Market Corrections

The stock market got “interesting” again this week. Volatility is back after having disappeared for the last year and a half. Volatility in the markets is normal and over the long-term, a 10 percent decline in the U.S. stock market happens once a year – on average.

This week I’ve been watching the financial media try to whip this up into something it’s likely not. I’m guessing it’s good for ratings as financial shows have seen a dramatic viewership decline in the last several years. Now, it’s way too early to start calling for bear markets, but you would think we are in the middle of one if you watch the financial news. And interestingly, each barking head has a different reason for what is happening, how can that be?…. but I digress. 

The market is down a little over 10% from its all-time highs, after running up over 100% cumulatively, the last five years – with dividends reinvested. But I do understand the pain we feel from investment losses is twice the joy we get from gains.

So what should we do when the market goes down?

#1. Stick to your plan and remain focused on your long-term objectives.

If you do anything, it may be a good time to rebalance your portfolio back to your targeted asset allocation percentages.

#2. Don’t pay heed to the pundits, they are looking to stir controversy or sell something or both and don’t obsess about the market value of your investments.

We are inherently irrational when it comes to investments, it may be wise to talk to your financial advisor or planner to discuss or revisit short and long-term expectations.

No one knows whether this correction will be short-lived or turn into a long, drawn-out affair. No one can predict how investors will react given the hundreds of variables that shape global market returns daily. But if you have a plan of attack or have put one in place working with your advisor, you sidestep the emotional flight response and hopefully will look back on this another behavioral vulnerability overcome. 

CBlakely, CFP®, CTFA                            02-2018

Its Never Too Late to Start Investing for Retirement

Michael Kitces, director of wealth management Pinnacle Advisory Group, sees it regularly in his financial planning practice: clients who are close to retirement but haven’t saved. “They fall into two groups — either they don’t focus on it, or they are despondent,” says Mr. Kitces. “They think their retirement is doomed — it’s a real lose-lose scenario.”

His clients are not alone. Among workers age 55 or higher and nearing retirement, almost half have saved less than $100,000, according to the Employee Benefit Research Institute. A third have less than $25,000.

The savings shortfall means many Americans face the prospect of retiring solely on Social Security, which replaces just 39 percent of pre-retirement income for the average worker retiring at 65, according to the Center for Retirement Research at Boston College.

But near-retirees do have some opportunities to improve their financial scenario in retirement. Which is not to give up on saving. Therefore, rule number one is to save more. If you don't live below your means, financial freedom is not within your reach.

If you start saving 25 percent of a $100,000 salary at age 50 could potentially have about $650,000 at 65 or about $1,000,000 at 70 (assuming a 7.5 percent investment rate).

So to start, create a household budget to reallocate spending to retirement saving - it is more challenging until your children are out of the house. But if possible, maximize contributions in your 401(k) account and open an IRA. Over the age of 50, you benefit from higher “catch-up” limits on tax-deferred savings, for 401(k) accounts it's $24,000; for I.R.A.s, it's $6,500.

The contribution limit for 401(k)'s and 403(b)'s increased to $18,500 in 2018. Take advantage of the additional pre-tax savings and future tax-deferred growth. The catch-up contribution limit for employees age 50 and over will remain at $6,000.

If you or your spouse has access to a workplace retirement plan such as a 401(k), you may not be able to additionally make a tax-deductible contribution to an IRA if you earn too much. The IRA tax deduction is phased out for high earners. The IRA contribution limit is $5,500, with an additional $1,000 catch-up contribution allowed for those age 50 and over. That’s potentially a total of $31,000 that can be invested in tax-deductible tax-deferred vehicles.

Also, waiting to file for Social Security offers another opportunity to increase retirement income. Social Security benefits, which are adjusted annually to account for inflation, can be claimed as early as age 62, but monthly benefits rise 8 percent for every year that you wait up to age 70, increasing your benefit by over 60 percent.

When investing be wary of high-cost funds, academics agree, generally the lower the cost of the fund, the more you keep – this translates to a larger balance at retirement.

As always, you should seek out a credentialed professional that is fee transparent and offers holistic, evidence-based advice.

CBlakely, CFP®, CTFA              01-2018

Sources: The New York Times, Center for Retirement Research at Boston College,  Employee Benefit Research Institute

Active v. Passive Investing - What Works and for Whom

The next several posts will attempt to add some clarity as to which strategy may work best for different types of investors.

Its fund managers whom the vast majority of us trust with our long-term stock and bond investments. They choose which stocks and other assets to invest in on our behalf - and decide when the time is right to buy and sell. But, time and again, research has shown that we over-estimate quite how talented fund managers are and how much value they add.

For all the talk of “star” performers, the empirical evidence shows that only a tiny fraction of them outperform the market with any meaningful degree of consistency. In the UK, researchers examined 516 UK equity funds between 1998 and 2008, and found that just 1 percent of managers were able to produce sufficient returns to cover their trading and operating costs.

The remaining 99 percent of fund managers failed to deliver any outperformance - either from stock selection or from market timing (always a suckers bet).

While a tiny number of “star” managers do exist, they are incredibly hard to identify. Furthermore, the research shows it takes over 20 years of performance data to be 90 percent sure that a particular manager’s outperformance is genuinely due to skill.

According to the research, for most investors, it is simply not worth paying the vast majority of fund managers to actively manage their assets. We think we’re paying for better performance and that greater skill will produce superior results. But investing almost always works the opposite way round. The less you pay, the more you keep. Counter-intuitive, but it’s true.

