Miscellaneous Provisions

Dwaine van Vuuren: Too Early To Call US Recession

2012-01-25T17:28:00.000-08:00

Using a nine composite index consisting of:

Dwaine van Vuuren argues the recession call by ECRI was premature. Although, ECRI does have a one year time horizon on their call. Based on his U.S. Economic Growth Super-Indexes, there is only a 15% chance of recession as of December 29, 2011. He goes on to note the chance of recession has risen quite sharply, but similar spikes were observed in March 2003, September 2005, and July 2006. None of these periods resulted in an NBER-dated recession.

The difficulty in forecasting a recession is obvious from his charts. The descent into recession is generally quite abrupt. Many of the indicators in and of themselves are coincident or short-leading making it difficult to know when the economy has reached the end of cliff. In other words, a coincident or short-leading index won't tell one much more than the stock market. Consequently, it won't be helpful in avoiding stock market losses. He provides a few additional graphs which compare the current recovery to past recoveries noting the current recovery is lackluster, and therefore, potentially more prone to falling into recession. A recession is generally underway when four or more of the nine indexes are in recession territory. There are currently two in the doldrums now: ECRI Weekly Leading Economic Index and e-forecasting.com monthly Leading Index. The other seven indexes are currently well below their respective recession thresholds.

He concludes with a 4-6 month Leading Superindex which currently shows the economy is susceptible to a recession. However, the current reading is consistent with other periods in which no recession occurred. His advice: monitor the leading indexes for continued deterioration or rebound. If it was easy to read the tea leaves, everyone would be on top of the early warning signs of recession risk. It does appear that the 4-6 month Leading Superindex lends support to the idea that there is, as John Hussman would say, a syndrome of conditions present that have in the past lead to recession.

Advisor Perspectives: US Recession - An Opposing View

ETF Screeners

2012-01-22T18:07:00.000-08:00

Like search engines, ETF screeners are quick to advertise the total ETF's available for search. ETFdb lists 1,434, XTF 1,383, and Morningstar 1,374. All three offer enhanced subscription services. The subscription services offer ranking systems, model portfolios, research reports, additional statistics such as fund flows and valuation estimates, and enhanced search functionality such as comparison tools (sometimes with additional information) and export to Excel features. For most ETF research, the important data is offered for free.

The major differences between the sites is the search interface. All three sites are cumbersome to use at first with none standing out as having a brilliant user interface. Familiarity will be your best friend.

XTF makes comparing up to six ETF's really easy. Either enter in the ticker symbols or select up to six ETF's via the ETF explorer. XTF also provides great pie charts under "Fund Exposure" to graphically show the industry, sector, style, capitalization, and other types of exposure.

ETFdb allows investors to easily locate funds with significant exposure to a particular security. It really shines if you are looking for an ETF with exposure to a particular country via the "ETF Country Exposure Tool." This tool makes finding an ETF with the largest exposure to Kazakhstan simple, if you know where to find the country on a map.

Morningstar didn't stand out other than it was easy to add ETF's to a portfolio, and if you are already familiar with Morningstar, the interface will be easier to use. In addition, Morningstar offers much more bang for the buck as the monthly subscription fee covers mutual funds, ETF's, CEF's, stocks, and options.

Site Links:

XTF
ETFdb
Morningstar ETF

New Federal Income Tax Provisions for 2012

2012-01-21T15:02:00.000-08:00

While the New Year ushers out a slew of federal tax provisions, a few new provisions also come into effect.

The Usual Inflation Adjustments
Inflation is the taxpayer's friend in 2012. From Revenue Procedure 2011-52, the taxable income for each tax bracket expands and the personal exemption rises to $3,800. The standard deduction rises to:

Married Individuals Filing Joint Returns
and Surviving Spouses $11,900

Heads of Households $8,700

Unmarried Individuals (other than Surviving Spouses
and Heads of Households) $5,950

Married Individuals Filing Separate
Returns $5,950

Contributions to retirement plans increase as well. From IR-2011-103, the elective deferral for 401(k), 403(b), most 457 plans, and the Thrift Savings Plan increases to $17,000. The catch-up contribution for the 50 and over crowd remains at $5,500 for plans other than those described in Section 401(k)(11) or Section 408(p). The annual compensation limit increases to $250,000 and the defined contribution limit rises to $50,000.

ROTH IRA and Traditional IRA contribution limits remain at the smaller of $5,000 or the amount of one's taxable compensation. The limit can be split between a traditional and ROTH IRA, but the combined amount cannot exceed $5,000. The 50 and over crowd can add an additional $1,000 for a maximum contribution of $6,000.

Modified adjusted gross income phase-out ranges for Traditional IRA's are as follows:

IRS.gov: Modified AGI Limits for Traditional IRA contributions if Covered By Retirement Plan at Work

IRS.gov: Modified AGI Limits for Traditional IRA contributions if NOT Covered By Retirement Plan at Work

Modified adjusted gross income phase-out ranges for ROTH IRA's are:

Married filing jointly - $173,000 to 183,000
Single and head of household - $110,000 to $125,000.
Married filing separate covered by retirement plan at work - $0 to $10,000.

The social security wage base rises to $110,100.

See Revenue Procedure 2011-52 for many more items.

Capital Gains and Losses
IRC Section 6045 was amended in 2008 to require brokers to report to the IRS and customers, the customer's adjusted basis in securities sold and to classify the gain or loss as short or long-term. The basis reporting applies to "covered securities," which basically means any security acquired after its corresponding applicable date. For 2011, the basis reporting rules covered corporate stock purchases, mutual funds and DRIP purchases will follow in 2012, and other financial instruments in 2013 (commodities, bonds, options, and so on).

