INTRODUCTION

The lead article of the fall Otto & Associates Newsletter centers on our view of the future prospects for both the stock and bond markets. This may be a different perspective from ones you are likely to read in your newspaper. The second article makes an important distinction between the economy and the markets, a difference not often highlighted which we think is important for investors to keep in mind. The final two articles include a reminder that now may be a good time to refinance your home, and some of the important considerations to keep in mind before purchasing long term care insurance. We conclude with several office matters.

 

WHAT'S AROUND THE CORNER?

Does it seem like the markets are changing direction every other day? Are you often confused about whether the trend is up or down? Did you notice that pundits who said discouraging things about the market in early 2009 changed their tune later last year, only to return to being cautions again three or four months ago? And today (Sept. 18) there is another decrease in pessimism, if not actual optimism, in the air. What is going on?

A useful way to see this extended period is to view it as an inflection point. While an inflection point sometimes refers to a very specific event (the fall of the Berlin wall has been described as an inflection point in global politics), it can as well refer to a longer period. The Great Depression may be seen as an "inflection point," even though it was a nearly ten-year period. An "inflection point" can be viewed as a positive, negative, or a mixed juncture, but one that invites us to pause as we go forward. We will argue that the current situation in the markets is largely positive for investors if they recognize that ongoing investment adjustments may be required.

During the past 10 years, investments in the stock market have performed in a quite unusual way. Two significant downturns occurred - from March of 2000 through March of 2003, and from November of 2007 through February of 2009 - in which the stock market lost more than 45% each time. Even with a gain in 2009 of 27% - something that no one projected - the return for the decade was 0%. And in 2010, we have had additional excessive choppiness, which included a 13% loss in eleven weeks ending in early July. Such an extended period of positive and negative returns may indeed signal a turning point. We will explain why we believe this will be positive for stocks, after examining bond market history, specifically long-term U.S. government bonds.

If we take a broad look at long-term government bonds from end of World War II until the present, we will see two distinct trends. From 1945 to 1981, interest rates for bonds went steadily upward, and the price of bonds went steadily downward. During this period bonds had mostly positive returns. However, after accounting for inflation, the returns were largely negative. For the entire 36 year period, bonds returned an annual rate of 2.2%, while inflation was 4.6%, resulting in an annual inflation-adjusted return of -2.4%. The direction of both interest rates and the value of bonds changed in the early 1980s, starting the second distinct trend. And while there is always unevenness year to year, for the last 28 years (1981 -2009), bonds have largely had positive returns in excess of inflation, often by significant amounts. For this 28 year period, long-term government bonds have returned 10.2% while inflation has been 3.2%. That means bonds have returned a real, inflation-adjusted return of 7.0% per year!

Even though bonds have been relatively stable and rewarding in recent years, the high returns are unlikely to continue. The reason bonds made money for 28 years is straightforward: when interest rates fall, bonds make excessive returns. The interest rate on long-term government bonds in 1981 was 11.6%. The interest rate in 2009 was 3.5%. The result was that during that extended period, the price of bonds and bond funds continually went up.

But interest rates on bonds will not go down indefinitely, and when they begin to rise from these very low rates, bond holders will not do well. An illustration may help. Were bond rates to go from 3% to 4%, a buyer of bonds would have a choice: to buy a new bond at 4% or an older bond at 3%. The only way the buyer would consider the 3% bond would be to buy it at a reduced rate, thereby in effect getting a higher interest rate. Specifically, if he could buy a $1,000 bond paying 3% for $750, it would yield 4%. The combination of low interest payments on the bonds that are held, along with a declining value in the bonds because of rising rates, can easily result in losses.

If this idea that the realities of today's markets have led to an "inflection point," with the stock market set to increase in value over time, and long-term government bonds likely to decrease in value, we need to look carefully at the implications for investors. With this scenario, the holders of long-term U.S. government bonds will likely lose money, at least on an inflation-adjusted return, for reasons spelled out above. Likewise, the "inflection point" we envision has implications for stock investors. While the various media have carried a lot of bad news recently, many companies are making a good deal of money. In addition, if investors sour on the bond market, some of them are going to begin to put some money back into the stock market. When that happens, it could drive up the market quickly. We have written in the past about the way stocks can tumble on nothing more than negative investor sentiment. The reverse can also happen. The last ten month period of 2009 is an example.

We anticipate that today's trend might be most difficult for retirees who have most of their investments in bonds. They had gotten used to bonds that paid a quite favorable interest rate and at the same time increased in value. Retirees invested primarily in bonds, and who have already experienced difficulty in this low interest rate environment, are likely in for additional difficulty when they also see their bonds and bond funds losing value.

While we are just beginning discussions with our clients, very few of whom have a high bond allocation, we anticipate that we will start reducing some of their bond investments. We will also consider increasing exposure to foreign and/or emerging market bonds, since those markets have quite different histories and characteristics from the bonds discussed in this article.

Additionally, we will look for investment opportunities that are unique to the current situation. To that end, we at O&A have kept our eyes open for non-traditional investments that don't move with stocks and bonds, including private placements, investments not traded on the stock exchange because they are too small for that marketplace. We believe there are particularly good values in some real estate assets where cash is needed to refinance debt, to upgrade foreclosed properties that banks have let slide, or to finish building properties that have gone through bankruptcy and can be purchased for a small fraction of the original price. In this environment, the traditional sources for lending (often banks, but also insurance companies and others) may be completely out of the lending business. This is part of the ongoing credit crisis. We have a relationship with two particular real estate investment companies which have found potentially good values in the past and we expect to do more investing with them in the future. These investments are generally offered to clients who meet a certain minimum net worth. More information is available by contacting O&A.

Investing at inflection points is never easy. It always involves exploring a variety of options, being open to new opportunities, and being able to sit tight through volatility. But we are optimistic that stocks and stock mutual funds, as well as private placements of both equity and debt, are likely to appreciate in value in the next few years.

Thoughtful investing requires much more than reading the headlines. In fact, it often means re-contextualizing investment strategies.

 

THE ECONOMY VS. THE MARKETS

Many people today do not distinguish clearly between the concepts of the economy and of the stock market. The two are very different and they can "perform" very differently. The economy can be in difficulty, as it is now to some extent, and the market can, at the same time, be robust.

An understanding of the economy emerges from observations about important statistics, such as the Gross Domestic Product (GDP), inflation, per capita income, the unemployment rate, and a host of less well known statistics, such as what a country produces per capita. Definitions of the economy include phrases like "the careful and thrifty management of resources, such as money, materials, and labor." All of the statistics for the U.S. economy are designed to reveal how efficiently various resources are used.

The stock market is quite different. Technically, the stock market is the exchange where shares of stock of publicly traded companies are bought and sold. More colloquially, we make reference to the stock market as the aggregate price of a representative group of stocks (e.g. Dow Jones Industrial Average, the S&P 500 Index, or the Wilshire 5000 Total Stock Market Index). With the stock market, attention is paid to whether the numbers associated with one of the indices or averages goes up or down. The economy will have an indirect effect on the increase or decrease in the market indices or averages, but investors need to be clear not only how the economy can affect the market, but also why and how the market can move independently from the economy.

With regard to the economy today, there is an ongoing focus on the discouraging unemployment numbers. What does not get as much attention is some of the numbers that are more encouraging. Without getting into a long explanation, the U.S. GDP is actually doing reasonably well, even while unemployment seems locked in at something close to 10%, with predictions that it will not decrease appreciably for some time. Americans are also concerned about global trade, per capita income, and the balance of income between the rich and everyone else. Still the primary economic concern that is oozing over to affect the market seems to be the depressing information on the unemployment rate.

Now, having acknowledged the effect that perceptions of economic realities can have on market performances, it is important to notice as well that markets can act more or less independently of economic trends.

Benjamin Graham once said that "In the short run, the market is a voting machine but in the long run it is a weighing machine." We might translate that to say that while the stock market in the short-term may be unduly influenced by the mood of investors, in the long run it goes up or down to the extent that companies make money. The short term can sometimes be many months, but ultimately whether companies make money determines the direction of the stock market.

Unfortunately, there is little ability to forecast with certainty when profits will become the factor that moves the market. Thus it is important for investors to stay in the market. because investor sentiment, as witnessed particularly this calendar year, can change quickly.

Companies themselves can also play a role in turning the market around. Do you remember when the term "lean and mean" was first introduced to describe companies in the U.S.? While the phrase may have come into vogue more than twenty years ago, it sought to highlight a shift that corporations made from being paternalistic by taking care of their employees and not laying off more people than absolutely necessary during downturns in the economy. The "new" lean and mean paradigm includes closely monitoring customer needs and desires and when there is less demand, making changes quickly. Overtime pay is cut back, the number of shifts is reduced, people are laid off, and inventory is not allowed to build. Our companies today, as a whole, are very much in the "lean and mean" mindset. The result today is high unemployment, limited wage increases, and very low inventories, to mention three of the most obvious realities. That way of doing business can mean that companies will respond quickly to challenging times and show increasing profits. While profits are increasing, this year's stock market prices have yet to reflect the fact.

The Depression provides a useful illustration of companies making money when the economy is in difficulty. While investment returns during the first few years (1929 - 1932) were abysmal, long term returns beginning in 1933 and through the balance of the Depression were generally positive. If you invested money at the beginning of 1933, you would have made annual returns in excess of 11% in the next 8 years.

Investors need to recognize that markets can make money even when the economy is not doing well. The confusion between the market and the economy that is promulgated in the media and in discussions around the water cooler at work is unhelpful. We are staying invested in the stock market so that when prices increase, we will be ready.

 

TIME TO REFINANCE?

The amount that banks charge for interest on home mortgages is at historic lows. Recent rates for a 15 year mortgage have been at 4.125% with no points. Thirty year rates are about .5% higher at 4.625%. A 15 year, fixed-rate mortgage has monthly payments of $746 per $100,000 borrowed. We recently helped a client get such a mortgage. The total borrowed was $417,000, and the new monthly payment is $3,111. While calculating the total savings over the life of the loan is difficult, the client will save $1,050 per month on a cash flow basis.

For those who have adjustable rate mortgages of home equity loans that will not be paid off in the next 1 - 3 years, this is a particularly good time to refinance. Although the interest rate on such mortgages may be low now, there is considerable risk that it will go higher - perhaps much higher - in the future. Today it is possible to lock in historically low costs for the duration of the loan.

While there are always considerations beyond the interest rate, if you or someone you know has a rate of 5% or higher, you should think about refinancing. We are happy to discuss the options available and their pros and cons.

 

LONG TERM CARE

Nearly all of us are intimidated at the potential expense involved in getting old. People observe that it could cost $100,000 or more a year for a nursing home. Such an observation may be followed by a thought that buying long term care insurance is essential. With those kinds of costs, what is there to lose?

We at O&A recognize that there are genuine concerns about the whole issue of paying for care if one is unable to care for one's self or one's spouse. We also know that people often think of long term care (LTC) insurance as a ready solution to this worry. However, in order to evaluate the need, we begin at a different point. On average, we all lose money on insurance policies. Insurance companies cannot pay out more than they take in and still stay in business. They not only have claims to pay, they have broker fees and other expenses required to run the company. We begin with the assumption that it is likely that we will lose money on nearly all insurance purchases.

As an example, many of us have paid a lot of money to insure our home over the years. Even so, nearly everyone seems to agree that paying one or two percent of the value of the home and its contents to guard against the risk of a total loss is well worth the money. Term life insurance, for families where the death of the breadwinner(s) would be catastrophic financially, is also generally considered a wise way to spend some of the family money.

However, the circumstances may be very different for a family thinking of buying a LTC policy. Such a policy is not bought to protect an asset, nor is it bought for income replacement for the family, as with life insurance. It also should not be purchased as a way to turn small premiums into large cash payments at a later date. While that can happen for some people, it does not happen for the average person.

There is also the issue with LTC insurance of looking very far into the future, which is always a problem. You buy a homeowners' policy for one year at a time and have the ability to change the terms of the policy as needs change. In buying a LTC policy, it is assumed by both the insurance company and the purchaser that it is very unlikely that you will collect any money in the first year - or even the first five or ten years. There is a many year commitment implied in purchasing a LTC policy, with little or no ability to change the terms, and both add to the dynamic in evaluating whether or not it is right.

The basic questions in considering LTC have to do with running out of money.

1. Is the person married and would long term care expenses risk the financial well- being of the healthy spouse?

2. Does the person consider it very important that certain assets are protected to leave as a legacy to heirs or charity?

3. If either of the above questions is answered yes, then the next question is: Is the person willing to pay the price in modestly diminished resources to avoid the risks inherent in the previous two questions?

There is also a related question of money that may be available to support LTC with reduced insurance coverage, or no policy. Resources are likely to be freed up to support a person in a care facility because a number of expenses disappear when a person moves out of his house. The new care facility resident would normally spend very little money beyond the monthly fee at the facility. Such a person does not normally go out to dinner, buy expensive clothes, spend money on automobiles, or take expensive trips. While medical expenses will go up, much of that could be covered with health insurance. In calculating whether a person may run out of money, or not have enough money for the healthy spouse to live comfortably, diminished spending needs should be included in the mix.

There need to be clear answers to all of these questions and they may well involve other people: a spouse, children, a charity which might suggest other ways to leave a legacy, a financial planner to make calculations, etc.

In addition to considering LTC insurance as a way to pay the expenses involved in aging, you should also think about these options:

1. To self-insure. While LTC is expensive, a number of normal expenses will likely go away, particularly for a single person who would no longer need a house if she enters a care facility. Couples can also self-insure, but the cost of maintaining a home will not be significantly reduced if one person enters such a facility.

2. To consider a Continuing Care Retirement Community (CCRC). There are more and more of these facilities around and if you can afford to go into one and think that would fit your lifestyle, you do not need a LTC policy.

3. To use Medicaid as a back-up. For a variety of reasons, this is not a likely option for most of our clients. There are a number of requirements to qualify and they vary from state to state. But if you have money available (whether you self-insure or have a LTC policy), can pay for up to five years of care, and then run out of money, Medicaid will generally step in. While the majority of people who enter a care facility do not live more than three years, Medicaid may be an option for those who live a longer time in such a facility.

If this article has focused more on the reasons why not to buy a LTC policy, that is so because most of what we read seems to be focused on why to buy such a policy. There are definitely those for whom buying a policy is the right decision.

If you ultimately decide that you want a LTC policy, it is useful to shop around. Get more than one proposal and consider carefully the many options. Consulting with O&A, financial planners who have no vested interest, is often useful.

While we have sketched out the considerations above, a client's unique circumstances will provide the most relevant factors in charting a course toward proving adequate financial resources for the future.

 

OFFICE MATTERS

CONVERT NOW? For the first time, there are no income restrictions on those wishing to convert an IRA to a Roth IRA. We are in the process of reviewing each client's situation to assess whether it is advisable for an individual or a couple to convert some or all of an IRA. We will be in touch with you if we think it is at least a topic worth discussing with you, and we would welcome your questions.

CLASS ACTION SUITS: Many of our clients have received notice of class action suits brought against Janus, Columbia, and a number of other companies. We have been investigating whether there is any likelihood of actually collecting on the claim and will contact you if completing the paperwork would be advantageous. For most of our clients, there will be no award from this recent group of mailings, because money awards below a certain threshold (often $50) are not processed.

TAX RETURNS: If we don't have a copy of your 2009 tax return, please send it to Kathy Patton in our New York office. If your accountant can email us a pdf file, this is preferable.

PERSONNEL: Deborah Maher and Judy LaPorta plan to attend the Baron Funds investment conference in October, as they have for years. Most of our clients own a Baron mutual fund and, if you do and would like to spend an informative and fun (with big name entertainment) day in NYC, go to their website www.baronfunds.com for information or to register. Also in October, Deborah plans to volunteer again for the Financial Helpline. David will attend the Regional NAPFA conference in Boston the first week of November.

Susan Otto Goodell is in the final stage of the process to qualify for her Certified Financial Planner designation. She will take a preparatory class in Denver from Oct. 18 - 22 and then sit for the exam three weeks later. We are keeping our fingers crossed.