Posted by Don Martin on Thu, Jun 30, 2011 @ 12:44 PM
Tech Bubble Understood Best by the Story of MySpace
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MySpace went from zero in 2003 to $580 million sales price in 2007 (at a P.E. of 150), then four years later it was sold yesterday for $35 million. This is typical of Silicon Valley where a company often has a few glorious years and then quickly fades to obscurity. This is why Buffett won’t buy Tech stocks because buyers overpay for them so that an investment in them is not available at a fair price. The risk-adjusted value of tech stocks is quite low because of the risk of sudden obsolescence. Buffett said that in a 100 years airline stocks as group have broken even. This is an example of investors overpaying for an investment in a glamorous industry.
The current IPO Tech bubble is focused on Social Media stocks none of which can verify a reasonable, robust earnings history, and also they have ultra-high P.E. ratios. They definitely they can’t offer a corporate moat against competition. While there is a chance that Facebook could make money from selling targeted ads to its members there is no guarantee that the members would stay with Facebook if they burned out due to being bombarded with ads.
Vast sums lost in Tech crash of 2000
So except for the unverified hope that Facebook might have a good business plan, the rest of the Social Media bubble reminds me of the 2000 dotcom bubble where lofty valuations were based on theories that instead of using earnings to value a stock they would value it based on “sticky eyeballs”! (“Eyeballs” refers to the number of website viewers). What happened to those eyeballs? They quickly lost interest, especially when asked to pay for something.
I wrote a post “Tech IPO bubble affects real estate” and “Inflation protected investments overpaying for insurance” which is similar to the idea of overpaying for Tech stocks.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 30, 2011 @ 10:51 AM
Mortgage Loans to Relatives Have Hidden Risks
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My opinion about family mortgages (where the parent loans money to his children) is that the borrower may seek one because he is not qualified to borrow from a bank. This means the family is taking too much risk to lend to someone who can’t get bank approval. If someone can’t get bank approval then they should not get a loan from relatives. The bank is the expert on judging who is an excessively risky borrower. Let them decide if the prospective borrower is qualified; if they are not qualified then you certainly don’t want to be a lender, especially with your retirement nest egg. Also the borrower may be tempted with “moral hazard” to think that he will be able to default with no risk of damaging his credit rating or that he can beg the family for additional larger amounts of loans.
News stories have been written by others claiming that a way to help parents afford retirement is for them to create mortgage loan with their children as borrowers. However, if this is more than 2 to 5% of the parents' assets that is risky because it is an undiversified investment. The parents should not be gambling with their retirement nest egg. They can earn a similar return investing a mutual fund that invests in bonds.
Lending to a relative means that the mortgage Note is an illiquid asset that can’t be sold at a reasonable price. This makes it harder to construct a balanced, well diversified investment portfolio. It is risky because during a stock market crash one should sell bonds and cash in CD’s, and then use the proceeds to buy stocks at a discounted price.
If you lend someone money then for tax purposes it would be best to hold the mortgage Note in an IRA or other tax deferred retirement account. However, that is not allowed if it is a loan to a close relative. Further, a private loan is so risky that it is almost like equity, so that implies it would better to hold it in a taxable account. If the Note goes into foreclosure you will need to spend cash to hire an attorney, etc. and you can’t spend cash from a taxable account to fix a problem inside of a tax free or tax deferred retirement account.
Keep the family vault closed!
Reverse Mortgages are bad from a Financial Planner’s Perspective
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Reverse mortgages are often suggested by planners when a retired person is over-consuming resources and all they have left is a house and a pension. Instead of getting a reverse mortgage the consumer should be encouraged to cut his standard of living by selling the home and buying a less expensive home or simply own no real estate and be a tenant. The other problem with reverse mortgages is that the income tax’s interest deduction is only allowed when interest is paid (which would be in a lump sum when the loan is paid off), thus the deduction will be taken when the home is sold, which may be when the borrower has died and is in a low tax bracket, plus the present value of the deduction is reduced by the long delay in taking the deduction. However, the lender has to report accrued interest income each year, so this would be bad for a family lender because they have to pay tax at a high tax bracket on phantom income while the borrower in a low tax bracket gets a deduction after he dies. Clearly the tax consequences are a bad asymmetric relationship.
Of course in rare situations someone may owe capital gains tax on their residence even with the $500,000 exclusion, so before taking any action people should consult with a financial planner to see if the tax consequences of selling a home would be worse than the savings realized by living in a smaller home.
The tax code will probably change and the tax-free exclusion of gain from sale of a residence will probably be significantly reduced.
I wrote a post “Real estate valuations may be wrong” and “Why real estate forecasts are wrong”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 29, 2011 @ 01:23 PM
Real Estate Valuation is Very Different From Stocks
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When a recession occurs several events occur that camouflage or retard bearish market data, and it takes an extra 18-36 months for the truth to come out. Thus the true state of the housing market during a recession is probably worse than the statistics.
- During recession the few people who buy are able to cherry-pick the best homes that have been over-improved. These homes may have the same square feet and bedrooms and bathroom as their competitors, but they have better overall quality which is hard to compile in a data base. These homes should sell for more than homes with the same size, but if only quality homes are being sold then their sales give the appearance values have not dropped. The people trying to sell tacky homes will simply refuse to cut the price and then they give up and take them off the market, thus creating a situation where the only trades occurring are higher than they should be in a recession.
- Some sellers will entice a buyer by offering cash-back rebates which inflate the value. For example a seller could offer $100,000 cash back on a $300,000 value home if it sells for $400,000, thus enabling the buyer to get a loan that is greater than 100% of the value of the home. This would result in a $400,000 sales price being registered in various databases, giving the appearance that all is well in the market. This act would not be legal, because it is required to be disclosed to the bank, which would not accept such a contract.
- A tract developer may report false sales prices in a tract sale in hopes that future buyers would be willing to buy at the old price, instead of a new, lower value. This is illegal and would result in a suit against the seller.
- Real estate salespersons, when seeking a listing for a property, may find the only way to recruit a client is to “list high” (offer it for sale at a high price) and then hope the home will somehow get sold. It may take the seller a long time before he switches to a brutally honest real estate salesperson who tells the seller to ruthlessly cut the price very deeply to sell it. The code of ethics of real estate agents does not allow properties to be listed at artificially high asking prices, but unfortunately a rogue agent might ignore that.
- Data in appraisals is not as good as it should be. For example, appraisers do not evaluate the influence that a good school district has on values, so during a recession perhaps only homes in a good school district will sell thus creating an average price that is higher than the previous year’s average price!
Vast sums of money were wasted in real estate
The only fair way to track real estate would be to have an index that specified the type of homes that could be compared as a result of a sale. For example the home would need to be specified as having 3 bedrooms, 2 baths, 1,500 to 1,700 square feet, a certain age, in a certain school district in a certain city, a single family house, not a condo or Townhome. Even then there would need to be manual adjustments for over-improved or recently remodeled homes versus properties with deferred maintenance. I have seen some housing reports that did not even bother to differentiate between condos versus detached houses.
Stocks are often evaluated using cash flow analysis. By contrast homes are evaluated using three recent “comparable sales”, which is risky because the recent purchases during a bubble could have been based on emotion instead of on cash flow analysis. Appraisals of owners occupied homes are supposed to examine replacement cost and cash flow analysis but if the home is to be owner occupied then cash flow analysis is deemed not applicable and is not used. Yet that would have been the best way to fairly evaluate real estate, since rents are more stable than bubble era asset prices. But published reports about the broad housing market do not use the detail that an appraiser uses to manually adjust for defects or over-improvements or for square feet or age or number of bedrooms, etc. Thus real estate market reports are subject to the potential for drastically skewed data even if the report’s author is very honest.
I wrote a post “Why real estate forecasts are wrong” and “Bearish news items suggest caution”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 28, 2011 @ 02:30 PM
Many people's 401K's have suffered from a decade of bubbles and crashes, so investors need to be prepared to maxmize their opportunities and avoid mistakes. Investors need an independent 401K rollover advisor who is a fee only fiduciary.
Don't let opportunities fly away from you
I have written other blog posts about 401K's "Buying a business with a 401K" and "Are your funds trapped in a 401K?".
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 28, 2011 @ 09:08 AM
Mortgage approval is the key to real estate prices
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Real estate values for one to four unit residences are a function of the ability to get a loan, which in turn is a function primarily of mortgage underwriting. (Low and declining rates help somewhat to facilitate the ability to buy a property but do not help enough).
Many investment experts are quoted in the news as saying that the ratio of house prices to income is the lowest since either 1975 or even 1965. However this assumes that personal income is:
- Evenly distributed between all consumers (your pay is, on average, the same as Warren Buffet’s).
