Category Archives: Finance

Fiscal Cliff Resolution’s Impact on Taxes and Investing

Given the large US budget deficits of the past several years, tax increases were inevitable. No doubt, this will be a drag on economic growth going forward. For starters, those earning wages will experience an increase in payroll taxes. The withholding for Social Security taxes will revert back to 6.2%, the amount it was before the financial crisis.

The Bush-era tax cuts will remain in effect for those earning less than $400,000 per year with the top tax bracket being 39.6%. Long-term capital gains and dividends will remain at 15% for those earning less than the $400,000 threshold. The top rate for long-term capital gains and dividends has risen to 20%.

Most importantly, however, is the permanent patch to Alternative Minimum Tax (AMT). Previously, AMT had to be patched every single year, leaving an element of uncertainty for many filers. Had this not been resolved this year, many taxpayers would have been caught by surprise with a stiff tax increase.

Although this resolution will be a fairly minor drag on the economy, it will not be sufficient for solving our budget problems. Our budget deficits are too massive and spending cuts will still be needed to bring our budget to a reasonable level. Simply put, the government will still spend far more than it receives in taxes.

One of the buggest dangers is a sharp increase in interest payments for the national debt. Interest alone on the national debt is around $29 billion per month. A spike in inflation and interest rates could make this amount multiply. Currently rates on US government bonds are near zero with the 30 year bond being around 3%. This is why any increase will be huge. These rates are historically low and cannot get much lower. That being said, the risk involved does not favor US taxpayers.

The Fiscal Cliff consisted of mostly media hype. The real problem involves the mushrooming amount of debt. If this is not dealt with, then we will experience a real crisis. According to Reinhart and Rogoff’s This Time is Different, once debt-to-GDP rises to over 90%, it becomes a significant drag on the economy (We have already passed this level). In most cases cited by the authors, governments eventually default. Currency devaluations, resulting in inflation from printing money, are considered to be an indirect form of default. And is the most common method used by governments with fiat currencies.

Slower Growth Impacts Equities

Currently, the stock market is priced with the assumption of GDP growing at the rate of its historical trend. This is roughly 3% per year. Since the Great Recession, we have not been anywhere near that. Corporate earnings for the majority of S&P 500 companies have been disappointing for the last 2 quarters. This suggests that earnings are near their peak for this business cycle.

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Filed under Economy, Finance, Investing, Taxes

Fiscal Cliff is Mostly Media Hype

Each time I turn on CNBC, there’s a clock showing the countdown of the fiscal cliff (regardless of which show is on). This is merely a recurring theme: make you think the world is ending in dramatic fashion to keep you watching the news. CEO’s like to come on the shows to tells us it’s armageddon if we raise taxes. Isn’t this just an attempt by them to avoid paying more taxes themselves?

The real truth is that the economy is already weak. Corporate profits have been below analysts’ forecasts in the second half of 2012. In addition, we are interwoven in a global economy which includes a European recession and a slowing Chinese economy. Because the global economy is so interconnected, recessions elsewhere will have an impact.

Politicians also add drama. That is, they have an interest in “standing tough”. If an agreement were reached right off the bat, it would appear as one side lost the battle or was not doing it’s job. In other words, the longer they drag this out, the more it appears they are not letting the other party win.

In the end, the US government will be forced to deal with its budget problems. Because of the massive gap between tax revenue and its expenditures, there will be no options left except higher taxes and reduced benefits. Whether a consensus is reached in the short term or not, the huge deficit will be a drag on the economy for years to come.

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Filed under Economy, Finance

Like Europe We Have Our Own Problems

Lately, the media has been extensively covering the bad financial news coming out of Europe. Meanwhile, the financial problems here in the U.S. have persisted. This is not intended to downplay the importance of Europe to our economy and the global financial system. On the other hand, we have our own critical economic headwinds to be concerned with.

