Yes, there at lots of things we just don’t know and can’t completely plan for, and that is just the nature of life.  But, perhaps the best we can hope for is to make some basic assumptions and at least get started on a plan.  As with a business plan, a personal retirement plan works best when it is first created, and then modified each year to meet changing circumstances and the twists and turns life brings to us all.

So let’s get started with some homework you should do before any calculations are made. 

 How much money do you make today?

Your current income is a logical starting point for calculating your retirement planning savings needs. Generally, the more you make today, the more savings you’ll need for retirement to keep pace with the lifestyle you will be accustomed to at the point you retire.  For most of us, the incomes we earn when starting out, and the lifestyles we lead, are far more humble than those later in life.  When you retire, you want to maintain the last and/or best lifestyle you have grown accustomed to if at all possible.

 When do you want to retire?

If you wait longer until retirement, not only will you be retired for a shorter amount of time, but you will also work more years, meaning you can save more before you do finally retire.  Conversely, the younger you are when you retire, the longer you can expect to live during retirement and the more you need to have saved beforehand.  In addition, the effects of inflation can severely impact retiring too early, or even retiring then maintaining your lifestyle.

What do you want to do once you retire?

What do you envision for your retirement years?  Does your vision of life in retirement look like the one you have now with more spare time, or do you dream to do all the things you were not able to do during your working years, like travel to exotic places, own a vacation home on the lake, or perhaps buy an RV and travel the country?  Conversely, perhaps you fancy the idea of an early retirement in exchange for a lower standard of living.  There is no right or wrong answer to this of course, but understanding your desired retirement lifestyle is an essential element in answering the “How much savings will I need?” question.

How much will you collect from Social Security?

Most financial planners will calculate retirement needs assuming that monthly social security payments will defray living needs in retirement.  Expected future benefit payments are available annually from the Social Security Administration and are based on your lifetime earnings to date.  Personally, if you are currently under 50 years old, I would not count on the social security income in retirement.  In fact, as a practicing CPA and money manager, I have advised my clients for the last 30 years NOT to count on social security as we planned for retirement.  Believe me, I do hope it is there for you and me, but I consider it only icing on the cake at best, and simply would not count on it being there the rest of my life.  One needs only look at massive budget deficits and the political landscape today to see just how possible the reduction or elimination of social security is more than possible.

Will you receive any 401(K), IRA, or other pension benefits during retirement?

If you contribute to an IRA or your employer 401(K) plan, or if you are covered under another type of pension plan, then congratulations and do continue funding as much as possible where you can do so.  These plans not only defer taxes, but increase the amount of money you will have available to meet your living needs during retirement.  Calculate your expected retirement benefit from these plans when calculating the amount of savings you will need to provide to meet your living needs.

How do you invest?

During your working years, to the point of your retirement, how you invest will help determine what you might be able to accumulate towards your retirement nest egg.  Historically, if you invested more aggressively over 20 years or more, you would reasonably expect a higher rate of return on your investments as compared to investing more conservatively.  That would mean you would have had to save less money compared to another individual who insisted on keeping all investments safe but low return types of portfolios or bank accounts.  Having said that, the truth of the matter is that the last decade has produced a very volatile stock market, and when measured by the S&P 500, returns have been flat to down during this time frame.  However, a mix of small cap, international and emerging markets investments, along with a proper balance of fixed income, has actually produced reasonable results.  The point is then, that traditional thought of investing aggressively in large cap US stocks has not provided superior returns, while a well diversified multiple asset class portfolio has, with less risk to boot.  Therefore, getting some very good advice on how to construct your portfolio for retirement is critical.

How old are you now, and how much have you saved already?

The younger you are and the more you save, the less you’ll need to save in the future in order to achieve the same retirement standard of living as someone older or with less money saved up until this point.  Unfortunately, many cannot start a significant savings program until the kids are out of college and on their own.  Waiting too long is of course a real disadvantage, but not impossible.  If you are ten to fifteen years to retirement and still have not amassed any savings, it’s not too late, but you must start now in a serious way. 

Up to this point, the above items can reasonably be determined and are based on your personal facts and circumstances.  Just recognize that over time, these too will change and that is why you should review your retirement plan at least annually.

Now for any of the online calculators used for retirement planning, there are several numbers you must enter that we cannot possibly know with certainty.  Again, annual updates will help to smooth out changes in the economy, markets, or personal circumstances to help you stay on track.

Unknown number 1 – the rate of Inflation        

For the last decade or so, we have enjoyed a very low rate of inflation, but it has not always been that way.  During the 1980s and other periods in our history, the rate of inflation has been very high.  Currently, inflation is running about 3.5% per year.  The government publishes several inflation indexes, the most popular known as the consumer price index (CPI).  The CPI is often reported as the “core rate” which excludes food and oil.  Personally, since I use food and oil to a large extent in my daily life, I prefer the CPI “Headline” rate of inflation, which includes food and oil.  It is usually a much higher number than the core rate, but a much better reflection of real inflation.  The CPI rates are available on line monthly.  Many believe that the inflation rate will spike up in the next few years, due to the massive spending and money printing policies to stimulate the economy.  The higher the rate of inflation you use, the more conservative your retirement savings calculations will be.  At a minimum, use the current headline rate, but make sure to update annually.  Don’t underestimate the rate of inflation issue.  You may be shocked to learn that the amount of money you need to live on today will likely be a much higher number 20 or 30 years from now.  For example at the current rates of inflation, if you spend $40,000 per year today, you will need $113,000 per year in 25 to 30 years just to maintain the same standard of living.   While many planners also assume that you will need less than your current income when you retire (75% to 80% of your current income), I do not subscribe to this theory.  Most of my clients are spending as much or more during retirement, not less.

Unknown number 2 – the rate of return on investments

All retirement calculators require you to enter an assumed rate of return on your investments between now and the date you expect to retire.  The truth is, the brightest minds in the country have no way of knowing this any more than you or I do.  They just sound really confident when they guess.  Up until the early part of this decade, most financial planners assumed the average rate of return on the S&P 500 (the stock market) would be about 11%.  At least that is what is was from the depression forward.  If you look at the last 10 years or so however, the S&P has been flat – no return at all.  If we couple that with the fact that long term treasury bonds are only paying under 3% right now, it would appear that returns will be muted in the short term.  Again, a balanced portfolio of many asset classes, global and domestic, is the approach we take to balance returns and risk.  In addition, the older we get, less money should be allocated to stocks and equities, and more to fixed income to control risk.  For now, an estimated return on investments should be a more reasonable number, such as 6% or less for a conservative investor.

Unknown number 3 – the “safe” withdrawal rate

The withdrawal rate is the annual percentage of money you would expect to be able to take from your investment portfolio during retirement, and never run out.  Ten years ago, most planners used an annual withdrawal rate of 5%, but that was when market returns were much higher.  I would suggest an annual withdrawal rate today, of 3.5% to 4% per year to be safe.  The worst possible outcome would be to run out of money during retirement, so I tend to lean conservatively on the withdrawal rate.           

In conclusion, you can see that there is no one size fits all way to plan for retirement.  The earlier you start this process however, the greater chance of success in saving enough to retire comfortably. 

Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years.  Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.

Many investors today utilize mutual funds as part of their overall investment plan.  Whether you must make your own mutual fund selections for your 401(K) or employer sponsored retirement plan, or use a professional investment advisor for other types of investment accounts, mutual funds can be an effective way to own baskets of stocks or bonds, with a small amount of investment dollars.

Understanding Mutual Funds

To successfully invest in mutual funds, you should understand what they are and how they work, so let’s start with some basics.

A mutual fund is a company that gathers money from many investors, and allocates that money by buying stocks, bonds or other assets.  A mutual fund is like a big basket which holds a number of investments like stocks or bonds.  When you buy a mutual fund, you actually buy a piece of the basket.  In this way, you can own a small percentage of many different assets that you might not otherwise be able to afford on an individual basis. 

The value of the fund is based on the value of the assets it holds. As the stocks or bonds within the fund increase in value, the fund increases in value. Conversely, as the stocks or bonds within the fund decrease in value, the fund also decreases in value.   Mutual funds only trade at the end of the day based on their net asset value (NAV). To determine the NAV at the end of the trading day, the mutual fund company looks at all of the assets that are in the basket, determines their value and divides that number by the total number of outstanding shares in the fund.

Types of Mutual Funds

Mutual funds are divided into two categories: closed-end funds and open-end funds.

Closed-end funds have a fixed number of shares issued to the public.  If you want to purchase a piece of the fund, you have to purchase an existing share from a shareholder that is selling.

