Q410
Ocean View
A Quarterly Newsletter from Private Ocean
letter from the founders
The sky is falling. Again.
We’re kicking off 2011 with a shocking statement: the economic sky is falling. And an equally controversial follow-on
statement: a falling sky is normal. It’s actually required for
positive returns.
In September 2010, the National Bureau of Economic Research
declared that the most recent American recession ended
in June 2009. In spite of that announcement, many Private
Ocean clients have continued to express serious concerns
about macroeconomic events. They’re concerned that America’s preeminence is behind it, that structural problems like
the budget deficit cannot be solved, that the US dollar will
decline in value against the euro, and much more. In essence,
these clients believe, things will only get worse.
A 2009 book, This Time is Different: Eight Centuries of Financial Folly, puts these issues in perspective. The two authors,
economics professors at Harvard and the University of Maryland, use large amounts of historical data to make the case that
this time is not different. In their words, “We have been here
before. No matter how different the latest financial frenzy or
crisis always appears, there are usually remarkable similarities
with past experience from other countries and from history.”
The scholars analyzed economic data from 66 countries—
going all the way back to the 13th century. They found common patterns that lead to government defaults, bank failures,
currency crises and high inflation. Time after time, politicians
ease financial regulations, banks take advantage by overleveraging and lending too much, and countries take in money
from foreign investors. These recurring events create asset
bubbles. Then political and business leaders say, “There’s no
reason to be fearful, this time is different.” And of course, the
bubble bursts, every time.
The frequency of problems is an eye-opener. Some kind of
financial crisis occurs somewhere in the world virtually every
year. And not just in third-world countries. “For the advanced
economies over the full span, the picture that emerges is one
of serial banking crises. The world’s financial centers—the
United Kingdom, the United States, and France—stand out
in this regard, with 12, 13, and 15 episodes of banking crisis
since 1800, respectively…Thus, although many now-advanced
economies have graduated from a history of
serial default on sovereign debt or very high
inflation(above 20%), so
far graduation from
banking crises has proven elusive.” Proving the
point, as recently as September 2008, Lehman Brothers failed. Since then, hundreds
of smaller institutions have closed. And of course banking
giants like Citigroup and Bank of America were saved only by
massive government assistance.
A near-sighted view makes 2008 look unique. However,
through a longer historical lens, it was quite typical. For example, over the last 100 years, real estate bubbles have coincided
with 21 major banking crises. Contagion has caused global or
regional chaos many times. As examples, the book highlights
the crisis of 1825-1826, the panic of 1907, the Great Depression
of 1929-1938, the debt crisis of the 1980’s, the Asian crisis of
1997-1998, and the Global Contraction of 2008. Financial crises, based on human foibles like arrogance and
greed, are inherent in the global economic system. With a
high degree of confidence, we can predict that something else
will go wrong in the near future. Should we fear the next meltdown? On the contrary, we should be comforted by history.
Positive investment returns occur only under conditions of
risk. The return is the reward for taking risk. Financial crises
are dramatic evidence of risk. Ergo, we still can expect posiContinued on page 4
tive returns over the long term.
California Municipal Bonds: Are Concerns Justified? . . . 2 The Tax Relief Act of 2010 . . . 3 Community Corner . . . 4
Ocean View
no fear. no greed.
Theo A. Gallier, MBA, Chief Investment Officer
California Municipal Bonds:
are concerns justified?
The credit rating of California general obligation bonds, A-, is
the lowest in the country. The state’s budget deficit is a high
profile problem, and the causes of the fiscal imbalance, including a high unemployment rate, a dysfunctional legislature, and
Proposition 13, are well known.
In the spring of last year there were claims that California debt
was like Greek debt (not an apt comparison, but it made a media
splash). Recently a great deal of angst has been expressed about
the fiscal problems of certain states, including California. Yet
there has been no sell-off in California municipal bonds. Why is
that? And if there is a big decline in the value of your California
funds in 2011, what impact will it have on your portfolio?
Why No Decline?
At the end of 2009, California had the eighth largest economy
in the world, behind Italy and ahead of Brazil. The state’s GDP
equaled 13% of the US total. California’s economy is highly diversified. The state enjoys huge agricultural production and
remarkable technology leadership. It also has great universities. In short, it is tremendously productive and innovative.
The continuing belief in the awesome economic power of the
state has supported municipal bond values.
Another reason prices haven’t plunged is that securities issued
by states, counties, cities, and other entities with taxing authority are considered very safe investments. Historically, municipal bonds have experienced extremely low default rates.
