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Class A shares carry the traditional front-end load. Class A shares have the lowest ongoing expense ratio and are the only shares to have "breakpoints," in which commissions get cut if you invest big chunks of money. Most experts consider the upfront sales charge the best option for long-term investors who are buying a fund and plan to hold it for five or more years. Class B and C shares have no upfront load but levy a 12b-1 fee and a back-end load, paid for selling within a few years of investing. According to Lu Zheng, the Michigan professor who conducted the study with Vikram Nanda and Z. Jay Wang, that trading in C shares is part of the problem. When a fund company adds share classes, the advisory community goes out and pushes the fund, noting the choices an investor has when it comes to paying for advice. That brings in additional money, which can help the fund in the short term. But with the trading inherent in B and C shares and the fact that larger funds typically have a tough time outperforming their benchmark index, the change tends to show up as a drag on performance. "When a firm creates B and C shares, it is imposing liquidity costs on the portfolio," says Zheng, who noted that the study examined all diversified domestic equity funds from 1993 to 2000, by which time nearly half of all loaded funds had more than one share class. "The additional money that comes in at first is good; but after two years, we found that multiple-class funds underperform no-load counterparts by about 1.5% annually." For investors who are looking to hire a financial adviser, the implication is that fee-only advice -- where the customer pays a flat fee, typically about 1 percent of assets under management -- might be a better alternative than paying sales charges.
That's all the more common when preliminary numbers, like the GDP, are involved. It's worth remembering that Friday's figure - 3.4% - amounts to little more than a guess at what happened in the quarter. Revisions will be made for months, maybe years. So how much can we rely on this early number? Recent history provides a clue. Remember the economy's so-called soft patch? That's a term that Alan Greenspan used earlier this year to describe unexpected weakness in the economy. In March, the United States added a mere 110,000 nonfarm jobs, and orders for durable goods dropped for the second month in a row. So when the preliminary GDP numbers released at the end of April were disappointing, soft patch became a favorite phrase for commentators describing the economy. At that time, the Commerce Department's Bureau of Economic Analysis reported that the economy grew in Q1 at an annual rate of 3.1%, much lower than many economists had forecast. But two months later, the GDP number was revised substantially higher to 3.8%, greater than the growth rate in the previous quarter and 22% higher than initially thought. So the evidence that the economy was in a soft patch has pretty much disappeared. It's hardly the first time that initial impressions of the economy have turned out to be wrong. Remember the 2001 recession? There's now a dispute about whether it even happened. Officially, the National Bureau of Economic Research, which dates the business cycle, still maintains that a recession occurred, but according to the classic definition of a recession - two consecutive quarters of decline - it never did. At the time, the data indicated three consecutive quarters of negative growth. But two years later, after painstaking revisions by the Bureau of Economic Analysis, the middle quarter turned out to be positive. Still, these revisions are minor compared with those that occur routinely elsewhere in the world. A 2000 study by three economists at the Federal Reserve Board, Jon Faust, John Rogers and Jonathan Wright, found that revisions for GDP were smaller in the United States than they were in what was then the Group of Seven countries. The problem isn't that the data is shifting; it's that it is often treated as solid fact. At best, the preliminary GDP numbers are a helpful but incomplete aid to perceiving changes in the economy. As J. Steven Landefeld, the director of the Bureau of Economic Analysis, put it: "Our job is to get the general snapshot of the economy about right. We want to tell you whether growth accelerated in a quarter. Or if the economy slows, to capture that." Look again at that first-quarter revision, to 3.8% from 3.1%. If it seems a small difference, consider this: If sustained over a long period, the difference between 3.1% growth and 3.8% growth is roughly the difference between the economy of the Carter administration and that of the Clinton years. That's a big deal to investors, business executives and policymakers. According to Mr. Landefeld, the size of the first-quarter revision was well within the normal range. In fact, it could have been larger and still been unexceptional. He maintains that, on average, the revision for quarterly GDP is typically of the magnitude of one percentage point, up or down. In other words, if GDP is first reported as 3.1%, it probably will turn out to be somewhere in the band from 2.1% to 4.1%. The main reason for revisions is that much final data for a reliable GDP report simply isn't available when the advance report is released. That means that the bureau makes hundreds of extrapolations to come up with the initial figure. Just how much of the figure released on Friday is fact and how much is a best guess? Mr. Landefeld says that one-third of the 1,500 or so data points used to construct the quarterly advance number are estimates - in essence, place holders - that will have to do until the actual numbers come in, sometimes months or years later. The remaining two-thirds of the preliminary data are based on early monthly surveys and other numbers that can also be subject to large revisions. Then there are seasonal adjustments - numbers massaged to account for fluctuations linked to the calendar's changes. These seasonal computations actually tend to transform data over the long term, as every passing year alters the typical factors used in the shift. And because the United States economy is continuously changing, previous ways of calculating the GDP simply do not capture the structural changes taking place. One current quandary for the bureau involves just how to calculate investment in computer software, which has become a much bigger part of the economy in recent years.
Based on its estimates of earnings over the next year, Morgan Stanley reckons that the average P/E ratio of companies in its utility index is 94% of the P/E of the S&P500. That is one reason the bank advises keeping less money in the sector than its weight in the S&P500 warrants. Tim O'Brien, who manages two utility funds for Evergreen Investment Management, says that this near-parity in valuations has not occurred since at least the 1950's. He finds this troubling and warns investors not to expect further outsized gains. Still, Robert Becker, a manager of utility funds for Cohen & Steers, said the stability of utilities could bring in more buyers. "We believe we're in a low-return environment," Mr. Becker said. "Companies with predictable earnings and cash-flow growth are attractive, and utilities offer that." They also offer growth potential through mergers, he said. A bill passed by Congress last week allows utilities greater latitude to buy one another. Richard Bernstein, a market strategist at Merrill Lynch, is hopeful, too, in part because Mr. Becker's enthusiasm for utilities is not widely shared. The absence of much desire to hop on the bandwagon after the rally, contrary to Wall Street custom, is one reason that Mr. Bernstein describes utilities as "our favorite sector." Investors are underestimating utilities' earnings growth, he said, while counting on growth from economically sensitive sectors when the country's expansion may be running out of steam. "The only sector that is supposed to have accelerating earnings in '04 to '06 is utilities," he said. "They deserve a superior valuation." It was just a few years ago that the sector was egregiously undervalued, with a P/E barely 40% of the S&P500's, by Morgan Stanley's calculation. That discount was a byproduct of the taint from "Enron and the Enron wannabes," Mr. O'Brien said. The Enron bankruptcy and scandal, and efforts by other companies to expand their business mix beyond power generation and other staid activities considered traditional for utilities, led to a "reign of terror" by credit rating agencies, he said. Utilities are big borrowers, so they are especially sensitive to the opinions of firms that judge creditworthiness. Those firms advised many utilities that their ratings would be cut if they did not reduce debt on their books. Utilities scrambled to sell new shares to pay down the debt, sending their stock prices lower. After tough years in '01 and '02, life became better for utilities. Rating downgrades abated, and yields on long-term government bonds plunged. When bond yields fall, the dividend yields on utilities become more attractive and shares are snapped up. The 2003 tax cut on dividend income provided an additional incentive to buy. The lower tax rates had the effect of raising dividend yields in the hands of investors. Even after the recent runup, Cohen & Steers' Becker calculates that the after-tax yield on utilities, compared with Treasury bond yields, remains higher than the historical average. Mr. Becker favors companies that have opportunities to sell excess output elsewhere at whatever price the market will bear. Some examples are the Southern Company and Exelon. Another holding is Duke Energy. Apart from the straight-ahead utility, Duke is engaged in a number of businesses - it processes natural gas and owns pipelines - that could be spun out into separate entities, enhancing value to shareholders. Mr. O'Brien looks abroad for companies he thinks offer better-than-average growth prospects, but without higher-than-average risk or valuations. His favorites include British water companies like Kelda, United Utilities and Pennon. Other European holdings include two German electricity producers, Eon and RWE. In the United States, Mr. O'Brien likes Exelon and TXU for their "above-average earnings growth and above-average sensitivity to energy prices." Mr. Bernstein rates Cinergy, Constellation Energy and Entergy highly for their ability to benefit from differences in fuel prices. He also likes several high-yielding utilities that are less free to raise customers' rates, including PG&E, Progress Energy, FPL, Dominion and Ameren. Utilities can't maintain their high-octane performance forever, but if Mr. Bernstein's and Mr. Becker's assessments are accurate, there may be plenty of mileage left in the stocks.