For starters, we have many states and localities that are nearly bankrupt. This is somewhat comparable to the members of the European Union. States, like European Union countries, cannot control their own money supply. Therefore, they have to raise taxes and cut benefits. One key difference, however, is that states don’t have the option to leave the union unlike the members of the EU.

The federal deficit is one of the biggest problems we currently face. The aging demographics only compounds the problem. Medicare especially will add strain to our government’s financial problems. The mushrooming costs of Medicare are simply not sustainable. In the future, our health care system will have to adapt and become more cost efficient. Health care costs have been rising much faster than incomes and inflation.

Our national debt has reached a level in which it will be a drag on the economy. According to Carmen Reinhart and Kenneth Rogoff’s This Time is Different, large federal deficits are a drag on economic growth. In this type of situation, government spending crowds out private investment. In addition, government spending has a slightly negative multiplier on the economy. This is the opposite of private investment.

The odds of government debt default are very high once a nation’s debt to GDP (Gross Domestic Product) ratio gets to be over 90%. That said, the term ‘default’ is much broader than simply failing to make the payments. The most common form of default is through inflation. In this situation, the decrease in value of a country’s currency reduces its debt burden. This is a form of cheating creditors because they are being repaid with money that’s less valuable compared to the principal that was originally lent.

In the end, large and growing federal deficits lead to subpar economic growth. Recovery from large deficits can be long and painful. At best, we will go through a muddle through period. This is a period similar to the environment we are currently in. Yes, GDP is growing. On the other hand, the growth rate is slow with unemployment persistently high. To many, this feels as if the last recession never ended. This has all happened despite the fact that the government has been on a spending binge.

The largest spending binges occur after financial crises according to the research done by Reinhart and Rogoff. The financial crisis of 2008 was no exception. In the long run, however, the extra spending will only add to the problem.

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Filed under Economy, Finance

Three Headwinds that Today’s College Students Face

You should always treat your education like it’s an investment. That said, when the cost of any investment rises beyond that point at which a reasonable return can be made, it’s time to look at different options. This may include not making a decision at all. It is also important to note that by doing nothing, you are still taking a position. In fact, we see this in investing all the time. For instance, by deciding not to be in the stock market, you are taking a position in either cash or an alternative investment.

In recent years, tuition prices have risen to unbelievable levels. Despite this, young students are advised they should go to college regardless of the cost. This can be bad advice. There are three major problems that students are dealing with today. Obviously, the high tuition fees result in high student loan balances. The average borrower in his or her 30’s today has a student loan debt balance of $28,500.

The second major headwind is the fact that the job market has been weak since the 2008-09 recession. This economic recovery has been unusually weak. Indeed, the unemployment rate for those who have degrees is generally lower. However, companies are reluctant to hire inexperienced workers and invest a large amount of capital to train them. This only makes the debt woes worse. Coupled with a high balance, new graduates are unable to make their loan payments. If they get behind on these payments, penalties and interest raise the loan balance. Student loan debt is also difficult to get rid of through bankruptcy. This is because most debt is issued or guaranteed by the federal government. Similar to that of income taxes, it’s much more difficult to default on government debt than private debt.

The third headwind college students face today is globalization and technology. Many mid-level professional jobs have been eliminated through automation and outsourcing. Being able to obtain a steady career with long-term employment is becoming rare. Since the economic recovery, retail and food service have been the fastest growing job sectors. This shows that there is a mismatch between what the market demands and what colleges are preparing students for.

The media, especially the financial news, likes to talk about the value of human capital. With the price of robotics falling and the productivity improvements of software, companies can get more done with less people. Where the jobs will come from in the future is unclear. This does not ensure that the future will be grim. Productivity gains lead to lower prices which is a great benefit for consumers. Lower prices can, in the end, lead to new industries and new innovation. If consumers can get more for less, history shows they willingly spend more. 

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Filed under Economy, Finance

How We Make Financial Decisions

Financial decision making is simply more tricky than it seems. When we make our decisions, they always seem rational at the time. In addition, economists mistakenly have looked for ways to justify our decisions as being rational. Obviously, this cannot be the case.

