Q&A Series – Derivatives Regulation

This week’s question comes from Sue, a client who is concerned with how the lack of regulation and the enormous size of the derivates market can pose risks to her investments.

Q. To what extent does the continued lack of OTC (over-the-counter) derivatives regulation jeopardize the personal accounts of “little guys” like me?

A. Politicians, regulators and financial institutions continue to debate this very question, Sue, and although I acknowledge that we aren’t experts in the field of derivatives, I’ll attempt to answer it.

In some ways, not much has changed since the financial crisis, but in other ways, the overall landscape is much different than it was in 2007. Banks and financial institutions are bigger than ever, but on the other hand, they are far better capitalized compared to 2007 and have been held to higher regulatory standards since the crisis. In addition, financial institutions are far more conservative in their lending and investment initiatives than in years past. More regulation, more capital and more conservative lending standards all contribute to a far more stable, if less profitable, environment. For these reasons, we feel that the risk due to a lack of specific OTC derivatives regulation is far lower today than a few years prior.

Derivatives are used by a wide variety of market participants. Many corporations and industries use derivatives to hedge specific risks, which translates into more stable prices for consumers and businesses. Farmers might hedge against lower crop prices and, alternatively, food producing companies might want to hedge the risk of rising input prices like corn and wheat. Transport companies use derivatives to hedge the negative impact they feel when fuel costs rise. In each instance, these industries are attempting to maintain viability by using derivatives, and require specific agreements with their counterparties which are designed for a very special situation.

Many investment firms like Pimco also participate in the derivatives market in order to lower or hedge a risk that their investors might be exposed to. Two common risks that these funds look towards reducing are interest rate risk and currency risk. A common derivative used to protect investors from rising interest rates or a depreciating foreign currency is called a “swap.” Swaps typically have very large nominal values, but the payments are often netted. Netting often results in the cash trading hands from the payer to the receiver in being a very small amount compared to the value of the swap on the books.

We would argue that when firms, financial or otherwise, use inexpensive and customizable derivatives to hedge their risk, this actually increases the stability and efficiency within the economy. Requiring derivatives to trade on an exchange could increase the cost of hedging techniques and reduce the customization that many firms rely on. The sheer size of this market, though, can be unsettling. In fact, the derivatives market is estimated to be valued at an unfathomable $600 trillion, while the entire world produces annual GDP in the range of about $60 trillion per year.

But it has always been the use of leverage, or debt, that has jeopardized our economy, regardless of what kinds of positions were leveraged and regardless of whether positions were purchased through a transparent exchange. It’s the lethal combination of risk and leverage that poses a systemic danger to the economy and, therefore, our investments. Regulating risk and the ability of a financial institution’s capital ratio is at the heart of preventing the next financial crisis and avoiding the next bailout.

But all signs pointing towards leverage in the system having been significantly reduced. Citigroup and Bank of America, forever beleaguered banks, have significantly stronger capital positions than they once did, although neither has shaken the malaise of the crisis. And the worst of the worst, AIG, is a shell of its former self after selling several business units and accepting a healthy dose of government capital.

Financials are not nearly as likely to get another crisis in the immediate aftermath of a generational event like 2008. And anyone who has tried to purchase a home or refinance a mortgage recently is likely to tell you that lending requirements are far more stringent than they were in 2007 – and probably more restrictive than at any time in the last 20 years. This anti-risk taking attitude extends to financial institutions’ willingness to participate in speculation through the derivatives market.

However, an institution might create a severe systematic risk to the greater economy if it were involved in serious amounts of speculation as opposed to hedging. For example, AIG wrote hundreds of billions of dollars worth of insurance on bonds that they never could have covered. Clearly, this action by an insurance company was a speculative business practice that should have been more vigorously regulated. This would be analogous to a bookie accepting numerous bets on one team without regard to his ability to pay and/or adjusting the spread as bets came in and/or laying off some of the exposure to another bookie.

In theory, the failure of AIG and the enormous bailout could have been avoided with some combination of additional and better regulation on the firms themselves. Good regulation of AIG could have encouraged or forced the company to limit their credit-default swap exposure to a sensible and affordable level.

There should be a distinction between firms that use derivatives to hedge risk as opposed to those trying to magnify risk. If “too big to fail” institutions are going to exist, it seems that simple capital requirements alongside vigorous oversight of the specific institutions are necessary regulatory initiatives. Higher capital standards alone would reduce the probability of these institutions from failing and, therefore, putting taxpayers in a no-win situation of paying for a bailout.

Simple, straight-forward risk reducing global regulation should be government’s initiative. It’s important to have global solutions to an evolving regulatory environment given the global nature of the economy and the investment landscape. If new rules are put into effect in just one jurisdiction, it seems unlikely to have an effect as transactions are sure to flow towards those jurisdictions with the lowest cost and the more favorable conditions for those parties entering into derivative contracts. Another question to consider is whether a firm is hedging their risk or using derivatives to speculate. Certainly, the firms involved in speculation pose a more significant risk and therefore deserve more regulatory attention.

Sue, I hope my answer above has given you some useful information regarding the derivatives markets. This is a very complicated matter, which is sure to spark debate for some time to come.

We encourage our clients and readers to send us questions for our Q&A series at Contact@RollinsFinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Eddie Wilcox

Social Security – I’M ENTITLED!

From the Desk of Joe Rollins

Rep. Paul Ryan’s (R-Wisc.) proposed federal budget plan for 2012 is receiving attention from a number of senior protestors who are denouncing his recommended changes to Social Security. This past weekend, quite a few distinguished senior citizens protested Rep. Ryan’s plan. They argued that because they paid into the Social Security system, they are entitled to benefits under the current program.

In my view, this argument is not based on reality since nothing in Paul Ryan’s proposed federal budget changes to Medicare and Medicaid would impact anyone over the age of 55. From the footage of this past weekend’s protest, no one in the crowd appeared to be under that age, and while I respect their passion, I respectfully question where they obtained the facts to form their position.

Because I will soon hit Social Security retirement age, I decided to evaluate my own circumstances regarding the benefits I’ll be entitled to and how long the money I paid in will last. My Social Security benefit statement issued in 2010 reflects my earnings all the way back to my very first job in 1966 when I earned a total of $563. I vividly recall that first job – I raked in a whopping $1.25/hour which was the minimum wage at that time. As a 17-year old, I couldn’t imagine being any richer than I was when I netted $40.40 for a week’s work.

To perform the most accurate calculation regarding the longevity of my Social Security contributions, I had to make a few assumptions regarding my earnings and other important variables. I assumed that all of my contributions to Social Security have earned a total of 3%, compounded annually. Given that one-year Treasury bonds are paying less than one-half of one percent per annum, my assumption may be on the high side.

In addition, I assumed that my employers – which have mostly been my own firms during my professional life – contributed exactly the same amount with the same return. I also assumed that I will begin receiving Social Security retirement benefits at age 66, and that my benefits will increase by 3% each year (commensurate with the rate of inflation). Additionally, for the vast majority of my career, my Social Security earnings record reflects that I contributed the maximum allowable amount each year based upon my earnings.

Based on my earnings record and my calculations, I will have contributed approximately $152,097 to Social Security by the time I turn 66-years old. If my employers have contributed a like amount, then a total of $304,194 will have been contributed under my record when I turn age 66. With the 3% assumed return on the contributed total amount, the total in my Social Security account would be approximately $492,940. And so, using my monthly benefit amount as provided on my Social Security benefit statement – and assuming that the unpaid balance continues to earn 3% – my account would hit zero 17 years after I start collecting benefits. I will be 83-years old at that time, and my children, Joshua and Ava, will be 38 and 22, respectively.

It’s important to note that this example only reflects the retirement benefits I will be collecting from Social Security; it doesn’t reflect any benefits my wife, my children (and my former spouses, for that matter) may be entitled to draw. Additionally, the entire calculation would change if I were to become disabled and had to start drawing Social Security disability insurance benefits at an earlier age.

If my example is consistent with what typical individuals contribute to the Social Security program, then recipients would realistically only be entitled to draw benefits for approximately 17 years after reaching full retirement age if taxpayers were not subsidizing retirement benefits beyond those years.

Taking my example further, let’s assume that the government could earn a minimum of 6% on my account instead of the 3% illustrated above. Additionally, let’s assume that after I retire, any money not distributed to me would continue to earn 6%. My monthly benefit amount would remain exactly as it is indicated on my current Social Security benefit statement. Using these assumptions, my account would never hit zero, and in all likelihood, there would be a balance to share with my fellow taxpayers or bequeath to my heirs at my death.

