Perspective II

After reading Mark's comments below on keeping current events in perspective, try this quick exercise.

Go to GlobalRichList.com and enter your income from last year (be sure to select "$ US" from the pull-down menu).

Click "Show me the money" and see the result.

Next, thank the Lord - and recommit yourself to being generous.

Posted by Joseph at 1:53 PM

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Perspective

Austin and I are going to be tied up in meetings most of the day today, but I did want to touch base briefly about something important.

We've been commenting on a lot of negative stuff lately, from government actions to market direction. There's lots of gloom in the investing world right now, and everyone's feeling it.

Dark times like these bring the greatest risk of plan-destroying emotional decisions. The pain has been high, there's little light seen shining at the end of the tunnel, and it just seems smart to pull your money out and head to the sideline.

Don't do it.

Despite the current gloom, some perspective is needed. With stocks down some 50% from their highs, investor reaction should vary quite a bit by age.

Anyone under 45 should be thankful for the market decline. This selloff hurts current portfolio values, for sure. But it provides a great opportunity to be pumping money in at these dramatically lower prices. With 20+ years until retirement, there's plenty of time for those seeds sown at these levels to grow as the market recovers. If anything, this group should probably be increasing their stock exposure, not decreasing it.

The 45-55 group likely feels the recent losses a lot more acutely, as they thought they were much closer to their savings goals, and with their shortened time horizon, it may be hard to see how the math is going to add up the way they thought it would. Still, in terms of what to do right now, this group still has enough time to reasonably expect the stock market to dig them out of this hole. Guarantees? No. But reasonable expectation? Yes. Selling here with the expectation of getting back in later carries a significant risk of its own, namely missing much of the upside that has the potential of erasing a significant portion of the recent losses. Missing that surge could be damaging for this group who may not have many of those surges left.

The 55-65 group is clearly the most severely impacted by the decline, but hopefully also had some protective measures in place by virtue of their asset allocation. This group has the most reason to consider further defensive measures at this point, as further losses from here coupled with their shorter time frame make the prospect of recovery less probable.

For investors in all three groups, it's important that any decisions made in the depths of this market gloom are made inside-out, rather than outside-in.

Being an inside-out investor doesn't mean you can never modify your plan. It doesn't mean having blind faith that everything will turn out fine in the end. But it does mean that when events change and you feel that defensive steps are in order, those decisions are measured and not emotional. Part of that likely means taking incremental steps rather than drastic ones. And all of these decisions should be made based on your portfolio, your time frame, your risk tolerance. Not what the market has done since the beginning of the year, the President's plans, or any external stuff.

I know there's been some confusion on this, given what we've been writing lately and the changes Austin has made in his own portfolio. But look closely. Austin is in that 55-65 group that is most affected by the recent downturn. He looked at all his internal factors at the beginning of the year, peeked at the external factors as well, and determined he thought the risk/reward ratio given his personal circumstances was tilted in favor of being aggressive.

When he changed his portfolio to make it less aggressive, it's true that adjustment was largely based on external factors, and that's what has been confusing to some. The key here is that the changes he made simply brought his plan back to "normal" from "aggressive." In other words, he basically just reverted to what his completely inside-out plan had him doing last year. These are incremental changes at the margin, not "should I be invested or should I sell and head to the sidelines" type changes.

Don't confuse making changes at the margin with abandoning core principles. We still absolutely believe you need to have a plan and be sticking to it. That doesn't mean you can never change anything. It does mean that if you make a change, you'd better have a well-thought out explanation that extends well beyond, "the market just looks so bad and I can't see when it's going to recover."

You need to think through what you're doing now as well as what you're going to do later. If you reduce your stock allocation now, what is going to trigger you to raise it later? The all-clear signal? If you switch to SMIVX with part of your Upgrading money now to reduce risk, is that a permanent move that makes sense given your personal circumstances, or is that something you're going to reverse later? If so, when? Based on what?

I'll continue to discuss some of these thoughts next week. Until then, don't do anything rash. Keep in mind that while things are still tough out there, and we may still have further downside to go, with the market 17 months into a bear market and already down 50%, history still says we're closer to the end of this thing than the beginning.

Posted by Mark at 9:44 AM

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Tax hikes arrive

I hope you didn't think that simply allowing the Bush tax cuts to expire was going to be the extent of President Obama's tax hikes.

In his 2010 budget proposal announced today, Obama addresses a couple of his chief priorities: health care reform and the energy/environmental outlook. Throw in a dose of "restoring fairness to the tax code" and you've got a hat trick (that's a hockey term for you non-Northerners).

First, to raise money for revamping the health care system, there's a significant new tax hike for the "affluent." In a nutshell, this change would reduce the value of itemized deductions for everyone in the 35% marginal tax bracket as well as many of those in the 33% bracket, by only allowing these taxpayers to deduct 28% of the value of their deductions rather than the 33% or 35% they can deduct now. For every $10,000 in deductions then, someone in the 35% tax bracket would pay $700 more in tax.

Here's how the administration expects this to play out, as related by this article from today's New York Times:

The officials said the resulting increase in revenues, estimated at $318 billion over 10 years, would account for about half of a $634 billion "reserve fund"? that Mr. Obama will set aside in his budget to address changes in the health care system. The other half would come from proposed cost savings in Medicare, Medicaid and other health programs.

If only the real world was so simple. The problem is that this type of estimate completely ignores the fact that people change their behavior when their tax incentives change. To assume they won't is simply naive.

Allow me to paint an extreme example to illustrate the point. You're a "rich" person with an extra $50,000 laying around. You have many options of what to do with that money, obviously. But two extremes of the risk/reward spectrum would be buying T-bills, which would be completely safe but not earn very much, and starting a new business, which would be very risky but potentially very rewarding.

