Schwartz Financial Weekly Commentary 9/19/11

The Markets

Are the world’s economic leaders focused on solving the wrong problem related to Europe’s sovereign debt woes?

As you may know, Greece and several other European countries are in debt up to their eyeballs. Much of their debt is held by European banks and there’s a big worry that if Greece or some other countries default, then some European banks may face major write-offs that could severely jeopardize their viability.

Unfortunately, what the powers that be in Europe are doing is akin to you going to the doctor and being treated for severe back pain with a heavy dose of pain medication. Rather than “heal” your back, the pain killer simply “masks” the pain.

Last week, five of the world’s leading central banks announced a coordinated action that made it easier for European banks to borrow U.S. dollars to help fund their loan needs, according to The Wall Street Journal. This move addresses the “liquidity” of European banks, but not the “solvency” of them. In other words, it helps ease the symptom of the problem without actually solving the problem.

Simply put, a liquidity problem means you are short on cash and unable to meet current payments due. Typically, it’s a temporary situation that’s resolved by a loan or selling an asset to raise cash. By contrast, a solvency problem is much different. It means you have a structural defect and your revenue/assets are not high enough to support your expenses/liabilities. In effect, your business model is unsustainable. Frequently, it leads to a restructuring or bankruptcy.

In Europe, Greece has both a liquidity problem and a solvency problem. And, by extension, the banks heavily exposed to Greece and some of the other weak euro zone countries may be facing a solvency issue if they don’t raise additional capital.

So far, European leaders have been unable to agree on a once and for all solution to solve the liquidity and solvency problems facing the euro zone. Until they make the tough decisions, we may be stuck in this volatile market environment.

Data as of 9/16/11	1-Week	Y-T-D	1-Year	3-Year	5-Year	10-Year
Standard & Poor's 500 (Domestic Stocks)	5.4%	-3.3%	8.0%	0.1%	-1.6%	1.6%
DJ Global ex US (Foreign Stocks)	1.0	-13.1	-4.1	0.1	-2.2	5.7
10-year Treasury Note (Yield Only)	2.1	N/A	2.8	3.5	4.8	4.6
Gold (per ounce)	-3.1	27.2	41.0	32.0	25.3	19.9
DJ-UBS Commodity Index	-1.9	-3.0	14.6	-2.0	-0.2	4.3
DJ Equity All REIT TR Index	4.1	4.0	10.6	1.6	-0.3	10.6

Notes: S&P 500, DJ Global ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.

Sources: Yahoo! Finance, Barron’s, djindexes.com, London Bullion Market Association.

Past performance is no guarantee of future results.  Indices are unmanaged and cannot be invested into directly.  N/A means not applicable or not available.

“BEWARE OF GEEKS BEARING FORMULAS.” --Warren Buffett

On October 19, 1987, the Dow Jones Industrial Average went into a free-fall that was exacerbated by computerized “portfolio insurance” trading strategies. By the end of the day, about $1 trillion of market value evaporated, according to CNBC.

In the fall of 1998, hedge fund Long-Term Capital Management imploded and had to be bailed out by a consortium of investors orchestrated by the Federal Reserve, according to Investopedia. The fund was led by Nobel-Prize winning economists and employed sophisticated computerized trading strategies that eventually ran amuck.

During the week of August 6, 2007, as the subprime mortgage crisis was gathering speed, several large hedge funds employing quantitative investment strategies “blew up” and lost billions of dollars in just a few days, according to Scott Patterson, author of the book, The Quants.

A “Flash Crash” on May 6, 2010 wiped out $862 billion in market value in a matter of minutes and was triggered by a computer-driven sale, according to Reuters and Bloomberg. Within four days, the entire loss was recouped, according to data from Yahoo! Finance.

Last week, Goldman Sachs announced that it was closing one of its well-known hedge funds that relied on computer-driven trading strategies after it racked up substantial losses this year. At its peak, the fund had $12 billion in assets, according to CNBC.

Despite the occasional headline-grabbing failure of computerized high-frequency trading, it still accounts for roughly 50 percent of all trading volume in the United States, according to Bloomberg. Based on complex mathematics, computer-driven trading is defined as, “A technique that relies on the rapid and automated placement of orders, many of which are immediately updated or canceled, as part of strategies such as market making and statistical arbitrage and tactics based on momentum,” according to Bloomberg.

With this technology takeover of Wall Street, a new element of unpredictability has entered the financial markets. The above examples show how volatile things can get when computer models go haywire.