The 15 brain-damaged participants who were the focus of the study had normal IQs, and the areas of their brains responsible for logic and cognitive reasoning were intact. But they had lesions in the region of the brain that controls emotions, which inhibited their ability to experience basic feelings such as fear or anxiety. The lesions had a range of causes, including stroke and disease, but they impaired the participants' emotional functioning in a similar manner. The study suggests the participants' lack of emotional responsiveness actually gave them an advantage when they played a simple investment game. Players were more willing to take gambles that had high payoffs because they lacked fear. Those with undamaged brain wiring were more cautious and reactive during the game. The 41 participants in the study included people with and without brain damage, including a control group with brain damage that didn't affect their emotional processing. Players received $20 and played a simple gambling game that involved 20 rounds of coin tosses. If they won a coin toss, they earned $2.50. If they lost the toss, they had to give up a dollar. They could choose not to play in any given round, in which case they kept their dollar. Logic indicates that the best strategy was to take the gamble in every round of the game, since the return on a win was much higher than the potential loss, and the risk in each round was 50-50. The players with emotion-related brain damage took a more logical strategy, investing in 84% of rounds, while the nonbrain-damaged players invested in just 58% of the rounds. Emotionally impaired participants outperformed the nonbrain-damaged participants, winding up with an average of $25.70 versus $22.80 at the end of the game. "If you just observe these people, they know the right thing to do is invest in every single round," says Baba Shiv, an associate professor of marketing at the Stanford business school and a co-author of the study. "But when they actually get into the game, they start reacting to the outcomes of the previous rounds." Wall Street executives already are paying attention to the findings, since it offers insight into what motivates investors. "This branch of inquiry and economic investigation is really fortifying and buttressing our understanding of investor behavior," says David Darst, chief investment strategist at Morgan Stanley. While the brain-damaged players did well in the specific game in the study, they didn't perform well when it came to making financial decisions in the real world. Three of four of the brain-damaged players had experienced personal bankruptcy. Their inability to experience fear led to risk-seeking behavior, and their lack of emotional judgment sometimes led them to get tangled up with people who took advantage of them. Their life experience suggests emotions can play an important role in protecting our interests, even if they sometimes interfere with rational decision making.
In their book, they point out that a simple diversified index portfolio consisting of four basic index funds (20% S&P 500, 20% Russell 2000, 20% MSCI EAFE and 40% Lehman intermediate government bond) would have returned 12.7% a year during the 25 years from 1979 through 2004. That's a pretty good return. How good? Try these examples. Dodge and Cox Balanced, a fund frequently mentioned in this column and now closed to new investors after years of stunning performance, clocked in at "only" 11.4% over the same period. Vanguard Wellington, another top performer, returned "only" 10.4% over the period. And Fidelity Puritan, another stalwart, returned "only" 10%. Basically, the index fund portfolio blew away the very best managed funds and did it with less risk. The index fund portfolio returned that 12.7% while the S&P 500 was returning about 12%. Whiddon and Alston believe they can beat even simple indexing by using institutional asset class index funds from Dimensional Fund Advisors. The Santa Monica, Calif., firm has deep academic roots in the research of Rex Sinquefield, Eugene Fama and Kenneth R. French. This research shows that it is possible to increase portfolio returns by investing in small cap stocks and "value" stocks with low price-to-earnings and price-to-book value ratios. The financial planners' 80:20 Market Return Portfolio consists of seven asset class funds, including small cap, real estate and emerging market indexes. Only 20% is committed to fixed income. Although the simple index fund portfolio crushed the returns earned by active managers, the Whiddon/Alston model portfolio was returning a whopping 14.29%. And it did it with less market risk. How can this happen? Whiddon attributes the superior performance to several factors: (1) relatively low costs, (2) asset class funds that contain over 15,000 securities compared with fewer than 4,000 securities for a typical index fund portfolio and (3) such broad diversification that downside risk is muted. During a recent interview, he called it "super-diversification." He said that, in practice, portfolios were constructed with 12 to 14 asset classes. This is important. One of the dramatic exercises in their book is a simple probability question: What are the odds that an active manager can select a portfolio of funds that will do better than a portfolio of index funds? If only 30% of active fund managers beat the "U.S. large blend" index, 26% of the managers beat the "U.S. large value index," 39% beat the "U.S. small value index" and 29% beat the "large international index," the probability of a portfolio (or wrap account) manager picking index-beating funds is only 0.88% – less than 1%. In other words, the same major diversification that works to reduce portfolio risk also makes it a near mathematical certainty that a portfolio of managed asset classes will underperform a portfolio of indexed asset classes. Mr. Whiddon put it in broader terms: "The idea with the Market Return Portfolio is that you own the market. You own the entire casino. You own capitalism, which has been successful since it was created."
Money Myth: Co-signing a loan is not a big deal. I'm just a backup. Financial Fact: When you co-sign a loan (or credit card), you are agreeing to pay that debt in full if the primary borrower defaults or misses even one payment. Money Myth: You can't get credit after you file for bankruptcy. Financial Fact: Not only can you get credit, you may actually get more credit offers after declaring you can't pay your debts. So why are lenders willing to give folks a credit card when they know they have filed for bankruptcy? Because once you file for bankruptcy, you can't do it again for many years. In the past, it was six years. Now, under the recently passed bankruptcy law, debtors who file for Chapter 7 bankruptcy court protection will not be able to get any future debts dismissed for eight years. Money Myth: You can't take a tax deduction for home equity loan interest if the money is not used for home improvement. Financial Fact: As long as the loan is secured by the residence and you are not over the home equity limit, you can deduct that interest no matter what the proceeds are used for, according to a spokesman for the IRS. Money Myth: Student loans are dischargeable through bankruptcy. Financial Fact: Student loan debt (either private or government-backed) for the most part is not dischargeable in bankruptcy. There is a provision that allows student loan debt to be wiped out but only in hardship cases. A hardship discharge is a near-impossible standard to meet. You have to prove you can't maintain a minimum standard of living for yourself or any dependent if forced to pay the debt and that you can't pay the debt at the time of your bankruptcy filing or in the future. Money Myth: There is such a thing as too much credit. When credit card companies extend bigger lines of credit to you without your having requested it, it can actually hurt your score. Financial Fact: Having a lot of available (unused) credit is not taken into consideration in the scoring models produced by Fair Isaac, which created the FICO credit score model used by many lenders. That's because it is not nearly as predictive of future repayment risk as how you have managed your actual debt. If you don't pay your bills, or if you use more than 50% of your available balance, that can cause a drop in your credit score. So don't worry about your credit limit being raised. Money Myth: If a credit card holder dies with a balance, the debt is wiped out [and] the estate does not have to pay. Financial Fact: Do your debts die with you? Sorry to say, but no. Many companies may choose to forgive the debt, but others may try to collect from a deceased person's estate. The trustee of an estate is required to contact creditors and pay debts before distributing any money or property to any heirs. Creditors can lay claim to any assets, even if you haven't named a trustee. Of course, for many people there isn't any money to satisfy debts, making the issue moot. The good news is that you can't really inherit someone else's debt (unless you took on that obligation somehow -- by co-signing a loan, for example -- before the person died). So if one of your parents dies owing lots of money that the estate can't cover, the creditors won't be able to take it out of your pocket. How Fund Categories Fared Barrons 7-08-2005
Two causes of this faster turnover: [1] Program trading, which has begun to account for more than half of the NYSE volume; and [2] The Internet, which makes it easy to check the value of our investments. Psychological research has shown that investors tend to trade more frequently the more often they check their portfolios' values. One survey I have on file, conducted in 1996, showed that 21% of online investors check their portfolios' values more than once a day. I'll bet the percentage today is a lot higher. This increased turnover is having an impact on companies' long-term value. Researchers report a frustrated and cynical reaction from companies' boards of directors when asked about whether they are serving the shareholders' interests. "Which shareholders do you have in mind?" they would ask the researchers. Should corporate leaders focus on serving the shrinking number of investors who truly are interested in the long-term over many years, if not decades? Or should they instead cater to the growing proportion of their shareholders who will not even own the stock in a year's time? It would be one thing if these two groups of shareholders had similar interests. But they don't. Short-term traders clamor for anything that will boost the stock price right away, including the sacrifice of long-term value.
