Concord Investment Counsel

Rising Consumer Confidence Leads Equity Markets Higher!

2017-01-11T10:35:00.000-08:00

2016 was a volatile year for the global economy and the world’s financial markets. The year began with the markets and the economy drowning in pessimism, but ended with consumer confidence at a 15 year high and the DJIA knocking on the door of 20,000. One might say that investors have blind optimism in pushing the DJIA to all-time highs given the fact that significant obstacles remain in the path of our economy. Mr. Trump is likely a big part of the reason for this optimism. His campaign identified and shouted from the mountaintop the problems that have handcuffed the globe’s economic superpower for the last decade.

Whether Mr. Trump can seek and destroy these obstacles and clear the path for America’s economy remains to be seen. Nonetheless, investors seem excited about his plans despite no improvement in the earnings recession that has gripped America for the last two years.

Domestic US stocks moved higher in 2016 with the S&P 500 gaining over 11% for the year and close to 4% in the last quarter. Leadership in the equity market changed after the election. Growth stocks carried the baton during the first through third quarters of 2016 and then handed the baton to value stocks after the election. Defense, aerospace, industrial giants, energy, and bank stocks, that had performed poorly for the last few years quickly came to the top in the last few months of 2016 as leadership in growth stocks paused as investors weighed Mr. Trump’s plans to renegotiate trade deals with Asia and end the theft of US technologies in China. Foreign markets sold off as a result of these statements and emerging markets fell 5% or more in the fourth quarter (EEM -5.4%).

Mr. Trump’s plans for cutting corporate taxes caused a significant selloff in the bond market. Treasuries and investment-grade corporate bonds performed poorly in the fourth quarter. Long treasuries dropped over 12% in the fourth quarter (TLT -12.6%). Gold likewise plunged 13% in Q4 along with other commodities. The rise in interest rates was not greeted well by real estate investors and REITs fell 3% to 10% in the fourth quarter. US Stocks were the sole asset class that performed well in 2016 and as a result diversified portfolios had only modest gains for the quarter and the year. Volatility also chipped away at performance as nervous investors braced the storms that occurred in February as the economy threatened to fall back into recession.

2016 was marked by modest but steady growth in consumption. Retail sales rose over 3% led by strong demand for consumer durable products. Demand for financial services continued to improve and the banking sector is finally showing modest growth. Demand for healthcare remains at all-time highs with strong growth in pricing. Consumer confidence as measured by the conference Board rose to 113.7, a level not seen since 2002. Most of this rise came after the election. Corporate investment remained flat to lower as corporate America seemed content with its capacity given only modest growth in trends with consumer spending.

Global debt remains the primary obstacle to strong economic growth and is compounded by poor political policy and a regulatory environment that is burdensome and ineffective. The size of government is far too large and the cost of supporting it is a burden on American consumers and corporations.

Inflation remains benign despite the US economy now at or near full employment. Central bank policy continues to be accommodative but is gradually turning toward neutral. The Fed has now raised rates twice as it works to bring policy back to normal.

Washington policy remains the wildcard with much still unknown about Mr. Trump’s plans. Trump has talked a good story but can he deliver? America needs better trade deals, better protection of its products in the global markets, and objective leadership. These problems are not new and we have not had a president in decades willing to take on this sort of challenge. Mr. Trump seems serious about his plans for significant change and is surrounding himself with a cabinet of accomplished business people to help him achieve his goals.

Historically, Washington has not had much impact on the economy due to politicians inability to increase confidence. The White House’s biggest hammer lies in its ability to foster confidence so Americans will spend and consume. The President along with the Congress can also be effective by creating a fertile environment for economic growth. This means favorable trade deals and just the right amount of regulation for fair competition.

The markets will likely move higher as Mr. Trump continues his plan of change.

We remain optimistic.

POST-ELECTION TRUMP LOOKS A BIT DIFFERENT THAN PRE-ELECTION TRUMP.

2016-11-25T11:33:00.001-08:00

Industrial and Defense Stocks have led the Market to new highs as consumers and investors have embraced the post-election statements of Mr. Trump optimistically.

Mr. Trump’s poise and dignity, that seemed lacking throughout the campaign, has emerged, and as a result optimism as developed throughout America and the world. Financial markets have rallied globally. The Dow Jones industrial average broke 19,000 for the first time and most industrial based stock indices are at new highs. Contrarily growth indices have encountered fear-based obstacles and have lagged the industrial based leadership in the market. Since the election defense and aerospace, heavy construction, and bank stocks have led the market and have advanced double digits, despite virtually no confirmation from Wall Street analysts with higher revisions to earnings for these groups.

