Brighton Perspective

Morningstar 2012 Economic Outlook

Outlook for the Economy

by | 12-27-2011

After smoothing out bumpy GDP results, the economy is probably growing at about 2%. Potential sources of an upside surprise include increased U.S. oil production, a sharper rebound in auto production and aircraft production (Boeing), and a stronger housing market. Though corporations continue to remain cautious, consumers have continued to spend. The U.S. economy grew in 2011, but at a slower rate than I had hoped when the year began. I had predicted that the economy might grow as fast as 3.0% to 4.0% when the year started, and it now looks as if the economy will turn in a more modest 2% or so growth rate on a fourth-quarter-to-fourth-quarter basis. Even more surprising than the overall growth rate was the pattern of that growth rate throughout the year. Growth plunged to 0.4% in the first quarter and accelerated throughout the year with the fourth quarter now likely to produce annualized growth well in excess of 3%. A combination of poor weather, a shocking jump in oil and gas prices due to political unrest in the Middle East, and supply-chain disruptions related to the Japanese tsunami all contributed to the pitiful level of economic growth in the first half. As those factors reversed themselves in the second half, economic growth spiked. When the first half and second half are combined, I think the overall 2% growth rate is more representative of the state of the U.S. economy than the first half doldrums or the second half spurt. Although the overall GDP for 2011 was below my forecasts, given all the first-half shocks, followed by more severe sovereign debt issues in the second half, I am not that disappointed with the U.S. economic performance. I may have started the year too bullish, but I didn't cave into the chorus of economists who were overly focused on manufacturing data and calling for another recession late this summer. Instead I remained focused on the U.S. consumer, which continued to power ahead throughout 2011. More Upsides Than Downsides (Though the Downside Is Scary) My overall forecast for 2012 is for slightly higher growth than the consensus, but not by a lot. However, I think the odds of an upside surprise are substantially higher than a downside surprise. Potential sources of an upside surprise include increased U.S. oil production, a sharper rebound in auto production and aircraft production ( Boeing BA), and a stronger housing market. Recent news seems to support each of these potentials. U.S. oil production is now growing again after years of decline, led by increased production in North Dakota and Texas and facilitated by higher prices and new technologies. U.S. auto production is on the mend as consumers can't put off the purchase of a new automobile indefinitely. Further fueling U.S. auto production is news out of Honda HMC that the company will produce substantially more cars in the U.S. in the years ahead, many of those for export from U.S. plants. Boeing finally appears on the cusp of a major production jump, especially for its 787 Dreamliner. However, Boeing has been optimistic in the past only to hit snag after snag, so no one really believes them. But with real deliveries under way now and commercial flights a reality, I think the investment community is underestimating the ability of Boeing to boost the U.S. manufacturing economy in a major way. Finally, the housing market seems to be ambling its way out of the valley of death, too. Housing starts, housing permits, and builder sentiment have all been improving over the past several months. Inventories are approaching normal levels, and affordability is at a record high even as rents continue to go up in most markets. I'm not calling for a boom, mind you. But I think for once, housing is going to be a positive for the economy in 2012. I would be shocked if housing starts in 2012 aren't meaningfully ahead of those in 2011. Corporations Are Scared Even as Consumers Accelerate Spending Another potential positive is businesses' cautionary stance and low inventories even in the face of decent customer demand. It looks like U.S. corporate managers are far more scared about Europe and the economy in general than the U.S. consumer is. Recent reports out of Oracle ORCL and Accenture ACN seem to suggest at least some precautionary spending cuts by corporations in the software arena. Managers also seem to be paring inventories to the bone, as inventories were a massive detractor to GDP growth in the third quarter, in anticipation of slowing consumer demand. Instead, it appears that U.S. consumers are accelerating spending as they seem to be "thrifted out" and can no longer delay certain purchases, especially autos. I believe this asymmetric world will resolve itself with the need for greater production both in the U.S. and in other world economies that export to the U.S. sometime in 2012. So, If U.S. Growth Were to Accelerate, Could Corporations Handle It? Even as most economists worry about Europe, deleveraging, and slow economic growth, I am more worried that if the economy does begin to rebound in a bigger way, corporations may not easily meet the new demand. Closed plants, reduced labor forces, and rock-bottom inventories just don't leave much room for upside growth, if it were to occur. The Japanese auto industry has been rocked not once, but twice in one year by major supply-chain issues (the tsunami in Japan and the floods in Thailand six months later). Even the personal computer industry (and consequentially the semiconductor industry) has been shaken by the Thailand issue. The dangers of razor-thin inventories and sole-source, single-region agreements have been laid bare over the past year. Though I don't expect to see change overnight, I've got to believe that a major rethinking of supply-chain issues is going to occur over the next several years. Europe Remains at the Top of the Worry List Risks remain, however. Certainly the European sovereign debt crisis remains front and center in investors' minds. The issue isn't so much that a softening in European growth prospects and austerity could kill worldwide economic growth. Instead, the concern is related to the crisis's potential to wreck havoc on the worldwide financial system. U.S. exports to Europe represent just 3% of U.S. GDP, and a lot of that is for basic necessities that can't be bought elsewhere. However, with a web of lending in which European banks lend to sovereign governments, and those governments lend the money back to the undercapitalized banks, the failure of any one link could bring down a healthy chunk of the European banking system. The problem is, no one can see inside the relatively opaque balance sheets of European banks, so it is difficult for me or anyone else to provide a lot of reassurance to investors on this front. This type of opacity and cross-lending dependency turned a potentially minor recession in the U.S. into a near catastrophe for the world economy in 2008. China Slowing Is an Issue for Some, but Potentially Good News for the U.S. China certainly remains an issue, too, as growth there slows modestly and the construction industry pulls back from its break-neck pace. Slowing there is bad news for Europe, Australia, and perhaps Brazil, which are major exporters to China. It is also bad news for a lot of high-profile capital goods manufacturers in the U.S. But overall, China is an even smaller part of U.S. GDP than Europe. Furthermore, slowing growth in China could mean significantly lower commodity prices, especially in the U.S.--which would be good news for low-end U.S. consumers, who were particularly crippled by rising commodity prices in 2011. Regulation Continues to Affect a Lot of Industries Regulation is another risk for investors to consider. I approach this issue with some trepidation, as remarks on regulation in my last quarterly review drew more negative comments than any other single article I have written during my years at Morningstar. For now, I will stay out of the business of judging whether regulation in general was/is too light/tight, and instead say it is "impactful." A quick perusal of our stock analysts' sector outlooks shows a regulatory/government factor in almost every one. The utility team notes new emissions protocols moving forward, the health-care team describes cuts in payments to nursing homes and potential cuts to physician payments under Medicare, and even our industrials team mentions the potential consequences of a long-term decline in the defense budget. That's on top of the Dodd-Frank legislation and pipeline meddling that I mentioned in my last outlook. One bit of good news is that Boeing resolved the labor issue with its South Carolina plant and Dreamliner production in the last three months. However, the fight and the Labor Relations Board intervention probably had the desired effect of giving any manufacturer pause about shifting manufacturing to right-to-work states. Again, I am not saying any of this is good or bad for the long term, only that investors really need to keep a close eye on government actions. A Savvy Consumer May Limit Profit Growth I suspect corporate margins could begin to shrink as consumers start to gain the upper hand. Consumers are fighting every price increase tooth and nail, with the possible exception of the very high end of the market. The most recent example comes in the banking industry, where a pushback by consumers forced several major banks to cancel proposed increases in debit card fees. Another example of consumer price sensitivity is the market for gasoline, which saw declining volumes for three quarters in a row as prices rose. Then volumes increased modestly in the third quarter when prices fell. Auto and apparel sales have also been exceptionally sensitive to price increases and decreases. Europe Will Hurt Big Firms More Than U.S. GDP Although U.S. GDP growth may escape the worst of the effect of a slowing Europe, U.S. multinationals may not. Many of these firms derive 20%-40% of their revenues from Europe. Since many of those goods are produced in Europe or in other non-U.S. markets, they are not counted in the U.S. GDP calculations, and they don't directly add to U.S. employment. Therefore, a weak Europe could significantly affect U.S. companies even if it doesn't make a dent in the U.S. GDP growth rate. This is the exact opposite of what we have seen over the past several years as revenue growth and earnings at S&P 500 companies have far outstripped U.S. GDP growth rates. Does Uniform Conservatism Mean Better Times Ahead? On balance you will find that almost all the sector analyses in this special report are cautious and guarded in their outlook, with our analysts focusing their best investment ideas on conservative, well-managed firms that feature wide economic moats. That approach makes a lot of sense in light of the big European question mark that is balanced against a desire to have some exposure to equity markets (given the paltry rates available in the bond and money markets today). However, I will add that once everyone has become uniformly cautious, it is just about the time that equity markets can provide an upside surprise. I might add that the U.S. economy is probably better positioned than most of the rest of the world economies, showing accelerating growth even as Europe falls into a recession and as growth in Asian economies slows to a more modest pace.