- Is all a guaranteed, stable, salaried “base pay” instead of irregular overtime pay, or income from self-employment.
- Based on the assumption is that the crash of 2009 somehow did not affect the two year average of income used to underwrite loans for self-employed people.
Examine the details to find the secret
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The qualitative nature of nation’s personal income has changed a lot since the 1970’s. Back then there were a lot fewer self-employed and commissioned people. A lesser amount of the work force were employed as temporary workers in previous decades.
During the last several decades the qualitative nature changed in manner that is analogous to a stock market breadth indicator. During a market top a few prestigious companies continue to make new highs pushing the broad marker average slightly higher while the vast majority of stocks languish and fail to make new highs. The job market in the past decade consisted of the top 10% of the population getting good pay raises while the bottom 90% had stagnant wage growth. People may now hold two jobs or may have their income from a series of temp jobs with big employment gaps, or they may be an independent contractor or a small business owner. This type of income is riskier than an old-fashioned salaried job with a few years of seniority. This change was the price to pay to make America’s labor force globally competitive. But adjusted for the quality of income (a risk adjusted measure of income) the nation’s personal income has declined. Mortgage lenders evaluate loans according to this. It is more important than credit rating or having a large down payment, although that does not excuse bad credit or lack of a reasonable down payment.
Another analogy would be that today’s irregular workers (temp’s, independent contractors, etc.) are like Small Cap companies and their former salaried job was like a Large Cap company. During recessions Small Cap companies may be hurt by competition from Large Cap companies; it is during boom times that Small Caps get their best income because the Large Caps can’t fulfill orders fast enough. Until another boom comes along then the independent contractors will have aharder time buying a home.
Unlock the secret combination
Diagnosis foiled by smokescreen
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This income problem was camouflaged by the use of “Easy Qualifier” no income documentation loans which were offered from 1984 until 2009. It was also camouflaged by the stock speculation of the 1990’s and the real estate speculation of the 1997-2008 bubble. Since Easy Qualifiers are now illegal and people’s incomes are much shakier than that of a generation ago that means that one can’t compare simple metrics of income to house prices over the past several decades. I wrote "80% of loans were not safe" and "Housing not comparable to the past" about this matter.
The best comparison would be that of the post Great Depression mentality of consumers who for 20 or 30 years after the Depression would resist taking on excessive debt. It took 28 years for stocks to return to their 1929 highs in “real” terms. By analogy real estate should take that long also.
This misunderstanding by Wall Street about real estate finance reminds me of Bernanke, when asked during the real estate bubble about high house prices, responded by saying that high prices were symptom of a prosperous society that could afford to pay more for houses. Instead he should have seen through the smokescreen and realized that people were actually speculating in real estate in an attempt to earn more income becuase some of them may not have had enough income and not because they could afford more real estate.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jun 27, 2011 @ 11:09 AM
Prepayment decision must be custom tailored to each client’s needs
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A mortgage prepayment is usually a good idea which I often recommend. My forecast is for the stock and bond markets to produce a low rate of return for the next several years so one may be able to get a better return by paying down their mortgage. If the SP returned about 2 or 3% annually in the past decade and bonds are now paying about 3 to 4% then a mortgage pay down is attractive. The recommendation needs to be tailored to each client’s needs. So if a client is self-employed or financially shaky they may need to have a lot of liquid assets and thus it would be wrong to use up liquidity to pay down a mortgage. It is hard to get a cash-out refinance so if you pay down your mortgage and then later need cash you may not be able to get hold of funds that were used to prepay the mortgage principal.
The amount of cash-out refinancing you may get
Another caution is that if a mortgage becomes small by the standards of lenders then it may be harder to get good economies of scale when later shopping for a refinance. For example a lender may be unwilling to work for a 1% fee on a $50,000 mortgage but would be willing to do so at $300,000. So if the decision is made to prepay a huge amount of principal it may be better to pay off the whole thing rather than have a small mortgage.
The most important criterion is to be sure the client will have plenty of liquidity after paying down the mortgage. The current era is a “credit crunch” era where people could find that they can’t get loans at precisely the time they needed funds the most. This includes the risk that lines of credit and credit cards could be cut off by a bank even if the client was in good shape financially and not in violation of any loan covenants. I wrote “Housing not comparable to the past” and "80% of loans were not safe” warning about the problem with attempting to get mortgage loan approval.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 24, 2011 @ 11:22 AM
Wrong prescription about inflation
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Rob Arnott, a prominent mutual fund manager, was interviewed in marketwatch.com on 6-23-2011 and he said that investors should prepare for inflation by avoiding a traditional 60/40% stock/bond portfolio and instead investing in things that he feels will protect from inflation. He advocates buying TIP’s, commodities, Emerging Markets bonds (though he did not say if they should be denominated in local EM currency or dollar denominated, which is a critical missing piece of information), domestic high yield (junk bonds).
My opinion is that, except for EM bonds denominated in EM currency, that these inflation hedges could backfire and perform worse during a period of rising inflation. My opinion is that a long term Japan-style soft deflation will be the dominant theme for the next several years. I wrote a post “Inflation creation machine is broken". I wrote "Contrary view of inflation hysteria". However, it is very important to plan ahead for inflation in case it occurs.
If inflation occurs then the best analogy would be that of the 1970’s. The 1970’s were one of the few times when inflation occurred that was not directly related to a major war. Even that observation should be modified by the cot of the Vietnam War and Cold War. So what can we learn from the 1970’s?
Is this the reward for investing in inflation?
- TIP’s, which did not exist until 1996 would have performed well in the 1970’s but then in October 6, 1979 when Paul Volcker’s Fed raised the “real” interest rates TIP’s would have gone down in value because TIP’s real rates remain the same. Since their real rate would be lower than the new real rate then TIPs would have declined in value. An article in WSJ cited a study that TIPs might decline 22% in that scenario. In addition Congress could pass a punitive windfall profits tax on TIP’s owners during a time of runaway inflation. By contrast, during the 1970’s the best investment to protect from inflation was the two year Treasury Note. The risk of inflation was modest since it was repaid in two years. As inflation increased, so did the interest rate, so every two years an investor could rollover the Note into a new higher yielding one.
- Commodities did well in the 1970’s. However in those days fewer people were futures contract speculators so the Backwardation and Contango phenomenon caused a “yield roll” to be earned by bullish speculators. Now the situation has reversed with a huge surplus of speculators compared to physical producers, so the producers earn a negative yield roll from the speculators. That means that there is an opportunity cost to be “long” in a futures contract. Further there is serious risk that China is going to cool off and when it does a huge correction will occur in the highly leveraged and volatile commodities markets. Since commodities have no cash flow they are harder to predict and thus more subject to emotional speculative bubbles, thus subjecting them to deeper crashes when investors run for the fire exit. Thus the risk adjusted return of commodities is inherently lwoer due to its difficulties in being analyzed. So if the risk of inflation is low but the risk of a crash in commodities is high the the risk-reward ratio is a “set-up to failure” regarding commodities investing. I wrote a post ”Copper bubble explained” about how commodity speculation regarding China has affected the world market prices.
- EM bonds sound fine to me but only they are if investment grade credit quality (based on a mutual fund’s average holdings) and denominated in local currency, which the article failed to specify. I think the article implied by omission that Arnott is indifferent to currency denomination.
- High yield “junk” bonds. I disagree with Arnott’s theory that inflation will bail out poor credit quality bond issuers. Inflation makes us all poorer so we would buy less from corporations, thus corporations will earn less in “real” terms and become weaker financially. Weaker companies (those who issued junk bonds) during an inflationary depression could simply collapse and file bankruptcy. Bonds are a work tool to be used to hold investment grade assets that are to be a haven from the risk of equities; using a bond allocation to hold junk bonds is a way of investing in equities disguised as debt which results in taking on too much hidden risk. Since the stock market did poorly in the 1970’s then I would not want to own junk bonds either.
My diagnosis is that problems in the Eurozone, UK and China plus growing fiscal austerity in the U.S. mean that we are headed into a worldwide slowdown, so inflation investing would be overpaying for protection. If you want to “invest in inflation” you need to buy at the right price, not at an overpriced level. Also you need to be sure if buying inflation “insurance” (as a metaphor) that the “insurance company” is solvent enough to pay you, with no hidden traps in the contract. I wrote a post “Inflation protected investments overpaying for insurance”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 23, 2011 @ 10:51 AM
The economy needs negative interest rates
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People ask about things like “will the dollar be devalued?” Or “what investments hedge against devaluation”? To answer these questions one should look at the big picture of the economy and see that there is a need for interest rates to be negative in order to stimulate the economy.
