PacWest Financial Management Newsletter
3rd Quarter 2007

Volume XI, Issue III

    October 2007

Market Overview

As we come to the end of September, market indices are approaching record highs despite inflation fears, recession fears, credit quality fears, consumer spending fears, and volatility fears. It has been said that bull markets climb a wall of worry, and it seems this past quarter contained plenty to worry about. Nevertheless, the essential elements were positive.

Historically, the two primary drivers of stock returns are corporate earnings and interest rates. Over the long term, a particular stock’s return is most related to the earnings results of the underlying company. Regardless of what else is going on in the world, the stock of a company that delivers strong earnings growth will rise over time. In the intermediate term, the level of interest rates, as well as changes in the level of interest rates, affect not only the future level of economic activity and thus the “business cycle”, but also affect the relative attractiveness of stocks as an asset class compared to other asset classes.

The Federal Reserve lowered interest rates earlier this month (see chart below), which will help to sustain the current economic expansion and also help to bolster earnings. The rate cut also reduces the yields on cash and fixed income instruments, making them less attractive relative to stocks. Thus, stock valuations are more compelling which allows P/E multiples to expand so that even as money reallocates into equities, bidding up the prices of stocks, the rise in prices do not necessarily result in an over-valued market.

As individual companies report earnings over the next six weeks or so, we expect the strength of international markets as well as weakness in the U.S. dollar, to translate into strong earnings results for the quality companies that make up your diversified equity portfolio.

As for fixed income, because we buy bonds of higher quality corporate names and well-regarded government sponsored entities, we have weathered the "liquidity crisis" and "credit crunch" well. Our fixed income strategy remains the same as we continue to create laddered bond portfolios, holding bonds until maturity and choosing to lengthen or shorten the bond ladder based on expectations about the direction of future interest rates.

PacWest’s approach of “Quality for the Long-Term” has once again served us well over the past quarter. We appreciate your continued trust and once again thank you for your business.

Grace Y. Lau, CFA, Elliot C. Kauffman, CFA and Daniel S. Flack, CFP

ETFs and Why We Use Them
 

An ETF or exchange-traded fund is an investment that is similar to a mutual fund in that it is made up of a basket of stocks, but unlike a mutual fund, it trades on an exchange. (Please note that for the purposes of this article we are talking exclusively about open-end mutual funds.) Because ETFs do trade on an exchange, an ETF can be shorted or even bought on margin. ETFs are typically passively managed and designed to mimic the performance of an index such as the S&P 500. There are ETFs designed to track the performance of individual countries, individual sectors, various commodities, as well as the broader bond and stock market indices

Many times ETFs are compared to index mutual funds since they are both designed to track the performance of an index. While both index funds and ETFs feature low expense ratios, ETFs and index funds do differ in some important ways. For example, mutual fund shares are bought from and sold to the mutual fund company. ETFs, on the other hand, are bought from, and sold to, other investors through the secondary market. Because of this important difference, ETFs were designed to be more tax efficient than mutual funds and you’ll see how this plays out in the following paragraph.

If a mutual fund is facing heavy redemptions due to its investors panicking and it does not have enough uninvested cash, the mutual fund is forced to sell individual stocks to raise cash for these redemptions. Furthermore, if the stock is sold at a gain and the fund company is unable to offset its gains with other losses, then this gain is passed on to its shareholders in the form of a capital gains distribution and of course, the shareholder then has to pay taxes on these distributed capital gains. Contrast this with what happens to an ETF in the event of an investor panic. Since the shares are not sold to the ETF company, just because one investor, or for that matter a multitude of investors, sell his shares, this does not have a tax implication for an investor who is holding on to his ETF shares, just as the millions of investors buying or selling Exxon Mobil stock on the NYSE does not impact your Exxon Mobil holdings from a tax perspective.

However, when a stock is removed from an index, this could have a tax implication for both mutual fund and ETF holders. This is because the composition of the underlying index has changed so both mutual fund companies and ETF companies also have to sell that stock in order to match the underlying index.

At PacWest, our core competency is selecting individual company stocks. We believe our investment process allows us to select stocks from the available universe of large and medium size companies that will, over the long term, out-perform the market. We use ETFs to round out our core portfolio stock holdings to make sure that our clients have exposure to every area of the market, so that no matter which part of the market does well, our clients’ portfolios will participate in that appreciation. Specifically, we have used and continue to use ETFs to gain exposure for our clients to international markets and small companies.

We believe ETFs are a low cost and tax-efficient investment vehicle to gain exposure to these areas and complements our efforts to build a well-diversified portfolio for our clients that stands the test of time.

Tax Corner - Year-end Planning Checklist for Investors

If you or a family member are thinking of selling appreciated stock, and your (or their) income is taxed at a rate less than 25%, it may pay to hold off on the sale until 2008. That way you may pay a zero tax on the gain; if you sell this year, you will pay a 5% tax on the gain. Under current law, long-term capital gains on securities and qualified dividends are subject to a 0% federal income tax rate for the years 2008 through 2010 for those individuals in the 10% and 15% tax brackets.

This year, the kiddie tax rules apply to kids under age 18; next year they will also ensnare most children age 18 and most full time students age 19 through 23. If your child holds appreciated stock, and isn’t in kiddie tax territory this year but will be in 2008, consider having him or her sell the stock this year. In many cases, this will result in a 5% tax on the gain, instead of 15% if the sale is postponed till next year.

You can save gift and estate taxes by making gifts sheltered by the annual gift tax exclusion before the end of the year. You can give $12,000 in 2007 to an unlimited number of individuals, but you can’t carry over unused exclusions from one year to the next.

If you are age 70 ½ or older, and own IRAs (or Roth IRAs), and are thinking of making a charitable gift before year-end, arrange for the gift to be made directly by the IRA trustee. Such a transfer can achieve important tax savings, but it won’t be available after 2007 under current law.

L. Jane Heist, CPA  

Chindia

China and India are two of the fastest growing economies in the world. The two countries make up 40% of the world’s population. Chindia is the world’s biggest exporter of goods and services. They also consume 50% of the natural resources in their building boom. However the countries have dramatic differences in their demographics and the future trends of their economic development.

China’s GDP is about 3 times larger than India’s and its exports are 8 times larger. China’s saving is 22 times more than India: at $4,800 billion versus $215 billion. China also has $1,400 billion in foreign reserve, almost 7 times more than India.

Because of excess liquidity in the Chinese economy, investments have been concentrated in infrastructure, i.e. roads, bridges, ports, factories and high-rises. In India, capital is not so readily available and the country has focused on services that are less capital intensive. The return on investment is higher in service industries versus capital-intensive expansion.

China’s impact on global liquidity will be more significant than India in the future because of its large foreign exchange reserves of $1,400 billion. Recently China has started to allow its nationals to access the global securities market. It has also continued its investments overseas in various capacities.

In another 8 years, two thirds of China’s population will be over 50, while 60% of India’s population will be under 30. India will be a major market for basic consumer goods but wealthier Chinese will spend more on cars and vacations. While China’s manufacturing is moving up the value chain, it is challenged by the need to feed 22% of the world population with only 7% of the world’s arable land. 50 % of India’s land is fertile but the yield is lower. Once the farm yield is improved, India can be an exporter of grain to China, while China can supply India’s consumers market.

We invest in China and India for you through international mutual funds and via U.S. corporations that have significant operations in these countries.

Grace Y. Lau, CFA