Random Thoughts For The New Year

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 2, 2008

IN THIS ISSUE:

1. The Politics of Taxation

2. A Zero Percent Tax Rate?

3. For Candidates, Mum’s The Word

4. Mutual Funds Are Looking Up

5. Subprime Woes Likely To Continue

6. Do-It-Yourself (DIY) Investors

7. A New Program For Very Aggressive DIY Investors

Introduction

First, let me wish all of my readers a Happy New Year! It seems hard to believe, but we’ve now entered into the ninth year of the new millennium. The Baby Boomers are starting to retire, the war in Iraq will enter into its fifth year, and we face a crowded field of presidential candidates, one of which will be elected the 44th President of the United States.

For most newsletter and e-letter writers, early January usually means producing a forecast of some sort, in an effort to give you an idea of which way the economy, stock and bond markets will go in the coming year. I’ll be the first to admit that I have no idea where the markets or the economy will go. To me, it looks like a toss-up as to which direction they may head. With no shortage of geo-political uncertainty, rising energy prices, continued unveiling of subprime mortgage woes, etc., etc., I’m more than happy to leave the forecasting to others who believe they know what lies ahead, but probably don’t.

On the other hand, I do pay close attention to The Bank Credit Analyst’s forecasts for the New Year and beyond, as always. BCA’s latest “Outlook 2008” just arrived, and over the next week or two I will summarize their latest forecasts on the economy and the major investment markets. The short story is that they continue to believe a recession in 2008 is not the most likely scenario, assuming the Fed continues to cut interest rates. BCA further expects continued slow economic growth in 2008, probably with GDP averaging around 2%.

In this year’s Outlook, the BCA editors offer some forecasts beyond 2008, and quite frankly I can see numerous potential problems with their scenario for 2009 and beyond. As I continue to research and analyze these longer-range forecasts, I will write about them, and the potential problems I see, in the coming weeks.

In the meantime, here is a collection of thoughts and issues to think about as we begin the New Year. I often run across stories or topics that I think would be of interest to my readers, but are not enough material for a full E-Letter. So, I hope you enjoy touching on a number of different issues that may affect you in the coming year.

Tax Code Politics

No one seems to like the income tax code. Even though many professionals and tens of thousands of government employees owe their livelihood to it, the tax code is always the brunt of jokes, evasion and endless political posturing to “fix” it. Even politicians, who have used the tax code to grant political favors for decades (leading to much of the complexity, I might add), speak out against it.

Thus, it’s no big surprise that the 2008 presidential race has already produced proposals to completely revise the tax code, or do away with it completely. Most recently, Mike Huckabee shook up the recent GOP debate in Iowa by proposing to abolish income taxes and the IRS, and replace it with the “Fair Tax.”

The idea of the Fair Tax is nothing new - both the Fair Tax and the Flat Tax have been proposed in Congress a number of times. However, the Fair Tax is getting more attention now because Huckabee has risen from near obscurity as a GOP candidate to the front-runner in Iowa, according to some polls. Since Americans, by and large, do not like income taxes or the current complex tax code, it’s not hard for Huckabee to get an “amen” to his proposal from likely voters.

Huckabee also gets some traction with GOP voters because he is considered to be a true fiscal conservative (remember those?). Yes, I know that Bob Novak criticized Huckabee for allowing a 47% increase in the state tax burden while he was governor of Arkansas, but a recent column by Dick Morris sheds more light on the subject. While the Arkansas tax burden did increase as Novak stated, the total state tax burden for all 50 states increased by as much as 98%. So in Morris’ view, Huckabee helped to hold increases to a minimum.

Perhaps the most telling act, however, was in regard to an income tax surcharge enacted as a result of a drop in state tax revenues after the 9/11 terrorist attacks. Three years later, when it was no longer needed, the surcharge was repealed. When is the last time you heard of that happening?

The Fair Tax and Flat Tax proposals are both popular because they propose to get rid of the current Tax code and replace it with something that seems to be far easier to understand. The Fair Tax would replace income taxes with a national sales tax, while the Flat Tax would keep income taxes, but greatly simplify the calculation through a flat tax rate that applies to all.

The problem with these alternative taxation schemes is that they both look good on the surface, but start to break down once you look closely at exactly how they would work and be administered. For example, Huckabee’s Fair Tax claims that the prices you pay would not increase by the amount of the national sales tax because embedded taxes are no longer part of the prices of goods and services. Thus, an item that cost $100 under the old tax code might drop to only $80. What they don’t tell you is that those same embedded taxes show up in your wages, so some experts say salaries would need to decrease by as much as 20% to make the Fair Tax work.

The Flat Tax has similar problems when you get into the details. I don’t have time to get into all of the pros and cons of each program this week, but I did outline the details of each income tax alternative in my April 17, 2007 E-Letter. I suggest that you go back and read about these proposals when you have time. It just might change your opinion about them.

I also thought it might be interesting to see how the front-runners in each party plan to deal with income taxes. According to the website information of the top candidates (Clinton, Obama, Edwards, Richardson, Giuliani, Huckabee, McCain, Paul, Romney and Thompson), only Mike Huckabee and Ron Paul propose to completely overhaul the income tax system.

Thompson proposes a compromise of sorts, in that he would allow taxpayers to choose to stay under the old complex tax code, or voluntarily choose another simplified system with only two tax rates. All of the others only offer suggestions to “tweak” the existing tax code, with most Democrats putting priority on repealing the Bush tax cuts, and most Republicans proposing to keep or even expand them.

In the end, however, don’t look for anything to happen. Alternative tax systems are trotted out frequently by politicians who are seeking to make points with voters, but even they know these programs don’t stand a chance. After all, there are untold thousands of politicians, bureaucrats, lobbyists, etc. that have a vested interest in keeping the tax code just like it is, if not making it even worse.

Did You Say A Zero Percent Tax Rate???

Speaking of the tax code, you may or may not be aware that 2008 ushers in a zero percent tax rate applicable to long-term capital gains and qualifying dividends, under certain conditions. These tax-free income provisions were part of the phased in tax cuts enacted by Congress in 2003, and later extended in 2005. While tax-free income is always of interest, it doesn’t apply to everyone. As they say, the devil is in the details, some of which I will discuss below.

At present, the zero percent tax rate will apply to certain taxpayers for tax years 2008 through 2010. In 2011, these rates will sunset and revert back to those applicable prior to the 2001 Bush tax cuts. This, of course, is because the Republican-controlled Congress and Republican president couldn’t get the job done on making them permanent, even though they had six years to do it, but that’s another story.

As a general rule, the zero-percent tax rate on qualified dividends and long-term capital gains applies to taxpayers in the 10% or 15% tax brackets. For married couples filing jointly, this means a taxable income of up to $65,100, or up to $32,550 for singles, based on the IRS 2008 Tax Rate Schedules. And note that these levels are taxable income, and not adjusted gross income prior to deductions.

However, you can’t get an unlimited amount of tax-free income from dividends and capital gains, even if you have a low taxable income. That’s because the qualified dividends and long-term capital gains are added to your income to determine your tax applicable bracket, even though they are not taxed. Thus, sufficient long-term capital gains and dividends would eventually put you over the 15% bracket threshold, and then become taxable.

There are other qualifications that apply to this tax treatment of dividends and long-term capital gains, but I’ll leave that to your CPA or other tax professional to explain to you. The main thing to get from this discussion is that there may be tax planning opportunities open to you for the next few years that may disappear in 2011.

If you are still working, this special tax treatment is unlikely to apply to you. However, if you are at or near retirement and have some flexibility as to how much taxable income you take each year, the zero percent tax rate may help reduce or eliminate the tax bite on certain dividends and long-term capital gains. If you think you might benefit from this special tax treatment, contact your CPA or other tax planning professional to begin the process.

For Presidential Candidates, Mum’s The Word On Taxes

Before leaving the subject of income taxes, I just couldn’t resist saying something about the current group of front-runners from both parties refusing to release their income tax information. While it’s not required by any law, most major presidential candidates have released their tax returns for public inspection ever since the Watergate fiasco back in the 1970s. Since then, only Bill Clinton (wouldn’t you know it!) refused to release his tax returns in 1992, but did consent to release them during his 1996 bid for re-election.

So far, among all of the front-runners of both parties, only Barak Obama has released his 2006 tax returns. You have to wonder what is hiding in these tax returns that make these candidates not want to release them? Are there embarrassing deductions, questionable business practices or controversial charitable contributions? We may never know.

What can we learn from tax returns? Other than the usual “gotcha!” items listed above, the press usually doesn’t pay much attention. However, in the hands of a skilled tax professional, tax returns can reveal a wealth of information about how a candidate handles his or her business affairs and compliance with governmental taxing authorities.

Such scrutiny can cause political damage, but not releasing tax returns can potentially cause just as much. You may recall that back in 1984, vice-presidential candidate Geraldine Ferraro suffered a significant amount of political damage when she would not release her husband’s tax returns. However, I guess the current batch of presidential hopefuls have figured out that such political damage can be minimized if almost all candidates refuse to release their tax returns.

What I find interesting about this whole thing is that the front-runners from both parties are in full agreement about non-disclosure. Isn’t it ironic that the greatest level of bipartisan cooperation among those who would be our leader is to withhold information from the very public they depend on to put them in office?

What can I say? It’s politics as usual for everyone but Obama – at least for now.

Mutual Funds Are Looking Up (Literally)

2008 is also an important year for the mutual fund industry, in that the five-year time window numbers will now be completely free of any negative influence from the 2000 – 2002 bear market. Actually, funds providing a rolling five-year monthly or quarterly performance number have been slowly erasing 2002’s negative returns from their five-year averages all year, but in 2008, the job is complete. All in mutual fund land will be happy.

Why? Because, according to some experts, the five-year average annualized return is among the most watched statistics by mutual fund investors. The better this average return, the more attractive the fund becomes. However, since the year 2000, the five-year numbers have had an ugly bear market to deal with.

In 2002 alone, the S&P 500 Index dropped over 22%, following losses of 9.11% and 11.88% in 2000 and 2001, respectively. The Nasdaq Composite fared even worse, dropping 39.29% in 2000, 21.05% in 2001, and 31.53% in 2002. Unfortunately, most mutual funds followed suit during the bear market. Some funds did better, some did worse, but most lost money.

Ever since then, mutual funds have had to include these dismal performance statistics in their three-year and five-year average annualized return numbers. At the end of 2005, the three-year averages got a reprieve as they were then able to only include 2003 through 2005 returns. However, the five-year averages still languished.

Until now, that is. As we enter 2008, five-year mutual fund average return statistics will include only 2003 through 2007, completely eliminating any effect of the bear market that ushered in the new millennium. Here’s an example:

The five-year average annualized return for the S&P 500 Index from 2002 through the end of 2006 is approximately 6.19%, including dividends. However, based on the preliminary S&P 500 Index returns for December 2007 (without December dividends), the average return for the five-year period of 2003 through 2007 is a whopping 12.79%, more than double the 2002 – 2006 five-year period.

Of course, the 10-year averages will still include the bear market returns, but also remember that the 10-year numbers also include both 1998 and 1999 returns, which were quite large due to the tech bubble. Plus, there are plenty of mutual funds that haven’t been around for 10 years, so unless you look beyond the five-year window, you may never see the bear market effect.

The moral to this story is that time-window analysis is but one of the many tools you should use in evaluating mutual funds or any other investment. That’s because a lot of performance issues can be hidden in an overall average. Among other things, it’s important to always look at each calendar-year return for any investment, especially those spanning the 2000 – 2002 bear market.

Likewise, it is very instructive to look at all rolling 12-month windows to see the various returns and drawdowns in the past performance record. Of course, there are a number of other statistics and analysis tools that should be performed to evaluate a mutual fund’s (or any other investment’s) performance. My company uses both sophisticated software analysis tools and the wisdom gained from many years of experience to make our selections. If you would like more information on the process we use, call one of our Investment Consultants at 800-348-3601 or e-mail us at info@halbertwealth.com.

Subprime Woes Likely To Continue

As we begin the New Year, remember that much of the fallout from the subprime debacle is scheduled to happen this year. The FDIC estimates that about 1.7 million ARM-type mortgage loans worth $367 billion are scheduled to reset during 2008 and 2009, increasing payments and likely leading to higher foreclosures, bankruptcies and housing-related economic woes.

The Bush Administration, Federal Reserve and major mortgage lenders teamed up together to develop a way to help those who cannot afford the higher payments scheduled for 2008. However, it’s not clear that this plan will make much of a dent, and we all know about the law of unintended consequences that may pop up long after the bailout is history.

The FDIC predicts that the subprime bailout will also benefit investors who bought investments secured by subprime mortgages. However, it doesn’t seem to do much about the related problem of institutional investors that cannot accurately value these investments because of the uncertainty of eventual repayment. In fact, one expert said that, “Modifying loans too aggressively may harm mortgage-bond investors more than it helps them…” I guess we’ll just have to wait and see what happens.

As for the continued effects of the subprime mortgage debacle on the stock markets, the efficient market folks would have us believe that much of this news has already been priced into the market. However, just watch what happens as bad news about subprime loans hits the airwaves, even though the news may consist only of the confirmation of what was predicted to occur. As a result, I expect the subprime debacle to trigger just as much emotional trading in 2008 as it did in 2007.

All of that is to say that housing and mortgage related news is still likely to be one of the major market movers in the coming year. Some forecasters, including BCA, expect the equity markets to post modest gains for the year, but no one can predict what might happen if the news sparks more periods of emotion-charged trading.

Do-It-Yourself (DIY) Investing

As I noted in the October 16, 2007 E-Letter in which I summarized the results of our readership survey, close to half of our readers like “doing their own thing” when it comes to investing. This is not a surprising finding on our part, since there is a lot more information available to investors now that can help them take charge of their own portfolios. What is somewhat of a surprise is that this was the reason given for not having an interest in the investment programs my company recommends. The surprise is that we have always tried to appeal to Do-It-Yourself (DIY) investors and, as a matter of fact, a very large percentage of my current clients are DIY investors.

If you have had an opportunity to review our company history on our website, you know that I started my original company, ProFutures, Inc., back in 1984 to develop and market managed futures funds. While such funds are more common now, we were blazing new trails back then. Though our public futures funds are now closed to new investment, the one thing I remember is the response we got from DIY investors.

Even when we launched our AdvisorLink® program back 1995, it was still geared toward the DIY investor. We felt that our strict due diligence review, coupled with our access to major managed account databases, would give DIY investors a leg-up in their efforts to find suitable investment alternatives. This was especially true in the case of investors looking for risk-managed programs.

While we later expanded AdvisorLink® to assist those who wanted help with their entire portfolio, our bread and butter still remains the DIY investor. This is evidenced by our periodic client surveys that show our investments account for about 20% of our clients’ overall portfolios.

In light of our past history, I was actually somewhat surprised to see that the most often-cited reason of those who had not considered our investment programs was that they were DIY investors. It may be that, by broadening our appeal to investors who need help with their entire portfolios, we have drowned the message that we actually welcome and have the most experience catering to DIY investors.

Therefore, I want to take this opportunity to clarify our commitment to those who want to manage their own portfolios. I believe our approach to investing fits perfectly with those who want to manage their own portfolios for the following reasons:

First, you are always in charge of your investment decisions. We do not take discretion in regard to which managed accounts are included in your portfolio. While we will keep you informed about the programs you select, we’ll never make the decision for you, or move you from one program to another without your written consent.
Second, we won’t constantly bug you about investing the rest of your portfolio with us. While we will make you aware of new investment programs as they become available, this is not an effort on our part to get you to move your entire portfolio over to us. Instead, we are providing you with an opportunity to examine other investment alternatives that may or may not fit within your portfolio.
Finally, we will offer investment programs that you may not find via your other search resources. We are constantly amazed by the number of excellent money managers that do not appear on any “radar screens,” such as managed account databases, publications and Internet search engines. If we find it that hard to find potential money managers, it’s likely to be even harder for the DIY investor who may not be willing or able to pay the thousands of dollars some of these database subscriptions cost.

The bottom line is that if you are a DIY investor, please don’t overlook the various investment programs we recommend. I can assure you that nowhere else on the Internet or otherwise will you find the exact same combination of mutual fund portfolios and professionally managed accounts that can be added to your portfolio at your discretion.

And if you are not a DIY investor, don’t feel excluded. We can also help you allocate your entire portfolio to investments that are suitable for your financial situation. If you would like to learn more about how we can help you, no matter what type of investor you are, give one of our Investment Consultants a call at 800-348-3601 or e-mail us at info@halbertwealth.com.

Are You A Very Aggressive Investor?

In keeping with the idea of DIY investing, we have been developing a portfolio of investments specifically designed to appeal to very aggressive investors. I actually got the idea when I was working on my June 26, 2007 E-Letter in which I discussed the SEC’s proposal to raise the net worth requirement for “accredited” investors. In that E-Letter, I said:

“…I have also met or spoken with many individuals over the years that were very sophisticated investors, even though they didn’t have a $1 million net worth. In my opinion, there are plenty of investors who are capable of evaluating the merits of sophisticated investments even though they do not have a net worth of $1 million…”

While many high-net-worth investors seek out hedge funds for absolute returns and risk management, some of them are also interested in very aggressive strategies that utilize leverage, net short positions, “quant” trading, emerging markets, emerging managers and so on. If wealthy investors are seeking out strategies with the potential to produce large gains, albeit with greater risk, why can’t non-accredited investors have access to much the same thing?

Just because you do not meet the SEC’s definition of what they consider to be “sophisticated” shouldn’t preclude you from participating in programs that dial up both the risk and potential returns, in my opinion. Thus, Halbert Wealth Management is developing what we call our “Venture Investment Program,” or VIP for short.

This new program will allow qualified “very aggressive” investors to participate in the kind of investment opportunities that have the potential to produce outsized returns, though with much more risk than most investors can stomach. It’s definitely not a program for everyone, and in fact, it’s not a club that everyone can join.

Best of all, it’s tailor-made for the DIY investor because, as a general rule, very aggressive investments should only be a relatively minor part of any investor’s overall portfolio. Such programs can also add diversity to your portfolio, and may not be highly correlated to your other investment holdings.

Since we’re still working on the details of the program, there’s not much else I can share at this time. I can tell you we are looking at some very interesting programs and strategies. If this sounds like something that would be of interest to you, we’d like to know. If you would like to be among the first to hear more about how you can participate in VIP, click the following link to go to our VIP Response Form.

This form will allow you to register your interest in VIP, and provide contact information for when we finalize the program. In fact, we’ll even be able to get the ball rolling as soon as you respond, so don’t delay if this sounds like it may be of interest to you.

Conclusion

Yes, it looks like 2008 is shaping up to be an interesting year. With the presidential primary season now upon us, I look forward to keeping up with the domestic political scene and commenting on the race. All I know is that it could be a year of surprises. At the beginning of last year, Hillary was almost certainly going to be the Democratic presidential nominee, but now that’s being called into question. On the Republican side, the lead in the polls seems to keep changing, so it’s hard to guess who might come out on top by the convention. What we do know is that it should be a very interesting year on the political front.

On the economic and investment fronts, it seems that the economy and markets are teetering on the brink of a recession and a possible bear market. Will the Fed be able to walk the tightrope and keep a recession from occurring as BCA and others believe, or will we fall into a recession just in time for the next president to be elected?

On the investment front, will foreign countries continue to purchase large hunks of US companies? If so, what short-term and long-term effects might this have on the stock and bond markets? And then there are the Baby Boomers – will their increased number of retirees set in motion the stock market sell-off that some have predicted?

And just in case that’s not enough excitement for you, we still have the geo-political challenges of Iran, Iraq, Afghanistan and now Pakistan to keep us busy, not to mention the resurgence of Russia as a major international power. And that brings us full-circle back to the US elections and what the international reaction might be if US voters put a Democrat in the White House.

If nothing else, it doesn’t look like there will be a shortage of topics to write about in 2008. As always, I appreciate your readership and your feedback and suggestions for future articles. Just send me an e-mail at GDH@halbertwealth.com if you have a topic suggestion or comment.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

So Much Economic Good News Amid So Little Cheer
http://www.bloomberg.com/apps/news?pid=washingtonstory&sid=a.VtABIaN5ck

Your Income Taxes – What the Candidates Want
http://money.cnn.com/2007/12/12/pf/taxes/campaign08_incometax_proposals/index.htm?postversion=2007121210

What We Want in a President
http://www.opinionjournal.com/editorial/feature.html?id=110011069