The above example follows former President George W. Bush’s 2005 proposal to reform the Social Security program through partial privatization of the system. Of course, Congress never enacted any major changes to the Social Security program at that time. Democrats in Congress unanimously opposed Bush’s changes and many Republicans were also unenthusiastic about his proposal.

However, my opinion is that if the U.S. government were to allow independent third parties (i.e., professional money managers) to invest the contributions with the potential to earn a minimum 6% rate of return over time, then Social Security would be fully funded and would actually have excess funds. To my mind, the problem would be solved and there would be no further issues. Since the stock market has averaged well in excess of 6% over the last 100 years, I feel relatively sure that this is doable.

My point in the first illustration is that by the time I reach age 83, I will have utilized 100% of the money contributed to Social Security by my employers and me. After that point and until my death, the taxpayers will have to foot the bill for my monthly benefit amount. Of course, if family/survivor’s/disability benefits come into play, then the account will be extinguished at a faster pace and more of your tax dollars will be required.

There are many ways to fix Social Security: The retirement age could be slowly increased; the method for annual increases could be changed from a wage-based increase to a simple CPI escalator, and/or; by seeking out a higher rate of return for amounts contributed via third parties. The issue is so controversial, however, that it just keeps going round and round in circles without any progress being made towards a resolution. It’s time for our elected officials to appropriately address and fix the Social Security problem, and I would be happy to offer my advice.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

Q&A Series: Estate Planning under the Tax Relief Act of 2010

Marge and George are trying to get their estate documents in order, and they have some questions about how to title their assets to be of the greatest benefit to their estates.

Q: I’m proud to say that we’ve been financially diligent over the years, accumulating a moderate amount of assets. We’re now in the process of updating our estate documents. Do you have any suggestions for how we should title our assets? Our old documents are very complicated, with each of us having trusts. Is this still necessary?

A: Good for you for being such industrious savers, Marge and George! It looks like all your hard work has paid off. I’m glad to see that you’re being just as conscientious about making sure your estate is in order. I can’t tell you how many times I’ve seen negative estate tax implications and probate issues arise because proper estate planning was not accomplished.

Since the Tax Relief Act of 2010 was enacted, we’ve been reaching out to clients with enough assets to worry about the estate tax about the importance of reviewing and updating their estate documents (or creating them if none are currently in place). Based upon the tax simplification this legislation provides, most of our clients have found that it’s time for an estate planning tune-up.

The Basics

The amount a taxpayer can leave to heirs free of federal estate and gift tax is known as the applicable exclusion amount. Over the years, the exclusion amount has increased from $600,000 in the 1980s to $5 million in 2011 and 2012, with married couples being allowed to leave $10 million estate tax free since each spouse is granted a separate exclusion. In the case of a decedent’s death on or after January 1, 2012, the basic exclusion amount will be indexed for inflation.

In prior years, it was important for the assets of a married couple to be titled in each spouse’s individual name and not in the joint names of the married couple. While this may seem counterintuitive, it was the only way to ensure that each estate could benefit from using both exemptions since an exemption could not be shared. In other words, regardless of which spouse died first, you wanted to make sure there were enough assets in that spouse’s estate to fully utilize the exemption.

Under the old law, it was also important for married couples with significant assets to establish marital trusts under their Last Wills & Testaments as a way to ensure that the estate or gift tax exclusion amount for the first spouse of a couple to die could be preserved and passed along to the surviving spouse. I am one of the many people who complained that these requirements were overly complicated. Simply put, the tax code needed to be simplified to allow a married couple to share their exemptions – regardless of which spouse died first and how the assets were titled. This concept is commonly referred to as portability.

And so, with the passage of the Tax Relief Act of 2010, portability was finally enacted for the 2011 and 2012 tax years. This means that for the estate of a spouse who dies at any time during those two years, the remaining exclusion amount in his or her estate will directly pass to the estate of the surviving spouse for both estate and gift tax purposes.

The law doesn’t change the fact that you are allowed to make unlimited gifts to your spouse, in life or through your estate plan if he or she is a U.S. citizen, with no tax applied. But until the legislation was passed, if proper documentation was not in order, anything above the exempt amount that was not going to charity would be taxed upon the death of the second spouse.