Taxpayer's will notice a new form for 2011, Form 8949, "Sales and Other Disposition of Capital Assets," which will aide them in reporting the new Form 1099-B information. Schedule D will become a summary form with capital gain and loss information flowing from other forms.

Form 8949 will segregate capital gain and loss reporting to three categories:

1) When basis is reported in Box 3 of Form 1099-B
2) When basis is not reported on Form 1099-B (non-covered securities)
3) When no Form 1099-B is received

Veterans Work Opportunity Credits
The Three Percent Withholding Repeal and Job Creation Act, P.L. 112-56, extended the Work Opportunity Tax Credit and enhanced the name to Returning Heroes and Wounded Warriors Work Opportunity Tax Credit (has a more noble ring to it?) for business that hire certain military veterans. The employer may be eligible for a credit up to $9,600 for each qualified veteran they hire after November 21, 2011 and before January 1, 2013. There are several layers of credits, with up to a $2,400 credit for hiring a veteran who has been unemployed for at least four weeks, up to $5,600 for hiring a veteran who has been unemployed for more than six months, and up to $9,600 for hiring a veteran with a service-connected disability and who has been unemployed for more than six months. The last credit amount is up to $4,800 for hiring a veteran with a service-connected disability who does not meet the Returning Hero credit requirements or who qualifies for food stamps.

More Foreign Asset Reporting
The Foreign Account Tax Compliance Act increased the reporting requirements for individuals holding specified foreign financial assets. The aggregate value of the assets must be at least $50,000. The IRS has a page devoted to the specifics. The information is reported on Form 8938, "Statement of Specified Foreign Financial Assets." For more on the Foreign Account Tax Compliance Act, see IRS.gov: Foreign Account Tax Compliance Act (FATCA).

Bonus Depreication
While the 100% bonus depreciation expires on December 31, 2011, the 50% bonus depreciation remains for 2012. The 100% bonus depreciation lives on for longer-lived and transportation property (LLTP). LLTP property consists of certain property with a recovery period of ten years or more or to transportation property property that has an estimated production period greater than one year and a cost in excess of one million.

EITC Due Diligence
The penalty for failing to comply with IRC Sec. 6695(g) Earned Income Tax credit due diligence requirements increases to $500 for returns filed after December 31, 2011. The EITC due diligence requirements are broken down into 4 parts. The final EITC regulations (click here for full text: TD 9570) included the following updates:

1) Form 8867 must now be filed with the tax return.

2) The tax preparer must retain a copy of Form 8867, the completed Earned Income Credit Worksheet, how and when the information used to complete Form 8867 and the Earned Income Credit Worksheet was obtained, including the identity of the person, a copy of any documents provided by the taxpayer on which the tax return preparer relied to complete Form 8867 or the Earned Income Credit Worksheet, e.g. interview questions and answers from the client.

3) The documents above must be retained for three years from the latest of the following dates in either electronic or paper form so long as the IRS can access it, as applicable:

a) The due date of the tax return
b) In the case of an electronically filed return, the date the tax return was filed
c) In the case of a paper filed return, the date the tax return was presented for signature
d) In the case of a nonsigning tax return preparer, the date the nonsigning tax return preparer submitted to the signing tax return preparer that portion of the tax return for which the nonsigning tax return preparer was responsible.

4) A firm may be subject to penalty if one or more members of the principal management of the firm participated in or knew of the failure to comply with the due diligence requirements. The firm failed to establish reasonable and appropriate procedures to ensure compliance with the due diligence requirements. The firm disregarded its reasonable and appropriate compliance procedures through willfulness, recklessness, or gross indifference.

5) There is an exception to the preparer or firm penalty if the prepare can demonstrate to the IRS the normal office procedures are reasonably designed and routinely followed and the cause of the penalty was an isolated event.

The previous EITC due diligence rules that were not updated are still in effect. See the IRS webpage devoted to the new EITC due diligence rules including access to a webinar (45 minutes long).

Voluntary Classification Settlement Program
The IRS introduced a voluntary classification settlement program (VCSP) in September 2011 enabling eligible taxpayers to voluntarily reclassify their workers as employees for federal employment tax purposes for future tax periods while receiving relief for part of the tax liability resulting from past treatment of the workers as nonemployees. See IRS Announcement 2011-64 for more information.

Expired Business Income Tax Provisions as of December 31, 2011

2012-01-21T12:33:00.000-08:00

The business provisions expiring at the end of 2011 include a few significant items and several narrowly focused provisions:

1) The 100% first-year bonus depreciation expires. IRC Sec. 168(K).

2) Section 179 deduction is reduced to $125,000 with a phaseout threshold of $500,000 for 2012. IRC Sec. 179.

3) Research and development credit (IRC Sec. 41) and most parts of the work opportunity credit (IRC Sec. 51(c)).

4) 15-year straight-line cost recovery life for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements. IRC Sec. 168(e)(3)(E).

5) Basis adjustments for S corporation charitable contributions of property (Sec. 1367(a)). Applies to the contribution of appreciated property. The deduction is for the fair market value of the property and shareholder basis was reduced by the adjusted basis of the property. The provision for reducing the basis by the adjusted basis of the property goes away.

7) The reduced S corporation recognition period for the built-in gains tax goes back to 10-years from 5-years in 2011. IRC Sec. 1374(d).

8) There are many other provisions that appear to be fairly narrow in their application to the average business. See "Many Tax Provisions Set to Expire at Year-End" for a complete list.