If your portfolio's well-balanced to begin with, rebalancing is generally a waste of money. Instead, just pick your initial asset mix, save regularly and simply add new money to depressed areas to keep your portfolio in line with your ideal portfolio. In a study published in early 1997, the Schwab Center for Investment Research compared once-a-year rebalancing with rebalancing every three years. The annual results were 13.43% with annual rebalancing and 12.53% with rebalancing every 3 years (selling funds in the bottom 25% of their category). Schwab continues to recommend annual rebalancing over a buy-and-hold strategy, to cut risk. Recently, Vanguard's consulting and research group did a similar study using market data from 1960 to 2003. It said if you don't add any new money, market swings alone will knock your portfolio way out of whack. The gist of the Vanguard & Schwab studies is that rebalancing makes sense on an annual basis, but you don't have to do it monthly or quarterly as many commissioned brokers suggest. A portfolio starting in 1995 with a mix of 60% stocks and 40% bonds whould have shifted - without rebalancing - to 77% stocks and 23% bonds, due simply to movements of the markets. "The greater exposure would have led to larger losses during the bear market of 2000-2003," the Vanguard study found. Should you worry about increased risk? Not if you have a portfolio that already minimizes it. That's what Bill Schultheis, a former Smith Barney insider, does with his Coffeehouse Portfolio. It's so simple, boring and effective that commissioned brokers hate it. Just seven funds: 40% in a total bond index fund, and 10% each in six diversified stock funds. Ten-year average annual returns are near the market's and in the 2000-2002 bear maul, this mix beat the S&P500 by roughly 15 percentage points each year, with no rebalancing. Many unbiased advisers say annual rebalancing is enough. Others suggest rebalancing when allocations deviate 5 to 10 percentage points from the ideal. I say get the right balance up front and you can erase the word "rebalancing" from your vocabulary. Focus attention on your initial balance, not future rebalancing. Add regular savings (new money) to whatever part is below-target to keep your portfolio in balance. Compounding will do the heavy lifting. Rebalancing Stats John Waggoner, USA TODAY 7-08 Once you've set your portfolio, how often should you fiddle with it? Not very. Even if you're not counting commissions or taxes, overtrading is counterproductive. Suppose you had a portfolio of 60% stocks and 40% bonds. You invested $10,000 10 years ago. (We're using the S&P 500-stock index and the Lehman Aggregate Bond index here for illustrative purposes.) If you rebalanced your portfolio every month - a Type A approach if there ever was one - you'd have $23,732 now. If you rebalanced only when your portfolio was 5 percentage points out of kilter, however, you'd have $24,213, and you would have rebalanced seven times in the past 10 years. If you waited until it was 10 percentage points out of whack, you'd have rebalanced twice - and have $24,436.
Whether professional investors place much faith in timing the market is closely aligned with how they earn a living. Fund managers, who are paid to pick stocks, tend to put little store in timing, while market strategists and editors of advisory newsletters are more likely to adhere to it. Timers make their case first by making the same observation that John Pierpont Morgan did a century ago when asked what the market would do: "It will fluctuate." Pete Kendall, co-editor of the Elliott Wave Financial Forecast newsletter, said: "There's a reality in the marketplace; it moves up and down. If you're saying buy and hold, you're essentially denying that reality." The stock market tends to rise over the very long term, but there are significant and persistent declines along the way that Mr. Kendall and other timers believe can be avoided by following certain signals. He cited an example from not so long ago. "There are signals and methodologies that have worked over the long haul by which you can time long-term trends," he said. "In 2000, there were many things taking place that you could have used as signals. "The belief in buy and hold is a signal in itself," he said. "It was at an all-time high" during the technology boom. When the market moves down, that is when timing comes into fashion, as it did during the 1970's, which Mr. Kendall called "a golden era for market timers." Today is not such a time for timers, not after a two-year run that has put 3,000 points onto the Dow Jones industrial average. Stock pickers and other opponents of timing point to studies showing how much worse returns would have been, compared with those from buying and holding, if investors had been out of stocks on certain important dates. Standard & Poor's examined the effect on its benchmark 500-stock index of being on the sidelines during the 10 best trading days in the 10 years through 2004. An annualized gain of 12.1% would have shrunk to 6.9%. But anyone who was fully invested on all but the 10 best sessions would be the unluckiest trader alive. What if another mythical trader had the astoundingly good fortune to have been in the market on all but the 10 worst days in the last decade? The annualized return would have ballooned to 17.8%. So rather than showing that market timing is bad, timers would suggest, the study merely shows that bad market timing is bad. But, for the pro-timing camp, an uncomfortable conclusion is found in another study, conducted by Dalbar. It may be true that market timing is a sound practice as long as it is done correctly, but Dalbar's research shows that investors buying and selling mutual funds in the real world have a chilling knack for not doing it right. Over the 20 years through 2004, the average stock mutual fund investor earned a reed-thin 3.5%, annualized, compared with an annualized gain of 13% for the S&P500. Susan Hirshman, an adviser to financial planners for J. P. Morgan Funds, explained that investors habitually underperform because they give up on weak investments and trade them in for strong ones just before a reversal is due. "Why haven't people done well in the stock market?" she asked. "It's not the market. It's the behavior." Such findings underpin the discouragement of market timing. "People who can do timing of the market are going to be the best performers, but the probability of doing it is very low," said Robert Olstein, manager of the Olstein Financial Alert fund. "Look at all of the great forecasters of the market. There aren't any who have done it with enough consistency to benefit their firms. It's the futility of gauging the psychology of the masses." Catherine Gordon, head of the investment policy group at the Vanguard fund management firm, expressed similar reservations. "In general, it's a bad idea, only because [timers] have to be right on both sides of the decision, when to move in and when to move out," she said. Another drag on timers' returns is the costs - extra commissions and capital gains; if traders move in and out enough, they will be taxed at the higher rate for short-term gains. Ms. Gordon suggested using a middle approach, which is rebalancing, which is not quite timing or buying and holding, either. A reasonable asset allocation is 60% to stocks and 40% to bonds. If stocks rise to the point that they account for 70% of a portfolio's value, an investor can sell some of them and put the proceeds into bonds.
The apparent disconnects among cheap money, flush corporate coffers, fancy earnings gains and stagnant equity performance could partly be a problem of aggregation. That is, looking at market-wide valuations and profit growth obscures the fact that all of the upside in earnings growth has come in areas that the market doesn't pay much for -- energy and materials. And with another low-multiple group, financials, accounting for some 40% of all S&P 500 profits, it's perhaps less surprising that the index hasn't evidenced more pep. It's common to hear that the S&P 500 is at "only" 16 times expected 2005 earnings, "cheap" considering 10-year rates at 4%. But there's no trusty relationship between these two things, valuations and rates -- conceptually or practically. The highest S&P 500 forward earnings multiples of the past 20 years of around 19 to 20 -- achieved a couple of times in the 'Nineties -- happened with yields near 7%, points out quantitative strategist Gary Tapp of SunTrust Robinson Humphrey. Aggregating all sectors into a single P/E multiple conceals the fact that only three of the nine industry sectors have multiples below the index multiple: energy, materials and financials -- the sources of much of the earnings gains and all the profit outperformance this year. Richard Steinberg of Steinberg Global Asset Management has built earnings forecasts for each S&P sector exchange-traded funds, and the breakdown shows technology and consumer discretionary stocks at 20 times 2005 profits and the other two groups between 17 and 19. The trend of multiple compression coexisting with low rates may be due to moderating growth trends and weaker appetites for equity risk in a post-bubble period. It's arguable that the public has turned to condo-flipping and online poker to sate its speculative tastes. But this isn't a big help in handicapping the market's short-term course. But note: Earnings-report season approaches, and the Q2 preannouncement season had the highest ratio of negative to positive previews in eight quarters. Jason Trennert of ISI has chronicled an apparent pattern in which particularly negative preannouncement periods tend to precede a stronger market during reporting month. Yet Morgan Stanley's Henry McVey notes that earnings months since Q2-04 have shown an average decline of 1.6%, contrasting with gains in other months. So pick your verdict.
