In a press release from the Federal Open Market Committee released on September 21 indicates that by June of 2012, the Federal Reserve is going to simultaneously sell $400B worth of shorter-term securities and purchase $400B of longer-term securities.  Some refer to this decision as “operation twist.” The expected effect of this maneuver will be to place downward pressure on longer-term interest rates.  The Federal Reserve is expecting that the average maturity of bonds in their portfolio will rise from 75 months currently to approximately 100 months by the end of 2012.

The extended impact of this decision will be felt through the economy for many years to come, so it is critically important to understand exactly what the decision really means.  Since the active part of “operation twist” will spur a second-level effect, we are prefer to think of it as a “double twist.” Specifically, we expect for there to be two stages in the double-twist.  The first will be when the systematic shift toward longer-term treasuries in the Fed portfolio takes place, and the second will be when past monetary expansions roll through in the form of continued, persistent price inflation.

Double-Twist: Stage 1

The first part of the double-twist is what has already been communicated by the Federal Reserve.  Specifically, the simultaneous purchase of longer-term treasuries and mortgage backed securities while shorter-term securities of the same type are being sold.  The Federal Reserve is estimating that market uncertainty over the global economy will keep short-term capital in US treasuries for a significant period of time, and that selling their short-term treasuries will have a minimal impact on short-term interest rates. When this initiative was announced, it did very little to calm jittery markets, and key indexes continued their downward trajectory.  It is most likely that the reason for this is because market concern is not in regards to the price of credit, but rather in regard to the fiscal problems of the United States government that are not on any meaningful path to resolution.

The government is currently spending approximately $1.5 Trillion dollars more per year than is collected in revenue.  All of this additional debt is either purchased by the Federal Reserve or must be floated out on the open market. To date, the Federal Reserve has purchased a massive amount of US government debt, which has had an inflationary effect on prices for goods and services.  The reason for this is because when the Federal Reserves buys Treasuries from the open market, it pays for them with a credit to the bank’s reserve deposits.  This ultimately means that the net amount of money in circulation increases.  Furthermore, the banks who just sold their bonds to the Fed can now loan out the money they just received at a 10 to one ratio.  Thus, large purchases by the Federal Reserve have the ability to create large amounts of inflation very quickly as the amount of money in circulation grows faster than the amount of goods and services in the economy.

Double-Twist: Stage 2

Now comes the second act of operation Twist, which we contend turns it into a double-twist.  As the Federal Reserve actively works to suppress the interest rate of longer-term securities, it is effectively locking in long-term monetary inflation and negative real interest rates.  This is resulting because the Fed is printing money to subsidize low interest rates while that new money floods into the economy, pushing up prices.

By reducing the amount of short-term treasuries held by the Federal reserve, this decision is effectively locking-in negative real interest rates and inflation as long-term policy.  This is especially true since the Fed will now need to take more aggressive action if it wishes to reduce the money supply in response to price inflation that is likely to result from its repeated injections of capital into the market.

Consider that if the Fed primarily owns short-term treasuries, it can simply let those notes mature and naturally pull money out of circulation as those notes are repaid.  However, if the majority of Fed holdings are longer-term treasuries, the only way that they can pull money out of the market is by selling these treasuries.  When these sales happen, it will suppress the price.  When the prices are pushed down, it will increase the net rates.  When the rates of these treasuries increases, it will also increase the interest rate of associated credit such as mortgages.  When the price of credit increases, it will suppress the price of credit based assets such as housing.  This will create a major head-wind against whatever form of economic recovery is beginning to emerge.

Since the Federal Reserve will be very reluctant to take an action that actively suppresses the economy, it is highly likely that they will simply allow prices to continue inflating.  This will place significant pressure on people who rely on pensions, government assistance, bonds, and fixed-income retirement programs.  By shifting the Fed portfolio toward longer-term securities, it is locking-in this effect.

What Double-Twist Means For You

The extended impact of this maneuver is that people who purchase cash producing assets with fixed-rate debt will be made wealthy.  The way that this effect will take place is through price inflation that pushes up the cash flow and price of these assets while the cost of capital remains fixed by the interest rate.  The way that you can benefit from this effect is by gaining ownership of assets that produce cash flow and are financed with fixed-rate debt.  The most typical way to take advantage of this effect is with rental real estate.  The effect can also be captured to a lesser degree by acquiring stocks that pay high dividends from their earnings.

In both cases, the important part is to own assets that will have their value and cash flow pushed upward by inflation.  This will put the impact of inflation in your favor, as the purchasing power of cash, debt, and fixed-income payments is eroded.  In this manner, the debt you use to purchase your assets will be eroded by inflation while the value and cash flow from your assets are enhanced.  In the current environment, this is possibly the best path to wealth that exists for investors who are not corporate insiders or affiliated with prominent politicians.

 

The recent rise of gold prices and volatility within the economy has begun to challenge the notion of wealth, productivity, and output that many people hold in their minds.  The typical situation for most people, is that they think of wealth as being measured in money.  For people like Ben Bernanke, money means currency.  For people like Bill Bonner, money means gold.  However, in both cases, wealth is something much deeper.

Wealth as Money

It is not surprising that most people view wealth and money as being the same thing.  After all, your 401k is measured in money, your house is measured in money, and you salary is paid in the form of money.  The thing that is important for people to consider is that money doesn’t represent wealth itself … it represents a medium of exchange for wealth.  By producing something that is worth one dollar and receiving that dollar, it allows you to purchase something else that is worth one dollar without the necessity of bartering and trading.

The benefit of money to the functioning of a smooth economy cannot be over-stated.  However, it is important to understand that the money itself is not your goal.  Money is a medium of exchange that makes it easier to purchase the things you want when you want them.  However, without a population of people who recognize the value of money for trade and exchange, it is just paper.