Wall Street analysts are almost always late to the party and their earnings expectations generally lag investor’s intuitive moves in the market. These Intuitive forward-looking investors unfortunately get things wrong more than right and one must wonder if the current moves in these industrial groups is well thought out. Will Donald Trump makes substantial investment in new weaponry for America despite America being $17 trillion in debt? Will that same debt prevent Mr. Trump from building the wall and rebuilding our infrastructure? Investors sold bonds and have driven up interest rates on US treasuries by three quarters of 1% since the election on speculation that America will spend trillions over the next four years on Mr. Trumps plans. These questions will remain unanswered for months as we await announcements by the Trump administration and the opponents of his agenda. In the meantime the markets will be volatile as the views of intuitive investors settle.

In the meantime economic data continues to tilt up toward. Consumer confidence continues to rise and retail sales and US consumption shows early signs of accelerating. The nation’s money supply (M2) has been growing above trend for several months and it is highly likely this blip in growth will lead to acceleration in consumption for the next six months or more. This will be a welcome change to the stagnant growth we have had for the last few years. It is not surprising that the market is moving higher given this improving economic picture combined with a president-elect who now looks Presidential.

The political maverick scores a victory and creates uncertainty for the economy and the markets.

2016-11-15T19:10:00.001-08:00

The failures of our political leaders over the last decade ushered in an opening for Donald Trump to obtain the presidency. Trump cleverly realized this and seized on the opportunity. Trump’s campaign was full of rhetoric and promises seemingly made without true regard to what was achievable. Now that Trump has captured the presidency we will likely see an agenda laid out that is more realistic with what this country can afford and the Congress will accept.

Wall Street and corporate America was a strong supporter of Clinton as she promised the continuation of policy that they had grown comfortable with and sought to have continued. Several sectors of our economy received favoritism by the Obama regime that may not continue under Trump. The media and Wall Street got so caught up in attacking Trump by fabricating policies and extrapolating on policies they claimed Trump would unleash on our economy and the world, that they began to believe this nonsense themselves. Wall Street and emotional investors are now seemingly making poorly researched investments based upon the policies and rhetoric talked about during the campaign. As a result the four tech giants have declined by 5 to 10% since the election. Amazon has fallen over 9%. Fixed income markets have fallen 5% or more with yields on treasury rising by over 50 basis points. Emerging markets have fallen over 10%. Gold has declined close to 10%. Conversely Industrial stocks have gained over 5%. Biotech has gained over 12%. Small-cap stocks have gained 8%. Financial stocks have gained over 10%. The broader market as measured by the S&P 500 has risen 1.5%, the Dow Jones industrial average has risen 3.3%, and Concord’s Dynamic Growth has gained 0.2%.

While the markets have changed a bit overall, and quite a bit among sectors, the economy remains the same. The outlook for growth is still challenged with the growth in global consumption at the lowest level it has been in years.

Prior to the election the best growth in earnings for 2017 was expected from technology, healthcare, and consumer cyclical sectors, as measured by the consensus of Wall Street analysts and as evidenced in the weightings of our portfolio. Those expectations remain the same today but the recent market performance indicates that investors believe we are on the verge of a change in leadership in earnings for the year ahead. Experience has told us that markets become emotional in the short-term but eventually are fairly efficient at discounting earnings growth. Is the new leadership in the market an irrational emotional response to the rhetoric of the campaign of Mr. Trump? We suspect that this is true. Most presidents generally seek to move on their campaign promises, but this maverick is clearly known to not be accountable to previous statements or promises. Now that Mr. Trump has the presidency secured, information about his true intentions will start to emerge and the markets will react as that information leaks out. Further, it is not unreasonable to infer that some of the things Mr. Trump has promised will unfold. These things will likely include but not be limited to strong reforms to immigration, tax cuts for corporate America, de-regulation of the unfair handcuffs on small businesses, opening up more land for drilling and energy production, changes to trade policies with China and other emerging markets, healthcare reform that abolishes Obama care with a new program that centers more on lower prices from free markets across state lines, and a significant reduction in spending on entitlement programs.

I suspect that Mr. Trump will go to the American people with a plan to clean up the swamp in Washington with some sort of term limit legislation as well as tough enforceable legislation prohibiting self-dealing.

This is a lot for Trump to accomplish. Who will benefit if we are correct. It would seem like our exposure to small-cap stocks needs to be raised at the expense of large caps exposed to significant trade with China. Energy will benefit from less regulation and is already cheap given where the price of oil is today. Energy needs to increase in our portfolio and be reallocated.

The financial and industrial sectors were already expensive prior to the Trump presidency as investors pushed these areas up despite a poor outlook for earnings. With American government debt already at 15 trillion, the idea of spending another trillion or more on infrastructure may be re-evaluated by Mr. Trump. The selloff in treasuries and the rally in bank stocks is likely overcooked in the short term.

Overall, we do not expect a significantly different looking economy over the next few years than we have already experienced over the past few. We believe Mr. Trump will make change and will likely go down as a highly successful president but we believe it will take a second term to accomplish all of his agenda and make a significant dent in the problem we have currently with growth. There is simply no quick solution to our growth problem.