Those involved in the new research say they have found at least a partial answer to the puzzle in something so basic that past studies all but overlooked it. All that is needed for the size and value advantages to exist is for some stocks to be overpriced and others to be priced too cheaply. Several researchers have been involved in this line of study. One is Robert D. Arnott, editor of the Financial Analysts Journal and chairman of Research Affiliates, a research and asset management firm. An article by Mr. Arnott outlining this research appeared in the March-April issue of that journal. His argument is based largely on simple logic: By definition, an overvalued stock has a larger market capitalization than would otherwise be the case. Its price-to-book ratio is also higher, and thus it is closer to the growth end of the growth-value spectrum. Portfolios of large growth stocks will contain a disproportionate number of overvalued issues, and should, on average, lag behind the market. The opposite is the case for undervalued stocks. So small-cap value portfolios will have more than their share of them and should beat the market in the long term. Notice that this argument does not depend on anyone being able to identify undervalued or overvalued companies. Nor does it depend on a specific definition of fair value. All that is required is that some stocks are overvalued and some undervalued. Only the most diehard believer in market efficiency would deny this precondition. Consider again the S&P 500. According to S&P data, an equal-weighted 500 index would have outperformed the cap-weighted version by 1.3 percentage points a year, on average, since the beginning of 1990. One index fund that uses the equal-weighted system is Rydex S&P Equal Weight, an exchange-traded fund. Related: [Arnott's Funds at Pimco] Buidling a Better Index Fund - Tom Petruno, LA Times
The consensus calls for modest but slower growth in the next 12 months. It also calls for inflation that is tame but still near the bounds of what the Fed considers unacceptable. The delicate task for the Fed is to tighten policy enough to keep inflation in the central bank's comfort zone without tightening so much that it threatens growth. The nation's GDP is expected to expand at a rate just shy of 3.5% during the remainder of the year and at 3.3% during the first half of next year. By contrast, the growth rate has exceeded 3.5% during seven of the past eight quarters. And the consensus calls for the CPI to rise 2.8% in the 12 months through November and 2.5% in the 12 months through May 2006. Forecasters also expect business to add 180,000 jobs a month for the next year, just enough to push the unemployment rate down slightly to 5% by next May from 5.1% today. Economists have other concerns - from high oil prices to froth in the housing market to record trade deficits - that could swiftly change the outlook. They also have a list of economic puzzles that could affect their projections. How, for instance, does the emergence of China as an economic power affect the fancy econometric models they use to make forecasts? What will the world look like when Greenspan steps down from the Fed in January? And why are long-term interest rates falling when short-term interest rates are higher? Eleven of the 56 economists surveyed said the booming housing market is their biggest worry. Right now, this boom is providing a big boost to consumer spending. Dean Maki, chief economist with Barclays Capital, notes that, during the past year, the net worth of households has increased by nearly $4 trillion, thanks in part to rising home values. Combined with robust gains in inflation-adjusted incomes, "this ensures that consumer spending will stay relatively healthy through the end of the year," he says. But because households have so much wealth tied up in their homes, a bust in the housing market could create a negative wealth effect, a decline in asset values that cuts into spending. As a group, economists played down the possibility of an all-out housing crash. Thirty-four said that, if the housing market does soften, it will be isolated to a few markets without hurting the broader economy. But their worries are mounting. "People have used a tremendous amount of home-equity-loan money to support spending," says Susan Sterne of Economic Analysis Associates. With short-term rates rising, she thinks the interest burden for many households could get heavy and slow spending. She predicts growth will average 3% in the next year, a bit less than consensus expectations. Ten economists said they are concerned about the record U.S. trade deficit, which has been driven by booming imports and soft exports to slow-growing economies like Japan. An additional 11 said high oil prices were a concern. Economists at the Conference Board, an independent business-research group, were even bigger bulls at the start of the year, expecting GDP to advance about 5.4% during the first half of this year and less than 4% for the second half. But now they expect growth of about 3% for the remainder of this year. Their index of leading economic indicators has been falling, and they worry that consumer confidence is fragile. "I don't see...a pickup in consumer spending," says Ken Goldstein, a Conference Board economist. If the Fed slows the pace of monetary tightening, as the forecasters expect, it would be good news for the stock market. Thirty-one economists said they expected the Dow break above 11000 by the end of the year. A healthy profit outlook also should help stocks. Corporate profits, broadly measured across the whole economy, are expected to grow by 11.8% in 2005 and 6.1% in 2006. But economists are keeping a wary eye on how companies manage profit margins and labor costs in the months ahead. In nonfarm businesses, unit labor costs were up 4.3% in Q1 from a year earlier, the largest increase in five years. When labor costs rise like that, it gives companies an incentive to push prices higher to preserve profits. It all might be a temporary blip, but 35 of those surveyed said they worried the labor-cost increases might be a signal that broader inflationary pressures are building, a factor that would keep the Fed on a tightening path. Another source of substantial uncertainty is the path of long-term interest rates. Economists predict the yield on 10-year U.S. Treasury notes will rise to 4.6% [4.5% mode prediction] by year's end and to 4.8% by this time next year, from 4% today. But they have been consistently wrong when predicting long-term rates for the past few years, calling for increases that haven't come. If long-term rates unexpectedly fall instead, it would add more fuel to the housing sector's fire by lowering the cost of financing a home. That is something Fed officials have made clear they want to avoid. It also could cause an "inverted yield curve." In the past, that has signaled recessions, and that is something the Fed also wants to avoid, especially in Mr. Greenspan's final days in office.
As a result, investors and their accountants -- along with the banks, brokerage houses and insurers holding IRAs -- are making plenty of mistakes. No matter who's at fault, individual IRA holders usually wind up paying the price. The cost can be steep, both in lost opportunities and in big penalties if withdrawals aren't done correctly. Until recently, few people paid much attention to the rules because IRA balances were relatively modest compared with other retirement savings. But now, three decades after the accounts were created, Americans hold $3.5 trillion in IRAs, and they make up 27% of the $13 trillion U.S. retirement market, according to ICI. Assets held in IRAs are increasing on average 13% a year, and that growth is expected to accelerate as baby boomers retire and roll over savings from defined-contribution plans. Those same boomers are also starting to inherit hefty accounts from their parents. And for the first time, the federal government is watching to make sure you take your withdrawals, and pay any resulting tax. Last year, the IRS started requiring the institutions that hold your IRAs to report annually whether you have to make a withdrawal from your account. To help you avoid IRA angst, here are some of the most common, and costly, mistakes that investors and financial experts alike make with IRAs -- and how to fix them: Failed Rollovers There are two times when you might roll assets into a new IRA: When you retire or otherwise leave a job with a defined-contribution plan, like a 401(k), or when you simply move an IRA from one financial institution to another. In either case, you have 60 days to get the money from one tax-deferred account to another, though it can sit in a taxable account while you decide what to do with it. The problem: It's easy to let the deadline pass you by, which means you would have to pay income tax on the entire amount that year, rather than continue to let your assets grow tax-free until you start making withdrawals. Most of the financial planners, investment-firm executives and accountants interviewed for this story say this is the worst IRA mistake they see. Here's the good news: So many people were missing the 60-day deadline, and often blaming the investment firm or bank that was supposed to get the money into the IRA for the mistake, that the IRS set up what it calls an "automatic waiver" for the problem a few years ago if you meet several conditions. They include: You moved the money to the financial institution setting up the new IRA within the 60 days, and you asked it to put the money into the new IRA, following all of its procedures for doing so. And even though you missed the 60-day window, you still moved the money into the IRA within a year of the first day of that period. The bad news: A lot of would-be IRA investors don't get the money moved within a year, so they don't qualify for the automatic waiver. Ms. Choate says many people aren't reading their financial statements, which would alert them to the problem. Instead, the first inkling they have that something went wrong comes the following January when they get a 1099 form showing they took a distribution and owe tax on the money. There is a fix, however. You can request a "private-letter ruling" from