Only one state, Arkansas, defaulted on its debt in the Great Depression, and none has defaulted since then. Between 1970 and
2009, there were only 54 municipal bond defaults, out of tens
of thousands of issuers. Recovery rates have been high, averaging 60% or more.
What Happens If?
But what if California’s inability to come to grips with its problems creates a significant decline in municipal prices? First,
let’s determine how much exposure to California debt you have.
Our municipal fixed income model contains four sectors, two
California and two national. Nominal exposure to the state is
66.7%, but at present the national sectors contain 12.8% and
14.0% in securities issued within California. As a result actual
total state exposure is 71.1%. The relatively high allocation takes
into account our high state income tax rates, which make aftertax yields on California bonds higher than those on out-of-state
bonds. This, of course, applies only to California residents.
If your portfolio contains 30% fixed income, and all your assets are in a taxable account, then 21.3% of your total portfolio
is in securities issued by the state and other California-based
entities. The greater the portfolio’s weight in fixed income, the
greater the weight in California. Across our models, exposure
ranges from 10.7% to 53.3%.
The historical average default rate on municipal securities
is miniscule. But let’s take an extreme case and use the Great
Depression national figure of 2.7%, without recoveries. Then
your portfolio losses would range from 0.3% (10.7% X 2.7%)
to 1.4% (53.3% X 2.7%), depending on your model and assuming flat performance for all other assets. Any fixed income in
a tax-deferred account and any recoveries from default would
reduce the losses.
The takeaway is that it’s not actual defaults that are likely to
significantly hurt portfolio performance. Instead, it’s paper
losses, if the broad municipal market declines in response to
some high-profile defaults in the Golden State or elsewhere.
Given that there has been tremendous municipal issuance in
the last decade, and that California and some local issuers are
indeed under financial stress, there is a possibility that such
contagion could occur. But as long as you don’t sell out in a
panic, you should be okay, because the fundamental causes of
the decline will eventually be resolved, and the municipal bond
market will right itself. That is the nature of markets.
In Conclusion
Other states and localities have already begun taking drastic actions,
including raising taxes or fees, freezing worker pay, reducing
staff, selling or monetizing assets, and changing benefits for
new employees. It remains to be seen whether Governor Jerry
Brown and the state legislature, and local California politicians,
will be willing to take similar measures. But there are extremely
strong economic and political incentives to do so.
I can’t predict 2011 returns on California municipal funds.
The history and recent performance of the municipal bond
market provide a fair amount of comfort. The concerns may
be justified but in many quarters they’re overblown, and in any
event current prices already reflect the anxiety. The California
Bear Flag was designed as a symbol of strength—the state will
remain strong.
Q410
planning is power
The 2010 Tax Relief Act:
Top-Line Review
By Shannon McNutt JD, Advisor
On December 17th, President Obama signed into law the Tax
Relief, Unemployment, Insurance Reauthorization, and Job
Creation Act of 2010. This legislation delivers tax relief for
most taxpayers, particularly when compared to what the tax
laws would have been in 2011 and 2012 without congressional action. Here are highlights of the bill:
Income Tax Brackets Extended
The income tax rate cuts from 2001 and 2003 legislation that
were scheduled to expire at the end of 2010 were extended
until the end of 2012. The six income tax brackets will remain at 10%, 15%, 25%, 28%, 33% and 35% for 2011 and 2012.
They’re scheduled to revert to 15%, 28%, 31%, 36% and 39.6%
as of January 1, 2013.
Capital Gains Taxes Also Extended
The capital gains tax rate cuts were also extended to the end
of 2012. These rates are scheduled to return to 20% for those
in the 25%, 28%, 33% and 35% tax brackets, and 10% for those
in the 10% and 15% brackets in 2013 . They’ll remain at 15%
and 0% respectively in 2011 and 2012.
Qualified Dividends Taxed at Capital Gains Rates
Qualified dividends will continue to be taxed at the 15% and 0%
capital gains tax rates rather than at ordinary income tax rates
(10%, 15%, 25%, 28%, 33% and 35%) for the next two years.
Personal Exemption and Itemized Deductions
Phase-outs
All taxpayers may fully claim their personal exemptions and
itemized deductions in 2010, 2011 and 2012 regardless of
their income.
Miscellaneous Deductions, Credits and Provisions
The Child Tax Credit, Dependent Care Credit and Adoption
Credit were extended through 2012. The deduction for state/
local sales taxes paid was extended through 2011. A number
of education-related provisions, including the tuition deduction, expanded student loan interest deduction, and expanded Coverdell Education Savings Account provisions were
extended.