Another insidious problem with money is that it can have its value debased by government action.  Since the government controls the amount of currency in circulation, it has the ability to influence the price of items through its monetary policies.  If the government prints a lot of money in order to finance its spending, it will de-value the money already in circulation.  In this scenario, money serves as a superior way to transfer value, but a very poor way to store value.

Wealth as Stuff

Another popular view of wealth is to think of it in terms of things.  This is where most gold and silver investors place their sentiment.  The fundamental belief is that commodities hold a constant real value while government currencies frequently become de-valued.  The general thesis of this belief is quite accurate.  Gold and silver are constant value commodities that cannot have their value directly eroded by the Federal Reserve.

However, there is another factor of gold and silver that must come into consideration.  Their value is exclusively a product of what other people think they are worth.  For most people, gold and silver do not have a very  high use value.  You can’t eat them, and they don’t directly improve your life in many manners outside of jewelry.  They are a store of value that depends on other people wanting to use them as a store of value.  Your house represents a store of value that gets pushed up in value when other people wish to live in your area.  However, its value is also subject to the willingness to pay of buyers, and can fluctuate very wildly.  In this way, a commodity-based view of wealth has some of the same deficiencies as a currency-based view of wealth.

Another view of wealth in regards to stuff is thinking about wealth in terms of consumable commodities.  By and large, consumable commodities have a much higher use value than gold or silver, since they can be eaten or used to make clothing, or any number of things.  However, the principal deficiency of consumable commodities is that they tend to be perishable.  Oddly, the strength of gold and silver is the deficiency of consumable commodities and vice-versa.

Wealth as Economic Resources

Finally we come to a view of wealth in terms of economic resources.  Another way of stating this is to say that wealth represents the ability to produce things of value.  In the ancient days, wealth came from livestock that would produce milk, eggs, and offspring that were valuable as a source of food or for breeding more livestock.  In the contemporary world, a ‘share’ of ownership in a company produces dividends that result from the value that is captured through profitable operations.  As individuals, our greatest source of wealth is our ‘human capital’ … or our ability to deliver valuable services in exchange for compensation.

In most cases, this great source of wealth is not directly valued since it is intrinsic.  It does not sit on a balance sheet, and is not tallied in a statement.  An investment such a rental property that produces value for the tenants whom pay rent in exchange for the right to occupy the property is a real source of wealth.  However, the creative mind that purchases the property and organizes a system for using it to create revenues that exceed the cost of operating plus the cost of capital represents a much greater and much more powerful source of wealth.

In the end, real wealth always is and always has been produced by people who are able to generate products and services that are valued by others.  When the value of these services exceeds the cost of delivering them, it results in a profit.  For most people, their greatest source of wealth (their human capital) is slowly used to acquire secondary sources of wealth that are not limited by the extent of their personal efforts.

The individual ability that each of us possess may be much greater than any of our investments that we own, but those investments have a very important characteristic.  That characteristic is the ability to create passive income … income that does not require constant effort.  In this way, wealth becomes a much more complex subject since it is inclusive of both our efforts to produce value and the passive effort of investment vehicles that we own to produce value.

Ultimately, all forms of real wealth must produce value.  As we are starting out in life, most of that value will come from our personal efforts.  Over time, our personal efforts allow us to invest in vehicles that produce passive value.  As more time passes, those investments will generate returns that allow us to purchase more investments in a process known as compounding.  This cycle of wealth all starts with a decision to focus on creating value through both our efforts and our investments.

 

How are we going to pay for college? That’s the question families are increasingly asking themselves as they see education costs soar while their savings dwindle.

Just when college savings and other investments were starting to recoup some of the heavy losses of the past few years, markets took another tumble earlier this month. State budgets are still constrained, forcing many public schools to further raise tuition, reduce aid or cut grants altogether. Private universities are raising tuition as well, and in some cases, offering less aid. And deficit-reduction efforts could lead to cuts to federal programs such as the Pell grant.

All this makes it all the more urgent to get started on a plan. Here’s a three-year countdown on what you should be doing and when you should be doing it.

Three Years Out

Savings: While you’ve hopefully been setting money aside since your teen was a baby, this is the time to get your college savings on the fast track. “The greatest asset is time,” says Mark Kantrowitz, founder of financial-aid sites FinAid.org and Fastweb.com.

You can’t afford a lot of investment risk this close to the college years, but unfortunately interest rates on savings accounts and certificates of deposit are pretty paltry these days. And they’re likely to stay that way with the Federal Reserve indicating earlier this month that it will keep interest rates low through mid-2013.

So your best bet for boosting college savings is still a tax-advantaged plan, such as a 529 college-savings plan and Coverdell Education Savings Account. These accounts let you withdraw money tax-free to pay for qualified education expenses.

Many 529 plans took a hit during the recession and the recent market dives. So many states have added safer investments, such as CDs, to their plans. Investments and fees vary by plan. And annual contributions to a 529 plan exceeding $13,000 may be subject to a gift tax. You can compare all 529 plans at Savingforcollege.com.

If you have an underperforming or high-cost plan, you can roll over your money to another state’s plan once a year, but fees may apply. Some states offer tax breaks as well.

A Coverdell is like an individual retirement account, with your child serving as beneficiary. There are income limits for contributing to a Coverdell and you can put in a maximun $2,000 per child per year.

Financial Aid: It’s never too early to start thinking about how much financial assistance you can get — and from where.

Online tools, such as SimpleTuition.com’s TuitionCoach, can help you figure out where to put your money to qualify for the most aid, depending on the individual college and the methodology it uses for financial aid.

Janet Krochman, a certified public accountant in Costa Mesa, Calif., says you should start juggling money now so it won’t weigh as heavily in the calculation when you apply for aid. But speak to an accountant or financial adviser before making any moves. For instance, discuss whether to keep a child’s money in his or her name or transfer it to your name.

