Fagan Associates Archive for January, 2008

A week ago Friday, as we were shutting the doors to our offices on Hoosick Street, my brother and I both noted that we were looking forward to the long weekend as the markets would be closed the upcoming Monday in honor of Dr. Martin Luther King. One of us stated that, after three consecutive down weeks in which the Dow Jones Industrial Average had shed more than ten percent, “it would be nice to relax for that extra day and not have to worry about where stocks were headed.” We knew that over the weekend we would hear all of the news reports on how stocks were off to their worst start in history and how the sky was falling. Little did we know was how that extra day off would make this past week feel like it lasted a month. (One quick note prior to our tale of the trials and tribulations of stock investors this past week: due to the time difference, markets, the Far East (India, Japan, Hong Kong, China et. al.) open first, then Europe and then the United States.)

After watching the beloved New York Giants squeak past the Green Bay Packers last Sunday night along with the rest of my family, I turned on the television to the Bloomberg Financial network which covers the global markets and noticed that the markets of the Far East were down nearly five percent in early trading and that the projection for the European markets was not much better. It was with this knowledge that, while continuing to watch the losses mount, I pulled out the computer and logged on to the internet to find out what was roiling the emerging markets and found that there was a rumor circulating that a major European bank was about to declare bankruptcy due to more than $45 billion in losses stemming from the global mortgage crisis. Needless to say, neither my brother nor I had a good night’s sleep.

The next day, despite the fact the markets in the United States were closed, we came to work and pulled out our plan of action which includes, among other things, taking a look at all of our investments and all of our accounts to makecertain that we are holding securities which we believe will help our clients achieve their objectives over the long-run. That task being completed, we then evaluated what the impact of an acceleration of the subprime mortgage mess would mean to our stock and bond markets. The result was a list of the actions we would take should certain events transpire. In between, we met with a couple of clients. Late last Monday morning, the results were in and it wasn’t pretty. The markets of Southeast Asia were down anywhere from five to ten percent while the European markets were down about five percent. Please remember that our stock market was closed. Sometimes the anticipation is worse than reality.

Monday night about ten o’clock, I once again checked the Bloomberg Financial Network and noticed that it was almost a repeat of the previous night with the markets of the Far East down five to ten percent and Europe pointing to a similar move downward. The rumor mill continued to whisper of a major European bank experiencing severe financial strain and perhaps bankruptcy. Once again, the result was a sleepless night.

Tuesday morning confirmed what we had feared most, which was for a projected 500 point drop in our stock market upon its opening at 9:30 a.m. However, at approximately 8:30 a.m. the Federal Reserve announced that it was cutting interest rates from 4.25% to 3.50%, the largest between regularly scheduled meeting rate cut in history citing that it was taking this action “in view of a weakening of the economic outlook and increasing downside risks to growth.” The Dow Jones Industrial Average bent, but did not break like other global markets, ending down “only” 128 points as represented by the Dow.

Once again, Wednesday morning, stock futures pointed to a sharply downward opening and unlike Tuesday, this time the Dow did not disappoint dropping over 300 points during the morning and early afternoon as investors panicked. However, as usually happens when pessimism and panic reign, the market turns and turns with a vengeance. This time was no different as the Dow Jones Industrial Average made up those 300 points that it was down over the remainder of the afternoon and tacked on another 300 just for good measure.

Turn the page to this past Thursday morning. We woke up to the fact that the major European bank mentioned earlier in this article that was to be taken down by more than $45 billion in losses stemming from the mortgage misery was inaccurate, yet still astounding. The fact of the matter was that French banking giant, Societe Generale, had discovered losses of more than $7.5 billion as a result of bogus trades put forth by a rogue trader. Although devastating for investors in Societe Generale, the global stock market breathed another sigh of relief that the company was not writing off billions in response to losses in their mortgage investments and that this was a company specific problem.