Open-end funds have an unlimited number of shares. If you want to purchase a piece of the fund, the fund creates a new share and sells it to you. There are significantly more open-end funds than there are closed-end funds.  Closed end funds can trade at values that are above or below their NAV, while open end funds only trade at their end of day NAV.

Mutual Fund Research – Do Your Homework

Expenses

All mutual funds have expenses. Some funds’ expenses are low while other funds’ have very high expenses.  These include everything from the advisory fee paid the fund manager to administrative costs like printing and postage.

With a little bit of homework, you can determine a fund’s expenses before you invest.  This is important because those expenses can have a dramatic effect on your investment returns. The three expenses you should be aware of are loads, redemption fees and operating expenses.

Loads are commissions or fees that can be charged either when you buy or sell a mutual fund.  A front-end load (usually associated with class “A” shares) can be up to 8.5% of your investment.  A back-end load (usually called redemption fees, are associated with class “B” shares) can also be quite high, but reduces over the years, the longer you keep your investment in the fund.  Class “C” shares do not have a front or back end load, but have extremely high operating expenses deducted each and every year.  These loads are usually used to pay a commission to the agent who sold you the fund. No-load funds, on the other hand, do not charge any commission at the front or back end.

Operating expenses are generally stated as an annual percentage called the operating expense ratio. These fees cover the operating and trading costs for the fund, as well as management fees that go to pay the fund manager for his expertise and time.

12(b)-1 are fees that cover advertising and distribution expenses for the fund.  These fees are charged in addition to a front- or back-end load.

When doing your homework, look for no load funds that do not charge 12(b)-1 fees, and have a low operating expense ratio.  Studies have shown that load funds with high expense ratios perform no better than comparable no-load funds.

Taxes
Another point to consider when investing in mutual funds is taxes.  When a fund manager sells a stock or bond within the basket for a gain, IRS regulations provide that this gain be taxed to the shareholders of the fund.  This means that a fund with a high “turnover” (a fund that buys and sells a lot within the basket each year) could have a great deal of gains that will be taxable to the shareholders.  The tax gains are passed through to the shareholders who own the fund as of a specific date each year.  This means that someone buying the fund just before the taxable distribution date, will pay the tax on the gain for the entire year, even though they did not own the fund all year.  For more tax efficient funds, look for funds that have a low turnover rate.

Prospectus

By law, a mutual fund company must outline all of the above expense information, and a great deal more, in their prospectus.  A fund’s prospectus will specify a fund’s objectives and its past performance, information about the fund manager and the fees associated with the fund.

Past Performance

A common mistake for novice investors is to select a mutual based solely on its past performance record.  Past performance may not be a food indicator of future performance, given possible changes in the global or domestic economy, the markets, or specific sectors the fund invests in.  While past performance is a useful tool and one item to consider, it should not be the sole criteria.  In many cases last year’s winners are next year’s underperformers.

History

A fund that has been in existence five to ten years or more has a much better track record to assess than a relatively new fund that have not necessarily had performance measured during various economic or market periods.  The longer the period of history you have to review, the higher the quality of historical performance data.

Portfolio Holdings

When investing in mutual funds (or any investments), it is important to be diversified (see my blog titled “The Truth About Diversification”).  Sometimes, owning a few different mutual funds may give the appearance of being well diversified, but on closer inspection, if the funds you own, each have major holdings in the same stocks, you may not be diversified at all.  One test is to check the fund’s ten largest holdings. In the more concentrated funds, the ten largest holdings may comprise a significant percentage of the portfolio; in the less concentrated funds, they may hold a much lower percentage.  Always know what specific investments your fund or funds own to remain diversified.

Portfolio Manager

Mutual funds are managed by a portfolio manager, or in some cases, by a team of portfolio managers.  The success of a fund by an individual fund manager may be largely dictated by his performance.  That is important to know, because a fund with a good track record historically, may perform differently in the future if the fund manager changes.  It is always prudent to review the tenure of the fund manager in concert with past performance.

Statistics

There are several key statistical numbers that provide valuable information about a mutual fund.  Fortunately, we do not have to calculate those statistical numbers ourselves as they are readily available.

Alpha – measures the performance of a fund on a risk-adjusted basis. Alpha calculates a risk factor relative to a fund, and then compares that risk-adjusted performance to a benchmark (such as the S&P 500).  A number is then assigned that reflects how that fund performs, relative to the amount of risk the investment is exposed to.  For example, a positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%, or a negative alpha of -1.0 would indicate an underperformance compared to the benchmark  of 1%. 

Beta – measures how a mutual fund performs in relation to the market as a whole.  A beta of 1 for example, means that a mutual fund will move up or down in value in tandem with the market.  A beta of 2.0 would mean a mutual fund would go up twice as much as the market when it the market increases, but it will also go down twice as much when the market decreases.  That means this would be a much more volatile fund.  A conservative investor would look for investments with a lower beta, rather than a higher one. 

Standard Deviation – measures the risk, or volatility of a mutual fund or investment.  For example, a mutual fund might have a ten year average annual return of 8%.  At first blush, that might look very good.  But let’s say that this fund had a standard deviation of  20.  This would tell us that although the fund had on average returned 8% over ten years, it did not earn 8% each and every year.  Some years may have been up and some may have been down, but the average was 8% overall.  The standard deviation number tells us that we should expect that this fund “could” return 20% more or 20% less than 8% in any given year, most, but not all of the time.  There are certain times, more rare but possible, that a fund might move two or three standard deviations above or below the average 8% (60% more or 60% less).  In a down market, that could be painful.  The lower the standard deviation, the less risk or volatility a fund has.         

In conclusion, doing a little homework on mutual funds can really pay off later on not only in terms of performance, but also in terms of understanding risk and diversification.  You will find that all of the information discussed above is easily available on a number of internet sites, including Yahoo, MSN, and Morningstar to name a few.

Why You Should Diversify
Let’s say you have a portfolio of only one investment, all in a large insurance company.  It grows nicely and pays a handsome dividend for years, but then, a series of tornados in the Midwest devastate thousands of homes.  A short time later, two major hurricanes hit Florida then the gulf region.  Potential claims are so substantial that the insurance company could go bankrupt, and its stock plummets.  Your portfolio is crushed.  But now let’s say that instead of putting all of your money in to owning one insurance company, you had split your money equally putting half in to the insurance company and the other half in to a home improvement and building materials company.  In this instance, while the storm damages would cause your insurance stock to lose value, at the same time, homes would have to be rebuilt or repaired and the demand for building materials would skyrocket, as would your investment in the building materials company.  A statistician would say that because these two stocks seem to counterbalance each other, they do not have a strong “correlation”, meaning that they do not act the same way.  In building a diversified portfolio then, we want to have asset classes that not only do not act the same way, but actually have some degree of “inverse correlation”, meaning that if some investments go down, others will go up to offset losses (stocks and bonds often move in opposite directions).  This is why diversification keeps your risk of losses in check.  Now as you might imagine, the more you diversify your portfolio with inversely correlated asset classes, the better chance you have to lower risk.

Diversification or Diworsification?
Diworsification is a play on the word diversification, coined by the famed fund manager Peter Lynch.   While diversification involves a selection of assets with inverse correlations, which reduces risk and can increase potential returns, “diworsification” occurs by investing in too many assets that may appear to be different, but in fact act the same way.  A common mistake for example, would be for an investor to split his money over the top five performing U.S. large company mutual funds, with the assumption that five different mutual funds would be five totally different “diversified” investments.  On closer inspection however, by drilling down and looking at the top 25 stocks that each of these different mutual funds owned, one would be surprised to see that they all owned almost the exact same individual stocks.   

Two Kinds of Risk
When we talk about managing risk in the investing process, it’s important to note that there are actually several types of risk we need to be concerned with.

Systematic Risk – These are risks that affect the entire market and cannot be completely diversified away. Interest rate increases, recessions, political instability, exchange rates and wars are examples of systematic risks.

Unsystematic Risk – These are risks that are specific to individual stocks or investments, and can be diversified away as you increase the number of stocks or investments in your portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the advantages of diversification will exist only if the securities in the portfolio are not perfectly correlated
.

What is Asset Allocation?
Asset allocation is the strategy of dividing your total investment portfolio among various asset classes (that are not perfectly correlated), such as equities (stocks), fixed income (bonds), real estate, commodities, precious metals, etc. Asset allocation is the method we use to achieve effective diversification.
  
Some common asset classes are as follows:

• Large-cap stock – These are shares issued by large companies with a market capitalization generally greater than $10 billion.
• Mid-cap stock - These are issued by mid-sized companies with a market cap generally between $2 billion and $10 billion.

