PERSONAL FINANCE NEWS AND COMMENTARY

July 12, 2010

Stocks' "Lost Decade" Revisited

Despite the sharp rise in global stock markets over the past year, many stock market commentators have been calling the 2000s “the lost decade” for investors. It’s been an easy case to make. A glance at a stock market chart over the past decade shows that the Dow Jones Industrial Average began the year 2000, at about the 10,000 level, roughly where it stands today. So from that simple perspective investors as a whole have made no progress over the past 10 years. However, this simple analysis ignores the bigger picture of long-term investing, global investing, and stock market bubbles.

For instance, it just so happens that 10 years ago, the U.S. was in the midst of the biggest stock market bubble in our nation’s history. It took several years for the Federal Reserve to blow up the stock market bubble, beginning in the mid 1990s, reaching extreme velocity in 1998 and 1999 and its apex in early 2000, before crashing to reality by 2002. Although the downturn in the stock market was painful for many investors, it was certainly not unexpected (and had been predicted by many, for those who chose to listen). By the time the stock market fell to its nadir in late 2002, the valuations of the stock market had merely reached a more historically appropriate level. From being grossly overvalued for several years, they had reverted to a more normal valuation.

From that point in late 2002, into the mid- and late-2000s, the economy, earnings and stock prices grew, as real estate and other credit bubbles were inflated, thanks again primarily to the Federal Reserve. By 2007 and 2008, the U.S. economy was again in bubble territory and while stock market valuations did not appear overly excessive, they were based on a bubble economy, which logic dictated would eventually break. As the economy turned for the worse so did stock prices. Once again, the Federal Reserve tried to come to the rescue with super-easy monetary policies as well as other monetary experiments like money-printing, exchanging banks’ bad debt for good Treasuries, and bond market manipulation. During 2009 stock prices again soared as these effects, though inevitably temporary, covered over the structural problems of the U.S. economy.

For an investor, it is not realistic to compare how the stock market has done over a relatively short period of time, and particularly when it follows a stock or economic bubble, such as existed in 2000 and 2007. In fact, if you must compare current stock prices to a previous level in the past decade, I believe the most appropriate level to look at was the period in 2002 as the stock market was making a short-term floor. Because of the continually easy money policies during the 2000s, this period in 2002 and 2003 was about the only period in the 2000s that the stock market was not in a bubble. From that point, the U.S. stock market is up roughly 50% over the past 8 years, or an average of about 5% per year. Including dividends, the U.S. stock market was up an average of about 7% or 8% a year, comparable to its historical average.

The main problem with the “lost decade” idea however, is that it assumes that an investor only invests for a decade or less, or that such a time period should be considered long-term. But while 10 years may be long-term for a personal relationship, owning a car or having a pet, when it comes to investing, it’s not really long-term. True investing means buying companies with the expectation that their participation in the long-term growth of the economy over many economic cycles will produce long-term that outpace inflation. Individuals and companies who start and run businesses don’t typically have expectations of businesses that last a few years. Their expectation is to grow their business over decades, even 100 years or more. Similarly, an investor with money invested in the stock market, should think in terms of decades, not months or years. And although many investors’ time-spans have grown shorter with pervasive 24-hour financial news channels and hourly stock market updates, longer lifespans and longer retirements suggest that for most investors, their idea of long-term investing should be increasing, not decreasing. Even for a worker that is already 40 years old, he or she will probably have at least two decades of working, saving and investing, and then perhaps another two or three decades of living on those savings during retirement. A younger worker, accompanied by even better health and a longer lifespan could easily see six or seven decades of an investment horizon.

So let’s look at how an investor in the U.S. stock market might have done over the truly long-term, one measured in decades. Well, looking back to 1990, just two decades ago, the Dow Jones Industrial Average was at about 2,700. So the Dow has nearly quadrupled since then, giving an average yearly return of about 7%. Including an average dividend yield of about 3%, that’s about an average 10% return for the two decades. During that same span, the S&P 500 index, which includes larger stocks, tripled, and the Russell 2000, which is made up of smaller companies, nearly quadrupled during that period.

Looking back three decades, to 1980, we see that the Dow Jones Industrial Average, which began the 1980s at 834, has gone up about twelve times since then, giving an even more impressive nearly 9% yearly average, not including dividends. During those same 30 years, the S&P 500 index, has gone up ten times, giving a yearly average of about 8%. Including dividends we see quite impressive returns for the U.S. stock market, if one is willing to truly look long term. Yes, the stock market is volatile and is prone to stock market bubbles, particularly with meddling Federal Reserve officials. The stock market on average goes down every three years and falls more than 20% every five years or so. And yes, there are periods that the stock market seems to make limited headway for years on end. During those times, it’s a great case to be saving money, accumulating stocks, buying low, with the expectation of realizing future gains.

By the way, while stocks in the U.S. seem to have given meager returns for much of the past decade, many investments around the world have seen much stronger returns. The “lost decade” idea seems to assume that the U.S. stock market is the only market available for investors. Most U.S. investors are woefully deficient in foreign stocks, often with less than 10% or 20% of their stock portfolio in foreign stocks. That’s surprising since most of the globe’s economic activity occurs outside the U.S., and the U.S.’ share of company profits on the global stage decreases yearly.

Correspondingly, many international stock markets have more fully participated in the world’s economic growth. For example, looking at some major stock market indexes around the world, the Argentine and Mexican stock markets are up about five times just from the beginning of 2000. Similarly, Brazil’s stock market quadrupled over the past decade. The Canadian stock market, most Asian stock markets, and most European stock markets, have also increased more than the U.S. stock market, not even including their dividends, which are often higher than U.S. companies. The Dow Jones Global stock market index, which tracks the stock market performance of most major stock markets around the world has doubled since its lows in late 2002, significantly outperforming the U.S. stock market.

It is impossible to know whether or not foreign stocks will continue to outperform U.S. stocks. However, it seems clear that foreign economies have generally weathered the latest economic downturn, some with negligible ill-effects. And as the majority of global growth has taken place outside of the U.S. in the past decade, it seems reasonable to expect this to continue to happen in the coming years and decades.

This also underscores the need for international diversification. There is no excuse anymore for a lack of diversification with your investments into foreign stocks. Over the past decade there have been hundreds of new mutual funds that invest exclusively in foreign markets, whether in large companies, small companies or foreign bonds. These options have spilled over to 401(k), 403(b)s, and their equivalent, giving workers more foreign options than ever before. The proliferation of Exchange-traded funds (ETFs) has also given investors the ability to easily invest in a global index, specific geographic regions of the world, individual countries, and even sectors within foreign countries. In fact, one problem now is that the wealth of options can be confusing for investors, making it difficult for investors to remember to include international options for their savings.

Despite the sharp ups and downs and overall lackluster stock market returns in the U.S. over the past decade, its true long-term record is very strong. It's true that the world will need to deal with structural deficiencies in the coming years, particularly excessive debt, that will weigh on economic growth. However, for those who choose to attach themselves to the world’s economic growth via mutual funds, Exchange-traded funds, or similar vehicles, while controlling costs and their emotions, will be rewarded over the long term. In the coming years and decades, there will be continued stock market volatility both inside and outside the U.S., but worldwide economic growth will march on, giving those who fully avail themselves of it the best course to secure a promising retirement and financial future.

This article is for informational purposes only. Nothing in this article is meant to provide specific investment advice and is not a substitute for professional advice from a qualified advisor. Since every investor’s investment and personal circumstances are unique, he or she should always enlist the help of a competent and trustworthy professional in addressing their financial needs.

April 26, 2010

Converting to a Roth IRA: A Slam Dunk?

The year 2010 brings lots of tax changes, including changes in tax credits, tax rates and other exemptions. One change that may potentially affect millions of IRA holders is the increased availability for converting IRAs to Roth IRAs.

There are tens of millions of Individual Retirement Accounts, or IRAs, in this country, representing trillions of dollars. Since Roth IRAs came out several years ago, many individuals have been able to convert their regular IRAs into Roth IRAs. These conversions have been done mostly in the hopes of paying lower taxes. Remember that with regular IRAs you�re able to get a tax deduction for your yearly contributions into your IRA. So if I�m eligible, and if I invest $5,000 into an IRA during the year, and I�m in the 25% tax bracket, I would see a $1,250 lower tax bill ($5,000 * .25) compared to not making that contribution. In addition, the earnings over the ensuing years avoid any taxes as long as it remains in my IRA. The downside to these regular IRAs is that when I start to take out my money, typically when I�m 59 � or older, I have to pay taxes on the earned income.

Roth IRAs behave similarly in their tax deferral aspect, but the mechanism for tax savings is opposite to that of a regular IRA. With Roth IRAs you get no income tax deduction when you put money into your account, but when the money comes out (again, after age 59 �) no tax would be due. So the decision of whether to prefer individual IRAs or Roth IRAs, usually comes down to one�s current income tax bracket now compared to what he or she expects to see when retiring. For example, if I�m in a 25% tax bracket now, but expect to be in a 15% tax bracket when I retire, I would lean toward investing in a regular IRA (or 401(k) or 403(b), which works similar to a regular IRA), compared to a Roth IRA. If I can get a 25% tax deduction now, and pay just a 15% tax when I retire, that seems like a pretty good deal.

Conversely, if I�m currently paying 15% taxes, but think I might be paying 25% on my income when I retire, I would be inclined to lean toward the Roth IRA. In that case, I wouldn�t get any current deduction, but would completely avoid taxes on my investment earnings over the coming years. Of course, there are other factors to consider, such as years until retirement, expected earnings, etc., but this basic example is the typical starting point for such a Roth IRA-Regular IRA analysis.

The many people who have a regular IRA and currently pay a low tax rate may conclude that since they expect tax rates to be higher in the future (probably a pretty safe bet), will be inclined to convert their regular IRA to a Roth IRA. Millions already have. However, up until this year, upper income taxpayers, those with incomes over $100,000, have been unable to convert their regular IRAs to Roth IRAs. That income limit is removed for 2010 and millions of upper income taxpayers are considering making the regular IRA to Roth IRA conversion.

Now, everyone�s financial and personal situation is unique and personal finance decisions properly reflect unique circumstances. However, when it comes to tax planning, the planning aspect can only take you so far. The problem with doing such tax planning scenarios is that they involve current tax law, not tax laws one, two, or three decades in the future. From decade to decade, even year to year, we typically see big changes in tax laws, tax rates, tax rules, etc. Specifically, although we may be able to predict that tax rates will generally be higher in the coming decades due to increased government spending, we can�t accurately predict what will be taxed and how. In the case of the Roth IRA, we don�t actually know what the tax laws regarding it will be in the years to come. For instance, because of government debt, the government may decide to tax the Roth IRA upon withdrawal during retirement, fully or partially.

This would not be unexpected. In recent history such tax law changes have occurred, and these have been under times where there has not been severe financial distress in the government which will be occurring in coming years. For example, Social Security benefits were originally promised to be tax free for recipients. Now, many modest income retirees, can expect to see part or all of their Social Security benefits taxed. By the way, the same can be said for Social Security benefits themselves. In the past you could make as much other income as you desired during retirement and you would get the full Social Security benefits you were promised. That�s not the case now. If you make �too much� earned income during retirement, at surprisingly low levels, your Social Security benefits are reduced. So you can easily see lower benefits than promised and higher taxes on those earnings. Similarly, in the 1980s, the tax laws were radically changed, negatively affecting certain investments and �tax shelters�. There have been many other �bait and switch� changes within the tax system in past decades. Again, given that our government will be even more desperate for revenues in the coming decades, it seems likely that these tax law tricks will become more prevalent. If one converts a $100,000 IRA to a Roth IRA, pays 35% taxes on it, but discovers fifteen or twenty years later that he will have to pay another 35% on the proceeds, hindsight will have shown it to have not been the best move to make.

So taking this back to the Roth IRA, I don�t want to dissuade people from investing in or converting to Roth IRAs. I have been a proponent of them for years and I invest in one myself. The decision to convert or not, or even to invest in a Roth IRA, is an individual decision that should be made with careful analysis, and preferably, an unbiased advisor. However, I believe the uncertainties underscore the need for diversification. We often talk about diversifying across various types of investments, countries, and economic sectors, but I think diversifying should extend across available investment vehicles. As with choosing specific investments, one should not have all their investment vehicles in one basket, so to speak. These efforts are simply to guard against possible, and probable, changes in the tax code that will occur in the coming years. As in any other area of life, if it seems too good to be true, it probably is. I�m not predicting doom for the Roth IRA, but I certainly would not be surprised to see Roth IRA tax changes in coming years, probably negatively.

So again, to convert or not, or deciding what and how much to convert, is an individual decision, but it should not be a quick one. The government has extended the bait (conversion) in hopes of hopes of getting immediate revenue, but IRA owners need to consider all the possibilities. Planning is fine, but you can only project what you know. The future is unknowable, and that is certainly the case when it comes to taxes.

This article is for informational purposes only. Nothing in this article is meant to provide specific investment advice and is not a substitute for professional advice from a qualified advisor. Since every investor’s investment and personal circumstances are unique, he or she should always enlist the help of a competent and trustworthy professional in addressing their financial needs.

October 19, 2009

Searching for Yield

A couple of articles ago I was talking about the problems with interest rates being pushed to excessively low levels by the Federal Reserve and the problems it will eventually bring to the U.S. economy. Although the interest rate manipulations have benefited the Fed’s fellow bankers who got burned by taking excessive risks with taxpayers money, these low interest rates have made it hard for savers to earn more than a minimal yield.

Partly as a result of the recent stock market downturn, there is lots of money on the sidelines, earning minimal returns. U.S. savers currently have close to a trillion dollars sitting in money market mutual funds, which are currently paying an average of about 0.6% a year, close to nothing after fees and expenses. Similarly, hundreds of billions of dollars is being held in bank checking and savings accounts, most of which pay minimal interest. In an effort to achieve higher yields, a significant amount of money is going into bond mutual funds. Over the past six months, while just $10 billion of investor money went into stock mutual funds, more than $200 billion went into bond mutual funds. Besides those looking for higher returns than they’re seeing in their bank savings or money market accounts, many of these bond fund investors are those who were burned by the stock market volatility, and are looking for a “safe” place to put their money. In reality, many of these recent investors into bond fund may be doing no more than chasing bond fund returns, just as many of them did with stocks in the years preceding the recent stock market downturn. Even after the stock market’s sharp gains over the past six months, the overall bond market, as measured by the Vanguard Total Bond Market fund, has outperformed the S&P 500 index by close to 10%.

Remember that when you buy a bond mutual fund, there are typically two components that determine your total return. The first is the nominal yield (also called “current” or “SEC” yield). This is the average yield based on the current value of the underlying assets, typically a group of corporate or Treasury bonds. The second component of the return is based on the change in the average of the market value of all the individual bonds in the bond fund. The price of almost all bonds goes down as interest rates go up, and goes up when interest rates go down. The reason that investors in bond funds have generally done well in recent years has not been the result of high current yields on their investments. Indeed, most bond yields, especially government bond yields, have been very low in recent years, with some recently hovering near all-time record lows. The reason that investors have seen such solid and steady investment returns in recent years is mostly a result of declining interest rates. These in turn were a result of Federal Reserve and Treasury manipulation of interest rates in response to economic weakness (and are primarily responsible for the many economic bubbles the U.S. has experienced and is currently experiencing). However, eventually, interest rates will hit a bottom (they may have already done so), and may rise sharply in the months and years ahead. In fact, the extreme financial indebtedness of U.S. consumers and the government warrants a significantly higher level of interest rates that reflect the increased risk of government default and potential for a dollar collapse.

That is not to say that bonds or bond funds don’t deserve a place in investors’ portfolios. For most they probably do. The types of bonds an investor owns and the percentage they should make up of an investment portfolio depends on personal circumstances and individual risk tolerance. The point is simply to be aware of the risks of higher interest rates and recognize what will happen to the price of a bond or bond fund if and when rates rise. For some bond funds, the risk from higher interest rates is very small, while for other bonds funds, investors will see sharp losses from higher interest rates. When observing bond fund volatility, it's clear that short-term bonds are going to be less sensitive compared to longer-term bonds. (A short-term bond is usually defined as having a maturity of less than 2 years; an intermediate-term bond matures in 2-10 years and long-term bonds typically mature in 10-30 years.) Short-term bonds will react less to movements in interest rates compared to longer-term bonds. For example, an investor who owns a two-year (coupon) Treasury bond, at current interest rates, would see the value fall almost 2% for a 1% increase in interest rates. For a ten-year Treasury bond, a one-percentage increase at current interest rates would result in about an 8% decline in the value of that bond. (For the same bond, a two-percentage point increase would result in a 16% decline, and so forth. The value of the same bond would also rise by 8% and 16% if interest rates declined by 1% and 2%, respectively.)

Since bond funds are just a collection of individual bonds there should be a way to measure the interest rate risk for those as well. And there is. It’s called duration. The duration of a bond fund is the percentage that the market value of the mutual fund changes for every 1% change in interest rates. Again, the value will go up with lower interest rates, and go down with higher interest rates. For example, looking at a bond fund, American Funds Bond Fund of America, the average duration is 4.4 years. That tells me that if interest rates immediately increased by 1%, I can expect the value of this specific bond fund to decrease by 4.4%. Note that this does not factor in the higher interest that a fund generates as interest rates increase. Thus, in this way, even though the value of a bond mutual bond fund typically declines with higher interest rates, the higher interest payments offset the bond value’s decline to some extent. Taking another example, Vanguard’s Short-term bond fund’s duration is currently just 2.6 years, so a 1% increase in rates would result in just a 2.6% decline in the value of the fund. Conversely, Vanguard Long-term Bond Index fund’s duration is 11.6 years, resulting in a significant 11.6% decline in value if interest rates increase by 1%.

As with all investments, the tradeoff between risk and return is what all bond fund investors face. While the Vanguard short-term bond fund is much less volatile, the current yield is just 1.6%, so an investor is paid little for the security of a “low-risk” bond fund. At the same time, investors in Vanguard’s long-term bond fund, who currently receive a 5.0% yield, could easily see a 10% or 20% decline in the value of their bond fund.

Although interest-rate risk may be the largest risk for bond fund holders, there are other factors that bond fund investors need to be aware of: the average credit quality of the individual bonds, the leverage used (in some cases), and the industry concentrations. During the credit problems in the last two years, many bondholders who thought they were holding “safe” bond funds, many of which included risky mortgage-backed securities, resulted in sharp losses for their supposedly safe bond funds.

