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 IHA Quarterly
October 2010 
In This Issue
Third Quarter Commentary
Quarterly Asset Class Returns
2011 Tax Uncertainty
What We Have Been Reading
What's New
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 History Speaks
At a time when the Federal Reserve is expected to engage in another expansion of the money supply we thought it would be worthwhile to take a look back at the hyperinflation that afflicted Weimar Germany in the aftermath of the First World War.
The value of the German mark had begun to decline from the outset of hostilities but the efforts undertaken by German government to repay the debts and reparations incurred by the war was what ultimately led to inflationary hell. The German Central Bank started printing millions upon millions of marks and foreign investors began fleeing financial assets priced in German currency. A U.S. dollar worth 4.2 marks before the war was worth 2000 by 1922. At the end of 1923 that dollar got you 4.2 trillion marks as the German currency essentially lost all value.
The result was widespread poverty throughout Germany as peoples' savings turned worthless. The price of coffee could rise 40% between cups, barrels of marks were necessary to buy a loaf of bread. Much of the economy was reduced to bartering. Things did not stabilize until the old mark was recalled and replaced with the new Rentenmark in late 1923.

Barrels of Money

Market Commentary

The 2010 see-saw continues as equity markets more than recovered losses from August - in fact the Dow Jones Industrial Average had its best September in over 70 years. This is certainly not a result of improved economic reports as nearly all important measures of economic output, including industrial production, housing and employment are essentially flat over the last three months and most remain far below pre-recession levels. The most recent press release from the Conference Board notes that "latest data from the U.S. Leading Economic Indicators suggest little change in economic conditions over the next few months. Expect more of the same - a weak economy with little forward momentum through 2010 and early 2011." The source of the most recent rally has been the increasing belief amongst investors that the Federal Reserve will engage in another round of "quantitative easing". This is a form of monetary policy used by central banks to increase the supply of money in an economy when the primary interest rate is at or near zero. The actual mechanism for doing this is that the Fed will credit its own account (create money out of air) and use that credit to buy some kind of financial asset, usually government bonds from banking institutions. As you probably recall, the Federal Reserve last engaged in this behavior in a yearlong program started in March 2009 in which they purchased $1.2 trillion of government backed mortgage bonds. The goal would be to encourage businesses and individuals to borrow money due to low interest rates and at the same time ensuring banks have sufficient reserves to make those loans. It also tends to increase the value of financial assets as the increased supply of money has to find a home somewhere. Those are the desired longer term results but, of course, financial markets tend to discount such policy actions in real time and the immediate effect has been a decline in the U.S. dollar and gains in commodity and equity markets.


The selloff in the dollar is due to the fact that quantitative easing reduces the rates of interest in an economy while at the same time increasing the risk of higher inflation sometime further down the road. This has translated into higher prices in hard commodities because they tend to be safer stores of value in times of inflation. While a weaker dollar does not always equate with higher stock prices (over the long term we would argue the opposite) the negative correlation over the last month has been undeniable as you can see on the chart below.


 Dollar Equities Relation


Part of this is due to the fact that U.S. exporters benefit from a lower dollar as their sales in foreign currencies are suddenly more valuable. More of it is from the hope that further quantitative easing will provide real stimulus to the economy and perhaps kick start employment.


What are the downsides to quantitative easing? Well the most immediate is to anybody who actually has savings as the interest they receive goes lower while the potential for inflation gets higher. Those on fixed incomes can also be negatively affected. The government recently announced that Social Security beneficiaries will not get an increase for a second straight year. Knowing that the government is pursuing an inflationary policy at the same time your income is staying flat is pretty disconcerting. It is also questionable whether the policy will be effective. The Japanese have been pursuing similar policies on and off over the last decade without a sustained period of economic growth. The point of injecting money into the system is to encourage bank lending. The graph below compares the growth in Federal Reserve credit with the growth in total commercial bank lending since the start of the financial crisis. This indicates that while the Fed has aggressively pushed money into the banking system, that money has not resulted in more credit being extended by banks. Instead it has been used to cover bank losses and increase their reserves. There is no guarantee that further additions to the money supply will be any different.

Fed Asset Grows Vs. Bank Loan Growth


Finally, a weaker dollar is not a desired outcome for most of our trading partners. It can translate into volatile and unpredictable prices and put their companies at competitive disadvantage. Thailand has already introduced measures to limit the appreciation in its currency and that trend seems likely to spread. A global round of competitive devaluations could be devastating to trade and is probably the worst possible outcome for all involved.


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Asset Class Returns
3rd Quarter 2010
 Monthly and 52 week returns for major asset classes. Performance information is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.
Asset Class Returns

Financial Planning Highlight 

2011 Taxes  

As we approach the end of the year there is, to paraphrase Ben Bernanke, "unusual uncertainty" in regards to what everyone's 2011 tax bill will look like. While the expiration of the Bush income tax cuts has received the greatest media attention there are a host of other tax related issues that have not been addressed. While we normally applaud when Congress does nothing, their inaction on these items leaves the potential for tax increases on nearly all Americans. We will detail the issues that will have the biggest effect and should also be the subject of the most intense debate when Congress does try to address these issues before the end f the year.


Income Taxes

If all the Bush income tax cuts expire (as is the law right now) the rates for all brackets will go up with the maximum rate rising to 39.6%. This would be a massive tax hike affecting everyone who pays taxes. President Obama would like to limit the increase to the top income bracket. He has received a lot of resistance from Republicans and an increasing number of Democrats on this issue, many of whom would prefer to extend all the tax cuts.  We predict that Congress will vote to extend the cuts until 2012 and this will be a big issue in the Presidential election in that year.


Dividend Taxation

 As things stand now, the term qualified dividends will lose meaning since they will be taxed as ordinary income not as capital gains- a shift from 15% to as high as 39.6%. This would have a serious impact on the value investors would place on dividend paying stocks since those payments are already taxed at the corporate level before paid to shareholders. At the maximum rate, it would mean the company would need to earn $2.54 in order to provide the shareholder $1.00 in actual benefit. We think Congress will keep the lower rates on qualified dividends and are more hopeful they will make this tax cut permanent.


Estate Taxes

The Estate or 'Death' tax, which expired at the end of last year (to the good fortune of a few billionaires that died this year, or more exactly to their heirs' good fortune), will be reinstated at 55% on an individual's net taxable estate (pretty much on everything above $1 million). In some areas of the country, this is not much more than the value of people's homes and we are of the belief that a 55% rate (and that's just the federal governments take) approaches confiscatory levels and is not really justifiable.  There is a wide spectrum of opinion regarding this matter on Capitol Hill, with many Republicans looking to abolish the tax completely while some Democrats are looking to raise the rate, albeit with a higher exemption amount. Our best guess is that there will be an estate tax in the 30%-40% range with individual (so that both a husband and wife can use it) exemption in the $3.5 - $5.0 million range. Logic would index these amounts for inflation but we should not expect miracles from Congress.



We believe that Congress's inaction on these items has contributed to the unwillingness of U.S. businesses to fully buy into the recovery. Particularly from a small business owner's perspective, where  business income generally flows through to the owner personal tax statements, uncertainty about future tax liabilities gives one more reason to act cautious in this environment. We also think that delaying a decision on these matters until the lame duck session will add even more volatility to these decisions. If Republicans make the type of significant gains that appears likely right now, it is hard to see how the current Congress will possibly agree on a package of reforms that would settle all these tax measures before the end of the year.


What We Have Been Reading  

An almost unbelievable description of how Greece drove itself to financial ruin.

Dividends are Back 
High dividend paying stocks have outperformed market for nearly the entire year.

A two part article from SmartMoney magazine with more details on the tax uncertanty.

A breakdown of asset class performance in expectation of easing by the Fed. 

What's New With Us 

InnerHarbor Advisors was featured on a the Financial Adviser blog of DowJones Newswires in the section called Staying Ahead of Your Clients.The article details a recommendation to a client that help them reduce their current income taxes while increasing their retirement savings. The article was the source of not one, but two of Joe Connolly's Small Businees Reports, heard on WCBS 880 radio.


Mike and John InnerHarbor Advisors

Contact Info:
InnerHarbor Advisors, LLC
212-949-0494 and