March 2009 INTRODUCTION Because of positive client response to our November Newsletter and the view that it was helpful to people in putting their investment portfolio in perspective, we have decided to put out this Newsletter earlier than usual. The uncertain times continue. The first two articles, one on the stock market and one on the U.S. Treasury bond market, are attempts to put current happenings in perspective. Though others will differ, it is our view that we are much closer to the bottom of the stock market than the top. A couple of commentators have even suggested that we have already seen the bottom, but no one can know for sure. In any case, we are likely in for some additional periods of volatility, at a minimum. Those two articles are followed by pieces of a more general nature, including an original David Otto parable. -David W. Otto, Editor STOCK MARKET UPDATE As time goes on, investors are still faced with an extraordinarily difficult market, one that is testing our clients' patience. This article will relate our views about the overall investment environment. Perhaps the biggest question we are asked is whether at Otto & Associates we have fully taken account of the potential economic damage that is increasingly apparent as the government pumps money into failing companies, unemployment rates are on the increase, and stock market prices continue to fall. The short answer to that question is that we believe we have. The powerless feeling of watching the value of your investments decline can create a desire to do something to try to change things. Selling everything and putting the proceeds into a money market may lock in losses, but at least it creates a certainty in the midst of fear. The conflicting forces - to wait it out or take charge - affect all of us at this point. As financial planners, our hope is to be as informed, thoughtful, and as communicative as possible in order to advise our clients well and help them keep world financial events in perspective. In thinking about investments, it is important to differentiate between the economy and the stock market - but that is rarely done in the media these days. Statements such as "We expect the stock market to retreat as the country suffers more job losses" link two things that are related, but different: the economy and the stock market. People often conflate the two concepts and suggest that things like job losses will have a direct effect on the market. The "economy" includes all aspects of the production, distribution and consumption of goods and services. The effect of these things on the market is not necessarily predictable. In recessionary times such as these, the general wisdom is that the market is likely to go up before the economy reverses. I Two exercises give added perspective on the current situation in the stock market. The first is to examine the annual returns of the stock market during the Great Depression of the 1930s. The Depression lurks in the background of many discussions about what lies ahead for us. Perhaps, commentators sometimes argue, there will be years and years of negative returns ahead. The Great Depression lasted more than a decade. The information below is from a book that is updated each year, edited by Ibbotson Associates, called Stocks, Bonds, Bills, and Inflation. What follows are the returns for Large U.S. Company Stocks from the end of 1928 through 1940. (Although the "crash" happened in 1929, stocks in the first three-quarters of that year were up sharply, so the decline was surprisingly undramatic.) 1929 -8% 1930 -25% 1931 -43% 1932 -8% 1933 +54% 1934 -1% 1935 +48% 1936 +34% 1937 -35% 1938 +31% 1939 -0% 1940 -10% What is often overlooked when discussing the Great Depression is that there were several years with very impressive, positive returns. In fact, in examining the above figures, we note that there were three years with losses greater than 25%, but four years with returns in excess of 30%. After accounting for deflation during this period, investments in large company stocks were exactly even: no loss; no gain. And, these twelve years were not as negative as the Great Depression is often portrayed to have been. The new Ibbotson book that was published this month shows that during the most recent twelve years, the return, after inflation, for Large Company Stocks (1997 - 2008) was +1.0%, very close to what happened in the Depression years. Looking back at the time of the Great Depression, we see as largely unfounded worries about the approach of a similar time. One important reason for our perspective is that we have already been through a period almost as long as the Depression with long-term returns very similar to those of the Depression. The Ibbotson book also gives information on longer periods. Those who fear we are in for years of more negative returns should be reassured to know that there are no 20 year periods (since 1926) of negative returns and, with 3 exceptions*, all sixty-four 20 year periods between 1926 and 2008 (i.e. 1926 - 1945, 1927 - 1946, etc.), have returns above 6% annually. There is good news in these statistics. Given that the return for the last 10 years is -1.4%, we will need to have average annual returns in excess of 13% in the next 10 years for the 20 year period to average 6% annually. While you may not hear anyone