Consumer spending increased a seasonally adjusted 0.7% in December, above expectations, according to the Commerce Department this morning. Incomes rose 0.4% in December. Consumer spending has risen in six straight months. Economists had expected a 0.4% increase in income and a 0.6% gain in spending. With spending out-pacing income, the savings rate fell to 5.3% in December from 5.5% in November. This is the lowest level since last March for savings.
Stock futures, despite the unrest in Egypt, are higher, signalling a positive open for stocks. Dow futures are up 32 points, NASDAQ futures are up 7.5 and S&P 500 futures are up 6, with about 20 minutes to go before the open.
Monday, January 31, 2011
Saturday, January 29, 2011
It stands to reason that the stock market should experience a significant correction in the short-run. We have seen multiple new yearly, multi-year, and historic highs for stock prices of late, and the overall level of the Dow (12,000), and the S&P 500 (1,300) are at nosebleed levels.
Last year we saw stock prices drive strong gains in the Dow (up 11%), the S&P 500 (up 13%), and the NASDAQ (up 17%). Interestingly, the best performing sectors were Consumer Discretionary (+26%) and Industrials (+24%), while Technology was only up 9%, and the Health Care sector managed less than a 1% advance.
The real question is: where do we go from here?
I have been anticipating a sizable correction in the first part of 2011 for several months. Could yesterday's sell-off signal the beginning? Possibly, but we must keep in mind that earnings have been solid, and sentiment is fairly strong. GDP growth for the fourth quarter was reported to be 3.2% (initial reading; annualized) this past week, while growth for 2010 was reported at 2.9%.
Investors appear to be confident that stocks can continue to drive higher, and this could result in continued stock market advances. However, I believe that stock valuations are extremely expensive, and would not be a buyer here. Further, I do expect a correction of at least 10% to 15% to come shortly, and would not risk new capital in stocks at this time. I would also trim positions, particularly in those sectors that have shown the strongest upside during the rally.
Does building green make financial sense? (published in the Santa Barbara News Press in July of 2009)
Green building has gained in popularity over the past few years. Just about any new building, whether residential, office, or commercial, will have green features, either because they are mandated by the state or federal government, or because they are believed to be cost-saving in the long-run, and good for the environment. But are they really either of these?
First, we need to understand that while it is possible to have materials, technologies, and methods of construction that are both cost-saving and good for the environment, in many cases this will not be the case. In other words, many of the things that make a building green—improve the building’s impact on the environment—cost more than the alternative, non-green element.
While there have been many studies claiming to prove that green building improves energy efficiency for buildings, the vast majority of these (if not all of them) have severe flaws that make their conclusions akin to comparing apples to oranges, and thus, their conclusions are unreliable at best. Also, the green building movement is relatively new, and many of the green building methods, technologies, and products have not been around long enough for adequate testing in real-world applications to know yet if they truly offer cost savings or even reduce the building’s impact on the environment.
One study, widely quoted by advocates of green building, conducted by the U.S. Green Building Council (USGBC), uses information from the Energy Information Administration (EIA) for comparing green buildings with “the national building stock average from the 2003 Commercial Building Energy Consumption Survey (CBECS) for all building types.” (The USGBC is the organization responsible for the LEED (Leadership in Energy and Environmental Design certification process.) This study claimed that LEED certified buildings save 24 percent when compared with the average “national building stock.”
The EIA survey includes a large sample designed to reflect all buildings in the United States, many of which are quite old. The detail of the study shows that 74 percent of the buildings in the baseline are more than 20 years old, and 59 percent are more than 30 years old. Thus, in the USGBC study, new LEED buildings are being compared to buildings which are, on the whole, quite old.
It is not surprising that new buildings are more energy efficient than old buildings, so it is disingenuous to claim that those energy savings are attributable to LEED certification, as opposed to the simple fact that the buildings are taking advantage of improved energy technology developed in the last forty years.
So does green building make sense from a cost perspective? The answer may depend on just that; perspective. If the person, organization, government, developer, etc, that builds a green building is planning to own the building long-term, and if the green elements including in the building’s construction prove to be cost-saving (eventually), then it may make sense for the owner to spend the additional money to build green. If however, the owner does not plan to own the building long-term, as in the case of a developer planning to sell the building soon after construction is completed, the question of green viability becomes even more complicated.
Also, there are perspectives with regard to the costs and utility of a building. For example, one owner might be most concerned with up-front building costs, while another may care more about ongoing operating and maintenance costs, while a third may be focused on how long the building will last, and still another might look at the productivity of workers using the building.
A commercial or residential building with green features may generate higher rents/lease rates due to the tenants’ perceptions that they will save on utilities, or because tenants believe they are helping the environment (whether true or not). If a green building can demand sustained higher rental/lease rates, the developer may be able to sell the building for incrementally more than the additional cost of the green elements. Estimates vary widely as to the additional cost, if any, of building green versus traditional, non-green building.
Many of the most effective green elements are things that don’t necessarily cost money, or at least don’t cost significant money. Probably the most effective green element of any building is its orientation to the sun. By positioning the building to avoid solar heating in the summer months, and to take advantage of natural light to reduce electricity usage, the efficiency of a building can be increased dramatically, potentially without adding to the building costs.
According to Mark Schniepp, economist with the California Forecast, another very inexpensive green approach is to simply paint the roof of the building white, or use white or light-colored roofing materials with glass and rubber chards embedded in them that reflect sunlight, thus reducing the heating effects of the sun on the building.
A large percentage of the total energy usage of buildings (as much as 85 percent) is used to cool and light the building. By using site planning and orienting the building appropriately to efficiently avoid the heating impact of the sun while maximizing the capture of natural light, a building can dramatically reduce its energy usage.