the IRS (by filing an application and paying a $95 fee, plus other fees if you hire an adviser) to get off the hook. Since October 2003, nearly 400 taxpayers have done just that, according to an IRS spokesman. Mid-Year Rollovers Another possible pitfall: If you're already over 70 and a half years old and taking required distributions from your IRA every year, be sure to make your annual withdrawal before doing a rollover. If you're already in pay status, you aren't allowed to roll over that year's minimum distribution. If you don't know about that rule and move the money anyway, and then take the distribution from the new account, both custodians could wind up reporting your distributions to the IRS -- even though you took only one withdrawal. It's not illegal to take twice as much from your IRA as required, but it means you'd have to pay more in taxes. Untangling the mess requires professional help. Roth Conversion Confusion If you plan to pass along your IRA to your children and you want them to have it as a Roth, you have to do the conversion -- you can't leave it up to them to do it after you die. But it's still easy to make mistakes when you do the conversion in advance. Pat Freeman persuaded her elderly mother to convert her traditional IRA to a Roth last June, figuring "that her tax rate for the conversion was much lower than mine," she says. "My accountant failed to inform me about certain rules," including the need to take her mother's required distribution from her IRA before doing the conversion. Once Ms. Freeman realized the mistake, she took the distribution from the Roth, and did so in the same calendar year, [Roth rules prohibit distributions for the first five years] she adds. Although the IRS could hit her with a 50% penalty, it probably won't, says Mr. Slott, the tax adviser, because she corrected the error quickly and in good faith. Putting Company Stock in Your IRA If you have company stock in your 401(k) plan, take a step back before you roll it into an IRA -- or before you make any withdrawal, at any age, of any assets from the plan. A little-known tax break for what's known as "net unrealized appreciation" allows you to pull out some or all of your shares in the company where you work at the same time you roll the rest of your assets into an IRA. The big advantage: By taking the stock out of your 401(k), any increase in the stock price after you originally acquired the shares would be subject only to long-term capital-gains tax, with a maximum 15% rate, rather than ordinary income tax, up to 35%. You have to pay income tax on the original purchase amount, or "cost basis," when you take it out of your tax-deferred plan. But you wouldn't owe any capital-gains tax until you sell the stock. You have a one-time opportunity to do this. You're no longer eligible once you take any distributions at all from your company retirement plan, including required distributions from your company plan after age 70 and a half. Also make sure that both parts of the transaction -- the withdrawal of the stock and the rollover of any remaining assets into an IRA -- are completed in the same year. Otherwise, the IRS could deny the tax break. One other note: Use the company stock first to fund your retirement needs or make charitable donations. Upon your death, most stock that your heirs inherit gets what's called a stepped-up basis, which means they wouldn't owe capital-gains tax. But employer stock that already has gotten the favorable treatment described above does not receive the same bump in value. Taking Too Little or Too Much from 72(t)'s It's possible to take regular payments from your IRA and avoid paying the 10% penalty for withdrawals taken before you turn 59 and a half years old. But it's also easy to make mistakes with those payments, by taking out too little or too much, that could cost you in retroactive penalties and interest. (They are called 72(t) payments for the section of the tax code that governs them.) The big rules: You have to take what the IRS calls a series of substantially equal periodic payments, on a schedule. And you must continue taking them for at least five years or until you turn 59.5, whichever period is longer. So, if you start taking withdrawals at age 50, you're on the hook for 9.5 years; if you start at age 57, you'd have to take the withdrawals until you turned 62. And you should work with a financial adviser, accountant, or IRA custodian familiar with 72(t) payments to set up your plan. But once you get the payments established, it's easy to forget the rules' rigidity after a few years, says Ellie Deskin, a financial planner. She rescued one client just months shy of turning 59.4, who had been taking payments since age 52, after she received a letter from the insurer that held his IRA saying it was "in receipt of the request for additional payment" and would mail the check. It turned out that his daughter was expecting twins, and he wanted the money to buy nursery furniture. "It would have cost him $10,000" -- a 10% penalty on all his seven years of payments so far, plus interest, she says. "You call and ask [the IRA custodian], 'Can I take the money out?' They'll tell you, 'Yes, you can,' but that doesn't mean there won't be huge tax ramifications." You can also get into trouble for taking out too little money after setting up scheduled withdrawals, though you're allowed to change the way you take payments one time. After the stock-market downturn, the IRS ruled in 2002 that you could switch from higher payments to lower ones calculated using your life expectancy (the same way you would calculate minimum withdrawals after age 70.5). The idea was to keep retirees from using up their retirement accounts too quickly. But the fix is of limited use, Ms. Deskin says. The minimum distributions often are so much smaller than the original withdrawals that "it doesn't help the person who needs income." Missing a Low-Tax Opportunity There's one mistake that you could make by not taking money out of your IRA -- particularly if the bulk of your nest egg is tied up in such an account, as is often the case for self-employed professionals. You probably think you're doing the right thing by leaving your IRA money untouched until age 70.5, when you have to start making withdrawals. After all, that allows you to take full advantage of the tax-free growth your financial advisers have touted for years, right? Perhaps not. If your tax bracket drops after you stop earning a regular paycheck, and you expect your tax rate to increase again when you start taking mandatory IRA withdrawals, it may be a good time to take some money out of your IRA. That way, you pay lower taxes on your IRA money than you would by postponing those withdrawals. To figure out how much to take out, you would subtract your income for the year from the ceiling of your current tax bracket, and then withdraw as much as you could from your IRA without bumping yourself into a higher bracket. For example, a retired, married couple with $50,000 in income would be in the 15% tax bracket, which has a ceiling of $59,400 in income. They could withdraw $9,400 from their IRA before bumping their tax rate for additional income to 25%. Taking your money out of an IRA now to save on taxes down the road doesn't mean you should run out and spend it. Since you've paid taxes on the withdrawal, you could roll it into a Roth IRA, an account in which you can invest after-tax money in exchange for tax-free growth. Stretching Inheritied IRAs Dorothy Galvin and Barbara Rubinstein realized their mistake too late. When their mother left the two sisters an IRA worth $212,000 last year, they were advised to roll the money into new IRAs to avoid a big tax bite all at once. The IRA custodian cut each sister a check, which they deposited into new accounts. But at tax time this spring, Ms. Rubinstein's accountant had bad news: To preserve an inherited IRA, you have to keep your hands off the money by doing what's called a trustee-to-trustee transfer into an account specifically designated for inherited funds. Now, the sisters have to undo the new IRAs, and pay taxes immediately on their whole inheritance. Inherited IRAs don't work like regular IRAs. So don't assume that any of the rules governing the IRAs you own would apply to any that you inherit. For example, if you inherit an IRA from anyone other than your husband or wife, you cannot, under any circumstance, roll it into your own IRA. You also can't withdraw the assets from an inherited account and then deposit them into a new IRA. And you can't consolidate IRAs you inherit from different people into one account. But traditional IRAs and Roths that you inherit have one important thing in common with the ones you hold yourself: You can stretch out the withdrawals across your lifetime, rather than taking them as a lump sum. That gives you a chance to postpone the tax bite and lengthen the time that tax-free earnings can accrue, possibly increasing your inheritance by thousands of dollars. Unfortunately, few heirs realize that's even an option. Until 2001, when the IRS proposed new IRA rules that became final the following year, most people -- including all types of financial advisers -- assumed that you had to cash out an inherited IRA within five years of the owner's death. That's because the government had made that option the default. But the new rules make it easier to stretch those withdrawals across your life expectancy. Even if you successfully get the money into your own account, it's important to recognize the unique way you must withdraw it. With your own IRA, you have to start taking minimum withdrawals by April 1 of the year after you turn 70.5, and you determine the minimum amount each year by looking up your life expectancy in the appropriate table and then dividing your year-end account balance by that number. (The tables are at www.irs.gov7 in Publication 590.) But with an inherited IRA, you first need to retitle the IRA so it's clear that the owner died and you are the beneficiary. After doing that, you would look up your life expectancy one time. Each year, you simply subtract a year from your initial life expectancy to figure out how much to withdraw. And if you inherit an IRA along with other