So, some of the volatility we see in the markets these days may be exaggerated by computerized trading—both on the upside and downside. While we may not like it, we need to get used to it.

Weekly Focus – Think About It

“Interest on debts grow without rain.” --Yiddish Proverb

Value vs. Growth Investing (9/16/11)

Name	1-Week	YTD	4-Week	13-Week	1-Year	3-Year	5-Year
US Market	5.45	-2.06	2.11	-3.95	11.22	2.93	1.17
Large Cap	5.40	-1.54	2.13	-2.99	10.55	1.97	0.51
Large Core	5.53	-2.04	2.52	-3.85	9.41	1.11	1.51
Large Growth	5.92	0.96	3.50	2.22	16.30	4.75	2.81
Large Value	4.61	-4.04	0.08	-7.43	5.86	0.11	-3.07
Mid Cap	5.47	-2.57	2.14	-6.04	12.94	5.38	2.82
Mid Core	5.32	-2.43	1.95	-6.15	13.81	5.95	3.05
Mid Growth	5.83	0.62	2.74	-3.97	18.51	6.81	4.78
Mid Value	5.25	-5.95	1.75	-8.01	6.60	3.25	0.35
Small Cap	5.97	-6.28	1.88	-7.96	12.50	4.74	2.56
Small Core	5.48	-6.94	1.25	-9.11	12.20	4.24	1.67
Small Growth	6.89	-3.54	2.86	-6.12	17.79	5.56	3.67
Small Value	5.57	-8.33	1.59	-8.54	7.49	4.29	1.99
US Core	5.49	-2.42	2.33	-4.63	10.56	2.46	1.97
US Growth	5.97	0.70	3.31	0.36	17.07	5.31	3.34
US Value	4.81	-4.75	0.53	-7.63	6.10	1.00	-2.00

©2004 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) is not warranted to be accurate, complete or timely. Morningstar is not responsible for any damages or losses arising from any use of this information and has not granted its consent to be considered or deemed an “expert” under the Securities Act of 1933. Past performance is no guarantee of future results.  Indices are unmanaged and while these indices can be invested in directly, this is neither a recommendation nor an offer to purchase.  This can only be done by prospectus and should be on the recommendation of a licensed professional.

Office Notes:

529 College Savings Plans are an Ideal Choice for Grandparents

Once their own retirement income stream is secure, many grandparents find it rewarding to contribute to the funding of their grandchildren’s education. Yet, whereas nobody worries about what becomes of the $50 tucked inside a birthday card, gifting much larger sums often gives grandparents reason to pause. What happens if, come graduation, Johnny cashes out his savings account and buys a car to drive cross-country rather than heading off to college?

The 529 college savings plan is tailor-made for grandparents who want to help with college expenses, but want to ensure their contributions go toward a B.A. or a B.S., not an MG. Named after Section 529 of the IRS code, 529s are investment plans sponsored by individual states and managed by an independent investment firm or state agency. Created in 1996, these college savings vehicles offer tax-deferred growth and distributions used to pay for qualified expenses such as tuition, room and board, mandatory fees, books, and required computers that are tax-free. And, thanks to the Pension Protection Act of 2006 that eliminated the 2010 sunset provision for tax-free withdrawals, 529s seem destined to gain in popularity.

As great as tax-deferred growth and tax-free qualified withdrawals are, the major 529 attraction for grandparents may be that 529 assets remain under grandparent control. With 529s, the account owner, not the beneficiary, directs the use of distributions. As the 529 account owner, you can choose to change the beneficiary to another family member at any time. You can even take the money back at any time, for any reason. However, unqualified distributions are subject to income tax and a 10% penalty on the earnings.

Sound too good to be true?  It gets better. In addition to being a problem-solving college savings vehicle, the 529 plan doubles as an estate planning tool. That’s because although assets in the 529 are in your name, the value of the 529 account is removed from your taxable estate. No other investment vehicle allows you to retain full control over the account, including the right to take the money back at any time, while reducing the value of your estate.

Currently, you can make up to $13,000 in 529 gifts each year to any grandchild ($26,000 if your spouse gifts, too) and not be subject to the gift tax. What’s more, if your attorney or financial adviser has recommended that you move significant money quickly out of your estate, 529 plans offer an additional estate planning advantage, often referred to as accelerated gifting. Section 529 offers an election on Form 709 that allows the donor to treat a contribution of more than the $13,000 annual exclusion as occurring ratably over five years for gift tax purposes.