Managing Volatility

Despite being up over 7% for the last 5 trading days of November, the S&P 500 Index ended the month down (0.22%) and the MSCI World Index ended the month down (2.69%). These results are a clear indication of the volatility we’ve witnessed in equity markets over the last several months. When markets are volatile, sticking to a long-term investing strategy can be a challenge. To keep the ups and downs in perspective, it might help to look at past market cycles to see how recent market action compares.

Corrections of 10% or more and bear markets of at least 20% are a regular occurrence. Since 1929, there have been 18 previous 20%-plus bear markets (not including 2011 market action). Losses on the S&P 500 in those markets ranged from almost 21% in 1948-1949 to 83% during 1930-1932; the average loss for all 18 bears was 37%.* However, since 1929, the average bull market has tended to last almost twice as long as the average bear, and has produced average gains of about 79%.* Individual bull market gains have ranged from 21.4% at the end of 2001 to the nearly 302% increase registered during the 1990s.* The worst annual loss--47%--occurred in 1931, but the all-time best annual return--a capital appreciation gain of just under 47%--happened just two years later in 1933.**

This year has seen extreme volatility, with weeks and even days when swings of several hundred points in both directions on the Dow seemed to become commonplace. In the first week of August alone, 2 of the Dow's 11 best days in history alternated with 2 of its 11 worst daily point losses ever.***

While by no means normal, the highs and lows are hardly unprecedented. Even though the 634-point drop on August 8 felt historic, it didn't begin to match the real record-holders. The single biggest daily decline occurred in September 2008, when the Dow fell 778 points. The biggest percentage drop was October 1987's "Black Monday," when the Dow fell almost 23%; that makes the Dow's 5.5% loss on August 8 of this year seem relatively tame by comparison. And August 8 was followed by the Dow's 10th best day ever, with a gain of 430 points. While that upward movement may seem exceptional, the Dow's best day ever came during the dark days of October 2008, when a 936-point move up on October 13 represented a gain of more than 11% in a single day.***

The last decade has been a challenging one for stocks. Between 2001 and 2010, the S&P 500 had an average annual total return of just 1.4%, while the equivalent figure for Treasury bonds was 6.6%.**** For much of that time, interest rates were falling, helping bonds to outperform stocks. However, interest rates are now at record lows, and rising rates could change the relative performance of stocks and bonds.

Many experts predict that the global economic recovery will continue to create an uncertain investing environment in coming years, with both strong rallies and strong downdrafts. Take steps to manage your portfolio volatility as best as possible to maintain it within your risk tolerance.

Past performance is no guarantee of future results. Market indices listed are unmanaged and are not available for direct investment. All investing involves risk, including the risk of loss of principal, and there can be no guarantee that any investment strategy will be successful. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The Standard & Poor's 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy.

DATA SOURCES: *Bull and bear market time frames, gains/losses: all calculations based on data from the Stock Trader's Almanac 2011 for the Standard & Poor's 500.

**1931 and 1933 annual stock returns: based on Ibbotson SBBI data for capital appreciation of S&P 500.

***Based on data from the Stock Trader's Almanac 2011 .

**** 10-year rolling stock returns: based on Ibbotson SBBI data for annual total returns between 2001 and 2010 of S&P 500 and an index of U.S. Treasury bonds with an approximate 20-year maturity.

