Rolling Stone

It’s (almost) never too late to get important things done. We all know the saying “A rolling stone gathers no moss” and moss, in this case, is missed opportunities that expire at the end of this year (the most pressing deadline at the time, of course). Remember 529s funding, charitable contributions, portfolio sales, annual exclusion gifting and IRA Required Minimum Distributions (including inherited IRAs) must be completed by 12/31 to be recorded in the 2010 tax year.

Additionally, for those considering Roth IRA conversions, you must have the conversion complete by 12/31 to qualify for the special two-year deferral of income recognition (this is only available for conversions performed in 2010). This opportunity should be considered along with recharacterization opportunity changes, investment holdings outlook, other tax goals, etc. when deciding whether to wait or act now.

Last Minute Race

Last Friday President Obama signed into law the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.” The implementation of this bill signaled the end of a last-minute race at the end of this year to avoid significant tax increases scheduled to occur January 1, 2011. There are a number of ramifications of this bill, none of which are insignificant.

One outcome was a temporary, two-year “fix” of the federal estate tax. There are many details of this provision although a few points are; the federal estate tax exemption, generation skipping transfer tax exemption and lifetime gift tax exemption have all been “reunified” and set at $5 Million per person, and the federal estate tax exemptions are now “portable” (i.e. a spouse can use their deceased spouses unused federal estate tax exemption amount). There are many planning opportunities created by these changes that must be addressed in the next two years and evaluating those opportunities in context of a broad wealth plan will be more important than ever.

Why are interest rates rising in the US?

When the Federal Reserve announced a second round of quantitative easing (QE2) in early November their goal was to lower long-term interest rates to help further boost the economy.  However, we’ve seen the exact opposite effect in the market.  Interest rates on a wide variety of bonds have been rising over the past month.  Why?  The reason rates have been increasing is because the economy continues to improve, investors now have a greater appetite for risk, the US tax compromise deal working its way through Congress, and because of concern that inflation will increase as a result of QE2.

November 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

"It takes far less courage to cling to the past than it does to face the future"

- Sandra Brown (author of over fifty-five New York Times bestsellers)

MARKET COMMENTARY

The markets faced renewed challenges in the month of November due to the continued debt crisis in Europe (most recently affecting Ireland), monetary tightening in China, North Korea’s military attack on South Korea, and FBI raids on several well-known hedge funds for possible insider trading violations.

Although the “wall of worry” has reappeared after a 2 ½ month hiatus, we take comfort in the gains we have experienced for the year and over the past 12 months. As we wrote in last month’s commentary, year-to-date returns from both stocks and bonds have likely exceeded investor expectations coming into this year. This leaves everyone with the question of how to properly position investment portfolios for the future.

Our expectations for bonds in the US are tempered with a concern that present low interest rates and a second round of “quantitative easing” (QE2) will combine to result in upward pressure on bond yields and downward pressure on bond prices and returns. We are concerned that inflation expectations will build as the Federal Reserve continues to pump money into the bond market. How and when they start to remove this additional stimulus and can they do it before inflation starts to escalate is a big question? We may also see foreign investors demand higher interest rates on our Treasury bonds to compensate for additional US government credit risk.

On a positive note, the US economy continues to improve. The latest revision to GDP for the third quarter was a better-than-expected 2.5% and many economist estimates for the fourth quarter of 2010 are heading higher. Key leading economic indicators, like falling unemployment claims, are rebounding after a summer lull. Consumer spending has been ahead of expectations for five straight months. Business and consumer confidence are recovering and recently, hours worked and real wages/salaries have been increasing.

We continue to position investment portfolios based upon the following longer-term themes:

1. The US and Europe will see slower economic growth in the years ahead.

2. Emerging market economies, like Brazil, India and China, will continue to grow more strongly than the rest of the world.

3. Emerging market currencies will have long-term strength against slow growth, debt-burdened developed markets. Thus, we expect the US dollar to continue to weaken over time.

4. It’s important to have some protection against higher inflation rates.

5. Active equity mutual fund managers can add substantial value as they find those companies that will succeed in a world that rewards winners and punishes losers more than ever before.

6. Active bond mutual managers can add value through diligent credit analysis and trading expertise in a world where debt levels and credit risk have increased significantly.

Our guidance to investors and to ourselves: Be prepared for short-term volatility, but use it as opportunity to tactically position for maximizing long-term returns.

PLANNING COMMENTARY

As we referenced on our blog last week, the draft proposal issued by Simpson and Bowles as co-chairmen of the Federal Deficit Commission released earlier in November created quite a stir. The draft is not an official proposal, yet it still came under a great deal of scrutiny particularly regarding the reductions in “entitlement” benefits (primarily Social Security and Medicare). It is important to note that any official proposal must receive 14 votes out of the 18 member commission to be submitted to Congress- something that no one sees as likely. Furthermore, even if a proposal survives the commission’s vote there is no requirement for Congress to address the recommendations. This speaks to the tendency to “cling to the past” and avoid making difficult, often contentious decisions needed to improve our future.

Of course it doesn’t take much courage to attack difficult proposals that include shared sacrifices on the basis that everyone is “entitled” to benefits, low taxes, social programs and pork projects. What does take tremendous courage is to face today’s challenges and be proactive about shaping the future in a positive way. This action inevitably leads to controversial decisions that are difficult to make but absolutely necessary for a positive future.

What we really need is a proposal from the Federal Deficit Commission, un-amended, that Congress must vote up or down. That would take courage on the part of Federal Deficit Commission members, Congress and citizens of this country alike. What all this means to a personal wealth plan is an understanding of the responsibility one has for their own financial future and how these important decisions made (or not) in Washington, Indianapolis and here at home affect that plan. Tax policy, “entitlements,” the state of the domestic and world economy along with many other variables will change as these developments occur. We continue to monitor client wealth plans in context of these developments and keep working to provide proactive recommendations that help our clients face and control their future.

Tick Tock

President Obama agreed to work with Republican leaders earlier this week in dealing with Bush-era tax cuts set to expire at the end of this year. The compromise, which we still await details on, includes a temporary (2 year) extension of current income and capital gain tax rates for all taxpayers. In order to reach this agreement there will be an extension of unemployment benefits and temporary payroll tax reduction (2% cut in Social Security tax collected in 2011) among other sweeteners for Democrats. Some Democrats are fighting the deal and may derail the current version (see http://tinyurl.com/2awtu4w for more details), largely due to the estate tax reductions included in the deal when compared to 2009 estate tax law.
While these are good signs that our leaders are finding their way to compromise so that action can be taken to address key issues, these decisions remind many of “business as usual” as it relates to deficit spending. There was no mention of revenue raisers or spending cuts now or in the future to even partially offset the costs of this compromise (i.e. all new spending). While a weak economy needs to be addressed we must also realize that the clock is ticking as it relates to facing our financial responsibilities as a country.

Kick the Can

Today, the Federal Deficit Commission held their vote (originally scheduled for Wednesday) to determine whether a formal proposal would be released for Congress' consideration.  As many predicted, the commission failed to garner the 14 votes required for this to occur, out of the 18 member panel.  There were 11 votes for the proposal, more than what many predicted the vote would generate.  This is why some are arguing that we may see action from our nations leaders, yet others feel this is the reason Washington was looking for to go back to business as usual.  A member of the panel, Andrew Stern, was quoted as saying "We have changed the issue from whether there even should be a fiscal plan for this country, to what is the best fiscal plan for this country."

The fact that it has taken this long and this much debate for someone to realize our country needs a fiscal plan is precisely why it is easy to believe our leaders will keep playing the political games- "kick the can" if you will, as long as they have the room to do so.  The goal of the game- kick the issue down the road so we don't have to deal with it now.  The good news- the terrain is all uphill from here- the longer we chose to kick the can, the harder it will become to continue doing so.  Hopefully this will spur our leaders into acting to face these challenges sooner rather than later. 

What is it like to be German today?

First it was Greece and now Ireland. Who’s next? On Sunday the European Union (EU) agreed to give $89.4 billion in bailout loans to Ireland to help it weather the storm created by its massive banking crisis. Two of the 16 euro-zone nations have now sought financial support from the EU and the International Monetary Fund (IMF). Portugal and Spain are rumored to be next on the list of countries needing financial assistance. Germany has reluctantly supported the bailouts so far. The question is: Will they continue to offer their support if Portugal and Spain need a bailout too?


Germany is in a decent fiscal position today compared to the rest of the euro-zone with a Debt to GDP ratio of about 63%. Reference www.visualeconomics.com/gdp-vs-national-debt-by-country/ Germany has been proactive with their fiscal responsibility. They have a very hardworking culture and several years ago increased their “normal” retirement age from 65 to 67 to compensate for a rapidly ageing population that is living longer. However, in neighboring France a recent plan to raise the official retirement age from 60 to 62 provoked massive protests and outcry. Could the European Union shrink from 16 nations to something smaller so that Germany doesn’t have to continue supporting the bailouts of weaker countries like Greece and Ireland? At what point does the market start to demand higher interest rates on Germany’s debt because of the sins of their neighbors?