Tax Planning for Life Events - Inheritance

2012-01-30T12:32:00.000-08:00

Heirs reckon with capital gains and income taxes

Many Americans find themselves landing on “Inheritance” as they course along the tax-game board called "Find the Money". Being an heir is a mixed blessing as you grieve the loss of someone close to you. Your inheritance may arrive with a strong emotional connection to your loved one, either joyful or painful. Maybe you’ll add it to an already healthy investment portfolio – or maybe you’ll need to spend cash and reduce financial strain.

In any case, knowing the tax consequences of your inheritance is important. Here we’ll consider typical inherited assets and the taxes associated with them.

If You Inherit Assets

If you receive a gift of stock or real estate, you’re likely to be affected by capital gains taxes. If Aunt Rose leaves you shares of General Electric (GE) worth $200,000, you’re grateful for her gift. But if you sell the shares, what would you owe in tax? Here’s how it might work for you:

Would you rather have column A or B? Thanks to a provision of the Internal Revenue Code, most assets receive a step-up in cost basis to the value on date of death. So if the cost basis of Aunt Rose’s GE stock is stepped-up from what she paid to its value on her date of death just over a year ago (Column B), the taxable gain is only $3,000. You’ll pay just $450 in tax.

While most heirs receive a stepped-up basis, that’s not true if your benefactor died in 2010. The tax law called EGTRRA suspended the step-up in basis for 2010. If Aunt Rose died in 2010, you’ll inherit her cost basis as in Column A and owe $26,250 in tax. Not only that, determining her cost basis may be a challenge unless Aunt Rose kept good financial records, so some research and tax advice may be in order.

If You Inherit an IRA

If you inherit an IRA, cost basis doesn’t matter – traditional IRA distributions are taxed annually at income tax rates. While it’s best to continue deferring the income tax on your inherited IRA as long as possible, your options will depend on the age of the person who died and how you were related.

If You're a Non-Spousal Beneficiary

If you inherit IRA assets from your 68-year-old uncle, you must begin annual distributions and may stretch them over your life expectancy. If you inherit IRA assets from your father who was 79 and taking required minimum distributions, you may base your annual distributions on either your life expectancy or on your father’s remaining life expectancy, whichever is longer.

If You're a Surviving Spouse

If you’re a surviving spouse and a 100% beneficiary, you have the widest range of options. You may:

Treat the inherited IRA as your own
Roll the IRA into your own IRA
Or defer making RMDs until your deceased spouse would have been 70½

It’s your choice.

You Can't Break the IRA - Income Tax Bond

One point is clear. Traditional IRAs are tax-deferred, not tax-free. Someone at some point will need to pay income tax on distributions. It’s tax-smart to stretch out or defer IRA distributions to take advantage of investment compounding – but income taxes cannot be avoided.

What you can avoid is making costly IRA mistakes, like draining your inherited IRA all at once and ratcheting up your tax bracket for that year. You can also make sure you name at least one beneficiary for your own IRA. Otherwise, all the assets will need to be paid out within five years after you die.

As Benjamin Franklin so famously wrote in 1817, “In this world nothing can be said to be certain, except death and taxes.” The two come together in this section of our "Find the Money" tax game, so it’s wise to know what to expect.

Tax Planning for Life Events - Highly Appreciated Assets

2012-01-23T10:54:00.000-08:00

Sell an asset for profit and you'll pay capital gains taxes, right? Maybe.

As you move your token along the tax-game board called Find the Money, you land on the space labeled “Sell a highly appreciated asset.” Nice. There’s a lump sum of cash coming your way. But hold it there, Rockefeller – you only get to keep what’s left after taxes.

The things you own and use for personal and investment purposes are considered capital assets by the IRS. These include your home, collectibles, and stocks & bonds. If you sell a capital asset for more than you paid for it, you realize a capital gain. When you realize a capital gain, you’ll pay a capital gains tax. The tax you pay will be either a higher short-term rate for a one-year holding period or a lower long-term rate if you’ve owned the asset twelve months or more.

So, if you recently parted with the beach house you bought in 1966 and banked the cash, you’ll pay a 15% long-term capital gains tax. If you also sold the Warhol you bought for the housewarming, you’ll pay 28% in long-term capital gains tax since art & collectibles fetch a higher rate. Or if you sold the El Paso Corp (EP) stock yesterday at $27 per share that you bought last October at $18, you’ll pay income tax rates on the short-term gain.

I like a profit – but that’s a lot of taxes. Isn’t there a better way?

Glad you asked. There are other trails on the game board you might take before landing to the space labeled “Write a check payable to IRS.” Consider these options:

Throw down a net

Since the tax you pay will be based on your net capital gain, you can reduce your gain dollar-for-dollar with an offsetting loss. For example, you remember you bought shares in First Solar Inc (FSLR) last July at $132 because everyone’s gonna make millions in green technology. Now the stock is trading at $38 per share. I know – “Ooouuch.” But make lemonade from that lemon.

