Broker Check

Quarterly Newsletter January 2006

Quarterly Newsletter | January 2006                                                                                                Belmont Financial

Attention: You may already have won $1 Million. That’s because the estate tax exemption for 2006 has risen from $1.5 million to $2 Million per person. So a married couple can now pass $4 million to heirs without worrying about estate taxes if the estate plan is set up to take advantage of each spouse’s exemption. Single people can pass on $2 Million. The annual gift tax exclusion also increases to $12,000 per person from $11,000. Many states, including Mass. have decoupled from the federal estate tax system and tax estates at lower values. For Mass. the exclusion is only $1 million per person. What to do now? Check you net worth and review your estate plan. If you have any questions about this, give me a call. Belmont Financial partners with the best estate planning attorneys in Boston. And they will meet you in my office.

Is the World Really Flat?

How does the reference to Tom Friedman’s new book apply to the various aspects of financial planning? Well very simply, it means we all have access to the same information and investment products. Companies like Belmont Financial can compete with behemoths like Merrill Lynch(and very effectively I might add). What flattened the world? --- Lots of things, from the internet to Regulation FD (fair disclosure). This is overwhelmingly great news. While the benefits are obvious, there are dangers as well. For example, the flattening gave average folks access to investment products previously reserved for the very wealthy. Let’s look at two: separate accounts and hedge funds.       Separate accounts, the rage a few years ago, are like your own personal mutual fund. They promised access to the manager to tell him what stocks you don’t like e.g. for socially conscious reasons. You get to review your personal tax situation with the manager so he may delay selling a stock with a gain until later. Sounds good, right? One problem, it was too good to be true. Think about a manager managing thousands of custom portfolios. And the paperwork nightmare: every time the manager buys or sells a security you get a confirmation. And mangers use small transactions usually taking weeks or even months to build or liquidate a position. So what was supposed to manage your tax liability became a full employment act for your accountant, costing you big bucks for tax prep. To make matters worse, the performance of these separate accounts was lackluster and changing a manager is very painful. More recently, hedge funds have become the “product du jour”. These unregulated (although this is scheduled to change) investment pools often use leverage (borrowed funds) to amplify returns (and losses). Basically, hedge funds fall into 3 broad categories based on their investment strategy: relative value (arbitrage), equity, or special situations. Over the past year, I’ve attended several presentations on hedge funds including one by Mercury Advisors, a division of Merrill Lynch. With fees over 30% in some cases (fund of hedge funds), the volatile, risky, expensive products with little transparency left me unenthusiastic to say the most. Per the Journal of Investment Management, investors may actually pay out more in fees than they earn in returns! But worst of all, with over 8,000 hedge funds chasing the same opportunities, performance has suffered. Buyer beware!  
Bottom line: Although the flattening of the world has leveled the playing field, we need to be skeptical of any new investment products. I have access to the same products as Merrill Lynch, Smith Barney and other industry giants, but I will only recommend them if I believe they are in the best interest of my clients. If I would not use them in my own personal account, they’re not good enough for anyone else.   

Performance Commentary

We’re often reminded of the importance of discipline and long-term thinking in achieving sustained investment success. The lessons of 2005 also reflect the importance of discipline and patience. It was a year with lots of macro-level worries (Iraq, hurricanes, etc.). For much of the year markets were flat or falling but there were short periods when returns came in bunches. Timing these short bursts of performance would have been difficult. It was also a year when diversification away from the most mainstream asset classes paid off. Committing to a fundamentals-based asset allocation paid off. So, in the end, even though 2005 didn’t feel like a very good year for investors, relatively speaking for our clients, it was a great year. Even conservative portfolios, which include fixed income (bonds), did better than the S&P 500 which returned a boring 4.8%. I attribute this to my asset allocation discipline and fund selection. Analyzing the performance and risk of over 50 world-wide asset classes kept us in foreign stocks and domestic mid- and small-caps with a value bent. The long heralded shift to growth and large cap appears to be underway and we made some incremental shifts to large growth over the year. Outside of the equity markets, fixed income offered only small nominal returns and non-dollar bonds delivered slightly negative returns due to a stronger dollar, which resulted in currency losses. In short, in 2005 investors were rewarded for diversifying beyond domestic stocks and bonds.