Leaving A Legacy

You've worked hard over the years to accumulate wealth, and you probably find it comforting to know that after your death the assets you leave behind will continue to be a source of support for your family, friends, and the causes that are important to you. But to ensure that your legacy reaches your heirs as you intend, you must make the proper arrangements now. There are four basic ways to leave a legacy: (1) by will, (2) by trust, (3) by beneficiary designation, and (4) by joint ownership arrangements. A will is the cornerstone of any estate plan. You should have a will no matter how much your estate is worth, and even if you've implemented other estate planning strategies. You can leave property by will in two ways: making specific bequests and making general bequests. A specific bequest directs a particular piece of property to a particular person ("I leave Aunt Martha's diamond broach to my niece, Jen"). A general bequest is typically a percentage of property or property that is left over after all specific bequests have been made. Typically, principal heirs receive general bequests ("I leave all the rest of my property to my wife, Jane"). With a will, you can generally leave any type of property to whomever you wish, with some exceptions, including: Property will pass according to a beneficiary designation even if you name a different beneficiary for the same property in your will Property owned jointly with rights of survivorship passes directly to the joint owner Property in a trust passes according to the terms of the trust Your surviving spouse has a right to a statutory share (e.g., 50%) of your property, regardless of what you leave him or her in your will Children may have inheritance rights in certain states You can also leave property to your heirs using a trust. Trust property passes directly to the trust beneficiaries according to the trust terms. There are two basic types of trusts: (1) living or revocable, and (2) irrevocable. Living trusts are very flexible because you can change the terms of the trust (e.g., rename beneficiaries) and the property in the trust at any time. You can even change your mind by taking your property back and ending the trust. An irrevocable trust, on the other hand, can't be changed or ended except by its terms, but can be useful if you want to minimize estate taxes or protect your property from potential creditors. You create a trust by executing a document called a trust agreement (you should have an attorney draft any type of trust to be sure it accomplishes what you want). A trust can't distribute property it does not own, so you must also transfer ownership of your property to the name of the trust. Property without ownership documentation (e.g., jewelry, tools, furniture) are transferred to a trust by listing the items on a trust schedule. Property with ownership documents must be re-titled or re-registered. You must also name a trustee to administer the trust and manage the trust property. With a living trust, you can name yourself trustee, but you'll need to name a successor trustee who'll transfer the property to your heirs after your death. Property that is contractual in nature, such as life insurance, annuities, and retirement accounts, passes to heirs by beneficiary designation. Typically, all you have to do is fill out a form and sign it. Beneficiaries can be persons or entities, such as a charity or a trust, and you can name multiple beneficiaries to share the proceeds. You should name primary and contingent beneficiaries. You should consider the income and estate tax ramifications for your heirs and your estate when naming a beneficiary. For example, proceeds your beneficiaries receive from life insurance are generally not subject to income tax, while your beneficiaries will have to pay income tax on proceeds received from tax-deferred retirement plans (e.g., traditional IRAs). Check with your financial planning professional to determine whether your beneficiary designations will have the desired results. Be sure to re-evaluate your beneficiary designations when your circumstances change (e.g., marriage, divorce, death of beneficiary). You can't change the beneficiary with your will or a trust. You must fill out and sign a new beneficiary designation form. Two (or more) persons can own property equally, and at the death of one, the other becomes the sole owner. This type of ownership is called joint tenancy with rights of survivorship (JTWRS). A JTWRS arrangement between spouses is known as tenancy by the entirety in certain states, and a handful of states have a form of joint ownership known as community property. You may find joint ownership arrangements are useful and convenient with some types of property, but may not be desirable with all of your property. For example, having a joint checking account ensures that, upon your death, an heir will have immediate access to needed cash. And owning an out-of state residence jointly (e.g., a vacation home) can avoid an ancillary probate process in that state. But it may not be practical to own property jointly where frequent transactions are involved (e.g., your investment portfolio or business assets) because you may need the joint owner's approval and signature for each transaction. There are some other disadvantages to joint ownership arrangements, including: (1) your co-owner has immediate access to your property, (2) naming someone who is not your spouse as co-owner may trigger gift tax consequences, and (3) if the co-owner has debt problems, creditors may go after the co-owner's share. As always consider these suggestions in the context of your personal situation. The legal and tax issues involved in estate planning can be very complex so don’t go it alone, instead consult with an attorney and with an accountant with strong backgrounds in estate planning.

Why Europe Matters

As the possibility of default on Greek sovereign debt has become headline news, many people have found themselves wondering, "How is it possible for the financial problems of a country so small and so far away to create such turmoil in the world's markets?" What's happening in Europe is probably affecting your portfolio right now, regardless of the quality of your holdings or how well diversified you are.

It's no secret that the so-called PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) are having difficulty coping with the debt that years of deficit spending have created. A robust global economy helped to mask the problem, but in recent years the burden of sovereign debt--bonds issued by sovereign governments--has become increasingly unsustainable. With debt at roughly 140% of its gross domestic product,* Greece is particularly troubled. Imposing austerity measures required by its European colleagues has added to the country's recessionary woes. That in turn has made it even more difficult to achieve mandated deficit reduction targets in order to qualify for additional installments of financial aid from the European Financial Stability Facility (EFSF) set up last year by 17 eurozone countries.

One of the chief concerns about the possibility of default on sovereign debt has to do with the financial stability of banks that hold it. Some of the largest French banks have already suffered downgrades of their credit ratings because of their extensive holdings of debt from troubled European countries, particularly Greece. If a Greek default made banks reluctant to lend to one another, that could affect credit markets worldwide.

American banks hold very little Greek debt compared to European banks; however, they could face a different challenge. Understanding why requires some basic awareness of a type of derivative known as a credit default swap. Investors with large bond holdings from a particular borrower often try to protect themselves against the possibility that the borrower will default by buying a credit default swap on that debt as a type of insurance. The company that issues the credit default swap agrees to cover the bondholder's losses in case of default. The more risky the issuer--for example, Greece--the more likely bondholders are to try to protect themselves with swaps. However, in some cases, a company may have issued so many default swaps on a particular issuer that it could be overwhelmed by the claims resulting from the issuer's default.

Such derivatives can create a ripple effect in financial markets. If the company that issued the swaps can't make good on them, the institutions that relied on that protection can also find themselves in trouble, which multiplies the impact of a major default. U.S. financial institutions are major issuers of credit default swaps, and the potential impact of a Greek default on them is unclear. However, since the 2008 financial crisis, U.S. banks have been forced to hold greater capital reserves to deal with contingencies, and Treasury Secretary Timothy Geithner recently said that banks here have reduced their exposure to the debt of troubled countries.

Lending worldwide hasn't fully recovered from the last financial crisis, and has helped keep global economic recovery sluggish. Fiscal austerity measures taken to try to reduce deficits have also taken their toll, hampering economic growth and making it even more difficult for countries such as Greece to balance their budgets. If banks' lending ability were impaired further by a financial crisis brought on by a default on sovereign debt, tighter credit could increase the odds of renewed recession.

Even though Greece is the immediate concern, larger economies in Europe actually could represent a bigger threat. Italy and Spain both face sovereign debt burdens and deficit problems. Italy's economy is more than five times that of Greece; Spain's is more than four times bigger.* If either country were to decide it needed to restructure its debts as Greece is attempting to do (which ratings agencies could see as a form of default), that would have a much bigger impact than Greece. If a Greek default would have a ripple effect, a default by either Spain or Italy could cause waves.

To compound the problem, as investors have become increasingly concerned about the possibility of debt contagion in Europe, borrowing costs for both Italy and Spain have risen. At recent auctions, nervous investors have been demanding higher interest rates to compensate them for the higher perceived risk of buying that sovereign debt. As any credit card holder knows, having to pay a higher interest rate makes paying off debt and balancing the budget more difficult. A Greek default could make investors even more nervous about buying other troubled countries' debt, and being frozen out of credit markets would likely aggravate fiscal problems abroad.

There have been signs in recent months that voters in stronger economies such as Germany are beginning to question why they should continue to support countries that have not been as disciplined about balancing their budgets. Also, investors worry that the financial support available from the EFSF may not be sufficient or available quickly enough to avert problems. Though there has been no shortage of suggestions for how to deal with the situation--issuance of euro bonds backed by all eurozone members, leveraging the EFSF's existing assets, greater fiscal integration among countries, Greece returning to its own currency--questions about the ability and willingness of other countries to support the eurozone's weaker members have caused investor anxiety worldwide.

Financial markets hate uncertainty, and the situation has contributed to the recent volatility across a variety of asset classes that don't usually move in tandem. However, Europe has the benefit of having watched the United States deal with its own difficulties during the 2008 crisis. Also, European leaders have generally reaffirmed their determination to defend the euro at all costs.

Uncertainty about Europe could persist for months, but it's important to keep it in perspective. While you should monitor the situation and attempt to manage risk accordingly, don't let every twist and turn derail a carefully constructed investment game plan.

