Letter - April 2010





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The Age of Wonder

"The Age of Wonder" is what English historian Richard Holmes called the period between Captain Cook’s first voyage in 1768 and the sailing of Darwin on The Beagle in 1831. In that period scientific experimentation and exploration produced a wondrous new understanding of the physical world. Mungo Park explored Africa and Joseph Banks circumnavigated the world with Captain Cook. William Herschel scanned the skies, discovered Pluto and then went on to build the first forty-foot telescope, a wonder of the age. French aeronauts ascended in hot air balloons drawing crowds as large as 250,000 to the Tuileries Garden in Paris. It was an age of optimism that looked to the future with expectation.

Today we live in a new age of wonder. In contrast to the earlier age, ours is marked by anxiety about the future. The great Obama experiment promises to bring government intervention and regulation into our lives to an unprecedented degree. The crushing weight of government expenditure and debt makes us wonder what the future will bring for our children. Unlike the baby boomers who have enjoyed a standard of living higher than their parents, we wonder if the same will be true for future generations. We wonder whether America will be able to maintain its place in the world, projecting influence in support of its ideals. We wonder what is going to create wealth if it is confiscated by high taxes and consumed by entitlements. As Margaret Thatcher famously said, “The problem with socialism is that eventually you run out of other people's money to spend.” We wonder if the great American experiment is beginning to consume itself.

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Despite these gloomy thoughts, the stock market continues to rally on the growing consensus that the economy is picking up and that a new downturn is unlikely. Though still below pre-crisis levels, corporate profits are strong especially compared with the dismal reports of a year ago, helping fuel stock gains.

One cause for optimism is that individual investors remain skeptical of stocks. Should that change, a flood of money into equities could keep the rally going longer than would otherwise be sustainable. For now, though, investors appear to be very underinvested in equities, preferring bonds for their supposed safety. We consider the perception of bonds as safe to be illusionary. Yields are to our mind unattractively low and bonds with maturities greater than five years are very vulnerable to inflationary pressures that are sure to arrive eventually in the wake of high government deficits. Furthermore, in 2011 the Bush tax cuts expire and top marginal tax rates will rise, taking a further chunk out of pre-tax interest earned. And tax-free municipal bonds are not necessarily an answer. High-tax states like New

York and California are struggling with huge deficits too, which raises questions about the quality of their debt. Caveat emptor.

Year-to-date, clients have enjoyed robust performance. Yet we are cautious in our outlook for the market. It has led fundamentals on the way up. Now that fundamentals are looking better, what can the market look forward to?

We are trying to remain disciplined by not selling stocks just because they have gone up. Nonetheless, we do have opinions on what our stocks are worth and will take profits as they approach those targets. We also note, unless Congress acts, next year Federal taxes on qualified dividends will once again be taxed as ordinary income with marginal rates as high as 39.6% compared to a flat 15% rate now. This makes dividends substantially less valuable. We may well lighten up on stocks that are owned primarily for dividends.

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There has been much discussion in the financial press recently about converting a traditional IRA to a Roth IRA. Like a traditional IRA, a Roth enables investors to earn investment income and take capital gains without paying taxes. Unlike a traditional IRA, a Roth enables investors to take distributions without paying future income taxes as well. Herein lies its appeal. Once a Roth is established it is truly a tax-free investment vehicle providing tax-free distributions…unless at some later date the government changes the rules, a not unlikely outcome.

We consider conversion to be attractive under certain circumstances.

If you do not intend to spend the money in your Roth. Once you convert, you cannot withdraw money from your Roth for five years without penalty.

If you have heirs to which you intend to leave the Roth. The Roth is particularly attractive as an estate-planning tool. By leaving a Roth to the next generation, which has a much longer investment horizon, the value of investing tax-free is magnified tremendously. If you are relatively young, that enhances the value even more.

If you can afford to pay the substantial up-front tax. Converting to a Roth is considered a full distribution for tax purposes and therefore the whole value of your IRA is considered taxable. So there is a large up-front tax payment. For many people, this will put them in a high tax bracket for the year in which they convert, resulting in an especially large tax payment for that year. We note that for conversions made in 2010 only, the tax can be paid over two years.

If you are interested in the possibility of converting your traditional IRA to a Roth, we would be glad to discuss it with you in further detail and answer any questions you may have.

Tom Herzig


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