Start searching and applying for scholarships and grants. Fastweb.com has a free tool that matches your child with scholarships. You also should reach out to your child’s guidance counselor, your employer, and religious and service organizations about scholarship and grant options.

Two Years Out

Savings: Continue funding your 529 and other savings accounts, upping the amount if possible. This also is the time to start taking a serious look at potential schools — and estimating the cost of each.

Starting in October, schools that award federal financial aid are required to publish a net price calculator (most on their websites), which lets you enter basic financial information to get an estimate of the school’s bottom-line cost of attendance and how much need-based aid a student could get.

Financial Aid: If you’re planning to sell assets to help pay for college, and will have capital gains, some financial advisers say now is the time to do so. You don’t want to show a big capital gain on tax returns you’re going to submit to the school, Ms. Krochman says.

When planning campus visits, make an appointment with the financial-aid office to learn how the school determines financial need. Schools use the same formula for federal aid but some consider supplemental income and assets.

Loans: You still don’t know how much you’ll need to borrow, but you should start looking at your loan options — including federal loans for students or parents and private bank loans, which can have fixed or variable rates.

One Year Out

Savings: By this point, you should have the bulk of your money in less-risky investments, such as money-market funds, CDs and Treasurys, since you won’t have much time to recoup any losses. Mr. Kantrowitz says no more than 20% of college savings should be in at-risk investments when your child is this close to college.

Financial Aid: Your child will be applying to schools and filling out the Free Application for Federal Student Aid, or Fafsa. Be sure to submit all necessary paperwork. Delays could hurt your chances of getting money since some schools dole out aid on a first-come-first-served basis. If you haven’t already done so, apply for grants and scholarships.

Loans: Once you’ve figured out how much you’ll need to borrow, first look into federal loans, which typically have the lowest interest rates. There are the Perkins and subsidized Stafford loans for students and the federal PLUS loan for parents. Private bank loans should be your last option since they tend to have higher rates.

When it comes to borrowing, “a good rule of thumb,” Mr. Kantrowitz says, is that the “total debt at graduation should not exceed your child’s expected starting salary” upon graduation.

Write to Emily Glazer at emily.glazer@wsj.com

Article source: Wall Street Journal

 

Hey, Harvey Golub — I’m sorry to hear about your tax problems!

In a rebuttal to Warren Buffett’s call for higher taxes on the super-rich, you wrote in Monday’s Wall Street Journal: “Of my current income this year, I expect to pay 80%-90% in federal income taxes, state income taxes, Social Security and Medicare taxes, and federal and state estate taxes.”

Yikes!

Harvey, you came to the right place. We’re here to help.

I don’t know your exact financial situation, of course. But I figure you must have at least $100 million in the bank. After all, you were a high-earning corporate honcho for decades, including twenty years of the biggest bull market in history. Over that time you were a senior partner at McKinsey Co., the chief executive of American Express, and the chairman of Campbell Soup.

According to the American Express proxy statements, you were collected about $50 million in salary, bonus, and stock options just in one year, 1999.

At age 72, you’re presumably mainly living off your investments. But I would assume you’re earning several million a year.

Here’s an action plan to help you out on those taxes.

Fire your accountant

You’re paying 80-90% in taxes? Where are you living, Cuba?

The top rate of federal income tax is 35%. Medicare tax is another 2.9%. Social Security is trivial at your level — it tops out at around $13,000 in a normal year, and $11,000 this year.

Then there is state and local tax. But how high are they? New York City charges a maximum of about 12.8% in state and city income tax. Most other places charge far less.

Let’s do the math. I don’t know how much you make, but let’s say, for the sake of easy calculations, it comes to $10 million this year.

If you live in New York City you will pay just under $1.3 million in state and city income tax, and $3.3 million in federal income, Medicare and Social Security taxes.

Total: $4.6 million, or 46% of income.

If you were to die this year (and of course I hope you don’t, but let’s just say, for the sake of calculations), then the federal government would take another 35% of what’s left in estate taxes. That’s another $1.9 million.

The total tax: $6.5 million. That’s 65% of your income — a long way short of “80-90%”.

What am I missing? Property taxes?

By my math, to get the total to 80-90% you’d have to pay property taxes equivalent to somewhere between 38% and 63% of your income.

Forget Cuba! Where are you living — Buckingham Palace? The top ten stories of the Chrysler Building?

Harvey, you need a new accountant. Something doesn’t add up here.

Buy a new home

This is a great move right now for all high earners. You can deduct the interest on a $1 million mortgage and another $100,000 home equity loan. With interest rates at 4.5% right now, that can save you $17,300 a year in federal taxes alone. As you are in the top tax bracket, you get a bigger break than people who earn less. And this has to be a good time to borrow money to buy a home anyway. Interest rates are at record lows. Ben Bernanke is probably gearing up for “Quantitative Easing III.” And real estate is a bargain in many parts of the country. Check out Palm Beach!

Move

It sounds like you’re getting hosed on state taxes. You can save a bundle by moving to a lower-tax state. Why pay through the nose to live in New York City? If you are worried about how much you are paying in taxes, try moving to Connecticut, where the top rate is 6.5%. Or Pennsylvania, where it’s just 3.1%. According to tax information company CCH, seven states charge no income tax at all. How do you feel about South Dakota? Wyoming? Alaska? Just think — living is cheap, there’s no state income tax, and you’ll never have to meet another “liberal” again! States without income taxes also include Florida, Texas, and Washington. And if you move to Texas, you’ll escape U.S. taxes completely once President Perry secedes.

Restructure your portfolio

Harvey, with your wealth, and at your age, I’m guessing most of your income today comes from your investments. And if you are paying 35% tax, it sounds like you’re loaded up with bonds, and maybe hedge funds generating a lot of short-term capital gains.

