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Active Asset Allocation Trend Updates: June 2013

The Active Asset Allocation Portfolio utilizes a trend following strategy by buying and selling securities based on established price trends in each asset class. Below is a snapshot of the current trends we are following:

US Equities:

The trends in US Equities are currently in question. The markets have not responded positively to the news from the recent announcement from the Fed regarding the efforts to stimulate the economy. What does this mean? If recent history is an indication for what to expect, a market correction would occur but has not yet affected the overall positive trend. It could be a “speedbump”. When QE1 ended, the S&P 500 Index dropped by 15% but quickly rebounded leaving the overall trend positive. The same thing happened with QE2.

We continue to see some bright spots – technology, healthcare and financials seem to have avoided the same sort of decline as the S&P 500 experienced over the last few weeks. These groups might provide leadership in any “rebound”.

Foreign Equities:

The trends that exist in the U.S. equities are similar to the ones we’re seeing in the foreign markets.

Bonds:

During the month of June, we have lightened up on our bond holdings. Again, this can be traced back to the Fed. As the economy shows more signs of improving, the Fed will reduce its bond buying program and slowly raise interest rates. As interest rates rise, the value of existing bonds become less valuable since they pay a lower interest rate than newly issued bonds..

Real Estate:

Our longest held position is currently trying to find a trend. We have been pulling back on some positions and will continue to monitor it closely. The reasons for the trend reversal are similar to what was outlined above.

Commodities:

Our holdings at this time are minimal.

 

 

Keeping the Fed in Perspective

It’s been a big week! But don’t lose focus on the long term.

Too many people are making a big deal over the Fed’s announcement earlier this week, resulting in traders kicking up a lot of dust in the markets and the talking heads dissecting the meaning of the announcement.  Let’s keep a few things in perspective:

1) Nothing substantially new was stated except that the Fed’s bond buying may begin to taper off at the end of this year as opposed to early next year.

2) This was not unexpected news. This was already hinted at a few weeks prior. We already knew this.

3) The life support, QE3, or Fed’s efforts to help the economy must end someday.  Did everyone forget that it was bound to happen?

4) Bernanke even stated that any policy changes would be contingent upon the economy’s CONTINUED growth.  As the economy strengthens and can stand on its own, the Fed would reduce aid accordingly.  And at that time, shouldn’t it be celebrated rather than shunned?
There is some volatility in the markets as a result this announcement.  It may continue for a while. Is it a little speed bump or is it the sign of something more?  We will wait for the dust to settle to see where things stand. We may see opportunities as the market rebounds.

Bonds turning negative. Real Estate closely watched.

During our last trend update, we wrote about trends starting to change in bonds. While US bonds have not maintained a clear direction for the past few months, we were pleased with the performance of emerging market debt and many actively managed funds. In a rather sudden series of events, many of the trends changed direction and turned negative resulting in several funds being sold off early last week.

We attribute this turnaround to a few factors:

1) Rising US Treasury yields.

2) Speculation that the Fed will reduce bond purchases.

3) Fed indications that it will raise rates if the economy continues to improve.

Real Estate has experienced a strong pullback over the last few weeks. Looking over the course of the last 10 months, it is still a positive trend. But this trend could be changing soon, like bonds have.

 

Why is my portfolio lagging the stock market?

We’ve fielded a few phone calls from clients in the past few weeks confused about why their statements are not reflecting the same rate of return of the S&P 500 which they’re hearing about in the news.

We’re not surprised by the observation.

The S&P 500 has been having a banner year so far! US equities have been our best performing asset class. Actually, it’s one of the few asset classes that has maintained a positive trend over the last few months. While almost all other asset classes have been struggling to show any gains, such as commodities, bonds, real estate, and some foreign holdings, the US equity market has been surging ahead.

It’s as if the US equities were the last ones at the party and didn’t notice that everyone else left the room until the music was shut off!

You are correct. Your portfolio is not reflective of what you see in the headlines, and has not surged ahead like the US equities as measured by the S&P 500. But, then again would you want a portfolio consisting only of US stocks? What if the Fed raised interest rates or stopped buying up bonds? Would you be fearful that a market correction could occur, wiping away all of your gains (or most of them)?

In effect, a portfolio consisting too much of any asset class would be, as a result, taking on excess risk. We work with our clients to diversify their portfolios to lower risk and volatility. In case some asset class declines, the other asset classes can support the ones in declines. We are maintaining diverse portfolios for our clients in order to spread risk out and try to minimize volatility.

Three Retirement Strategies I Forgot to Tell My Client.

I recently met with prospective clients who needed a lot of guidance. They were entering retirement with substantial assets and sources of income, but there were important health issues to consider. It was complicated.

They had not been well served in the past. They had outlived all their previous advisors as two of them in succession had retired from the business. They had been left with several accounts of investments, IRAs and annuities, and they have to deal with multiple organizations to get the answers to their questions.

No one is helping them coordinate their planning. Nobody else knows all the pieces of the puzzle.

We spoke for a while about their situation and how I could help them. After the meeting, I thought about three other strategies that I wish I had shared with them.

1) Check to make sure the entire portfolio is working well together. Consolidation of accounts can help keep paperwork organized and simplifying tax preparation, but doesn’t help the performance of the investments. All too often, we see client’s combined portfolios inadvertently skewed too aggressive or too conservative because they never stepped back and looked at the whole portfolio. There are even cases, were a client owns several mutual funds only to realize that about 10% of their underlying investments are invested in just three stocks. While they thought they were diversified, they never took the time to review the overlap that existed between the funds.

2) As a rule of thumb, we recommend that clients spend down their accounts in the following order to minimize tax consequences: Cash, Individual and joint accounts, 401(k)s and IRAs, ROTH IRAs. There are, of course, exceptions and we don’t recommend spending an account down to zero before moving on. As a client transitions into retirement, this rule of thumb may help in planning the order of tapping each account.

3) A client should go into retirement having a good idea of what their expenses have been for the last few years so we can develop an income stream to meet their expenses without taking on unnecessary risk. If a client has yearly expenses of $50k pre-tax and $30k coming in from a pension and Social Security, we know that we need a portfolio that can generate $20k plus extra for inflation. If a client has a portfolio of $600k, then a $20k withdrawal represents about 3.5% – That’s acceptable. Now, if the client had a portfolio of $200k, then a withdrawal of $20k would be 10% and would warrant some further discussion about how to bring that down to a more reasonable rate of withdrawal.

If this situation sounds familiar or if you think you can benefit from any of these strategies, we’d be happy to offer you a complimentary consultation. Please email me to get started.

 

What to do if you forgot your RMD

While there are a couple of exceptions, you’re required to take distributions from an IRA or a 401k under two circumstances. These are known as the Required Minimum Distributions, or “RMDs”, and they generally apply to:

a. Your own IRA, in the year you’ve reached age 70-1/2; and

b. An IRA you inherited, from someone other than your spouse, in the year following that person’s death.

Failure to take the RMD results in one of the most severe penalties you can imagine: the penalty is 50% of the missed distribution amount. So if your IRA is worth $100,000, and the RMD calculation is, say, $4500, the penalty for not taking that distribution is $2250. Ouch!

Luckily that penalty can be waived if you have a good excuse and you correct your oversight. The details are in the IRS guide to IRAs, Publication 590. But Boston area attorney Natalie Choate, a specialist in retirement distribution planning, summarized the process for me when I attended a seminar sponsored by the Boston Tax Institute a couple of weeks ago.

It appears that the IRS will generally waive the penalty when there is both a “reasonable cause” and “remedial action”. Reasonable cause can be an error by the IRA custodian, or bad advice from an advisor, or your illness, military service, or, surprisingly, your incarceration! The remedial action is usually your making up for the distributions that you had previously missed.

You also have to file IRS Form 5329 as follows:

·On line 50, enter the amount of the RMD that you missed

·On line 51, enter the amount of the RMD that you took, usually $0

·On line 52, enter the difference as $0, and mark “RC” in the margin to indicate “reasonable cause”

·Attach a statement on the “reasonable cause”, and provide evidence of the remedy or corrective action.

Form 5329 can be filed as a stand-alone form for the tax year in question, and no amendment of your prior return is needed.

If you find yourself in this situation, you should contact a tax accountant to guide you through the process.

If you have specific questions about your RMDs, please email me at ron@ol-advisors.com

 

A Case for Emerging Market Debt

Emerging market debt has recently become a more-widely accepted asset class for income investors looking to diversify their portfolio. It consist primarily of bonds issued by countries with emerging economies (Australia, Brazil, Taiwan, China to name a few) backed by taxes.

It was not long ago, however, that this asset class was basically off limits, frowned upon, or just impossible to access. And there wasn’t much demand, either, since this had been a volatile asset class. But as demand for this asset class has increased, so have the number of investment vehicles that can access it.

In the 1990’s and early 2000’s, many emerging economies experienced a significant fiscal crisis, similar to what the U.S., Europe, Japan and several other developed countries are experiencing today. These emerging economies have rebuilt their fiscal houses and are much further down the road to recovery than many developed countries.

With their fiscal issues “solved”, they are now reaping the benefits. Their credit rating is improving. Once, thought of as default prone, they are becoming much more stable. There are a few standout results, such as Russia which went from a C rating to BBB+ in about two decades. South Korea went from BB to AA- in the same time frame. And now, the average for all emerging market debt is almost BBB+.

Specifically, the issues they “solved” that resulted in higher credit rating can be summarized:

1) Emerging economies have reduced spending and are more fiscally prudent than before.

2) With spending limited, more funding can be directed to pay down debts which improves their balance sheets and debt ratios.

3) Long term issues have been addressed. The Social Security debate we are having in the U.S. was addressed years ago in emerging markets. Their solution: compulsory self-funded private retirement system. This clarity means it will be more likely for developing countries to pay down other debt.

4) A more stable local currency and better access for investors has opened them up to foreign investment.

 

Understanding your unique perception of risk

Investment risk comes in many forms and is talked about so frequently within the industry, that every type of risk has it’s own name. Just a few are longevity risk, inflation risk, interest rate risk, liquidity risk, political risk, and market risk. This post is not about the risks themselves, rather, it is about the factors that affect our response to the risk and why it may differ from our spouse’s risk tolerance – It’s what contributes to your unique perception of risk.

Usually, when spouses disagree over how aggressive or conservative they want to be with their portfolio, the disagreement can boil down to a few key factors that can influence risk. Below are a list of some of the most common factors that influence our feelings toward risk in general.

Trust: The more trust an investor has in their financial plan, their advisor, the markets, their specific holdings, etc, the less afraid they will be.

Risk/benefit: investors who can weigh the benefits of taking on certain level of risk., the investor may be less fearful of the perceived risks if the perceived benefit outweighs the risks. Millions of people living along the ocean are taking a risk of having their homes flooded. And yet they are highly desirable pieces of property.

Control: The more control or the feeling of control an investor has over the outcome, the less likely they are to be fearful.

Choice: Risk that is imposed on us tends to cause more fear than risk we chose for ourselves.

Uncertainty: This comes as no big surprise, not knowing the likelihood of the risk occurring can cause more fear than actually knowing the likelihood.

Natural/man made: Risk related to a natural event (storms, floods, snow) tend to cause less fear than man-made events (wars).

Horror: The scarier the event, the more fear it causes. A traumatic death is much scarier than a death caused by a sudden heart attack.

Catastrophic/Chronic: Temporary events that cause lots of damage to a small population causes more fear than small amounts of damage caused over time to a large population. Think about how much more damage is caused by pollution or heart disease, and yet we are more afraid of a house fire, car accident, or terrorism. Many investors are more concerned about the sudden market drops, yet completely unaware of the bigger and ever present issue of inflation.

New/familiar: A new risk tends to cause more fear than a risk we’ve been subject to for years. Over time and with more experience and familiarity, the fear of the risk can subside.

Personalization and fairness: risks that affect people we know, children, the poor or the vulnerable tend to evoke a strong negative response.

Awareness: Lastly, simply being aware of the risk raises the level of fear. Knowing that it could happen after reading about it in the news, tends to elevate fears.

These perceptions are constantly changing based on our experiences and as events unfold. As you read this, you may find yourself thinking that a few of these perceptions affect you more than the others, but a whole new set of perceptions could become important if the markets changed.

It is our experience that many of these perceptions have a negative effect on investment decisions. All too often, these perceptions cause investors to sell out at the bottom of a temporary market decline. Investors make their decisions out of fear and emotions rather than facts. Understanding the root cause or key characteristic that drives investor fear and then finding a way to overcome and solve that fear is the first step a fearful investor should take when thinking about getting back into the market.

 

Trend Updates: May 2013

The Active Asset Allocation Portfolio utilizes a trend following strategy by buying and selling securities based on established price trends in each asset class. Below is a snapshot of the current trends we are following:

US Equities:

The trends in US Equities have continued a positive trajectory and have strengthened even further. Kiplinger believes that “the underlying fundamentals are sound” but admit that the“pace of gains is bound to slow” and “a correction is due”. The trend will most likely not continue at this pace, although we expect this trend to be positive for the rest of year..

We are watching a few opportunities develop within certain sectors. Specifically, we have recently added to the technology sector of our existing holdings.

Foreign Equities:

This asset class is starting to show signs of a positive trend developing throughout the asset class. We recently wrote (LINK) about a divergence in the performance between emerging markets and developed markets – where emerging markets were declining while developed markets improved. But for the last month or so, these two markets have at least been moving in the same direction, bucking the unusual trend we have seen develop at the end of 2012.

If the trend in emerging markets continue to strengthen, we would likely add a small position.

Bonds:

The trend continues to remain flat, which we noted at the end of the 1st quarter (LINK) and last month (LINK). While the threat of rising interest rates looms over us, it probably won’t happen this year. But If interest rates were to rise, we see bonds responding in different ways.

1) The value of the existing bonds would decline and, given how the markets have been performing, interest rates will likely go up rather than stay put (they can’t get much lower, either).

2) Municipal bonds could offer more protection and can provide tax benefits, although their value could go down quickly.

3) GNMA securities, mortgage pools guaranteed by the government, could be a better option compared to the previous two.

4) Corporate bonds, including “junk” bonds have performed the best over the past few years, although it tends to correlate with the stock market.

5) Emerging market debt continues to be an attractive option as it diversifies our bond holdings. We’ll be touching upon this more next week.

Bottom line, there are a lot of moving parts..

The indexes and ETFs we track have been bumping around the 200 day moving average. Many of our specific holdings in the portfolio have held up well, showing less volatility than the passive indexes due in part to their diverse nature and active management. We are fully invested in this asset class at this time.

Real Estate:

One of our longest held positions continues to perform very well. This asset class has had a few bumps in an otherwise positive trend that has existed for a few years.

Recently, this positive trend has even outpaced that of the overall market.

Commodities:

Our holdings at this time are minimal. Most commodities have been in a negative trend for a few months. We have recently sold out of our positions in gold.

This trend has continued to weaken due in part to the improving U.S. economy. Investors are not fleeing to the safety of precious metals like they have for the past few years. Rather, they are pulling out of gold and other precious metals to go into equities.