Calpers Looks at Cutting its Return Assumption

The Wall Street Journal reported this morning that CALPERS, the California Public Employees' Retirment System, is considering lowering its return assumption for its portfolio. Apparently the discussion has focused on lowering the assumption from 7.75% to 6%, though nothing is final.

For some time clients of South Shore Capital Advisors have been hearing that appropriate targets are in the range of 6%. After all, one must consider the impact of fees and transactions costs when contemplating this, and for taxable investors, there is also the bill due to Uncle Sam for income and capital gains.

In addition to the three P's that institutional investors often consider - Philosophy, Process, and People, an important fourth consideration that investors should consider is Price, or the fees that one pays for the service received. While this is not new news it never hurts to be reminded of it, particularly because if the lower return world is in fact the new reality, the fee as a percentage of total return on the portfolio increases. Particular bugaboos of mine are potentially expensive savings vehicles such as variable annuities, and also wrap accounts from brokerage firms that posess high fees in order to cover the expense of a.) the management of the assets, b.) the compensation to the broker/advisor, and c.) the take for the brokerage firm itself.

Taylor Thomas

External Debt To GDP For PIIGS, BRICs and a Few Others

The CIA and World Bank websites offer current data on External Debt to GDP. I recently gathered this data and created a table of these statistics for a select group of countries that have been in the news lately - Portugal, Greece, Italy, Ireland and Spain - the PIIGS. While I was at it, I also pulled data for other key countries in order to use it as a basis for comparison.

External Debt is the total public and private debt owed to non-residents, repayable in foreign currency, goods and services.

The goal here is to merely shine a light on the topic and to offer what I believe are a few simple truths:

First, the world is a very interconnected place! Countries and their banks own a lot of each others' assets. Given the leverage this table illustrates, the problems of one country's government or its largest financial institutions can quickly spread to others if a cross border contagion develops.

Second, there are a number of countries that would be hard pressed to bail out their own banks. Think Ireland, and the United Kingdom.

Third, this is yet another measure where Brazil, Russia, India and China - the BRICs - look to be in good shape.

Lastly, all this debt underscores why deflation is potentially a greater threat than inflation. Banks want the value of the assets they lend against to rise not fall, and governments need the value of their tax revenues to increase not decrease. Deflation means shrinking asset values, fewer capital gains and smaller incomes.

Here is a link to a recent upgrade of San Juan Basin Royalty Trust (SJT) by well respected energy stock analyst Kurt Wulff of McDep LLC an independent research firm.

http://www.mcdep.com/rtweek91211.pdf

SJT was presented in this forum last spring under the heading "US Royalty Trusts for Income - Oriented Investors." In his note published mid December Wulff points out that holders of SJT benefit from its 100% natural gas focus with no leverage and no hedging. He forecasts an 8% distribution yield for the security over the next 12 months - which by the way is a tax advantage yield.

A Principal of South Shore Capital Advisors, and certain South Shore Capital Advisors clients are holders of San Juan Trust.

Individual 401k Potentially Superior to SEP IRA for Self Employed Individuals

The following is a discussion of the merits of the Individual 401k plan as a retirement savings alternative for self-employed individuals such as independent contractors, sole proprietors, and single employee C and S corporations. The sources for this discussion are materials that originally appeared in the Journal of Accountancy in 2003, as well as material from the IRS Website (IRS Retirement Plans Navigator), IRS Publication 560 and Charles Schwab.

Background:

Beginning with the Economic Growth and Tax Reconciliation Act of 2001 (EGTRA), self employed individuals obtained a strong incentive to establish individual 401k plans as opposed to the more common SEP IRA. The SEP IRAs had been the vehicle of choice prior to EGTRA because they are easy to set up, and because employers had been required to deduct employee salary deferrals from the maximum tax-deductible retirment plan contribution (1). After EGTRA the advantage shifted to the Individual 401k. Employers were no longer required to deduct the Employee salary deferral from their calculation of the maximum retirement plan contribution. Hence, self employed individuals were entitled to take their maximum salary deferal and have their business make its maximum annual contribution to their retirement plan.

Quantifying the Advantage of the Individual 401k:

Let's put some numbers on this. For 2009/10 the maximum annual employee contribution to a 401k is $16,500. Employees above the age of 50 may be eligible to make a catch up contribution of $5500. The maximum total contribution from Employer and the Employee is 20% of eligible compensation or $49,000 (or $55,000 if over 50). Self employed individuals can contribute this amount to their Individual 401k plans.

Self employed individuals using a SEP IRA in 2009 are entitled to contribute the lesser of $49,000 or 20% of eligible compensation.

For 2009, $245,000 is the maximum allowable compensation that may be used to calculate the amount of benefits. This applies to both Individual 401k and SEP IRA. It is only at this $245,000 level that the SEP IRA provides an equal maximum contribution to the Individual 401k. For all lower levels, the Individual 401k allows a greater maximum contribution (2).

Individual 401k vs. SEP IRA Breakeven Analysis

Individual 401k Candidates (3)

An individual 401k is designed for self-employed individuals, and owner-only businesses with no employees, other than a spouse (includes corporations, partnerships and sole proprietorships).

Target profile

1. Wants to make larger contributions than are typically allowed by SEP IRA or QRP.

2. Needs flexibility on annual contributions

3. Wants an easy to administer, low-cost plan

Eligibility

1. Must have no employees other than a spouse

2. A partnership is eligible only if each partner owns 5% of the business

3. A corporation is eligible only if it has no employees other than a sole shareholder and his or her spouse

Disclaimer: This report was produced by South Shore Capital Advisors LLC for information purposes only. It is not intended that this serve as tax advice. Individuals should consult with their tax advisors prior to making any tax-related decisions regarding their retirement savings. South Shore Capital Advisors is a Massachusetts and Rhode Island Registered Investment Advisor.

(1) “The Single Participant 401K”, Journal of Accountancy, March 2003.
(2) IRS Publication 560 p. 1, p. 24.
(3) Charles Schwab

Copyright 2009, South Shore Capital Advisors, LLC, 16 North Street Hingham, MA 02043

This Holiday Season, Pour Your Guests the Wines the Four Seasons Pours at a Fraction of the Cost

If you want to pour the same wine for your holiday guests that the Four Seasons pours its clientele, it doesn't have to cost you an arm and a leg.

In the spirit of the Holiday Season, this commentary provides an assessment of value in one corner of the wine world and shows how readers can "get in on some of the action," at prices that are well within reach.

Here in Boston, the Bristol Lounge at the Four Seasons Hotel is a wonderful place to relax, meet some acquaintances for a glass of wine and possibly have a bite to eat. Albeit at prices that reflect its status as a "home away from home" for celebrities and international business elite. Those who have been there, or to any other Four Seasons, recognize that the wonderful atmosphere, service, food and drink all come at Four Seasons prices. So when paying the bill, it is helpful to remember that - in the words of Warren Buffett - Price is what you pay but Value is what you receive. How much value you place on the ability to sit, on any given night, near members of the E Street Band or the back court of the Chicago Bulls, determines how much sticker shock you feel when the bill comes at the Bristol Lounge.

While the Value of a glass of wine poured and consumed at the Bristol Lounge is unique to the person enjoying it, the Price is the same for everyone. In a word, expensive.

Various restaurant folks will quote different ratios for an establishment's wine price per glass to the cost of the bottle. In some cases the first glass poured will pay for the entire bottle and in others it may only pay for half. My research indicates that this holds true at the BL.

On a recent field trip to the Bristol Lounge in what Wall Street analysts might refer to as a "store check," I observed the following per glass prices:

Chardonnay: Laetitia Estate 2006, $15/glass
Sauvignon Blanc: Russian Jack New Zealand 2008, $12/glass
Riesling: Dr. Loosen L Mosel 2008, $9/glass
Pinot Noir: 12 Clones Santa Lucia 2007, $18/glass
Malbec: Catena Vista Flores Mendoza 2006, $10/glass
Merlot: Souverain Alexander Valley 2006, $14/glass
Cabernet: Flora Springs Napa 2005, $22/glass
Cabernet Blend: Chappelet Mountain Cuvee Napa 2006, $18/glass

In checking with my local wine merchant, Taylor Tibbetts of Harborside Wine & Spirits in Scituate, MA I was able to find the following wines available on order by the case:

Sauvignon Blanc: Russian Jack New Zealand 2008, $163.10/case = $13.59/bottle
Riesling: Dr. Loosen L Mosel 2008, $122.30/case = $10.19/bottle
Merlot: Souverain Alexander Valley 2006, $193.70/case = $16.14/bottle
Cabernet: Flora Springs Napa 2005, $336.50/case = $28.04/bottle
Cabernet Blend: Chappelet Mountain Cuvee Napa 2006, $336.50/case = $28.04/bottle

and rounding out the investigation with a trip to a few of the producer websites

Chardonnay: Laetitia Estate Chardonnay 2008, $194.40/case = $16.20/bottle (not the same year as at the BL)

The only wines that did not seem to be available were the Malbec and the Pinot Noir.

For the holidays, treat your company to the same wines the Four Seasons pours without the sticker shock. The Price should be right for everyone, but since they are at your home it is up to you to supply the Value.

Don’t Be Afraid to Rebalance Your Portfolio

With the S&P 500 having advanced 20.4% year to date as of 10/16/2009, and the MSCI EAFE index up 28.2% over the same period, it is legitimate and prudent to question the sustainability of this advance. The equity markets have been fueled by liquidity, a steady diet of improving news flow about the economy, and bona fide improvements in corporate performance. Nevertheless, after such a torrid advance from the lows of March, there is scope for a pullback, suggesting that investors should practice prudent portfolio rebalancing in order to keep portfolio risk aligned with their tolerance and capacity for volatility.

A few notable observations have crossed my desk in the last few days:

S&P 500 Fair Value

According to Bank of America Weekly Strategy Insights dated 10/19/2009, Bank of America strategists believe the fair PE multiple for the S&P 500 is 16.5x (this is based on 6% real cost of equity capital). According to this multiple, at 1097.25 the market is implying $66.00 in normalized earnings, in line with the current quarter’s annualized EPS. However, Bank of America believes that the current quarter’s earnings are still cyclically depressed, and they expect that the S&P 500 will grind higher as investors raise their expectations for the S&P’s normalized earnings power.

Visitors to the Standard & Poor’s website will see that S&P’s estimate for 2010 S&P 500 operating earnings is $73.55 (as of 10/19/2009). Using the Bank of America Fair PE Multiple of 16.5x on this earnings estimate would imply a fair valuation of 1214 at some point over the next six to nine months.

I have often used the “Rule of 20” to calculate a fair value multiple for the S&P 500. The crude assumption behind this rule is that 20 minus the rate of inflation represents a fair value multiple for the S&P 500. Using the yield of the 10 Year Treasury minus the real yield on the 10 year Treasury Inflation Protected Securities (TIPS) one can derive today's market expectation for inflation of 2.05%. (10 year treasury yield 3.37% - 10 year TIPS yield 1.32%). This yields a fair value multiple of 17.95x using the Rule of 20. While this is somewhat higher than the Bank of America Fair PE it is within the same ballpark.

Regardless of which method one uses to calculate a fair value multiple, the market appears to offer upside from here if earnings do not disappoint versus current expectations.

The Rush to Buy Bonds

In this weekend’s Barron’s, Michael Santoli pointed out that there have been $11 dollars in net inflows to bond mutual funds for every net dollar into equity funds over the past three months.

Bonds are an important part of most investor portfolios. Treasury bonds because they offer tremendous liquidity and are backed by the full faith and credit of the U.S. Government, and other types of bonds (Investment Grade Corporate, Municipal, Mortgage, Senior Secured Loans) because they can offer income and portfolio diversification benefits alongside cash and stocks. Amidst the recent market turmoil, many investors have reintroduced themselves to this asset class in search of the previously mentioned benefits. We have supported this notion. However, we cannot overlook the current love affair that investors of all stripes are showing toward this asset class and not point out that this supports the overall attractiveness of equities.

Equities remain an asset class that is vitally important for many investors who possess the goal of growing the value of their principal and preserving its purchasing power versus inflation. With a nod to the above data point from Barron’s, it is fair to say that investors have not been rushing to buy stocks despite the significant advances year to date, and particularly from the lows. This, combined with valuations that certainly appear reasonable, continues to support the case for owning equities, as well as bonds, and not being afraid to rebalance in the direction of equities for investors who possess the capacity for the potential volatility.

Important Legal Information:

Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.

Taylor Thomas

10/20/2009

Are we faced with another bubble in risky assets?

With the recent sharp rallies in virtually all risky asset classes the question has come up several times about whether or not we are now in overvalued territory or on the cusp of another financial markets bubble.

One needs look no further than the U.S. market that has seen the S&P 500 advance 51.68% from its March 9th trough as of 8/21/09. The more volatile BRIC markets (Brazil, Russia, India and China) have advanced by an average of 59.83% during the same period.

In recognition that markets are subject to short term fluctuations based on technical patterns such as overbought and oversold levels, and also with regard to the fact that September is historically the poorest performing month in the U.S. stock market, how “safe is the water” for taking advantage of a potential pullback to put additional cash to work? (According to Bespoke Investment Group data, September and February are the only two months that have seen a negative average monthly return for the Dow Jones Industrial Average over the past 100 years.)

In trying to answer this question, Standard Chartered Bank U.S. Economist John Calverly's “Checklist of Bubble Characteristics” is a useful tool. This was published in his 2004 book Bubbles and How to Survive Them when the author was Chief Economist at American Express Bank.

Checklist: Typical characteristics of a bubble (assessment by the author of this comment in italics)

1. Rapidly rising prices » stocks yes, housing no, commodities no
2. High expectations for continuing rapid rises » no
3. Overvaluation compared to historic averages » no
4. Overvaluation compared to reasonable levels » no
5. Several years into an economic upswing » no
6. Some underlying reason or reasons for higher prices » prices still below highs
7. A new element, e.g., technology for stocks or immigration for housing » no
8. Subjective “paradigm shift” » no
9. New investors drawn in » no
10. New entrepreneurs in the area » no
11. Considerable popular and media interest » no, still fear and doubt
12. Major rise in lending » no
13. Increase in indebtedness » no, savings are rising
14. New lenders or lending policies » perhaps central banks
15. Consumer price inflation often subdued (so central banks relaxed) » yes
16. Relaxed monetary policy » yes
17. Falling household savings rate » no
18. A strong exchange rate » no
Source: John P. Calverly, Bubbles and How to Survive Them, p.13.

No apparent bubble in Emerging Markets:

As of August 18th Global Emerging Markets (GEM) had rallied 56% since OECD lead economic indicators troughed in December 2008, making the current rally about twice the average seen after previous episodes when OECD lead indicators troughed. However, the trough valuation for GEM in December 2008 was 1/3 lower than in previous cycles, and GEM valuations are only now at just 5% above their average when lead indicators bottom.

GEM Historical P/E – now versus previous cycles when OECD leading indicators troughed

Source: Datastream, OECD, Credit Suisse Estimates published in Credit Suisse Asia Daily 8/18/2009

No apparent bubble in U.S. Equities:

In the U.S., stocks have advanced by 51.68% from their March 9th closing low as of 8/21/2009 according to Bespoke Investment Group. This naturally causes worries about a bubble. However it appears far premature to give this label to the present market.

The S&P 500 valuation now resides at 18.89x 2009 using Standard & Poor’s current $54.40 bottoms up S&P 500 operating earnings forecast. For perspective, the same multiple of operating earnings was consistently in the high 20’s during 1999 through the first half of 2000 as the S&P 500 was topping out at the peak of the last bull market. For even further perspective, a look back to the Nifty 50 era of 1972 shows that the original Nifty 50 traded for between 46 and 92 times earnings according to Forbes magazine. Therefore it seems that there is plenty of scope for stock valuations to move higher before we can be considered to be in a bubble; particularly if there is a steady diet of positive news flow.

No apparent bubble in Investment Grade Corporate Bonds:

As highlighted by Argus Research on August 24th, as of July 31st the average yield spread between a AAA-rated corporate bond and the U.S. Government long bond was 185 basis points. Over the past 55 years this spread has averaged 80 basis points. For BBB rated bonds, the average spread was 353 basis points as of July 31st, versus a historic average of 178 basis points (as published in Argus Market Watch 8/24/2009).

Conclusion:

With few conditions for a bubble present, and financial markets exhibiting inexpensive to normal valuations, there are no signs of a bubble in any of the aforementioned risky assets – U.S. stocks, emerging markets stocks or corporate bonds.


Absent an external shock such as a terrorist attack, or significant problems with a major trading partner, and assuming continued improving economic news, stock and corporate bond markets offer scope for solid returns from these levels despite the healthy advances of the recent past.


Important Legal Information:

Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.

Taylor Thomas 8/30/2009