If you offset a $95,000 gain in EP with an $80,000 loss in FSLR, you’ll be left with only a $15k net short-term capital gain – and a lower tax. But what if you lost $120k in FSLR? (What were you thinking?) Now you can make lots of lemonade since you can realize a net $0 capital gain this year, reduce your income by $3k on your tax return, and carry forward a $22k loss for the future.

Be a Giver with a Charitable Trust

The win-win nature of a charitable strategy makes sense for many middle class Americans. If you own highly appreciated stock, art, or real estate that your family won’t need in the future, you can give the assets away and make some powerful things happen.

Life income

Setting up a charitable remainder trust (CRT) and funding it with highly appreciated wealth means it will pay you income for the rest of your life before passing to charity when you die.

Flexibility

Since you retain control of your gifted assets, you can add, change, or remove charities from your trust at any time. Also, you may choose to inform the recipients about your gift in advance or reveal it after you’re gone.

Get by giving

Creating a CRT has a positive impact all around:

Get rid of a capital gains tax
Get income for life
Get a charitable tax deduction
Get assets out of your taxable estate
Give resources to a worthwhile cause

Some or all of these ideas may be financially savvy for you depending on your situation and how you play the game. But you need to work that game board. That’s why it’s called Find the Money.

Tax Planning for Life Events - High Income

2012-01-12T11:20:00.001-08:00

Smart tax ideas are up for grabs - can you find the money?

During tax season we reckon with multiple facets of the massive, quirky, and complex US tax code. While most tax activity involves cash flowing passively from us to the government, some of it requires action on our part to reverse the flow back to us. For perspective on these tax management activities, let’s think of the US tax code as a board game.

That’s right, Hasmo presents America’s family night sensation, “Find the Money.” What a thrill as you roll the dice and advance your game token around the IRS labyrinth! Take the trail to a charitable contributions deduction and collect $350! Climb the hill to the energy-saving home improvements credit and get $500! Miss the ramp to foreign taxes paid, and – no dough for you, Charlie!

The truth is there are smart ideas you can employ to find more money. Otherwise, the IRS keeps it. It’s their game.

Life events, their taxes (and strategies to deal with them)

While the tax management strategies that work for you will reflect your specific financial life, here are some general life-tax events to consider. Perhaps these will stir your spirits to “Find the Money” on your game board.

● High Income. Professional success leads to the reward of high income – but also higher income taxes.

● Highly Appreciated Assets. If you sell an appreciated asset like stock, art or real estate (remember when we could do that?), you’ll face capital gains taxes.

● Inheritance. If you inherit a brokerage account or real estate, you’ll reckon with capital gains. If you’re the beneficiary of an IRA, you’ll have income taxes.

● Retirement. In retirement you’ll need sustainable income that may come from a variety of sources like Social Security, retirement accounts, brokerage assets, or a company pension. These generate income and capital gains taxes.

● Death. Since death and taxes are still a certainty, they come together with the estate tax – in 2012, for personal estates worth over $5.12 million.

High Income

If you’ve achieved the goal of professional success and the income that comes with it, you face a problem you might have relished when you were on the way up and eating ramen noodles – higher income taxes. Such high income can exceed the level of current living expenses, so it’s smart to look for ways to channel extra cash away from current income taxes. You’ll pay taxes on the money and its growth eventually, but hopefully at a lower rate.

To postpone some of your income, look to one of several deferred compensation plans. The traditional non-qualified deferred comp plan for executives allows your employer to sock away a portion of your income, invest it on your behalf, and pay it to you in the future. A deferred comp plan eases your present income tax burden and entices you to remain with your firm for the payout.

Perhaps the most common way to defer compensation is to make pre-tax contributions to a qualified retirement plan, such as adding part of each paycheck to your company 401(k). For 2012, you may contribute up to $17,000 plus a $5,500 catch-up amount if you’re 50 or older.

If you’re part of the senior management team at your company, your 401(k) options improve. Your company may use safe harbor provisions combined with tiered profit-sharing contributions to maximize the benefits to key employees. For safe harbor provisions, the company makes special contributions to non-key employee accounts that are immediately vested to satisfy top-heavy discrimination tests. The tiered profit-sharing feature allows up to 90% of the employer contribution to be allocated to key employees. These strategies also allow key employees to maximize their own income deferrals.

If you’re self-employed and are the only employee of your company (like a consultant, real estate professional, or doctor), you have the most attractive options. You might consider a SEP-IRA for its simplicity and contribution level (the greater of 25% of comp or $50k). To stash away the most income for retirement though, a defined benefit plan lets you as employer contribute up to $200k of business income on your own behalf. You may also combine a defined benefit plan with a 401(k) for up to $200k of employer contributions and employee deferrals.