heirs, typically your siblings, you can split up the account, allowing each heir to spread withdrawals across his or her own life expectancy. Otherwise, you get stuck using the life expectancy of the oldest heir. Watch out: Some IRA inheritors are finding they must hold the hands of the institutions that maintain their accounts. Naming No Beneficiary, or the Wrong One When it comes to your IRA, your will is irrelevant. The way an IRA gets passed along to your heirs is governed by the beneficiary form you are supposed to fill out when you open the account. It's a good idea to review those forms regularly and keep your own copy in an easy-access spot, because banks and brokerage firms can lose track of the paperwork over time. And make sure you fill out a beneficiary form when you inherit an IRA as well. You may see a box on the forms to check for a "per stirpes" designation. That means the assets would go to your beneficiary's children if he or she dies before inheriting your IRA. If you name no beneficiary, or you name your estate, your heirs lose the ability to stretch their withdrawals over their lifetimes, which means they would also lose out on the potential for decades of tax-free growth of your assets. In some cases, naming the estate as the beneficiary could even prevent your spouse from being able to roll the plan into his or her own IRA. Take extra care with your beneficiary form if you're in a complicated family situation. Maryann Bolles, a 67-year-old retiree, set up a trust in her will that left her money to her second husband. But upon his death, it would go to her two children from her first marriage. Only one problem: Most of her assets are in her IRA, and she designated her estate as her IRA beneficiary. That means everyone would get the money, but they wouldn't have the opportunity to keep it as an IRA. Leaving Your IRA to a Trust Naming a trust as a beneficiary can create problems, too, even though many people are advised by estate planners to do so. It can make sense if your heir is a minor child (because minors can't make tax elections), has a disability or needs help managing IRA distributions, or if you're trying to shelter assets in a divorce. Otherwise, using a trust to inherit an IRA poses two big risks. First, it could wind up paying higher taxes than your heirs would, because trust tax rates are higher than most individuals' rates. (The 35% tax rate kicks in on a trust when income exceeds $9,750, compared with $326,450 for individuals.) Second, the IRS could decide that the trust doesn't qualify as a "look-through" or "see-through" trust, meaning your heirs wouldn't qualify to take stretched-out withdrawals -- even though you may have set up the trust in the first place to make sure they did just that. Trusts that fail to qualify typically include beneficiaries who aren't people, such as the estate, a charity or another trust. Since those entities don't have life expectancies, stretched-out withdrawals would not be allowed for any of the beneficiaries involved. If you have reason to use a trust but are wary of the cost or fear it might not meet the test for stretched withdrawals, a possible fix is a "trusteed IRA," a combination of a trust and IRA in which the trustee can have more active responsibility, withholding payments from the beneficiary or making payments to a disabled beneficiary. Overlooking the Estate-Tax Break When you inherit an IRA on which federal estate tax has been paid, you're entitled to a little-known tax break called the Income in Respect of a Decedent, or IRD, deduction. It often gets overlooked because the accountant or attorney who prepares the estate's tax return doesn't break out the amount of tax caused by the IRA; the accountant or financial planner working with the heir doesn't ask for it; and the heir doesn't know it exists. Gerry Mandel and her two sisters inherited an IRA in 2002 from their mother. Four months ago, financial planner Rich Winer asked one of the sisters if they had taken the deduction, and they had not. "Both my accountant and the accountant that my sisters used missed it," Ms. Mandel says. "On my return this year, it was over $7,000 as a deduction" -- enough to cover the tax she owed on her $17,000 withdrawal from the inherited IRA. Now, she and her sisters are amending their 2002 and 2003 returns. 54%: Portion of IRA-owning households with IRA assets in stock mutual funds $5,000: Median amount they withdrew $8,600: Median value of each household's Roth IRAs $10,000: Median amount converted from traditional IRAs to Roth IRAs $24,000: Median value of each household's traditional IRAs 5.5 million: Number of households that made withdrawals from traditional IRAs in 2003 14 million: Number of U.S. households that own Roth IRAs 16.9 million: Number of households that have rolled over assets from employer-sponsored retirement plans to traditional IRAs 37 million: Number of U.S. households that own traditional IRAs 45 million: Number of U.S. households that own IRAs Source: Investment Company Institute As great as the above article was, it was not an all inclusive list of mistakes. A 30 minute search on the net resulted in finding these additional 'mistakes'. Are there even more? Probably. AdvisorToday.com [http://www.advisortoday.com/200409/WebExclusiveArticles/webexart_tenkey.html] Making inappropriate spousal rollovers - Oftentimes, spousal beneficiaries will roll an IRA into their own IRA. Your clients will benefit from your informing them it’s often more tax efficient to leave it in the original owner’s name. For instance, if the spouse beneficiary is under 59-and-a-half, he may want to leave the assets in a “Beneficiary IRA” to allow him to take distributions free of the 10 percent premature-distribution penalty that would apply if he took distributions after the account was rolled over into the survivor’s name. Bruce Lefavi, a nationally recognized financial expert and talk show host [http://www.lefavi.com/ira.html] Most company 401(k) plans are so inflexible that they make it almost impossible for someone to use multi-generational planning. Therefore, one of the most important things you can do is, as soon as you are allowed, to immediately get the money out of your 401(k) and into an IRA where the funds can be treated in a more flexible manner. Most people in the financial world do not understand how IRAs can and should be used. A Forbes study showed that 90% of the IRA account administrators did not know the options available for IRAs. This means that your chance of finding someone who really understands how IRAs should work is small. But don't abandon hope. Keep searching until you find someone who does. If you name a charity or a trust as a partial beneficiary of an IRA, the IRA is considered to have no designated beneficiary. The money must then come out of the IRA and be taxed within five years of participant's death. You should not make any non-person a beneficiary of an IRA because then the entire IRA must come out and be taxed within five years of the participant's death. [This may NOT be current law.] 1040form.com [http://www.1040form.com/02_tax_tips/ira_mistakes.htm] Don't choose just one IRA beneficiary. Naming a contingent or backup beneficiary gives your heirs tax planning opportunities after you die. Military Officers Association of America [http://www.moaa.org/FinancialCenter/financialforum/Mar2002.asp] Holding too many IRAs: Unless you have a real need to separate IRAs—such as different IRAs for multiple heirs or an IRA designated solely for a charity—consider consolidating them. Otherwise, multiple IRAs can create more paperwork, generate higher fees, and make it difficult to track investments. Space Coast Credit Union [http://www.sccu.com/Benefits/edarticles/commonira.asp] Naming the Estate as Beneficiary - When you name your estate as beneficiary of your IRA, it becomes an asset of your estate and must go through probate. This is an unnecessary expense. Even worse, the entire account balance may have to be distributed to the estate by the end of the fifth year after your death. Credit Union National Association [http://hffo.cuna.org/story.html?doc_id=172&sub_id=12433] Many IRA owners plan to leave the funds to their spouse. Some believe naming a trust as beneficiary means their spouses avoid probate court. However, an IRA already is a nonprobatable asset. Others believe naming their estate will be easier for their spouses, but this could cause unnecessary steps, costly legal expenses, and could prevent their spouses from rolling over the funds to their own IRAs. Naming a minor as beneficiary also can create a pickle. Because minors don't have access to the funds, the minor generally can't directly receive payments. Payment must be made to a parent or guardian of the minor. That could involve the courts—causing costly legal expenses and delays. Michelle's pickle—Michelle made nondeductible contributions to her IRA in 1997, but she didn't file IRS Form 8606. This form tracks her IRA basis—the total amount of her nondeductible contributions. Filing this form ensures that she won't pay taxes at withdrawal on money that's already been taxed. Failing to file IRS Form 8606 subjects Michelle to an IRS penalty and means a smaller nest egg when it's time for her to retire. Doug Brown, VP of Investment Services, Financial Advisor, Power Investment Services [http://www.p1cu.org/site/link_art_7.html] Double distribution – Assume you turned 70 in January 2004. Technically, you may wait until after April 1, 2005 to make the required minimum distribution (RMD) for 2004 from your traditional IRA. But your withdrawal for 2005 must occur before December 1, 2005. If you wait until after April 1, 2005 to make your 2004 RMD, you’ll have a "double distribution" in 2005, which could push you into a higher tax bracket. Work with a financial professional to determine the best timing for your first RMD. University Federal Credit Union [http://www.ufcu.org/browse.php?content_name=cuso_inbalance_0204] Holding IRA with restrictive custodian — Some IRA custodians require a five-year payout of an IRA account balance after the death of the IRA owner. If your custodian has such a policy, you may want to transfer your IRA to a more flexible custodian during your lifetime.
A: No. You can't convert required IRA distributions to Roth IRAs to avoid tax on your distributions. And you can't do such a conversion even after you pay the tax, though you could use the after-tax money to contribute to a new Roth if you qualify by having earned income. The government created IRAs and Roths so you could have money for your own retirement, not as a wealth-transfer vehicle. Q: Can a person convert assets in a traditional IRA to a Roth IRA after age 70.5? A: Yes, as long as your modified adjusted gross income doesn't exceed $100,000 and you don't use married-filing-separate status on tax returns. That $100,000 limit doesn't include income generated by the conversion itself. Starting this year, required minimum distributions from traditional IRAs don't count toward the limit, either. Q: Can you roll proceeds from a 401(k) plan directly into a Roth IRA after you pay the income tax on their full value? A: No, you can't roll 401(k) assets directly to a Roth. First, you have to roll the assets into a traditional IRA. Then, you can convert that IRA to a Roth (as long as you meet the income and tax-filing qualifications), paying the income tax owed at that point. Q: If I'm 65, will I have to hold a Roth IRA five years before I can make tax-free withdrawals? A: It depends on whether you're talking about Roth contributions, assets converted from a traditional IRA, or earnings. You can withdraw contributions or converted assets at any time and at any age without owing tax. If you withdraw converted assets and you're younger than 59.5, you have to wait five years to avoid a 10% early-withdrawal penalty. (If you're older, there's no penalty.) What's at issue for older Roth holders are any earnings: If you are 59.5 or older, you pay income tax on earnings withdrawn in the first five years. After that, they're tax-free. If you're younger, you pay a 10% penalty plus the income tax. There's no benefit to putting assets in a Roth if you're going to pull them right out. Q: My IRAs have been invested for more than five years. If I convert to a Roth, must I leave it there another five years to avoid early-withdrawal penalties? A: However long it's in a traditional IRA doesn't make any difference. Once you open a Roth IRA, then the five-year clock starts. If you withdraw the converted amount before five years are up, there would be no tax, but you would owe a 10% penalty if you were younger than age 59½. If you withdraw earnings before the five years are up, you would owe tax regardless of your age -- along with a 10% penalty for the younger folks. Q: My 75-year-old mom died in June 2004. Earlier that year, we converted her traditional IRA to a Roth. My accountant failed to tell me to take an IRA distribution before conversion. I took it at year end. Will I be penalized for taking it after the conversion? Must I take a distribution every year? A: You and your mother did err, and the IRS could hit you with a 50% penalty on the distribution that she failed to take -- but you probably won't be penalized because you corrected the error quickly and in good faith. Original owners of a Roth aren't required to take distributions, but Roth beneficiaries must. More IRA QnA From RetireEarly [http://www.retireearlyhomepage.com/wdrawfaq.html] article from 1999 Do you have to use your IRA account balance from December 31st of the prior year as your valuation date? Although the IRS has not prescribed the date as of which the account balance is to be determined, using the December 31 account balance is the most consistent with the overall guidelines. Some [private letter] rulings have allowed the use of account balances for the month before the first distribution, and others have allowed the use of account balances sometime during the same month as the first distribution. Although the sketchy guidelines offer no guarantees, it seems the IRS will approve account balances determined at any of those times. If you want to be 100% sure you'll survive an IRS audit, get your own private letter ruling. When I retire from my job and rollover my 401k into an IRA, can I break up the account into two IRAs? You can split your 401k into two different rollover IRAs if your former employer agrees to cut 2 checks, one for each IRA custodian. If your former employer won't cut 2 checks, then you need to put it all in one rollover IRA. You can then subsequently rollover a portion of the IRA into a second rollover IRA at any time. Monthly Employment Stats
Economists, who had forecast the creation of 200,000 jobs, said the June report indicated that the economy continued to expand at a solid, if not exuberant, pace. They also noted that the Bureau of Labor Statistics had revised the May and April data to show that job creation rose by a total 44,000 in those months. "This number is even stronger than I was expecting, because you got a 44,000 increase in jobs that we didn't know about," Anthony Chan, a senior economist at J.P. Morgan Asset Management, said. The report "understates the true strength of the labor market," he said. Mr. Chan said the unemployment report would also have a positive impact on consumer confidence, because the public would see the lower unemployment rate as a sign that things are getting better. "That's a headline that consumers watch," he said. The report showed that professional and business service employment grew by a robust 56,000 jobs. The construction industry, which has benefited from the nation's housing boom, added 18,000 jobs for the month and 282,000 jobs in the past year. And health care employment rose by 25,000. But there was weakness at the nation's factories, which shed 24,000 jobs, far exceeding the loss of 5,000 jobs that economists had predicted. Much of the decrease came from the automobile industry, which shed 18,000 jobs. The economy has lost 96,000 factory jobs since August 2004 and manufacturing employment has been at its lowest levels since the late 1950's. Mr. Chan said the worst may be coming to an end in that sector because recent manufacturing surveys by the Institute for Supply Management and others indicated that factories were increasing production. The Commerce Department reported earlier this week that new factory orders were up 2.9% in May. But other economists are not so sure. They note that manufacturing and the overall economy still do not show signs of the kind of robust growth needed for companies to hire large numbers of people. Today's report, for instance, showed that the average hours of work (33.7 a week) and pay ($16.03 an hour) were little changed from the month before or early this year. Rising work hours and wages are early signs that companies plan to, and need to, hire more people in the coming months. "Going forward you are going to see continued moderate job growth: only hiring when you absolutely have to," said Joshua Shapiro, chief United States economist at MFR. Average payroll gains have been 166,000 for [the last] four months, [noticably] less than the 251,000 average of the 1993-99 recovery. In all, 43 months into this recovery, payrolls are up 2%. That compares with an 11.5% average over the last five recoveries, says Morgan Stanley chief economist Stephen Roach. Workers between ages 25 and 54 lost 181,000 jobs in June. Over the last year, workers over 55 have taken nearly 60 percent of jobs created. Meanwhile, corporate layoff announcements were up 111,000 in June and are running 14% over last year. (Danielle DiMartino, Dallas Morning News 7-14)
Just the Facts A Connenction Between Obesity & Smoking? Daniel Gross, NY Times 7-24 The percentage of Americans over 20 who are regarded as obese has more than doubled, to about 30%, from about 14% in the early 1970's. Because of an aggressive public information campaign, new restrictive laws and huge increases in federal and state taxes, the percentage of the population that smoked fell to 22.5% in 2002, from 37% in 1970. Strange as it may sound at first, many economists and health care experts say they believe that the two trends may be related. Broadly speaking, said Michael Grossman, an economics professor at the Graduate Center of the City University of New York, a 10% increase in the price of cigarettes leads to a 5% reduction in cigarette consumption. In a 2004 study, Professor Grossman, along with Shin-Yi Chou of Lehigh University and Inas Rashad of Georgia State, mined state-by-state behavioral surveys from 1984 to 1999 to get to the root causes of rising obesity. While they found that the prevalence of fast-food restaurants was responsible for most of the climb, they concluded that the decline in smoking accounted for about 20% of it. Over all, they found that "each 10% increase in the real price of cigarettes produces a 2% increase in the number of obese people, other things being equal." There is one study that disputes this finding. Yield Curve Gets LEI Demotion Mike Dolan, Reuters 7-14 The Conference Board, the firm which publishes the U.S. Leading Economic Indicators series, said its index has declined 1.9 percent in the year to May, with about half of the drop due to the flattening of the yield curve. This would typically signal a sharp economic slowdown this year. But it is a lonely signal. Top forecasters polled by Blue Chip Economic Indicators this week raised their outlook for U.S. growth in 05 for the second straight month, now focusing on a robust 3.6%. Perplexed, the Conference Board announced last month that it is changing how the yield spread affects its reading of where the economy is heading. It said declines in the yield spread will no longer act as an outright negative on its leading