• Small-cap stocks - These represent smaller-sized companies with a market cap of less than $2 billion. These types of equities tend to have the highest risk due to lower liquidity.
• International securities - These types of assets are issued by foreign companies in developed nations, and are listed on a foreign exchange.  International securities allow an investor to diversify outside of his or her country, but they also have exposure to country specific economic or political risk.
• Emerging markets - This category represents securities from the financial markets of a developing country. While investments in emerging markets can offer a higher potential return, there is also higher risk, often due to political instability, country risk and lower liquidity.
• Fixed income securities - The fixed-income asset class comprises bonds or other debt obligations that pay the owner a set amount of interest, periodically or at maturity, as well as the return of principal when the security matures.  Maturities can range from short term to intermediate or long term.  These securities are intended to have lower risk because of the steady income they provide.  In reality, bonds can fluctuate in value and be worth more or less than the price you originally paid, if you seek to sell them before maturity.  In addition, there is always a risk of default if the issuer cannot repay the principal when due. Fixed-income securities include corporate and government bonds.
• Money market - Money market securities are debt securities that are extremely liquid investments with maturities of less than one year. Treasury bills (T-bills) and short term commercial paper make up the majority of these types of securities.
• Real-estate investment trusts (REITs) - Real estate investment trusts (REITs) trade similarly to equities, except the underlying asset is a share of a pool of mortgages or properties, rather than ownership of a company.

There is no standard formula that can find the right asset allocation for every person.  A customized asset allocation plan should only come after a professional assessment of an investor’s age, level of risk tolerance (how much can he lose in the short term and still sleep at night), anticipated future additions to the portfolio during working years, investment objectives (such as how big does the portfolio need to be at retirement age to meet expected living expenses) and other pertinent financial planning issues.  Only then can his specific investment goals be properly understood, and a roadmap to get there be designed.

Strategic and Tactical Asset Allocation
After an assessment is made and a suitable asset allocation plan is determined, a portfolio is divided in to various percentages of each asset class.  Over time, some classes will grow in value, and others will lose in value.  Using a strategic asset allocation method, those asset classes are periodically “rebalanced” back to their original starting percentages to keep risk management and diversification on track.  For example, an investor with a $200,000 portfolio may start with an asset allocation of 50% in stocks and 50% in fixed income.  After a year, when stocks have outperformed bonds, the portfolio now holds $130,000 in stocks and $110,000 in bonds.  Rebalancing would result in the sale of $10,000 worth of stocks from the portfolio, and the proceeds would be used to buy bonds, to get back to the original 50%/50% allocation.

On the other hand, if a tactical asset allocation method is used, a portfolio manager seeks to create extra value by modifying the percentages in each asset class to take advantage of certain economic or market conditions.  This is a more active strategy where a portfolio manager only returns to the portfolio’s original strategic asset mix after desired short-term profits are achieved.

Conclusion
Diversification via asset allocation is a fundamental investing principle, because it helps investors maximize profits while minimizing risk. Choosing an appropriate asset allocation strategy and conducting periodic reviews will ensure you maintain your long-term investment goals and reach your desired return at the lowest amount of risk possible.

 On August 2, 2011 the President signed the debt deal, insuring that we averted a global financial catastrophe and collapse of the western world as we know it.  Or did we?

Massive numbers of both Democrats and Republicans really hate the deal, though for totally different reasons.  The truth of the matter is that not nearly enough spending cuts were made, and those that were made are spread over a decade, assuming that they will be made at all. 

You see, the government does not have to live by the same spending and lifestyle rules you and I do.  Let’s say for example, you have a neighbor, whom we will call Don.  Don works for a man we will call Tom.  Now Tom built his business starting with nothing but determination, long hours and very hard work and sacrifice.  Even after 30 years, Tom still works at least 60 or more hours a week, ensuring his clients receive the best quality work possible, and that Don and his other employees are not only well compensated, but are also provided with an enjoyable work environment, and security for themselves and their families.

Don arrives promptly at 9:00 AM, and leaves daily at 5:00 PM sharp.  Even though certain times of the year it is extra busy at work, Don chooses not to work any extra overtime hours because that would interfere with the quality of life that he so cherishes.  Don also has a bit of resentment towards Tom, since he feels Tom probably makes an unreasonable amount of profit from his business and that is just not fair.  Tom then takes that unfair profit and he always seems to be putting it back into the business, buying more computers and expensive software, expanding products and services, and hiring new employees to better serve new and existing clients.  Don feels that Tom should not be spending so much on expanding the business, and should really give more of that profit to him. 

Because Tom is so unfair, Don cannot live the lifestyle he so deserves.  Tom probably does not realize just how expensive Opus One Mondavi and Baroness Philippine de Rothschild 2007 really is, but obviously a man of Don’s refinement can’t be expected to drink the cheap stuff.  Don deserved a much bigger house a few years ago, so he bought a beautiful place with a very low rate adjustable mortgage.  The problem is that now his mortgage payments have increased quite a bit, and he can barely make these payments.  That is not fair.  Because it is very important to have some quality vacation time, to decompress from the 9 to 5 grind, several weeks in Europe every year is a must.  The vacations have to go on charge cards along with weekly dining out costs, new clothing, golf clubs, private lessons, greens fees, club dues, and personal trainer fees because the private school, and BMW payments, are so darn expensive and there just is not enough to go around.  The shortfall of money to pay these bills is really unfair because Don really deserves these things.  Fortunately, at least until now, Don has had pretty good credit, so many credit card companies have sent him cards so he could charge more.  In fact, on his biggest credit card, called the “China Card”, he has racked up a very sizeable amount of debt.  He has been paying the minimum interest payments on the China card by taking cash advances from many of the other cards he has.  When those cards need payments, there are yet other cards to borrow from.  If he gets close to maxing out a card, he simply requests that they raise his debt ceiling so he can charge more. 

This has been going on for quite a while, but recently, the very smart management people at the China Card have figured out what Don has been doing.  They are very concerned about this as you can imagine, and have cut off his charging privileges for fear he will default on his obligations.  Unless he cuts his spending to what his income will support, they will not loan him another dime.  Now Don is very worried about a downgrade to his credit score.  If his credit score is downgraded, he will either not be able to get any new credit cards, or if he does, they will charge him an exorbitant amount of interest.      

So what you have here then, is the government looking an awful lot like Don. If Don does not stop spending and live within his means he will go bankrupt.  If the government does not live within its means, well, that’s another story.  And that’s where the disagreement lies.  Some feel Don (the government) should just make Tom pay more (raise taxes on those unfair wealthy folks) and keep spending.  Others believe that Tom should keep his money so he can expand his business, hire more people, have those employed people pay low and reasonable taxes thus raising revenues, and cut back on the excessive spending beyond their means.   

Which brings us to now.  The government credit card limit (the debt ceiling) was just raised by over two trillion dollars.  Unfortunately, the debt deal does little to nothing to reduce America’s debt burden today, and the $14 trillion we owe now could easily exceed 20 trillion over the next ten years.  The deal just signed only cuts spending about 900 billion over ten years, and a special congressional committee must “find” another 1.5 trillion by November.  Thus far during the term of President Obama, 4 trillion dollars have been added to the debt alone.  According to the Congressional Budget Office (CBO) even the 2.5 trillion dollars the government claims will yet be cut, will be more than lost to inflation and reduced economic output.  Can higher taxes (or as the president calls it, “a more balanced” approach) be far behind?

The S&P rating agency said that at least four trillion dollars in spending cuts would be necessary to avoid a downgrade (lower credit score).  The debt deal is no where near that.  On August 5^th, S&P actually followed through on their warning and downgraded the US Treasury rating from AAA to AA+ and the global markets reacted very badly.  The longer term consequences of this are yet to unfold.  Thus far, the other two major rating agencies, Fitch and Moody’s, have caved in to the political pressure and will not downgrade at this time.  They have however, issued a “negative outlook” on our credit worthiness (or as Dean Wormer would say, “you guys have been put on double secret probation”).  Now that S&P has let the cat out of the bag, they may be compelled to do the same just to maintain a sense of credibility.  On the other hand, there have been reports of the government launching “a full investigation” into S&P, with possible Senate hearings to be determined.  That sounds like Michael Corleone going to the mattresses with the Tattaglia family, or perhaps the current Chavez led government which does this type of thing just before nationalizing a private business.  In both cases, something really bad happens to management.  Nothing quells an uppity ratings agency like a good old fashioned government investigation.  Moody’s and Fitch take notice.