We often buy things on emotion. Economists would rationalize this by saying that the item we bought gave us the most utility at the time. In reality, the thing we bought could have been a snickers bar or a soda. Something with no real value, in other words. But it gave us a feeling of satisfaction. Does this qualify as a rational decision? I think not.

Many irrational decisions people make involve those that provide the most pleasure or the least pain. This casuses even the most disciplined of people to slip every once in a while. For instance, a motivated health guru doesn’t eat healthy 100% of the time.

Another decision making problem we have lies with our illusion of being able to predict the future. We are hardwired to look for patterns. Then, we take those patterns and expect trends to continue indefinitely. Obviously, very few trends continue indefinitely. Most of these trends are nearly random and regress to the mean over time.

Bull markets start once everyone has given up on a particular asset class. This makes it undervalued. Anything that’s undervalued will begin attracting savvy investors. A new trend is born. When a new asset establishes a track record of rising prices, it attracts more investors. The trend strengthens and becomes psychologically reinforcing. Usually, the asset is at or above its intrinsic value at this point.

When prices get unreasonably past their fair values, a bubble is born. A crash becomes inevitable. But its difficult to stop and cash in. This is because it’s impossible to know when prices peak. A rational investor could stand to miss a big portion of the upside because a bubble could persist for longer than one would reasonably assume.

Governments also play a big role in bubbles. In fact, they will do anything to keep the party going. Keeping interest rates low is the perfect example. Lax lending standards and rising debt levels are a red flag that a bubble exists. Examples of this include buying stocks on margin and leveraging real estate.

The nature of bubbles reflects that most investors buy near the top. If an upward trend doesn’t exist for an asset, no one talks about it. Out of sight, out of mind. Gold simply wasn’t discussed in the 1990’s. The law of large numbers would show that the asset pool was too small at the beginning of the bull market in order for the majority to have owned it. If the masses were holding any particular thing, the prices would have been higher. And no new trend could get any traction.

We make our decisions based on what others are doing. In order to achieve long term success, try looking for the assets no one else is buying or discussing.

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Filed under Finance, Investing

Tough Economic Times Call for More Liquidity

Liquidity is one of the most important factors when deciding on how to manage your financial assets. Tough economic times are usually temporary. During times like these, you should err on the side of caution and have plenty of liquid and non-volatile assets. This does not mean you need to turn into a gold bug. However, when deciding to pay down your mortgage, think twice. Should you need access to that money within 5 years, you should find a more liquid investment for your capital instead and keep making the minimum monthly payments.

The equity in your home is not liquid. This means that you simply cannot withdraw and use it anytime as if it were money in the bank. You must plan for the unexpected. You should always maintain some liquidity because there will inevitably be times in which you need cash fast.

There was a time where people believed that equity was almost equal to cash. In a healthy market, you would indeed be able to refinance or sell quickly to extract your equity. This is not the case anymore. It is much harder to quality for a refinance even if you have positive equity. Your credit must be very good and you need to prove your income has been steady for the last few years. In the current environment, you cannot assume that all of your home equity is readily accessible.

When the economic environment is good, people seldom need cash. And cash is much easier to borrow. This is especially the case when asset prices are rising. When the economy is contracting or at stall speed, it is a different story. Lending will often seize up and the capacity you had to borrow will also be gone. Most people take this for granted during the good times.

The harder times generally present the best opportunities. The real catch is that they are difficult to take advantage of. For example, real estate is a great buy in many regions today. At the same time, how many people can afford it right now? How many people are lendable especially for investment purposes? So, despite the enormous opportunities that exist, they are out of reach for many. The statement that bear markets present great opportunities for investors is only a half truth. This is only true to either a new investor or an investor that is buying that asset class with no prior holdings of it. This also assumes that you both have the ability to recognize the opportunity and the means to be able to afford it.

A cynic usually says that a bank will only lend you money when you can prove you don’t need it. This has been quite true at times.

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Filed under Finance, Investing, Real Estate, Uncategorized

Why Almost Everything is a Numbers Game

We always think of business as being a numbers game. However, numbers apply to almost anything, especially sports. In football, Bill Walsh developed a system that resulted in scoring more points and reduced risk by limiting turnovers. In baseball, Billy Beane used statistics to find undervalued players to fit his team’s tight budget. This shows that you can find an arbitrage and increase efficiency in almost anything.

Michael Lewis, a financial writer, wrote two great books on applying numbers in sports. The first was Moneyball. In this book, Lewis uncovered how batting average was a statistic that was over used. This has traditionally been the biggest statistic in which a player’s performance would be judged. Billy Beane, having to replace key players that left the team for more money, had to find a way to maintain production (scoring runs) without these major stars. He found that batting average wasn’t a perfect indicator as to how many runs a team would score. Of course, the higher the batting average, the better in general. But, there were other stats that did the job more accurately.

The key point here is that slugging percentage, walks, and on-base percentage are better metrics than batting average at estimating runs scored. However, the market (other teams), were using batting average as their key metric. This created enormous opportunities in the marketplace. Baseball has long been a game of tradition. And those working within the game were reluctant to change. This included everyone from owners to general managers and coaches. Billy Beane was able to replace stars with low budget players while the team kept winning.

In the investing world, we see examples of this all the time. Quarterly and annual earnings are an over used statistic, not to mention the fact that they’re also heavily manipulated. Also, there are those who only buy securities based on recent price performance. Stocks that have been going up generally attract more buyers. We’ve seen Benjamin Graham and Warren Buffet take advantage of these arbitrage opportunities by separating the real value of the company from the price of the stock. They care more about the business’s fundamentals than the stock.

In The Blind Side, Michael Lewis described the evolution of football over the last few decades. When Bill Walsh took over the San Francisco 49ers in 1979, he revolutionized the game. He introduced an offense that consisted of shorter passes. Not only did this new offense score more points, it also reduced risk. Shorter passes get intercepted less often. Plus, the quarterback gets rid of the ball quickly which reduces the likelihood of getting sacked. Replacing the traditional approach with higher percentage plays, Bill Walsh would win 3 Super Bowls.

Sports is a numbers game just like any other business. We can learn quite a bit from the competitive world of sports. The first is that most people favor the traditional ways of doing things which creates opportunity for you. The second thing is that we should always strive to maximize productivity while reducing risk. Many games are won or lost based on how many mistakes were made.

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Filed under Finance, Small Business

Why Opportunity Cost Should Always be a Consideration in Your Financial Decisions

Let’s say that you are in a position where you have extra money to pay off your mortgage. Is it worth doing? The short answer is that it depends. To arrive at a good answer, you must consider the other opportunities that you have with that money.

For starters, there may be other investments available to you. I am not referring to the stock market or any other exchange traded security. These tend to offer low yields over very long periods of time. The historical return for stocks has averaged around 6% over the past 100 years. Therefore, if I had a choice between paying off my house versus purchasing stocks, I would rather pay off the home loan. In addition, the stock market is very volatile and returns can be significantly below their long term averages over 10 to 15 year periods. We are in such a cycle now. If the interest rate on my mortgage is 6%, then I will not likely gain anything by deploying the extra cash into stocks.

What if you had more opportunities than this? What if you were considering to start or expand your own business? Obviously, there is more risk to that. However, the return on your capital investment will likely be much higher than investing in securities. In this situation, the rate of return would be much greater than the amount of interest that you’re required to pay on the mortgage. In this case, you’re better off investing the money rather than paying off your loan.

The opportunity cost demonstrates that my returns are negative if I pay off my mortgage when I have better ways to invest the money. If you plan on starting a new business, home equity is much cheaper than most of the alternatives. SBA loans, in particular, consist of higher fees and higher interest rates. This is because it’s hard for lenders to value the collateral and default rates are high. When they take possession of the collateral after a default, it’s much harder to sell at fair market value than a residential property.

Lastly, depending on your tax situation, the true cost of borrowing may be below your interest rate. Since mortgage interest is tax deductible for most taxpayers, the tax savings could be factored into offsetting the amount you are paying in interest. Your tax savings depends on what tax bracket you’re in. So, if you’re thinking about paying off your home loan, definitely look at all your other opportunities first.

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Filed under Finance, Small Business

The Reality of Wheelin’ and Dealin’

Making deals sounds fun and exiting, right? Not so fast. If you’re survival always depended on making deals, how stressed out would you be?

Imagine you had a period of success. In fact, you had several months in which you had deals that gave you a surplus of money. Also, this was your only income from a business in which you owned. Therefore, you had no steady paycheck. Eventually, things tend to even out. You have a slow month or two. At first, you do not worry because you accumulated some extra cash from previous months.

Yes, you were stressed out a little bit at the very beginning. But things came together and money was flowing in. Then the dry spell came. Within the first month, you changed none of your habits and were not worried. You assumed that since you had some recent success, more deals must be around the corner.

Then the second month passes and things are still slow. You start to get nervous and begin to wonder when things will return to normal. You still have some money left so there is no need to panic yet. However, things start to get stressful. In the back of your mind, you start playing the ‘what if’ game. You ask what if I cannot make the mortgage payment or buy food a couple months from now. You wonder if the last few successful months were just an anomaly.

After considering that, you look at your average income over the last year. Not bad. But, what if you had a steady income and every two weeks you were guaranteed to get paid? It would seem like you got a raise.

If your income relies on your investments or by collecting commissions, you will not have a steady income. A steady income is simply worth more than making an equivalent amount that comes in bursts. It is also much more stressful.

This is a big reason why most successful investors place more emphasis on risk than on returns. Managing risk first will relieve much of the stress that comes from deal making. The more erratic your income stream is, the more cash you need to have as a reserve.

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Filed under Finance, Investing

Debt Restructuring for a Fresh Start

Debt restructuring is a process that allows individuals facing cash flow problems and financial hardship, to reduce and negotiate their outstanding debts in order to restore liquidity in order to make progress. Financial debt problems threaten large numbers of folks. Many companies offer financial debt restructuring and consolidation services. Debt restructuring and debt consolidation offers the opportunity to reduce debt, handle your finances and start all over again with additional understanding of management of your capital.

Many debt consolidation programs are useless because they just change the terms of your loans without of addressing the main issue which simply is too much debt. If fact, the wrong program can cause you to pay more money in interest and for a longer duration. This type of situation often involves ‘kicking the can down the road’ and doesn’t attack the root of the problem. You should have an accountant look over your financial situation before agreeing to a debt consolidation program.

There are times in which bankruptcy is your best option. Bankruptcy has a very negative connotation to it. This is unfortunate because it can give you the opportunity for a fresh start. For example, if you lose your underwater home in a bankruptcy, you’ll be eligible to purchase another home in just 2 years. This is good in the end because the next home you buy will likely be much cheaper. Therefore, the monthly payment will be much less. Also, you will have a clean balance sheet.

Many personal debt problems ultimately stem from having negative equity in their home. Attempting to pay down the loan is too overwhelming and simply makes no business sense. This is why you should approach your financial situation like a business. In many cases, restructuring is the only sensible option. There are definitely consequences involved. On the other hand, there are consequences of doing nothing and consequences of believing that paying your debts is a moral issue.

When there is no realistic change to pay off a debt, some form of restructuring is inevitable. This is the case for the Greek government. Greece has already accumulated so much debt that there is virtually zero chance of paying it off. Even if the government raises taxes, it will still be nearly impossible because the economy would collapse as a result of the tax increases. Your personal balance sheet is no different than that of a coporation or a nation.

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Filed under Finance, Real Estate