Expired Individual Income Tax Provisions as of December 31, 2011

2012-01-20T23:30:00.000-08:00

Even the most ardent supporter of a simplified tax code would feign excitement over the expiration of the following tax provisions as of December 31, 2011. The AMT patch will most likely be extended, particularly in an election year. Many of the provisions are widely used such as the deductibility of state and local sales tax, deduction for certain teacher expenses, and the mortgage insurance premiums deduction.

1) The "AMT patch" will need patching in 2012. The AMT exemption reverts to its previous statutory amounts. IRC Sec. 55(d). Personal credits allowed against regular tax and AMT expires as well. IRC Sec. 26(a), although certain exceptions apply. The patch will no doubt be extended as it would subject significantly more taxpayers to the AMT. The lack of personal credits against the AMT and regular tax would disallow the benefit of some credits for certain taxpayers.

2) The deductibility of state and local sales tax instead of state income tax on Schedule A expires. IRC Sec. 164(b). For the few sales tax only states, this will create a noticeable increase in taxes.

3) The deduction of up to $250 for certain elementary and secondary school teacher expenses. IRC Sec 62(a)(2)(D). The teacher's unions will no doubt find this annoying.

4) Deductible mortgage insurance premiums as interest. IRC Sec 163(h). With many individuals struggling to make payments on homes with little or no equity, this certainly won't help.

5) The tuition and fees deduction (above-the-line) of up to $4,000 for qualified tuition and related expenses. IRC Sec. 222. The name and amount of the education credits continue to change, which makes longer term planning more difficult.

6) Tax free treatment of charitable distributions from IRAs. IRC Sec. 408(d)(8). Mitt Romney might want to keep this one around for his supersized IRA.

7) Several other less common provisions including:

a) Transit pass exclusion from income will no longer be equal to the parking benefit exclusion. IRC Sec. 132(f). The amount excluded from income falls from $230 per month in 2011 to $125 per month in 2012.

(b) Expanded adoption credit, IRC Sec. 36C, and adoption assistance program IRC Sec. 137 amounts.

d) Nonbusiness energy property credit. IRC Sec. 25C. This provision already took a substantial cut in 2011. Many of the eligible items are too expensive to justify purchasing them to receive the credit such as furnaces (afu >=95) and hot water heaters (tankless only) for two examples. It's easier to get a rebate from your local utility company. The Energy Star websites has an easy to read comparison of the changes from 2011 to 2012.

e) 100% exclusion of gain on sale of certain small business stock. IRC sec. 1202(a).

The AMT Sweet Spot for High Income Individuals

2012-01-06T14:51:00.000-08:00

With all the negative publicity received by the AMT, it is helpful to note there is a sweet spot for certain high income taxpayers. It is obviously an unintentional gift from Congress. Knowing that it exists is the first step toward taking advantage of it.

Forbes published an easy to read blog post detailing the whereabouts of the sweet spot and how to take advantage of it. Cutting to the chase, the sweet spot begins, for married couples filing jointly, at $447,800 of AMT taxable income. At this point, the AMT effective marginal tax rate drops from 35% to 28%. This is a tax planning opportunity that is best investigated with tax planning software such as BNA Income Tax Planner. The sweet spot will vary in size depending upon the taxpayer's AMT adjustments and preferences. These items are shown on Form 6251.

The example used by Forbes is a married couple with no kids whose itemized state, local, and real estate taxes tally $60,000. The AMT sweet spot in this case stretches from $447,800 to $680,400. From $447,800 to $680,400 the taxpayer is taxed at 28% on the margin instead of 35%. A sweet deal, if one can take advantage of it.

Taking advantage of the sweet spot requires the ability to generate additional ordinary income that will be taxed at the 28% rate, but stop right at the point above which the taxpayer returns to the 35% marginal tax rate. Some ideas to generate this income are ROTH IRA conversions, exercising stock options, accelerating income into the current year or defer expenses to the following year if one has control of business income.

Forbes: The Alternative Minimum Tax Sweet Spot

Bob Farrell 10 Market Rules

2012-01-03T19:46:00.000-08:00

Bob Farrell was Merrill Lynch's Chief Market Strategist from 1967-1992. His market rules provide a simple framework for making investing decisions. It's a good warm up for Howard Mark's, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.

1. Markets tend to return to long-run averages over time

2. Excesses in one direction are usually followed by excesses in the opposite direction

3. There are no new eras

4. Exponentially rising or falling markets usually go further than you think, but they do not correct by going sideways

5. The public buys the most at the top and the least at the bottom

6. Fear and greed are stronger than long-term resolve

7. Markets are strongest when they are broad based and weakest when they narrow to a handful of blue-chip names

8. Bear markets have three stages - share down, reflexive rebound, and a drawn-out fundamental downtrend

9. When all the experts agree, something else is going to happen

10. Bull markets are more fun than bear markets

Another great investing rule akin to Bob Farrel's 10 Rules of Investing is the following rule coined by Don Coxe of Cox Advisors, LLC:

"Never invest on the basis of a story on Page One, that is the efficient market. Invest on the basis of a story on Page Sixteen that is on its way to Page One."

The Taxation of Gold Investments for Individual Investors

2012-01-03T19:41:00.000-08:00

Individual investors may experience a substantial difference in the taxation of various investment vehicles used to track the price of gold. To detail out these differences, let's assume that an investor wishes to compare the tax implications of investing in the SPDR Gold Trust (an exchange traded fund), DB Powershares Gold Fund (an exchange traded fund), PowerShares DB Gold Double Long ETN (an Exchange Traded Note), and gold bullion.