When tax rates are very low, the idea of taking the risk to start a business is appealing, because you know you'll get to keep most of the reward if the business succeeds. When tax rates are very high, there's little incentive to take the risk of losing your capital, since you won't get to keep much more of the profit than you would if you simply kept your money safe in T-bills.

Now nobody is saying these tax changes, in and of themselves, are going to cause everyone to suddenly stop starting businesses (or expanding the ones they currently operate). But there's a continuum here. And each tax increase pushes people a little further down that risk/reward continuum. Different people, different ideas - they all have different tipping points along that continuum. Let the Bush tax cuts expire? A few percent tip over from risk-taking to playing it safe. Cut itemized deductions? A few more tip over. Implement a cap and trade tax on businesses? A few more.

The problem isn't so much that those individual taxpayers will pay less taxes themselves as a result of becoming more conservative in their economic decision making, though that's certainly a factor. It's that the group we're talking about includes 45%-55% of the small- and medium-sized businesses in America, who happen to be the nation's primary employers. As they tip over, job creation slows, business growth slows, GDP slows, and so do tax revenues.

If that sounds like theoretical, "supply side" thinking, check out the following table illustrating "Hauser's Law." It illustrates that over the past 60 years, Federal tax revenue has stayed almost exactly at 19.5% of GDP, despite marginal tax rates fluctuating from 90% to 28% during that period. The point:

The data show that the tax yield has been independent of marginal tax rates over this period, but tax revenue is directly proportional to GDP. So if we want to increase tax revenue, we need to increase GDP.

What happens if we instead raise tax rates? Economists of all persuasions accept that a tax rate hike will reduce GDP, in which case Hauser's Law says it will also lower tax revenue. That's a highly inconvenient truth for redistributive tax policy, and it flies in the face of deeply felt beliefs about social justice.

Moving on, Obama's concern regarding traditional energy sources causing global warming is addressed with a "Cap and Trade" proposal. This environmental priority will generate revenue by forcing companies to buy permits to exceed pollution emission caps. There are lots of issues rolled into one here, but we'll leave those aside for another day to focus squarely on the economics of this.

It's basic, although often demagogued by politicians and misunderstood by the public, that corporations don't pay taxes - individuals do. That is, corporations take their tax expenses into account, just like all their other expense, when setting prices.

In a stunning back-handed admission of this, the administration isn't pretending that most of the billions of dollars in cap/trade revenue will go to researching and promoting alternative energy sources. Rather, they recognize that the billions in taxes paid by businesses will ultimately be passed on to consumers in the form of higher energy (and other) bills. So the administration is planning to take the money from this tax to extend and increase the "Making Work Pay" tax credit.

In other words, government is going to collect an energy tax from all citizens, then give that money back to low- and middle-income citizens. A very small amount gets siphoned off for alternative energy research. But this is primarily a tool to accomplish two goals: (1) redistribute wealth, and (2) make renewable energy sources more competitive with traditional "carbon" energy sources. (Though it's worth noting they won't be making renewable energy more competitive by lowering its price, they'll be doing so by artificially raising the price of traditional energy.)

The New York Times article sums it up pretty well:

The combined effect of the two revenue-raising proposals, on top of Mr. Obama's existing plan to roll back the Bush-era income tax reductions on households with income exceeding $250,000 a year, would be a pronounced move to redistribute wealth by reimposing a larger share of the tax burden on corporations and the most affluent taxpayers.

I'll say. But here's the real kicker:

Behind the numbers in Mr. Obama's first budget is one of the most far-reaching domestic agendas in years, and at a time when the president and Congress are already grappling with an economic crisis worse than any in decades.

That's really the rub. During normal economic times, I can get my brain around something like the cap and trade proposal. I wouldn't like it or agree with it, but I could understand the desire to promote renewable energy sources, with the hope that the artificially level playing field might lead to breakthroughs that could help solve the long-term energy needs of the country. I get that. But now? In the face of this economic crisis, with all the other tax increases already on the table? Don't tell me this is okay because they won't kick in until 2012: wealthy people usually got that way by being forward-thinking. You better believe they are making financial decisions today based on what's coming down the road 2-3 years from now.

There's plenty more: a dramatic tax increase on foreign profits of U.S. businesses, a repeal of oil company tax "breaks", excise taxes on oil, and so on. These are part of a package that will supposedly raise taxes on business by more than $350 billion over the next 10 years.

"The budget also begins to restore a basic sense of fairness to the tax code, eliminating incentives for companies that ship jobs overseas and giving a generous package of tax cuts to 95% of working families," Mr. Obama said in his budget message.

All well and good, except for the two points made earlier. Businesses don't pay taxes, individuals do as those costs are passed on to them. And individuals (who often own or influence business decisions) change their behavior in response to tax incentives.

We haven't touched on what the cumulative impact of these proposals does to the calculus surrounding where businesses will want to locate - here in the U.S. where they'll already be subject to one of the highest corporate tax rates in the world plus all these new extras, vs. other countries where they won't. But we've probably covered enough ground for one day.

Posted by Mark at 1:22 PM

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Not a promising beginning

In my latest editorial, I listed a few of the reasons my hopes for 2009 have suffered a setback.

The editors of Investor's Business Daily (aka America's other daily business newspaper) have offered a more detailed look at the various actions of the new administration that add to, rather than reduce, investors' anxiety. They introduce them with:

Today, as the market continues to sell off and we plumb 12-year lows, we wish we had a different explanation. But it still looks, as we said four months ago, "like the U.S., which built the mightiest, most prosperous economy the world has ever known, is about to turn its back on the free-enterprise system that made it all possible."

How else would you explain all that's happened in a few short weeks?

This is followed by a lengthy, rather discouraging, laundry list of concerns. This is not recommended reading for the faint-of-heart breadwinner/taxpayer.

Posted by Austin at 5:11 PM

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Signs of life

MarketWatch's chief economist, Irwin Kellner lists 21 specific data points that indicate the recession is easing. He's not saying it's over, just that there are some encouraging "signs of life" beginning to emerge amidst the scalded landscape.

Kellner has this to say about the cause of the improvement:

Clearly, this has nothing whatsoever to do with the stimulus package that the president signed into law last week. As a matter of fact, if the recession does end within the next few months, it will probably be in spite of this package, rather than because of it.

If you want a policy to credit, it's monetary policy. The combination of liquidity that the Federal Reserve has pumped into the economy, along with its special lending programs and capital injections into the banks, is largely responsible.

While I don't really have an opinion one way or the other regarding his overall assertion, it is worth pointing out that economists have long said that the impact of monetary stimulus typically kicks in between 6-12 months later. February is the sixth month since the huge deluge of new money supply started being infused into the economy. So Kellner's observations would seem to be consistent with this long-held economic rule of thumb.

Posted by Mark at 2:16 PM

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Policy disputes, not partisan personal attacks

The times, they are a changin'. And not for the better.

It's increasingly apparent that the people at the financial controls in Washington are guessing their way through the rescue/repair/recovery process. It doesn't inspire confidence.

Because these are momentous times when ambitious federal government policy prescriptions are being debated, I expect a number of our blog links may gravitate in that direction.

None of our comments, I trust, will be disrespectful of our president or congressional leaders as individuals (and we ask that your comments avoid these sorts of attacks as well). But, when appropriate, our posts will take issue with their policy prescriptions which we believe, based on historical precedent, are misguided.

All this is to say that, while we don't intend these to be partisan posts, they might come across that way due to the stark lines now being drawn between the two political parties. Don't interpret our disagreement with policy proposals as a personal attack on any individuals.

Personally, I'm an equal-opportunity critic. The eight years of spending and government expansion under President Bush were, in my view, a disaster. On balance, congressional Republicans were complicit in the pork barrel spending, and many of those who lost their seats in recent election cycles deserved to do so.

Unfortunately, the congressional Democrats, in control since 2006, are proving to be as spendthrift, as corrupt, and worse. And President Obama has started his term with spending decisions that will haunt the country for many, many years to come. So long, "change we can believe in." Hello, "spreading the wealth around."

The articles we'll be sharing in the coming weeks/months reflect our free market perspective. Consequently, they will often focus on the specific dangers and weaknesses inherent in the "solutions" being proposed (and enacted) because we believe it's important you be informed of opposing viewpoints.

Naturally, in addition to these matters, we'll continue to comment on the market and other financial topics. But the changes being proposed for our economic system - to our tax system, Social Security, health care - are so significant that they merit our concentration and study as they come to the fore of the national debate.

Posted by Austin at 2:00 PM

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Revisiting The Coming Economic Earthquake

In recent weeks, several SMI message board posts and blog comments have mentioned Larry Burkett's 1991 (and revised in 1994) book, The Coming Economic Earthquake.

When published, the book was widely criticized as being 1) unnecessary scare mongering and/or 2) too simplistic in its view of the U.S./world economy.

As one who helped research that book, I am convinced that much of the criticism came from people who didn't actually read it. Larry simply presented the idea, consistent with basic economics and documented by history, that debt - whether it be personal, business-related, or governmental - cannot continue to expand indefinitely. At some point, a time of reckoning must occur.

I heard echoes of Larry when reading a long interview in a recent Barron's with Ray Dalio, chief investment officer of Bridgewater Associates.

[I think we are experiencing] a "D-process," which is different than a recession - and the only reason that people really don't understand this process is because it happens rarely.... This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle - a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes.

At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt.

Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.... The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again....

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes - the cash flows that are being produced to service them - or we are going to have to raise incomes by printing a lot of money.

It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue....

A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation - and that will last for as far as I can see out, roughly about two years.

On this last point, I'm not sure Larry would agree. In his book, he expressed concern that trying to inflate the money supply by printing a large amount of new money would stoke inflation, even hyperinflation.

Dalio is arguing that, at least in the near-term, combining printing money with a devaluation of the currency can achieve the necessary balance. Maybe. But I am reminded of one of Larry's favorite sayings: "The man who tries to ride on the back of the tiger is likely to end up inside." (To be fair, Dalio's comment is specifically focused only on what he expects this year and next. He may well agree with Larry regarding the longer-term; we don't know from this interview.)

Focus on the Family recently re-aired a 1992 interview with Larry in which he talked about the Earthquake book. You can hear it here. (NOTE: The timetable Larry envisioned played out in 1997 in Asia. It was delayed here in the U.S. for several reasons, including technological innovation, a slowing in the rate of growth of government spending in the mid-1990s, and a long period of low interest rates that helped keep debt "affordable.")

Posted by Joseph at 1:45 PM

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Musical encouragement?

Everyone can use a little encouragement, so here's a musical first for the SMI blog - a praise song. It was sung at our church recently in connection with a sermon reminding us of God's faithfulness, even in the midst of economic upheaval. Here are the words:

Even though I walk through the valley of the shadow of death
Your perfect love is casting out fear
And even when I'm caught in the middle of the storms of this life
I won't turn back
I know You are near


Chorus:
And I will fear no evil
For my God is with me
And if my God is with me
Whom then shall I fear?
Whom then shall I fear?
Oh no, You never let go
Through the calm and through the storm
Oh no, You never let go
In every high and every low
Oh no, You never let go
Lord, You never let go of me

And I can see a light that is coming for the heart that holds on
A glorious light beyond all compare
And there will be an end to these troubles
But until that day comes
We'll live to know You here on the earth

Chorus repeats:

Yes, I can see a light that is coming for the heart that holds on
And there will be an end to these troubles
But until that day comes
Still I will praise You, still I will praise You

Warning for traditionalists: it gets a little loud. Not sure if Matt Redman writes your kind of music, but if you'd like to listen, go here and click on "You Never Let Go" in the music section. (Your browser may need additional plug-ins to play the song. Sorry, we can't troubleshoot that for you.)