*Source: CIA World Factbook 2011

Balancing Your Investment Choices with Asset Allocation

Balancing a portfolio means combining various types of investments using a recipe that's right for you. The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, accounts for most of the ups and downs of a portfolio's returns. There's another reason to think about the mix of investments in your portfolio. Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may be chosen for their growth potential. Others may provide regular income. Still others may offer safety or simply serve as a temporary place to park your money. And some investments even try to fill more than one role. Because you probably have multiple needs and desires, you need some combination of investment types. Balancing how much of each you should include is one of your most important tasks as an investor. That balance between growth, income, and safety is called your asset allocation, and it can help you manage the level and type of risks you face. Ideally, you should strive for an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let's say you want to get a 7.5% return on your money. Your financial professional tells you that in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there's no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start. Someone living on a fixed income, whose priority is having a regular stream of money coming in, will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that's 30 years away. Many publications feature model investment portfolios that recommend generic asset allocations based on an investor's age. These can help jump-start your thinking about how to divide up your investments. However, because they're based on averages and hypothetical situations, they shouldn't be seen as definitive. Your asset allocation is--or should be--as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. You should make sure your asset allocation is tailored to your individual circumstances. When financial professionals refer to asset allocation, they're usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you've got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don't necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio. Even within an asset class, consider how your assets are allocated. For example, if you're investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies. Or you might allocate based on geography, putting some money in U.S. stocks and some in foreign companies. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held. There are various approaches to calculating an asset allocation that makes the most sense for you. The most popular approach is to look at what you're investing for and how long you have to reach each goal. Those goals get balanced against your need for money to live on. The more secure your immediate income and the longer you have to achieve your investing goals, the more aggressively you might be able to invest for them. Your asset allocation might have a greater percentage of stocks than either bonds or cash, for example. Or you might be in the opposite situation. If you're stretched financially and would have to tap your investments in an emergency, you'll need to balance that fact against your longer-term goals. In addition to establishing an emergency fund, you may need to invest more conservatively than you might otherwise want to. Some investors believe in shifting their assets among asset classes based on which types of investments they expect will do well or poorly in the near term. However, this approach, called "market timing," is extremely difficult even for experienced investors. If you're determined to try this, you should probably get some expert advice--and recognize that no one really knows where markets are headed. Some people try to match market returns with an overall "core" strategy for most of their portfolio. They then put a smaller portion in very targeted investments that may behave very differently from those in the core and provide greater overall diversification. These often are asset classes that an investor thinks could benefit from more active management. Just as you allocate your assets in an overall portfolio, you can also allocate assets for a specific goal. For example, you might have one asset allocation for retirement savings and another for college tuition bills. A retired professional with a conservative overall portfolio might still be comfortable investing more aggressively with money intended to be a grandchild's inheritance. Someone who has taken the risk of starting a business might decide to be more conservative with his or her personal portfolio. Things to think about Don't forget about the impact of inflation on your savings. As time goes by, your money will probably buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you think of yourself as a conservative investor, your asset allocation should take long-term inflation into account. Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested keeps you awake worrying at night, you may need to rethink your investing goals and whether the strategy you're pursuing is worth the lost sleep. Your tax status might affect your asset allocation, though your decisions shouldn't be based solely on tax concerns. Even if your asset allocation was right for you when you chose it, it may not be right for you now. It should change as your circumstances do and as new ways to invest are introduced. A piece of clothing you wore 10 years ago may not fit now; you just might need to update your asset allocation, too.

Borrow from your 401k?

From Morningstar, good example of why it's not necesarily a great idea to borrow form your 401k.

"Barbara is 40 years old, has a child in college, and needs to take out a loan to help with tuition.
She is considering either a home-equity loan or a loan from her 401(k), and is not sure which
would be the better choice. She has heard that taking out a loan from a 401(k) is painless, since
“you don’t pay penalties and pay the interest to yourself, not to a bank.” What should she do?
Many 401(k) plans offer a loan provision and the process is fairly easy. There is no credit check
(since you are borrowing from yourself); the interest rate is usually low (maybe a percentage
point or two above prime); you can generally borrow up to 50% of your vested account balance
to a maximum of $50,000; you have up to five years to repay the loan (longer for loans used
to purchase a primary residence), and the plan administrator usually deducts the loan payments
automatically from your paycheck.

However, the real cost of borrowing from your 401(k) is not the rate you pay yourself in interest, but
the amount you would have earned on your balance had you just left the money in the account.
This is called an “opportunity cost,” and it can be significant. In addition, if Barbara loses or changes
jobs, a 401(k) loan will most likely come “due in full” within a limited amount of time, while a
home-equity loan will not. The balance is taxed as if it were ordinary income and, unless she is at
least 59 years old, failure to pay the 401(k) loan back by the due date triggers a 10% penalty.

So, what are Barbara’s choices? In general, if she can take out a home-equity loan at a lower after-tax
cost than the return she expects to receive on her 401(k), she should choose the home-equity loan."

Financial Reform Act

The financial reform bill recently signed into law is an attempt to address some of the problems that contributed to the 2008 financial crisis. The legislation, officially known as the Dodd-Frank Wall Street Reform and Consumer Protection Act, is considered the most wide-ranging overhaul of the U.S. financial system since the aftermath of the Great Depression. Because the problems it addresses are complex, the legislation itself is complex; much of the real impact will be felt only after regulations are developed to implement the law's provisions. Also, some provisions, such as those dealing with lending practices, will have a direct impact on individuals and investors; others will primarily affect the ways in which Wall Street functions.

Lenders

The Act requires originators of residential mortgages to disclose any conflicts of interest and compare costs and benefits of mortgages offered to a potential borrower. Lenders also will be required to verify whether, based on income, credit history, and other data, a borrower has a reasonable ability to repay a loan plus its associated taxes, insurance, and other costs. Lenders will no longer be able to give loan officers financial incentives that induce them to steer customers to a mortgage with a higher interest rate simply to increase their own commission. Their ability to impose prepayment penalties when a borrower repays a loan early also will be more limited, and a holder of a hybrid adjustable rate mortgage must receive notice of any change in the interest rate six months in advance. Lenders are prohibited from refinancing an existing mortgage unless the new mortgage offers a net benefit to the borrower, and they may not coerce or induce an appraiser to make a faulty appraisal of a property's value. High-cost mortgages are subject to special regulations. Any balloon payments on high-cost mortgages cannot be more than twice as large as the average of earlier payments, and a borrower must receive qualified counseling on the advisability of a high-cost mortgage before credit can be extended. Homeowners who are unable to make mortgage payments as a result of losing their jobs or because of a medical condition may now qualify for up to $50,000 in assistance loaned through HUD's existing Emergency Mortgage Assistance Fund.