The SPDR Gold Trust, consistent with Internal Revenue Service Chief Counsel Memorandum , is structured as a grantor trust for federal tax purposes and directly invests in gold. Shareholders are treated as if they own a pro rata share of the underlying assets of the Trust. The Trust's income and expenses flow through to the shareholder. Accordingly, the shareholder is subject to the maximum 28% capital gains tax on collectibles when the investment is held for more than one year. The definition of collectibles is found in Code Section 408(m)(2). If the holding period is short-term, the usual short-term capital gain rules apply. More information about the taxation of this ETF, or any ETF for that matter, can be found in the ETF's prospectus. The SPDR Gold Shares prospectus is located here.

In contrast, the DB Powershares Gold Fund is structured as a partnership for federal tax purposes and invests in actively traded futures contracts. The investor is purchasing a publicly traded partnership. Shareholders are taxed on their pro rata share of income, gain, loss, deduction, and other items. The shareholder will receive a Schedule K-1 each year denoting these amounts.

Because the fund holds futures contracts, six-tenths of the profits will be taxed at long-term capital gains rates and the remaining four-tenths will receive short-term capital gains treatment. This calculation is done at the partnership level and flows through to the Schedule K-1. One may also report interest income from the Schedule K-1 from overnight investments and swap agreements entered into by the partnership. At year-end, regardless of whether gains or losses have been realized, the futures contracts are marked to market. This causes the partnership to report gain or loss even though nothing was sold. The partnership is not required to distribute any of these gains, losses or interest to the investor, so the investor may be paying tax, but not receiving any distributions!

When the investor sell the ETF, he is selling his share of the partnership. Consequently, he will report a capital gain or loss, short-term or long-term depending upon the holding period, equal to the difference between the proceeds and his adjusted basis in the partnership. The adjusted basis will most likely be provided to him on a schedule by the partnership, but not always.

The PowerShares DB Gold Double Long ETN is an exchange traded note. ETN's are long-term, unsecured notes issued by a bank that do not require any interest or principal payments prior to maturity. The ultimate payment at maturity is equal to the value of the principal payments as if it were invested in the underlying benchmark the ETN was designed to track, less any fees.

ETN's are currently taxed as prepaid financial contracts. If one reads the prospectus for this ETN, one will find that "significant aspects of the U.S. federal income tax consequences of an investment in the securities are uncertain." The IRS issued Notice 2008-2 seeking comments on the appropriate tax treatments of instruments decribed as prepaid forward contracts. If the ETN is treated as a prepaid financial contract, then the gain or loss will be subject to long-term or short-term capital gains tax when the ETN is sold just as if one bought a stock. However, the prospectus also provides for two alternative tax treatments detailed here in the prospectus. Until the IRS comes out with definitive guidance, there may be an issue here for investors if the prepaid financial contract position is disallowed by the IRS.

By purchasing gold bullion, one is subject to the maximum capital gains rate on collectibles of 28% if the bullion is held for more than one year and short-term capital gains if held for less than one year. The primary issues with bullion are storage and insurance costs.

It's important to read the prospectus before you invest in Exchange Traded Funds (ETF) and Exchange Traded Notes (ETN) in order to understand the tax implications. The option that is best for one's investment portfolio and tax situation varies by investor. For example, with bullion one can defer gain until one sells it. With the grantor trust (SPDR Gold Trust) or partnership (DB Powershares Gold Fund), it may be harder to defer gain as the SPDR Gold Trust may sell gold to pay trust expenses and one will be taxed on one's share of partnership income on the DB Powershares Gold Fund whether or not one sells one's investment. It's important to read up before you leap for the gold.

The Taxation of Master Limited Partnerships for Individual Investors

2012-01-03T19:31:00.000-08:00

A Master Limited Partnership (MLP) is a limited partnership publicly traded on a securities exchange. The partnership must meet the exception under Code Section 7704(c) that allows it to be taxed as a partnership instead of a corporation. Being a flow through entity, the investor is taxed on his share of the partnership's income, gains, deductions, losses, and other items. Certain investors with large positions may experience state tax issues. Tax information is reported to the investor via Schedule K-1, which may arrive after the April 15th filing deadline.

According to Standard and Poor's, during 2008 the size of the MLP market exceeded $100 billion, with most listings falling in the energy sector. There are at least 100 MLP's currently listed on stock exchanges. MLP's typically engage in the exploration, development, mining, production, processing, refining, transportation, and storage of oil, gas, coal, propane, minerals, timber, certain other natural resources, and certain real property (see StoneMor LP or Cedar Fair for real property examples). Investors are typically drawn to MLP's for high current income.

Some MLP Schedule K-1's suggest a Section 754 disclosure statement be made on the Form 1040 when the partnership investment is purchased because the interest may contain basis adjustments and a Section 751 disclosure statement when the interest is sold. In addition, some Schedule K-1 packages from MLP's include Form 8886 reportable transaction information that may need to be reported on the investor's Form 1040. These are typically small inconveniences and should not dissuade the investor from making an investment.

When the taxpayer sells his partnership units, he generally reports a capital gain or loss determined by the difference between the proceeds received and the taxpayer's adjusted basis in the partnership. However, the MLP is subject to Code Section 751, which may subject part of the realized gain to ordinary income treatment. The ordinary income treatment is related to the investor's share of unrealized receivables, inventory, unrecaptured depreciation for real and tangible personal property, and recapture of depletion taken for intangible drilling and development costs of oil and gas wells, mining development, and exploration expenditures. The allocation between capital and ordinary income is provided by the MLP.