index unless the curve inverts, or long rates fall below short rates. Since the mid-1950s there were three occasions when the yield curve did not invert ahead of a recession and one time when it inverted and there wasn't a recession. Bad Breadth Michael Santoli, Barrons 7-04 The S&P100 index has made a halting attempt at its late 2004 high. But the percentage of S&P 100 stocks above their 200-day average shows this advance has been carried by a narrower group of stocks. This measure of breadth suggests the market -- at least for large-cap stocks -- has shifted from a democracy to something like oligarchy. Natexis Bleichroeder technical strategist John Roque, who keeps these breadth data, says, "Market internals are slowly weakening." CIBC World Markets technician Larry Berman notes that even as the S&P 400 Mid Cap and S&P 600 Small Cap indexes made new all-time highs in June, the number of the index stocks making new highs was "anemic" at less than 20%. "When a market makes new highs and less than 20% of stocks in the index are making new highs, then the sustainability of the rally needs to be questioned." The End of the Double-Didget Streak? Ellen Simon, AP 7-03 With second-quarter earnings season just days away, it looks like the largest U.S. companies might break a notable winning streak - 12 straight quarters of double-digit earnings growth. The consensus estimate is that earnings will grow 7.1% for Q2, compared to 25.3% in Q2-04. So far, there have been twice as many companies in the Standard & Poor's 500 warning that they'll miss Q2 earnings targets as there are companies saying they'll beat expectations. Despite the warnings, other factors make many on Wall Street optimistic. Douglas Cote, senior portfolio manager at ING Investment Management, is cheered by how frequently earnings estimates are wrong. In eight of the last nine quarters, Wall Street underestimated earnings, often missing by a dramatically wide mark. Earnings growth for 2004 was expected to be 14.98%, for instance. Instead it was 20.9%, he wrote. Mike Thompson, director of research at Thomson Financial, notes that upside surprises historically have added three percentage points to consensus estimates, which means double-digit growth is still within reach [on the aggregate S&P500 profits]. Investors have been spoiled in recent quarters by results that bested estimates dramatically. Should the margin between earnings and forecasts shrink, disappointment is sure to follow, adding to the market's recent woes. (Vito Racanelli, Barrons 7-04) Quick Facts, Stats & Opinions Toyota is launching the Lexus in its home country for the first time this month. Toyota's rivals [Nissan's Infiniti and Honda's Acura] still market luxury brands in the U.S. but not in Japan. Toyota officials concede that Lexus won't be an easy sell. In Japan, wealthy consumers tend to favor German engineering -- Volkswagen AG's Audi, BMW AG and Mercedes-Benz from DaimlerChrysler AG. Last year, industry officials say imports accounted for 90% of the Japanese market for cars that retail at $50,000 and up. But Europe's car makers charge far more for luxury cars in Japan than elsewhere, tapping into a long-held Japanese association between high prices and quality. According to brokerage CLSA Asia Pacific Markets, a BMW 545i that lists for about $56,000 in the U.S. sells in Japan for $84,000; an E500 Mercedes sells for $57,000 in the U.S. but is more than $85,000 in Japan. (Jathon Sapsford, WSJ 8-03) Folks have flocked to socially responsible mutual funds in recent years, with assets up 137% since year-end 2000, easily outpacing the 24% asset growth for all stock and bond mutual funds, according to data from Chicago's Morningstar Inc. and Washington's Investment Company Institute. These funds have returned an average 9.1% a year over the past decade, only slightly behind the 9.4% average for all U.S. stock funds. (Jonathan Clements, WSJ 8-03) While the good times in stocks come in unpredictable fits and starts, this view puts too much emphasis on short-term fluctuations. Typically, the juiciest capital gains [distributed by mutual funds] are amassed over multiyear periods. That explains why capital gains distributions by mutual funds were much higher -- $55 billion, according to the ICI -- in 2004 than they were in 2003, when they totaled $14 billion. Note that the S&P 500 gained a relatively modest 10.7% in 2004, including dividends, after jumping 28.4% in 2003. True, capital gains may swing wildly from one year to the next. Funds' gains distributions tumbled to just $16 billion in 2002 and $14 billion in '03 from $316 billion in 2000. (Chet Currier, Bloomberg 7-24) S&P found funds that performed in the top half of their categories over the past five years tended to have longer manager tenures, lower expenses and limited losses during the bear market. Over the past three years ended May 31, only 10.7% of large-capitalization funds, 9.2% of midcap funds and 11.5% of small-cap funds managed to maintain performance that kept them ranked in the top quarter every year, according to S&P. When the period is extended back five years, the percentages are even smaller, with 2.3% of large-cap funds consistently landing in the top quarter, and 2.9% and 4.7% for midcaps and small-caps, respectively. (John Spence, MarketWatch 7-18) Only three times in the past 30 years [1982, 1994, and 2004] has the Dow overcome a first-half deficit to finish in the black. (Gaston Ceron, WSJ 7-10) People spend less as they got older. Data from the U.S. Bureau of Labor Statistics' Consumer Expenditure Survey says that the average annual spending fell 27% to $32,243 for the 65- to 74-year-old age group in 2002 from $44,330 for people ages 55 to 64. Likewise, spending fell still more to $23,759 for the 75-plus age group. (Kelly Greene, WSJ 7-10) Despite a slight improvement in June, the UBS Index of Investor Optimism remains substantially below its level in the first quarter. That may explain why net new cash flows into stock funds were down 38% this year through May, versus the corresponding period last year, according to ICI. (Paul Lim, NY Times 7-10) Conventional wisdom says that when the Fed stops tightening, a rally could ensue in the stock markets, maybe one that is similar to the year-end rallies of 2003 and 2004. But history shows that periods immediately after the end of Fed rate increases aren't always rosy. Although stocks went on a tear after the Fed stopped raising rates in 1989 and 1995, equities have more typically lost ground during such times. Ned Davis Research studied Fed tightening cycles back to 1920 and found that the Dow Jones industrial average was down 4.9%, on average, six months after the Fed stopped raising rates. A full year after the end of rate increases, stocks were typically down 3.9%. (Paul Lim, NY Times 7-10) So far this year, dividend-paying stocks in the S&P500 have returned 2.9%, on average, while those that don't pay dividends have lost 1.5%, according to S&P. And since stocks hit their recent lows in April - amid fears of shrinking profits in the face of rising oil prices and interest rates - the fastest-growing sectors in terms of dividends have performed the best. Those include technology, financial services, industrial, consumer staples and consumer discretionary stocks. (Paul Lim, NY Times 7-10) Investors anticipate continued price increases in the housing market, and they are more optimistic about the performance of real estate investments than returns offered by the stock market, according to the June UBS/Gallup Index of Investor Optimism. Among the findings: 63% of investors expect housing prices to rise over the next six months, only 13% foresee a decline in housing prices over the next six months and 23% expect prices to hold steady. About 38% think now is a good time to buy. (LA Times 7-03) July 1 is an unusually interesting date this year. This July 1 is the date when the very oldest members of the baby-boom generation turn 59 and a half, the age at which they are allowed to begin making penalty-free withdrawals from their IRAs and other retirement savings accounts. Mandatory withdrawals don't begin for 11 more years, when these folks reach 70 ½. And in two and a half years, at age 62, they will be able to start drawing Social Security. Again, they don't have to, but they can. The baby boom, which added an estimated 76 million Americans to the population, began in 1946 and ran until 1964. (Albert B. Crenshaw, The Washington Post 7-03) American businesses are upbeat about hiring prospects in the next quarter, with nearly a third saying they plan to hire more people this summer, a new jobs survey shows. More than half the employers surveyed in the U.S. by global staffing firm Manpower foresee no change in employment; 31 percent expect total employment to increase in the third quarter, according to the survey. Six percent forecast a decrease. The results of the survey of 16,000 employers were virtually unchanged from last quarter's survey, when 30% forecast an increase and 7% saw a drop. Firms' hiring expectations have been stable for six quarters. (AP 7-03) "An investor, given a choice between capital gain potential (uncertain because the stock market does odd things sometimes) and dividends (much more stable), should prefer the dividends because they are a lot less risky" says Ralph Wanger, a 45-year star of the mutual fund firmament who retired in 2003 as manager of a mutual fund group that includes the $14 billion Columbia Acorn Fund. (Chet Currier, Bloomberg 7-03) Home Page Previous Factoid Top Sites
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