 JUNE 2006 INTRODUCTION In this edition of the O&A Newsletter we begin by looking again at the current environment of the financial market. Is this a bull or bear market? Our view seems to swim against the common wisdom, at least of the popular press, but it is a position we hold to with a certain firmness. The next article is on the new income tax law, the relatively modest changes it contains, and one far from modest change. Other articles include the benefits of receiving information electronically from Charles Schwab & Company, socially responsible investing opportunities, the negatives (and some alternatives) to annuity products, and Buddhist economics. This edition concludes with an article on the future of housing prices and, of course, "Office Matters." David W. Otto, Editor BEAR MARKET? In the March, 2005 Newsletter, we predicted a secular (i.e. long-term) bear market. Explaining that there could be quite a range in annual returns, we suggested that for the next 5 - 15 years investors should expect sub-par returns. (We didn't actually predict a specific percentage, but suggested that a 5% average return would be the most one could hope for. You can go to the website at www.ottoandassociates.com to read the text of what was actually said.) So what has happened in this first, somewhat brief, period? And do we still hold to our belief that we are in a secular bear market? As for what has happened, it might appear that we have been wrong. In the past 14 months the U.S. stock market returned 10.7% (annualized)! A blended index including foreign stocks (which did much better) and domestic bonds (which did much worse) returned 10.3%. Because Otto & Associates clients generally did better than both, it might appear that the predictions don't seem to matter. That would be an incorrect conclusion. It still appears that we are in a long-term bear market period where the U.S. stock market will deliver sub-par returns over the next 10 years, more or less. While there will be good years during this period, we also expect bad years which will significantly diminish the returns of the good years, to provide a disappointing average. The "not so bad" stock market returns of the first five months of 2006 (3.3% for the period, which would be 8% on an annual basis), do nothing to change our thinking. But there is another important consideration here. In early 2005 we modified most portfolios in a more conservative direction, still expecting that if the market went up significantly, we would capture most of the returns. Further, if the market went down, we expected to lose significantly less. As already noted, the market did go up significantly and we did capture most of the returns - in fact, most of our clients surpassed the market returns. The corollary statement that when the market goes down we expect to lose significantly less, has yet to be tested this time. However, during the three down years of 2000 - 2002, our clients lost less than the market or a blended index. Not surprisingly, client portfolios continue to be positioned in a somewhat conservative manner. We have made recent adjustments in some accounts to compensate for disparate returns in both stocks (including international stocks that have had even better returns in the last year than the U.S. market) and bonds (which have had disappointing returns in the same period). We are pleased that for a number of years, the returns for virtually all of our clients have out performed both the U.S. stock market, and a blended index comprised of the U.S. and international stock markets, and the U.S. bond market. Helping make this possible has been the use of closed end funds and several investment opportunities outside the normal channels. Stay tuned and expect periodic updates as time goes on. In fact, we suspect there will be a nasty period sometime in the not-too-distant future, although predicting that kind of thing is impossible. What our investors can depend on is that we will monitor the markets, look for opportunities that seem to have limited risk, and make adjustments as appropriate. NEW TAX LAW Changes in tax rules can create difficulty for both tax payers and financial planners alike. Normally, the most we can do is help clients make plans based on the current tax code. If the rules change, we need to go back to the drawing board. On May 17, 2006, President Bush signed into law the "Tax Increase Prevention and Reconciliation Act of 2005." It includes a number of benign and/or uninteresting modifications. In addition, it extends the favorable Long Term Capital Gain treatment on investments held more than one year. This is a provision that the Congress votes on every couple of years, and, while it is easy to assume Congress will continue to extend the code because it has done so for a number of years, it is never guaranteed. This time it was extended until 2010 (although Congress has been known to amend such a provision prior to the stated end date). Taxpayers with lower incomes will pay 5% until 2007 and zero in 2008. (The zero rate will be a new benefit for low income people, but very few low income people have investments, so don't have capital gains.) For most of our clients, the long term capital gain rate will continue to be 15%. The Alternative Minimum Tax (AMT) was originally designed so that despite