predicting such a return, Ibbotson research suggests that would be a reasonable projection, based on history. History of course, is not the only way to make predictions. However, the longer the return period, the more likely the future will begin to replicate the past. *The exceptions were for the 20 years beginning in 1928, 1929, and 1930, when returns were 4.7%, 3.0%, and 3.8% annually. II Another important exercise in evaluating the stock market is to look at Price to Earnings (P/E) ratios, sometimes called the earnings multiple. Analysts ultimately determine the worth of a company by the profit it makes - or more accurately, is expected to make in the future. One author who has written about P/E has been particularly clear and easy to understand is David Leonhardt, The New York Times Economics Editor, who also writes a weekly column. Readers might want to look at some of his articles. One piece on the topic of P/E ratios was published on March 2 and entitled "Stocks Finally Start Looking Affordable." Right now the P/E ratio shows that Earnings are relatively high compared to Prices (which creates a low P/E.) While the P/E ratio is not at historic lows, which suggests that stocks could go lower, Leonhardt's research concludes that anyone who invests in the stock market at this point is likely to have at least an average (10%) annual return in the next five years. We have a high level of confidence in Leonhardt's findings, and they are in line with what a number of other investors and writers are saying. In fact, we expect that the strategies that we have used in the past (e.g. buying Closed End Funds at a discount, and owning mutual funds headed by managers who excel when the market is in recovery mode) will help us to modestly outperform the markets. III While the market will eventually turn around, we do not know what will happen in the short term. People throughout the U.S. continue to persist in taking money out of the stock market (the latest figures show that money market funds now hold almost 60% as much cash as the entire value of the stock market; the normal percentage is around 20%), and when investors take money out of the market, the market inevitably goes down. Auctions (including the NY Stock Exchange) thrive on buyers, particularly enthusiastic buyers. Auctions with more sellers than buyers, and cautious buyers at that, result in depressed prices. With trillions of dollars on the sidelines, the market can go up very quickly when a small percentage of investors decide to move from money markets to equities. In seven trading days in March (3/10 - 3/18), the market gained 17%. That is not to make any predictions, and it is also true that the market had lost 24% during the previous 10 weeks (12/31/08 - 3/09/09). But it is to note that the market can jump up with investors hardly noticing. If you are uneasy with your mutual fund investments, we urge you to discuss your concerns with us. As always, we greatly value the trust and confidence you place in us to manage your investments and oversee your larger financial picture. TOMORROW'S PROBLEM? The previous article discussed the stock market. In this article we turn our attention to the bond market, and particularly to bonds issued by the U.S. Treasury. Recent articles caution against buying Treasury bonds, even though that is one of the few investments that has made money recently. How can that be? Consider the following. Markets are counter-intuitive. When stocks or bond prices soar, one should think about selling. When stock or bond prices fall, one should think about buying. But we are inclined to do just the opposite. Why sell a stock or bond when it is going up? Likewise, we might ask, why buy a stock or bond that has been going down? Sell winners? Buy losers? Yes, maybe. In recent months with the stock market plummeting, investors have rushed to buy U.S. Treasury bonds and have been rewarded for their purchases. If you bought a U.S. government intermediate bond fund six months ago (ending Feb. 28), your return would have been 6.1%. The U.S. stock market during the same time lost 41.4%. And in the past ten years the bond fund returned 5.1% annually, while the U.S. stock market returns have been -1.4%. It would appear obvious what to invest in. Not so fast, says Roger Lowenstein in an article titled "No Safety in Numbers," which appeared in the Magazine Section of the Sunday New York Times on March 22. Lowenstein sees two potential problems. One is inflation. Recently the U.S. Treasuries with the longest duration (our government issues bonds of a duration between 30 days and 30 years) were paying 3%. If someone buys a 30 year bond and inflation is, on average, above 3% in the next 30 years, that person will lose money in real dollars (sometimes called "purchasing power"). Treasuries also have market risk, the chance that the bonds will lose value if they are cashed in before the maturity. If interest rates rise to 6%, for instance, the 30 year Treasury bond bought today for 3% will lose upwards of half its value. Lowenstein explains this phenomenon: "The reason is largely intuitive: if the market rate is 6 percent, nobody would be interested in a 3 percent bond, and its price would fall." With Treasury interest rates near their lows, there are several reasons interest rates are likely to go