Investments

Institutional investors' inability to determine the amount of global financial exposure to derivatives--investments based on the value of other investments--contributed to the panic at the height of the financial crisis. Over-the-counter derivatives must now be traded on a public exchange, and trades must be cleared through a registered clearinghouse. Nonstandard derivatives can still be traded privately, but must be reported to a central authority in order to increase regulators' ability to monitor the overall level of activity. Hedge funds and private-equity advisors will be required to register with the Securities and Exchange Commission (SEC) and disclose to the commission information such as investment positions and the amount of leverage involved. Also, the $1 million minimum net worth required to be an accredited investor eligible to invest in such funds will no longer include a principal residence, and that $1 million threshold will be reviewed every four years.

Credit rating firms, which were criticized for being too lax in their evaluations of securities based on subprime mortgages, will be subject to oversight by the SEC, which can fine those that issue too many faulty ratings over time. Also, investors will now have the right to sue an agency for issuing ratings it knew or should have known were flawed. Shareholders of public companies will have the right to a nonbinding vote on compensation for the company's executives. Also, protections for people reporting securities law violations have been enhanced. Whistle-blowers with information that leads to monetary sanctions of more than $1 million will be eligible for 10 percent to 30 percent of the funds collected from the offender; if an employer retaliates, a whistle-blower can sue without waiting until administrative remedies have been exhausted.

Banks

Banks will be required to hold additional capital to cover potential losses, and some securities are no longer acceptable as vehicles for capital reserves held by large banks. Banks also will be required to retain at least 5 percent of a loan on their books if the loan is sold and/or repackaged with other loans and securitized. (However, some relatively low-risk mortgages, such as fully documented loans with a fixed interest rate, are exempted.) Banks also will be more limited in their ability to engage in proprietary trading in their own accounts, which could represent a conflict of interest with their responsibility to their clients. They also will have to set up separate operations to handle their most risky derivative trades, such as swaps. A bank will not be permitted to invest more than 3 percent of its core capital in hedge funds and private equity, but it may still organize and offer them as long as certain conditions are met. A Consumer Financial Protection Bureau overseen by the Federal Reserve will be created to regulate consumer financial products and services.

A new Financial Stability Oversight Council is charged with assessing and managing risks that could threaten the entire U.S. financial system. Also, the FDIC will manage the liquidation of a bank whose failure the Treasury Secretary determines would disrupt the stability of the nation's financial system. That will include firing corporate management responsible for the failure and prohibiting any payments to shareholders until all other claims are paid. The FDIC may borrow from an Orderly Liquidation Fund to pay for a liquidation, but those costs must be replenished not from taxpayer funds but from claims on the bank and, if necessary, assessments on large financial institutions. The Act does not permit the Federal Reserve or the FDIC to lend to or provide a guarantee for individual or insolvent companies or banks, but both may lend funds to provide liquidity. During the financial crisis, the Federal Deposit Insurance Corp. (FDIC) temporarily increased from $100,000 to $250,000 the amount it will insure on deposit accounts in FDIC-insured banks. The $250,000 limit is now permanent. That means that a couple who each had separate deposit accounts as well as a single joint account could qualify for up to $750,000 worth of protection on those accounts.

(Source - Forefield, Inc.)

 

Not looking so good for Goldilocks!

Per David Rosenberg - "Next year's scheduled tax hikes are significant - the top marginal income tax rate goes from 35% to 41%, capital gains goes from 15% to 20%, the top dividend rate rises from 15% to 39.6% and estate taxes from 0% to 55%." "Meanwhile, we have at least 1.5 percentage points of fiscal drag coming our way next year..." and per Kenneth Chenault (CEO of American Express) -" While spending among affluent consumers and businesses remains strong, today's card members are borrowing less and paying down more of their outstanding debt."

Earnings appear strong but economic activity appears to be weakening, suggesting earnings are a lagging indicator here. The economic headwinds appear to be getting stronger. Yes, the equity markets tend to be discounters of forward expectations and thus turn early, but skepticism should remain the order of the day here.

Tax Cuts or Government Spending - Which will help more?

Greg Mankiw - "Perhaps the most compelling research on this subject is a very recent study by my colleagues Alberto Alesina and Silvia Ardagna at Harvard. They used data from the Organization for Economic Cooperation and Development to identify every major fiscal stimulus adopted by the 30 OECD countries between 1970 and 2007. Alesina and Ardagna then separated those plans that were in fact followed by robust economic growth from those that were not, and compared their characteristics. They found that the stimulus packages that appeared to be successful had cut business and income taxes, while those that evidently did not succeed had increased government spending and transfer payments.

The data in the Alesina-Ardagna study are mostly European; only a small portion comes from the United States. But the evidence leads to conclusions that are very similar to those from Mountford and Uhlig's work using American data. These conclusions are also consistent with the work of Ramey and the Romers, which looked at the historical record to identify multipliers. There appears to be a growing body of evidence, then, suggesting that taxes may be a better tool for fiscal stimulus than conventional models have indicated.

Why would that be? At this point, there is no clear-cut answer, but it is easy to come up with plausible conjectures. The most obvious candidate would be the supply-side effects of tax cuts. Tax rates, for instance, clearly influence work incentives. And economists who focus on supply-side incentives argue that Keynesians overestimate the importance of aggregate demand while underestimating the role that people's willingness to work and invest plays in the performance of modern economies"

Read the full article

To Roth or Not To Roth

Roth Conversions -

This is a link to an interesting discussion on Roth conversions. I generally believe they make sense for younger investors and/or investors with small IRA balances. The need to pay conversion taxes with assets outside of the IRA is often the biggest obstacle. It can make sense but pros/cons need to be weighed carefully, as this discussion highlights.

There are ways to track down past contributions to retirement accounts | - NJ.com

There are ways to track down past contributions to retirement accounts | - NJ.com.

This column highlights a couple of points:

1) You can track down old 401ks

2) Save yourself the trouble and transfer the 401k from your prior employer to either your new employer's plan or to an IRA. I'd suggest the IRA as it gives you more control over the assets and more investment options.

Asset Allocation

There are various approaches to calculating an asset allocation that makes the most sense for you.

The most popular approach is to look at what you're investing for and how long you have to reach each goal. Those goals get balanced against your need for money to live on. The more secure your immediate income and the longer you have to achieve your investing goals, the more aggressively you might be able to invest for them. Your asset allocation might have a greater percentage of stocks than either bonds or cash, for example. Or you might be in the opposite situation. If you're stretched financially and would have to tap your investments in an emergency, you'll need to balance that fact against your longer-term goals. In addition to establishing an emergency fund, you may need to invest more conservatively than you might otherwise want to.

Some investors believe in shifting their assets among asset classes based on which types of investments they expect will do well or poorly in the near term. However, this approach, called "market timing," is extremely difficult even for experienced investors. If you're determined to try this, you should probably get some expert advice--and recognize that no one really knows where markets are headed.

Some people try to match market returns with an overall "core" strategy for most of their portfolio. They then put a smaller portion in very targeted investments that may behave very differently from those in the core and provide greater overall diversification. These often are asset classes that an investor thinks could benefit from more active management.

Just as you allocate your assets in an overall portfolio, you can also allocate assets for a specific goal. For example, you might have one asset allocation for retirement savings and another for college tuition bills. A retired professional with a conservative overall portfolio might still be comfortable investing more aggressively with money intended to be a grandchild's inheritance. Someone who has taken the risk of starting a business might decide to be more conservative with his or her personal portfolio.