Just like with stock mutual funds, bond fund holders need to understand the risks of their investments. While bonds can make sense for many investors of all ages, the strong performance of bonds during the past decade, has lulled some bond fund holders into believing that bond funds are “riskless”, that never lose money. But there have been many instances of specific bond mutual funds losing 20%, 30% or more in short periods of time. For example, during the past two years, as economic conditions deteriorated, some bond mutual funds that invested in “safe” mortgage-backed securities, resulted in sharp losses for many bond fund investors. Bond fund holders need to understand what they’re buying or thinking of buying. In the follow-up to this article I’ll discuss some other things to think about when investing in a low interest rate environment.

This article is for informational purposes only. Nothing in this article is meant to provide specific investment advice and is not a substitute for professional advice from a qualified advisor. Since every investor’s investment and personal circumstances are unique, he or she should always enlist the help of a competent and trustworthy professional in addressing their financial needs.

September 8, 2009

Why Social Security won't give you a real retirement

This past week, tens of millions of Social security recipients were informed that they would receive no increase in benefits for not only this coming year, but the following year as well. This continues a multi-year trend of seniors not being fully compensated for the realities of living in an inflationary environment.

For the past 35 years, Social Security benefits have been increased yearly by the rate of inflation, as measured by the Department of Labor. These changes are meant to keep up with the increases that seniors see each year in their cost of living. But do they really? I�ve remarked before that one of the government�s main goals is to create inflation, while at the same time giving the impression that there is very little inflation. Our government needs inflation to increase company sales and asset prices, like stocks and real estate, which will result in higher tax revenue and allow the government to continue to rapidly expand its various programs. At the same time, the government will benefit from underreporting actual inflation so it can give modest cost-of-living increases for its Social Security payments and other government pensions that are tied to the level of inflation. Also, keeping the appearance of a low-inflation environment allows them to keep interest rates very low which keeps their borrowing costs on their multi-trillion debt somewhat manageable. Several times during the past two decades the government has modified the way inflation is calculated, each time resulting in lower reported inflation. The government knows that people must believe inflation is low (called �inflation expectations�), because once inflation gets a hold of the populous it is hard to wring inflation out of the system. In the end, the government looks for a fairly high level of inflation, but reports a negligible level.

To underscore this point let�s look at how well Social Security benefits have kept up with actual cost of living expenses over the past decade. Since 1998, the average yearly increase in Social Security benefits (to the end of 2008) has been 3.0%. Compounded over 10 years, that amounts to a 35% increase in Social Security benefits. Now let�s look at some consumer costs have changed over those 10 years and see how they compare with the Labor department�s 35% in reported inflation.

A decade ago, in 1998, a gallon of gas cost about $1.40, less than half of what it was last year, at over $3 a gallon. Likewise, health insurance premiums rose more than 100% over the decade from about $5,900 to almost $13,000 in 2008. To the frustration of parents of college-age kids, college education costs continued to rise sharply during the 2000s from $14,508 for the average private four-year college in 1998 ($3,243 for public four-year college) to $25,143 for the average private four-year college in 2008 ($6,585 public four-year). Those are 73% and 103% increases, respectively. The largest expense for most individuals, the price of a home, has also risen sharply during the past decade. The average house price nearly doubled from 1998 to 2008, from about $113,000 to $215,000, even after recent declines in many real estate markets. And of course, most Americans are paying significantly more for utility costs, auto insurance, property tax rates, food, and most everyday services.

Inflation is correctly called the stealth tax. It�s a hidden tax that most Americans pay little attention to, which is exactly how the government likes it. It�s the result of overspending and excessive money-printing by the government. Basic economics says the more of something that exists the less valuable it becomes. So it is with money. With inflation, every year your dollars are worth less and it requires more of them for everyday expenses. Judging from recent spending intentions and money printing going on in Washington, the government has every intention of continuing their inflationary ways. Imagine if the government suddenly printed a quadrillion dollars. While the price of almost everything would go up, it would do so because each remaining piece of paper money would be nearly worthless. This is what is happening every day but at a slower pace (so far).

The government�s back is against the wall. They are running out of money and realize it will become increasingly difficult to pay Social Security benefits (as well as Medicare and other so-called entitlements), particularly as increasing numbers of baby boomers demand more retirement and health services. At the same time, the government is guaranteeing more than ten trillion dollars in bad debts in the mortgage and financial industry. As these debts go bad, more money will be printed, furthering the inflationary fires. Our dollar will continue to weaken. The price of oil and gas will rise sharply, along with the majority of the things we buy.

Even more so than in decades past, in the past several years we have seen an increasing disparity between reported inflation and what individuals experience in their common everyday experience. Because of their fiscal demands and debt woes, this disparity may grow ever wider, with seniors find their real (after their true cost-of-living) Social Security checks getting smaller. While to this point, Social Security benefits have been primarily reduced by the stealth tax of inflation, fiscal realities will soon demand more overt changes such as increasing the age that retirees will be entitled to full Social Security benefits.

Over the past few decades, seniors have become increasingly reliant on Social Security benefits. The majority of Social Security recipients rely on Social Security for more than half of their income. A third of Social Security recipients rely on Social Security for more than 90% of their income. These realities will create challenges for tomorrow�s retirees. Unfortunately, while real Social Security benefits decline, a greater percentage of workers will have no private pension. Even with a larger workforce, two-thirds of defined-benefit plans (traditional pensions) have closed over the past twenty-five years. And while some investors are saving for retirement, others aren�t. A full third of workers say they have saved nothing for retirement. A similar percentage has saved minimal amounts that will contribute little to provide for a comfortable retirement.

The financial realities of over-spending, over-indebted governments will mean that today�s pre-retirees cannot depend on the government to take care of them. Social Security will be modified outright to take full retirement benefits to 70, 72 or 75 or higher or benefits will be taken through the stealth effect of inflation. In the years ahead lifestyle changes will be made by pre-retirees as they are forced to save more and spend less. This will be the reality of living with the decline of the Social Security system and a government moving rapidly toward insolvency.

-------------------------- I realize I did not follow up on my previous article as I indicated I would do. With a six-week old baby available time has been somewhat limited. In the coming week I will add a follow-up.

July 15, 2009

Living in a low-interest rate world

As everyone knows, for the past year there�s been a shortage of good news for most stocks and mutual fund owners. However, it�s not just stockholders who have been disappointed this year. Savers in banks and bonds have not been overjoyed when examining their monthly statements.

As part of the Federal Reserve�s and Treasury�s scheme to revive the economy, they have lowered short-term interest rates to 0%, and have jaw-boned the bond market to reduce long-term interest rates. In an effort to keep interest rates artificially low, we�re even seeing the Treasury print money and then use the monopoly money to purchase the government�s own bonds.

Unfortunately, from an economic perspective, these actions will have little positive effect on long-term economic growth. The misguided leaders of the Treasury and Federal Reserve believe that the remedy for every economic downturn is for individuals, businesses and governments to borrow and spend even more than before. But it is this mentality that has caused much of the economic distortion and resulting bubble-bust cycle within our economy through much of the past two decades. Within just this past decade, these reckless policies managed to create the biggest housing and credit bubble we have ever experienced, with Americans suffering from the resulting high inflation and the inevitable bursting of these bubbles. These problems would have been much less severe if not for the irresponsible actions of our Federal Reserve, namely ultra-low interest rates and excessive money creation.

This cycle will continue to repeat itself until the government-led borrow-and-spend response to economic downturn is broken. When an economy, or an industry, has excessive artificial demand (such as housing, autos, and venture capital in the mid-2000s, �dot.com� companies in the late 1990s, Japanese real estate in late 1980s, etc.), lower interest rates will not stop an economy or those bubble sectors from contracting. Simple economics dictate that supply must fall to a more normalized level of demand. That is what our economy is going through right now. In the latest bubble, key industries in finance, autos, and housing had become such an inflated part of our economy due to excessive and easy credit, that the natural contraction in those industries is having a very strong ripple effect across our entire economy. At this point it would be folly to try to re-inflate those sectors because a normalized level of demand won�t allow it. Trying to do so via low interest rates, excessive borrowing and money printing will go simply cause money to once again go into unproductive areas and create high levels of overall inflation.

It is a fundamental economic law that it is savings that sow the seeds for future economic growth. In the absence of savings, encouraging excessive borrowing to increases spending will only pull future growth to the present, create further distortions in the economy and lead to sub-par long-term economic growth. It will further perpetuate inflation as well as the boom-bust cycle.

The ways that individuals suffer from these harmful interventions should be clear by now. Business cycles become more severe, debt grows must faster than it should, further destabilizing the entire economy, not to mention individuals and businesses. Inflation is much higher than it would otherwise be with a more sane and stable monetary policy. It�s the ordinary Americans who are left holding the bag in the form of higher inflation and sharp increases in job losses in bubble areas of the economy.

Lastly, these imprudent decisions from our government punish the country�s savers. That�s a shame, since it�s their savings and investment that would ordinarily furnish the capital, the fuel, for future economic growth. But currently, the reward for savers who put money in their local bank is usually close to nothing. Low savings rates in the bank and increasing interest rates in credit cards have encouraged more Americans to work on paying down their credit cards. Over the past several months we are starting to see small declines in consumer debt (though at about $2.5 trillion, it's still very large). Though the media spins higher savings and paying down debt as a negative, paying down higher-interest credit cards is always a good step for individuals and will actually lead to stronger long-term economic growth (especially if it is matched by falling government debt, though that doesn't appear likely any time soon).

Next time I�ll look again at saving and investing in a low interest-rate world. It�s certainly more difficult, but there are things we can do to save money and increase returns.

May 4, 2009

Deflation Will Slow; Inflation Will Grow - Part II

In my last article (sorry for the delay, tax season leaves little time for writing), I talked about the reasons why inflation will persist in coming years. Because of the very high debt levels among consumers, corporations and governments, an economic environment in which prices are stable is unthinkable for the government. Since collectively, our country saves almost nothing, the only path to economic growth, in the eyes of the government, is for debt to continue to rise sharply. And the only way to pay for these large increases in debt is to attempt to increase the price of assets like stocks, bonds and real estate. Inflation is the �solution� to this goal. Without inflation, the whole debt bubble will come tumbling down. We can see how strenuously the government is trying to avoid any reduction of debt. The government has transferred trillions of dollars of bad debts from shaky financial companies onto the balance sheet of the federal government, with current and future taxpayers to pick up the bill. Why would it do such a foolish thing? In their view, if they didn�t, asset prices would decline further, tax revenues would decline, and the government would have no choice but to shrink, something it is committed to avoiding at all costs.

But of course, the government must cloak its true intentions, so it obfuscates the situation by publicly stating the myth that if we don�t have �healthy� inflation, prices will decline. According to these �experts�, this will then lead to debilitating deflation, a greater risk to our economic prosperity than even inflation. After all they say, we see how deflation can destroy an economy, pointing to the economic contraction of the 1930s. That the contraction was in fact the inevitable result of inflationary policies of the 1920s as well as restrictive trade policies, debilitating price controls and a generally anti-business economic environment is not discussed.

No, the real enemy is deflation, they say. Even stable consumer prices are not appropriate. In early 2009 San Francisco Federal Reserve head Janet Yellen said the Federal Reserve would not let inflation fall below 1%, stating, �We need to make it clear that (inflation less than 1%) would be unwelcome and we would fight it.� I�m sure the average American who has real bills to pay would find it difficult to understand why steady consumer prices would be a bad thing and something to �fight�.

Thus, for the past two years, the Treasury and the Federal Reserve has been on an all out war to defeat the enemy of stable prices. For leaders at our Treasury and Federal Reserve, the only real treatment they know in response to an economic downturn is money printing. Recently the U.S. Treasury has been printed hundreds of billions of dollars out of thin air which it is using to buy bonds from our own government, as well as shaky mortgage debt that other financial institutions are staying away from. Thus far, various government institutions have guaranteed more than ten trillion dollars to shore up weak companies and bad debts. With these trillions of dollars of extra debts they�ve taken on, the government is even more committed to creating inflation, to help reduce the debts they�ve taken on.

The problem with this money creation is that every dollar printed reduces the value of American�s money. Just like any with anything, if you make more of something, its value is proportionately reduced. The reason that diamonds and gold are so valuable is because the amount (supply) is so limited. Every day the government prints more dollars and increases the money supply, it decreases their value. The holders of U.S. dollars, American consumers, as well as investors in U.S. bonds, are daily seeing the value of their money continue to decline in value. For example, in 1971 the U.S. government abandoned the gold standard allowing them to print money at will. In the 38 years since then the dollar has lost more than 80% of its value, even based on its own (understated) levels of inflation. Put another way, something that cost $100 back in 1971, will now require more than $500.

Since we can expect the government to continue their inflationary efforts, we will continue to see our dollars become less and less valuable, and the products we buy become more and more expensive. Every effort our government is currently employing to increase inflation will further impoverish American consumers. Again, the point should be clear: while the government benefits from inflation, ordinary Americans are the ones who suffer.

Given the realities of continual and increasing inflation, what can you do to protect yourself? Unfortunately, one of the distortions that the Federal Reserve is engaged in is manipulating interest rates to very low levels. This takes away the incentive for individuals to save and invest, who are then often tricked into spending more. While the government likes this, since it helps to keep a short-term stimulus to the economy, in the long-run it is a recipe for below-average growth for the economy as a whole, and results in millions of families who over-extend themselves and wind up with severe debt problems, foreclosures and bankruptcies. Another result of these interest manipulations is that they increase speculation, often in areas of the economy that are not appropriate, resulting in misallocation of our resources. We saw this in the late �90s with the dot.com bubble and again in the mid 2000s with the real estate bubble. It is incredulous that the Federal Reserve, who has acknowledged that ultra-low interest rates helped to fuel these bubbles, is now trying to reflate another bubble, further distorting the economy, which will again lead to an economic bust down the road.

As far as saving money in a low-interest rate environment, it�s always a good time to save. If you don�t like keeping money in a checking or savings account that earns almost nothing, you can look at higher-rate CDs (look at bankrate.com). These are very safe, liquid and will generally be insured up to $250,000 (check with the institution). With a little more risk, you can look at individual bonds and bond mutual funds (generally safer than individual bonds). There is a lot of variability among bond funds so do your research or find a capable advisor who can help you understand the risks.

Given that inflation seems destined to be with us for some time to come, owning equity (stock) investments will be appropriate for many individuals. We can see that over time, a few investments generally keep up with inflation over the long-term. These include company stocks, real estate, gold and other commodities. The caveat here is that, like anything, these investments will generally keep up with inflation over the long-term, but in the short-term will be volatile. Also, the attractiveness of these investments is dependent upon not buying these when they�re overvalued, which all investments occasionally are. If you consider stock investments, don�t ignore international stocks (or international stock funds). It is nearly a certainty that many areas of the world will experience higher economic growth compared to the U.S. in the years ahead. The massive debt overhang in the U.S. will weigh on economic growth for years to come and will likely get worse as baby boomers retire and further strain our debt-laden economic system. Therefore, quality stocks in stable foreign economies should be a part of any American�s stock portfolio. In addition, if our dollar depreciates because of misguided economic policy, the value of these international stocks will rise, when priced in our dollars.

Inflation is a reality in the life of Americans. While the government may pretend it isn�t significant, everyday consumers know better. If you have long-term goals, at least some of your money should be invested in a way that will keep up with inflation. If you�re retiring in 25 years, you will have to deal with an economy in which prices aren�t where they are now, but perhaps 3, 4 or 5 times that amount. That is the reality of an inflationary economy. One should save and invest accordingly.

February 3, 2009

Deflation Will Slow; Inflation Will Grow - Part I

One of the primary reasons for the current global economic downturn is because of overly cheap debt, and excessive debt, in past years, which helped lead to unsustainable economic bubbles. Over the past two years, these bubbles have burst, causing declines of tens of trillions of dollars in the market value of worldwide assets, which has led to a retrenching by business and consumers. Much of the debt buildup over the past few decades, and especially the past decade, has been in the U.S. For example, over the past ten years, total U.S. household debt increased from roughly 60% of GDP (Gross Domestic Product) to more than 100% of GDP. Federal debt outstanding more than doubled during this same period. Most other levels of consumer debt and debt ratios are at or near record highs. At this point, the proper course of action is to allow consumers, businesses and governments to continue retrenching and adapt to a less-leveraged, lower debt economic structure. Incredibly, the government is trying to prevent this by forcing interest rates to the lowest levels on record, massively expanding the government�s balance sheet with debt (a trillion dollar increase in three months), and further weakening our country�s financial balance sheet with massive new spending programs. Unfortunately, most of any proposed spending will be determined by special interests, big finance and backroom deals, not sound economics.

The reason for the government�s extraordinary efforts? The same reason used by Alan Greenspan, past Chairman of the Federal Reserve and other government officials back in the recession of 2001-2002: an alleged fear of deflation. Remember that deflation is defined to be generally falling prices in an economy � this includes asset prices like stocks and housing as well as everyday consumer goods. The fear of deflation is based on the idea that falling prices will weaken consumer demand, weakening job growth, reducing prices still further, further weakening the economy. But is this often-repeated statement, and the associated fears based upon deflation, really accurate? Further, why should a recession, which is a normal part of the economic and business cycle, automatically give rise to fears of �dangerous� deflation? The U.S. has had dozens of recessions in its history and until recent times, deflation, and certainly flat prices, were not seen as an economic threat, as they are now. Indeed, over the entire 19th century, roughly the first half of our nation�s history, the price of a basket of goods actually decreased, by an average of about 1% per year. This was primarily due to efficiencies and improved productivity in its production of goods and services. Indeed, flat prices or slightly deflationary prices are normal, reflecting productivity improvements, not something to be feared.

But wait? Wasn't it deflation that turned what would have been a recession in the early 1930s into the Great Depression? Certainly asset prices fell as the stock market bubble burst, which coincided with the reversing of a credit explosion, as well as a structurally weak banking system. But what caused the recession to then turn terminal was the government's misguided efforts to restrict global trade, severely reducing foreign markets for American-made products. Further, and unbelievably, taxes were sharply increased during the 1930s. The top income tax rate for individuals was increased from 25% to 63%, while corporate income taxes were doubled. This had the predictable result of stiffling business innovation and job-creation and reducing saving, spending, and economic incentatives, among working Americans. During the 1930s prices generally fell, but it was not deflation that caused the economy to deteriorate but simply a by-product of previous excess speculation and on-going government policy mistakes.

So overall, does economic growth really suffer with deflationary or flat prices, as opposed to an inflationary economy, as our leaders and the media often state? Generally speaking, the evidence does not support that theory. During the entire 1800s, economic growth was roughly comparable to average growth during the following 110 years (generally 1% to 2% in long-term yearly �real� economic growth throughout our nation�s history).