How Portability Works

Let’s say a married couple’s assets are titled jointly, and that they have a total net worth of $8 million. Under this scenario, if the husband dies in 2011 (and he hasn’t made any taxable gifts in prior years) he won’t need to use any of his $5 million estate tax exemption since all the assets are titled jointly and the unlimited marital deduction allows him to transfer his share of the joint assets to the wife without incurring any federal estate taxes.

Then, if the wife dies in 2012 and her estate is still worth $8 million, the husband’s unused $5 million estate tax exemption will be added to the wife’s $5 million exemption. The result is that the wife’s estate will receive the full $10 million exemption, and her $8 million estate won’t owe any federal estate taxes at all.

Prior to the enactment of the Tax Relief Act of 2010, the husband’s unused applicable exclusion would have been lost if the assets were titled jointly and no marital trusts were in place. Without the portability provision, at the time of the wife’s later death, she would only be able to pass on $5 million of her total $8 million estate free of federal income taxes. And with today’s estate tax rate of 35%, the wife’s estate would owe $1,050,000 upon her death.

One important caveat is that portability is not automatic. To get the husband’s unused exemption, the husband’s executor would have to file a federal estate tax return on which the unused portion is calculated and allocated to the wife. Without this filing, the wife’s estate would be unable to take advantage of the portability provision.

Besides the obvious tax advantages, another major advantage of the portability provision is that, for the most part, it makes marital trusts unnecessary for preserving the federal exemption amount. Accordingly, it would be unnecessary to go through the hassle of probating a marital trust, which is often a complicated ordeal.

The Controversies

While many estate planners argue that portability isn’t a good enough reason to revise estate plans that are already in place, I tend to disagree unless a couple has a combined estate greater than $10 million. I’ve heard several comments from legal professionals that dealing with marital trusts is not a problem. My feeling is that it’s often difficult for a grieving spouse without any financial training to deal with probate issues concerning trusts, the passing of assets and other issues that must be addressed through probate.

Furthermore, the portability provision was designed to simplify small estates and excludes the vast majority of estates from having to go through probate and file estate tax returns. By allowing married couples to combine their exclusions up to $10 million via portability, a high percentage of all U.S. estates will be excluded from being required to file an estate tax return.

It’s true that the portability provisions may not be continued after 2012 and that the law will revert back to pre-Bush era provisions if not extended. But my opinion is that there’s a very slim chance portability will be done away with entirely. You may recall that Congress couldn’t agree on any tax changes before the Bush-era tax cuts were set to expire at the end of 2010. Because of rushed negotiations and some horse trading in Congress, the new estate tax laws were based on the existing $5 million exclusion and 35% tax rate. At the time, President Obama was pushing for a $3.5 million exclusion with a 40% beginning incremental tax rate. But instead, President Obama comprised and agreed to a two-year extension of the Bush-era tax cuts.

Since the subject of estate taxes is so important to wealthy donors, my personal opinion is that there is little chance that the estate tax provisions will not be extended in some form similar to the current legislation. With the Republican-controlled House, and with the potential for Republicans also gaining control of the Senate in the next election, I think it’s possible for portability to become permanent. It would not surprise me to see the exclusion decrease to $3.5 million and the tax rates increase, but even so, I believe the portability provision will remain in effect.

Nevertheless, several states have their own estate taxes without portability clauses, most with exemptions capped at $1 million or less. For residents of those states, utilizing marital trusts to preserve their state estate tax exemption is a wise choice. You can check with your tax professional or Rollins Financial to find out if your state has its own estate tax and whether or not it contains a portability provision.

Thanks so much for your questions, Marge and George. As I’ve stated before, it’s important to fully evaluate your particular situation when making estate planning decisions. There are other issues regarding portability that complicate matters, like what happens if the surviving spouse remarries. It would be impractical to cover all of the “what if…” implications in this post, but I am always happy to discuss case-by-case scenarios with readers or clients personally. As I’ve said in the past, it’s important to consult with a financial adviser when developing your estate plan, and in that regard, Rollins Financial is here for you.

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

GIMME A BREAK!

From the Desk of Joe Rollins
I received a lot of criticism from readers of the Rollins Financial Blog regarding my June 1st post, “News for May, 2011 – A Satisfactory Month.” In it, I indicated that even though May was a negative month for the stock market overall, it was still satisfactory because it kept the upward trend of the bull market intact.