Things to think about

•    Don't forget about the impact of inflation on your savings. As time goes by, your money will probably buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you think of yourself as a conservative investor, your asset allocation should take long-term inflation into account.

•    Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested keeps you awake worrying at night, you may need to rethink your investing goals and whether the strategy you're pursuing is worth the lost sleep.

•    Your tax status might affect your asset allocation, though your decisions shouldn't be based solely on tax concerns.

Even if your asset allocation was right for you when you chose it, it may not be right for you now. It should change as your circumstances do and as new ways to invest are introduced.

how-people-lose-money-trying-to-save-on-taxes: Personal Finance News from Yahoo! Finance

how-people-lose-money-trying-to-save-on-taxes: Personal Finance News from Yahoo! Finance.

I would add to this not selling a position with a loss because the investor doesn't want to recognize the loss. This shouldn't be the primary consideration when making a sell decision. The primary considerations should be the future prospects for the holding and the relative value of the position vs a new holding. If another position provides greater potential - total return, asset allocation, etc, then it may make sense to realize the loss.

Bottom line - investment thesis should carry more weight in the final decision.

David Rosenberg

For anyone unfamiliar with David Rosenberg, I highly recommend clicking on the link and reading his commentary:

https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_042910.pdf

You may not agree with his thoughts but they are always well reasoned and frequently run against the grain.

401ks and Investment Advice

A recent survey by Hewitt and Financial Engines (Bill Sharpe) suggests that participants who use the "help" options available via their 401k plan - target-date funds, managed accounts, online advice, etc. do much better than their peers who do not.

Interestingly, those not using the "help" services typically had higher risk levels which did not decline as they approached retirement. I have noticed while reviewing client 401k portfolios that often the risk is "embedded" in their portfolios and typically not something someone with little free time to review their portfolios would notice. For example, many will have significant allocations to company stock, which is risky given their current financial health is also dependent on said company. Further, they may have excessive exposure to their own industry, following the mantra to invest in what you know. However, again, their current financial health is wed to the same industry. A downtown in the industry, think financials in 2008, could lead to job loss, investment losses as the company stock declines and additional investment losses as the sector declines. That's a lot of risk that can be overlooked easily by uniformed or busy participants. And that's just one type of risk! Using the available services and/or having your financial advisor review your401k allocation quarterly makes sense now and for retirement.

PLANADVISER.com - More Retirement Plan Participants Want Investment Advice

PLANADVISER.com - More Retirement Plan Participants Want Investment Advice.

This is a worthwhile pursuit! Many investors have the time and expertise to manage their own 401ks. Good for them! Most participants, however, don't have the time or the expertise to adequately manage their retirement accounts, yet these accounts will constitute the bulk of their post-retirement income. Many respond by simply investing in money market funds or stable value funds or target date funds. This approach can be detrimental. While target date funds can be valuable, investing 100% of assets in money market funds or stable value funds can introduce purchasing power risk (inflation exceeds the participants gross return) and potentially reduce their post-retirement standard of living.

Thus, the services of an independent advisor can be useful. The usual caveats do apply - experience, commitment, integrity of advisor, etc. but an good advisor can add value by providing insight into investment options, market and economic expectations, and asset allocation decisions. Many advisors provide these services as an adjunct to other services they may already be providing participants (discretionary investment management or advisory services on taxable accounts for instance). Software enables the advisor to aggregate the 401k information with the asset accounts he/she is already monitoring and incorporate the retirement account allocation into the broad client allocaiton.

If you haven't given this some thought yet, do so. An independent third party review can be beneficial.

Emerging markets debt - Seeking Alpha

http://seekingalpha.com/article/196319-high-conviction-emerging-markets-debt-offers-strong-potential?source=hp_wc This is a link to an article on the Seeking Alpha website regarding our interest in emerging markets debt as an appropriate fixed income strategy.

Plan your Investment Strategy

Setting investment goals means defining your dreams for the future. When you're setting goals, it's best to be as specific as possible. For instance, you know you want to retire, but when? You know you want to send your child to college, but to an Ivy League school or to the community college down the street? Writing down and prioritizing your investment goals is an important first step toward developing an investment plan.

Your investment time horizon is the number of years you have to invest toward a specific goal. Each investment goal you set will have a different time horizon. For example, some of your investment goals will be long term (e.g., you have more than 15 years to plan), some will be short term (e.g., you have 5 years or less to plan), and some will be intermediate (e.g., you have between 5 and 15 years to plan). Establishing time horizons will help you determine how aggressively you will need to invest to accumulate the amount needed to meet your goals.

Although you can invest a lump sum of cash, many people find that regular, systematic investing is also a great way to build wealth over time. Start by determining how much you'll need to set aside monthly or annually to meet each goal. Although you'll want to invest as much as possible, choose a realistic amount that takes into account your other financial obligations, so that you can easily stick with your plan. But always be on the lookout for opportunities to increase the amount you're investing, such as participating in an automatic investment program that boosts your contribution by a certain percentage each year, or by dedicating a portion of every raise, bonus, cash gift, or tax refund you receive to your investment objectives.

No matter what your financial goals, you'll need to decide how to best allocate your investment dollars. One important consideration is your tolerance for risk. All investments carry some risk, but some carry more than others.How well can you handle market ups and downs? Are you willing to accept a higher degree of risk in exchange for the opportunity to earn a higher rate of return? Whether you're investing for retirement, college, or another financial goal, your overall objective is to maximize returns
without taking on more risk than you can bear. But no matter what level of risk you're comfortable with, make sure to choose investments that are consistent with your goals and time horizon.

Where's your 401k?

If you’re leaving your company because of a downsizing or a switch in jobs don’t forget about the assets in your 401(k) plan. All too often, departing employees leave behind their retirement plans without giving much thought to the consequences.

According to a recent survey by Charles Schwab, almost half of the money held in 401(k) plans by employees who left their jobs during the first quarter of 2008 had not been moved a year later. While there is no penalty for leaving your 401k with your prior employer, there are benefits to moving the account. In fact, you have three other principal options: take a cash distribution, move the funds to a new employer’s plan, or roll over the assets to an IRA.

The cash distribution option should be considered the last resort, hardship option only. Under this scenario, you elect to take a lump-sum distribution from a 401(k) plan when leaving. Unfortunately, that election could result in a hefty tax bill. The amount representing pre-tax contributions and earnings in the 401(k) is taxed at ordinary income rates reaching as high as 35% on the federal level. If you’re under age 59½, the IRS will generally tack on a 10% “early withdrawal” penalty. And you still have to worry about state and local taxes and state penalties.

Besides incurring tax liability now, this approach means forfeiting the future benefit of tax-deferred savings and leaving a gap in your retirement plan. After 60 days have passed, you’ll have lost the opportunity to transfer the funds to another tax-advantaged plan. The final kicker? The employer’s 401(k) administrator will automatically withhold 20% of the payout, regardless of your personal circumstances. Again, this is the last resort, hardship option only.