There appears to be great fear right now, judging by the words of government officials, financial commentators, and media, that consumers aren�t spending �enough�. Specifically, Their spending �only� increased 3.6% for all of 2008. Believe it or not, that was the lowest measured increase since 1961! Given the generally high levels of consumer debt and low savings rates, you would think this would be welcome news from economic commentators. Likewise, the personal savings rate, which had been down to 0% in recent years, has rebounded in recent months to over 3% (yet still just 1.7% for all of 2008). Is this �excessive� saving? Of course not. Citizens in many European countries save more than 10% of their income while average residents in India, China, Korea, Hong Kong, and others in Asia, often save 20%, 30%, even 40% of their income. By comparing economic growth and savings over a country's history as well as comparing countries to each other, it is well-established that economic growth is based on the level of savings and investment, as well as productivity. No surprise then that for decades, many of these �high-saver� countries have seen much higher growth rates compared to the U.S. It�s bewildering that the majority of our elected officials, as well as heads of the Federal Reserve and Treasury Departments (who should know better), state, at least publicly, that spending, not saving, is the key to economic growth. A first-year economics student, and certainly the chairman of the Federal Reserve, knows that real, long-term economic growth is based on high levels of saving, investment and productivity. While it�s true that a reduction in spending will have a short-term effect on certain industries, particularly retailers, higher savings rate produce higher economic growth over the long-term and a much more balanced economy and financial system.

Economists are often puzzled as to why our economic expansion in recent years has produced �sub-par� growth rates. One very important reason is explained by our meager savings rates. Even this low economic growth was due in part, to savers in other countries who were able to buy our stocks, bonds and businesses. In effect, they have been doing the saving for us. We can only wonder (with great fear) what will happen if those foreign savers decide to invest in their own countries instead of ours, which they appear to be in the process of doing.

So then, back to our original question: what is the real reason for the great fear among government officials of deflation? The real reason is not their concern for the economy per se, but specifically, on asset prices. The reality is that our economy has become so dependent upon rising asset prices and debt has grown to such enormous levels that the government feels it cannot allow any meaningful slowdown in asset prices, such as stocks and real estate. If such prices fall, which they have done the past couple years, this results in lower tax revenues, which makes it more difficult to pay back those debts. Governments need strongly rising asset prices in order to have a chance to come close to balancing their budget and be able to pay the interest on their mountain of debt. Since 2001, the U.S. government has added an average of more than $500 billion each year, which increased to more than $1 trillion the latest fiscal year. Trillion dollar deficits may continue for years. Given these incredible increases in government debt, not to mention the debt of America�s consumers, businesses and financial companies, the government has a strong interest in creating high inflation to enable the government to make their interest payments on their debt. Given these debt realities and excesses, even flat prices asset prices will not suffice. So when you hear the government talking about the dangers of deflation, what they�re really worried about is asset prices that don�t rise quickly enough. Since much of the taxes we pay, including income taxes, property taxes, corporate taxes, and capital gains taxes, rise as inflation rises, the government needs to have inflation to pay its bills and pay for its taxpayer promises. If there�s no inflation, then taxpayers won't pay higher taxes each year. The government needs inflation and it works tirelessly to create it. We�ll look into this a bit more, and how it impacts your finances, next time.

December 1, 2008

Bear Market Thoughts

Excepting an incredible December surge, the performance of the U.S. stock market looks to go down as the worst market since the 1930s. While the market, based on the S&P 500 index, is currently up more than 10% from the market�s lows last month, it is still down more than 40% for the year. At the same time, volatility has taken a very noticeable leap upward this year, with volatility levels far higher than in past years and close to all-time high levels. In recent months, nearly every day we have seen news of lousy economic conditions, news of tottering banks and insurance companies and the near-collapse of previously strong companies. The U.S. government is fighting an uphill battle in its single-handed efforts to rescue the entire financial sector in an effort to prop up an over-leveraged and ailing industry.

Every economic cycle is unique, but many economic downturns are the result of the bursting of a bubble. This time the bursting is particularly damaging to the economy because we had so many bubbles simultaneously � a housing bubble, a credit bubble, a mortgage bubble, a commercial real estate bubble, derivatives bubbles - generally asset price and financial bubbles. The range of these current bubbles, each in various stages of the deflating process, will likely necessitate an acute and long-lasting economic downturn. Worse, many of these bubbles extended around the world causing the simultaneous implosion in asset prices we are seeing around the world. Government efforts to prop up and re-inflate all these bubbles simultaneously will be impossible, and such efforts will likely cause more problems than they solve. The normal course of an economy after any bubble is to regress to the economic level that preceded the bubble. Just to take the case of the housing bubble, which existed roughly from 2001 to 2006, we would expect for housing prices to regress to those levels (accounting for inflation) that existed at the beginning of the bubble. That will be most noticeable of course, on those areas that participated most fully in the housing bubble. Those areas could see prices fall another 25% or more before they get back to trend-line (other areas that are already at or below fair-value will see stable or gradually rising prices).

It�s a similar story for credit expansion. From the beginning of this decade, consumer debt (autos, credit cards, etc.), mortgage debt, business debt, and federal and state government debt all increased far more than incomes, overall economic growth and normal trends. Clearly, excessively low interest rates and large increases in the money supply encouraged all economic participants � governments, businesses and individuals � to take on excessive debt. Simultaneous increases in asset prices prompted excessive risk-taking, more debt expansion leading to an enormous credit bubble. Excepting extraordinary efforts from government action, the amount of outstanding credit will fall to more normal, "trend-line" levels.

This appears to be happening now, as excess credit is liquidated and will continue to do so for some time until ratios decline toward a normal level. This will continue to have a short- and intermediate-term impact on the economy, with certain sectors especially hard-hit. The financial sector � including mortgages, derivatives, banking and credit - will be the hardest hit and have the greatest decline compared to the bubble years. Many areas in the financial and banking sector will go away entirely, while others will survive, but significantly reduced in importance. In the past two decades, and especially in the last decade, the financial sector built up an incredible level of debt. At such incredible leverage and debt levels it took just a small decline in the asset prices the debt was built upon � houses, stocks, derivatives, junk bonds, etc. � for these companies, and the entire financial sector, to be technically bankrupt, prompting the government to step in and offer taxpayer money to attempt to prop up the industry. The financial sector cannot be �restored� (the term Federal Reserve Chairman Benjamin Bernanke keeps using). It must be allowed to be rebuilt piece by piece but in a more sane and appropriate manner. Pushing more money into obsolete and failing financial (and other) companies does more harm than good by putting productive capital into declining and wasted assets.

We are now seeing how the changes in the financial landscape are impacting the general economy. For instance, over the past year, more sensible lending standards and extensions of credit have reduced demand for �big-ticket� items like automobiles and houses.

Given the extent of the changes in the economy, and that the stock market generally reflects economic conditions, it would be surprising if the stock market had not taken a serious stumble. It's the result of the transition from a bubble economy to a more normal, but healthier, economy. While the stock market will continue to be volatile and may fall further in the short-term, in the long-term, ten or twenty years out, the stock market will be higher, perhaps significantly so.

So as an investor, how does one respond to all these changes on the financial and economic landscape? Well, we can start with the good news. Based on various valuation benchmarks such as price to book and sales ratios and dividend yields, this is the best investing environment in perhaps fifteen years (with the possible exception of the market�s absolute post-bubble lows in late 2002). Certain areas of the U.S. stock market and many foreign stock markets are finally at reasonable valuations where they haven't been in years. This is not to say markets can't go down further, but if so it will mean even better valuations and higher returns for long-term investors. For someone investing for the long-term, say ten, twenty or thirty years, this is a great time to invest.

With the tremendous volatility we�re currently seeing in stock markets, and with most markets down by half or more this year, it�s more important than ever to keep an eye on the long-term. If you�re young and will continue to be investing in a retirement plan, this is a wonderful opportunity to take advantage of lower prices. Your contributions and reinvested dividends will translate into better long-term returns than would have been the case just a year or two ago. But this only works if you are able to look the other way when the financial �news� spouts their daily commentary and that you can maintain perspective when you see your investment statements. Long-term investors need to be truly long-term. Someone who thinks he or she is a long-term investor but is an actually a short-term investor at heart is typically the investor who buys high and sells low. An investor who thinks long-term investing means investing for a single year should not have much money in the stock market. Long-term investing in the stock market means investing for ten, twenty years and more.

Unfortunately, with the rapid-fire media environment and a short-term oriented society, regarding their investments, most people are fixated on the past several months, or perhaps couple of years. More appropriate, if looking in the rear view mirror, is to look back 25 years, to see how the stock market has done. Based on the S&P 500 index, the broad U.S. stock market index, the market has gone up by more than five times, not counting reinvested dividends. Looking out 25 years into the future, given today�s reasonable valuations I think we could expect to see similar numbers. But that�s only possible if you�re willing to look (and stay invested) beyond today�s troubles.

September 19, 2008

Bailout Nation

The federal government continues its march toward socialism with yesterday's scheme to create a "resolution" fund, whereby the Treasury, and U.S. taxpayers, take on much of the bad debts of the entire financial services industry. This is similar to what it has done in past months in its bailouts of overindebted mortgage-holders, as well as the private and publicly-traded companies of Bear Sterns, Fannie Mae, Freddie Mac, and AIG.

Despite being wildly unconstitutional, unethical and irresponsible, the U.S. government has decided to take money from its taxpayer to give to the banks, hedge funds, foreign nations and other entities that bought, leveraged and layered those risky loans. Just to be clear: these bailouts are directed toward, and will benefit the most, those entities that took the biggest risks. Bear Sterns, Fannie and Freddie and AIG, and many others being rescued all were reckless in their investments and extremely overleveraged. At the same time, many more responsible companies, especially smaller ones, are allowed to go bankrupt daily without any sort of government assistance.

Because of fear of a so-called �contagion� effect, these bailouts are being done with the guise to maintain the health of the economy and the housing market. Unfortunately, there appeared to be little concern for the long-term health of the economy while these problems developed over a period of many years. The Federal Reserve, the head of the banking system, encouraged banks to relax lending standards to almost nothing, especially on mortgage loans; it encouraged banks to slice and package their debt and sell it to investment banks, pension funds and insurance companies, ostensibly to �reduce risk�; it encouraged financial companies to lever up, notably in the case of Fannie Mae and Freddie Mac; it kept interest rates excessively low, and generally encouraged excessive risk-taking thoughout the economy.

Incredibly too, the enormous buildup of financial derivatives has been with the support of the Federal Reserve and Treasury. Indeed, Alan Greenspan, former head of the Federal Reserve, spoke on several occasions of how this massive buildup in financial derivatives changed the financial landscape for the better, which they said would allow companies to reduce risk. Going all the way back to 1998 when the head of the Commodity Futures Trading Corporation (CFTC), expressed concern about the huge increases in derivatives, Greenspan said any regulation risked disrupting the capital markets and economy. So while others could see even then this problem was a growing danger (although the derivatives market was a tiny fraction of what it is now), the head of the banking system and other government leaders did nothing, and would continue to do nothing for the next decade to rein in or regulate these risky derivatives and their inevitable consequences.

Even after the credit downturn hit in the summer of 2007, the amount of outstanding derivatives on mortgage loans has continued to increase substantially. Worldwide derivates outstanding are estimated to be in the area of $600 trillion, up about six times since 2001. This of course is a primary risk to the financial system and perhaps the major reason these companies are being rescued. If a company has hundreds of billions of dollars of debt with trillions of dollars of derivatives based on that debt, any default on that debt can create a snowball effect that can rampage though the system. It was for this reason that for years Warren Buffett, the incredible billionaire investor, has called these credit derivatives �financial weapons of mass destruction�. Again, our Congress, the Treasury, and Federal Reserve did nothing during the time this derivative time bomb was building but in fact was there helping to make the bomb bigger.

So now taxpayers are absorbing the losses from the errors of the government and the extreme risk-taking from corporate executives. These bailouts generally involve exchanging taxpayer dollars for illiquid and often worthless bad debt, notably mortgage debt (often called �toxic waste� in the industry). The Treasury hopes to unwind this debt at some point in the future when the industry is more stable. But who would ever be willing to buy assets at full face-value that intrinsically have almost no value? These various swap and loan schemes are somewhat like going to a garage sale, but instead of paying reduced "garage-sale" prices, everything is bought at the original retail price for those products with the hope to sell it at a later date at the same high price you paid. It is an impossibility that taxpayers will ever be made whole on this money since the mortgage loans much of it is based on continues to be defaulted on daily.

Adding up all the past bailouts the last several months and the proposed bailouts it is likely to cost taxpayers in the neighborhood of $1 to $2 trillion, perhaps much more. Government officials and commentators who suggest a lower number are being unrealistically optimistic, as they often are. Benjamin Bernanke, current head of the Federal Reserve estimated last year that the total losses from the subprime meltdown would not exceed $100 billion. So far they are over $500 billion and rising daily. Also last year as economic conditions were starting to unravel, Henry Paulson, the head of the Treasury said, �this is the strongest global economy I�ve seen in 32 years." For many months thereafter Paulson repeatedly claimed that mortgage debt problems were �contained�. Apparently not. Remember that even if this money is simply created out of thin air, via the printing press, every American will see a corresponding loss of value of the dollars in his or her pocket, bank and 401(k).

You will hear commentators and governments officials say these bailouts had to be done to maintain the economy and financial system. But we should never have been in a situation where the financial system is so fragile, so leveraged, so exposed to bad loans, that the (inevitable) bursting of the real estate bubble would lead to its collapse. (By the way, previous Federal Reserve Chairman Alan Greenspan continued to deny the existence of a real estate bubble during the years it grew, though the most cursory assessment clearly showed one.) This buildup of debt, leverage and risk has been fostered, especially by Greenspan and the Fed�s current chairman, Benjamin Bernanke, over a period of twenty years.

It�s sad to see the state of the American economy, specifically the financial system, that it had to be rescued by its taxpayers, with or without their consent. Even more sad is that this was not inevitable. Lawmakers, the Federal Reserve and the Treasury have had years to avoid this situation but they pretended not to notice, more concerned about keeping risk-taking and therefore government revenues as high as possible. Now, of course, just like after the government tightened lending standards after the damage had been done to the mortgage industry, the government is ready to step in after the damage has been done to the entire financial services industry. For years this crisis will be used as an excuse for more government regulation, which will further damage a crippled industry. The damage has been done. To the reputation of American companies, the government, the taxpayer, the dollar and our standard of living.

Unfortunately, while Wall Street temporarily celebrates a bit at this government intervention and a respite from further banking failures, I fear that this collapse will cause the current recession to last much longer. Just like in 1989-1992 the bailout of the savings and loan industry (which cost taxpayers �only� $160 billion), helped lead to three years of recession and an extremely weak economy, I believe this current financial collapse will further weaken the economy, undoubtedly the standing of American financial institutions, possibly for years to come. While the Federal Reserve, the Treasury, Congress, and the crony heads of many financial institutions are responsible for the current mess that we�re in, it will be ordinary Americans that will suffer during this long recession as they try to rebuild our broken economy.

One final note. Many people are rightly concerned with their money, given the many financial institutions that have gone belly-up or are currently on the ropes. Remember, that if your money is in a FDIC insured bank, which most are (there should be �FDIC insured� signs at your bank or you can check at www.fdic.gov), you are government-insured up to $100,000 per individual, per bank. If you have more than $100,000 in two or more accounts, you may be covered depending on the ownership. For example, you may have $80,000 in a joint account, $70,000 in a personal individual account and $80,000 in an IRA. In this case, it is likely that all three are protected up to $100,000 each (again, assuming it is an FDIC insured bank). Your bank should be able to tell you if your various accounts are federally insured and completely protected. If your accounts exceed those insured limits it would obviously be wise to spread your money among banks and/or accounts such that all your money is insured.

For a brokerage account, such as one at Merrill Lynch, Fidelity, E*Trade, etc., your securities (stocks, bonds, mutual funds, etc.) are guaranteed up to $500,000, including up to $100,000 for cash holdings. These are SIPC (Securities Investor Protection Corporation) insured. The same advice holds: if you have more than $500,000 in securities or $100,000 in cash, it would be wise to diversify some of it to another institution.

August 25, 2008

With Investing How Long is Long-Term?

The last year has been challenging for investors around the world, with many stock markets down 15%, 20%, 25% or more during that time. With 24-hour financial news coverage most investors are hyper-aware that the markets are �doing badly�. Recently I read an article by a commentator bemoaning the loss of stock market wealth and how retirees were going to have a very difficult time. Given his apocalyptic tone, you would have thought that the stock market had been going down for ten years and was a fraction of what it had once been. In fact, the overall U.S. stock market hit an all-time less than a year ago. And while the stock market is down about 20% from that point, it is now roughly equal to where it was in mid-2006. And that doesn�t account for dividends which have paid investors about 2.5% per year.

It�s important to remember that stock market declines, corrections, bear markets, whatever you want to call them, are normal. On average, the U.S. stock market sees a 10% pullback every two years, and a 25% decline every six. Not surprisingly, the last 25% decline occurred almost exactly six years before the current decline began last fall. And up until the current downturn, the U.S. stock market had gone up a lot, doubling from its 2002 lows to October 2007. Including dividends, the market had risen an average of 17% a year for those five years, far above its historical average of about 10% per year. In other words, the market was due for a correction. And with the busting of the housing bubble, the credit contraction, and the wave of corporate takeovers subsiding, all of which has significantly slowed the economy, it�s no surprise that investors haven taken prices down to a less lofty level.

Of bigger concern to the economy than a recently sluggish stock market is the inflation flowing through the economy. The cost of living has risen sharply over the last couple years, faster than most workers� paychecks. This is a primary factor which makes it difficult for investors to wait out the stock market correction. Also, with such low interest rates people have little incentive to put their money in the bank since they know they�ll earn a negative return because of inflation (and taxes). So investors have put more of their money in the stock market (and real estate) in hopes of earning a return that will keep up with inflation. With flat stock prices and negligible bank yields, investors are caught between a rock and a hard place. People are more aware than ever that they have to deal with increasing costs yet their investments don't seem to be keeping pace.

I�ve talked before about not being �tricked� in a low interest-rate environment. The trick is that the government (and the Federal Reserve) want you to be very aggressive with your money, more than you should be. There are three ways this happens. First, they know that if they keep interest rates low enough, they�ll encourage consumers to invest in the stock market and housing market more aggressively than they otherwise would. Over the long-term this can bring more wealth, but is often not appropriate for all one�s money and ignores shorter-term spending needs. Second, very low interest rates will also encourage borrowers (and businesses and the government) to take out more debt than is often prudent. Third, since returns are generally negative at the bank after factoring cost-of-living increasing, much of that money will be spent instead of saved, which is harmful to individuals over the long-term. It is saving and investing, not spending, which brings financial wealth, to a family and the economy as a whole.

In the long-run these very low interest rate schemes do more harm than good. They encourage consumers to be riskier with their money, borrow more and save less. Low U.S. interest rates are also not good for inflation since they (generally) weaken the dollar and increase speculation, increasing inflation even more.