With the risk of an unfundable series of sovereign bond defaults in the Eurozone, and a potential for a crash in China, the whole world is at risk of falling into Japan-style deflation. I wrote a post “Probability of deflation”.
If rates become negative then foreign investors would sell their dollar holdings to invest in countries with higher interest rates and this would make the dollar go down. But that would also help create more export jobs, thus ending the high jobless rate.
There was a study published recently (sorry I can’t find it) that showed that short term rates need to be negative 1.65% for the economy to be in equilibrium and thus return to a normal level of employment and production.
Below zero rates needed
How can interest rates become negative?
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It seems counter-intuitive for interest rates to go below zero. Let’s look at the history of banking to understand why this is possible. In ancient times there were no banks, so people used gold as money and when they wanted to store it they paid a goldsmith to store their gold (a form of money) in his vault. The act of paying a fee to store money is a form of negative interest rates. Leasing rates for gold are often close to zero and when you subtract the cost of storing, shipping, assaying, insuring gold from the lease income then you have a negative number.
U.S. TIPs have short term negative real interest rates. (Although Treasuries are not money, they can be instantly converted to money, subject to a three day settlement). Bu negative rates I am referring to nominal rates.
If the marketplace believes that nothing is safe then the market would be in the same position as ancient times when people had no choice but to pay a fee to someone to store their gold (money) instead of getting interest on a bank deposit.
So the concept of negative interest rates should not bother anyone. It should simply be a practical question of how does the Fed create negative interest rates.
The Fed could buy any Treasury with a maturity of less than three years at a premium price. For example, a two year T-Note could be bought by the Fed at 104, a 4% premium, thus creating a market price that implies the buyer would lose 2% a year from amortization of principal, less the note rate of 40BP = 1.6% annualized negative rate of return.
The FDIC might need to impose a used fee on short term bank deposits (under two years) of 2% per year to be paid by depositors.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 22, 2011 @ 12:03 PM
Beware of the high risks of buying a business inside of a 401k
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You can take money out of your 401k with no penalty at any age to buy a business. This is done by first becoming a business owner, then opening a new 401k with a Custodian who will allow this. (Very few do). Then you roll your IRA to your new 401k. Next the 401k purchases shares of stock in the business that you are trying to buy. You do not get to actually handle the cash from your 401k, instead the Custodian transfers cash from your 401k to the seller of the business.
There is a big potential problem: the tax code does not allow retirement accounts to lend money to the account owner (except for a 60 day IRA temporary withdrawal or a 401k maximum loan of $50,000). So in theory the newly acquired business could not loan it money to the 401k owner not could the 401k owner loan funds from his taxable account to the business. This could create catastrophic cash flow crisis because it may be hard for a small business to qualify for a bank loan and if the business needed cash and the owner was not allowed to loan cash to his own company then the business could fail resulting in a ruined 401k.
So I can’t recommend buying a business with a 401k (that is held inside of a 401k), unless you are simply getting a $50,000 loan from your 401k. If you get a 401k loan be sure the payments, amortized over five years, are affordable.
A similar idea is to buy rental real estate with an IRA. This bad because if the property needed extra cash for improvements or operating expenses, etc. then the owner can’t loan money to the IRA and it may not be possible for an IRA to qualify for a bank loan. Further, both IRA’s and 401k’s are not supposed to borrow money and if they do that triggers unrelated business taxable income (UBTI).
If you decide to pursue this type of investing then it would be important to have a huge surplus of cash left over in the 401k or IRA to pay for emergencies.
Also if you buy a business or rental real estate inside of an IRA or 401k it is urgent to get tax advice from a very experienced CPA or tax attorney. Avoid getting advice from someone who is promoting these things and instead find a tax expert who is somewhat neutral and skeptical about this matter so that he can be objective.
There are serious IRS penalties for making improper investments inside of a tax-deferred or tax-free retirement account. By “improper” that could mean doing something which the IRS deems is loaning money back to the account owner by indirect methods such as having the business buy something from the owner. For example, if an IRA account owned a business and the business bought equipment from the IRA account owner’s personal taxable account that is prohibited and penalties for improper withdrawal and failure to disclose to the IRS would apply. Then, the IRS would deem that to be a taxable withdrawal with early withdrawal penalties and penalties for making tax errors.
Too much at risk to own a business in a 401k
Another tax problem: what if the 401k sells the business or a rental property at a profit? Then the long term gain would be treated as ordinary income, not the lower long term capital gains rate. If an asset is owned outside of a retirement account and it appreciates, and is never sold until the owner dies, then the basis is stepped-up and thus its sale would be free of capital gains tax. By contrast, the 401k when disbursed to the owner pays out only ordinary income and has no basis step-up at death.
Basically it is not a good idea to put your retirement account at risk with the purchase of a small business inside of the retirement account. Small businesses are much riskier than publically traded companies and small cap publically traded companies are riskier than large Fortune 500 firms. Further, it is important to diversify. The purchase of a business in a 401K would probably use up all of the funds in the 401k resulting in a dangerously undiversified account with a concentrated investment in a ultramicrocap stock. 80% of small businesses fail; even franchises have a high failure rate, so please don’t buy a business with your IRA or 401k retirement account.
I have written "Are your funds trapped in a 401?" and "401k contributions are nto always a good thing".
Investors should seek independent financial advice. In this case get an independent viewpoint from whoever is advocating an exotic strategy.
Posted by Don Martin on Tue, Jun 21, 2011 @ 11:51 AM
What should you do if you need more retirement income from your portfolio?
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People often ask about income investing. My contrarian opinion is that sometimes it is better to meekly accept a low yield from a low risk high quality bond mutual fund rather than chase after high yielding junk bond types of investments. If someone needs more cash flow than a low yield allows then they will simply have to sell off and spend down a sliver of principal each year until the economy returns to normal and rates go up and default risk (hopefully) goes down.
Senior citizen’s first priority is to avoid excessive risk so that means avoid things that are similar to junk bonds. Buying high yielding stocks is risky because the stock could be going through the “value trap” and its price could drop drastically with a permanent loss of principal. The only reasonable choices are bond funds paying no more than 5% but they need to be diversified with more conservative funds paying 2.9%.
Life is unfair. Currently retirees are having their savings drafted into Bernanke’s army and paid less than the "minimum wage", (just as soldiers can be drafted out of a good paying civilian job and then paid a nominal salary in the Army) which is my analogy about the Fed’s actions to push rates down to absurdly low levels.
A bond expert said in a speech that junk bonds actually produce a total return that is lower than “A” paper bonds because of losses to principal from defaults.
I am shocked at the opinion offered by many advisors that since some stocks yield over 3% then they say “why not buy stocks instead of bonds because they yield more than bonds”. The problem is that stocks are overpriced and could easily drop 30% or even 50%, while bonds (though they have inflation and currency devaluation risk) are far less risky than stocks.
Ridiculously low yields
Avoid these interesting but risky investments
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Some interesting high yield stocks to avoid are some mortgage REITs that yield in the mid-teens. They borrow at the Fed funds rate of under 1% and invest in mortgages yielding 3% and lever up the 2% profit by a factor of 8 thus producing a yield of mid-teens. But this is extremely risky because if interest rates rise then they will have no profit and the mortgages they own will drop in value resulting in losses that will probably be permanent. This would trigger mass panic selling of the stock and the shares would drop significantly in value.
Avoid closed end funds that increase payouts by paying a dividend that includes some of the amortization of principal that comes from a maturing loan portfolio. This type of dividend yield is really part of the shareholder’s principal (which is not the same as earnings). It is misleading and causes investors to accidently, unknowingly spend down part of their principal. If they want to spend down principal it should be part of a clear, explicit plan.
Another misunderstanding that creates the appearance of reliable, recurring income is when a bond mutual fund makes clever trades by buying distressed, defaulted loans at fire sale prices and then selling them off at a profit after the loans improve. Unfortunately, while this is a commendable act by the fund companies, it is a one trick pony because eventually all the loans that can be salvaged and sold at reasonable prices will have been sold and then this source of extra income will end in a few years. Because the income stream has lasted for more than a year and it is income and not cash flow from amortization of principal then this is theoretically income that a retiree could spend but unfortunately it is not sustainable income, instead it is a temporary surge in income due to the cleanup of the mortgage mess. Further those operations incur risk that foreclosures could get worse causing unexpected losses to those mutual funds.
