The Financial Forum

The Perfect Storm; Bubble Trubble

2011-03-11T09:47:00.002-05:00

This is a reprint from a 2005 Article I wrote regarding the Real Estate Bubble (Before it burst). An interesting re-read for me, after watching the market for the past few years.

The Perfect Storm; Bubble Trouble
By Michael J. Rebibo, CFP®
April 2005

A friend of mine recently asked me if I were interested in going “in with him and some of his neighbors” to buy some townhouses to “flip for a profit”. They were forming a partnership in order “to get in on some of the hot real estate deals” that are now available. These were not traditional real estate investors but successful businessmen in the cable industry. Another friend said she doubled her investment on a second home she purchased at the beach less than a year ago. A few others have purchased speculative condos and are “hoping to make a killing”.

It all reminds me of 1989, the year I purchased my first home. The market was red hot and interest rates were on the rise. I couldn’t wait to get into the real estate market so I could enjoy some of the appreciation everyone else was realizing. I purchased the home for $289,000. Less than three years later, I listed it for $262,000, a drop of nearly 10%. After fix up and closing costs, I had to write a check for $14,000. Most of you will remember this time when rates were increasing, housing prices were falling, and the stock market was stagnant. Is this what the next 3 years have in store for us? As financial planners, it is our job to see through the noise and lead our clients down the safer path.

Real Estate Reaches Record Appreciation Levels
Recently, the Office of Federal Housing Enterprise Oversight, the government entity charged with ensuring the capital adequacy and financial safety and soundness of FNMA and FHLMC, published its House Price Index for 2004. For the 5th consecutive year, housing prices have increased by more than 7.5% nationwide. National housing prices increased by 10.24% in the 2004.

Conundrum
The Federal Reserve has increased short-term rates at a “measured pace” 8 times since June of 2004. Yet long-term rates such as mortgages remain below their levels of 1 year ago. Fed Guru Greenspan recently referred to the current low long term interest rates as a “conundrum” (which by the way is also a great white wine made by Caymus Vineyards)! Fed tightening, higher core inflation, near record oil prices, lower dollar, record federal budget deficit, and above trend economic growth create the perfect storm for higher long term rates and an immediate halt to appreciating property values.

Testifying before the House Financial Services Committee last month, Greenspan stopped short of calling home buyers “irrationally exuberant”, but stated "I think we're running into certain problems in certain localized areas. We do have characteristics of bubbles (in those markets) but not, as best I can judge, nationwide." Publicly traded homebuilders stocks fell 10% on the comment.

Home Sales Slowing
According to Merrill Lynch economist David Rosenberg, “the backlog of unsold homes has risen steadily, and in January approached a five-year high of 4.7 months supply. However, raw data, excluding seasonal adjustments indicate that the backlog has reached six months, which would mark an eight-year high.” While our local markets remain strong, this may be the last rush to purchase property before rates increase by too much.

Home Appreciation Outstrips Personal Income
“Median house prices have risen about 30% since March 2001, well ahead of an 11% gain in personal income”, says Michael Youngblood, head of asset-backed research at Friedman Billings & Ramsey.

Speculation on the Increase
Meanwhile, “unfettered access to easy money has inflated home prices nationwide, particularly on the coasts, and lately has let to an upsurge in speculative buying.” says Kopin Tan of Barron’s. Just as with the stock bubble in 2000, recent increases in speculative buyers and property flippers have driven up values in many urban areas like Washington DC.

“Household real-estate assets now equal nearly 14% of Gross Domestic Product, the highest proportion in two decades and eerily close to the ratio of household mutual fund and equity holdings relative to GDP at the stock market’s peak in 2000.” says Kopin Tan of Barron’s.

David Berson, the chief economist for Fannie Mae, observed in his weekly commentary that investor ownership of housing hasn't been this high since the late 1980s, which led to a crash in housing prices. "Many analysts think that a high investor share in the Northeast and California helped exacerbate the housing downturn that happened during the 1990-1991 recession”.

Bubble
Yale University economist Robert Shiller, author of "Irrational Exuberance," the 2000 best-selling book about the '90s stock-market bubble, said the only similar housing boom in U.S. history was when GIs returned home from World War II, lifting a depressed market. The latest addition of “Irrational Exuberance includes a chapter on the current real-estate trend.He thinks the current boom is a "classic bubble" because people keep buying houses they know are too expensive because they expect prices to rise even higher.

Conclusions
Ultimately it will be the level of long term interest rates that will create a local or national housing bubble. If rates exceed 6%, expect a 10% correction across the board. Larger homes will most likely be hit harder. If rates stay below this threshold, we may still see some localized drop in values in the higher end prices of homes in localized areas. The question is when?

As financial planners, it is our job to help our clients steer clear of disaster. Most real estate acquisitions are highly leveraged. This leverage works against you in a falling market. If your clients have an over allocation of real estate, it may be time to rebalance.

1st Portfolio Lending is the new name for Pineapple Lending

2009-07-24T14:43:00.005-04:00

FOR IMMEDIATE RELEASE:

1st Portfolio Lending is the new name for Pineapple Lending.

Tysons Corner, VA - July 22, 2009 – 1st Portfolio Holding Corporation’s mortgage lending subsidiary, Pineapple Lending has officially changed its name to 1st Portfolio Lending. Clients of the new 1st Portfolio Lending can expect all of the great service, customer care and thoughtful advice that the 1st Portfolio name has come to stand for.

1st Portfolio Lending specializes in conforming and FHA mortgages up to $729,750 as well as portfolio jumbo mortgages that are necessary for larger home purchases. The difficult housing and mortgage markets of today necessitate a high quality loan advisor like 1st Portfolio Lending to assist those that want to get the best possible loan and get their transaction completed. There may never have been a better time to refinance or purchase a new home than today. Interest rates remain artificially low because of massive, but temporary, purchases of mortgage backed securities by the Federal Reserve. Home prices also have fallen more than 30% from their 2006 peak.

For additional information on 1st Portfolio Lending or to discuss your potential mortgage loan needs, please contact Barbara Evans at 703.564.9100 or visit www.firstportfoliolending.com

Contact:

Barbara Evans

bevans@firstphc.com

8300 Boone Blvd. Suite 200

Vienna, VA 22182
www.firstportfoliolending.com
Ph: 703-564-9100

###

Losers are Winners and Winners are Losers

2009-07-23T16:17:00.001-04:00

Why do individual investors typically under perform institutional investors? The answer lies in the chart below. Many individual investors chase returns - buying last years’ winners and selling off losers. After being burned in the stock market in 2008, these investors moved to bonds, cash and gold, last year’s top asset classes. I call this the Money Magazine strategy. Pick up Money Magazine in December and buy what they recommend. Then watch last years winners become this year’s losers as institutional investors reallocate assets. Next year’s Money will have a whole new set of losers to chase.

The top 3 asset classes on the Chart below have now moved to the bottom of the chart in the first 6 months of 2009. Last years losers are this year’s top performers as Emerging Markets and Growth oriented stocks out performed all other classes.
Show all

(click to enlarge)

Book Review: Outliers - The Story of Success

2009-07-23T15:46:00.002-04:00

Outliers: The Story of Success
by Malcolm Gladwell
Malcolm Gladwell takes us on an intellectual journey through the world of "outliers"--the best and the brightest, the most famous and the most successful. He asks the question: what makes high-achievers different? His answer is that we pay too much attention to what successful people are like, and too little attention to where they are from: that is, their culture, their family, their generation, and the idiosyncratic experiences of their upbringing. Along the way he explains the secrets of software billionaires, what it takes to be a great soccer player, why Asians are good at math, and what made the Beatles the greatest rock band. -B&N

Book Review: The Ascent of Money

2009-07-23T15:43:00.002-04:00

The Ascent of Money
by Niall Ferguson
With the clarity and verve for which he is known, Ferguson elucidates key financial institutions and concepts by showing where they came from. What is money? What do banks do? What’s the difference between a stock and a bond?

Perhaps most important, The Ascent of Money documents how a new financial revolution is propelling the world’s biggest countries, India and China, from poverty to wealth in the space of a single generation—an economic transformation unprecedented in human history.
-From jacket

Emerging Markets Offer Emerging Opportunities

2009-07-23T15:28:00.005-04:00

Emerging Markets Offer Emerging Opportunities by Neil Macker

For many U.S.-based individual investors, emerging markets represent the “Wild West” of investing, offering unmatched and almost limitless returns. In the view of others, the term “emerging markets” invokes the specters of extreme risk and political instability. Most investors tend to either lump emerging markets into one large bucket or simply examine the BRIC (Brazil, Russia, India and China) markets. Financial pundits have recommended emerging markets as an asset class for hedging due to historically low correlation with the U.S. stock market. Let’s discuss these commonly held beliefs and why we still believe in the importance of an emerging markets allocation in your portfolio.

Wild West?
Until recently, many investors viewed emerging markets as a magical place that provided astronomical returns, driven by “China” and “commodities”. The idea that emerging markets can move upwards without large downward swings, though is hard to justify. Even before the events of 2008 the two largest, most diversified emerging markets (India and China) experienced wild swings in annual results as seen in Chart 1. Also, note that the S&P 500 outperformed the primary emerging market indices in only two of the nine years from 2000 to 2008. Both outperfomances occurred during recession years (2001 and 2008).

(click to enlarge)

Despite the large downward swings, the two primary emerging markets offer significantly higher average returns since January 2000. Table 1 shows what a hypothetical investment of $10,000 in each index at the beginning of 2000 would have been worth as of June 30, 2009. Returns for both of the emerging market indices are more than three times that of the S&P 500.

(click to enlarge)

Even when we cherry pick the best four-year continuous sample for the S&P, the U.S. index provided lower returns as shown in Table 2.

(click to enlarge)

Frontier Markets vs. Maturing Developing Markets
The large swing in returns likely causes some investors to adopt the pessimistic view of emerging markets as pools of extreme risk and political instability. Part of this belief may lie in the inability of investors to segregate emerging markets. A simple method of separating emerging markets is to define a non-developed market as either a frontier market or maturing developing market.

Frontier markets include countries such as Bahrain, Bangladesh, Botswana, Bulgaria, Cambodia, Colombia, Cote D’Ivoire, Croatia, Ecuador, Estonia, Georgia, Ghana, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Nigeria, Oman, Pakistan, Panama, Qatar, Romania, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, Vietnam, and Zimbabwe. The equity exchanges in frontier markets feature undercapitalization and weaker regulatory frameworks along with lower levels of foreign ownership, borrowing, liquidity, and transparency than maturing developing markets. Most frontier markets also suffer from political instability, tenuous financial policies, and lesser- developed/diversified economies. Historically these countries have conformed to the pessimistic view of emerging markets and as such, most investors outside the most aggressive should stay clear of frontier markets.

Maturing developing markets include the big four BRIC markets along with familiar names such as Israel, Mexico, South Africa, South Korea, Taiwan, and Turkey. Many investors have focused on the BRIC countries as those markets have benefited from investor in-flows and high GDP growth sparked by export growth (China and India) and commodity price increase (Russia and Brazil). However, the other markets also offer relative political stability, more diversified economies, larger domestic markets, lower levels of official/government corruption, and more robust ties to the developed countries.

Diversification, Not a Hedge
Ties to developed countries have in part led to the demise of the “de-coupling” theory, which stated that emerging markets had effectively moved far away from developed countries and would not be affected by a meltdown in the developed world. Some financial pundits advised that emerging market investments would act as a “hedge” against investments in developed markets. Even before the events of last year, the theory was already beginning to lose adherents as correlations between emerging market ETFs and the S&P 500 ETF (SPY) rose and as investment dollars began to flow in larger amounts into emerging market funds. After the global meltdown in 2008, where correlations among all asset classes increased, the idea of “de-coupling” faded as did the concept of hedging using asset classes.

The Future
So with no appreciable value as a hedge and increased risk, why allocate funds into emerging markets? While emerging market investments do not provide a strict hedge, the investments do offer diversification benefits as the correlations remain below one (at correlation of one, two assets classes would move in lockstep). Also, emerging markets provide access to different risk premia in the same way that an allocation to U.S. small and mid-cap stocks does despite the two sectors having a much higher correlation to each other than US equity and emerging markets. Another factor in favor of emerging markets is higher GDP growth over the near future. The only two major economies, developing or otherwise, that are projected to have GDP growth in 2009 are China and India as seen in Chart 2. Projections for 2010 also predict that China and India will also have the largest GDP growth of 9% and 7% respectively, versus 6% for emerging markets and 1% for developed economies.

(click to enlarge)

Another reason to allocate to emerging markets is as the U.S. and most governments in the world inject funds into domestic economies, the level of public debt is projected to increase dramatically. As seen in Chart 3, the U.S. was in relatively decent standing with public debt at 40% of GDP at the end of 2008, but was well behind three of four BRIC countries. Current Congressional Budget Office projections estimate that the U.S. public debt to GDP will reach 51% at the end of 2009 and will peak at 54% in 2011. These projections reflect the belief that the government will move back towards a more balanced budget versus the $1.5 trillion deficit projected for 2009. Some commentators such as Bill Gross of PIMCO, suggest that the U.S. government may have to continue running trillion dollar deficits over the next several years and that the new “normal” GDP growth rate will be 1% to 2% versus the 3%+ of the past.

(click to enlarge)

As the U.S. and other developed countries increase overall debt levels, their corresponding stock markets will experience increased risk levels with lower expected returns. As a result, emerging markets may provide greater risk/return rewards.
Given these factors, we continue to believe that allocation to emerging markets is appropriate for many clients. The amount allocated to emerging markets will vary by portfolio given individual risk tolerances/time horizons and will change over time as we continue to monitor the economic factors.

Stocks Rebound Strong, But Will it Continue?

2009-07-23T15:27:00.004-04:00

The Second Quarter of 2009 most likely marked the beginning of the next bull market and the first increase in the stock market since 2007. US stocks, as measured by the S&P 500, were up nearly 16% for the quarter and up nearly 37% since the market low on March 9th. However, it will take three more rallies of this amount to regain the market peak reached in 2007.  
While we may be nearing the end of this recession, don’t expect things to get back to “normal” quickly. The US and international developed markets are likely to grow much more slowly in the coming years than over the past decade. Aging populations, increasing savings rates, high unemployment rates and the deleveraging of both corporations and individuals are likely to keep GDP (Gross Domestic Product) growth lower than during previous recoveries. In addition, the massive debt piled up by the US along with likely higher taxes in the future will slow growth for the foreseeable horizon.

With a slower U.S. economy, the U.S. stock market is likely to advance at a slower pace than in the recent past. From 1990 to 2007, GDP grew at an average rate of 2.8%. During the same period, the S&P 500 expanded at an annual rate of 7.5%, a 4.7% premium over GDP. If the average GDP growth for next several years falls between 1% and 2% as predicted by some observers including PIMCO’s Bill Gross, expect average US stock market returns to average only 5.5% to 6.5% in the coming years.

However, significant growth in US companies may occur in particular sectors. These sectors are likely to be the industrial sector, high tech, renewable energy and clean technologies, natural resources and the beaten down financial services. Internationally, we expect emerging market countries to continue to outperform developed markets.

Money For Nothing and a Mortgage for Free

2009-04-21T11:55:00.004-04:00

The US government is spending trillions of dollars to keep our ailing economy afloat. This has already softened the free fall in the equity markets and hopefully we will see it in our housing markets. But it comes at a cost, which is the likelihood of higher taxes and inflation in the future.

My friend Tom Millon, a secondary mortgage market specialist in the U.S. mortgage business, says it this way in his recent newsletter, "Never fear. We have a new put option protecting us. Remember the Greenspan put? That's the one that protected the stock market in the late 'Nineties. It was always safe to buy stocks because Greenspan would lower rates to support stocks every time they dipped. Today we have the Obama-Bernanke-Geithner put option." The new put option Tom is referring to is government subsidized mortgages. Our government is using printing money to buy mortgage back securities, which has pushed mortgage rates down to an artificially low price. This free money is being offered to you or anyone else to go spend on a new house or refinance your existing one. Everyone in the country who can afford to buy a house or refinance must take advantage of this "put option". It is basically free money and will not last!

The downside of this government generosity is it debases our currency and increases our debt. There are no free lunches and it may unleash inflation. Imagine a future with inflation above 5% and interest rates above 8%. Your house will be going up at this time and you will have locked your mortgage at 5% or below! There is no better way to protect yourself, except maybe moving to a Latin American Country, from the pain that is yet to come! Pay down your loan if necessary to qualify. Conforming loans are now up to $729,000.

1st Portfolio recently purchased a mortgage company, previously known as Pineapple Lending, now called 1st Portfolio Lending. Please give us a call so that we can analyze your personal financial circumstances and help you save on a new home mortgage. If you mention this newsletter, we will provide you with a $250 closing cost credit to reduce your expense.

A Light at the End of a Long Tunnel

2009-03-09T13:31:00.015-04:00

A year ago I began writing this article, but concluded that the “light at the end of the tunnel” was a train. Again last summer I set pen to paper on the same theme and came to the same conclusion. I tried in December and failed. As I write, I wonder that it might be a little too soon to release this. I was early when I wrote my article in April of 2005 entitled Bubble Trouble, calling for a major drop in real estate prices and I may be a bit early in suggesting we may be very close to a bottom in home real estate values.

There are still significant forces putting downward pressure on real estate values. These include the insane run up in values over the first 6 years of this decade; very tight credit markets; increasing unemployment; record foreclosures; excess capacity; and general market fear.

However, many of these forces may increasingly be “priced in” and are being replaced by positive forces that may create a real estate bottom in the coming months. These positive forces include the precipitous drop in prices from market peaks creating greater affordability; record low interest rates, a record drop in new home starts; the near trillion dollar stimulus plan; the $8,000 first time homebuyer tax credit; and the increases in the FHA and Conforming loan limits for both purchases and refinance transactions. Let us first take a look at where we are now before we dive into where we might be headed.

Falling off a Cliff
At the Chicago Mercantile Exchange (CME), where many financial instruments such as interest rate swaps, currencies contracts, and commodities are traded, options and futures on residential real estate also are available. These products are based on the most accurate real estate index available on the market, the S&P/Case-Schiller U.S. National Home Price Index. This measure is generally considered the best and most unbiased indicator of real estate prices. The index is calculated from data on repeat sales of single family homes, an approach developed by Yale economists Karl Case and Robert Schiller. The index is normalized to a value of 100 in the first quarter of 2000 and measures home values in the 20 largest US metropolitan markets or MSAs.

According to the Case-Shiller Index, average U.S. single family housing values peaked in the summer of 2006 (July to be specific) doubling in value since January of 2000. Since that peak, housing prices nationwide have fallen off a cliff, dropping about 30% on average. This drop varies significantly in the 20 Metropolitan Statistical Areas (MSAs) listed. For example, in Charlotte, North Carolina, home prices fell just 4% compared to Phoenix, Arizona where prices fell 45%. Coincidently, Bank of America, BB&T and Wachovia are all based in North Carolina. Maybe this explains why these banks were willing to make such aggressive bets in the residential mortgage market.

Forces Pushing Prices Down
In Real Estate Finance class, students generally are taught to assume a 3% appreciation rate for real estate growth in all financial calculations. This was always considered to be the historical long term rate of growth. For some reason, the rating agencies and large brokerage houses missed this in their Real Estate Finance class. Home values appreciated at a rate of about 14% per year from 2000 to 2006 due to low rates, easy credit and speculation. Assuming values revert back to the mean of 3% per year, we may still have a ways to go. Using the Case-Schiller Index values from 20 years ago in 1989, and projecting forward appreciation of 3% per year, average real estate values nationwide must fall another 9% from their year-end values before they reach a 3% year over year appreciation rate. While this is a big number, home values fell 6% in the forth quarter of 2008 alone. Thus it would not be a much of a stretch to see a 9% drop by summer.

Tight Credit Hurts
Tighter credit standards are hurting home buyers. Conventional and FHA loan standards have tightened dramatically. In addition, many of the mortgage products available to home buyers have vanished. No income verification loans, so called 80-20 loans, sub-prime loans and even competitivly priced jumbo products are no longer in existence. This means that few potential buyers can pick up the slack of excess homes.

