden.

If you do a Roth IRA conversion in 2011 or in a later year, you don't get to spread the income or tax bill over two years. So for one year, your phone will ring off the hook and your mailbox will be stuffed to bursting. Just kidding.

You don't HAVE to split the income however. You and your advisor should engage in "tax planning". If you think splitting the income will create a larger overall tax bill, you can opt out of splitting the income over two years. But the election is all-or-nothing. No piecemeal splits.

Enquiring minds might want to know, given present market dynamics, what happens if you convert to a Roth IRA when there is basis (the original amount invested) in the traditional IRA but it's worth less now than the original contribution(s)? Alas, there's no guidance on that issue. Perhaps a loss can be recognized or perhaps the basis will fully carry over. No one knows yet.

More in our next article. Stay tuned!

Inflation Investing Tools

2009-08-10T05:00:00.001-04:00

Once more, into the breach.

If inflation is to rear its ugly head once more, what are investor's choices for protecting their portfolios? Luckily, we are no longer wedded to stocks and bonds in our arsenal. The 60/40 portfolio, simple and prevalent, has some serious competition. We can now choose among a variety of asset classes that should do quite well in an inflationary environment. Let's take a look.

What doesn't do well? Traditional bonds as their fixed returns are eaten away by inflation. Case in point a 5% fixed instrument in a 4% inflation environment. Real return? 1%.

Stocks don't necessarily perform well with an inflationary backdrop. Companies can't pass along costs quickly enough and margins erode from higher input prices. In the 1970s we saw the result of this. The market declined steadily as inflation pressures, especially commodity (oil) shocks, decimated the economy.

Real Estate Investment Trusts (REITs)offer a measure of protection. Rents can be adjusted upwards, sometimes annually. Oftentimes the leases themselves have provisions that increase the rent automatically to increases in the CPI or other index.

Timber is said to be an inflation hedge although those other than institutions have difficulty accessing the asset class.

Commodities are a direct inflation play. While the rising cost of inputs shrinks the margins of many businesses it obviously is a great benefit to the equities of the producers, refiners, and miners.

Treasury Inflation Protected Securities (TIPs) are a government bond that has embedded inflation protection. Their nominal return adjusts upward so that the return is protected from inflation.

If you fear that inflation may take hold in the economy at some point discuss with your advisor ways to protect your portfolio.

Housing As "An Investment": Followup

2009-08-06T05:42:00.002-04:00

According to Bloomberg, Deutsche Bank has authored a research piece estimating that nearly 50% of U.S. homeowners could owe more on their homes than what they are worth by the time the housing recession ends. See here.

The percentage of “underwater” loans may rise to 48 percent, or 25 million homes, as prices drop through the first quarter of 2011, Karen Weaver and Ying Shen, analysts in New York at Deutsche Bank, wrote in a report today.

As of March 31, the share of homes mortgaged for more than their value was 26 percent, or about 14 million properties, according to Deutsche Bank. Further deterioration will depress consumer spending and boost defaults by borrowers who face unemployment, divorce, disability or other financial challenges.

Seven markets in states with the fastest appreciation during the five-year housing boom -- including Fort Lauderdale and Miami, Florida; Merced and Modesto, California; and Las Vegas -- may find 90 percent of borrowers underwater, according to the report.

The share of borrowers owing more than 125 percent of their property’s value will increase to 28 percent from 13 percent.

Home prices will decline another 14 percent on average, the analysts wrote.

I don't know whether this will turn out to be true or not but the trends don't look promising. Prices are still falling and talk of stabilization seems premature to me. More "green shoots". But my point is that housing itself has never been a great "investment" according to the data and one should not lump it in to that category for planning purposes. It provides shelter, maybe other psychological benefits, but little in the way of real appreciation. See my prior posts on this topic for additional proof.