Is the Economic Cup Half Empty or Half Full?
Part 1: Perception = Reality
PERCEPTION IS REALITY
Albert Einstein once famously said, “Reality is merely an illusion, albeit a very persistent one.”
Wikipedia, on the other hand, defines reality to the contrary: “Reality is the state of things as they actually exist, rather than as they may appear or may be thought to be.”
As we monitor the domestic economic data and stock market activity, we find ourselves appreciating the concept that perception is reality. Depending on your perspective, we are either in very good shape and getting better or on the verge of having the other shoe drop.
If you are unemployed, your perception of reality is quite bleak. If your house was foreclosed upon, or even if it merely dropped significantly in value, your perception of this economic recovery probably is severely jaded. If you were about to retire and your portfolio dropped in 2008 by 40-50%, you had better love what you do because you will be doing it for a lot longer.
When we look at the stock prices of various companies selling luxury goods, it looks and feels like a bull market. However companies selling their products to people who are struggling economically are looking less robust.
Let’s consider the chart of two companies to help paint a picture.
The first company is Coach Incorporated (COH). Coach sells high-end luxury leather products and has stores in the toniest of malls. For our foil, we will choose Walmart (WMT). They are not in luxury malls. Once famous for creating a profitable brand known for cutting prices to the bone, their growth has faltered and their customers do not appear to be spending. Here is the two-year (2009-2010) chart, with the dark line representing Coach and the yellow line showing the stock price of Walmart.
We wonder if the reported “increase in consumer spending” (and sentiment) isn’t mostly weighted on the side of the higher-end consumers who a relatively small percentage of the consumer base which has been the engine of our past economic growth.
ECONOMIC PROGRESS, NOT PERFECTION
We believe there is sufficient economic data to justify cautious optimism. As a nation, we clearly avoided falling into the precipice of a second, perhaps Greater, Depression. The feared double-dip recession has not materialized. The dreaded deflation that Japan experienced, causing what is referred to as the Lost Decade, has not materialized here, either.
Much of the credit goes to Federal Reserve Chairman Bernanke who both created and steered monetary policy. While still a politically sensitive subject, we think some of the credit also has to go to government policies that, among other outcomes, created a powerful perception of a country on the road to recovery. Perception can be reality.
Our economy has gone through a three year regimen of extreme physical therapy, but is still not yet ready to run a marathon. Many unanswerable questions remain. Some believe that a jobless recovery is not a recovery at all. Others are convinced that the recent QE2 government stimulus and an ever-increasing burden of debt are leading us into another crisis. As the economy finally shows signs of standing on its own two feet, there is a fear that the Federal Reserve will withdraw the stimuli and interest rates will rise. After all, there is no more room for rates to fall further.
Imagine refinancing your home at an interest rate 2-3% higher than it is now. Rising rates will mean that the government will pay out a significantly higher portion of our economic output just to pay the interest on our national debt. Corporations, currently enjoying cheap borrowing rates to spark their growth, will find higher interest rates to be an impediment. They could perhaps delay even further the hiring back of the currently unemployed or recent college graduates, and creating worse structural unemployment in the process.
We have clearly made some progress. However, there continues to be major global and domestic challenges to sustaining this recovery and moving to expansion.
Part 2: Our 2010 Year in Review
SILVER OAK’S 2010 YEAR IN REVIEW
Beginning with our successful avoidance of the extreme declines of 2008, Silver Oak’s investment approach has been twofold. First, we want to create solid, sustainable portfolio growth based on each client’s required rate of return. Secondly, yet certainly as important, we want to achieve that rate of return at the lowest possible level of risk.
We define the required rate of return as the combination of income and appreciation that is shown to make each client’s financial plan successful. It is a growth rate that we believe is realistic based on reasonable expected returns of the various investment vehicles from which we can choose.
