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By Mat Johnson "The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant." — Arthur C. Pigou Flying in the face of continuing bank failures, expected double-digit unemployment rates, falling housing prices, record foreclosures and an economic "re-pression," stock markets around the globe have posted rallies over the past six months of historic proportions. Since March 31st, the U.S. equity market has advanced 34%, reversing the entire decline that occurred in the first three months of the year and reclaiming levels seen just as last year's financial meltdown got underway. Viewing the stock market as a gauge for future economic prospects, as conventional wisdom suggests, it would seem to indicate the economy is clearly on the mend. The "evidence" however, has yet to point in the same direction. Over the past six months, U.S. GDP has continued to decline, now down nearly 4%, or -$510 billion and since mid-2008, while an additional two million jobs have been lost. Sales and earnings per share among the companies that make up the S&P 500 index (approximately 95% of the total stock market) fell by -20% (-$1.1 trillion) and -19%, respectively, in the past 12-months through June 2009. There is an old adage that the market climbs a "wall of worry." Time and time again throughout market history, the prevailing climate during powerful rallies is most often one where conditions are deeply negative with the majority of investors being "bearish" and pessimistic on the economy and the equity market's short-term prospects. If we were to look for reasons as to why this disparity between market recoveries and economic recessions occurs, we might look no further than the media influence. Given the headlines over the past year, not to mention the conjecture of media market pundits' predictions of an economic doomsday, it isn't terribly surprising that investor fear would trend toward a negative fever pitch. The dire predictions tend to come in short snippets and sound bites that conveniently leave the details of the coming "economic catastrophe" to our imagination, with vague and ominous references to the Great Depression, or the Japanese "lost decade." This is convenient journalism, but more than anything tends to lead emotions to become detached from the fundamental realities. While the market has more recently been reflecting an unwinding of the recent extreme pessimism, the fundamentals underlying the broader economy have been improving too. In fact, from the perspective of companies, fundamentals have improved from an already healthy situation to begin with — and arguably far more so than they were given credit for earlier this year. With the recent sharp equity market advance, and the less than obvious improvement in economic and company reports, it seems reasonable that many investors will need to begin seeing the improved fundamentals rather than relying upon expecting them — the so called "show me" sentiment. Today there is still some lamenting that sales aren't going up, but the reality is that what we get as investors isn't sales, but the residual profits. On this score, companies, in aggregate, have managed to generate profits throughout the past year. Yes, profits have been lower, but actual profits rather than losses nonetheless. Most companies have accomplished profitability through drastic cost cutting and rapid downsizing of their businesses. While this clearly impacts individuals as employees in the near term, it strengthens the long-term viability and profitability of these companies — and importantly, their capacity to be long-term employers. Remarkably, many companies are currently recording their highest levels of profitability, which is how they are able to generate profits at all in light of the near 20% collapse in sales versus one year ago. If the economy truly is on the mend, and eventual upswing, this profitability should translate into a sharp recovery in the actual profit growth in the quarters ahead. With the vast majority of companies having whittled down their inventories to the bare essentials, a continued recovery in end market demand from consumers and businesses, even if modest, should quickly translate to companies returning to hiring sooner rather than later, and adding some stability to the recovery. After all, few companies can grow sales if they don't produce a product. This, above all else, would be a point of true encouragement. At the end of the day, what drives economic, earnings and labor market prospects is how much businesses need to produce to meet customer demand, and ultimately how much they earn doing so. With respect to how the market might reflect this unfolding of events, it may well rest with investor demands. Interestingly, there has not been a complete shift from fear to optimism. While many investors have returned in greater proportions to the equity market, the vast flow of funds has continued into fixed income markets, as evidenced by flows into bond funds (2.5x faster than in 2008) and today's historically low interest rates on long-term Treasury bonds. This will likely make for an interesting situation in the markets in the months ahead; and perhaps not too dissimilar from two sailboats sailing downwind, directly at one another. Clearly one will discover that the wind is suddenly no longer at their back. We suspect that the attractiveness of earning 3.25% a year for 10-years in "safe" Treasury bonds will prove fleeting in the months ahead. With the economic fundamentals improving and quite possibly even spring-loaded due to the low inventory situation, any upside surprise in economic growth could further tilt investor preference toward the historically higher real returns associated with equities. Back to TopThe Next Shoe to Drop By Mike Vogel, CFA, CFP® Over the past two years as the economy slowed, we have seen a decline in both the value of our homes and our equity portfolios. While all this was going on, the values of high quality bond portfolios have been increasing. Many people seeking to avoid the perceived risk of the stock market turned to bonds as a safe harbor. Investors have poured more than 200 billion into bond funds this year alone. This has created a situation that will come to haunt them. In time, as interest rates rise, and rise they will, the value of a bond portfolio will decline. The Fed has been keeping interest rates artificially low in an effort to jump start the economy. In the most recent (Sept. 23rd) FOMC committee meeting, the Fed again stated they will keep rates low through the first quarter of 2010, but were careful to say that, as the economy begins to rebound the Treasury will slowly exit out of the emergency aid programs. When the Fed stops buying securities in the open market, interest