Enter the Dragon.  China, the largest foreign investor in U.S. government securities, joined Russia in scolding American policy leaders for failing to rein in the burgeoning national debt, calling it a “madcap farce of brinkmanship of American lawmakers”.  China?  Calling us madcap?  Lucy and Ethel were madcap maybe, but it’s a bit disturbing to think our leadership is globally viewed as the wacky neighbor.  The icing on the cake is that China’s Dagong Global Credit Rating Co. did what all of their U.S. counterparts should have already done – they cut its grade for the U.S. to A from A+ with a negative outlook.

Merrill Lynch Gets Sued.  During the rip roaring 90s, Merrill Lynch made big money as an investment banker.  When yet another new internet company wanted to “go public”, Merrill would sell their stock to the public, which consisted mainly of their brokers pushing these shares (usually of companies that never made a penny of profit), to their own clients, collecting commissions from the clients and huge fees from the company along the way.  In early 2002, Eliot Spitzer, New York’s Attorney General, uncovered a number of e-mails written by Merrill Lynch investment analysts describing as “junk,” “crap,” and “a disaster,” stock that they were publicly rating at “buy.”   Spitzer argued that this biased investment advice was rooted in an undisclosed conflict of interest. The analysts had continued to give favorable coverage to Internet companies through 2000, even though their stocks had been in continual decline. The investment advice, Spitzer charged, was biased by the analyst’s desire to support Merrill Lynch’s investment banking interests.  Merrill ultimately settled for 100 million dollars and that was that. 

And the point is?  The three top rating agencies in the U.S., Standard and Poor’s, Moody’s and Fitch issue ratings on bonds that investors rely on to determine investment decisions.  While governments do not pay fees to have their debt rated, any idea who does pay these agencies their fees to issue ratings?  Why the bond issuers of course.  No conflict of interest there. Remember that little credit meltdown we had a couple of years back – you know, the one where it turned out that mortgage backed securities and credit default swaps weren’t as great as their ratings promised?  It seems that the big three were “drinking the Kool-Aid” that housing prices could only increase, and that even sub prime mortgages wouldn’t be a problem, since the borrower could always refinance the mortgage or sell the house at a profit.  Either that or the fact that Goldman Sachs paid them an awful lot of money and it would be rude to say bad things about your employer.

So maybe S&P is just trying to get some credibility back by making a call everyone else in the world has seen coming for some time now.  The real impact of the downgrade may take a while to unfold, and none of it will be good, unless it results in politicians getting to work rather than continuing to blame each other.  I would not bet on it though.

A)    The 1920’s stock market rise and 1929 crash

B)    The roaring Japan stock market in the 1980s

C)    The Dot-Com boom of the 1990s

D)    The real estate boom post 9/11

E)    None of the above

If you said “none of the above”, then congratulations on your knowledge of history!  

Generally considered to be the earliest recorded speculative bubble was the Dutch “tulip mania.”  In fact, at it’s peak in early 1637, some single tulip bulbs sold for more than 10 times a worker’s average annual wages at the time.  When tulips were introduced to the Netherlands, they became a coveted luxury item and very profitable to sell.  As demand grew, so did the numbers of growers, some creating “exclusive” varieties that commanded high prices.  There were even contracts written to buy “future” production, which were the precursor to what we know today in modern finance as a futures contract.   When the tulip bulb market suddenly fell apart, many were economically destroyed.

Next came the South Seas Bubble in the early 1700s.  The South Sea Company began in 1711 as a joint venture with the government of England.  Heavily debt ridden, the government exchanged government loans it could not repay (sounds like what might happen with U.S. Treasury loans today), for company stock shares that were then given to the note holders.  In exchange, the South Sea Company was granted a monopoly for trade between South America and Europe.  The company then began starting rumors that the profit potential of the company was enormous, which caused a stock buying frenzy. At its peak, the share price had risen to over 1000 pounds, which in those days, was an incredible sum.  From members of Parliament and the wealthy elite, to peasants, all were begging to invest their money.  Many borrowed money or leveraged all their possessions just to buy shares.  Even Sir Isaac Newton was a substantial investor.  When the bubble finally burst, bankruptcies, scandal and financial ruin spread across all levels of society.    

During this time period, a number of other stock companies were also “floated” in England on the stock exchange, many making fraudulent claims of potential profits. These new stocks were nicknamed “Bubbles”.  After the collapse of the South Sea Company, Parliament enacted a law requiring strict regulation of new corporations, which became known as the “Bubble Act”.

Around this same time period came the “Mississippi Bubble” in France, on speculation of profitable trade with the West Indies and the new world.  This of course ended as all bubbles ultimately end – badly.

Then there was the British “railway mania” of the 1840s, the real estate bubble of the early 1920s in the U.S. and especially Florida, the stock market bubble of the 1920’s, the Poseidon bubble in Australia in 1969 based on the discovery and demand for nickel, the “nifty fifty boom for large cap stocks in the 60’s and 70’s, Japanese stocks in the 80s (when the Nikkei went from 38,000 then to about 9,500 today),  the dot com boom of the 90s and real estate boom of this decade, right up to this moment with silver, commodity and bond prices (precariously poised to crash once interest rates begin to rise). 

As George Santayana said, “Those who do not learn from history are doomed to repeat it.”  In fact, one could say that is true not only for market bubbles, but many other things that are unfolding right now. 

So, will there be more bubbles, you ask?  Absolutely.  Will fortunes be lost yet again?  You bet.  Don’t get me wrong, fortunes are made during bubbles, too.  The problem is that the fortunes are made by the same people generally responsible for creating the bubble in the first place, with some knowledge as to its likely demise.  That kind of tips the odds out of your favor, n’cest pas?  Well, maybe yes and maybe no. 

The trick to the bubble business is knowing when to get on and when to get off the bubble bus, which is easier said than done.  Fear and greed control most non-professional investors, and therein lays the problem.  Now, I have no crystal ball, but I did know that the end to the internet boom was imminent in late 1999 while waiting for a prescription to be filled.  As I waited, a 19 year old pharmacy technician was talking with a forty-something pharmacist about how Cisco was going to quadruple from there, given the need for more networking horsepower over the expanding fiber optic information highway.  What?  When my lawn guy starts talking about why a six thousand PE ratio on Facebook is a reasonable valuation, I know it’s time to get out of Dodge.

Speculating and investing are two entirely different things.  Like all things in life that are fun or bad for you (like gambling, pizza, beer, and Hagen Daz), a little bit in moderation probably won’t kill you.  A little speculation with some mad money is probably ok if you have the self control and stick to predefined rules.  Many do not. Investing though, is a much different state of mind.  It’s about asset allocation, risk, a game plan, and not letting your emotions take charge of your head.  Next time, I’ll talk about some of the methods top advisors use to invest money for their “wealthy” clients.     

Anthony Caruso is a certified public accountant and investment advisor and can be reached at tcaruso@carusoandcompany.com or visit his website at www.carusoandcompany.com

I manage investment accounts for a number of our clients. As I meet with them to discuss the global economy, and investment research and strategy, It occurs to me that some of my other tax clients might benefit by our current thinking, where we are currently with the US and global economy, where I think things are heading, and what to consider to plan strategically for what may lie ahead.

Before we begin, let’s review the concept of asset allocation, and why it means everything when building a portfolio. As you know from our past discussions, and updates I have previously sent to you, individual stock or ETF or fund selection doesn’t really matter. What really matters, over the long term, is asset allocation decisions. It’s not what investments you buy. It’s when you buy equities versus when you buy bonds, or gold, or commodities, or real estate, etc. that matters.

I always refer to the academic studies that consistently demonstrate why asset allocation (how much of which type of assets you own) is far more important in determining your results than simply which individual investments buy. The most famous study by Gary Brinson, was published in 1986. Roger Ibbotson later published a follow up study in 2000, which I believe was even better work. Both Brinson and Ibbotson concluded that the differences in asset allocation among the funds used in portfolios explained virtually 100% of the differences in their returns. Differences in individual stock or bond picks made virtually no difference whatsoever to total portfolio returns.

Because of inflation and rising interest rate fears, it is prudent to review all bond and fixed income holdings, and assess these for redeployed to other more strategic and risk hedging positions. For the last several years I have been concerned about pending inflation, primarily, and thus have used only very short term debt funds to generate income. Short term debt is far less susceptible to interest rate increases (from inflation) which can cause significant loss of principal to intermediate to longer term bonds or bond funds. Having said that, even short term bonds have some exposure, though much less, to rising interest rates and inflation. Portfolios should be analyzed to take some gains and reposition to the safety of cash or less inflation sensitive investments.