Posted by Austin at 3:23 PM

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New SMI Offering

We're pleased to announce the Blogger Referral Program. If you're a blogger and like to talk about us, we want to make sure you get credit (ex: two free issues or web months) for anyone you refer who becomes a member (beyond the 30-Day Free Trial). In the past this wasn't always easy because at sign-up, a new member would forget or pick the wrong "How Heard" selection or leave an inadequate description for us to work off of.

But now, we can offer you a special SMI destination URL to use on your blog that will incorporate special code so that new orders come to us with your information as the source of the referral, regardless of what the new member selects in the "How Heard" portion of the order form.

If you are interested in getting your own SMI Destination URL, please email customerservice@soundmindinvesting.com with "Blogger Referral" in the subject. If you have other questions, you can post them here on the message boards or send them to the email above.

Posted by Matthew at 1:16 PM

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Retesting the lows

I hoped to be wrong when I warned in separate posts back in October, November, and January that a retest of the market's lows was likely. But today we had the first serious run at those levels.

The Dow closed just a fraction of a point above its Nov. 20 low today. While the S&P 500 is still nearly 5% above its prior low, that's not much comfort. Hopefully the fact that we were discussing the likelihood of this turn of events months in advance may be some small encouragement. That was the main reason for pointing it out at the time.

Retests of significant market bottoms are a familiar pattern. In 2002, the market bottomed in October, then retested those levels the following March. So this year's timetable of a low in November followed by a retest in February would be reasonably consistent.

Of course, the 800-pound gorilla in the room is whether this is merely a retest of a previous low, or whether we're about to take out that low and start a new leg down. There's no way to know that yet, but clearly a close below the S&P 500's Nov. 20 low of 752.44 wouldn't be good.

On a different note, one thing that has puzzled me has been that more Upgraders haven't looked to SMI's Managed Volatility Fund in the midst of all this market uncertainty. Sure it's going to give up some upside when the next bull market arrives. But I would have thought more investors would give greater weight to its ability to avoid some of the downside while we wait for the market's trend to change. Through yesterday's close, SMIVX was down just 2.1% so far in 2009, versus a loss of 8.1% for the S&P 500 (and a loss of 6.1% for SMIFX). After today, that gap will likely be even wider. For those (like me) who don't want to completely take their money out of the market at these levels, but do want to have some measure of downside protection, it seems like a natural half-step to take.

Posted by Mark at 4:45 PM

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TIPS update

MarketWatch has a good update on TIPS (Treasury Inflation-Protected Securities). If you've been thinking about investing in TIPS, or don't know much about them and need a refresher course, it's worth reading the whole article.

In a nutshell, their view of TIPS mirrors my own view of the current situation. Specifically, we are currently in a de-leveraging, deflationary environment. This will most likely last a year or two (though predicting this time frame is realistically impossible). During that time, inflation won't be a problem - deflation is the problem.

However, right now, TIPS are being priced as though that deflation will last indefinitely. Relative to regular Treasury bonds, TIPS are priced as if inflation will average ~1.3% over the next 10 years. While inflation will likely be low (or even negative) over the next couple years, many people (including me) expect it to come roaring back once the economy starts to finally gain some traction again. The massive spending and borrowing the government is doing now will be offset for a while by the deflation gripping the economy, but once the economy starts to recover, inflation seems likely to kick in big time.

So as an investor, you're left with the fact that TIPS are a a great buy right now relative to Treasurys. If those were your only two options, you might be inclined to switch over your whole bond portfolio to TIPS in anticipation of that future inflation. But those aren't your only two options, and that's where this decision gets complicated.

There are other flavors of bonds to choose from as well: corporates, junk, municipal bonds, and so on. And it's much less clear that TIPS offer a compelling valuation story relative to these other types at present. In fact, I'm reading a fair amount right now about high-quality corporate bonds offering compelling yields and valuation.

Because of this, it's probably a reasonable course to continue with the Vanguard bond-index funds we normally recommend for bond investors. Like any indexing vehicle, you know when you use them that you're not going to be in the very best performing fund when you look back with the benefit of hindsight. Index funds are never the top-performing choice. But they do ensure that you're going to participate in at least some of the best performing types of bonds, and that your returns are probably going to look decent relative to the whole range of fund options available.

So at this point, readers following SMI's standard recommendations don't need to feel pressure to change their bond holdings. We will likely have some more analysis on bonds to roll out within the next few months. But we don't think it's urgent to make changes right now.

Posted by Mark at 9:36 AM

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Another money-saving-tip resource

Amidst the Crown Financial Ministries and Mary Hunts of the world, smaller sites don't often get the attention they deserve. The Simple Dollar is one such site. But that seems to be changing for the author, Trent Hamm, as his 2 1/2 year-old-site is garnering a nice following of active posters and breadth of content.

Last week he posted "Little Steps: 100 Great Tips For Saving Money For Those Just Getting Started." Here are a few of my faves:

6. Master the thirty day rule. Whenever you're considering making an unnecessary purchase, wait thirty days and then ask yourself if you still want that item...

10. Don't spend big money entertaining your children. Most children, especially young ones, can be entertained very cheaply. Buy them an end roll of newspaper from your local paper and let their creativity run wild...

50. Swap babysitting with neighbors. We live in a neighborhood with an army of young children out and about. Because of that, there are a lot of parents out there who are quite willing to swap babysitting nights with us, saving you the money of hiring one for an evening out...

If you're looking for an additional resource of money saving ideas, check out Trent's site. Or if you have a favorite site (besides SMI, of course), please share.

Posted by Matthew at 4:34 PM

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Say goodbye to money market funds?

The Obama administration may soon set its sights on radical changes in money market funds.

From MarketWatch:

When the Group of Thirty issued its proposals [last month] for reforming the financial industry [few observers noted a proposal about money funds].