If you spread your contributions ratably over five years (20% per year) for gift-tax purposes, you can frontload up to $65,000 per beneficiary (or $130,000 for a married couple) into a 529 plan without generating a taxable gift, assuming you make no other gifts to that beneficiary during the five calendar-year period. There is one catch. If you make a five-year election but die before the first day of the fifth calendar year, contributions allocated to the years after your death are included in your taxable estate. Note, too, if you take the money back, the assets return to your taxable estate.

The 529’s flexibility as a college savings and estate planning tool mean that it’s here to stay. Your only remaining worry might be that you stash too much cash in the plan. Remember, however, if the grandchild you first name as the beneficiary doesn’t drain the plan, you can change the beneficiary to a younger grandchild. And in a really progressive plan provision, you can name yourself as the new beneficiary.

Now, haven’t you always wanted to take an art history class?

Best regards,     

Michael L. Schwartz, RFC®, CWS®, CFS

P.S.  Please feel free to forward this commentary to family, friends, or colleagues.  If you would like us to add them to the list, please reply to this email with their email address and we will ask for their permission to be added. 

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Schwartz Financial Service, Inc is not an affiliate of First Allied Securities, Inc.

This information is provided for informational purposes only and is not a solicitation or recommendation that any particular investor should purchase or sell any security. The information contained herein is obtained from sources believed to be reliable but its accuracy or completeness is not guaranteed.  Any opinions expressed herein are subject to change without notice.  An Index is a composite of securities that provides a performance benchmark.  Returns are presented for illustrative purposes only and are not intended to project the performance of any specific investment.  Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.  Past performance is not a guarantee of future results.

Section 529 plans vary from state to state.  If your state or your designated Beneficiary's state offers a 529 plan you may want to consider what, if any, potential state income tax or other benefits it offers, before investing.  Contributions are made with after-tax dollars, but any earnings grow tax-deferred.  Withdrawals are federally tax-free, if used for qualified higher education expenses (tuition, fees, room and board and supplies).  For withdrawals not used for qualified higher-education expenses, earnings are subject to income taxes at the owner’s rate plus a 10 per cent federal tax penalty.  The tax implications of a 529 savings plan should be discussed with your legal and/or tax advisors before investing.   There is also the risk that the plan investments may lose money or not perform well enough to cover college expenses as anticipated.

As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan.   The official disclosure statement and applicable prospectus, which contain this and other information about the investment options and underlying investments, can be obtained by contacting your financial professional.  You should read these materials carefully before investing.   

* The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.

* The DJ Global ex US is an unmanaged group of non-U.S. securities designed to reflect the performance of the global equity securities that have readily available prices. 

* The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market.

* Gold represents the London afternoon gold price fix as reported by the London Bullion Market Association.

* The DJ Commodity Index is designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities and was launched on July 14, 1998.

* The DJ Equity All REIT TR Index measures the total return performance of the equity subcategory of the Real Estate Investment Trust (REIT) industry as calculated by Dow Jones.

* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.

* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.

* Past performance does not guarantee future results.

* You cannot invest directly in an index.

* Consult your financial professional before making any investment decision.

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Ponzi Scheme?

On behalf of all Social Security advisors, I'd like to thank Governor Perry for calling Social Security a Ponzi scheme during the Republican debates last week. By getting it out on the table, he gives us a chance to refute this long-held belief that the Social Security system is a scam and doomed to fail.

Here's what he said: "It [Social Security] is a monstrous lie. It is a Ponzi scheme to tell our kids that are 25 or 30 years old today you're paying into a program that's going to be there."

Never mind that he's spent the last week backpedaling on the statement lest he lose too many votes. But the words are out and the press is having a heyday with them, mostly in refutation. The New York Times published a very good explanation of why Social Security is not a Ponzi scheme, and the Washington Post published a primer on Social Security which you might find useful for explaining basic Social Security financing.

Your best resource, however, will come from the Social Security Administration itself, which published a piece in 2009 called Ponzi Schemes vs. Social Security.

Charles Ponzi rose to fame in the 1920s as a purveyor of foreign postal coupons. Claiming there was money to be made by arbitraging such coupons in international trading, he issued bonds that promised investors returns of 50% if held for 45 days or 100% if held for 90 days. The actual postal coupons returned only a fraction of a penny each. But that didn't matter. When the bonds of the first investors came due he paid them, along with their miraculous profit, using the money collected from the second round of investors. The news of these extraordinary profits swept up and down the east coast and thousands of investors flocked to Ponzi's office for an opportunity to give him their money. Using the money from this new surge of investors he paid off the next round of bonds as they came due, with their full profit, which excited even more frenzy.