Since we must now invest for where we are going, we should understand where we are at the moment. Our government deficit is about 30% of GDP, or the total value of all goods and services produced in the country. That is an astounding number. As interest rates rise, and they will, the cost to the government to simply pay the interest could be over one trillion dollars per year. There are only several ways to cover this cost. They can raise taxes, or simply print more money. Raising taxes will take capital out of circulation for new business, growth, new jobs, etc and likely kill the economy. Printing money (which the Federal Reserve and Bernanke vehemently deny) will cause inflation and perhaps hyperinflation. Despite the denials, I believe the Fed is trying to inflate their way out of the debt, which is why China and other world powers are slowly divesting their US Treasury bond holdings. In fact, the entire concept of “quantitative easing” (and now QE 2) is for the Fed to buy treasuries. Think about this. The government needs to borrow money my issuing treasury obligations. Interest rates are so low, and world governments are so concerned that less and less people want to buy them, so the Fed actually buys them ( a little more complicated than that but effectively that’s the story). So the government is actually both buying and lending to itself at the same time, thus printing money out of thin air. How long can this go on?

The printing of money has happened many times before in history. The most famous was in Germany after World War I during the Weimar Republic. They printed money to try to pay off war debts. Hyperinflation was so bad, that workers were paid several times a day and used wheelbarrows to haul near worthless Marks to buy bread. Could this happen to the dollar? Many, including myself, think is absolutely possible.

There is a third option, and that is the most dire. This would be where the U.S. government actually defaults on it’s debt. This is where the safe treasury obligations owned by widows and orphans, would not be repaid by the government. Before you say this is impossible, it is sadly, very possible.

Consider Greece. Last year, we saw the crisis in the Euro zone, the ECB and IMF pumping money to save Greece from defaulting, a band aid at best. They were (and still are) rioting in the streets there. There are more government workers there than in the private sector, and their pensions, early retirement age, and fat wages can simply no longer be paid by a government that is out of money. So they riot. They do not want to retire, they want their pensions, they want their wages, yet there is not enough money in the government accounts to pay these obligations. The rioters do not care. They just want what they are “entitled to”. Quite the quandary. Now the problem in the Euro zone is that Greece was the tip of the iceberg. More recently Ireland was in the same boat, then Portugal, and Spain is close behind. If not for Germany, this would have collapsed before now. But what happens when Spain or Portugal does fall. Germany, the ECB or IMF cannot save them all. Europe and the Euro will fall.

Now if you think that this simply could not happen in the US, then you have not been watching the Wisconsin teachers’ protests filling the streets of the capital the last several weeks. It can happen here and it is, and Wisconsin is only the first. The protesters do not care that the money is gone, that the wages and pensions are too high, or that the unions have negotiated their way in to financial ruin. They don’t care. Get the money from the rich. Raise their taxes, take it from someone else and redistribute it to the more deserving. Forget the fact that the government workers are paid significantly higher wages and benefits than the private sector. It matters not. You see the problem. The money is gone and the bills can’t be paid.

What we are seeing now in Egypt, Libya, Bahrain, etc is a thread that is connected to this entire conversation. While these have thus far had some impact on oil prices, if Saudi Arabia falls, then it’s “too the moon, Alice”.

As I see it, the US dollar has no where to go but down. That is why gold, silver and precious metals have continued to skyrocket. On top of all of this, we are facing food shortages on a global level. At totally separate conversation mind you, but food shortages, unemployment, riots, inflation, skyrocketing oil prices and the like are a recipe for disaster.

So as we go forward, the changes I will be making to the portfolios we manage are intended to hedge again these grave concerns. The theme will be investing in a world of devalued dollars, debt defaults, food shortages, and rising oil prices. The stock market has had a nice run these last few months, but now, the market is overvalued and poised for a correction (or worse). The bond market is in no better shape as investors have fled due to pathetically low interest rates. So now, we play a game of chess. Rather than chase returns, we should continue to be smart, strategic, patient, and pick out spots as they come along, to best position our portfolios.

I am available to meet or discuss investment strategy, and to review your current portfolio at no cost or obligation. Let me offer you a second opinion as to your investments, long term strategy, risk and reward. Call me to set up a conference.

Dear friends and clients:

As our money management clients are already aware, we have been rebalancing our portfolio accounts. My overview below provides a summary of my thoughts, of where we are now, and where I think we are heading. As always, financial planning, investment management, and tax planning go hand in hand, and because we are able to advise and coordinate all of these areas simultaneously, we believe this is an extraordinary advantage for our clients.

A year in a trading range

For most of the year, we have bounced up and down in a trading range. Some good news propels higher then the reality of staggering unemployment and depressed housing brings it back. The news is not really any better on that front, but two things have moved the markets the last six weeks. First, it is highly likely that the Fed will implement “QE2” early next month. This will be yet more buying back of treasuries, printing money and battering the dollar. In and of itself more of this action will do little to nothing to fix unemployment or spur housing, especially in light of the foreclosure problems and questionable title issues. In the near term, the stock market likes this because it lowers the value of the dollar, which in turn helps large multinational companies sell more US goods overseas. When the Fed loosens the money supply, it is almost always good for stocks. The second part of the equation is the election. The expectation is that the Republicans will take the House, with a remote chance at the Senate. With the advent of some gridlock, the thought is that it might be enough to stem the anti business sentiment and be positive for business and the economy.

Trading ranges are always difficult to navigate because any rise in the markets is met with uncertainty that it is anything other than a head fake. Having said that, from a technical standpoint, we have just experienced a “Golden Cross” – whereby the 50 day moving average has crossed above the 200 day moving average. Historically this has been a positive indicator for the market to break out of a trading range and continue to the upside. Another indicator, the ECRI (Economic Cycle Research Institute) Weekly Leading Index (WLI), has retreated from the negative 10 percent growth rate of a few weeks ago to about -6% now.

Negative growth of 10% or more is almost always an indicator of recession (or double dip recession in this case). Time will tell if this is a true turning point or not of course. Unexpected Fed retracement on the next round of QE, unexpected bad economic data, or my worst concern, a negative trigger event, could pose real trouble. The trigger even can never be predicted. A new terror attack, Iran bombing Israel, Israel bombing Iran, or any one of a hundred potential world crises, could be taken badly by the markets. However, to live in fear of this from the standpoint of being frozen in our tracks is not the answer either. So, what to do.

Why investing in certain foreign markets, commodities, and gold may make sense now.

During the recent market storms, such as the credit crisis in 2008 and more recently the 17% correction in May and June, the only places to hide have been cash, Treasuries, and gold. As the storm has passed, it has made little difference whether you were in small or large caps, domestic or international, growth or value. They all went up the last few weeks. Given the trading range we have been in this year, up then down then up then down, we have now passed through some key support and resistance levels that for the time being, seem to hold.

While the fundamentals of the economy, unemployment, and the like have not really changed much, the market is focused on the recent Federal Reserve language indicating that yet more “QE” is to come. While in the near term, the stock market likes that, despite the underlying fundamentals, long term this is not a good thing. In fact, it sets up an even more drastic inflationary spiral in the background. It also appears that this is intentional, since devalued U.S. dollars in the future, will make it cheaper to pay off what looks to be an insurmountable debt.

For now, I have revised our portfolios to capture both a solid core of asset classes, and a number of surrounding satellite asset classes that are poised to benefit from the current economic uncertainty and global environment. This means special emphasis on the non U.S dollar equity markets (emerging and international markets) and the producers of commodities and precious metals, as well as the commodities themselves. Here’s why.

Stocks: buoyed by the Fed

For some time now, I have believed that stocks are likely to rally eventually, either because the economy picks up or the Fed does more quantitative easing (QE). In the past, the Fed had signaled that it would do more QE if the economy got worse. Now it seems to be saying that it will do more QE if the economy doesn’t get better. That’s a big change.

Currently, I believe the economic data may still be “polluted” by one-time factors such as the end of both the homebuyer tax credit and census hiring. So, in my view, we don’t know how bad housing and jobs really are right now. Once those have passed through the system, I think growth may pick up a bit going into 2011, which, I believe, should be favorable for stocks.

How favorable? Households are still deleveraging, banks still aren’t lending, and companies still aren’t hiring. So one has to wonder how much of a rebound we may get. But investors priced in a double-dip recession over the summer, so anything better than that could lift stocks.

