April 2009

April 30, 2009 03:00 p.m.
Contracting Less

First, for those who are interested in more details about the Bernard Madoff scam, the most details to date have been published by Fortune online. The article indicates Madoff was not acting alone but says there is no evidence is family was involved. You can read the article here.

Now, let’s turn to the markets.

Stocks have been on the move for almost eight weeks. After a bottom on March 9, the major indexes have returned almost 30%. There is a lot of talk about the worst being over and the economy reaching a bottom. As they say in the movies, “Not so fast.”

The bright spots are the economy is not falling as fast as it was late in 2008, and some statistics even are improving instead of falling at a slower rate. But falling at a slower rate than the precipitous drop in late 2008 is not the same as growth. Even the data that are improving still indicate declining growth ahead. Good examples are consumer confidence and the Institute of Supply Managers survey. Both are above their recent low points. But they also are at levels that traditionally point to further economic decline.

The latest earnings reports had many positive surprises with companies beating estimates. But in many cases the way the earnings beat estimates was not encouraging. Companies held their profit margins by reducing expenses, especially payroll. The GDP report revealed that business investment fell the most ever. That does not bode well for future economic growth.

While new weekly unemployment claims are below their peak of a few weeks ago, the continuing claims continue to set new records each week. Rising unemployment means consumers spend less and businesses continue to reduce expenses.

The economic stimulus law is providing some benefits by putting more cash in consumers’ pockets for them to spend. But the effects are temporary and are not strong enough to offset the deleveraging cycle that is in place.

We have not looked at the technical aspects of the stock market for a while, and there the results are mixed. Stock valuations are tough to assess, because earnings have been so volatile. Valuations that use the historic profit margins before the crisis show stocks to be reasonably priced or cheap, but those profit margins are not likely to return. Valuations using historic profit margins show stocks to be expensive. The advance-decline line and ratio of new highs to new lows are in good ranges. But trading volume is not high for a new bull market. In addition, much of the trading volume appears to be generated by short covering, program trades, and the like. The funds that aim to earn two or more times the returns of the indexes (and the inverse funds) also seem to be generating a lot of the trading volume and even market direction.

I continue to believe the enthusiasm among investors for recovery is premature. I recommend maintaining our capital preservation positions.

April 24, 2009 09:30 a.m.
Autos vs. Banks

Sometimes it is hard to explain or reconcile actions in Washington. This is one of those times.

In recent weeks the government, through the Treasury Department and the President’s car czar, has been negotiating with creditors of Chrysler and General Motors. The basic message to the bondholders and other creditors has been: Take a big hit.

Creditors are being offered deals that involve receiving a relatively small amount of cash now plus stock. The bonds, loans, or other debts would be extinguished. The details of the proposals are not important for this discussion. Instead, there are two other interesting points.

The government has lent money to the car companies but is acting as though it owns them. It is offering the creditors money from the car companies and proposing to give them stock, which would dilute the holdings of current shareholders. Existing shareholders apparently do not have any say in this process and do not even appear to have a representative in the talks. The creditors are responding with counterproposals of their own that put them in much better positions. The creditors generally have security interests in assets of the car companies and believe they would do better in bankruptcy court than under the government’s proposals.

A more interesting point is the contrast between the automaker proposals and those involving the banks and other financial companies.

With the exception of Lehman Brothers, there has been no consideration of having creditors of the financial companies absorb any losses. They have been paid in full, and in many cases debt issued by financial companies is guaranteed by the government. Taxpayers and stock holders have taken big hits and are likely to absorb even more of the losses. Even unsecured creditors of the financial companies are made whole.

The financial companies by and large would be solvent if their liabilities were converted to equity or otherwise extinguished. Yet, the possibility isn’t even mentioned in public.

Another interesting angle: U.S. banks are the major creditors of the auto companies. A number of U.S. retirees and private citizens also own stock and debt in the automakers. But many of the creditors of the finance firms seem to be foreign investors, especially foreign banks and governments.

As I’ve said before, we should at least have a public discussion of whether or not the creditors of the financial firms should incur some losses. The creditors, after all, did lend money to the firms and should bear some consequences for their poor decisions. If there are good reasons why taxpayers and shareholders (along with employees) should bear all the losses, the reasons should be stated publicly.

April 22, 2009 03:00 p.m.
The Pause that Confuses

Is the worst over? Investors seem to think so. The stock buying binge that began March 10 continues, creating more optimists.

Two factors are the main drivers of the market rally and rise in optimism.

One factor is the end of the panic and economic freeze of the fall of 2008. The credit markets were frozen, the economy in a free fall, and consumers in a panic last September, October, and part of November. That phase has ended. Credit markets are better, though not healed. The economy is struggling but not in a free fall.

The other factor is what I can describe only as manipulation.

When the rally began on the heels of a leaked, optimistic e-mail from the head of Citigroup, I was suspicious. The e-mail was followed by some other announcements and government actions that were not very substantive but gave heart to investors. The manipulation continued with the announcement of bank earnings. Citigroup, Bank of America, Goldman Sachs, and JP Morgan Chase all issued better than expected earnings. The positive results involved a lot of tricks. For example, the value of bonds issued by the banks declined. Accounting rules allow the banks to recognize these price declines as gains. Details of the earnings manipulation are in this New York Times article.

Yes, things are better than last fall. But do not confuse that with a recovery.

There still are many more losses to be recognized by financial firms. Issuance of new short-term debt is low, showing that investors are not willing to take much risk and potential borrowers are not interested in borrowing. The spreads between treasuries and riskier debt (such as corporate and high yield bonds) have improved but remain high by historic standards.

Take a look at housing. Foreclosures continue rising, and prices still are declining in most areas. Mortgage applications are up, but most of the applications are for refinancing, not for purchasing new homes. High standards mean that many of the people who want to buy homes at today’s prices cannot afford borrow to buy them. Data indicate that a new wave of foreclosures might be on the way. We made it through the subprime foreclosure bulge. Now the prime mortgage foreclosure surge might be on the way.

Employment continues shrinking at a high rate. There is a lot of unused manufacturing capacity globally, and demand for most items is low.

Don’t be fooled by the financial markets rally. A few weeks ago I told you that most of the 50 most bullish stock market trading days occurred in the midst of sharp economic declines, such as the Depression. They were not signs of imminent economic recovery. Do not rely on the stock market as an economic forecaster.

While the rate of decline is less steep, the economy still is contracting. At best, we have a pause in the plunge, but without a significant change further decline is in the cards.

Once again, most investors are treating the current situation as a typical recession that is deeper than average. We are in a different environment. There is too much debt, and borrowers are deleveraging. Government efforts to stimulate borrowing will not help the economy.

I recommend staying with our capital preservation portfolios. While we have missed some short-term gains and might miss some more, this is an opportunity only for nimble traders.

April 17, 2009
9:00 a.m.
A Dangerous Retirement Myth

Many retirement plans fall short of their goals because they were built on myths and misunderstandings. One of the great myths of retirement planning is: Taxes will be lower in retirement. This week of tax returns and tea parties is a good time to discuss the issue, and a new survey proves a point I have made for years about retirees and taxes.

There was a time when the myth was true. Taxes did decline in retirement. When income tax rates were higher and there was a heavily graduated tax system, there were 13 tax brackets. Many people received less income in retirement than during their working years, and it did not take much of a drop in income to push a new retiree into a lower tax bracket. In addition, there were numerous tax breaks for seniors.

Things are different now.

We have only a few tax brackets. One needs to have a significant drop in income after retiring to drop into a lower bracket.

More importantly, retirees are making up a larger share of the taxpaying public as the Baby Boomers age. Congress cannot afford to let them pay less in taxes, and it has not.

Social Security taxes once were exempt from income taxes. For a while now, the benefits have been taxable to “upper income” recipients. The number who pay taxes on the benefits rises each year, because the income levels at which the benefits are taxed are not indexed for inflation.

Many retirees also are likely to be caught in the alternative minimum tax. Many middle income taxpayers pay higher taxes under the AMT. That is usually because income declines after retirement but tax deductions remain the same. The combination can trigger the AMT.

In fact, unknown to many pre-retirees, taxes are likely to be your largest expense in retirement. While most people worry about medical expenses and long-term care, the biggest drain of your retirement income will be taxes. Income taxes are likely to take the largest share. There also will be sales taxes, real estate taxes, personal property taxes, and taxes on capital gains.

The new survey of retirees between ages 70½ and 75 with a net worth of at least $1 million, by Securian Financial Group, found taxes were the largest expense by a wide margin. Taxes, in fact, took about 4% of net worth every year. That is 4% of net worth, not of income. The percentage of income taken by taxes is much higher. It is tough to have net worth increase or remain stable when one expense is taking such a large portion.

Compare this with the expectations of most people. They express the most concern about medical expenses in retirement. Yet, medical expenses were an average of $6,681 annually while total taxes were $40,578. Retirees in the survey group spent more on travel, cars, charity, food, gifts, and mortgages than on medical expenses.

Tax planning needs to be an integral part of your retirement money management. Strategies that effectively reduce taxes for many retirees include:

? Tax-exempt bonds instead of taxable bonds. These won’t help reduce taxes on Social Security benefits, but they will reduce income taxes. Tax-exempt bonds carry attractive yields relative to treasury bonds now, but they also carry extra risks because of the economic distress of many state and local governments. Don’t take high risks to reduce income taxes.

? Monitor the stealth taxes each year. Relatively small adjustments in income or expenses in the last part of the year might avoid higher taxes due to the itemized expense reduction, the personal and dependent exemption phaseout, and the alternative minimum tax.

? Investments. Simple strategies such as minimizing trading, holding investments more than one year so the capital gains are long-term and not short-term, and buying mutual funds that traditionally make low annual distributions are easy ways to boost after-tax investment returns.

? IRA management. Once distributions begin, managing the IRA is more complicated than many people realize. Taxes can be reduced and the life of a portfolio extended by withdrawing money from your different accounts in the right order and carefully calculating which assets are held in which accounts. Some retirees reduce lifetime taxes by taking money out of their IRAs faster than required under the law or converting a traditional IRA to a Roth IRA.

? Maximizing deductions, such as those for charitable contributions and medical expenses, also are key to reducing taxes for many retirees.

Many retirees are surprised by the amount of taxes they pay. They believed the myth that taxes decline in retirement. The truth is without some planning taxes will stay the same or even increase during retirement. Tax breaks specifically for seniors are rare these days. Tax traps and a retirement tax ambush are more likely. You need to continue tax planning through retirement to ensure your retirement fund lasts a lifetime.

April 7, 2009 09:00 p.m.
Some News Worth Highlighting

There have been a lot of interesting things in the news the last few days. Here are some web links that are worth your time.

Here is perhaps the best short explanation of the current financial crisis you will find. The lesson for countries and investors is leverage is great in on the way up and painful on the way down. One of the co-authors is a Nobel Prize laureate. Bottom line: Consumers took on too much debt.

Last December we moved portions of our portfolios into Treasury Inflation-Protected Securities (TIPS) last December. Though we are not market timers, it turns out that was very timely. You don’t have to believe me. Read the proof here.

High yield bonds are tempting to many investors. They are double digits, and many have succumbed to the temptation of various high-yielding investments the last few years only to see yields the yields cut or the principal lose value or both. Here is a forecast that the default rate on today’s high yield bonds will reach 53%. It still might be too early to add high yield bonds to your portfolio.

In recent months we introduced you to the concept of the wealth effect. For many months we have been talking about the excess amount of consumer debt and how it is making this cycle different from others. Here is a video with a good explanation of the wealth effect, excess consumer debt, and other important concepts. It gets interesting around the three minute mark.

In past issues of this Journal we have identified shortcomings of the Treasury’s recent program to transfer bad debts off the books of banks and other financial institutions. Many others are criticizing the program. Here is a piece from the Financial Times that addresses a couple of the more egregious flaws. In effect, banks will be able to swap their bad debts with each other, transfer the losses to taxpayers, and reap any profits.

Investors See the Bright Side
April 3, 2009 11:30 a.m.

January and February were among the worst months on record for U.S. stock investors, and March was one of the best months. The gains continued rolling in April. Investors and the financial media found something positive in each data report. Let’s take a look at the recent data and market action to see if long-term bullishness is warranted.

The avalanche of money and programs thrown at the economy definitely are having an effect. There credit markets have their basic functioning again, and the rate of descent in the economy has slowed. Lower mortgage interest rates and the refinancing activity they generate also are positive for the economy. Will these positive trends last and be strong enough to turn around the economy?

The first warning sign is in the details of the market action. The stock market leaders have been lower quality stocks and distressed stocks beaten down in the bear market. This type of leadership is a hallmark of a short-covering rally and speculative short-term trading. When higher quality companies lead or at least keep pace with the indexes that is a sign long-term investors are back in.

Housing was a major source of good news. It is true that sales of homes is higher than in previous months. But they still are well below sales levels of a year ago. Also, a large portion of the sales are of foreclosed properties selling at distressed prices. The prices of homes still are declining.

The housing markets that are stabilizing are those that already declined the most and had the most subprime mortgages. The bulk of subprime mortgages resetting at higher rates is behind us. Unfortunately, the systemic problems caused by the subprime crisis have spread to the rest of the economy. Defaults and foreclosures still are increasing in higher quality mortgages, and price declines are continuing in markets that have not declined as much as the subprime centers. Even the traditionally strong Manhattan market now is having problems. In those areas, the economy and falling incomes are the problems, not reset interest rates on mortgages.

This doesn’t even consider the emerging problems in commercial real estate. This week the John Hancock Building in Boston, the tallest building on the East Coast, was sold for half the price its owners paid three years ago. There was only one bid at the auction, and the buyers put down a small amount of cash and took over the existing first mortgage. Many commercial property owners are facing refinancing problems and cash crunches. This crisis is reflected in the prices of real estate investment trusts but not in the values of many buildings and on the books of their lenders.

Many analysts are latching on to the fact that the rate of decline in housing and the economy in general is less than the steep fall of last October and November. But a reduced rate of decline is not the same thing as a bottom. The current data, including early indicators such as the Institute of Supply Management Index, still point to an economy in decline. The economy in general carries too much debt. Increased unemployment and falling incomes make the problem worse. While the government seems focused on increasing the debt and leverage in the economy, a better focus would be restructuring the existing debt.

There is no rush to increase the risk in our portfolios. When the economy and markets reach a bottom, there will be plenty of time to capture gains in the next bull market. The key strategy is to manage risk and preserve our capital. The portfolio changes we made in December (the January 2009 issue of Retirement Watch) were timely. Most of our portfolios had very modest losses in January and February. Even after the strong gains of March, our portfolios still are well ahead of the stock indexes for the year. The stock markets now are looking overbought. Preserve your capital and wait for clear signs the decline is ending.