Thanks to a spectacular 4th quarter, which was largely attributable to Ben Bernanke announcing a new round of “quantitative easing” and to the renewed Bush tax cuts, the stock market as measured by the S&P 500 rose about 15%. Yet for those who do not recall, the picture for the full year looked like a roller coaster ride. Through August, the S&P 500 had experienced a loss of 5% year-to-date. Meanwhile, Silver Oak’s typical portfolio advanced in a very different pattern.
The following graph reflects the volatility of the stock market during 2010 as measured by both the S&P 500 and Dow Jones Industrial Average. The yellow line is a bond index and includes components that formed part of Silver Oak portfolios. The lighter blue line is representative of many of our portfolios which contained a high allocation to fixed income as well as a lesser allocation to our “higher risk bucket.”
2010 Index Returns: Barclays Capital U.S. Aggregate Index: 6.55%; DJIA: 14.06%; S&P 500: 15.07%
It is clear that while the stock market (dark blue and red lines) ended higher than the light blue line (Silver Oak portfolio), it did so with terrific volatility, which we have observed is quite unsettling for most clients. It is our belief that building portfolios intentionally with a steady and gently upward sloping growth line (our light blue line) is preferable for most investors.
Part 3: The Year Ahead
SILVER OAK’S INVESTMENT PHILOSOPHY & OUTLOOK FOR 2011
We’ll now take this opportunity to review our investment approach and outlook at Silver Oak Wealth Advisors for 2011.
In these challenging economic times, we feel that the ability to make tactical changes to our portfolios is an invaluable component of delivering returns with less volatility. We always utilize the most advanced scientific, analytical tools and research available. We do not try to predict the stock market, and we do not consider our approach to be market timing; no one has shown that they can do that successfully.
What we can do to a significant extent is to estimate the risk that our clients are assuming and provide our guidance as to whether they are being fairly compensated for taking that amount of risk. By noting the relative likelihood of both positive and negative impactful macro-economic events, tactical portfolio decisions provide us with a tool to recalibrate the portfolio risk levels while identifying asset classes that are likely to help reach each client’s targeted or required rate of return.
As we contemplate 2011 and scrutinize the data, we see a different picture than we saw a year ago. The implications and potential effects on our existing client portfolios have caused us to make some modifications as we have entered this new year.
First, fixed income is unlikely to produce the substantial gains we experienced over the past two years. Various bond holdings and bond funds experienced double-digit returns annually over that period. This was possible due to a combination of factors including declining interest rates and a reduction in the perceived riskiness of the market in many individual bond categories; plus the perceived riskiness of the stock market.
Rates are now more likely to rise than decline, although we believe the government will continue to push for low short-term rates for an extended period of time. Longer-term rates are a function of various market forces that are out of the government’s control, including inflation. Therefore, we have sold a number of appreciated bonds and bond funds and have repositioned that money.
Due to our concern about the relative weakness of the U.S. dollar, we are continuing to hold and add new investments that will help maintain purchasing power.
The investment outlook for equities is obscured by continuing mixed messages. Because the economy has shown signs of improving, there is certainly cause for optimism that corporate earnings can continue to improve. As earnings improve, and as investors feel more optimistic, there is room for stock prices to also rise. However, we are aware that by some stock market measures the U.S. stock market is overvalued and vulnerable to a correction. This is NOT the time for a “Mission Accomplished” banner to be displayed over the U.S. economy.
There are any number of known risk factors around the country and globe that might derail this recovery and precipitate a market correction. Housing, unemployment, rising commodity prices, rising interest rates, an emerging market hiccup that may be caused by China slowing its economy, and sovereign debt issues in Europe, to name just a few, are all risks that would negatively impact stock markets globally. Again, these are known risks. In this unstable world, we continue to also be concerned about unknown risks.
