Investment Commentary

February, 2010
By Richard W. Boyer, CFP, CFA

Housing Uncertainty Still a Drag

In my April Investment Commentary, I printed a chart illustrating the increasing number of new home foreclosure filings for the past several years. Under the chart I wrote that, until the trend is a downward one, we continue to wait for better opportunities to purchase equities (stocks). As it turns out, the stock market rallied the rest of 2009 and I shouldn’t have waited to purchase equities. Throughout the second half of the year, there was a tug of war between investment professionals who feel the recession is over and those who feel we have a lot of pain yet to endure. Admittedly, I have leaned toward the latter (and still do). To that end, I present an interesting update to the April home foreclosure chart. Following are the number of new foreclosure filings beginning last July:

• July 360,149 (the peak)
• August 358,471
• September 343,638
• October 332,292
• November 306,627

Notice the downward trend? Every month, there are fewer foreclosure filings than the previous month. The “mortgage modification” seems to be having a positive effect….maybe the economy ACTUALLY IS improving….that is until the December new foreclosure filings were announced January 14th.

There were 348,519 new foreclosure filings in December!! What happened? Below is the updated chart.

click image to view larger version in new window

What is interesting is that, looking over the past 5 years on the chart, there have been several periods that might have led you to believe the mortgage crisis is behind us. These were periods in which the number of new foreclosure filings declined for several consecutive months. You can see this in the summer of 2006 as well as the last few months of 2007, 2008, and 2009. There seems to be something about the new year that gets bankers motivated to kick people out of their homes. The point of this is that several months of declining foreclosures DOESN’T necessarily mean the mortgage crisis is behind us.

Here are some more interesting, staggering and depressing housing statistics:

• Close to 3 million homeowners received at least one foreclosure filing in 2009.
• Interestingly enough, only 871,086 homes were actually repossessed in 2009. My guess is that the persons charged with the job of “repossessing” the homes are few in number. To use an analogy, imagine a viral plague hitting the city in which you live and many people become seriously ill all at once. There would not be enough hospitals, hospital beds, nurses or doctors to handle the sudden massive number of patients. What we are experiencing in our country is an “economic” viral plague. We had three million foreclosure filings but not nearly enough workers to carry out the foreclosure process and the evictions that follow. But that doesn’t mean final foreclosure won’t ultimately happen. Most of them WILL happen. And that is one reason why this country is going to continue to feel pain.
• Almost 11 million homeowners hold a mortgage with a balance higher than the property’s value (i.e. “negative equity”). President Obama’s Home Affordable Modification Program (HAMP) is having a negligible effect.

Meanwhile, the “recovery” continues to be a jobless recovery. Unemployment is over 10% after losing another 85,000 jobs in December. You might think it doesn’t make sense that 85,000 could lose their jobs but that the unemployment rate remains at 10%. You are right….it doesn’t make sense. The method by which “the official keepers of the unemployment data” use to calculate the percent of workers who are unemployed ceases to count those who have lost hope and have given up looking for a job. So even though they are unemployed, they are not counted as being unemployed. However, if you count EVERYONE who is unemployed, whether they are actively seeking employment or not, most estimates are closer to 17% unemployment.

This is not exclusive to the United States. Unemployment in the Eurozone is around 10%. Three million people lost their jobs in 2009 bringing the total number of unemployed in the Eurozone to 15 million. The worst is Spain with an unemployment rate of 19%.

Good news came at the end of January when it was announced the that U.S. economy grew at an annualized rate of 5.7%. Expectations were for growth of 4.6% so this was a pleasant surprise. However, 60% of the growth (3.4%) was a result of an increase in inventories. When our economy came to a screeching halt a little over a year ago, companies scaled back their inventories dramatically because consumers weren’t buying anything. It doesn’t make sense to produce a product if no one is going to purchase it. Inventories were so low that, when a hint of an economic recovery emerged, companies began manufacturing again just to get their inventories back to normal levels. This is growth that will not likely be repeated at this same rate in future quarters. Once inventories have been restored, production is adjusted so as not to create excess inventory. A good part of the remaining growth was the result of government stimulus. This also cannot be repeated indefinitely. Eventually the economy has to run on its own without government stimulus. And there is no question it will eventually run on its own. The only question is…..when?

How long it takes for the economy to run on its own is extremely important for several reasons. One of the most daunting reasons is that we are accumulating a large amount of debt in an attempt to stimulate our economy. In previous recessions, we, the consumer, could spend our way out of the recession. Credit card companies were happy to extend credit and we had excess equity in our homes against which we could borrow. It was EASY! Today? Not so easy.

Remember when you used to receive 3-4 “pre-approved” credit card applications in the mail every week? Receiving those is a much less frequent occurrence today. Equity in our homes? I already mentioned that 11 million homes have “negative” equity. Those that have equity don’t have nearly as much as they used to. It is highly unlikely the consumer is going to spend our way out of this recession as we have in the past.

So who is going to spend our way out of it? It appears the U.S. government is making an attempt. When the private sector is unable to spend its way out of the recession, it becomes necessary for the government to attempt to jump-start the economy….but here should be the alarming concern: The government will discover (the hard way) what the American consumer already discovered (the hard way). Accumulating ever increasing levels of debt has a finite life….it also has an ugly ending. Eventually the point was reached where we couldn’t borrow anymore and were forced to endure a long and protracted recession while we began to reduce our debt levels (so we could borrow again). What the Bush Administration, the Obama Administration (and possibly the next administration) are going to discover is that the same holds true for governments.

The Bush Administration had budget deficits (that’s when you spend more than you earn so you put the rest on a credit card) in excess of $1 trillion during its last term. The Obama Administration ran up a deficit of $1.4 trillion in just its first year in office and is estimated (by the Office of Management and Budget) to have a deficit of $1.5 trillion this year and over $1 trillion next year. And we still haven’t paid back the $1 trillion that the Bush Administration borrowed! Eventually the credit card company is going to call the U.S. Government and say “you have exceeded your credit limit and we are raising your interest rate”.

The U.S. Government doesn’t really use a credit card when it borrows. What actually happens is that they ask investors in our country and other nations to lend the money. When we have borrowed too much (and we don’t know what is “too much” yet), investors will be reluctant to loan our government any more money….unless they receive a higher interest rate in return. The government debt is manageable today because interest rates are low. If and when interest rates increase, reducing the government debt could prove to be difficult. Higher interest rates would mean that a larger portion of our annual tax revenues would just pay interest on the debt instead of reducing the debt….kind of like the person who just keeps making the minimum monthly payment on his/her credit card but never reduces the balance because the interest rate is 24.99%.

Just like high unemployment is not exclusive to the United States, government debt problems are also popular throughout the globe. The PIIGS (Portugal, Ireland, Italy, Greece and Spain) are already starting to get those irritating calls from the credit card companies…..”your debt is too high. We are worried you are not going to pay us back. We may have to cut you off”.

At Boyer & Coporon Wealth Management, we are as worried today about the global economy as we were three years ago. Although we don’t anticipate that our economy will approach the precipice of the financial abyss like we did in September, 2008, we continue to anticipate a difficult investment environment.

ROTH IRA Conversions Planning

by Kenneth P. Woodward, Certified Public Accountant

Many people in the income tax world are referring to 2010 as The Year of the Roth. Now I know that's not nearly as much fun as The Year of the Barbecue Ribs or The Year of the Diamond Earrings but when you make a living preparing tax returns and doing tax planning, you get your thrills where you can and with the Roth IRA, there are some planning possibilities that haven't been available to many taxpayers in the past.

Beginning in 2010, all taxpayers, regardless of their income levels or filing status, have the ability to convert all or a portion of their traditional IRA accounts to a Roth IRA if they elect to. In the past, these conversions were restricted or prohibited if your income exceeded certain levels or if you filed a return separate from your spouse, so many taxpayers were precluded from electing this option. These restrictions are all lifted as of January 1, 2010.

Roth IRA's provide some tax features that are appealing as compared with traditional IRA accounts. Most significantly, once a transfer has been made to a Roth, any future appreciation in the value of that account, either through earnings or capital gains, will be tax free. Also, Roth IRA's are not subject to the Required Minimum Distribution rules, so you are not forced to withdraw funds from your account once you reach age 70 1/2 as you are with a traditional account.

In addition, for conversions that take place in the year 2010, you also have the option of reporting the income from the conversion entirely in 2010 or deferring the income into years 2011 and 2012 (50% each year). Furthermore, a special provision in the law allows you to convert to a Roth IRA in 2010 and then, if the value of the account has declined some time before the filing deadline of your 2010 tax return, you can opt to recharacterize the conversion back to the traditional IRA account effectively treating the transaction for tax purposes as if the conversion never happened. These options provide some potential for tax planning for the right individuals with the right circumstances.

The first and most important fact to acknowledge about these conversions is that they are a taxable event, so there will likely be some tax consequence with a decision to execute a conversion. The taxable amount of the conversion is treated as ordinary income and is taxed at your marginal tax bracket. How much tax you will incur depends on your individual tax situation.

Here are a few factors that could impact your decision:

• Your current tax bracket;
• Your expected future tax bracket;
• Your traditional IRA account balance;
• Whether or not you have been making non-deductible contributions to your IRA;
• Whether you have unused tax losses or credits that are available; and
• Whether or not you are exposed to estate taxes.

It is also important to acknowledge that a Roth conversion has a mandated five year holding period before amounts can be withdrawn without penalties. So, before you elect to convert, you want to be sure the likelihood of needing to access these accounts within five years is very small.

Following are just a few examples of situations where a Roth conversion may be advisable:

• If you have a significantly high tax basis in your traditional IRA as a result of non-deductible contributions made over a period of time.
• If you are in a lower tax bracket now and expect to be in a higher tax bracket in the future.
• If you have lower tax brackets that could be 'filled in' with additional income to take advantage of the favorable rates.
• If you have significant financial resources outside of your IRA accounts.
• If you have a significant amount of time before you plan to retire to allow Roth account assets to grow tax-free.
• If you have a large taxable estate and would like to never have to invade your IRA account while you are living.

There are many more situations and circumstances that might dictate that a possible conversion to a Roth could be in your best interest. Unfortunately, there is no easy answer that can be generalized with regard to who should and who should not convert. Any final decision in this regard will be highly individualized. If you believe that a Roth conversion might be advantageous in your situation, you should contact your tax preparer for a more in-depth analysis.

Kenneth P. Woodward
Certified Public Accountant