However, it�s always good to save, even if you�re losing a little to inflation. If you�re not able to get a satisfactory interest rate via a savings account at your local bank, try a higher-yielding CD (Certificate of Deposit), from a local bank or, for some of the best CD rates available, compare banks at bankrate.com (click on �CDs and Investments�). Likewise, you could consider a money market fund (also at bankrate.com). Money market funds are essentially the same as CDs, investing in Treasury bills and bonds, but are usually more liquid than CDs.

As far as investing, remember that investing at lower prices now will give you higher future returns. So for truly long-term investors, one should welcome lower prices and the chance to buy more shares. Even for those not continuing to invest in the stock market (such as retirees), the dividends from stocks and mutual funds will be reinvested at lower prices, giving you more wealth down the road.

Ultimately, this is one of those times where an investor and a consumer needs to be patient - with spending, the economy and with the stock market. There are several problems in today�s economy that will take a while to sort itself out, notably the unwinding of the credit and housing bubbles. Until then, try to keep your debt manageable, spending controlled, which should lead to continued saving and investing. Lastly, think about how long long-term investing is supposed to be � 10 years, 20 years and more. A good investing mind-set is in terms of decades. For example, despite how �bad� the stock market has been the last couple years and earlier in the decade, the U.S. stock market, as measured by the S&P 500, has more than quadrupled over the past twenty years, not including dividends. Over the same period, the Nasdaq stock index is up over six times. Over 30 years, those two indexes are up about 15 times.

It�s always more difficult to be a long-term investor during down markets. But the downturns and volatility are the price of admission for a vehicle that can give you inflation-beating returns. Over the long-term.

June 20, 2008

Proposed Housing "Solutions" are not the answer to economic downturn

As has become all too predictable, lawmakers are reacting to the latest economic downturn with calls for costly action that will cause more problems than it solves. Under the guideline that even bad action is better than no action, policymakers have been busy hatching housing/mortgage schemes that they hope will rescue the economy.

These days the word �crisis� is often used in any discussion of housing, but the decline in home prices is a predictable result of a bursting in the housing bubble that was visible as early as 2004. What Congress and many commentators fail to realize is that the housing correction and credit correction are normal responses to a highly inflated and overly leveraged economy. While the proper thing to do now is to let these excesses naturally unwind, the government is ungainly trying to prop up what it mostly can�t and definitely shouldn�t.

By now, this is a familiar story. In 1998, after the East Asian Financial Crisis (which itself was the result of excessive credit, as exists now in the U.S. and other countries), the Federal Reserve responded with �emergency� interest rate cuts that not only extended the U.S. stock market bubble but intensified it, ensuring a devastating fallout when the bubble burst eighteen months later. One might have thought at that point, the Fed would have learned the dangers of encouraging excessive leverage and speculation but they did not. The proper course for the Fed would have been to allow the natural unwinding of the technology stock bubble and trusted America�s citizens and its businesses to go back to business and reallocate its energy and resources where appropriate. But the Federal Reserve and other government officials seem to have little confidence in America�s citizens and its businesses to do their job of allocating capital and energy efficiently and effectively in worthwhile new industries. So the Fed responded irrationally again with extremely low, inflationary interest rates. Its goal was to either reinflate the stock market bubble or more likely, to create a new (and better!) bubble, in the form of rapidly rising housing prices.

At the same time, various government agencies prodded the lending community to loosen their mortgage underwriting standards to get anyone and everyone to buy a home, preferably two or three as well as tap the increasing equity in their homes. This combination would eventually give the government what they wanted � a housing bubble to replace the tech stock bubble � that would keep the necessary tax money coming in and the economy growing. That this would grossly distort the appropriate use of the economy�s labor and resources and cause future distress for �busted� speculators, investors and homeowners was apparently of no concern to the Fed. As usual, it took the easy, short-sided �solution� to the complex issues facing an economic slowdown.

So now the housing bubble has busted and predictably, the government is trying desperately to blow it back up again. The Fed has taken its predictable tack of lowering interest rates to a level far below the inflation rate, with the goal to increase inflation (this was also done to bail out the financial industry but housing prices have also been a major focus of the Fed). Unfortunately, the other major avenue to reigniting the housing bubble, loosening credit standards, isn�t an option now since banks and other lenders are not eager to see any more of their loans go bad. So while home prices haven�t yet inflated as the Fed is so yearning for, commodity prices have inflated, in a big way. The Fed�s inflationary tactics are causing pain throughout the world in the form of incredible increases in energy and food prices and generally high inflation worldwide.

So what�s left? After two years of generally falling housing prices, the government has proposed various schemes to artificially increase housing demand. One current proposal is offering tax credit ($7,500 or so) to new home buyers. The government has also tried to get banks to reduce the amount of their borrowers� loan balances and/or the interest rates the borrowers agreed to pay. At the same time, the government is trying to get banks to lend even more money. The government has also loosened the already loose standards to allow lenders (especially government lender Fannie Mae) to use still more leverage despite the credit default dangers we've seen this past year from overly leveraged lending institutions. There�s also been talk of the government taking over individual mortgage loans from banks, as it has done this year with mortgage-backed securities. This would add still more bad loans onto the balance sheet of the government and its taxpayers to cover.

The proposed legislation is incredibly unfair. Whom do you give these benefits? Would the people who lost their homes over the past two years (or ten or twenty) not get their loan balances reduced after they had financial hardships and couldn�t afford them, but people who happen to default on their mortgage at the right time - say late 2008 or 2009 - be rewarded? Will they give tax credits for new house purchases in 2008 or 2009, but not for those in previous (or later) years? If so, why? Most home prices are lower now than they were a year or two ago, so if anything, new buyers should get *less* help than those buying a home from 2004 to 2006. If the goal is to bail out the homeowners who bought more house than they could afford, what is the reward for the prudent homeowners or renters � those individuals and families that chose not to take on an overly large and risky mortgage? Similarly, many homeowners in bubble areas didn�t refinance their mortgage(s) on ridiculous terms, depleting the equity of their house in the blind hope that the bubble would continue and their home price would continue to rise 15%, 20% a year or more. Millions of individuals sat on the sidelines during the housing bubble years, refusing to put themselves at high financial risk by buying more than they could afford.

All the various government housing schemes proposed are with the stated desire to �stimulate demand�. However, in a fair and free marketplace, you don�t need to artificially stimulate demand. The previous years of artificial demand with below-market interest rates, zero underwriting standards and ultra-creative loans are what got the country�s housing situation where it is now. This artificially created excessive demand and too little supply. To get back to equilibrium, demand will fall and supply will increase, as has been happening and will continue, government intervention or not, until equilibrium has been reached. Furthermore, government intervention of forcing lenders to reduce the amount of contractual mortgage loans, will only demonstrate to future buyers and lenders that the government can intervene and break contracts whenever it feels the desire. This will create huge distortions in the market, reduce the willingness of lenders to lend and raise borrowing costs for future homebuyers. Lastly, if these measures do succeed in (temporarily) propping up housing prices, it will further delay the opportunity for individuals, especially younger buyers and minorities, to buy housing in these still overpriced areas.

If you allow the housing market to clear naturally, it will balance at the point where housing prices are appropriate for average incomes (generally about three times the average family income in an area), the way they always are, in the absence of a bubble. At this equilibrium price, buyers will come in and the market will stabilize the market, every time. This equilibrium is still in place in many areas of the country which did not experience the housing bubble and have seen little, if any, price declines. Those that experienced the bubble will need to see their house prices come down enough to a level where demand will satisfy supply. Simple and easy economics. As long as the economy is sound and buyers and mortgage lenders know that their contracts won�t be subverted by the government, this will ensure plenty of demand and stabilization in the prices of all houses � sooner in those areas not affected by the bubble, later in those areas with still too-high prices in bubble areas � but will create a much more efficient and robust long-term marketplace for buyers and sellers.

The current and proposed government �solutions� in the form of excessively low interest rates, taxes and government spending, and inflationary financial policy has already added to the list of problems the economy already faces, including the current fallout from the government-created housing bubble. We don�t need more government �solutions� that will distort housing prices and create a less robust housing market going forward. The economy and the housing market will recover, with the government or without, but in the long run, better without.

May 20, 2008

You may not like inflation but the government does

Last week a survey found that Americans� number one economic concern was inflation. This is not surprising given the tremendous increases over the past year in gas and other energy costs, along with food, healthcare, education and other areas. Last week it was also reported by the U.S. Department of Labor that inflation was up a miniscule 0.2% for the month. And the price of gasoline? Despite the fact that the actual price of gasoline was up about $.30 for the month, or about 10% from the prior month, because of a �seasonal adjustment�, the government reported that gas prices actually fell 2%. Imagine that.

What�s going on? How can inflation be the number one economic concern among consumers yet according to the government is very modest and contained? Essentially, the government has an enormous incentive to create inflation while simultaneously underreporting it. Let's start by looking at government spending.

The U.S. federal government has incredible spending demands and (partly because of inflation) spends significantly more each year than the prior year. It spends more money each year on its personnel (more than 15 million employees and contractors), maintenance, military equipment, healthcare, benefits, new programs, as well as the ever-increasing interest payments on its outstanding debt (now about $450 billion a year).

The federal deficit, the amount the government spends over what it takes in, is now growing at about five hundred billion dollars a year, or more than fifty million dollars an hour. The current amount of Federal debt outstanding is about $9,400,000,000, or almost nine and a half trillion dollars. That�s up from about six trillion dollars in 2000 when George Bush became president, four trillion dollars when Bill Clinton became president in 1992, and one trillion dollars when Ronald Reagan�s presidency began in 1980. In addition, including promises to pay for future Social Security and Medicare expenses, the total accrued federal debt is closer to $80 trillion.

A major part of the government�s spending are these interest payments on its debt from excess spending in prior years. In fact, if the federal government didn�t have any debt and therefore not need to make those interest payments, the government would currently have (roughly) a balanced budget. Since its debt payments are such a huge expense it has a vested interest in seeing that interest rates are as low as possible, in order that its debt payments are also as low as possible.

In order to pay the government�s huge expenses in interest costs and ongoing expenses, it wants to create economic growth and/or inflation. Naturally the government would prefer if the economy was strong enough to generate the necessary tax increases but as we have seen the last several years, in a weak economic environment, the government is not shy about creating inflation in order to increase the prices of almost everything. In particular, since last August, the Federal Reserve has been desperately trying to create inflation to counter the effects of falling home prices and an unwinding of credit excesses.

Inflation generally increases asset prices, real estate, company profits in many industries, which results in more tax revenues. Likewise, state and local governments strongly benefit from inflation since they increase property taxes (from increasing house prices) and sales taxes because of inflationary increases in the price goods.

At the same time, after inflation has been successfully created by the government, it doesn't want to accurately report the resulting high inflation for several reasons. First, it needs to be able to make those large interest payments on its federal debt. Interest rates on long-term bonds, including federal Treasury bonds, are controlled by the marketplace and largely a function of inflation expectations. If the government reported the actual level of higher inflation, this would cause the bond market to sell off, and the resulting yields the government would have to pay on the bonds would have to increase, increasing interest payments. Given the government�s incredible debts, imagine if it had to pay an interest rate that reflected true inflation of 8% for instance, instead of about 4%. This would double the interest expense on those debts making it that much more difficult to pay those debts.

Another very important reason to report low inflation, and keep interest rates low, is because the economy relies on cheap money for financial institutions to borrow at low rates and lend or invest at higher-yielding rates. Although excessively leveraged financing is extremely dangerous, as we have seen these past few months in the U.S. economy, this is what interest rates below the actual level of inflation lead to. But the government knows that if interest rates were allowed to increase substantially, this would reduce much of this leveraged activity, reducing profits, and most importantly for the government, reduce tax revenues.

A major reason the federal government reports artificially low inflation is to reduce the cost-of-living increases for its employees, Social Security recipients and Medicare beneficiaries. These individuals all suffer when inflation is under-reported but the federal government benefits in a big way.

Lastly, inflation is underreported so that real (after-inflation) economic growth will appear stronger than it really is. This often results in higher stock prices, higher business confidence, and signals to foreign debt-holders (especially China, Japan, and the Middle East) that taxpayers have the economic wherewithal to pay back those debts.

Incredibly, despite the tremendous conflicts of interest in a government agency reporting inflation that can have such a potentially positive or negative impact on its finances, the government does not rely on outside professionals to report on the nation�s inflation, but is allowed to do that �in-house� via its Department of Labor.

So the next time you hear an inflation statistic (or any other government statistic) that seems far removed from your experience you�ll understand why. Your own economic experience is infinitely closer to reality.

April 28, 2008

Fed Follies - Part II

For much of the past 20 years, the Federal Reserve has made a concerted effort to increase economic leverage, speculation and inflation. Although the primary goal of the Fed initially was initially to control price fluctuations (inflation), over the past two decades one of its primary goals has been to create inflation. In an infamous speech that current Fed Chairman Benjamin Bernanke gave a few years ago, he outlined how the government can and does create inflation. It's rather easy. You simply increase the supply of money in the economy and you get higher inflation. To that end, over the last year, because of the Fed's fear of a weakening economy, the yearly money supply increase in the U.S. has exceeded 10% and is recently near 20%, laying the foundation for continuing significant inflation in the U.S.

One of the main tools of the Federal Reserve is interest rate policy. It can directly control short-term interest rates, and can indirectly control longer-term interest rates. Lower interest rates benefit financial institutions who can borrow at a low interest rate and invest in higher-earning assets. They also encourage individuals and businesses to invest more aggressively and move away from safe investments. When you hear that at a Federal Reserve meeting the Fed lowered or raised interest rates, this refers to short-term interest rates. Longer-term interest rates are generally set by the marketplace although the Fed can have significant influence there too. These long-term interest rates are normally a product of inflation expectations, but the Fed has learned to control these rates through its various commentary/propaganda as to whether economic growth is stronger or weaker than it appears and whether there is more or less inflation than actually exists. In other words, the Federal Reserve will make economic assessments that the marketplace cannot.

For example, at the start of the most recent economic cycle, in 2003 after the Fed had lowered short-term interest rates to 1%, and the Fed was unwilling to let the economy expand on its own, the Federal Reserve desperately wanted longer-term interest rates (and thus mortgage rates) to also come down so that real estate prices would sharply rise to give the economy a boost. So for many months, Fed members went on a campaign of spreading the message that deflation (falling prices) was a real concern, with the result that eventually longer-term bond yields fell (lower inflation expectations normally result in lower long-term bond yields) and the real estate market rose to bubble proportions in many areas of the country. Then, in 2005, when then-Federal Reserve Chairman Alan Greenspan realized the real estate bubble was out of control and long-term interest rates were now too low, he talked about the �conundrum� of the �too� low bond rates. This was an attempt to get long-term yields higher and take some of the air out of the housing market. But by then of course, the damage and distortions to the economy had been done.

Interestingly, in February 2004, Chairman Greenspan took the role of the nation's financial planner and publicly wondered why relatively few house-buyers were using Adjustable Rate Mortgages instead of fixed-rate mortgages to buy homes. Even though long-term fixed rates were very low by historical terms, Greenspan advocated using ARMs to �save money� (in the short-term). Unfortunately, too many buyers and speculators took this advice and after the bubble burst wished they hadn�t. Yes, it was the Federal Reserve Chairman who suggested that taking out a loan based on an adjustable mortgage rate, at a time when rates were lower than they had been in decades and had nowhere to go but up, would be a wise financial decision. The Fed's internal goals also explain its lack of regulation of the banking industry and lending practices in general during these boom/bubble years. They simply didn't want to do anything to get in the way of any potential borrower despite the long-term consequences.

Since low interest rates reduce the amount of interest that savers receive on their earnings, they punish savers and often encourage them to invest, speculate and borrow more aggressively than would otherwise be appropriate. Unfortunately, many individuals did just this in the late 1990s by buying technology stocks before that bubble imploded and likewise in the mid 2000s by buying speculative real estate, often with no money down and with risky loan terms, in the years and months before overvalued real estate took a tumble. Lower interest rates trick savers into being more risky than they would otherwise be. This is the Fed's goal, to encourage aggressive buying, speculation and leverage to maintain as high a growth rate as possible. That it simultaneously creates inflation and causes massive economic distortions does not generally appear to be a concern to the Fed.

The bottom line is to ignore the Fed's interest rate and inflation distortions. Just because interest rates are too low, doesn't mean you have to take out more loans and spend more than you make. The Fed's goals are different from yours. Prudent spending and borrowing may not make the Fed happy but you'll be doing yourself a favor in the long run. Individuals, not the Fed, are the ones to suffer from overly aggressive borrowing and speculation. Although maintaining spending and borrowing discipline is even more difficult in this time of high inflation, it's even more necessary to stay on the financial path that's best for you in the long run.

April 21, 2008

Fed Follies - Part I

(My apologies for the delay in my writing. It's been a busy tax season.) Since I last wrote, the U.S. economy has markedly deteriorated and inflation has noticeably accelerated. We can lay most of this at the hand of the Federal Reserve and its distortionary actions over the past several months, as well as past years.

The Federal Reserve Bank was created in 1913 to monitor the U.S. banking system and control its money and credit flow. Over the later part of the 20th century, the Fed has become increasingly preoccupied with controlling the economic cycle. Economic booms and bust cycles are natural events that serve to reallocate capital and resources toward appropriate economic and financial activity. For example, the recent housing bubble clearly misallocated resources and prices toward the real estate sector with the inevitable result that such prices and activity will revert to more appropriate levels.

However, the "new" Federal Reserve believes it can control the economic cycle through expansionary or contractionary actions, principally via interest rate manipulation and changes in the economy's money supply. Likewise, the Federal Reerve has been increasingly concerned not only with these actions in the U.S., but with these actions around the world. Because of the global financial interconnectivity, the Fed has come to the conclusion that it must help dictate economic policy for countries around the world, who presumably, are unable to do so for themselves.

The Federal Reserve appears to be obsessed with what it thinks are "correct" prices in the economy. This usually means keeping prices artificially elevated. On April 2, 2008, the Federal Reserve Chairman, Benjamin Bernanke, told the Joint Economic Committee of Congress, "We will not let prices fall at 10 percent a year. We will act to keep the economy growing and stable." In other words, the Fed chairman does not believe the marketplace is setting the correct prices for privately traded assets, so it needs to do so for them. In fact, the Fed believes it is clever enough to control all prices - interest rates, house prices, stock prices, bond prices, as well as basic goods, all with a few crude monetary elements as well as its everpresent spin. Furthermore, it believes it can raise prices of some goods, real estate and stock prices, for instance, while limiting the increase in commodities and prices overall. Although this goes against economic and financial fundmentals, as well as common sense, the Fed believes it is clever enough to do this.

