Three months ago in this space we contemplated the appearance of 'green shoots' of revived economic activity as convincing evidence that the worst, as experienced just one year ago, is over for investors. Indeed, one year on from the collapse of Lehman Brothers, the world economy has apparently backed away from the precipice of disaster and stocks and bonds are rallying strongly. For the 3rd quarter, the S&P 500 rose 15% and is now up 17% for the year. To be sure, the S&P 500 is still some 38% below the highs set in October of 2007, but it has been an impressive run just the same. Emerging market equities and high yield bonds have returned to their pre-Lehman bankruptcy levels. Yet the story of the past quarter has not been exclusively one of rising risk tolerance. Government bonds have continued to rally and gold has broken through the $1000 level - moves which are normally associated with increasing risk aversion. This suggests that investors have not forgotten the events of last year and are not exactly unanimous in embracing the risk trade. These seemingly contradictory events are just some of the cross currents that cause us to appreciate the stock market rally but remain mindful of the many flies in the ointment.

 

By far the biggest worry remains unemployment, as a sustainable recovery depends on consumers being employed and, importantly, confident enough about the future to spend money. Total employment, generally regarded as a coincident economic indicator, continues to drop, with a quarter million fewer Americans on payrolls in September compared to August (seasonally adjusted). Since the official start of the recession in 2008, some 16 million workers have lost their jobs.
 
Having rallied some 57% from its March low, the S&P 500 index is discounting some really good earnings in the near future. We are not able to say whether companies will meet those expectations or not. The weight of the evidence would indicate however that profit growth will be muted given high unemployment. On the bright side, companies have been quite successful in deleveraging balance sheets and saving cash, leaving businesses much better able to pursue growth opportunities.
 
The US housing market has been showing signs of improvement and prices are stabilizing. The $8,000 tax credit for first time home buyers is bringing people into the market and houses aremore affordable than they have been in years. The mortgage modification effort by lenders is having some positive effect on the number of mortgages going into default.  Of some concern are the statistics around the total number of outstanding mortgages in default but not yet in foreclosure. As the summer selling season winds down and the tax credit is set to expire, the next few months will be critical in confirming the positive trends or conversely, causing that plug of green shoots to wither.

 

Individuals over age 70 ½, or the owners of inherited IRAs, must take what is called a "required minimum distribution" (RMD) from their IRA each year.  Because of the significant declines in the financial markets, Congress passed a law last year that allows IRA owners to skip their required minimum distribution in 2009. 
 
We have spoken with many of our clients about their RMD needs for 2009.  For those who do not need the funds, we have suspended the distributions for 2009.  The suspension allows one to avoid paying any income taxes on those RMDs this year. 
 
Individuals who have not had a chance to speak with their portfolio manager about their 2009 RMD should consider giving them a call, because at this time, there are no plans to extend the RMD holiday into 2010.  So for those who were taking monthly distributions that were suspended in 2009, they will commence in January 2010.
 
For those who were taking a lump sum distribution each year and elected to skip the 2009 distribution, the lump sum distribution date has been pushed forward to the same month and day in 2010.  For instance, if your lump sum RMD was scheduled for November 1, 2009, we have pushed it forward to November 1, 2010.

 

In 2010, all investors who have regular IRAs will have the option of converting those IRAs into Roth IRAs.  Currently, the general rule is that you cannot convert a regular IRA to a Roth IRA unless your income is below $100,000, so that excludes many people from the conversion option.  Starting in 2010, there will no longer be an income ceiling on conversions.
 
The conversion question requires a rather detailed analysis of your current and future tax and investment situation.  The reason is that upon a conversion, you must pay ordinary income tax on the amount of the traditional IRA that you convert.  This means you will accelerate income taxes that you could have otherwise deferred.
 
For instance, assume you convert a $100,000 IRA, and assume your combined federal and state income tax rate is 33%. That means you will owe $33,000 of income taxes on the conversion.
 
Accelerating the income tax generally only makes sense if you think you will avoid paying higher income taxes down the road, and you have funds outside of the traditional IRA available to cover the income taxes due on the conversion. 
 
The conversion also reduces the amount of investable assets that you currently have as the taxes owed on the conversion are paid out of your savings.  So there is also an investment aspect of any conversion that needs to be considered.
 
On the plus side, if you convert, then there are no income taxes owed on any future distributions from the Roth and the funds in the Roth IRA are no longer subject to the RMD rules in retirement. But of course, you had to pay all the taxes at one time.
 