rates will rise. The consensus among 59 strategists and economists in a Bloomberg survey is that the 10 year Treasury will yield 3.75% to 4.15% by the first half of 2010 compared to the current rates of 3.30% to 3.40%. Does this mean one should "bail out" of bonds completely? No, bonds have their place in many portfolios. They provide an income stream and in the case of municipal bonds, they can provide a tax advantage. If you purchased a bond with a 5% yield to maturity and you hold it until maturity you have not lost anything. Your investment did exactly what you intended it to do. However if you look at the value of your bond portfolio over time it will fluctuate, just as the value of your home fluctuates over time. In both cases, your investment is providing you with the value it was purchased for and should not be discarded with every swing of the market. Municipal bond yields are at a 42 year low. Many municipalities are taking advantage of this opportunity and borrowing money at low rates. The federal government has created a program called Build America to make it even more cost effective for cities and counties to borrow money. The interest income from Build America bonds is federally taxable, but tax free in the state of issue. Corporate credit spreads have tightened dramatically over the past year as investors gained confidence in the economy but as interest rates rise, spreads will begin to widen, accelerating the price decline. Taxable Build America Bonds should maintain value better then corporate bonds because 35% of the interest payment is paid by the Federal Government, therefore the spread to treasuries should stay tighter. Bond funds pose the biggest problem for individual investors because as interest rates rise the fund goes down in value, people start to sell and the fund must liquidate holdings. Some of these holdings will have capital gains and those get passed on to the investor. So at the end of the year the investor has a fund with a lower value but they must pay capital gains taxes. Most bond holders will find it hard to avoid price declines in the portfolio over the next year but just remember why you own the bonds in the first place, either for income or for overall diversification and that they will mature at par. Back to TopRoth IRA Conversions for 2010 By Adam Breech Even in turbulent storms, there are places to find shelter. One possible place to find shelter from the recent economic overcast is with a Roth IRA conversion. Under current tax law, in 2010, there are no income limits on an IRA to Roth IRA conversion. Here's why it may (or may not) be to your advantage to make the switch. The Case for Conversion The most attractive features of a Roth IRA are that it allows for tax-free growth of assets and tax-free income distributions in retirement (as long as you have held the Roth IRA for 5 years or longer and are 59 ½ years of age). You can contribute to a Roth IRA after age 70½, without having to take mandatory withdrawals. It is also worth remembering that tax rates could increase in the years ahead, which makes the Roth IRA even more appealing. So what's the catch? Well, the downside is that contributions to a Roth IRA are not tax-deductible and there are income restrictions on who can contribute. This makes the Roth IRA an attractive investment vehicle for younger investors. However, older investors have a reason to use a Roth IRA as well — especially if they don't really need to withdraw IRA assets. Under present tax law, converting an untapped traditional IRA to a Roth will shrink the size of your taxable estate, and careful estate planning could foster decades of tax-free growth for those IRA assets. Currently, if you name your spouse as the beneficiary of your Roth IRA, your spouse can treat the inherited IRA as his or her own after you die and forego withdrawals. So those Roth IRA assets can keep compounding untaxed across the rest of your spouse's life. If your spouse then names a son or daughter as a beneficiary, that heir has the choice to make minimum withdrawals according to his or her life expectancy, all while the assets continue to compound tax-free. Currently, withdrawals from an inherited Roth IRA are not subject to income tax. Reasons to Think Twice The biggest reason to reconsider a traditional IRA to Roth IRA conversion is because the IRS regards the event as a taxable one. Not everyone has enough money to pay for this new tax bill. This brings up an interesting counterpoint, in that the tax owed is only on the current IRA value, and that value might be lower than it has been in years. This means paying less tax on your gains. To take this point a step further, there are two times when converting a traditional IRA to a Roth IRA is ideal. When your IRA value is abnormally low, which we have covered, or when your income is abnormally low. The latter case may be a situation that some of us find themselves in, and if so, means that when converting, your tax bill would be low, due to your income tax brackets being lower than usual. As far as this new tax bill in concerned, you may be tempted to simply use some of your IRA conversion dollars to pay for this bill. Be careful though, because if you are younger than 59½ , you have to pay a 10% penalty on the amount that you withdraw, not to mention that those assets will no longer be compounding tax-free in the new Roth IRA account. This brings me to my final point, that while the income limit for Roth IRA conversions is slated to go away in 2010, the income limits on Roth IRA contributions still applies. This means that if your AGI is more than $120,000 if single or $176,000 if married, you are not allowed to contribute more money to your Roth IRA. The rules and regulations surrounding these issues are constantly changing, so please make sure to consult your tax professional before you convert. Back to TopNew Addition to Quantum By Stephen Bradley We are pleased to announce the addition of a new member to the Quantum staff. Mike Vogel joins us after spending more than 20 years in the financial industry working for Fidelity, Sutro, Piper Jaffray and Paine Webber in the area of Institutional Fixed Income and Capital Markets. Mike is both a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP). At Quantum he is part of the Investment management group with specialization in Fixed Income management. Mike is a graduate of U. C. Davis where he earned a degree in Economics. He is a member of the CFA Institute and the Security Analysts Society of San Francisco. He is an ex-rugby player and a private pilot, and his hobbies include skiing, boating and camping. Mike and his wife Maureen are longtime Marin residents and enjoy spending time with their three boys. Back to Top |
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