Several readers questioned how I could possibly view the results for May as being satisfactory, especially in light of the significant change in economic conditions and the seemingly constant negative news coming out of Washington for the last two weeks. Some readers wondered why I am not forecasting another meltdown like we suffered in 2008. My suggestion to those readers is that they should stop, think and analyze before they push the button to sell.

I’m having a hard time understanding the correlation to 2008 that some of my readers are drawing. I suppose that if you watch the news long enough, you might come to the same conclusion. However, there are many differences between 2008 and what we are currently experiencing. While the growth in employment for the month of May was only in the 50,000 range, those results are significantly better than in 2008 when 650,000 jobs were being lost per month. And while GDP was anemic at 1.8% for the first quarter of 2011, that percentage is light years better than it was when it was negative 6.0% in 2008.

In 2008, credit was contracting at a staggering rate while interest rates are low today. Moreover, for the first time in many years, banks are actually lending. Besides all of that, there are plenty of explanations as to why employment and GDP were weak in the first quarter. One only needs to reflect on the catastrophes in Japan this winter which cut down the supply line of automobile parts and cars to the United States. Additionally, weather in the Midwest has been horrible, and many of the agricultural workers have yet to even plant their fields, much less harvest them. Of course, we all certainly know that the home building industry has virtually shut down. Natural disasters, high energy prices, etc. – these are all short-term issues that should not bring long-term negatives to the economy. Therefore, drawing economic parallels between 2008 and 2011 is not reasonable.

You might think that we’re experiencing a significant market correction, but we actually are not. Since the market reached a temporary high in April 2011, there’s been a decline of 5.9%. This relatively modest decline could hardly be described as significant. It is perfectly possible to suffer a 10-15% decline before the market begins to turn up again. Moreover, even though it might not feel like it, the markets are still positive for 2011.

Another major component impacting the market is professional traders. Professional traders do nothing but trade all day long, day-in and day-out. They really don’t care whether the market is up or down; they’re only interested in incremental gains on large transactions. After the market’s nearly straight-up increase since March of 2009, it wouldn’t be surprising for professional traders to try to force the market down before they would reverse course to make it go up again. With all the short-term bad economic news, it would’ve been surprising if the professional traders hadn’t tried to force the market lower to enable stock purchases at a lower price.

At 3:30 p.m. yesterday, the Dow Industrial Average was up 89 points when Dr. Bernanke began a televised key speech at the International Monetary Conference in Atlanta. Bernanke indicated that the economy had lost momentum, but was expected to accelerate in the last half of 2011 (only three weeks away). As Dr. Bernanke spoke about the economy having lost momentum, the Dow Industrial Average turned completely around and wound up closing 19 points down for the day.

Yesterday’s large swing in the Dow could only be attributed to professional traders, since it’s highly unlikely many typical investors were actually watching TV at that time of day. If there were investors watching Dr. Bernanke’s speech, they would’ve heard what he had to say after he noted that the economy had lost momentum – that he expected the economy to pick up during the last half of 2011.

Since I began managing assets for clients 20 years ago, I’ve been asked time and time again why we wouldn’t bail out for a few weeks when the market is declining and then buy back in once the market hits a bottom. I wish it were that easy, but it’s been proven through numerous studies that market timing simply doesn’t work – no one can precisely time the market.

If we traded out our positions for the short-term, then we would have to pick another type of investment that we would deem to be better than what we currently own. Let’s evaluate our options to see what’s available:

Investing in cash –Money market accounts are currently returning almost zero. In fact, municipal money market accounts actually have a negative rate of return right now. Also, if you’re paying a maintenance fee on your account, it’s highly likely that over the course of the year, a positive return would only be marginally possible. Of course, as we all know, inflation (which is at about 2% right now) would likely cause a negative rate of return in purchasing power at the end of the first year for cash invested in money market accounts.

CDs – This is another type of investment that is currently paying an almost zero return. Like cash, CDs are providing negative rates of return once you take inflation into consideration. I’ve heard many people say that these products are appealing because they care less about making money than losing money. However, due to the inflation component, it’s almost guaranteed that a CD investor will actually lose money or purchasing power over the CD’s term.

