In This Issue
 |
• |
Market Overview |
|
• |
Tax Corner - TIPRA (Some Good--Some Bad) |
|
• |
Portfolio Strategies |
|
• |
Disentangling Risk and Volatility |
|
|
Offices
|
|
|
|
Phoenix: |
|
1643 E. Bethany Home Rd. |
|
Phoenix, AZ 85016 |
|
Tel: |
602-997-8882 |
|
888-997-8882 |
|
Fax: |
602-997-8887 |
|
|
|
Los Angeles: |
|
2540 Huntington Dr. |
|
Suite 105 |
|
San Marino, CA 91108 |
|
Tel: |
626-286-4029 |
|
888-295-4419 |
|
Fax: |
626-286-0624 |
|
|
|
http://www.pacwestfn.com |
| |
| |
| |
| |
|
|
Market Overview
|
Equity Returns Table
Sources: Wall Street Journal & Russell.com |
| Index |
Q2 2006
Returns |
YTD 2006
Returns |
| Dow Jones |
0.37% |
4.04% |
| S&P 500 |
-1.90% |
1.76% |
| NASDAQ |
-7.20% |
-1.51% |
| Russell 2000 |
-5.02% |
8.21% |
Since May 9th, the stock market has been under pressure. We believe there are a few factors that have created uncertainties in investors’ minds. These include the tug of war between further interest rate increases to prevent inflation from raising its ugly head and some visible signs of economic slowdown. Moreover, global interest rate hikes may cause the decline of liquidity.
Rising inflation and interest rates impact the economy negatively. The University of Michigan publishes monthly the results from its high profile consumer sentiment index, a telephone survey of 500 adults. The survey asks its participants about their short-term and long-term inflation expectations. In May, the results from the survey indicated that consumers had the highest inflation expectations in over a decade. If expectations are for rising inflation, workers will push for higher wages and businesses will increase prices sooner, rather than later, potentially leading to a self-fulfilling inflationary spiral.
U.S. Treasury
Yield Table
Source: Wall Street Journal |
| |
12/2005 |
06/2006 |
| 3 month |
4.08% |
5.00% |
| 2 year |
4.40% |
5.16% |
| 5 year |
4.35% |
5.10% |
| 10 year |
4.39% |
5.14% |
| 30 year |
4.54% |
5.19% |
One of the most visible signs of a potential slowdown in our economy is the slowdown in housing activity. The United States has gone through one of its strongest housing booms ever. From statistics such as inventory of new and existing homes, and the time it takes to sell, it is obvious that the housing market has slowed significantly. Sellers are not willing to lower their asking price, but at some point they will have no choice. The stress will first show up in investors that hold multiple properties. They are over-leveraged, have next to no equity in their homes and have chosen to borrow using adjustable rate mortgages. As previously discussed, a slowdown in home prices has significant impact on consumer spending. Continuously high gasoline prices do not help the pocketbooks of the consumers either.
When interest rates rise, investors require a higher rate of return for their equity investments. Without taking any principal risk, they can now earn a higher return by staying in money market funds and treasury bills. On the borrowing side of the equation, when interest rates rise, companies require a greater return from projects they undertake, causing fewer projects to be funded. Investors may be able to benefit when companies do not make capitals investments, but use their cash to buy back their own under-valued shares as their best investment. Fewer shares outstanding means increased earnings per share, which may lead to a higher stock price.
Investors are also concerned with interest rates rising around the world. The 10-year Treasury note recently reached 5.24%, its highest level since the first quarter of 2002. The Federal Reserve raised the fed funds rate from 5% to 5.25%. Europe and Japan have both recently increased their interest rates.
Global investors are concerned about the unwinding of the “carry trade”. The carry trade refers to the phenomenon of investors borrowing money cheaply in one place to invest in other places. The Bank of Japan (BOJ) adopted a zero interest rate policy in an effort to ignite their economy which had been stagnant for the better part of a decade. Investors were borrowing yen at zero interest and buying virtually risk-free U.S. Treasuries paying between 3% and 5%. The cheap money was also being invested in increasingly risky assets. Because prices of these assets have been rising, investors have ignored the risk in the last five years. Even though the BOJ has yet to raise rates, that prospect has caused investors to think about risk again, which has caused a widespread sell-off in all assets, especially the riskiest ones.
Grace Y. Lau, CFA and Daniel S. Flack
Tax Corner - TIPRA (Some Good--Some Bad)
The Tax Increase Prevention and Reconciliation Act (TIPRA) was signed into law by President Bush on May 17, 2006. It includes both favorable and unfavorable provisions. Following are those that might affect your investments.
Preferential Tax Rates on Capital Gains and Dividends Extended through 2010
The maximum rate on most long-term gains and dividends will remain at the current 15%. Even better, the current 5% rate will continue through 2007 for individuals in the 10% and 15% regular tax brackets, before dropping to 0% for 2008 through 2010.
One-year Alternative Minimum Tax Fix
TIPRA includes two changes that will prevent millions more from owing the dreaded AMT this year. Under the first fix, the 2006 AMT exemption amounts are increased. Under the second fix, you can use your nonrefundable personal tax credits (such as the dependent care and the Hope Scholarship and Lifetime Learning higher education credits) to reduce both your regular tax and AMT bills. You will also be able to use the new residential and nonbusiness energy property credits. So, if you are considering making energy efficient improvements to your home, you might want to do it now rather than waiting until next year.
Kiddie Tax Rules Apply to Older Kids, Starting Now!
You may have a dependent child who is exposed to the Kiddie Tax this year, even though it didn’t apply last year. These rules can cause a dependent child’s income from investments to be taxed at the parent’s higher marginal federal income tax rate. TIPRA extends the Kiddie Tax rules through the year before a child turns 18, starting with 2006. Previously, it only applied through the year before a child turned age 14.
L. Jane Heist, CPA
Portfolio Strategies
Because the bull market is in its fourth year of expansion, valuation is less attractive than in 2002 and 2003. Energy, financials and basic materials are the only groups trading below the market price to earnings ratio. Short term bondholders are earning 4% to 5% versus 2% to 3% a couple of years ago. The market is highly sensitive to the moves of the Fed Chairman, Ben Bernanke. Volatility has returned.
We have become more cautious toward the portfolios. We currently favor large cap stocks as they generally possess lower relative valuations and superior quality. Companies that pay dividends suit most of our clients. A rising stream of dividends is even better. Because the yield curve is flat, we are still investing in bonds that only have maturities of less than five years. Extra cash on hand can take advantage of investment opportunities that are still on the horizon. We have also been reducing our exposure to the financial sector (the largest sector in the S&P 500 at 21%), taking profits and realigning the holdings.
But we also know we cannot predict interest rates, direction of the markets or where GDP is going to be for the next quarter. We do know how to find good companies to invest in for our clients. In this turbulent time, the ability to choose the right investments is critical.
Grace Y. Lau, CFA
Disentangling Risk and Volatility
At the heart of every investment decision beats an assessment of the relationship between risk and expected return. While calculating a return is very straight forward, quantifying risk is another story.
The return is how much you make. And while measuring returns may be complicated by using complex methodologies (such as average capital base or time weighted geometrically linked internal rates of return), an exact return can be calculated.
Risk is the chance you take. And while the risk of a bet at a roulette table can be calculated, the odds at the stock exchange are impossible to exactly quantify. The complexity involved in approximating investment risks results in essentially a subjective evaluation based upon a myriad of factors and assumptions. We like to view risk as the degree of conviction about an uncertain future.
To evaluate risk, the investment industry has adopted quantitative statistics (such as Standard Deviation and Beta) as measures of risk. Standard Deviation actually measures the volatility of a series of returns, while Beta measures the volatility of a stock price relative to a market index. However, volatility is not risk.
A great stock climbs much faster than a market index, which would result in a high Standard Deviation or a Beta of greater than one. Let’s say you have a higher degree of conviction about the future success of this company than your conviction about the market as a whole. If your conviction proves correct and the stock price heads higher at a faster rate than the market, did you undertake a higher degree of risk to make your return? Standard Deviation and Beta also assume a stock that rises faster than an index will also fall faster when the market index heads lower. However, great stocks may continue to head higher even as the market falters.
We suspect that such quantitative measures of volatility are used as a proxy for risk assessments because computers can calculate exact statistics rather quickly. And even though computers often display fanatical conviction, we do not recommend relying on such quantitative measures of volatility as a substitution for developing an assessment of risk.
Elliot Kauffman, CFA, CPA
|