This is nuts. Most hedge funds are a racket. You know this — you’ve been around Wall Street long enough. And bonds are paying bupkis: At the moment the Vanguard Bond Index Fund, a mixture of Treasurys and corporate, yields just 2.3%. And those coupons are taxed as ordinary income. Yuck!

The main reason to own bonds here is if you can’t handle volatility. But with your level of wealth you can ignore that. You can afford to ride out the market’s bumps and invest your family’s wealth for the long term.

Move your money into blue chip stocks instead. You can easily earn 3% just in dividends. And those dividends are only taxed federally at 15%. We’ve just cut your federal income tax by more than half!

Give to your family

This is a great time to make gifts to your family, says Janet Tighe, a financial planner at Mintz Levin Financial Advisors in Boston. Until the end of 2012 you can give $5 million, tax-free. If you are married, your wife can give another $5 million. These limits used to be just $1 million each. In addition you can give $13,000 a year to each recipient — each child or grandchild — and a spouse can do the same. So a married couple with, say, three children and eight grandchildren can give another $286,000 a year, on top of that one-off $10 million. Over ten or twenty years that really adds up. Your heirs won’t have to pay a penny in estate or income taxes on the loot.

Put your grandkids — and great-grandkids — through college

This is a tax-free gift. Money paid directly to schools or colleges escapes estate taxes. It’s like you’re getting 35% off! If they’ve all finished their bachelor’s degree, send them to grad school. And how lucky for them! Right now most children are struggling to afford college. Many are going to graduate tens of thousands of dollars in debt. Your grandchildren will get a college education, completely free — and will save on the estate taxes as well! (You can also pay their medical expenses. Give them all braces! Botox! Nips, tucks and silicone implants!)

Buy life insurance

This is a great maneuver. The proceeds are tax-free to your heirs. The original rationale was to help widows and orphans, but even the super-rich can use it to cut their estate taxes. There a few wrinkles to make it work, says Linda Campbell, a financial planner at Budros, Ruhlin Roe in Columbus, Ohio. “Typically you put the policy in an Irrevocable Life Insurance Trust,” she says. “The premiums that you pay annually are gifts to the beneficiaries.” And when you die, “the proceeds of the policy go to the trust, for the beneficiaries, free of estate tax.”

What about you? New York Life tells me that a 72-year-old man in excellent health could buy a $1 million permanent life insurance policy for premiums of $37,000 a year.

Talk to an estate planner

There are other moves that can cut your estate tax, too. A Qualified Personal Residence Trust can slash the estate taxes on a residence. A Grantor Retained Annuity Trust, or GRAT, can slash them on an investment portfolio. So, too, can setting up a Family Limited Partnership. Financial planners say this is a great time to put investments — like stock — into a GRAT. The IRS has slashed a key interest rate it uses to calculate future GRAT gains to just 2%. “It limits the future appreciation, for estate tax purposes, to 2% a year,” says Susan Elser, a planner in Indianapolis. Anything above that passes to your heirs tax-free, she says.

How does it work? Let’s say you put $100 million into a two-year GRAT, says Linda Campbell. Over the next two years you withdraw $104 million — the principal, plus $2 million a year. But if the investments earn, say, 7% a year, what’s left over — nearly $7 million — passes to your heirs completely free of estate tax. What a deal!

Your heirs will benefit so long as the money earns more than 2% a year. And, Harvey – if you can’t earn more than 2% a year on your investments, fire your investment manager.

Give to charity

You could give money to the American Enterprise Institute, where you serve on the board. Or you could even give to the needy. How much does it cost to save a life in Somalia right now? Fifty bucks? So if you cut a check for $5 million you could save the lives of maybe 100,000 children. And that money comes off the top of your estate. Melissa Labant, at the American Institute of CPAs, says this is a particularly good time to make charitable donations. That’s because right now the old phase-outs on your income tax deductions have gone. They were eliminated as a result of the Bush tax cuts, and who knows how long this will last? (There are still limits to the amount of your adjusted gross income you can deduct each year.) Harvey, you can make your own choices, but if were 72 and I had $100 million, I couldn’t imagine anything better to do with my next $5 million than saving the lives of 100,000 people. How many Ferraris can you drive?

Get some perspective

I hate to talk semantics, but please stop pretending that “you” will have to pay estate taxes. You won’t, because they won’t kick in until you are dead. Technically your “estate” will pay them — which actually means that your heirs will. And while you earned this money they didn’t. My father’s estate, I suspect, was a lot less than your annual income, but we paid hefty estate taxes, and it never occurred to me to complain — I didn’t earn the money, so anything I got was a windfall anyway. Taxes have to come from somewhere: I’d rather pay tax on an inheritance I didn’t earn than a salary I did. If your children and grandchildren don’t understand that, the most valuable thing you could do for them right now is to pass on some wisdom instead of just money.

Spend the money

If you really don’t want to help pay the country’s bills after you’re dead, why not just enjoy the money now? Spend it! You’ve seen Brewster’s Millions. Go one better! Hire Placido Domingo to walk behind you, singing your praises! Pay Steven Spielberg to make a movie of your life. Go smoke a cigar in Mike Bloomberg’s office. Who cares about the fine? Or maybe you could vindicate Marie Antoinette, at long last: Open your own bread factory, and hire staff to hand out free cake to the poor. You earned the money. Enjoy it! And all that spending will help the economy anyway.

Article source: Wall Street Journal

 

One of the most famous institutions in American cultural history during the 20th century is the Circus.  During the early portion of the 20th century, many Circuses moved from one small town to another, setting up a “Big Top” for their main show, and sponsoring side-shows, performance, and greasy food alongside carnival games in an area called the midway.  Traditionally, these carnival games were “difficult” (meaning that they were constructed so that you had an extremely low chance of winning) and required many attempts before the desired prizes were won.

