The Bull Market – Real or an Illusion?

Posted on May 19th, 2009 in Investments, Newsletter Articles, Risk Management by wayne

Since March 9th, the S&P 500 has increased by almost 35%. In normal times, this increase would signal a major bull market rally. However, these are not “normal times.”

As an asset manager, I must continually consider whether I should be increasing, decreasing or maintaining my clients’ equity (stock market) allocations. My decision has been to use the market rally to lower my clients’ equity positions. While my crystal ball is no better than yours, here are a few of the factors that that I believe could negatively impact the market.

1) Valuation – Most economist are predicting that the S&P 500 will end 2009 with operating earning per share (before write-offs) of between $45 and $55. With the S&P 500 index at approximately 900, these earnings provide (pre-write off) P/E (price earnings) ratios of between 16 and 20. In a healthy, growing economy, those P/E values would signify a fully valued market. Can these P/Es be justified in our current environment?

2) Federal Debt – Many ‘bulls” argue that low interest rates justify paying a higher P/E on equities. In normal times, they would be correct. However, with the $700 billion stimulus package, a $1.8 trillion 2010 federal deficit and over $1 trillion dollars committed to federal bail outs, our federal debt will likely increase by well over $2 trillion in the next 18 months. (Remember, a trillion is 1,000 billions)

At some point, China, Japan and other “saving” countries will only buy our federal debt if it is offered at much higher interest rates. When interest rates increase, debt oriented investments become more attractive and equity investments less so. Higher interest rates will also make corporate borrowing more costly, which could easily damage our economic recovery.

3) Commercial Real Estate – The recent financial crisis, requiring $700 billion in TARP funds (not to mention TALF and PPIP), was mainly created by consumer debt. Defaults on mortgages, home equity lines and credit card debt created most of the current “toxic assets.” However, the next “shoe to fall” is commercial real estate. Large commercial real estate bankruptcies are beginning to proliferate. As these failures continue, expect to see more toxic assets appear on our bank’s balance sheets.

4) Toxic Assets – Many banks have balance sheets filled with toxic assets, with more likely to come. The Treasury has proposed the PPIP program to help banks remove these toxic assets to a “private/public partnership.” It seems unlikely that these assets are worth the value at which they are carried on the banks’ balance sheets. Assuming these toxic assets are purchased, much of any losses suffered, as reflected in the difference between their final value and the price paid under the PPIP program, will be assumed by the tax payers (you and me). These losses will increase our federal debt, putting even more pressure on interest rates.

5) International Event – Shortly after the election, our new Vice President predicted that the administration would be tested with an international crisis within its first six months. Most recent administrations have been tested during their early phases. Needless to say, there are many candidates to test our will and resolve. If such an incident occurs, the market will react negatively until the situation is resolved.

While “green shoots” may be appearing, along with signs that the recession may be slowing, our economy still faces many daunting problems. Until there are workable solutions to these problems, it will be difficult for the economy to have a significant recovery.

Considering the problems facing our economic recovery, it is hard to see significant stock market upside at current market prices. While it never pays to time the market, practicing “market intelligence” is always wise. If you are a long term investor, it may be prudent to stay at the low end of your investment policy’s equity allocation. In turbulent markets, investors should focus on asset preservation. The goal of asset preservation is to have the maximum assets available to invest when the economy truly begins to recover and grow.

Use Caution with Deferred Annuities

Posted on May 19th, 2009 in Investments, Newsletter Articles, Risk Management by wayne

With the stock market in turmoil and interest rates at all time lows, you might be tempted to purchase a deferred annuity. The deferred annuity sales person will tell you about the tax deferred benefits, the guaranteed return if you were to die and may even provide a product that gives you market related returns when the stock market is up, while guaranteeing that you will not have a loss in value during a down market. If this sounds too good to be true, it probably is.

Since the deferred annuity sales person will be paid a commission as high as 10% on your deferred annuity purchase, let’s take a closer look at what he/she is trying to sell you. Here are some areas that are not always well explained by the deferred annuity sales person.

1) Mortality and Expenses (M&E) Charges – All deferred annuities have M&E charges to pay for the life insurance guarantee, the sales person’s commissions and the administrative expenses of the contract. M&E charges are usually between 1% and 2% of the contract value, paid every year. If your deferred annuity has a value of $100,000, up to $2,000 annually will be used for M&E expenses. Even though you will likely never see these charges, they are being taken from your investment each year.

2) Surrender Charges – Virtually all deferred annuities that are sold through commissioned sales people will carry a surrender charge. Typically, these charges begin at 7% for the first year of the contract and decrease by 1% per year. Seven years after you purchase the contract, you may still have to pay 1% of its total value if you want to cash it in. Sometimes, you are allowed to withdraw up to10% of contract value yearly. However, the surrender charges assure that the insurance company will have your money long enough to pay for the high sales commissions required.

3) Management Fees – If you buy a variable annuity, the subaccounts are very similar to mutual funds. A typical subaccount will have a 1% or higher management fee. This expense is over and above the M&E fees that were previously discussed. While these fees are somewhat consistent with the fees charged for actively managed mutual funds, they are up to 5 times as high as the fees charged for indexed mutual funds and Exchange Traded Funds (ETFs). The subaccount returns will be net of the management fees, but they will not show the M&E fees that are assessed each year.

While it is true that a deferred annuity will be tax deferred until you cash it in or annuitize it, all gains of the deferred annuity will be taxed at your ordinary income rate when you receive your returns. Since the deferred annuity is typically held for 10+ years, this tax advantage may completely disappear when you cash it out.

If you believe that a deferred annuity is right for you, before you buy the product that your sales person is offering, contact Schwab, Fidelity, Vanguard or another discount brokerage house. They will likely have a similar deferred annuity product. Compare M&E expenses, surrender charges and management fees of the non-commissioned product with the one you are being sold. You will likely find that the non-commissioned product provides a better total return than the one that you are being sold.