Unemployment Continues to Increase
The unemployment rate, currently at 8.1%, is expected to continue to rise throughout this year and into next year. The Fed is projecting a rate of 8.8% by the end of 2009 and possibly higher in 2010. Unemployment has a direct impact on housing prices. As people lose jobs, they lose their ability to make house payments, and many lose their homes in foreclosure. Unemployment can be devastating to housing markets, but is a lagging indicator of economic activity and is likely to remain high well after the economy starts to grow.

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Delinquency Rates Increased in Q4 but Foreclosures Rates Began to Drop
The Federal Reserve reported that fourth quarter 2008 mortgage delinquency stood at 6.29% up from 5.2% in the third quarter. Mortgage delinquency is generally below 2% under normal market conditions. “Foreclosure filings were reported on 274,399 U.S. properties during the month of January, a 10 percent decrease from the previous month but still up 18 percent from January 2008” according to the RealtyTrac U.S. Foreclosure Market Report.

“The extensive foreclosure efforts on the part of lenders and government agencies appear to have impacted the January” said James J. Saccacio, chief executive officer of RealtyTrac.

“January REOs, which represent completed foreclosure sales to the foreclosing lender, were down 15 percent nationwide from the previous month.

Excess Capacity
Total housing inventory peaked in November at an 11.2-month supply meaning that it would take 11 months before all of the homes listed were sold at the current rate of absorption. However, at the end of December, this figure fell to a 9.3-months supply due to a substantial increase in home sales. “The higher monthly sales gain and falling inventory are steps in the right direction,” according to Lawrence Yun, chief economist at the National Association of Realtors, “but the market is still far from normal balanced conditions.”

General Market Fear and the Herd Mentality
The same factors that pushed housing up to insane levels are now pushing it down at an even faster rate. In 2006, buyers were willing to enter bidding wars and in some cases write “escalator” clauses to compete against as many as 20 or more purchasers on the same property. Today, fear of further price deterioration has kept renters from buying, which in turn stops the move up buyer from moving up the chain. I call this the “Herd Mentality”. It is what creates all bubbles and eventually busts.

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Now for Some Good News
Ok, enough of the bad news, lets look at the positive factors that may be establishing a floor in housing. Why is this important? I believe that the fall in housing prices led us into this recession and a floor in prices will spark the end of the recession.

Affordability
The National Association of Realtors, biased though they may be, reports that their Housing Affordability Index is at 135, which means that the average American family can not only afford to purchase a home, but also will have excess money for living expenses. According to the association, a score of 100 indicates that a typical family would have the exact amount required based on a 20% down payment and monthly payments of no more than 25% of their household income.

I did my own calculations based on Fairfax County’s numbers. For the past few years, an average Fairfax County couple earning the median household income of $105,000 per year could not even afford to purchase a home in Fairfax County. Now that prices have fallen 30% from 2006, a home that used to cost $600,000 now costs $420,000. Using the a conventional loan limit of $417,000 or the new higher FHA loan limits of $729,750, this couple can now purchase this home with 10% down with a conventional loan or as little as 3.5% down at a rate near 5%. Add Obama’s $8,000 first time home buyer tax credit and things get even better. These first time home buyers are the key to the real estate chain. As they buy new and existing homes, existing owners are free to sell their homes and possibly move up. This is a huge step to establishing a floor on real estate values.

Record Low Rates and New HUD and FNMA Guidelines
As of February 26th 2009, the national average mortgage rate is 5.07% with an average of ¾ of a point according to Freddie Mac’s Primary Mortgage Market Survey. This rate is near all time lows and allows buyers to afford significantly more house for the money. For example, mortgage rates were approximately 8% in the year 2000. In that year, the Case-Schiller Composite 20 Index was set at base of 100. Today the index stands at 152 showing a 52% increase in home values from the year 2000. Should homes be worth 52% more today than in 2000?

Considering real income are the same today as in 2000 and the population has grown by less than the number of new homes built, not likely. But if rates were at the same level as they are today, then home buyers can afford a 35% larger purchase price. This has a direct correlation on home values. This would put the index at 135 vs. 152 where it stands today. Combine that with the new max FHA insured loan amount of $729,750 and the more lenient FNMA guidelines on refinance transactions indicates that we may be approaching the bottom.

Record Drop in New Home Starts
According to Bloomberg, “U.S. builders broke ground in January on the fewest houses on record as a lack of credit and plunging sales exacerbated the worst real-estate slump since the Great Depression. Housing starts plunged 17 percent.” While this may seem like bad news it has a very positive impact on future home inventories. Eventually the demand for housing will exceed supply again and home prices will begin to recover. This may take some time but a virtually moratorium on new homes certainly helps.

Government Stimulation
Over the next two years our government will spend nearly a trillion dollars stimulating our battered economy. While one can debate the value of this stimulus, there is little debate that it will have a positive impact on stemming foreclosures, increasing employment, and providing prospective purchasers a nice credit of $8,000 to purchase a home in 2009. The administration will also use $75 billion to bring down mortgage rates and encourage loan modifications to stem repossessions. “The problem with the build-up in inventory is coming from the increasing number of foreclosures,” Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts, said in a Bloomberg Television interview. “It’s about time the government intervened so directly in the problem.”

So Where Does This Leave Us?
As I explained earlier, falling real estate values led us into this recession and stabilizing values will mark the beginning of the end. If one can accurately predict when and at what level home values will stop falling, one can predict when the stock market will likely turn positive and when the economy will truly begin to rebound. We live in a world of uncertainty, and it is this uncertainty that defines risk and ultimately opportunity or failure. Predictions on when the real estate market might begin cannot be relied upon at all. There are far too many factors that are still unknown. However, now that I have hedged myself, here is a summary of my thoughts on the light at the end of the tunnel.

A bottom in the current residential real estate cycle will be reached between April and September of this year at a value of 11 to 15% below year end 2008 values. While an additional drop of this magnitude will be painful, it will be reached shortly. Capitulation caused by short sellers and foreclosures will likely end this spring. Thus some of the best buying opportunities may be right around the corner. If my predictions are correct, this would mean a peak to trough decrease in values of about 37% and put properties priced at their 2002 levels. These estimates are based on national averages and will vary significantly in different parts of the country and in different price points in each MSA. For example, property values inside the Washington DC Capital Beltway have fallen by less than half that of those further out. So if you are in the market for a home and plan to stay at least 5 years, 2009 might just turn out to be the ideal time to buy.

Do Your Part To Help Economy

2009-03-09T13:28:00.001-04:00

Do Your Part To Help Economy: Take Some of the Government Hand Outs, Lower Your Mortgage Payments or Buy a New House.

Our government is giving away tax dollars in an effort to stop home depreciation and help the economy. Here is a summary of how to get some of these tax dollars in your pocket while helping the faltering economy. Falling real estate values are killing the Nation’s financial institutions, not to mention damaging the stock market and to the equity in your home. Take advantage of the $787 Billion Stimulus Package and the $75 Billion Treasury’s “Making Home Affordable” Programs and help stop the bleeding. Here is a quick summary of how you can help:

1. Refinance Now: The US Treasury has been buying mortgage backed securities at an unprecedented rate. This has lowered fixed mortgage rates to the low 5% range. This, combined with the new, higher loan limits of $625,000 has helped many to lower their mortgage payments. If your loan amount exceeds $625,000 or if you are over 80% loan to value, consider paying down the mortgage to meet the lender’s guidelines. Remember, if you reduce debt costing you 6%, you are guaranteed to earn that rate of interest on your investment.

2. Get your first time homebuyer $8000 tax credit[1] when you buy a home before December 1st 2009. A “first time home buyer” is anyone who has not owned a home for three years. If you plan to buy before the deadline, you can begin saving by reducing your withholdings now. The law also allows taxpayers to choose ("elect") to treat qualified home purchases in 2009 as if the purchase occurred on December 31, 2008. This means that the 2008 income limit (MAGI) applies and the election accelerates and can be applied by filing 2008 returns instead of for 2009 returns. Income must be lower than $75,000 for individuals and $150,000 for couples. If you already own a home and have a twenty something year-old living in your house, give them a push! Now is the time to pick up a steal!

3. The Home Affordable Refinance[2]: This program will be available to 4 to 5 million homeowners who have a solid payment history on an existing mortgage owned by Fannie Mae or Freddie Mac. This program is aimed at homeowners whose loan to value is greater than 80% and do not qualify for a traditional refinance. These borrowers may be eligible to refinance their loan and take advantage of today’s lower mortgage rates or to refinance an adjustable-rate mortgage into a more stable mortgage, such as a 30-year fixed rate loan. The Home Affordable Refinance program ends in June 2010. Only homeowners in good standing whose loans are held by Fannie Mae or Freddie Mac qualify. The property must be owner-occupied and the borrower must have enough income to make payments on the new mortgage debt. Borrowers can't owe more than 105 percent of their home's current value on their first mortgage. Borrowers with a second mortgage still can qualify as long as their first mortgage isn't more than 105 percent of their home's value. Homeowners can't take cash out during the refinancing to pay other debt.

4. The Home Affordable Modification[3]: This program will help up to 3 to 4 million at-risk homeowners avoid foreclosure by reducing monthly mortgage payments. Who can qualify? The program applies to mortgages made on Jan. 1 or earlier. If your mortgage payment including taxes, insurance and homeowners association dues exceeds 31 percent of your gross monthly income you may qualify for modification. The property must be the homeowner's primary residence. Home loans for single-family properties that are worth more than $759,750 don't qualify. Homeowners are eligible for up to $1,000 of principal reduction payments each year for up to five years! You do not need to be behind on your mortgage to qualify for this program.

5. Mortgage Analysis: Need help to figure it out? Call for a free mortgage analysis. 703-821-5554

[1] http://www.federalhousingtaxcredit.com/
[2] http://www.treas.gov/press/releases/reports/guidelines_summary.pdf
[3] http://www.treas.gov/press/releases/reports/guidelines_summary.pdf

Obama Signs Economic Stimulus Package into Law

2009-02-19T10:02:00.002-05:00

Here is a great summary of how the stimulus package might effect your taxes:

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009, which contains nearly $800 million in economic stimulus spending and tax relief designed to help individuals and businesses in the current economic climate. While the tax and accounting specialists at Cherry, Bekaert & Holland, L.L.P. (CB&H) review the Act to develop more detailed guidance for our clients and friends, here is a list of some of the new law's major provisions. Note that most of the benefits included in the new law are eliminated or phased out for higher income individuals; however, there is something for virtually everyone in this Act:

"Making Work Pay" Tax Credit
For 2009 and 2010, the Act creates a refundable tax credit of up to $400 for working individuals or $800 for couples with modified adjusted gross income (MAGI) that does not exceed $75,000 or $150,000 respectively. Qualified taxpayers will receive this credit either in the form of reduced withholding from their paychecks during the year or when they file their annual tax returns.

AMT Patch for 2009
The Act includes an alternative minimum tax (AMT) patch for 2009, which raises AMT exemption amounts above 2008 levels to $70,950 for joint filers and surviving spouses (up from $69,950 in 2008); and $46,700 for single filers and heads of households (up from $46,200).

First-Time Homebuyer Tax Credit
The Act expands the first-time homebuyer tax credit, originally enacted under the Housing Assistance Tax Act of 2008, increasing the maximum amount of the credit to $8,000 and eliminating the repayment obligation for qualified principal residences purchased from January 1, 2009 through November 30, 2009.

New Car Deduction
Effective for new vehicle purchases on or after February 17, 2009, the Act allows qualified taxpayers an above-the-line deduction for all state, local sales and excise taxes paid relating to the first $49,500 of the purchase price of a new car, light truck or other vehicle through the end of the year.

"American Opportunity" Education Tax Credit
For 2009 and 2010, the Act expands and renames the existing HOPE education credit, increasing the credit amount (subject to income limits) from $1,800 to $2,500 a year and applying the credit to all four years of college. The Act also makes 40% of the credit refundable and adds course materials as qualifying expenses.

Bonus Depreciation
The Act extends the first-year 50% bonus depreciation enacted under the 2008 Economic Stimulus Act for new business equipment purchases through December 31, 2009. The Act also extends through 2010 bonus depreciation for other qualified property.

Section 179 Expensing
The Act extends through 2009 the Section 179 depreciation deduction, originally enacted under the 2008 Economic Stimulus Act, for new and used business equipment, increasing the expensing amount to $250,000 and the threshold for reducing the deduction to $800,000.

Net Operating Loss Carryback
The Act enables qualified small business with average gross receipts of $15 million or less to carry net operating losses (NOLs) back for up to five years. The carryback provision applies to any NOL for tax years beginning or ending in 2008.

Cancellation of Indebtedness
The Act allows qualified businesses to recognize cancellation of indebtedness income over five years, beginning in 2014, for specified types of business debt repurchased or forgiven by the business after December 31, 2008, and before January 1, 2011.

Qualified Small Business Stock
The Act allows investors to exclude, through 2010, up to 75% of the gain from the sale of qualified small business stock acquired after February 17, 2009 and before January 1, 2011 and held for more than five years.

S Corp Built-In Gain Period
For C corps that become S corps in 2009 and 2010, the Act reduces the holding period to seven from 10 years for assets subject to the built-in gains tax.
This short summary is by no means a comprehensive review of the new law. Look for more details soon about how these and other provisions of the Act may provide you and your business with considerable opportunities to maximize tax savings, or contact your local CB&H tax professional today to ensure that you and your business receive the maximum possible benefit of these provisions.

FOR MORE INFORMATION, PLEASE CONTACT:Brooks Nelson, Partner bnelson@cbh.com 1.800.849.8281

About Cherry, Bekaert & Holland, L.L.P. (CB&H) www.cbh.comAs the Southeast’s accounting and consulting Firm of Choice, Cherry, Bekaert & Holland, L.L.P. (CB&H) is uniquely positioned to provide quality, cost-effective and value-added services to a diverse and successful client base. The Firm sets itself apart by delivering the extensive industry specialization and service opportunities of a national firm, but with the accessibility, service continuity and level of personal relationship expected from a local business. Ranked nationally among CPA firms, CB&H’s resource network stretches regionally across six states, including the large metro markets of Atlanta, Charlotte, Hampton Roads, Raleigh, Richmond, Tampa, South Florida, and Washington D.C., and nationally and internationally through an alliance with Baker Tilly International, a worldwide network of independent accounting firms.

U.S. Treasury Department Circular 230 Disclosure: In accordance with applicable professional regulations, please understand that, unless specifically stated otherwise, any written advice contained in, forwarded with, or attached to this communication is not a tax opinion and is not intended or written to be used, and cannot be used, by any person for the purpose of (i) avoiding any penalties that may be imposed under the Internal Revenue code or applicable state or local law provisions or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Source: Cherry, Bekaert & Holland, L.L.P. (CB&H)

Target Funds Miss The Mark!

2008-12-10T11:34:00.005-05:00

Nearly every mutual fund, index or exchange traded fund has lost significant value in 2008. However, one group, Target Date Funds, specifically the “2010” funds, have performed worse than nearly all others given their objective. These mutual funds, also known as lifecycle funds or age based funds are designed to provide a simple investment solution through a portfolio whose asset mix becomes more conservative as the target date (usually retirement) approaches.

Laura Bruce with Bankrate.com describes them as follows: “The formula seems simple. Determine the year in which you want to retire and put a bull's-eye on the calendar. Go to your employer-sponsored 401(k) or IRA, or to your individual brokerage account, and find the "target date" mutual fund that matches your retirement date. Start pouring your retirement dollars into that one fund. As the years go by, your fund is routinely rebalanced and becomes incrementally more conservative. The theory is that as your retirement date arrives, the changing asset mix will provide the proper recipe for stability and growth.”

In addition, a February 2008 article of Kiplinger Magazine touted this simple approach to investing. “Target-date funds simplify long-term investing. Choose the year you wish to retire, then pick the fund with the date closest to your target.” Simple as that! The article goes on to recommend their favorites, T. Rowe Price, Fidelity and Vanguard, coincidently the same companies that advertise in Kiplinger’s Magazine.

Investors have pumped nearly $26 billion into Target Date funds. Most of these investors are the leading edge of the baby boomers born in the mid-1940s and are now nearing retirement. So how has this “simple” new investment performed in the current environment?

Target Date 2010 funds, those with the earliest retirement target and presumably the most conservative, were pounded in 2008. Here is a sample as to how these funds performed so far this year:

How did this happen? According to Craig L. Israelsen, Ph.D., an associate professor at Brigham Young University, the Target 2010 Index had an equity allocation of about 8%. However, the four largest Target 2010 funds had equity allocations in excess of 50%. In order to compete for more assets, fund managers went for higher returns in an attempt to beat the index. They failed.

There are a number of lessons to be learned from this. First, investing is never “simple” or “easy”. If it were, we would have a lot more wealthy people on this planet. Second, Kiplinger and Money Magazine are in the business of making money, not investing your money. Following their advice generally ends you up at the bottom of the heap. Third, never put all of your eggs in one basket. There is simply too much risk in investing in one fund.

US Financial Crisis: Selling Two Legged Stools

2008-10-15T13:22:00.010-04:00

Many people ask me how the financial sector got so messed up. Here is the best analogy I can give you:

Imagine a world where stools are a critical component to the economy. Stupendous Stool Store, Inc (SSS) is one of the five largest stool companies in the world. For years, SSS sold four legged stools with various degrees of quality to retail stores

worldwide. SSS sells its stools in bundles of 10, improving efficiency and lowering costs. They bundle together both high and low quality stools to give the retailer a nice mix to sell to consumers. For many years, this was a very profitable business.

One day, the SEC (Stool Exchange Commission) relaxed the capital requirement laws for companies like SSS. Before, they could only borrow 10 times their equity for the inventory needed to make the stools. Now they could borrow 40 times their equity to purchase and make stools for repackaging. SSS set up more lines of credit to purchase more raw materials to make more stools. In order to carry this new debt load, SSS needed to make lower cost stools. One highly paid executive at SSS decided that they could lower prices of the stools, by including a few three legged stools in their bundles. They modeled the use of the new stool by sending “Stool Samples” to various bars and pubs around the world. They quickly determined that the three legged stool is just as good as a four legged stool, but costs less to make and takes up less room. Buyers of the stools did not seem to mind at all.

SSS then sent the Stool Samples to their independent external rating agency, Dumb and Dumber, Inc. After speaking with the executives at SSS and reviewing their “Stool Samples”, those at Dumb and Dumber, Inc. concluded that the new stool bundles should receive the same AAA rating as before. Now SSS could sell both three and four legged stools in bundles for the same price as they sold a bundle of higher quality four legged stools. The executives and sales people at SSS pocketed the additional profits and were happy.

Then one of the highly paid commission sales persons at SSS came up with an even better idea. How about adding some 2 legged stools to the package? These stools would only be effective for sober customers with good balance. Since they are only going to put a few of these stools in each bundle, along with three and four legged stools, they were able to lower their costs yet again. They went to Dumb and Dumber, Inc. with their “Stool Samples” and explained that since 20% of the customers who buy stools were sober, the two legged stools really had no effect on the quality of the stool package. Those at Dumb and Dumber, Inc. agreed and rated the stools packages AAA yet again. SSS could sell its stool package at the same price as before, but with much lower costs and pocket a handsome profit.

In order to keep production going, SSS always maxed out its leverage so that it had plenty of Stool Bundles available for the market. Eventually however, the stools reached a saturation point in the market and sales began to decline. At the same time, people were getting hurt falling off the three and two legged stools. Some companies began to return their stool bundles and others simply stopped buying.

It was at this point that Dumb and Dumber decided to lower the rating of the Stool Packages from AAA to BBB. Now no one wanted to buy any stools from SSS. SSS was still holding forty times its equity in lower rated stool packages in its inventory. These Packages were now “marked to market” by SSS’s auditor, an arbitrary process used to kick you when you are down. When they are marked down just 4%, the entire equity of SSS is wiped out. It is about this time that the banks that lent money to SSS began calling in their loans. They wanted their money back. At the same time, giant hedge funds began shorting the SSS stock, hammering its value even further. Eventually SSS had to either declare bankruptcy, be forced into a shotgun marriage with a stronger company, be taken over by the government or, as an interim step, be converted to a bank to be taken over later.

Imagine now that there are two legged stools hidden in dark pubs around the globe. They are owned by various institutions who no longer want them and the stools cannot be valued. As you can see, the world would be in quite a pickle if we relied on stools as a major source of financial security.