When the Circus pulled into a new town, the local residents were frequently referred to as Rubes, which is a euphemism for an unsophisticated country bumpkin.  When these Rubes came to the midway, they frequently spent substantial sums of money buying food, playing rigged games, and paying to see side-shows or freaks of nature.  Another mainstay of the Circus midway was the announcer who would talk-up all of the shows and events to draw large crowds of people into the shows and attractions to spend their money.

There were some Circuses of a less than savory nature who would employ con-men that would cheat people at the midway games and pickpockets who would steal their wallet in the crowd.  Over time, these sketchy operations eventually collapsed, but the spirit of attracting people to the midway for the express purpose of separating them from their money remains.  Even among the carnival operations that remain today, the midway games are still extremely tilted against the player, and the prizes can be purchased at the store for much less than the cost of playing multiple games in an attempt to win.  Regardless, it is the excitement, lights, sounds, and smells of the midway that attract people to the games of chance that most people inwardly know are tilted against them.

An interesting parallel to the world of the circus is the realm of investments.  Many investment funds invest great amounts of fanfare and marketing behind their manager or fund family.  High budget advertising campaigns are created for the purpose of convincing you that the manager in charge of a particular investment fund or that the characteristics of a particular insurance product are going to provide everything you could every want.  In this environment, people who have not yet learned a tremendous amount about about investing are attracted like Rubes at the midway.  The excitement of a high-profile investment fund, the advertising campaigns and the colorful brochures all serve to attract new investors (Rubes).

Unfortunately, what the investors ultimately find out is that this game has been tilted in favor of the house as well.  The high-profile fund manager takes 2% of the asset base as a fee, but can’t consistently beat the market indexes.  Maybe he’ll do better than the market for a year or two, but then he does worse for a year or two.  When all of the fees are subtracted out, most of the investors would have been better off buying an index fund with low costs and no commissions.  The investors just got fleeced like Rubes at the midway.

This same phenomenon repeats itself over and over again with each new financial product that is rolled out for the investment Rubes.  The insurance product with an investment account may have some tax advantages vs. a regular brokerage account, but your cash is subject to fees and charges for the insurance part of your policy, and the associated expenses for each of the sub-accounts.  Some products even have a “guaranteed” rate of return from the insurance company that make the Rubes feel warm and cozy since they have a guarantee to fall back on.  However, that guarantee only holds water if the insurance company makes enough on its other investments to meet it’s capital reserve requirements.  Many people make the mistake of assuming that a guarantee from another party is guaranteed … it is nothing of the sort.  The guarantee of another person or company is only good if that company can make good on the promise when it becomes necessary.  What happens if the insurance company goes bankrupt before they can make good on your guarantee?

Another things that people frequently overlook is the fact that every time somebody touches your money in a financial product, they take a cut, a percentage, a taste.  By the time your money has passed through multiple sets of hands, it will be exceedingly difficult for you to realize a rate of return that exceeds the market by a large enough margin to dissipate the costs.  The way that financial companies make their profits is by attracting money to “manage” for a percentage of the asset base.  The way that they attract capital to “manage” is by making loud, outlandish claims about their great skill and amazing ability.  Strangely, this is remarkably similar to the barker at the midway trying to fleece the Rubes.

One of the things that are very important for people to understand is the difference between financial products and direct investments.

Financial Products:

• Financial products are packaged together by a bank, brokerage, or other financial institution.  Typically, they involve multiple riders, proviso’s, or conditions that are all packaged into a single product.
• Each level of intermediary or “middleman” between you and the actual investments will take a percentage.
• The incentives are set such that manager succeed by attracting large amounts of capital.  This means that they will either produce average rates of return or must take very high risks to beat the market.
• If the returns end up being average, the high costs will push you behind simply purchasing the market portfolio.
• If high risks are taken to produce large returns, you will be unknowingly bearing a risk of substantial loss.
• Products frequently involve “guarantees” that are subject to change in the future … especially if there are financial problems.
• The financial companies who sell products to you will take your money and make direct investments into assets like bonds and real estate.

Direct Investments:

• As the name indicates, direct investments involve directly purchasing ownership in a company, property, or debt instrument.  There are no additional intermediaries between you and the investment.
• You must become educated about the investments available, the process of purchasing, and the management of these investments.
• As the owner of the investment, there will be nobody to take a cut from your returns.
• As the owner of the investment, there will be nobody to shield you from risk if problems arise.
• Direct investments can have rates of return that are much higher than market indexes, due to small fragmented opportunities that cannot be efficiently collateralized by a financial institution.

Ultimately, the question of direct investing or purchasing financial products comes down to one of personal comfort, preference, and willingness to do one’s own research and analysis.  There are some financial products such as Term Life Insurance or indexed mutual funds that offer minimal costs, and no additional layers of middlemen between you and the underlying investments.  There are also some financial products with exceedingly high fees, high levels of complexity, and a very confusing value proposition.  In the end, each person must make their own choices when it comes to investments.  However, in most circumstances it is quite safe to say that if you do not fully understand how a financial product or direct investment works, then it is probably not a good idea to place your money there.  It is almost always best to start with the products and investments that you understand, and then seek to expand that universe of understanding.

This is how you avoid being fleeced like a Rube at the midway.

 

The recent release of an S-1 Document by Groupon for the purpose of a public stock offering has brought the failures of its business model into the light.  At the end of 2010, Groupon refused a reported $6 billion dollar buyout offer from Google.  Their public stock offering is for $750 million dollars, which is significantly less than what was offered to them by Google and will be insufficient to finance their current rate of operating losses for more than another couple of years.  In retrospect, it appears that refusing the offer from Google was a monumental blunder.

The past few years have seen a tremendous rate of growth for Groupon’s “Revenue” while operating losses have ballooned.  In 2010, Groupon registered a $420M operating loss, with another $117M being piled-on in the first quarter of 2011.  In response to this, Groupon insists that “Non-GAAP” measurements of profitability be used to evaluate the company.  In shorthand, this is code for saying that the company doesn’t “really” make money, so they need to come up with clever ways of convincing the world to part with it’s money when the IPO goes public.

There are also many deceptive parts of Groupon’s business model that make its financials appear to be much more positive than they really are.  The most deceptive is the company’s revenue, which is touted in all of the media articles about how fast the company is growing.  What these media reports fail to mention is the fact that the “Revenue” of Groupon includes the amount that they are contractually obligated to pay the vendor.  It is only the “Gross Profit” part of their income statement that represents real money flowing through the company.  It is most certainly true that Revenue and Gross Profit for Groupon grow at similar rates, but the top-line needs to be viewed through the lens of reality.

Enthusiasts will most likely point to the rapid rate at which Groupon is growing its Revenue, Gross Profits, and Subscribers.  Their business model relies on marketing deals for local businesses to a (large) list of subscribers, and taking a substantial percentage of the total sale amount in the form of a commission.  This means that converting subscribers into buyers is a critical part of their growth strategy.

In the first quarter of 2010, 1.7M Groupons were sold to 3.4M subscribers for a net total of 0.5 Groupons per subscriber.  In the first quarter of 2011, 28M Groupons were sold to 83M subscribers for a net total of 0.3 Groupons per subscriber.  As time goes by, Groupon must acquire more subscribers for each sale.  This means that their customer acquisition costs will increase over time, creating a major cost problem if the company seeks to continue its current growth trajectory.

As more and more new subscribers are required for every new sale, Groupon is going to face a permanent problem of profitable growth.  Consider that many of the most profitable subscribers have already been acquired.  This means that more advertising, marketing, and other expensive forms of customer acquisition are required to keep Groupon growing.

In a previous post, we explored the dichotomy of Groupon as a potential boon for small business or an epic fail.  The fundamental problem we saw then (and now) is that high-quality vendors will be dis-inclined to commit to the large net price discounts required to list through Groupon.  This will steadily erode the quality of deals offered through Groupon, and shift vendors to other services such as Living Social that offer their services for a smaller commission.

Fundamentally, the IPO of Groupon represents a re-iteration of the tech-boom mentality where high growth was pursued over profitable growth.  Because of this, companies needed to invent clever sounding metrics for pretending to be successful since their non-existent profits could not be measured.  Many companies started, many grew, and many failed.  The fundamentals cannot be ignored forever.  Businesses exist to earn profits for the shareholders.  Ignoring this fundamental fact has historically been a road to disaster.

Attempting to grow rapidly by spending money and generating losses eventually creates the dilemma of when to stop pursuing growth and focus on making money.  Complicating this further is the fact that Groupon’s business model has already hit a point of diminishing returns, and continuing to scale-up the size and scope of their operation will only serve to exacerbate this problem and inflate the cost of generating incremental sales.

It is most certain that when the stock strikes its initial public offering, it will be to great fanfare and adoring media coverage.  It is also possible that this fact alone could be enough to create a speculative frenzy that drives the price of Groupon stock upward based on expectations of tremendous future growth.  However, for fundamental investors who purchase based on sound business viability, the IPO of Groupon seems to be an offer of failure to anybody who is foolish enough to invest.  Sticking to fundamentals is the road of wise investors who see through gimmicks and fads to build real long-term wealth.

 

The Great Rollover Hunt is on.

Some $350 billion will be rolled over into individual retirement accounts from 401(k)s and other workplace accounts this year, up from $330 billion in 2010, according to Financial Research Corp., an investment industry research firm. That amount is expected to rise more than $20 billion a year for the next few years.

All told, more than $1 trillion could be rolled over into IRAs over the next three years, and the financial-services industry would love to capture your account. Firms are sending letters or calling people as they leave jobs or retire—or even simply because they have reached 59½, the age when withdrawals can be made without tax penalties.

Don’t be too quick to take the bait.

There are some good reasons to roll your money into a new IRA account: You may want a clean break from your old company. You may not like your 401(k) investment options. You may want to consolidate several retirement accounts into one. Or you may feel like you need more help in managing your accounts.

But despite the sales pitches, you don’t have to take your money out of your old company’s plan, especially if you are happy with your investment choices. Though plans vary, many in recent years have made it easier to take regular withdrawals; T. Rowe Price Group, for instance, is rolling out a retirement-income program that allows its 401(k)-plan participants to easily set up monthly distributions.

Here are some other things those folks who want your rollover money should tell you—but may not:

• “I’m not acting in your best interest.” Typically, the people who send letters and call you to discuss rolling over your workplace plan are sales representatives and brokers. Unlike registered investment advisers, who, as “fiduciaries,” must put their clients’ best interests first, these reps only must offer investments that are “suitable,” which can cover a wide range of less-than-ideal products.

There’s more: The sales agent can make commissions or receive bonuses for reeling in your money and selling you certain products. In a 2008 lawsuit, two small investors alleged that Principal Financial Group sales reps sold them high-cost mutual funds for 401(k) rollovers, and the reps earned prizes for bringing in rollover funds. The suit was settled last year.

Principal says the investors were given a range of options, and that when funds are rolled into an IRA, “our representatives sometimes receive mostly low-cost awards or incentives that are meant to build team morale.”

The U.S. Department of Labor has weighed whether to require those who pitch IRA rollovers to act as fiduciaries but hasn’t yet proposed specific regulations.

• “You probably will pay higher fees in a rollover account.” If your 401(k) is with a midsize to large company, you should have access to a range of low-cost mutual funds. When you are investing on your own, however, you may not qualify for the cheapest funds.