Certainly additional fiscal tightening is needed across the region. Tax increases are also likely to occur. Fiscal austerity is a must but does it threaten the structure of the EU or push the euro-zone back into Recession? Expect the financial problems of Europe to play out over a number of years and keep an eye on Germany as the key opinion in terms of both future bailouts and any eventual changes in the makeup of the European Union.

Wake up and smell the coffee

The Federal Deficit Commission issued it’s initial draft proposal earlier this month that began to lay the groundwork for it’s recommendations to cut the federal deficit by a cumulative $4 Trillion by the year 2020 (the full draft can be found here: http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/CoChair_Draft.pdf). As many predicted, the draft proposal included a number of hotly contested recommendations, many of which had to do with cuts in “entitlement spending.” For example, the Social Security “Full Retirement Age,” which is the age at which one can collect unreduced Social Security retirement benefits, would increase to 69 by 2075. To put this in perspective, the current Full Retirement Age for those retiring today is 66. Note that actuarial estimates for increases in longevity are projected to fully offset these changes.

Of course there is usually broad public outrage when it comes to reducing “entitlement” benefits, whether or not it is needed or makes intellectual sense. An article titled “Taming Federal Deficit will require shared sacrifice” makes an excellent point that the only solution to the financial challenges our country faces is shared sacrifice (this article can be found here: http://www.thenewstribune.com/2010/11/15/1425125/taming-federal-deficit-will-require.html). We can all hope that U.S. leaders will have the courage needed to make tough decisions and help everyone realize that it is shared sacrifice that will make our country stronger and that without it, political bantering and further deterioration of our financial health is imminent. To the extent sacrifices must be made, how will they impact personal wealth plans in the future? How much should one depend upon Social Security income in their planning? One thing is for sure- it's time for all of us to wake up, smell the coffee, and get to work being proactive about our future. 

October 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

Before anything else, preparation is the key to success.

Alexander Graham Bell, inventor 1847-1922

MARKET COMMENTARY

In October, U.S. stocks as measured by the S&P 500 returned 3.8% representing about one-half of the year-to-date return of 7.8%. Developed international markets had a similar October return of about 3.6%, although their year-to-date return of about 5% is not as strong as in the U.S. Emerging markets enjoyed October gains of 2.8%, but still are the year-to-date equity return winners at about 12%. October’s equity gains can be at least somewhat attributed to the market’s expectation that further quantitative easing by the U.S. Federal Reserve will be good for stocks.

Investment grade bonds in the U.S. returned about .7% in October, bringing their year-to-date returns to parity with U.S. stocks at 7.7%. Expectations going forward for bonds are now tempered with the concern that present low yields and quantitative easing will combine to result in upward pressure on bond yields and downward pressure on bond prices and returns.

Returns on both stocks and bonds in the U.S. of about 8% for the first 10 months of 2010 likely exceed investor expectations going into this year, and this all leaves everyone with the question of how to position portfolios going forward. In this we must concentrate on proper preparation. At Payne Wealth Partners we have certain key investment themes for the long-term, however we also must recognize the possibility, or maybe even probability, of short-term volatility to the downside. In the short-term we feel investors must be prepared for possible negative market reaction due to:

• Disappointment if the Fed’s quantitative easing program is smaller or more tentative than expected

• Discouragement with election results or actions by Congress and the White House for the remainder of 2010 and beyond

Still, to us the long-term themes apply. Those key themes should guide how portfolios are constructed, and any significant volatility in the short-term should be viewed as an opportunity to reposition portfolios to further address the long-term themes. These themes include:

1. Emerging market economies will continue to grow more strongly than the rest of the world.

2. Emerging market currencies will have long-term strength against slow growth, debt-burdened developed markets.

3. Active mutual fund managers can add substantial value as they find those companies that will be the winners in a world that rewards winners and punishes losers more than ever before.

Our guidance to investors and to ourselves: be prepared for short-term volatility, but use it as opportunity to position for maximizing long-term returns.

PLANNING COMMENTARY

As election day nears, there are numerous financial concerns among U.S. citizens related to income taxes and/or estate taxes and, more specifically, how any changes will affect each family’s financial future. A recent Wall Street Journal article titled Key Tax Breaks at Risk as Panel Looks at Cuts details several income tax benefits rumored to be at risk due to the deficit commission’s goal to balance the federal budget by 2015. Potential recommended cuts include the mortgage interest deduction, the child tax credit and the ability of employees to pay health insurance premiums using pretax dollars. These possibilities – along with the looming departure of the Bush tax cuts which would affect not only ordinary income tax rates but also long-term capital gains and qualified dividend income – may cause significant increases in income tax rates in the near future.

When considering how all these possibilities relate to one’s personal financial situation, what wealth planning strategies should (and should not) be considered in light of these (and other) potential changes? What if tax rates do not increase- how can we concurrently be prepared for this possibility? We continue to work to help our clients understand the impacts that legislative changes have on their overall financial goals as they occur. More importantly, all of the continued uncertainty speaks to how important being prepared for all the possibilities is to successful completion of long-term goals. For example, the mixture of assets one creates and manages on their balance sheet as it relates to taxes (taxable, tax-deferred, tax-exempt, etc.) is a critical tool in remaining prepared for change and must be managed continuously as it relates to one’s goals and circumstances.

The best way we’ve found to accomplish this is to continue updating our clients’ personal wealth plans at least annually and make continuous recommendations to adapt. It’s one thing to react to happenings, it’s another entirely (and of much greater value) to proactively address potential changes and be prepared in advance. We’ll continue to provide our best guidance so that our clients can remain prepared for these many uncertainties.

Global Economic Rebalancing

Later this week, President Obama and Treasury Secretary Timothy Geithner join other world leaders in a G-20 meeting in Seoul, South Korea.to address an agenda (http://tinyurl.com/24odlxl ) that includes "build on this less-than-robust recovery and further enhance international cooperation to generate strong, sustainable and balanced growth."  The world for some time now has grown in an unblanced way, with emerging countries like China enjoying above average savings and investment but below average consumption, while developed countries like the U.S. had high levels of consumption and low levels of savings and investment.

Certainly, a rebalancing must occur.  However if that rebalancing occurs too rapidly, the effects of reducing consumption in the U.S. could cause significant global economic problems including another dip into recession in the U.S.  Each country sees the manner and timing of this global rebalancing differently. 

China and the U.S. are the 2 most important players in this rebalancing.  In China consumption represents approximately 36% of GDP, while savings and investment is about 50% of GDP.  Consider the U.S. where consumer spending is about 70% of GDP while the savings rate is around 5%.  There is a neat diagram of components of GDP at http://www.moneychimp.com/articles/econ/gdp_diagram.htm.

It will take a long time to rebalance China and the U.S. to something significantly different than their present components of GDP.  Also, the rebalance will periodically happen in sudden and unsettling fashion.  As governments take different approaches to the rebalance we should all be hopeful that G-20 and other vehicles can help the world avoid problems as much as possible.

Quantitative Tightening

The emerging market economies of the world are taking tightening steps, in part to offset the effects of the U.S. Fed's "quantitative easing".  Yesterday Australia raised interest rates by 1/4% to 4.75%.  Australia is widely viewed as a proxy for China given their commodities exports to the Chinese.  India has also raised rates with their central bank rate for short-term funds now at 6.25%.

These countries are worried about capital flows from the U.S. (and other developed markets) being enhanced by the increased liquidity from the anticipated next step of  Fed quantitative easing.  As capital flows to the emerging markets it will cause inflationary increases in all goods.  Increased interest rates and increases in their currency relative to the U.S. are two ways these emerging economies can fight inflation.

All of this reminds us that the effects of any market or policy changes are global.  The key for investors is to keep this global point of view in mind as they make portfolio decisions.

Grantor Trusts

We just attended one of the top estate planning conferences in the country. Held October 28th and 29th the Notre Dame Tax and Estate Planning Institute had speakers from around the country who presented as to the most current thinking on estate planning issues. In this era of legislative uncertainty there is one wealth transfer strategy with significant appeal for high net worth families-- grantor trusts.

Grantor trusts require the grantor (Dad) to pay the income taxes on the trust earnings while the full amount of the trust may accumulate for next generation beneficiaries (children and grandchildren). Structured properly, the income tax paid by Dad on a grantor trust represents transfer to next generation free of estate and gift tax. There are many possible enhancements to the strategy, however at the core stands the grantor trust as a powerful strategy that high net worth taxpayers should consider using.

Public-Employee Union is Biggest U.S. Election Outside Spender

One can't help but notice that on the heels of the U.K. announcing significant public-sector job cuts in an effort to balance their budget, in the U.S. the biggest outside spender for the 2010 elections is the American Federation of State, County and Municipal Employees (AFSCME).  Given an early 2010 Supreme Court decision that permits corporations and unions to use their own funds to pay for political ads, AFSCME is directing $87.5 million to help elect Democrats and presumably protect public sector jobs.

AFSCME's membership has grown 25% in the last decade, the Wall Street Journal reports http://tinyurl.com/284zude.  As government spending at all levels comes into the cross-hairs of those determined to reduce deficits, it is astounding to see the open effort by AFSCME to elect those who they will then turn to and ask for job protection.  Here's hoping the election winners are the candidates who will most honestly approach our budget deficit issues at the local, state and national levels!

U.K. Government Planning Significant Cuts

The U.S. should sit up and take notice at the significant cuts planned by the U.K. government http://tinyurl.com/26lpupc.  As many as 500,000 public sector jobs will be cut, although it is worth noting the U.K. presently has 6 million government jobs in a country with 62 million population, while the U.S. has about 2 million government jobs and 300 million population.

Still, the U.K. is taking the route of trusting that significantly shrinking the public sector will permit the private sector to flourish.  Maybe after the November elections some in political leadership will have the courage to follow a similar theme in the U.S. while we still have time to do more measured cuts and before we are backed into the same drastic cuts corner where the U.K. now finds themselves!

September 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

Change before you have to.

Jack Welch, author, commentator and former GE CEO

PLANNING COMMENTARY

Change is something we all deal with in our lives- whether it is in our financial, personal or social lives. There are different forces of change that occur all around us. One would be change that “collides” with us and that we are reactionary to. This is change that occurs on its own whether we like it or not and whether we’re prepared or not. Another force of change we initiate on our own, under our control, on our timing. We would argue that this second type of change is proactive in nature and can provide the path of least resistance when compared to being strictly reactionary.

In planning for our financial, personal or social lives, if one can confront the fear of change and be proactive about planning for the future they will arguably be more prepared for what’s next down the road. One of our primary goals is to recommend proactive changes in our clients’ wealth plans to help prepare them for what the future holds. We have found that individuals that sit and wait for change to occur in the economy, their income, family situation or family goals are grossly unprepared for the results of that inevitable change. In these instances the only action left to take is reaction- and the options are limited.

This is not to say that we (or anyone that we know of) can predict what changes will occur in the future and jump out in front of them. This inability to predict what change will impact us next is precisely why wealth planning and changing proactively is so crucial to remain prepared for the unknown.

MARKET COMMENTARY

For several months leading up to August, investors avoided equities with mutual fund flows instead favoring cash and bonds. In the month of September, the compelling valuations of stocks combined with somewhat favorable economic news to give stocks a lift. The S&P 500 returned 9% in the month of September, bringing the year-to-date return up to about 4%.

Investors have continued to invest with their eye on the rear view mirror picture of past volatility. This has resulted in continuing inflows to bond funds and significant strength in gold as a safe harbor. We wonder if all investors in gold understand that gold as an investment has no intrinsic value and pays no dividend or interest, or are people buying gold because it is going up and they have lost confidence in other choices.

Since the 2008 credit crisis we have changed our investment approach to be more tactical. Even though many market participants are driven away by market volatility, we believe this offers opportunity to buy lower priced assets at times and sell higher priced assets at other times. This is what we mean by being tactical. For instance in mid-July equities looked to be attractively priced and therefore we increased the portions of client portfolios that we put into equities.

Another example of change that we believe investors must recognize and adapt to is the rise in worldwide importance of emerging market countries like Brazil, Russia, India and China. A significant portion of worldwide economic growth will come from these emerging economies and we think client portfolios must reflect this strength with significant allocations to this area. Demographic forces generally favor these countries with younger workers who are improving their economic circumstances and will expand their consumption of goods and services.

Austerity

Two small articles in today's Wall Street Journal addressing deficit reducing steps by countries outside the U.S. are eye-catching. 

French workers are trying to organize open-ended strikes to protest President Nicholas Sarkozy's plans for raising the retirement age from 60 to 62.  The strike may not be taking hold as the state-run railway SNCF said Tuesday saw 40% of workers on strike and then Wednesday this number was down to about 25%.

In the U.K. plans were announced to cut 192 government agencies (out of 901 agencies reviewed), while another 118 agencies will be consolidated down to 57.  The U.K. government goal is $815 million of annual savings from such cuts.  Interestingly, comments from the U.K.'s largest union, Unite, protested the cuts.

It would seem that the global winners will be those countries, states, and municipalities (and for that matter, corporations) that can most quickly and effectively identify and implement appropriate austerity moves.

90% Tax Rate over Two Generations

Gregory Mankiw is an economist and a professor at Harvard University.  As a conservative (unusual to find at Harvard), he has good insight into income tax rates and how they motivate, or de-motivate, economic taxpayer activity.

Yesterday he wrote an editorial in the NY Times http://tinyurl.com/26j3o3g that sets out how tax rates affect him as one of the taxpayers who make over the magical $250,000 line drawn by the Obama administration to define "rich".  The interesting conclusion that Mankiw arrives at is that he can afford to pay more taxes, but that the very high share which goes to taxes (including estate tax) serves to demotivate him in terms of the effort required to earn more money.  He also makes the point that all consumers will be affected by higher tax rates in terms of the limitations of goods and services supplied by the higher income taxpayers (example recording artists, medical practitioners) that are similarly demotivated.

Knowing that the income tax debate will certainly heat up after the elections with the scheduled December 1, 2010 release of the National Commission on Fiscal Responsibility, readers of this blog may well want to take a look at the Mankiw editorial.

Who pays what share Income Tax in the U.S.?

There is significant debate over U.S. income taxes and who should pay and at what rate.  Any sensible debate should start with facts, and we have found that the Tax Foundation has good facts at  http://www.taxfoundation.org/news/show/250.html. 

The IRS has released new date on calendar year 2008 individual income taxes, with some key points being:

1. The top .1 of 1% of tax returns (adjusted gross income or AGI over $1,803,585) earned 10% of the nation's adjusted gross income and paid 18.5% of all federal individual inocme taxes with an average income tax rate of 22.7%.
2. The top 1 percent of tax returns (AGI over $380.354) earned 20% of the nation's AGI and paid 38% of all federal individual income taxes and had an average tax rate of 23.3%.
3. The top 5% earning taxpayers (AGI over $159,619) earned 34.7% of the nation's AGI and paid 58.7% of all federal individual income taxes at an average tax rate of 20.7%.  This means the bottom 95% of taxpayers paid 41.3% of all federal individual income taxes.
4. The bottom 50% of tax returns (AGI under $33,048) paid a total of 2.7% of all federal individual income taxes at an average tax rate of 2.6%.

We present this data with no editorial comment.  The goal is merely to inform the reader as to who is paying what share of federal individual income taxes in our country.

Fat tails and other talk of risk

An accepted tenent of investing has been that returns group in a "normal distribution" around long-term averages.  As the thinking goes, some years are good, some bad but the possibility of really good and especially the really bad are so remote as to be somewhat dismissed.  The time period that started about two years ago with the September 15, 2008 bankruptcy of Lehman Brothers taught everyone that there was a very distinct possibility of really, really bad returns.

Now some are coming forward with studies to support the idea that the chances of bad returns are really much higher than had been previously thought.  The statistical probability of really bad returns occurring in any quarter by one study is about 5 times higher than previously thought.  The statisticians call such return outliers "fat tails" to describe their higher frequency than the "thin tails" previously assumed.  A very good study on this was recently released by Welton Investment Corporation and can be found on their web site at http://www.welton.com/.  We recommend this study to all who want to better understand the risks of investing going forward.

Muni bond implications of public sector vs. private sector wages

State and local governments are struggling with their budgets as the economic slowdown shows up in lower revenues such as income taxes and property taxes.  However the spending side of things shows what a disconnect has occured in public sector wages and benefits.  We ran across the chart below on the blog site Pragmatic Capitalism (http://www.pragcap.com/) and thought it was important to include in our blog:



One implication for investors would be to recognize the heightened risk this poses for tax exempt investing and therefore stay with very diversified high quality municipal bond holdings as the public sector has to wrestle with trying to reduce costs (including high wages and benefits) in an environment of reduced revenues.

Currency politics

Since the 2008 credit crisis we have seen central bankers all around the world reduce their policy rates and generally keep them low (remember the Federal Reserve has our fed funds rate presently at almost zero).  We have also seen "quantitative easing" where the central bank buys government bonds to push down long-term rates.  These low rates haven't generated the growth hoped for because businesses have been reluctant to borrow and banks have been tighter on their lending standards.

Also, there has been much fiscal stimulus in form of government spending, but such fiscal policy has its limits given the already high U.S. budget deficit.  Congress doesn't have much appetite for additional stimulus spending as voters are sending a message with every primary that they expect responsible decision making in Washington.

Now we are seeing currency considerations getting more attention.  The general idea is that every country wants its currency to go down to help growth by making exports cheaper to foreign customers with the stronger paper.  The U.S. continues to pressure China to allow its Yuan to strengthen.  Japan recently intervened with significant dollar purchases to try to slow yen appreciation versus the dollar.

It all gets very confusing, but one thing is clear.  If everyone tries to cheapen their currency relative to other countries then no one wins such a race to the bottom.

August 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena…o that his place shall never be with those cold and timid souls who neither know victory nor defeat.  Theodore Roosevelt, 26th President of United States

PLANNING COMMENTARY

100 years ago people were very obviously facing challenges- economic and other- much like they do today. Roosevelt was very wise to point out the fact that facing those challenges head on is what we should all strive to do. We would further this thought with one of our own- if one decides not to face those challenges (note that doing nothing is a decision) and “stick their head in the sand” they will most certainly fail.

This speaks very strongly to planning for one’s financial future. There are those that decide to ignore the future and its challenges while crossing their fingers and hoping that “it will all work out.” Then there are those individuals that are proactive about their financial life and goals by seeking out more sophisticated solutions to the challenges they face.

In addition to jumping into the arena (we would equate this with getting started with wealth planning) Roosevelt points out that one must “actually strive to do the deeds.” We would equate this with preparing written action items as part of the plan to ensure the appropriate actions are taken (not only discussed). We’ll keep working hard to help our clients recognize their challenges and overcome them with proactive action and advice.

MARKET COMMENTARY

Markets for August were much like the quote to start this letter. Investors generally did not want to get “in the arena” and could well be characterized as “timid souls”. The S&P 500 ended the month down about 4% leaving it down year-to-date by a similar amount as investors continued to avoid the risk of equities and instead sought the perceived safety of government bonds.

The inflows to bonds left the yield on the 10-year U.S. Treasury bond for August month-end just under 2.5% (this same bond was yielding 4% in April of this year). At the same time the price-to-earnings (PE) ratio for the S&P 500 is now under 12x (using forward 4 quarters estimated earnings). The stock yield is seen as the inverse of the PE or 1/12 which expressed as a percentage yield is over 8%. Many market observers are now pointing to the present gap between stock yields and the 10-year treasury yield as evidence of significant valuation opportunity for the owners of stocks. This strong argument for valuation has seemingly been more than offset at present by worries over the economy with the result being the August market declines.

In July Payne Wealth Partners moved our portfolio allocations to neutral, being the mid-point between our highest and lowest allowable allocation to equities for any particular risk level. This change was made based upon the attractive equity valuation argument, as prior to this we were under-allocated to stocks. We still believe this is appropriate as we observe money in markets we would characterize as “fearful” continuing to flow to bonds and wonder when those funds will return to stocks and push prices up.

We also continue to believe in the economic growth and strong currency story of the emerging markets, resulting in significant allocations in client portfolios to both stocks and bonds of emerging market countries including China, Brazil and India. Demographic forces generally favor these countries with younger workers who are improving their economic circumstances and will expand their consumption of goods and services.

Payne Wealth Partners will continue to work to stay “in the arena” by helping our clients make important planning steps and maintain the appropriate diversified portfolios in these challenging times. As always, we thank you for your trust in each of us and in Payne Wealth Partners.

Shelf Life

One of the biggest risks anyone faces within their financial plan is longevity. The chances for maintaining financial security naturally decreases as one lives longer. In the real world none of us knows what our expiration date is. One tool we can turn to when trying to determine our “life plans”- whether those be financial related or a “bucket list”- is the averages. Sure, it’s not perfect, but at least it gives you a sense of what you and your family should be prepared for.

For example, take a couple where the husband is age 75 and the wife is 74. There is a 54% chance that at least one of them will live to see 90. What about the century mark? There is almost a 10% chance that one of these individuals will see 100. Of course it’s the chance that either spouse attains these ages that most couples are concerned with- they want to ensure there are funds available to support both of them until the second death.

These statistics are based on a life table developed in 2004 by actuaries given historical data at that point in time. This does not compensate for healthcare improvements and general lifestyle awareness which will continue increasing these odds as the average life expectancy is extended due to these trends.  This is certainly a key item to consider as one makes decisions affecting their long-term plans.

Market Weakness and 529s

Many of our posts focus on the investment markets, the economy, and global events, however these are usually issues we and our client's cannot control or predict consistently.  This is part of the reason being proactive about one's planning is so valuable- doing the things we can control (and doing them correctly) is critical to long-term success. 

An area with growing importance is 529 accounts and general college planning.  As costs skyrocket and advanced education becomes more critical to future careers, the 529 can be one of the most powerful (and important) accounts on a young families balance sheet (or for grandparents saving for grandchildren).  When investment markets are low and assets are potentially underpriced, a contribution of cash to a 529 is very opportunistic.  The primary reason?  Future earnings are tax-free to the extent they're used for college education expenses. 

We can't control what the market does day to day, but we can identify the opportunities it presents and take advantage of them.

Could U.S. November Elections be Catalyst for Stocks?

A recent scoring of projected Congressional election results for this November as seen in the Wall Street Journal showed Republicans picking up 42 House seats to take majority at 220 to 215, and 7 Senate seats to close to 48 Rs and 52 Ds.  We recently listened to a money manager (with $45 billion under management) explain his optimism for stocks in a variety of terms, including those political.

The political positives per this manager were that the November election results would see enough change in Washington to give investors comfort of a more stock-market-friendly set of office holders, thus proving a catalyst for market gains.  If the projection for Republican gains proves accurate, we may well get the opportunity to see if the "catalyst" theory proves true.

The Disconnect Between Bonds and Stocks

The current interest rate yield on 10-year U.S. treasury bonds is about 2.6% as compared to about 4% on these same bonds in April of this year.  Those worried about a double-dip back into recession have aggressively purchased the U.S. 10-year resulting in this very low rate.  Comparable rates around the world are similarly low, with German 10-year at about 2.3%.  Japanese 10-year bonds are yielding under 1%, but this is a special situation with years of deflation and the vast majority of such bonds purchased and held by the Japanese themselves.

Now consider stocks.  A buyer of all 30 stocks in the Dow Jones Industrials Average would receive a dividend yield of 2.7%, plus any future dividend increases, plus any future growth in the price of the stocks.  When comparing this to the 10-year U.S. treasury bond yield of 2.6%, a bond buyer is essentially valuing future dividend increases and future stock price growth at zero.  This week we listened to a conference call by a stock mutual fund manager (who manages about $45 billion) where he indicated never in his career had he seen such a compelling case for owning stocks as compared to bonds.

It would seem that only one of these will turn out to be correct- either the case for bonds or for stocks.  Investors should pay close attention to this disconnect as they determine how to allocate their portfolios.

July 2010 Market & Planning Update (Posted to our blog two weeks after sending to clients.)

The conventional view serves to protect us from the painful job of thinking.

John Kenneth Galbraith, Canadian-American economist 1908-2006

PLANNING COMMENTARY

Galbraith was on to something when he inked the above quote. The conventional view has been called many things- group think, the beaten path and conventional wisdom, to name a few. What we should remember when reading this quote, particularly in these times, is that the conventional view isn’t always the correct view. Taking that a step further you find that the conventional view (many times thought of as rules of thumb in wealth planning) is rarely the best approach when considering one’s specific situation, circumstances and goals.

We have discussed in recent commentary some of the wealth planning strategies we’re using in our clients’ wealth plans that provide significant value to their family in this environment. In many cases these strategies defy the conventional wisdom in a number of ways. What we have found is that a well-though-out wealth plan makes taking the path less traveled not so scary (that thinking leads to the best path for our client). This however, takes thought- and lots of it. We’re preparing more wealth plans than we have in the history of our firm and helping clients find the answers to their questions- not by referring to the rule of thumb, but by developing customized plans that address their specific needs.

On a related note, based on Federal Reserve data, mortgage rates are at (another) all-time low (the 30-year fixed rate is just below 4.6%, although we’ve seen rates lower than this locally). In client wealth plans we’re evaluating whether refinancing makes sense given current mortgage characteristics, financial goals, and cash flow circumstances. Even a decision that seems as simple as whether to refinance a mortgage or business loan typically cannot be made in the best way by following a rule of thumb. There are just too many variables to consider, without a wealth plan, if you want to find your way to the option that makes the most sense for you and your family. We’ll keep thinking about what is best for our client’s in their wealth plans- whether it follows conventional views or not.

MARKET COMMENTARY

Investment markets regained their footing in the month of July, with the S&P gaining 7% (bringing YTD to about breakeven). Developed international markets did even better with the EAFE index earning a July return of about 10 ½%, although still down for the year about 1%. Emerging markets returned about 9% in July and are up about 2% year-to-date.

For the 2 months prior to July stocks had declined amid concerns of a slowing economic recovery and possible “double-dip” back into recession. Such concerns had found their way into headlines in May and June along with other negative news generally, such as the BP gulf oil spill and continuing reform and regulation from Washington DC and other governments.

The positive returns in July may well have been market recognition that the May and June declines had been overdone and created stock valuations that were very attractive as of the end of June. This is exactly what we told clients in communication dated July 14 when we indicated our portfolio changes generally moving about 10% of most client portfolios from bonds to stocks.

We still have a U.S. economy and world economy generally that is experiencing the after-effects of the 2008 credit crisis. Many countries (including the U.S.) now have high levels of debt and budget deficit. Those countries are now trying to navigate the challenging trade-offs between continuing stimulus to support growth and addressing their budget deficit & debt issues. Consumers are saving more and spending less. Companies have rebuilt inventories somewhat, but remain cautious with very high levels of cash on their balance sheets. Unemployment levels remain high and job growth has slowed.

There is some good news. As of July 30, the 2nd quarter earnings had been reported by 336 of the S&P 500 companies with 68% of those exceeding analyst estimates. The S&P 500 price/earnings ratio was 12.5 (on forward earnings) as compared to a 10-year average of 16.1 telling us stock still trade at a sizeable discount to their historical levels.

Recognizing the many challenges and concerns & also opportunities, we at Payne Wealth Partners have tried to use our independent thinking to adjust client portfolios in what we feel is appropriate fashion. Our equity (stock) allocations are now about mid-point in the planned low-to-high ranges. We have significant allocation to emerging markets in both the stock and bond areas (due to our belief in the long-term growth story of those countries).

Deflation concerns at the Fed

In their release after meeting on Tuesday, August 10, the Federal Reserve Open Market Committee (FOMC) indicated they would now begin to purchase long-term Treasury bonds with the maturity proceeds of the approximately $1.3 trillion of mortgage-backed securities the Fed purchased during the 2008-2009 credit crisis.  Prior to this FOMC decision, the Fed plan was to let the mortgage-backed securities just roll off as they matured and gradually remove that stimulus.  The Fed made clear their concerns in their published statement after the meeting with language of "the pace of recovery in output and employment has slowed in recent months".

The fear now seems to be the possibility of Japanese-style deflation, with the U.S. 10-year Treasury now yielding 2.8% as compared to a 2010 rate peak of about 4% in April.  Note that even at 2.8% U.S. rates are 1.7% above comparable government securities in Japan, so there is still far to travel to reach those levels.  Further, in Japan the average monthly inflation since end of 1992 has been minus 0.1%, while in the U.S. the June 2010 data showed annual core CPI (excluding food and energy) of 1%, so we still aren't seeing U.S. deflation.

It is comforting to some that the Fed is tuned into slowing growth and deflation risks.  Others see the Fed as ineffective as they can't force monetary stimulus into a banking system where credit standards have tightened and loan demand declined.  Still others see the Fed actions to fight possible deflation in the short-term as leading to U.S. dollar currency devaluation and inflation in the long-term.  No one can clearly see where this is all going and investors have to be careful not to be whipsawed as the markets react to the latest news and government policy actions.

Deflation or inflation: Which poses the greatest risk?

The U.S. Federal Open Market Committee meets next week to discuss policy and they will likely be debating the question posed in this blog headline.  The potential of a policy mistake would seem to be rising.  Tighten too soon and the Fed could push the U.S. towards another dip into recession.  Wait too long (or be too loose with stimulus) and the seeds for future inflation could be sown broadly and deeply.

Many experts have said that while there is no concern about inflation in the next year or two, they expect the Fed to err in the direction of avoiding deflation, raising the prospect of higher inflation in the long term.  This makes good sense to us, but time will tell.

The important thing to recognize is that the chances of a policy mistake and the ultimate effects of such a mistake on both the economy and the markets are on the rise.

A halting recovery, but recovery nonetheless

Last week the U.S. government released numbers showing the economy grew at an annualized rate of 2.4% in the quarter ending June 30, 2010.  Compare this to a growth rate of 3.7% in the first three months of 2010 and 5% in the last quarter of 2009.

One can see a slowing of growth as businesses have achieved their desired level of inventory after allowing stocks of goods to decline significantly during the uncertainty of the credit crisis in fall of 2008 and first one-half of 2009.  Unemployment continues at high levels and weighs on consumer confidence.  Deleveraging by governments and individuals also is expected to hold the consumer back for some time.

Still,  the economic recovery continues in the U.S.  Stock investors seem to have become at least less pessimistic about the recovery and pushed stock prices up about 7% in July.  Things can always change, but those who were exiting stocks in May and June amid worries of a double dip back into recession seem to have missed the recovery story and the stock gains that accompany recovery. 

Los Angeles area city is example of outrageous public spending

On Thursday July 23, the city of Bell, California (population 37,000) accepted the resignations of three top officials due to public outcry over their high salaries.  The city manager salary was the highest at  $787,000 annually, the police chief at $457,000 per year and the assistant city manager at $376,000 per year (see article at http://tinyurl.com/27deo2k).

The debate at all levels of government over how to control spending is beginning to pick up as taxpayers are struggling with their personal finances.  There is also much discussion over what to do with income taxes and other taxes on the revenue side of the equation.  One wonders how many situations of excessive government spending exist across our country like in Bell, California.  Taking steps to control spending first would certainly make any revenue increases easier to accept for those who work hard, earn good incomes and create investment and wealth.

June 2010 Marketing and Planning Update (Posted to our blog two weeks after sending to clients.)

The greatest enemy of a good plan is the dream of a perfect plan.

Carl von Clausewitz, Prussian military leader, 1780-1831

As with prior letters, this letter will address both planning and investment market issues. At Payne Wealth Partners we believe proper handling of both planning and investments is important for clients to best achieve their goals.

PLANNING COMMENTARY

On May 20 we blogged about the opportunities that these unusual market and economic conditions continue to present to us in wealth planning for our clients. To the pessimistic observer it would be easy to conclude that investment market and economic weakness is entirely bad. As wealth planners we’re concentrating on the opportunities these conditions present in the form of planning strategies that maximize the legacy our clients can leave to future generations.

Roth IRA conversions are one way in which we are taking advantage of market weakness. When an account owner converts IRA assets to a Roth IRA when the assets are trading at lower values, there is a smaller amount of resulting tax due for conversion of the same assets. Second, there is a greater chance that any subsequent market improvements will occur inside the tax-free Roth IRA (after conversion).

Additionally, this is one of the most attractive times in recent history to implement wealth transfer techniques such as Grantor Retained Annuity Trusts (GRAT) and Intentionally Defective Irrevocable Trusts (IDIT). While the federal estate tax is still in limbo there are very few experts that believe Congress will settle on no estate tax. In light of this realization, there is continued need for those with sizeable balance sheets to timely implement strategies such as “GRATs” and “IDITs” that permit transfer of excess wealth to future generations. Wealth identified as excess through our wealth planning process that is transferred to future generations via GRAT or IDIT techniques reduces the cost of estate taxes that could take 50% or more from beneficiaries in the future.

To expand on the quote at the beginning of this letter, a well-thought-out and deliberate plan may not be perfect but it is certainly better than no plan. This well-thought-out planning process is what allows us to identify opportunities for our clients even in tough times. Only with the basic building blocks of a comprehensive wealth plan can we (acting as a team with our client’s other advisors) provide the highest level of guidance and advice on these complicated issues.

MARKET COMMENTARY

The first one-half of 2010 has turned south in both economic and market terms, amid worries of a dip back into recession in Europe and other parts of the world. China, a key driver of world growth, has taken several policy steps to cool a potential bubble in residential real estate but those same steps have led to concerns that China’s economic growth could fall short of the once expected 9% for 2010.

For the quarter ended June 30, 2010 the S&P 500 Index return was a negative 11.4% bringing the first one-half return for 2010 to a negative 6.7%. China, with a 23% loss in the second quarter, led the MSCI Emerging Markets Index to a down 9.1% for the second quarter and 7.2% loss for the first six months of 2010.

With the decline in stock prices has also come a decline in the interest yields on the 10-year U.S. Treasury (now 2.9%) as investors are shift money from stocks into treasuries, somewhat like they did in late 2008, early 2009. The yield on stocks, measured by the S&P 500 has now risen to 2.1% and is 72% of the treasury yield. The higher this percentage relationship, the better value stocks are as compared to treasury bonds (note the peak of Fall 2008 and Spring 2009 in retrospect was a good time to buy stocks). See the chart below for some historical perspective.

Certainly stocks may continue their decline as confronted by economic challenges, however we feel the long-term investor should recognize the value proposition of stocks at this level and consider when to begin increasing their allocation to stocks. Payne Wealth Partners is actively following market activity and considering at what point we will increase our stock allocations (as a reminder stocks as a percentage of client portfolios are presently near the low end of our ranges). Just like the quote at the top of this letter, we don’t want to be frozen by waiting for the “perfect” time to increase stock allocations.

These are challenging times, no doubt. Please rest assured that Payne Wealth Partners and each of us on the professional team will continue to do our very best for you.

The Ultimate Home Run

The recent death of NY Yankees owner George Steinbrenner makes for the 4th billionaire to die in 2010 and pay no estate tax under current law.  Mr. Steinbrenner's estate has been estimated at $1.2 billion and absent some action from Congress, the expiration of the estate tax effective January 1, 2010 will permit his heirs to receive the full estate assets free of tax.

The as yet unresolved question of where the estate tax law will end up has caused much concern for estate planners and their clients.  In the meantime, each passing day with no estate tax fix makes any law that Congress might eventually pass that much more of a constitutional question should the fix be retroactive to the beginning of 2010.  You can bet the estates of the 2010 deceased billionaires will vigorously contest any efforts at retroactive effective date.

Had Mr. Steinbrenner died in 2009 or 2011 the estate tax would have been about $500 million.  This has prompted some observers to call the timing "the ultimate home run."

Are double-dip recession risks overblown?

We recently read an economist's pronouncement that the risks of a double-dip recession had now increased from one-in-five to one-in-four.  Another economist we follow stated that while a decline back into recession was certainly possible, it was not at all probable.

Economic problems are getting such a high level of play in the media that one wonders if market participants have overreacted.  The front page of today's Wall Street Journal carries an article discussing how small investors continue to "flee stocks".

The second quarter of 2010 saw the S&P 500 decline by about 11 1/2% amid these concerns.  At the same time many of the market valuation measures continue to improve.  Of course, the U.S. economy could descend into another recession and validate all of those who are reducing their equity holdings, but if equity pricing over the long-term does return to near its historical levels investors may someday look at this as a buying opportunity.

Escape Velocity

Scientists use the term "escape velocity" to describe the speed an object must have to escape the gravitational pull and not fall back down to the earth.  The term comes to mind in observing the U.S. and world economy as it attempts to escape the pull of deflationary forces and avoid falling back down into a double dip recession.

The deflationary forces include sovereign debt problems of Greece and other southern European countries, China's policy efforts to slow real estate speculation and deficit cutting challenges of all developed countries.  Today's unemployment report for the U.S. had net job losses (125,000) for the first time this year and adds to concerns over the ability to continue economic growth in the second half of 2010.

No one can say when we will reach escape velocity, but we all know at some point we will experience sustained economic growth.  In the meantime the market worries are resulting in some increasingly attractive valuations for the S&P 500.  Price to sales is 1 compared to a 10-year average of 1.4.  Price to earnings is 11.5x (on forward earnings) as compared to an average of 16.1x for the past ten years.  We make no prediction as to the market but would observe that the valuation case for stocks is definitely strengthening.

Currency exchange rates

Since the U.S. dollar is the reserve currency of the world, we as U.S. citizens tend to not think much about rates of exchange into other currencies.  Oil is priced in dollars, gold is quoted in dollars and there are many countries in the Caribbean and the Americas where prices at local shops and restaurants will be presented in dollars. 

We in the U.S. are beginning to understand that currency exchange rates matter greatly.  Currency is where the basic economics of any country come to rest.  Those countries with lower fiscal deficits (or even surpluses) and lower trade deficits will have currencies that grow stronger as compared to the weaker countries.  This means investments denominated in those strengthening currencies will also perform better, all other things being equal.

Sometimes governments and central bankers will effect policies intended to have a certain currency result.  For example, some countries may want a weaker currency to help stimulate exports or some may want a stronger currency to help attract and retain investment.  Eventually any such policies give way to the forces of the marketplace, if they are in any conflict with underlying economic facts.

Last Saturday China indicated it would permit its currency to float (within certain constraints) as opposed to their policies of the last 2 years of fixing the exchange rate to the dollar.  The market is responding today with increases in Chinese bonds and equities.   The Chinese currency situation helps point out the importance of giving serious consideration to the effect of currency exchange rates in the planning and implementation of any investment program.

May 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

Solvency is maintained by means of a national debt,

on the principle, “If you will not lend me the money,

how can I pay you?”

Ralph Waldo Emerson, philosopher and poet

As with prior letters, this letter will address both planning and investment market issues. At Payne Wealth Partners we believe proper handling of both planning and investments is important for clients to best achieve their goals.

PLANNING COMMENTARY

Like many things in life, you get out of wealth planning what you put into it. When we prepare client wealth plans we put particular emphasis on getting our facts and assumptions straight- there’s nothing we’re more serious about getting right. Some “plan inputs” are facts yet some must be assumptions- life expectancy, investment rates of return and tax rates, just to name a few.

What separates a meaningful plan from a plan not worth the paper it’s printed on is the independent critical thinking involved in determining what those assumptions should be (the facts are the easy part). As to investment rate of return- the “industry standard” seems to be, even after all the market turmoil of late, to “take the historical average” when determining what to expect from an investment portfolio in the future. While this is certainly the easiest approach (historical rates going back to the early 1900s are published annually by providers such as Ibbotson) it’s hardly adequate when determining the direction of our client’s financial future- and at this point seems overly optimistic.

Our approach has been to revisit these assumptions at least annually (this has been semi-annual revisits since 2007 due to market swings). Historical averages are a very small piece of the puzzle, while current market prices, economic outlook and macroeconomic trends are the vast majority of the puzzle (historical returns truly are not predictors of future performance!). As a part of this process there is always a vast amount of technical information gathered along with commentary from economists and thought leaders we follow. This aids us in formulating our best estimates to use in planning.

The point is that we must be intellectually honest with our clients about where investment markets will take them in the future, and how much we can rely purely on market returns to fuel financial goals. In the 1990s it was customary to see plans using average annual portfolio return assumptions well in excess of 10%. To our dismay we see others in our industry using similarly high returns even today, while our portfolio return expectations are much less than this. While it may be fun to look at how big the numbers can get when using a high return assumption, it certainly doesn’t aid in making prudent, informed decisions. We will continue doing our best work to determine the appropriate returns to use while planning our clients’ financial futures as we seek honest answers grounded in independent, unbiased thinking.

MARKET COMMENTARY

The month of May saw the S&P 500 decline 8.2% amid increasing concerns over European debt problems and their possible effect on worldwide growth. Greece received most of the media attention, but several European countries have high levels of debt relative to their overall economy including Portugal, Italy, Ireland and Spain. Observers have coined a term for these countries, PIIGS. With the concerns over PIIGS debt the Europeans together with the International Monetary Fund set up a one trillion dollar facility to purchase debt when needed; markets initially reacted in a positive manner as European stocks, currencies and debts appreciated, but by months-end all had resumed their decline.

Receiving less attention, but important nonetheless, are China’s efforts to control inflation and rapidly increasing real estate prices. During May China implemented rules requiring high levels of down payment on 2nd and 3rd homes and on May 31 announced what looks to be their first property tax at the homeowner level. May saw the Chinese Shanghai index drop about 10% to bring the year-to-date decline for the index to 22% as investors worry how much China’s economic growth rate will drop.

The “flash crash” also happened during May, with the Dow declining almost 1,000 points in just minutes and then recovering a majority of the losses before the day’s close. The regulators still don’t have a full explanation as to what happened, but computer generated orders undoubtedly played a major role. Unexplained volatility can only harm investor confidence in an already fragile market.

Despite the many problems, there is a positive backdrop of U.S. companies showing nice profit growth (1st quarter was 57% growth versus 1st quarter 2009), low inflation, and low interest rates. It would not be surprising to see stock price gains if the news flow would become a little less negative. But we are much more focused on key long-term themes to build our client portfolios, with such themes including:

• Most developed economies have issues with debt due to present historically-high levels combined with new debt to fund ongoing deficits, all exacerbated by the 2008 economic crisis. The better government debt to own over time is that of the emerging economies who as a whole have a debt to GDP ratio of 37% while developed markets are at 94%.

• Although the U.S. dollar has seen recent strength in a flight of money to perceived safety, expect the dollar to be pressured over the long-term (when compared to countries with sound fiscal policies) by dollar creation to fund deficits.

• Shorter maturities of debt are more attractive (as compared to longer term) since the trend of declining interest rates in place since 1981 will at some point reverse and become one of interest rate increases which could last for decades.

• Well managed companies (as chosen by experienced managers) will benefit from present economic challenges by gaining market share and making strategic acquisitions. Investments in these companies are favored to earn an above average return over time.

• Equity investments in emerging economies will benefit from their higher levels of growth, but will experience significant volatility.

These themes are expected to significantly affect our portfolio management decisions going forward and were reflected in our recent decision to increase portfolio allocation to emerging country debt. To get a better sense of our thinking you may wish to sign up to receive our weekly blog posts via email by visiting www.paynewealthpartners.com.

Our staunch ally

Remember Iraq in 1990 (Desert Shield/Desert Storm), then Iraq II in 2003 (Operation Iraqi Freedom), then Afghanistan (Operation Enduring Freedom), and so on.  There was one country that always backed the U.S. and that country was the United Kingdom.  Visit http://icasualties.org/oef/ and see that Afghanistan fatalities suffered by the U.K. ranks second only to the U.S.

Now we have the BP oil spill and the dramatic effects on the Gulf coast.  There is no doubt that BP has a significant and primary responsibility for containing the spill and paying damages.  However, President Obama has shown his seemingly politically contrived anger at BP in a variety of ways including condemnation of dividend payment and demand for payments to those idled by Obama's ban on offshore drilling.

BP has turned to the British government for help and received same as demonstrated in the attached article from yesterday's Financial Times http://tiny.cc/eheo4.  We can only hope that President Obama and his advisors remember who our most staunch ally is and contain their politically motivated rhetoric while continuing to seek solutions to the spill.

Interest rate history might help today's bond investors

This is a chart of the 10-year US Treasury interest rate going back to 1962.  The rate started 1962 around 4% and over the next approximately 20 years rose to a high of almost 16% in 1981.  The general trend in rates for the 30 years since the 1981 high has been down, with the 10-year US Treasury now yielding approximately 3.2%.

Returns from bonds are helped by declining interest rates and hurt by rising interest rates.  Concerned about stock market volatility, investors moved $379 billion into bond funds in 2009 (while withdrawing $9 billion from stock funds).  Could it be that investors are increasing their bond allocations just before bond returns are again harmed by rising interest rates (like the 20 years starting in 1962)?  No one can say what future interest rates will do, but the above chart does give some nice historical perspective.

Appropriate "investor behavior" adds more value than stockpicking

We had the pleasure to attend a presentation last week by one of our favorite fund managers, Christopher C. Davis of Selected American Shares (http://www.selectedfunds.com/).  To underline Chris's credibility, the Davis family, Davis Advisors and their employees and directors have over $2 billion invested in their fund.

Chris presented information from a March 2010 study by Dalbar, Inc. that showed for the period of January 1, 1990 to December 31, 2009 the average stock fund returned 8.8% per year while the average stock fund investor earned only 3.2%.  The 5.6% differential is attributed to behavior of the average investor buying and selling at the wrong time.

The comment that put all in proper context was when Chris discussed how as a portfolio manager he worked with the goal of selecting stocks in such a fashion as to beat the S&P 500 by 1% to 1 1/2% per year.  Chris wanted all in his audience to understand that while he would constantly work to pick stocks that would beat the averages, the real opportunity to improve investor returns was in improved behavior.  Well said!

The bright side of market weakness

We all know someone that looks at everything with the "glass half empty" mentality.  For those of you who can endulge your positive side, read on.  There's always a bright side to events happening around us- even investment market weakness as we're experiencing today. 

There are wealth planning strategies that can benefit from market weakness- one of them happens to be Roth IRA conversions.  When an account owner converts IRA assets to Roth IRA when the assets are trading at lower values there is a smaller amount of resulting tax and greater chance that corresponding market improvements will occur within a tax-free Roth IRA (after conversion).

Additionally, for those account owners that have previously converted to Roth IRA the weakness creates an opportunity to weight recharacterization opportunities (reversing a Roth IRA conversion) and subsequently "re-converting" after satisfying certain waiting periods required by the IRS.

We'll keep looking at the full half of the glass for our clients.

April 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

“We have met the enemy and he is us.”

Pogo, popular comic strip character of 1960’s and 1970’s

You will see below that we divide this commentary into two sections: Market Commentary and Planning Commentary. We do this because we think each is equally important in achieving our clients’ wealth management goals.

PLANNING COMMENTARY

The passing of April 15 reminds us of how important tax planning of all forms is in building wealth plans for our clients. The Economic Growth and Tax Reform Reconciliation Act of 2001 (otherwise known as the “Bush tax cuts”), reduced income tax rates substantially and changed a number of other taxes such as capital gains and the federal estate tax. As part of the Act, “Clinton-era” tax rates were scheduled to be reinstated or “sunset” starting 1/1/2011 as a way to stay within PAYGO rules. If Congress does nothing, top income tax rates will return in 2011 to 31%, 36% and 39.6% (versus current 28%, 33% and 35% respectively). Also the maximum long-term capital gains tax of 15% presently would revert to 20% while the tax on dividends would go from 15% presently to be taxed as ordinary income with maximum tax rate of 39.6%. This all seems quite possible as it would allow current leaders to blame past leaders for the tax increases yet still reap the benefits of increased revenue.

In addition to income tax rates that are scheduled under current law to increase, the Health Care and Education Reconciliation Act of 2010 imposed a special Medicare tax equal to 3.8% on certain taxpayers with taxable investment income (to start in 2013). The tax will be imposed on certain investment income over Modified Adjusted Gross Income limits ($250,000 for Married Filing Joint taxpayers) and will certainly amount to a considerable tax on wealthier individuals.

Most recently economists and tax experts have been whispering about the potential for a Value Added Tax (VAT) as a way to generate more tax revenue (this acts similar to a national sales tax). All these taxes are in addition to what is being paid in a number of other forms (state sales tax, gasoline tax, real estate and property taxes, etc.) and will be increasingly important in fueling entitlement programs promised by our government.

The reason we point out these current and potential tax changes is to remind ourselves and our clients of the importance in having a meaningful plan to deal with these tax-related headwinds. Only through purposeful and truly comprehensive wealth planning is one able to envision strategies that can help their family protect their future against risks like these.

MARKET COMMENTARY

The stock market strengthened in April as corporate profits grew and investors became more convinced of the sustainability of the economic recovery. As we write this, the S&P 500 has returned 2.0% in the month of April and 7.4% year-to-date (through April 28). Further, investors who didn’t sell during the credit crisis are seeing their accounts move closer to the levels before the 2008 credit crisis and are becoming increasingly more confident.

While we are glad to see accounts recovering, our views are toward wealth preservation at least as much future market gains. There are many concerns, including the debt levels and budget deficits of U.S. and other developed countries. The U.S. dollar and other currencies are not backed by gold or silver (as was the case at points in the past), but instead by confidence in the issuer’s economy. Unfortunately the fiscal policies in the U.S. may not continue to instill sufficient levels of confidence and we believe it is most likely that the U.S. currency will fall over time as compared to those countries who act in a more responsible fiscal manner. It is popular sport in America to blame our politicians, however those same politicians merely are a reflection of the general electorate—and sadly the electorate has shown no willingness to accept the shared sacrifice (of entitlement cuts and tax increases) necessary to restore fiscal health. Thus the quote to start this letter: “We have met the enemy and he is us.”

Given our concerns about the U.S. fiscal policies, we are increasing our client portfolio positions in emerging markets bonds. These emerging countries do not have the high public debts (as compared to GDP) of the U.S. and other developed countries, nor do they generally have the structural budget deficits. We are funding this emerging bond increase with reductions in U.S. dollar denominated investment grade bonds. We recognize that these emerging market bond positions would suffer if we had another market similar to 2008 when money fled to the perceived safety of the U.S. dollar; however our belief in the story for long-term dollar weakness is so strong that we would very likely use such an occurrence to further build emerging market stock and bond positions.

We are not diversifying further into currencies of other developed world countries (like U.K., France, Japan) because we think their fiscal problems are as bad or worse than the U.S. (with the exception of Germany). One merely needs to read current headlines of bond downgrades in countries like Greece, Portugal and Spain to get a feel for these problems.

Spain and Portugal to enact austerity measures

Spain and Portugal have each announced austerity measures aimed to reduce the size of their budget deficits.  Spain will reduce public-sector wages by 5% this year and freeze them next year, along with freezing pensions.  Portugal is cutting salaries of government ministers and other top officials by 5% and raising their value added tax by 1% to 6% for necessities, 13% for restaurants and 21% for other items.

These countries are part of the European Union countries that market concerns about their debts led to a $1 trillion European debt backup plan that was announced last weekend.  All of this was kicked off by Greece and their economic problems.

The issue is simple.  At some point lenders (those that buy your countries debt) no longer believe you have the financial strength necessary to support your debt at its present rate, and they demand much higher rates.  The 2-year notes of Greece went up as high as 18% rate of interest.  Portugal and Spain are trying to get their house in order before something similar happens to them.  The question is when will the U.S. get serious about its financial situation!?

