Spring Cleaning (April, 2009)

As the stock market does some spring cleaning of its own, we wanted to suggest some unique ideas for your spring cleaning this year! Even if you don’t do a complete spring cleaning each year (and I must admit that I do not do a thorough job each spring either), I do have a few ideas for organizing your life. These are easily implemented ideas that really can change your life by making each day a bit easier, and they can help you save money too! Here are ten unique organization ideas:

1) Take your to-do list into the 21^st century with a digital voice recorder. For only $16, you can buy a small Sony voice recorder that will fit in your pocket or purse and will hold 8 hours of recorded notes. These voice recorders are an ingenious way to de-clutter your mind and convert mental notes into messages that you can listen to at the end of the day. You can also record ideas, thoughts, and musings, which can be a very calming practice. (Look for model Sony ICD B120 for a low cost choice.)

2) Have each member of the family choose their favorite color, and stick with it. This is the key to serenity in a house with children… buy each person’s necessary items such as toothbrushes in one consistent color. You will never again wonder whose toothbrush is missing or whose book bag is in the middle of the living room floor! Color coding your family can take a lot of hassle out of your life.

3) Turn mismatched socks into dusters. Every house ends up with socks that have no match, so instead of tossing these socks or saving them in case the mate magically reappears, slip one sock on each hand and start dusting!

4) If you have children or grandchildren, eliminate dust mites or other bad germs living on your kid’s stuffed animals and toys by placing them in the freezer overnight. The germs and dust mites will die, stuffed animals will last longer, and this is good for your children’s health too.

5) Spring clean your PC! Throughout the year, everyone accumulates applications, documents, and programs on their computers that are no longer used. These idle programs slow your computer, steal memory, and clog your desktop space. Instead, try Revo Uninstaller to eliminate unnecessary programs and applications. Revo Uninstaller is free, and it is much more effective and faster than Window’s uninstaller. Also, if you are tired of a slow-booting PC, try Startup Delayer. This is another free piece of software that allows you to choose certain programs to load later, therefore reducing the simultaneous loading of every program on your computer each time you boot up.

6) Post a stain chart in your laundry room or the kitchen. Print this stain-removal chart and keep it handy so you will always know exactly how to treat any type of stain from ink to red wine.

7) Invest in a few unkillable indoor plants. Anyone in this office will tell you that I am a death sentence for plants, and within the first 6 months of working at The Alder Financial Group I managed to almost kill every plant in this office before Charles had to step in and save them. I just can’t seem to keep plants alive! I either water them too much or not enough. But there are a few plants that even I can keep alive, and I have found that the Cast Iron Plant, Philodendrons, and Snake Plants are almost indestructible. They are a great way to brighten up your home for spring.

8) Throw away or give away all but 2 bottles of each kind of toiletry in your bathroom. I am guilty of one major cleaning crime… I insist on keeping every moisturizer, shampoo, and makeup product I have ever accumulated in my entire life. However, once a year I have to throw away all but 2 of each product simply to keep my life sane. I have to admit that there is no need for me to keep 17 half-used bottles of shampoo sitting in my bathroom! Each year, try to purge as many half empty bottles as you can.

9) Set up a paper center near the front door. Every time you bring in the mail, magazines, or paperwork, choose one of three paths: file, shred, or re-locate. Keep a file cabinet with a section for bills, correspondence, and other categories in the same location you typically open your mail. File right then to help de-clutter your life. Also keep a shredder in the same place to get rid of unnecessary paper immediately. If the paper needs to be re-located to another room in the house, such as a magazine for living room reading, go ahead and re-locate it. In such a digital world, the amount of paper coming into the average household is still overwhelming but is manageable.

10) Stand your shirts on end. I tend to wear the same 20 or so shirts over and over, mainly because I cannot see the other shirts I own in the bottom of my drawers! A good tip I have found for eliminating this problem is to fold your shirts in half one more time and then stand them up in the drawer. This way you can see all of them and get to the one you want easily.

I hope these tips help you organize your life this spring. As our economy and the stock market purge unnecessary clutter, it is a great time to do the same in our own lives.

Budget Doesn't Have to be a Dirty Word (March, 2009)

Most people cringe when they hear the word “budget.” They think of words like confining, restrictive and penny-pinching. Like diets, budgets are often started with the best of intentions but are quickly dismissed when the going gets tough. The truth is, a budget is essential to any sound financial plan and it is often avoided simply because we don’t like to think about how much we spend. Sometimes it is mind-boggling to see how much little luxuries like dining out and entertaining add up to over the course of a year. It is important to remember that the object of a budget is not to eliminate all unnecessary expenses, but rather to live within your means.

Maybe a better term for a budget is a spending plan. It is nearly impossible to sit down and plan out exactly what expenses you will have each month. But what you can do is identify fixed expenses that don’t vary much from month to month such as your mortgage, car payment, and insurance premiums. Subtract this number from your net take-home pay and the result is your discretionary income, the money that you are free to spend however you wish. This type of plan is flexible and allows you to adjust your monthly allocations to your changing wants each month. As long as you stay within your discretionary amount of money, you are living within your means. So if the opportunity arises to go on a weekend getaway, it is fine to go, but this means that you need to avoid discretionary spending somewhere else. You must prioritize. People get in trouble when they expect their paycheck to cover everything they want, and when it doesn’t they turn to their Amex or Visa, which is a bad idea.

In fact, overextension of credit is what got our economy in the mess it is in now. Ways to save are on everybody’s mind. We’ve found a few ideas around here that you may find beneficial as well:

