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October – December 2008

Last update on: Dec 20 2018

RMD Relief for 2009, not 2008 December 19, 2008 05:00 p.m.

Many IRAs experienced steep declines in their values in 2008. This can put a strain on those over age 70½. They are required to take minimum distributions from their IRAs and other qualified retirement accounts based on their values as of Dec. 31, 2007. In bear markets, they are required to take distributions based on values that no longer exist, reducing their accounts by a greater percentage than anticipated. Failure to take the RMD results in a penalty of 50% of the amount that was supposed to be distributed.

The IRS was asked earlier in the year if it could waive the RMD penalty for 2008. On Thursday the IRS sent a letter to lawmakers saying that it is not able to find a solution. IRS officials told the Washington Post that the law does not give the agency authority to waive the penalty. Only Congress can do that. In addition, it could not develop a remedy for those who already took all or part of their 2008 RMDs before December.

On December 11 Congress did pass a law waiving the penalty on those who do not take their RMDs in 2009. In effect the Worker, Retiree, and Employer Recovery Act of 2008 suspends RMD for 2009. The next RMD will be for 2010 based on the Dec. 31, 2009, value, unless Congress extends the law. The waiver applies to both original owners of accounts and to beneficiaries of IRAs and other qualified retirement plans.

The tricky part is for those who turn age 70½ in 2009 so that their first RMD is due by April 1, 2010. For these IRA owners, no distribution is required for 2009, meaning no distribution is required by April 1, 2010. However, that does not change the required beginning date for the distributions. What this means is that for the year 2010, an RMD must be taken by Dec. 31, 2010.

Unintended Consequences 2 December 17, 2008 05:00 p.m.

When careful people in government set policy, they try to look two or more steps down the road. They try to divine the responses of people after the initial response. Otherwise, the unintended consequences of a well-intended action can make things worse or create a new problem. The financial crisis has been a series of unintended consequences. Consider a few recent actions:

§ When bank failures became a worry, the limit on insured accounts was increased to $250,000. The new problem is that investors started to shift cash out of money market funds to take advantage of the new insurance. That, coupled with the Reserve Funds’ “breaking the buck,” caused the government to insure money market funds at least temporarily.

§ The Federal Reserve pushed down interest rates to inject liquidity into the economy. But investors were in a flight to safety and bought treasury debt regardless of the interest rate. Mortgage rates, which is what the Fed really wanted to decline, were stable or rose. The spread between mortgages and treasuries increased. That dynamic made mortgages less prospective to those who were potential home buyers and those who needed to refinance.

§ To bring down mortgage rates, the Fed yesterday announced that it would begin buying long-term treasuries and mortgages. This prompted mortgage rates to decline sharply, generating a nice one-day gain in TCW Total Return Bond. Unfortunately, it also worried foreign investors. The dollar declined sharply. Given how much the U.S. needs overseas investors to purchase our debt, it is not good for investors to lose confidence in the dollar’s value.

Yesterday’s stock rally probably was largely short sellers covering their positions plus other panic buying. The credit market still is a long way from being fixed. Despite lower rates, home buyers are not coming out of the woodwork. Many who would like to refinance their mortgages cannot meet the new lending standards.

There are several things I would like to see. It would be nice if the markets would have a positive reaction without the aid of a government action or announcement. Beyond that, asset prices need to stabilize and debt needs to be restructured. Much of the debt owed by both individuals and businesses is more than they are able to repay in the new economic environment. Growth will not return until this debt is restructured and forced asset sales end.

Bear Market Rally and Items in the News December 16, 2008 03:00 p.m.

Most investors are focused on the U.S. stock market rally that began around Thanksgiving. It is giving hope that the bottom has been reached and better times are around the corner. A number of long-term bears are turning bullish, at least for the short-term. We are not traders, so the potentially for a rally lasting even several months is not something we respond to. Instead, we look at trends for one to three years and valuations.

Consider the following before abandoning caution.