And generally, why should it? Normally, if markets are truly allowed to work, they will gravitate toward the appropriate price level. Investors want to make money (and not lose money) and will bid up or down prices to achieve this goal. Two obvious examples are the bubble in technology stocks in 1998 into 2000, and real estate prices in 2004-2006. In both cases, it was clear to many economists, and probably the Federal Reserve, that prices were far above a level that fundamentals would support. So why would the Federal Reserve try to intervene and stop prices from falling to a more normal level? Falling prices give investors the necessary incentive to reinvest in companies and real estate to restore proper economic activity.

Unfortunately, as has become its habit, the Fed is not allowing the economy to adjust to where fundamentals would dictate. Of course the Fed isn't concerned with fundamentals, only the extent to which it can control the economy. I'll talk more about this next time.

Why a weaker dollar is bad for your pocketbook

With this week�s surprise interest rate cut by the Federal Reserve, focus continues to be how these actions will revive the ailing U.S. economy. Indeed, for the past six months, the prospect of lower interest rates from the Fed has been viewed as an easy medicine for the economy. Unfortunately, this one-sided commentary ignores an important factor, that lower interest rates are helping to weaken the U.S. dollar. This has negative implications for the U.S. economy and the American consumer.

A weaker dollar leads to higher prices for almost everything we buy, which we call inflation. As the economy has weakened over the last several months, the Fed has been lowering interest rates in an attempt to limit the amount of economic contraction. However, each time it does so, the dollar weakens compared to other currencies. For instance, yesterday�s interest rate cut led to a 1% fall in the dollar compared to the day before. What that means is essentially the U.S. became one percent poorer compared to the rest of the world. Put another way, it became 1% more expensive for Americans to buy foreign assets or products compared to the day before.

Some commentators like to put a positive spin on a weaker dollar, that it is actually good for America because it makes our exports cheaper. It's true that everything priced in our depreciating U.S. dollars will thus become cheaper for foreign governments, companies and individuals. And some of our companies will see higher profits to foreign countries. At the same time, while it makes it easier to sell our products, it also makes it easier for foreigners to buy our assets. We have recently seen foreign governments and businesses bailing out our banks in the midst of financial turmoil. In fact, over the last several months foreign companies have been buying hundreds our companies, healthy and not. As the dollar stays weak or continues to decline, we will continue to steadily transfer our wealth to foreigners. But unfortunately for these buyers, if the dollar continues to decline, this will erode the value of their investments, and there are signs that foreigners are tiring of holding our assets as they depreciate via a falling dollar.

More immediately, the weak dollar has caused the price of American goods to go up. Take the price of oil as a very obvious example. Across the world, oil is priced in dollars and traded in dollars. If the dollar weakens, to compensate for that lower price, foreign traders bid up the price of oil a corresponding amount. The result is higher oil prices and higher prices at the pump. This is the same with any commodity, almost all of which are priced in dollars. The weaker dollar has had a big part in leading to higher commodity prices and a big reason that food prices have risen so much over the past couple years. Of course, commodity prices are determined by other factors as well, but all else equal, a weaker dollar, means higher natural gas, oil, and food prices. For example, since August, when the Federal Reserve began its interest rate cutting campaign, the U.S. dollar has fallen 7% versus the combined currencies of the rest of the world. During this time, the price of oil, corn, wheat and gold have all risen more than 30%, with many other commodities up more than 10%. But it doesn�t stop with these worldwide commodities, but with anything that we buy from other countries where our dollar has weakened (which is almost all countries). For anything that Americans buy from these countries, we will have to pay a higher price for those products. Since these foreign companies have no desire to see their profits decrease, they must increase the price that they charge to Americans as their currency strengthens. So for almost anything that Americans buy from foreign companies, as well as commodities, we will see higher prices. Also, because all fuel costs must either be passed down to the consumer in the form of higher prices, reduced company profits or lower employee wages, this also has a negative economic affect.

Regardless of how they spin it, the process of transferring the wealth of America to foreign countries via a weaker dollar is not sound economic policy, and not good for Americans.

Tax changes in the New Year

The New Year brings a new tax season, one with many updates and changes. Here are just a few:

Alternative Minimum Tax: One very important development for millions of Americans is a "patch" for the Alternative Minimum Tax, or AMT, recently passed through Congress. This patch will allow millions of taxpayers to avoid having to pay the higher AMT this tax season. However, because this bill was passed so close to the tax-filing season, more than ten million taxpayers who would have had to pay the AMT, will have to wait several weeks before the corrected tax forms will be available.

This AMT law was passed decades ago to catch a few very-high income taxpayers and has mushroomed to now snare millions of middle- and upper-income taxpayers. This recent patch is just a temporary fix for a long-term problem.

Cash Contributions: In recent years, the IRS has made efforts to tighten down on deductible charitable donations. These efforts continue this year as the IRS now requires any claimed cash contributions, for any amount, to have a bank record of the transaction (cancelled check, bank statement with the charity name, etc.) or a written letter from the charity acknowledging the gift. Last year, new IRS rules required non-cash gifts to charities to be in "good" or better condition to be deductible and for single contributions over $500 to include a qualified appraisal with the tax return. Total non-cash charitable gifts in a single year over $500 require form 8283 to be filed with information on the date each gift was acquired and sold, their cost, and the fair-market value on the date of the contribution. So when it comes to charitable contributions keep those records!

0% Capital gains tax-rate for certain taxpayers: For 2008, there's a new capital gains tax-rate available for many Americans. For tax year 2008 investment sales (investments sold during 2008), qualified dividends (most company dividends) and long-term capital gains will be taxed at 0% (Federal) for taxpayers in the two lowest income-tax brackets. Specifically, this affects single taxpayers with taxable income below $32,550 and married couples filing jointly with taxable income below $65,100. Note, that this is taxable income, not gross income, after most deductions have been taken. So this will impact more taxpayers that it may first appear. As an example, take a married couple with two children, a gross income of $90,000, and itemized deductions of $20,000, who will have personal exemptions of $14,000 (4 exemptions X $3,500). These deductions will take their taxable income down to just $56,000, well below the $65,100 taxable income threshold for the 0% tax rate. Note that the dividends and capital gains that may be subject to this 0% rate are included in overall gross income. So if your capital gains and/or dividends put you over that threshold, you will be paying a higher tax rate (probably 15%) on some or all of those gains. Also remember that long-term gains are those that are held more than one year. For those held less than one year the rate reverts to the normal rate. As always, investment considerations should include more than just taxes, including portfolio diversification, valuation, and personal circumstances. Tax rates, Exemptions and phaseouts

For 2008, there are again six marginal income tax rates: 10%, 15%, 25%, 28%, 33% and 35%. For Single filers: 10% for taxable incomes up to $8,025; 15% of income from $8,025 to $32,550; 25% of income from $32,500 to $78,850; 28% of income from $78,850 to $164,550; 33% of income from $164,550 to $357,700; and 35% of incomes over $357,700.

For Married filing jointly filers: 10% for taxable incomes up to $16,050; 15% of income from $16,050 to $65,100; 25% of income from $65,100 to $131,450; 28% of income from $131,450 to $200,300; 33% of income from $200,300 to $357,700; and 35% of incomes over $357,700.

Note that these are the tax rates on taxable income (income after deductions). Including the effect of the lower income tax rates as well as deductions and exemptions, your overall effective tax rate will be lower than your highest marginal tax rate. Your marginal tax bracket just tells you the Federal income tax for the last dollars you earn.

The Social Security Income tax (6.2% for employees) threshold increases to $102,000 for 2008.
For eligible taxpayers, the child tax credit will again be $1,000 in 2008 (as it was in 2007) per eligible child. This credit is phaseout as gross incomes exceed $110,000 for Married filing jointly filers and $75,000 for most other taxpayers including single taxpayers. Since this threshold was not increased for inflation, few taxpayers will benefit from this credit.

Inflation is back...and it looks like it's here to stay for a while

Despite official government reports that inflation is modest and "well-contained" at around 2%, every American knows otherwise. The price of almost all our usual expenses has been going up sharply in recent months, many of these increasing by 5% to 10% or more over the year. This includes utilities like electricity and natural gas, food, gasoline, medical care, insurance, college tuition, rental costs and taxes. In other words, most of the things we spend money on every month.

At the same time, the government has an incentive to underreport this inflation because it keeps interest rates low and keeps government benefit payments (Social Security, Medicare, etc.) lower than they would be otherwise. However, governments also have an incentive to create inflation because it helps governments, individuals and businesses "inflate away" high debt levels. It generally leads to higher incomes (for individuals), higher earnings (for businesses) and thus higher taxes for the government. However, if my wages are rising by 4% a year, while my expenses are going up 5% a year, I'm not really better off. This is the lesson of the debilitating effects of inflation that Americans learned all too well in the 1970s and many are learning again.

Why is there so much inflationary pressure the last few years? The U.S. Federal Reserve is very afraid of any economic slowdown resulting from housing price declines. In response, they're flooding the economy with money, creating inflation that they hope will lead to higher prices for houses, stocks and other financial assets. For various reasons, foreign governments have been forced to match the Fed's action. Central banks around the world are now increasing their money supply by 10%, 15%, 20% or more, compared to a year ago.

Unfortunately, this manufactured inflation doesn't just make stocks and other financial assets go up in price. It makes the cost of everything higher. Economics 101 tells us that too much money chasing too few products results in higher overall inflation. We have seen this lately in the galloping price of oil, currently around $85 a barrel, up more than 50% from the beginning of 2007. Gasoline, heating oil and natural gas have likewise seen substantial rises. Besides oil and related products, we have seen this price inflation in the past couple years in commodities like corn, wheat, milk, beef, pork, coffee, sugar and orange juice. Many of these items, and others, have risen 20%, 30% or 50% year-over-year. While so far inflation has been most noticeable with gasoline, utilities and food, companies are passing through more of their higher expenses to consumers. For example, almost every company is seeing higher packaging and shipping costs and many are passing along these costs to consumers. Electricity costs are also going up across the country as utilities pass along their higher commodity costs (natural gas, coal, etc.) to consumers.

The inflation genie has been let out of the bottle with no signs of turning back any time soon. For the consumer, the ability to live within one's means in the midst of an higher inflation environment may be more critical than ever. And perhaps more difficult.

Fed to the Rescue?

In recent days, the Federal Reserve along with central banks around the world have been pumping tens of billions of dollars, yen, and euros into their respective financial markets along with various market interventions. This has been done with the supposed intention to "provide financial stability" in the financial markets. Unfortunately, this flood of liquidity will not solve the problems that the Fed itself, and other central banks helped create. Back in 2002 and 2003, in response to the fallout from the tech-stock bubble meltdown, the Federal Reserve essentially panicked, flooded the economy with money, lowered short-term interest rates down to 1%, talked the bond market into lowering long-term interest rates down to as low as 3.5%. This has created a wildly inflationary environment in the last couple years, accompanied by lofty stock prices, extremely high commodity prices and record-low credit spreads.

It was this liquidity that also led to the enormous credit, financial and real estate bubbles that we've seen over the past couple years. This has directly led to the current problems in sub-prime mortgages that is now spilling out into the rest of the credit markets and the economy as a whole. Although it's highly unlikely that the Federal Reserve will do so, the correct response now is to let the air come out of these bubbles on their own. In coming months and years, the economy would then realign itself naturally and provide capital and resources to previously neglected areas and away from those bubble areas. This will produce a stronger long-term economy and more balanced and stable financial markets.

Unfortunately, the Federal Reserve, along with certain other world financial banks, is prone to excessive market manipulation. They have an inflationary bias, which you've probably noticed in the last couple years in the amount you're spending on food, energy, health expenses and taxes, to name a few areas of galloping prices. This inflation also shows up in financial markets in the form of rapidly increasing prices. While this sometimes seems good for investors in the short-run, it creates long-term economic and financial distortions, which leads to excess speculation and market panics.

Investors however, must participate in the financial markets to meet their own financial goals, most notably, dealing with inflation. They will also have to accept higher volatility on the upside (which most don't mind) and the downside. To participate in such an environment, the investor has to make sure he or she is well diversified, with enough invested in low-risk investments (such as high-quality bonds, money market funds), to ride out the downturns in the financial markets.

The downturn in the credit markets (mortgage, bonds, etc.) is for real and is already having a substantial impact on the economy. These markets were overextended on the upside, creating economic distortions and must be allowed to pull back and create a more balanced economy. As for this recent downturn in the stock markets, it certainly seems to be overblown by the media. Before the increase in stock prices in recent days, the U.S. stock market at its recent lows was down only about 11% from its highs. It is still up almost 15% from a year ago, and nearly twice what it was about four years ago. It's a similar story with foreign stock markets. While many of these have come down 15% or 20% from their highs, many of these same markets were up 40% or 50% for the year and much more over the past few years. In this context it's hard to see the reason for panic, from the Federal Reserve, as well as investors. As always, money in the stock market should be money that investors don't plan on using for at least five or ten years. Lower stock prices mean reduced prices for those investing money in the stock market (such as in a 401(k)) as well as better prices for reinvested dividends. While there's no way to know whether the next 10% move in the stock market will be up or down, the long-term investor really shouldn't care. In the event there are lower stock prices in coming months this is likely to lead to a fatter investment account in ten or twenty years ahead, assuming investors don't panic and are able to stay the course.

The return of stock market volatility

A few months ago I talked about how stock markets have been seeing below normal volatility for a few years. From those low levels it seemed likely that volatility would have to increase somewhat. Investors around the world saw some of that higher volatility last week. Over the week, the total stock U.S. stock market was down more than 5%, the largest decline in five years. The popular stock market averages, such as the Dow Jones Industrial Average (DJIA) and Nasdaq Composite were equally volatile, if not more so. This week has seen similar volatility with the DJIA up or down more than a hundred points on three successive days.

If anything, this stock market movement simply brings back the market to normal stock market volatility, as opposed to its abnormally low stock volatility over the past few years. The level of stock market volatility these past two weeks has been comparable to the average volatility prior to 2004. But because volatility has been so low for a long time now, investors (and the media) perceive the recent movement as excessive, especially when it's to the downside. It doesn't help when you have newspaper headlines that describe the stock market as "plunging" when the Dow Jones Average falls by 100 or 150 points. Part of the volatility-perception problem is simply that the stock market is so high now so the numbers are much larger. On a percentage basis, and from a historical perspective, the stock market volatility these last two weeks is actually modest. With the Dow Jones Industrial Average at close to 14,000, a 140 fall in that average is only 1%, hardly a "plunge" in the stock market. In fact, even a a 1,000 point move in the Dow Jones Industrial Average over a few days should not be considered unusual. Looking back, on a percentage basis, this Dow Jones average fell the equivalent of more than 1,500 points over 12 days in 1973, 10 days in 1974 and 5 days in 1998. It feel more than the equivalent of 2,000 points during the month of August 1990 and 10 days in 2001. And the biggest one day downturn, in 1987 would be equivalent of more than 3,000 points in the Dow Jones Industrial Average in a single day (more than 4,000 points over three days). On the other hand, the Dow Jones Industrial Average rose the equivalent of about 2,000 points in 2 days in 1987, over 10 days in 1982, and about 1,500 DJIA points within three weeks in both 1984 and 1987

Volatility is simply the price to pay to participate in the stock markets. Over the short term, they are inherently volatile, over the long term, less so. Stock market volatility comes from uncertainty with the economy along with individual companies. Over the long term, returns in the stock market generally stay ahead of inflation but in the short-term this will not necessarily be the case. Long-term investors (those investing for five, ten or more years in the future) have the advantage of time to be rewarded for assuming this higher level of short-term volatility.

If you feel your overall investment portfolio is too volatile during these periods for you to feel comfortable, there are ways to reduce the volatility. Portfolio diversification reduces volatility, particularly if it includes lower volatility investments such as high-quality, short-term bonds or cash-like investments (money markets, CDs, etc.). If you are a long-term investor and your portfolio is already well-diversified, then the best thing to do during times of higher stock market volatility is just to ignore it and focus on long-term investing to move you toward your financial goals.

Riding the downturn

In my last article I mentioned the growing risk in the stock market. With such a nearly straightup rise in the stock market, it is increasingly due for a decline (the broad U.S. stock market has risen an average of 18% a year for the past four years without even a 10% pullback, the second longest streak in recorded history). Although many investors feel assured that in the event of any significant stock market decline the Federal Reserve will swoop in to the rescue with lower interest rates, this is not likely to happen in an environment of a weak U.S. dollar and rapid asset inflation throughout the world. If this happens, it will only create more instability in the financial markets as well as the world economy. In any case, the risk is certainly growing of a significant decline in the stock market.

So if there's a higher chance of a significant pullback, what is the typical investor to do? Since investors have not really had to test their resolve during four years of gains, some investors will bail out at the next downturn. And of course the longer and deeper the downturn lasts the more likely investors are to throw in the towel. But before that happens there are ways to reduce your risk, and ride out any possible storm. With that in mind, here's a few things to keep in mind.

- First of all, you need to have a diversified investment portfolio. In a stock market downturn such a portfolio will most likely decline less than a more concentrated position. This means making sure you have exposure to the various sectors of the financial markets - international stocks, small cap stocks, bonds, "value" stocks, and so forth. However, I don't recommend indiscriminate or wholesale selling of your investments. Sweeping changes should never be made to an investment portfolio without considering how the changes may impact the rest of your financial situation, including your taxes.

- Taxes: Particularly if you have an individual stock or mutual fund outside of a retirement account that has a large, unrealized capital gain it's not an easy choice to sell it in the chance the stock market will fall because of the taxes that result from any sale. You need to think about whether you had already been considering selling the investment or whether you had intended to hold the investment for many years. Of course, you have to consider your income tax bracket and whether you think it may rise or fall the following year or thereafter. Taxes and investments can be very complicated with lots of variables and it makes sense to talk to a professional who understands the investment and tax implications of any financial decision.

- If you have a large individual stock or fund, there are ways to hedge against a decline in that stock or the broader market. This may be particularly desirable if you have a gain on a stock or fund that you hesitate to sell for fear of a large tax bill. In this case, using hedging vehicles such as options, exchange-traded funds, and others, can be very useful. However, they can also be somewhat complicated and probably best used in conjuction with an advisor knowledgeble of such strategies.

- For investors who have a significant amount of their investments in retirement accounts such as IRAs or 401(k) there are opportunities to rebalance, diversify and become more defensive without tax ramifications. Rebalancing techniques are generally most successful in producing higher risk-adjusted returns where they move money from outperforming funds or assets sectors (large-company stocks, international stocks, etc.) and towarded more stable areas (such as bonds) or underperforming asset sectors. While one certainly doesn't want to overtrade in their tax-deferred investment accounts, periodic rebalancing often makes sense, especially when markets have had a period of strongly outperforming or underperforming, such as we've had the last couple years.