I wrote a post “Bond investing during low rates” and “Berkshire losses 48% on junk bonds”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jun 20, 2011 @ 01:07 PM
“In service” withdrawals and Brokerage Windows
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You could ask your employer to do an “in service” transfer to your IRA. 401k’s with in service transfers are not common. ("In service" means that you are still working at the employer). Usually the Plan Documents do not allow an employee to transfer the funds out of his or her 401k while they are still an employee, so the funds may be trapped in the 401k until the person is no longer an employee of their company. If you are allowed to transfer the funds out of a 401k while still at the employer then be sure to rollover the funds directly into an IRA to avoid tax. If you withdraw the funds with a check payable to yourself then that is a taxable transaction which probably can’t be undone, resulting in a catastrophic tax consequence. Ask the new IRA Custodian how to engineer the transfer and have them pull the funds from your 401k. The IRA Custodian can open a zero balance account before receiving any transfers, to hold the money. That way there will place for the 401k Custodian to send the funds to.
Some employers allow 401K money to be invested in a “brokerage window” where the employee can buy any publicly traded stock or bond or mutual fund, but most employers don’t allow that.
Unlock trapped 401k funds
Exotic strategies for working funds trapped in a 401k
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Suppose you have $100,000 in a 401k that offers poor choices. You could get a loan for $50,000 from it and invest that in a taxable account. The remaining $50,000 in the 401k could be invested in a short term or intermediate term bond fund in the 401k, assuming that there were no good investment chocies in the 401k and assuming that you share my bearish viewpoint that stocks are overpriced and should not be bought.
The best place for bonds is in a retirement account because of the tax deferrals. However, since U.S. Treasuries are free of state income tax (9.3 to 10.3%% in California) then they should be held in a taxable account, since income earned in a retirement account when withdrawn is treated as ordinary income and thus the character of tax-free income is washed out and becomes taxable ordinary income.
Now suppose you have $1,000,000 in a 401k. If you borrow $50,000 from it, how do you invest the remaining $950,000 if the investment choices are very poor? (I wrote a post “Tax traps in 401k’s” warning about tax traps when borrowing from 401k’s, so please don’t borrow from a 401k). One hypothetical solution, which is risky, confusing, and needs to be analyzed with a personalized consultation with a financial planner to see if appropriate for each unique client, would be to invest the $950,000 in a generic short term bond fund in the 401k and then in a taxable account buy the desired investment using leverage that is used to acquire $950,000 of desired assets. For example, in a taxable account one could be a commodity futures contract on the stock market or on foreign currency with only a modest down payment, thus replicating ownership of stocks or foreign currency. The problem is that commodity futures by law are taxed as a blend of short and long term gains and require marking to market and recognizing gains every year. But the big risk is that most investors lack the sophistication and discipline to handle this. For example suppose you buy $950,000 of stock futures with $50,000 down payment and the market crashes 25% in a day. Now you lost $250,000 and have a $200,000 negative equity at the futures brokerage. You are not allowed to get more funds from you 401k so what do you do to meet the margin call? That is simply too risky. Buying Call options is risky since they could expire worthless. However, if someone had $3,000,000 in a taxable account, small or no debt and then he or she could try buying stocks on margin in a taxable account instead of using futures contracts. This means they would own the stocks and mutual funds and would get long term gains treatment if they were successful in investing. This as a way of avoiding the constraints of a 401k that would be somewhat less risky than a futures contract, but still too risky. Basically, to invest, it is best to avoid leverage because leverage can make someone nervous and cause them to panic and sell under pressure during a temporary dip in the market. In addition derivatives such as futures contracts or options do not always properly track the “real” or underlying asset that they are based on and may have some bizarre “tracking error” that causes the derivative to behave differently than the underlying investment that it is based on. The best thing to do if you have “too much” in a 401k is to be grateful that you have it and to consider simply investing in a low cost bond index fund in the 401k and wait until it is time to change jobs when you will be free to roll the funds to an IRA where there is unlimited freedom to invest in publicly traded securities that are traded in the U.S. If you have a million in a 401k perhaps you are a high ranking executive and have some connections at work and can ask the management to approve of a new 401k Plan Document that gives employees freedom to do “in service” withdrawals or freedom to use a Brokerage window. Or perhaps it is time for a job change in which case your trapped 401k funds will be free to migrate to an IRA.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 17, 2011 @ 11:39 AM
Contrarian opinions about 401K’s
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Someone enquired why a friend of theirs who is a 401(k) participant who was auto-enrolled at a 3% contribution rate has stayed at 3% instead of maxing out their contributions.
The stereotype is that everyone should max out their 401k contributions.
Benefits in favor of 401K’s:
* Asset protect from lawsuits, depending on complex rules
* Encourages people to avoid spending their savings
* Encourages people to save for retirement
* Shift income into future years when retired when maybe in a lower tax bracket
Hear the other side of the story:
Reasons against 401k contributions:
* Retirement accounts create problems including double taxation of them at up to 85% for people wealthy enough to have to pay estate tax
* People who want to start a business or buy a home (large down payments may be required in today’s tight lending standards) need access to their funds (although there are some restrictive work-arounds to this that may be available)
* If long term capital gains or U.S. Treasury income (U.S. Treasury interest is free of state income tax) is generated in a tax deferred retirement account they lose their special tax status and when withdrawn from the account they are taxed as ordinary income
* Capital Gains tax is waived by using basis step-up at death for assets in a taxable account but not in a retirement account
You will need a lot for retirement
Of course if someone can get an employer match they should participate to get it. Probably the simplest explanation why someone contributed 3% is that they were too poor to save. For a person who is in a 15% tax bracket the tax savings is not that appealing as simply getting enough current spendable income to buy the basic staples, assuming they are a low income person.
Generally the reasons against a 401k are only applicable to people wealthy enough to pay estate tax. But with inflation and a need to raise taxes it is possible that in a few decades people who are middle class will have the potential to come close to paying estate tax. That would depend on how long they live and what excessive medical costs they encounter, assuming Medicare in the distant future has huge “means testing” fees.
I have written about “Taxes need adjusting for inflation”.
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 16, 2011 @ 03:30 PM
Lehman failure was a huge waterfall event
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Lehman Brothers field for bankruptcy on September 14, 2008. Only a week earlier it looked like a shaky company that would somehow survive. The result of Lehman’s failure was that contagion to spread to other large banks and insurance companies, resulting in the use of TARP funds to bailout the banks.
Today on Bloomberg there was talk that a Greek default could be like a Lehman failure for Europe.
If (or should I say “when”) that happens then major European banks will suffer huge losses on their bond portfolios, making some banks insolvent. One news story in January estimated the damage from of Eurozone defaults would cost $9 Trillion. That is in addition to the government debt that already exists in Europe which is at about 80% of GDP. So then European sovereign debt would double in a bailout to roughly 160% of GDP at which point there would be no way for the economy to escape the gravitational tug of such an excessive amount of debt. This would mean that Europe would be in a Great Depression.
Is this what investors will get for their Greek bonds?
How would a European default affect the world?
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A European default would mean that the world would be stuck in series of rolling bear market rallies that will eventually collapse, like what happened in Japan where for years their economy kept trying to break out of a recession with bear market rallies that eventually failed. Add to that the risk that China has some need to cool off its economy which will hurt commodity exporting countries and then the whole world will be in or close to a Japan style soft depression.
I wrote in January a post “Probability of a Eurozone default”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 16, 2011 @ 09:28 AM
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What is the role of individual financial advisors in selection of mutual funds?
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When an investor buys a mutual fund typically the fund is dedicated to investing in one particular asset class or strategy. Rarely does a fund manager say “even though my fund is the best in asset class “X”, I think the asset class is bad, so please sell your shares in my mutual fund.”
Investors need an independent financial advisor who can recommend types of asset classes to invest in and then drill down and recommend a particular mutual fund that is a good match for the client’s risk tolerance ability and goals. It is not enough to simply pick a good mutual fund; instead an investor needs to be aware of what asset classes are best to invest in and what should be avoided.
Asking the mutual for advice about asset classes is not a good idea because they are not objective. Their goal is to sell you on the idea of using one of their family of mutual funds. The problem is that some mutual fund families lack expertise in certain investment segments. For example many fund families lack a suitable foreign currency denominated bond fund. So if you asked some of the largest fund families about this asset class they would either have to mislead you into accepting a water-down poor quality in-house fund or they could try to sell you on the idea that you should avoid that asset class.
The most important thing in investing to pick the correct asset class. This is hard because the one that is now going up may have reached its top and will reverse course, so often one must be a contrarian and pick an unloved and undiscovered underperforming asset class.
The 2nd most important thing in investing is to avoid excessive risk. Strategies to do this could be to choose funds with lower than average risk characteristics rather than ones with the highest rate of return
Unlock investment secrets
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How can an independent financial advisor save investment costs?