? Prime, nonagency mortgages took a beating in the last week. These are mortgages of top-rated borrowers who are making their payments. Investors sold the in a panic after concluding that a new round of increasing mortgage defaults is coming. That is at odds with the recent surge in stocks.

? The rest of the credit markets also are not doing well. They are priced for high levels of defaults, and prices have not been rising along with stock prices. As has happened so many times over the last five years, the bond market is more bearish than stock market. So far, the bond market has been right.

? Unemployment is on the rise, not only in the U.S. but also in Asia. Unemployment tends to create a cycle of falling sales and profits followed by more unemployment.

? The Federal Reserve reported Friday that the wealth of American households plunged in the latest quarter for the fourth consecutive quarter. Americans lost $7 trillion of wealth since the peak, and the decline is not stopping. In a future journal entry we will discuss how the wealth effect causes investors to spend less and save more (another bit of news in the Fed report), and that there is a lag between wealth changes and the behavior changes. See more details here.

? Too many analysts still do not accept that this cycle is different. The amount of debt, deleveraging, declines in asset values, and other factors are unprecedented. Data from past cycles is not useful in evaluating this one. So far, using past data has only caused investors to enter the markets prematurely, believing that the bottom was reached.

That is enough bad news for this entry. Stay safe in your portfolios. Consider the following recent news items:

? Are you interested in how the crisis is causing Wall Street’s formerly well-paid workers to reduce spending? Check this article from Vanity Fair.

? Wondering how to stay reasonable happy and well during the crisis? Spend lots of time with your friends. See here for details.

? How did Bernard Madoff convince so many apparently sophisticated investors to invest in his scam? More importantly, how could people collect fees for doing such a poor job of investigation and due diligence? For our very low subscription rate, you can avoid scams and be invested with quality managers through Retirement Watch. One interesting theory is here.

Untethered Markets December 5, 2008 11:30 a.m.

The biggest mistakes in the last year (other than those by the government) have been made by investment managers who continued to apply the old rules.

Many investment managers, especially those who manage stock funds, focused primarily on the fundamentals of the companies they reviewed. When they considered the broader picture, their analysis was only whether the economic downturn would be short and fairly modest as in 2001-2002 or would be more severe. They generally did not consider the possibility that we were in a once-a-century environment or that the fundamentals of a company would have no effect on market prices. If they did consider such possibilities, it was with the assumption that things would reverse after a few months.

In general, traditional money managers-especially value managers-viewed each market decline as a buying opportunity. That is why so many usually savvy value stock managers have seen their portfolios decline as much as the market indexes or more.

A recent example was Fannie Mae. We recently covered some of the managers who bought into that stock even as it neared a government takeover.

Yet, the disconnection between fundamentals and market price movements continues months later. A great example of these is real estate investment trusts as represented by Cohen & Steers Realty Shares. Take a look at the chart below, showing the price movement of the fund since Oct. 1.

The decline in October and early November is easily explained by the market panic and credit freeze that followed the bankruptcy of Lehman Brothers. But look at this week’s action. On Monday, Dec. 1, the fund declined over 19%. This was due to declines across the portfolio and little economic news. Over the next two days the fund gained 18.66%, recovering most but not all of the losses.

This kind of market is ideal for traders who can catch the bulk of these rapid changes, but not for anyone else. The REIT market in fact is having its worst year ever, though it had positive returns for the year as of the beginning of December. The fundamentals of the companies did not change that quickly and did not change in all REITs across the board, though almost all have been heavily sold.

The broader market has been almost as jumpy recently, with changes little-related to news or fundamentals.

We have to be prepared for this kind of activity for a while. We took a lot of risk out of the Managed Portfolios even before 2008, so we have done better than traditional buy-and-hold investors. The prices of many assets are well ahead of the economic fundamentals, with REITs being a prime example. Prices of REITs declined about 50% while the fundamentals of most properties still are feeling only mild effects of the economic downturn. In coming weeks we will determine if this means there is much worse to come for the economy or if there are many solid bargains available in the markets.