up, in which case the value of Treasury bonds will go down. So, again, it is wise to be cautious. The recent direction of the stock market will not continue forever, and those who are out of the market could lose out when the market turns. Lowenstein's caution might be stated this way: just as the market will not go down forever, Treasuries will not go up forever. TONE IT DOWN A brief article in a recent edition of the AAII Journal (American Association of Independent Investors), a useful publication for individuals who choose to do their own investing, captured what a lot of us are saying about media coverage of the investment markets. One person wrote: "I urge members of the news media…to step back from the brink in over-hyping investor concerns about the state of the economy and the markets. It is one thing when bad news is digested for investors, …[but it] is entirely another thing when investors are barraged around the clock with what bad news there is and left with the impression that a financial melt-down is nearly upon us. "In reality, the current financial situation is not as dire as current media and on-line reports imply. Investors need to take a breath and make a level-headed assessment of the situation….It would be most helpful if the news media put a damper on what almost seems to be a cheering on of the worst possible outcome." AMEN! IMPORTANT 2009 CHANGES RETIREMENT PLANS The limits on the amount an employee can contribute to a retirement plan have been raised for 2009, nearly across the board. We list below the most common retirement plans: 401(k), 403(b), and 457 Plans Maximum annual contribution $16,500 Additional catch-up for those 50 years old and above $ 5,500 Simple IRAs Employee maximum contribution $11,500 Additional catch up-for those 50 years old and above $ 2,500 If you are covered by any of the above plans, we recommend maximizing contributions if at all possible. It is vital, however, that an employee contribute at least enough to get the full company match. IRA and ROTH IRAs Contributions to a traditional IRA and a Roth IRA have additional limitations: for those workers covered by an employer pension plan, deductions to the traditional IRA are phased out for those who have incomes over a certain amount. The phaseouts begin at $89,000 of modified adjusted gross income for married folks and $55,000 for singles. However, when a married person is not covered by an employer plan but the spouse is covered, the phaseout begins with an income of $166,000. A worker can contribute to a Roth IRA even if they have a company pension plan. Phaseouts apply only when modified adjusted gross income exceeds $166,000 for a married person ($105,000 for singles). As a reminder, a person must have earned income at least equal to the contribution, and contributions can be made up until April 15. The contribution limits for both IRAs have not changed for 2009. The maximum is $5,000, plus an additional $1,000 for those 50 and older. This is a combined maximum; money can be contributed to either IRA, or split between them. In 2010 the rules for the Roth change again, but that is for a future Newsletter. OTHER AREAS The government has suspended for one year the Required Minimum Distribution (RMD) from retirement accounts. Under normal circumstances, everyone over 70½ is required to take out a specific percentage (beginning at about 4% and increasing annually) of the total value of their retirement accounts. Under the Worker, Retiree, and Employer Recovery Act of 2008, that requirement is suspended for 2009. Retirees are well advised not to take money from a retirement account this year unless that is the only money available. The Social Security COLA (cost of living adjustment) was a particularly generous 5.8% this year. This is a large increase considering that the average COLA has been around 3%, and it occurred because there was a spike in inflation (the price of oil contributed a good deal) at the time that the Social Security COLA was calculated. This is very unlikely to be repeated for the 2010 calculation. The Gift Tax Exclusion has increased beginning 2009 from $12,000 to $13,000. Each person can give to up to $13,000 to as many individuals as they want. Over that amount, a Gift and Estate Tax form must be filed, although it is likely no tax will be due. This provides an excellent opportunity for some to pass money on to family and friends to avoid or reduce estate taxes. A PARABLE Once upon a time a train boxcar got loose, coasted down a hill, ran off the tracks, and crashed into a forest. The front of the car split open. The boxcar was loaded with 50,000 good quality drinking glasses with a wholesale value of $100,000 and a retail value of $200,000. Upon inspecting a few of the boxes that fell out of the car, a local retailer found that some of the glasses were not broken. And it was clear that the front of the boxcar sustained more damage than the back of the car. Since the retailer sold drinking glasses, the agent that insured the merchandise approached him about buying the entire contents of the boxcar. The agent would make arrangements for getting rid of the broken glasses. What would be a fair price? Certainly it was not worth $100,000. While it appeared that well under half of the glasses were broken, one could not be sure, and there would be some