Tucked into three paragraphs amid an 82-page report [PDF] was a suggestion that money-market funds should either let their net asset values float freely or convert to "special-purpose banks" - steps that fund-industry representatives say would effectively kill money-market funds in their current form.

"If the recommendations are implemented, there will be no more money-market funds, period," said Paul Schott Stevens, president and chief executive of the Investment Company Institute, the fund industry's trade group.

How likely is it that the new administration will push for MMF changes? The chair of the Group of Thirty study group is former Fed chairman Paul Volcker, chairman of President Obama's Economic Recovery Advisory Board. (Other members of the G30, a Washington-based group of international financiers and academics, include Treasury Secretary Tim Geithner and Lawrence Summers, Mr. Obama's chief economic adviser.)

During an appearance this month before the Senate Banking Committee, Volcker echoed the G30 recommendation that MMFs should be regulated like banks. "If they're going to act like a bank and talk like a bank, they ought to be regulated like a bank," he said.

But pro-money-fund observers argue that Volcker is overreacting to the brief run on money funds that occurred last fall after the Reserve Primary Fund "broke the buck."

"[T]he Group of 30's recommendations represent an overreaction that would force the reintermediation of a $2 trillion dollar commercial paper market, protect banks from their primary source of competition, and deprive investors of the ability to obtain reasonable returns with a high degree of safety and liquidity," writes investment attorney Steven Keen in Financial Week.

If you're invested in a money market fund, stay tuned.

UPDATE: The Wall Street Journal reports that MMF assets are "close to hitting a record $4 trillion." The story explains how MMFs, with some undergirding from the Treasury Department, have bounced back from the run of last September. Reporter Shefali Anand also touches on Mr. Volcker's idea of regulating money funds as banks.

Posted by Joseph at 3:35 PM

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Home equity and emergency savings

The idea of opening a home equity line of credit (HELOC) as a source of emergency cash is a fairly common bit of financial planning advice. Setting up an HELOC gives you the ability to tap the equity in your home in case of a job loss or other financial emergency. It's the sort of thing you should set up when times are good (you're employed and have good credit) in anticipation of a possible time when things are bad (no job) and you might have trouble getting credit extended to you.

Note that an HELOC is different from a home equity loan. With the line of credit, you ideally wouldn't have any balance actually borrowed most of the time, so you aren't paying any interest typically. It's there for emergencies if you need it, but isn't costing you anything (some have annual fees to watch out for, so it pays to shop around). With a home equity loan, you're borrowing the money up front and paying interest. So they're two different animals.

This article is nearly 10 months old, but I just came across it today and thought it was worth passing along. It details how banks have been freezing HELOC's based on general housing price declines in an area, regardless of the actual value or loan-to-value ratio on specific houses. Most troubling are the numerous confirmations I've seen elsewhere that some banks (especially Citibank) have often suspended the HELOC prior to notifying the customer, causing checks to bounce and credit ratings to be damaged.

This post highlights a key issue in using an HELOC as part of your emergency savings strategy. That point is simply this: Your HELOC exists at the whim of your bank. As such, you can't count on it being available when you need it.

That's not to say I think having an HELOC is a bad idea. It's not (as long as you aren't paying much in fees for the privilege) - I have one myself. But it's crucial that you recognize an HELOC is not the same thing as actual emergency savings. It can be a helpful supplement to real emergency savings, but you really can't rely on it being available when you need it most.

Liquidity matters, particularly in a financial emergency. With layoffs rising, more and more people are realizing the importance of that 3-6 month savings reserve. Seeing these HELOC's being frozen and/or closed just as people need them most is eye-opening. There simply is no shortcut that allows a person to avoid the sacrifice involved with living below their means and saving for the future.

As a side note, this is also a good example of why we typically don't recommend people use every available dollar to pay off their mortgage. Until you have a fully funded emergency fund, it's probably more important to be building that emergency fund than paying down your mortgage, even if you're only earning 2% in your savings account and your mortgage is at 6%. In the past, many people might have felt secure paying down the mortgage without any liquid emergency savings, figuring that they had the safety net of a HELOC backing them up if needed. This post clearly exposes the flaw in that plan.

New readers sometimes question why we don't include the mortgage when writing about our Level 1 - Getting Debt Free goal, and instead indicate that it's okay to move on to Level 2 when your consumer debts are paid off. This is the main reason. Paying down your mortgage is a great idea, but it needs to be secondary to establishing a reasonable level of emergency savings.

Posted by Mark at 9:43 AM

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Buffett metric

According to this chart in Fortune magazine, stocks have reached the point where they may be representing a good long-term bargain.

The chart compares the value of the overall stock market with the GNP, or output of the U.S. economy. When Fortune first asked Buffett about this metric, it was 2001 and stock values, though lower than they had been a year previously, were still 133% of GNP. At that time, Buffett said, "If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you."

Fast-forward to the present, and that's exactly the situation, with the ratio coming in at an estimated 75% these days. Consistent with his remarks of 8 years ago, Buffett famously went on the record as a stock buyer on October 17 with an op-ed in the New York Times.

While all that is well and good, I have to admit that when I look at that chart, the thing that jumps out at me isn't how attractive the current level appears. It's that this ratio clearly has gone considerably lower in the past than the current 75% level. I'm a little surprised that Buffett would consider the 70-80% range an especially attractive point of entry. I would have expected a famous value investor to hold out for the 50% level, or something close to that.

But enough quibbling. The chart does help illustrate the extreme valuations of a decade ago, when this ratio hit 190%. To see it down in the 75% range now tells us volumes about market valuation relative to the real profits-producing capability of the economy. It may not tell us we're at the absolute bottom, but it indicates that valuations are getting back to their historical norms.

After the rough decade the stock market has had coming down off its late-1990s highs, that's good news.

