BURT ASSOCIATES, INC.
6010 EXECUTIVE BOULEVARD #900-ROCKVILLE, MD 20852
(301) 770-9880 FAX (301)
770-9885
Volume 13 Issue 1 www.burtassociates.com
August 2003
THE ECONOMY AND
THE STOCK MARKET
By
Dr. Marvin R. Burt, CFP®
This has been a very volatile year for the economy and the U.S. stock market. We have fought a war, witnessed continued malfeasance by corporate officers, experienced a slowly growing economy, and are in the process of stimulative fiscal policy in the form of tax cuts at the Federal level, have been buoyed by a remarkable run-up in U.S. stocks, and interest rates have fallen dramatically then spiked back up. What do these and other things portend for investing?
The picture is very much mixed, though encouraging. While the economy has been growing, the growth is slow and unemployment has gradually increased. Profits are improving significantly. However, the improvement is primarily related to increasing corporate efficiency, not top line revenue growth. In other words, sales are not expanding significantly for most businesses. The main reasons why profits are improving are related to continuing improvements in productivity, reduction in corporate debt, lower interest rates, write downs over the past several years, etc. Because businesses are not expanding and productivity is improving, employment is not expanding, thus the continued high unemployment rate.
The U.S. stock market has experienced double digit returns this year. The question on our collective minds is the extent to which this is sustainable. The stock market has come so far so fast that one would normally expect a “breather” and the market would essentially mark time or move downward while waiting for news that would drive it up or down. And there are some positive factors that could help to drive it up. The Federal Reserve again lowered short-term interest rates. The Federal tax cut should provide some stimulus to the economy. However, a significant part of the stimulus will be offset by higher taxes at the state and local levels. Another positive is that returns on alternate investments, such as bonds and cash, remain at historically low levels and dividend and capital gains taxes have been reduced significantly.
Inside Periodic Meetings: A Wealth of Information
Page
2 Does It Pay to Invest in International Stocks?
Page
4 Fees in 529 Plans
Page
5 Another Year, Another Tax Act
Page
7
Negative factors include continuing geopolitical uncertainties, concern about deflation, continuing concern about corporate malfeasance, and the quality of corporate profits, as noted earlier.
What is really needed for the stock market to continue its upward climb is continued improvement in corporate profits. Based on the price/earnings ratio, using projected profits, the stock market is not cheap at its present level. We need economic expansion with improved top line corporate revenue growth to stimulate the stock market. In the absence of this development, we run the risk of inflating another “bubble” with possible consequences of which we are only too aware.
What are the implications of all of this for investments? We continue to advocate substantial diversification among major asset classes: U.S. equities, foreign equities, high quality bonds and cash equivalents. We expect to outperform other assets for the foreseeable future. However, other asset classes cannot be ignored because we need to control risk.
We are very pleased at the performance of our portfolios. During 2002, we again performed better than the markets in stocks, bonds and cash equivalents. We recently completed a bear market analysis of all our portfolios for the period March 31, 2000 (approximately the stock market peak) to June 30, 2003. During this period, our portfolios declined on average 0.5% per year. In contrast, the NASDAQ Composite Index declined more than 27% annually and the S&P 500 Index declined more than 11% annually. During this period, the Thompson Balanced Global Mutual Fund Index declined nearly 7% annually. We are very proud of this accomplishment during the worst stock market performance in more than 40 years. It proves that we were remarkably successful in protecting our clients’ capital during this dismal period.
PERIODIC MEETINGS: A WEALTH OF INFORMATION
By
Fred Cornelius, CFA, CFP®
From time to time, some financial advisers meet with clients simply to review their investments. At Burt Associates, Inc. (BAI) we use this opportunity not only to provide our clients with investment and performance information, but to explore and make recommendations on all aspects of their finances (e.g., managing cash flow, mortgage refinancing, home sales, inheritance, long-term care decisions, etc.). As our current clients know, their BAI adviser comes to the meeting prepared with a comprehensive agenda of items to discuss. This agenda could be thought of in three parts; 1) the past, 2) the present and 3) the future. The agenda, talking points and subsequent discussion often uncover opportunities to make changes and implement strategies to further achieve your goals and objectives.
“The past” is a summary of what has happened in the client relationship since inception. This part is much more comprehensive than a performance recap. Some of the topics that would be discussed here are initial and revised client goals and objectives, changes in risk tolerance, and, of course, investment performance over various time periods. We often discuss past economic conditions to highlight prior transactions and strategy. This enables us to illustrate the significant ongoing benefits of monitoring the portfolio so that it is consistent with client expectations and risk tolerance. Ongoing reevaluation of risk tolerance has been one of the most important factors to our success during this most recent bear market. This has enabled our clients to preserve or grow their capital while being able to “sleep at night.” In this section, we may also review notes and pending items from prior meetings, economic reviews and portfolio changes and rationale behind prior transactions.
“The present” is where we discuss your current portfolio, cash flow needs, retirement planning, tax planning and estate planning needs to name a few. We consider all of the above factors (based on your feedback on the client questionnaire as well as our verbal discussions during this and prior meetings) to revise the strategy and implement transactions to address these issues. We also take this time to look for opportunities to provide educational material and insight on any financial planning issues that seem to be pertinent to your specific situation. In this section, we may also review IRA beneficiaries, asset values for estate purposes, asset allocation vs. a model (commensurate with risk tolerance), etc.
“The future” is where we convert any previous discussions or present conditions into well-defined action items. Some of these items involve the client taking some action while others may be tasks for the BAI adviser to complete. In any event, the tasks are recorded into our contact management system as pending items until they are completed by the client and/or the adviser. This system of tracking all open items is specifically designed so that any important items that are discussed are addressed. Our advisers prepare notes from each meeting that highlight important aspects of the discussions and decisions made and provide a list of action items to be completed. We also review pending issues being discussed by our investment committee, anticipate how we may react to various economic scenarios, and highlight securities we are evaluating for possible purchase or sale and how such transactions will benefit you.
We receive constant feedback from our clients because they really value our meeting and follow-up system. We have been told this is quite rare in today’s environment of diminished client service. While this type of follow-up is quite time-consuming for us, it enables your advisor to perform their job at the highest possible level. The bottom line is that our system results in better wealth management for our clients and is thus well worth the extra time and effort.
In addition to competitive performance, we are convinced that our disciplined systems and procedures are a big reason why our firm and advisors have received many professional awards over the years. If you know of someone who would be interested in this type of exceptional client service, please contact your adviser.
DOES IT PAY TO
INVEST IN INTERNATIONAL STOCKS?
By
Maria G. Cornelius, CFP®
In our opinion, the answer to this question is yes. It has been difficult over the past several years to have both international and domestic stocks dropping at the same time. Over the past several decades, the correlation between the U.S. and International markets has ebbed and flowed. These markets have the highest correlation during market downturns, global shocks and periods of globalization. We believe that the high correlation over the past several years is largely due to the effect of the bear market. Over a longer period of time, foreign stocks have frequently outperformed the U.S. stock markets.
You may be surprised to know that between 12/31/00 (before the market downturn occurred) through 6/30/03, the Morgan Stanley EAFE Index (a broad index of foreign stocks) outperformed both the S&P 500 (slightly) and the NASDAQ. In 2002, the EAFE outperformed the Dow Jones Industrial Average, the S&P 500 Index, the NASDAQ, the Russell 2000 (small stocks) and the Wilshire 5000 (large, mid and small stocks). Our clients who have been working with us since 1993 will recall that this was the year that the international stock funds were up 40%+ and the US market was limping along. In 1999, international stock funds outperformed the other asset classes as well.
Only part of the reason that we invest in international funds is related to enhancing performance. The other reasons have more to do with reducing portfolio risk through diversification and exposure to markets outside the U.S. By investing in only U.S. stocks, you eliminate more than 50% of the world stock market capitalization. You are also limiting your exposure to some of the world’s fastest growing economies and the world’s global industry leaders. In addition, no one knows what the future will hold. We feel that it would be a mistake to exclude international investments.
Our four international stock funds are quite varied by design. In one, the portfolio manager concentrates on undervalued sectors and companies. In another, the managers focus on the fastest growing sectors and industries. Though a significant percent of assets are invested in large companies, there is a certain percent invested in mid to small companies, which we believe is wise. We have always avoided regional funds or sector funds since these investments tend to be very volatile. All of our funds are spread among many countries and industries.
We will continue to watch the correlation between the U.S. and International markets. Although we are likely to change our allocation at some point, it is unlikely that we would ever eliminate foreign stocks.
FEES IN 529 PLANS –
ARE THEY THE CRITICAL DIFFERENCE?
By
Chris Rhim, CFP®
An April 6 article in The Washington Post was critical of many state 529 college savings plans for the fees they charge investors. We feel that there are several factors, other than fees, that need to be considered as well.
The investments within all 529 plans are managed by large institutional players such as T. Rowe Price, Vanguard, TIAA-CREF and Fidelity. However, the author claims, states such as Utah (Vanguard) and New York (TIAA-CREF) benefit from lower management fees and fund expense charges. The range of expense ratios for the Utah, New York, Maryland, Virginia and D.C. plans are listed below:
*Expense Ratios
Utah 0.00% to .75% (0.00% for Money Market/Public Treasurer’s Investment Fund )
New York 0.65%
Virginia 0.85% to 1.00%
Maryland 0.84% to 1.18%
D.C. 1.04% to 2.01%
*The range of expense ratios for all fund options, plus any management or administrative fees.
Source: Money Magazine (May 2003)
The article claims out-of-state investors who invested in the Utah and New York plans and paid out-of-state income taxes on the earnings would still end up with more college. In addition, while MD, DC, and VA residents receive state income tax deductions on contributions to their own state plans, the authors charge this is not nearly enough to compensate for differences in annual expense charges.