I used the stool in this analogy for two reasons. First, for many years, banking decisions were made by analyzing the 4 “C’s” of lending. Think of these 4 “C’s” as the 4 legs of a stool. They are Character, Cash Flow, Credit and Collateral. In residential lending, character was eliminated some time ago when loans were securitized and borrowers and their ultimate lenders never met. That left a three legged stool that functioned pretty well through the 1990s. However, in the first few years of the new millennium, new products were coming out that eliminated one of the remaining legs of the stool. No income verification loans, no down payment loans, and loans to people who exhibited poor credit decisions were created. Soon the three legged stools became two or even one legged stools. They were then packaged and sold and somehow obtained AAA ratings.

Loose lending guidelines combined with leverage and poor regulation has been the recipe for an unprecedented financial meltdown in this country. The mortgage back securities created by these firms have filled our financial institutions with financial crap; the second reason for my “stool” analogy.

Who Does Your Financial Adviser Represent?

2008-10-08T13:35:00.005-04:00

In a world of uncertainty, where one hundred and fifty year old financial institutions declare bankruptcy or are seized by the government over night, it becomes crucial for investors to understand who the advisers handling their money represent. Does their financial adviser put their clients’ interests above those of their own and their company, or are they simply selling them the recommended investment product du jour.

In 2008, customers of UBS, Merrill Lynch, Wachovia, Bank of America, and other larger financial institutions were shocked to find that their savings were locked up or wiped out when their “safe” option rate securities were no longer liquid. They were “sold” these products by their trusted advisers as an alternative to money markets. Meanwhile, their companies were being paid to create these securities. These companies were sued by their customers and several state attorneys' general and forced to pay for any losses incurred.

Others are now being told by their investment advisers that variable annuities are an excellent alternative for investing. These annuities offer a minimum “guaranty” of principal invested so that when the market goes down, “your money is still safe”. Thus, if you invest $100,000 and wait ten years past the penalty period, you will be “guaranteed” at least your money back. Why were these products not offered before the market collapsed? What are the costs associated with them? How good is the “guaranty” when companies as large as AIG can fail?

The people dispensing financial advice are split primarily into to two camps; those that have a legal fiduciary relationship to their employer, and those that have a fiduciary relationship to their client.

Fiduciary Relationship Lies With Employer or Broker Dealer

Financial Advisors that have a fiduciary relationship to their employer are called “Registered Representatives”. They are registered with their broker dealer, usually their employer, which they represent. They carry cards with such titles as “Financial Advisor”, “Investment Advisor”, “Financial Consultant”, “Financial Planner”, “Registered Representative”, “Insurance Agent”, and many others. In most cases, they work for large brokerage firms like Lehman Brothers, Bear Sterns, Merrill Lynch, Morgan Stanley, just to name a few. Some work for insurance companies such as AIG or banks such as Washington Mutual or Wachovia. These advisers generally carry Series 7 and insurance licenses so that they can legally receive commissions or referral fees on products they sell.

These individuals are tasked with selling products their organizations have created or recommend to their customers. Their regulator is the National Association of Securities Dealers, or the NASD. According to Scott Simon, author of the Prudent Investor Act: A Guide to Understanding, “registered reps follow the “suitability” standard under NASD regulations. This standard doesn’t require a registered rep to place the interests of its clients ahead of its own. Under this non-fiduciary suitability standard, a registered rep need provide only “suitable” advice to its clients-even if it knows that the advice is not the best advice.”

As Liz Pullium West, author of Easy Money: How to Simplify Your Finances and Get What You Want Out of Life, puts it, “At best, they're held to a "suitability" standard, which means they're supposed to reasonably believe that the investment and insurance products they want you to buy are appropriate for your situation. Just "appropriate" -- not "the best choice" or "in your best interests." Let's say you have $10,000 a year to save for retirement. Your financial adviser could recommend you invest the money in a low-cost index fund that might net you a return of 8% a year. After 30 years you'd have over $1.1 million. But let's say the adviser could earn a fat commission for recommending a higher-cost investment being promoted by his financial-services firm. So instead of netting 8% a year, you might net 6%. After 30 years, your nest egg would grow to just under $800,000, a difference of more than $300,000. The high-cost investment might be perfectly "suitable," since it meets your financial objective of saving for retirement, even if it could leave you significantly poorer than had you invested in the index fund.”

Merrill Lynch has gone to court to defend this concept of having a fiduciary duty to the company instead of the client. In an attempt to have its cake and eat it too, Merrill Lynch was able to get a court ruling, now called the “Merrill Lynch Rule”, to allow them to operate like a true advisor to the client while still representing the firm. This rule was overturned in 2007.

Fiduciary Relationship Lies with the Client

The second camp of investment advisors are Registered Investment Advisors (RIAs). Under the law, these advisers have a fiduciary duty to their client. They must register with the Securities Exchange Commission (SEC) once they have over $25 million under management. According to Mr. Simon, “Given its fiduciary status, an RIA must follow the “trust” standard- the highest known in the law-which requires it to place the interest of its clients ahead of its own and fulfill critical fiduciary duties…” Most hold the Certified Financial Planner designation which has its own separate “code of ethics”. Unless they are also a “registered representative”, they do not receive commissions or referral fess for investments they recommend. As a fiduciary, they have clients rather than customers. The have no incentive to select products based on commission paid nor are they required to provide specific investment products by their employer. They are free to select the best investments for their clients based on what is best for the client.

So why do so many wealthy individuals take the advice of those that represent their company rather than their client? The answer is the implied additional security combined with the sales power of a large firm. Here is a quick comparison of the financials of Charles Schwab and Merrill Lynch as of June 30, 2008:

(click to enlarge)

According to Wikipedia, “leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.” ML is levered up 60 times! This is a primary cause of its forced sale to Bank of America.

With an increasingly complex financial world it becomes more important than ever to seek sound advice. Just make sure that advice comes from a professional who puts your interests first.

Book Review: Hot, Flat and Crowded

2008-10-05T13:53:00.003-04:00

by Thomas L. Friedman

This is Friedman’s sequel to his widely popular book, The World is Flat. Friedman explains that the old problems of the cold war have been replaced by a host of new problems in what he terms the “Energy Climate Era”. Friedman argues, “We can no longer expect to enjoy peace and security, economic growth and human rights if we continue to ignore the key problems of this new era. These new problems include:

• Energy Supply and Demand
• Petro Dictatorship
• Climate Change
• Energy Poverty
• Biodiversity Loss

Friedman describes these problems in detail and precisely how we can solve them. If you want to learn how we can make the planet a better place for our children, this is a must read.

Market Update

2008-10-04T13:56:00.004-04:00

Today’s investment environment is reminiscent of a recent article on fox hunting by Dominic Bliss of The Financial Times, entitled “Manhunt”. Since fox hunting has been banned in England and Wales since 2004, Bliss went to Blackpool England to see how things have changed. She described the modern day fox hunt as follows:

“At Peagram's Farm [Blackpool, England], 35 excited riders - the huntsmen in smart red jackets, the rest in black or tweed - are waiting for the hunt to start. They sip port and sherry to brace themselves against the wind coming in off the Irish Sea, while their finely groomed horses jig their heads and stamp their hooves.

Below them, whining and barking in anticipation, is a pack of about two dozen bloodhounds. Mingling with the dogs, and looking decidedly apprehensive, are two "foxes" - Richard Davies, a 49-year-old civil servant from Kirkham, and Matthew Ray, a 32-year-old (off-duty) journalist from Brighton. Both are accomplished athletes.

As they pet the hounds, allowing the animals to memorize their scent, the master huntsman Clive Richardson offers a few words of encouragement. "Don't worry," he says. "When a limb's torn from you, it really doesn't bleed that much."

I believe many investors feel a little like the human quarry in this fox hunt as they try to navigate the financial wreckage that was third quarter of 2008. This historic quarter will be found in the next generation’s financial and history text books. It is a period when companies recently valued at a combined $500 billion vaporized. It is a time when the oldest money market fund “broke the buck” and fell below $1.00. A period when people were willing to buy US Treasury Bills for more than they would be re-paid after holding them for 1 month. It also marks the creation of the world's largest sovereign wealth fund, the US Treasury.

For the quarter, the S&P 500, the index which holds the 500 largest companies in America, was down 9% and down 20% for the year to date. More alarming is that the S&P 500 is up only 2.8% for 10 years. Investing internationally did not help with this bear market. The EAFE index was down 21% for the quarter and 31% for the year to date! Emerging markets where especially hammered, with the EM index down 27% and 37% year to date. The bond market, which usually moves in the opposite direction as equities also fell 0.6% for the quarter and was up only 0.5% for the year to date.

Is there a silver lining in all this bad news? Yes. Recessionary environments and market corrections are the best time to make smart investments. Today, everything is on sale. The question of the day is, "Will there be a “clearance” tomorrow?” The key to navigating this mess is to focus on the long run. If your investment horizon is seven years or longer and you can handle the risks of the market fluctuations, this may prove to be the best time to invest in a generation.

Sector Performance Report

2008-10-01T13:52:00.002-04:00

As of September 30, 2008

Nowhere to Hide: All sectors were down in the past 12 months with telecom getting hit the hardest. In the past three months, Consumer Staples, Financials and Health Care were the only sectors that did not fall. Expect that trend to continue over the coming year.

(click to enlarge)

The US Government Take Over of Fannie Mae and Freddie Mac: Winners and Losers

2008-09-08T14:12:00.007-04:00

Over the weekend, our government seized two of the largest financial institutions in the world, Fannie Mae and Freddie Mac. They fired the boards of directors and the CEOs and they diluted the shareholders by 80%. Who are the winners and losers of this historical takeover?

First the losers:

↓Common stock holders of Fannie (down 89% from Friday to $1.18) or Freddie (down 85% from Friday to $1.08). As Warren Buffet said this morning on CNBC, The common shareholders are going to get nothing until the Treasury gets paid back, and even then, as I understand it, the Treasury is getting a warrant at a nominal sum for 79.9 percent of the resulting common, so assuming there is anything left for the common four or five years down the road, the Treasury will get 80 percent of it, so they're getting paid very well for stepping in. And like I say, the question of whether the common gets anything is problematical. The common is an option at this point.”

↓Preferred stock holders of Fannie or Freddie

↓Holders of long term U.S. treasuries: Given the additional risk the US is putting on its books its only natural that its bonds would be down graded.

↓Shareholders or executive level employees of one of the 17 banks that had a concentration in common or preferred shares of Fannie Mae or Freddie Mac that surpassed 10% of their Tier 1 Capital. For example, Sovereign bank’s (down 10% on the news) securities losses could wipe out an entire year of earnings.

↓Owners of Dodge and Cox Funds which as of June owned nearly 119 million shares of FNMA.

↓Owners of Bill Miller’s flagship Legg Mason Value Trust which placed huge bets on Freddie Mac and Fannie Mae. The fund is already down 31% year to date.

Now the winners:

↑Home owners and potential home owners in need of a mortgage: Mortgage rates should improve. According to a Tom Millon, a mortgage backed securities guru, owner of Capital Markets Cooperative and good friend, “Mortgage yields have every reason to come down. The spread between mortgage and Treasury yields has been a thorn in the mortgage industry’s side. The spread has spent the past few weeks again at historic highs – exceeding a whopping 2.75%. All of a sudden there are two key reasons to believe that mortgage rates will drop relative to Treasury yields. First, mortgage yields have contained at least 0.50% of credit premium due to fears that the agencies might fail. That fear has been eliminated. Standard & Poor’s said Sunday that the government’s AAA/A-1+ sovereign credit rating would not be affected by the takeover. Second, in an unprecedented move, the government is enacting a program to buy mortgage-backed securities. Aptly named the GSE Mortgage Backed Securities Purchase Program, the program will allow purchases (nobody has said how much the government will buy) starting later this month.”

↑Home owners: The falling real estate market should begin to stabilize. According to the most recent Case-Shiller Home Price Index, the value of homes in the largest 20 US metropolitan areas have fallen an average of 18.8% in the last 24 months. With an improvement in mortgage rates and some stability in the credit markets, real estate stabilization should follow.

↑Mortgage backed securities holders will receive a wind fall. Now that the government guaranty is no longer implied but actually guarantied, the securities should increase significantly in value.

↑Banks that hold Fannie/Freddie issued mortgage backed bonds will have an increase in value.

↑US Equities should rally, at least in the short term. This is because one of the biggest market uncertainties has now become certain. The market hates unknowns and generally sells off in the face of uncertainty. Now that the government has stepped in, the market can value these securities properly. Most of the financial sector will be winners propelling the market upward.

↑Tax payers. Yes, tax payers. The government did not bail out the shareholders of Fannie and Freddie. They wiped them out. It may take 5 years for the companies to get healthy again and I believe this government will be able to sell them back to the market at a healthy profit. This is far better than the hit the government would have taken should Fannie and Freddie been allowed to fail.

↑Daniel Mudd and Richard Syron, ex-CEOs of Fannie and Freddie will be walking away with exit packages of around $14 million each.

I am sure I missed a few winners and losers so please send your feedback in or leave a comment below!

KLD Green Returns

2008-07-24T11:17:00.014-04:00

I just received this press release from KLD and wanted to share it. KLD's Global Climate Index has three year anniversary and posts an average annual return of 15.24%! This compares quite favorably to the S&P 500 return over the same period of just 4.4%. Another good reason to invest in companies committed to a sustainable planet. They make money!

The KLD Global Climate 100 Index
Marks Three Year Anniversary:
The First Climate Change-focused Index
Returns 53% since Launch

Boston, MA, July 17, 2008 – KLD Research & Analytics, Inc. has marked the third anniversary of its Global Climate 100SM Index (GC100) – the first global index focused on solutions to climate change. The GC100 has returned 53% (15.24% annualized) from its launch on July 1, 2005 through June 30, 2008. The index holds a diversified group of companies that are leaders in renewable energy, clean technology & efficiency, and future fuels.

“Over the past three years, we’ve witnessed formation of a scientific, public policy and business consensus on the need to combat global climate change. If our economy must depend less on fossil fuels, then our portfolios must do the same,” said Thomas Kuh, Managing Director of KLD Indexes. “Renewable energy is part of the answer, but energy conservation and pollution prevention are also essential. The GC100 looks for opportunities on all these fronts.”

The GC100 includes companies who make promising energy-saving products, such as “smart” electric meters and superconductors, as well as alternative energy stocks.

(click to enlarge)

KLD Global Climate 100: Holdings and Top Performers
The GC100 holds leading companies in the climate solutions value chain, including small, pure-play firms like Novozymes and GS Yuasa as well as large diversified companies, like Siemens and General Electric. The Index is equal weighted to ensure that investors benefit from these innovative companies regardless of their size.

“As the following chart shows, the holdings in the GC100 are positioned to profit from the trend toward de-carbonization of the economy in response to climate change,” said GC100 Index Manager Jed Sturman. “As the price of oil has soared, GC100 constituent stocks like Vestas Wind Systems of Denmark and SolarWorld of Germany have shown strong returns; smaller firms such as Conergy, Solon, and American Superconductor have also performed well.”

(click to enlarge)

KLD created the GC100 in partnership with the Global Energy Network Institute, a research organization that seeks to build connections among the world’s energy systems, with an emphasis on renewable energy resources. “In the energy sector, we get what we invest in. If we want a cleaner, more sustainable world in the future, we need to invest in climate solutions today,” said Peter Meisen of GENI.

KLD Global Climate 100: Methodology and Index Performance
The GC100 includes a mix of 100 global companies that will provide near-term solutions to global warming while offsetting the longer-term impacts of climate change. GC100 constituent companies include producers and distributors of:

Renewable Energy, such as solar and wind;
Future Fuels, such as biofuels and hydrogen; and
Clean Technology & Efficiency, such as technologies and services that help to reduce energy consumption and emissions of greenhouse gases.

The GC100’s constituent companies include large-, mid-, and small-capitalization companies representing sectors ranging from energy and utilities to industrials and consumer products. This broad focus distinguishes the GC100 from other carbon-sensitive investment strategies that include only energy and utility stocks. The GC100 is an equal weighted index, which means that KLD allocates a 1% weight to each of its 100 constituents. This increases the GC100’s exposure to small-capitalization companies and ensures that investors benefit from innovative companies who are poised for growth.

The GC100 has returned 57 percent (17.23% annualized) since index launch, as of 5/31/08. The same constituents under a market cap weight would have returned 39 percent (12.54% annualized). As explained by Peter Meisen of GC100 partner GENI: “It just makes good business sense to reduce one's dependence on fossil fuels – for investors as well as companies.”

KLD Global Climate 100: Licensees and Investment Products
The GC100 serves as the basis for an assortment of investment products including:
Institutional and Separate Accounts
Northern Trust • USA
Shinko ITM • Japan

Mutual Funds
Shinko ITM • Japan
Chikyu Ondanka Boushi Kanrenkabu Fund I (06312066:JP)
Chikyu Ondanka Boushi Kanrenkabu Fund II (06311077: JP)
Chikyu Ondanka Boushi Kanrenkabu Fund PLUS
Cominvest Asset Management • Germany
Cominvest Klima Aktien PLUS (WKN: A0MSTB)

Unit Investment Trust
Advisors Asset Management • USA
KLD Global Climate 100 Index Portfolio, Series III (ADTKFX)

_________________________
About KLD Indexes
KLD Indexes is a unit of KLD Research & Analytics, Inc., a leading provider of environmental, social and governance (ESG) research for institutional investors. KLD Indexes develops and licenses benchmark, strategy and custom indexes that investment managers use to integrate ESG criteria into their investment decisions. KLD Indexes are designed to be transparent, representative and investable.

Products based on KLD Indexes include:
Mutual Funds
ETFs
Separately Managed Accounts
Unit Investment Trusts
Variable Annuities
Structured Products

More than $10.5 billion is invested in vehicles based on KLD Indexes. For more information about KLD’s indexes visit http://www.kldindexes.com/
For information about licensing a KLD index for the creation of an investment product, please email indexes@kld.com

Contact:
Amy Blumenthal/Karen Myers
Blumenthal & Associates
617-879-1511

Peter Ellsworth
KLD Research & Analytics, Inc.
617-426-5270 x218

How to Fight a Bear

2008-07-16T14:58:00.008-04:00

In my last newsletter I suggested a recession may have begun in the first quarter of this year. I was wrong. The economy squeezed out a 0.6% annualized growth rate in Q1 ‘08. However, according to Warren Buffet anytime that GDP is less than U.S. population growth, we are in recession. The U.S. population growth rate in 2008 is estimated at 0.88% leaving us with a real economic growth of -0.28%. I think I will go with Mr. Buffet’s definition!

Either way, it sure feels like a recession. The stock and real estate markets are both down nearly 20% from their peaks. Even bonds, which are normally a good bet going into a recession are getting hit due to inflationary fears. Recessionary times are generally accompanied by “bear” markets, a term investors refer to when the market declines by 20% or more. The last recession, which started in March of 2001 and lasted about eight months, was primarily due to a bubble in technology related stocks. That recession was accompanied by a bear market, which began in January 2000 and lasted until October 2002. Stocks lost 49% during this time period. However, the real estate market was very strong and helped to offset losses investors had in the equities markets. In addition, bonds rallied as interest rates fell and inflation remained low. This time its different. Both stock and real estate markets are in bear territory, while the credit crunch and inflation issues are causing havoc in the bond market. We may be closer to a 1970s style bear market than the 2001 bear.

The average bear market lasts about 14 months with a drop of 32%. However, averages do not tell us what to expect. One of the largest market drops was during the 70’s oil crisis when the market fell 48%.

In nearly every case, the stock market bottoms well before economic activity bottoms. This is because the stock market provides a signal for future earnings, generally at least six months out.

Fighting the Bear

Should we abandon the picnic basket and give it to the bears? Definitely not. First things first, don’t panic. I searched the web for stories written in late 2002 and early 2003 near the end of the last recession. After three straight years of declines, the US markets were off by nearly 50%. Market commentators were fueling the panic with pessimistic articles about expectations in 2003. Many were predicting 30% market sell offs, while others suggested moving entire portfolios to cash. These are the same folks that coined the term “The New Economy” and helped to fuel the tech bubble. As it turns out, 2003 was one of the best markets on record - up 28.7% including dividends and led by “old economy” stocks. The good news about today’s market is stocks are cheaper in relative terms than at the end of 2002!