However, assuming you don't sell all of your stock holdings (which is almost never appropriate) there is going to be financial risk from your investments. This being the case, investors have to be able to emotionally handle any declines. You can do a little thought experiment to get a better handle on how you would handle a given downturn. For example, take the value of your stock or mutual fund (with mutual funds, the amount of stock holdings) portfolio, then cut it by 10%. This might be roughly the amount your stock portfolio might go down with a broad 10% decline. So say you have $150,000 in stocks and $50,000 in bonds, a 10% market pullback might bring the value of your investments from $200,000 to $185,000. If you think you could handle that, consider a broad 20% decline, which might occur from a deep recession or major economic shock. In this case, your portfolio's value go from $200,000 to about $170,000. You can consider this thought experiment for your individual portfolio and situation and consider how much you will be able to bear.

Although many investors have forgotten the risk in the stock market, the investor who's not willing to absorb a 10% or 20% (or more) decline in the stock market, need to talk with a suitable advisor as to how they can lower their personal risk. It's not all about returns. It's also about being able to sleep at night.

The end of stock market volatility?

Stock markets around the world are booming. Corporate profits have exploded. The Dow Jones industrial average has risen 23 of the last 26 trading days, the strongest streak in 80 years. In fact, a broad U.S. stock market average (the S&P 500) has gone more than 4 years without a 10% correction, the second longest on record. And while foreign markets still have their occasional pullbacks (the Turkish stock market down 8% one day last week, the Russian stock market recently taking a 7% one-day correction, China's market falling 9% on a single day in February), the U.S. stock market rarely corrects even 1% in a single day, if at all. Until a 3.5% pullback in February, the U.S. stock market had gone almost 4 years without a single-day decline of more than 2%, the longest streak in U.S. stock market history. Finally, for the last two or three years, a popular measure of stock market volatility, the VIX, has been trading at roughly half the levels it traded at from the prior decade. This indicates half the stock market volatility that previously existed.

So what happened?

Over the past few years, the The Federal Reserve brought interest rates down below inflation and simultaneously flooded the country, and the world, with liquidity. This encouraged risk-taking, speculation, excessive leverage and directly led to the inflationary environment we have seen in the galloping prices for real estate, commodities, art, and stocks and bonds. A by-product of this has been a stronger economy, but one that has been distorted, creating problems that have become increasingly evident. But for now, investors seem to think risk is a problem of the past.

Hedge funds have increased their leverage (borrowed money) to record levels. Buyout artists and corporations are borrowing money and taking businesses private at record levels. Corporations are leveraging themselves up - taking on more debt and buying back shares of its stock - which reduces outstanding shares, increases earnings and often, boosts their stock price. Even pension funds and state and local governments have more aggressively delved into the stock market to boost increase revenues, in order to pay for excessive spending. The federal government itself is "playing the market" by relying so extensively on taxes from corporate profits, investment capital gains and real estate and art speculation. But despite its windfall over the last few years, the federal government still spends more than a billion dollars a day more than it takes in. If there is a real economic slowdown, or a real recession, the federal government will be on even shakier ground and unable to further stimulate the economy without causing a total loss of confidence in the government's fiscal policies.

In an economy where risk-taking seems to be rewarded, prudence, not volatility, is seen as the real risk, and these players are certainly not anticipating the possiblity, or probability, of a slowdown.

That is probably a mistake. Many investors have forgotten the lessons just a few years ago that markets do not always go up. Although there is a widespread perception that the government will swoop and solve any financial crisis, there is little it can do that will correct the problem that it has itself created. Without going into great detail, the government may try to entend it a few more months or years even, but such a move will only deepen the pain during the inevitable correction.

So, with a riskier-than-appears stock market and economic environment, what is the individual investor to do? I'll talk about that in my next article.

Tax law updates for 2007

This year's tax bill has lots of changes for taxpayers, including:

Health Savings Accounts (HSAs): Starting 2007, HSA owners can contribute up to $5,650 for a family and $2,850 for individual coverage. Add an extra $800 for account owners born before 1953. Unlike previous years, now contributions are not limited to the deductible for the accompanying health plan. Also, you can contributions up to this limit regardless of when the account is opened during the year. Another new rule in 2007 allows IRA funds to be rolled into HSAs. A one-time transfer from your IRA, up to the yearly maximum allowable, can be made directly to your HSA account.

Charitable Contributions: Starting this year, you must have written proof for any cash contributions to churches and other charities, regardless of the the amount. You need a receipt, bank record or cancelled check with the organization's name and donation amount.

Vehicle Donations: Related to this, donating vehicles to charity has generally become less advantageous, though perhaps slightly less complicated. In a response to some taxpayers inflating values on their vehicle donations, the IRS has made their vehicle donation rules more stringent. While previously, taxpayers could simply take a deduction for the amount of the "Blue Book" or other estimated value for their vehicle, now taxpayers are limited to the amount the charity actually receives for selling the vehicle. The charity is required to give the taxpayer evidence of the amount of the allowed donation within 30 days of receiving the vehicle or after the vehicle's sale, whichever is later. This evidence needs to be included with the taxpayer's return. Note that if the value of the donation is less than $500 no documentation needs to be included and the taxpayer is allowed to deduct the estimated value of the vehicle.

Maximum Retirement Plan Contributions for 2007

401(k), 403(b) and 457: $15,500; $20,500 for those age 50 and over, up $500 from 2006.

Traditional and Roth IRA: $4,000; $5,000 for those 50 and over.

Simple IRA: $10,500; $13,000 for those 50 and and over. This amount will be indexed to inflation.

SEP (Simplified Employee Pension): $45,000

Mileage and tax rates

Standard Mileage Rates: For 2007, the standard rate for business miles was 48.5 cents a mile.

Mileage rate for deductible medical expenses and moving expenses: 20 cents a mile.

Mileage rate related to charitable contributions: 14 cents a mile. Social Security Income Threshold: For 2007 the amount of wage income that will be subject to the 6.2% Social Security tax (and duplicated by your employer) will be $98,100 up from $94,200 in 2006. And Medicare tax of 1.45% will continue to be taxed on all earnings, with no wage limit.

Federal Marginal Income Tax rates for 2006 tax returns (returns due April 17, 2007):
10% bracket: up to $7,550 for single taxpayers; up to $15,100 for married taxpayers filing jointly
15% bracket: $7,551 - $30,650 single; $15,101-61,300 married filing jointly
25% bracket: $30,651 - $74,200 single; $61,301-123,700 married filing jointly
28% bracket: $74,201 - $154,800 single; $123,701 - $188,450 married filing jointly
33% bracket: $154,801 - 336,550 single; $188,451 - $336,550 married filing jointly
35% bracket: $336,551 or more single; $336,551 or more married filing jointly

Standard Deduction: $5,150 for single and married filing separately; $10,300 married filing jointly; $1,000 extra
for each individual over 65 or blind, $1,250 for married or widowed taxpayers over 65 or blind .

Personal Exemption per taxpayer and dependent: $3,300.

Child Tax credit: $1,000 per qualifying child - phased out after income exceeds: $110,000 (married filing jointly); $55,000 (married filing separately) and $75,000 (head of household)

As an example of putting these rates and exemtions together, calculating the tax for a married couple (filing jointly)
with two dependents using the standard deduction and a gross income of $80,000 looks like this:

$80,000 less their $10,300 standard deduction and 4 X $3,300 (personal exemption) gives a net taxable income of $56,500 and a tax of $7,720.
Less 2 X $1,000 child tax credits for each child gives a net federal income tax of $5,720, or an effective tax rate just over 7% of their gross income. However, this doesn't include Social Security and Medicare tax (7.65%) on their salary earnings, nor state income taxes, which in many states reaches 8% or 9%. (Effective tax rate is the total income tax paid divided by the total income earned. This is distinguished from the a taxpayer's top marginal tax rate, as from the tax tables above, which is the tax rate paid on the last dollar earned during the year. Since much of a typical taxpayer's income is reduced from deductions or is taxed at a low marginal tax rate, the typical taxpayer's effective tax rate is often much lower than their top marginal tax rate.)

November 12, 2006

Record stock prices: good news?

Stock markets around the world have been buzzing. News of the Dow Jones Industrial Average surpassing the 12,000 mark made front page headlines around the world, while smaller-company stocks here have been hitting record highs for months. Likewise, outside of the U.S., stock markets from Australia to Botswana to Singapore have also been setting record highs.

In the wake of this global rise in stock prices, investors have become increasingly confident in the economies and the stock markets of the world. Is this a sign for investors that it's time to embrace the stock market again? Now, after the Dow Jones Industrial average is up 70% from its lows in 2002? Now, after the S&P 500 index has climbed 80% from its lows four years ago. Now after the Nasdaq Index, as well as the average emerging-market stock, has more than doubled?

Well, unless you are an investor who is taking all your money out of the market, higher stock prices are generally not welcome news, except they often coincide with good economic conditions, which is generally good for everyone. For you are still investing in the stock market, say in your company 401(k), you are now investing at higher prices. This means that prices will have to rise that much higher to get a good return on your investment. Likewise, at higher stock prices the dividends paid by the companies you own will buy fewer shares of new stock. Unless you are retiring tomorrow and taking everything out of the stock market, you really want lower prices. But only if you can hold on when prices go down again. At higher prices you should be investing only if you are a long-term investor, who can weather the inevitable downturn in the stock market and the global economy in coming months and years.

It seems reasonable that the stock market cycle of the last several years will be repeated in the coming years. In response to the market downturn in 2000 to 2002, the Federal Reserve and other countries' central banks lowered interest rates to extremely low levels and flooded their economies with money. This then encouraged investors and speculators to bid up prices for stocks, real estate and commodities, resulting in sharply higher stock prices, record increases in real estate and record highs in many commodities, including oil. To get a handle on this inflation, the Federal Reserve will have to continue raising interest rates, causing turndowns in these markets, with the Fed finally lowering interest rates enough to support the market.

An investor in the stock market should recognize the increasing risk of lower prices, but the long-term investor can also recognize the opportunities that will follow any downturn. Except for money that an investor will need within the next few years, the investor should stay invested, despite any market downturn. And for those continuing to invest in retirement plans and other investment accounts they'll be buying more shares at lower prices which will get them to their financial goals that much quicker.

New laws gives 529 plans more appeal

A few weeks ago, the government made some changes with 529 College Savings Plans that greatly increase their appeal. One of the most important, and uncertain, aspects of these plans was the ability to take tax-free withdrawals for college expenses. Unfortunately, until the latest tax-law changes, this tax benefit was set to expire in 2010. These 529 College Savings Account changes, part of the Pension Protection Act of 2006, will preserve the federal tax-free treatment for withdrawals from these plans if used for college expenses.

Even before the changes, there was a lot to like about these plans. These include state income tax deductions for plan contributions (in certain states), low minimum and high maximum contribution limits, large tax-free gifting opportunities, no income nor age restrictions. An especially appealing aspect of these plans is that anyone can contribute money to them while ownership and control can be kept away from the beneficiary. This has favorable financial aid implications since any money in these accounts will be considered an asset of the owner (usually the parent) and not the student. This reduces financial aid eligiblity much less than if the assets are considered the student's.

These plans still aren't perfect. There are more than 100 different plans spread over the fifty states. Each one has its own set of rules, tax benefits, and expenses that can make choosing one (or more) a cunfusing and challenging task. In addition, as with regular mutual funds, the fees and expenses can be significant if you choose the wrong one. And within any particular plan, there is generally a very limited selection of investments to choose from. In other words, you have to do you homework to find the one that's right for you. However, these tax law changes have taken away much of the uncertainty of these plans and greatly increased their appeal.

Retirement healthcare costs growing

For years, pre-retirees have been bombarded with the message that they're not saving enough for retirement. The new spin on this old message is that sharply higher medical costs and lower employer benefits might make retirement that much more strained.

A big problem is that fewer companies, big and small, are offering retiree health benefits. According to the Kaiser Family Foundation, in 1988 66% of large companies - those with 200 or more employees - offered retiree health benefits. By last year that percentage had fallen in half, to 33%. In fact, according to Blue Cross/Blue Shield, only 60% of employers now offer health benefits for any of their employees, down from 69% in the year 200. With employers' number one employee benefit goal to control healthcare costs, it seems likely that the trend of reducing health benefit eligibility will continue. A survey by Watson Wyatt found that 14% of companies plan to eliminate it for their future retirees over age 65, and 6% plan to eliminate it for their current retirees. Further, for those that plan to keep their employee health benefits, almost two-thirds of employers expect to increase the financial contribution for future retirees.

At the same time, medical costs have risen sharply, thanks in part to longer lifespans, wider availability of advanced medical procedures and more drugs to treat an increasing number of maladies. According to consulting firm Milliman Inc, in 2006 the average yearly medical cost for a family of four participating in a PPO (preferred provider organization) is $13,382. It's estimated that an average of about $8,362, or 62%, will be paid by employers and about $5,020, include premiums and actual health expenses, will be paid by the employee. According to Blue Cross/Blue Shield, these healthcare expenses have roughly doubled over the last seven years. in

As a result of these factors, average retiree medical costs have soared over the past two decades. A recent report from Fidelity Investments estimates that a 65-year-old couple retiring today will spend over $200,000 during retirement. Interestingly, this report didn't take into account any expenses for long-term care, which should comprise an increasing part of medical expenses for retirees and a larger number of individuals, thanks to longer lifespans.

Healthcare costs have always made up a big part of retiree expenses. Hewitt Associates says an average of 20% of retiree income is spent on healthcare. Given the changes in the healthcare environment, many future retirees will spend much more. And staying in the workforce to have the employer pick up most of the healthcare tab will become less of an option, as more employers avoid the benefit altogether. For most retirees, how well they handle healthcare costs, along with other retirement expenses, will mostly be a result of how well they saved in the years before retirement

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The high price of auto loans

While the price of gasoline has been in the news much in recent months, what is often forgotten is the price of the cars themselves. For 2006, the average transaction price for a new vehicle in the U.S. is expected to be about $28,000, according to the National Automobile Dealers Association (NADA). At the same time, interest rates have risen, pushing the average new car auto loan above 8% (five-year new car loan), according to Bankrate.com.

To pay for these cars, car buyers are taking on longer loans. According to the Consumer Bankers Association, about 55% of new auto loans are now five years (60 months) or longer, up from just 22% in 2000 And about a third of new loans are now at six years (72 months). Extending an extra year can get that car buyer into a car that might have been otherwise unaffordable. A $28,000 five-year loan at 8% results in a $567 monthly payment. To ease that payment a bit, you can just extend it to a six-year, dropping the payment down to $493. Unfortunately, it increases the total costs of buying the car, by way of higher interest costs. That $567 payment over 60 months comes to about $34,020 ($6,020 in interest), while over 72 months the $493 payment adds up to about $35,496. That's about an extra $1,500 in cash out of your pocket over the life of the loan.

An even bigger problem is when it comes time to sell or trade in your auto. It's estimated that more than a third of auto loan buyers are "upside down" on their loan. That's where the value of the car is less than the amount owed. Typically $2,000 to $3,000 but sometimes much more. In this case, when it's time to sell the car, you're going to still owe to the bank and you'll either have to come up with the cash to pay off the loan, or tack that amount on to a new loan, increasing it that much more.

What to do? You can opt for a used car, which on average are about half the price of a new car, or a smaller new car, which are usually less expensive on sticker price, gas expenses and insurance. If you're still set on a more expensive car or truck, try to finance the car with a four-year loan, preferrably a three-year loan (which used to be the average auto loan length). If you have to go to a five year loan, and especially a six-year auto loan, it's a message that it's probably not the right car for you.

And when it comes to deciding how much you can afford, don't use the auto dealership as a guide. Their job is to get you into the most car possible - that results in the most money for them. Likewise, the longer the length of the loan, the more interest and money for the dealership. There are several good personal finance websites, such as bankrate.com and smartmoney.com, that can give you a good idea of how much you loan you can really afford. Of course if you go with a shorter loan (like 36 months) and an expensive auto, the payment may seem uncomfortably high, even though it will mean less interest and probably less pain in the long run.

New tax-cut bill goes into effect

The new tax bill signed by Bush this past week, called the Tax Increase Prevention and Reconciliation Act of 2005, will extend some previous tax cuts and bring continued savings for many taxpayers and investors. For most investors, the greatest benefit will come from the extention of the 15% maximum tax rate on dividends and capital gains, which were due to expire in 2008. This should provide a bit more confidence in some investment decisions. Other highlights from the bill include:

Alternative Minimum Tax (AMT): The new law gives a one year extention to a higher tax exemption, giving temporary relief to millions that otherwise would have been hit with higher taxes, by way of the AMT. The AMT is projected to snare increasingly more Americans, even middle-income taxpayers, many of whom will lose the benefits of lower tax rates for capital gains and dividends. For now, a long-term solution to this problem will be shelved until at least 2007.

Roth IRA conversions: For the year 2010, taxpayers with incomes over $100,000, who previously were not allowed to contribute to Roth IRAs, will be allowed to convert traditional retirement accounts into Roth IRAs. For the taxpayer, this means paying tax on the rollover amount at the time of coversion, but potentially saving many times the amount of conversion taxes in future years as the account grows tax-free.

Age Increase for Unearned Minor Income taxed at parent's tax rate: Currently, for any amount over $1,400 per year, a minor's non-wage income (dividend or interest income) is taxed at the parent's income tax bracket. However, previously this only applied to children under the age of 14. The new law increases the age to 18, potentially increasing income taxes for teen-age children, their parents, or both, but primarily those with significant financial assets owned by an older child.

On balance the new tax law will prevent taxpayers many from seeing a higher tax bill than would have been the case without the changes. How much less? According to the Tax Policy Center, a typical family earning between $40,000 and $50,000 will pay $47 less for the year, with their effective income tax rate going from 14.5% to 14.4%. For a family earning $500,000 to $1,000,000 a year, they would see a greater tax benefit, about $5,656 on average, with their effective tax rate going from 27.5% to 26.7%.

Tax law updates for 2006

The new year always brings some changes in the tax world. This year, it's even a bit more than usual. Following are some of them:

Maximum Contributions for 2006

401(k), 403(b) and 457: $15,000; $20,000 for those age 50 and over. These levels are up $1,000 from the previous year. Beginning next year, maximum contributions will be adjusted for inflation.

Traditional and Roth IRA: $4,000; $5,000 for those 50 and over. This is a $500 increase from last year for those 50 and over, the same for those under 50.

Simple IRA: $10,000; $12,500 for those 50 and and over. This amount will also be indexed to inflation beginning 2007.

SEP (Simplified Employee Pension): $44,000

Mileage and tax rates

Standard Mileage Rates: Computing mileage expenses for 2005 will be more complicated than usual since Congress adjusted rates to reflect the sharp increases in gas prices in the last third of the year. For 2005, the standard rate for business miles was 40.5 cents a mile from January 1 to August 31, and 48.5 cents a mile from September 1 to the end of 2005. For 2006 the standard rate is 44.5 cents (unless it's also later amended).