The passive activity loss rules are applied to MLP's on an entity-by-entity basis. The loss from one MLP cannot offset the gain from another MLP. A loss from an MLP cannot be used to offset other sources of passive income. Losses that cannot be deducted will be suspended until there is income from the same MLP that created the loss or the investor sells the MLP. See Code Section 469(k) for more information. One last item to note is portfolio income from the Schedule K-1 will not be offset by any losses reported on the Schedule K-1.

Tax-exempt investors, which includes investors with MLP's held in IRA, SEP,and ROTH retirement accounts and nonprofits, may pay tax on unrelated business income (UBIT) if the gross income from unrelated business income exceeds $1,000 (See IRS Publication 598). If unrelated business income is an issue there are investments such as the JPMorgan Alerian MLP Index ETN, which would avoid UBIT, and provide exposure to the MLP asset class. However, the ETN does expose the investor to credit risk as the investment is essentially an unsecured note from JPMorgan. Additional products have been released which house the MLP investments in a corporation. This eliminates the Schedule K-1 issue for the investor, but creates additional tax issues which lowers over all returns. See "Tax Quirk Crimps Returns of MLP funds (Marketwatch)" for more information. Even so, certain individual investors may choose to gain exposure to MLP's via closed-end funds like those managed by SteelPath. The investor would then avoid the complications caused by Schedule K-1, Section 751 issues when the MLP is sold, state filing requirements, and other disclosure requirements. While MLP's may require cumbersome tax reporting, it should not deter investors from investing in them.

Further reading:
The CPA Journal: Master Limited Partnerships: Tax and Investment Issues
Cohen Fund Audit Services: A Practical Guide to the Tax Issues of Investing in Master Limited Partnerships
National Association of Publicly Traded Partnerships

The December 7th issue of Barron's discussed further tax issues related to Master Limited Partnerships in the article entitled "Even Better Than Bonds." [subscription required]

The article notes that 70% or more of many large master limited partnership's distributions may be tax-deferred because the distributions can be larger than the reported net income of the partnership due to noncash depreciation or amortization expense. The tax-deferred distributions reduce the partner's basis in the partnership. Think of it as a return of invested principal. Eventually, the partner pays tax on the distributions when the interest in the partnership is sold as the distributions reduce the partner's basis in the partnership, assuming the investment is sold at a gain. The portion that is not tax-deferred is typically ordinary income consisting of interest, royalties, and other types of ordinary income.

In addition to the current tax savings, some investors may be able to make the tax-deferred savings permanent by holding the master limited partnership until death. If there is a "step-up" in the basis of the master limited partnership to fair value at death, the prior reduction in basis as a result of the tax free distributions is eliminated.

Christopher Wood of CLSA Asia-Pacific Markets on China and Euroland

2012-01-02T18:12:00.000-08:00

Barron's interviewed Christopher Wood in the December 12, 2011 issue.

Barron's: China and the Euro: Connected Concerns (December 12, 2011)

Points of Interest:

1) The two most important events for 2012: when do we get to the endgame of the euro-zone crisis and when does China ease.

2) Southeast Asian markets such as Indonesia, Philippines and Malaysia outperformed in 2010 because the central banks were not tightening. India and China under-performed due to central bank tightening. Indonesia has begun easing again. When China and India begin easing, it makes sense to move money from Southeast Asia to China and India.

3) China and India have room to ease central bank policy in 2012.

4) When China eases monetary policy, the Shanghai market will move. If the China shares in Hong Kong outperform the Shanghai, that is not a good sign. That is a sign the Chinese are not really easing, but rather, the Hong Kong market is going up.

5) Two items to watch in China: interest rates and the property market.

6) There has historically been a close relationship between Chinese property prices and Chinese property stocks. If Chinese property stocks are not rallying, the Chinese market cannot rally.

7) Notes China is the most policy-obsessed stock market in the world. Policy moves the market more than earnings.

8) Brazil and Russia are commodity plays. They will trade up on a resurgent Chinese market. They need China to rally before they can outperform.

9) The key variable for the US market is the US dollar not the US economy.

10) You want to add to Asia when Europe causes Asia to sell off. When the Shanghai has rallied and decoupled, you want to add aggressively to Asia.

Determining an Appropriate Asset Allocation for your Portfolio

2011-08-15T12:53:00.000-07:00

"Investors have too often extrapolated from recent experience. In the 1950s, who but the most rampant optimist would have dreamt that over the next fifty years the real return on equities would be 9% per year? Yet this is what happened in the U.S. stock market. The optimists triumphed. However, as Don Marquis observed, an optimist is someone who never had much experience." - Triumph of the Optimists: 101 Years of Global Investment Returns

Deciding upon an asset allocation strategy for one's portfolio is not as simple as relying on the hackneyed "stocks for the long-run." Based on the long-term data in Triumph of the Optimists, it is generally true for most countries that stocks outperform bonds and bonds outperform bills [see Table 4-1]. The higher return earned by stocks is compensation for the additional risk taken on. From Table 4-3 and 4-2, the minimum annual real return [real return is the nominal return minus inflation] for stocks during 1900-2000 for the 16 countries listed was negative 48%, the maximum annual return was 90%, the standard deviation averaged about 23, which measures how widely returns will vary around the average, and the average return was 7.6%.