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Of course a mutual fund family may also try to sell you a fund that is expensive when a less expensive one can be found at a competitor. For example many mutual funds have different share classes such as “A” shares and “I” (institutional class) shares. The A shares often have a load fee of 5% which is a one-time upfront charge and an annual management fee of 1%. But investors can get the fund in “I” class shares with no load and with a management of only about half charged by “A” shares. The way to find out about that is to slowly and carefully read every word in the world’s driest document, the mutual fund prospects where it is a fully disclosed. If you ask the fund company over the phone they will say you need $5,000,000 per each mutual fund to buy “I” class shares.
However, a loophole exists that allow the purchase of “I” class shares in reasonable amounts. Find a Broker who will aggregate their clients holdings and then they may let you buy “I” class shares with $100,000 per mutual fund. So a $700,000 portfolio could be invested in seven different funds with “I” class shares, thus avoiding expensive fees. This is something they won’t tell you when you contact a mutual fund, or if they do write about it in the prospectus it is written in such an artful “hide-in-plain-sight” way that an investor would not know that he could have bought “I” class shares in reasonable increments.
A registered investment advisor (my company is one) can assist you in finding which “I” class mutual fund shares can be bought through retail Brokers and without requiring you to place your assets under management with the advisor.
I have written "Do you need an advisor in a bear market?"
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 15, 2011 @ 03:30 PM
Ricardian equivalence implies economy to remain in a deep slump
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Keynesian economics suggest that when in a slump the government should borrow more and spend in order to stimulate the economy and get out of the slump.
Economist David Ricardo suggested that when taxpayers know that extra debt is incurred they assume that extra taxes will occur in the future and they assume that they must reduce spending and save more in order to pay those extra taxes. So the stimulus becomes self-defeating. Austrian free market economist believe this and their polar opposite, the Keynesians reject that.
My opinion is that even if government stimulus programs may work during normal recessions they can’t work during a time when there is extreme debt because debt overwhelms other economic events. Yesterday I heard former Federal Reserve economist Lacy Hunt say that on John Mauldin’s website, which confirms my opinion.
blizzard of debt
So we are in a new era of suffering under a huge amount of debt. It is an unprecedented era because, except for wartime and the Great Depression, there has never been an era in the U.S. where people had to endure austerity for a long time. Since this is not a war, where rationing may be customary, then it will be hard to implement austerity.
The result of the austerity is that real estate, stock prices and dividends will go down and bonds will go up in value.
We are in a Japan style soft depression. I wrote "Western Nations have learned nothing and may repeat Japan's mistakes".
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 15, 2011 @ 12:46 PM
Interest rates drop even though headline inflation rose
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Inflation statistics released today show headline inflation is 3.6% which is higher than expected. However, Producer Prices for 12 months are 2.1% (remember when they peaked at 4.7% in 2008 just before the Lehman crash?). The consumer price index Core rate of inflation is 1.5% over 12 months, well within the Fed’s target to avoid inflation.
Bonds reacted by increasing in price with the ten year Treasury bond increasing by 1.66%. Interest rates for ten year Treasuries declined from 3.10% to 2.97%. The SP500 declined by 1.9%. The Euro is down by 1.9% due to fears of Greek bond defaults.
The risk is that both the Eurozone and China could go through a crash at the same time, while the U.S. has not recovered from the recession of 2008. The economists claim that GDP has grown during the recovery of the past two years, but how much of that growth is private sector GDP growth as opposed to expenditures by recipients of transfer payments and subsidies that were financed with new debt? The fundamental driver of inflation and of economic recovery is the jobless rate. It is 16% for the broad U-6 measure. The recovery only added back 20% of the jobs that were lost in the recession. To have only climbed 20% out of a hole that the economy fell into means that we have not climbed out of the hole, since we still have to reclaim another 80% of the lost jobs to be back to par. Then one must look at the fact that “real” wages have declined slightly over the past decade.
Unlocking the code to the economy
How did the economy get into this problem?
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Starting in 1983 the Shadow Banking system (lightly regulated non-bank lenders who issue bonds instead of accept deposits) produced excessive loans to consumers which created a bubble in perceived wealth in real estate and stocks and a bubble in consumption. Jobs were created to service the demands of consumers who were deluded into thinking they were better off than they really were. So consumers became addicted to overspending and they financed it with loans. About 1990 the ratio of debt to GDP took off to unprecedented peacetime highs. So there has been a 25 year bubble in Shadow Banking enabled over-lending and over-consumption which ended with the bankruptcy of Lehman.
The lost jobs that were created to service excessive consumption are permanently lost because people can’t afford to buy those goods and services. Job hunters simply must change careers. And investors must stop comparing previous economic cycles of the past 25 years to the current era because we are in a new era of austerity where the old paradigms are not applicable.
Example: high water marks like the highest price for the SP or the highest value for your house are irrelevant due to society’s loss of purchasing power. More news stories are being written about experts who say it will take 20 to 28 years for some of the worst eras of the real estate bubble to reach the high water mark. During the Great Depression it took 28 years for stocks to return to their old highs after adjusting for inflation. Throw in taxes on phantom gains caused by inflation and you might have had to wait until the market top of 1966 to truly breakeven on stock prices (but not dividends) if you bought at the 1929 top.
So we are in a similar era and we must prepare for a long term lack of purchasing power which means that those lost jobs are gone forever.
This means a long term trend of low inflation and low interest rates. It means panic buying of Treasuries driving the yield down to new lows because the alternatives: the Euro, Yen, equities, commodities are risky and will go down.
I have written "Inflation creation machine is broken".
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 14, 2011 @ 12:40 PM
Faith based investing is the common theme of gold and Treasuries
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Most investment assets have a cash flow that is vital to use to evaluate their value. Rental real estate, stocks, bonds, intellectual property that produces a royalty fee, a lease on oil producing property that requires payment of royalty fees all produce a cash flow that can be analyzed to estimate its durability, reliability, stability and then using Discounted Cash Flow analysis an estimate of value can be made.
However, zero duration assets such as precious metals, rare art lack a cash flow. Further, because they are rare that increases the probability that buyers may make an emotional decision and overpay for the asset in a bidding war.
So what do U.S. Treasuries have in common with gold? During normal times when the government is solvent one could say that Treasuries are almost like a hard asset, as a metaphor, although that is not true since government policies could change leading to insolvency and inability to pay the debt. What Treasuries have in common with gold is that they can’t be analyzed by cash flows, as gold has none, and Treasuries are a very unique type of debt.
Treasuries are unique because in addition to the normal reasons for rational private sector bond investors to buy a bond (where they use Discounted Cash Flows as a valuation model), there is an additional incalculable "value" to owning Treasuries. That is an impossible-to-estimate-value as a safe haven asset suitable for gigantic investors such as China with its $3 trillion of U.S. Treasuries.
Both ultimately are a type of money and both have “faith based” values. Can you really tell me the intrinsic value of gold? It is a better type of metal for industrial purposes than silver, so perhaps it is worth a few times the price of silver, but why is it often trading at about 42 times silver? And what is the intrinsic value of a U.S. Treasury? For example, if America went bankrupt and Yosemite National Park was auctioned off and became a private park the residents of the U.S. would be too poor to pay exorbitant fees to enter the park so it would not be worth that much during a bankruptcy liquidation sale. So the cash flow or assets owned by the U.S. government are not justification for assuming repayment of Treasuries. Regarding the cash flow of the U.S. economy, in several decades the Treasury debt will be 500% of GDP and so obviously there would be no way to repay the debt. So when someone buys a Treasury part of their decision making process is analogous to the decision to buy gold! It is based on faith. They are telling themselves: just trust that somehow the valuation makes sense. They are 180 degrees opposite each other because gold can’t be easily replicated and Treasuries can be increased by the whim of Congress and the President.
Why are Treasuries so special?
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When wealthy foreign governments have excess funds they buy foreign currency from the largest developed countries and because they want to earn interest the can either put the money in a bank and risk losing it if the bank fails or they can buy sovereign bonds issued by high quality credit worthy governments. Since the U.S. has much more debt than any other government then our Treasury market is the natural repository of foreign investors because the US. Treasury market is deep, liquid, and gigantic. As the world economy grows those who make a trade surplus need a storehouse of value. The amount of gold in the world is far smaller than sovereign debt so investors can’t buy gold, so they buy Treasuries.
Because foreign governments us the dollar as a reserve currency instead of gold then the dollar has a unique faith based role that is unlike anything that has existed before. The only similar currency was the British Pound during the 100 years after Napoleon from 1815-1914 and that was gold backed.
Thus the dollar really is similar to gold, but only if the faith continues. What is needed for the faith in the dollar continue? If there is no inflation, no default, and a credible deficit reduction plan is enacted by Congress and the President.