If you work for a company who provides them, another smart way to take some of your income at a lower tax rate is with incentive stock options, a favorite of many company executives. In this way, you may use half of your income to purchase company stock to be sold later at lower capital gains tax rates. The stock needs to grow in value for ISOs to work properly; but the results can be rewarding.

These are some of the ways to play the tax game and keep more of your money if you’re blessed with the problem of having a high income. For help with other taxable life events like retirement, selling assets, and death taxes, please visit our blog in the coming weeks.

January 2012: Economic Review and Outlook

2012-01-10T16:42:00.000-08:00

Anchored by the Scars of the Last Cycle

The outlook for global growth is not bright as wounds and fat left from the sins of the last cycle have become a significant scar on the face and body of global growth. Despite the ugliness, the global economy is pushing forward and seems likely to continue on this path. The overall health of the global economy is not easy to diagnose when weighing its obstacles against the consumption engines of growth. The obstacles are clearly significant and may be the worst in modern history. Fortunately the global engines of growth are likewise significant, leaving the globe hanging in a delicate balance.

The scars on the face of growth are ugly. They are deep pockmarks from an unhealthy appetite for debt. The globe accumulated a mountain of debt over the last few decades, so the resulting deleveraging cycle has forced the mature parts of the world to reduce consumption. The US and other obese areas could well be on a Jenny Craig diet for the next decade. Less significant but still notable would be: the ongoing and costly fight against terrorism, persistent global disasters, and geopolitical events.

On the better side of the face of growth is a profile that we have grown to like. The engines of growth for the globe are mostly about rising consumption due to a growing base of middle class consumers in emerging areas of the world (ie: Brazil, Russia India and China). This is not a new trend but one that has accelerated over the last decade as repressive governments have fallen and Capitalism has taken hold in many areas including Eastern Europe, Asia, Africa, and the Middle East.

Product innovation is another significant engine that made the 90’s such a great cycle for growth and is still alive today. The most exciting and notable areas include healthcare, energy, consumer electronics, and telecom. Fortunately, capitalism is still alive and growing and is the root of great innovation.

How does a reasonable investor balance the engines of growth against the obstacles on the road? This difficult problem may bring rationality to those of us having a difficult time understanding the volatility the financial markets have produced over the last few years.

Will the good defeat the bad or will the globe fall into a terrible depression? Clearly one needs to have a deeper understanding of the obstacles in the road to recovery. The subject matter here is far greater than the scope of this article but will be summarized in a series of articles to come on the Concord Blog:

The Economic Revolution

Part 1 – Global Debt – Are We Past the Point of Return?

Part 2 – The Evolution of the Political Environment – US and Global Trends

Part 3 – Weighing the Cost of Terrorism and Global Disasters

Part 4 – Capitalism & Communism – Under Fire

*Be sure not to miss the most recent Concord Quarterly Newsletter, filled with more of our insightful commentary and outlook.

Where is Western Europe Headed?

2011-12-13T09:36:00.000-08:00

Global markets hang in the balance as Europe's economy grapples with financial crisis.

The European Union accounts for 20% or more of global GDP and has a huge middle class that consumes on par with their Socialistic governments. There are 27 countries in the EU, of which 17 are part of the Eurozone who adopted the Euro as their currency. Germany, France, the UK, and Italy appear to be on paths of modest but sustainable growth; but a debt crisis in Portugal, Ireland, Greece, and Spain (so-called PIGS) has put these countries into likely recession. With the globe climbing a delicate path of recovery, problems in Europe cannot be discounted.

To understand where Europe is headed, we must first tune into the nature of their current problems. Europeans in general have been responsible consumers and did not entirely follow the path of Americans’ wild, debt-fueled consumption journey over the last decade. Unfortunately, many of the European governments were not nearly as responsible as their citizens and other countries around the globe. These governments behaved more like US consumers, accumulating debt far in excess of what their economies could support. In fact, Greece, Italy, Portugal, Ireland, and Spain have debt levels of more than 1.25 times their annual GDP. The most troubled of these have debt that is close to 2 times annual GDP. History has shown us that debt levels of over 1.5 times GDP generally have led to default or at least severe inflation after attempts to monetize the problem.

Given this situation, global investors have stopped loaning money to the troubled PIGS group, while other nations on the cusp of trouble have seen their borrowing costs skyrocket. In the near-riot that has resulted in the European financial markets, counter-party risk is difficult to understand. Banks have curtailed mutual lending for fear of what debt the others might hold in their portfolios.

Is there a solution to the problem? Will light emerge at the end of the EU tunnel? While central banks generally intervene during a financial crisis, the European Central Bank has not been quick to act with strong monetary medicine in the way the Fed has in the US. The Fed supports just one nation with a dual mandate of price stability and full employment, giving the US central bank flexibility to use monetary policy to stimulate growth. The Fed has not had inflation concerns with buying US debt because the US Treasury is the most responsible borrower in the world and can borrow at the lowest rates.

