Economics of the downturn – thoughts for investing

Researchers are still trying to explain why we had a bubble that burst, or if we had a bubble at all….

The January 11, 2010 issue of the New Yorker has a great article on Posner, the Chicago School of Economics and other matters that have come from the sub-prime mortgage mess (a summary appears below).

Also, there is a humorous video on line, comparing Keynes and Hayek on their approaches in rap format at:

Let me know what you think



John Cassidy, Letter from Chicago, “After the Blowup,” The New Yorker, January 11, 2010, p. 28

Read more:


LETTER FROM CHICAGO about the state of the Chicago School of economics after the financial crash. Earlier this year, Judge Richard A. Posner published “A Failure of Capitalism,” in which he argues that lax monetary policy and deregulation helped bring on the current economic slump. Posner has been a leading figure in the conservative Chicago School of economics for decades. In September, he came out as a Keynesian. As acts of betrayal go, this was roughly akin to Johnny Damon’s forsaking the Red Sox Nation and joining the Yankees. Ever since Milton Friedman, George Stigler, and others founded the Chicago School, in the nineteen-forties and fifties, one of its goals has been to displace Keynesianism, and it had largely succeeded. In the areas of regulation, trade, anti-trust laws, taxes, interest rates, and welfare, Chicago thinking greatly influenced policymaking in the U.S. and many other parts of the world. But in the year after the crash Keynes’s name appeared to be everywhere. In “A Failure of Capitalism,” Posner singles out several economists, including Robert Lucas and John Cochrane, both of the Chicago School, for failing to appreciate the magnitude of the subprime crisis, and he questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis and the rational-expectations theory. In Posner’s view, older, less dogmatic theories better explained how the problems in the financial sector dragged down the rest of the economy. In the course of a few days, the writer talked to economists from various branches of the subject. The over-all reaction he encountered put him in mind of what happened to cosmology after the astronomer Edwin Hubble discovered that the universe was expanding, and was much larger than scientists believed. The profession fell into turmoil, with some physicists sticking to existing theories, while others came up with the big-bang theory. Eugene Fama, of Chicago’s Booth School of Business, was firmly in the denial camp. He defended the efficient-markets hypothesis, which underpinned the deregulation of the banking system championed by Alan Greenspan and others. He insisted that the real culprit in the mortgage mess was the federal government. Mentions John Cochrane. Gary Becker, who won the Nobel in 1992, says that Posner and others raised fair critiques of Chicago economics. Mentions Robert Lucas and James Heckman. If the economic equivalent of a big-bang theory is to emerge, it will almost certainly come from scholars much less invested in the old doctrines than Fama and Lucas. Mentions Richard Thaler. Raghuram Rajan, an Indian-born Chicago professor, is one of the few economists who warned about the dangers of the financial crisis. In 2005, he said that deregulation, trading in complex financial products, and the proliferation of bonuses for traders had greatly increased the risk of a blowup. In a new book he’s working on, “Fault Lines,” Rajan argues that the initial causes of the breakdown were stagnant wages and rising inequality. With the purchasing power of many middle-class households lagging behind the cost of living, there was an urgent demand for credit. The side effects of unrestrained credit growth turned out to be devastating. The impact of the financial crisis shouldn’t be underestimated, especially for Chicago-style economics. “Keynes is back,” Posner said, “and behavioral finance is on the march.”

Read more:

Let us know if you have questions or comments. Thanks,


In divorce, do you keep the house or the 401(k)?

Real Estate: Bubble or not? How does it effect our Divorcing clients

By Howard I. Goldstein and Steven A. Branson

This article was wrtiten a few years back and appears at the following link on line at, and on Howard Goldstein’s site. However, the financial calculations are still relevant.

Copyright 2005. Steven A. Branson and Howard I. Goldstein

Comments on health insurance, tax changes and asset allocation (not even having all investments in cash is safe)

Starting with my reoccurring theme of asset allocation, I post below two comments on investing.

The first short comment from Morningstar reaffirms that you need to diversify by class, as well as in each class, of investment.

The second comment from Merrill Lynch provides a year to date summary of returns, showing that the people who tried to market time, by going to cash last year, missed out on substantial returns by being out of the stock markets in 2009.

Finally, as another example on diversifying, we had some clients invest in Euro bonds. They made over 20% in the last two years, which is much having gone to cash.

So, again, I urge anyone who has not reviewed their allocation to do so now …..

Tax impact of Health Care Reform
On the health care reform and its impact on your taxes, I reprint a section from the Kiplinger’s Tax Letter below.

As with many other sources, they believe a bill will pass and that it will have an impact on taxes.

The impact is likely to be predominately on people with income in excess of $250,000, but not beginning until 2011. When we know more on this, we will give you an update.