Posted by Mark at 4:46 PM

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Tax breaks in the stimulus bill

I vented my frustration with the stimulus bill yesterday, so today we'll move on to more positive endeavors, like figuring out if there's anything in there that will benefit you. Marketwatch provides a good summary of the bill's provisions (remember, there are actually two versions of the stimulus bill that the House and Senate will be reconciling over the next few days).

I wish I could say there was a lot to get excited about here, but for most readers I suspect the impact will be fairly minimal. AMT tax relief is probably the biggest item for many, but as the article points out, that probably would have been passed anyway without the stimulus bill. Still, there are quite a few narrowly targeted provisions that will be helpful if you happen to be one of the people who qualify, so take a quick look.

Posted by Mark at 9:18 AM

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New Gov't actions = 5% loss

There's a saying that goes something like, "Once is chance, twice is coincidence, third time is a pattern." If that's true, what does the 9th time make it?

Because that's what we witnessed today. As Marketwatch put it, "The equities market is reacting to the Obama administration's latest attempt to stabilize the economy largely as it did the last eight times the government unveiled steps to curb the crisis, beginning in October 2007."

In other words, Government put out its latest, greatest attempts to "fix the economy" and the stock market sold off 4-5%.

Granted, some of today's selloff was undoubtedly an extension of the old Wall Street saying, "Buy the rumor, sell the news." The market has a tendency to rise in anticipation of big events, then fall in their aftermath.

But it also seems that the market understands all these government efforts have failed to address the root causes of the problems we face. And there seems to be a rising recognition that the government is likely making things worse at this point rather than better.

It's a bit depressing, but today's newest bailout plan still fails to address the fundamental problem in the first bailout plan that I wrote about way back on September 23:

The problem is that nobody knows exactly what these potentially bad loans should be priced at. The financial institutions have them "marked" at a certain price, but that price is almost certainly too high, as most of them would love to unload them but can't because there aren't any buyers at the prices these bad loans are supposedly currently "worth." ...

The Treasury bailout plan is drawing a lot of heat from a broad range of critics, over a range of different issues. But probably the biggest one is this: what price is the government going to pay for these assets?

Fast-forward five months to today, and in the middle of the article linked to up top in this post you'll find this quote:

"We have no clarity on what pricing will look like for these troubled assets that we hope to take off the balance sheets, that's been a problem from the start," said Hogan.

So they aren't any closer to figuring out the central factor in the whole banking mess. But the Treasury is prepared to spend another $1.5 trillion on a new financial rescue plan, and Congress is ready to spend an additional $800 billion on a stimulus plan that is primarily about government expansion rather than stimulating the economy (see post below).

Given all that cheery news, is it any wonder investors voted thumbs-down today?

The one positive note in the new rescue plan is the idea that banks are going to be subjected to a "stress test" before getting any of the new money. It wasn't spelled out, but if this means that banks which fail the stress test are going to be wound down and closed (i.e., taken out back and shot), then at least we'll have some progress to show for this round of $1.5 trillion. If the first plan had included some provision to identify the banks that needed to be allowed to fail and had helped that to proceed in an orderly fashion, we'd likely already be half-way through this mess.

Posted by Mark at 4:00 PM

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Who are you?

The Wall Street Journal has an article today on the psychological trauma many people go through when they lose their job. For many people, it's not just the lost income that's the issue, it's the fact that their identity has been so closely defined by that job.

"The deepening recession is exacting punishment for a psychological vice that masquerades as virtue for many working people: the unmitigated identification of self with occupation, accomplishment and professional status. This tendency can induce outright panic as more and more people fear loss of employment."

What a huge relief to realize, as a Christian, my true identity is not defined by my job, my family, my activities, or anything else other than who I am in Christ. As with many areas of faith though, it's one thing to know that intellectually and quite another to truly internalize it.

Posted by Mark at 10:42 AM

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Stimulus for your consideration

A couple of quick items brought to my attention in the past few days:

Dr. Adrian Rogers, 1931-2005:

"You cannot legislate the poor into freedom by legislating the wealthy out of freedom. What one person receives without working for, another person must work for without receiving. The government cannot give to anybody anything that the government does not first take from somebody else. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that my dear friend, is about the end of any nation. You cannot multiply wealth by dividing it."?

(Thanks to Toby J., a good friend who happens to be a charter subscriber of SMI, for that quote.)

Milton Friedman on free enterprise, 1979:

(Thanks to friend Rob Y. for that timely clip.)

And finally, from our own "Keith" discussing Wesley's paradox on the SMI weblog Friday:

"May I suggest that capitalism succeeds when Biblical compassion in society balances its harshness? Without Biblical compassion, capitalism will destroy the culture which once flourished through its practice."

Posted by Mark at 4:06 PM

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"This is not something any business can afford to do"

CNN reports that State Farm is getting out of the homeowners' insurance business in Florida.

The reason? The company is losing money in the Sunshine State, having paid out $1.21 in claims for every dollar of premiums it has collected since 2000. Many of those payouts, of course, were hurricane related. Florida was hit by four major storms in 2004.

State Farm asked state insurance regulators to approve a rate hike, but was turned down. Without the prospect of being able to turn a profit, State Farm says it can't continue in business in Florida. "This is not something any business can afford to do," company president Jim Thompson said.

I don't have any great affection for insurance companies - sometimes they can be quite irritating - but there's a lesson here: a company cannot stay in business (or at least cannot continue all aspects of its business) if government, however well-intentioned, insists that the company follow an unprofitable business model.

The State Farm-Florida situation offers a cautionary tale regarding too much government involvement in the decision-making process of the private sector.

Indeed, it is a cautionary tale likely to have multiple sequels as we see government flexing its muscles via the TARP (Troubled Asset Relief Program). Business decisions will take second place to political considerations.

Is that good for the consumer and for the economy? Time will tell.

Meanwhile, the New York Times offers this helpful table showing where the TARP money has been going.