risk in buying the lot for $50,000. But if the agent would sell the lot for $40,000 or $30,000, the retailer would clearly be well advised to buy it. He could hold out to see if the agent would take less than $50,000. However, holding out would run the risk that someone else could step ahead of the retailer to purchase the glasses. Deciding what to do would not be easy. But it is highly likely that buying from a train wreck would result in a profit higher than the normal 50%. Profits could be closer to 75%. There are certain similarities between this retailer's opportunity and opportunities available in today's market. Questions abound, but it is a good time to make a decision and move ahead. HEALTH CARE REFORM This article on health care is related to financial planning in the long-term sense. The impetus for it was an article that appeared in the Valley News, the daily newspaper of Norwich, VT, and Hanover, NH, featuring Dr. Elliott Fisher, a major figure in the health care reform scene today. For more than two decades researchers and physicians from Dartmouth Hitchcock Medical Center (DHMC) in Hanover, NH, have been studying the cost and effectiveness of health care in our country. Currently their work - called "comparative effectiveness research" - is being used extensively by national policy makers in Washington. As a result of their many years of study, it has become abundantly clear that medical care and medical costs are highly inconsistent throughout our country. The heart of the study demonstrates that Medicare spending varies widely from state to state. At the root of the differences are discretionary decisions by physicians, who are rewarded for providing care even when it is not needed. According to Fisher, the waste "is in the physicians in Miami who see their patients for well-controlled blood pressure tests once a month, when physicians in Oregon are seeing them once a year." Fisher continues, "The waste is in an unnecessary hospitalization where you could have been cared for at home. The waste is in the unnecessary referrals to specialists and all the testing that goes on with that….A lot of the activity in medicine is unnecessary." The article concludes that the additional tests and other forms of care do not necessarily result in a healthier outcome for the patient. In fact, sometimes fewer visits to a physician produce a better outcome. The study at DHMC is on-going and will likely be cited as the health care reform discussion ratchets up in Washington. If you want to know more, this comprehensive, but not overly long, article can be found at: http://www.vnews.com/03222009/5508059.htm. Readers can also find a link to this article on the O&A website by clicking on Newsletter tab and then choosing the March edition. The link is: www.ottoandassociates.com. OFFICE HAPPENINGS From time to time clients ask how information is conveyed between the Katonah office and the Vermont office, and how having two offices is working. The general answer is that things on a daily basis go amazingly smoothly, whether David is in New York or in Vermont. With the tremendous help of computer consultant Mark Kandle (son of Katonah resident George Kandle), who runs Parrot Computers in Manchester, NH, everyone is connected to the same server, which is located and maintained in Katonah. By now, virtually all of our files are stored electronically, which makes access in both locations instantaneous. Added to that, telephone companies in both locations offer unlimited long distance service, another way to keep in close communication. We all work hard with an eye to supporting one another to do the best possible job for clients. With this kind of efficiency and with the addition, over the last couple of years, of two new members of the office staff-Kathy Patton in Katonah and Susan Otto Goodell in Norwich, Otto and Associates is prepared to take on a limited number of new clients. From the early days it has been word of mouth that has contributed most to building the client base of the office, and we trust that will continue to be the case. So, if you know of friends or family in need of financial planning services, we would be happy to talk to them. Referring them to our website, www.ottoandassociates.com, could help introduce us. Many thanks, again, to all of you who have made referrals in the past. Deborah Maher recently volunteered with other members of the Financial Planning Associates (FPA) at a financial literacy program sponsored by Girls Inc., for teenage girls and their mothers. The title for the day was "A Man is Not a Financial Plan." The Journal News, the local Westchester newspaper, covered the event with an interesting article that can be found at www.lohud.com/apps/pbcs.dll/article?AID=2009903220336. In April, Deborah will attend the Annual Spring Forum given by the FPA. Ben Stein, a writer, economist, and television personality, will receive an award for advancing financial understanding, and there will be seminars on a wide variety of financial planning and economic topics. David and Susan will be attending the National NAPFA Conference (this is the Fee-Only financial planning organization) in Alexandria, VA, in early June. Among the speakers is Bob Woodward from The Washington Post, who won a Pulitzer Prize in 1973 for his work on the Watergate scandal.