If the returns in this sample follow a normal distribution (which they don't by the way - see Nassim Taleb's The Black Swan), then 68% of the time stocks will return between (15.4)% and 30.6% and 95% of the time stocks will return between (38.4)% and 53.6%. The same exercise can be done for bonds and bills noting the average annual real return falls to 1.69% and 0.57% and the standard deviation falls to 12 and 8, respectively. The standard deviation is sometimes mistaken as a measure of risk, but it is generally much better to think of risk in terms of a permanent loss of capital. I like to think of standard deviation as the number of nights a year one will spend thinking about a given investment instead of sleeping. While stocks may provide a higher average return over a given period of time, the dispersion of returns is much wider than that of bonds and bills. Bonds and bills provide a much more predictive return for part of the portfolio, although at the cost of higher potential returns.

One of the great, free resources on the Internet for building a portfolio is Paul Merriman's "Fine Tuning Your Asset Allocation." First the caveat, the data is historical, which means the table showing the hypothetical returns of balanced asset class portfolios (1970-2010) will not be predictive of future returns. The returns also assume a 1% management fee is deducted annually with the exception of the S&P 500 column. If one wanted to, one could use the asset class forecast data from GMO, LLC to estimate future 7-year returns to update the estimated returns. For a 40% equity and 60% bond mix, the estimated 7-year return as of July 31, 2011 would be approximately 4% annualized compared with 9.4% in the chart. The difference is due primarily to the over-valuation of bonds and to a lesser extent stocks compared with the 1970-2010 period. With that being said, it does provide a great way to assess one's tolerance for volatility and to choose a broad asset allocation that makes sense with one's investment time horizon.

Take for example, a 40% equity and 60% bond mix. The worst 60 month period provided a 1.6% annualized return. As equity exposure increases beyond that point, the annualized returns become negative over the worst 60 month period. This point of negative returns may be different if we were to look forward into the future, but in general, assuming one purchased intermediate term individual bonds, the higher the bond allocation, the less likely one would be to lose money (in nominal terms, i.e. not adjusted for the effects of inflation) over a 60 month period.

There are also interesting trade-offs when accepting more equity exposure. If we calculate a simplistic Sharpe Ratio for the portfolios, it continually falls as the equity exposure increases. In essence, the dispersion of returns the investor is facing grows with increased equity exposure and return potential. This is shown in the worst month, worst 12 month, and worst 60 month data. Lubos Pastor provides interesting thoughts on why the notion that stocks are less volatile over long periods of time than in the short-run may be overstated due to the uncertainty facing an investor looking out over a long and uncertain future as opposed to academics looking in the rear view mirror. Most individuals can determine quite quickly where their comfort level lies, or more importantly, what makes sense given their investing horizon. Then adjusting the data to look forward provides a more realistic expectation of future returns. Unfortunately, the worst month, 12 months, and 60 months going forward is impossible to predict. The search for higher returns often comes with more sleepless nights.

James Grant on Consuelo Mack's WealthTrack

2011-06-08T16:37:00.001-07:00

Discusses Fed policy and economy.

Items of interest:

1) Fed targets 2% inflation
2) Believes there will be a coming adjustment in financial assets due to realization of a new inflation cycle.

Marilyn Cohen on Consuelo Mack's WealthTrack

2011-06-08T16:24:00.000-07:00

Discusses the bond market in detail. Also publicizes her new book.

Topics of interest:

1) Believes the bond bear market will last about one year to two and one-half years, once it begins.
2) Once the bond market gains momentum, it will be a fairly quick, but ugly adjustment to normalization.
3) Shorten duration
4) Sacrifice yield today for opportunities down the road

Paul McCulley on Consuelo Mack's WealthTrack

2011-06-08T16:16:00.000-07:00

Discusses the US economy and Fed policy.

Points of interest:

1) Fed may raise rates in 2012 (noted 6-12 months to signal or raise rates during various parts of the video), but believes the Fed will signal that they will move to raise Fed funds rate

2) When Fed raises (signals the intent to raise) rates, the market will fall by around 10%.

3) Notes if you have been riding cash for two years, don't invest your cash money in the stock market. If you stuck it out this long, wait a bit longer. When the Fed hikes rates, the stock market will have a "wicked" correction. Don't buy into the face of the Fed hiking interest rates.

4) Indicates this is not a propitious time to make a lot of money in the investment portfolio. Don't try to squeeze performance out right now. In the fullness of time, the Fed needs to normalize rates. He believes eventually the Fed funds rate will normalize in the 2-3% range, not soon, but that is where he believes we will be headed. Real rates will be right around 0% then.

5) 10-year bond at 4-5% as rates normalize.

6) For retail investors, he doesn't see any reason for individual investors to play around with the 30-year
bond.

David Herro on Consuelo Mack's WealthTrack

2011-06-08T16:02:00.000-07:00

David Herro, manager of three Oakmark International Funds, provided several useful insights during his recent WealthTrack appearance.

Points of interest:

1) It was mentioned that his portfolio turnover has doubled over the last three years because prices were moving to fair value much quicker than in the past. His holding period for stocks has fallen from 4-5 years to 2 years.

2) What it takes to be a truly successful long-term investor:
a) Need to be grounded. Have a very sound investment policy.
b) Apply discipline
c) Stay in the pocket, don't get rattled, and stick to your investment philosophy

3) What is his value philosophy?
Value is comprised of two characteristics:
a) Low in price or "cheap." - Based on free cash to enterprise value.
b) Quality - Achieve satisfactory rates of return over medium and long-term and management team that proactively and successfully allocates the free cash of that business.

4) People abandon common sense when macro trends disrupt them.

5) The herd is piled into emerging markets, resource stocks, and energy. He sees value in Japan, consumer discretionary, and select financials.

6) Notes that it is foolish to view Europe as one asset class. There is a wide variety of economic conditions in Europe which can be exploited through active investment management.