Seven months later, it all came crashing down. On July 26th, 1920, at the insistence of the Massachusetts District Attorney, Ponzi quit accepting deposits from new investors. It was estimated that Ponzi had been taking in $200,000 a day of new investments prior to the halt. At that point he had already collected almost $10 million from about 10,000 investors. On August 13, he was thrown in jail. After about seven years of litigation, Ponzi's disillusioned investors got back 37 cents on the dollar.

Here's why Ponzi schemes never work. To pay a 100% profit to the first 1,000 investors you need the money from 1,000 new investors. Now there are 2000 "investors" in the scheme. To pay the same return to these 2,000 investors in the second round of payouts, you need the money from 2,000 new investors—bringing the number of participants to 4,000. And to pay these 4,000, you will need 8,000 "investors," then 16,000—and so on.

If all the investors stay in the scheme, the number of participants would double after every round of payouts. Even starting with only 1,000 "investors," by the 20th round of payouts you would need more new investors than the entire population of the U.S. Eventually, the number of new investors that would have to be found would exceed the population of the earth. But of course, Ponzi schemes always collapse long before they reach their theoretical limit as an ever-increasing number of new participants cannot be found.

Social Security, on the other hand, is a "pay as you go" system. While it also uses the money from later participants to pay the earlier participants, the key difference is that it does not require a doubling of new participants to keep the system going. If 40 million workers are paying into the system and 40 million retirees are taking money out, and if the payroll taxes and benefits are relatively in balance—not 50% or 100% higher as Ponzi's payments were—the system can sustain itself forever.

A more accurate way to describe Social Security is that it is a system of transfer payments. Money from the younger generation is transferred to the older generation. Then when the younger generation retires and becomes the older generation, it receives money from the new younger generation. The payments to the older generation may seem to be much larger than the amount they paid in, but they are in line with what the younger generation is currently paying in. Then when that generation goes to collect, they will receive much larger payments too, because everything escalates with inflation.

If demographics were stable—that is, if each generation were the same size—no one would ever be tempted to call Social Security a Ponzi scheme. But there are several reasons why young people are being led to believe they won't collect any Social Security by the time they retire.

First, because the baby boomer generation of 76 million is so much larger than Generation X of about 46 million, it's easy to think that baby boomers will take it all and leave nothing to the next generation. But the Millennial generation that follows Generation X, also called the "echo boom," has 80 million members who are just now starting to work and pay into the system. These demographic variations are normal, and the purpose of the trust fund is to hold excess contributions from larger generations to pay benefits to smaller generations. Chief Actuary Steven Goss says that the problem of too many retirees for not enough workers that will cause benefits to drop to 77% of normal in 2036 is a one-time problem. If the system can be tweaked to take care of that one shortfall, the problem will be solved permanently (assuming people don't suddenly start having fewer children on a permanent basis).

Second, there's a "debt overhang" from the earliest recipients, who paid far less into the system than they took out. For example, Ida Mae Fuller, the first recipient of monthly Social Security benefits, paid a total of $24.75 in payroll taxes. By the time she died at age 100, she had received over $22,000 in benefits. This imbalance is being made up by all future generations who are essentially being forced to subsidize the earliest recipients. Pretty much everyone receiving Social Security now, except the oldest of the old who started working before 1935, has paid their fair share, so this debt overhang is about as large as it's going to be. There have been calls for the U.S. government to transfer enough funds into the Social Security system to make up for the overhang so the system is fair to everyone. But that's not likely to happen in this political environment.

Third, some people think Social Security should be abolished. Ultra right-wing conservatives see it as a welfare program and they are opposed to welfare of any kind. They would rather eliminate the payroll tax and have each individual be responsible for their own financial well-being. One way they attempt to gain support of their agenda to abolish Social Security is by convincing today's workers that they won't see a return of their payroll taxes.

And fourth, our own financial services industry must share some of the responsibility for denigrating Social Security as we've worked to convince clients to save for retirement. While the argument that Social Security will replace only a portion of your income has validity, many advisors and product sponsors have gone overboard, focusing on the diminishing ratio of workers to retirees and generally suggesting that people had better not count on Social Security. While the net effect may have been positive in that it has inspired people to save more for retirement, it often has resulted in a twisted and overly pessimistic view of Social Security.