Reasons to be Thankful and Hopeful November 26, 2008 11:30 a.m.

Recent times have been tough for investors, and they are starting to get tough in the economy. As we prepare for our national day of Thanksgiving, we should realize that there are reasons to be optimistic about the future.

The government officials seem to realize not only the extent of the problems but also what to do about them. They also seem inclined to do whatever it takes to provide liquidity, reduce credit spreads, and restore confidence. We can expect the Fed and the Treasury to guarantee more securities and spend more money to help the financial markets.

The officials also realize that short-term interest rates are not the issue. They now are focused on bringing down other rates. Tuesday they acted to reduce rates on some mortgages, and that had a powerful effect. Going forward they probably will take actions to bring down rates on other debt, such as corporate bonds and long-term treasury bonds.

The new administration has selected a group of experienced, center-right financial people who seem to understand the problems, the recent failures, and steps that can be taken. We will see a strong fiscal program to supplement the monetary program very early in 2009.

The monetary base is expanding at a rapid rate. This liquidity eventually should stimulate growth, though it could take a while.

Because of the current deflationary effects, it will be a while before these moves put us at risk of higher inflation. That might happen, but it is not today’s problem. The Fed can continue to pump up the monetary base without fear of near-term inflation, and worry about dealing with inflation after things turn around.

International monetary and fiscal authorities also seem to be joining the program. Not long ago, the credit crisis was viewed primarily as a U.S. problem. Many international economies still were growing, and there was a belief that the rest of the world could grow, though at a slower pace, no matter how bad things in the U.S. became. That view has been refuted. Global officials are coordinating some actions, but all are taking steps to shore up their banks and stimulate their economies.

At the same time, many assets are at very low valuations. The biggest potential bargains are in the credit markets, not stocks. Both high yield bonds and corporate bonds are trading at yield spreads that price in very substantial default ratios-rivaling those of the Depression. Real estate investment trusts slid significantly the last couple of weeks, again pricing in a Depression scenario.

Many of the confidence problems are based on the freezing up of the commercial paper market and the reduction in lending by banks. Many firms depend on short-term loans to pay their regular expenses. If they cannot roll over these loans, they cannot pay their bills. If the government actions unthaw credit markets and bank lending, prices on many assets will rise quickly.

The main issues are how long it will take for the actions to take effect and how bad things will become before the economy turns around. But there are reasons to be optimistic that sometime in the next year the picture will be brighter and we will be seeking profit opportunities instead of ways to preserve capital.

Unintended Consequences and Unresolved Issues November 21, 2008 11:00 a.m.

Stocks are cheap, but keep getting cheaper. Bonds, other than treasury bonds, are cheap but keep getting cheaper. Real estate prices continue to fall, with commercial real estate joining housing in the fall. The Federal Reserve cut interest rates almost to 0%. The government has guaranteed assets, taken over companies, and invested in other companies. So why haven’t things turned around?

The first answer is that investors realize stocks are at the end of the line in a financial failure. Why buy stocks when bonds and other debt have senior positions? Bonds pay high yields these days and have better protection in a bankruptcy.

The second answer is that the commercial paper and securitization markets still aren’t working. Investors are willing to buy debt only when it has been guaranteed by the federal government. In addition, banks are hesitant to lend to each other; they don’t trust each other’s balance sheets or solvency. They also won’t lend to many companies.

Investors who used to buy securitized loans are in the same boat. Because of the major problems with securitized mortgage loans, investors don’t trust securitized loans now. When banks and other lenders are unable to package and sell their loans, they can lend only the capital they have on hand. In the past, they would lend, sell the loans, and have new capital to make new loans.

The sharp declines in the last two weeks, especially in real estate companies, is due to the continuing freeze in the loan markets. A number of companies, especially commercial real estate firms, have debts that need to be refinanced between now and 2011. In the current market, they cannot refinance the loans. Failure to refinance will lead to defaults. Lenders will take over the properties, and stockholders and unsecured lenders will receive nothing. That is why investors are selling everything except treasury bonds right now.

The government took over some companies to prevent more widespread bankruptcies among their creditors. It also has guaranteed a range of debts. But the decline in underlying asset values has not been halted, and in some cases it might be increased by the moves. Investors want only government-guaranteed debt, which reduces the value of everything else.

That is why this downturn is different from others. Investors who have re-entered the markets based on historic patterns. From the outset I have said that one of the keys to identifying the end of the crisis is the asset-backed security market. Continue watching that and short-term treasury rates for clear signs that the crisis is reaching a resolution.

Items in the News and Some Observations November 18, 2008 11:30 a.m.

There has been quite a bit in the news lately that needs some comment and amplification. Myths are being spread, and interesting data is pushed aside. Considering the following:

Banks aren’t lending. We hear that a lot. People complain the banks took taxpayer money and are sitting on it. The facts do not support this argument. Weekly data from the Federal Reserve show that revolving home-equity lines outstanding have skyrocketed in recent months, and commercial and industrial loans are rising and well above their levels of early 2007.

Companies are having trouble getting credit, but not from banks. The commercial paper market and asset securitization market are severely diminished. Investors do not trust them. Instead, companies are drawing on bank lines of credit to meet their cash needs. The overall effect is a credit contraction, and banks are unable to make other loans because of the equity line draw downs by companies. I have said from the start of the crisis that the issuance of commercial paper and asset-backed securities are key signs to watch for a recovery.

Commercial real estate joins the crisis. Real estate investment trusts and other real estate stocks took quite a tumble last week for several reasons. A few prominent real estate companies announced potential bankruptcies, dividend reductions, or cash flow problems. Real estate companies are having problems obtaining short-term financing and rolling over debt the same as other companies. In addition, more conservative lending practices and reduced access to public credit and stock markets make doing deals more difficult. In other words, forces that helped propel real estate prices higher no longer are in place. Bankruptcies by retailers and fears of a severe global recession also cause investors to flee commercial real estate investments. Both dividends and asset values of REITs are uncertain right now.

And another shoe drops. In the December issue of Retirement Watch I discuss current worries about insurance companies and how it affects the safety of variable annuities. I’ll just touch here on the severe decline in insurance company stocks. Genworth Financial now is trading around $1 after being around $28 last December and $15 in September. Hartford Financial trades just over $7 after being near $100 last December and over $60 in September. Investors now are worried about mortgage exposure plus guarantees made in annuity contracts. Regulators might force the companies to seek additional capital, and some insurers are buying small banks so they can become bank holding companies and qualify for federal funds and insurance.

How low can stock prices go? Many blue chip stocks are trading at or below their prices of 10 years ago, apparently providing values. The Wall Street Journal on Monday showed that stocks such as GE, Eli Lilly, and Intel are selling 45% and more below their prices of Nov. 1998. That sounds like discounts. Many traders are encouraged that the markets were able to stay above the low prices of Oct. 10, which was around 850 on the S&P 500. They believe this indicates a bottom for the markets. That doesn’t mean we safely reached a bottom. There are many more potential shoes to drop, such as the a more severe recession that results in earnings declines, dividend reductions, and bankruptcies. Two analysts who have been very accurate about the developments of the last few years say that based on history if the current situation develops into one of the worst in history say the worst-case bottom probably is 625 or so on the S&P 500. So, while stocks are cheap, they could get cheaper. It might be a good time to begin slowly increasing risk in the portfolio, but don’t buy as though this is a clear bottom. Wait for clearer signs that the financial system is on the mend. A key factor will be whether companies are able to refinance or roll over short term debt in 2009 and 2010. In the last month quality companies such as GE have had troubles doing so.