1. Home phone - Over the past several years, the use of cell phones has skyrocketed. Even those of us who refused at first to own a cell phone have given in. While we can’t seem to live without cell phones, many of us don’t want to part with your home phone for one reason or another. Did you know that you could be saving hundreds of dollars each year by using Voice Over IP? T-Mobile now offers a service that adds a home phone line (you can keep the same number) to your cell phone bill. Sorry AT&T, your glory days are over. You avoid paying junk fees twice and pay as low as 10 dollars a month for you home line. There are other companies that offer this Voice Over IP service as well. Several of us in the office have been using this and have been very impressed. The quality is no different than a traditional phone line and included are all the calling features of a cell phone (caller ID, voice mail, free long distance, etc.). If you have broadband internet service at home, Voice Over IP is a very good option to consider.
2. Generics – How many of you are apprehensive about buying generic prescriptions because you are worried about the quality? The FDA requires generic drugs to have the same quality as brand-name drugs. Be sure to ask your physician or pharmacist if there is a generic brand available for any medicines prescribed to you. Also, pharmacies at some stores such as Kroger and Walmart have extensive lists of generics for as low as $4, so before you fill your prescription, check to see who has the best price. Publix has a list of 8 antibiotics that you can get for free with your prescription. This “generic over brand” concept applies to over-the-counter medicines as well. Before you buy Excedrin, read the label of the knock-off version and you will see that they have exactly the same active ingredients, for a much lower price.
3. Car Maintenance – Any oil change station will tell you that you should get an oil change every 3,000 miles. The truth is today’s car manufacturers usually recommend oil changes less frequently. Sometimes these can be as long as 5,000 to 7,500 miles. Check your owner’s manual for the recommendation for your car and you will probably be surprised. When it actually is time to get an oil change, almost all of the well-known service centers offer online coupons. When you get your oil changed, 9 times out of 10 they insist on changing your air filter. It is really easy to change your own air filter and save on the labor charge. A final suggestion is to keep your tires inflated at the right pressure to prolong their life, get better gas mileage, and get better control and traction. Also, rotate your tires as recommended in your owner’s manual for longer life. Some national tire center chains will even offer free rotations in an effort to get your business when you do need new tires.
4. Unnecessary fees: With a sound spending plan in place and proper organizational skills, there is no excuse for returned check or overdraft charges. However, mistakes happen and if you do get hit with an occasional fee, try calling the company and charming them with your niceness and remorse for this one-time slip up. Many companies that you have a good history with will waive the fee which is worth the few minutes you spend on the phone with them. One of the benefits of having a long relationship with a business is that they value you as a customer. Many companies such as cell phone, banks and credit card companies depend on have low customer turnover rates. They will often bend over backwards to keep a long term customer. Many of these businesses have a department solely designated to customer retention. If you don’t get the answer you want, hang up and call the 800 number again. You’ll likely find a representative who is willing to help. And speaking of unnecessary fees… if you signed up for a service to get the introductory rate but now that rate is scheduled to increase, call the company and mention that you are considering switching companies. Often, they’ll want to keep you and extend the introductory rate for a few more months.
5. Utilities – A programmable thermostat can adjust the temperature in your house automatically when you’re away or asleep. While you can find them for as low as $70, they will save you twice that much on your power bill each year. Florescent light bulbs can save you $60 in electricity per bulb and last ten times longer than conventional bulbs. Putting weather strips around the frames of your doors can save about $30 per year. With these minor adjustments, not only will you save money, but you will also do your part in going green.

Now that you have new ways to save and possibly a tax refund coming your way, what are you going to do with your excess discretionary income? Hold off on buying the big flat screen that is now 60% off. If you have any credit card debt, eliminating it should be the first thing you do with extra money. If your card charges 20% of your balance in interest, you might as well throw that money in the trash can.

Second, do you have an adequate emergency fund? A family should have between 3 and 6 months of expenses available in cash-like investments in case something unexpected occurs. This fund should be separate from the investments you have saved for retirement or future expenses. Third, how much are you saving? In theory, those working should be saving 10% of your income. Now I know that may seem like a lot and if it’s not possible to save that much, don’t get discouraged. Just save what you can. A good way to ensure that you are saving is to set up an automatic draft and treat it like any other bill.

If you are still looking for productive ways to use discretionary money, paying a little extra each month towards your mortgage or car note really goes a long way. Any extra money goes directly toward principal, reducing the amount of interest you pay and the time it takes to pay it off. For example, on a $100,000, 30 year 5% fixed mortgage, an extra $50 a month will save you over $18,500 in interest and cut your term by 5 years! Prioritize these extra principal payments to the highest interest rate debt first.

Lastly, don’t forget to reward yourself. You work hard and deserve a treat every now and then, just don’t get carried away!

I hope you will find the ideas in this article useful. While budgeting is not anyone’s favorite topic, having financial security and knowing that you are living within your means should go a long way in bringing you peace of mind, even in turbulent times.

Market Flash Commentary

Testing New Lows

As I sit here and write, the major stock market averages are nearing the lows set back in November. There is no mistake as to what is driving this latest down move. For several weeks the markets have been deluged with bad news and uncertainty.

Among those concerning topics are the massive stimulus bill, the second half of the TARP program, unemployment data, near-term deflation, long-term inflation, constrained lending, foreclosures and more. With each new headline there follows some quick analysis in the media. The problem with most news outlets is that each topic is only afforded five minutes or a couple of columns of coverage. It’s important to realize that most of the concepts that are driving the negative market sentiment right now are very complex issues that are well above the head of most reporters and surely take longer to explain than five minutes. In many cases these media reports are highly political publications ripe with misinformation.

In our effort to keep our clients informed, we wanted to take this opportunity to cut through the clutter and share with you our thoughts on the three most important components of the recovery efforts.

The Stimulus Bill

The federal government has just enacted the largest spending bill in the history of the nation. In addition, governments around the world are enacting their own stimulus programs. Ultimately, the goal of any stimulus plan is to fill the void in GDP left by the reduced spending by businesses and individuals. There are numerous problems with these programs.

First, it’s difficult to gauge the appropriate size for a spending package. In theory the level of government interaction should be just enough to offset the private sector shortfall. This is about impossible to measure. You’ll hear a lot of debate about whether or not the plan is too big or too small.

Another issue is that all spending is not alike. Ideally, you would want to inject money in a way that would encourage job creation in the private sector. This is the action that will have a lasting effect. Transfer of payments, where the government simply takes money from one entity and gives it to another, is not helpful in creating sustainable GDP.

The stimulus bill wasn’t written by economists, but instead was written by politicians. As such, there is a lot of wasted money being thrown around. The wasted money, which I estimate to be about two thirds of the package, may have a simulative effect in the short term but once those monies are gone the hole in the GDP will reappear. This is one of the lessons from the New Deal era. Temporary spending will only postpone the inevitable.

Hopefully, the economy will show signs of recovery before much of the money is spent in 2011. We then would have the chance to withdraw that portion. Either way, any benefit from this bill won’t likely be felt until late this year or early next year.

TARP II

The markets are looking for immediate help, and we believe the second half of the bank bailout is where it will come from. The current downdraft in the stock market can be traced back to the latest round of TARP planning, or lack thereof. There has been such an absence of guidance as to how the remaining funds will be used that banks and investors have been left paralyzed.

It is important to understand that this legislation and funding is separate from the stimulus bill. The first round of TARP financing was originally meant to buy troubled debt. As we have written many times in the past year, there is a lot of sound reasoning behind this idea. Removing this debt from the balance sheets of financial institutions and creating an active market in these securities would help the overall markets considerably.

For various reasons, the first round of TARP money ($350billion) was instead directly injected into banks via the purchase of preferred stock of those banks. This action was not necessarily gratuitous but it was not in keeping with the original proposal made to Congress.

Since then questions have been raised about the effectiveness of the first half of TARP funding and what the new administration plans to do next. So far only goals have been announced. We have yet to be shown a plan.

There has been such uncertainty that no one even knows what to call the program anymore. The latest version is the Term Asset Backed Securities Loan Facility (TALF). This name implies that the Treasury Department is refocusing its efforts on jumpstarting the market in asset back securities including those backed by student loans, mortgages, and credit cards.

We believe that of all the recovery plans floating around, this one stands the best chance of really making a difference. For one thing it is the least politically influenced. It is also being crafted by economists in consultation with the private sector.

Hopefully a definitive plan will be announced within weeks. Assuming the market likes what it hears, we would expect a strong short-term rally in equities once a plan is put in place.

Housing Foreclosure Bailout

Dealing with the rising housing foreclosures has also become a hot potato. The debate crosses philosophical, economic, and political lines. Our guess is this aspect of the stimulus debate will ultimately have the least amount of influence on a recovery.