special provisions in the tax code that allowed certain high income earners to pay little or no tax, everyone with significant income would pay a certain amount of income tax. As widely reported in the news media, the problem was that the tax grid was not indexed for inflation. As a result many people now pay more income tax because they increasingly fall under the AMT rules. The new law did make a couple of modest changes affecting AMT. It extended for one-year tax credit provisions that were set to expire. Thus families that have received tax credits will continue to receive them even if they pay AMT. In addition, the law lifts the exemption levels for 2006 to account for inflation for one year. Those who file jointly and make no more than $62,550 (the limit is $42,500 for those who file as single individuals) will not be subject to AMT. Perhaps the biggest surprise is seen in taxation of "passive income" for minors. Here the change is anything but modest. Children who have investments (passive income) have always been taxed at their parents' rate until they reach the age of 14. The new law raises the age to 18, retroactive to January, 2006. For those affected, this is a huge change and will undoubtedly seem unfair because the government has modified the rules in the middle of the game. Those who have children/grandchildren in or near the 14 -17 age bracket and have been making plans on the basis of the previous tax code plans will now need to re-evaluate. eWhat? Interested in reducing the amount of paperwork you receive from Schwab? Sign up for one or all of the following features that are available via e-mail:
Most clients have been contacted about receiving Schwab documents and information electronically. However, if we missed you, or you have misplaced what we sent you, let us provide another invitation with this article. Not only will you have significantly less paper cluttering your mailbox if you sign up for Schwab eStatements and eConfirms, but you will also receive the added benefit of reduced transaction costs on all equity trades where there is such a fee. The reductions apply primarily to the purchase and sale of closed end funds, where the fee for trades of up to 1,000 shares is reduced from $19.95 to $12.95. Clients with accounts totaling over $1 million already receive a reduced fee, but by signing up for delivery by e-mail, they will have still less paper to deal with and should normally get documents (particularly monthly statements) at an earlier date. In order to enroll in eDelivery, you must activate your Schwab Alliance account at www.schwaballiance.com. If you need assistance in enrolling, please call Judy at the office or email her at info@ottoandassociates.com. DO GOOD AND DO WELL As you know, we at Otto & Associates spend time evaluating mutual funds to make sure that they are performing well and to find new funds that we think will be beneficial for our clients. When it makes sense, we are happy to help clients invest in socially responsible funds. Unfortunately, a number of these funds haven't performed well. Also, there aren't satisfactory social funds for every category in which we invest. Still, we're always on the lookout for more options. A few excellent socially responsible funds that we have been using for some time include those with a broad social mandate: they don't invest in stocks of tobacco, weapons, liquor, or gambling companies. These funds may also promote shareholder activism and community investing, as well as contribute to various charitable causes. In addition, there are social funds that screen out companies with poor labor or environmental records, and there are funds that have a narrower mandate, investing in companies that promote religious, feminist, political, or environmental agendas. One such fund is Ariel, which doesn't advertise that it is both a minority owned and socially responsible fund. Instead, it promotes itself to be a small company stock fund that invests in undervalued companies for the long term. The fund company's motto is "Slow and steady wins the race," and their logo includes a tortoise. You may have seen their ads on TV or in magazines. This fund is a good fit with some of the other U.S. stock funds that we use, and we like the value orientation in addition to its being a fund that is socially aware. Its performance has been very strong. Since it began operations 20 years ago, it has returned just under 14% per year. Sometimes it is possible to do good AND to do well. We have also used Pax World Balanced fund successfully for quite awhile, particularly in smaller accounts where it often makes sense to use a balanced fund that invests in both stocks and bonds. It has been around since 1971 and its 20 year return is 10% per year. We are in the process of evaluating a couple of new funds that we may add for some client accounts, one with a broad social mandate and another that invests in companies that have made a commitment to environmental sustainability. If socially responsible investing is of interest to you, please let us know, and we will make certain you have one or more such funds. ANNUITIES Have you heard what a bad deal annuities are? Over the years the public has become increasingly aware that the added expenses of an annuity more than wipe out any tax advantage the average investor