Market Summary

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

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

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

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

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