Alternative Minimum Tax
The legislation included a one-year “patch” for the Alternative
Minimum Tax (AMT). The AMT is a parallel tax system that
disallows many of the credits and deductions that taxpayers
are entitled to under the conventional tax system and is designed to prevent taxpayers from deducting away their entire
income tax liability. The AMT exemption was retroactively
adjusted for 2010 and extended for 2011. For those subject to
AMT in 2009, you will likely be subject to it in 2010 and 2011,
assuming your overall tax situation is similar. This law does
prevent more taxpayers from being subject to AMT until 2012
when the patch expires and the issue will arise again.
Payroll Taxes
Employees’ portion of Social Security taxes has been reduced
by 2% for 2011.
Estate Planning Provisions
The most significant changes to come from this legislation
are the alterations to the federal gift and estate tax structure.
The estate tax and generation-skipping tax exemptions were
increased to a $5,000,000 applicable exclusion for 2011 and
will be indexed for inflation in 2012 with the top estate, gift
and generation-skipping tax rate reduced to 35% from a maximum of 55%. The gift tax exemption is also $5,000,000.
The increased estate tax exemption amount and the reduced
estate tax rates were also retroactively applied to 2010, although a taxpayer may opt to use the 2010 rules. For decedents
in 2010, their estates will choose between the 2010 law (paying no estate tax and receiving a limited step-up in tax basis)
and the 2011 law (paying a maximum 35% estate tax rate and
receiving a full step-up in tax basis on all inherited assets).
Another notable provision allows the unused portion of a
deceased spouse’s estate tax exemption of $5,000,000 to be
transferred to the surviving spouse. This new portability of
the unused exemption only applies to those dying in 2011 or
2012 and technically requires an estate tax return to be filed
for the decedent’s estate and a portability election to be made
by the executor.
Summing It Up
Overall, the Tax Relief Act of 2010 has brought certainty and
relief for the next year or two regarding income and estate
taxes. We’ll continue to help you assess the law’s impact on
your personal situation, as well as monitor the tax landscape
and keep you abreast of changes. We invite you to call us with
any questions and for further discussion.
Ocean View
Q410
community corner
Golden Gate University. As part of the curriculum, he’ll share
his experiences running a wealth management practice and
educate students about building and managing a financial
planning operation. Our own advisor Ralph Latza is serving
as president of the San Francisco Chapter of the Financial
Planning Association. It’s an honor to have a member of the
Private Ocean team leading the local financial planning community.
New Faces
Community Service
The holidays flew by this year, but we managed to make time
to celebrate the season. As we do every year, we volunteered
to make sandwiches for the St. Vincent de Paul Society in
San Rafael, putting together more than 200 bag lunches for
Marinites in need. We also hosted a festive afternoon at the
San Francisco Ballet’s Nutcracker for residents of Alma Via
Retirement Community.
Private Ocean is reaching out to the community in other
ways. Greg has accepted an invitation to teach a class at
Two new members have joined the Private Ocean family. Tim
Curley, our newest client service representative, was a case
manager at a Marin law firm. He brings with him a special talent for taking care of clients. Jennifer Taylor joins in a dual
role as executive assistant to Richard and a member of the
marketing team. Her diverse experience includes working as
a legal secretary and as executive assistant to an aeronautics
executive and winery owner in Sonoma. Both Tim and Jennifer live here in the North Bay.
Bring on 2011!
We hope you had a wonderful 2010 and that 2011 is looking
even brighter. Thank you very much for choosing to work
with Private Ocean. If there’s anything we can do to enhance
your experience with us, simply ask. We’ll be in touch. In the
meantime, Happy New Year!
the sky is falling. AGAIN.
Continued from cover
How can you use the knowledge that economic shocks will
regularly occur? You may be able to better handle bear markets, psychologically speaking, and be realistic about portfolio losses. There will never be an extended period with
only positive returns—never. Yet the probability remains
that average returns will be positive. Ari Rosenbaum, managing director of O’Shaughnessy Asset Management, sums
up the situation eloquently:
on an annual basis the market goes up about 70% of the time
from the year prior. Through that time we’ve had Democrats
and Republicans, war and peace, booms and busts. We’ve had
cheats and scoundrels and heroes. We’ve been through Spanish Flu, Hong Kong Flu, Avian Flu, Asian Flu and Swine Flu.
We’ve stood in line for bread, we’ve stood in line for gas, we’ve
stood in line for iPads. The reality is that 70% success shows
that the odds are in favor of the long-term disciplined investor.
Since the founding of the New York Stock Exchange in 1792,
Warmest wishes for a happy, healthy and prosperous New Year,
750 Lindaro Street, Suite 130
San Rafael, CA 94901
Tel 415.526.2900
www.privateocean.com