If you are considering a rollover, you need to weigh the expenses you are paying in a workplace plan, including any administrative fees, against the expenses and fees you would pay for an IRA. Those costs are one of the biggest factors in how your money increases.

Such comparisons should get much easier next year, when new Labor Department rules will require 401(k)s providers to detail fees and costs clearly.

• “If your account is small, you’ll be treated like a second-class citizen.” If your portfolio is less than $50,000, the services you get will be limited and may include extra expenses. T. Rowe Price charges $10 for each fund in your IRA with less than $5,000, and Vanguard Group charges $20 for each fund with less than $10,000, though the fees may be waived under certain circumstances, such as when forgoing paper statements.

Once you have $50,000, such fees go away and you may be entitled to more-specialized advice. Additional services and support are available if your account climbs into six figures.

If have less than $5,000 in your account, you will be required to roll the amount into an IRA to keep your tax advantages. Resist the urge to cash out. The funds will be subject to income taxes and penalties, and you won’t have that money and its accumulated growth when you retire.

• “Your workplace plan offers more federal protections than your IRA.” Federal law protects both workplace retirement plans and IRAs from creditors in bankruptcy proceedings. It also keeps creditors from tapping 401(k)s for lawsuit judgments or other debts—but not IRAs. Some state laws, however, extend the protection to IRAs.

• “You will have more choices—but you may pay for them.” A rollover to, say, Fidelity Investments gives you access to thousands of mutual funds, plus stocks, bonds and exchange-traded funds, but you may have to pay commissions or transaction fees. If you wanted to put together a portfolio of all-star funds from Fidelity and Vanguard, for instance, you would pay a one-time fee of at least $75 for each Vanguard fund you buy.

Write to Karen Blumenthal at karen.blumenthal@wsj.com

Article source: Wall Street Journal

 

Jean-Baptiste Say

One of the ideas that have been advanced repeatedly during the recent economic crisis, recession, and prolonged stagnated recovery is the notion of “stimulus” as a way to revive the economy.  This strategy is based on Keynesian economic theory, and is predicated on the notion that when an economy drops into recession, the fundamental problem is a shortage of people consuming.  The solution offered by Keynesian economist is intervention by government entities through monetary expansion, and spending to fill the perceived gap in spending.  The fundamental underpinning of Keynesian theory is the notion that consumption creates production.

A alternative view to the Keynesian theory is the one advanced by Jean-Babtiste Say, contributing to the larger Classical economic theory.  A principal idea advanced by Say was known as Say’s Law or the idea that “Products are purchased with Products.”  This theory underscores the fact that wealth is defined by what is produced, and shuffling products from one person to another in an accelerated manner does not increase the total amount of wealth.  According to Say’s law, a general economic recession is not the result of insufficient consumption, but incorrect production … namely that production has been over-pursued in some areas (such as home building) and under-pursued in others.

Furthermore, attempting to “solve” problems by printing more money does absolutely nothing to increase or change the total amount of production or the total amount of wealth.  When more money chases the same amount of products and services, the result is high prices or inflation.  Recent increases in food and energy costs, in the wake of massive monetary expansion by the US Federal Reserve have caused many to re-visit Classical and Austrian economic theory.

The importance of Say’s law is frequently difficult for people to directly see, since most employees don’t work for products … they work for money.  Thus, people equate the money that they earn with wealth.  However, it is nothing of the sort … money is simply paper.  Wealth is what you can buy with the money.  Since most people work in the preparation, sale, or delivery of some product or service, it is ultimately true that the products and services we buy are purchased with the products and services we create.  Money is simply the medium through which this transaction takes place.

Another important aspect of Say’s law is the notion that products and services are not homogeneous.  What this means is that producing more of something people aren’t willing to pay for is not the path to wealth.  This situation is actually the cause of market sector crashes when excess production cannot be sold profitably.  Furthermore, if government bailouts are created to “save” the companies that gambled incorrectly, it results in a perpetuation of low-value production that impedes economic growth.

In a dynamic, market economy, downturns in a sector such as home building will result in price declines that eventually attract investment capital without the necessity of government incentives.  The people who built speculative houses in the expectation of big profits would go bankrupt.  The assets of those companies would be sold off at a discount.  The companies that acted prudently would be able to purchase those assets very inexpensively and launch new growth initiatives.  The problem confronted with bailouts is that they reward irresponsible behavior while punishing those who are responsible by denying them investment opportunities that would emerge if prices adjusted to their true value.

This is where the fundamental flaw of Keynesian theory comes to bear.  In the view of Kenesians, supply and demand are aggregated.  This view combines the production, consumption, and unemployment from healthy sectors with unhealthy ones.  Whenever a large correction occurs, this leads to the conclusion that the whole economy is unhealthy.  However, that is not necessarily true … even in the worst of recessions, there are frequently sectors of the economy that are perfectly healthy.  Attempting to address a so-called aggregate problem with aggregate solutions results in subsidies for foolish investments and penalties for responsible investors.

Furthermore, stimulus programs are necessarily administered by government agencies and financial institutions that extract a significant amount of overhead from the total amount that is spent.  This is where the problem of intermediaries emerges.  In a market system, intermediaries only exist in situations where they add value to the system … otherwise the buyers and sellers would ‘cut out the middleman’ to get greater volumes and lower prices.  However, in the world of legislative fiat, middlemen stand between the money and the products, taking a percentage of the transaction and doing absolutely nothing to enhance or optimize the quantity or quality of total output.

This ultimately devolves into what many have called “Crony Capitalism” where large corporations dominate the marketplace, not because of any particular skill in creating or selling products and services, but because their connections to lawmakers allow for advantages that other firms do not enjoy.  The financial institutions and automotive companies that avoided bankruptcy and maintained all of their leadership / business practices serve as primary examples of this principal.  If AIG had been allowed to go bankrupt, its assets would have been sold off at a discount and a new competitor would have emerged to fill the vacancy created by AIG’s departure.  This company would have every incentive to hire the AIG employees who were responsible, and would have no incentive to hire the people who cause the company to collapse.

In the end, products and services are truly paid for with other products and services.  Attempting to circumvent this simple economic reality has resulted in tremendous mis-allocations of capital, and enriched politically connected organizations, while preventing real economic growth from emerging.  Unfortunately, we do not have the capacity to stop this trend as individuals.  However, we do have the ability to adjust our own decisions so that the impact of these trends on our lives is minimized.

The most important thing that any person can do is to work and live in the “real” economy that produces real products and services for real people that they purchase by producing real products and services for other real people.  The runway for extracting resources through smoke-and-mirrors financial manipulation is drawing short.  The time is quickly approaching when governments can no longer afford to rely on smoke-and-mirrors to disguise fiscal problems and unfunded promises that cannot be kept.  When this reality finally emerges, it be very painful for many people who have become dependent on the fictional reality.  Make sure that your well being is built on a solid foundation.

 

Recent news has been ablaze with news of commodity price volatility.  Prices for gold, silver, and oil have all taken a sharp drop after rising significantly over an extended period of time.  These rapid price fluctuations demonstrate the effect to which commodity prices are being driven by leveraged futures contracts and speculation concerning future price movements.  The situation that has emerged in major commodity markets is one where upward movements have resulted in more people purchasing futures contracts to profit from future price increases, but any weakness in prices is met by a rapid rash of selling by investors who are looking to limit their losses

The implicit problem that is uncovered by this recent price volatility is that returns from commodity investment singularly flow from price increases.  Naturally, the only way that prices rise is if an imbalance of buyers vs. sellers pushes up the price at which people buy.  If this trend continues for too long, a ‘bubble’ results where people buy simply because they believe others will continue to buy and drive up the price.  During bubble markets, many investors will begin to make leveraged investments on anticipated price movements through instruments such as futures contracts.  A futures contract is where two parties agree to exchange a specified asset of standardized quantity and quality for a price agreed today but with delivery occurring at a specified future date, the delivery date.  People who correctly predict upward price movements when using futures contracts can make a lot of money very quickly by selling the contract before its delivery date for a profit.  Conversely, if prices move counter to what an investor anticipates, a lot of money can be lost very quickly.

The ability to buy/sell contracts for future delivery allow investors and speculators to employ a tremendous degree of financial leverage.  This leverage increases the perceived returns of asset bubbles since increases in prices are seen as pure profit to futures traders who simply flip a contract and make money.  This phenomenon then attracts more people seeking easy money until prices are driven so high that nobody can be found to take physical delivery of the product in question at the inflated prices.  At this point, the investors who have no desire to take physical delivery of commodities must sell quickly to cover their position.  If many investors end up liquidating their positions simultaneously, price crashes can occur.

In recent months, “speculators” have been a popular political target for attempting to draw attention away from turmoil in the Middle East, a continued ban on US offshore drilling, and money printing by the Federal Reserve as drivers of increased energy prices.  However, it is important to note that speculators can only capture profits if somebody else buys the other side of their contract.  In other words, they can only profit from the price of oil going up if people reasonably expect the price of oil to escalate in the future.  It would be very difficult to find people willing to pay increasingly higher delivery prices for oil if new exploration contracts were approved and drilling resumed on existing offshore wells.

The important thing to understand in regard to commodity price fluctuations is that they move in accordance with the number of people who are willing to purchase the commodity in question at a given price.  The advent of price collapses is nothing more than a by-product of chasing profits with leveraged futures contracts.  The same forces that compel people to pursue big money in commodity trading also compels people to sell their positions rapidly when prices decline, because of the high leverage they are using for their transaction.

Ultimately, price bubbles and price collapses are two different sides of the same coin.  All bubbles eventually end in a collapse, and collapses do not occur unless prices become disconnected from fundamentals.  In the end, market prices will always regress back to fundamentals over time.  It may take a series of gyrations, but the one principal that has born out throughout financial history is that no bubble can endure indefinitely.

 

The economist Frederick Bastiat was famous for his writing about the seen and the unseen aspects of life.  His primary supposition was that people do not contemplate the impacts of things that they cannot directly see.  Another way of saying this is that people never notice dogs that don’t bark.  The importance of this insight is that as human beings, we are naturally biased toward impacts that we can see and measure.  This frequently leads us to disregard decisions that we did not make or options that we chose to avoid because we cannot see their impact.

Bastiat explained this danger in what he called the “Broken window fallacy.”  If somebody throws a rock through the window of a store owner, the proprietor must pay to have the window replaced.  As this is happening, many from the mainstream school of economics will point to how the economy is being stimulated by the store owner paying a glazier to replace their window, and how he will re-spend the money on other products and services.  What these people fail to internalize is that the store owner is now worse off than before.

If the window had never been broken, the store owner may have expanded his business, or any number of things that cannot be seen because they never happened.  In this case, the dog of lost opportunity does not bark so people simply assume that it is not there.  The unfortunate extension of this metaphor moves into the current frenzy of ‘stimulus’ projects that are being financed with borrowed or printed money to finance ‘shovel ready’ projects with little to no long term value.

The masses of copycats in the news media frequently hail such actions as being necessary to save the economy, but none have the insight to see the lost opportunity that is being thrown away by dedicating resources to these ‘makework’ projects for the purpose of stimulus.  Simple math dictates that if you spend more money without increasing production, the only thing it will accomplish is to create inflation.  Thus, we can see how dogs that don’t bark can be very loud indeed.