Foreclosures may be on the rise, but still 93% of mortgages are just fine. With nine out of ten people acting responsibly, it’s hard to imagine a bailout of those who are in over their heads to get much political traction. Our guess is that any legislation in this area will be limited in scope.

It is estimated that there are an annual 2 million new homes needed in this country due to demographics. Housing is the one area that will fix itself given time. As prices come down demand will rise. We’re already seeing this in some areas of the country that have experienced the biggest declines in prices.

We don’t agree that everyone who is “upside down” on their mortgage will just walk away from their home. Developers and speculators would be far more likely to default, but they represent a relatively small percentage of property owners.

In Conclusion

Last year we summarized the economic environment as one in which the entire globe was deleveraging. Nothing has changed from then. Virtually every development we’re experiencing today can be attributed to a world downsizing. Individuals and businesses are reducing their debt, spending less, and saving more.

The short-term result is a swift contraction in GDP, and the fallout will be fewer items manufactured and bought. Demand for long-term assets will be temporarily depressed as assets backed by debt are unloaded.

These effects are unavoidable. The government’s job should be to help ease these effects, but they cannot make them go away. We pray that the government’s activities don’t saddle the economy for years to come with the unintended consequences of spending billions of dollars.

We are far less concerned with the Federal Reserve’s activities. While they have greatly expended their balance sheet, the Fed’s actions are far more short-term in nature and can be easily removed as economic conditions improve.

Contrary to the terminology loosely thrown around in the media, the Fed is not spending billions of dollars. They are, in fact, investing billions of dollars or guaranteeing billions of dollars in securities. They are also being paid dividends and interest on those monies. The Fed has openly said that it expects to earn money on its investments. Today Bank of America made a $402 million dividend payment to the government on their TARP preferred shares.

I find it amusing and a little disingenuous to hear politicians talk of “investing” in education, job training, and the like when they are really spending money. But when the government does actually invest in something such as TARP assets, it is referred to as spending.

Unlike TARP, the stimulus bill is plain and simple spending. The only hope to get something in return on those dollars is if the spending spurs developments that will increase future tax revenue. We’ll see.

The media and the government tell us that the American people are causing this “meltdown” by reducing their debt, saving more, spending less, and accumulating cash. Is this really a bad thing? As a nation we are acting more fiscally responsible. We haven’t done that in a long time and it’s a shock to the system. You have to wonder if the solution is for the government to then fill the void by acting irresponsibly.

Yes, this shift towards saving more and spending less has caused short-term economic pain. Let’s try to minimize the current pain while the country goes through rehab, but let’s also hope this responsibility trend continues. We’ll be much healthier in the long run.

Market News

A Year of Change

2008 will certainly go down as a year of change. Whether it is by choice politically or forced financially, things will definitely be different as we move forward. 2008 will also be remembered as the year that permanently changed Wall Street.

We would sum up 2008 as the year in which the U.S. received a massive margin call. Across the economy, wary lenders demanded that borrowers put up more collateral or sell assets to reduce debts. For years, the U.S. economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer.

The aftermath has left us with tighter lending standards, a financial system under-capitalized, and trillions of dollars worth of securities (at issue) that no one seems to be able to correctly value. The result is a slowing global economy that hasn’t found a bottom. Throughout most of the year stocks proved remarkably resilient to the bad news. That changed dramatically in the fourth quarter.

Going through the numbers, all of the major stock averages were down substantially at the end of the year. The S&P 500 was off 38%, NASDAQ down 40%, Dow Jones 30 down 33% and the Russell 2000 off 34%. European and Asian markets fared even worse, declining between 45 and 50%.

As we’ve written over the past year, bonds didn’t offer much of a hiding place either. Most issues saw their prices decline as risk was re-priced in the market place. There is still no market for a wide range of asset-backed bonds. Even the normally boring municipal bond market took a hit when the bond insurers lost their AAA ratings. Treasury bonds were the only exception to this retraction as invertors sought safety over anything else.

Many lessons can be learned from the experiences of last year. Among other things, those lessons include the dangers of excessive leverage, the interdependence of our financial institutions, the importance of transparency in the markets, and the unintended consequences of government policies.

It is yet to be seen how the regulatory landscape will be changed as a result of the past year, but it surely will. There are two observations that can be made regarding the financial system regulatory environment. The first is that it is highly unlikely that government regulations can keep up with the speed of evolution in the markets. Some of the most significant trading venues today were only niche markets a few years ago. Secondly, it is unclear how many of these problems can be legitimately attributed to a failure to regulate.

Government’s never ending desire to get bigger would have us believe that the solution to avoiding this kind of pain in the future is increased regulation. However, it’s interesting to note that if you were to rank the severity of problems in the system, you would find that the most affected companies and industries are also the most regulated.

We believe systemic changes in the financial markets are what is most needed, not increased oversight. An obvious and necessary change is for investors to require issuers of asset-backed bonds to continue to have some culpability after the securities are sold. Underwriting standards would be greatly improved. Also, markets that are large enough to pose an economic threat should be transparent and have a central clearinghouse that would allow others to gauge the inner dealings. Accounting rules should better address how to handle pricing securities that don’t have a liquid market.

These are not necessarily regulatory changes in oversight, but instead are changes to the way Wall Street does business. These types of changes do need to be initiated through legislation. There are plenty of oversight rules in place. The problem seems to be how well the overseers are doing their job, which leads us to the next subject – scandals.

Show me the Money

Times of stress always expose the weaknesses in a system. So it goes with the current market crisis. Among all of the bad news in the financial markets, one of the most shocking developments was the self-disclosed Ponzi scheme run by Bernard Madoff. The reported 50 billion dollars in losses was yet another blow to the already shaken markets. Not only are these losses the largest ever of this type, but they impact an amazing array of individuals and institutions.

One of the more surprising elements of this case was the apparent failure by the securities examiners to catch this scheme in the twenty-plus years it continued to grow. Throughout those years there were a number of clues that something was amiss. The most obvious clue was the remarkably consistent returns by the fund. These supposed returns spanned both good times and bad. This time period included the collapse of Long Term Capital, the global currency crisis of the mid 1990’s, and the bursting of the tech bubble in which the overall market lost half its value. During those same times the fund reported double-digit returns year after year. This incredible performance is what allowed the fund to attract so many assets.

The secretive nature of the fund’s investment techniques led other managers to question the ability of Madoff to generate such consistent returns. Several people went so far as to raise these questions directly with the securities regulators only to be dismissed. Now that the scam is out in the open, fingers are being pointed in every direction.

How could this have gone on for so long? While the details are only now emerging, there are two factors which could account for the ability of Madoff to deceive so many people. First, investor greed led many people to suspend their critical thinking because they wanted to believe that this was easy money simply there for the taking. Secondly, Madoff owned both the fund management company and broker/dealer that held the accounts. This meant that he was both reporting the performance and generating the statements to back up those performance claims.

The two lessons from this scheme are: 1) The importance of asking hard questions when your investment manager is always making money regardless of the market conditions, and 2) the need for checks and balances in monitoring your portfolio performance.

You should always be concerned when your managers’ performance is radically different than their benchmark over time. This means they are doing something very different than that benchmark. While this can be good when the benchmark (aka, market) is going down, that strategy should not work when the benchmark is going up. Conversely, a strategy that is greatly over-performing in up markets should get clobbered in a down market. Managing risk should be accomplished through asset allocation and not changing strategies within an asset class. When investors see this, they should be prepared to ask a lot of questions and get specific answers. Your investments should never be a “black box”.

Never underestimate the need for checks and balances. Whether it is intentional or not, mistakes can happen. You should always know what controls are in place to protect your assets and accounts. A good example in our business is the role of the custodian, which for our clients is Schwab. We report positions, performance, trades, etc to our clients at least every quarter. What we send out can be independently verified by the statements and trade confirmations our clients get from the custodian. In the Madoff case, his company was generating both, which as you can see is a major conflict of interest.

We reconcile our portfolio balances and activities to Schwab’s reports every day using software that is completely independent from theirs. So if there is ever a difference, our staff indentifies why and what to do about it the same day. While rare, the differences are almost always due to timing of payments. We adhere to the principle put forth by Ronald Regan as he would say about arms treaties, “trust but verify.”

Another troubling aspect of the Madoff case is the fact that no one really knew what his fund owned. Even the other investment advisors directing their client assets to him didn’t know what his fund was doing or what investments it owned. As investment managers ourselves, we cannot imagine putting our clients in that situation. This is every bit as egregious as Madoff’s thievery. Unlike Madoff and the many financial advisors who kept their clients in the dark, we believe it is important for you to understand the strategies we are employing and know what securities you own.

So What Do I Own?

We attempt to send out commentaries and articles on a regular basis because we want you to understand the activity occurring in your portfolio as well as the securities it contains. You may have noticed a few consistent investments in the core area of the equity portion of your portfolio, and we want to alleviate any confusion as to what these core mutual funds and exchange-traded funds are designed to achieve. Some focus on capturing the broad market while others are more focused.

While each client’s personal situation is different, we include these few common investments and strategies in almost all of our client accounts because they are broadly diversified and thus less volatile. However, we want to stress that we do not use “cookie-cutter” accounts in which each portfolio contains the same investments in the same amounts. We simply include these investments as the backbone of your portfolio due to their well-diversified nature and then structure the rest of your portfolio around these investments based on your individual circumstances. The exposure to these holdings will vary from one client to the next, as it should, but we still wish to take this opportunity to explain exactly what these common investments are and what they seek to accomplish.

SNXSX – Schwab 1000 Select Index Fund

Indexing is an important component of any diversification strategy, and that is what this mutual fund from Schwab is accomplishing. The Schwab 1000 consists of the 1,000 largest companies in the United States, and the index is designed to be a measure of large-cap stocks. What is large-cap and why would you want a large-cap mutual fund? Market capitalization is a measure of public consensus on the value of a company, so bigger companies carry the investor sentiment that these companies will continue to survive and thrive. Large cap companies also became large for a reason, usually attributable to significant competitive advantages and domination in their respective markets that will most likely continue. Therefore, your equity portfolio is heavily weighted in large-cap indexed assets because these stocks are proven strong performers.

We chose this particular large cap mutual fund because it has very low fees and high diversification across a very large number of companies, thus reducing risk. You might wonder why we chose a fund run by Schwab, but the company that operates the fund is generally unimportant because the fund is not actively managed by a portfolio manager. In other words, the fund owns a set of stock and the fund changes value as the stocks it owns change value. No one at Schwab or any of the other following companies are buying or selling securities in the fund each day. This is a positive situation because it means you do not have to rely on a portfolio manager to perform. You must simply rely on the companies contained in the fund to perform.

MDY – Standard and Poor’s MidCap 400

The large, mid, and small-cap indexed components in your accounts can be seen as the building blocks of a diversified equity portfolio, and this S&P MidCap 400 exchange-traded fund is the main mid-cap element. We use MDY because it carries the inherent advantages of being an ETF; low fees and simple trading rules. This particular ETF consists of 400 mid-cap companies chosen based on their size. While mid-cap companies have proven their worth and are still quite large relative to all companies in the country, they are smaller than their large-cap counterparts and thus carry slightly more risk. However, with higher risk comes higher reward, and this mid-cap holding tends to outperform large-cap holdings during periods of growth. But even with this somewhat increased risk due to smaller companies, this ETF avoids company-specific risk by diversifying across many mid-cap companies.

SWSSX – Schwab SmallCap Index Fund

The final portion of your main equity holdings will be this small-cap indexed fund. This fund invests in 1,000 of the largest stocks that can still be classified as small-cap. Many of the stocks in this category will eventually grow to be re-classified into the mid-cap and large-cap groups. While this mutual fund carries more risk than the large or mid-cap holdings, the fund is sufficiently diversified across 1,000 companies, thus reducing the risk intrinsic to investing in small-cap stocks. While we wish to avoid the high risk of investing in individual small-cap companies, we take advantage of the high possible returns of small-caps by investing in this well-diversified fund.

DLN – WisdomTree LargeCap Dividend Fund

Like the Schwab 1000 fund, this ETF also focuses on the large-cap portion of the stock market. However, the WisdomTree LargeCap Dividend fund chooses companies based on their dividend rather than their size. Basically, WisdomTree looks at the total universe of stocks, and then chooses 1,200 with steady and high dividends. Then, WisdomTree takes the top 300 large-cap companies from this list, resulting in a group of well-known companies with high dividend payouts. The fund accomplishes two goals; it includes only large-cap and thus less risky stocks, but it also provides a healthy cash flow due to substantial dividends. Investing in dividend-paying stocks has historically proven to be a winning strategy in the stock market because dividends have historically made up half of the market’s total return. This fund allows us to capitalize on that strategy without exposing your portfolio to the risk of individual companies.

DON- WisdomTree MidCap Dividend Fund

This ETF is very similar to the WisdomTree LargeCap Dividend fund, except it focuses on the mid-cap portion of the market. It operates by again looking at the list of 1,200 dividend-paying stocks, removing the 300 stocks included above in the WisdomTree LargeCap Dividend fund, and then taking the next large chunk of stocks that would classify as mid-cap size. These companies have reliable dividends and the ETF is diversified across more than 600 companies.

DES – WisdomTree SmallCap Dividend Fund

Again, this ETF follows a dividend philosophy, but it contains small-cap stocks from the list of all high-dividend paying stocks. While any small-cap fund is more risky than the mid-cap or large-cap holdings, the fact that these stocks can afford and are willing to pay a dividend despite their small size is a great sign of financial strength. Therefore, we believe this ETF will provide the opportunity to receive income through dividends, reduce the risk that might be present in other small-cap stocks, and potentially make larger gains than are possible with large or mid-caps.

DWM – WisdomTree Dividend Index of Europe, Far East Asia, and Australasia Fund

This is a dividend-weighted fund that includes dividend-paying companies in the industrialized world outside of the United States. It is comprised of over 2,300 companies from 21 countries, including 16 developed European countries, Japan, Australia, New Zealand, Hong Kong and Singapore. As you can see, this is a highly diversified ETF with the intention of gaining international exposure while reducing the risk of adverse events in individual countries. While the fund contains large, mid, and small-cap companies, 70% of the companies are large-cap. Thus, the fund includes the most successful companies from each of the countries. We believe diversifying outside of the United States is a smart idea because it reduces the risk of being invested in only one country, and it also allows investing into foreign markets that are expanding.

EFA – MSCI Europe, Australasia, and Far East Asia Fund

This indexed ETF is very similar to the WisdomTree international dividend fund, however the MSCI Europe, Australasia, and Far East Asia (EAFE) fund includes companies based on size rather than dividends. It consists of companies from the same 21 countries as the WisdomTree fund, but it simply ranks companies based on size and chooses the largest. This fund also avoids emerging markets, and it is well diversified. While we could have chosen to only include the WisdomTree fund or the MSCI fund, we chose to include both a dividend-weighted and capitalization-weighted international fund in our accounts to attain increased diversification and less risk.

EPP – MSCI Pacific ex-Japan Index Fund

This ETF is unique in that it diversifies your portfolio into the Far East pacific regions of the globe. It includes companies from 9 countries: China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. So why does the fund exclude Japan? The simple reason is that the fund is attempting to focus its attention more southward than Japan, but also Japan is included in many other MSCI international funds and this fund provides an opportunity to diversify away from Japan. While this fund is more risky than the very large and extremely diversified global funds listed above, the MSCI Pacific ex-Japan ETF provides an opportunity to get invested into a region that shows great growth potential.

ILF – S&P Latin America 40 Index Fund

So what about this side of the globe? We are diversified in the western hemisphere as well. The S&P Latin America 40 ETF represents major companies from the Mexican and South American markets. The index draws from the four major Latin American countries: Argentina, Brazil, Chile, and Mexico. South America has recently shown great growth, and as these markets become more developed and industrialized, they will grow even more. We chose this particular fund because it includes only the very largest 40 companies from a region that could otherwise be more risky. These 40 companies are the strongest members of their respective segments of the market in Latin America and South America.

SDS – UltraShort S&P 500

The UltraShort S&P 500 exchange-traded fund is one of our most important hedging devices because it seeks to provide the opposite of the S&P500, times two. So, the ETF attempts to protect against losses on your core equity holdings by returning twice the opposite of the market. For example, if the S&P500 moves down 3% in one day, the UltraShort fund moves up approximately 6%. SDS is a great hedging tool during difficult market times because it moves upward as the general market posts losses. SDS alleviates some of the downward pressure on your equity portfolio.

Summary of Portfolio Positions

In response to the difficult economic conditions this year we have made significant changes to our equity allocations. First of all we have greatly reduced our equity allocation overall. Next we have reduced or eliminated the company specific risk by moving away from individual stocks and using indexed ETF’s. Lastly, we have spread our equity exposure around the globe to help reduce the volatility of any one currency.

Of course, the previous equity descriptions do not include the fixed income allocations present in our client portfolios, such as bonds or alternative fixed income. These also serve to reduce volatility and provide income during these difficult times.

What's up in Washington? (February, 2009)

What is really going on in Congress and the White House? In the past year, the word "change" has become the most overly used word in the English language. But what change will actually occur and how will it affect your life? President Obama made over 800 campaign promises... it is impossible for him to deliver on every one of those promises in only four years. But however you feel about the new administration, some things are about to change. I have sifted through the media muck to highlight the probable affects of this new administration and our new Congress. I am pleased to present the top 10 ways Washington will affect you in the next few years:

1) It’s all about the ice cream. Now what does that mean? To explain, I will simply relay a story that I received as an email forward. This story was first told by a teacher in the Nashville area:

"The most eye-opening civics lesson I ever had was while teaching third grade last year. The presidential election was heating up and some of the children showed an interest. I decided we would have an election for a class president. We would choose our nominees. They would make a campaign speech and the class would vote.

The class did a great job in their candidate selections. Both candidates were good kids. The day arrived when they were to make their speeches. Jamie went first. He had specific ideas about how to make our class a better place. He ended by promising to do his very best. Every one applauded. He sat down and Olivia came to the podium. Her speech was concise. She said, "If you will vote for me, I will give you ice cream." She sat down. The class went wild. "Yes! Yes! We want ice cream."

A discussion followed. How did she plan to pay for the ice cream? She wasn't sure. Would her parents buy it or would the class pay for it? She didn't know. The class really didn't care. All they were thinking about was ice cream.

Jamie was forgotten. Olivia won by a landslide.

Every time the government offers ice cream, fifty percent of the people react like nine year olds. They want ice cream. The other fifty percent know they're going to have to feed the cow and clean up the mess."

Unfortunately, this story sums up the first big change coming out of Washington... Some people will get ice cream and the other half will be left cleaning up after the cow.

2) Tax relief for some and pain for others. The Obama Administration plans to keep the estate tax even though it is scheduled to expire in 2010. This will hurt wealthy people, since the wealthy are the ones with an estate to tax. However, the White House has included a series of tax cuts in the $850 billion stimulus plan which you may be able to take advantage of.... a tax credit of $500 per worker or $1,000 per working couple. Those tax breaks would phase out for individuals making more than $75,000 a year and for couples making more than $150,000 a year. The stimulus plan also intends to add $70 billion in tax cuts for middle-class taxpayers stuck paying the Alternative Minimum Tax. And finally, President Obama has expressed a desire to wait to implement his tax hikes on the wealthy, which is a good sign. But the tax increases will come eventually, probably in 2010 once a recovery is underway.

3) Overhaul of the healthcare system. There are so many billions of dollars earmarked for healthcare projects that I cannot even begin to list them now. But in the end, Medicare and Medicaid are set to expand by over $100 billion. Also, the Administration wants all Americans to have access to healthcare... even those with pre-existing conditions. This is equivalent to crashing your car into a tree and then calling Allstate for insurance coverage of that wreck. In reality, you cannot buy an insurance policy on something you have already wrecked... unless it is your body and you are poor enough to qualify for it. The private insurance companies may not be able to afford these costs, so patients with pre-existing conditions could end up on a government funded program.

4) Your energy bill will go down! But this is after $59 billion in spending on energy and our power grid with benefits not being seen until 2011. However, an updated power grid and energy system would strengthen our nation's competitive advantages.

5) A more competitive public school system for our children. Now this is a cause I can get behind. The President has supported pay-for-performance public schools. Our schools would greatly benefit if our best teachers were nicely compensated... because other teachers would find an incentive to work harder and become better teachers too! He also supports the rights of parents to decide which schools their children attend.

6) Breaks for businesses, but mostly for losing companies. While I cannot understand the thinking behind only rewarding those who are failing, I'll take what I can get. The stimulus plan includes a provision to allow money-losing companies to carry current net operating losses back 5 years instead of 2 to reduce tax liabilities in previous years (and maybe get some money back now!) Loss carrybacks are similar to loss carryforwards, except companies apply their net operating loss to preceding years instead of subsequent years’ income. For example, if a company had a loss of $1,000,000 this year but had a gain of $1,000,000 five years ago, the company could apply this year’s loss to the gain five years ago and wipe out the tax liability five years ago. Since the company paid taxes back then, the company should get a refund. The stimulus plan will also offer relief for companies investing in new plants and equipment as well as those hiring youths and veterans. Any stimulus for business is crucial right now.

7) "Cut taxes on all Americans making under $250,000 a year." Not exactly. When the Bush tax cuts expire in 2010, taxes will rise on everyone and probably settle around Clinton-era levels. And the $250,000 number is probably going to be lower, but no one knows exactly what it is going to be.

8) The South becomes the new Detroit. While the stimulus bill has preoccupied most people’s minds lately, I have not forgotten about the bailout of GM and Chrysler. The magnification of such major problems in Detroit served to also magnify the success of car manufacturers in the South. An interesting development that has already been under way in recent years is the South’s new role as host to foreign-owned automobile plants. But foreign-owned does not mean foreign workers, and the car companies that call Georgia, Alabama, Mississippi and other Southern states home employ thousands of Americans. In fact, two-thirds of foreign cars are actually built in the South in nonunion shops where it costs at least $2,000 less to build each vehicle than it does in Detroit. And to make matters worse for the Big Three, GM supports 400,000 retirees while Toyota only supports 700 because the Southern autoworkers are a fairly young population. But there is good news… GM, Chrysler, Ford, and Congress are catching on! The South is the place to be to build vehicles due to a small union presence, lower taxes, and a welcoming attitude towards automobile plants. The South is becoming the new Detroit, which is a boon for small Southern towns that are supported by automobile plants.

9) The government enters the hedge fund business. TARP could be renamed “The United States Hedge Fund” because it would more aptly describe what the bailout money is accomplishing. Hedge funds borrow short, lend long, and hope to make money off the spread between the short and long rates, which has become the government’s new business. While this is the first time the government is truly “investing” directly in securities, neither the government nor the media will be calling it that. Even though we are told that every other spending program in this country is an “investment” in our country’s future, TARP does not get the golden title of “investment” that every other entitlement program gets. Instead, it is an ugly “expense” with the taxpayers footing the bill. In actuality, all of the programs are expenses and we foot the bill for every spending program. But expenses are necessary evils, and hopefully the investment in our banking sector will pay off.

10) The need to dodge traffic cones. The government’s new New Deal includes huge infrastructure spending that won't really begin to affect the economy until 2010. But get excited about dodging lots of traffic cones! From bridges to water slides, construction cones will be everywhere. And that is about the only way the new New Deal will affect you until these projects approach completion in 2011 and 2012. But once they are completed, our infrastructure, particularly bridges, will be much more stable.

It is important to remember that we have elected a president, not a king. Congress makes the laws and The President in fact only has two major powers; the ability to veto and send the troops to war. So, the real success of the Administration hinges on the success of the new Congress and the ability to keep special interests at bay when important bills are proposed. Every single one of the ten points above falls outside of the power of the President, and therefore we should be much more watchful of Congress. President Obama has shown an admirable desire for bipartisanship in Congress, and I think we all commend him for that. He appears to truly want the best for America, and I remain hopeful that he and Congress will make the best choices for our ailing economy and for each of you.

Market Flash Commentary

And Then There Were Two

2008 will undoubtedly be remembered as the year the face of the U.S. financial system was redrawn. With the failure of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America, only two independent investment banks remain in this country – Morgan Stanley and Goldman Sachs.

What began last year as a housing market collapse has spread into every corner of the global financial system. We have previously written about the trickling of housing troubles into the credit market, and the events of this summer are just a continuation of that process. But now, the magnitude of the fallout is a new development.

This month alone we have seen the failure and subsequent takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the sale of Merrill Lynch to Bank of America, and the Treasury bailout of AIG. The ripple effects continue to raise questions about the solvency of Washington Mutual and the viability of Morgan Stanley’s independence.

As much as these events make the world seem to be spinning out of control, the underlying problems can really be distilled down to three areas: complexity, leverage and counterparty confidence. We believe that the housing meltdown was the primary contributor to this crisis, but it was also the catalyst that exposed the weaknesses in the overall credit system.

Over the past decade, the once obscure world of derivatives and hedging has grown to dominate the credit market. Years ago credit default swaps (CDS) were used to insure against financial losses when one company lent money to another. CDS’s gave large lenders the ability to off-load credit risks from their balance sheets. With those risks gone, lenders then had the ability and willingness to make more loans. CDS’s were simply an insurance policy. And like most insurance policies, they were hugely profitable to the issuers because defaults rarely happened.

These profits quickly caught the attention of other financial institutions and the number of contracts grew. In addition, a notional market for these contracts developed so that participants were able to trade these instruments with one another. This created a strong environment of financial interdependence among various institutions. Basically, this is how the credit default swaps market works:

Imagine company A loans money to company B. Company A buys a CDS from company C to off-load the risk that company B will default. C sells this packaged credit risk (or CDS) to company D who buys many other CDS’s thinking that the economy will expand, which will improve the overall default rates and increase the general value of CDS’s. Maybe company D borrows the money to buy these and more CDS’s are created by more companies as a result.

You can quickly see how the fate of everyone involved is connected. Not only do you have to worry about doing business with company D but also anyone else that does business with company D. Company A supposedly offloaded their risk of company B defaulting, but what if the owner of that CDS can’t make good on the contract? Company A, B, C, and D are all in trouble.

Furthermore, when these contracts are created the guarantees must be backed by capital. This capital is used as a backstop should a default occur, and thus the value of this capital is an important component in the transaction. This capital is not cash sitting around. Instead, companies often hold capital in other investments such as bonds.

While this is a relatively simple example, it is easy to see how all these firms become dependent on one another. It also gives some insight as to why the market reacts so violently when one of these participants fail. We have now seen several very large participants in this market go under, which has led to a real and justified lack of confidence in the financial system.

Magnify all of these relationships with leverage, and you have nothing but a recipe for volatility. In many cases these firms’ leverage ratio exceeded 30 to 1. This means that for every $1 in capital a firm controlled $30 of securities. With that level of leverage and interconnectivity in the system, troubles with a limited number of institutions can quickly cascade into a systemic problem.

To be clear, the CDS market does play an important role in an efficient credit system. It is an effective mechanism by which the market can collectively render an opinion on the credit worthiness of companies beyond the traditional credit rating agencies. However, it is a largely unregulated and opaque market with no central exchange.

Fortunately, there is one financial institution which has the full confidence and sheer size to make a difference, and that’s the Treasury. The US Treasury has been called to the rescue more than once for this very reason. Whether the term “bailout” accurately applies in all of these situations, the Treasury has been very effective in putting out the fires over the course of this year starting back in the first quarter when it orchestrated the merger of JP Morgan and troubled Bear Sterns.

The Plan

While fighting fires is important, the Treasury has not addressed the fundamental problems that have kept the markets on edge. Knowing this, the Treasury has announced a plan to essentially remove many of the riskiest securities from the market place.

The details have yet to be finalized, but in general the Treasury will create a fund that will buy these securities at some price to unfreeze the market in these instruments. In essence they will make a market where one no longer exists for an estimated $700 billion in securities. So with this giant group of securities removed from the balance sheets of so many companies, faith will be restored in the capital level and solvency of each counterparty.

The debate over this plan is currently in full swing and as such there is a lot of information being reported that is wrong, incomplete, or misleading. It is also obvious that all but a few politicians, including both presidential candidates, have very little understanding of what is going on. The Fed and Treasury, however, have a very good understanding of the situation.

Let there be no doubt that the numbers being thrown about are extremely large. That being said, it is wrong to say that the government is going to “spend” $700 billion. They are in fact going to purchase several hundred billion dollars of bonds. While a lot of these bonds have bad loans wrapped inside them, the vast majority of these securities are currently performing as expected. No one knows what these things are worth or what the government is going to pay for them, but one thing is for sure; the government will be buying these securities at a steep discount.

This actually presents an interesting situation. Through the treasury market, the federal government has access to the cheapest money in the world. They are going to use those funds to buy income producing securities that are surely yielding higher than the government’s borrowing cost. Ultimately, the level of defaults realized in the future will determine the actual cash flows. But it is very hard to imagine how the Treasury can’t profit from this plan.

The high likelihood that the Treasury will make money on this plan has been downplayed because it is a politically sensitive issue, but it is worth noting that this is the same business model that has made huge profits on Wall Street. The difference is that unlike Wall Street, the Treasury can not get squeezed on the short end and forced to sell. There is a saying on Wall Street that goes, "The market can stay irrational longer than you can stay solvent." That does not apply to the Federal government.

The Blame Game

Plenty of people are plenty mad. Shareholders are angry over diminished portfolio values. Politicians are unhappy about the state of the economy. Homeowners are upset over their declining property values and foreclosures. Now tax payers are being told the deficit is going to skyrocket because “Main Street” is having to bailout “Wall Street”.

This is a huge mess for sure and it has done a lot of harm to the image of our country in the eyes of the global financial community. But there is plenty of blame to go around.

Let’s start with Wall Street. There is blame on two fronts. First, Wall Street has spent years inventing ever more complex financial instruments without fully vetting them in a stressful environment. Not only did companies sell these securities to others but they then held them on their books. Secondly, the risk management department in all but a few investment banking firms had become complacent and incompetent. We suspect the brightest minds are working in private equity and hedge fund firms and not the major brokerage houses.

Next, let’s not forget who took out all of those bad loans and drove up property values to insane levels. You are going to hear a lot of talk in this election year about poor victimized “Main Street.” Actually, this started on Main Street. The mortgage industry merely gave these folks the rope with which to hang themselves. Flipping houses became the new career path for many. Television was full of “flip this house” programming and no money down real estate schemes. Loans were taken out by Joe-next-door lying about his income. To debunk the “poor mistreated Main Street” idea, the increase in foreclosures is in new purchases where the person taking out the loan never could afford the house long-term, the person knew this but did not care, and instead planned on flipping it before they ran out of money.

Finally let’s look at the role of government. This crisis has not been due to a failure to regulate. There are major regulatory changes that need to be made, but mostly the changes need to promote standardization and transparency in new markets. If this mess was due to a regulatory failure, then why is it that the least regulated firms (private equity and hedge fund firms) seem to be holding up the best? On the other hand, the center of the storm is within the much regulated banking, brokerage and insurance industry.

Then there is the issue of home ownership. Politicians have for years been pushing home ownership to the masses, and they have been using their influence to force the lending industry to comply. In hindsight it is becoming clear that there is a group of people out there that is really meant to be renters. Homeownership is not in the Bill of Rights and maybe requiring a substantial down payment and healthy credit is a good idea after all.

I came across a good article in the Wall Street Journal written by Mr. Calomiris, a professor of finance and economics at Columbia Business School. I wanted to share it here because it does a good job of enlightening us as to the government’s role in this mess. Try to remember this when our elected officials express their rage to the media.

Many monumental errors and misjudgments contributed to the acute financial turmoil in which we now find ourselves. Nevertheless, the vast accumulation of toxic mortgage debt that poisoned the global financial system was driven by the aggressive buying of subprime and Alt-A mortgages, and mortgage-backed securities, by Fannie Mae and Freddie Mac. The poor choices of these two government-sponsored enterprises (GSEs) -- and their sponsors in Washington -- are largely to blame for our current mess.

How did we get here? Let's review: In order to curry congressional support after their accounting scandals in 2003 and 2004, Fannie Mae and Freddie Mac committed to increased financing of "affordable housing." They became the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion. In doing so, they stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse.

It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers (a belief that has now been reduced to fact). Thus they were able to borrow as much as they wanted for the purpose of buying mortgages and mortgage-backed securities. Their buying patterns and interests were followed closely in the markets. If Fannie and Freddie wanted subprime or Alt-A loans, the mortgage markets would produce them. By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans. Their accounting had just been revealed as fraudulent, and they were under pressure from Congress to demonstrate that they deserved their considerable privileges. Among other problems, economists at the Federal Reserve and Congressional Budget Office had begun to study them in detail, and found that -- despite their subsidized borrowing rates -- they did not significantly reduce mortgage interest rates. In the wake of Freddie's 2003 accounting scandal, Fed Chairman Alan Greenspan became a powerful opponent, and began to call for stricter regulation of the GSEs and limitations on the growth of their highly profitable, but risky, retained portfolios.

If they were not making mortgages cheaper and were creating risks for the taxpayers and the economy, what value were they providing? The answer was their affordable-housing mission. So it was that, beginning in 2004, their portfolios of subprime and Alt-A loans and securities began to grow. Subprime and Alt-A originations in the U.S. rose from less than 8% of all mortgages in 2003 to over 20% in 2006. During this period the quality of subprime loans also declined, going from fixed rate, long-term amortizing loans to loans with low down payments and low (but adjustable) initial rates, indicating that originators were scraping the bottom of the barrel to find product for buyers like the GSEs.

The strategy of presenting themselves to Congress as the champions of affordable housing appears to have worked. Fannie and Freddie retained the support of many in Congress, particularly Democrats, and they were allowed to continue unrestrained. Rep. Barney Frank (D., Mass), for example, now the chair of the House Financial Services Committee, openly described the "arrangement" with the GSEs at a committee hearing on GSE reform in 2003: "Fannie Mae and Freddie Mac have played a very useful role in helping to make housing more affordable . . . a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing." The hint to Fannie and Freddie was obvious: Concentrate on affordable housing and, despite your problems, your congressional support is secure.