We are currently witnessing both known and unknown risks case leading to an Egyptian regime change. The Dow Jones Industrial Index tumbled 166 points on the news in one day. As the regime change did occur peacefully, the market has resumed its steady climb. However, Egypt is not ready to raise its own version of George W. Bush’s “Mission Accomplished” banner quite yet, as more uncertainties and internal conflicts emerge. And the many other Arab countries caught in this contagion are raising new concerns. While it is impossible to ponder all the potential risks, we believe it is prudent to incorporate a certain level of sensitivity to presently unknown possibilities into our portfolio design.
When we look at various indicia of equity valuations we again see that some indicators suggest valuations are high and others suggest valuations are reasonable. After factoring in these conflicting views, we do believe that the level of risk in the U.S. equity markets is lower than in the past two years due to the present growth in our economy. Since we had previously minimized equity exposure, we are now recommending a slight increase in higher risk assets for most clients. We think that selectively adding about 10% more to our higher risk bucket will provide the potential for additional portfolio returns this year.
We are adding equity exposure in a couple of areas that will provide a good dividend or income component to our portfolios. Our objective is to augment the cash flow previously generated by our fixed income investments, which requires taking on greater risk to duplicate. To enhance our diversification, for example, we recently added an international energy-related holding with an almost 9% dividend. We expect that this addition will contribute both cash flow and a potential for good appreciation.
In many respects, 2011 represents to us the Chinese character for “dangerous opportunity.” We will not be taking these “better times” at face value or for granted, but, as always, remaining ever-vigilant over the safekeeping of our clients’ financial well being.
As always, we welcome your questions and comments.
Sincerely,
Joel H. Framson, CPA/PFS, CFP® Eric Bruck, CFP®
President Principal
If you’re shopping for life insurance, you’ll find myriad policies with innumerable options and riders. But individuals often face a choice between two common types of life insurance: whole life or term. While whole life provides permanent coverage and some cash value, it’s normally much more expensive than a term policy that merely promises a death benefit if you die within a specified length of time. After years of steadily declining, the premiums for some term insurance policies have recently started to creep up. That could lead you to rethink your options.
Consider these differences between the two types of policies.
Whole life insurance. This is the traditional form of permanent life insurance. (Variations include “universal” life insurance and other cash-value policies.) The annual premiums are generally fixed when you buy the policy, which remains in effect for as long as you live if you continue to pay the premiums. In addition to providing a death benefit, the policy builds up a cash value on a tax-free basis. Typically, you’re able to borrow against that value, or take the cash with you if you surrender the policy. If you decide to surrender the policy, you will receive the accumulated cash value less any surrender charges or fees. But the premiums for whole life insurance are sharply higher than those of a term policy, particularly when you’re younger and term insurance is relatively cheap.
Term life insurance. As the name implies, you can buy term insurance covering a specified term, usually 10 years or longer. You could tailor the length of a policy to the amount of time you project that you will need coverage, perhaps choosing to have it expire at your expected retirement date, when replacing your income becomes less of an issue. Most term policies let you continue coverage at a higher rate. One main reason why term premiums are lower than those for whole life policies with the same death benefit is that term insurance doesn’t have to divert part of what you pay to fund a cash build-up.
The bottom line. The standard financial advice on life insurance has been to buy a term policy and invest the difference between that cost and what you would pay for a whole life policy. Of course, every situation is different. For instance, with the cost of term insurance rising, you may prefer the peace of mind of having permanent insurance. But your choice doesn’t have to be either/or; you could combine both kinds of insurance as part of an overall financial plan.
Major life events such as the birth of a child or grandchild, the start of a new business venture, or a change in your personal health are important times to review your life insurance coverage. We are happy to help you evaluate the right mix of insurance for your unique situation. Please feel free to give us a call.
If you’ve seen one of the new $100 bills, it probably looked like a piece of play money. Ironically, that’s because counterfeiters have gotten so good at faking our real currency. The old bills were tastefully understated, but easy for any dictator, drug dealer, or common crook to duplicate with a scanner and high-end printer. Right now, there’s probably $70 million in fake U.S. legal tender out there, and 75% of it has Benjamin Franklin’s face on it.