There are many other elements like high-efficiency/low water usage (low flow) toilets and motion sensor light controls that have short cost recovery periods. Some other green elements, such as solar panels, have a much longer cost recovery period, even with government subsidies. Keep in mind as well that government subsidies come out of our collective pocket, so the cost is still there, even if it is absorbed by society and not incurred by the building’s owner. Without subsidies, it is still unclear as to whether the cost of solar panels can be recouped within their expected economic life.
As Bruce Allen relates in his recent book, “Reaching the Solar Tipping Point, the cost per watt of power generated for solar panels has decreased to about $0.90 per watt, and is expected to fall to around $0.60 per watt shortly. As costs come down, the pay-back period shortens, leading to the possibility of a more economically viable green element.
So far I have discussed the economic issues surrounding green building, but there are other considerations. Protecting the environment is, of course, a key issue and reason for green building. Many of the so-called green products require chemicals harmful to the environment during the production process, or simply come from so far away from the building site that any energy gains they may offer are dwarfed by the energy burned to get the product to the site. We must balance any environmental gains a green product offers during its life with the environmental cost or producing and delivering it to determine if the product is a net positive for the environment.
There are other issues to consider as well. Many green building elements offer cleaner air, improved natural light, a more pleasing working environment and many other quality of life improvements that are difficult to measure, but are nonetheless valuable.
At the end of the day, we may never get a clear answer to the question of the cost effectiveness of green building. Green building methods, products, and materials are constantly being introduced and improved, so any measurement of their effectiveness would come well after they have been made obsolete.
I think, as with any new movement or industry, there will be good and not so good developments. Ultimately, for those considering a green building project, the costs and benefits of going green must be weighed in the context of their individual perceptions and attitudes. Whether or not a green building is judged to be a success will not simply hinge on the cost in dollar terms to build the building, or even the cost to the environment, but rather on the long-term utility, enjoyment, and long-term costs of the building, both to build, operate, and maintain throughout its life.
Is it really different in Santa Barbara? (published in the Santa Barbara News Press in February of 2009)
I moved to Santa Barbara from La Jolla about seven years ago, and one of the first things I heard when looking at real estate was that it’s different here in Santa Barbara. When other markets experience price declines, I was told, Santa Barbara just keeps right on going. So, with the recent real estate debacle and accompanying price declines and resultant global recession, I thought it would be interesting to take a look at the local economy and real estate market to see if I could determine if it is truly different here.
First, I looked at the median home price for Santa Barbara, and compared it to the California median home price, and that of the nation as a whole. What I found was that the median home price in the city of Santa Barbara actually increased by 12.7 percent in 2008, while in the U.S. the median home price fell 9.3 percent, and for California, the median price fell by a shocking 41.5 percent during 2008. At least on the surface, these results seem to support the idea that it really is different here.
However, there are some problems with making this simple comparison. First, Santa Barbara is a smaller city, and as such, we just don’t have the number of monthly home sales as other larger cities, states, or the country as a whole. So evaluating our local economy or real estate market based strictly on a snapshot of median home price isn’t going to be reliable. This smaller number of sales can act to skew the median home price up or down from one month to the next, so we must examine the median home price over time, to identify any trends that might be developing.
Second, we need to consider seasonality, as real estate sales are not consistent throughout the year, but instead are lumpy, with a larger percentage selling during the spring and summer as compared with winter, for example. Finally the 12.7 percent increase was at least partially the result of the median home price falling by such a larger amount from October of 2007 through December of 2007, from $1,275,000 to $845,000, a 33.7 percent decline in only two months. This meant that the starting median price for 2008 of $845,000 was very low, and therefore it was easier to have the unusually large increase for 2008. The big drop in the last two months of 2007 highlights the tendency for the median home price to jump around month to month due to the lack of a large number of sales. Still, we did end 2008 with a median home price of $952,500, and while that price was twenty-five percent below the peak price of October 2007, it is still one of the highest in the nation for any city.
A little closer to home, the median home price for Santa Barbara County, which includes the city of Santa Barbara, fell 31.9 percent during 2008. While there were more sales included in the calculation of the county’s median price, this is a striking contrast to the 12.7 percent gain we experienced in the city itself. Based on the county information, and that of the state of California, I would have to conclude that, at least up until this point, Santa Barbara is certainly experiencing a much less significant impact from real estate price declines as compared with the county, state, or other areas where real estate prices skyrocketed, like Phoenix, Las Vegas, Florida, etc.
The real question is: Where do we go from here? Another way to try and find an answer to this question is to look at inventories of unsold homes. For Santa Barbara County, inventories fell from about 8 months supply to 5.5 months supply over the course of 2008. What these number mean is that it takes, on average that amount of months to sell every house in inventory at the current rate of sales. The rate of sales can increase or decrease, so this number is a bit esoteric, but basically what we can take away from it is that a lower number means that the supply is diminishing and / or demand is increasing relative to supply.
We had an even more dramatic reduction in inventories for the state of California in 2008, with inventories falling from a 13.4 months supply to a 5.6 months supply. With steep price declines in Santa Barbara County and the state, the reduction in supply makes complete sense: if you lower prices, sales should increase, and therefore inventories will be reduced.
On the commercial real estate side of things, I spoke with Steve Cushman, the Executive Director of the Santa Barbara Chamber of Commerce, who keeps a close eye on commercial vacancies in town. He stated that vacancies during the depth of the 1991 recession, the last time we had a major real estate contraction, were as high as 44 out of the 410 retail store fronts on State Street. Today, he says there are 37, so in comparing the two periods, it appears on the surface that this real estate recession is not quite as bad as the last.
But, Cushman cautions, he sees some businesses subletting space to reduce overhead costs, making the number of vacancies less reliable, as it understates the true magnitude of the recession. One optimistic way of looking at the subletting issue is that businesses are likely subletting instead of giving up the space entirely because they expect the slowdown to be temporary, and therefore want to maintain control of the space so they can expand once things get better.
Unemployment is another major factor in determining the impact of the recession and real estate contraction. If unemployment continues to climb, we could very likely see continuing and more intense pressure on the real estate market and economy. As incomes are lost, homes will follow. This is another area where we may be able to say that it is truly different in Santa Barbara, again, at least so far. In the county, we have an unemployment rate, according to the California Employment Development Department, of 7.2 percent, about in line with the country as a whole, while California’s rate is at 10 percent, and about to go a lot higher as the legislature failed to pass the budget this week, forcing Schwarzenegger to lay-off 20,000 more state workers, and counting.
The state has lost the largest number of jobs in the construction industry, which makes sense as new home construction has all but gone extinct. With the recent Tea Fire, as devastating as it has been for so many local families, we may benefit as a community through maintaining construction jobs that may have otherwise been lost, somewhat insulating us from the same unemployment rates as those of the state or the nation. Some estimates show our local unemployment rate jumping to 10 or 11 percent. While I expect the national rate to climb as high as 8 to 9 percent, I am still hopeful that we will not experience the severe economic impact of an unemployment rate in the double digits.
We will need to watch the trends in median home prices, commercial real estate vacancies, and unemployment to get our answer, but based on what we have seen so far, I think there is reason for optimism that it is truly different here in Santa Barbara.
Removing mark-to-market accounting rules is the exact opposite of what we should do (published in the Santa Barbara News Press in February of 2009)
Mark-to-market accounting is essential to our financial system, and to the health of our economy. Recently, many have called for relaxing or the complete abandonment of mark-to-market accounting rules. They feel that the only way to get us out of the financial calamity we find ourselves in today is to remove the requirement that firms place the correct value of assets like mortgage-backed securities held by banks, on their financial statements, no matter how low those values may be.
The idea is that by removing this requirement, the banks and other financial institutions will not be forced to write-down the value of these troubled assets, which in turn will not force them to go out and raise more capital. The problem with the write-downs is that the falling value of these assets reduces the shareholder’s equity section of the balance sheets of these firms, which is the basis for their borrowing ability, and affects the covenants on their existing debt. If their equity ratios fall beneath a certain level, they may violate these covenants, which could force liquidations and potentially bankruptcy.
My position on this issue is simply this: Two wrongs don’t make a right. Changing the rules and reducing regulations because the current system of regulation failed to prevent a catastrophe is the exact opposite of what we need right now. The problem is not that financial institutions were required to properly account for the value of their assets; it’s that they created and purchased so many of these securities that the system couldn’t handle the gargantuan amounts of debt and subsequently imploded. Now that these firms took-on all of this risk, wiped out ten years of prosperity, and cost taxpayers hundreds of billions of dollars, some want to change the only mechanism we have in place that provides any hope of understanding exactly how bad the current situation is, and how much risk there is in the system.
We need to know what these assets are truly worth. There is no sense in deluding ourselves any further. The financial firms have done that for us for long enough. What we need right now is more regulation, more disclosure, more transparency, and a more accurate accounting of what is out there and how much risk it all entails. By telling firms they don’t have to report what their toxic assets are really worth, we will only act to prolong the financial crisis, and will send the wrong message to these firms, which is that they can screw-up, and we will not only bail them out, but we will turn a blind eye to what they have done. This is not the America I know. When you make a mistake here, you take responsibility for it, and you take significant steps so that you don’t repeat the same mistake.
We need to force these firms to take responsibility for buying these assets in the first place, and we need to understand the magnitude of the problem we are facing. Most importantly, we need to put rules in place to ensure that the chances of this happening again are significantly reduced.
The recent discussions about establishing a “Bad Bank”, which Treasury Secretary Tim Geithner discussed this week, have sparked this mark-to-market debate. The idea of a bad bank is that troubled assets could be purchased from financial institutions by the bad bank, or that these assets could be deposited with the bad bank in exchange for cash that the institutions could then use to make loans. The problem arises when these transactions take place because the financial institutions that sell or deposit the toxic assets with the bad bank must account for these transactions. The question is: What price do they place on the assets?
If they mark them to market, meaning they account for the assets at the price they are given for the assets, they may be forced to take even more extensive losses than the write-downs they have already taken, which have resulted in the massive price declines of their stocks that we have already witnessed. These additional write-downs will no doubt have a devastating impact on their ability to operate, and may be so significant that they offset any positive impact that the money they get from the bad bank might have. If the additional losses equal or exceed the cash they get from the bad bank, then they are no better off and could be worse off, and there would be no point in doing any of this in the first place.
This is the reason some are calling for the “relaxing” of the mark-to-market rules, so that financial institutions which take money from the bad bank can avoid writing-down the value of their troubled assets further. While there is logic to this argument, the underlying problem still remains, which is that ignoring risk is what got us into trouble in the first place. The value of these assets is what they are worth in the open market—it’s what a free market buyer of these securities is willing to pay, period. If we simply ignore this basic tenet of free market capitalism, and try to artificially price these securities, or worse, ignore their value, we are setting ourselves up for even more severe economic consequences to come.
I have seen this happen too many times. It is no different than when countries try to artificially support or constrain the value of their currencies. One need only look at Latin America where too many times, countries tried to peg their currencies to the U.S. dollar, only to have their entire economies collapse when the currency eventually devalued drastically under the weight of this manipulation.
We got into this mess because regulators were asleep at the switch, and didn’t understand the complexities and systemic risks associated with all of the new derivative investment vehicles created during the real estate boom. Sufficient rules were not put in place, and those that were, failed to capture the true risk within the financial system. Many off balance sheet investment vehicles, like CDSs, or Credit Default Swaps, were not accounted for at all on company financial statements because they are private contracts. With a private contract, there is no active market for these securities, so there is no way to accurately price them. The failure of a large number of these contracts was a key reason that the financial system failed. How can it possibly make sense to move closer to a system where securities, like CDSs are not properly accounted for on financial statements, and therefore the inherent risk of these securities cannot possibly be known?
This is what those who are proposing to abandon mark-to-market rules are advocating, and it is a recipe for more disaster. The answer is to force firms to recognize the true value of all assets, including CDSs, and if there is no market mechanism for valuing these contracts, then a new active market must be established where these contracts can trade so that we can understand what they are worth and what their true risks are; not just to the individual companies that own the CDSs, but to the system as a whole. Only by understanding the true risk to the entire system can we hope to avoid a repeat of the financial crisis we find ourselves in today. And, if this happens again, the magnitude will likely be so great that no amount of government intervention will be sufficient to save the world economy.
Limiting Executive Compensation is a Bad Idea (published in the Santa Barbara News Press in February of 2009)
Limiting executive compensation is a bad idea. This week President Obama announced that a limit of $500,000 will be placed on executive compensation for any company that took government bailout money from the $700 billion TARP fund. In his speech, Obama stated, "We all need to take responsibility. And this includes executives at major financial firms who turned to the American people, hat in hand, when they were in trouble, even as they paid themselves their customary lavish bonuses. As I said last week, that's the height of irresponsibility. That's shameful."
There are some unfortunate consequences of this policy, which I believe will lead to competitive disadvantages for the major financial institutions and other companies that took money, even though I firmly agree that paying huge salaries and bonuses for losing billions of dollars is probably a bad idea.
First, many of the current top executives running these companies were not there when the bad decisions were made that led to the financial crisis. The people who made the mistakes, for the most part, were fired, and new executives were brought in to clean up the mess. Now, with these restrictions, what we are saying is, come in and save the company, but oh by the way, we don’t want to pay you much for your efforts. (I realize $500,000 is a lot of money, but to a top executive accustomed and able to make millions, it is a pittance.)
Second, the type of individual that rises to the level of top executive at a major public company is there for a reason, and that reason is to make money. If you remove that incentive, and there is another company out there that is willing to pay them what they are worth, in many cases, they will leave for greener pastures.
Third, companies that really need money from the government will be far less likely to accept it, since the top executives responsible for deciding whether or not to take the money are the very individuals that will have their pay capped. This conflict of interest could very likely result in some companies taking unnecessary risks that could ultimately lead to bankruptcies, or at a minimum, lingering poor performance. While some may say good riddance; let them fail, the negative impact to the economy could be severe, and let’s not forget that when companies go bankrupt, employees who had nothing to do with making these bad decisions lose their jobs too.
Fourth, bonuses are a key component of total compensation on Wall Street and at banks, and they typically account for a large percentage of total compensation, especially for the best performing and most valuable employees of these firms. While I understand and feel the outrage personally over firms paying bonuses after they have taken TARP money, keep in mind that most of the bonuses Obama is referring to, were paid in early 2008, before these companies took any money from the government.
Merrill Lynch paid bonuses at the end of the year, and the combination of that decision, and his decision to spend $1.2 million redecorating his office led to John Thain’s dismissal (technically he resigned , but we all know he was fired). These blatant, inexcusable actions have poisoned the public’s perception of Wall Street and the financial industry as a whole. Granted, some of that perception is certainly warranted, but there are still a large number of honest, hard-working people—hundreds of thousands of them—that go to work every day, work hard, and deserve to be paid fairly. Ask yourself: Should the person taking John Thain’s job suffer for Thain’s actions?
Another component of the plan Obama announced is that any compensation above the $500,000 annual cap can only come in the form of stock awards that cannot vest until after all money borrowed from the government is repaid. Since we just don’t have any realistic visibility as to when (if ever) this money will be repaid, top executives will have little incentive to stick it out for the long-term, which is certainly what it will take to turn these companies around. No quick fixes here.
A fifth consequence could be that, if top executives leave, who will replace them? Why would any qualified executive want to go to work for a struggling bank that is under intense scrutiny in this economy, with this much negative public sentiment against it, for $500,000 a year and some worthless stock options that won’t vest in this lifetime? I don’t know about you, but if that job description was posted, I don’t think I would apply.
We need the best, most qualified people dealing with this problem, and we have some of them already at the helm of these troubled companies. The last thing we want to do is to run them off by limiting their compensation, right at the time when we need them most. There simply are not that many top executives with the level of knowledge and expertise sitting around twiddling their thumbs with nothing to do, hoping to get a job at a troubled financial institution, so we had better hang on to the ones we have.
One final consequence would be that foreign companies would gain a significant competitive advantage over their U.S. counterparts, as the brain drain that could occur due to low compensation may force these troubled companies to hire less-capable executives, resulting in more bad decisions, further losses, and poor overall financial performance. Do we really want some of our largest banks to steadily decline until some Japanese, Chinese, or European financial institution buys them at a discount?
We are witnessing first hand in the auto industry how poor decisions, weak management, and an exorbitant cost structure are killing these companies; allowing the Japanese automakers to gain market share and dominate the U.S. car market. Do we really want the same for our banks?
There is a better way.
What I suggest is tying top executive compensation to performance; not to performance of the stock, but to things like appropriate loan generation, management of troubled assets within the company’s portfolio, cost management, risk management, long-term profitability, etc. Admittedly some of these concepts are hard to quantify, but it can and should be done so that top executives have well-defined incentives to turn these troubled companies around. We need it for the economy in general, and we need it because hundreds of thousands of U.S. citizens’ jobs depend on the success of these executives.
I agree that we need executive accountability for performance, and no one should get paid when they perform poorly, or when they make terrible decisions or take-on undue risk, regardless of the results. But this is the United States, and we have a capitalist system here, where people get paid for what they do, and they typically go to the highest bidder, with the best and brightest usually making the most money. We are in a deep recession, and a lot of mistakes were made, but we are still the greatest country on earth for a reason, and that reason is capitalism. Let’s leave with who brought us to the party.
I am a student of history, whether it’s the history of the stock market, the economy, the country, the development of civilization, politics, or just about any other subject. I believe very strongly that by studying history, we can learn to better deal with the present, and the future. I believe this because history, as with the present and the future, is driven by human behavior, and people don’t change. We are motivated by the same factors today as the Greeks, the Romans, the Europeans, and I would say every other people throughout history.
Because history tends to repeat itself, and because human behavior has a direct and significant impact on history, I believe, by understanding history, I can make better decisions for my clients, in terms of investing their wealth. I see the current stock market valuation as a significant opportunity; one which we will not likely see again for many years to come. For some of us, it may very well be the best opportunity we will see for the rest of our lives.
If we look beyond the November 2008 lows, stocks are down to levels we have not seen since 1997. But, on a valuation basis, if you compare stocks to Gross Domestic Product (GDP)—the value of all goods and services produced in the United States within one calendar year—which is a useful and relevant measure of the value of the stock market, stocks today are much cheaper than they were even in 1997. While this does not mean that stocks cannot go even lower, it should offer some perspective in terms of how cheap stocks are today. For comparison, in 1997 the value of the S&P 500 represented 88 percent of U.S. GDP. Today, the S&P 500 only represents about 50% of 2009 estimated GDP. We would have to go back as far as 1994 to find a time when the S&P 500’s value was as low in relation to GDP as it is today.
In addition to the GDP comparison, stocks are incredibly cheap in comparison to all other asset classes, whether we look at bonds, commodities, real estate, or even cash. Although real estate prices have come down substantially, they are still well above where they were at the bottom of the last real estate bear market, back in 1993 through 1996. Commodities have come down big from their highs in the first half of 2008, but they are still elevated, and I would expect commodity prices to continue to decline throughout 2009 and beyond.
Although there are some opportunities within the bond segment, treasuries are at yields lower than we have seen over the past sixty years. Since bond prices move in the opposite direction as yields, treasury prices are at historically high levels, and I believe are in a massive bubble, similar to the bubbles we saw in oil and real estate over the past year or so. Even cash is expensive right now, with most money-markets paying virtually zero percent returns at present. So, when we compare stocks to any of these other assets, the valuations for stocks look very attractive.
Time provides perspective. It seems so obvious now that oil was in a speculative bubble at mid-year last year, when oil was trading above $140 per barrel. But, at the time, with so-called experts like T. Boone Pickens pounding the table every day, saying oil was going to $200 or higher, it was easy for most people to believe that oil was never going to decline in price. Now we know that there was no shortage of oil, and that speculators like Boone Pickens were simply talking oil prices up. Boone Pickens’ $2 billion fund lost substantially all of its value in the second half of 2008, and we don’t see him on television anymore.
Real estate prices back in 1993 through 1996 were incredibly cheap; we all realize that now. It seems so obvious to us with the benefit of time and perspective. But, at the time, between 1993 and 1996, no one was buying real estate. We had just been through a major recession in 1991 and 1992, and real estate seemed like it would never improve. Looking back, it seems so obvious that this was the perfect time to buy, and those that had the foresight to do so have benefited tremendously, again, even after the latest price declines from the recent highs.
The point of all of this is simply that when you are in the midst of one of these major economic episodes it is very difficult to see the forest for the trees—to see the opportunities for making wise investments—when there is so much negativity. Today, we have people like economist Nouriel Roubini, AKA Dr. Doom, coming out almost daily with another doomsday prognostication that the economy is in a depression that will last for years and that the only answer to the financial crisis is for the government to nationalize the major banks. With the constant bombardment of negativity in the media, it’s no wonder that investors are clamoring for cash and gold right now.
I believe, based on the current valuations for stocks, and comparing stocks to every other asset class, that stocks represent the best buying opportunity we have seen since the early 1990s, and probably the best opportunity we will see for at least a generation. For some of us, this will very likely be the best opportunity, and perhaps the only opportunity, to buy the highest quality U.S.-based companies at valuations comparable to micro-cap companies or international companies, with negative cashflows and questionable financials.
I believe that markets are driven by human behavior, and that people are motivated by the same factors generation to generation. This is one key reason why we have a repeating cycle of boom followed by bust, about every twenty years or so, as each new generation must make their own mistakes. A generation is born, they grow up, they make their own money, and then they invest that money, often without the benefit of experience or perspective. Again, because it is human nature, this new generation must make their own mistakes, and therefore we are forced to repeat the same overexpansion of debt and leverage, and to suffer the consequences in the form of deleveraging and economic contraction.
However, those who can take a big picture perspective and can learn from history, have a unique opportunity, in my opinion, to buy the stocks of great companies for dirt cheap prices today, if they can stand the daily negativity that is surely going to persist for some time to come. But, for those long-term investors who can ignore the negativity and can see the forest of giant sequoias, opportunities abound. For the rest, I believe they will be kicking themselves in a few years, when they can look back and see how obvious today’s opportunities in the stock market appear with some perspective.
(Saturday, February 28, 2009)
With all of the financial turmoil we have experienced over the past year or so, many of us find ourselves asking a lot of questions, such as: What should I do about my portfolio? Should I have my will, trust, and other financial documents reviewed by an attorney? How should I evaluate the performance of my investments over the past year, three years, or five years? Do I have a viable investment policy, or is it time for a change? What impact will the changes to tax laws have on my investment and estate plans going forward?
These are just a few of the tough questions many will try to answer as we end 2009 and look ahead to the new year; a year after which we will see the Bush tax cuts “sunset,” meaning they will expire, unless new legislation is passed. In this week’s column, I will try to answer some of these important questions, and to provide some guidance and insight into the possible changes to the tax law, and how they might affect financial and estate planning decisions.
This is the perfect time to review all of your financial and estate planning documents. If you don’t already have a financial plan and estate plan, this is a great time to prepare one. In my opinion, every person, regardless of age, income, assets, or financial situation, should have a will, trust, and a financial and estate plan.
If you are young, the financial plan is most important, since you must maximize the growth potential of your investments to plan for retirement and other expenses. If you are nearing retirement, the retirement planning aspects of your financial plan gain in importance, as you will need to analyze your available assets in the context of their ability to provide you with the lifestyle you desire during retirement. If you are somewhat older and already in retirement, or if you have substantial assets, your estate plan will typically be most important, as it will address your wishes with regard to asset disposition upon your death, as well as the needs of your family members, your charitable intent, and personal and/or family legacy issues.
Because so much has happened in the financial markets over the last year or so, it may be difficult for some to get a handle on whether or not their investments are properly allocated. The question of proper asset allocation is critical to successful investing, as studies have shown that up to 90 percent of total portfolio performance can be attributed to how investment dollars are divided amongst the various asset classes, such as stocks, bonds, real estate, commodities, cash, etc, and within each of these broad categories as well. Unless investors have been actively tracking asset value changes within their portfolios during the previous several quarters, it is highly likely that asset allocations have drifted far from long-term targets. (If you do not have a well-defined asset allocation strategy for your investment portfolio, I strongly suggest you develop one, or that you work with a professional skilled in this area.)
If asset allocations have changed materially from targets, this is a good time to reallocate. A thorough examination of current economic and market conditions, coupled with more specific research on the prospects for each asset class and sub-class should be undertaken to determine the best asset allocation for portfolios, in the context of the investor’s individual investment objectives and risk tolerance—what you are trying to accomplish with your investments and how much risk you are willing to take to achieve these objectives.
Depending on the amount of time the investor has to invest—until retirement, throughout their life expectancy, or transcending multiple generations for wealthy investors with substantial assets—asset allocations must be adjusted on an ongoing basis to reflect the time horizon and shifting risk tolerance for the portfolio.
In 2001 and 2003, President George W. Bush proposed, and Congress passed, a series of tax cuts. Due to what is known as the Byrd Amendment (where tax bills that lose revenue are limited to 10 years in duration) these tax cuts will expire on 12/31/2010, unless extended by an act of Congress. While there were many individual tax provisions in the final version of the bill that passed into law, the key items that I believe could have a major impact on the economy (and you and me) are the income tax rates, the dividend tax rate, and the estate tax exemption amount and rate.
Currently, the highest individual income tax bracket is 35 percent (for single people or couples filing jointly, earning over $372,950). The 2009 estate tax exemption amount is $3.5 million per individual ($7 million per couple), and the maximum tax rate on estates for amounts above these figures is currently 45 percent. You also have a lifetime gift tax exclusion amount of $1 million, which is part of your individual $3.5 million total exemption amount (in 2009).
According to Paul Graziano, Partner and attorney with Allen & Kimbell, every individual can transfer up to $13,000 in cash or other assets to as many donees as they like on an annual basis totally outside the gift tax system, meaning no gift tax returns are required to be filed, so long as the gifts qualify as present interest gifts. Basically, a present interest gift is one where the donee has control or absolute access to the gift immediately.
As currently written, in 2010, the estate tax is repealed for one year. The annual exclusion and lifetime gift tax provisions remain unaffected, however. If you happen to die next year, you can pass-on all of your assets to your children (if you want to), or anyone else, with no taxes at all. The problem is that on January 1, 2011, unless Congress passes new legislation, income tax rates will revert back to the pre-Bush tax cuts levels, with the maximum individual tax rate at 39.6 percent, the rate on dividends also at 39.6 percent (from the current 15 percent for qualified dividends), and the estate tax exemption goes back to $1 million per individual ($2 million per couple) and a maximum tax rate on assets above those levels of 55 percent.
Just this past Thursday, the House voted to make the current, 2009 estate tax rules permanent. While it is unlikely that the Senate will have time to pick-up this issue before December 31st, I would expect something to get passed that kills the 2010 unlimited exemption.
These potential changes have massive implications, both for the economy and for decisions on investments. For example, investments currently paying qualified dividends will be far less attractive, meaning that their values will likely decline. Further, investors currently holding these investments must make a difficult choice to either hold them, receiving far less in after-tax income (assuming they are in a high tax bracket), or sell the investment, possibly at an unattractive price. The question for this investor then becomes, “How do I replace the lost income?”
One place to look would be municipal (tax-free) bonds, which will likely increase in value if these income and dividend tax rates increase. The sticky part is finding municipal bonds that will not suffer from possible defaults by municipalities struggling to meet their financial obligations with lower tax revenues from plummeting real estate values, sales tax revenues, etc.
From an estate planning perspective, the potential for the estate tax exemption changing poses some serious challenges. For one, if existing estate plans have been developed using assumptions that the current, more favorable tax rates and exemption amounts will continue indefinitely, these plans will need to be revised to reflect the new law, once known. Depending on the amount of assets an individual or couple may have, there could be dramatic changes to estate plans, resulting in some complex trust structures that only an expert attorney who specializes in this area can address.
The best course of action is to review all documents as well as portfolio structure to ensure that you have a well-defined, coordinated and comprehensive Investment policy, and financial and estate plan. If you don’t, my advice is to seek the assistance of professionals to help you gain control of your finances.
To convert or not to convert: Special circumstances for taxation of Roth IRAs may make conversion a good idea (for some) (published in the Santa Barbara News Press in December of 2009)
With the recent “Great Recession,” we have seen many individuals losing their jobs in and around Santa Barbara. Our most recent data from November 2009 shows 19,900 people unemployed in the county, which represents an 8.9 percent unemployment rate. While we are still doing better than the state of California at 12.3 percent unemployment and the nation at 10 percent, having this large number of people unemployed is certainly placing a strain on our economy and our citizens.
Many of us have worked for more than one employer, and have accumulated several IRA accounts over the years. Whether we have a traditional IRA, an IRA rollover, an existing Roth, and/or employer retirement accounts, such as 401(k)’s or pension/profit-sharing accounts, there are numerous decisions that must be made concerning how best to manage these assets.
Among the many issues that a recently unemployed person will face is the decision about what to do with their 401(k) or other retirement assets with their previous employer. Also, for anyone with traditional IRAs or IRA Rollovers, the option of converting to a Roth IRA may offer some compelling benefits.
Beginning in 2010, more people should be able to convert a traditional IRA to a Roth IRA, and take advantage of potential tax benefits. Prior to 2010, conversion was only available for those making $100,000 or less (adjusted gross income), whether single or married. (If you earned $110,000 or more ($160,000 for married joint filers) then you also were not eligible to contribute to a Roth IRA.)
The key benefit of converting to a Roth is that, although you will pay taxes on the pretax assets you convert, your money will grow tax-deferred in the Roth IRA, and withdrawals will be tax-free as well, when you have met certain requirements. New 2010 conversion rules may make converting to a Roth IRA more attractive, depending on your circumstances.
The $100,000 income limit that currently exists for Roth IRA conversions will be repealed for 2010 and future years. Also, the income from a conversion in 2010 can be reported either on your 2010 tax return, or you can split it between your 2011 and 2012 tax years, meaning you would not have to make the first payment until April 15, 2012.
One thing to keep in mind is that, if you have a non-deductible IRA, meaning that you contributed after-tax money to an IRA, you cannot just convert your non-deductible IRA balance (or part of it) and avoid the taxes you would have incurred, had you converted the deductible IRA (or part of it). The federal government uses a pro-rata system of calculating taxes due. Here is an example:
One thing to keep in mind is that, if you have a non-deductible IRA, meaning that you contributed after-tax money to an IRA, you cannot just convert your non-deductible IRA balance (or part of it) and avoid the taxes you would have incurred, had you converted the deductible IRA (or part of it). The federal government uses a pro-rata system of calculating taxes due. Here is an example:
Let’s say you have $50,000 in a traditional (deductible) IRA, and another $50,000 in a non-deductible IRA (a total of $100,000). If you wanted to convert $20,000 of your IRA assets to a Roth, you would owe taxes on $10,000, since the amount in your non-deductible IRA represents 50 percent of the total. This 50 percent is $10,000 of the $20,000 you wish to covert, leaving the remaining $10,000 that comes from your regular IRA, and which is taxable upon conversion.
One of the potential benefits of converting soon is that most IRAs and qualified plans hold assets with depressed values. The current value will be taxed at conversion (assuming we are talking about deductible money in a traditional IRA) and the future growth will be tax-free (if qualifications are met). Another benefit, and a key reason to convert, would be if you have a long time remaining before you will access your retirement assets, leaving a lot of time for the converted assets to grow tax-free. I would want to have at minimum five years for assets in the Roth to grow to make the conversion make sense.
Roth conversions can be recharacterized, and you have until October 15 of the year following the year you converted to recharacterize back to a traditional IRA for any reason. However, if you do recharacterize your 2010 Roth conversion, a reconversion will not be allowed until the following year, and you will no longer be able to spread income tax from the conversion over two years.
If you hold after-tax money in a 401(k) plan, you can request a direct rollover of pretax contributions and earnings to a traditional IRA and convert after-tax assets and earnings directly to a Roth IRA. This allows you to fund a Roth IRA conversion and pay income taxes only on earnings from after-tax contributions.
Roth IRA conversions can reduce the size of your taxable estate because of the income tax already paid and can allow you to pass income on to beneficiaries income tax-free. (The Roth assets may still be subject to estate tax though.)
Roth IRA conversions can be a great opportunity but they are not for everyone. Before you convert to a Roth IRA, consider the following:
· Your tax bracket - Because you pay taxes when you convert pre-tax contributions and earnings to a Roth IRA, doing so would be most advantageous if your tax bracket is lower now than it will be when you withdraw the assets. With this said, if you have a long time between now and when you will need to withdraw funds from the Roth, the tax bracket differential is less important.
· Your time frame - You need a significant amount of time to accumulate the earnings that will be distributed from the Roth tax-free. A minimum of five years is needed, but a longer time frame is usually advisable. A Roth IRA conversion can be especially effective when the money is passed on to your heirs.
· Your ability to pay conversion taxes with non-IRA assets - Paying taxes with non-IRA assets makes Roth conversions more advantageous. If you pay the taxes from the assets in your traditional IRA, you reduce the amount that will be able to grow tax-free in the Roth IRA. In addition, while assets you convert are not subject to penalty, any amount you withhold to pay for the conversion taxes is. In other words, if you pay taxes due on conversion with your IRA assets, that amount is treated as a distribution and is subject to income tax and a 10 percent IRS penalty if you are under age 59½. Therefore, you either need to have the additional cash available, either for April 15, 2011, (or, if you spread the tax burden over the 2011 and 2012 allowed years, you will need half of the taxes due for each tax year), or you will be forced to pull money out of the IRA assets and pay the 10 percent penalty in addition to the taxes.
This is the time to look carefully at converting in 2010. For many local residents who have accumulated large IRA balances, the early withdrawal penalty may make a Roth conversion unattractive. If you have very large IRA balances, and will not have the additional cash to cover the tax burden, even if you spread the taxes over the 2011 and 2012 tax years, it probably does not make sense to convert to a Roth. Also, if you do not have at least five years to leave the funds invested before you need to make withdrawals, I would not recommend converting. However, if you have the time, and you can afford to pay the taxes, I would highly recommend taking advantage of the conversion and the two-year tax payment option, because the ability for your assets to grow tax-free, especially from current levels, could make a huge difference down the road. As with any significant financial decision, one should always consult their financial advisor or tax expert before deciding whether to convert to a Roth IRA.
The New Healthcare Bill (HR 3200) Will Raise Taxes on High-income Earners (published in the Santa Barbara News Press in August of 2009)
The new healthcare bill (HR 3200), “America’s Affordable Healthcare Choices Act of 2009,” promises to provide every American with affordable quality healthcare and to control healthcare cost growth. The Democrats who drafted and support the legislation point to provisions in the bill that would build on what works in today’s health care system and fixes the parts that are broken, protect current coverage–allowing individuals to keep the insurance they have if they like it–and preserve their choice of doctors, hospitals, and health plans.
The bill proposes to achieve these reforms through offering:
· A “Health Insurance Exchange”—a transparent and functional marketplace for individuals and small employers to comparison shop among private and public insurers;
· A public health insurance option that promises to operate on a level playing field, subject to the same market reforms and consumer protections as other private plans in the Exchange, and it will be self-sustaining–financed only by its premiums.
· Essential benefits - A new independent Advisory Committee with practicing providers and other health care experts, chaired by the Surgeon General, will recommend a benefit package based on standards set in the law.
· A sliding scale affordability credits - Affordability credits will be available to low- and moderate-income individuals and families.
· Caps on annual out-of-pocket spending
· Increased competition
· Expanded Medicaid - Individuals and families with incomes at or below 133 percent of the federal poverty level will be eligible for an expanded and improved Medicaid program. Recognizing the budget challenges in many states, this expansion will be fully federally-financed.
· Improves Medicare - Senior citizens and people with disabilities will benefit from provisions that fill the donut hole over time in the Part D drug program, eliminate cost-sharing for preventive services, improve the low-income subsidy programs in Medicare, fix physician payments, and make other program improvements.
· Individual responsibility - Except in cases of hardship, once market reforms and affordability credits are in effect, individuals will be responsible for obtaining and maintaining health insurance coverage. Those who choose to not obtain coverage will pay a penalty of 2.5 percent of modified adjusted gross income above a specified level. (More on this below.)
· Employer responsibility - The proposal builds on the employer-sponsored coverage that exists today. Employers will have the option of providing health insurance coverage for their workers or contributing funds on their behalf. Employers that choose to contribute will pay an amount based on eight percent of their payroll. Employers that choose to offer coverage must meet minimum benefit and contribution requirements specified in the proposal. (More on this below.)
· Assistance for small employers - The smallest businesses—those with payrolls that do not exceed $250,000—are exempt from the employer responsibility requirement. The payroll penalty would then phase in starting at 2% for firms with annual payrolls over $250,000, rising to the full 8 percent penalty for firms with annual payrolls above $400,000. In addition, a new small business tax credit will be available for those firms who want to provide health coverage to their workers. In addition to the targeted assistance, the Exchange and market reforms promise to provide a long-sought opportunity for small businesses to benefit from a more organized, efficient marketplace in which to purchase coverage.
So far I have provided a lot of information about what the new healthcare bill promises to offer. Here’s the rub: How will we pay for it?
Section 441 of the new bill states that there will be a surcharge on “high-income individuals with the following sliding scale:
(1) 1 percent of so much of the modified adjusted gross income of the taxpayer as exceeds $350,000 but does not exceed $500,000,
(2) 1.5 percent of so much of the modified adjusted gross income of the taxpayer as exceeds $500,000 but does not exceed $1,000,000, and
(3) 5.4 percent of so much of the modified adjusted gross income of the taxpayer as exceeds $1,000,000.
Republican’s in their dissenting view, provided in written form on July 13, 2009, point-out many flaws in the new healthcare bill, including:
“… Americans with health insurance would pay thousands of dollars more per year for coverage, and a host of new taxes on individuals and businesses would further hamper efforts to revive an already struggling economy if this bill becomes law. The bill violates oft-repeated promises by the President and others that health care reform won’t cause people to lose coverage they like, that taxes won’t increase on families with income less than $250,000 and that tax rates won’t increase above what they were during the 1990s.”
Republicans point-out that only one hearing was held on the discussion draft released in June, and that, despite claims that the United States is already spending too much on healthcare, the bill finances even higher spending with more than $820 billion in new taxes that will be paid for by families making as little as $20,000, small businesses, and manufacturers—all while we are in the midst of a recession and with unemployment moving quickly toward 10 percent.
Section 441 of the bill (addressed above) attempts to plug part of the fiscal hole it creates with a new surtax on individuals and small businesses, with a 5.4-percent surtax rate, combined with the already scheduled increase in the top marginal rate to 39.6 percent, which would result in an increase in the top Federal income tax rate from 35 percent in 2010 to 45 percent in 2011.
Adding in the 2.9-percent Medicare payroll tax and hidden marginal rate increases that operate by phasing out certain deductions, the proposed top Federal rate would jump to about 48 percent, and the average top Federal-State marginal tax rate would be over 52 percent.
While nominally aimed at individuals, the surtax will fall heavily on small businesses, the engine of job creation. According to a Joint Committee on Taxation data projection for 2011, 42 percent of small business income (including the income of sole proprietorships, partnerships, and S corporations) would be subject to the surtax.
Not content to just tax “the wealthy,” the bill also imposes large taxes on some of America’s poorest families. Effective in 2013, section 401 would impose a tax on individuals without “acceptable coverage”, which would hit single filers with incomes as low as $9,350 and married couples with incomes as low as $18,700 (in 2009 dollars). This undermines President Obama’s ongoing promise not to raise taxes on families with incomes under $250,000.
The overall conclusion by Republicans is that the bill adds nearly $240 billion to the deficit this decade, with the bulk of those costs occurring at the end of the budget window. In 2015 alone, the bill will add $40 billion to the federal deficit. By 2019, that figure will rise to $65 billion and the deepening debt impact shows no signs of slowing down in future years. In short, the $240 billion that this bill would add to the deficit this decade is just the tip of the fiscal iceberg.
Regardless of which side one believes, there can be no denying that the costs associated with this bill would be enormous, and are projected to be $1 trillion or more over the next decade. That money will have to come from somewhere, and it is clear that taxes will have to be increased, very likely on all of us, and on all businesses, to cover this cost. While the distribution of these taxes can be debated, the numbers are so large that every one of us will feel the sting, should the bill go forward in its current form.