In light of the collapse of Fannie and Freddie, both John McCain and Barack Obama now criticize the risk-tolerant regulatory regime that produced the current crisis. But Sen. McCain's criticisms are at least credible, since he has been pointing to systemic risks in the mortgage market and trying to do something about them for years. In contrast, Sen. Obama's conversion as a financial reformer marks a reversal from his actions in previous years, when he did nothing to disturb the status quo. The first head of Mr. Obama's vice-presidential search committee, Jim Johnson, a former chairman of Fannie Mae, was the one who announced Fannie's original affordable-housing program in 1991 -- just as Congress was taking up the first GSE regulatory legislation.
In 2005, the Senate Banking Committee, then under Republican control, adopted a strong reform bill, introduced by Republican Sens. Elizabeth Dole, John Sununu and Chuck Hagel, and supported by then chairman Richard Shelby. The bill prohibited the GSEs from holding portfolios, and gave their regulator prudential authority (such as setting capital requirements) roughly equivalent to a bank regulator. In light of the current financial crisis, this bill was probably the most important piece of financial regulation before Congress in 2005 and 2006. All the Republicans on the Committee supported the bill, and all the Democrats voted against it. Mr. McCain endorsed the legislation in a speech on the Senate floor. Mr. Obama, like all other Democrats, remained silent.

Now the Democrats are blaming the financial crisis on "deregulation." This is a canard. There has indeed been deregulation in our economy -- in long-distance telephone rates, airline fares, securities brokerage and trucking, to name just a few -- and this has produced much innovation and lower consumer prices. But the primary "deregulation" in the financial world in the last 30 years permitted banks to diversify their risks geographically and across different products, which is one of the things that has kept banks relatively stable in this storm.

As a result, U.S. commercial banks have been able to attract more than $100 billion of new capital in the past year to replace most of their subprime-related write-downs. Deregulation of branching restrictions and limitations on bank product offerings also made possible bank acquisition of Bear Stearns and Merrill Lynch, saving billions in likely resolution costs for taxpayers.

If the Democrats had let the 2005 legislation come to a vote, the huge growth in the subprime and Alt-A loan portfolios of Fannie and Freddie could not have occurred, and the scale of the financial meltdown would have been substantially less. The same politicians who today decry the lack of intervention to stop excess risk taking in 2005-2006 were the ones who blocked the only legislative effort that could have stopped it.

Market News

Investing in Turbulent Times

As everyone knows, investors have faced an extremely challenging investment environment over the last twelve months. The confluence of higher inflation driven by energy costs, the still unresolved credit crisis, and election year politics has left many wondering “where to from here?” If you compare the global financial markets today to the financial environment ten years ago, today’s markets are substantially more interconnected and complex, which means that situations change at an amazing and sometimes alarming rate.

“Where to from here?” is a question with an answer somewhere in the tangle of hedge funds, leverage, swaps, CDO’s, quantitative finance and the like. But anyone who says that they have the answer to this question is kidding themselves.

As most people now know, the investment community’s capacity to anticipate the timing and triggers of financial shocks is virtually nonexistent. The last nine months has further supported that reality. Attempting to avoid a market downturn is just as risky as missing out on the gains. The only game in town is to ride it out.

To be sure, contemporary finance has become incredibly complex and there is no safe asset class. Admittedly, there are asset classes that do have stable values. But in a world of properly priced risk, good luck maintaining your purchasing power with their meager returns. This is a tangible problem. For example, go to the gas station or the grocery store and imagine the adjustment that you would have to make on a static income. This is especially true as we live longer in retirement. Prefer a CD? Then you must consider the long-term solvency of your bank. Risk is everywhere in life and it’s unavoidable. The trick is to find the right risk for you.

Risk is an interesting word that means different things to different people. For some, it refers to the potential of losing money. For others it means risk of not meeting goals, and still to others it could mean variability of returns. The classic definition of risk generally refers to the latter. But like you, we live in the real world and realize that it means all of the above. In times like these, risk assessment is very important and we take it very seriously. Be assured that we are always looking for ways to minimize any of the risk your portfolio might face.

The Lost Decade

We have all been told that stocks provide the best long-term investment returns. This is not an academic argument but in fact a historical truth. The only problem with this statement is that the definition of “long-term” is poorly defined.

A case in point is the last ten years. The approximate return of the S&P 500, which is widely viewed as a proxy for the U.S. market, is roughly 1.5% per year for the last decade. That’s right. Over the past ten years stocks have returned roughly half of money market rates. Adjust this for inflation and the true return is just short of zero.

So when does this faith in the equity market payoff? How long is “Long-Term”?

Rules of the Road

The current turbulence serves to remind us to expect the unexpected. The economy, both domestic and global, is always changing and with that goes the investment landscape. Such changes require that an investor live by a set of rules to help guide investment decisions during the occasional and inevitable market downturns. As a firm, we are no different. While we may not have a rigid and inflexible doctrine, we do follow certain standards when we invest your money. During these unusual times, we think it to be wise and useful for you to take note of some of the rules we think are important.

Market Timing
History has shown us that it is difficult at best to correctly guess market movements over the long run. Therefore, it is best to have a plan and stick with it.

Stay Invested
In turbulent markets it is critical to remain calm. One must avoid the temptation to panic and sell in such times. The goal is to “buy low and sell high,” not the other way around. Patience is a key attribute to have in volatile markets. If you have faith in the resiliency of the economy, the fundamentals will eventually present themselves and you will be successful.

Diversify
Diversification is a time tested rule. Live by the old saying: “Do not put all of your eggs in one basket.” This concept is a key risk reducer. By spreading investments into many companies, countries, and sectors, you effectively spread your risk. This is what asset allocation accomplishes. As you know, for each client we maintain a unique allocation to various asset classes such as domestic stocks, international stocks, large and small caps, fixed income bonds, preferred stocks, and cash. The goal is to invest in different markets, thus reducing the chance that all of your investments will go down at the same time.

Re-allocate
This concept is tied to asset allocation. Once your mix of assets is established, you must periodically rebalance the portfolio to get the asset allocation levels back in line. Different assets will grow at different rates. Therefore, by re-allocating your investments you are in effect selling this year’s higher performers (selling high) and buying the lower performers (buying low). Historically, these actions result in long term success.

“Cash and Cash Flow is king”
Having readily available cash is more important than ever during times like these. For those in the accumulation phase, having cash available when the market is going down gives us a chance to invest at lower prices. This is very similar to going to a department store and feeling excited when you bought something that was on sale rather than at full price. For those in the distribution phase, i.e. retirees, we always have a certain amount of cash available for everyday needs. Having additional cash available prevents selling assets at the wrong times to cover any cash needs that may arise.

Our clients should be accustomed to our talking points about cash flow. For any investor, maintaining investments that produce cash flow is critical. If our goal is the growth and protection of wealth then the production of cash flow should be paramount to success.

Controlling the Controllables
We feel it is smart to avoid worrying about those variables you cannot directly control, such as market movements. Instead, we focus energy on those issues we can control, namely expenses and taxes. We employ strategies that give our investors the ability to influence each of those variables. By using low cost index funds and individual securities, we keep a tight lid on ongoing investment expenses and control the timing of taxes. Additionally, we utilize loss-harvesting strategies to minimize the taxes on future realized gains.

In Summary

We want everyone to take a deep breath and relax. We have to put these markets into historical perspective. A long term investor must expect troubled markets to occur every so often. It is perfectly natural to feel both nervous and cautious. In fact, in good times and bad, we are always cautious in our investment decisions. The main point we want to stress is that it is unwise and unhealthy to worry too much about everything. Leave the worrying to us. We will always do what we think is best for your accounts.