PacWest Financial Management Newsletter
4th Quarter 2005

Volume IX, Issue 4

January 2006

Recap of 2005
 

What will we remember from 2005? 

1. Surges in prices of real estate and hard assets became the investment of choice by many.

2. Record high energy prices helped the economy of many emerging markets, especially those in South America. This led to out performance of these countries’ stocks.

3. Corporate America generated so much cash that $500 billion has been given back to shareholders in the form of dividends and buyback of stocks. Companies did not spend surplus cash on capital investments. Over half of the S&P 500 companies increased their dividends. There is now approximately $630 billion of cash on the balance sheets of industrial companies that are part of the S&P 500.

4. Consumers kept the economy going. We spent more than $8 trillion a year on everything. Spending was sustained by refinancing mortgages and spending the proceeds. We spent more than we earned for the first time since the statistic was created in 1947.

5. The yield curve (short term interest rate versus long term interest rate) went flat to slightly negative in December, for the first time since February of 2000. An early indicator of recession? Although short term rates increased significantly, long term rates were almost unchanged. Much of this was caused by heavy buying from foreign governments.

6. After 18 years of service, Chairman Greenspan is retiring at the end of January of 2006. Ben Bernanke has been named as his successor. The new Federal Reserve chair believes in having an inflation target number. Mr. Bernanke is a student of the Great Depression of 1930s. He does not think that aggressive tightening to “pierce bubbles” is healthy for the economy. A balancing act between inflation and deflation is critical for the long term health of the economy.

What do we expect for 2006?

1. Stocks are cheaper than bonds. Earnings are at 5.6% of the price of an average stock in the S&P 500. Ten-year treasuries are yielding 4.3%. The market has had sub-par returns for five years. Is it time for a recovery?

2. There is more room to make money in the international markets. But beware of chasing the emerging markets. Their political and economic systems may have improved since the 1980s, but the risk is still higher.

3. The US economy will continue to grow in 2006, although closer to 3.5% versus 4.1% for 2005. We need corporate America to spend some of that cash on capital investments, to take up the slack of consumer spending.

4. Factors that can take the economy off track include higher energy prices, higher interest rates, and significant slowing in the housing market and in corporate profits.

Portfolio Strategies

1. We continue to emphasize quality in the choice of equities. Rebalancing will be concentrated on reducing exposure to companies that rely heavily on consumer discretionary spending, and increasing exposure to companies that will benefit from investments by businesses. Big companies are cheaper than small companies after the run in prices of small cap stock in the last three years.

2. Additional returns are not there in investments of longer bonds or corporate bonds. Most of the buying has been in government agencies with AAA ratings and state tax exemption.

3. Cash returns have been rising. Thus, leaving extra cash for investment opportunities can help performance.

4. We are creating a “portfolio for all seasons” for our clients, based on investment objective. Broad diversification may not increase wealth significantly, but it protects the wealth of our clients. Three factors shock portfolios: recession, resurgence of inflation, and sudden crisis. If recession comes, owning high quality bonds will help. If inflation returns, it may hurt stock prices in the short run but will help longer term because earnings will climb with inflation. If the dollar nosedives, owning international securities will help. A sudden crisis, such as a terrorist attack, should not affect returns long term.

Key Financial Planning Numbers for 2006

Here are some key numbers that changed from 2005 to 2006.

Retirement plan contribution limits:

IRA Maximum contribution - The maximum IRA contribution for both traditional and Roth IRAs remains at $4,000 in 2006, the same as in 2005. The catch-up contribution for individuals 50 and over rises to $1,000, up from $500 in 2005.

401(k) & 403(b) Plans - The maximum employee salary deferral rises to $15,000 from $14,000 in 2005. The catch-up contribution rises to $5000 from $4,000.

SIMPLE Plans - The elective deferral limit stays at $10,000, but catch-up contribution rises to $2500 from $2000 in 2005.

Roth 401(k) - This is new in 2006. It has the same limits as traditional 401(k) and the same Roth IRA’s features of after-tax contribution, not taxable at distribution (provided not early withdrawals), and no required minimum distribution. Roth IRA has income restrictions. Eligibility phases out between $95,000 and $110,000 for single filers and $150,000 to $160,000 for those who are married and file jointly. There are no income restrictions for Roth 401(k)s.

SEP IRA - The maximum contribution rises to $44,000 from $42,000 in 2005.

Defined Benefit Plans - The basic limit rises to $175,000 from $170,000 in 2005.

Gift Tax - The annual gift tax exemption amount rises to $12,000 in 2006, up from $11,000 in 2005. This is the amount an individual may give to another individual without reporting it on a gift tax return. Married couples may give $24,000.

Estate Tax - The estate tax exemption equivalent (the amount a decedent may leave without triggering the estate tax) rises to $2 million in 2006, up from $1.5 million in 2005. The maximum estate tax rate is 46%.

Standard Mileage Rate - In 2006 the standard mileage rate is 44.5 cents per mile for business, 14 cents for charity, and 18 cents for medical and moving.

Social Security Cost-of-living Adjustment - The adjustment is 4.1% effective January 2006. This brings the maximum benefit to $2053.

FICA - The amount of income subject to social security tax rises to $94,200 in 2006 (up from $90,000 in 2005).