The weakness seen in stocks over the summer turned into an absolute rout in September as equity markets finished  with their worst quarterly performance since the fourth quarter of 2008.

(U.S. stocks - red, developed international stocks - blue, emerging markets stocks - green)

The main driver of these movements remain the lack of faith in the ability of Europe to stop the fall in their periphery nations sovereign debts from spreading to the Continental banking system. In the last few weeks, however, we have seen increased worries about the strength of the emerging market economies, particularly China. While we have noted the relative underperformance of emerging markets in several newsletters this year it is worth looking at a longer term chart of China's leading stock market index to get perspective on the poor returns, in absolute numbers, in what is supposedly the strongest growth story in the world.

While the relative weakness of the emerging markets' stock indexes has been evident over the last year or two, the fundamentals of these nations' economies has caused a lot of hot money to seek shelter in their bonds and currencies. That confidence has been shaken in the last month as large investors have increasingly seen the U.S. as the safe haven . In September alone, this has resulted in nearly a 10% outperformance of U.S. stocks to their emerging counterparts and a big movement back to the U.S. dollar, perhaps most vividly shown by the performance of the Brazilian Real.

The last few days have seen more optimism on the European front as "German Chancellor Angela Merkel and French President Nicolas Sarkozy said in Berlin yesterday they have given themselves three weeks to devise a plan to recapitalize banks and find a durable solution for Greece's debt load." (As a side note, what have they been waiting for the last three, oh sorry,  thirteen months?). While it seems likely that Europe will endure at least a period of negative growth, if not outright recession there are mixed signals on the U.S. economy. Financial indicators such as the stock market, government bonds yields and junk market spreads indicate a likelihood of recession here within the next twelve months, but there has been little support for that probability in actual economic data such as new unemployment claims, new car sales or retail sales. We suspect the answer to that question will lie in events outside our borders as it relies on how well the Euros settle their own debt/banking problems and emerging markets (read China) respond to a possible slowdown in their torrid growth rate.

The U.S. Internal Revenue Service is not noted for its propensity to issue "do-overs" but one of the few times you get that chance is in the case of an IRA conversion. Last year we reviewed the rules about converting a traditional IRA to its Roth counterpart. In 2010, there was an option to make the conversion and then pay the tax bill over the next two years. Going forward, IRA conversions will be more prevalent as income restrictions on the utilization of the tactic have been lifted. If you did convert an IRA last year you might be regretting that decision because you owe taxes based on the value of the IRA on the conversions date but many account values are down 15%-20% since that time. Even more if you happened to own Bank of America or Citigroup (see ugly chart below) in your account.

The "do-over" option still exists if you were one of those individuals who converted last year, even if you have already filed this year's tax return. If you "recharacterize" your Roth conversion back to a traditional IRA, it will be as if you never made the conversion in the first place. Therefore, you will not be taxed on the conversion amount. You do have to make this recharacterization by the due date of your tax return plus extensions (for most people, October 17th, 2011 for their 2010 return). If you have filed your return already, you can still make the recharacterization  but you will have to file an amended return by Oct 17th. 

Best of all it will still be possible to convert your traditional IRA into a Roth again in the future. After a mandatory 30 day waiting period you are allowed to re-convert, and (presumably) pay less taxes on the reduced value of your IRA. Please note that the two year payment option that applied to 2010 conversions will no longer be available.

If you did make a conversion in 2010, it is worth contacting your financial and tax advisor to examine the value of the account now and at the time of the conversion. If there has been a significant decline, recharacterizing that conversion might make a lot of sense.