Is this criticism justified? The answer depends upon investor expectations and what the investor hopes to achieve in terms of total return. Lower fees are justified on index funds such as Vanguard Institutional Total Bond Market Index and Vanguard Index Fund Plus Shares in the Utah plan. These are passively managed funds, which are designed to track the Lehman Brothers Aggregate Bond and S&P 500 Index respectively. The Lehman Index is an unmanaged index generally representative of intermediate-term government bonds, investment grade corporate debt securities and mortgage-backed securities while the S&P 500 is widely regarded as the standard for measuring large-cap U.S. stock market performance.
Fund managers of index funds are limited to issues within the index. Expenses are lower because turnover is very low. This can handicap any index fund when there is a market shift away from one asset or asset class to another. While investment grade bond and large-cap stock index funds have many desirable characteristics, the Utah plan offers no other investment choices except for a cash trust fund. Since education funds can be invested for up to 18 years, it is important to have a number of options, which will expose the investor to a variety of asset classes and investing styles in an ever-changing investment world.
The New York savings plan is similar to Utah’s plan in that it too offers funds, which mimic both the Lehman Aggregate Bond (TIAA-CREF Institutional Bond) and Russell 3000 (TIAA-CREF Institutional Equity Index). There is also an enhanced growth index fund and one international index fund based on the EAFE Index (a popular foreign stock index). Essentially, the New York plan offers 3 large-cap US growth funds, 1 international and 1 bond fund. What is missing in these two states’ plans is more style (growth – blend – value) and capitalization (small – medium – large) diversification. While indexing has its place and may be suitable for many investors, passive strategies may be inappropriate for others with differing risk tolerance and total return expectations.
In contrast, the Maryland 529 plan offers a variety of age-based portfolios as well as fixed portfolios. The six equity funds include options in enhanced growth, the S&P 500, mid-cap, small-cap, value and international stock funds. The bond funds are also diversified including international, US Treasury, GNMA, high-yield, short-term, equity income as well as a few more options. A variety of funds with more investment choices are important for better diversification and changing market conditions.
Investment
in any state 529 plan should occur after careful consideration of many complex
factors. Most in-state plans have the
advantages of deductible contributions and no taxation of earnings. Recently, Illinois, Maine, New York and
Tennessee have passed laws taxing investors on earnings and withdrawals if they
choose to use out-of-state plans. Also,
if a Tennessee resident owning a non-Tennessee 529 plan dies, the plan will be
considered part of their taxable estate.
This taxation trend will likely continue as mounting state budget
deficits put pressure on governments to seek all available revenue sources.
Expense ratios, investment options, manager experience, time horizon, risk
tolerance are but a few important variables which should be examined in detail
before deciding how to cover the cost of a college education. Indexing does cost less but in the end you
may end up with exactly what you pay for.
Note: On 8/1/03, the state of New York announced it would replace TIAA-CREF. New York residents who withdraw their money within 3 years of opening an account pay a 10% penalty on earnings[1]. New York residents who leave the state plan will have to pay state taxes on any earnings. Effective in 2003, those who switch will also have to repay any tax savings on their deductible contributions[2].
ANOTHER TAX YEAR, ANOTHER TAX ACT
By
Christine D’Amato, CFP®
On May 28, 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). This new tax act includes reductions in marginal tax rates, reductions in tax rates on capital gains and dividend income, increases in child tax credits, and accelerated business and equipment deductions.
Retroactive to January 1, 2003, marginal income tax rates drop. The highest rate of 38.6% drops to 35%, the next highest rate of 35% drops to 32%, 30% drops to 28%, and 27% drops to 25%. The lowest marginal bracket of 10% is expanded as well but for only two years. In addition, the child tax credit jumps from $600 to $1,000 per child this year. Taxpayers affected by this can expect to receive a check in the mail.
Dividend income from qualifying corporations will now be taxed at a maximum rate of 15% (with lower brackets paying 5%). Previously, dividend income was taxed at the individual's marginal rate, which could run as high as 38.6%. Note that most REIT income does not qualify for this lower tax rate.
A surprise provision of this tax act was the lowering of the capital gains tax rates. Effective May 6, 2003, most taxpayers will pay 15% tax on capital gains (was 20% before). The lowest income brackets will now pay 5% for capital gains instead of 10% or 15%.
The effect from these changes for taxpayers this year alone can range from tax savings of several hundred dollars (about $500 for single taxpayers with household income of $63,000) to several thousand dollars ($3,000 or more for household income of $170,000). Businesses can save many thousands of dollars in taxes due to increased business expensing and depreciation rules.
Several planning tips to consider under the new tax law:
1. Review your estimated tax payments for the third and fourth quarters of 2003
2. Review your business capital spending to take advantage of the large first-year write-offs
3. Review your corporation structure (if a small business)
4. Review your investment income and allocation (including dividends, interest, gains and losses)
5. Expect more companies to issue preferred stock with a tax-favored dividend
6. Review like-kind exchanges and reorganizations
7. Review the alternative minimum tax impact (the exemption amount increases for two years)
As a word of caution (as with the 2001 Tax Act), most provisions may expire at some point over the next 8 years unless further legislation is enacted.
For example, under current law the capital
gains rate of 15% ends after 2008 and the marginal tax rate reductions end
January 1, 2011. Contact your financial
advisor and tax accountant before year-end to review your situation now and to
plan for the next few years.