PacWest Financial Management Newsletter
4th Quarter 2006

Volume X, Issue IV

 January 2007

Market Overview

 

The U.S. equity market remained strong throughout the 4th quarter as interest rates remained steady at historically low levels, weakness in the housing market failed to spoil the holiday season and lower oil prices helped keep economic growth and corporate profits from slipping. Energy and Basic Material sectors lead for the quarter, while Consumer Discretionary, Telecom and Utilities also continued to outpace the overall market. Healthcare was the weakest sector for the quarter and for the year, while still tuning in gains for both time periods.

Tight Federal Reserve

The yield curve remained inverted all quarter as the Federal Reserve stayed patient, waiting to see if their prior interest rate hikes would be enough to slow the economy, or too much. When all was said and done, more was said than done as the Fed left interest rates unchanged at every meeting. While an inverted yield curve at this point in the cycle implies an expectation of slower growth, the Federal Reserve spoke mainly about containing inflation and keeping a lid on growth rather then expressing any concerns about slowing growth or a recession.

Weak Housing Market

The housing market remained slow as expected, even as the inventory of homes on the market has swelled and prices have declined in many areas. However, there have also been some signs of strength and some reports by homebuilders that they are already near a bottom. The fear that weakness in the housing market would spill over into the overall economy via lower spending by consumers failed to materialize, even as consumer credit expansion was lower this year than last. Despite some headlines concerning increasing default rates in the sub-prime area, it seems that on balance, the strength of the U.S. consumer should not be underestimated.

Corporate Earnings

The big story this quarter has been overall strong earnings results. Despite guidance to the contrary and continued cautionary remarks by corporate management, reported results exceeded estimates more often than not, which propelled stocks higher given steady interest rates and oil prices.

Grace Y. Lau, CFA and Elliot C. Kauffman, CFA, CPA

The newest tax law is almost all good news for taxpayers, particularly because it retroactively restores and extends key tax breaks that went off the books at the end of 2005. However, it will also prove to be a challenge when it comes to filing 2006 returns. That is because the IRS had to send key forms and schedules for the 2006 year off to the printer before the new law extended these tax breaks. The IRS has said it will not reprint forms and schedules to reflect the new law, but will issue supplementary instructions instead. Filing 2006 returns could be a real challenge for the uninformed, and refunds could be delayed because the IRS will have to retool its computers and procedures to reflect the law’s changes.

The most widely applicable tax breaks for individuals that have been restored and extended through 2007 include the deduction for qualified higher education expenses, the tax break allowing individuals to elect an itemized deduction for state and local general sales tax instead of the itemized deduction permitted for state and local income taxes, and the above-the-line deduction for up to $250 of qualifying out-of-pocket costs incurred by elementary and secondary school teachers and certain other school professionals.

For 2007 only, there’s a new itemized deduction for the cost of premiums for mortgage insurance on a qualified residence. The deduction is phased-out for taxpayers whose adjusted gross income exceeds $100,000.

The new law also includes many changes for health savings accounts (HSAs), including: allowing one-time rollovers from health flexible spending accounts (FSAs) and health reimbursement arrangements (HRAs) into HSAs before 2012; repeal of the annual plan deductible limit on HSA contributions after 2006; expanded contributions limit for part year coverage after 2006; and allowing one-time rollovers from IRAs into HSAs after 2006. This change is designed to give employees quicker access to their funds for medical expenses.

Pacwest: Reflections on 2006

With the closing of 2006 and the approach of 2007, we naturally want to reflect on the past year. For PacWest, in 2006 we increased our value to our clients. A recent article in the Arizona Republic cited a survey of 1000 adults being asked what are the top five attributes they seek in a financial advisor. Here are those attributes along with how PacWest is better positioned to address those areas:

We see ourselves as wealth managers and we believe we provide expertise regarding all areas of our client's finances, not just investments. To further solidify ourselves as wealth managers, we added more credentials to our already impressive roster. In 2006, we hired two portfolio managers, one operations specialist and a part-time trust specialist. In all, we ended 2006 with two more CPAs, one more MBA, and one more CFP than we started with. With these added credentials, we can better provide tailored advice to our diverse client base.

Once again in 2006, PacWest has been named as one of the top Financial Advisors by Bloomberg Wealth Manager magazine and the Arizona Business Journal. We believe we achieved these recognitions by earning the trust of our clients.

During this year, we standardized the packet of information we review with our clients during portfolio meetings. As part of this process, we use, what we call, a client engagement roadmap to uncover financial questions and needs that our clients have in areas such as estate, education, insurance, and tax planning. Many times, we are able to provide solutions, offer resources and bring clarity to these areas.

Above-average investment returns

We always say that while we can promise superior service, we cannot promise superior returns. However, what we can do is improve the process by which we hope to achieve superior returns. During this past year we have been slowly implementing a new investment process which involves identifying and selecting the highest quality companies. During this process, we narrow a list of 2000 potential stocks to 400 names that we like based on, among other things, profitability, return on equity, economic margins, and future earnings prospects. Industry by industry, and sector by sector, we take this list of 400 companies and do exhaustive company comparisons where we look at all the above factors as well as competitive position, market share, analyst estimates, earnings momentum, economic margins, balance sheets and a host of other factors. This results in 120 names to which we apply three different valuation models in order to ascertain how much we are willing to pay for a company. When our buy target is reached, we invest in the stock.

Each month, as part of a new process we implemented in 2006, we are sending our clients monthly communications explaining the rationale behind some of the investment decisions we made on their behalf. We have received very positive feedback regarding these updates and will continue to send them. As always, we are available to answer any questions. This monthly update is just to supplement our scheduled investment portfolio reviews and the impromptu questions that come to us via phone and e-mail.

Daniel S. Flack, CFP

Education Funding

1. There are actually two types of 529 plans, a pre-paid plan or the more commonly known savings plan. (Unless otherwise stated, all points reference the 529 savings plan.)

2. You do not have to be a resident of a state or have your child attend school in a state in order for you to invest in that state’s 529 plan. (However, if the state you live in provides tax deductions for 529 contributions and you decide to invest in another state’s 529 plan, you will miss out on those deductions. Currently Arizona does not offer such a deduction.)

3. Generally, the 529 plan’s beneficiary does not have rights to the funds, which means that Junior cannot use the 529 assets to buy himself a Ferrari, instead of attending college.

4. The Pension Protection Act of 2006 made permanent the favorable federal income tax treatment of 529 plans, in that distributions for qualified higher education expenses are federal income tax free.

5. There are no income restrictions affecting eligibility for contributions to a 529 plan.

6. For federal financial aid purposes, the assets in a 529 are considered to be assets of the parent or account owner, instead of the student beneficiary. This means that, at most, only a small percentage of the 529 plan’s assets are considered when assessing whether a student is eligible for financial aid.

7. The beneficiary of the 529 plan can be yourself or anyone else. The person does not have to be related to you and can even be changed later.

8. You can change your investment options in a 529 plan once every 12 months.

9. You and your spouse can each make a one-time contribution of $60,000 to a single beneficiary and avoid paying gift taxes. The maximum lifetime contribution allowed per beneficiary is at least $140,000, with the specific amount determined by the state.

10. Generally, a 529 plan is not considered to be a part of the donor’s estate even though the donor had control over the asset during their lifetime. This is akin to having your cake and eating it too.

11. You can use your 529 savings plan to pay qualified education expenses at virtually any college.

12. If your child receives a full scholarship, you can withdraw from your 529 plan an amount equal to the amount of the scholarship and not pay penalties. (However, you may have to pay taxes on the earnings for the amount withdrawn.)