7) Finds stocks in emerging markets to be expensive. Anytime there is positive macro trends there tends to be a flood of money into that asset class.

8) Valuation of small cap stocks in US pricey in comparison to large cap. Believes there is a small discount to fair value for international small cap stocks.

Valuation Models for the S&P 500 and Other Asset Classes

2011-06-08T15:41:00.000-07:00

"It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value." - Benjamin Graham from The Intelligent Investor: The Definitive Book on Value Investing.

A typical cocktail party conversation consists of talk about winners, percent gains, yields and individual stocks from popular sectors. You rarely overhear someone bragging about a new valuation model they found which provides reasonable estimates of future returns, and more importantly, works consistently over time. Here are four models that I believe would pass the "well-established standards of value" test.

GMO 7-Year Asset Class Return Forecasts

GMO's Jeremy Grantham provides one of the best quarterly investment commentary that money cannot buy. In his quarterly commentary he often provides GMO's estimate of the fair value of the S&P 500, which is useful in and of itself. In addition, the firm also provides access to its 7-Year Asset Class Return Forecasts, which are published monthly (with about a month lag). This forecast provides the estimated annual real return GMO expects for 12 broad asset classes: US large cap stocks, US small cap stocks, US high quality stocks, International large cap stocks, International small cap stocks, Emerging market stocks, US bonds, International bonds, Emerging market debt, Inflation linked bonds, cash, and timber.

Like any model, there are assumptions and range of outcomes to consider. The long-term inflation assumption is currently 2.5% per year. The nominal return is equal to [(1+real rate)*(1+inflation rate)]-1. Most investors think of their investment returns in nominal terms, i.e. not adjusted for inflation. The second item to consider is the estimated range of each 7-year annualized real return. For example, the April 30, 2011 forecast shows a real return of 4.5% for Emerging stocks with an estimated range of +/- 10.5%. The 4.5% is most likely the average of the two annualized return extremes: 15% and -6%. Lastly, this is a black box model that uses GMO's proprietary valuation methodologies. As it notes in the small type at the bottom, "actual results may differ materially from the forecasts above."

Note that the forecasts exclude some asset classes such as commodities, real estate and subsets of asset classes such as high-yield bonds, municipal bonds, and investment grade bonds to name a few. You can't get everything for free. Unfortunately, it takes somewhere in the neighborhood of $1 million or more to get into a private timber investment. Head over to John Hancock Timber Resource Group if that fits your profile (or another similar firm). Yet, there is clearly enough information here to be of use to the long-term buy and hold to fair value investor.

In Jeremy Grantham's 2011 First Quarter Investment Letter, he provides a "very crude way" of showing that the asset class forecasts provide value to the price conscious investor. Take for example his cognitive exercise: Starting in 1994 when the forecasts first started, place 100% of a portfolio in the single asset class that GMO estimates will provide the highest return. Rebalance each month, if necessary, when the new asset class forecast comes out. The example assumes zero transaction costs such as trading commissions and other investment fees. The "Max Forecast Portfolio" provided a 16.7% annualized return compared to 8.8% for the S&P 500, however, the enhanced return was also accompanied by an increase in volatility. As Grantham notes, this strategy "would not be tolerable for much more than 5 or 10% of one's money, rebalanced each year." However, for our purposes, it lends support to the idea that the asset class forecasts may provide a useful tool for comparing the absolute and relative value of the asset classes. This information can be used to intelligently underweight, overweight, or avoid certain asset classes in a given portfolio or benchmark.

Using the 2001 1st Quarter Asset Class Return Forecast, I tested a few asset classes using Morningstar.com's portfolio tool and Yahoo! Finance's historical quotes:

US equities large cap - 2.2% nominal [(1+0.00)*(1.022)]-1. S&P 500 total return index. 2.53%.

Emerging market stock - 13.9% nominal [(1+.114)*(1+.022)]-1. T. Rowe Price Emerging Markets Stock Fund ($10.25 to $36.06 or approx 14.84% per year with reinvested dividends and capital gains)

Small cap stock - 6.5% nominal [(1+.042)*(1+.022)]-1. iShares Russell 2000 Index ($43.75 to $84.17 or approx 6.79% with reinvested dividends).

I didn't try to find the best fit forecast with 10 years of data available, but as one can see, the estimates are accurate in this instance. In the case of the 10 year period ending March 2009, the actual return should be probing the low end of the estimated range. For the 10 year period ending April 2000, one would expect the return to be at the high end of the estimate range. In any event, the forecasts appear to be a useful tool in my opinion.

The 7-Year Asset Class Forecasts are available at GMO's website with a free registration.

John Hussman's Forward Operating Earnings S&P 500 Valuation Model

This model is outlined in John Hussman's August 2, 2010 weekly commentary. To gain a thorough understanding of the model, read his piece. He does a great job of explaining how he arrived at the equation, the assumptions embedded in the model, historical accuracy via graphs, and caveats. The model is used to estimate the 7-10 year annualized return of the S&P 500. He notes "the long-term annual total return for the S&P 500 over any horizon T can be written as:

Long term total return = (1+g)(future PE / current PE)^(1/T)-1 + dividend yield (current PE / future PE + 1)/2"

The first term, up to the first "+" sign, represents the annualized capital gain and the second term approximates the average dividend yield. The return is based upon the sum of the capital gains and dividends. As he notes, the two most important things to get right are g, the long-term earnings growth rate, and the future PE (price/earnings multiple). Based upon his work, the best estimate for g over a 10-year horizon is:

g = 1.063 * (0.072 / (FOE/S&P 500 Revenues))^(1/10) - 1

He also notes that over a 7-10 year period, the correct future PE to use is 12.7. Note this is different than the typical 15, which is the ratio of the S&P 500 to trailing 12-month net earnings.