In contrast, there are a couple of reasons the ECB has been slower to act. First, it’s set up differently than the Fed, supporting 27 nations with a sole mandate of price stability. Second, when a central bank like the ECB seeks to lower interest rates to stimulate growth or provide liquidity for a system in crisis, it buys treasury debt of the nations it supports, and must choose its borrowers carefully. But the 27 nations supported by the ECB are not all responsible borrowers. Some of EU members may create inflation with borrowed funds or take on too much debt and risk default. This is the potential problem in Europe.

As a result, the ECB is now playing a game of poker with the EU’s troubled nations and refusing additional loans without asserting control over spending. The most recent signs of progress emerged when an agreement was reached at an EU summit the week of December 5, 2011. All but one of the 27 member nations conceded mild control of their treasury spending, with the UK holding out over national sovereignty. With few choices left, the Euro-zone’s troubled nations seem to be willing to accept even tougher terms set by the EU. Among their few options:

1) Leave the union and revert back to their own currencies

2) Fan the flames of chaos and hope the riot forces the EU to help them without concessions

3) Accept the EU’s terms

Neither of the first two options would seem to produce a winning hand for the PIGS. Leaving the EU would be devastating to their liquidity needs and most certainly cast them into a long recession. Another riot is possible but not likely as central banks around the globe have already formed credit facilities to keep markets orderly during this period of negotiation.

The likely outcome?

It seems reasonable that the European Union will eventually get limited control over the spending of its members so the ECB can provide needed market liquidity to keep Europe on a path of growth. While Europe is clearly evolving for the better, the process will take time. Meanwhile, markets are impatient due to the delicate global balance.

These Annuity Pitfalls can be Bruising

2011-12-05T10:41:00.001-08:00

Two risks to consider when deciding if an annuity is right for you.

Thick with intricacy well beyond stocks, bonds, and mutual funds, annuities are some of the more vexing financial instruments around. Their guarantees can attract investors from two extremes – those who avoid Wall Street and choose annuities as a safe alternative to CDs, and those reeling from stock market upheaval who want a certain retreat from risk.

Annuities can meet an important need for some investors; and with so many options available, the right product is within reach. But before signing near the X, investors are wise to look beyond a smiling salesman or glossy brochure and consider that annuities may be more sold than bought – and it’s easy to invest in them for the wrong reasons. We’ll explain a couple of them.

First, some basics: An annuity is an investment contract with an insurance company that produces returns in one of two ways. A fixed annuity earns interest like a CD that’s paid and backed by the insurance company, while a variable annuity captures the performance of underlying mutual funds.

One benefit of annuities is tax-deferral. A $250,000 annuity earning 4% per year net of expenses would grow to $305,249 at the end of five years. The $55,249 in growth would have no tax consequences until withdrawn at ordinary income tax rates. Investors like tax-deferral.

Investors also like the guarantees unique to insurance products, especially in times of market turmoil. One guarantee is a death benefit that pays the higher of the account’s market value or original investment value to the heirs of a variable annuity owner. Another works likewise, paying an income stream based on the higher amount during an owner’s life. You can add a number of these riders on a basic annuity contract. Insurance features come at a cost, however, and can add 1% to 3% per year on top of mutual fund expenses.

So what two pitfalls should you consider?

1) Safety

You might think an annuity guarantee gives you the safety of FDIC-insured bank deposits. After all, it’s a guarantee. But what happens if the company you trusted goes belly up? FDIC insurance won’t help you here.

The past decade is a daisy-cutter landscape with the corpses of corporations that were once household names, from accounting to energy to automotive to financial. We’ve learned never to say “never.”

Insurance companies are among those companies hit hard in the 2008 financial crisis, leaving some more distressed than others and bringing guarantees into question. The result? If Company A’s bond debt is investment grade but Company B’s is junk, so are their annuity guarantees. In some cases, there also may be a cautionary gap between an insurance company’s corporate bond rating and its A.M Best industry rating. In any case, you should think twice about the quality of insurance guarantees when the industry’s bond debt is dipping below investment grade.

Your backstops against default are asset protections provided by your state’s insurance guarantee association plus the insurance company’s own insurance policies. But no one wants to see these put to the test. With annuities, “safety” is a relative term.

2) Tax-deferral

Let’s think about the two general ways an annuity can provide returns from a tax standpoint and see if you agree with this astounding conclusion:

A fixed annuity may offer a better value than a variable annuity with stock funds.

How can this be? Stay with me a sec. In a brokerage account, bond interest is taxed each year as ordinary income, with rates as high as 35%. A fixed annuity paying similar interest defers the tax until withdrawal, but also is taxed at the same ordinary income tax rate.

Stocks, however, are ideally held long-term until profits are taxed at lower long-term capital gain rates, currently 15%. Owning growth stocks outright actually provides tax deferral until sold AND a lower tax rate. But owning stocks in an annuity means the growth will be taxed at withdrawal as ordinary income.