After this tumultuous time, the question now becomes “was this a bear market rally, one which will fade fast with the downside reasserting itself” or “have stocks seen the worst of this nearly top to bottom twenty percent correction and will now begin moving back toward Dow 14,000?” Although too early to tell, we believe that we have seen the worst of this correction, but that stocks may certainly retest the low on the Dow of 11,645 set this past Wednesday. However, should a successful retest occur, the all clear bell will ring! Another scenario, which we deem possible, is that the monetary stimulus from the Federal Reserve along with the fiscal stimulus promised by the Bush Administration and Congress will now be interpreted positively by stock investors resulting in a bull market for stocks, one in which will not look back. Either way, we believe that after a long month this past week, more restful nights are ahead.

Exchange-Traded Funds (ETF) have become the rage over the last year or so. They have challenged mutual funds for investment dollars. ETFs provide investors with diversification like a mutual fund but also enable an investor to sell his position during the trading hours of the stock market. Mutual funds tabulate their positions at the end of the trading day and give investors the opportunity to buy and sell at that time, but only at the close of trading.

As with mutual funds, you can invest in an ETF for a myriad of objectives. Certain Exchange-traded funds will be conservative and buy only US government bonds while other of these funds find aggressive investments in emerging markets that gyrate wildly. Investors need to know what types of investments are in ETFs before blindly putting money into them. One ETF that seems to make sense to us right now is the iShares Dow Jones Select Dividend Index (DVY). This ETF is comprised of 100 of the highest yielding stocks in the Dow Jones Total Market Index ?” excluding real estate investment trusts. Dividends can be a cushioning factor in a difficult market environment. Through January 16^th, the S&P 500 was lower by 6.31% and the NASDAQ Composite was down over 10% while the DVY was off only 3.81%.

This ETF has a dividend yield of 3.66% and a low expense ratio of 0.40%. This makes it attractive for investors who want some income, a chance for growth and low expenses. The low turnover ratio of six percent also gives investors comfort in that “what you invest in is what you get.” The ETF trades nearly twenty percent off its 52-week high of $75.82 at approximately $61.00 per share.

Some of the top 10 holdings (as of December 31, 2007) were Merck, AT&T, Altria Group and PNC Financial. There is a solid mix of dividend paying stocks ?” some having strong performance while others have suffered with the sub-prime crisis. This investment is appropriate for investors seeking current income, desiring diversification and willing to accept the risk of a stock investment.

Given the current stock market environment, one in which we would expect to continue well into 2008, the iShares Dow Jones Select Dividend Index is a good place to gain market exposure yet have the comfort of dividend income.

One word of caution when considering purchasing an Exchange-Traded Fund is that many of these funds are not broad stock market index funds as they were once intended to be. The majority of ETF’s are either sector, industry, region or country specific and therefore carry additional risk other than stock-market risk.

One word regarding the current state of the stock market, please exercise caution. We do expect extreme volatility to continue as the positive catalyst that should come from the recent reduction in interest rates by the Federal Reserve has yet to impact the economy. Furthermore, any fiscal stimulus that the congress chooses to enact is also a month or two away. We therefore strongly recommend that investors keep a good chunk of “dry powder” on the sidelines in the form of cash.

This past Wednesday, in a note to clients, economists at renowned investment bank Goldman Sachs, the brokerage firm that was brilliantly shorting and therefore profiting from fixed-income products that were related to the subprime mortgage mess, predicted that the U.S. economy would enter into a modest recession during 2008. We couldn’t agree more.

Most economists define a recession as two consecutive quarters of negative growth in Gross Domestic Product (GDP) which, also by definition, measures the expansion of contraction of the economy of a nation. Goldman Sachs predicts that “the recession is likely to last two to three quarters and should be relatively mild by historical standards, with a cumulative decline in GDP of only about a half percent,” this according to Goldman Sachs economists’ Jan Hatzius and Ed McKelvey. For all of 2008, Goldman Sachs expects GDP to rise by 0.8%. According to the two economists, keeping the recession “relatively mild” is the assumption that the Open Market Committee of the Federal Reserve, the body that determines the direction of short-term interest rates, will aggressively lower rates in order to provide liquidity to the credit markets and ease the credit crunch. Ultimately, the impact of this mild recession will be an increase in the unemployment rate from its current level of 5.0% to 6.25% by the end of this calendar year.