An enormous pile of debt
What could destroy faith in the dollar?
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If Congress and the President are unable to negotiate about raising the debt ceiling in a civil manner and a default occurs then Treasury debt holders could view Treasuries as just another risky bond that should be dumped. If they sell their Treasuries then they would probably sell their dollars and invest the funds in another country. This would make the dollar crash. It would hurt world trade since the world’s Central Banks have about 60% of their reserves in dollars. So if Central Banks lost money on their dollar investments this could create imbalances in the world economy.
I wrote "U.S. Treasury default is a bad idea".
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jun 13, 2011 @ 01:32 PM
People worry that bonds don't pay enough to live off of without an investor drawing down his net worth during retirement. Even with that concern I recommend 100% bond portfolios.
The question is always raised about how to get a higher yield, etc. This is not the correct way to approach bond investing. The purpose of bond investing is to have a “sanctuary asset” to ride out the storm. This means giving up the chance to make a lucrative yield in junk bonds and instead accept a low rate of yield in low risk, high quality bonds. The idea is that eventually after QE2 has faded away that stocks P.E. will ratio revert to the mean and thus stocks will crash. Then it will be time to make a decision about reallocating to stocks.
Worried over shrinking bond yields?
If an investor needs more yield it would better to sell off and spend down a sliver of principal rather than gamble with junk bonds in hopes of living off of the high yield. Over the long run junk bonds actually provide a total return that is less than “A” paper bonds.
What fascinates me is when the investment conversation drifts to ideas like “since Treasuries pay 3% then one might as well own a quality stock that pays a 3% dividend”. This is wrong thinking because a stock is not a bond and stocks are 30% to 70% overpriced, thus a stockholder could lose 30% to 70% of principal while collecting a 3% dividend which can be cut at any time. Treasuries are free of state income tax, can be sold with minimal Broker-Dealer spread costs, and are non-callable.
During times when interest rates were very high the “real” inflation adjusted yield was often low and yet people had to pay tax on the entire coupon without adjusting for inflation, so during the 1970’s investors with a 12% coupons made less after-tax and after-inflation than they do today, in some cases. Example: If you earn 12% interest in the 1970’s and lost all of that to inflation at 12% and then paid 40% tax then you lost 4.8% a year. Today a 10 year Treasury at 3%, less 35% tax is about 2% after-tax yield, and some measures of inflation are about 1.5%, so the in some cases people may get a “real” return of 0.5% after-tax today.
I have written "Will rising rates kill bonds?"
My investment opinions can change suddenly. The economy can change suddenly.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 10, 2011 @ 03:59 PM
Housing affordability ratio irrelevant
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The housing affordability ratio is the lowest since 1975 or 1965, so housing bulls tell people that this is a sign of a real estate bottom. I disagree because:
The qualitative nature of borrowers has degraded in terms of reliability of income and credit rating, and this change is not reflected in home ownership affordability statistics because they don’t adjust for credit rating or income verification problems. The index does not consider that underwriting rules have morphed into a very strict new paradigm in 2008, so the previous 25 years of mortgage lending is not comparable with today’s market because lender’s underwriting rules are perhaps the toughest in decades.
In the old days most people had a salaried job, there was less job hopping and less career changes and far less temporary work or independent contractor work. Lenders discriminate against people who are career changers, independent contractors or temp workers. With the lack of “Easy Qualifier” "stated income" loans many people who earned enough to afford a home but had an unreliable, short term self-employed independent contractor status won’t qualify because they lack the durability and stability of income that comes from having been in the same old salaried job for several years.
Further, there could have some buyers who used “Easy Qualifier” loans to exaggerate their incomes and now they can’t qualify for a loan. “Easy Qualifier” loans were first offered in 1984 and were outlawed in 2009. For 25 years they facilitated the funding of an extra source of homebuyers who were participating in bidding up the cost of housing. Now those potential buyers can’t buy.
Regarding credit ratings, roughly 10% of the homeowners (15% of the general population) have become delinquent or gone into foreclosure so that is a huge loss of potential borrowers who may earn adequate income but have ruined their credit rating and thus can’t get a loan.
So if you subtract the 15% of homeowners with bad credit and perhaps another 20% who need “Easy Qualifier” loans and then subtract those who lack a 20% or 10% down payment then there is a huge loss of potential buyers. This loss is far more important than merely comparing the ratio of income to payments. Even if you assume that most of the people who are disqualified have overlapping reasons for not qualifying (a combination of shaky income, bad credit, and inadequate down payment) and thus assume that only 15% to 20% less people can qualify that is still a huge loss of buyers. Then add to that the loss of motivation due to the perception that housing is a bad investment.
The metrics of affordability indexes are comparing apples to oranges. People paid more than they could afford for housing during the debt fueled bubble of the past four decades. This is because people desperately wanted to buy a home before the price rose out of reach to unaffordable levels. Just because people made a mistake and overpaid to participate in a bubble does not mean that those purchases are a benchmark on which to judge relative affordability.
Open the door to understanding the economics of home buying
Using the “real” inflation adjusted cost of money there were times in the 1970’s when mortgage interest was quite cheap and the perceived profit from appreciation very high. Today short term nominal interest rates need to be "negative" 1.65% in order for the economy to function properly according to the Taylor rule. Since interest rates can’t go below zero then this implies that the cost of mortgage interest is not that affordable compared to the 1970’s when nominal rates were high.
Underwriting standards have changed the qualitative nature of how income is used to qualify for a mortgage. See my essay “80% of loans were not safe” based on a news story that said only 20% of borrowers who bought a home in the past would qualify today.
I don’t think it is that bad, but it is very reasonable to assume a “casualty rate” from the mortgage bubble crash “wars” of at least 20% of would-be borrowers are MIA (Missing In Action) and thus the home buying army of consumers is understaffed and losing the war against deflation.
I wrote about this in “Housing not comparable to the past”.
More news stories are being written about the attractiveness of Emerging Markets Bonds. Important: Get more information in my free Special Report about Emerging Market currency investments.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 10, 2011 @ 11:15 AM
Dow in worst slump in nine years
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Today the WSJ said “Dow Jones Industrials fell below 12000, pointing to a sixth straight weekly decline that would be blue chips' longest slump since 2002.“
Rob Arnott, a Pimco fund manager, said that the U.S. private sector GDP in “real” (inflation adjusted terms) terms has not increased since 1998. Wages have slightly decreased in “real” terms during the past decade. So this implies that stocks should be priced at about what they were in 1998 when the Dow was around 10,000. That would imply another 20% drop in the Dow.
However, a better way to analyze stocks is to use the Shiller PE 10 and that implies that the SP has a PE ratio of 23. Since a PE of 15 or 16 is fair value then that implies stocks are roughly 50% overpriced even with recent declines. Further, since stocks may go down and momentum could build in a downtrend where they go beyond fair value then stocks could go even lower. One prominent bearish advisor, David Rosenberg, has said the SP has fair value at about 900.
Unlock the combination to the mystery of the market
Assuming that the economy falls into a growth slowdown and near recession and that there is no stimulus, no QE3, and that the Euro debt crisis gets worse then long term U.S. Treasuries could increase in value (and their yields would go down).
I wrote in April "Bears should not capitulate".
More news stories are being written about the attractiveness of Emerging Markets Bonds. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 09, 2011 @ 01:03 PM
China real estate bubble popping
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WSJ had an article today that China’s real estate bubble may be popping. In 2006 condo prices in Beijing were 32 times average annual income, now they are 57 times. By contrast in developed countries like London or Paris they are roughly 8 times income and in the U.S. about four times income. This is important because the value of an asset is best calculated by comparing the annual yield or rent in proportion to its price. In Shanghai condo sales in units are down 37% in the past quarter.
The implication of a Chinese real estate bubble cooling down is that there will be less global demand for commodities and less global inflation. This could cause a severe deflation in commodity countries like Australia. The Shanghai stock market is down 15% in the past year from its peak.
My concern is that the Chinese real estate bubble has warped the statistics about commodities demand causing bullish developed world forecasters to assume that a new economic boom and inflation are underway.
I discussed this in "China economy cooling".
In the long run China will be better off after the real bubble has cooled down because their resources can be used to build factories, etc.
White House response seems to be one of grudging acceptance (of the weak economy)
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In Yahoo! Finance there was an article today “The White House View: The Grind-It-Out Economy” by Daniel Gross. “The response at 1600 Pennsylvania Avenue seems to be one of grudging acceptance: The U.S. economy is methodically plowing its way through the post-bust mess, grinding out economic growth one job, one export order, one modified mortgage at a time. And for political and temperamental reasons, the administration isn't going to freak out and roll out a bunch of initiatives that could radically speed that process anytime soon.”