So, the variable annuity might cost you 20% more in taxes in addition to higher fees. That’s not such a good deal. There may be other reasons to own a variable annuity with growth investments, but tax deferral alone is not one of them.

The upshot? An annuity’s chief benefit is tax-deferral on conservative income for taxable assets. Virtually every other facet of owning an annuity from safety to fees to growth to flexibility is available elsewhere, usually in better measure. That said, contract guarantees and the ability to annuitize have their place – for those with such needs who consider the trade-offs and count the costs.

Hopefully, these examples show why it’s important to put on your thinking cap before you take out your pen. When designed properly for the right situations, annuities offer effective solutions to financial problems. We know every financial decision involves trade-offs – but annuity pros and cons may not be easy to identify. You should take your time and get good advice.

America’s Orphaned 401(k) Plans

2011-11-16T13:55:00.000-08:00

Would you treat your children this way?

Statistics show if all the people who fall asleep in church on the average Sunday were laid end to end starting at the Pacific Ocean, they’d be a lot more comfortable. Too bad it’s not that simple for Americans to feel so at ease about their retirement.

According to a 2007 study by BAI Research and Mercatus LLC, “mass affluent” Americans are 35-70 years old, make upwards of $92,000 per year, and have $50k to $2 million in assets. The most pressing financial priority for 59% of those surveyed is saving for retirement.

To accomplish this important goal, Americans turn to the prime means to build retirement wealth – employer-sponsored retirement plans. Yet too often when they change jobs or retire, instead of consolidating their retirement funds in an IRA, they leave their investments behind. The BAI/Mercatus study shows that 1/3 of mass affluent households have at least one orphaned 401(k) account with an average balance of $100,000.

That’s a fascinating disconnect. Why would so many people leave such an important part of their future livelihood at arm’s length? The research suggests an answer. Three-quarters of mass affluent Americans consider themselves “less confident” about their future; worried they don’t have enough assets for retirement and feeling they don’t know enough about investing.

It’s no wonder – if you feel uncertain about reaching your number-one goal and don’t know how to fix it, “less confident” may be an understatement. Pile on the S&P 500’s first 10-year loss in history from 2000-2009, America’s long-playing economic illness, and geo-political turmoil across the globe, and many investors feel paralyzed. This may explain how the estimated $1 trillion in assets languish in orphaned 401(k) plans.

Once people realize that deer-in-the-headlights image is in their own mirror, many spring into action. There are several motivators. Those who transfer assets from 401(k)s to IRAs typically recognize they:

- Are overlooking a vital piece of their retirement wealth
- Are getting no advice, yet their 401(k) and fund fees can cost upwards of 1% annually
- Are empowered by taking control of their wealth
- Prefer more investment choices and easier management than the 401(k) plan provides
- Feel liberated by cutting ties to a former employer

The BAI/Mercatus research shows most people consult a trusted financial advisor when they decide to consolidate their retirement wealth. Mass affluent investors turn to investment firms 67% of the time for their 401(k) rollovers, compared to only 18% for banks (who are more generalized, transaction-oriented, and product-focused).

A good financial advisor can be an invaluable asset for the mass affluent. With a straightforward financial planning approach and an effective, fee-based investment strategy, financial advisors can help the mass affluent investor close the knowledge gap and raise their level of confidence for retirement. That’s more comfortable than a nap in church.

The Perils of Market Timing

2011-11-11T12:11:00.000-08:00

It looks promising but rarely works - and failure can be tragic. There is another way.

Economic uncertainty. Volatile markets. Abundant index funds. Ease of trading. Taken together, these elements offer investors the ability to indulge a long-standing tendency – market timing. In an era when crazy financial markets almost feel normal, the past quarter netted a 12-14% decline in major US indices, with weekly swings of 4-7%. This summer, attention bounced between America to Europe and moods shifted from hopeful to dreary to encouraged to dismal. Such a setting may be the new normal for the time being. In the grip of it all, armed with keyboards and touchscreens, what are investors to do? It seems many trade index funds, buying when they sense a bargain and selling when they’re scared.

The 21st Century has given us access to markets and ways to trade them that never existed before, imparting the basic tools to build wealth across the masses. But if people can trade markets more easily than ever, are they successful in practice? The answer appears to be “no.” The latest annual DALBAR study from April 2011 shows investor returns lagged the market itself. Their research illustrates that over a 20-year period, equity investors earned 3.8% compared to the S&P 500 return of 9.1%. Average equity investor retention or holding time was just 3.3 years. It seems people have the tools to invest wisely but are too flighty to stick it out. Add trading costs to buying high and selling low and the result is wealth erosion.

John Bogle can say he told us so. In his book “Don’t Count on It!” the father of the index fund says, “The simple broad market index fund of yore, which I believe is the greatest medium for long-term investing ever designed by the mind of man, has now been engineered for use in short-term speculation.” He says even if you’re right about the market some of the time, you won’t be all of the time, and you’ll get into trouble.