The new money clamps down on counterfeiting by incorporating high-tech features that no commercial printer can duplicate. Older security features are still there, but now there’s also a blue ribbon running across the face of the bill that contains three-dimensional images of the Liberty Bell and the number “100.” Tilt it and the images move, thanks to about 650,000 tiny lenses imbedded in the paper.
It’s a pretty colorful design, with copper accents here and there to contrast with the familiar green ink. Those accents hide another trick—a second Liberty Bell in the little copper inkwell that turns green when you move the bill.
All of these new features may take a little getting used to, but they’re ultimately for our own good. Every counterfeit bill out there devalues real U.S. currency, and this is one form of inflation we can avoid.
The U.S. economy has served up plenty of negatives in the past couple of years, including a stock market that hit 12-year lows and 140 bank failures in 2009 alone. So it’s not surprising that financial institutions and products have come under fire.
But in some cases, critics seem determined to throw out the baby with the bath water. That has certainly been true of the 401(k) retirement plan. Introduced during the great bull market of the 1980s and ’90s, the 401(k) seemed a perfect alternative for companies that didn’t want the expense and hassle of a traditional pension plan. The 401(k) let employees put away pre-tax dollars, and employers could offer workers matching contributions. Any company without a 401(k) was at a competitive disadvantage in recruiting top employees.
When the stock market plummeted in 2008, however, many 401(k) participants suffered big losses—just as almost every other investor did—and that led to claims that the 401(k) itself should be put to rest. A Time magazine cover story opined that “the ugly truth is that the 401(k) plan is a lousy idea, a financial flop, a rotten repository for our retirement reserves.”
Wait a minute! Sure, these retirement plans have flaws—for example, some carry unreasonably high expenses and insufficient investment options. But they’re still the best option for many employers looking to help employees save for a secure retirement. Here’s why:
1. The 401(k) remains an important recruitment tool, particularly for small companies. It’s a perk that helps employees feel they’re being given something special. Workers know they can contribute to their own savings success and that their employer will help them.
2. The 2006 Pension Protection Act provides a “safe harbor” that lets your plan avoid the non-discrimination testing that’s normally required to ensure that highly paid executives don’t reap disproportionate benefits. If you automatically enroll all new employees (letting them opt out if they choose) and deduct 3% of their salary to contribute to the plan the first year, then 4%, 5%, and finally 6% in subsequent years, you need not test for discrimination—and may be able to offer more generous benefits to top management.
3. Some plan sponsors elect to match a percentage of employees’ salary, contributing, say, 3% to workers’ accounts. That’s another way to avoid non-discrimination testing.
4. The 2006 act also encourages employers to retain financial advisors to provide one-on-one investment advice for employees—an option that could increase the value of your plan to its participants.
5. The 401(k) will not go away, though 2010 will be a year of needed reforms, particularly involving self-adjusting target-date funds, which have been criticized for high expense rations and overly aggressive allocations to stocks that hurt investors during the downturn.
In the not-so-distant past, it wasn’t particularly easy to roll over funds from a 401(k) plan to a Roth IRA, which can provide tax-free income during retirement or for your heirs. Now, it’s a relative snap. What’s more, the IRS has provided new guidance on how to complete this maneuver.
Prior to the Pension Protection Act of 2006 (PPA), it took two steps to complete a 401(k) to Roth rollover, and it was possible only if your income didn’t exceed a specified limit. First, you transferred funds from your 401(k) to a traditional IRA. Next, you converted the traditional IRA to a Roth, paying income taxes on the amount of the conversion. But you could do this only in a year in which your modified adjusted gross income (MAGI) didn’t exceed $100,000.
The PPA fixed part of the problem. Beginning in 2007, you were allowed to roll over funds directly from a 401(k) plan to a Roth, bypassing the traditional IRA. But you still might have been blocked by the $100,000 limit.