All of the above loudly begs the question, “fine, but what does this mean for my investments?” Simply put, we believe that the during the fourth quarter of 2007 the U.S. economy entered a period of slow to somewhat stagnant economic growth that will most likely last throughout the majority of 2008. Whether this is the slight majority or vast majority of 2008 has everything to do with just how aggressive the Fed is when it responds to interest rates. Thus far, we believe that the Fed has not acted aggressively enough when regarding interest rates and that the downturn in the economy, if one thinks of it as a moving car or other vehicle, has maintained its distance over the Fed. The Fed must do something to close this gap and to eventually move ahead of the economic downturn. It is with the efforts of the Fed, perhaps along with fiscal (tax) policy relief coming from congress and the Bush Administration that the economy will eventually turn for the better.

The Chairman of the Federal Reserve, Ben Bernanke, in a recent luncheon speech in Washington, D.C., stated that the Fed stands “ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” The jury is still out as to what Chairman Bernanke defines as “substantive” when it comes to the action required to stem the economic downturn that is facing America.

To determine where the stock market may go one must look back at historical data. We did just that and found that during economic downturns when the Federal Reserve has lowered interest rates at three consecutive meetings, the stock market has responded favorably as measured by a time frame of one year. In fact, there have been thirteen times in which the Fed has cut interest rates at three consecutive meetings and the stock market has been higher one year later on every occasion, save one. That was during the early 1930’s when the United States was on the verge of the Great Depression. Therefore, if you believe as we do, that we are not entering into an era of depression, stock investors have a golden opportunity to add to their holdings and reap capital gains one year hence. Unfortunately, during times like this it is very uncomfortable to invest in stocks, but we cannot see anything other type of investment that we would rather be in than equities. That said, maintain a disciplined investment approach and always have a plan for selling a position after making the purchase.

According to Boston College’s Center on Wealth and Philanthropy, baby boomers alone are positioned to inherit more than $7.2 trillion from assets in retirement accounts. Getting assets transferred after the death of the original IRA owner involves several issues that could affect the beneficiary’s tax liability. Therefore, it is wise to involve your beneficiaries in the planning process.

When you inherit an IRA, choices on how to handle the transfer are based on the type of IRA (Traditional or Roth), the relationship of the beneficiary to the deceased (spouse, non-spouse, trust, estate, charity), and the age of the original account holder at the time of death.

For example, a traditional IRA with a spouse designated as sole beneficiary, can transfer assets into the spouse’s own existing or new IRA after taking the required minimum distribution for the year of death, if the original account holder was over age 70 ½ at the time of death and did not previously take the distribution. In the case of multiple primary beneficiaries, assets must be transferred into separate Inherited IRAs.

Non-spouse beneficiaries have fewer options. Most significantly, they are not allowed to transfer the assets into their own IRA account. Non-spouse beneficiaries are required to transfer assets into an Inherited (five years or life expectancy) IRA and taxable distributions must begin within a certain amount of time. Check with your financial advisor for details.

When a trust is the beneficiary, it must be irrevocable; it must name identifiable beneficiaries; it must be valid under state law; and the custodian must have a certified copy of the trust. When an estate is the beneficiary, the executor can take a taxable lump sum distribution or open Inherited IRAs depending on the age of the original account holder.

Any beneficiary may also elect to take a lump sum distribution. However, while there is no 10% early withdrawal penalty, the beneficiary will need to pay income taxes on the distribution.

New wealth presents new opportunities and with any inheritance, it is likely that a beneficiary will want to reassess their total investment strategy. A meeting between the account holder, beneficiary, and financial advisor can avoid costly mistakes. Discuss what options are available to the beneficiary for taking the proceeds of the assets when the account holder dies as well as the tax and investment implications of each. Also, consider naming contingent beneficiaries in case the primary beneficiary is no longer alive when the account holder dies. These assets go to the beneficiary automatically instead of through the probate process. Beneficiary designation forms typically override a will therefore it is very important to keep beneficiary information up to date.

These are only some of the issues involved in beneficiary designations. Please contact your investment advisor or give us a call with any retirement planning questions.