Dear Clients and Friends:
Tax Relief Act of 2010
Since our last newsletter, Congress has set the rules for federal income and estate taxes for 2011 and 2012. This was accomplished by the passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, more commonly referred to as the Tax Relief Act of 2010.
Unfortunately, while clarity exists for the next two years, the ability to coordinate planning extending beyond that time period remains just as difficult as it did before the new law. Dealing with uncertainty is what we all do on a day to day basis. You deal with the uncertainties of employment, the soundness of pension plans, home values, investment returns, the weather, your health, and the happiness of loved ones. Sometimes it seems like the only thing that is certain, is uncertainty.
As planners, our role is to understand your objectives and help you deal with uncertainty in the financial world. Uncertainty cannot be ignored, but it can be managed to a degree.
Looking ahead, we believe that some combination of tax increases and spending reductions will be required to strengthen the federal balance sheet, the government’s net worth statement.
Therefore, we would not be surprised if the income tax rates for upper-middle and upper income taxpayers will be increased after 2012. Our income tax planning will reflect that assumption.
The Tax Relief Act of 2010 increased the individual estate tax exemption amount to $5 million and capped the maximum estate tax rate at 35%. In addition, the exemption amount is portable, meaning that a married couple has the potential to shield $10 million from estate tax. The unused portion of a deceased spouse’s exemption can be made available for the benefit of the surviving spouse.
With the estate tax provisions expiring as well after 2012, long range estate planning remains difficult, but should not be avoided. The importance of well drafted trusts to protect the interests of your loved ones or your favorite charities should not be underestimated.
The past year was kind to investors as virtually all assets, save cash, posted attractive returns. While we, as investors, welcome these results, it is hard to ignore that they occurred at a time when the government was using unconventional measures to stabilize the economy. Those measures include Federal Reserve Bank (Fed) monetary policy (printing money) and legislated fiscal stimulus (extension of tax cuts and a reduction to payroll taxes). The Fed has induced investors to take risks by holding Treasury rates at lower levels across the spectrum of maturities, than would otherwise be determined by normal market participants. Suffice it to say, these actions have worked, at least from the perspective of promoting asset price appreciation, since September of 2008 (Lehman Brothers collapse). Stock returns have nearly doubled from their lows in early 2009, including dividends.
It is important not to be complacent. From even recent history, we have seen how a few negative years can wipe out returns for whole decades. The Nasdaq Composite is about fifty percent off its peak value more than a decade later. The Nikkei Index (Japan’s stock market index) is trading at a discount of nearly 75% from its peak in 1989. Ultimately, it is evident that performance over full market cycles determines whether we are successful investors. How do we do that? The following guidelines significantly increase an investor’s odds:
1. Buy right.This seems to be stating the obvious, but paying too much for an asset will lower your overall return. The gauge for price valuation that is most widely used is the P/E (price-to-earnings) ratio. P/E ratios that have historically had the best predictive value are ones with normalized earnings (earnings averaged over a number of years).
2. Be contrarian.Warren Buffet said it best "Be fearful when others are greedy and greedy when others are fearful." This is easier said than done. Most people would rather fail conventionally, and succeed unconventionally. In other words, it is always easier to be wrong when everyone else is wrong (following the herd), than go out on a limb and be wrong alone. Misery loves company.
3. Keep emotions in check.The reactive part of our brain kicks into high gear when we perceive a threat (financial insecurity). This is the same part of our brain that reacts by slamming on the brakes when a deer crosses in front of our car. The reactive part of our brain serves a vital role in our survival, but this part of the brain sends exactly the wrong signals when making investment decisions.
4. Stay diversified.John Maynard Keynes famously said, "The market can stay irrational longer than you can stay solvent." An investor can have the greatest conviction in an investment idea, and therefore, invest a disproportionate amount of wealth in it. The longer the investment idea under-performs, the greater the investor’s frustration, and the more likely he or she will pull the plug. Diversification is the risk management tool that helps avoid selling out early, promoting the ability to be patient.
5. Be patient.Constant action has its appeal. Financial news has become a 24/7 obsession by many. Technology has only enhanced the media’s ability to deliver a constant thread of investment noise. Every piece of economic data is treated as a tradable piece of information. Constant media coverage has translated into shorter and shorter investment holding periods. In short, the more one follows financial media, the more often one is apt to trade. In general, this has not resulted in better investment results.