That impediment no longer exists. Based on a tax law change that took effect in 2010, you may now convert to a Roth regardless of your annual MAGI. And, for conversions completed in 2010, you can split taxable conversion income between 2011 and 2012. That lets you postpone the tax hit of converting to a Roth, and you may pay less overall if the smaller taxable amount keeps you out of a higher tax bracket.
The IRS recently issued rulings clarifying aspects of a direct rollover. The guidance included these points:
- You can convert to a Roth IRA from retirement plans including 401(k)s, 403(b)s, and 457(b)s.
- A direct rollover to a Roth isn’t subject to automatic 20% withholding. But you can agree to voluntary withholding.
- Beneficiaries may make rollover contributions to Roth IRAs. Also, surviving spouses who complete a rollover to a Roth IRA may treat the Roth IRA as their own.
- If funds in a designated Roth 401(k) account are rolled over to a Roth IRA, the rollover isn’t taxable, whether or not the transfer is a “qualified distribution.”
- Other transfers, except for amounts representing after-tax contributions to your plan, are taxable.
- If you own company stock in a 401(k), you will not be taxed on the “net unrealized appreciation” (NUA) of the stock when it’s distributed. But you can’t avoid tax on the NUA by rolling over assets directly to a Roth.
- If you’re married, you no longer need to file a joint return to benefit from the rollover provisions.
This is just an overview. We can work with you to weigh the merits of a Roth conversion and help you follow the rules governing such transfers.
Municipal bonds have long been prized for their tax-exempt status and because they aren’t as likely to default as are corporate bonds. However, the default rate has skyrocketed amid the global economic crisis, increasing the need for transparency in this specialized market.
Regulators have responded with three new measures designed to help investors navigate the complex world of municipal bonds, which are debt instruments issued by cities, counties, and local agencies such as school districts, publicly owned airports, and development agencies. Munis pay for projects such as hospitals, schools, public buildings, roads, and utilities. Bonds that fund programs for the public good are usually exempt from most taxes, including federal. While mutual funds, banks, hedge funds, and corporations all invest in the $2.7 trillion municipal bond market, 64% of muni investors are individuals.
In 2008, 140 issuers defaulted on $7.6 billion in muni bonds as states and cities across the nation faced massive budget deficits. That compared with just $226 million in defaults during 2007. This trend, which is likely to continue, makes munis a bigger risk, and means investors need timely information more than ever. Here are three ways the federal government is bringing more transparency to the muni market.
Putting it all online. Over the summer, a new website called Electronic Municipal Market Access (EMMA, at http://emma.msrb.org) began offering free information, from financial filings to trading records, on most of the 1.2 million outstanding municipal bonds. Operated by the Municipal Securities Rulemaking Board (MSRB), the site allows investors to research municipal bond issues and keep track of new filings. In the past, investors often were not aware if an issuer had failed to file statements or had taken some action affecting a bond or its rating. The site also offers educational materials.
Into the open, and quickly. The Securities and Exchange Commission has proposed a new rule that would force issuers to disclose on EMMA any change in their financial status within 10 days. That would include changes in an issuer’s credit rating, withdrawals from reserve funds, and late payments of principal or interest. In the past, investors have complained about delays in receiving this information and issuers’ failure to file required disclosures.
Turning up the heat. The Financial Industry Regulatory Authority (FINRA) is looking into the sales practices of brokerage firms that sell municipal securities and has asked for detailed information on business conducted during 2009.
All of these actions should make for a more transparent municipal bond market. If you have questions about municipal bond investing or your muni holdings, please give us a call.
The term “municipal bonds” is typically used to describe all tax-exempt bonds. Although such bonds are commonly referred to as “tax-exempt,” there are numerous federal and state tax consequences associated with the acquisition, ownership, and disposition of such bonds. The tax-exempt status of municipal bonds does not extend in all instances to the Alternative Minimum Tax. Please contact your tax advisor for more information.