Back to the Future

When any investment or asset class is universally loved, investors should beware. But when an investment or asset class is hated, investors are often presented with great opportunity. Today most asset classes are neither loved nor hated. The hated asset classes of 2000—value stocks and small caps—have hugely outperformed, while growth has been pummeled. With a sense of history it is perhaps not surprising that some of the best stock-picking opportunities probably now lie in the large-cap growth universe. After almost six years of huge underperformance and losses that are not yet close to being recouped (despite a strong rebound since late 2002) many companies are at least reasonably priced. And I continue to hear from many valuation-conscious managers that they are able to buy high-quality growth companies at prices that don’t reflect the usual “quality” premium. This is highly unusual.                For several years now our portfolios had no exposure to large-cap growth stocks, were overweighted to smaller-caps (including mid-caps) and value stocks, and included REITs, high-yield bonds, and foreign stock exposure. As it turned out, these asset class moves were major contributors to our strong record over the last few years. But times change. The overall large-cap stock market looks somewhat undervalued and thus reasonably attractive given the possibility that at least mild multiple-expansion will move it closer to fair value. Small-cap stocks look less attractive than they did a few years ago and less compelling than large-caps. Given their significant outperformance since the late 1990s, they now look slightly pricy relative to large-cap stocks. They also tend to perform best early in the economic cycle. Though it is hard to say how much of this cycle is left, it is not early.

2005 was a big year for foreign equities. While momentum could very well result in continued strong performance for some time, the data suggest that foreign stocks are in a fair-value range compared to U.S. stocks. The   Japanese market was particularly strong in 2005 and this reflected continued and important improvements in the health of the banking sector and corporate restructuring. But while the prospects for Japan look better than they have for more than 15 years, the country is still experiencing price deflation and the population is both shrinking and aging. Still, it all nets out to a more positive outlook than we’ve seen in close to a generation and this is reflected in the highest allocations to Japanese stocks in our international funds in over a decade. On a valuation basis REITs look somewhere between fairly valued to slightly overvalued, and for as long as that is the case they will continue to be excluded from our portfolios. Investment-grade bonds did not perform particularly well in 2005 as a wide variety of factors (including but not limited to the Federal Reserve rate hikes, foreign capital inflows within a world of capital abundance, oil prices, and inflation) contributed to the slight rise in intermediate-term rates from very low levels. My view for some time has been that the return potential from bonds is not exciting with expected returns over extended time periods fluctuating around their yield. In this environment bonds serve one purpose—to dampen volatility for conservative investors.

What About The Economic Imbalances?

The trade deficit, budget deficit, debt levels, and housing prices are all issues that I have written about and that continue to worry me. Macro forecasting is notoriously difficult—with that caveat, here are my thoughts. It appears likely that the global economy will continue to put off any day of reckoning for some time. In the words of PIMCO, a highly regarded fixed-income firm, we are in a state of “stable disequilibrium.” As long as it is in the interest of Asian central banks to provide the funding for the U.S. consumer (when needed), the U.S. and the global economy will experience adequate growth. It is likely that this environment will continue for the next several years unless Asian inflation spikes higher. This will likely occur within a backdrop of only moderate inflation given healthy productivity growth and an abundance of global labor and productive capacity. Thus, consumer spending, though slowing, is likely to stay strong enough to support the U.S. economy. And, happily, Europe’s economy is showing signs of strengthening and so is the Japanese economy. A worry is that the housing market is showing signs of rolling over in some areas and that if this spreads it would be very likely to slow consumer spending. However, the most likely scenario is that house prices slow and flatten but do not collapse. In that scenario, most likely spending would also slow but not collapse and could be largely offset by a healthy corporate sector and improved growth in the rest of the developed world. In the very long run the imbalances cannot indefinitely continue to grow worse. There will have to be a reversal. However, the large supply of global capital is the ultimate reason why it seems likely that the day of reckoning is not near.

Watchful in 2006

As we head into the new year we can take comfort in the reasonable valuations we see in almost all asset classes  (the P/E ratio of the S&P 500 is the lowest in 10 yrs.) and the risk reduction we gain from prudent diversification. I am not particularly worried about the slight yield-curve inversion that was widely reported as 2005 drew to a close. It is true that when short-term interest rates move higher than longer-term rates a recession often follows, but there have been exceptions and this is likely to be one. Dan Fuss, manager of Loomis Sayles Bond, and others I respect believe that the overall level of interest rates is too low to constrain economic activity to recession levels. He also believes that the inversion is impacted by the imbalance between long-dated bonds and the demand for them. These views make sense. Most importantly we will stick with our core competency and carefully assess asset-class valuations (which are also impacted by many of these variables), for signs of opportunity or increased risk.                       

Wishing all our friends and clients a healthy and prosperous new year.  
Thank you for your continued trust and confidence and a special thank you to clients who have referred family and friends to Belmont Financial. Please contact me if you have questions or comments.                 I look forward to seeing you during our periodic review meetings.                                                                                                                                                                                                        Mike Durant CFP, January 2006                          617-489 0040