(click to enlarge image)

1. Invest for the Long Term
Investing in the stock market is for long-term investors only. Investment horizons should be at least seven years or longer. I cannot predict what the market will do in the next 12 months, but a well balanced equity portfolio should be up at least 9% over the next 7 to 10 years. Why? Because bear market sell offs present terrific buying opportunities for patient investors. When was the last best time to buy equities? In October of 2007 when the market reached the end of it bull market cycle, or in December of 2002 when investing in stocks felt like jumping into a bottomless pit? If you invested in the S&P500 in January of 2003, you would be up an average of 12.8% a year over the next four years. Despite the occasional sell off, the market (S&P 500) on average has increased by 11.9% per year over the last 60 years.

2. Do Not Try to Time the Market
Trying to time market swings is a classic investor mistake during bear markets. It is nearly impossible to predict when the market will rebound. Rebounds are usually swift and erratic. As I said earlier, the average bear market drop is over 30%. However one month after the market bottoms out, the average recovery is 10.6%. After three months, the average recovery is 14.7%; six months after bottom, the average recovery is 23.1%. Finally, investors who held on were rewarded with an average 34.8 percent recovery 12 months following a bear market bottom.

3. Doing Nothing Will Not Work Either
Investment portfolios need to be reviewed periodically. During bear markets, additional scrutiny must be made. Now is the best time to shed poor investments. Not every position will come back to its previous value and some will go to zero. We still have not reached the 2000 NASDAQ peak and may not for several years, and this is because many of the highest fliers never recovered.

(click to enlarge image)

4. Converting to Cash May Be a Mistake
Unless you had the prescience to convert to cash in October of 2007, converting to cash now after a 20% correction may not be the best idea. How will you know when to get back into the market? Inflation rates are currently almost double what you can get in a money market, so in addition to missing a rebound, you will lose real asset value due to inflation.

5. Search for Value
It is markets like these where fortunes are made. Many investments are selling at cheap values due to overall market devaluations rather than specific investment risk. For example, nearly all banks are off 50% from their market peaks. However, not all banks are in bad shape. The current environment will make some folks very rich and others lose fortunes.

6. Rebalance
Steep market drops are the best time to rebalance your portfolio. For example, if you held TIPS or other government bonds in your portfolio, now is a great time to sell off some of your profits and re-invest in other sectors that have been hit hard. This allows you to increase your profits when the market improves.

Certainly, the best time to buy is when something is on sale. At this point, equities are now 20% off. The question is, will there be a bigger sale later? Are they about to go on clearance? The approach here is to buy some on sale, but to maintain some powder for a clearance.

The Next Tech Boom

2008-07-16T14:52:00.000-04:00

Fossil fuels provide over 85% of the fuel used on the planet. The triple dilemmas of limited supply, controlled by unfriendly nations, and the unwanted side effects of global warming have created the perfect environment for new sources of renewable, alternative energy to take hold. If you combine oil costs at nearly $150 per barrel, gas prices over $4 per gallon, war in Iraq and possibly Iran, and global warming, we might just be seeing the perfect storm to launch the next big tech boom. Today, more money than ever is being spent on alternative energy sources as plans for the end of the fossil fuel economy are being laid. Much of the information from this article is derived from a Special Report on the Future of Energy in The Economist and sections of Value Investing by Hal and Jack Brill.

The 1990’s tech boom was lead by companies like Dell, Microsoft, Cisco, and Intel. These old “tech” companies, however have done little in the last ten years to solve the world’s primary problems. The late Richard E. Smiley, PhD compiled a list of Humanities Top Ten Problems. The first five on the list are energy, water, food, environment and poverty in that order. The New Tech companies will be industrial manufacturers that invent solutions to these world problems.

New Tech includes companies that create new sources of energy, use energy more efficiently or clean up existing sources of energy. For example, Wind Power is now the fastest growing energy source on earth. Growing at 30% per year, this renewable energy source will reach 100 gigawatts this year. In May, T. Boone Pickens, one of Texas’s most famous oil tycoons, announced a $2 billion venture with GE to build the countries largest wind farm. Today, wind represents only 1% of America’s electricity, but this figure is expected to reach 15% within the next 10 years. The cost of energy created by these turbines has come down to just 8 cents per KWH (kilowatt hour) compared to 5 cents per KWH for coal power. However, according to a study by MIT, the cost of coal power would rise to 8 cents per KWH, if coal power companies were required to capture and store their CO2 emissions underground or if a carbon tax was imposed.

Wind power is considered only an interim step in moving to a world of renewable energy sources. Solar Energy is the ultimate goal. However the costs of solar energy are still high compared to other forms of energy. According to Cambridge Energy Resource Associates, photovoltaic electricity cost 50 cents in 1995. This cost came down to 20 cents in 2005. Other sources of renewable energy such as biofuels, geothermal, and hydroelectric are dropping in cost per KWH. At some point soon, one or more of these alternative energy resources will drop below the cost of oil and change the entire energy landscape as we know it.

New Tech also includes Clean Technologies. These are companies that produce products or services that improve operation, performance, productivity or efficiency, while reducing costs, inputs, energy, consumption, waste or pollution. For example, the new tech boom will include companies in the water industry. These companies focus on water treatment, water recycling and the technology and services that are directly related to water consumption. New Tech includes companies that solve the world’s food needs with innovative new healthy products. Finally, New Tech will include companies that provide infrastructure to the developing world.

We will not find the solutions to the world’s major problems by looking at 1990’s style tech companies. They are busy producing products like Grand Theft Auto IV. The solutions to today’s problems of sky rocketing energy prices, a lack of clean water in many areas of the planet, solving basic food shortages, cleaning up our environment, and providing infrastructure for undeveloped nations may just be solved by innovative companies in the U.S. industrial manufacturing sector.

Market Summary 2Q2008

2008-07-16T13:06:00.004-04:00

Over the past 50 years, there have been nine “bear” market cycles. A “bear” market is one with a 20% or more drop in value. This decade, we have had the misfortune of having two bear markets.

The explanations Wall Street analysts give for the current bear market cycle sound like bad breakfast foods. I can just here them saying, “Mr. Chairman, we don’t want Mortgage Meltdown, Credit Crunch or Real Estate Bubbles again this morning. Just a cup of Over Priced Oil.”

For the 2nd quarter of 2008, the S&P 500 was down 2.7% and nearly 12% for the year-to-date. International markets faired about the same with the MSCI EAFE index falling 1.9% and 10.6% year-to-date. The bond market, normally a safe haven during times of trouble, also fell 1% for the second quarter and is up just 1.1% year to date. Ok, so maybe cash was safe…not really. Money markets are currently paying about 2% and inflation is running over 4%.

So what has performed well in 2008? A portfolio of TIPS, commodities, energy and Brazilian stocks would have been a nice combination. Although the declines are unwelcome, the current market cycle is terrific for diversified long-term investors. Equities are priced lower today in relative terms than they have been in many years. However, if you have a short-term need to liquidate, you may be disappointed six months from now.

New Relief From Our Old Friend "AMT"

2008-07-16T11:36:00.007-04:00

This interesting article was sent to me by Oren M. Chaplin, Esq. with Norris McLaughlin & Marcus, PA

With increasing frequency, taxpayers are becoming subject to the alternative minimum tax (“AMT”). It is an additional tax (i.e., it is imposed to the extent it exceeds the regular income tax liability) that can cast a wide net over many taxpayers. The AMT is a particular problem for taxpayers who exercised incentive stock options (“ISO”) since the exercise of an ISO would be taxable for AMT purposes and could create a substantial AMT liability even though the
exercise was generally not taxable for regular tax purposes.

The Tax Relief and Health Care Act of 2006 brings significant AMT relief in the form of a “refundable credit” resulting from the payment of the AMT. A brief review of how the AMT works is helpful in order to better understand the mechanics of the new tax relief.

How AMT Works

The AMT is the amount by which the “tentative minimum tax” exceeds your regular income tax liability (i.e., your tax liability as you would compute it using the IRS rate schedule). The “tentative minimum tax” is the sum of 26% of the “taxable excess” up to $175,000, and 28% of the remaining “taxable excess.” The “taxable excess” is the amount by which alternative minimum taxable income (“AMTI”) exceeds an exemption amount. AMTI is the regular taxable income increased by items of preference and adjusted for certain items known as timing items which have income deferral components (e.g., gain from exercise of incentive stock options and accelerated depreciation.) AMT (for individuals) which is attributable to such deferral adjustments generates a minimum tax credit allowable to the extent regular tax exceeds the AMT tax in a future year. If these credits are not used, they are carried forward indefinitely. Credits such as these can reduce your future income tax liability dollar for dollar.

AMT and ISOs

In the case of ISOs, the theory behind the AMT is that it results in only a tax payment timing issue since when the stock is eventually sold, the AMT credit would be available to offset the regular tax due on the sale of the stock. By way of example of how AMT strikes, consider an individual taxpayer who exercises a grant of ISOs. Although this exercise will generally not cause a regular income tax liability, the excess of the fair market value of the underlying stock at the date of exercise over the amount paid for the stock is treated as income for AMT purposes and often results in a substantial AMT liability. While such liability results in a credit that is carried forward, taxpayers often find that the value of the stock obtained from an ISO exercise decreases substantially from the date of ISO exercise to the date of sale, so that on the sale of the stock there is little or no regular income tax gain on the sale. This means that AMT is paid on “phantom gain” and the AMT credit may carry over for years without being used to any substantial extent.

The New Rules

Congress responded to this tax anomaly by creating a refundable AMT credit. Beginning in 2007 and effective through 2012, an individual who previously paid AMT that gave rise to a credit can recover a portion of the “long term unused minimum tax credit” (tax credit from years that are more than three years earlier than the applicable tax year). For example, for the 2007 tax year, individuals can recover AMT paid for any year up to and including 2003. The annual limit of recovery is generally 20% of the carry-forward AMT credit each year subject to the reduction of the refundable credit (by applicable percentages) based upon the taxpayer’s adjusted gross income. However, if the applicable AMT credit is $5,000 or less, the taxpayer may be permitted to use the entire credit amount in a single year. By way of illustration, if an individual has $50,000 of AMT credit (from an ISO exercise in 2003), he can now use $10,000 (20% of the $50,000 AMT credit) of the credit in the 2007 tax year and then use the remaining $40,000 AMT credit for the 2008-2011 tax years at the rate of $10,000 per year.

A key aspect of the new legislation is that the credit is refundable to the extent it exceeds the taxpayer’s regular tax liability. This means you can claim a refund to the extent that the AMT credit exceeds the amount of tax you previously paid through withholding or estimated tax. Under the prior AMT credit rules, you would have been able to use the AMT credit only to the extent of your regular tax for that year and would be able to carry forward any unused amounts. The new legislation results in an “acceleration” of the AMT credit that did not exist under prior law.

Planning Opportunities

Although the refundable AMT credit is not limited to ISO exercises, clients who have exercised ISOs in prior recent years should examine their current situation to determine if they can take advantage of this new provision. The mechanics of calculating the credit amount can be determined by completing IRS Form 8801. Of course, the AMT effects should be examined in light of an individual’s income levels and the other limitations of the new law.

If you have any questions about this topic, or any other tax law concerns, contact Charles A. Bruder or Melinda Fellner Bramwit to discuss.

The Tax Law Alert provides information to our clients and friends about current legal developments or general interest in the area of tax law.The information contained in this Alert should not be construed as legal advice, and readers should not act upon such without professional counsel.

Copyright © 2008 Norris McLaughlin & Marcus, P.A.
This Alert was authored by Charles A. Bruder and Melinda Fellner Bramwit.

Book Review

2008-05-30T10:02:00.005-04:00

More Than You Know by Michael Mauboussin
A true eye-opener, More Than You Know shows how a multidisciplinary approach that pays close attention to process and the psychology of decision making offers the best chance for long-term financial results.

". . . a wonderfully thoughtful and insightful book on how to think about markets and investing . . . These short essays are at once sophisticated and accessible, intriguing and entertaining . . . ideal . . . for investment novices or sophisticates."
--The Washington Post

Book Review: The Post-American World

2008-05-14T10:00:00.002-04:00

The Post-American World by Fareed Zakaria

This is not a book about the decline of America, but rather about the rise of everyone else." So begins Fareed Zakaria's important new work on the era we are now entering. Following on the success of his best-selling The Future of Freedom, Zakaria describes with equal prescience a world in which the United States will no longer dominate the global economy, orchestrate geopolitics, or overwhelm cultures. He sees the "rise of the rest"—the growth of countries like China, India, Brazil, Russia, and many others—as the great story of our time, and one that will reshape the world.

The Real Estate Market and Herd Mentality

2008-04-28T10:02:00.008-04:00

For thousands of years, the American Indians of the Great Plains hunted buffalo by stampeding the animals off a cliff or ravine, and then collecting the remains at the bottom. This technique, referred to as “jump-kill,” often times destroyed the entire herd. There have been over 40 jump kill sites identified in the Great Plains area. Some of the sites have wonderfully descriptive Indian names such as Head-Smashed-In, Bone Yard Coulee, and Bison Trap. The Indians, never wasteful, used 100% of the buffalo and honored its sacrifice.

Many times, Americans, like the Great Plains Buffalo, move as a herd and once in a while, run straight off a cliff. These cliff sites have names like ’49 Gold Rush, Oil Speculation, the Roaring Twenties, gold and silver speculation of the late 1970’s, the commercial real estate market in the 1980’s, the “Dot Bomb” era of the late 1990’s, and the subprime housing debacle of the current age. Each boom and bust has legendary collapses in markets and companies. Some of the current names are long standing companies such as the Carlyle Group, FBR, Countrywide, and Bear Sterns. Herd mentality is what caused the real estate boom and the resulting real estate bust we now face. It is this type of herd mentality that creates opportunity for those waiting at the bottom, to feed on those who ran off the cliff.

For well over a decade, I worked in the mortgage and banking industries helping to finance the “American Dream.” However, in late 2004, I walked away from my job and the public company I helped create. I left not only my company, but also the industry all together. Why? I felt like I was a buffalo in a mass herd of greed that was about to run off a cliff. The real estate market was becoming vastly overvalued. The big Wall Street firms were creating mortgage products allowing virtually anyone to qualify for a $500,000 plus mortgage. Real estate agents and mortgage bankers were encouraging the stampede. People earning $150,000 a year were taking on million dollar interest only mortgages with adjustable rates and little or no money down. The greed was fueled by ever increasing real estate prices and the ability to use leverage in a rising market. As it turns out, I was about a year and a half too early from a well timed exit.

How Did We Get Here? We Are All To Blame
Congress and the press have hammered the mortgage industry and the big Wall Street firms for the subprime loan debacle, the ensuing credit crunch, and the collapse of the residential real estate market. Ultimately, we are all responsible. The blame must be cast broadly. Let’s take a look at a few examples of some of the culpable parties.

Wall Street: For years, the mortgage industry was dominated by banks and mono-line mortgage companies. Then, the big Wall Street firms like Merrill Lynch, Lehman Brothers, and Bear Sterns entered the picture. The new players created “exotic” mortgage products that could be bundled and sold as mortgage backed securities to investors on Wall Street. With these loans, mortgage brokers and bankers were able to provide loans to people with no money, no income, and bad credit! These loans were then packaged and sold on the secondary market as AAA rated bonds. These new products were like releasing tigers into an already stampeding buffalo herd. I believe this group should take the largest portion of the blame. In their quest for outsized profits, this group not only has damaged the real estate market as a whole, but practically destroyed the credit markets as we know them today.

Loan officers and Real Estate Agents, eager to earn bigger and bigger commissions, encouraged their customers to buy larger houses. Not enough money for a down payment? No problem, there are plenty of 100% financing alternatives available. Can’t afford the payment? Go with a negative amortization loan or an interest only loan. What if the customer can’t make a payment later? Neither the loan officer nor the real estate agent has a stake in what happens to the customer after the home closes. The real estate agent gets their commission and the mortgage broker sells the loan within ten days of closing. This group, myself included, should take second place in the blame game.

Financial Planners/Investment Advisors: On radio talk shows, books, blogs, and newsletters, financial planners and investment advisors encouraged their clients to buy the big houses and leverage them to the hilt. Others encouraged their clients to take cash out of their homes and invest the difference in the latest investment du jour. By utilizing cheap credit, Americans could leverage a small down payment into a fortune.

The Government, the Federal Reserve, and the “Quasi Governmental Agencies”: Congress and the president continue to push for greater home ownership in America. Presidents and senators alike routinely tout homeownership rates as a measure of success. The Federal Reserve helped fuel the fire by pushing short-term rates to record lows of 1%. Mortgages, especially Adjustable Rate Mortgages, became temporarily cheaper and cheaper. Meanwhile, Fannie Mae and Freddie Mac expanded their product line from conforming loans to “Alt A” and subprime. Everyone got into the game.

(click to enlarge image)

The Press: As usual, it is the press that adds significant fuel to the fire. Here are some head lines from some of the top US Magazines. Too late on both occasions, note the timing of the headlines and the timing of the articles:

The Herd, i.e. all of the rest of us:
Fueled by greed and the desire for bigger and bigger houses, Americans super-sized their home purchases and bought homes they could not afford. The buy now, pay later mentality enhanced the demand for interest only loans and negative amortizing loans. The speculators, flippers, and “investors” with little knowledge of boom and bust cycles pushed the herd into a full stampede and then vaporized at the bottom of the cliff.

Where Are We Now?
As of December 31st 2007, the S&P Case/Schiller Home Price 20 City Composite Index has dropped 9.1% from a year ago. This is the largest decrease in the 20 year history of this index. For comparison purposes, the 90-91 housing recession bottomed at -2.8%. The table below shows each of the 20 markets represented in the Index. Miami, Phoenix, and Las Vegas top the list with drops in excess of 15%. For more information on how this index is calculated, go to http://www.homeprice.standardandpoors.com/

(click to enlarge image)

According to the index, nationwide housing values peaked in May of 2006 at an index value of 205 or roughly two times the value of a home in 2000. Thus, home prices more than doubled since the beginning of this century. In the Washington DC market, which includes Northern Virginia and Maryland, average home values peaked at nearly 250% of value in 2000. The December 2007 figure is down 10% from its peak nationally and the Washington DC market is down 13%.

Using the same index, we find that today’s home values have now fallen back to their levels of April of 2005. If you purchased your home prior to the spring of 2005, you may not have experienced a drop, yet. These statistics are national in nature and reflect averages. Homes in places like Portland, Seattle, and Dallas have not experienced much of a drop. This is because they did not participate in the run-up that other areas experienced.

Another well known housing index is published by the OFHEO (Office of Federal Housing Enterprise Oversight), the group that authorizes the annual “conforming loan limits” for Fannie Mae and Freddie Mac. This index shows a much milder drop including an annual price decline of just 0.29% and an annualized fourth quarter 2007 drop of 5.16%. The major difference here is that this index represents loans closed by Fannie Mae and Freddie Mac, which for 2007, were all below $417,000. As you would expect, lower priced houses have not decreased nearly as much as higher priced homes.

Below is a table summarizing the two indices over the past five years:

Where Are We Headed?
In the last major residential real estate cycle, the peak of the market was reached in October of 1989 and it was not until January 1998 before the market came back to its 1989 peak. Will the current cycle be similar? Not likely. The run up in prices and the disparity from personal income is far greater during this cycle than in the late 80’s. It now seems likely that we will have a 20% market correction from the peak to trough that was reached in May of 2006. This is in line with the prediction I made in 2005 when I stated we were due for a 10% correction. This would put values at the summer 2004 level using the Case/Schiller Index. The good news is that we are more than half way there.

As with many boom and bust periods, a market that is artificially pushed to extreme heights takes many years to come back. For example, gold prices peaked in 1980 and did not come back for over 25 years. The same goes for most of the internet companies that were vaporized in the dot bomb era and in nearly every other boom bust cycle. The NASDAQ market index is less than half of its peak in 2000. However, during each of these cycles, there are incredible opportunities to pick up the survivors at very cheap prices. While I do not believe there will be a material rebound for a few years, the opportunity to pick up some choice real estate at depressed values has not been this good since the early 1990s.

The next time you see a herd of buffalo stampeding your way, such as the current commodities markets, head in the other direction!

Book Review: When Pride Still Mattered

2008-03-11T16:03:00.003-04:00

WHEN PRIDE STILL MATTERED : A Life of Vince Lombardi
By David Maraniss

As coach of the Green Bay Packers from 1959 to 1967, Vince Lombardi turned perennial losers into a juggernaut, winning back-to-back NFL titles in 1961 and 1962, and Superbowls I and II in 1966 and 1967. Stern, severe, sentimental, and paternal, he stood revered, reviled, respected, and mocked--a touchstone for the '60s all in one person. Which adds up to the myth we've been left with. But who was the man? That's the question Pulitzer Prize-winner David Maraniss tackles. It begins with Lombardi's looming father, a man as colorful as his son would be conservative.