Estate Taxes
Kiplinger’s expects Congress to keep the estate tax much like it is today, rushing to avert the year of no estate tax and the year after or a $1 million credit (we now have a $3.5 million credit)…

Kiplinger’s also has comments on the “cash for clunkers” and changes likely in 401(k) plans…..

Let me know if any of this raises questions or comments please. Thanks,


From Morningstar:
Theoretical and empirical research, as well as long-term data from financial markets, confirms that risk is minimized significantly and performance can be enhanced when a portfolio holds, for long periods of time, different asset classes with dissimilar price movements. This approach, which fulfills the fundamental underlying objective of modern portfolio theory, is also in accord with the standards of modern prudent fiduciary investing.

From Merrill Lynch:
…. In the meantime the S&P 500 Index had its best quarterly return since 1998, rising almost 16%. Most US equities rose sharply in the second quarter as investors regained their appetite for risk; investors bid up stocks beginning in March after it appeared that the financial sector had stabilized and this momentum continued through the second quarter. Investors seized upon indicators such as retail sales, industrial production and ISM survey data that suggested economic growth, although weak, was showing improvement. Indeed, retail sales and durable goods orders were higher than expected and employment figures showed a moderation in worsening trends. After the strong end to the first quarter, analyst estimates for company earnings were on average revised higher as the depression scenario faded into memory. During the quarter, the riskiest assets were bid up the most, with the Russell 2000 Small Cap Index returning more than 20%.
Outside the US, the story was similar: markets improved sharply on the turn in economic data. The MSCI Emerging Markets Index had its best quarter in U.S. dollar terms since it was launched in 1988 – rising almost 35% in the second quarter…..

The Kiplinger Tax Letter (ISSN 0023-1762)
Health care reform may seem stalled for now, with both the House and Senate missing the deadline that Obama set for action on a bill…early August.
But work still goes on behind the scenes, so Democratic leaders can make a final push this fall.
Readers are asking what’s going to happen to the legislation and what it will mean for taxes.
We’ll share our answers to those questions.
What are the chances that no bill will pass?
Very unlikely, given all the political capital that the president has spent on this issue. He’s sure to insist Congress keep at it.
But if gridlock continues, Obama may have to accept a scaled down bill… a lesser expansion of the government’s role in providing coverage to the uninsured.
A smaller bill would lower the price tag, reducing the need for tax hikes. The odds of a big-ticket tax increase such as an income surtax would go way down. It wouldn’t be needed to offset higher federal spending from revamping health care.
Does a smaller bill mean no employer mandate? No, although the number of small businesses that would be covered by the mandate and the tax penalties for failing to provide coverage to employees would be smaller than originally thought. The tax would be somewhat less than the $750 per worker proposed in the Senate, and would be phased in for those businesses with payrolls that exceed $500,000. As first proposed, the tax would have covered firms with payrolls over $250,000.
Would a mandate apply beyond the private sector? Yes. The coverage rule and tax penalty are sure to cover nonprofit groups and state and local governments.
Could employers avoid the mandate by classifying workers as contractors?
Theoretically. However, it’s a risky move. Tax pros predict that a mandate would spur many firms to consider reclassifying employees to avoid covering them, forcing them to buy their own coverage. But you can expect that angry workers will squawk to the IRS, giving the agency lots of leads for employment tax exams.
Are middle incomers likely to see higher taxes to fund the overhaul?
Don’t rule it out. Lawmakers are considering, for example, a new tax on gold plated insurance plans. Those policies aren’t owned just by upper incomers. They are included in the contracts of many union members…police, firefighters, etc.
Would Congress consider making tax hikes start in 2010? Definitely not. Figure that 2011 would still be the earliest year that hikes would become effective.
Will continuing delays on health care push estate tax changes into 2010?
Not very likely. Lawmakers still intend to act before the end of the year to prevent the estate tax rate from dropping to zero in 2010. The exemption amount for 2010 will be kept at $3.5 million and the rate will stay at 45% for another year. The estate tax bill is sure to include extensions beyond 2009 of popular tax breaks, such as tax free IRA payouts to charity and the deductions for tuition and sales tax.

The “cash for clunkers” program has tax angles for people and businesses. Vouchers are tax free for individuals. Therefore, if you trade in a vehicle for a more fuel efficient one and get a $3,500 or $4,500 dealer credit on the trade-in, you owe no tax, even if the amount of the credit far exceeds the trade-in’s value. And if you purchase a qualifying hybrid or a lean diesel vehicle as a replacement, you still can claim the hybrid or diesel credit, even though the voucher isn’t taxed.
But car dealerships don’t benefit from the tax break, IRS officials say. The voucher amount is included in the gross receipts from the sale of the vehicle.

Many 401(k) plans will have a different look a couple of years from now. The economic downturn is prompting changes that firms will implement to reduce plan expenses and to prompt their employees to save more for retirement.
More employer payins will be discretionary. Although most plan sponsors that suspended matching contributions during the downturn will reinstate them, those payins won’t return before 2011, and they’ll probably be in a different form. Fewer firms will automatically match a set percentage of pay. More contributions will be tied to company performance. And many firms will stop obligating themselves to a contribution level at the start of the year but will wait until year-end to decide.
Companies will try to get more 401(k) accounts on autopilot to help workers boost savings. One idea: Having employee payins increase automatically each year until reaching a preset level…around 10% of pay…if the employee selects this option. The number of companies adopting automatic enrollment will continue to grow, though some will limit it to employees with at least two years of service. That way, firms can avoid incurring the administrative hassle and expense for short-timers.

Another subject:
Bad news from IRS for exchange-traded funds that invest in metals: Those funds do not qualify for the 15% rate on long–term capital gains. Instead, their top tax rate is 28%. It applies if the fund owned the metal for more than one year and the investor owned fund shares for over a year, IRS says privately.
The fund’s investors are deemed to own a share of the metal, such as gold, silver or platinum. The gain is treated as coming from the sale of a collectible.
The Service takes a different stance for IRAs investing in these funds. If the metal is held by an independent trustee, the Service will not treat the IRA as owning a share of the fund’s underlying metal. This favorable interpretation keeps the IRA from running afoul of the rule barring direct investments in bullion.

Inflation fears are misplaced! affects future refinancings, as well as the markets

The article below brings Nobel laureate analysis to the recent inflation fears, concluding:

1. The fears are misplaced
2. We are dealing with deflation now, not inflation
3. There could be future inflation worries, but we have much to get past before that happens, and
4. The fears are more politically inspired than founded on real analysis, bringing pressure against the programs of the Obama administration trying to restore credit and stimulate the economy

When the fears ease, mortgage rates should fall again to around 5%…. so review your mortgages and let us know if you want to refinance (even if you keep the same payments, so you do not lose years that you have paid down, you are better off refinancing as the total interest paid will be less)

As for investing, some people are shorting bonds right now!

Good luck, and let me know if you have quesitons …. And pass this on please.



OP-ED COLUMNIST The Big Inflation Scare By PAUL KRUGMAN Published: May 28, 2009 in the New York Times

Suddenly it seems as if everyone is talking about inflation. Stern opinion pieces warn that hyperinflation is just around the corner. And markets may be heeding these warnings: Interest rates on long-term government bonds are up, with fear of future inflation one possible reason for the interest-rate spike.

But does the big inflation scare make any sense? Basically, no — with one caveat I’ll get to later. And I suspect that the scare is at least partly about politics rather than economics.

First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.
So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.

The first story is just wrong. The second could be right, but isn’t.

Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.
But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.

Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell.

All in all, much of the current inflation discussion calls to mind what happened during the early years of the Great Depression when many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, “Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah’s Flood.” And he went on, “It is after depression and unemployment have subsided that inflation becomes dangerous.”

Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced.

Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I.
But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems.

So is there any reason to think that inflation is coming? Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now.
All of this raises the question: If inflation isn’t a real risk, why all the claims that it is?

Well, as you may have noticed, economists sometimes disagree. And big disagreements are especially likely in weird times like the present, when many of the normal rules no longer apply.

But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.

Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.

Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.

Are all investment styles dead? Hedge funds? Asset allocation? … we think not

Hedge funds have gotten bad press, most recently as a target for some blame for the financial meltdown

But, as the Morningstar author says, “These funds offer individual investors access to investment styles, such as managed futures, currencies, merger arbitrage, long/short equity, and market-neutral equity that have historically been dominated by hedge funds. As long as these funds exist, it’s too soon to write off alternative asset classes, either.”

The article ends with alternatives for those lacking the net worth to have a true hedge fund LP or LLC as part of their portfolio. For those who can, the hedge fund vehicle, with a good manager, provides access to alternate investments that funds do not … and you need that access for the tactical ideas we have been discussing in recent e-mails…

Let me know about your reactions on hedge funds……. good luck,



Don’t Write the Obit for Hedge Funds Yet
by William Samuel Rocco | 05-26-09

Lots of ink has been spilled about the demise of hedge funds since turmoil in the financial markets accelerated in last year’s third quarter. Some pundits have predicted that hedge fund assets would shrink by as much as 75% and that half of those in existence would close up shop. There’s no denying that many are closing. So far, nearly 30% of hedge funds in our database have either told us that they’ve closed or have stopped reporting performance to us for at least six months (a sign that they have likely ended up in the hedge fund graveyard). Many more are suffering large asset declines, but it’s premature to say that hedge funds are history.

The (Alternative) Resistance Lives On
It’s true that the pace of new fund launches in the first quarter of 2009 was roughly half that of the past five years, causing a decline in the number of funds for the first time in memory. Expecting the hedge fund industry to shrink further is not outlandish following the Bernie Madoff* and Alan Stanford scandals and the fact that hedge funds experienced their worst year on record in 2008. But even during the market’s darkest days of late 2008 and early 2009, new hedge funds were opening. A search of Morningstar’s hedge fund database recently revealed nearly 100 inceptions in the fourth quarter of 2008 and 75 launches in the first quarter of 2009. * [his was a Ponzi scheme, not a hedge fund ….]

New hedge funds continue to come to life, and one might expect them to look different now. After such a tumultuous year, it seems reasonable to expect new funds to assume less risk, but that does not appear to be the case. Emerging-markets equity funds account for 15% of the new funds, for example, despite having been in one of the market’s toughest corners (the Morningstar Emerging Market Equity Hedge Fund Index was the worst-performing and most volatile hedge fund category index in 2008). And while the fact that some new hedge funds are not yet reporting to our database makes them difficult to quantify, we’ve seen news reports announcing the launch of many distressed-debt, currency, and futures funds.

Best of Both Worlds?
Two of the knocks against hedge funds have been their lack of transparency and hefty fees, which are clear disadvantages versus more-transparent and inexpensive mutual funds. Yet, mutual funds don’t offer the same flexibility; they are limited to having less than 15% in illiquid securities and have strict limitations on their use of investment leverage. Hedge funds have no restrictions on their concentrations in illiquid securities, and some strategies boost their returns significantly by borrowing and investing many times the amount of their net assets. One case in point is the Treasury’s plan to have money managers purchase distressed assets from banks. The limits on illiquid securities and leverage make it nearly impossible to create stand-alone mutual funds dedicated to benefiting from the proposed Public-Private Investment Program, or PPIP. Although re-establishment of a market for those assets is a stated goal of the program, it’s a stretch to call them anything but illiquid at this point.

The noted liquidity and leverage restrictions prevent many alternative strategies from being offered to non qualified investors in mutual fund form. But there are a significant and growing number of alternative style mutual funds working within these limits. Morningstar tracks more than 100 mutual funds that use an alternative strategy or asset class. These funds offer individual investors access to investment styles, such as managed futures, currencies, merger arbitrage, long/short equity, and market-neutral equity that have historically been dominated by hedge funds. As long as these funds exist, it’s too soon to write off alternative asset classes, either.

Take, for example, the following three mutual funds that were recently launched. Each offers a hedge-fund-like flavor:

AQR Diversified Arbitrage I ADAIX
The first mutual fund offering from a long-standing alternative manager combines various arbitrage strategies not typically found in mutual funds. Arbitrage strategies identify groups of securities trading at prices that don’t agree with their expected relationships. For example, merger arbitrage investors seek to exploit price discrepancies that occur when one company is buying another one. Open since January 2009, this fund combines merger arbitrage, convertible bond arbitrage, capital structure arbitrage, and other arbitrage techniques aiming to generate investment returns with low correlations to the stock market.

Legg Mason Partners Permal Tactical Allocation LPTAX
Legg Mason is making the services of its alternative asset-management team, Permal, available to mutual fund investors. Although tactical allocation is not on its own an alternative concept, Permal has a long history of success operating strategic and tactical asset management within funds of hedge funds. Open for about a month, this fund allocates among various asset classes aiming to outpace a traditional asset mix.

Turner Spectrum Fund TSPEX
The newest entry, just opened on May 7, combines six long/short equity strategies managed by Turner Investment Partners that are not otherwise available as mutual funds. Previously, the underlying portfolios were only available to institutional investors through separate accounts.

Benjamin N. Alpert, CFA is a hedge fund analyst at Morningstar.

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The “buy and hold” vs. “active trading” seems to have become a lively debate lately

The article from Money & the Economy at Morningstar has the story of Janet Briaud then several responses, of which I like the person who says “There is a lot of potential risk in changing 100% of a strategy and being wrong, versus changing 2-5% of a strategy and being wrong..”

What I find important is that certain tactical moves have merit, but not as wholesale strategies (e.g., going 100% to cash). In fact, “tactical reallocation” moves describe much of what I have said since late last fall, as in the strategies involving muni bonds, corporate bonds, and international REITs, stocks and bonds)

The key then is to add value from the advice, using both history and an understanding of what is going on, to make moves within the total allocation – not to scrap the allocation in its entirety.

Have you considered these tactical moves or are you in the “buy and hold” category? I would be curious to know ….. (for those with managers with whom I constantly speak, I know the answer…)

Good luck and let me know what you and your friends or business associates think…