would gain by buying it. The saying that used to apply to life insurance was even more true in the purchase of annuities: annuities are sold, not bought. But before we go further, we need to make a distinction in the uses of the word "annuity." It is the purchase of an annuity product that is the potential problem. Annuity as a payout option is a choice many retirement plans offer, and that is a whole other story. That choice is sometimes a very good one for those in retirement who want to receive a monthly check for living expenses. This article addresses only the issue of annuities which are purchased. While there is some hyperbole in the first paragraph, the warning applies to many people. Yet now there are some annuities that have very low expenses and are attractive for a limited number of investors. For those who are employed, the first place to put investment money should be a retirement plan. In fact, retirement plans should be funded to their maximum before annuities are ever considered. But when retirement plans are fully funded, annuities might become a viable option. (Employees should be aware that some company retirement plans have options that include purchasing an annuity. We have yet to see an annuity in a company retirement plan that is good for the employee.) The tax advantage for using annuities as a retirement savings vehicle (after all tax deductible retirement options have been fully funded) is quite straightforward. Money on which taxes have been paid can be placed in annuities and any gain is tax deferred. Taxes are not due until money is withdrawn from the annuity, and then taxes are paid on only the gain. The withdrawal rules for annuities are generally the same as for retirement plans; money must be withdrawn starting when an investor is 70˝. While the tax rate of older people is often assumed to decline from what it was during income earning years, resulting in lower taxes on annuity payments, another down side with annuities is that all gain is taxed at the higher ordinary income tax rates. That is, no gain qualifies for long term capital gains treatment, even though many of the gains are, in fact, long term. A primary reason for including this article is that we sometimes find that clients have been sold an annuity but didn't realize the consequences at the time. For those who have high expense annuities, there is an option: they can be exchanged. An annuity offered by one company can be exchanged for an annuity offered by another company with no tax consequences. In recent years, we at Otto & Associates have helped clients exchange a number of these annuities, where one annuity can simply roll into another in the same way that one IRA or 401(k) can be rolled into another IRA. The annuity companies that we use more frequently have Vanguard funds available, and these are competitive products. If you are a client of O&A and wish to discuss this matter, feel free to give us a call. BUDDHIST ECONOMICS Deborah recently passed on to me an article that approaches one of the key financial planning issues from a different perspective. While the title "Buddhist Economics" is intriguing, Buddhist principles provide only a starting point for an article that goes on to convey some very useful financial planning solutions to the problem of not having sufficient money. The author, Jim Grote, quotes a number of people, some of whom are clearly not Buddhists. One book that is referred to is Your Money or Your Life: Transforming Your Relationship With Money and Achieving Financial Independence, by Joe Dominquez and Vicki Robin, where the authors offer what they call a "financial triad," three basic solutions to insufficient money: 1) increase your resources, 2) decrease your desires, and/or 3) find meaningful work that is desirable in itself and increases resources. One issue that is discussed focuses on limiting spending, or "decreasing your desires," to use the nomenclature of the article. The author quotes a professor of finance who addresses the economic principle of "opportunity cost" in an intriguing way.* "There is a huge difference between what you pay for an item and what it actually costs you. If I buy a $25 tie, my opportunity cost in future retirement assets is only $200 because I'm close to retirement. But if my son buys that tie, it costs him almost $2,000 in future retirement assets that he would have had if he had invested that $25. If people knew what they were spending in lost financial security, they would be aghast." A second focus of the article is the question, Why do I work? "The supply solution of conventional economics encourages [people] to work at those jobs that pay the most." Grote suggests another solution: find a meaningful job. He makes his point with a somewhat rhetorical question: "Is it more efficient to spend 30 years at a highly paid job you hate or tolerate (in order to retire early) [or]… spend 50 years at a less remunerative job you love (and you don't care if you retire)? This question shows that there are no value-free solutions in the real world of financial planning. Either choice has its potential downside. The current obsession with retirement is based on the assumption that rich is good because work is bad. But a good job adds a lot of value to life. And if work is good, rich is not so important." Grote concludes: "To reach their financial goals, [people] need to diversify their attitudes about money and financial security. The financial triad points out many roads to overcoming economic scarcity. While [it is easy to emphasize the need to] increase investment return, it may be that the frugal [person] is king." *If the reader does not understand the economic concept of "opportunity cost", an explanation follows. Opportunity cost is the cost of something in terms of an opportunity foregone. For example, if a city decides to build a hospital on vacant land that it owns, the opportunity cost is some other thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt. HOUSING PRICES Many people seem interested these days in the housing market. Are we about to see the popping of the housing bubble? Will prices continue to go up, but at a slower rate? So much of the information we get is anecdotal. "They can't build houses fast enough in Boise, ID." "Sales of middle to upper middle priced homes in Katonah have dried up." "We sold our house last month for a very good price." Because a house is by far the most expensive item most of us will ever own, and virtually every house is different from the one next door, it is hard to gain perspective on housing costs, except in retrospect when one can see large trends. However, the mutual fund company that buys more mortgages and other fixed income instruments than any other company has recently provided a helpful overview of our current situation. Because PIMCO has $200 billion invested in mortgage-backed and other asset-backed investments, they have an entire department devoted to housing. They are not in the housing market, but they need to understand it if they are going to buy packages of mortgages. As part of their research they recently sent real estate professionals to 20 cities to do "ride-alongs," i.e. accompany real estate agents with potential buyers as they look at properties to buy. (We have an extensive article in the office that we would be happy to share.) PIMCO also examined 200 years of housing bubbles. They found some good (and more recent) examples in the U.S. where housing bubbles burst: California in 1990 and Texas in 1980. However, these were aberrations because "typically…[housing] bubbles don't end with a bang. They end with a whimper." The article also conveys historical evidence that when there is a significant increase in the price of houses (a bubble), the increase is not normally followed by a precipitous drop in prices (a bust), but rather by a period of modest decline and/or an extended period where prices are flat and homes stay on the market longer. The exception is when there is high unemployment. While there are no signs that unemployment in the U.S. is about to go up significantly, that is the one thing that could trigger a major decline in housing prices. It was unemployment of 35% that brought about the declines in California and Texas, referred to above. For any readers who are trying to sell their homes, the following quote may be reassuring. "We asked the question 'How much can price increases change over periods, barring something crazy?' There are just not that many slowdown periods where you can go from 12% [annual increase] to zero, or 12% to minus 12%. You need epic unemployment to make that happen. There are some natural boundaries that seem to exist on how fast things can decelerate - if history is any guide." A "buyer's market" is not the time you want to be a seller. However, if PIMCO is correct, what sellers need to do now is to 1) resist panicking, and 2) lower expectations modestly while being prepared to have their house on the market for a longer period of time. OFFICE MATTERS It has been a busy spring for the staff of O&A. Judy and her family joined 30,000 other cyclists in the 42 mile, Five Boro Bike Tour in May. More recently she and her husband planned a trip to Washington, D.C., when they also expected to retrieve Kevin, their youngest, from his first year at the University of Virginia. Unfortunately the days of rain scuttled the Washington part of the trip. And on June 17, Deborah and her family will celebrate the Bar Mitzvah of son Harry. This is the third and final Bar/Bat Mitzvah the family has celebrated in the past four years. David was the proud papa at the photomontage exhibit of Marianne Brandt that opened on June 8 at the International Center for Photography in New York City. This exhibit, which was reported on more extensively in the last Newsletter, was curated by his daughter Libby. In July David will participate in the 25th Annual Prouty Century Bike Ride. The goal of the ride is to raise $1,000,000 for cancer research. The route goes throughout the Upper Valley of VT and NH and includes more hills than a rider wants to think about. To learn more about the The Prouty, go to www.theprouty.org, then go to "Sponsor Participant" and type in "David Otto." To see a cute picture, go to top center and click on "My Team Page." Our summer schedule has yet to be finalized but someone will be in the office virtually every day. If that is not the case, one of us will be picking up telephone messages. O&A is completing its 15th year of business and we are discussing ways in which we might celebrate that event with our clients, probably in September. We will keep you posted. |