Mileage rates for deductible medical expenses or moving expenses:

These rates are also split for 2005 - 15 cents a mile for the first eight months of 2005 and 22 cents a mile from September until the end of the year.

Social Security Income Threshold: For 2006 the amount of wage income that will be subject to the 6.2% Social Security tax (and duplicated by your employer) will be $94,200, up from $90,000 in 2005. And Medicare tax of 1.45% will continue to be taxed on all earnings, with no wage limit.

Federal Income Tax rates for 2005 tax returns (returns due April 15, 2006):
10% bracket: up to $7,300 for single taxpayers and those married filing separately; up to $14,600 for married taxpayers filing jointly
15% bracket: $7,301 - $29,700 single and married filing separately; $14,601-59,400 married filing jointly
25% bracket: $29,701 - $71,950 single and married filing separately; $29,701-59,975 married filing jointly
28% bracket: $71,951 - $150,150 single and married filing separately; $59,976 - $91,400 married filing jointly
33% bracket: $150,151 - 326,450 single and married filing separately; $91,401 - $163,225 married filing jointly
35% bracket: $326,451 or more single and married filing separately; $163,226 or more married filing jointly

Standard Deduction: $5,000 for single and married filing separately; $10,000 married filing jointly; $1,000 extra
for each individual over 65 or blind.

Personal Exemption per taxpayer and dependent: $3,200.

Child Tax credit: $1,000 per qualifying child - phased out after income exceeds: $110,000 (married filing jointly); $55,000 (married filing separately) and $75,000 (head of household)

As an example of putting these rates and exemtions together, calculating the tax for a married couple (filing jointly)
with two dependents using the standard deduction and a gross income of $80,000 looks like this:

$80,000 less their $10,000 standard deduction and 4 X $3,200 (personal exemption) gives a net taxable income of $57,200 and a tax of $10,965.
Less 2 X $1,000 child tax credits for each child gives a net tax of $8,965, or an effective tax rate of just over 11% of their gross income.
However, this doesn't include Social Security and Medicare tax (7.65%) on their salary earnings, nor state income taxes, which in many states reaches 8% or 9%.

What's wrong with short-term focus

It's difficult to read a financial magazine or see a television program that doesn't spotlight the impact the Federal Reserve will have on investment returns. Will the Fed raise rates? Will the Fed lower rates? 1/4 point? 1/2 point? Even on a given day, the movement of the stock market is often attributed to Federal Reserve actions, or non-actions. Yes, interest rates have a general impact on equity prices: everything else being equal lower interest rates are favorable to higher stock prices and vice versa. Fifteen percent interest rates affect the investment climate differently than three percent interest rates. But the Federal Reserve only has one short-term interest rate it directly controls, the Fed Funds rate. Long-term interest rates are determined by simple supply-demand factors, expectations for economic growth, inflation expectations, and increasingly, the buying and selling from foreign central banks. These Fedwatchers would have a better chance at figuring out what's going to happen to stock prices if they whould spend their time looking beyond the Fed, to economic, financial and fiscal movements, inside and outside the U.S.

The biggest problem of short-term rate fixation is that it leads to leads to overtrading, both for individual investors and professional fund managers. Boston-based Dalbar, Inc. found that over the prior 20 years ending in 2004, the average individual stock mutual fund holder earned an average of 3.5% a year. This was during a time that the broader U.S. stock market, as measured by the S&P 500 index, averaged more than 12% per year. Clearly, individuals have not shown great accumen at timing their investments based on the interest rate (or economic) cycle. Similarly, the average equity (stock ) mutual fund now has a turnover rate of more than 100%. This means the typical manager turns over his or her entire portfolio within a year's time. This leads to higher expenses, higher trading costs, higher taxes (for investors in taxable accounts), and not coincidentally, lower returns. It is for mostly this reason that the average fund manager underperforms the market, usually substantially. Just like individual stockholders, the best mutual fund managers out there are buy and hold investors who typically hold their stocks for several years, sometimes decades. They recognize that they are buying real businesses, not merely pieces of paper, and they buy these companies with a long-term focus.

Even if we had perfect information as to what the Fed was going to do over the next five or ten years should it really have an impact on our investment decisions? There will still be economic cycles, changes within the Federal government, tax law changes, military engagements, and financial and social shocks. Take a 60-year-old investor who's been continually investing over the past three decades, in IRAs, 401(k)s, personal accounts, in mostly stocks and low-cost mutual funds. Looking back now, with a large portfolio of stocks, bonds and mutual funds that will finance his or her retirement, would this investor really have wanted to spend those years worrying and guessing the actions of the Fed? I don't think so. And I think in twenty or thirty years, today's investors who had focused most on the things they can control - diversification, owning low-cost investments, undertrading, and keeping taxes low - won't be bothered at all that they ignored the actions of the Federal Reserve.

Although it's boring and basic to some, investors succeed by focusing on investing for the long-term, in a diversified group of low-cost investments. For decades this has been a recipe for success. On the other hand, focusing on the mechanisms of the Federal Reserve may be harmful to an investor's financial health.

Why go international?

Every investor knows to diversify his or her investment accounts, dividing up between stocks and bonds, big companies, small companies and so forth. The reason is simple, spreading your investments reduces volatility and risk. Indeed, this is one of the primary attractions of mutual funds which typically invest in a hundred or more stocks. And many investors own several funds, potentially further increasing diversification, and limiting risk. Why then, the aversion to foreign companies, considering that economies outside of the U.S. account for much more than half of the world's economic activitiy? Studies show that U.S. investors typically limit their foreign exposure to less than 10% of their total portfolio.

One knock against foreign investing is that foreign markets offer less diversification benefits than there used to. Analysts point to a more integrated global economic and market environment in recent years, evidenced they say by increasing levels of market correlation. But there are still diversification benefits to be had by investing in any sector of the global market. Whether it is increasing or decreasing is less relevant. Likewise, just because a U.S. investor owns U.S. companies that do some of their business outside the U.S. does not indicate that they have fully diversified their investments. The investor in California or New York does not typically limit his or her investments to companies based in that state, though there are hundreds to choose from. Nor does a typical U.K. investor limit investments to those of her own country although there are plenty to choose from there. Why then, would U.S. investors limit exposure to companies based in other countries?

There's still the perception among many U.S. investors that most foreign companies, even those publicly traded, are more dishonest or aren't held to the same accounting standards as U.S. companies. This is certainly not the case. In fact, all of the more than 1,000 foreign companies that are traded on U.S. stock exchanges as American Depository Receipts (ADRs) are subject to the same SEC reporting and disclosure requirements as U.S. publicly-traded companies. Some investors also have the perception that investing in foreign companies will make their investment portfolio more volatile. This is also not true. While some markets, especially emerging markets, have higher volatility than the U.S. market as a whole, many are not strongly correlated with U.S. stocks. Many studies have shown that combining ADRs (as well as non-ADR publicly-traded foreign companies) with a U.S. stock portfolio can reduce risk without reducing returns.

If you ignore foreign companies you're ignoring some of the fastest growing and best-managed companies and markets in the world. This includes companies like Canon, Toyota, Honda, Samsung, Mitsubishi, Sony, Nintendo, Nokia, BP, Carnival, Ericcson, Fortis, Novartis, Pioneer, Roche Holdings, Rolls Royce, Royal Dutch Shell, SAP, Unilever, Volkswagen, Volvo and Zurich Financial, just to name a very few.

While the world's economies may be more integrated than they used to be, they do not move in lockstep, nor do their markets. When one is up, another will be down and vice versa. For instance, as I write this, the broad U.S. stock market is up about 2% so far this year. Our neighbor to the south, Mexico, has a stock market up 29% year-to-date, while the market of our northern neighbor, Canada, is up about 18%. The stock markets in Europe and Asia have also generally outpaced that of the U.S. While the U.S. has enjoyed several years with booming stock returns, the importance of other economies outside the U.S. will grow in the years to come. In my opinion, it will be increasingly important to be exposed to countries outside the U.S.

How then to invest in foreign stocks? Just as with the U.S. stock market, mutual funds are probably the easiest path to foreign diversification. Although mutual funds that invest in foreign companies are typically more expensive than U.S. company funds, there are several lower cost fund companies such as Vanguard, T. Rowe Price and Fidelity that offer a good selection of relatively inexpensive, well-managed international funds. For exposure into a specific country, such as Hong Kong or Italy, buying a country ETF through a brokerage fund is probably the way to go. However, investing into a single country will entail more risk so it would probably be wise to limit such investment to a small part of your total portfolio.

What percentage of a total investment portfolio that should be invested in foreign companies? Assuming it's well-diversified across Asia, Europe, Latin America, etc., I think most investors can feel comfortable with at least 25% of their equity (stock) portfolio in foreign markets with perhaps as much as 50% depending on their comfort with international investing and personal circumstances. The bottom line is that a U.S. stock investor needs as many well-managed companies as possible to maximize his or her return while minimizing risk. Limiting investments to a single country makes this job much more difficult.

The Roth 401(k)

The Roth 401(k) is yet another retirement plan that will soon be available to many employees in the everchanging world of saving money. Although it's one more plan to sort through on the path to retirement, it's one that could improve the odds of a comfortable retirement for millions of Americans. Starting January 1, 2006, these two plans will be combined into the Roth 401(k). Not all employers will choose to offer this new plan but employees who see this new offering on their retirement menu should understand if it will be a good option for their personal situation.

The 401(k) retirement plan has been familiar to employees for decades and for many now makes up the largest part of their retirement money. Total 401(k) assets have grown more than five times since 1990 to more than two trillion dollars. The benefits of 401(k) are well known - tax deduction of employee contributions and tax-deferral of investment earnings until retirement.

Though less known perhaps, the popularity of the Roth IRA has also grown steadily since introduced seven years with the number of households with Roth IRAs now over fourteen million. Roth IRAs have given workers another way to save money outside of their employee retirement plan. With the Roth IRA there are no tax-benefits when one contributes to the account but the earnings grow tax-deferred and avoid taxes altogether if held until the account-holder reaches age 59 1/2. The Roth is especially appealing when an employee has maxed out their retirement plan, when they don't have an available 401(k)-type retirement plan at work or simply when personal circumstances makes the Roth IRA a better choice.

Eligible employees of the companies that offer the Roth 401(k) will be able to contribute up to a total $15,000 for 2006 ($20,000 for those over age 50) in either the Roth 401(k), the traditional 401(k) or a combination of both. It is expected that the plans will behave similarly with investment choices, etc., with any preferance between the two plans revolving primarily around taxes. Although it's difficult to predict the popularity of the Roth 401(k) it seems that it will be particularly appealing to two groups of employees. The first are those with high incomes currently excuded from investing in Roth IRAs. Since the "traditional" Roth IRA doesn't allow contributions when a single taxpayer's income exceeds $110,000 or a joint income higher than $160,000 while the Roth 401(k) has no such income restriction, it seems that those high income taxpayers might prefer to diversify into another available retirement account. Although these individuals wouldn't see any immediate tax benefits from contributing to a Roth 401(k), earnings in these accounts can avoid taxation altogether, potentially saving a high income-earner a significant amount of taxes during retirement. And since the tax laws can change substantially before a high-earner enters retirement a retiree might want to hedge his or her bet with different types of retirement accounts.

The second group of taxpayers who might find the Roth 401(k) especially appealing are those with a modest income and in a low tax-bracket but who want to contribute more than their current traditional Roth IRA allows (currently $4,000 per year). And with federal income tax rates currently low (a maximum of 15% for the majority of taxpayers), the current tax savings from contributing to regular 401(k) may not be as compelling as avoiding taxes on a retirement plan during retirement, which would be the case with the Roth 401(k). Actually anyone who is particularly concerned that their income tax rates will be much higher when it comes time to start taking money from their retirement plan would want to lean toward the Roth, whether an individual Roth IRA or via an employer's Roth 401(k).

I believe that one shouldn't put all their eggs in one basket, particularly when it comes to retirement money. Not just with choosing the individual mutual funds, stocks, etc., but also the various retirement and other savings accounts. These include traditional IRAs, Roth IRAs and Education IRAs (when eligibility allows), 401(k) (or equivalent 403(b), 457, etc.), 529 savings accounts for children's education and now, if appropriate, the Roth 401(k). Yes, it means making the effort to stay on top of the various accounts, but with diversification brings flexibility and opportunity. And that's appealing in an uncertain world.

Insuring your home

The last few days we've been reminded how important it is to adequately guard against loss to our homes. We can't outwit Mother Nature but we can take steps to limit her wrath.

Having adequate homeowners insurance seems like a basic thing, but experts say that more than half of Americans don't have adequate insurance for their home, often by amounts in excess of 30% or more. The reasons for this are many, but a primary one is that many homeowners have seen the value of their homes rise substantially in the past few years without a corresponding increase in their coverage levels. Similarly, many homeowners have spent a lot upgrading and updating their home without notifying their insurance agent of these improvements. The objective is to insure your property for what it will cost to replace or rebuild the property in case of a total loss. Many homeowners who have seen their homes destroyed after tornadoes or fires found they were unable to rebuild the property with the amount they received from their insurance company.

When you talk to your insurance agent or look at your homeowners policy make sure you fully understand what your policy covers and what it doesn't. The most common homeowners policy (HO-3) covers loss from fire and thunderstorms but it doesn't cover protection from earthquakes or floods. Flood insurance is provided through the federal government and extremely valuable for those who live in flood-prone areas. Specific insurance coverage for computers, jewelry, water damage and other areas may vary from state to state as well as with different insurance companies.

Beyond having adequate insurance to the house itself, remember to adequately account for the contents of your home. An itemized list of a house's contents including each asset's approximate age, value and make and model number (when appropriate) should be kept, preferrably with accompanying photographs or videotape. This could be invaluable in case of a loss. This information should be kept off of the property such as in a safe deposit box or with a relative. In the event of a loss, matching up before-and-after photos will help make the claims process faster. An important distinction is whether a policy covers "replacement value" or "actual cash value" on the contents of a home. A replacement value policy, though slightly more expensive, is preferrable since it pays the full cost to replace an object, while actual cash value would only pay for what the adjuster thought the object was worth, accounting for age, depreciation, etc. So for example, a four-year-old computer might only bring a couple hundred dollars, much less than having to buy a new one.

Lastly, don't skimp on insurance. Although the chance of a loss in a given year is small, typically less than one in ten, if there is a loss, you'll be glad you had the coverage. To offset possibly higher premiums, consider raising your deductible to $500 or $1,000. Most homeowners losses are usually modest and infrequent enough that you can absorb the loss, but having adequate insurance guards against those rare occasions where you won't mind paying the deductible.

Social Security - retirement system or safety net?

The current administration has designs on changing the current Social Security structure, from the current "pay-as-you-go" program where current workers provide the Social Security income for their parents and grandparents' generation of retirees. The benefits paid under the current system are much like a traditional pension plan in which retirement income is based primarily on the number of years a worker pays into the system and his or her income during those years. One current proposal is to change the system, at least partially, into a 401(k)-like plan where each worker sets aside a part of employment earnings into an individual account that could be then invested in one or more of several stock or bond mutual funds. From a worker's perspective, an argument for such a system is that retirement income from such a "self-directed" account would exceed the income that current Social Security payers will receive, particularly those with higher incomes. That remains to be seen of course, and in any case, would produce new challenges for the government and individuals alike.

I think to understand the role of Social Security income we should step back to when the Social Security system was begun in 1935. At that time, the U.S. was recovering from a depression that saw millions of elderly and disabled in dire poverty with minimal government assistance. To help with this problem, Social Security was developed - not just as a retirement system, but a safety net to help the elderly and disabled. Initially the amount of the payroll tax was 2%, up to 6% by 1961 and gradually increased up to the current 12.4% (this includes the amount matched by the employer) up to $90,000. Of course the "problem" with the system, is that over the years average life expectancies have risen, the number of individuals over the age of 65 has skyrocketed, leading to significantly higher benefit payments, and corresponding higher payroll taxes. Despite paying higher payroll taxes, government actuaries currently forecast Social Security shortfalls in the tens of trillions of dollars within the next few decades. This has led to suggestions of even higher payroll taxes and/or delaying Social Security income eligibility to a later age, maybe 70 or 75.

This last suggestion seems the most reasonable and certainly easier that some other suggestions being brought to the table. The reality is that the average Social Security recipient at age 62, 65 or even 67 is not old, but often "in the prime" of his or her life. Social Security was meant to help the poor, not to provide an extra income to already well-off individuals, many who still work. It seems that over the years Social Security evolved into a system to help the poor, elderly and disabled to one meant to provide a primary retirement income for all but the wealthiest of Americans. Since the amount that we've been made to put into the Social Security system is so high, I think that we can look at the Social Security system as part retirement income for the middle and upper-income retirees and part safety net for the lower income and neediest individuals of society. There's little doubt that Social Security is a primary reason that the percentage of elderly poor has fallen so much over the past several decades. Instead of freting about how our Social Security benefits would be higher if we had been allowed to invest outside the System, perhaps we can enjoy a modest income stream from Social Security that, in combination with our savings, 401(k)s, IRAs, and individual pensions, will allow us to live an even more comfortable retirement at the same time we help those who are less fortunate than ourselves.

Bonds vs. Bond Funds

In a recent article I discussed the reasons why retirees need adequate exposure to equities (company stocks) up to and during retirement. At the same time, bonds are an important part of an investment portfolio and perhaps an increasing one as investment money is needed to pay for retirement expenses. Bonds have historically been less volatile and oftentimes offset adverse swings in stock prices, thus diversifying and stabilizing an investment portfolio. And just as one can purchase stocks individually or as a basket of stocks, typically a mutual fund (there are also exchange traded funds - ETFs - for bonds though I'll leave that for another time), so too can one purchase bonds. And as with holding a group of stocks in a stock mutual fund, a mutual fund that invests in a broad and diverse group of individual bonds will provide diversification that would be difficult for an individual investor to achieve.

Diversification is good, but it can come at the expense of well, expenses. If you use an investment advsior to purchase your mutual funds you may pay a "load" fee, typically 3-5%, which goes to compensate the advisor for his or her expertise. Even if you purchase a no-load mutual fund directly and avoid this fee, there are still the yearly expense the fund company itself charges. The average bond mutual fund charges more than 1.0% yearly for its management. At a time of low interest rates of just 4% or 5%, this yearly charge can be tough to swallow. Better to give your money to one of the low-cost mutual fund companies. There are many bond funds from Fidelity, T. Rowe Price, Vanguard and others that have yearly expenses closer to 0.5% or even 0.25%. It would be difficult for most investors to improve on these costs by buying individual bonds, after the trading costs of buying and selling those bonds.