Treasury bonds – As of today, the 10-year Treasury bond is paying a rate of approximately 3%, which is practically an all-time low. It’s almost assured that this rate will go higher in the coming months. Given that the rate of inflation is approximately 2% and the Treasury rate almost always exceeds the rate of inflation by 3%, then you can see that Treasury rates need to be at least 5% to protect you from the current rate of inflation. These bonds may lose money over the next few years, especially if interest rates increase significantly.

Residential real estate -- It’s well known that this hasn’t been a good investment for the last decade or so. Almost daily, a client tells me they want to buy a property down the block “because it is so cheap.” In each and every case, I advise the client to sit tight, because it’s highly likely that the property will be just as cheap three or four years from now. I’m not negative on residential real estate, but I do think it’ll be a slow climb out of the rut we’re in and other investments are much more attractive.

High-yield bond funds – These funds are attractive right now because they pay a high rate of interest and are also not as impacted by higher interest rates into the future. We own many high-yield bond funds in our client portfolios.

Stocks – This is the most attractive asset class for investing at the current time. Corporate profits are at all-time highs and corporate America has never had such solid balance sheets. With cash held by American corporations, you have the triple advantage of high corporate profits, solid balance sheets and excess cash available for new investments. Stocks have rarely offered such compelling advantages over income securities in the past.

Utility stocks – These stocks offer the opportunity of high dividend payments that are significantly greater than interest bearing certificates with a major tax advantage over interest earned on money markets and CDs. For taxpayers in higher income brackets, interest income is taxed at 35% while dividends are taxed at 15%. The disadvantage to these stocks is that they very rarely have significant market appreciation, as utilities typically exhibit lower overall volatility than the broad market. However, if you are looking for a return on your investment, it makes little sense to invest in cash, which returns almost zero when you can invest in high quality utility stocks earning 5% or greater with more favorable income tax rates.

It should be fairly evident to investors that nothing has really changed due to the soft economic numbers from the last several months. It should also be clear that the situation in Japan, the higher gas prices, and the turbulent weather led to a very soft GDP in the first quarter of 2011. However, almost every economist, including Dr. Bernanke, is forecasting higher GDP growth for the rest of 2011. While it won’t be gangbuster growth, unlike in 2008, it will still be growth.

Given that corporate profits are high and getting higher and corporations are very cautiously hiring additional employees, we should see higher stock prices in the second half of 2011. The only time to anticipate a stock market decline is when GDP is plunging and corporate profits are deteriorating. We have neither of those scenarios today.

One of the interesting aspects of current corporate America is that we receive the benefits of U.S. and international profitability. As of today, 40% of American corporations’ profits are realized in international commerce. It’s estimated by Bob Doll, Chief Equity Strategist and Lead Portfolio Manager for BlackRock (one of the world’s leading providers of investment, advisory and risk management solutions) that 70% of the profits of U.S. corporations will be international in the next five years. U.S. corporations are now accomplishing the best of the developed and the emerging markets in one entity. Unlike any other time in recent memory, these corporations are generating extraordinary profits even with the U.S.’s tame GDP growth (but superior 6% GDP growth in the emerging countries). I can only imagine what corporate profits will be if GDP continues to increase here in the U.S.

There is no solution for the problems in our government; they have proven themselves to be inept at doing anything to help the economy. The economy is being held back by endless bureaucracy, red tape and government intervention, and it’s unlikely that these obstacles will be removed within the next few years. But even with all of the headwinds that American corporations are up against today, their profits continue to be spectacular. Given the available options of different investments I have listed above, stocks, high yield bonds and dividend-paying stocks are the best choices. And that is exactly where Rollins Financial has substantially invested the portfolios under our management.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

NEWS FOR MAY, 2011 – A SATISFACTORY MONTH

From the Desk of Joe Rollins

You might be confused by my sentiment that May was satisfactory since all three of the major market indices lost money for the month. However, there are many reasons for my opinion, which I will explain in this post.

The biggest reason for my satisfaction with May’s financial results is that, in spite of all the geo-financial turbulence, the indices continued to support fairly handsome returns for the year. For example, while the S&P 500 had a total loss of 1.1% for the month, its return for the first five months of 2011 was still a positive 7.8%. To put this in perspective, for 2009, the S&P 500 had a total return of 26.5%, and for 2010, it had a total return of 15.0%. As you can see, this represents nearly two and a half years of excellent returns for the S&P 500 index.