The data to populate the model is available via free registration at Standard and Poor's. Based on my understanding of the inputs, the S&P 500 was set to return approximately 4.06% as of June 3, 2011. This is close to the 3.9% John Hussman provided in his June 6, 2011 weekly commentary (his value may be an average of several models he uses). See spreadsheet below for details.

John Hussman's Price to Sales S&P 500 Valuation Model

This simple revenue-based valuation model is outlined in John Hussman's May 23, 2001 weekly commentary. The model follows the same form as the previous model. The first term represents the estimated annual capital gain and the second term estimates the expected dividend yield. The correlation of the model to subsequent returns is provided in his weekly commentary. Below is a spreadsheet with the model populated with data from Standard and Poor's. The June 3, 2011 expected return for the S&P 500 is 4.04%.

Schiller P/E

Robert Schiller's cyclically adjusted p/e ratio averages profits over a 10-year period in an attempt to smooth out the effects of the economic cycle. The ratio is the real S&P 500 price divided by the 10-year average real earnings of the S&P 500. The Schiller P/E is controversial. Here is a piece from The Economist's Buttonwood's Notebook in defense of the Schiller P/E. In any event, the ratio should be mean reverting around an average over time. John Hussman provides, in his March 14, 2011 weekly commentary, a general framework for using the Schiller P/E to provide expected market returns over a 5 and 10-year horizon. The table of his findings is provided toward the top of the commentary. Clearly, when the Schiller P/E is high, returns tend to be lower in future years and vice versa. This effect is more pronounced over a 10-year total return period than a 5-year total return period. This is due in part to the bubbly 1990's. The really interesting data is the frequency of P/E level. The current P/E levels around 23-24 have not occurred very often in the history of the data set and provide average annual returns over a 10-year period of 3.5%. This jives quite well with the previous valuation methodologies.

Other Models

Two other models that may come in handy are the Tobin Q and Market Cap to GDP ratio. Tobin Q was oulined by Andrew Smithers and Stephen Wright in their book Valuing Wall Street : Protecting Wealth in Turbulent Markets. The model compares the value of the market with the net replacement cost of corporate assets. The model is used with the same mean reversion assumption of the Shiller P/E. When market prices exceed corporate asset values, investors would be best off buying corporate assets directly instead of equities. An updated Tobin Q graph can be found here. It's best used as a broad view of over and undervaluation.

Another broad valuation model is Total Market Cap to GDP. Gurufocus.com provides a nice explanation and anticipated future return calculation based on this model. The green line in the first graph is the total market cap to GDP value. The green, brown, and red lines in the lower graph provide the anticipated annualized return over an 8 year period with green being the lower bound, brown the middle bound, and red the upper valuation bound.

The Long-Term Buy and Hold To Fair Value Investor

2011-05-27T16:22:00.000-07:00

"Imagine a world where the stock market is open for trading only one hour of every year."

This quote from Mark Spitznagel's Wall Street Journal article "Investment Strategy: All About the Benjamins" either elicits feelings of panic or insouciance from holders of financial assets. Panic from those who base their investment strategy solely on a constant stream of prices: traders. Insouciance from those who base their investment strategy on a claim to a long-term stream of cash flows that will be received in the future: investors. Neither method is superior in and of itself. However, it is rare to find an individual that is capable and knowledgeable in both. This blog will be focused primarily on long-term investing and the arguably dead art of "buy and hold to fair value investing."

The long-term investor is typically unfashionable, stubborn, skeptical, uninterested in what others think of his opinions, obsessed with the wonders of compounding, and prone to arguing that dividends still matter. James Montier, of GMO, LLC, refers to him as "A Man from a Different Time." The average holding period for a NYSE listed stock has decline from roughly 5-6 years in the 1970's to1 year today [See Exhibit 2 from "A Man from a Different Time]. As James shows, the return for holding stock one year is primarily based on changes in valuation where as the return for holding a stock for five years is primarily based on dividend yield and dividend growth. Yet at the end of the day, the long-term investor is just like everyone else; he wants to buy something today that will be worth more in the future.

There is a universal difficulty in becoming a successful long-term investor for the vast majority of people. That is lack of time. Most people spend their days toiling away at occupations far removed from investment management. Free time is usually (hopefully) not spent pouring through financial statements and investment commentary. This leaves two options. Hire a financial advisor or do-it-yourself. Either way, it makes sense to spend time learning about investing. It might even help prevent your favorite financial advisor from selling you a discounted AAA mortgage backed security on an ocean front property in Arizona.

Another common difficulty is whether one is even capable of valuing a company, assessing the safety of a stream of interest payments from a bond, valuing puts and calls, or knowing when or if hoarding commodities makes sense. If you are like me, you may have a slight inkling of how to go about it, but that's as far as you wish to take it (or can take it). If that is the case, then intelligently investing in individual stocks, bonds, currencies, derivatives, and commodities may not be doable. This blog will focus primarily on mutual funds and exchange-traded funds (ETF), although creating "copycat" portfolios and investing in individual bonds will be covered.

At the heart of the matter is getting the valuation work correct. Investing money in financial assets that are priced to provide, with a reasonable probability, the return you are hoping for over a given period of time and avoiding assets that are overvalued will in time provide reasonable returns to the long-term buy and hold to fair value investor. What the market is saying on a day-to-day basis will be nothing but background noise.