This Time Is Different

This Time is Different
Government Debt Rises
Investment Outlook
China
Annuities for an IRA Rollover???
Annuity Taxes
Low CD Rates
Blue Chip Dividends

This Time is Different
Over the last couple of weeks on the MaxOut Savings Show the main subject was “This Time is Different”, which is the title of a new book by Carmen Reinhart and Kenneth Rogoff. The subtitle, Eight Centuries of Financial Folly, does a better job of identifying the subject of the book. Professor Reinhart of the University of Maryland and Professor Rogoff of Harvard do a thorough job detailing the results of economic crises. The book, somewhat academic in nature, has a huge amount of charts and tables to back up the authors’ assertions about the effects of a financial crisis. The book was a great read for people, like myself, who study economic history to help guide us through these tough economic times. The book has caused quite a stir worldwide and could be the first book in history to cause a stock market slide!

To quote the book “The essence of this time is different syndrome is simple. It is rooted firmly in the belief that financial crises are things that happen to other people in other times, crises do not happen to us here and now”. Does this sound familiar? What history tells us instead is that these crises happen time and again.

Among the things the good professors found was that this banking/debt crisis economic slowdown is generally very different from your garden variety economic slowdown in a number of ways. A debt crisis tends to last three to four years longer than your standard crisis. During that time, unemployment tends to remain high over an extended period of time averaging 4.7 years. According to their research, on average, unemployment rises for almost five years with the average being a 7% increase. So far, unemployment in the United States has moved up about 6%, just under the average. We are only about one and a half to two years into the problem. As we have written and talked about previously, this recovery will take time and unemployment will remain high.

Government Debt Rises
Another interesting finding was that “on an average during the modern era, real government debt rises 86% during the three years following a banking crisis”. That is what we are seeing here in the United States, a huge run up in reckless government spending. The recent Obama budget is now projected to be over $ 1.5 trillion; that is on top of last year’s $1.3 trillion budget deficit. This does not include a $1 trillion plus increase in debt on the Federal Reserve’s balance sheet. What the professors found is that time and again governments rush in with massive spending after a banking crisis. This is the result of two main drivers. To be fair, the first is a general plunge in tax receipts as the economy slows dramatically. Second, governments ramp up spending to stabilize the economy and lower unemployment. This combination has led each time over the last thirty years to an average increase of 86% in real government debt, which countries are saddled with three or four years after the crisis.

Herein lays the problem; the professors report that after two years we begin to see sovereign debt defaults as countries find that their economies are showing little improvement and they can no longer fund their deficit spending. The book is one of the reasons the spotlight was turned on to Greece’s financial problems and markets worldwide began to fall. Another way to look at Greece’s debt problem is to notice that their debt is over $300 billion, more than twice what Russia’s ($70 billion) and Argentina’s ($77 billion) debt combined was when they defaulted in 1998 and 2001, respectively. This gives us an idea of how much sovereign debt has grown worldwide in the last ten years. We do not expect Greece to default anytime soon and they will receive help in some form from the EU. But, they will have to get their financial house in order and reduce deficit spending. Sound familiar?

Dollar
The problem is that there are a number of other countries out there with the same problem; Ireland, Italy, Portugal, Spain, Lithuania, Latvia, Ukraine, Ecuador, just to name a few. This is why we are seeing a worldwide correction at the present time as investors assess the effects of the deficit problems in many countries on investments worldwide. This is why the US dollar has stabilized and strengthened over the near term. The Dollar is a known quantity and the Euro is suddenly suspect. We continue to like the Chinese Yuan and gold in this market. Given the problems with debt that has “suddenly” developed, the US stock markets should decline but will perform relatively better than many other markets.

China
We get quite a few questions on investing in China. Long term, we think they have a great future; short term, we would be cautious. It has been an interesting year for China so far. In mid January, China announced a program to cut back bank lending to slow the economy. There is real concern that its real estate markets are overheating and concern about inflation, so the Chinese acted to slow things down. The problem in China is commercial real estate. According to Jim Chanos on CNBC, about 30 billion sq. feet of commercial real estate is under construction right now in China that he would consider office space. “That works out to a 5x5 cubicle for every man, woman and child in China. They are building high rises in cities with already 15-20% vacancy rates, and those are the government’s numbers”. Clearly, China has a major real estate bubble; the good news is that they have the savings and foreign exchange reserves to cushion the fall. Even so, China is headed for an economic slowdown and major lending problems in the near future.