As we get into 2010, we will be talking with clients about the Roth conversion option and working with their tax advisors to determine if a conversion, or partial conversion, may be appropriate for their circumstances.

 

 Each year, Schwab Institutional holds one of the largest conferences for investment advisors.  The conference provides advisors with access to some of the best thinking in various areas of economic and investment management.
 
Several of us attended this year's conference in September, and thought you might be interested in a few highlights from the event.
 
Halfway There.  The general feeling from speakers in both the fixed income and equity markets was that while we avoided a potential disaster, we were only about half way back to normalizing the financial markets.  Clearly, the interventions by the Federal Reserve and U.S. Treasury halted the economic meltdown, but now we are faced with a very deep recession that may take quite some time to recover.
 
Recession Ending.  While the U.S. economy appears to no longer be shrinking, economic growth, particularly in the area of job creation, will be quite slow.  Employers are understandably cautious about increasing their payrolls and expense structures.
 
But, because of the cost cutting and aggressive debt reduction taken by many large companies, corporate balance sheets are in the best shape in over 20 years.   This means many companies have come through this recession in good shape and ready to expand when the demand is there.  And now we must wait for the demand.
 
Inflation Tame.  The general feeling was that inflation was under control for the foreseeable future, and that deflation was still a threat to the economic recovery.  Given the fragile nature of the economy, the Fed will likely keep rates low until it feels that the roots of economic growth have taken hold.  Frankly, at this point, the Fed would like to see some inflation to give them a sense that their policies are working.  From the Fed's perspective, inflation is easier to solve than deflation, and right now we still have a bit of deflation plaguing the markets. 
 What Worked.  Last year caused a number of high profile investment funds and managers to incur sizeable losses.  Many of the holdings that they thought would not be correlated with the stock market ended up being highly correlated, meaning that when stocks went down so did these other holdings.  The end result was that their portfolios didn't provide much downside protection from the declines in stock values.  These investments tended to be concentrated in various types of what are called "alternative" holdings such as hedge funds and private equity.
 
It turns out that simple balancing between diversified stocks and high-quality fixed income worked the best in this crisis.   Fortunately, that is a strategy we have fundamentally followed in many of our portfolios and will continue to emphasize going forward.

 

We have all heard the statistic: 50% of marriages in the United States end in divorce.  Sadly, this is true.
 
If a person in Colorado gets divorced, they should expect to receive or give up at least 50% of the joint marital assets.  If children are involved, child support and alimony payments may be necessary for a certain period of time.
 
After a divorce, if a spouse didn't work before (to take care of children, for example), tough choices may lie ahead, including selling the marital residence received in the divorce, living on a tight budget, getting a job, or remarrying.
 
Northstar can help clients throughout the divorce process, beginning well before a settlement is awarded.  Receiving a large settlement can be unnerving-people risk falling prey to investment advice from relatives, friends, and commission-driven sales people-so we meet with clients and their divorce attorneys to map out what to do with the settlement before it's awarded.
 
Once the exact terms of a settlement are known, an individual must devise a budget and determine if selling the marital residence is necessary.  It often doesn't make sense to keep it-emotionally or financially.  If that is the case, clients need a good real estate agent to price the house correctly, stage it to sell, and get it on the market quickly.
 
If an individual received an IRA in the divorce, they will need to manage that asset differently than a taxable account from a tax and risk perspective.
 
One of the upsides to the massive decline in the stock market last year is that the current investment environment is extremely favorable for recently divorced individuals to build portfolios yielding at least 4% using a balanced portfolio invested 60% in equities and 40% in fixed income instruments.  Dividends paid on blue chip large cap stocks are higher than the current yield on the 10 year US Treasury bond for the first time since 1958.
 
During every market cycle since 1926, a 4% income distribution from a diversified portfolio with 60% in stocks and 40% in bonds is sustainable and will protect the principal value.  If someone can live off a 4% withdrawal rate, annually adjusted for inflation, then the principal value should remain intact for the next 30 years.

 

 

We are proud to announce that Charlie Farrell's book, Your Money Ratios: 8 Simple Tools for Financial Security, will be published on January 1, 2010 by Penguin Group. The book will be available in January at all major bookstores and from online retailers, such as Amazon.com.
 
To learn more about the book and Charlie's research, you can visit his book website at www.yourmoneyratios.com  
 
Charlie has also been writing the Retirement Roadmap column for CBS MoneyWatch.com, and you can visit www.moneywatch.com to read some of his recent columns.