If and when you find another job, you often can move your 401(k) balance to another 401(k) or other tax-qualified retirement plan available through your new company. That way, your assets will continue to grow tax-deferred without interruption. This direct transfer is also exempt from the early withdrawal penalty, and there’s no tax withholding as long as you arrange a trustee-to-trustee transfer from one plan to another. Avoid taking the funds yourself, because if you do, 20% will be withheld, and you won’t be able to recover that money until you file your tax return for the year of the transfer.

Finally, you can role the 401k account into an Individual Retirement Account (IRA). This may be the most advantageous approach. An IRA generally offers greater investment flexibility, letting you invest in a wide variety of stocks, bonds, and mutual funds, compared with 401(k) choices that tend to be more limited. And the IRA may give you greater control over distributions during retirement.
Beginning in 2010, all employees now also have a fourth option—rolling over employer plan funds to a Roth IRA that provides tax-free distributions during retirement. (Previously, Roth conversions were allowed only in a year in which your adjusted gross income didn’t exceed $100,000.) But moving money to a Roth means paying income tax on the untaxed portion of your account, unless you have large tax deductions that you can claim to offset this extra income.

Is it or isn't it?

Visited Walmart this weekend and overheard several conversations among shoppers about bargains. Meanwhile, credit unions are offering 2.9% auto financing on used cars to get consumers on the lot. Businesses continue to say their markets are as bad as ever and they're just trying to tough it out.

Meanwhile, the VIX is near recent lows, equity fund manager cash balances near all-time lows, and NASDAQ and the Russell 2000 (small cap stocks) are leading equities YTD. Yet, bond managers are near all-time cash balance highs.

Are we waiting for another shoe to drop, like fixed income managers, as consumers continue to tighten their finances? or are we on the leading edge of a recovery, as equity investors apparently believe, led by something other than consumers?

Economists vs Analysts

Consensus 3% GDP growth is inconsistent with consensus 30% earnings growth. True or False.

Depends on perspective. I've looked at the last 20 years of S&P 500 earnings (gathered from the S&P website) and GDP growth info from the Economics and Statistics Administration. I don't see a defined correlation. That is earnings can grow more than 30% in a low growth economic environment. That doesn't mean it will happen.

The fallacy in this Morningstar post is that because investment analysts expect 30% earnings growth and 1Q results were good (until you parse out financials) that economists forecasting GDP must be wrong and therefore will have to revise their forecasts up. I disagree - I think it's more likely that economists are spot-on and analysts are incorrect and will be reducing earnings growth expectations as the year wears on.

Where does substantial growth come from with tight credit, nominal CAPEX spending and high unemployment?

Consumer asset allocation

According to a study referenced by Dave Rosenberg, U.S. Consumers have their assets allocated accordingly:

34% Real Estate

34% Equity

16% Cash

9% personal property (durable goods)

8% Corporate/Muni fixed income

1% Treasuries

This represents roughly $53 Trillion in assets. Not much yield, huh! Liquidity is also a potential issue. Many investors consider 16% cash to be money on the sidelines waiting to be invested but I've noted before that several studies have shown that that money never does come off the sidelines. Instead, investors will alter their "investable" allocations. This allocation looks ripe for risk reduction and an improvement in yield. Rosenberg believes that suggests high quality fixed income. Makes sense.

The Real Reason Gold's Above $1,000

The Real Reason Gold's Above $1,000.

This article dovetails nicely with news today that the Fed wants pay interest to financial institutions on long-term deposits  . This is intended to be one of the Fed's exit strategies in the coming year(s). Cowen is doubtful of the Fed's ability to pull it off successfully as am I.

He believes gold has run up because investors are fearful but are uncertain of what exactly is the basis of their fear. Inflation is a key element but unlikely the sole determinant. As for me, I believe there are two groups of gold buyers - first, is central banks hedging the dollar decline in hard assets, second, is speculators buying momentum. I expect any improvement in the dollar will cause a corresponding decline in gold over the near term.

The key question is what will cause the dollar to improve? I don't have answers to that as I believe we'll continue to see a weak recovery in 2010 and continuing misguided calls for a second stimulus. Neither will do much to help the dollar improve.

Inflation will be an important measure to track in 2010. I believe we'll see inflation creeping back in as energy prices begin to climb again and as the economy continues to improve. I will be more surprised if inflation is not back over 3% by year-end 2010 than if it is.

Is it time for your annual checkup?

Most everyone has, formally or informally, a financial strategy that should be regularly reviewed. For example, you probably follow a budget, save for special goals, or look over your retirement savings from time to time. Whether paying bills or preparing your income tax return, you frequently look at various parts of your finances. However, at least once each year, you should pull all your records together and take a close look at your entire financial picture. Here’s a brief description of what a typical annual review might entail:

1) Cash flow analysis. Does your income equal or exceed your fixed and variable expenses? The amount of income that exceeds what you spend is called positive cash flow. If your expenses exceed your income, you have negative cash flow. If your cash flow is negative, it may be time to reorganize your budget and minimize any unnecessary expenses so that you can focus on saving for your future.

2) Provide money for special goals. For every financial goal you establish, you need to address the projected cost, the amount of time until your goal is to be realized (time horizon), and your funding method (a scheduled savings plan, liquidating some assets, or taking a loan). You should plan your goals according to priority. Most importantly, you should have an emergency fund of at least three months of income to handle life’s unexpected turns. Secondly, you may establish a savings plan for larger, long-term goals, such as your child’s wedding or educational expenses. Finally, consider the priority of more flexible goals (e.g., purchasing an automobile, enacting home renovations, and planning a vacation).

3) Enrich your retirement. Are you going to have enough money when you retire? Pensions and Social Security may provide insufficient income to maintain existing lifestyles during your retirement years. Consequently, review your retirement needs and plan a disciplined savings program for your retirement.

4) Minimize income taxes. Many taxpayers reduce their liability by taking advantage of tax breaks, such as contributing pre-tax dollars to an employer-sponsored retirement plan. Most also claim deductions for mortgage interest, traditional IRA contributions, or charitable donations. In addition, there may be other ways of reducing your tax liability. For example, under appropriate circumstances, losses or expenses from previous years may be carried over to the next tax year.

5) Beat inflation. Suppose the current inflation rate is 4%. In order to maintain your buying power, you would need a 4% annual wage increase so that your income keeps pace with rising prices. A decline in your buying power would certainly lower your standard of living and affect your lifestyle. Consequently, consider putting your money to work for you to beat inflation.

6) Manage unexpected risks. You are probably well aware that life involves risk, which could lead to financial loss. For example, you could become disabled without income, or an untimely death could cause financial hardship for your family. As a result, many have made insurance the cornerstone of their overall finances because it offers protection that can help cover potential liabilities and risks.

These six steps will help you focus on the important issues that affect your finances. As you review your financial situation on at least an annual basis, you will probably need to make alterations due to changing goals and circumstances.

Fighting the Sliding Dollar

Fighting the Sliding Dollar.

