Target Funds Miss The Mark!

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

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?

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

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

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

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

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

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

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

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

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"

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

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

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

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

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

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

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

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

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

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

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

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.)

Copyright © Reed Business Information, a division of Reed Elsevier Inc. All rights reserved.

Mortgage Update