July 15, 2010
Stocks Take a Summer Vacation
In the space of a few months the collective mood of the market went from cautious optimism to just cautious. While we don't discount the glass-is-half-empty economic, political and environmental scenarios in the short term, we are also encouraged by the continued strong performance of companies in this period of uncertainty. Indeed, corporate earnings were positive on balance this quarter as 75% of companies reporting produced earnings which exceeded analysts' expectations. Additionally, those earnings were 45% higher than during the same period of 2009. As a result of their own successful austerity programs, companies are carrying healthy balance sheets with high levels of cash. Much of this cash is being deployed to pay down debt, buy back stock, or increase dividends. Since January of this year, 136 companies in the S&P 500 stock index have increased dividend payouts or initiated new dividends. The collective impact of this trend has increased dividend payouts by $11 billion. In all of 2009 there were 157 dividend increases and 78 suspensions of dividends - resulting in a net decrease of $37 billion - a record. Meanwhile, a litany of events and worries has demanded the attention of the world.
Deepwater Horizon blowout/huge oil spill, 'flash crash', European sovereign debt debacle, deficit spending for years to come, financial reform, a slowing Chinese economy, a housing market that still needs life support. Oh and jobless claims are expanding (again). These are just a few of the hurricane force headwinds that assaulted the markets during the second quarter. Small wonder then that the S&P 500 was down 11.3% including dividends for the quarter. The Barclays US aggregate bond index was up 3.49%.
The above inputs have helped to shape the mood of investors for the time being. None of these challenges have an obvious solution, let alone an easy or quick one. The optimism of seeing a recovery take hold a few months ago has faded, replaced by prospects of a daunting struggle to clean it up, protect against, avoid at all costs or just make it go away. Unfortunately, political will seems to be in short supply as well. Fresh memories of 2008 are prompting investors to favor bonds over stocks or a return of principal over a return on principal once again. A balanced portfolio that utilizes a mix of bonds and stocks allows Northstar clients to enjoy the best of both worlds - a stable, fixed income stream from high-quality bonds of various maturities along with capital gains and dividend income from fundamentally sound and well-run businesses. |
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Supply and Demand in the Bond Market
The economic laws of supply and demand are alive and well and in full display in the bond market. The chart below tracks the yield on a weekly basis for the ten year U.S. Treasury Note going back to mid-2007, or roughly three years. There are a few observations worth noting. While the rate exhibits a slight downward trend over this period, it has traded essentially in a range from about 3% on the low end and 4% or just over on the high side. This of course is with the exception of late 2008 and early 2009 when the markets were in the throes of the worst financial and economic distress since the great depression. The downward sloping solid line in the chart represents the 200 week moving average. It is very interesting to note how the rate has approached the line from below on several occasions, only to recede back to lower levels. In technical analysis parlance, this is known as overhead resistance. The other observation that is not apparent from this chart is the much longer term trend in interest rates. The yield on the ten year U.S. Treasury Note has been trending irregularly lower from over 15% in the late 1970s/early 1980s to the current 3%. It is fair to say that current interest rates are very low.
What have been the driving forces exerting downward pressure on rates recently? Renewed concern about the sustainability of our domestic economic recovery, the intractability of the unemployment situation, sovereign debt concerns in the Euro zone, and a meaningful correction in the stock market are just a few of the likely culprits. You may want to add supply and demand, at least in certain segments of the bond market, to the list of those forces. On the supply side, Bloomberg reports that total global corporate bond issuance fell 39% to $1.17 trillion in the first six months of this year compared to 2009. More telling was the 48% decline in issuance from the first quarter of this year to the second quarter. On the demand side, we have commented before about the extraordinary amount of money that is being invested in bond mutual funds. According to the Investment Company Institute, stock mutual funds had net cash inflows totaling $40.5 billion in the first four months of this year. That compares to $118.6 billion in bond funds. However, the past eight weeks saw a reversal for stock funds and a continuation of the pattern for bond funds. Stock mutual funds have had net outflows of $36.6 billion and bond funds enjoyed a net inflow of $37.6 billion. All of those funds flowing in to bond mutual funds need to be invested and therein lies the increase in demand. Therefore, decreased supply and increased demand likely contributed to the higher prices and lower yields on bonds.
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Tax Update
The year 2011 will have big implications for taxes. As you may know, the income, dividend, capital gains, and estate tax cuts that were implemented by the Bush Administration are scheduled to expire at the end of 2010. Between now and then, Congress needs to establish new tax rates for each of those categories. Since this is all politics, it's anybody's guess what we'll get. But we thought we would summarize the current thinking on where tax rates are likely headed, and how they may impact investments.