Posted by Joseph at 3:25 PM

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Wesley's paradox

Long-time SMI contributor Mike Cave forwarded me an extremely insightful article recently, questioning whether free markets can survive in a secularized world. It begins:

The 18th Century English cleric and theologian John Wesley was troubled by a paradox that emerged as his teaching spread. He, like other Protestant thinkers stretching back to Calvin, taught that one could honor God through hard work and thrift. The subsequent burst of industry and frugality generated by Wesley's message improved the lot of many of his working-class followers and helped advance capitalism in England. But, "wherever riches have increased, the essence of religion has decreased in the same proportion,"? Wesley observed, and subsequently pride and greed are growing more common, he complained.

Wesley could see only the beginnings of this trend; two hundred years later, the world is reaping the full brunt of its aftermath. So where do we go from here?

The meltdown of the financial markets in the last few months has left us grappling with how we can keep markets free and principled at the same time. The only debate so far is between those who want more government regulation - who want to impose from the outside via the regulator's eye the restraint that our institutions once tried to instill in us - and those who think that more government will only undermine our prosperity. Neither side seems to be winning the public debate because most Americans are probably equally as appalled by the shortcomings of the markets as they are by the prospect of more government control of them.

A weighty subject to say the least. Can free markets stay free when the majority of their participants no longer hold to the traditional "Protestant Ethic"? While obviously a return to values like thrift and honesty aren't enough to save a man's soul, is it possible for our society to return to those values short of a widespread religious revival? And if so, will that be enough to allow another run of prosperity for our economy after the current poisons are flushed from the ailing economy's body?

Let's open this up and discuss - your comments on these questions, or any other related thoughts, are invited below.

Posted by Mark at 3:40 PM

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I have good news!

With gloomy economic news getting most of the attention these days, I thought I'd brighten things up going into the weekend with a list of recent "good news" stories you may have missed:

    "? Pending home sales rise

The National Association of Realtors reports pending home sales increased during December by 6.3 percent.... The South and Midwest posted big gains in pending sales.... The Pending Home Sales Index is a major indicator for the housing sector.

    "? Geico to hire 870 in first quarter

Geico Corp. said it plans to hire 870 new associates in 19 states in the first quarter of 2009.... Geico is currently looking to add customer service, claims, sales, and auto damage adjuster positions to the company's regional offices and service centers.

    "? Evidence points to recession's end by July

Economists Nicholas Bloom and Max Floetotto of Stanford University say that "based on the analysis of 16 previous economic shocks... and using the latest data on uncertainty measures, our model predicts that the worst has been avoided.... [W]e believe growth will resume by mid-2009."

    "? Kellogg reports 7% increase in profit

Kellogg said Thursday its profit rose 7% during the fourth quarter.... Revenue increased 5% to $2.93 billion.

    "? Silicon Valley has a few rare bright spots

Executive recruiters in Silicon Valley, and the tech business in general, see glimmers of hope in some areas of technology. "It's not all doom and gloom," said Robert Greene, founder and CEO of GreeneSearch, Inc. in San Mateo, about 20 minutes north of Silicon Valley.... "Overall, hiring for engineers and product managers remains pretty strong."

    "? Wal-Mart U.S. same-store sales up 2.1%

Wal-Mart Corp. said Thursday that January same-store sales... rose 2.1%, ahead of the target of 1.1% in a Thomson Reuters survey. January total world sales for the company rose 1.8%.

    "? Panera Bread Co. expects to open many stores in 2009

Panera Bread Co., the chain of 1,250 bakery-cafes, plans to take advantage of its debt-free balance sheet and the U.S. real estate slump to open as many as two locations a week in 2009, said Chief Executive Ronald Shaich.... "A recession is a time to develop if you have the balance sheet to do it, and we do," Shaich said. "There will be opportunities."

H/T for some of these to PositiveEconomicNews.com.

Posted by Joseph at 2:51 PM

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Past financial crises

According to this pair of economics professors from Maryland and Harvard, the U.S. crisis is following a very similar path to past serious financial crises in developed countries. Naturally, this doesn't mean our experience will be exactly like these others. But the information in "What Other Financial Crises Tell Us" does provide a frame of reference for what might be in store.

Here are a few excerpts, though it's worth reading the whole thing.

Let's start with the good news. Financial crises, even very deep ones, do not last forever. Really. In fact, negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. ...

In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels. ...

Equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough -- dropping an average of 55% in real terms, a mark the S&P has already touched. However, given that most stock indices peaked only around mid-2007, equity prices could still take a couple more years for a sustained rebound, at least by historical benchmarks. ...

Needless to say, a near doubling of the U.S. national debt suggests that the endgame to this crisis is going to eventually bring much higher interest rates and a collapse in today's bond-market bubble. The legacy of high government debt is yet another reason why the current crisis could mean stunted U.S. growth for at least five to seven more years.

The bottom line of their analysis seems to be this: this could last a while. The good news, if there is any, is that perhaps stock prices won't decline a whole lot more than we've seen, and the economic conditions may not get tremendously worse. The bad news is that conditions could stay roughly the way they are for at least a few more years.

As usual, your outlook on this projection depends quite a bit on your personal situation. To someone in their 30s or 40s with a pretty stable job, this isn't awful news. The prospect of funneling a couple years' worth of contributions into a stock market at these levels might actually hold some appeal. But obviously for many, this is anything but a cheery forecast.

Again, it's worth reiterating, just because this is the "average path" doesn't mean it will necessarily be the course of this particular crisis.

Regardless of your outlook on this scenario, prudence dictates a continued emphasis on reducing debt and increasing emergency savings. People who have those two elements firmly under control are going to be much better positioned to withstand the rest of this economic down turn than those who don't.

Posted by Mark at 11:40 AM

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Past managers of the year

This article following up on how past MarketWatch Managers of the Year fared in 2008 vividly reinforces what we say in SMI's Performance Momentum & Upgrading bonus report:

Upgrading is necessary because, as economic conditions and expectations change, market leadership rotates among large-, medium-, and small-sized companies. Furthermore, as this rotation takes place, it naturally favors some strategies over others. At times, a cautious value strategy is best; other times aggressive growth investors are rewarded. But although market conditions are constantly changing, fund managers rarely do. ...