Buyer’s strike? When the indexes decline, commentators often say there is a buyer’s strike or there were more sellers than buyers. This makes no sense. For every sale, there is both a buyer and seller. There cannot be more sellers than buyers. What happens is that those interested in buying stocks are willing to pay lower prices than the day before and sellers are willing to accept lower prices. It does mean that there is less optimism. It is a small point, but it shows how widespread misunderstandings about markets are.

Your Retirement and the New Washington November 8, 2008 12:35 p.m.

Come January, Democrats will be in charge all over Washington. They campaigned on a theme of change, and we should expect major changes. The questions are which changes and how will they affect your retirement finances?

I will focus on the changes I think are most likely to occur. When evaluating the prospects for change, it is important to keep in mind the tension that will exist in the New Washington. Congress will be run by very liberal politicians who have a long list of legislation they wanted to pass for many years. These wish lists generally involve higher spending, more government control and regulation, rewarding favored activities and punishing others, and of course higher taxes. The new President, on the other hand, wants to be re-elected and probably recognizes that the country is center-right, not liberal, on most issues. There will be tension between the President and Congress, and the great unknown is which one will prevail. I assume that for at least the first couple of years the President will have the upper hand and will be able to move the more extreme liberal measures to the back burner.

Here are things you should prepare for over the next year or two. Other changes might be coming after that.

Medicare: This health program for those over 65 is approaching bankruptcy. Social Security will begin spending more than it receives in a few years. Medicare passed that point long ago. It soon will have exhausted the “trust fund” set up for it and rapidly is taking a larger share of the federal budget.

A few years ago “means-tested” premiums began as we discussed in Retirement Watch. Premiums increase as a beneficiary’s income rises. Similar changes are likely to occur. Premiums for higher income beneficiaries could rise even more and some types of care might not be covered for higher income beneficiaries. Or deductibles and co-payments also might be means-tested. Higher income beneficiaries might be required to cover the first $5,000 to $10,000 of their medical expenses in addition to paying higher premiums.

The government might have a stronger role in “negotiating” drug prices. Medicare prices are a basis for prices providers charge to private insurers. If the government negotiates very low prices, manufacturers might conclude that some drugs are unprofitable to produce or reduce research spending on new drugs.

The government also might take over the Part D prescription drug program instead of allowing private insurers to compete for beneficiaries.

Medicare Advantage plans also might take a hit. Democrats in Congress have targeted these since returning to the majority after the 2006 election. These plans run by private insurers receive higher reimbursements than other Medicare plans but usually offer greater benefits. Democrats want to eliminate them and bring everyone back into traditional Medicare.

Greater use of technology is likely to be mandated across the medical profession, and the government will assume cost savings from this move. It also is a way of pushing costs from the government to the private sector. That could affect the quality or availability of care for a while and increase costs on care not covered by Medicare.

Estate tax: Congress has to address the estate tax soon. The current law eliminates the estate tax for 2010 and returns to the 2001 law beginning in 2011. Congress is unlikely to let either the expiration or return to 2001 law occur.

The most likely outcome is, after a great deal of debate, something similar to current law will be enacted. That means the estate tax exemption will be fixed at $3.5 million and might be indexed for inflation. The top estate and gift tax rate will be 45% or 46%, though it could go up to 50%. It will be interesting to see if the lifetime gift tax exemption remains capped at $1 million or is allowed to rise. Also unclear is whether the current step-up in basis that is allowed for inherited assets will continue or whether heirs will have to take the deceased’s basis and pay capital gains taxes on appreciated that occurred during the deceased’s ownership.

Retirement plans: Here is a sleeper issue that came up only in the last month. Many in Congress do not like President Bush’s “ownership society” concept, and they view 401(k) plans as part of that. They are looking at ways to change qualified retirement plans.

A longstanding goal was to require private employers to provide minimum pensions. That might be replaced by a plan to have the government take over private pensions. Recent committee hearings highlighted a plan that eventually would eliminate tax breaks for 401(k) plans and give individuals a window during which they would receive some benefits for converting their private 401(k) plans into government retirement plans. This approach clearly has support from congressional leaders, but its support beyond that is unclear.

Investing: Anticipate some surprises here. Presidents are not able to implement all their campaign proposals. Congress and circumstances can change the plans. Don’t invest based on campaign rhetoric. Wait until proposals are closer to becoming laws.

There could be a positive surprise in the change of power. The financial problems largely have developed into a confidence problem. People do not trust current leadership or the information it puts out. Financial companies do not know what to expect from the government, so they are hoarding cash to protect themselves. Investors simply are not buying anything with risk, and financial firms are not doing business.

Some shrewd moves by the new President in the next few weeks could start to restore confidence at least temporarily. Appointment of a popular choice for Treasury Secretary and announcement of an effective tax cut and regulatory reform plan could spur optimism among investors.

Of course, stumbles on any or all of these issues could extend the crisis. Further down the road, higher taxes, spending, and regulation could reverse any positive trends. But there is an opportunity now to restore optimism even as the economic slump deepens for the next quarter or so.

Congress also could squander the opportunity. There is a movement to expand the government rescue plan to include a range of industries and to impose very tight regulations on financial and other firms taking government money that effectively nationalizes them. A move in that direction would further diminish investor confidence.

Don’t believe simple analyses of how the new administration will affect investments. It is normal for analysts to look at campaign proposals and target companies they believe will benefit from the proposals. Those forecasts almost never work out. Ignore analysts who recommend that you buy “green companies” and short defense contractors and health care companies. Wait for detailed plans to be proposed and make their way through Congress.

Taking action simply on the new election of politicians can be a risky business. I have outlined what I think are the most likely changes over the next few years. But be prepared for surprises. You need to build a cash cushion in your retirement plan for the possibility of paying a higher share of medical expenses. Be ready to revise your estate plan sometime next year or early in 2010. Keep an eye out for early signs of changes in retirement plans and be ready to move your assets into other types of accounts in case a major change is in the works. With your portfolio, don’t fall for obvious analysis. There is the potential for surprise in the next few weeks.

From my Reading List November 5, 2008 05:30 p.m.

What was behind today’s big stock sell off? Simple profit taking. We are in a trading range. When the indexes near the top of the range, traders will sell. When indexes near the bottom of the range, traders will buy.

Later this week I will have some comments about how the New Washington, as CNBC was calling it, might affect your retirement finances. For now, take a look at a couple of articles from the last few days that are well worth your time.

Harry Markowitz, father of Modern Portfolio Theory and an inspiration for our investment philosophy, gave his thought on the credit crisis and how to resolve it to The Wall Street Journal. His take, like Anna Schwartz’s, is that the current remedies aren’t really addressing the problem. First, the article explains true correlation much as described in my book, Invest Like a Fox…Not Like a Hedgehog. A major mistake of the failed and failing investment banks is that they did not diversify with uncorrelated risks. Instead, their idea of diversification was to buy a lot of assets with correlated risks but different probabilities of failure. As always, he mentions that today’s financial engineers are misapplying his insights, which I agree with.

Markowitz thinks it could take a year or more to resolve the financial crisis. He says we need transparency of what these firms own and significant analysis to determine what they are worth. The interview is available here.

The other article is on Morningstar.com. It attempts to answer the question: How could so many smart investors have missed the dangers in AIG, Fannie Mae, and other now failed firms? The article focuses on Dodge & Cox. The answer in the article is that while these value investors did significant fundamental analysis of the companies they made one mistake. They stress-tested the companies for a worst case scenario, but the actual worst case was far worse than the firm’s analysts imagined. I also add that forces outside the markets had significant effects. For example, the government seized Fannie Mae and Freddie Mac though there was no immediate cash crunch or threat of bankruptcy. The article is available here.

What’s the Big Deal? October 31, 2008 12:15 p.m.

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