In addition, the Chinese have reacted negatively to the United States selling arms to Taiwan and President Obama’s meeting with the Dali Lama. Our concern with China is two fold: on one side you have the economic slowdown and on the other you have the potential for protectionism.

In the United States, on the left and right, the mantra is jobs, jobs and jobs. China has been responsible for more job losses than any other country in the world. They have taken advantage of our open trade policies to compete with us. In addition, China has kept its currency, the Yuan, artificially low to produce jobs for Chinese. Couple that with lax pollution laws, nonexistent intellectual property rights, and state sponsored companies and China has become a one-way trade street. We think the Obama administration will pressure China on trade and it will not proceed smoothly because they have little choice as jobs are now the number one issue. We expect trade tensions to increase as the year progresses. The latter part of 2010 should offer a better opportunity to invest in China.

Annuity for your Rollover???

A question that often comes up on the MaxOut Savings Radio Show concerns annuities in an IRA or tax advantaged vehicle. Are annuities suitable investments in an IRA? The problem with putting an annuity in an IRA is that the IRA already has tax-free growth just as an annuity does. In many cases by putting an annuity in an IRA, all you are doing is adding higher fees to your plan. This is because the real advantage of an annuity is that you get tax-free growth until the money comes out, then it is taxed at ordinary income; tax-wise it is the same as an IRA. We spoke with our partners at Fidelity Investments about their no-load annuities. The first thing they reminded us is that that will typically not allow annuities in an IRA, IRA Rollover or qualified plan. The reason being is that these plans already have tax-free growth internally and there is no need to use an annuity, as we have stated. Let me repeat that, Fidelity Investments, one of the largest custodians of retirement assets in the world, does NOT recommend annuities in IRAs, IRA Rollovers and Qualified or 401-K Plans. In a retirement plan, you already have tax-free buildup. The annuity simply adds a higher cost and locks in your money long-term, limiting investment choices. In many cases, once you put your money in an annuity, the money is not available without a surrender penalty for up to ten years! The surrender penalty is there because the insurance company pays commissions that are typically 5-10% to the selling broker. Outside of your plan, Fidelity can provide no-load annuities that MaxOut Savings Advisors will manage for you with no surrender penalty. If your advisor recommends an annuity in your IRA rollover, change advisors or brokers!

Annuity Taxes
The tax advantages of annuities are also their weaknesses. The annuity grows tax free until you take out the income. At that point, the income is taxable as ordinary income—preferably after retirement. This compares with taxable investments that are taxed at a long term capital gain rate of 15% if held for more than one year. In addition, any dividends are taxed at a 15% tax rate. This compares to a 35% tax rate if you are in the higher tax brackets for an annuity. Depending on how you manage your assets, annuities are not as efficient on a tax basis because the taxable rate to take money out is generally higher than the capital gain tax rate.

Another disadvantage of annuities is during probate of an estate. Annuities do not get a stepped up basis. At death, most investments receive a stepped up basis with the exception of retirement plans and annuities. You can hold a stock long-term and not pay taxes on it in the estate in many cases and your heirs receive a stepped up basis. In an annuity, that capital gain comes out as taxable income.

We have found that the advantages and disadvantages should be closely weighed when considering an annuity. Remember, once you purchase an annuity you are generally locked in over the long term and your gains will be taxed at ordinary income tax rates.

Why are CD rates so low?
We have seen a historic drop in CD rates and yields on money markets over the last year. The reason CDs are yielding very little is that the Federal Reserve has lowered the Federal Funds rate to a record low. The Federal Funds rates are the rates banks lend money to other banks. It is used as a benchmark for what money market funds and short term CD rates are set to yield. The Fed Funds rate is set by the Federal Reserve. As can be seen by the first chart below, the Fed Funds rate has been moved from 5.25% to 0.25% since July of 2007. The Federal Reserve is keeping rates low to subsidize the banks that have large loan losses. These low Fed Funds rates and corresponding CD rates allow the banks to make loans with very cheap money from CD owners. They then use the profits to offset their bad loan loss provisions. Unfairly, it is the savers that are being forced to subsidize the banks in the form of very low CD rates. As can be seen by the second chart, a Fed Funds rate of 0.25% is the lowest rate in over 50 years!