But what good is a static, buy-and-hold approach when you have a lost decade in stocks like the last one? We believe the answer is neither risky market timing nor plodding buy-and-hold. We feel active asset-class management based around economic trends is one of the most effective ways to get consistent outperformance. Since market moves can be deceiving, gauge ongoing portfolio adjustments on established economic data. This can be one of the best ways to avoid market head-fakes.

According to an InvestmentNews interview on 11/10/2009 of NYU Stern School of Business' David Hoffman, “The fund managers who invest based on macroeconomic trends – and are willing to adjust their portfolios as those trends change – are the managers most likely to add value for investors.”

How do You Rate Your Advisor?

2011-11-03T13:38:00.000-07:00

An "A" may be asking too much - but you shouldn't settle for mediocre or worse.

You did your homework. You used an objective approach. You considered your advisor’s experience, compliance record, fee structure, and certifications before making your decision. The firm held up to your due diligence, so you took the big step and placed your hard-earned assets with your new advisor to manage. Now what? How do you rate their work?

As a client of a wealth manager, you have several ways to evaluate them. Do they seem to care about me? Do they understand my situation? Have they invested my assets appropriately? Are they responsive to my needs and questions? Do they communicate effectively? Yes, yes, yes. You’re still satisfied, and you’re confident in the choice you made. Then there’s performance. Oh yeah…that. But how should you evaluate a wealth manager’s performance during a lost decade for stocks?

Here are some thoughts. Since our boom and bust markets and lots of economic turmoil make it difficult to provide consistently good returns, you shouldn’t expect your advisor to outperform. Or should you? It’s true the S&P 500 was flat-to-down for much of the last ten years – but there were bright spots along the way. And other assets performed quite well during the same period, such as Treasurys and gold.

What separates good wealth managers from the also-rans is their ability to understand and adapt their portfolios to the stormy dynamics of today’s markets. On the other hand, managers who lock in to a static investment approach have had a harder time of it lately. These guidelines can help you decide whether your wealth manager makes the grade.

Getting an A

You should give your advisor an A for outstanding performance over the past 3-5 years if they were able to properly understand central bank activities and interpret the effects on the money supply. Since 2008, the Fed has taken unprecedented measures to shore up the US economy by pushing interest rates to historic lows and using bond markets to print dollars. The effect has been a declining Dollar and successive new highs in Treasurys and in gold. The excellent portfolio manager understood these movements and captured them. Meanwhile, stocks slumped, with the S&P 500 declining 12% and posting losses for 28 out of those 60 months, so an outstanding manager prudently limited or avoided exposure to large cap stocks when it mattered. Since March of 2009, however, risk assets roared back. The prescient advisor who captured the gains in the S&P 500 and the Dow Jones US Real Estate Index would have garnered returns of 60% and 138% respectively. Did your wealth manager perform so acrobatically? Most did not.

Getting a D or F

Let’s consider the other extreme, absurd as it is. You should give your advisor a D if they tried the acrobatics described above and fell off the high wire. They misread the environment and got it exactly wrong. Perhaps they doubled down on risk assets when they should have moved to T-Bills. Maybe they went to cash just as the tide turned in 2009 and stocks began a 74% percent advance off their lows. You should give your advisor an F if they bought high, bought more high, sold low, waited; and then bought back high again. The people at Schleprock Advisors deserve a failing grade for vaporizing your shares when just staying invested would have kept you out of the soup line.

Getting a C

Working our way up, you should give your advisor a C if they understood your needs and invested your assets appropriately, but kept your portfolio mostly static for the past 5 years. After using care and prudence to design the proper asset allocation for you and avoid being over-exposed to risk, they got that deer-in-the-headlights look during the economic meltdown. Maybe they didn’t know what to do next, so they just froze. “Set it and forget it” may work for the rotisserie you bought on the Shopping Channel, but it’s not a prudent approach for your life savings.

Getting a B

You should give your advisor a B if they’re somewhere between the “A” performance of the economic athlete and the “C” performance of the static manager. Your wealth manager is above-average if they have attended to your investment needs and done a reasonably good job of responding to changes in the economy and markets. They got some things right, like becoming defensive at the right time. Maybe they waited too long to act once or twice, but they correctly understood the trends and made prudent adjustments. Their actions boosted your bottom line by shifting toward protection or growth in a timely way.

Finding a Grade A advisor is most desirable; but few managers can execute so well repeatedly. While you clearly should avoid the bottom tier, you also needn’t settle for mediocre results of the average, static advisor. During these trying economic times, you may not be accustomed or pleased to getting lower returns than in the past. But you should have confidence if your advisor is smart and responsive in their management technique, and qualifies for an above-average grade. Such a wealth manager will probably serve you well.