Sentiment in the Investing Cycle

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

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

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

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

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

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.

"Real" Bear Markets

If inflation continues to soar, you're going to have to work like a dog just to live like one. ~George Gobel

Not that I believe that inflation is about to rear its ugly head any time soon given the deleveraging that is still occurring in the economy, but it always helps to look at things in inflation-adjusted terms. Hence the humor from a 70s era comedian masquerading as economic pundit. As everyone becomes giddy over the recent rally in equity markets it pays to stand back and look objectively at market levels and what they mean for your retirement portfolios. The "non-practicing" financial planner cum blogger Doug Short has been doing a marvelous job of assembling such data, distilling it, and putting it into graphical form with lots of variants for all to see. I especially like his chart showing the "Four Bad Bears" (Nasdaq crash, Great Depression/Dow Jones crash, Nikkei 225 crash and the 2000-? crash in the SP500) in inflation adjusted terms. The results are quite startling, especially for a) those retiring during the last ten years and b) those having or making significant allocations to their equity portfolios during the last 10 years as they saved for retirement. Have a look:



Devastating.

You can click on the chart for a bigger image in your browser. Or, for an interactive version click here.

In real terms an equity portfolio initiated at the market top in 2000 is STILL down 50% despite the heady rally of over 45% from the March 2009 market bottom! Any wonder why people are still feeling the pain? Why consumer confidence is not returning? Why individuals are turning to fixed income annuities? Why disregard for Wall Street is so high?

A graphical lesson for those who think that investing in the markets at any level should get you average market returns "over the long run". For most, the long run isn't nearly long enough.

The Coverdell Education Savings Account

We continue our look at saving money for education, with an examination of the Coverdell education savings account. Once known as an education IRA, these accounts have crucial differences from a 529 Plan. They work like this:

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.

What are the disadvantages of a Coverdell?

* Income limits: Coverdell contributions are limited for single taxpayers with adjusted gross incomes higher than $95,000 and for joint filers who bring in more than $190,000. They phase out altogether for single filers with adjusted gross income over $110,000 and for joint filers with AGIs over $220,000. Contributors to 529s face no income limits.
* Contribution size: Coverdells come with a strict $2,000 per beneficiary contribution cap. Some 529 plans will allow contributions as large as $300,000. Under some circumstances, you can contribute up to $65,000 in a single year without incurring a federal gift tax.
* Age cap: Unlike Coverdells, 529 plans allow contributions to accounts for beneficiaries over age 18 and do not require withdrawal at age 30.


Have a look at IRS Publication 970 for more details. And, as always, see your tax professional or trusted financial advisor for more advice specific to your situation.