However, even given low costs and greater diversification possibilities with bond mutual funds there are still reasons why individuals might prefer to hold individual bonds. To begin with, bond mutual funds are subject to interest rate volatility that individual bonds are not. When interest rates rise, say 1%, the value of almost all bond funds will decline, (in different amounts depending on the average maturity and "duration" of the fund's portfolio of bonds). This will not be the case with an individual bond as long as it is held to maturity. If interest rates rise 1% the value of an individual bond may fall, but as long as the bondholder holds onto the bond until maturity, he or she will get the full investment back. This may not be the case with a bond fund, because the bond fund's portfolio never matures and its value at a given moment is always dependent on the interest rates at that time. For this reason, if an individual needs money at a specific period or at regular intervals and wants to be sure that the money will be there, holding an individual bond, or group of bonds with that given maturity date will meet that need. For example, someone who knows that they will need exactly $100,000 in five years, can invest that amount in five-year bonds, receive interest payments during that period, and at the end of the five years (assuming no default) will receive exactly $100,000. Bond mutual fund holders have no such guarantee. With the same $100,000 investment into a bond mutual fund, five years later, that investment could be worth $90,000, $100,000, $110,000 or whatever, depending on interest rates at that time.

In sum, a low-cost, no-load bond mutual fund or two will fit the needs of most individuals out there. It's much easier to choose a couple good bond mutual funds that will achieve high levels of diversification than to assemble a portfolio of individual bond holdings, sufficient in number to offset default risk (that a company can make its interest payments to bondholders), and that will be diversified in various economic sectors and bond types. But for those investors who want a greater degree of timing over their interest payments, less volatility in the value of their bond holdings, and have enough assets where individual trading expenses will not become excessive relative to a portfolio's size, individual bonds can meet that need.

Investment portfolio diversification and company stock

It's been several years now that investors have had a chance to digest the fallout from Enron, Worldcom, Healthsouth, Tyco, Adelphia, Qwest and other high-profile company-meltdowns. While we can never know the exact reason for the many problems of these companies, we have seen one glaring result for these companies' employees - disintegration of many of their 401(k) account balances. We heard of retirements put on hold, inability to pay for necessary health care and in some cases, the need to liquidate homes to pay the bills. The investing principle that we all know but which was reinforced by these events is the need for a diversified investment portfolio. This means not investing too heavily in a single company's stock. But when it comes to holding company stock, many investors still haven't gotten the message.

According to Hewitt Associates, in 2004 the average 401(k) participant held 27% of his or her account balance in their company stock, and this is the largest holding for the average 401(k) participant. However, this figure is skewed downward since company stock is not an investment option at many companies. In those companies where company stock was one of the available investment options, the average balance was 41%, a figure that has been quite consistent for the past several years. The latest study also showed that the average equity (stock or stock mutual fund) allocation of the typical 401(k) investor was about 70%. This means that participants are putting the majority of their 401(k) assets into equity investments which is usually considered appropriate since these retirement account assets should be long-term in nature, specifically targeted for retirement, often 20, 30 or 40 years away. Over long time periods, a diversified portfolio of stocks has historically surpassed those of bonds and such a stock portfolio can better protect against the rising cost of living, or inflation.

However, that applies to a diversified investment portfolio. Going back to the Hewitt study, if we put together the average 401(k) balances directed toward equities (70%) and the average company stock holding (41% for those where it is available) we see that more than half of the average 401(k) participant with company stock is invested in a single stock. This is an alarming figure since studies have consistently shown that an investment portfolio needs to have at least 20-50 stocks in various industries and geographic areas to achieve adequate levels of diversification.

While there are many reasons that employees invest such a high percentage of their 401(k) balances in their own company stock, including contributions that are matched with company stock, company loyalty, a "belief" in their company, and many others, that still doesn't necessarily make it appropriate. This portfolio "leveraging" simply increases the risk of an investment portfolio not meeting the needs of an individual during retirement. The question that a 401(k) participant with company stock should ask themselves is if they had absolutely no ties to the company, whether they would feel comfortable investing the same proportion (more than half for the typical 401(k) participant) of their retirement plan in a single company.

These under-diversification/over-concentration lessons have already been learned by millions of other investors both in recent years and years past. There's no need for us to re-learn them.

Stock up for a lengthy retirement

Many investors are familiar with the rule-of-thumb that they should subtract their age from 100 and that's the percentage they should have invested in stocks, with the remainder in bonds. So a 70-year-old would have 30% in stocks and 70% in bonds, while a 45-year-old would have 55% in stocks and 45% in bonds. This idea has been around for a long time and many investors have systematically sliced up their holdings to more-or-less correspond with these guidelines. And increasingly popular lifestyle or asset allocation mutual funds have done the work for investors by not only dividing investments up into stock and bond allocations, but adjusting it over time as the investor approaches retirement age. Unfortunately, this age/bond allocation guideline, as well as the stock/bond proportion within these lifestyle funds will not be appropriate for many. While they offer a good way to ensure an investor is getting a balanced portfolio, for most, they will underweight stocks and overweight bonds.

Since a broad-based basket of stocks has over the long-term historically surpassed bonds and has thus shown itself as a better guard against inflation, investors have been advised to weigh their portfolios mostly with stocks for any money won't be used for many years. And with longer lifespans as well as retirement spans, these stock allocations should be increasing. When investors think about the future when they'll begin to tap these retirement accounts, it doesn't make sense to target the exact year they'll retire.

Let's take an example. With the age/bond allocation formula, a 50-year-old woman would have a portfolio with 50% stocks/50% bonds. But the typical 50-year-old woman is expected to live another 32 years and about one in three will live another 40 years, to age 90. Assuming she lives another 40 years and an average yearly cost-of-living increase of 3%, for every dollar she has in 2005 she'll be able to buy less than 20 cents worth of food and shelter in 2045. In order to survive the ravages of inflation, she needs to have investments that will outpace inflation, including a hefty proportion of stocks. For a retirement that spans 30 years, even an investor who is on the brink of retirement should still have a long-term bias since most of his or her retirement assets shouldn't be used until at least 20 or more years in retirement. From this perspective a 45-year should be investing with a 35 or 45 year time-frame, not the date upon upon retiring from full-time work.

Think of the reality of today's 80 and 90-year-olds who have been living for 30 years on a fixed income, perhaps 3% or 4% a year from the local bank's CD. After inflation and taxes, these individuals who "played it safe", and their families, are now in a not-so-comfortable situation.

Don't misunderstand me. No matter what your age, I believe it's useful to include both stocks and bonds in your portfolio. Bonds represent another asset class that historically has done well in periods of weak stock returns, that often accompany lower interest rates and a softening economy. As such, they diversify an investor's portfolio, and lessen volatility. And it seems prudent to increase somewhat your bond allocation as you approach retirement. But it also appears prudent to remember the biggest risk of a long-term retirement - the loss of buying power during a long retirement and continual cost increases.

Mutual fund returns: expenses matter

Last week I discussed the various expenses that mutual fund owners pay, with many of them not knowing the kinds and extent of those fees. But fund owners should care about these expenses since they are a major determinant of how their fund will stack up compared to its peers.

While an investor may believe that an extra 1% or 2% a year may not matter much over the long haul, exactly the opposite is the case. The power of compound interest magnifies cost differences. Long time-periods punish the shareholder who pays high fees. As an example, let's look at the thirty years from 1970 through 1999, generally a very strong period for stocks, particularly the wildly bullish second half of the 1990s. During that entire period the average yearly return of the S&P 500 index was 13.7%. If an investor invested $10,000 at the beginning of 1970 and was able to exactly match that stock average, he or she would have seen their investment grow to about $471,000 at the end of those 30 years. That result would have been unlikely because it assumes no trading costs or management fees. So if we assume just 1% in total yearly expenses, the investor would then see the 13.7% yearly average reduced to 12.7%, and the ending account balance at the end of 1999 (which as it turned out, might have been a good time to take profits) would have been roughtly $361,000. That "small" 1% difference in yearly returns meant a difference of $110,000 compounded over 30 years. And unfortunately, for most investors the fees will be signficantly higher, and results depressingly lower.

The average expense ratio charged by the average actively managed stock mutual fund is about 1.5%. That doesn't include trading expenses, which we discussed last week and which were estimated to be, on average, almost half as large as the typical fund's expense ratio. Of course, many expense ratios are much higher - 2% is quite common, as well as estimated trading costs, often more than a fund's stated expense ratio. In addition to these, there are taxes to consider. Although many investors have much of their investments in tax-deferred accounts, many don't. Two studies - one by the Vanguard Group and the other by Lipper, estimated that taxes eat up another 1.6% and 2.5%, respectively, of yearly average returns. Even ignoring taxes, it's easy to see how many investors are paying 3%, 4% or more a year for the priviledge of investing in the financial markets.

So back to our hypothetical 1970 investor. Starting again with the yearly 13.7% average and docking two percent a year, gives our investor an ending balance of about $276,000. A 3% yearly expense hit, would have resulted in just over $211,000 at the end of the millenium, and a 4% yearly cost would have resulted in just $160,000, or just over one-third of the ending balance of that of the no-cost investor.

And while going from 13% to 10% might not seem so bad in an era of high returns, how about an era of low ones? The investor who pays 3% in fees in a 6% yearly return era will find the numbers particularly dismal.

When it comes to investing, fees have always been important. Now they're really important.

Mutual fund fees: transparency desired

There's a lot to like about mutual funds: they're allow for significantly higher diversification than most could acquire on their own. There are broad-based mutual funds as well as more focused ones that allow investors to decrease risk and participate in nearly any portion of the financial marketplace that one chooses. And the costs to assemble such a collection of stocks is often lower than one could achieve on ones own.

Unfortunately, the fees that funds charge aren't so clear. Most mutual fund investors know that a mutual fund charges an underlying yearly management fee (called an expense ratio) which is used to pay for the management and administrative costs for a particular fund. This can range from less than one-half of one percent of the amount of an investor's fund balance, to more than two percent annually, with a typical "actively managed" stock mutual fund charging about 1.5% a year. Many investors also know that there are "no-load" mutual funds and "load" mutual funds, with the latter charging an additional sales charge. This load can range from 1% a year as long as the shares are held to a 5.75% up-front or "back-end" charge. Over the past several years there has been an effort by regulators to make these charges more transparent, but many investors are still not fully aware of the existence of the charges, or the amounts themselves.

And very few mutual fund investors know how much they are paying in trading costs - the most obscure costs of all. A group of independent advisory firms, the Zero Alpha Group, had three professors look at 5,000 equity (stock) mutual funds. They found that trading costs, which are never revealed to shareholders, were on average 44% as large as the amount of a fund's stated management fee (expense ratio). Those trading fees were much higher for mutual funds that focus on small-company stocks, with almost half having trading costs that exceeded their annual expense ratios. Some mutual funds had trading costs that were four times as large as their listed annual expenses. Large-company funds had lower trading costs, and not surprisingly, index funds had the lowest trading costs, just 6% of the amount of their already low management fees. It makes sense that the funds that buy and sell the most (have high "turnover") should normally have the highest trading costs, and vice versa. Unfortunately, a fund manager with a desire to trade means more money coming out of investors' pockets.

When it comes to mutual funds, expenses may be the most critical factor for a shareholder's return (which I'll discuss next week). If that's so, pay careful attention to the type of mutual funds you own, the stated expense ratio, and the turnover of your funds. A mutual fund with high turnover creates a very high hurdle to clear for the fund manager, along with its investors.

Exchange Traded Funds: a mutual fund threat?

Over the past few years, while the mutual fund industry as a whole has seen modest growth, the growth of one investment vehicle has been explosive. From the end of 2001 to December of 2004, assets in Exchange-Traded Funds (or ETFs) nearly tripled, growing from $83 billion to $226 billion, according to the Investment Company Institute. While investments in these vehicles are still small compared to the broader mutual fund industry, (which holds nearly $8 trillion of assets), they're becoming more and more popular among investors, big and small. And the number of ETF options has likewise quickly expanded from just a handful a few years ago, to currently roughly two hundred.

ETFs are baskets of securities, either stocks or bonds, typically designed to track a particular stock or bond market index. Such indexes include those that invest solely in small-cap companies, "value" companies, as well as those that invest exclusively in the companies of a single country, such as Japan or Taiwan. There is even an ETF that is designed to match the price of gold.

ETFs are a kind of hybrid between stocks and mutual fund. They are traded just like stocks on a stock exchange, with associated brokerage commissions. And like stocks, they have trading flexibility - the ability to buy and sell throughout the day, as opposed to being limited to the close of trading, as with traditional mutual funds.

At the same time, as with mutual funds, ETFs charge an an underlying yearly management fee. However, the fees with ETFs are typically below those of mutual funds, even index mutual funds, which by design, normally have low annual fees. Assuming an individual investor can keep buying and selling of ETFs to a minimum and has access to a low-cost discount broker, ETFs should be less expensive than owning a traditional mutual fund, at least actively managed funds. Also, compared to most mutual funds, ETFs are generally more tax-efficient, which usually means lower taxable distributions.

Are they right for you?

Echange-Traded Funds might make sense for a part of your investment portfolio depending on:

Taxes: If you have a lot of mutual funds in taxable accounts and are getting burned by taxable mutual fund distributions, ETFs might make sense.

Long-term investor: If you are likely to hold on to these shares for a fairly long period, ETFs will be more appropriate. More frequent trading will lead to possibly higher taxes (from taking gains) and definitely brokerage commissions from buying and selling, which might negate any inherent advantage of ETFS.

Management style: If you prefer to invest in actively managed funds, ETFs probably won't work for you. Although there is talk of introducing a few actively managed ETFs in the coming months, ETFs are primarily "passively-managed" funds, that is designed to match a given index. Of course, the lack of fees paid to an active manager is a primary factor that keeps management fees low.

Trading Commissions: If you don't have access to an online low-cost discount broker, the higher trading costs of buying and selling ETFs might not give you any ultimate savings. This is particularly true if you tend to do a lot of buying and selling of your shares.

The bottom line is that ETFs can help you target particular market indexes with very low costs. This assumes that you don't eat up those cost advantages by overtrading, which like stocks, can cause your expenses to soar, and returns to go south.

Health Savings Accounts: A Welcome Prescription

There's been a lot of talk lately about Health Savings Accounts (HSAs). And there's a lot to like about them, for businesses and individuals. They combined a high-deductible health insurance plan with a health savings account. They allow consumers or businesses to save money on health insurance premiums and put those savings in tax-deferred savings accounts that can be used for future medical expenses, or upon reaching age 65, anything at all. During that time, savings build up tax-free and avoid taxes when withdrawn as long as they are used for medical expenses (upon reaching age 65 they can be used for other purposes but are assessed ordinary income tax).

HSA are most beneficial for the self-employed, or those who work at small companies with minimal health insurance benefits. They're limited to individuals under the age of 65. And they will be especially appealing to a healthy individual who wants to keep health insurance premiums low. An HSA owner gets what amounts to a tax-deferred retirement account along with the option to cash in some of those dollars should a substantial medical need ever arise.

These are insurance plans with high deductibles, which is a good thing here, since it keeps premiums low. Your health insurance plan has to have an annual deductible of at least $1,000 for individual coverage and at least $2,000 for couples or families. For 2005 you're allowed to contribute up to the amount of your insurance deductible, to a maximum of $2,650 for individual coverage and $5,250 for multi-person coverage. The nice thing about these are the tax-deductibility of the insurance payments, which comes right off the front of your 1040. Most states conform to federal law with HSAs so allow tax deductions for contributions and tax-deferral for savings. As an example, a family with a combined (federal and state) marginal income tax rate of 30% who makes $3,000 in premium payments during the year would see $900 immediately come back in tax savings. But any portion of the full $3,000 not used for medical expenses during the year would then go forward tax-free to be used in later years.

HSAs are generally available through the major health insurers as well as some banks, with investment options ranging from guaranteed-return funds to traditional mutual funds. Over the past few years many kinks have been worked out of these accounts, the benefits have been enhanced and more and more individuals and companies are discovering these plans. We'll hear much more about these in the coming months and years. I would not be surprised to see them have a positive impact on the state of the American health system by giving consumers and businesses more control of their healthcare spending.

Corporate Good?

It's often said that trajedies bring out the best in people. They can also show the heart in companies. After tsunamis devastated many Asia countries, corporations quickly responded with logistical expertise, medicine, food, water and shelter. And many did so before governments and international relief agencies came on the scene. Pfizer donated $35 million of medicine and other aid. In additon to a ten million dollar donation, Coca-Cola donated half a million bottles of water to Thailand survivors, along with the use of its manufacturing facilities. Other significant donators include Abbott Labs, Bristol-Myers Squibb Cisco Systems, Citigroup, Computer Associates, Dow Chemical, Exxon-Mobil, FedEx, Johnson & Johnson, Merck, Microsoft, Wal-Mart and Wells Fargo. The Red Cross reported that for the first week after the tsunamis more than half of the funds they received came via corporate donations. It's expected that U.S. corporate donations will exceed $500 million. Countless other businesses have given time and energy to the cause in whatever way they can. And these weren't public relations gimmicks meant to show their companies in the best light. Many of these companies are making donations with little or no public disclosure.

As with many disasters, this one has shown how generous individuals all over the world can be. It also shows that companies can likewise look beyond the bottom line.

Investing: Demystifying the stock market

The other day I read (not for the first time) a person say they "didn't trust the stock market". A 2003 report found that fully one-third of respondents "did not trust" the stock market. It's important to remember what the stock market, or simply an individual stock. A share of stock is simply a piece of a company. If I own one hundred shares of Wal-Mart and there are one hundred million shares of Wal-Mart stock, then I own one millionth of Wal-Mart. And any increases in Wal-Mart's earnings from year-to-year will be passed on to me, in the form of higher earnings, higher dividends, and at least over the long-term, a higher stock price. Taken as a whole, the prices of the broader stock market, within the U.S. and out, should reflect the economic growth of the companies within a particular country. While year-to-year gains or losses in the stock market, almost never match the growth of the broader economy, over the long-term, returns do generally track economic growth.

Where does economic growth come from? Investment and improvements in productivity are two of the most important aspects of economic growth. The financial marketplace itself fosters economic growth. Access to financial markets transform ideas and human capital into financial capital which leads to a growing labor force and higher capital investment. Companies continually tap into the improved technology in the marketplace to become more efficient, increase investment in capital and their workers, which leads to a virtuous cycle of a more skilled and educated workforce, more productivity, and economic growth.

We are fortunate to have access to such a marketplace where we can participate in the growth of other people's companies. And while there are occasionally periods where markets seem to dislocate from rational behavior, as well as periods when the majority of stock prices fall, over the long run investors are usually justly compensationed.