6. Be unconstrained.In the past, investors and investment advisors wanted to pigeon hole mutual fund managers to a certain style (value or growth) or market cap (large, mid, and small). This was done in an attempt to diversify holdings because, historically, there had been meaningful correlation differences across styles and market caps. We have loosely followed these guidelines as well. In today’s investment climate we believe that, intuitively, this makes less and less sense. Why require a manager to have all of their assets invested (i.e. hold no cash) if the manager isn’t finding stocks he or she wants to buy? In addition, why constrain a manager to designated market cap or style categories if opportunities are discovered outside those boundaries?
A number of the above guidelines are somewhat joined at the hip. For example, being diversified allows an investor to be more patient with regards to asset classes that are underperforming. By definition, being a contrarian means to buy when others are selling. This usually allows an investor to buy assets at bargain prices (buying right). The caveat to buying unloved stocks is that they can underperform significantly over short time horizons. There is compelling evidence that stocks with momentum can outperform in the short run, but at the expense of long-term results.
Following the above guidelines to select managers and funds is pretty straightforward. We aim to invest in predominately global, multi-cap funds that are value or growth style indifferent, but invest based on the concept of buying stocks at the right price, or not buying at all (holding cash, or even buying bonds). A notable exception from these guidelines would be a decision to overweight a certain area, based on either unique manager expertise, or compelling valuations. Ultra large capitalized U.S. stocks meet these criteria from a valuation perspective and the Matthews Asia Dividend Fund meets the criteria of unique management expertise.
U.S. stocks, using the S&P 500 Index as a proxy, are trading at a normalized 10 year P/E ratio close to 24. A ratio this high, when compared to a historical median P/E closer to 16, has mostly preceded below average stock returns over the following decade. The one bright spot, however, is that the largest stocks in the S&P 500 Index currently trade at a discount to their historical P/E ratios. As a result, an investor could expect decent returns from ultra large U. S. stocks over the next 10 years.
The Matthews Asia Dividend Fund deserves a special allocation. Asia has the highest growth prospect and a higher dividend payout than any other region in the world. Also, Matthews has an exceptional manager that only invests in Asia, and has been doing so successfully for over 20 years. Other than being confined to Asia, the manager meets all of the other criteria we believe is vital to long-term success.
In order to align client portfolios with the above equity investment approach, we will be looking to add the Evermore Global and Yacktman funds into client portfolios.
We will continue to gear our fixed income portfolios to be less interest rate sensitive versus the broad bond index (Barclays Aggregate Bond Index). This will be accomplished by holding some non-dollar denominated foreign and emerging market bonds, floating interest rate bonds, and a short (bearish) position in the 30-year U.S. Treasury Bond.
For portfolios with individual municipal bond holdings, we will be requesting opinions from fixed income specialists to see if any sales would be warranted. State and municipal finances have been getting a lot of press lately, and investors are understandably concerned. There are a few states and many municipalities that have come under immense pressure as expenses escalate and revenues decline.
The market is likely to paint municipal bonds with a broad brush, which will undoubtedly create some attractive buying opportunities. Triple A rated 10-year municipals bonds are yielding almost the same as 10-year U.S. Treasury Bonds, yet municipal income is federally tax-free and Treasury income is subject to federal tax.
There will be a modest change to investments recommended for our satellite category. As a refresher, this category holds investments that aim to have lower correlation to traditional stocks and bonds in an effort to smooth out portfolio performance (lower volatility), or to increase total return. We will be moving the Pimco Floating Rate fund to the Core Fixed Income category and adding Ivy Global Natural Resources to the Satellite category.
Net Worth Statements
We are in the process of preparing personal net worth statements as of December 31, 2010. These statements provide important information about your current financial position, often used as a starting point for reviews of casualty insurance, debt management, asset ownership, and estate planning.
Please respond to our requests in a timely manner. We only need rough estimates of values.
SEC Required Examination
We recently completed an examination of our compliance with certain provisions of the Investment Advisors Act of 1940. This examination was recently required by the SEC. We would like to express our appreciation to clients who cooperated with our auditors during a random selection of accounts.
Information for Tax Return Preparation
We will soon mail all clients a summary of financial planning and investment advisory fees paid in 2010, as well as a report of realized gains and losses from Fidelity accounts. It is very important that your tax preparer receives this information. Once you have reviewed your reports, please contact Lauren if you would like her to send a copy to them.
The taxable gains and losses that often appear as supplemental information on Form 1099s from Fidelity, may be incorrect. If you were not a client of Schiavi + Dattani for the entire 2010 year, gains and losses that occurred prior to our management will have to come from your own records, or those of your previous brokerage accounts.
Annual Delivery of Privacy Statement
We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.
We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA