Wise Money Decisions

The IRS is still working through the UBS tax evader cases, and now they’ve got another insider from another bank feeding them information on tax evaders.

I don’t know anything about Rudolf Elmer except what I read in the New York Times article Swiss Banker Blows Whistle on Tax Evasion. He’s not a character that’s going to generate much sympathy from the public. But he is helping the IRS and other tax agencies chase down wealthy clients of his former employer, Swiss bank Julius Baer, that allegedly evaded taxes.

In my work as a tax lawyer I have represented taxpayers on both sides of the line. Some were clearly victims of government overreaching, and others were clearly on the wrong side of the law.  My hunch is that many of the Julius Baer taxpayers whose names are turned over to the IRS will fall closer toward the latter than the former.

On the other hand the informant may really be the scumbag that Julius Baer wants us to believe he is, and the whole affair may be more about getting even with his former employer and less about exposing taxpayers that merit IRS investigation.

We shall see.

In any event, if you have been hiding income with Julius Baer, now is a good time to call a tax lawyer and figure out your options. 

A statement by IRS Commissioner Douglas Shulman got some attention today.

On C-Span Shulman talked about using a tax preparer:

“I’ve used one for years. I find it convenient. I find the tax code complex so I use a preparer.”

A lot of bloggers and readers are using the statement to argue the tax laws are too complex. 

That’s like saying Conan O’Brien is too juvenile for the Tonight Show. In other words, duh!  Tell us something we didn’t know already!

Nevertheless, it is a good soundbite to hear the Commissioner of the IRS “admit” that he doesn’t (can’t?) prepare his own taxes, whether it’s due to complexity or convenience.

Shulman rightly points out the ball is in Congress’s court, not his.  Bush put together a task force that studied ways to overhaul and simplify the tax laws. The task force released a report in 2005 that included some compelling ideas, but the report was largely ignored.

I’m a tax lawyer, which means the marginal value of my labor rises as the tax laws get more complex because fewer people can handle their own tax affairs.  Despite it being against my own financial interest, I would love nothing more than to see Congress simplify the tax system. 

When I think about how much money we spend to obey the tax laws, through government expenditures for enforcement as well as private expenditures for compliance, and then I realize that none of that money is used to build something or develop something or help somebody, well, it’s a thought I don’t like to dwell on.

If you’d like to know where your stimulus tax dollars are going, check out this report from Pro Publica.

It makes sense that the states with highest unemployment would receive the most stimulus dollars per capita, right? 

Not so fast.  California, Nevada, and Michigan have among the highest unemployment rates. California and Nevada received well less than average dollars, and Michigan received only slightly more than average.

But at least the states with least unemployment should receive the least dollars, right?   

Not so fast.  Check out Alaska. With an unemployment rate well below the national average, it received nearly 3 times as many dollars per capital as the national average. North Dakota received more than 1.5 times the dollars despite its microscopic unemployment rate of 4.2%.

And here’s the most interesting of all.  Which state received the most stimulus dollars per capita?  Here’s a hint: it’s not a state. 

The District of Columbia received more than 6 times the national average.  And it wasn’t even a close race (as if it is supposed to be a race).  D.C. received 2.5 times as many as its closest “competitor,” Alaska.  

D.C. received more than 7.5 times as many dollars as Nevada despite Nevada’a monumental rate of unemployment.

Hmmm, could it be that the people who are making the decisions about where your stimulus dollars go live and work in the District of Columbia?

This interview of Eugene Fama, who is commonly referred to as the father of the Efficient Market Hypothesis (”EMH”), was conducted in August 2009 by Dimensional Fund Advisors. 

A few highlights:

Responding to critics that the recent volatility has ”killed” the EMH: 

“The market can only know what’s knowable. It can’t resolve uncertainties that are unresolvable. So when there’s a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices. As far as I’m concerned that’s exactly what we’d expect an efficient market to look like.”

Paraphrasing other interesting comments:

Most behavioral finance advocates like to point out inefficiencies, but usually conclude that it’s too impractical to take advantage of these inefficiencies and therefore you’re better off to do your risk-return tradeoff.  In other words they conclude that you’re better off to presume the EMH is an accurate description of the way markets work.

The top insiders do better trading on their own company’s stock but interestingly only by about 1%.

The most potent challenge to the EMH is evidence of momentum in stocks that can’t be easily explained. Secondly, movements due to earnings announcements tend to persist longer that expected.  Those are the two biggest challenges. Remember, EMH is a model, not truth. It’s a simplification of the world that does a good job on almost everything, but a few things it doesn’t do a good job on, e.g. insider trading, momentum, and movement from earnings announcement.

The EMH is not a perfect explanation of everything that happens in the market, but it is the best working proposition for use by investors.  Most investors should presume that the only way to reliably affect the expected return from their portfolio is by varying the level of risk they’re prepared to take.  Nothing in the last 12 months has altered that. Some people are claiming the market isn’t efficient, but they aren’t claiming there are easy profit opportunities out there.  It’s one or the other.

Whether you agree or disagree with Fama and EMH, this is a must-see interview in light of the recent volatility in the debate about EMH (ha ha).

Seekingalpha has a fascinating and short interview with Roger Ibbotson (”fascinating” and “short” seem to be highly correlated for me).

If you want to learn more about Ibbotson, read the intro to the article.

In case you don’t have time to read the whole interview, here are the highlights and money quotes:

• Because many hedge funds had (have?) a similar strategy, many hedge funds had to unlever at the same time in summer 2007, contributing to the meltdown “as they rushed to the same exits.” 
• “In both cases, the quant funds that were able to stick with their strategies were able to quickly recover. But those who targeted volatility got whiplashed. Those who kept their leverage intact did reasonably well. Unfortunately, many investors lumped quant funds into one big category, and have become wary of the whole group.”
• “Investors often select funds with the highest returns, without tracing where the returns came from. Most hedge fund returns are actually associated with beta, rather than alpha….. they do not really provide alpha and can be replicated for less than typical hedge fund fees.”
• “The drop exposed the fact that many hedge funds are really not absolute return vehicles, but actually contain a lot of beta.”
• And the most interesting quote in the interview:  “[H]edge fund alphas are still positive, although not as high or significant as before….  [T]he majority of the returns can be classified as beta, then fees, then net alpha, in that order. Despite the fact that alpha makes up the minority of the return, it is still noteworthy that the net alphas are positive. This is in contrast to the mutual fund industry where there is little evidence of aggregate positive alpha, even on a gross level. On a net level, aggregate mutual fund alpha is usually negative.”

The last quote is interesting for a few reasons.  First, it shows that hedge funds are not about “hedging,” as most of their returns is beta.   

Second, it contradicts another study I’ve seen that concluded the hedge fund industry has net negative alpha.  Unfortunately I didn’t save a link to the study.  If I come across it I’ll post it.

Third and most intersting, it’s more ammo that mutual funds in general are bad investments. There’s too much to say about this topic.  I’ll save it for a future post, or series of posts.

If you are interested in asset allocation, or investing in general, you should check out Wall Street Journal’s graphs showing the correlation of various asset classes with the S&P500.

There are two graphs. 

The first shows a timeline from 1994-2009 showing the correlations over time.  The striking feature of the graph is the rise in correlation of just about every asset class with the S&P500.  For equities, it’s been increasing for several years.  For bonds, it’s a more recent rise (although notice that bonds were even more highly correlated with the S&P500 in the mid-1990’s).

The second graph shows similar data, except aggregated from 1973 to 2009. It also shows the correlation of each asset class with the S&P500 for 2008.  The point of the graph is the correlations became more extreme in 2008, either more positive (most asset classes) or more negative (short-term treasuries and TIPS).

The conclusion is that most asset classes become more correlated during a crisis, reducing the benefits of diversification.

Unfortunately I can only read the first 3 paragraphs of the attached WSJ article because I don’t have a subscription.  It seems to conclude that asset allocation as a strategy is not effective because the correlations rise during a crisis. 

I suppose there’s some truth to it if you only invest during crises.  But do you know anyone that only invests during crises?

On the other hand if you plan to invest long-term, the relevant data is the long-term correlation (the grey bar on the graph) and not the 2008 correlation (the blue bar).  I’m in the market long-term.  I don’t care if the blue bar rises during a crisis. It’s temporary.

And there’s one more salient point.  A well-thought-out asset allocation strategy, coupled with low fees/expenses and a strategic tax approach, is the only way to beat the market in the long-term that is : 1) Easily accessible to most investors, and 2) Legal. 

If you abandon an asset allocation strategy, you’re left with the problem of figuring out a better strategy. 

A few other points worth noticing on the second graph, going from right to left:

• The “U.S. Stock Market” to the right only shows a 0.64 correlation with the S&P500.  I would have expected something in the 0.90’s given that the S&P500 is often considered “the market.”  Not sure if their data is bad, or if there’s some other reason for the discrepancy.
• Hedge funds have a 0.35 correlation.  This shouldn’t be news to anyone, but hedge funds are not really for “hedging.”  There are half a dozen asset classes on the graph with correlations closer to zero, all of which would be better hedges.
• The emerging market stocks correlation is shockingly high at 0.99.  I would have expected much lower. 
• European stocks correlation is shockingly low at 0.05.  I would have expected much higher, perhaps in the 0.80’s.
• Junk bonds are essentially uncorrelated to the market, making them a good hedge against general market risk.

The latest going-ons in “big law” are starting to draw interest from the mainstream press. 

This week Yahoo Finance put up an article about big firms asking their incoming first-year associates to defer their start date, in some cases up to a year.  Many firms are paying a partial salary or stipend to retain their associates through the deferment.  Reportedly some stipends are as high as $80,000, which would be half the first-year salary at most big firms.

In many cases the associates do not have a choice.  But suppose you did.  Which would you rather, $160,000 to work as a “big law” junior associate, or $80,000 to do your own thing for a year? 

As a former big law associate, let me assure you there is only one right answer.  Defer for a year, and then see if you can get them to defer you a few more years.  Thirty would be ideal. 

Jim O’Shaughnessy of O’Shaughnessy Asset Management.

A few excerpts:

The 40 years ending February 2009 were the second worst 40-year period for equities since 1900, with only the 40 years ending December 1941 doing worse! …

We are talking about an event so rare, that most of us alive today will never see such an opportunity again.

Many will say that I got bullish too early, writing that stocks were a screaming buy in Fall 2008 and that they have only declined since then. That’s true. Yet major stock market bottoms are seldom defined by a single point in time. Stocks began presenting great opportunities in the fall of 2008, and those opportunities have improved even more since then. Disciplined long-term investors learn to take advantage of these broad market valleys and continue putting money to work as long as the huge opportunity remains.  

Now is the time for all investors to do the same — for young investors, this is perhaps a once in a lifetime gift, and they should do their best to open and make maximum contributions to their 401(k)s and other tax advantaged plans. 

For middle-aged investors like myself, I recommend increasing the equity allocation of your portfolio to 70 percent and consistently moving money into stocks over the coming months.

And for investors who are already retired, now is the time to increase your allocation to stocks, particularly if you are significantly overweight bonds. If you are 70 years old, the actuarial tables say you will live another 13 ½ years — and a robust portfolio will help you enjoy your remaining years more fully.  

I believe that this time will be no different and that investors who take advantage of currently depressed stock prices will be delighted with the outcome five to ten years from now. 

Nothing we don’t already know, but it’s good to get a reminder that stocks have followed historical long-term trends that tend to overwhelm the shorter-term trends, such as that of the last 18 months.  

And he has some very interesting charts about 40 year returns to back up his main point.   It’s worth clicking through just to see the charts.
 

Today the House and Senate agreed to a final version of the latest stimulus package.  The final package comes in at $789 billion.   Round it to $1 trillion.

In response Senator Joseph Lieberman said:

“This represents the beginning of turning our economy around.”

Wait a sec….. the beginning?    

I know it’s hard to keep track of things, but didn’t we pay about a trillion just a few months ago to turn our economy around? 

Or am I confusing that trillion with the trillion that we gave away for no reason?

The latest Jeremy Siegel column is one of the better summaries of the “Morton’s fork” faced by policymakers dealing with the problem of an undercapitalized banking sector.

Lately we have heard several proposals intended to relieve the banks of their “bad assets.”  The idea is the banks would be more able to meet their capital requirements, and therefore in a better position to lend, if they were not burdened with the bad assets.

The basic idea behind most of the proposals is that the federal government (read: taxpayers) put up money to relieve the banks of these bad assets.  In some proposals the government:

• Acquires the assets directly (the TARP program as originally proposed); 
• Becomes a debtholder (the actual TARP program in which the goverment holds preferred stock); or
• Becomes a shareholder (the government would hold common stock, or warrants in the case of the actual TARP program). 

Each scenario involves the participation of the government, the banks, and the banks’ stakeholders (shareholders and debtholders). 

Under any scenario the parties must determine an appropriate price for the bad assets.  However, people much smarter than I have assured me that it is very difficult to determine a market price for these assets because they are not trading in the market.

It boggles my mind that no one can figure out a suitable valuation method.  While the bad assets may not be trading now, they were trading before.  They were trading for several years.  There were valuation models.  The models may not be accurate with hindsight.  But with all the smart minds working on this problem, and with the benefit of all we’ve learned over the last few years, we should be able to come up with more accurate models that will help us peg a market value to these assets. 

On a related note, is it just me or does the so-called subprime meltdown seem like one of those stories where a man-made computer develops artifical intelligence, overthrows its creator, and turns on humanity. 

Very smart people created financial models and products that took on a life of their own.  Now no one can figure out how to stop them from destroying humanity.