What if the economy doesn’t recover from its summer slump? Well, the Fed has now signaled that it stands ready to do more QE. Will that lift asset prices? The first round certainly did, but one has to wonder if round two will be as successful. If QE2 does not have the desired effect on the economy (QE1 didn’t do much to boost economic growth), then any liquidity-induced gains for stocks might be fleeting. But that liquidity has to go somewhere, and it could be to stocks.

In my opinion, the worst thing that could happen now for stocks is if the Fed were to do QE2, yet it appears they will. The market decides however, not only will it not revive the economy. The Fed has now fired its last bullet and there is nothing left for the policymakers to do to fix the economy.

International: focus on emerging markets and the “CRABs”

I believe central banks in the developed world (the United States, Europe, and Japan) may remain engaged in monetary stimulus for some time in an effort to offset the deleveraging that is taking place either at the public level or with households. Austerity is happening in Europe as part of a policy movement, and in the United States by default, as households and state and local governments tighten their belts. Meanwhile, there is little momentum for more fiscal stimulus at the federal level.

A key question is which central bank will stimulate the most and therefore debase its currency the most. I think that the U.S. Fed may be less rigorous than the European Central Bank (ECB). After all, the Fed has a dual mandate (full employment and price stability), while the ECB only has only one (price stability). Also, the Fed is plagued by memories of the Great Depression (deflation), while the ECB has memories of Weimar Germany (hyperinflation). I think that the dollar could remain under pressure more so than the Euro.

For investors, especially those based in the United States, one idea, that also makes sense as part of a long-term investment strategy is to invest part of their assets overseas. But not just anywhere. If Europe is in the same boat as the United States, then it may make sense to have some assets in the stock and bond markets of countries that do not need to print money. Some examples: the emerging markets (EMs) and those backed by natural resources, the CRABs (Canada, Russia, Australia, and Brazil).

Commodities: a win-win?

Another strategy could be to invest in commodities through ETFs and mutual funds, or the producers of those commodities, especially those domiciled in the CRABs. One potential advantage of the commodity space is that it could win either way. If the economy recovers, then commodities could win because they are economically sensitive. If the economy does not recover and the Fed stimulates further and effectively debases the dollar, then commodities could also win because of a weaker dollar.

Gold: hedging against a weak dollar

Then there are precious metals. Gold is many things to many people, but I think it is very simply a hedge against central banks printing too much paper money. Gold has been keeping up with the growth in worldwide foreign exchange reserves. So if you are wondering whether to own gold, I believe a key question to ask yourself is this: Are the world’s central banks going to print more money?

Bonds: interest rate risk

If the Fed needs to do more QE2, it could be bullish for Treasuries (as interest rates go down, bond prices go up). But how much of that is already priced in? On the other hand, if the economy gets better “enough” to warrant no further action, then yields could rise (and bond prices fall), while stocks rally as investors switch from risk off to risk on. It’s a tough call, but I believe the latter scenario may be more likely. Within a fixed income allocation, which most investors should have as part of a long-term investment strategy anyway, I believe the credit markets – high-yield, leveraged loans, and emerging markets debt may make more sense than Treasuries or investment-grade bonds.

Midterm elections: historically good for stocks

According to Intertrade polls, the Republicans are expected to take the House, although perhaps not the Senate. Does that mean we get a repeat of late 1994, with gridlock helping stocks? Or could gridlock make matters worse by preventing policymakers from tackling important issues such as debt reduction? It’s impossible to tell, but we do know that the third year of the presidential cycle has historically been positive for stocks.

Conclusion

Putting all this together, rebalancing portfolios involves considers the global environment, opportunities, potential risks and rewards. There are many moving parts, and those parts must be constantly evaluated. I do not believe in a static, buy and hold only approach to portfolio management, as my clients know, because only in an active management environment can risk and reward be reassessed and acted upon.

We are always pleased to offer a complimentary portfolio review, and offer no cost or obligation opinions of what you currently own, and how they really fit with your goals and risk tolerance.

Sincerely,

Anthony C. Caruso

Certified Public Accountant

Personal Financial Specialist

Mid Year update – “Reform”, Socialism, Uncertainity, or Loss of Freedom?

Dear clients and friends:

At this mid point of the year, I wanted to take an opportunity to update you on taxes, my take on the domestic and global economy, implications for managing investments, and what we are doing now in the accounts I manage to protect assets and plan for the future.

Having recently celebrated Independence Day, it’s important to remember that the freedom we enjoy should never be assumed to be guaranteed. History shows that freedom is taken for granted, and often lost in a slow, almost imperceptible process over time, until one day the reality is all too apparent.

While we are still free to speak our minds and challenge the wisdom of our leaders, legislators, and regulatory bodies, hearing us is another matter entirely. Far too many politicians work on the premise that we are simply just not smart enough to know what is best for us. Few career politicians actually understand what it is to run a household or small business on a budget make a payroll, or live within means. Sadly, we have reluctantly come to accept the failures of our government, regulators, banks and financial institutions, as the way it is.

They have elevated political correctness, climate change, financial “reform” immigration “reform” health care “reform” and home ownership for all as their god, yet abandoned common sense in the process. “Reform” as it turns out, provides a much better marketing spin than buying votes or redistribution of wealth. We can make nice with terrorists all day long, but in the end, they still want to kill us, except now they think we are stupid infidels, which is really a step down from being a plain old infidel. Good is bad, bad is good, right is wrong and wrong is right. Everything is upside down. What happened to this country?

The “Bush” tax cuts expire this year, so taxes will increase to Clinton era brackets beginning January 1. Higher capital gains Tax (20%), the elimination of 15% on qualified dividends which will now be taxed to a top 39.6% rate, and higher estate taxes will resume. The problem is, these increases will not be enough to fund our enormous deficits and entitlement spending (health care and perhaps cap and trade). Tax planning before year end will be important.

The American dream used to be based on working hard, and enjoying the fruits of ones labor. It now means you still work hard, but the government will decide who will enjoy the fruits of your labors. The government has printed billions of dollars of “stimulus money”, yet I don’t know anyone who has really come to benefit by it in the least. The current budget deficit is beyond all comprehension, and this is only the beginning of more spending. Taxes are going to skyrocket (please don’t blame the CPA at tax time) which will only add to depressing housing, small business, and consumer spending.

When tax and spend Europeans, during the recent G-20 meeting, began lecturing us on fiscal responsibility, it may have been a hint that things have gone just a bit too far. Keynesian economics of spending our way out, did not work during the depression, nor has it ever worked anywhere, including Japan (where the Nikkei went from 38,000 in 1990 to 9,500 today). Add increased taxes on top of this and, as in 1932, it is a recipe for disaster. The mark of insanity it is said is to perform the same task over and over, yet expect a different result.

I would like to think that America is still the greatest country in the world, but we have lowered the bar too much and too often. We need to take more individual responsibility for everything in our lives, educating our children, our religions, our communities, within our government and within the institutions we empower to serve us.

So, what does any of this have to do with investment management? These things very much have an impact with what’s going on in the markets. Despite the solid week of gains, the recent sell off was because markets hate uncertainty. There is an awful lot of uncertainty to go around about right now.

What’s so uncertain? Here are a few to list:

1. How about the 2300 pages of the financial services reform bill that came out of “committee” last week. One Republican congressman summed it when he said the bill probably had three “unintended consequences” per page.
2. The “Fin Reg” bill does nothing to break-up the concentration of banking power in this country. The too-big-to-fail banks and other systemically dangerous institutions, that just got bigger with the help of government, are ticking time bombs. In addition, local community banks won’t be able to compete with these behemoths who want to destroy them.
3. The most conspicuous omission in Fin Reg was regarding any regulation of Fannie, Freddie, which are essentially insolvent, yet continue to add billions of dollars of losses (off the federal balance sheet, mind you) to their books every day. The roots of the housing crisis lie within the Community Reinvestment Act, mandating low income home loans, with the backing of the government (Fannie and Freddie).
4. The government has not only been “printing money”, but has been adding billions of dollars a day to the federal deficit and financing that debt with short term borrowings (treasury obligations). The interest rates the government pays to investors has been kept artificially low, but what happens when rates rise and we can’t roll over our short term debt which has been financed by foreign investors (such as China) and institutional investors? This is what happened to Russia in 1998, to Mexico in 1994, to Argentina, and to all the countries, regions and companies that failed and either died or had to be bailed out. It’s about to happen to Greece, maybe Spain, and perhaps other European (PIIGS) countries. If we don’t think it’s possible to happen here, guess again.
5. Billions in nearly free TARP money was pushed to the banks, courtesy of the Federal Reserve. The idea was to keep them solvent, avoid runs on the bank, and most importantly, for them to lend to other businesses to keep business and the economy going. Instead, credit is still very tight, and this free money was used to fund big bonuses, and generate bank profits (imagine being in a business where you could sell products that cost you nothing – that is what free money is to the banks). The concept of a “bail out” is really a myth. Banks are still holding hundreds of billions of toxic assets (which are getting worse, not better, as the economy heads south) and they aren’t in good health. The accounting rules that were in place (FASB Mark to Market) were designed to require banks and all companies, to take losses immediately when market prices became less than the value of assets carried on the books (such as loans receivable).The government basically pressured the FASB (Financial Accounting Standards Board – they make the rules on how financial statements must be prepared) to relax the mark to market recording of losses. The result is that the banks look like they are making a ton of money right now, (remember the cost of the money they are selling is given to them free by the Federal Reserve). The underlying problem of huge loan losses just has not been recorded on the books, but they are definitely still there! At some point, the piper will be paid.
6. Despite TARP money, banks aren’t lending much to consumers and small businesses. Without the flow of credit, businesses can’t produce goods and services, consumers can’t afford to buy them without credit, business can’t grow, and unemployment stays high, and so on.
7. Unemployment is at a reported 9.5%, but that’s not a real figure. It’s really (according to U6 unemployment reports) 16.5%, when factoring in 650,000 people who stopped looking for work (either out of frustration or because continuing unemployment benefits pay more than working) and therefore aren’t counted in the figures.
8. The 2000 plus page Health Care Bill has buried in it a number of new taxes and costs that will effect almost every American and employer. Employers, both large and small, are reluctant to hire new employees due to the known and unknown costs of adding new hires. Add on top of this rising tax rates for business and individuals, and the uncertainty of what new taxes and costs will be levied to meet soaring budget deficits, it’s no wonder businesses are reluctant to hire.
9. Without increased employment and consumer confidence, consumer spending will remaining depressed as with growth in the economy.
10. The European debt crisis is like the sword of Damocles, hanging by a hair. Greece sovereign debt (their government bonds, similar to our treasuries), has been downgraded to junk status. Citizens continue to riot in the streets because they do not want to lose their fat government salaries, short work week, long paid vacations and generous full salary pensions starting at age 50. As the saying goes, “Socialism is great until the other person’s money runs out.” The fact is, Greece is just out of money, and Spain and Portugal are not far behind. For a period, the global markets would swing wildly on any given day, depending on the tone of the European Union and the crisis. Recently, the European Union, in concert with the IMF (the US has contributed over 50 billion dollars to this fund); created a near one trillion bailout fund in case Greece defaults. The problem is that this is a mere band aid, and does nothing to fix the underlying problem. At some point, sooner or later, without a strict austerity program (remember the Greeks are revolting because they do not want to be austere) something will have to give. If Spain, Portugal, Italy or Ireland decline in the meantime, the one trillion won’t make a dent. . If this sounds eerily familiar, it should. California, New York, and Illinois are on the brink of collapse for the same reasons as Greece, and the federal government is considering bail out loans. Without fixing the underlying problems, however, loans might never be repaid, and we could see riots here as well.

In the short term, we will likely see some rally in the stock market, especially if earnings’ reports are strong. The problem with earnings, however, is that they are still largely based on a cut-to-the-bone work force and cost cutting, and will not be convincing until sales increase. You can only increase the “bottom line” for so long, without increasing the “top line” (sales). Sales won’t permanently increase without demand and demand won’t increase without reduced unemployment. Can there really be a “jobless recovery.” I think not. We may also be stuck in a range for a while. Time will tell.

Longer-term, we don’t look so hot. We may already be headed into a “double dip” recession. This is what happened in 1932, during the great depression. Higher taxes and massive spending crushed the country once again, back to 1929 levels. Even Erskine Bowles, former Clinton advisor and now appointed by Obama to his Debt Commission, says our huge government spending is a “fiscal cancer” and we are on the road to financial disaster. Sobering.

The list above just scratches the surface, but it speaks to what is going on. These are volatile and uncertain times for investing and the economy. Years ago, the “buy good stocks and hold them forever” approach used to work, because we knew that the capital markets were free and would rebalance themselves in the same way God applied the rules of nature to self regulate and balance itself. It’s only when mortal man steps in and tries to make things better that bad things happen. In the old days, a bank would not make a mortgage loan to someone they knew could not repay them. The bank kept the loan, the customer paid the bank, and it looked pretty much like George Bailey’s Savings and Loan in Its a Wonderful Life, with Jimmy Stewart as your community banker. That changed when the government decided everyone should have a house and get a loan, and that the banks could sell their loans or have Fannie or Freddie guaranty them. Is it any wonder what has happened? There are so many examples of government manipulation now, that it is impossible to know how markets, industries or economies will behave when all the rules are in flux.

In the client investment accounts I manage, I have made defensive changes in our asset allocations over the last few weeks to protect principal. If a double dip recession occurs, we may revert to a somewhat deflationary environment in the short term, but longer term, massive inflation and high interest rates are almost a certainty, given the deficit and monumental borrowing needs of the country. In my opinion, this means a very proactive management of both equities and fixed income will be critical to safeguarding your money and positioning to take advantage of areas of strength going forward. As always, I am pleased to offer a complimentary review of your portfolio, and offer my thoughts and opinions as to risk and strategy, and the appropriateness of the investments for your needs.

Sincerely,

Anthony C. Caruso

Certified Public Accountant

Personal Financial Specialist

Dear Friends and Clients:

The last six months have seen some pretty dramatic increases from the stock market lows. But is it for real, and is the worst behind us? Perhaps, or just perhaps it will be as the immortal Yogi Berra so eloquently stated “it’s like déjà vu all over again”?

In the business of managing money, a false sense of security is just as dangerous as a constant state of pessimism. One causes undue risk, while the other so immobilizes that we miss riding the financial bus uptown. So, while we may intellectually look at the stock market and ask why in heaven’s name has it gone up do much, given poor corporate earnings and no top line (sales) growth, increasing unemployment, tight credit, loan defaults and foreclosures, gone up it nonetheless has. The truth is that markets do what markets do, not what we think they should do. That is why we need to move money to those investments where the market trend is up (ride the uptown bus), and step back when the trend in those investments is down (the downtown bus). That simple philosophy will be critical, to successful investing now and in the future. The traditional buy and hold for the “long term” strategy no longer works the way it used to, for a number of reasons, (not the least of which is governmental and political manipulation of the free market system). It does not make sense to watch some investments decline 50% or more, and take years to recover. Sadly however, most brokers and advisors fail to follow such good advice. It’s not a matter of if that will happen again, but when. And when may be sooner than we know. That is why after significant research and analysis, I have implemented analytical exit and entry strategies for our clients, to better control risk in this volatile and changing world.

But back to the déjà vu issue for a moment. October 2007 marked the high of the stock market. Yet at that very point in time, the U.S. dollar was on a steady decline, while oil, commodities and gold were marching higher and higher. Now where have I heard that scenario before? Oh yea, that’s right. Now. Right at this very moment in fact. Middle East oil is priced in US dollars, and devalued dollars means the price of oil is spiking (not to mention the impact of Iran and Israel tensions). Gold has hit all time highs, and both Asian and Middle East governments are calling for the demise of the US dollar as the world reserve currency, due to our rampant spending, borrowing, and economic policies. Devalued dollars are highly inflationary, and inflation is bad, very bad, for the stock market.

While we can’t predict when or if the markets will change directions, I manage our client portfolios with a philosophy to follow the trends and choose to ride only the uptown bus. Weaker dollars and inflation mean that oil, gold, commodities, foreign currencies and international stocks denominated in non US dollars may do very well in the not too distant future (the uptown bus). Intermediate to long term bonds, domestic stocks, and other asset classes may not do so well if the threat of inflation mounts (the downtown bus). In part, success in managing money is having the discipline to change from one asset class to another, to capture the trend up, and leave those asset classes in a downward trend. More importantly however, is having the discipline to make those changes, when our analytical rules tell us to do so, despite what our gut feelings and emotions make us “think” we should do. That sounds easy, but is actually tougher than it seems.

Besides the typical CPA tax work, many years ago I added money management and financial and estate planning to my practice as well. In too many cases, my clients were benefiting their advisors more than the advisors were benefiting them. I knew I could do better for them.

