The events of the past year were disconcerting to all of us. We’ve seen home prices plummet, the bankruptcy of major corporations, and the inability of business owners to access credit. The list goes on and on. In response to these historic events the federal government has undertaken an incredible amount of intervention in the economy, including forcing companies to merge, enacting unprecedented amounts of fiscal stimulus and even taking ownership in private companies.

In my conversations with clients, family and friends over the past few months I have heard a recurring theme about this: The belief that all of this government intervention has to bad for future stock returns. The argument goes that the United States’ economy is the world’s strongest because it was built on free-market principles, so therefore more government intervention has to mean our economy – and, hence, stock prices – will suffer.

The leap in the argument that gives me pause is that more government intervention HAS to be bad for stock prices. The reason for my pause is that history has often told a different story. The fact is there are numerous examples in the past when massive government interventions were followed by periods of strong gains in the stock market. And stock return data by country shows little correlation between the degree of government intervention and that country’s stock market performance.

Weston Wellington of Dimensional Fund Advisors provides an excellent history lesson on this in the three-minute video linked below. I hope that after watching this short video you will agree that, while government intervention is certainly a major factor in the economy, it is just one factor among many affecting stock returns.

http://www.dfaus.com/library/videos/governme/ 

As we develop wealth management plans for our clients we find that discovering their goals and creating a plan to maximize the probability that they achieve these goals is sometimes the easiest part. The more difficult part, particularly in volatile markets like 2008, is putting the plan into action, particularly when it involves putting cash into the market. Why? One word – EMOTION.

We’ve had success with several clients who struggle with the decision by introducing a process that creates discipline and minimizes emotion. The process typically includes buy triggers that occur as a broad market index drops OR upon time intervals should the broad market index stay flat or rise. The important part is not the index or the selected trigger points but that there is a disciplined process that removes emotion from the decision.

Interestingly, in the midst of the recent market volatility, one of my clients asked about the other side of this coin, so to speak. He wanted to know if we wouldn’t have been better off using “sell triggers” that would have kicked in at a certain point so that we could have gotten out of the market and protected our assets from the twin bear markets we have experienced in the past ten years; for example, selling when the Dow climbs into a range between 13,000 and 14,000, and then buying back in when the Dow is in a range between 7,000 and 8,000. In such a scenario, the investor would try to generate all of the returns needed to fund retirement from the interest earned sitting in cash and from the appreciation between 8,000 and 13,000 on the Dow.

To see the problem with such an approach, let’s take a look back at June 1982:

An investor at that time would have looked back over the past two decades and seen a trading range in the Dow that was clearly evident, as seen in the graph below:

The Dow had flirted with the 1,000 point threshold on five occasions over that 20-year period, only to fall back to the 600 point level on two occasions and under 800 several other times. This represented drops of 40% and 20% respectively. It would have been very compelling in 1982 to implement a strategy that took advantage of this trading range, jumping out of the market around Dow 1,000 and then buying back in around Dow 700. 

The only problem is that after November 23, 1982 the Dow never went under 1,000 again. 

Now the investor would have had to decide when to get back in the market. Even harder to stomach would be the idea of making your old “top” your new “bottom” and establish a new range between, say 1,000 and 2,000. 

Such a strategy would have been nerve-wracking and ineffective in light of the Dow’s run over the next 20 years (and keep in mind this is a price-return graph that doesn’t factor in the reinvestment of dividends, which is historically 40% of total return): 

When the investment objective is retirement and you have a 20+ year time horizon, equity investing makes all the historical sense in the world. The trade-off is that you've got to BE IN THE MARKET to earn those equity rates of return. Anything else requires adhering more to guesswork than to disciplined strategy, and that is no basis for investment management.

(In describing our investment philosophy to clients we often tell them to not worry about things they can’t control (e.g., stock market gyrations) and instead focus on things they can control: fees, taxes, etc. The same thing goes for other areas of managing wealth. This is the last of a three-part series in which I have been exploring some areas of wealth management that clients’ DO have control over.)

There is no denying that we will see changes to federal tax policy over the next few years; newspapers and magazines are full of stories and opinions on the matter. One of our roles as wealth managers (in partnership with our clients’ tax advisors) is to identify provisions that may help them save tax and thereby enhance their wealth.

Many new provisions in the tax code were set into motion with the American Recovery and Reinvestment Act of 2009 that was signed into law in February. Among the more significant new items to consider:

• Sales Tax on Vehicle Purchases is deductible towards Adjusted Gross Income (AGI). For 2009, this legislation allows all taxpayers a deduction for state, local, and excise taxes paid on the purchase of a new car or light truck. The deduction phases out at AGI levels of $125,000 for singles or $250,000 for married-filing-jointly.

• Alternative Minimum Tax Relief is extended for 2009. The legislation increases the AMT exemptions for 2009 to $46,700 from $46,200 for individuals and $70,950 from $69,950 for joint filers. Also, beginning in 2009 an individual may offset the entire Regular Tax Liability and Alternative Minimum Tax Liability by the nonrefundable personal credits.
• Small Business Stock Capital Gains — An individual who invests in the stock of a small business and holds that investment for at least five years may exclude up to 75% of the gain realized on the disposition of that stock, provided certain requirements are met. This provision is effective for investments made after the date of enactment and before January 1, 2011. For this purpose, a small business is defined as a corporation with less than $50 million in gross assets.

Some provisions that may benefit your children or grandchildren:

• The First-Time Home Buyer’s 10% Credit is increased up to $8,000 for purchases between January 1, 2009 and December 1, 2009. Despite what was proposed as the legislation made its way through Congress, the final legislation continues to limit the home buyer’s credit to first-time home buyers (defined as someone who hasn’t owned a home in the three years before the purchase). The most significant change made by the legislation is that the new credit does not have to be repaid. The home must be occupied as the buyer’s principal residence within 24 months of the purchase. The credit phases out for taxpayers with adjusted gross incomes in excess of $75,000 ($150,000 in the case of a joint return). The credit is refundable and is recaptured if the home is sold within 36 months of the purchase date. A buyer who purchases a home after January 1, 2009 under the new rules can claim the credit on a 2008 return to speed receipt of the credit. A buyer who purchased a home before January 1, 2009, must go with the old “interest free loan” credit.

• The American Opportunity Education Tax Credit replaces and improves upon the HOPE scholarship credit. The American Opportunity Credit is allowed for up to four years of undergraduate education, and for 2009 and 2010 the maximum credit will be $2,500 in each year and 40% of the credit is refundable. The credit phases out at AGI levels between $80,000 and $90,000 for singles and $160,000 and $180,000 for married filing jointly.

• A Student Computer Purchase may be treated as a qualified education expense for Section 529 plans in 2009 and 2010. This includes software and peripheral equipment.

While many tax planning strategies sound great in isolation, when viewed from 30,000 feet they may have unintended negative consequences on other parts of your life. Therefore, the most important role we play as a wealth manager is in helping clients evaluate tax planning ideas to ensure they align with our clients’ values and help them accomplish their most important goals.

_{This summary is intended to highlight some of the provisions of the Act and is general in nature. As with any important planning matter, consult with us and your tax advisor before relying on the summaries above.}

(In describing our investment philosophy to clients we often tell them to not worry about things they can’t control (e.g., stock market gyrations) and instead focus on things they can control: fees, taxes, etc. The same thing goes for other areas of managing wealth. Over the next few months I will explore some areas of wealth management that clients’ DO have control over.)

“Obama Plans to Keep Estate Tax – Democrats Want to Freeze Levy at Current Levels Instead of Letting It Expire Next Year” reads the top headline in the January 12, 2009 edition of The Wall Street Journal. The article details recent history about the estate tax and various legislative initiatives to change it. The driving force behind the incoming administration’s desire to deal with this issue now is that current legislation calls for the estate tax to be repealed in 2010 only to see it sunset and return to Clinton-era legislation which taxed estates over $1 million ($2 million for couples) at 55%. Based on several conversations I’ve had with tax attorneys and confirmed by the Obama administration in the above-referenced article, the conventional wisdom is that the incoming administration will push to pass legislation that makes the estate tax permanent with a $3.5 million exemption - $7 million for couples –from any taxation. The values of estates above that would be taxed at 45%.

Many clients have pointed to the Bush administration’s efforts to “end the death tax” or the uncertainty of the exemption amounts to put off updating their estate plans. As a result, it is fairly common to learn from a client that they haven’t updated their plan in more than 5 years. Even more importantly, since their last update there has typically been a change in family circumstances (e.g., grandchildren) and/or a change in their financial circumstances. We know the law surrounding estate tax has changed over this time. Here are some additional reasons to update your estate plan in 2009:

1. Review Titling of Assets: Estate Planning 101 calls for each spouse to own assets equal to the exemption amount in their respective names. Effective January 1, 2009 the exemption amount has increased to $3.5 million and the odds appear high that this amount will be made permanent. This is a great time to review your net worth statement from an ownership perspective to make sure you’ve taken full advantage of the exemption amounts.
2. Review the Use of Exemption Amount in Your Will: Some married clients have adopted estate plans that leave an amount equal to their estate tax exemption to their children and the balance of their estate to their spouse. This is very common in second marriages. Because of the increase in the estate tax exemption, such a plan may have the effect of leaving more to children and less to a surviving spouse than was intended. With the increase in the exemption amount coupled with the downturn in the real estate and stock markets it is conceivable that such a plan could disinherit the surviving spouse entirely. A similar problem exists with plans that provide bequest to the grandchildren measured by the grandparent’s generation-skipping exemption; this year’s increase may leave more to the grandchildren than was intended.
3. Opportunity to Transfer Wealth: One silver lining to the current economic environment is that, if so inclined, it presents a rare opportunity to make gifts or sales of assets to children or grandchildren at significant discounts from their market highs. There are a variety of estate planning techniques that will transfer wealth from a senior generation to younger family members with little, if any, transfer tax consequences. Some of these techniques include outright gifts, sales to defective grantor trusts to GRATS and charitable lead trusts.

At the very least a conversation about your wealth transfer goals and a quick review of your current plan is a must in 2009 and is something that we DO have control over.