April employment information for U.S. is positive surprise

The Labor Department announced today that April saw 290,000 jobs added to U.S. payrolls (as compared to expectations of 180,000).  Additionally, March job creation was revised up to 230,000 from the originally announced 162,000.  For the last 4 months, job create has averaged about 140,000 per month.

It is important to consider that the U.S. continues to experience an economic recovery that is stronger than most economists and market observers were expecting.  This is just one piece of data that investors must digest, as concerns over a possible debt default by Greece (the costs of a Greece bailout are similarly concerning) spread over Europe and the world.

We simply remind investors not to lose sight of the hard economic data (like job creation) in the midst of all of the attention given to items like dramatic market swings and chaos in Greece.

Washington D.C. vs. Brasilia, Brazil

The Federal Reserve Open Market Committee met in Washington D.C. this week and issued their statement yesterday saying conditions "warrant exceptionally low levels of the federal funds rate for an extended period."  Those exceptionally low rates are 0% to .25%.  The full statement of the FOMC can be seen at http://tiny.cc/tqs22.

The Central Bank of Brazil Monetary Policy Committee (COPOM) also met this week, in Brasilia, and given the strength of their economy and their concern over inflation increased their rate target to 9.5%.  The full statement of the COPOM can be seen at http://tiny.cc/ex27j.

Our conclusion:  Brazil has a lot of strength in their economy as compared to the U.S.  Investors should consider the above comparisons when determining where to allocate their investment monies.  In this new era, emerging economies such as Brazil have much to offer.

Goldman Sachs- the SEC tries to create a villian

Last Friday the Securities Exchange Commission filed suit against Wall Street firm Goldman Sachs claiming that the firm did not properly disclose to buyers of a specific "synthetic CDO" investment that there were parties betting the other side of the February 2007 deal.  Surely the SEC knows that when such a synthetic instrument is created there are buyers on the "long" side and sellers on the "short" side (or the broker itself is acting as principal and taking a side of the deal).  The fact that the deal worked out great for the sellers and horribly for the buyers doesn't mean there was fraud involved.  In fact Goldman apparently had a little bit of the long side as they lost $90 million on the instrument involved.

This situation also should be a chance for the investing public to again understand the roles of various players, including firms such as Goldman who serve as broker and often as principal.  Lloyd Blankfein, Goldman CEO was quoted in 2004 to say, "In our market-making function, we are a principal.  We represent the other side of what people want to do.  We are not a fiduciary...we are not managing somebody else's money."

To fuel populist support for financial reform, the SEC apparently wants to cast Goldman Sachs in the role of a villian using the hindsight of a February 2007 trade on a housing market that everyone now knows was already in serious decline.  There is no such villian, simply a trade where the smart money profited enormously while another suffered serious losses, just the capitalist system at work.

The investing public should take this opportunity to again remind themselves of the various roles of different parties.  As Mr. Blankfein says, a broker is not a fiduciary (remember a fiduciary is one who is legally charged to act in the best interest of their client).  Just because someone calls themselves an adviser, doesn't mean they are acting on your behalf.  Just ask the investors who purchased the above referenced synthetic CDO with Goldman Sachs as their adviser.

p.s.  We  remind all that Payne Wealth Partners is a fiduciary and we take very seriously our obligation to act in the best interests of our clients.

March 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

“The world is full of people who know the

price of everything and the value of nothing.”

 Oscar Wilde, 19th-century writer

The U.S. stock market (as measured by the S&P 500 index) closed the 1st quarter of 2010 up about 5 ½% year-to-date and up about 70% from the low reached a little over a year ago on March 9, 2009. We can’t resist going back to what we were saying in this same communication sent at the end of March 2009 where we made what turned out to be a prescient comment “some positive evidence has emerged that shows we may look back at the 4th quarter of 2008 and the 1st quarter of 2009 as the low point in this recession.”

The problem for many investors a year ago was that they were bombarded daily with media reports of stock price declines- being human beings they responded emotionally by selling to avoid further paper losses versus recognizing the value opportunity at such low prices. Mutual fund money flows are very instructive in terms of what happened here where 2008 and 2009 saw combined domestic stock fund outflows of $181 billion while bond funds for the same period had inflows of $304 billion.

Now let’s consider current times. Although the economy and the markets have recovered nicely over the past year, we remain concerned with several key items that have worried us for some time, including:

• The U.S. (and most other developed nations) incurred tremendous amounts of debt in dealing with the credit crisis. Further, these same countries have a high level of purely structural deficits that exacerbate these debt problems.

• As the U.S. issues additional debt it fuels the concerns of purchasers of that debt which will eventually cause interest rates to rise. It is notable that 10-year Treasury rates that were 2.75% a year ago now stand at 3.83%.

• As government policy stimulus is removed worldwide, it remains uncertain whether or not the private sector can continue to grow in a healthy manner.

One example of U.S. government policy stimulus removal is the March 31, 2010 end of the Federal Reserve’s program of purchasing $1.25 trillion of residential mortgage-backed securities. While this program was in place it supported low levels of home mortgage interest rates, which many observers feel will now increase as much as 100 bps (1%) from present levels.

A key question going forward can be summarized as “will the U.S. and other worldwide economies have the ability to generate healthy growth on their own, as government subsidy of different types is removed?” At Payne Wealth Partners, we believe the answer is “it depends.” If only evaluating economies of developing countries such as China, India, Russia, Brazil and Mexico, we say “yes” these economies can grow in a healthy fashion. But for the U.S. and other developed countries the answer is much less clear to us. Some forecasters see healthy developed economy growth, but many see much more anemic growth. If the answer turns out to be that developed countries (including the U.S.) are in fact economic growth laggards, then the prospect for corporate profits and therefore stock prices would be challenging. Further, poor economic growth and continuing high budget deficits and resultant debt levels for such developed countries could well mean higher interest rates as markets recognize their “debt trap”.

Payne Wealth Partners is making no changes in client portfolios at this time, however we see an increasingly attractive case for moving up portfolio targets for bonds issued by government issuers we believe have a good and improving national balance sheet, such as Brazil and Mexico (we presently have 5% targeted for this area). Further, we believe the case for commodities is improving as those would be a good hedge against currency devaluation from excessive developed country debt issuance while commodities would also be expected to benefit from emerging country economic growth. We will continue to evaluate these and other possible changes to client portfolios as the path of economic recovery and growth becomes clearer.

Our firm also believes we should be commenting in these monthly letters to clients on matters related to wealth planning. As we have evolved to provide a majority of our clients with comprehensive services that include planning, we want communications to our clients to properly reflect the importance we place on wealth planning opportunities. In this month’s letter we want to address estate taxes.

As of January 1, 2010 the federal estate tax was eliminated. This applies to those dying in 2010 only. As the law is currently written, on January 1, 2011 federal estate taxes return for those dying with estates valued in excess of $1 million. One of the biggest moral issues this situation presents is the incentive for someone with a very large estate to die in 2010 and avoid federal estate taxes that can be as high as 45%. While this may be hard to imagine, there have already been numerous cases reported of families making questionable decisions as to wealthy relatives on life support and in critical condition. These provisions were part of legislation passed in 2001 and we were very surprised that Congress didn’t act prior 12-31-09 to correct this. Further, we would have thought that 2010 would have seen a timely solution to this problem with the resolution being retroactive to January 1, 2010 but have yet to see any action taken.

So here we are now having completed the first calendar quarter of 2010 and still no estate tax fix. To us, this is a major failure of this Congress. Our hope and expectation is that Congress will soon take up this issue and clarify the estate tax rules. When they do, individuals will need to evaluate how the new rules affect them and determine if any changes are required to their current estate planning documents. If Congress simply lets the present law continue as-is, this too should be addressed by individuals in evaluating their estate plan. In any event it is something we should all have on our radar going forward in 2010.

Complacency?

Merriam-Webster defines complacency as "self-satisfaction when accompanied by unawareness of actual dangers or deficiencies."  This may fit the average institutional investor who according to a recent survey by Citigroup have a consensus of S&P 500 return for 2010 of 11% with a greater chance of a sharp upside move than one that is sharply downward.

A few facts:   Dow Jones Industrial Average (DJIA) close on Friday, September 12, 2008 (before the Lehman Brothers bankruptcy announcement over the weekend) was 11,422.  The DJIA then bottomed on March 9, 2009 at 6,547 and has since recovered to yesterday's close of 11,019. 

There were certainly bargains to be had by purchasing (or even holding) at the lows, but what about now?  We see much to challenge returns over the next many years, including huge levels of global debt and a retrenching consumer.  In our view a well diversified portfolio that doesn't merely count on returns from an increasing stock market is more important than ever.  We caution all, starting with ourselves, not to let the significant recovery in stock prices dull our senses as to the risks going forward.