I have been in practice as a Personal Financial Specialist (PFS) and Certified Public Accountant for 30 years, and our firm is registered as an investment adviser (RIA). I have personally managed millions of dollars of client accounts for over eleven years. Over the last two years, with the market in turmoil, we not only made strategic moves in January 2008 that protected our investment clients, but we have also been engaged to manage a number of new accounts, from individual portfolios, retirement plans, trusts, IRA, 401(K) and others. Most recently, another CPA has hired me to manage not only his family trust funds, but millions of dollars of his firm’s client’s money. I am of course honored by this trust, but make no mistake; it is a trust that has been earned by doing the right thing for my clients. Specifically, I embrace the following:

• Fee based money management – we sell no products, nor receive any commissions of any kind; we charge a small percentage of the assets under management only
• Asset allocation portfolios based on the academic work of Harry Markowitz, (Nobel Prize economist known as the father of Modern Portfolio Theory), Fama and French (DFA) and other academics
• Account Custody with Fidelity Investments (No Bernie Madoff risks)
• No Buy and Hold (or buy and hope); we move out of falling asset classes, in to rising asset classes, as trends change, without being “market timers” or tax inefficient.
• No individual stocks or “load” mutual funds – we use only index or passive asset class funds, and ETF’s (these are cheap to buy and own, and are much lower risk than individual stocks).

I invite you to meet with me and allow me to review your investments at no cost or obligation. If they are good, I’ll tell you that. If not, I’ll tell you why. I will also spend less than an hour teaching you about what I do and why. I say teaching because this is the same type of “class” I do for other accountants for continuing education hours, as well as share with clients. No broker or advisor ever “teaches” his clients about how to do it right, because they either don’t know, or it causes a loss of income by empowering someone. I love to teach because when I do, two things happen. First, the client leaves knowing more than 95% of the brokers out there (I am absolutely serious on that number), and no matter what thereafter, it’s far less likely that any salesperson will ever take advantage again. And that’s just plain fun. Second, quite simply, “an educated consumer is my best customer.” I will also gladly provide a couple of things for you to look at. These include actual client brokerage statements from several accounts (with appropriate concealment of names and account numbers). I don’t know any advisors willing to do that.

My best to you, and I look forward to talking with you further.

Sincerely

Anthony C. Caruso

Certified Public Accountant

Personal Financial Specialist

Dear Friends and Clients:

As I have met with clients over the last 30 years, they are often frustrated with advisors, wealth managers, brokers, bankers, and the like, all wanting your money, but none doing a very good job with it. This puts you in a position of having no trust, faith or confidence in anyone, yet the body of investment advice and so called experts is so vast as to be overwhelming. This I understand better than you may know.

Over the last 30 years, I have prepared thousands of tax returns, mostly for “high net worth” clients as they are called. I have my own first hand “study” as to investment performance over hundreds of accounts and advisors. Most have investments with the likes of Morgan Stanley, Smith Barney, Merrill Lynch, Bank of America, Wachovia, SunTrust, and so on. Every tax season, I would sit with clients, and look at what their brokers and advisors accomplished. Clients would ask me questions such as “what are these investments – I don’t understand them?” or “can you tell me how I am really doing – my brokers says not to worry?”, or “my account is really down and I don’t understand why since I told my broker I wanted conservative investments – can you explain this to me?” I wish I could tell you that in all those years, I found one or two brokers that knew what they were doing, but I can’t. Even large trust companies have fallen short in this regard. Unfortunately the brokerage and financial planner business is really not about good advice at all. It’s about capturing assets, selling products such as load funds or annuities that pay big commissions, or turning stock over and over for commissions. In other words, it’s a sales business, not an advice business, and it matters not whether the client makes money or loses, the broker is paid either way.

I tell you this because there are two reasons I added money management to my CPA practice. First, my clients asked me to help them, because they trusted me, and appreciated my conflict free financial expertise and advice. Second, most of my clients have been with me for years, and they are like friends and family, and I didn’t like to see them taken advantage of, or be harmed financially. Many are in retirement and can’t replace lost principal. It’s difficult to sit with a widow, in tears, as her life savings have been crushed. I felt I could do better, with a simple formula of merely “doing the right thing.” Doing the right thing is not as profitable as selling garbage for big commissions, but it makes me feel awfully good. I spend much of my time telling people how much tax they owe (even though I get that amount down as legally low as possible). Frankly, it’s far more rewarding to build income and investments for a client, than to tell them how much tax they owe. That is why about twelve years ago, I became licensed as an investment advisor (my firm is an RIA – Registered Investment Advisor. An RIA is regulated by the State of Florida, the SEC, and FINRA. The Form ADV I sent you is filed and available to the public. You can look up any advisor on line and see if they have had any lawsuits, claims, fines, etc. It would surprise you to know just how many brokers and advisors have. My record is spotless.

Besides being a CPA, I also hold the PFS designation (Personal Financial Specialist). The PFS is similar to the CFP (Certified Financial Planner) except, a PFS must first be a CPA. A CFP can be anyone with a college degree – art or music, or finance – it matters not. Next, they take six “classes” – one each on taxes, investing, retirement, insurance, etc. To be a CPA on the other hand requires a masters degree, and hundreds of hours more of specialized training than a few classes can possibly provide. Add years of experience to that equation, and you see the difference.

When I manage an account, we first set up the brokerage account with Fidelity Investments, Institutional Brokerage Group. While the IBG at Fidelity is where managers manage money for clients, this is not the same as Fidelity Investments at the retail level (same company but two different “divisions”), where you can walk in to a storefront and open an account, and get some advice from a clerk on hand. The clerks are sometimes paid some commissions by recommending certain Fidelity mutual funds. Not that they are good or bad necessarily, but that’s how it works. I don’t use any of the Fidelity funds in my portfolios, nor am I paid one penny for ANY investment I use in building a portfolio. No commissions at all. I am paid strictly a fee of 1% per year of the assets managed. On a fee basis, you can appreciate that I want your account to grow as much as you do.

The investments I use are only index funds, passive asset class funds (which are like index funds), and some ETF’s. No stocks, usually no individual bonds (except for very large accounts under certain circumstances), and certainly no “load funds” that pay commissions to the selling advisor. I use these because they are dirt cheap to buy, and they allow me to construct a portfolio of multiple asset classes in a broadly diversified manner. My portfolio construction is purely academic, and is based on the work of Harry Markowitz (the father of “modern portfolio theory and winner of the Nobel Prize in Economics for this work), Eugene Fama (U. Chicago), Kenneth French (Dartmouth Finance chair), Roger Ibbotson (Yale), Robert Merton (another Nobel Laureate) and others from academia. Other that the late Harry Markowitz, the other names I mentioned are all board members of the Dimensional Funds advisors group, which are predominately the funds I use. The art is in the combination of asset classes, in concert with current economic conditions, leading and lagging indicators, trend analysis, etc. to best position a portfolio for risk and return. More importantly, the true art is in managing risk. Risk is more important than returns. Equities are far more risky than fixed income (bonds, treasuries, etc) yet the wrong kind of bonds or timing of duration of bonds depending on the economic climate can cause devastating losses. In other words, it’s no place for sales people or amateurs to be playing, when risk management is top priority. I have a number of husband and wife clients, where the husband (usually, but not always) comes to me to manage the money, keep it safe, and insure it will be there for the benefit of his spouse and children, if he is no longer able. Trust is a very precious commodity and a responsibility I hold dear.

Let me also address something that has been in the news of late, and is of concern to many investors. Specifically, can Bernie Madoff happen again? What allowed Madoff to execute his fraud was that the investments he managed were never in the “custody” of a brokerage house (such as Fidelity Investments). Instead, he produced dummy statements, with false transactions, and did this for years. Conversely, the accounts I manage are held at Fidelity Investments (Fidelity is the “Custodian” of all assets owned). They hold them for safe keeping. My authority as an advisor is to buy or sell within the account, to build a portfolio, manage, rebalance, etc. No money or investments can move in or out of that account without the client’s signature. Custody is a big deal.

I offer anyone with concerns about their investment plan, to come and meet with me and spend less than an hour as I teach you about what I do and why. I say teaching because this is the same type of “class” I do for other accountants for continuing education hours, as well as share with clients. No broker or advisor ever “teaches” his clients about how to do it right, because they either don’t know, or it causes a loss of income by empowering someone. I love to teach because when I do, two things happen. First, the client leaves knowing more than 95% of the brokers out there (I am absolutely serious on that number), and no matter what thereafter, it’s far less likely that any salesperson will ever take advantage again. And that’s just plain fun. Second, quite simply, “an educated consumer is my best customer.”

I will gladly review your portfolio, discuss your finances and planning and give you any and all opinions, at no cost or obligation. Call me anytime. I’m here to help.

Sincerely

Anthony C. Caruso

Certified Public Accountant

Personal Financial Specialist