Income Taxes. The current thinking is that the two top income tax brackets, 33% and 35%, would rise to 36% and 39.6%. The 36% and 39.6% rates were the top tax brackets prior to the Bush tax cuts.
Because President Obama promised not to increase income taxes on families making less than $250,000, it's likely the increases would only apply to your income once it exceeds $250,000 (or $200,000 for an individual). Thus, if your family income is less than $250,000, you probably won't see an income tax increase. But if it's above $250,000 ($200,000 for an individual), you may be paying 2% to 5% more in taxes for income above the threshold.
In those situations where you may be paying more income taxes, there are two basic strategies available: 1) maximize all of your retirement plan contributions so you get the largest income tax deduction you can, and 2) invest your taxable accounts in a tax efficient manner through the use of municipal bonds and other tax favored securities.
Capital Gains Tax. The current rate for long- term capital gains is 15%. That rate is scheduled to expire in 2011, and the current proposal is to raise the rate to 20% for families with incomes above $250,000. If your joint income is below $250,000, it's likely the 15% capital gains rate would continue to apply.
Dividend Tax. The dividend rate is also at 15% today, but will expire in 2011. The proposal is to also raise that rate to 20% for families earning more than $250,000. Thus, if your income is less than the threshold, it's likely the 15% rate will continue to apply.
Estate Tax. The estate tax is in limbo these days. Currently, there is no estate tax in 2010. But in 2011, it is scheduled to return with a $1,000,000 exemption per person (or $2,000,000 for a married couple), and a 55% tax rate for amounts above the threshold. The estate tax is a political hot button, and it's hard to tell how this will play out. There seems to be some consensus to increase the exemption per person to about $3.5 million ($7 million for a couple), and then apply a 45% tax for amounts above those limits.
Because every individual's estate planning considerations are unique, it's difficult to determine the impact of these changes. To assess how the estate tax may impact your investments, it is important to discuss your situation with an estate planning attorney.
Roth Conversions. As many of you may know, starting in 2010, anyone can convert a regular IRA to a Roth IRA. If you convert a regular IRA to a Roth IRA, you no longer have to pay income taxes on the distributions from the Roth IRA. But, in order to convert, you must pay all the income taxes owed on the amount converted.
For example, assume you had $500,000 in your regular IRA. If you convert it to a Roth IRA in 2010, you will owe tax on $500,000 of income. The conversion is basically treated as if you took $500,000 out of your regular IRA all at once, and that income is added to any other income you had in 2010.
Let's assume you will owe 40% in federal and state income taxes on the $500,000 you converted. That means you must pay $200,000 in taxes and leaves you with $300,000 in the Roth IRA that won't be subject to tax again. The entire conversion analysis hinges on whether the 40% tax rate (in the above example) you pay today would be less than the tax rate you might pay in the future if you took out smaller distributions each year. The analysis is highly dependent on your specific tax situation.
In general, if you are in one of the highest income brackets today, don't need the funds for your retirement, and have funds outside of the IRA available to pay the tax on the conversion, it may make sense to convert. But if you are not in one of the highest brackets, or don't have funds outside of the IRA to pay the tax, you may end up accelerating taxes, paying more than you otherwise would be required to pay or jeopardizing your retirement security by depleting a sizeable amount of your retirement savings to pay taxes.
In addition to the basic tax analysis, there are a few special situations that may make a Roth conversion attractive. For instance, if you have any sort of tax deduction (like a large charitable deduction) that can be used to offset the income created by the Roth conversion, then the conversion may clearly be in your favor.
The Roth conversion is a highly technical analysis and must be coordinated with a tax advisor.
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Happy Anniversary
July 2010 marks the 15th year of business for Northstar. We are proud to celebrate this milestone and look forward to the next 15 years.
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Northstar Investment Advisors, LLC, is a registered, independent investment advisor based in Denver, Colorado. A leader in Denver's investment community, Northstar has been providing clients with exceptional service, timely communications, and clear guidance in all aspects of personal portfolio management since 1995. The firm's five portfolio managers, well-known for developing innovative tools to help investors understand and prepare for retirement, oversee approximately $300 million in client assets. For more information, call 800-204-6199, or visit www.northstarinvest.com.
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 Charlie Farrell
Dick Kopp
Fred Taylor
Bob Van Wetter Tim Waymire
Northstar Investment Advisors 700 17th Street, Suite 2350
Denver, CO 80202
(303) 832-2300 phone
(800) 204-6199 toll-free
(303) 832-0034 fax
For archives of our newsletter and more places where Northstar is in the news, please visit our website. For reprints of any article in this issue, please call or e-mail us at the address listed above.
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