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The investment industry and the media (think CNBC) tend to focus on historical fund performance. But Morningstar research shows that the most reliable indicator of long-term investment returns is in fact cost. Nobel Prize-winning economist Eugene Fama says: "If you're paying big management fees, the cumulative effect of that, given the way compounding works, is enormous."

So what sort of impact do fees and charges have on the value of our long-term investments? Well, over 40 years, your retirement fund, worth say $500,000 with no fees, would be reduced to just $349,100 with an annual charge of 1.5 percent. If overall charges reach 2.5% - and when trading costs are included, that’s not uncommon - this reduces the value of your retirement fund to less than $280,000.





So, even at 1.5 percent, almost a third of your retirement fund is lost in fees, rising to 44 percent when charges increase to 2.5 percentage points.




The message for investors is clear: keep costs as low as possible or find the one percent of funds that truly outperform over the long-term, this is crucial to a successful investment experience. With the stakes so high it makes sense to seek out the advice of a credentialed investment advisor who will look at the big picture with you.

CBlakely CFP®, CTFA           10/2014

Sources: Transcript of interview with Nobel Prize winning Professor Eugene Fama, Pensions Institute (Cass Business School) Discussion Paper PI-1404, Morningstar

Should Individual Investors Buy an I.P.O.?

Twitter has an initial public offering (I.P.O.) for 70 million shares coming in a couple of days and has confidently upped the price range by about 30 percent in the last week. The new price range ($23-$25) will give Twitter around $1.7 billion to finance its growth.

These high profile I.P.O.’s beg the question: Should individual investors buy into an I.P.O.?

According to research from Fidelity Investments, the number of I.P.O.’s so far this year is up 40 percent from the same point last year, and the dollar values of those offerings has increased 10 percent. Sounds like a good deal for investors on the surface, but think back to the last high profile tech I.P.O., Facebook’s I.P.O. was a disastrous stock debut.

Twitter is the type of I.P.O. that creates all kinds of media attention which might entice people to try to buy the stock without doing enough (or any) research. The more of a household name a brand is the higher the probability it will attract a greater number of investors but excitement for a brand and financial success are uncorrelated.

I.P.O.’s don’t just rise in value as they did in the late 1990’s. There are many more flameouts than winners in this market, but most people don’t remember the losers, it’s not wired into our optimistic DNA. (Which is another reason to use a professional advisor, we are like Missourians in that we tend to say, “Show me.”)

For instance, information on the company ahead of an I.P.O. is limited (although there are exceptions). And larger offerings like Twitter’s, often mean more hype, which can cloud an individual investor’s judgment. Remember, as with any investment, it comes down to the fundamentals, current financials and long-term growth prospects. Not to mention, security fit in your overall investment strategy.

Buying with the intent to quickly flip the stock at a profit is a recipe for disaster. Even Wall Street insiders admit they can’t predict the future. A better approach may be to look at what a company does and ask if it is something that will be needed in the future. As always, take the long-view with stock investments. Is the company going to around for the next ten years, if you believe so, maybe the better strategy is to find several stock companies in that industry sector and buy a basket of stocks.

Conversely, not buying the I.P.O. does not mean you should forget about the company. If an investor bought Facebook shares at their low of $18 three months after the I.P.O they have a nice gain currently. Seventeen months after the I.P.O. the stock is trading around $52 a share.

Finally, if it’s something you know about and you have an insider’s perspective on it, an I.P.O.is a way to gamble on that perspective, with maybe better odds due to the depth of your knowledge. Put another way, if you have 20 years in tech and are determined that social media has continued upside for the foreseeable future, buy that I.P.O., but remember, it’s still a bet.

CBlakely CFP®, CTFA      11/2013

Source: New York Times - Business Day, Fidelity Investments

Viewer Discretion is Advised!

2012 seems like it could be the year prognosticators of doom and end of days theorists will be in the spotlight. Full disclosure: – I have a 2012 Mayan calendar and the kitten pictures are just too cute. But seriously, there is one prognosticator in particular that actually does scare me. Not because I think it is true, nope, that’s not even a consideration. It’s that it is loaded with exaggeration using scaremonger tactics to frighten investors into actually buying into this baloney.

Dis-infomercial

I was watching TV and saw an ad for an online video with the following warning label: “The following presentation is controversial and may be offensive to some audiences. Viewer discretion is advised.” “OK,” I said “you got my attention.” The production values are pretty high and I thought it made sense to at least skim the thing before passing judgment. So I watched this video proclaim the end of America and the dollar as we know it. Interestingly, it carried the requisite language ‘may’ and ‘likely’ added to avoid absolutes. This keeps the investment regulators at bay but makes for strange narration with phrases like – “there is absolutely no doubt that this may happen.”

What the video contains is about 45 minutes of hyperbole followed by thirty minutes of a really cheesy sales pitch for investor newsletters authored by the team at Stansberry Investment Research. Really?

Back in 2007 this group was substantially fined by the SEC for securities fraud. Now they make an end of the America as we know it pitch using scare tactics and specious charts and graphs (why are they not properly sourced or labeled?) to goad people into buying their newsletter.

While we are all entitled to our opinion a person who acts in a fiduciary capacity is held to a higher standard. Fiduciary law, putting others interests in front of your own, may be the highest law in the land. And to treat it lightly is to breach that duty. While I have read forecasts that are indeed dire, none of the pieces close by trying to sell you a way to actually make money, while the economy and the dollar and our standard of living collapse around us.

To give one example, at one point during the video Mr. Stansberry talks about something called the 100% Strategy. He claims you can make money without ever having to own a stock. OK, sure, that’s true. Then he makes the statement that you might be forced to buy a stock at less than its current value if something goes wrong with the 100% Strategy. These two positions are so obviously at odds with one another. This is one of myriad examples of how crafty yet misleading this report is.

Fool me once…….

Successful investing is difficult enough with an advisor that is working with you in your best interests, it is nearly impossible otherwise. My advice is to avoid this wolf in wolf’s clothing.

Chris Blakely, CFP® 01/2012

Useful Mutual Fund and Annuity Facts!

A study by Dalbar, a mutual fund research firm in Boston, found that in the 20 years ended December 2010,the average stock fund investor had annualized returns of 3.8 percent, compared with 9.1 percent for the Standard & Poor's 500-stock index. The average person would have been better off, much better off buying an index fund and holding it for 20 years. This again makes the case for professional management or at least index investing if you are a diy type. Why do we keep listening to Sam Waterston?

Why is it when questioned about retirement, nearly everyone prefers the certainty of guaranteed income, like a defined benefit plan, commonly referred to as a pension? But when offered the chance by buying an annuity, nearly everyone declines. Economists call this the "annuity puzzle." Using standard assumptions, economists have shown that buyers of annuities are assured more annual income for the rest of their lives, compared with those who self-manage their retirement assets. There is the term "self-manage" again. Professional advice is invaluable.
Buying an annuity can be scary, make a mistake and there is usually a large upfront penalty in the form of a surrender charge.There are psychological ramifications as well. Rather than view an annuity as insurance against living a very long life, they are viewed as a gamble, in which you have to live a certain number of years to break even. And they can be very expensive - guaranteed income for life, sounds like it should be an expensive option to me. Are they good or bad? Yes and no. It depends on your income needs and investment objectives and risk tolerance. Also, if you can, buy direct from the insurer, it's the least expensive way to purchase an annuity.

CBlakely CFP, CTFA   6/2011

sources: Dalbar, Richard Thaler - NYT

Where to Invest Now for the Next 30 Years (Give or Take)

The largest economies 2011:

U.S., China, Japan, Germany, France, UK

The largest economies 2041: (30 years from now)

China, U.S., India, Japan, Brazil, Russia

If you have a long-term investment perspective and think globally about asset allocation, it may be time to review where you are invested internationally. If you are considering international investing you may want to consider a deeper analysis of these up and comers. Growth generated by the large developing countries, particularly India, China, Brazil and Russia could become a much larger force in the world economy than it is now – much larger than many investors currently expect.

Goldman Sachs issued an optimistic research report on global economies in 2003 which illustrated how China’s economy would overtake Japan’s economy as early as 2016. Well, they were right, kind of, it did happen, it happened in 2010. Maybe Goldman wasn’t optimistic enough.

A lot can happen over 30 years and there is a good chance that the right conditions in one or another countries economy will not fall into place and any projection will not be realized. However, if the BRICs (Brazil, Russia, India, and China) pursue sound policies (I’m talking mostly to you Russia) these projections may indeed become a reality. Remember, fifty years ago Japan and Germany were struggling to emerge from reconstruction. Thirty years ago South Korea looked a lot like North Korea looks today.

The progress of the BRICs will be critical to how the world economy evolves; they could become a dominant force in generating spending growth over the next few decades.

As developing economies grow, they have the potential to post higher growth rates as they catch up with the developed world. China's economy during the past 30 years has changed from a centrally planned system that was largely closed to international trade to a more market-oriented economy that has a rapidly growing private sector and is a major player in the global economy, not to mention the green economy.

There is a well-known existing econometric model from Levine and Renelt (http://www.fordham.edu/economics/mcleod/LevineandRenelt1992.pdf) based on cross-country econometric research that explains average GDP growth over the next the next thirty years as a function of income per capita, investment rates, population growth and secondary school enrollments. This closely matches the Goldman projections (in parenthesis) which employ a very different technique. The results are as follows:

Brazil – 3.3 (3.7) Russia – 3.5 (3.9) India –5.3 (5.8) China -5.8 (5.6)

These numbers predict robust average growth for these countries over the next several decades. Higher growth may lead to higher returns and increased demand for capital in these markets.

What are the implications? Well, the weight of BRICs in investment portfolios could rise sharply. The movement of capital might move further in their favor and significant currency realignments would take place.

As we become a shrinking part of the world economy, the accompanying shifts in spending could provide significant opportunities for many global companies like Coke and Caterpillar. Being involved in emerging markets is likely becoming an important strategic choice for many firms large and small.

Therefore, being invested in and involved in the right markets –particularly the right emerging markets may become an increasingly important strategic choice. While international investing does not reduce portfolio risk by a significant amount, it is measureable. And it does increase a portfolios expected return slightly and in the long run that’s what equity investors are looking for – whether stocks are 20 or 80 percent of the portfolio.

CP Blakely - CFP®, CTFA, CMFC 12/2010

Sources: CIA The World FactBook, Global Economics Paper Number 99 - Goldman Sachs, American Economic Review Vol.82 pp. 942-963

PIGS Headed Off to Slaughter

The largest financial crisis in history has spread from private to sovereign entities to paraphrase Nouriel Roubini, founder of Roubini Global Economics..Europe’s recovery will suffer and the falling euro will subtract from growth in its key trading partners. At its worst it conceivably precipitates a double-dip recession.

Now, governments everywhere are releveraging to socialize private losses and jump-start private demand. But public debt is ultimately a taxpayer’s burden. Governments subsist by taxing private income and wealth, eventually governments must deleverage too, or else public debt will explode, precipitating further, deeper public and private-sector crises.

This is already happening. Greece is first over the edge; Ireland, Portugal and Spain (yes, the acronym for these countries is pigs) trail close behind. Italy, while not yet illiquid, faces serious risks. Even France and Germany have rising deficits. UK budget cuts are starting. Eventually Japan and the US will have to cut too.

At home, recent data on employment, GDP and personal income highlight the complexity of information, which is sometimes contradictory and adds to the difficulty in making appropriate decisions. What the numbers suggest is that underlying demand in the economy remains subpar relative to the typical recovery. Therefore the rub is: there is a recovery (granted it’s a recovery only a statistician could love) but it remains disappointing relative to expectations and therefore disappointing relative to the financial markets - the Dow 30 recently fell from 11,200 in April to under 10,000 in early June.

This recovery is going to take more time to coalesce than those in the past. Job growth will remain disappointing compared to prior recoveries and therefore personal income and eventually consumption will be disappointing. Moreover, persistently high unemployment suggests the labor market is seeing lots more structural unemployment, which is a mismatch between the needs of employers and the skills and training of the labor force) compared to earlier recoveries. Slower growth is also associated with continued low inflation and steady interest rates. Yet, despite very low mortgage rates I don’t see a jump in housing starts any time soon. But given the current state of the Euro community and the headwinds facing us domestically, I continue to see a subpar recovery.

I’ve said it before and I’ll say it again. A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways. A portfolio defined today must play out in the uncertainty that is our future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Since the stock market is not going anywhere anytime soon why not take a look at the debt side of your balance sheet. With 15-year mortgage rates at about four percent it may be wise to compare the cash flows of your 30-year loan to with those of a 15-year mortgage at the current market average of four percent (don't forget to factor in points). Running my own mortgage comparison, I found it was a cash flow push, meaning I would pay the same monthly mortgage payment on the 15-year note as I am on my 30-year mortgage, with one huge exception: my mortgage would be paid off 84 months sooner. That means huge interest cost savings (sorry Mr. Banker).

Christopher Blakely 07/02/2010

Sources: Roubini Global Economics, Bloomberg LP.

Tim Geithner Should Resign......Unless

Financial reform seems to be going nowhere fast. Legislation has been proposed, but it is complicated and diffuse. Most of the proposed fixes are incremental changes that don’t seem likely to prevent future meltdowns or bubbles.

The House and Senate are squabbling over which federal agency should take the lead in supervising banks. The Secretary of the Treasury, as well as Congress, have fallen into the trap of trying to fix everything. Instead, they should agree on the most important remedies.

The banking crisis exposed several serious problems:

• Mortgage regulation was too lax and in some cases nonexistent.
• Capital requirements for banks were too low.
• Trading in derivatives such as credit default swaps posed giant, unseen risks.
• Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed.
• Bankers were moved to take on risk by excessive pay packages.
• The government’s response to the crash also created a big hazard. Markets now expect that big banks won’t be allowed to fail, weakening the incentives of investors to discipline big banks and keep them from piling up too many risky assets again. It’s time to end too big to fail by making it less palatable for banks to remain big.

The first of these problems, mortgages, has already been addressed by the Federal Reserve and other regulators. It is much harder today to get a "ninja" loan or a mortgage with no money down. Banking regulators should ensure that the reforms stick by adding a policy principle: mortgages should be approved only on the basis of a borrower’s ability to service the loan, not on the expectation that the loan will be refinanced.

There has also been a hint of progress on the second problem - capital requirements. The Group of 20 nations have agreed to raise standards for banks when the world economy recovers. The U.S. does not need to wait we should insist on higher standards now. Leverage is already down from pre-crash levels, so regulation would ensure that banks won’t return to their old, highly leveraged ways.

The Securities and Exchange Commission and bank regulators should update model-based approaches that set leverage ratios according to Monte Carlo-type formulas. These formulas focus on too narrow a range of probabilities wherein we know that the tails, while statistically small, are significant.

The proposed legislation attacks the third issue by requiring that some derivatives be traded on an exchange where, presumably, they would receive adult supervision. Critics are unhappy because many derivatives still could be traded in customized, private arrangements.

But the issue of where derivatives are traded is secondary. AIG got into trouble because it had to post tens of billions of dollars in extra collateral as its positions went way against them. Thus, the relevant question is the amount of collateral supporting each trade.

A regulatory expert from Harvard Business School, has suggested an ingenious solution. Exchanges should require traders to post significant collateral, and the SEC should mandate that, for derivatives traded off exchanges in private transactions or elsewhere, traders adhere to the highest collateral minimums set on the exchange.

Moody’s, Standard & Poor’s and Fitch Ratings fed the mortgage bubble with crazily permissive ratings on mortgage-backed securities. The ratings companies were paid by the Wall Street firms who put the deals together and needed the ratings to market their products.

Yes this is a conflict-ridden arrangement but I believe the ratings agencies did not understand what they were rating. Chuck Prince the previous CEO of Citibank had no idea or understanding of what his derivatives desk was doing - he just let them do it (it was good for his bonus!). Also, a money management firm asked me to review a retail CDO (collateralized debt obligation) in 2008 and at first blush it looked fine, a triple A rated, 7 percent government agency bond (in a 3 percent market, hmmm). After a deeper analysis I realized this was a Wizard of Oz offering - lots of smoke and mirrors. The ratings agencies need to continuously educate their analysts to stay abreast of the new new securities coming out of Wall Street.

Inflated compensation, is endemic to all industries, not just financial firms. But it encouraged excessive risk-taking, and thus high leverage, on Wall Street (and in Charlotte). The government is trying to restrain compensation in various ways, such as rulings from the pay czar and Fed guidelines for banks. They aren’t working -- witness the return of big bonuses on Wall Street. Moreover, the new fixes suffer from micro- management. I really don’t want bureaucrats sifting through paychecks.

A better fix would be to require shareholder approval for large pay packages, say $3 million and up. Many banks would pay just under the threshold to avoid a vote. Investment bankers might discover that life can be acceptable on $2,999,999 a year. And for those who get shareholders to approve greater swag, that’s capitalism at work.

Finally, when regulators bailed out Bear Stearns, Fannie Mae and Freddie Mac, they insisted they weren’t setting a precedent for future rescues. Fed Chairman Ben Bernanke said addressing the problem of too big to fail should be a "top priority." In a perfect world, all banks would be allowed to fail.

We know from recent experience they aren’t. Endowing them with a privileged position promotes reckless behavior. The government, instead, should make it undesirable for banks to be within the circle of protection. It could do this by charging big financial institutions larger insurance premiums and by further raising their capital standard. This would encourage them to shrink to a size where failure didn’t pose a threat to the U.S. economy.

As bad as the financial crisis was, we don’t need the government running Wall Street nor do we need new federal agencies. We need a few carefully chosen rules to reassert proper incentives and proper limits. So get on it Tim, your time is running out

C Blakely 11/2009 VGKDWNUGWKGK

Sources: Bloomberg LP, WSJ, Harvard Business Review

Asset Allocation in a Flat World (think globally, not locally)

Global Diversification
One of the three big questions investors must consider today is: How and how much should one allocate to stocks in and outside of the U.S.? In his book, "When Markets Collide," author Mohamed El-Erian describes a multilateral economic future in which domestic demand in emerging markets is a counterbalance to U.S. growth. His recommendation is that U.S. investors be exposed to a globally diversified set of stocks, with only a third to one-half in the U.S.


If you agree, and we do, then what does "globally diversified" actually mean and how do you determine how much and where?


The difficult issue is determining a valid reference point. The obvious approach would be to start with an established benchmark as a frame of reference. A good neutral frame of reference would be the total world stock market value, except for the risk that constantly annoys capitalization weighted markets - you potentially overweight overvalued markets! A better alternative might be economic size as measured by GDP in that the weightings are not affected by short-term market momentum or overvaluations.



The total world stock market value and GDP for 2008 is as follows:
mkt. value GDP
U.S. 36% 23%
Europe 26% 36%
Asia Pacific 28% 26%
Mid East/Africa 3% 6%
Americas 4% 7%
Canada 3% 2%


Implementation


The most common approach is to achieve targeted international equity country weightings using a combination of developed international and global emerging markets strategies. Alignment with the MSCI EAFE (Europe, Australasia and the Far East) and the MSCI EM (Emerging Markets) Index will accomplish this.


These markets vary from relatively to significantly inefficient, therefore our suggestion would be to engage active portfolio managers who have the ability to create alpha (excess risk-adjusted return) consistently (keep the index funds for your short duration fixed income funds and large cap U.S. funds).


It is possible that the next ten years will bring lower correlations of international markets with the U.S., as regions like Asia decouple as they mature and become less dependent on the U.S. and continue to demonstrate growth in their domestic economies.



Christopher Blakely Sept. 2009

sources: International Monetary Fund, MSCI

Important New IRA Rules

Starting January 1, 2010 the qualifying income limits that have prevented many individuals from converting a traditional IRA or employer-sponsored retirement plan to a Roth will be eliminated. The change is one of the most important on the IRA landscape in years. The question most frequently asked is, “should I convert my traditional IRA to a Roth IRA?”

There is no simple answer but there are several important considerations.
First there is the fact that there is little to no advantage to doing a Roth IRA conversion if you have to withdraw money to pay the resulting income tax from other retirement plan assets.

Moreover, conversion to a Roth IRA should be account balance neutral (see the table below for a sample illustration).

And yet there may be several reasons to consider conversion. At RKM we have the capacity to run the numbers to assist you in making the right choice.

+ When rates are going down the conversion likely makes no sense.
+ When interest rates are going up the conversion is more likely to make sense.
+ Conversions are likely better for the person who doesn’t need to live off the funds. There are no required distributions associated with a Roth IRA. With traditional IRAs, you must begin tapping your account after reaching age 70½. In doing so, you increase your taxable income starting in your 70’s.
+ Conversions are generally better for a person that has other funds to pay the taxes. Paying taxes with IRA assets defeats the purpose.
+ Conversions for a couple may make sense.
+ Conversions for a person with an estate tax issues will make more sense than for a person without. Your estate ends up with a higher percentage in tax-favorable retirement plans.
+ Conversions to leave a Roth IRA to grandchildren often have merit. Because Roth IRA owners are not subject to required minimum distribution rules the assets in the account continue to grow tax-free. And over a period of years this growth can be exponential. Although Roth beneficiaries are required to take distributions each year the withdrawals are tax-free. Making the Roth a great retirement asset for which to transfer the greatest amount of wealth.
+ Conversions for a person with net operating losses or other loss carry-forwards can make sense. In order to realize this favorable tax attribute there is the option of using a Roth IRA conversion to “offset” the loss or carry-forward.
+ Triggering large capital gains to pay the income tax on the Roth IRA conversion, one essentially loses tax deferral that might otherwise normally occur in a portfolio – this may make a conversion to costly.
+ A person who will need the money in retirement will need to withdraw less from a Roth IRA, because they won't need to cover the tax liability. This leaves more money in the account and leaving more in the account can be a great comfort during retirement and adding a tax-free account gives you the most flexibility to keep taxes low in retirement.

Who Qualifies?

Individuals whose modified adjusted gross income for 2009 is $120,000 or more can’t contribute. For couples who file joint tax returns, the cutoff is $176,000.You can’t convert traditional IRA assets to a Roth if your household’s modified adjusted gross income exceeds $100,000. A married person who files a separate tax return is prohibited from converting—no matter how what their income level. While the income limits for funding a Roth will remain, the rules for conversions are about to change.

As part of the Tax Increase Prevention and Reconciliation Act, the federal government is eliminating permanently, the $100,000 income limit for Roth conversions, as well as the restriction on spouses who file separate tax returns. The changes also should allow more retirees—who rolled over their holdings from 401(k)’s and other workplace savings plans into IRAs—to convert to Roth IRA’s.

When you convert assets from a traditional IRA or workplace plan to a Roth, you have to pay income tax on all pretax contributions and earnings included in the amount you convert. However, you may either report the amount you convert in 2010 on your tax return for that year or spread the amount converted equally across your 2011 and 2012 tax returns, paying any resulting tax in those years. The two-year option is a one-time offer for 2010 conversions.

If you are age 70½ or older and taking required minimum distributions from a traditional IRA or workplace plan, you can convert remaining traditional IRA assets to a Roth.

If you hold traditional IRAs made up largely of pretax contributions, such as a 401(k) rollover, your tax bill could be steep. One way to mitigate the tax-bill pain is to get your tax advisor to help you figure out how much you could convert within your current tax bracket each year without bumping yourself into a higher one. Interestingly, the new rules come at a time when many IRAs have significantly declined in value, meaning the taxes on such conversions will likely be lower, as well. And with taxes expected to rise in coming years, the idea of an account that’s safe from tax increases may appeal to you.

If you expect your income to be lower in retirement—and tax rates to stay about where they are—then a Roth conversion might not make sense. Whether you convert or not basically depends on what you expect to happen with your income in retirement, compared with your income while working, and whether you’re more comfortable paying taxes sooner at current rates or betting on lower taxes later.

First Things First

First look at past tax returns you have in file boxes. You’re supposed to keep a running record of nondeductible IRA contributions on IRS Form 8606 and file it with your tax return. If you haven’t done so, you can either buy back your old tax returns from the IRS, using Form 4506, or you can order a free transcript of everything that’s reported about you to the IRS, using Form 4506-T. Included in your transcript is information from IRS Form 5498, which reports contributions you made to an IRA. Other resources are year-end statements from your IRA custodian.

Some owners of IRAs that hold variable annuities with depressed account values are planning to convert those investments to Roth IRAs as well. The current value of the underlying investments in their variable annuities has fallen below their income benefit or death benefit. In that situation, if you convert to a Roth, you’d pay tax on the lower account value—and potentially get a higher benefit in the future, tax-free.

Still, if you have a variable annuity and you’re considering a Roth conversion, make sure you value the account according to the latest IRS rules. The IRS ruled that you have to get the actual fair-market value of your account from the insurance company and use that number.

The Next Steps

Organize paperwork for any nondeductible IRA contributions you’ve made in the past. By taking that step, you should be able to come up with an estimate of how much of your potential conversion would be taxable. If you expect your 2010 income to be similar to 2009 you can look up the tax brackets at http://www.irs.gov/ to get an idea of the taxes to be paid.
It may help to consult a financial planner or tax advisor who has experience working with retirees relying on IRAs. The tax rules governing IRAs are convoluted and obtuse. A mistake may leave you with significant unintended consequences.

Chris Blakely, CTFA 08-09


Sources: The Wall Street Journal, IRS.gov, rothconversion.com

Out of the Frying Pan into the Other Frying Pan?

Recession Ending?

The pace of U.S. job losses slowed more than forecast last month and the unemployment rate dropped for the first time since April 2008, the clearest signs yet that the worst recession since the Great Depression is easing.
Payrolls fell by 247,000, after a 443,000 loss in June, the Labor Department said today in Washington. The jobless rate dropped to 9.4 percent from 9.5 percent.
The report stoked optimism for a recovery in the second half of 2009. While the Obama administration’s fiscal stimulus efforts are projected to have a significant impact on the economy, any rebound in hiring may be delayed as this recovery like the last may be labeled a jobless recovery. Unemployment is a lagging indicator.
We – as consumers - are by no means out of the woods, but we are moving in the right direction, many economists have revised forecasts to reflect moderate growth in the second half of 2009 and more of a pickup in 2010.
Even so, economists predict consumer spending, which accounts for 70 percent of the economy, will be slow to gain speed. Wages and salaries fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department data issued this week.

Tax Increases?

The current administration recently raised its estimate for this year’s federal deficit by 5 percent to a record $1.84 trillion as the recession reduces tax receipts and increases the costs of propping up the economy. U.S. consumer prices may rise from 2 to 4 percent in 2010, according to economists in a Bloomberg News survey, and may head higher from there.
On August 2, 2009, on ABC's This Week, Treasury Secretary Timothy Geithner refused to rule out middle class tax hikes in an interview with George Stephanopoulos. Following is some of the exchange from the show:
George: "I know you believe that passing health care is central for getting the deficit under control. But independent analysts say even with that you are going to need to find new government revenues. The former deputy Treasury Secretary Roger Altman said it is no longer a matter of whether tax revenues should increase but how. Is he right?"
Tim Geithner: "George, it is absolutely right and very important for everyone to understand we will not get this economy back on track, recovery will not be strong enough to sustain unless we can convince the American people that we're going to have the will to bring these deficits down once recovery is firmly established."
The U.S. Treasury expects the U.S. national debt to bump up against the debt ceiling of $12.1 trillion (yes that’s trillion with 15 zeros) in the final quarter of 2009. One way to bring down deficits is to raise taxes.

Monetary Policy as the Economy Recovers

From the Board of Governors of the Federal Reserve System Monetary Report to Congress (July 21, 2009):
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve's legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve's dual objectives of maximum employment and price stability.

While the Fed has done a yeoman’s job averting depression it looks as if they have given short shrift to recovery plans. Specifically on dealing with the expected inflation that heavy economic stimulus brings.
We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation. Therefore, inflation-hedge securities should be in most investor’s portfolios when the economy begins to gain some traction. (Refer back to the beginning of this piece.)
A well diversified portfolio includes asset sub-classes such as agribusiness, managed timber, Treasury Inflation-Protected Securities, known as TIPS, commodities, energy and others. These mostly real assets have historically done well in inflationary environments.

CPB, August 2009

Sources: Bloomberg LP, the Board of Governors of the Federal Reserve

The New Normal

The New Normal

In a recent speech Bill Gross of PIMCO outlined what his firm has termed the "New Normal." In a world of more regulation, private-sector deleveraging and less consumption, "it's hard for PIMCO to imagine" the Dow Jones Industrial Average/quotes/comstock/10w!i:dji/delayed climbing back to 14,000 or home prices returning to 2006 levels, growth will be stunted," he said. "It will be a different type of world and we have to get used to that."

“The U.S. economy will grow at between 1 and 2 percent a year rather than 2 to 3 percent a year for the next three to five years at least, that will make a significant difference for corporate profit growth," he said. Moreover, unemployment will hover around 7 to 8 percent rather than the recently typical 4 to 5 percent, he added, and the higher rate would be around "for a long time to come." Gross added that inflation would also start to accelerate in the near future.

This “New Normal” economic climate prompts investment advisors to question many previously held assumptions -- especially about whether stocks will outperform bonds, and what this means for their portfolios. Data shows that over certain time cycles, bonds have outperformed stocks.
Many experts have been pointing out how great U.S. government bonds have done the past 30 years – which they have - but in our view at RKM it's nearly mathematically impossible for bonds to do that again, based on current yields. The future can't be like the past; in fact it might be a mirror image – that is a reversed image.

We are convinced that equities now are priced more attractively. Government bond yields coupled with the looming threat of inflation - the curse of fixed-income investors - as the government prints money to combat the financial crisis provides more ammunition for this case.

What about the Banks? Financial engineering had supplanted real engineering in cities like London and New York and whole economies (Iceland) became dominated by the fast growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10 percent in the early 1980’s to 40 percent in 2007! The stock market value of financial services firms increased from 6 percent in the early 1980’s to 23 percent in 2007! Why didn’t they see this crisis coming?

Relying on financial innovation has proved disastrous - think 80’s S&L crisis, 90’s international banking and LTCM crisis and the debacle we are still living. In “A Short History of Financial Euphoria,” economist John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." At this point we recommend avoiding bank stocks and bank sector mutual funds until the smoke clears.

What to do
Maintaining your wealth in the future will require strategies that reflect this changed vision of global economic growth. Bond investors should confine purchases to shorter maturities where price protection is more probable and as inflation increases, cash from maturing notes can be reinvested at higher rates. Investors may experience lower rates of return than what they grew accustomed to until 2008. Returns are the result of an economic environment.
In light of this “new normal” reality, investors should look for stable income from a portion of their investments, rather than reaching for returns. Short-term bond ladders and income paying stocks are two good examples.

Also, there is a chance that the dollar will lose its reserve status. The U.S. simply has too much debt. To be ready for that day, investors should invest outside the U.S., in faster growth economies. In particular, the BRIC countries - Brazil, Russia, India and China, for instance, consumption in China is 35 percent of GDP compared to nearly 70 percent in the U.S.- that shows huge growth potential.

PIMCO’s co-CIO’s Gross and El-Erian sum things up succinctly with the following half dozen sentences. “For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 [U.S., Japan and Europe] and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector.”

“The banking system will be a shadow of its former self. With regulation more expansive in form and reach, the sector will be de-risked, de-levered, and subject to greater burden sharing. The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions as well as the investment management industry.”

“In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth.”

If the above holds true and you are paying your advisor 2 or 3 percent in total fees your portfolio may suffer needlessly, therefore think about lowering your costs. As John Bogle was recently quoted saying, “A financial system that takes too much out of investor returns doesn't create additional value. We want to beat the market but will inevitably fail because of [transaction] costs, so I question our values and what is really enough.”


Chris Blakely, June 2009

Sources: PIMCO, Bloomberg LP, JK Galbraith, John Bogle, Morningstar, Marketwatch.com, NBER

What Goes Down Must Go Up

Confidence or Prozac
In his most recent article, Jeremy Grantham describes seemingly reasonable people, armed with terrifyingly accurate data, foretelling of the end of the world. Investors with lots of cash become inert objects, mired in cement, and too terrified to invest. Those investors who are fully invested move from fear to denial and finally to panic, at the end becoming catatonic.
Grantham encourages all investors, before rigor mortis sets in, to evaluate where they currently are, where they want to be, and how they can get there. A clear “battle plan”, developed by taking motivation from both your head and your stomach, he says, should clear the way for investors to overcome “investment paralysis”.
Elaine Garzarelli, formerly a Prudential analyst, called the market correctly in 1987, when shortly before the market crashed in October she put her clients into cash, where they stayed until the mid 1990’s, ultimately missing out on much of the rally in the stock market during the Clinton administration. She was only half right. In other words, you have to be right twice about something that no one knows with any certainty.
For those who are waiting for the tide to turn before they purchase stocks, remember that human nature is hard to overcome. For instance, you decide to invest when the market moves up 10 percent. That day comes, but you may decide, “is this rally groundless?” Therefore, you wait until the market moves up another 10 percent – just to be certain. At that point, you decide to wait for the market to pull back a bit and then buy because you’ve already missed 20 percent. As you wait for a better day the market advances another 20 percent and now with current investor psychology very bullish (a condition usually evidenced somewhere near the top of the market) you decide to jump back in having missed 40 percent of the market’s appreciation. Unfortunately, at every signpost, the future is no more predictable than it was at the last one.
What goes down must go up
“Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.” This quote by Warren Buffett from his letter to Berkshire Shareholders sums it up quite well. It is worth noting that since market records have been kept, stocks have outperformed every other investment category – including the period of the Great Depression, when they lost nearly 90 percent of their value!
If you have substantial cash you will need to (re)invest at some point. There is motivation to start now (confidence), as long as you are willing to risk the possibility of short-term declines in return for long-term profits. Remember, the future is not foreseeable and the fundamental goal of equity investing is to buy lower and sell higher. RKM has long advocated a strategy of buying into market declines, given that the biggest risk for many investors is to over-allocate to cash, missing upward movements in the market, which normally happens rapidly and abruptly.
Year of the Ox (aka Bull!) –coincidence?
We don’t know when the market will bottom. But whether it’s this month or December of this year, we are confident it will. It the meantime there is a strategy for the large cap equity portion of a portfolio that offers high current income with the potential for long-term appreciation. We suggest adding high quality equity/income funds or “dividend aristocrat stocks” to the portfolio, as this likely increases current income with appreciation potential. The S&P 500 dividend “aristocrats” are the 52 companies in the S&P 500 index that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. The current yield on several equity/income funds averages about 5 percent. That’s comparable to starting a 100 yard dash on the 50 yard mark, given that large cap stocks returned on average about 10 percent annually over the last 70 years. Investment income, whether from dividends or interest provides a cushion in down markets and many top-quality stocks have higher yields than the 30-year Treasury and better appreciation potential.
Grantham calculates the “fair value” of the S&P500 at 900, approximately 30% above where the index sits now. Although he believes that the index has a 50/50% chance of dropping below 600, many stocks and funds will have posted a double digit return per year above inflation for the next seven years. This might not be the absolute bottom of the market, but it is so close to a bottom, prudent investors are now investing.


Christopher Blakely 03/2009

Sources: The Wall Street Journal; Bloomberg LP, GMO North America

Equity Investment Thoughts February 2009

Graham’s premise (which he did not abandon even during the great depression) was that sooner or later the markets will reflect underlying corporate valuations. Therefore, long-term investors had a “basic advantage” over other investors, because they could ride out the tough markets rather than be panicked into buying or selling.
While stock markets periodically make dramatic swings up and down the earning power of the U.S. economy endures (with fluctuations). As Roger Lowenstein phrased it recently in the New York Times Magazine, “The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.”
Therefore, it is with a heightened sense of perspective that we review the recent past and share our investment view for the future.
Great Depression II? We think not. The U.S. economy is experiencing what appears to be its deepest secular recession since the mid 1970’s and it may take a few more quarters for the economy and consumers to deleverage and turn the supertanker that is our economy around. In spite of this there are some bright spots for the upcoming year:

> The corporate sector is in relatively good shape with low debt and inventories
> Energy prices are down significantly with gasoline prices cut in half, now that the speculators are out of the market (good for consumer confidence and boosts disposable income)
> When aggregate demand for goods is insufficient, the solution is for the government to provide demand when the private sector will not – JM Keynes and Paul Samuelson (Recently signed into law by the new administration.)


Although stocks may weaken a bit further, for the long-term investor, many stocks are priced to deliver attractive returns. The ValueLine Survey estimates the appreciation potential of the broad market to be over 25 percent annually on average for the next five years. The current S&P 500 price to earnings ratio, commonly referred to as the P/E ratio, is currently just over 11X, while the P/E ratio of the S&P 500 over the last 25 years has been about 18X earnings. Therefore, if appropriate with your investment objectives take advantage of the relatively inexpensive stock market. We suggest adding high quality, dividend paying stocks or low cost, no load funds with that objective. The current yield on these funds averages about 5 percent, it’s like starting a 100 yard dash on the 50 yard mark, given that large cap stocks returned on average about 10 percent annually over the last 70 years. Investment income, whether from dividends or interest provides a cushion in down markets and many top-quality stocks have higher yields than the 30-year Treasury and appreciation potential.

Christopher Blakely

http://twitter.com/cblakely

Sources: Goldman Sachs, Standard & Poor’s, The New York Times, Bloomberg LP, ValueLine