That's why performance leadership among mutual funds is constantly rotating, and why numerous academic studies have shown that very few funds can consistently perform in the top ranks year after year. ...

The best approach, then, is not to try selecting one super-great fund in order to hold on to it for many years. Investing in a particular fund and staying with it for the long haul is unlikely to result in outstanding performance over the entire period.

Two of the past three managers of the year cited by MarketWatch lost at least 52% last year (the third manager took a leave of absence midway through last year - good idea, wish I'd thought of doing that!). While we were admittedly a bit disappointed with Upgrading's results in 2008, it's worth noting that these recent Manager of the Year funds lost a third again as much (an additional 13%) as Upgrading.

Don't misunderstand what I'm saying. These are likely all fine managers, running fine mutual funds. The problem isn't with the specific funds. The problem is with the idea of sticking with any "normal" mutual fund through the ups and downs of a full market cycle. Upgrading allows us to capture the best periods of each fund type, while shifting us elsewhere when their inevitable rough stretches arrive.

Last year reminded us that Upgrading won't always protect us as well as we'd like. But compared with other "top funds" of recent years, its performance looks a little better. More importantly, a longer view reveals that Upgrading has done an excellent job of moving us among funds of different styles and approaches in response to changes in the broader market.

Posted by Mark at 9:19 AM

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Cash levels of funds

On Monday, I noted that the cash level of our currently recommended Sector Rotation fund had soared during the 4th quarter of 2008. As this Morningstar article reports, several currently recommended Upgrading funds have also been beneficiaries of large cash holdings in recent months.

Some financial advisors don't like using funds that let their cash levels rise when conditions seem inopportune to the manager. That's understandable, as the advisor is trying to allocate investment capital between asset classes, and doesn't want to be left wondering if his 60% stock allocation is truly only 50% because of cash sitting around in his stock funds (an issue we discussed a bit recently in the comments of this post).

However, as Upgraders, we're not particularly concerned if a given fund has a high cash holding or not. That's because the performance impact of holding that cash is going to be reflected in the fund's momentum score. If the manager was just lucky to be holding cash when the market downturn occurred, that will likely be revealed when the market eventually rises and the fund lags due to the cash holding. But if raising cash was a result of skillful management, we benefit by avoiding damage as the market declines, and then potentially benefit again as that cash is intelligently deployed before the market rises again (as funds holding cash will lag in a rising market).

Upgraders can relax and simply focus on the MOM scores - the manager's cash management or lack of will show up there.

Posted by Mark at 3:35 PM

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Smoot-Hawley II

I was hoping to try to ignore the stimulus efforts for a while, as it seems we've been writing about them a lot lately. But I saw this today, and it's scary, so I figured I'd pen one more missive before laying the topic aside for a while.

First a bit of background. Economists argue about a lot of things, but one area that most of them agree on is that protectionism is bad (meaning, when countries put up trade barriers to try to direct their economic efforts inward towards their own products and services). While protectionist measures sometimes feel good, history shows they inevitably bring retaliation from other countries, and overall economic growth quickly declines because it's so much harder to trade with other countries.

The number one example of the negative impact protectionism has on economic growth has to be the Smoot-Hawley Tariff Act of 1930. Over 1,000 economists immediately petitioned President Hoover to veto the bill, and many industry heavyweights also vigorously opposed it. But it was signed anyway, and sure enough, the world quickly erupted into trade wars that many believe lengthened and made the global depression more severe.

"Why the economic history lesson," you ask? Because apparently the Congress is filled with men and women who missed the "Causes of the Great Depression" lecture in their American History course. Sure enough, faced with an economic environment some are comparing to the early 1930s, the House included a "Buy American" clause in the recently passed stimulus bill. This NY Times editorial summarizes the provision this way:

Steel industry lobbyists seem to have persuaded the House to insert a "Buy American"? provision in the stimulus bill it passed last week. This provision requires that preference be given to domestic steel producers in building contracts and other spending. The House bill also requires that the uniforms and other textiles used by the Transportation Security Administration be produced in the United States, and the Senate may broaden such provisions to include many other products.

The rest of that article warns of the slippery slope such provisions put us on. They haven't gone unnoticed either - ABC News reports the international response to these provisions has been swift and very negative.

Hopefully those legislators who did make it to class and learned some of the Great Depression's causes, or at least aggravating factors, will be able to muster enough support to avoid making the exact same mistakes this time around.

Posted by Mark at 3:52 PM

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Economic impact of abortion

Today WorldNetDaily is re-running a 1998 Larry Burkett article titled "The George Bailey Effect."

SMI's own Joseph Slife is cited as a contributor to the article, so here's an interesting peek at what Joseph used to do before joining the SMI team.

Posted by Mark at 12:49 PM

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Sector Rotation update

While our current Sector Rotation holding had a rather poor month of January (losing 9.7%), it remains within the top quartile, so it will continue to be held for February.

It's worth noting that this fund's cash allocation has now risen to over half of the fund's assets (as of 12/31/08). That's not all bad in a falling market, but comes as a bit of a surprise, perhaps, to those who understandably expect that their money is invested in small-cap financial stocks.

Given this cash buildup, and the fact that the fund slipped from the top of the rankings to the middle of the top quartile this past month, if I were a new investor contemplating buying into SR for the first time, I'd likely wait to do so until a new recommendation was offered (or until the current fund climbs back up the rankings a bit). Note carefully, this doesn't mean I'd sell an existing position in the fund. This is simply for new entrants to the SR strategy who are wondering if they should buy the current recommendation or wait for a new one (a common question). In this particular case, I'd be inclined to wait a month and see what the March rankings look like.

Posted by Mark at 2:35 PM

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