Still, from his father Vince Lombardi learned a sense of presence and authority that could impress itself with just a look. If a moment can sum up and embrace a man's life--and capture the breadth of Maraniss's thoroughness--it is one that takes place off the field when the Packers organization decides to redecorate their offices in advance of the new head coach's arrival: "During an earlier visit," Maraniss reports, "he had examined the quarters--peeling walls, creaky floor, old leather chairs with holes in them, discarded newspapers and magazines piled on chairs and in the corners--and pronounced the setting unworthy of a National Football League club. 'This is a disgrace!' he had remarked."

In one moment, one comment, Lombardi announced his intentions, made his vision and professionalism clear, and began to shake up a stale organization. It reveals far more about the man than wins and losses, and is the kind of moment Maraniss uses again and again in this superb resurrection of a figure who so symbolized a sporting era and sensibility. --Jeff Silverman

Book Review: Eckhart Tolle

2008-02-28T10:07:00.000-05:00

A New Earth: Awakening to Your Life's Purpose by Eckhart Tolle
and The Power of Now: A Guide to Spiritual Enlightenment by Eckhart Tolle

With his bestselling spiritual guide The Power of Now, Eckhart Tolle inspired millions of readers to discover the freedom and joy of a life lived "in the now."

In A New Earth, Tolle expands on these powerful ideas to show how transcending our ego-based state of consciousness is not only essential to personal happiness, but also the key to ending conflict and suffering throughout the world. Tolle describes how our attachment to the ego creates the dysfunction that leads to anger, jealousy, and unhappiness, and shows readers how to awaken to a new state of consciousness and follow the path to a truly fulfilling existence.

The Power of Now is a question-and-answer handbook. A New Earth has been written as a traditional narrative, offering anecdotes and philosophies in a way that is accessible to all. Illuminating, enlightening, and uplifting, A New Earth is a profoundly spiritual manifesto for a better way of life—and for building a better world.

Asset Class Winners By Year

2008-01-29T12:24:00.002-05:00

Below is a table showing the typical market asset classes and their performance over the previous ten years. As you can see, different asset classes perform differently from year to year. Many times one year’s winner is the next year’s loser. By diversifying among these asset classes in such a way that meets your individual risk tolerance, you can obtain market returns with an appropriate amount of risk. This can be done by purchasing index funds and exchange funds that mirror the asset classes. Now, if we simply select the asset mix that meets risk and return profiles, we can earn the market return and go play golf!

(Click on the image for a larger display)

2007 Year End Market Summary

2008-01-28T12:43:00.001-05:00

2007 will be remembered as a cyclical transition period for the stock market. This year, many long established trends have been upended. It’s the first year since 2002, the end of the last recession, that bonds out performed equities as measured by the Lehman Brother Aggregate Bond index and the S & P 500 Stock index. It also is the first year since 1999 that growth oriented mutual funds, up 15% in 2007, outperformed value oriented mutual funds, up only 0.4%. Finally, it is the first year since 1999 that large cap funds outperformed small cap funds. These trend reversals are typical cyclical changes that result near the end of a bull market and possibly the start of a recession or at least a significant slow down. This reminds us as to why it is critically important to keep a well–diversified, global portfolio and not to chase previous years’ winners.

The S&P 500 finished the year with a return of 5.5% including reinvested dividends, while the bond market, as measured by the Lehman Brothers Aggregate was up 7%. Non US markets out performed US markets again in 2007. International developed funds, buoyed by a falling dollar, had another big year up over 12% and emerging market funds posted a 36% return.

2008 Predictions: The Recession May Already Be Here

I expect 2008 to be a tough year for the equities market as the US economy navigates through the landmines left by the real estate bubble and the resulting credit crunch. I expect the US markets to perform better than the international markets this year and the large cap and growth oriented funds to exceed their small, value oriented brethren.

As for our beloved economy, I believe we already may have entered a recession. The current US housing bubble, the resulting credit crunch and the rapid increase in the price of oil to $100 per barrel may have put us into recession or at least will push us there very soon. The difficulty is that we will not know this for at least another year because that’s how long it takes for the government’s official recession counter, the National Bureau of Economic Research, to give us an answer. The most common definition of a recession is two consecutive quarters in which real gross domestic product, GDP adjusted for inflation, declines. This official definition means it is not possible to determine a recession is occurring until long after it has started. The government releases its quarterly GDP data two months after quarter end and these numbers are revised two more times. Thus, we will not know a recession has occurred until nearly a year after it has started!

Since World War II, there have been ten recessions averaging about ten months in length. Recessions are generally thought of as horrible events where unemployment rises, production falls, profits weaken and stocks crater. However, there are many positive aspects of recessions that are good for the economy and for investors. Recessions punish excessive risk taking, such as in the real estate speculation and credit risks taken in 2005 and 2006 and the tech bubble of 2000. They also reduce inflation and may even correct the balance of trade. Downturns also create tremendous buying opportunities for shrewd investors. The question we should be asking is not if we are going to be in a recession, but rather, when we will come out.

Book Review: The Ultimate Gift, The Prize

2008-01-28T12:39:00.002-05:00

The Ultimate Gift, by Jim Stovall is a must read for children and adults age 12 and up.

Red Stevens was a self-made man who gave his family everything -- and ruined them in the process. Now, as his estate of oil companies and cattle ranches is divided among greedy and self-serving relatives, one member is singled out for something special: Red's great-nephew, Jason.
In a darkened room, isolated from the rest of his family, Jason is confronted by the image of his deceased great uncle on a video monitor... and so begins a 12 month quest for purpose and meaning in an empty life, as Jason attempts to complete the tasks required to receive Red Stevens' greatest bequest....The Ultimate Gift. If your kids won’t read it, you can always see the movie

The Prize : The Epic Quest for Oil, Money & Power by Daniel Yergin
Although written in the early 90’s about the history of oil as an industrial product, it provides us a terrific understanding of the dynamics that shape the oil industry. A winner of the 1992 Pulitzer Prize for nonfiction, it is a comprehensive history of one of the commodities that powers the world--oil. Founded in the 19th century, the oil industry began producing kerosene for lamps and progressed to gasoline. Huge personal fortunes arose from it, and whole nations sprung out of the power politics of the oil wells. Yergin's fascinating account sweeps from early robber barons like John D. Rockefeller, to the oil crisis of the 1970s, through to the Gulf War.

Oil Over $100! This May Be Just What the Doctor Ordered

2008-01-28T12:38:00.001-05:00

The oil industry began in the 1850’s in an area known as Oil Creek in Northwestern Pennsylvania. Oil was cheaper and easier to bring to the market than coal or whale fat and quickly replaced both as the primary fuel for lighting and running machinery. Nearly one hundred and fifty years later, in the first trading day of 2008, the price of oil crossed over $100 per barrel, just shy of the inflation adjusted price of $102.81 hit in the late 1970s.

Since President Bush came to office, the price of oil has increased nearly 4 times. An enormous transfer of wealth has occurred during this period. The value of hydrocarbon exports from the Middle East and Asia is expected to be $750 billion in 2008. The Abu Dhabi Investment Authority, the government investment company for the United Arab Emirates, now has over $900 billion in assets and recently lent Citibank $7.5 billion with the right to purchase just under 5% of the equity shares. Other state owned Arab Emirates now own large stakes in the NASDAQ and the London stock exchange as well as other prized assets around the globe.

So how does the price of oil going over $100 help the US? It will increase the innovation in our country to find alternative sources of fuel. It will also increase our desire to purchase more fuel efficient products and ultimately it will reduce the US emissions of CO2 gas. Hopefully, future generations will look back at the “oil age” as just a short 200 year blip of time.

Children and Money: Instill the Value of a Dollar at an Early Age

2008-01-28T12:07:00.002-05:00

I last wrote about this subject in my 3rd quarter 2006 Financial Forum and received some very favorable feedback. In that article, I listed 10 ways to help teach children about money. Over the past two years, I have tried very hard to implement these steps and now feel it appropriate to write a condensed version in case some of you are struggling to teach your children ten steps about something as abstract as money and would prefer to start with just two. By the way, if you do not have children or if they have already moved out of the house, you can still apply these to yourself or your grown children. Like everything else with kids and adults, if you stick with it long enough, it will stick. If you did not get a chance to read the original article, just send me an email and I will forward it to you.

1. Form a Habit of Savings

When my son was about eight, we broke open his piggy bank, drove down to our bank and opened a savings account with the money he had saved. The process was a lot of fun and a great learning experience. He learned about interest, savings and balancing his account on a monthly basis. Each month he added a little of his working allowance and his gift money to the account. The account has grown to about $2,000, which is a lot of money for an eleven year old.

Recently, he started complaining about the amount of interest he is earning on the account. I suggested he take the money out of the bank and buy a stock or mutual fund with the possibility of earning more on his investment. We have had many discussions on the merits of Starbucks, Quicksilver and other public companies he was familiar with. He was not too happy to learn that stocks can go up and down sometimes rather drastically. However, it gave us the opportunity to talk about investing in general and about risk. Because he had saved the money himself, it really mattered to him that he not lose it on a speculative investment. I was willing to let him invest in whatever he wanted as long as he understood the risks relating to the investment.

After discussing the options, he finally said that I had a very boring job and that since I did this for a living, I should decide. I was happy to see that my brilliant son had the presence of mind to outsource his investment selection process. We decided to close the account and move the $2,000 he accumulated to two ETF funds (SPY and EMM). While this may seem very basic, it has been a very powerful experience for both of us. My son learned several important facets about money. He learned the value of saving, working for money, compounded interest, investing, and risk.

My daughter will be a new challenge. She is not as materially oriented as my son and as of yet, sees no real use for money. I will update you on our progress in a few years!

2. Create an Abundance Mentality with Regards to Money

Most people grow up with the perception that money is a limited resource that is only readily available to a few lucky people. They spend their lives chained to this concept, which keeps them forever a victim of money. Having an abundance mentality about money is a self fulfilling prophecy. It comes from these two principals:

Money flows to the greatest perceived value.
The less you need, the more you have.

Money flows to the greatest perceived value

Let’s review the first one from an adult perspective and then break down to the kid level. Take two attorneys, for example, that both focus on small business owners. One makes about $150,000 per year and one makes about $3 million per year. Why does one get 20 times the income of the other? The one who gets 20 times the income creates 20 times the value for her clients. One is focused on hourly billing, while the other is focused on the success of her client. This concept is focused on in Nassim Nicholas Taleb’s book, The Black Swan: The Impact of the Highly Improbable

Now, let’s look at it from your child’s perspective. Apprehension about college and job selection begins as early as age 16. As I have already said, my children find my job boring and thus will most likely pursue some other career. The teaching opportunity is not to focus your child on the jobs that pay the most, but on creating the greatest value in a job they will love. “Talk about what is of interest to them and how important it is to be happy with what you do,” says Dr. Jaye Roseborough, a director of career services for a small university in Vermont. In order to create extraordinary value in your career, you must be truly passionate about what you are doing. You cannot do this if you are pushed by your parents into a career you do not love. Examples of creating incredible abundance through creating tremendous value include Oprah Winfrey, Bill Gates, Chef Michel Richard, Lance Armstrong and thousands more.

The Less You Need the More You Have

Separating your needs from your wants is a powerful distinction I learned from my father at a very young age. Most children and adults have a never ending list of “needs” that drives them to immediate gratification with an endless supply of junk. In reality, 99% of these “needs” are really “wants”! “Needs” are things like food, shelter and medical care. “Wants” are everything else. Once we make this distinction, we can choose whether or not to make the purchase. If we can make this shift, the new “need” becomes the savings or investment account rather than the latest electronic gadget. One of the quickest ways to implement this distinction with your children is to ask them to pay for what they “want” with their own money. It is absolutely amazing to me how quickly the drop in desire is for this particular “want”. When they really want something, they will work hard to get it. This also instills the concept of delayed gratification which is an extremely healthy way of life. If you are having trouble with this concept, read the Dalai Lama’s The Art of Happiness.

Book Review: JFK

2008-01-02T16:17:00.001-05:00

Let Every Nation Know: John F. Kennedy in His Own Words
by Robert Dallek, Terry Golway

I really enjoyed listening to Kennedy’s great speeches and then reading the analysis and history behind them. This is a quick read that will provide you with some history review and inspiration. Here is a review from Publishers Weekly:

After Lincoln, John F. Kennedy is generally acknowledged as our most eloquent president. The words of such major speeches as his inaugural and his remarks at the Berlin Wall resonate still in the minds of Americans. But as this book and CD illustrate, Kennedy was equally articulate on a host of other occasions, including campaign debates with Richard Nixon, White House press conferences, commencement addresses and comments on such topics as the integration of the University of Mississippi and the Cuban missile crisis.

Of course, a large part of JFK's communicative excellence lay in his smart, confident delivery. Thus bestselling Kennedy biographer Dallek and Golway (The Irish in America) present the speeches on a CD featuring Kennedy's own voice, while their book sets each of the CD's 32 tracks in historical context. The speeches and commentary trace JFK's presidential career from the 1960 campaign through his death. Painstakingly, the authors lay out the parameters of real politics that lay behind particular phrases and positions. In the end, the reader/listener is even more impressed with JFK after learning the backgrounds and contexts and then hearing Kennedy so lucidly express the words. (Apr.)

Mortgage Update

2008-01-02T12:26:00.002-05:00

Book Review: The Age of Turbulence

2007-10-29T12:48:00.000-04:00

The Age of Turbulence: Adventures in a New World

In September, I was fortunate enough to see one of my favorite people live at my graduate school alma mater George Washington University’s Lisner Auditorium. The “Maestro”, Alan Greenspan, was promoting his new book, The Age of Turbulence. At 81, Greenspan is hardly in need of money to support his modest lifestyle. However, having been virtually silent for the past 18 years at the Federal Reserve, he is literally bursting to express his opinions, both political and economic, as well as providing us with some insight and history for future generations. I believe this book, and the controversy surrounding it, may have a significant positive impact on the future economic success of the US economy.

Greenspan explained that the Fed was weaker today than in years past due to the “global forces” beyond its control. These “forces” are part of the “Conundrum” mentioned in one of his famous speeches about the Fed’s inability to affect long-term interest rates in 2004. In a light moment during his speech, Greenspan said he received over 10 bottles of the famous Caymus Conundrum wine. When asked how it was, he said he never touched it because of the name, “Conundrum, by its very nature is unknown. Why would I want to drink that?” he explained.

Greenspan, often referred to as a Right Wing Libertarian Republican, took the time to correct this mistake. “I am not right wing. [I am] far from it.” He explained how he felt that the Republican Party has moved too far away from its fiscally conservative roots, and how this shift allowed the Democrats to take control the house in 2006 and possibly the presidency in 2008. There are many other political issues mentioned in his speech and in the book, including issues relating to Greenspan’s disappointment with the Bush administration and his admiration for Mr. Clinton’s fiscal restraint.

What keeps the Maestro up at night? He mentioned 5 topics:

US dependence on oil

The growing U.S. deficit

Lack of government funding for future Medicare requirements

Inequity of income in the US

The need to clarify the rules of intellectual property.

Greenspan was reluctant to talk about current Fed actions and the short term outlook for the economy. When pressed, Greenspan jokingly offered a highly precise a prediction of 42.5% chance of recession, up from the 30% chance he predicted in February.

Real Estate Corner: Catch a Falling Knife? Not Yet...

2007-10-29T12:47:00.000-04:00

There are several indices that aim to measure the value of residential real estate in this country. The most accurate and least biased is the S&P 500/Case Shiller Home Price Index. I decided to test the accuracy of this index by comparing it to my own purchases of homes in the Washington DC area.

I purchased my first home, a townhouse near Fair Oaks Hospital, in Fairfax, VA in October of 1989. My timing was impeccable. When I compared it to the Index, the value of Washington single family homes was at an all time high. The Index peaked just 4 months later before falling like a rock until it reached the bottom in February of 1992. It was at this point I abruptly sold the house at the bottom of the market. According to the index value my home should have dropped about 5%. In reality, the property had dropped 10% and after selling commissions I owed more than it was worth.

The 10% I had put down was gone and I was now underwater by about $10,000. The index, which peaked in the Washington area in April of 1990, did not reach that peak again until February of 1999, nearly 10 years later.

I was recently in Tampa, Florida visiting a client when the S&P 500/Case-Schiller Home Price Index for July of 2007 was released. The report showed that the worst real estate markets in the country were Detroit, Tampa, and Washington. I asked my client about the local market to check to see if this rang true. He told me about two completed condo projects with no owners and one large condo project with just one family living in it. The scariest thing about this is that the Index does not include condos!!!!

Most people consider the value of their homes to be whatever the highest value ever paid in the neighborhood. Nationwide, I believe home prices have now moved down to their October 2005 values. In Washington, these values are down to the May 2005 values. The index shows a drop of 4% year over year nationally and a drop of 7.2% in the Washington MSA.

In my April 2005 Newsletter, I predicted a 10% market drop nationwide. It appears as of July of this year, we are nearly halfway there on a national basis and 75% there in the Washington MSA. Let’s take a look at the housing data to see just how bad it might get. Most of this data comes from Greg Weldon’s website http://www.weldononline.com/ and John Mouldin’s Weekly E-Letter.

Existing home inventories have increased by more than 1,000,000 homes since March 2007 and have doubled since 2005. In January of this year, there was a supply of homes for sale of about 6.6 months on the market. This figure has moved up to 10 months. There are now over 500,000 homes in the process of foreclosure and this number is increasing at an alarming rate. New home sales in August saw the largest decline in 30 years. Mean new home prices are down 11% in the last five months. Expensive homes, those above $750,000 are down over 35% from last year.

Many of the loan products, which helped people buy homes the last few years, are now gone. This includes not only sub-prime and Alt-A loan products, but the every day jumbo variety as well. The impact of this mortgage credit crunch will not be felt until the forth quarter of this year. As a result, I still believe we have a significant drop ahead. Washington MSA may experience a 15% drop from the 2006 high; nationwide I am still sticking to my 10% drop prediction.

While this may seem bearish, the market will bounce back. There will be some terrific buying opportunities in 2008. A significant amount of patience, however, will be required.

Asset Allocation: Going Green

2007-10-29T12:37:00.005-04:00

In case you haven’t noticed, just about everyone, even the Nation’s capital, is going “green”. In December of 2006, Washington DC became the first city in the nation to pass legislation requiring not only government-owned office buildings larger than 50,000 square feet to adhere to green building standards, but privately owned buildings as well.

How can you make a positive impact on the environment and capitalize on the “green” phenomenon?

Take Steps Towards Becoming Carbon Neutral

The concept of becoming carbon neutral can be debated by many as is global warming in general. However, for the purpose of this article, I will assume we all want to make a positive impact on our environment. You can start by taking steps to move your household towards carbon neutrality. I took the test at http://www.carboncounter.com/ and learned that I generated 4 times the carbon of the average US citizen! Thus, according to the calculations on the web site, I need to donate $576 to “offset” my carbon emissions and become “carbon neutral”. The donation goes to the Climate Trust, a 501 (c) (3) working towards a more stable climate.

According to the website, offsets are used to:

Increase energy efficiency in buildings, factories, or transportation,

Generate electricity from renewables such as wind or solar,

Modify a power plant or factory to use fuels,

Put wasted energy to work via cogeneration,

Capture carbon dioxide in forests and agricultural soils.

Practice Energy Efficiency
Next time you buy a new appliance, remodel your home or buy a new one, factor energy efficiency into your decision-making process. According to the US Green Building Council, http://www.usgbc.org/, 10% of all carbon dioxide emissions in the country come from our homes. Typical American homes lack energy-efficient appliances, windows and insulation, thus consume extra energy to compensate for loss of heat and air conditioning. The up front costs of improvements will be recouped in the long run.

Recycle and Buy Recycled Products
Most people today recycle bottles, plastic and newspapers in their homes. However, few of us use recycled products. Using recycled materials, especially if they are locally made, can have a huge impact on the environment. Many of today’s building materials come from recycled waste. If you are in the Washington area, check out Eco-Green Living. Eco-Green Living, is the premier green, organic, and fair trade store in the Washington, D.C. metro region for lifestyle, home remodeling, and personal care products. You can find out more at http://www.eco-greenliving.com/

Invest in “Green” technology
The following is a list of funds that invest in various forms of “Green” technologies:

PowerShares Water Resources Fund (PHO) is based on the Palisades Water Index™. This Index seeks to identify a group of companies that focus on the provision of potable water, the treatment of water, and the technology and services that are directly related to water consumption.

PowerShares Global Water Fund (PIO) is based on the Palisades Global Water Index™. This Index seeks to identify a group of global companies that focus on the provision of potable water, the treatment of water and the technology and services that are directly related to global water consumption.

PowerShares Global Clean Energy Fund (PBD) is based on the WilderHill New Energy Global Innovation Index. The Index seeks to deliver capital appreciation and is composed of companies that focus on greener and generally renewable sources of energy and technologies facilitating cleaner energy.

PowerShares WilderHill Clean Energy Portfolio (PBW) seeks to replicate, before fees and expenses, the WilderHill Clean Energy Index, which is designed to deliver capital appreciation through the selection of companies that focus on greener and generally renewable sources of energy and technologies that facilitate cleaner energy.

PowerShares WilderHill Progressive Energy Portfolio Fund (PUW) is based on the WilderHill Progressive Energy Index. The Index is comprised of U.S.-listed companies that are significantly involved in transitional energy bridge technologies, with an emphasis on improving the use of fossil fuels.

The Spectra Green Fund (SPEGX) is a mutual fund that seeks long-term capital appreciation by investing at least 80% of its net assets in equity securities of companies of any size that, in the opinion of the Fund's management, conduct their business in an environmentally sustainable manner, while demonstrating promising growth potential.

By doing your part in the “Green” movement, you can feel good about the choices you make for a better world for you and your children.

Book Review: The 4-Hour Work Week

2007-10-11T15:56:00.003-04:00

The 4-Hour Workweek: Escape 9-5, Live Anywhere, and Join the New Rich

By Timothy Ferriss

What do you do? Tim Ferriss has trouble answering the question. Depending on when you ask this controversial Princeton University guest lecturer, he might answer:

“I race motorcycles in Europe.”

“I ski in the Andes.”

“I scuba dive in Panama.”

“I dance tango in Buenos Aires.”

He has spent more than five years learning the secrets of the New Rich, a fast-growing subculture who has abandoned the “deferred-life plan” and instead mastered the new currencies—time and mobility—to create luxury lifestyles in the here and now.

Whether you are an overworked employee or an entrepreneur trapped in your own business, this book is the compass for a new and revolutionary world.

Join Tim Ferriss as he teaches you:

• How to outsource your life to overseas virtual assistants for $5 per hour and do whatever you want

• How blue-chip escape artists travel the world without quitting their jobs

• How to eliminate 50% of your work in 48 hours using the principles of a forgotten Italian economist

• How to trade a long-haul career for short work bursts and freuent "mini-retirements"

• What the crucial difference is between absolute and relative income

• How to train your boss to value performance over presence, or kill your job (or company) if it’s beyond repair

• What automated cash-flow “muses” are and how to create one in 2 to 4 weeks

• How to cultivate selective ignorance—and create time—with a low-information diet

• What the management secrets of Remote Control CEOs are

• How to get free housing worldwide and airfare at 50–80% off

• How to fill the void and create a meaningful life after removing work and the office

You can have it all—really.

Mortgage Update

2007-10-02T12:55:00.002-04:00

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Sector Performance Report 9/30/07

2007-10-02T12:33:00.002-04:00

In 2007, the industry sectors that are dominated by large cap multinational companies have out-performed all others. As noted by economist Michael Albert on his blog http://www.leadlag.com/, the sectors of the S&P 500 with the highest multinational cap weighting, like energy, industrials, materials and technology, significantly outperformed the domestically dominated sectors such as financials, consumer discretionary and consumer staples.

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Bad Economic News…Good for the Stock Market?!

2007-09-29T12:32:00.001-04:00

The mortgage industry melts down, credit markets tighten, home prices plummet, the dollar falls and oil prices reach a record high of nearly $84 a barrel. Naturally, the stock market was up for the quarter -- go figure. After the Federal Reserve cut rates 50 basis points, the equity markets rallied and erased their previous losses posted in July.

The S&P 500 was up 1.6% for the third quarter and 7.6% (excluding dividends) year-to-date. International markets, as measured by the MSCI EAFE Index, were basically flat for the third quarter and are up 10.9% year-to-date.

Here is the good news; the futures market has currently priced in two more Fed cuts by the end of the year. This would leave the WSJ Prime Rate, currently at 7.75%, somewhere around 7% at the close of the year.

Pre-election Years May be Good for the U.S. Stock Markets

Since 1950, pre-election years like 2007 have produced an average return in the S&P 500 in excess of 19%. Thus we may be looking at a positive 4th quarter, even with a potential recession looming in 2008.

Now the bad news; inflation fears spooked the bond markets causing long-term rates to rise and the dollar to fall. According to economist John Mouldin, “The last three times the Fed initiated a new easing cycle, 10 year bond yields dropped 20 basis points or more in the next five days. This time they rose 20 basis points. Since mortgage rates are typically geared off the yield of the ten year Treasury bond, this is a cut that has not helped the consumer as of yet.”

Book Review: The Support Economy

2007-06-11T15:41:00.005-04:00

The Support Economy: Why Corporations Are Failing Individuals and Th e N ext Episode of Capitalism

By Shoshana Zuboff and James Maxmin

This husband-and-wife team Zuboff's a Harvard professor and author of In the Age of the Smart Machine, and Maxmin's the former CEO of Volvo and Laura Ashley give socialist utopians of yesteryear stiff competition with their manifesto for a more personalized capitalism. They strive for the pop socioeconomics of a David Brooks or a Malcolm Gladwell, but their heavy academic style may disenchant some readers before their thesis's more radical parts kick in.

Over the last two centuries, they argue, an increasingly efficient economy, coupled with a rise in democratic thinking and growing access to information, has opened up life's possibilities to increasing numbers of people. Because participation in the consumption-based economy is unavoidable, the general public looks to markets to provide "deep support" in their quest for individualization, but "are routinely punished for being complex psychological individuals in a world still fitted out for the old mass order." This macroeconomic structure treats people as either employees or consumers and inevitably hurts their feelings. Zuboff and Maxmin would eliminate the "little murders" of customer service interaction by replacing the current transaction-based model with a form of "distributed capitalism" based on a customer-supplier relationship, so semi-anonymous customer service reps will be replaced by "advocates" fully emotionally involved in their clients' needs.

It's not clear how society will make its way to the authors' dream of a fully automated lifestyle, or what life will be like for blue-collar workers and manual laborers. Pundits who celebrated the Internet's potential to thoroughly revolutionize the economy, however, will no doubt rally behind these impractical visions.

Credit: Publisher's Weekly

Retirement Matters: Is Your 401(k) Working For You?

2007-06-07T17:13:00.001-04:00

Eighty percent of our retirement income will come from our savings in retirement plans and other after tax savings accounts. The bulk of this money will come directly or indirectly from employer sponsored 401 (k) accounts. However, most Americans pay little attention to this most important portion of savings. Many of us are guilty of spending very little time analyzing our 401 (k) investment allocations and fund selections, very few people actually review the plan costs with their sponsors and some do not even attempt to maximize their contributions to the plan. As participants in any retirement plan, you have the right to have quality investment selections in nearly every asset class at a reasonable cost.

Your 401(k) can be one of the best investments you will ever make. And if your employer is matching, it is a real “no brainer” When an employer offers 401k matching, they are guaranteeing that they will match a certain percentage of your contributions. A common match is 50 cents on the dollar. That means if you put one dollar into your 401k plan, they will match your contribution by putting 50 cents in. You just made 50% on your investment!

Now you see why it is important to maximize your contributions. The 2007 maximum contribution is $15,500 and if you are age 50 or older, you can make an additional catch up contribution of $5,000. Perhaps one of the biggest mistakes investors make is to pull back on their 401 (k) contributions because the market or their portfolio is doing poorly. However, every time the investor puts money into their 401(k), they are making a guaranteed profit up front. Besides, when the market goes down, most investors benefit because you begin buying assets at a lower cost!

I must disclose one important detail about this wonderful investment: Some companies do not have quality investment selections, while others do not have the appropriate asset classes covered. As an example, Fidelity 401(k)s are limited to mediocre funds (most have new managers) in a single fund family. And there are some plans and investment vehicles that charge very expensive fees to participate. If you fall under any of these, talk to your Plan Administrator and ask them to look into new plan options. They have a fiduciary requirement to provide you with quality plan investments at a reasonable price.

1st Portfolio, Inc. offers a retirement plan consulting service designed to bring professional, unbiased plan consulting combined with competent objective investment advice to the trustees and the participants of the plan.

Book Review: Leadership

2007-05-10T17:11:00.001-04:00

Leadership By Rudolph W. Giuliani

I read this book back in 2002, but decided to pull it out again in light of the 2008 presidential elections. It makes for an excellent read from a historical perspective and also provides some insight on the author. -MR

From Publishers WeeklyNew York's celebrated former mayor explains how he used specific management strategies to run the city and handle crises in this captivating memoir. Giuliani's minute-by-minute account of his actions on September 11-trying to coordinate rescue efforts and reassure the populace while reeling from the deaths of firefighter friends he'd spoken to just minutes before-is harrowing. Other anecdotes are equally forceful, as when Yasser Arafat arrived uninvited to Giuliani's U.N. anniversary celebration, and Giuliani insisted on making Arafat leave while attempting to avoid an international scandal. Giuliani's main advice to leaders: surround oneself with talented people, hold daily meetings to keep everyone on track, define the core mission and make sure procedures and policies serve that mission efficiently, demand accountability from everyone (including oneself), show loyalty to employees and become knowledgeable about all subjects related to one's organization or business.

Federal Reserve Update

2007-05-07T17:02:00.000-04:00

The Fed met in late March and decided to keep interest rates unchanged at 5.25%. This was expected and the market read the statement to mean that the Fed is no longer biased towards hiking interest rates. Subsequent to the announcement future interest rate cuts were priced into the fed funds market. This reinforced the notion that the Fed would keep the U.S. economy out of recession. The notion of an easier Fed policy diminished, though, when the full minutes from the recent meeting were released. The minutes revealed that the Fed Governors still believe inflation risk remains and could even require additional rate increases.

The strong employment report in early April seems to confirm the Fed’s inflation wariness and subsequent to the release of the minutes the likelihood of a Fed rate cut occurring declined significantly in the future’s markets. Currently, economists are debating as to whether the economy is in a mid-cycle slowdown or on its way to recession. The current market volatility is caused by this uncertainty. Stocks typically do well during mid-cycle slowdowns (which we are at the very least experiencing now), as a refreshing pullback in demand relaxes inflation pressures and allows for lower interest rates. However, history shows us that stocks don't fare so well if the economy doesn’t just slow down, but actually contracts.

Estate Tax Summary

2007-05-06T17:03:00.003-04:00

Here is a quick summary of current federal estate tax rates. Be sure to consult your attorney before taking any recommendations listed below. If you have not updated your will and estate plan within the past 3 years, make an appointment with your attorney today!

Current tax laws concerning federal estate taxes provide an applicable exclusion amount of $2,000,000 per person. Don’t forget about your life insurance policy! This means that each person can give away during life up to $1,000,000.00 or at death a combined total of $2,000,000.00 worth of property, without any taxes being due and payable.

On May 26, 2001, Congress passed “The Economic Growth and Tax Relief Reconciliation Act of 2001,” which provides for the applicable exclusion amount to increase over time as follows:

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Additionally, current federal tax law provides for an unlimited marital deduction. This means that you may transfer an unlimited amount of property between you and your spouse without incurring any federal estate taxes. Combining the applicable exclusion amount with the unlimited marital deduction means that a married couple can have a combined estate of $4,000,000.00, which passes tax-free at the death of the second spouse. The tax rate on any amount in excess of $4,000,000.00 starts at forty-six percent (46%). To ensure utilization of the $2,000,000.00 applicable exclusion amount, both of you should have property worth at least $2,000,000.00 held in your own names or revocable trusts and not with rights of survivorship.

A typical plan to fully utilize both $2,000,000.00 applicable exclusion amounts for a married couple is to place $2,000,000.00 in a bypass trust at the death of the first spouse. The bypass trust typically provides that all income is payable to the surviving spouse and the Trustee may invade principal for the spouse’s health, support, maintenance and education. Upon the spouse’s
death, the principal is payable to the children outright or in continuing trust, free of any estate tax even on the appreciation of the assets in the credit shelter trust. The balance of the estate in excess of $2,000,000.00 is given outright to the surviving spouse and the surviving spouse, at his or her election, may place this additional inherited amount into his or her own revocable trust. Alternatively, the balance may be held in further trust. Upon the death of the surviving spouse, all of the survivor’s property is passed on to the children, either outright or in a continuing trust. The $2,000,000.00 in the bypass trust created upon the first spouse’s death, together with all appreciation therein, is not taxable again in the surviving spouse’s estate.

Warren Buffet on International Investing

2007-04-08T16:57:00.003-04:00

Each year I look forward to reading Warren Buffet’s annual report to the shareholders of Berkshire Hathaway. The 76 year old Buffet is the Chairman of Berkshire Hathaway, a holding company that owns a diverse group of subsidiaries.

With an estimated net worth of $28 billion, Buffet is one of the ten richest men in the world and considered by many to be the best investment analyst ever. In the past, he has stuck primarily with US investments, but as he says in his report to shareholders, things are changing.

In reference to the $2.2 billion dollars he made on currency exchanges and the nearly $3 billion earned on his investment in PetroChina, Buffet said, “As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. . . the U.S. had $.76 trillion of pseudo-trade last year - imports for which we exchanged no goods or services (only money).” By doing this, Buffet said, “the US necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy, but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.”

Buffet continued, ”The ‘investment income’ account of our country – positive in every year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card.

And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay for ever-increasing amounts of interest on interest.” In addition to our trade imbalance, non-U.S. companies are gaining ground in areas traditionally considered U.S. based businesses. As an example, the world’s largest producer of steel and the largest supplier of beer are US Steel and Anheuser Bush, right? Wrong. Mittal Steel, owned by an Indian and headquartered in the Netherlands, is the world’s largest steel producer. U. S. Steel is the 7th largest producer of steel behind six other non-U.S. companies. InBev, the result of a merger of a Brazilian company AmBev and a Belgium company, Interbrew, is the largest producer of beer in the world. Anheuser Bush is the third largest, behind InBev and SAB/Miller, a South African company.

The world’s best companies continue to make huge investments outside the U.S. We must follow their example and do the same. Over the past 5 years, the EAFE Index, has had an annualized compounded return of 16% compared to a return of just 7% for the S & P 500. A balanced investment portfolio must include a heavy dose of non-U.S. investments.

Buffet summarized his thoughts on this issue by stating, “It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future, U.S. workers and voters will find this annual “tribute” so onerous that their will be a severe political backlash. How that will play out in the markets is impossible to predict – but to expect a “soft landing” is wishful thinking.”

Sector Performance Report 3-31-07

2007-04-01T17:09:00.001-04:00

The utilities sector posted the strongest 12 month trailing return of nearly 28%, followed closely by the telecom sector at 24% annual return. The worst performing US sector in the past 12 months was the IT sector at just under a 3% total return.

(click to enlarge)

Market Summary

2007-04-01T16:53:00.002-04:00

A recent Wall Street Journal article depicted investors riding on a rollercoaster called the “Volatiler”. Quite appropriate, since the S&P 500, like most roller coasters, ended in the same location it started. The first quarter of 2007 moved up over 2% and down over 3%, more than a 5% delta, much like the “Volatiler”. In contrast the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East designed to measure overall conditions of overseas markets) posted another excellent quarter, up 3.5%. Over the past 12 months, the S&P 500 and the EAFE were up 11.8% and 20% respectively.

Going forward, the market is likely to remain quite choppy. The housing market slowdown, which may be worsened by the growing debacle in the sub-prime mortgage market and tighter lending standards, is of chief concern to the market. Warnings by homebuilders and new federal investigations into lending practices have the market on edge as do concerns that these problems may spread into the broader economy. Further, a spike in oil prices amid growing Iranian tensions is adding fuel to the fire. These inflationary pressures are likely to keep the Federal Reserve in limbo in the short run but may allow for a drop in rates by the end of the year.

Volatility in the market creates ideal conditions for portfolio rebalancing. Make sure you do not have all your eggs in one basket or you may find yourself in the hole!

Book Review: The Black Swan

2007-03-11T15:50:00.002-04:00

The Black Swan: The Impact of the Highly Improbable
By Nassim Nicholas Taleb

Four hundred years ago, Francis Bacon warned that our minds are wired to deceive us. "Beware the fallacies into which undisciplined thinkers most easily fall--they are the real distorting prisms of human nature." Chief among them: "Assuming more order than exists in chaotic nature." Now consider the typical stock market report: "Today investors bid shares down out of concern over Iranian oil production." Sigh. We're still doing it.

Our brains are wired for narrative, not statistical uncertainty. And so we tell ourselves simple stories to explain complex thing we don't--and, most importantly, can't--know. The truth is that we have no idea why stock markets go up or down on any given day, and whatever reason we give is sure to be grossly simplified, if not flat out wrong.

Nassim Nicholas Taleb first made this argument in Fooled by Randomness, an engaging look at the history and reasons for our predilection for self-deception when it comes to statistics. Now, in The Black Swan: the Impact of the Highly Improbable, he focuses on that most dismal of sciences, predicting the future. Forecasting is not just at the heart of Wall Street, but it’s something each of us does every time we make an insurance payment or strap on a seat belt.

The problem, Nassim explains, is that we place too much weight on the odds that past events will repeat (diligently trying to follow the path of the "millionaire next door," when unrepeatable chance is a better explanation). Instead, the really important events are rare and unpredictable. He calls them Black Swans, which is a reference to a 17th century philosophical thought experiment. In Europe all anyone had ever seen were white swans; indeed, "all swans are white" had long been used as the standard example of a scientific truth. So what was the chance of seeing a black one? Impossible to calculate, or at least they were until 1697, when explorers found Cygnus atratus in Australia.

Nassim argues that most of the really big events in our world are rare and unpredictable, and thus trying to extract generalizable stories to explain them may be emotionally satisfying, but it's practically useless. September 11th is one such example, and stock market crashes are another. Or, as he puts it, "History does not crawl, it jumps." Our assumptions grow out of the bell-curve predictability of what he calls "Mediocristan," while our world is really shaped by the wild powerlaw swings of "Extremistan."

In full disclosure, I'm a long admirer of Taleb's work and a few of my comments on drafts found their way into the book. I, too, look at the world through the powerlaw lens, and I too find that it reveals how many of our assumptions are wrong. But Taleb takes this to a new level with a delightful romp through history, economics, and the frailties of human nature.

Credit: Chris Anderson

Asset Allocation: Avoid Picking Individual Stocks

2007-01-10T16:34:00.007-05:00

I recently attended an economic presentation by Dr. Gene Fama of the University of Chicago, the leading champion of the efficient market theory and a favorite to win the Nobel Peace prize one day. Dr. Fama stated, “I’d compare stock pickers to astrologists, but I do not want to bad-mouth astrologists.”

One of the biggest mistakes individual investors make is following the advice of the media, a stock broker or money manager on individual stock picking. Why is it that every year Money Magazine selects its top stocks to beat the market and never reports on how they performed the next? Why does Fortune Magazine list different “top money managers” each year and forgets to tell you about their selections of previous years. Why does CNBC run experts with differing opinions 14 hours per day and never tracks their recommendations? The reason is that it sells magazines and ad space!

Let’s look at some of Fortune Magazine’s “All Star” stock picks in their July 2000 edition:

(click to enlarge)

In the January 2000 issue of Time Magazine, Amazon founder Jeff Bezos was declared man of the year. If you purchased Amazon in January of 2000, your stock lost 75% of its value within a year. This year’s person of the year is “you”! The ramifications of this prediction are a little scary. This phenomenon is not limited to just stock picking either. Money Magazine’s “timely” June 2005 issue touted the virtues of buying residential real estate and denied the existence of any housing bubble. According to the magazine, “These days, everybody knows someone who has made money in real estate, and rising prices have become a national preoccupation. We are a wealthier country than we have ever been, so it makes sense that we would spend more on real estate, pushing prices to new highs. After a l l , F e d e r a l R e s e r ve Chief Alan Greenspan complained of "irrational exuberance" in 1996, more than three years before the stock boom ended in tears.”

I feel truly sorry for those that followed that advice. Once a financial trend hits the main stream, it’s generally time to get out. Over the past 20 years, money managers failed to beat their market bench marks over 80% of the time. This leaves just 20% of money managers or stock pickers beating the market on an annual basis. The problem is that different managers beat the market each year.

There is very little consistency with these managers beating the market from year to year. On the occasion that one of these star managers floats to the top, so much money flows into their portfolio that it creates a drag on future investment performance. Maybe if we can locate these emerging managers, we can beat the market more consistently. So how do we find these guys? When Peter Lynch, arguably one of the best stock pickers ever, retired from his job as manager of Fidelity Magellan, he and the executives at Fidelity spent an enormous amount of time and money scouring the investment world for the best money manager. Three money managers later, Fidelity Magellan has underperformed its bench mark index by exactly the management
fee it charges. What makes us think we can pick a good portfolio manager when Peter Lynch and Fidelity cannot?

What about the great stock picker Warren Buffet? According to Buffet, he may find 2 or 3 good stock ideas every couple of years. Mutual fund companies typically hold 150 to 250 stocks. How does a mutual fund manager find 200 good ideas? I guess they simply select 2 good ideas and 198 average ideas. Buffet also inserts himself into the management of the good ideas he selects, a likely boon to his returns. This does not happen in the traditional portfolio managementindustry. So, if we can’t pick stocks that consistently beat the market and we can’t pick managers that consistently beat the market, what should investors do? Stop trying to beat the markets! Put your savings to work and earn a market rate of return. As investors, we are entitled to the market return. Anything less is our own mistake. How do we get this?

In order to answer this, we need to understand some basic facts about what the “market” is and risk. Here is a table showing the typical market asset classes and their performance over the previous ten years.

(click to enlarge)

As you can see, different asset classes perform differently from year to year. Many times one year’s winner is the next year’s loser. By diversifying among these asset classes in such a way that meets your individual risk tolerance, you can obtain market returns with an appropriate amount of risk. This can be done by purchasing index funds and exchange funds that mirror the asset classes. Now, if we simply select the asset mix that meets risk and return profiles, we can earn the market return and go play golf!

If you need help, don’t hesitate to call. This is our specialty!!!

Real Estate Corner

2007-01-04T16:19:00.004-05:00

The real estate market softened considerably during 2006. There have been pockets of depreciation in certain parts of the country and in the higher priced homes. I have seen drops of as much as 15% from recent peaks in the same markets. However, the overall market seems to have stabilized. We have not as yet experienced a significant broad based drop in home prices.

The Mortgage Bankers Association referred to 2006 as “A Normalization of the Housing Market”. In the aggregate, residential real estate seems to have remained roughly the same as a year ago. Home sales were lower by 10%, with new homes falling by 17% and existing homes falling by 8%. (This excludes data from December 2006, which will not be released until the end of January).

According to the Office of Federal Housing Enterprise Oversight, “US Home prices rose in the 3rd quarter, but the rate of appreciation declined significantly and some areas experienced declines. Nationally, home prices were 7.73% higher in the third quarter of 2006 than they were a year earlier.” Idaho topped the list of states with an annual increase of 17.5%, while Michigan, home of Ford and GM, was at the bottom with a slight price decline.

In our local market, the average sales prices of homes in Northern Virginia declined 4% in November compared to a year ago. Homes are also taking longer to sell, averaging 85 days on the market compared to just 35 days a year ago. There were also 30% fewer home sales than a year ago. One of the most interesting phenomenons is the switch from a seller’s market to a buyer’s market. Over the past 5 years, buyers have been paying on average 2% less than the listed price. However, in 2006, this number has increased to 7%.

I expect 2007 to be a true buyers market with sellers willing to provide handsome concessions and lower prices to entice buyers. If rates move north of 6.75%, there may be some true housing depreciation. Most economists however, are still expecting a soft real estate landing with a flat market over the next 2 years.

Sector Performance Report 12/31/06

2007-01-01T16:44:00.002-05:00

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Market Summary

2007-01-01T16:09:00.002-05:00

2006 turned out to be a terrific year for most investors. Stocks rose more than Wall Street analysts predicted after the Fed. halted 2 years of interest rate increases while energy prices fell 22% from their high in July. The S & P 500 was up 14%, the Dow Jones Industrial Average was up 16% and the NASDAQ moved up 9% for the year. Overall, the equities market performed remarkably well in spite of pressures from higher interest rates and energy prices.

In writing this newsletter, I reviewed my predictions from last year and would like to report the results. I suggested large cap stocks with high dividends or “value stocks” would have a big year. In fact, this asset class was up 23%. I also suggested the Fed would stop raising rates after another 1/2% increase. The Fed did stop, but not until after raising short-term rates another 1%. I suggested the energy and real estate sectors were due for a correction. I was way off here. The energy sector posted a strong 21% return beating the S & P 500 by 7%.

The real estate market was mixed. Commercial real estate continued to post excellent returns while residential real estate fell considerably. As for mortgage rates, I predicted a 1/2 % increase in rates. As predicted, 30 year fixed rates mortgages did increase from 6.25% to 6.75%; however, they came back down to 6.25% ending the year where they started.

For the record, my predictions are done mainly for sport. Predicting short term economic trends is more luck than skill and my predictions should not be acted upon at home. Market timing should never be substituted for sound asset allocation and rebalancing strategies.

Expectations for 2007 That thought in mind, let’s see what may be in store for 2007. As the current economic cycle matures, I expect larger stocks to perform better. This sector has been an underperformer since the late 90’s and is due for a good year. 2007 may be the year the S&P 500 and Large Cap growth stocks out perform all other asset classes. I also expect Healthcare and Financials to be in the top US sectors. As for rates, the market is pointing to a 50 basis point drop by the Fed and mortgage rates to lower by about 1/2%

Book Review: The Alchemist

2006-10-12T16:01:00.001-04:00

The Alchemist: A Fable About Following Your Dream by Paulo Coelho

Paulo Coelho's enchanting novel has inspired millions of delighted readers around the world. This story, dazzling in its simplicity and wisdom, is about an Andalusian shepherd boy named Santiago who ventures from his homeland in Spain to North Africa in search of a treasure buried in the Pyramids.

Along the way he meets a beautiful, young gypsy woman, a man who calls himself a king, and an alchemist, all of whom point Santiago in the direction of his quest. No one knows what the treasure is or if Santiago can surmount the obstacles along the way through the desert. But what starts out as a boyish adventure to discover exotic places and worldly wealth turns into a quest for the treasures only found within.

Lush, evocative, and deeply humane, Santiago's story is an eternal testament to following our dreams and listening to our hearts. - Taken from www.santjordi-asociados.com

This is an excellent little book about following your heart. Read it with your children and enjoy a wonderful fable. –Michael Rebibo

Retirement Planning

2006-10-11T15:58:00.001-04:00

Does Your 401(k) Plan Have All the Elements of a Successful Retirement Plan?

Planning and saving for retirement is a major financial issue for most Americans. We spend decades worrying about whether or not we will have enough money saved for the goal of being financially independent. One of the best tools to improve our odds of successful retirement is our company retirement plan. Since most companies today offer only defined contribution plans (primarily 401(k) and Simple Plans), we will focus on the key aspects of successful defined contribution plans. This is written for the plan sponsor/trustee, usually the owner or top executive in smaller businesses or the human resources director in larger organizations.

The key elements of a successful Retirement Plan are as follows:

Compliance: A successful retirement plan is in compliance with all necessary testing and government filings, distributes all legally required information to participants first and is administered exactly as the plan document is written. The fiduciaries of the plan, the trustees, members of the plan committee and members of the board of directors, meet the fiduciary requirements mandated under ERISA, the federal law that regulates retirement plans. Fiduciaries must exercise the “care, skill, prudence, and diligence” of an experienced fiduciary in fulfilling his/her duties. Fiduciaries are responsible for what they “should know” about investments-as opposed to what they actually know. More than one court has said, “A pure heart and empty head are not enough”. All plans should have an Investment Policy Statement which will assist the fiduciaries in meeting these stringent requirements.

Participation: This is the litmus test for a successful 401(k) plan. Average participation rates vary by industry and wage levels. The overall participation rate across all industries is about 75%. A successful plan will have higher than average participation rates.

Savings Percentage: The more money people put aside in their 401(k), the greater their chance for a secure retirement. Also, the higher the rate, the easier it is to pass discrimination testing. The overall average employee deferral percentage is between 6% and 8%.

Asset Allocation/Investment Selection: A 401(k) is fundamentally a long term savings and retirement plan. The difference between 6%, 8% and 10% rate of return over 20-, 30- and 40- years can be enormous. Asset allocation, or the relative percentage a participant puts into cash, bonds, and stock, is the fundamental investment decision and can have a huge impact on the funds available for retirement. Each plan must have the appropriate investment classes available to meet the Prudent Investor standards.

Investment Performance: In addition to having the appropriate investment options, the absolute and relative performance of the investments must be monitored at least annually against the appropriate benchmarks. In addition, high cost plans drain away returns from participants’ accounts.

Costs and Administrative Efficiency: It is the plan sponsor’s fiduciary duty to insure that the fees of the plan are “reasonable”. Many plans have fees buried inside the underlining mutual fund investments that increase overall fund costs. In order to know whether or not a plan's costs are reasonable, the plan sponsor must know what the actual costs are. This requires some due diligence on the part of the sponsor. An annual review of plan expenses will assist in determining reasonability.

Ask yourself the following questions:

1. Was your retirement plan provided to you by an objective party other than an insurance company, investment brokerage house or other commission oriented firm?

2. Are you happy with the performance of the funds in your plan? Are you or your investment advisor able to select from the best funds available in the market today? Are you or your advisor reviewing the performance of your funds and comparing them to their corresponding bench marks on an annual basis?

3. Have you reviewed the total costs of your retirement plan, both disclosed and undisclosed?

4. Does your retirement plan provider acknowledge the fiduciary responsibility under ERISA sections 3(38) and 405(d)(1)?

5. Is your overall participation rate in excess of 75%?

6. Is your overall savings rate in excess of 6%?

7. Does your plan have an Investment Policy Statement? Is this reviewed annually?

If you answered no to any of the above questions, consider having 1st Portfolio provide you or your company with a qualified plan review. We help plan sponsors make their plans more successful by increasing participation and savings rates and helping participants allocate their assets in an age and risk-appropriate manner. We also assist plan sponsors in meeting their fiduciary obligations by assisting them with the investment selection and monitoring process as well as in controlling and lowering the total cost of the plan. We provide our business services in a transparent manner openly discussing our fees and avoiding any real or perceived conflicts of interest. We act as fiduciaries to the plan, always keeping the interests of the participants and their beneficiaries as our top priority.

Children & Money: Instill the Value of a Dollar at an Early Age

2006-10-10T15:49:00.001-04:00

Most children today do not actually know where money comes from. Think about how different the world is from our childhood. While technology has greatly simplified our monetary transactions, it has created a significant disconnect for our children. Items are seldom purchased with cash; rather we use a magical plastic card to fulfill their material wants. Paychecks are deposited automatically into banking accounts, while money appears to be earned simply by typing a secret code into an Automated Teller Machine. Bills are paid electronically or automatically. To top it all off, there is very little taught in school on the subject of money. How are our children to learn?

When my son was five, we ordered him a scooter off the internet. As soon as I completed the transaction, he sprinted down to the mailbox to look inside. He came back disappointed to learn that the scooter had not magically appeared in the mailbox. I had to explain not only how the financial transaction occurred, but also how the order was fulfilled and then eventually mailed to our home. The instant gratification world our children and most of us live in does not prepare us for the long-term focus required to manage our money and create wealth and prosperity.

What can we do? Here are a few ideas to get you started:

1. Break the spending habit.

2. Explain how money flows through the economy. For example, “Our money is earned by creating some sort of value in our community. The greater the value created, the greater the money earned. This money is generally deposited directly into our account via electronic credits. Some of the money earned is immediately saved in a different investment account for our future. Some of the money is given to our favorite charities and/or our religious organizations. What is left is ours to spend on our way of living. We use credit cards to buy things but pay them off each month with the money we earn. If we spend too much, we have to pay the credit card company interest. This makes it harder for us to pay our expenses the next month”.

3. Consider replacing the allowance, an “entitlement concept”, with specific payments for specific services. In other words, let them earn their “allowance”. One of my clients implemented this with his children. The children asked if they were able to reduce the household utility bills by a percentage, could they keep 50% of the savings. Although the kids wanted to eat dinner in the dark and kept turning the lights out on their parents, they were able to cut the bills by $30 per month and kept $15 for themselves!

4. Open a savings account with their money. You can take them down to the local bank or better yet, open a mutual fund.

5. Teach them about interest and compounding! After completing the above step, your children will truly begin to understand this.

6. With the exception of birthdays and holidays, require your children to buy all or part of the items they really want. Teaching your children to earn money and buy the things the want will help them to develop the skills that will last them a lifetime.

7. Suggest they begin giving some of their savings to charity. If possible, let them experience your giving directly.

8. Teach them that it’s a “round world” that we live in. The more you give, the more get. Another similar concept is to “Pay it Forward”.

9. Together, learn how to sell things on eBay. This will provide them with many valuable tools that will help them in the future.

10. Teach them the importance of planning for their future. As we all know, a failure to plan is a plan to fail. Encourage them to save money for their future. If they are old enough to earn money outside the home, have them open a Roth IRA. Have them save up for the really big things they want. If you have your child save up for that new X-Box, they will develop a sense of accomplishment, take better care of their belongings and begin to appreciate the value of a dollar.

Market Summary

2006-10-07T14:09:00.001-04:00

The legendary Dow Jones Industrial Average Index reached a record high of 11,750 in September. It reached this magical peak only for a few seconds during the day and closed below the record. In fact, if you take inflation in to account, we are still a long way from a record. The DJIA index would need to be around 13,000 if you adjusted for inflation. You need to go back to January of 2000, during the peak of the dot com era, to find the market in a similar range. Today’s record comes with an abundance of caution. Investors and consumers share concerns over the high cost of energy, the war in Iraq and a weakening real estate market that threatens to knock the footings off the economy and send us into recession.

As usual, there is very little consensus as to whether we will pierce through this long standing market top into new higher territory in the months and years to come, or will we plunge into recession as we did in 2001 after the last time we reached this record. What we do know is this: relative to company earnings, the prices of US stocks as a whole are considerably cheaper than they were in 2000. In addition, the fall out from the Enron and WorldCom corporate disasters has eliminated a significant amount of corporate waste.

The S&P 500, the index measuring the 500 largest US stocks by their market capitalization was up a 5.2% for the quarter, while the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East designed to measure overall conditions of overseas markets) was down -2.92% over the same period. Year to date, the S&P 500 and the EAFE idecies were up 8.79% and 10.06% respectively. Why the big jump? Fed Chair Ben Bernanke and his friends at the Fed finally stopped raising rates. This, coupled with a drop in energy prices created a new market euphoria. Debt payments and energy costs have a huge impact on consumer spending.

Sector Performance Report 9-30-08

2006-10-01T14:12:00.002-04:00

The 12 month trailing returns for the energy sector fell to zero while the telecommunications, health and financial sectors rebounded strongly after being in the cellar for a few years. As so often is the case, last year’s winners are this year’s losers.

Book Review: It's Not About the Bike

2006-08-17T14:00:00.002-04:00

It's Not About the Bike: My Journey Back to Life
by Lance Armstrong, Sally Jenkins

This is a fantastic read about Armstrong’s struggle with cancer only to recover and win the Tour de France. It’s a great motivational book that shows that if you truly believe, you can accomplish almost anything. –Michael Rebibo, CFP®

Estate Tax Summary

2006-08-07T13:53:00.003-04:00

Here is a quick summary of the current federal estate tax laws. Be sure to consult your attorney before taking any recommendations listed below. If you have not updated your will and estate plan within the past few years, make an appointment with your attorney today!

Current tax law concerning federal estate taxes provides an applicable exclusion amount of $2,000,000 per person. This means that each person can give away during their life up to $1,000,000 or at death a combined total of $2,000,000 worth of property, without any taxes being due and payable.

On May 26, 2001, Congress passed “The Economic Growth and Tax Relief Reconciliation Act of 2001,” which provides for the applicable exclusion amount to increase over time as follows:

(click to enlarge image)

Additionally, current federal tax law provides for an unlimited marital deduction. This means that you may transfer an unlimited amount of property between you and your spouse without incurring federal estate taxes. Combining the applicable exclusion amount with the unlimited marital deduction means that a married couple can have a combined estate of $4,000,000, which passes tax-free at the death of the second spouse to die. The tax rate on any amount in excess of $4,000,000 starts at forty-six percent (46%). To ensure utilization of the $2,000,000 applicable exclusion amount, both of you should have property worth at least $2,000,000 held in your own names or revocable trusts and not with rights of survivorship.

A typical plan to fully utilize both $2,000,000.00 applicable exclusion amounts for a married couple is to place $2,000,000.00 in a bypass trust at the death of the first spouse. The bypass trust typically provides that all income is payable to the surviving spouse and the Trustee may invade principal for the spouse’s health, support, maintenance and education. Upon the spouse’s death, the principal is payable to the children outright or in continuing trust, free of any estate tax even on the appreciation of the assets in the credit shelter trust. The balance of the estate in excess of $2,000,000.00 is given outright to the surviving spouse and the surviving spouse, at his or her election, may place this additional inherited amount into his or her own revocable trust. Alternatively, the balance may be held in further trust. Upon the death of the surviving spouse, all of the survivor’s property is passed on to the children, either outright or in a continuing trust. The $2,000,000.00 in the bypass trust create upon the first spouse’s death, together with all appreciation therein, is not taxable again in the surviving spouse’s estate.

Federal Reserve Forum

2006-07-17T13:35:00.002-04:00

Interest Rate Hikes, When Will They Stop?
The Federal Reserve has met twice since my last newsletter. After the May 10th meeting, Ben utters the dreaded “inflation” word causing the stock markets to sell off in lock step. Then in June, Ben says, “the moderation in the growth of aggregate demand should help to limit inflation pressures over time”. In other words, the interest rate increases are working. No kidding but when will it stop?

These most recent Fed comments revealed the first hint that we may be nearing the end of the Federal Reserve’s 17 consecutive 1/4 point interest rate increases. (In case you’re wondering, 17 quarter points is 4.25%) For the first time since it began raising rates from a low of 1%, in June of 2004, the Fed didn’t explicitly say another rate increase was under consideration. Currently, the futures market has priced in a 63% chance of a rate hike to 5.5% in August. This would give us a prime rate of 8.5%.

This is 50 basis points below the previous peak Mr. Greenspan set in 2000. In the mean time, the Fed will continue to read the economic tea leaves over the next 45 days. The Bank of Japan and the European Central Bank are set to raise rates in the next thirty days.

How might the current series of rate increases affect you? First, if you’re in the market for a new home or need to refinance, mortgage rates for fixed rate loans should reach 7% in 2007. If you have a home equity loan tied to the prime rate, your interest rate will more than double to somewhere around 8.5%. The popular interest only ARM loans will also double in rate just when the housing market has stalled. This may make it difficult to refinance when homes have not appreciated or may have even dropped. The overall impact here may be a loss of value in residential real estate between 10% and 20% from the 2005 peak. Combine this with the increases in gas and other raw materials and you may get a recession in late 2007. However, as with all recessions, we will not know until we have been in one for at least 6 months!

Is there a silver lining? Sure, six month CDS are now paying over 5.5%, nearly 4 times their low back in 2003! Also, market slowdowns generally create great buying opportunities. Remember, the economy works in cycles and we are about five years into the current economic cycle.

Asset Allocation

2006-07-16T13:40:00.002-04:00

Buy Low, Sell High – Not As Easy As It Sounds

Small investors seem to continuously chase the market trend and use a strategy I call “recency”: What ever the most recent phenomenon of making money is, follow it. We have seen recency with dot bomb stocks, real estate, emerging markets, gold, etc. These investors are applying reverse market timing. Wait until something gets run up really high, then buy it only to watch it free fall. Then sell it! In other words, “buy high, sell low”.

Why does this happen? Most institutional investors apply an asset management strategy in their portfolios. This means that when one asset class of the portfolio grows beyond the tolerance set by the manager, they sell. It also means when an asset class falls below the tolerance level they buy. Here’s the rub: institutional investors have more money than retail investors. So when a retail investor is following a trend, and the institutional investors are selling what is high, the retail investor becomes the bug and the institutional investor becomes the windshield. So why play this game?

Fasten your seatbelts, do not panic, have patience and follow a long term plan. In its simplest form, asset allocation is a strategy with fixed percentages in cash; bonds both domestic and international, US Equities both large and small, and international stocks both large and small. The portfolio is then rebalanced periodically. This rebalancing process creates the “buy low sell high” discipline! It also removes guessing which generally creates havoc on the portfolio.

A Time For Giving

2006-07-10T13:49:00.000-04:00

You don’t need to wait until the holiday season to start thinking of others. Warren Buffet, the world’s second richest man, announced plans to give away 85% of his fortune ($30 billion) to the foundation started by the world’s richest man, Bill Gates. The Bill and Melinda Gates Foundation will then double in size to $60 billion, making it more than twice the size of the next 3 largest foundations combined (Ford Foundation $11 Billion, Lilly Endowment $8 Billion, and Andrew W. Mellon Foundation $5.5 Billion).

Foundations must give away 5% of their assets per year to keep their tax exempt status. Thus, the Gates Foundation will need to give away over $3 billion per year to the causes of their choice. The Foundation has been spending money on research, prevention and treatment for AIDS, tuberculosis, malaria, and vaccine-preventable childhood diseases. It focuses its efforts in developing countries, primarily in Africa and Asia. This leaves plenty of good causes for the rest of us to get involved with.

According to a survey produced by the Giving USA Foundation, Americans gave $200 billion to charities and other non-profits in 2005. In addition, nearly 80% of Americans give to at least one organization at least once per year and the average contribution per family is 2.2% of after tax annual income. That’s only $3,000 per year for a family earning $200,000 per year.

What’s the point of making lots of money and not giving anything back? There are many people who are less fortunate than us, who could benefit from even the smallest donation. And with all of the charities available today, it’s easy to choose one that you feel would best benefit from your help.

Life is short. Don’t be average. Give today!

Market Summary

2006-07-07T13:33:00.001-04:00

The 2nd quarter of 2006 was tough for virtually all market segments. The US market and international markets fell in May, but rebounded slightly in June. The S&P 500, the index measuring the 500 largest US stocks by their market capitalization, fell 2.3% for the quarter and the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East) declined .26% over the same period. Year to date, the S&P 500 and the EAFE were up 1.8% and 8.94% respectively.

What caused the drop? It started with comments made by new Fed Chair Ben Bernanke following the May 10th Federal Reserve meeting on the subject of inflation. For the first time, Ben did not speak in code as his predecessor Alan Greenspan always had, and actually used the word “inflation” in his speech. This sent the S&P 500 down 5%, while international markets got pounded nearly 10%. Then in June, the markets recovered slightly following comments where Bernanke did not specifically mention rate increases. It is amazing what a few simple words uttered by the Fed can do to world markets. As former Chair Greenspan has said, “I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said”.

Sector Performance Report 6/30/06

2006-07-01T14:03:00.001-04:00

(click to enlarge image)

Book Review: Unconventional Success

2006-06-11T15:37:00.004-04:00

Unconventional Success: A Fundamental Approach to Personal Investment
By David F. Swensen

Swensen, CIO of Yale University and the author of Pioneering Portfolio Management, reveals why the mutual fund industry as a whole does a disservice to the individual investor. Soft money, 12b-1 fees, overtrading, market timing, and other management practices lower performance and virtually guarantee that most mutual fund returns will fall short of their benchmark, such as the S&P 500.

Furthermore, for-profit mutual fund companies have a fiduciary obligation to their stockholders, not to their investors, and this relationship "inevitably resolves in favor of the bottom line." Swensen is also highly critical of the Morningstar rating system, which only causes investors to chase hot performing funds and managers.

He advises considering alternatives to the for-profit mutual fund industry, including Exchange Traded Funds and not-for-profit financial institutions such as Vanguard and TIAA-CREF. He highly recommends that as an individual, you should play a more active role in your financial future. This includes periodic portfolio evaluation and rebalancing, to ensure that your asset allocation remains diversified and suits your investment time line.

Credit: Booklist

Market Summary

2006-04-18T12:02:00.005-04:00

The first quarter of 2006 has started out with a bang! Nearly every sector except utilities, one of last year’s hot sectors, is up. You could have invested in just about anything and made money (and hopefully you did). US stocks, both large and small; international and emerging markets, all posted excellent returns. The S&P 500 index increased 3.7% for the quarter, more than all of 2005!

In fact the S&P 500 earned more last quarter than the average annual return of the index over the past 5 years. Small and medium sized stocks continued to out perform their larger brethren by a large margin. The Russell 2000 index of small stocks rose nearly 14% setting a new record high. “Value stocks” outperformed “growth stocks” nearly 2 to 1 for the quarter according to Morningstar, Inc.

During the first quarter, the Federal Reserve, under new Fed chairman Ben Bernanke, continued increasing short term rates. Two rate hikes of 1/4% were added to the previous 13, pushing the prime rate up to 7.75%. This is the index tied to most home equity loans. In my year end summary, I predicted the Fed would stop at this level. However, recent Fed comments like this, "some further policy firming may be needed.” indicate the fed will continue increase rates at least one more time.

When To Harvest Stock Options

2006-04-17T12:52:00.002-04:00

Employees with stock options are faced with a tough dilemma. In order to convert the option into real value, they must cash it in. If they cash the option in, they realize the intrinsic value of the option, the difference between the option price and the current market value. This removes the risk of having the option become worthless. However, by exercising, they lose any remaining time value left in the option and they incur the tax liability.

There are a variety of strategies designed to deal with this dilemma.

1. The “Need Approach”: Cash in the option when you need the money. This clearly does nothing to balance investment risk and reward

2. The “Prediction Approach”: Many optionees and some advisors, try to time the harvesting of the stock based on some prediction of how the stock is going to perform. The reliability of such perditions is not possible. This approach often fails and sometime with spectacularly disastrous results.

3. “Timeline Approach”: There are basically three options with this approach:

a. Exercise as soon as possible. In this case, exercise options as soon as they vest as long as you are in the money. This approach is conservative but wasteful because you will lose all of the time value of the option

b. Exercise as late as possible. In this case, options are exercised just before they expire. This approach avoids wasting any of the options value but leaves the optionee exposed to risks of stock devaluation for a very long period of time.

c. Select a random period of time such as 1 year before expiration. The idea here is to minimize the risk and still receive some time value for the option .

4. A Balance Approach: This approach provides the greatest possible return for the least risk. It is also different for just about everyone. The approach here is to convert a high-risk investment, into a normal diversified investment, while not losing a large portion of its value. Thus, converting the stock in the value to be gained is significantly larger than the time value that is lost. Thus, options deep in the money should be cashed sooner than those with smaller gains. One also has to take into account the value of the option relative to ones overall net worth. Options representing large portions of net worth should be exercised sooner.

Tax Implications for Nonqualified Stock Options
If a stock is exercised after vesting, then the optionee reports compensation income equal to the amount by which the stock value exceeds the exercise price. This amount is now included in the tax basis of the stock, so they have a basis equal to their fair market value. Any subsequent change in value will result in capital gain or loss, which will be long-term if the sale occurs more than a year after the option was exercised.

Most optionees exercise and hold for a year to take advantage of long-term capital gains treatment. This however exposes them to “capital loss whipsaw”. Imagine you own PSI Net with a $100,000 gain at the time of exercise. The stock proceeds to go down $90,000 before the shares are sold a year later. Now you will report $100,000 of in compensation income with a capital loss of $90,000. You can only deduct $3000 of the capital loss and will end up paying ordinary income taxes on $97,000 even though her true profit is only $10,000!

The benefits of exercising and holding nonqualified stock options do not outweigh the risks associated with holding them over time.

Tax Implications for Incentive Stock Options
AMT tax has made it more difficult for those with ISOs who’s with income between $150,000 and $380,000. This is because the AMT tax increases the tax rate for those income brackets. Individuals making more than $382,000 already are paying higher taxes and are not affected by AMT (ISO impact). Options are to exercise and sell, exercise and hold for one year in hopes to reduce the tax liability, or a combination of the two.

There is a significant amount of risk in holding the stock for a year in hopes of reducing the tax on the gain. This is due to the fact that you will pay tax in the year you exercise and may lose value in the stock by holding it an additional year. To get the best of both worlds, possible capital gains treatment with lower risk, consider selling 65% of the stock immediately and holding the remainder for a year. This allows you to take some of the risk off the table and still reap the benefit of the capital gains tax. Ratios will vary depending on the amount of the gain and the tax credit. It is important that you consult your tax advisor before making any decisions as they relate to non qualified and qualified stock options.

Source: FPA Seminar on Stock Option Planning for Corporate Executives by Kay Thomas, Founder of the National Board of Certified Option Advisors.

Federal Reserve Forum

2006-04-17T12:51:00.001-04:00

The Federal Reserve has now completed 15 consecutive 1/4 rate increases since June of 2004. This means that if you have a home equity line, your rate has nearly doubled from 4% to 7.75% over the past year and half. According to Tom Millon of the Capital Markets Cooperative, “The futures market placed 100% probability on a 5.00% funds rate in May, and 40% odds on 5.25% shortly thereafter in June. A week ago, the odds of a June hike were virtually nil. Rising commodity and energy prices, rising employment, rising gold, and a growing world economy create ripe conditions for the potential to add to inflationary pressures."

The Value of Asset Allocation: A Case for Indexing

2006-04-17T12:15:00.007-04:00

Large cap stocks or mutual funds are core to any portfolio. Allocations to this asset class range from 15% to 35% depending on risk tolerance. (If you have more than this, you may want to evaluate your portfolio!) Most of us have seen the articles featured in the Wall Street Journal where a chimpanzee throwing darts at a stock page tends to outperform Wall Street’s brightest managers. Over the past 20 years there have been numerous studies on the value of selecting managed mutual funds vs. simply buying an index fund.

An index fund is mutual fund designed to mimic the returns of a given stock market index such as the S& P 500. For example, the Schwab Institutional S & P 500 Index fund simply utilizes a computer model to purchase all of the US’s largest 500 stocks in a weighting equal to their market cap.

According to a recent article in the Journal of Financial Planning by Thomas P. McGuigan, CFP, the large cap fund index (S& P 500) outperformed managed mutual funds 72% to 84% of the time over rolling 5,10, 15 and 20 year periods since 1993. The study concluded that the longer the period of time, the more likely the index beat the managed funds. The percentage of mutual funds that outpaced the index fund was only 10.59%. Thus, only 18 of 171 mutual funds outperformed the index fund over 20 years. The majority of out performers, 12 out of 18, only outperformed by 1% or less. This study did not take into account all the funds that are no longer in existence. If this figure was included, the percentage of funds that beat the index would be even lower. The study also found that the cost of selecting the wrong fund was very high.

The majority of the underperformers (113 funds), missed the mark by 1 percent or more. In my opinion, these odds are just not worth the risk.

Why is it that a chimp can outperform a manager in large cap stock selection? The answer lies in market efficiency, managed fund expenses and taxes. The US stock market and particularly the large cap stocks are nearly perfectly efficient. This means that the markets impound information into prices so well that the analysis of publicly available information will not produce excess returns. Thus manager out performance is simply luck rather than skill.

In addition to market efficiency, fund costs have a huge impact on performance. Fund costs include expense ratios, commissions, bid ask spreads and impact costs. Expense ratios are the cost of staff and overhead. Commissions and bid ask spreads are the actual costs of trading stocks. Impact costs relate to the expense associated with liquidating a large position in a particular stock. These expenses range form 1 to 2 percent per year for all funds.

On the other hand, an index fund has considerable lower expenses. For example, the Schwab Institutional S &P 500 Index fund mentioned above has a total expense ratio of just .22%. This gives the index fund a considerable advantage over its peers. Not only do managed funds have to beat the index, they must also cover their expenses. If the case above for indexing is not powerful enough, consider the impact of taxes. Managed portfolios generate nearly twice as much tax liability as index funds.

If all of the hold true for large cap stocks, what about smaller cap funds and international funds? While fund costs for these asset classes are actually higher, markets are less efficient giving some managers the edge. I generally used index funds for large cap portfolios and best in class institutional money managers for other asset classes.

Book Review: The Intelligent Asset Allocator

2006-04-07T13:24:00.003-04:00

The Intelligent Asset Allocator
By William Bernstein

"As its title suggest, Bill Bernstein's fine book honors the sensible principles of Benjamin Graham in the Intelligent Investor Bernstein's concepts are sound, his writing crystal clear, and his exposition orderly. Any reader who takes the time and effort to understand his approach to the crucial subject of asset allocation will surely be rewarded with enhanced long-term returns."
– John C. Bogle

Founder & Former Chief Executive Officer, The Vanguard Group
President, Bogle Financial Markets Research Center
Author, Common Sense on Mutual Funds

Book Review: The Lexus and the Olive Tree

2005-06-11T16:07:00.000-04:00

The Lexus and the Olive Tree: Understanding Globalization
By Thomas Friedman

One day in 1992, Thomas Friedman toured a Lexus factory in Japan and marveled at the robots that put the luxury cars together. That evening, as he ate sushi on a Japanese bullet train, he read a story about yet another Middle East squabble between Palestinians and Israelis. And it hit him: Half the world was lusting after those Lexuses, or at least the brilliant technology that made them possible, and the other half was fighting over who owned which olive tree.

Friedman, the well-traveled New York Times foreign-affairs columnist, peppers The Lexus and the Olive Tree with stories that illustrate his central theme: that globalization--the Lexus--is the central organizing principle of the post-cold war world, even though many individuals and nations resist by holding onto what has traditionally mattered to them--the olive tree.

Problem is, few of us understand what exactly globalization means. As Friedman sees it, the concept, at first glance, is all about American hegemony, about Disneyfication of all corners of the earth. But the reality, thank goodness, is far more complex than that, involving international relations, global markets, and the rise of the power of individuals (Bill Gates, Osama Bin Laden) relative to the power of nations.

No one knows how all this will shake out, but The Lexus and the Olive Tree is as good an overview of this sometimes brave, sometimes fearful new world as you'll find. --Lou Schuler

Book Review: Pioneering Portfolio Management

2005-06-11T15:34:00.001-04:00

Pioneering Portfolio Management: An Unconventional Approach to Investment

by David F. Swensen

During his fourteen years as Yale's chief investment officer, David F. Swensen has transformed the management of the university's portfolio. Largely by focusing on nonconventional strategies, including a heavy allocation to private equity, Swensen has achieved an annualized return of 16.2 percent, which has propelled Yale's endowment into the top tier of institutional funds. Now, this acknowledged leader of fund managers draws on his experience and deep knowledge of the financial markets to provide a compendium of powerful investment strategies.

Swensen presents an overview of the investment world populated by institutional fund managers, pension fund fiduciaries, investment managers, and trustees of universities, museums, hospitals, and foundations. He offers penetrating insights from his experience managing Yale's endowment, ranging from broad issues of goals and investment philosophy to the strategic and tactical aspects of portfolio management. Swensen's exceptionally readable book addresses critical concepts such as handling risk, selecting investment advisers, and negotiating the opportunities and pitfalls in individual asset classes. Fundamental investment ideas are illustrated by real-world concrete examples, and each chapter contains strategies that any manager can put into action.

At a time when it is becoming increasingly difficult to cope with the relentless challenges provided by today's financial markets, Swensen's book is an indispensable roadmap for creating a successful investment program for every institutional fund manager. Any student of markets will benefit from Pioneering Portfolio Management.

Credit: Barnes and Noble

The Perfect Storm; Bubble Trouble

2005-04-04T13:44:00.004-04:00

A friend of mine recently asked me if I were interested in going “in with him and some of his neighbors” to buy some townhouses to “flip for a profit”. They were forming a partnership in order “to get in on some of the hot real estate deals” that are now available. These were not traditional real estate investors but successful businessmen in the cable industry. Another friend said she doubled her investment on a second home she purchased at the beach less than a year ago. A few others have purchased speculative condos and are “hoping to make a killing”.

It all reminds me of 1989, the year I purchased my first home. The market was red hot and interest rates were on the rise. I couldn’t wait to get into the real estate market so I could enjoy some of the appreciation everyone else was realizing. I purchased the home for $289,000. Less than three years later, I listed it for $262,000, a drop of nearly 10%. After fix up and closing costs, I had to write a check for $14,000. Most of you will remember this time when rates were increasing, housing prices were falling, and the stock market was stagnant. Is this what the next 3 years have in store for us? As financial planners, it is our job to see through the noise and lead our clients down the safer path.

Real Estate Reaches Record Appreciation Levels
Recently, the Office of Federal Housing Enterprise Oversight, the government entity charged with ensuring the capital adequacy and financial safety and soundness of FNMA and FHLMC, published its House Price Index for 2004. For the 5th consecutive year, housing prices have increased by more than 7.5% nationwide. National housing prices increased by 10.24% in the 2004. Here are the to 10 states ranked by appreciation over the past 5 years:

(click to enlarge)

Conundrum
The Federal Reserve has increased short-term rates at a “measured pace” 8 times since June of 2004. Yet long-term rates such as mortgages remain below their levels of 1 year ago. Fed Guru Greenspan recently referred to the current low long term interest rates as a “conundrum” (which by the way is also a great white wine made by Caymus Vineyards)! Fed tightening, higher core inflation, near record oil prices, lower dollar, record federal budget deficit, and above trend economic growth create the perfect storm for higher long term rates and an immediate halt to appreciating property values.

Testifying before the House Financial Services Committee last month, Greenspan stopped short of calling home buyers “irrationally exuberant”, but stated "I think we're running into certain problems in certain localized areas. We do have characteristics of bubbles (in those markets) but not, as best I can judge, nationwide." Publicly traded homebuilders stocks fell 10% on the comment.

Home Sales Slowing
According to Merrill Lynch economist David Rosenberg, “the backlog of unsold homes has risen steadily, and in January approached a five-year high of 4.7 months supply. However, raw data, excluding seasonal adjustments indicate that the backlog has reached six months, which would mark an eight-year high.” While our local markets remain strong, this may be the last rush to purchase property before rates increase by too much.

Home Appreciation Outstrips Personal Income
“Median house prices have risen about 30% since March 2001, well ahead of an 11% gain in personal income”, says Michael Youngblood, head of asset-backed research at Friedman Billings & Ramsey.

Speculation on the Increase
Meanwhile, “unfettered access to easy money has inflated home prices nationwide, particularly on the coasts, and lately has let to an upsurge in speculative buying.” says Kopin Tan of Barron’s. Just as with the stock bubble in 2000, recent increases in speculative buyers and property flippers have driven up values in many urban areas like Washington DC.

“Household real-estate assets now equal nearly 14% of Gross Domestic Product, the highest proportion in two decades and eerily close to the ratio of household mutual fund and equity holdings relative to GDP at the stock market’s peak in 2000.” says Kopin Tan of Barron’s.

David Berson, the chief economist for Fannie Mae, observed in his weekly commentary that investor ownership of housing hasn't been this high since the late 1980s, which led to a crash in housing prices. "Many analysts think that a high investor share in the Northeast and California helped exacerbate the housing downturn that happened during the 1990-1991 recession”.

Bubble

Yale University economist Robert Shiller, author of "Irrational Exuberance," the 2000 best-selling book about the '90s stock-market bubble, said the only similar housing boom in U.S. history was when GIs returned home from World War II, lifting a depressed market. The latest addition of “Irrational Exuberance includes a chapter on the current real-estate trend.He thinks the current boom is a "classic bubble" because people keep buying houses they know are too expensive because they expect prices to rise even higher.

Conclusions
Ultimately it will be the level of long term interest rates that will create a local or national housing bubble. If rates exceed 6%, expect a 10% correction across the board. Larger homes will most likely be hit harder. If rates stay below this threshold, we may still see some localized drop in values in the higher end prices of homes in localized areas. The question is when?
As financial planners, it is our job to help our clients steer clear of disaster. Most real estate acquisitions are highly leveraged. This leverage works against you in a falling market. If your clients have an over allocation of real estate, it may be time to rebalance.