What Malkiel had to offer:

Emerging markets generally will shine but specifically China, China, China.  He has visited 6 times and is convinced that China will be the global engine for growth. China is currently the third largest economy in the world. It should overtake Japan in a few years and the US in 15 years.

The government in China is absolutely committed to developing the western part of the country and has a larger and more targeted stimulus plan than the United States.  They have ambitious infrastructure investment plans and are starting to build a safety net so that Chinese consumers will start to consume instead of saving all their money (consumption is only 37% of GDP and savings rate is around 40%). China has the capacity to make enormous investments because its debt to GDP is only 25% today, vis-a’-vis Japan and the US where it is over 100%.

Malkiel’s take away is that China can continue to grow at 9% a year and will be able shift to more domestic sources of growth rather than a reliance on export of cheap goods abroad.

By contrast, the US has strong economic headwinds. He doesn’t think the US will go back into recession but he sees a very long drawn out slow growth type recovery. Bank of America and Citibank are insolvent, for all intents and purposes. Chinese banks by comparison are actually quite well capitalized. Given the significant issues that these banks had with bad loans to quasi-government institutions, this  is saying something.  It reflects a conscious effort to clean up the banks over the last decade so that as the market  slowly opened up the banks would be able to compete with foreign financial institutions.

US household liabilities over the last 50 years have gone from 40% of assets in the 1960s to 150% today.  Household debt as a percentage of GDP has gone from 20% of GDP to 100%. There will be a LONG adjustment period as the country deleverages.  Banks are not lending as they try and rebuild capital while exercising extreme caution.

Dollar weakness may continue, while other countries like China will express appreciation. Malkiel thinks that the Yuan (the Chinese currency) is the most undervalued in the world.

US has 42% of the world’s equity capitalization currently. Our investors have an extreme home country bias and people should consider an international allocation up to 40% (more if including US companies with a significant international presence).  In the short term, he has no idea what returns investors should expect. Over the long run, equity investors will be rewarded. At this point, equities still offer the potential for out performance over government bonds but no should expect  double digit returns.

He stressed the importance of looking at valuations using “normalized” profit margins. Current profit margins are much more realistic than they were a couple of years ago. There is still the challenge of knowing whether you can trust that earnings numbers are accurate. One alternative is to look at dividends, which cannot be fudged. The market is now much cheaper than it was in 1999, but is nowhere close to depression era levels. International values are reasonable, but not dirt cheap, and offer some inflation protection for investors. Chinese valuations, adjusted for growth, are attractive.

Should you diversify into bonds?  The answer is yes, because they are the only thing that is not correlated with other assets in a decline.

The Fed has expanded its holdings by $2 trillion which is concerning to a lot of people because of the challenges in unwinding all of these support programs and the potential for inflation. In the next couple of years, there is very little inflation risk but over the longer term inflation risk is significant.

And, oh yeah, China rocks.

And, oh yeah, Burt Malkiel is now the CIO of a company that is sponsoring China-based indices and investments. Just something to be aware of…

Axel, German by birthright, is hardnosed American free-marketeer to the core. He looked seriously pained describing the US government’s efforts to date to contain the financial crisis and fix the underlying problems that led to this crisis. Containment strategy? Supplant the private market as the supplier of capital. Reform? None.

In general, his views are similar to ours. Some things he discussed (heavily paraphrased):

The only 2 major financial insitutions that may have the strength to survive in their current form are Wells Fargo and JPM Chase.

The Chinese may be fine. The middle class has a lot of savings and the Chinese government, with its 20 years of planned investment, has some real options when it comes to stimulating the economy. This is consistent with our conversations with those actively involved in China who have noted some signs of slowing – emptier restaurants – but no indication that the bottom will fall out.

Within Asia, the winners look to be China, Singapore and Taiwan (through their Chinese connections). He was concerned about Korea with a rapidly aging population and an insular culture and countries like Vietnam whose ability to compete is based very narrowly on lower nonskilled labor costs.

He seemed more concerned about the long-term inflationary impact of the current monetary stimulus than potential short-term deflation. While this is not surprising as Mr. Merk runs a “Hard Currency Fund” whose explicit objective is to protect against a declining dollar, it is something to think about.

Merk offers a free periodic newsletter (sign up) that offers economic commentary. It looks interesting but the usual caveats apply.

This trade recently came undone. Everyone has had to sell their Australian dollars and buyback Yen. The Australian currency has been crushed. Below is a chart of the Yen/ Australian Dollar exchange rate. Sydney for Christmas, anyone?

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

[Formatting problems at the bottom are known issue. Webmaster on the case.]

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The financial sector had taken over our economy. Over 40% of all profits in the US were made by financial firms, a statistic more befitting a small Caribbean tax haven. Financial regulation in this country was inconsistent and ineffective.

Your messengers,

Elizabeth and Jessica

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

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Shocking VP picks, Russian invasions and now a government takeover of Fannie Mae (FNMA) and Freddie Mac (FHLMC)… the news just won’t stop coming.

Our overall view has not changed. The US will have to suffer through a few unpleasant years before the housing market normalizes, financial institutions can get back to business and our economy can get moving again. It will get worse before it gets better. At the end of the day, the financial sector should be smaller and more efficient which would be a positive thing. People will start saving money and that will be a positive thing.

Asset classes around the world have taken a beating lately. The rumors are that many hedge funds have had to liquidate large positions. While this is ugly for current holdings, most of you hold a lot of cash and we have identified a number of compelling investments.

Items of note from the government takeover of FNMA and FHLMC:

Mortgage rates will probably go down. The government is doing a lot of things to get rates down, many of which will eventually cost us all as taxpayers and mean much higher mortgage rates in the future. But in the meantime… there should be some deals available.

Future tax rates will be even higher than we have been assuming. This bailout will cost a lot. If you can contribute to a Roth IRA, you should seriously consider doing so.

This is not the final restructuring. The current specifics of the FNMA / FHLMC deal have the mortgage giants being responsible for something like 90% of all new mortgages over next year or two and then virtually ceasing issuance after that. The concept is that offering really, really low rates on mortgages over the next 18 months will stabilize the situation enough that the government can just leave. Methinks this is not very realistic. Who on earth will step up to fill the void? Homeowners and banks will be dependent on the US taxpayer for years to come. There are some eerie parallels to the Iraq war…

Debt issued by FNMA and FHLMC is money good. Many of you hold shares in your 401(k)s in the Pimco Total Return fund, which had gone “all in” on a bet that the government would do a bail out. It turned out to be a good bet.

In other news:

Washington Mutual (WaMu) got officially placed on super secret probation by its regulators. This is not a good sign. They are offering desperation-level high rates on CDs. This is not a good sign. We have sent out previous warnings about this bank. You should not have more than the FDIC minimum at WaMu. Your family and friends should not either.

Don’t shoot the messengers-

Elizabeth and Jessica

Things I learned:

1) These decisions have a huge impact over how much money people and their heirs end up with and are important to think about.

2) The calculations required to make these decisions are really hard, even for the country’s top financial professionals, and not always intuitive.

3) There were people of all political persuasions in the room and EVERYONE thinks tax rates are going up, way up. As someone said, if taxes were a stock, they would be rated a long term “buy”.

4) The Roth IRA / 401(k) can be great for people of even very high incomes.

5) Congress will allow unlimited conversions to Roth IRAs from regular IRAs in 2010. Currently, you can only do this if you earn less than $100,000. This is a fabulous opportunity for our clients but will be very costly for our nation’s finances without any obvious public benefit.

When you convert to a Roth, you have to pay the taxes on all the income that was sheltered in an IRA, but you and even your grandchildren who inherit that money never pay tax again on any investment or dividend income. You pay $1 today to avoid $2-$30 of tax in the future.

Even though Congress gives up a huge amount of revenues in the future, it still loves this idea because all its budget calculations are done on a 10 year basis. They get all of the benefit from people writing checks to the IRS today without having to account for the taxes people will avoid paying 10-100 years from now. When they passed the provision, they were able to count it as a revenue raising measure.

According to this New York Times article, this one little obscure tax law could cost over $50 billion when all is said and done. I guess we can just add unlimited Roth conversions as reason #932 that tax rates will be headed north.

Anyway, if you are our client, and you got a notice from the HR department about a new Roth 401(k) option and shoved it into a desk drawer, pull it out and give us a call.

If you happen to be a member of Congress, you need to consider revisiting the Roth conversion idea.

As always, everyone’s financial situation differs and you need to consult your own advisor.

Disclaimer: We are not single stock pickers, we generally do not use single stocks in our client portfolios and we use only very public information as the basis of any analysis. We are not offering buy or sell recommendations and you should not interpret any article as such. We are generally commenting on some metric of a company’s business. Stock prices and company fundamentals sometimes go in tandem, sometimes not. For example, a stock price often already reflects expectations of changes in fundamentals.

So why do we bother with single company commentary?

• Dissecting the individual players within the economy offers insights into broader trends.
• Many of our clients have significant concentrated stock holdings that necessitate analysis and sometimes what we learn is worth sharing.
• It also is fun, if you like making financial diagnoses from incomplete financial information like a company’s 10-Q filings. Kinda like House, but a company’s health instead of a real person’s.

For further reading:

An explanation of why it is a problem if the bond insurers blow up

Barron’s article by Vitaliy Katsenelson that explains why we should value stocks assuming profit margins are lower in future

New York Times article on American’s consumption habits

We sent the following note to our clients and those we have put on our “Friends of Alexis and Palmer” email list. If you would like to be added to this list, please send a request to info@alexis-palmer.com with your name and affiliation.

We are getting inquiries about E*TRADE, their financial future, and the safety of accounts held at E*TRADE.

General takeaway:

• E*TRADE is definitely over its head but has value as a going concern.
• Even if people try and take a lot of cash out of E*TRADE, it has numerous ways to borrow a lot of money.
• Cash deposits/CDs up to $100,000 are usually FDIC insured and safe. (Use the FDIC calculator to know exactly how much coverage you have)
• Securities in brokerage accounts up to $500,000 are covered by SIPC insurance and are safe.
• Accounts over $500,000 are covered by excess SIPC insurance – we have not done the math to see if it will cover all holdings.
• An easy way to increase the security of large cash deposits is to buy a money market fund or short term bond fund – this then becomes covered under SIPC.

More on E*TRADE
I worked for a brief period for E*TRADE five years ago and I still know people who work there. I became VERY concerned about their mortgage holdings several months ago after they publicly released certain portfolio information about their mortgage holdings. Since that time, the stock price declined over 70%. That said, E*TRADE has a number of strategic options which I think could keep it afloat. I actually published an “article” on SeekingAlpha.com (http://seekingalpha.com/article/54013-e-trade-a-bargain-at-these-levels) about E*TRADE last night that you can read for more background information on their woes.

Please remember that everyone’s financial situation is different and the information provided may not apply to your situation in particular.

The question we have is: if she had a financial advisor who understands the risks of employee stock options, why didn’t he convince her to exercise them before they fell off a cliff?

Financial planning is more than just telling a client the “right thing to do.” With our clients, most of whom are very capable professionals, the lore and lure of stock options have to be be dismantled before we can get them in the framework to make good decisions about their holdings.

Options are economically similar to buying stock on margin, equivalent to buying a house with very little money down. The first thing we do with clients is translate their option holdings into a share equivalent for them (downpayment -> house price, exercise value-> share position). The market value of these shares is usually dwarfs their other investments.

After the shock of that revelation wears off, we talk about the likelihood of them getting fabulously wealthy from their holdings, just like their neighbor John did.

Everyone in Silicon Valley has a neighbor John. John worked for XYZ Corp. and didn’t exercise any of his options and his company’s stock went to a zillion dollars and now he has enough money to buy a decent house in the Bay area.

Then we show them how much money they would have if they had exercised all their options in ABC Inc., paid the taxes and bought  options on Apple XYZ Corp. stock.

Then we do an analysis of their actual company and start looking at how different scenarios impact their overall net worth.

Then after all that sinks in, we can start talking about strategies for exercising stock options.