My opinion is that Obama has ended up accepting the Republican-“Austerian’s” strategy of minimal government intervention and subsidies. This is very deflationary. There is nothing left to stimulate the world’s economy except a few tech toys in Silicon Valley. So what if everyone buys an Ipad, will that be enough to make the economy recover? And if China cools off that will add to the odds of a deflationary outcome.
A big zero for remaining stimulus funds
Dollar devaluation or dollar collapse during a world economic crash?
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If the world economy crashes or goes into a recession will that cause the dollar to decline? It depends on whether the U.S. government decides to aggressively devalue or avoid devaluing. If the market is left alone then the marketplace will have capital coming in to the U.S. during a severe crash because of the U.S. safe haven status. Further, the major countries want to do competitive devaluations to make their currency the lowest so no one G7 country is likely to have an extreme devaluation.
I mentioned this in "Two things to know about devaluation".
Investors should seek independent financial advice.
Important: Get more information in my free Special Report about emerging market currency investing.
Posted by Don Martin on Wed, Jun 08, 2011 @ 05:58 PM
If the Treasury defaulted on its debt because Congress refused to authorize more debt this could hurt the world's capital markets.
It has been suggested that if the Treasury defaulted but then the default somehow led to Congress passing laws to improve the deficit that this would over the long run make Treasuries more attractive and increase their intrinsic value. However Treasuries are very unique. They are the world's benchmark for the "risk free rate" used to calculate or benchmark various investment returns and contracts, etc. It is like the Naval observatory clock that sets a standard for measurement of time. It is a special entity that should not be tampered with.
The political solution is for Republicans who have a goal of deficit cutting to simply wait until they have acquired more power in the 2012 elections. If the people, as of today, have not given them full power then they don't have the authority to engage in aggressive tactics to cut the deficit and will simply have to wait until the next election.
There is nothing like the U.S. dollar and the U.S. Treasury market. If the Treasury defaults it would be unprecedented for the issuer of the world's global reserve currency to default on it's bonds. There is no clear analogy or case history. It is not analogous to a large corporation filing bankruptcy because of the dollar's role as the world's reserve currency. Central Banks through out the world use the dollar instead of gold as a reserve asset. The dollar is merely a fiat currency with very little gold backing it. Respecting the value of the dollar is a matter of faith, since it is a fiat currency.
The dollar has benefited since WWII, or even since WWI, as a safe haven currency where it had an "exorbitant privilege" of being worth more than it should be due to a desire by foreigners to use it as a haven. This includes both the dollar as a currency and Treasury debt. What is hard to understand is how the Treasuries are in a unique class unlike any other debt that has existed in history. Any other sovereign or corporate debt with the U.S.'s problems would have long ago lost its safe haven and benchmark status and been downgraded. It is like someone who is a tribal shaman who is viewed by the masses as having magical powers, so the public lends money to this mystical shaman without reviewing his creditworthiness.
The U.S. should not do anything to shake up, or startle the world out of its slumber about the fact that the world's reserve currency is a fiat currency that has only a tiny amount of gold as reserves.
There is simply too much risk that some unknown economic phenomenon will occur if the Treasury defaults. Remember when the U.S. let Lehman go bankrupt how startled everyone was with the consequences? The analogy is that it was an unprecedented and unforecastable situation (by unforecastable, I mean the outcome of the bankruptcy, not the filing). I said there was no precedent to a U.S. Treasury default, but ironically an analogy is that a Treasury default would be so unprecedented that it would be analogous to the unprecedented default of Lehman.
The closest thing to the dollar's role as a reserve currency was the British Pound during 19th Century era. During that time Britain was very solvent, based on using income from its colonies to pay its debt, even though it had a lot of debt from the Napoleonic war. Further the Pound was then on the Gold Standard and thus was not comparable to today's fiat dollar.
When I say these gloomy words I am only talking about financial markets going into a traumatic experience. I expect that law and order will be enforced and law enforcement and military government employees will get paid and show up for work and retirement checks will get paid during a U.S. default.
Investors should seek independent financial advice. Perhaps an analogy to that would be to have investments that are independent of the U.S. government: Emerging Market bonds. Please see my Special Report on investing in Emerging Market bonds.
Posted by Don Martin on Wed, Jun 08, 2011 @ 04:37 PM
The IRA was established by Congress in 1974 with a $2,000 annual contribution limit. It was increased to $5,000 in 2001 by the Republican Congress and then indexed for inflation. It is an extra $1,000 per year for those over age 50. Since inflation has increased prices by about 6 fold since 1974 then then the IRA annual contribution limit should be about $12,000 to be fair about inflation. Unfortunately the inflation indexing law only applies since 2001. During the era of 1974-2000 taxpayers were denied tax savings opportunities for a tax-deductible IRA contribution because the tax code was not fully indexed to automatically adjust for inflation. This constituted a massive tax windfall for the government which should have been used to pay down the debt. Instead even more debt was incurred by the government due to spending increases.
The Reagan era tax changes adjusted basic income tax rates to automatically be indexed for inflation but did not adjust specific items such as IRA’s AMT or the basis of Capital Gains.
Alternative Minimum Tax or AMT
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The AMT was started in 1969 at an income threshold of approximately $40,000. If adjusted for inflation it would be about nine times bigger or $ 360,000. Imagine how much less tax would be owed if AMT threshold were adjusted for inflation. Basic tax rates are automatically indexed for inflation, but AMT is manually adjusted at the whim of Congress.
Taxpayers getting beat up by lack of inflation indexing
Long Term Capital Gains Tax
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The rate for long term capital gains tax was 28% during the Reagan administration and about 40% during the 1930-1979 era. But what about adjusting the basis (“basis” is the cost to buy an investment) for inflation? For example, if you bought a stock for $10 in 1965 and sold it today for $100 you would breakeven after adjusting for inflation. If you bought a stock in 1980 for $10 and sold it for $25 today you would breakeven. So a stock purchased for $10 in 1980 and sold today for $25 would be taxed at $15 profit times 15% or $2.25 tax, but there was no real income after adjusting for inflation. So in that case the tax rate was really over 100% since the $2.25 tax was more than the $0 inflation adjusted profit.
In yesterday’s blog post I wrote “Tax traps in 401K’s”.
The implications of this is that society is taxed enough and any attempt to raise taxes would reduce the purchasing power and self confidence in the private sector of the economy leading to a recession. This implies that the economy will remain stuck in the doldrums of low or receding growth which implies low inflation and declining stock prices.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 07, 2011 @ 01:10 PM
You are allowed to borrow half of the value of your 401K, up to $50,000 limited to 50% of the value of your account. You are required to charge yourself a reasonable rate of interest. The interest is not tax deductible because it is not a mortgage. So the interest your 401K earns will eventually be withdrawn when you retire and withdraw funds from your 401K, at which time the interest is taxed. But there is no symmetry in the tax code because you can’t deduct the interest expense when you made payments to your 401K, yet you must pay tax on the withdrawals from a 401K.
401K’s allow for a 15 year amortization for real estate loans, provided the Custodian has agreed to it in the Plan documents. A Custodian may not have bothered to set up this feature. Also I do not know if any Custodian has bothered to structure a 401K loan as a formal mortgage.
Since Custodians are trying to keep costs reasonable and avoid complexity then I doubt any of them would have bothered to allow a formal mortgage documentation process just to help someone get a tax deduction for a few thousand dollars of interest payments. Sponsors and Custodians of 401K’s are not required to give account holders all of the features that the law allows. If someone obtained a 401K and terminated employment they would usually have to pay back the 401K loan immediately, although some employers allow ex-employees to keep their 401K and continue the loan after they leave the company. Imagine the politics of an employer firing someone and then demanding immediate repayment of a 401K loan that was a mortgage, resulting a foreclosure. It would be cruel to do that, so the employer would probably not offer it as a mortgage.
To be tax deductible it would have to be recorded as a mortgage and not an unsecured loan. Further the loan could not be a cash-out refinance, except that a borrower is allowed $100,000 cash-out loan on his home as long as it does not exceed 100% of current value. Thus if the home had no previous cash-out refinances and has not declined in value then maybe it would be allowed. Please see your tax advisor for details.
My quick estimate of the tax asymmetry is that it will cost you $2,000 for $50,000 which is 4% (based on total expenses and deductions over the life of the loan, plus tax paid when making withdrawals). If the loan is for the purpose of paying off credit card debt then it is a no-brainer to suffer this tax injustice so as to avoid paying 22% for a credit card.