The Dow Industrial Average, even though it lost 1.7% for the month, had an even higher return than the S&P 500 for the year through May 31st of 9.6%. The NASDAQ Composite lost 1.3%, but had a return of 7.2% for the five months ended May 31st.

At the beginning of 2011, I indicated that double-digit returns for any of the indices would indicate a very satisfactory year. Although we are only at the beginning 2011’s sixth month, the major market indices are seemingly on their way to completing that financial goal. The fact that we have endured one losing month in 2011 should not influence your resolve to continue to invest and save for your retirement years.

There were many economic events during May that continue to batter the stock market. Of course, we are still feeling the repercussions from Japan’s earthquake and its ensuing nuclear disaster in March, which has created virtually no gains in the Asian markets thus far for 2011. Even though the economies in China and Southeast Asia continue to be quite strong, the consequences from the events in Japan have drawn down the markets for the whole region.

In Europe, the anticipation that Greece will soon default on its debt – with Ireland not far behind – has made those markets highly volatile. I suspect that neither country will actually default, and it should only be a matter of time before these markets also pick up. Furthermore, the German and French economies continue to be strong. Through May 31st, however, there have been little gains in the European markets due to the uncertainties regarding sovereign debt.

Another component affecting the stock market is the serious increases in the price of most commodities. Once again, oil exceeded $100 per barrel and virtually all food commodities continue to accelerate in price. During May, however, many of these commodities suffered a decline due to the misplaced fear that China will force their economy to grow at a slower pace. In short, the failure of the commodities to grow during the first five months of 2011 was a drag on the markets as a whole.

As far as the U.S. is concerned, our Congress was still unable to get a budget together for 2012. Moreover, we are now four months from the end of 2011 and the White House has yet to offer any budget for the current year. Interestingly, the Senate voted unanimously last Wednesday to reject President Obama’s $3.7 trillion budget plan, and it also rejected the House-passed budget sponsored by House Budget Committee Chairman Paul Ryan from Wisconsin on a 40-57 vote.

Despite that news, it seems that Congress is finally getting serious about cutting spending even though the White House has not started practicing financial austerity in its spending habits. Hopefully Congress will drag them kicking and screaming into financial reality, which will be a positive for the federal deficit going forward.

The negatives discussed above might give you the impression that the stock market is in deep decline, but that notion would be wrong. As I’ve pointed out many times before, the stock market’s success is mainly dependent upon corporate earnings, which are nothing short of spectacular right now.

The 10-year Treasury bond is at nearly 3% today. No savvy investor is interested in buying a 10-year Treasury bond yielding 3% when anticipated inflation is in excess of 2%. Why would an investor take a 10-year position in a security that is likely to produce a negative rate of return over that time-frame? The Treasury market is being manipulated by short-term traders who are looking for a hideout for some of their money. It’s only a matter of time until this money shifts from an investment that is unlikely to gain much to one that has the potential for gains, like equities.

I’m very encouraged about future stock market performance based on current high corporate earnings and low interest rates. As money flows out of money market accounts earning next to nothing and CDs earning less than the rate of inflation, the equity markets will be the beneficiaries.

Strangely, while the market is trading sharply down today, this might be good news for investors. Reportedly, the downturn is because fewer jobs were added during the month of May. While this is undoubtedly a negative for the economy, it’s not so negative for equity investors. With the continuing weak nature of the economy, it’s highly unlikely that interest rates will be going up anytime soon.

Additionally, corporate profits continue to explode on the upside. The fact that businesses are not hiring and are operating with a minimal amount of employees to make profits is quite good. I reiterate that the secret to higher stock prices is higher earning. Only when interest rates become so high that they attract new money will stock price levels be challenged. I don’t see that happening anytime during 2011.

Even though the U.S. economy could hardly be considered robust – and is unlikely to be anytime soon – it is still slightly positive and extraordinarily stable. While our politicians have been clueless about the economy, they are moving in the right direction. All of these attributes will bring higher stock prices to investors. While the stock market certainly won’t experience a straight-up increase – it will more than likely experience a volatile and slow-rising increase – 2011’s rate of return should still be positive by double-digits.

While we only have five months under our belt for the year so far, it appears that we are well on our way to realizing the double-digit rates of return that I forecasted going into the year. And so, while May could be considered a lost month, in the grand scheme of investing it was still quite satisfactory.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins