Gold May Drop If Political Winds Change (2010-08-30)

Gold May Drop If Political Winds Change

(2010-08-30) by David John Marotta

Gold recently hit a high of over $1,250 an ounce. Gold advertisers and gold investment newsletters continue touting their wares as though gold only goes up in value. Commercials are promising cash for gold, and people who normally don't concern themselves with investments are asking if they should buy gold. But now may not be the best time to buy gold.

Gold tends to maintain its value. It doesn't go up; it doesn't go down. It just holds its purchasing power and keeps pace with inflation. On average it stays constant, but only on average. In the short term, gold fluctuates wildly, at times even more than the stock market.

In January 1980, gold reached its high of $850 an ounce on the expectation of rampant inflation. But such inflation did not follow the doomsday predictions of straight-line projections. In fact, gold prices reversed and began dropping as chairman of the Federal Reserve Paul Volcker took action to strengthen the dollar and broke the back of inflation.

Under a sounder monetary policy, gold continued to drop from $850 in 1980 all the way down to $260 in 2001. It lost 69% of its value over a 21-year period for a consistent annualized loss of 5.5%. It didn't return to $850 until 2008, 28 years later. You can't afford nearly three decades of no return while inflation eats away your buying power.

That $850 in 1980 had the same buying power as $2,249 in today's dollars. Gold trading at $850 an ounce then was like gold trading at $1,000 more than its current price. Those people who purchased gold in 1980 have lost over half their buying power during a 30-year investment.

Had they invested $850 in the S&P 500, their investment would have grown not merely to $1,250 but to $17,261. Which investment would you rather have chosen in 1980: gold that is up 47% while inflation has been up 166% or the S&P 500 that is up 1,931% and averaging 10.8% a year?

In his book "Stocks for the Long Run," Jeremy Siegel analyzes investments over the past 200 years. Gold typically just maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation it would be worth about a dollar today. Because of inflation, a dollar today would only have had the buying power of about 7 cents back then! However, the stock market, on average, has been appreciating about 6.5% above inflation.

Inflation has been running at about 4.5% and equities have been averaging 10.8% over the last 30 years. You need to exceed inflation to grow the purchasing power of your portfolio and fund a long and successful retirement. Holding gold may help you sleep well tonight, but you won't eat well 10 years from now.

Although gold generally holds its purchasing value, it can fluctuate wildly based on other factors. The price of gold generally rises with expectations of inflation or worries about economic or political security. The recent appreciation of gold stems from an expectation that prolific and wanton spending by the federal government will excessively devalue the dollar and run up deficits that will lead to a catastrophic financial meltdown as well as worries that Iranian president Ahmadinejad is determined to nuke Israel and America.

Perhaps such dire predictions are correct and we are headed to Armageddon. If so, gold should not be your first purchase. First you should stock a year's supply of food. Then buy a gun to protect it. Only after you've purchased plenty of seed corn should you think about buying gold. Even then I would think that gold isn't a liquid asset at the end of the world as we know it. At that point a loaf of bread will buy a bag of gold. If you want liquid assets in such a catastrophic situation, try buying cases of Jack Daniels. It is cheaper, keeps just as well and will fetch more in trading value.

Perhaps we are rushing toward the meltdown of society as we know it. But perhaps not.

As strongly as I believe in the foolishness of government-created solutions to solve government-created crises, I believe even more strongly in the fickleness of the American voter. Who would have thought a Republican would be elected to Ted Kennedy's Senate seat?

Perhaps the pendulum is swinging back and reckless governmental socialism and spending will be repudiated in the midterm elections. If that happens, all the dire expectations that worried individualists have priced into the gold market will evaporate along with some of the value of gold investments.

We don't recommend holding more than 3% to 5% of your net worth in gold coins. You don't need any Eagles or Krugerrands to reach your financial objectives. Hard asset stocks do better than simply buying the underlying commodities. Holding diversified foreign equities protects against government monetary folly and would have protected even the citizens of Zimbabwe. Emphasizing those countries with a sound monetary policy is even better.

Having said all that, holding a few gold coins has had its benefits historically.

Some of our clients are old enough to remember Franklin D. Roosevelt's Executive Order 6102 in 1933 that restricted gold ownership. Owning gold was illegal until the early 1970s when Richard Nixon abandoned the gold standard for our currency and Gerald Ford signed a bill that legalized private ownership of gold.

Having gold during World War II was the only way to get family members safely out of Nazi Germany using bribery. Owning gold coins can provide some flexibility in dark and uncertain political times.

Although holding a small number of gold coins won't jeopardize your financial objectives, be prepared for their value to decline if the world's debt, deficit, socialist tendencies and Armageddon start looking a little less bleak.

from http://www.emarotta.com/article.php?ID=412

Dodd-Frank Bill Concentrates Financial Power (2010-08-23)

Dodd-Frank Bill Concentrates Financial Power

(2010-08-23) by David John Marotta

Congress recently passed the Dodd-Frank bill. At the signing, President Obama claimed, "Because of this law, the American people will never again be asked to foot the bill for Wall Street's mistakes. There will be no more tax-funded bailouts . . . period."

Washington excels at blame shifting. The financial crisis began and ended with the exercise of political privilege and power. Fannie Mae and Freddie Mac were given a lending environment superior to the private sector while the latter was forced to loosen lending requirements beyond reason. The blame for the financial meltdown belongs on federal regulators, not on a lack of regulation.

But beyond all this blame mongering is the assumption that the current legislation can bestow enough power in the hands of a few to steer the course of global finance for the better. As William F. Buckley, Jr. has often remarked, "Idealism is fine, but as it approaches reality, the costs become prohibitive."

The bill mostly just asks federal agencies to make sure that nothing bad happens in the future. It doesn't really tell them how to do that. But it does make it clear they will be held accountable. And they can't complain they didn't have the needed authority or clout. In the bill they are given a wide range of new and unchecked powers to do whatever it might take to make sure bad things don't happen.

Unfortunately, we now have to fear their exercise of these powers. Only if you swear by the genius of Caesar, trust in his altruism and believe in his divinity is this bill a cause for celebration.

For example, the bill creates a Financial Stability Oversight Council. The ten regulators in this group have the task of monitoring any systemwide risks in our financial system. They have also been given nearly unlimited power to address these risks by forcing financial firms to sell assets or close a portion of their business.

The utopian hubris of believing such a group will do more good than harm is unfounded by human history and experience. And the assumption that such a council will be untouched by self-interest is naive beyond belief.

In the chapter on politics in his book "The Blank Slate," Harvard psychologist Steven Pinker says, "We are all members of the same flawed species. Putting our moral vision into practice means imposing our will on others. The human lust for power and esteem, coupled with its vulnerability to self-deception and self-righteousness, makes that an invitation to a calamity, all the worse when that power is directed at a goal as quixotic as eradicating human self-interest."

Congressmen Christopher Dodd and Barney Frank themselves were given the simpler task of overseeing Fannie Mae and Freddie Mac. Their own self-deception and self-righteousness led them to defend and even praise Countrywide's reckless lending practices. In the meantime, they accepted more than $2 million in campaign donations from Countrywide, Fannie Mae and Freddie Mac.

The new bill is ripe for lobbying by special-interest groups. Almost all of the actual rule writing has been delegated to regulators. The legislation will be revised endlessly for decades, and all the power players with a stake in the game will be able through their contributions and lobbying efforts to leave their fingerprints on the rules.

Such concentrated power will be used to benefit one firm at the expense of another. The winners will be the most powerful financial firms, lobbyists and legislators. The losers will be smaller banks and financial firms, fee-only fiduciaries and consumers. Anyone who doesn't have millions of dollars at stake will not be a big enough stakeholder to bother gaming the system.

According to the Washington Post, "Some liberals have criticized the bill for failing to more aggressively alter the structure of Wall Street and for leaving so many critical decisions to federal regulators, who missed many of the warning signs before the crisis."

"'It's the dumbest argument I've ever heard,' Dodd countered. 'What do they expect me to write, a 100,000-page bill? This is far beyond the capacity, the expertise, the knowledge of a Congress to detail every new regulation,' he said."

Truer words could not have been spoken. Such work is also far beyond the agencies to which Congress has delegated the task. The bill is 2,319 pages long. It establishes 355 potential new agency rules. It mandates funding 47 studies. And it requires 74 different reports.

It will probably create more jobs than any of the bailouts efforts. But none of those hires will be working for consumers. Their number-one priority will be their personal reputation and power. Only tangentially will any of their interests align with yours.

None of this work will encourage competitiveness. No one will manufacture products for sale. These efforts will produce no real wealth. And hundreds of the potential new rules have nothing to do with financial stability.

The report has thousands of potential unintended and unanticipated consequences. For example, the Federal Reserve will now be authorized to limit the swipe fee that credit card companies charge merchants for debit card transactions. Such price controls have popular support. After all, who wants credit card companies to rake in high fees? But price controls are never good economics.

How will they decide what the limit should be? If limiting the fees to $6 is good, is limiting the fee to $3 even better? Why stop there? Why not limit the fee to $1? What are those fees for anyway?

Currently there isn't a limit on the fee because the fee can be a percentage of the total transaction amount. Part of the reasoning is that such a transaction may be fraudulent identity theft and the money transferred could be unrecoverable. Because the fee serves as insurance against this possibility, it is a percentage of the transaction. If the Fed limits the fee, such transactions could be eliminated as well. Alternatively, banks could simply charge the maximum and allow smaller transactions to subsidize the risks of larger transactions. None of this is good economics.

This is a consequence of price controls. Transactions that all parties would otherwise want to make become illegal. Either the price control is set too high and has no effect or it is set below the equilibrium and upsets the balance, making the service disappear altogether.

Maybe the genius of the Fed will set the swipe fee limit high enough so it will have no unintended consequences. But Fannie Mae and Freddie Mac should have been able to set lending requirements high enough to avoid the financial crisis in the first place. If politics did not allow something that simple, we certainly won't avoid mistakes with regulations as complex as this bill invites.

The Dodd-Frank bill can be likened to giving the government unlimited powers and asking them to eliminate evil. It sounds like a good idea in theory, but the task is impossible, and the means by which they will make the attempt is dangerous to life, liberty and the pursuit of happiness. Libertarians can't tell you exactly why the bill is a bad idea. No one can understand the complex interaction of our financial systems that well. And that is exactly why we know the bill will do more harm than good.

from http://www.emarotta.com/article.php?ID=411

Saving: The Most Fundamental Element of Wealth (2010-08-16)

Saving: The Most Fundamental Element of Wealth

(2010-08-16) by David John Marotta

Everything in wealth management begins with savings. All wealth comes from producing more than you consume. Unfortunately, most Americans are better at consuming than producing.

Have you ever met people who always have enough money to do what they want? Their peace of mind and confidence is no accident. Nor is it luck. It comes by carefully planning their spending and savings. They deny themselves some desires now in order to enjoy financial security later.

The character Mr. Micawber from Charles Dickens's novel "David Copperfield" offered a kernel of wisdom learned the hard way, now popularly known as the Micawber principle. He said (numbers updated), "Annual income $50,000, annual expenditure $48,750, result happiness. Annual income $50,000, annual expenditure $51,250, result misery."

Surplus income is wealth. Deferred consumption is the textbook definition of wealth, which can be used as a capital investment to produce additional wealth. Although by itself money certainly does not guarantee happiness, wealth can enable us to accomplish many goals in life. Without such a surplus we experience Micawber's misery.

Mr. Micawber is memorable for trusting that "something would turn up" to solve his financial problems. Americans are perennial Micawbers. The savings rate in America is abysmally low, and those who do try to acquire wealth are chastised by a punitive tax code. Micawberism, in contrast, has been rewarded so much, it is considered patriotic to shop until you drop simply to boost the economy.

Unfortunately, economics doesn't really work that way.

Most families who become mired in credit card debt do so because they fail to plan for emergencies. These unexpected events swamp their cash flow, and they have to resort to plastic. But cars break down. Roofs leak. And children need braces. We recommend saving 10% of your take-home pay just to meet these unanticipated expenses.

Saving fuels the financial engine that makes the rest of wealth management possible. Whatever your life goals, saving is most likely required to achieve them.

Saving is the logical choice if you have upcoming major expenses. Some families need to save small amounts to meet modest needs. Others have elaborate and expensive plans that require more complicated strategies.

One of the most important purposes of saving is financial independence or retirement. There isn't a simple dollar amount that will be sufficient. What matters is that you have saved enough to support your lifestyle. Having $1 million at retirement doesn't help if your lifestyle requires $200,000 per year. Dying young is never a good retirement plan.

Saving too little or too late requires more extreme adjustments in savings or lifestyle later in life. Worrying about how to meet your financial objectives should not haunt you. You will know if you are on track only if you know what that track looks like and you adjust your course regularly as needed.

Saving is powerful, but it is only half the story. If you do not invest your savings, inflation will erode your purchasing power every year. In contrast, savings that are invested grow and appreciate.

You should know how much to save today to exceed the needs and priorities of tomorrow. At a 10% rate of return, your savings will double every seven years. So for every seven years you delay saving, you are cutting your ultimate lifestyle and net worth in half.

All of this wisdom about saving can be summed up by the suggestion to "Start saving now." Beginning early in life is certainly the most significant factor in building real wealth.

Saving a million dollars isn't so difficult. Investing just $16.20 a day at a 10% rate of return grows to $1 million in 30 years. This phenomenal rate of growth comes simply by having $16.20 more in income than spending each day. By saving $162 a day, you could accrue $10 million after 30 years.

The most successful way to save is to automate your saving plan. Make savings your default setting. Establish an automatic electronic funds transfer from your checking account to your investment account the day after each paycheck is deposited. You won't miss what you don't see.

Making these decisions explicitly is much better than failing to plan and then being forced to take whatever options are still available late in the game with little time left for course corrections.

Comprehensive wealth management comprises many different elements. But saving is the most fundamental. It is like hydrogen, the first and most basic element. By its energy the sun gives us light and warmth, making all life on earth possible. Harness the energy of saving and put it to use for your life goals.

Most families with significant investments are simply the millionaire next door. They live well below their means and save and invest the difference. They grow rich slowly and steadily. Wealth is what you save, not what you spend.

Take control of your savings today. It is the cornerstone of your wealth management plan.

from http://www.emarotta.com/article.php?ID=410

Second Quarter of 2010 in Review (2010-08-09)

Second Quarter of 2010 in Review

(2010-08-09) by David John Marotta

The market fell to its lowest point this year on the last day of June, closing the quarter and the first half of 2010 with some significant losses. Short-term trends can signal or counter longer term trends. Distinguishing which is which can be difficult.

About 96% of market movements are noise. Even long-term trends are three steps forward and two steps back. That makes it challenging to distinguish short-term changes from long-term trends. Reviewing the market movements from last quarter is useful only to the extent that such distinctions can be made.

Aim to structure portfolio allocations for 3- to 5-year trends, not for monthly fluctuations. Some of the investments that will do well--if the dollar weakens or if we have inflation--are the same investments that did not make money this last quarter. Other investments that did better are part of longer term trends that should signal you to adjust your asset allocation.

Stocks fell during the second quarter of 2010 as government debt in Europe and malaise at home slowed hopes of an economic recovery anytime soon. Over the quarter, the S&P 500 was -11.43%; the EAFE foreign index, -13.97%, emerging markets, -8.37%; and the Goldman Sachs Natural Resources Index, -9.76%.

The EAFE foreign index was down 2.54% more than the S&P 500. The prospects of bailing out Greek budget deficits devalued the euro against the U.S. dollar. Much of the movement in foreign stocks was due to currency exchange. The euro dropped 11% over the second quarter from $1.35 US to $1.20. As a result, the dollar strengthened, but we don't expect this trend to continue.

Bill Gross, cofounder of the Pacific Investment Management Company (PIMCO) and the country's most prominent bond expert, recently evaluated countries based on their total public sector debt as a percentage of gross domestic product (GDP) as well as their annual deficit, which is making matters worse. Gross singled out seven foreign nations that are heaping significant deficits on their mountain of debt and called them "The Ring of Fire." These countries comprise significant percentages of the EAFE foreign index: Japan 22%, United Kingdom 21%, France 10%, Spain 4%, Italy 3% and Ireland and Greece 1%. In total, 61% of the EAFE index is invested in the ring-of-fire countries.

But Gross included an eighth country in the ring of fire: the United States. He also warned, "Once a country's public debt exceeds 90% of GDP, its economic growth rate slows by 1%." Gross is probably underestimating the drag that public debt puts on economic growth. Rising public debt in the United States has been at the expense of economic freedom.

For the first time in the Heritage Foundation's Index of Economic Freedom, the United States was moved from the list of "free" countries to the second tier of "mostly free" countries. Investors seeking to avoid the European malaise by not investing in foreign stocks will find themselves 100% in the eighth ring-of-fire country, the United States. The phrase "American level of growth" used to describe something significantly higher than a "European level of growth." Now the distinction may have been removed.

This may be a unique time in investment history. Tilting toward mostly foreign but specific countries with low debt and deficit and high economic freedom may produce superior investment returns.

Countries that still rank as free according to the Heritage Foundation include Hong Kong, Singapore, Australia, Switzerland and Canada. These five countries already have an average five-year return of 8.04% versus the S&P 500's five-year return of -0.79%. Economic freedom is significant both to investors and to the welfare of their citizens. Debt and deficit also matter.

Going forward, you should continue to emphasize foreign developed countries with lower debt and deficits as well as the emerging market economies.

The 2010 World Economic Database of the International Monetary Fund (IMF) reports that while the United States and most other developed nations are experiencing increasing budget deficits, a select group of countries have been able to run a surplus. Norway (+9.67%), Switzerland (+1.37%) and Hong Kong (+.81%) are three such examples of fiscal health. Norway is blessed with an abundance of natural resources that make it the world's fifth largest exporter of oil and gas. Soaring public debt in the 1990s prompted Swiss voters to approve a constitutional amendment requiring revenue and expenses to balance over an entire economic cycle. Hong Kong's government has been a beacon of fiscal prudence as evidenced by its number-one ranking in the Heritage Foundation's index for 15 consecutive years. We believe that on average, businesses run within these fiscally responsible economies will outperform companies in countries with high debt or government intervention.

According to the IMF, emerging and developing economies will experience 6.6% GDP annual growth during the next two years while the advanced economies will only experience 2.5%. Perhaps "Emerging market level of growth" has replaced America as the land of opportunity. The emerging market index has averaged 12.73% over the last five years versus the -0.79% return of the S&P 500.

Average investors have nearly all of their assets in U.S. large-cap stocks and U.S. bonds. This represents one and a half of the six asset classes we recommend. We believe that adding any of the other asset classes may both boost returns and decrease volatility.

Regarding U.S. bonds, municipal bonds (or "munis") are becoming more popular. We do not recommend this strategy. Although a tax tsunami is coming at the end of this year, trying to avoid taxes by investing in muni bonds has its own pitfalls. With municipal debt rising, the risk of credit downgrades and insolvency threatens these investments.

Municipal revenue tends to trail economic recoveries by the year it takes for higher income and property taxes to be assessed and collected. Aid to municipalities from the $787 billion stimulus package is starting to wind down. Some municipalities are looking at deficits requiring tremendous reductions in spending. Warren Buffett, whose Berkshire Hathaway Inc. has been paring down its municipal bond portfolio, predicted a “terrible problem” for state and local government debt in his June 2 testimony to the U.S. Financial Crisis Inquiry Commission in New York.

Not all municipal debt is created equal. California's replacement of paychecks with IOUs is one example. Current-day financial stresses are highlighting the divide between those municipalities that have been spending beyond their means and those that have acted prudently. Reviewing your municipal portfolios is more important now than ever before.

Rebalancing after market declines on average provides a better return than a buy-and-hold strategy. Exiting the markets after declines is the worst of all possible strategies because it abandons a wise asset allocation simply because of short-term market fluctuations. But before rebalancing, make certain you have set a wise asset allocation in the first place.

from http://www.emarotta.com/article.php?ID=408

The Summer of Our Employment Discontent (2010-08-02)

The Summer of Our Employment Discontent

(2010-08-02) by David John Marotta

The economy in the first half of 2010 has been disappointing, especially to investors and job seekers. High unemployment, market drops and less-than-stellar hopes for the future regarding taxes and regulation have all added to the general displeasure with our market environment. Now economists are generally predicting "more of the same" for the rest of 2010 at least. Evidently hope of a quick recovery was overly optimistic.

According to the Bureau of Labor and Statistics, the unemployment rate fell from a high of 10.1% last October to 9.5% in June. The decrease is hardly good news. More than 650,000 people are no longer counted as "unemployed" only because they are assumed to have given up even trying to look for work. The Bureau of Labor and Statistics U-6, a more comprehensive measure of employment underutilization, is currently at a seasonally adjusted 16.5%. Even this number excludes "part-time for noneconomic reasons." A survey by "Investor's Business Daily" suggests the number of people desiring more employment may be as high as 24%.

What little job growth is included in the statistics is mostly artificial stimulation from the government. Over a half million people were hired into temporary jobs as U.S. Census workers. As these temporary workers are let go, employment numbers are expected to remain sluggish through the remainder of the summer.

About 8 million jobs have been lost in the private sector since the start of the recession. About 2.7 million of those have been lost since the passage of the recovery act. But we need to add more than 100,000 jobs a month just to keep pace with population growth.

This worrisome shift from private sector jobs to public sector jobs has been measurable. In December 2007, 44.6% of personal income came from private sector jobs. By the first quarter of 2010, however, this number had decreased to 41.9%. Income from government programs rose from 14.2% to 17.9%. If every worker were paid the same, then for every 1,000 workers in America, 27 lost their job in the private sector and 37 of them were hired to work for the government. The remaining workers in the private sector paid an extra 9.8% of personal income to shoulder their increased burden.

Government assistance has taken what might have been a simple recession and turned it into a more lingering malaise. First we spent trillions bailing out corporations that should have just been allowed to fail. It would have looked worse, but it would not have really been worse. Banks would have failed, but the smaller bailout of those banks would have been less expensive and left the financial sector in the hands of those companies that practiced responsibility.

Then we tried simultaneously to juice the economy by spending like a drunken sailor and collect more revenue by raising taxes on sailors. Programs popularly described as "shovel ready," "homebuyer credit" and "cash for clunkers" wasted what could have been spent relieving the private sector from the coming tax tsunami. This reveille of utopia culminated in the health-care reform bill. It removed any limits on the increasing costs of health care other than government inefficiencies and rationing. It also laid the financial burden for those burgeoning costs squarely on the back of small business owners and investors by increasing taxes and capital gains on those with adjusted gross incomes (AGIs) of over $250,000.

Remember, although small business owners can have an AGI of $250,000, they only pocket take-home pay of $75,000 or less. They are heavily taxed on whatever they try to roll back into the business or when they expand their workforce. All this uncertainty is made even more dire with a tax time bomb set to explode in less than 200 days when the Bush tax cuts expire at the end of this year.

This bleak economic outlook sent the markets into a second dip for this recession. Over the second quarter the S&P 500 was down 11.43%. And from the peak on April 23 to the trough on the last day of the quarter, the S&P 500 was down 15.3%.

You might think all of this negative news would be a good reason to get out of the markets entirely. Many investors would agree and have done just that. But we believe that moving with the herd will underperform a more contrarian rebalancing strategy for four reasons.

First, all of this negative news has already been priced into the markets. The economy looks bleak, but it would have to look worse for the price to be driven lower. Second, many investors have already taken their money out of the markets. That is what drives the market lower. They can't drive the market any lower by staying out of the markets. Therefore a bottom often occurs when most investors are out of the markets. Whenever they move back in, they will drive stock prices higher.

Third, hundreds of millions of Americans work for publicly traded companies. Their very livelihood depends on them making those companies profitable for shareholders. I believe in the ingenuity of the American worker. I don't think all those American workers can be held back, not even by millions of new government hires.

And finally, I believe in the fickleness of American voters. They are willing to give new ideas about hope and change a chance. But they are also quick to reject those new ideas when they turn out to be nothing more than misguided and failed government intervention.

The Republicans proved they could spend like drunken sailors. Ultimately they were voted out of office. Now the Democrats have proven they can spend like drunken Republicans, and the electorate is taking note.

A full 59% of the electorate now describes themselves as "fiscally conservative and socially liberal." But only 26% would describe themselves as "libertarian." These changing winds will have their political effect in November. Even today more moderate Democrats are trying to break rank with Obama and Pelosi and extend the Bush tax cuts for the higher income tax brackets.

The economy will recover. Employment will rise. The ship of state will right itself. And even the American stock market will once again continue to advance and enrich its shareholders.

from http://www.emarotta.com/article.php?ID=407