I'm a fan of global strategies in general. When you have limited resources with which to conduct global economic research its best to leverage the skills and resources of others. Using global strategies enables you to select managers with a demonstrated ability to make the global asset allocation decision well.

This article refers to global bond funds which mute the impact of the declining dollar. I have been using global bond strategies for clients and do believe this approach is practical. I've done it primarily because I like the global, particularly emerging, balance sheets better than ours, but the active currency management is attractive as well.

These strategies can be more volatile than most domestic bond funds so keep that in mind when conducting your research and deciding if these funds can play a role in your portfolio.

Various Thoughts

While catching up on my reading over the weekend and this morning several thoughts came to mind (it does happen from time to time):

1) It seems to me that market performance over the last quarter has been driven by the weakening dollar rather than by expectations for economic performance. That is equity market performance has been driven by liquidity rather than fundamentals (someone else's phrase but fitting just the same). This is disconcerting as it suggests to me that a real correction is possible - greater than the 10-15% or so I have been assuming for awhile. I don't think it will happen in the next 5 weeks, though some suggest a sell-off is possible in late December as active investors lock in gains and reduce risk to ensure year-end bonuses. More likely it'll occur in the early part of 2010. I'm a strong advocate for constructing portfolios that are more conservative than an investor's risk tolerance. Such a portfolio pays an "insurance premium" to reduce volatility and hopefully hedge downside risk. If you haven't done so, give this some thought heading into year-end.

2) I went to grad school in the early 90's and Monetarism was favored over Keynesianism. I favor less government and more private enterprise but acknowledge that the government has a role in providing services private participants are unwilling to provide. However, these services should be provided in relationship to the government's ability to pay for them. This link is to a new study by two Harvard economists that finds that "Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions." I'm biased in this direction but it is nice to see new evidence that supports tax cuts over spending. Policies favoring increasing spending, increasing debt and increasing taxes are not good for investors. Which leads to point 3.

3)

Source: Mark Perry

The emerging markets, particularly Asia, despite recent equity market run-ups continue to look attractive. As this chart shows the Asian countries have significantly increased their contribution to global GDP and at the expense of the EU15. The dip in the late 90s is likely attributable to the currency crisis in 97 and the Russian default/LTCC debacle in 98. Lessons were learned at that time that helped in 2007-2008. Per the IMF, advanced economics (largely the EU, US, Japan) had a current account balance of (.66)% of GDP for 2009 and are forecast to only reduce that to (0.33)% by 2014. Emerging and developing countries, by comparison, had a current account balance of 2.02% for 2009 and are forecast to increase that to 3.5% by 2014. Additionally, gross national savings for advanced countries is forecast to 17.5% of GDP in 2010 but 33.5% for developing and emerging countries. Stronger balance sheets and higher savings rates lead to improvements in net worth (standard of living) and to better investment returns. Continue to consider emerging markets for your portfolios at the expense of the U.S. and other developed markets. This isn't to say eliminate developed markets just be skeptical of equity market returns in the near term.

Keeping Tabs on Your Portfolio - Morningstar - The Short Answer

Keeping Tabs on Your Portfolio - Morningstar - The Short Answer.

It is important to review your investment portfolios (taxable, 401k, IRA, etc) at least quarterly to ensure the asset allocation is as you want it to be, investments are performing in line with expectations, no management changes have taken place (of if they have, that they're not material to the management of the fund), etc.

If you're a buy and hold investor, that doesn't mean buy and ignore. Things change and its important to stay on top of that. Not doing so can lead to unintended consequences such as a significant overweight in domestic equities in early 2008 just as you were getting ready to retire.

Review and adjust, if necessary, at least quarterly. As part of the process consider your risk appetite at the time, liquidity needs, time horizon, etc. This isn't a cure all but will help you better manage risk over time.

The article provides a few good insights on things to consider as you conduct your review. If you don't have time to do this yourself, then get help from a financial advisor.

FinancialAdvisorMatch :An Alternative to Traditional Asset Allocation

FinancialAdvisorMatch :An Alternative to Traditional Asset Allocation.

Article written by me published yesterday.

What Should a Financial Advisor Do for You?

I've seen a number of articles lately on the role of the financial advisor. I've also been asked lately where do I think the markets are headed. Both thoughts dovetail nicely I think.

The financial advisor's role is to help protect and build your asset base. You have worked hard over the years to build up a 401k balance, own a nice home and build, hopefully, a taxable investment portfolio as well. You have also tried to save money for college, for retirement and for future generations. You want to retire earlier than your parents did and enjoy the "fruits of your labor". This is where the advisor comes in.

Most of us do not have the ability to forecast the future with precision. Thus, our objective is to forecast as best as possible and hedge the potential risks we expect to encounter along the way. We will attempt to protect your assets via financial and estate planning techniques so that you keep as much as possible of what you have earned and have the best opportunities to pass on a legacy to future generations of your family. A number of risks are encountered in this process - legal and regulatory changes, economic cycles, etc. Not all can be forecast with certainty and the advisor should account for that uncertainty.

With regard to investments, I believe advisors should be focused on constructing portfolios that attempt to meet basic goals - generate an absolute return that exceeds inflation plus a spending percentage and hedge against potential downside risks. These are competing goals and thus require constant examination. Asset allocation is not dead but does need to be revisited conceptually. I believe that rather than regarding asset allocation as an equity/fixed/other combination, advisors should be viewing asset allocation as core-satellite or on a risk basis. The allocation decision is driven by risk targets first, then by return. So the objective is to properly allocate risk among various assets. In this assessment, lower risk strategies are considered core strategies and can be fixed income, equity or other assets. Same goes for riskier assets (satellite). This does involve a degree of tactical asset allocation which involves trading more the riskier assets more frequently. I'm not trying to time the perfect entry and exit, rather, I'm trying to take advantage of volatility to provide excess return when assets are moving up and hedge downside risk when assets are declining. It's not perfect but I think better addresses my primary objectives than the traditional asset allocation approach.

So the financial advisor is attempting to preserve and grow what you've acquired. We should be more conservative than you most of the time and should be the "voice inside your head" attempting to reason you out of more aggressive decisions. We're not perfect, but if we successful one more time than we're not, we should do well for you.

As to where the markets are going, I don't know. I'm always skeptical (never truly a bull or a bear) and always more comfortable with a portfolio that has some "insurance" against a market decline. I think the "premium" paid to hedge some of the downside volatility is worthwhile.

Planadviser.com

Planadviser.com. The link is to a survey which states that Americans want more financial education. Unfortunately, the majority still do not intend to use a financial advisor. Obviously, I'm biased, but a good financial advisor who lives and breathes investing, financial planning, etc. can offer tremendous value to investors willing to tap into this knowledge.

If you're working with an advisor and haven't discussed educational topics, considering doing so. You'll increase your comfort level with your advisor and with the discussions you make as you'll increase your personal knowledge and your comfort level with your advisor's knowledge.

If you're not working with an advisor, give it some thought. If you're already a sophisticated investor then an advisor could be a sounding board. If you're less sophisticated, an advisor can help improve your financial situation while also increasing your financial acumen.