Short Term Chart Federal Funds Rate

As we can see from the above chart the Fed Funds are at an abnormally low rate to subsidize the banks. These low rates will not last for long and short term rates will move higher. Now is not the time to be investing in long term bonds with interest rates at historically low levels. The third quarter after the mid term elections is when we should see rate increases. It is also interesting to note that in the early 1980s the Federal Funds went to 18% as Paul Volcker and the Federal Reserve moved to crush inflation.

Compounding Interest?
What are the costs of these low CD rates over the long term? Let’s take a look at a $1,000,000 portfolio of CDs over ten years. If you are in 6 month CDs that yield 3.5% annually, after ten years you have $1,410,598; not a bad investment for little risk. Now if the CDs are only yielding 0.8% as they are now, that ten year return comes down to $1,082,942. Over ten years, this amounts to over $327,000 in lost income! So much for the power of compounding interest. The low CD rates almost halt the growth of your retirement savings. A word of warning, keep an eye on your CD if you have a longer term CD. Many CDs automatically renew with the same maturity. If this is the case, in this low interest rate environment you could be renewing for a new 2-4 year term at a low 1% interest rate and not even realize it! Short term corporate bonds with rates higher than CDs continue to be a good alternative. We would stick to higher quality companies that can ride through this economic slowdown.

Blue Chip Dividends
In this low interest rate environment we like large cap US blue chip stocks that have growth potential and pay good dividends. Dividends according to Standard & Poor’s have contributed over 44% of the total return in the S&P 500 over the last eighty years. Many large cap blue chip stocks now pay over 4% in dividends. In the past, many large cap blue chips traded at a premium to the market multiple. This is not the case at the present time, many of these companies now trade at the average market multiple. In addition the group is positioned to take advantage of overseas growth. At the present time we believe that we are in a corrective phase and would buy on pullbacks and maintain an overall very cautious stance. As we have seen, this crisis will take several years to work through and we will see a number of corrections along the way over that time we want to take advantage of the income from dividends.

Do you have an account at Fidelity?
Do you already have an account at Fidelity Investments? Why not let the MaxOut Savings Advisors Team actively manage the assets for you at Fidelity? We will make the investment decisions and you can sit back and relax. We use the same value based investment strategies we talk about on the MaxOut Savings Show. In most cases you can sign a simple form and we can use your same Fidelity account to get you started.

Considering an IRA Rollover?
If you are retiring soon or considering an IRA rollover, let the MaxOut Savings Advisors Team handle your IRA rollover. We can help you take advantage of the NUA tax break if you have low cost basis stock in your company plan. We will sit down with you and go over your financial situation and needs and come up with a plan. We will show you how we manage accounts using our value analysis strategy to grow your investments and reduce risk.

MaxOut Savings Advisors: Actively Managing Risk
In these volatile times, investing your retirement funds can be difficult and time consuming. Is your advisor looking at risk and actively managing your retirement? Hiring the MaxOut Savings Advisors team to manage your money or IRA rollover is a great first step toward a successful retirement. MaxOut Savings Advisors, LLC is an SEC registered, fee-only investment advisor based in Houston, Texas. Ted Geoca has over twenty year’s of investment experience managing clients’ retirement assets. We invest in stocks, bonds and mutual funds for our clients using a value analysis strategy that we have developed over the last twenty years. We look at risk as well as return to actively manage your investments through today’s changing markets. We use Fidelity Investments as the custodian for our clients’ assets. If you would like MaxOut Savings Advisors to manage your retirement investments using our value methodology, I would be happy to meet with you. To schedule an appointment please give us a call at 713-627-0400 or email me at ted@maxoutsavings.com.

Ted K Geoca Doug Saam Kellan Caldwell
President
MaxOut Savings Advisors, LLC
Houston, Texas
ted@maxoutsavings.com 713-627-0400