The big stash you'll owe the IRS
Early retirement withdrawals with no penalty from 401K’s
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When withdrawing from an IRA one must be at least age 59 ½ to avoid an early distribution penalty (exceptions may apply). However if one will be over age 55 by the end of the year in which they are “separated from service” then they can withdraw from a 401k with no early distribution penalty. Thus someone turning 55 in December this year who lost his job this January when he was 54 can withdraw from the 401k without an early distribution penalty. However, they must not become unemployed before the year they turn age 55. So if you lose your job at age 53, then the day before turning 55 get a job and then quit the day you turn 55 so that you can start withdrawing from your 401k which you would have to have kept at the old employer. However, most people roll a 401K into an IRA when they change jobs, so to be able to make the withdrawal one must keep the 401K with the old employer. If the employer went out of business then this might not be possible. It may be possible to roll the 401K to a new employer’s 401K but the fine print in the sponsor's (the sponsor is the employer) Plan documents would have to allow that. Both the Custodian that holds the funds and the sponsor (employer) need to authorize the formation of a policy such how 401K loans are created. They may be afraid of litigation or bad political consequences and want to cut costs so they may choose not to offer certain exotic features
So if you lose your job at age 53 you might be able to borrow from your 401K if the employer allows you to keep your 401K. Then when you turn 55 you find a job and then quit so that you can make penalty free withdrawals. This way you will have gotten funds penalty free out of your 401K since age 53.
Of course the best thing is to avoid being unemployed and avoid debt and use a 401K for what is intended for, as a savings vehicle and not a source of early retirement withdrawals.
Another tax trap is that 401K withdrawals are taxed as ordinary income, thus negating the benefits of long-term capital gains that occurred inside of a retirement account. If someone had the ability to make long-term gains then they may be better off building wealth in a taxable account instead of a retirement account, assuming they had no employer matching contribution. However, diversification implies that one should hold some bonds and the best place for bonds is in a retirement account.
I have written about tax planning here.
Investors should seek independent financial advice. They absolutely should meet with their tax expert such as a CPA or Enrolled Agent for a personalized consulatation about the risks of using a 401K loan or of attempting to do an age 55 "separation for service" withdrawal.
Posted by Don Martin on Mon, Jun 06, 2011 @ 02:24 PM
Mutual funds with no distributions
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When you own shares in a mutual fund you may get dividends from the fund company that were from the dividends earned by the individual stocks held by the fund. In additional you may get a “distribution” of short term and long term capital gains. These are usually issued in November or December.
Investors don’t like getting distributions from a mutual fund because this means taxes have to be paid. Investors emotionally feel that they should only have to pay tax when they take the initiative to sell an investment. However a mutual fund is a collective investment and when the fund manager sells assets then that may trigger a capital gain which must be paid by the individual shareholders because a mutual fund is a “pass-through” entity where taxable events in the fund are passed through to the individual shareholders.
Methods to avoid capital gains distributions:
- Hold mutual funds (that you suspect will give a distribution) in a traditional IRA. However that causes a worse tax problem: traditional IRA’s wash out the tax treatment of dividends and long term capital gains and convert them to ordinary income. So in most cases it would be very wrong to do this. Of course a Roth IRA is tax free, so that would be different.
- By mutual funds after the annual distribution has occurred. The problem is that investing (in theory) should be for the long run, so buying a fund in December and selling in October just to avoid distributions is wrong and impractical and would trigger short term gains tax (if it was profitable) on your sale of the mutual fund.
- Buy ETF’s to avoid capital gains distributions. They obtain shares of stocks through “creation units” which have a different tax consequence when these units are redeemed by an “authorized market maker” from a mutual fund. Unfortunately the goal of pursuing tax savings is trumped by the goal of getting good investments. I don’t recommend passive ETF’s because I believe in actively managed mutual funds. If an investor is trying too hard to chase after tax benefits an investor may not be able to make the right investment decisions.
- Recognize that distributions often occur for a reason: They may occur at the top of a bubble or just after the top when investors withdraw funds from a mutual fund the manager needs to sell assets to pay the investors who are redeeming mutual fund shares. These sales then trigger a distribution which is assessed on the remaining shareholders. So the best defense against distributions would be to avoid funds that are part of a bubble top because the fund’s assets will go down in value and will be sold to meet redemption requests. Thus you get two benefits by avoiding bubbles. Now the question is how do you spot and avoid bubbles? This is the real question that is far more important than avoiding distributions.
Risk of a pyramid?
To avoid bubbles one should avoid over-priced investments and be a contrarian and avoid investing in what the masses believe in. Avoiding over-priced investments means watching the P.E. ratio and buying when it is at a discount below fair value and then selling assets when the P.E. is too high. This is one of many indicators. In some cases a low P.E. ratio is a “Value trap” where a P.E. ratio is low because a company is going to fail soon. So besides buying at the right price the assets purchased must be quality assets. “Quality” means stable, healthy earnings which is something the dotcom bubble stocks did not have. It also means low debts, a good corporate moat, good corporate governance (not opaque or manipulative behavior).
I am concerned that the commodities boom was a panic caused by speculators and by China worrying too much about dollar devaluation. I expect China’s economy to cool off and commodity speculation to collapse as it did in 2008. This will provoke investors in developed countries to become bearish about developed country stocks and then they will go down.
I have written “U.S. equities are 70% overpriced”.
The Emerging Market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 03, 2011 @ 11:22 AM
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Shocking drop in new job creation
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The unemployment report today showed a huge drop in the number of new jobs. Only 54,000 new jobs were created in May, 2011 and the expectations were that 200,000 would be created and that 300,000 were needed each month for several years to get the country out of the period of high unemployment.
Unemployment including the economy’s inability to grow enough jobs to solve unemployment is the reason that interest rates stay low and that bond prices stay high and may go higher.
I have written “Unemployment problem unsolved”.
http://www.mayflowercapital.com/blog/bid/49814/Unemployment-problem-unsolved-independent-financial-advice
It appears that economic tightening is underway in China. If this continues then commodity prices could fall 25 to 75%, since China was the main source of demand for commodities. Small and medium companies in China are forced to borrow at 17% to 20% interest rates from private lenders because they can’t get bank loans.
So if China’s economy and commodity prices cool down then much of the world’s economic growth will be gone. Add to that the end of QE 2 and the Federal budget cuts to come when the Federal budget dispute is settled in August and the result will be that the economy will have tipped over into a recession.
EM Currency
The Emerging Market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 02, 2011 @ 01:19 PM
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Investment climate moving toward a crash
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The market continues to give bearish signs. The Conference Board Consumer Confidence index is at 60.8. It should be about 73 in a recession and 100 in expansions. On a chart the index has dropped to a level that is at the lows of the 2002 crash. The bad numbers of the past three years where it was below 60 were last seen in the 1992 recession.
There will be no QE 3 and there will be fiscal tightening with budget cuts in August when the Federal government runs out of borrowing authority. The new Republican members of Congress are determined to cut the deficit even if it causes them to be denied reelection. This is a new era of political will power that is rarely seen in Washington and this determination will result in less fiscal stimulus at a time when the Federal Reserve will stop Quantitative easing.
New political battles over budget
The bond market understands the gathering recessionary storm clouds and cut the rate on the 10 year Treasury bond to 2.95% yesterday. The stock market is too busy experiencing a tech bubble to notice that the economic fundamentals have deteriorated, but the stock market will eventually realize the market is overpriced and then it will crash.
I have written “Can independent investment advice protect investors from a crash?”
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Photo from Gregory Szarkiewicz
http://www.freedigitalphotos.net/images/view_photog.php?photogid=252
Posted by Don Martin on Wed, Jun 01, 2011 @ 09:01 PM
Today June 1 and yesterday I attended the San Francisco Financial Planning Association's annual two day conference.
Speakers included Michael Kitces who spoke about a need to re-interpret Modern Portfolio Theory, Elise Buie who spoke about how the "annual meeting IS the financial planning process"; Michael Lewis, author, who spoke about how the establishment journalists and economists ignored warnings of the housing bears in the years before the 2007-08 real estate crash; Kent Noard spoke about tax matters regarding ESPP, RSU, ISO options; attorney Trudy Nearn spoke about the new Estate Tax law; Neel Kaskari, formerly of the U.S. Treasury spoke about working on financial crisis during 2007-2009; Keith and Judith Mauer spoke about Life Insurance; attorney Chris Rupright spoke about new regulations for RIA's.
I especially enjoyed hearing Michael Lewis who said that the only serious studies of sub-prime mortgages were by those who short sold them. I remember being bearish about the mortgage and banking industry during the housing bubble, so I really appreciated what he said.
The whole common theme of the conference was of the importance of independent financial advice.