Remember when every neighborhood had an electronics repair shop where you could trade in your old stuff or get it fixed? Nowadays, American homes and businesses dump a staggering 41 million computers, 27 million televisions, and 140 million cell phones every year, largely because we have no idea what to do with all those devices when they break down or just get old.
Most of the hardware ends up in landfills or incinerators, which turns the waste of perfectly good components into an ecological nightmare, with dangerous metals escaping into the air or seeping into groundwater. But even if your old computer is in good shape, a lot of charities and schools won’t take it because they’re already flooded with everyone else’s hand-me-down machines.
The good news is that Goodwill will now accept your electronic devices even if they’re broken. Just take a look at reconnectpartnership.com and see if any of the1,900 locations that currently support this program are convenient to you. (Some will even pick up computers, TVs, or other equipment for a small added fee.)
They’ll refurbish, resell, or break down your gear for recycling. You’ll get a tax receipt; in general, working computers are worth a $100 to $500 deduction, printers and scanners $25 to $100, and even those clunky old monitors will get you at least a $10 tax write-off.
Like most other investments, lifecycle funds couldn’t escape the market downturn of 2008. These self-adjusting asset allocation funds, which dial down risk as shareholders approach retirement, still had sufficient equity holdings in their most conservative versions to be hit hard when stocks lost half their value. The funds’ performance left many near-retirees in a deep hole, and it has resulted in scrutiny by Congress, the U.S. Department of Labor, and the Securities and Exchange Commission. Changes may be coming, particularly in the rules that let company retirement plans use lifecycle funds as a default investment option.
Lifecycle funds, also known as target-date funds, are designed for investors who want a diversified portfolio appropriate for their stage in life. It’s an appealing idea to invest in a fund that takes care of everything, adjusting allocations as you age while also regularly rebalancing holdings to stay in line with target weightings. Introduced in the 1990s, lifecycle funds received a major boost a few years ago when they were designated as “qualified default investment alternatives” (QDIAs) for 401(k) plans that automatically enroll employees unless they opt not to participate. When a plan participant hasn’t indicated how to invest his savings, the money can be funneled automatically into a lifecycle fund as a QDIA.
But many investors in lifecycle funds were shocked at the magnitude of their losses in the market meltdown, and regulators at the DOL and the SEC recently convened a joint hearing on proposed reforms. Possible improvements include enhanced disclosure, uniform naming policies to reduce investor confusion, and stricter standards for fiduciaries of plans that use lifecycle funds. Other measures to increase investor education about the funds and their uses are also on the table. And some experts have called for substantial changes in the funds, from capping their stock market exposure near retirement to incorporating absolute-return strategies that might reduce volatility during market plunges.
Whatever reforms happen, it will be up to investors to understand the pros and cons of these special investments and to consider their possible role in a retirement plan. If you would like help reexamining your retirement portfolio, please give us a call.
There are certain risks and considerations to take into account prior to investing in a target-date fund. A target-date fund—also known as a lifecycle or age-based fund—is a fund portfolio that helps investors saving for retirement choose a single portfolio aligned with the year closest to their expected retirement. It is designed to provide an asset mix that becomes more conservative as the date for expected withdrawals to begin approaches. Consider in addition to your age or date of retirement other factors, including your risk tolerance, personal circumstances, and complete financial situation. A target-date fund is not guaranteed and it is possible to lose money by investing in the fund, even after the target date has passed. Certain funds’ asset allocations may be subject to change and the extent to which the allocations of a target-date fund among types of investments may be modified without shareholder vote.
Conference Call Recording on 10/21/2008 Click here to listen
The world of financial advice has endured a sea-change in recent months. As trusted advisors to our clients and caretakers of their wealth, we are probably for the first time being confronted with circumstances we have never before been compelled… Click here to view article PDF