Out Today

I'm out today. See you next week!

On Capital Gains & Losses Conclusion Tax Deferred Accounts.

Today we'll finish up discussing how we believe investors should approach capital losses in tax deferred accounts. The first thing to understand is that none of the potential tax benefits that apply to harvesting losses accrues to tax deferred accounts. You take a loss here its a loss with no governmental benefit. Never-the-less I think that everything we discussed regarding losses in taxable accounts also applies here, including trying to lower the cost basis of securities. That will likely mean realizing capital losses at some point. Here are some points to consider.

The loss has already occurred. Forget the old sayings about how it's not a loss until you book it. That's simply not true. Your portfolio is graded everyday by Mr. Market. Good grades are gains and bad grades are losses and its value is what the market will pay for your securities. Inevitably after a crash that worth is usually a good deal less. Taking the opportunity to lower your cost basis means that at some point you are likely adding to securities you like and perhaps selling parts or all of them at higher prices. When we've experienced declines of the magnitude we've seen in the past few years it is inevitable that in this process you will be booking losses previously incurred.

Losses as we have stated are part of the investment business. Everybody, even Warren Buffett, will incurr them during their careers. The investment process is a forward looking discipline. Each security should be analyzed with an eye toward the future. Inevitably this will mean that investments with a poor or cloudy outlook should be removed, without regard to what has already occurred. If this means at some point booking some losers then so be it. It is unrealistic to expect that a portfolio will never have any losers or poor performers. Nobody bats 1000 in this business.

Taking losses removes the often psychologically debilitating process of constantly staring at losing positions. For most of us it is often hard to stare at the same money losing investments, sometimes in the case of a crash, year after year. Too often the inability or unwillingness to remove these assets also removes the discipline needed to properly judge a portfolio and can blind investors to better opportunities in the future. Pruning losers by removing them or attempting to lower your cost basis can over time help take care of this problem.

There is never anything wrong with adding to good investments. Ideally you want to do this when the market is giving them away. That will often be when the world looks like it is coming apart as it did this past year. Investors who purchased securities at any given time in the last 8 months have likely felt scared, foolish or both. Right now with the market having advanced for much of July they are likely being rewarded. If they did the right thing by working to lower cost basis even in tax deferred accounts earlier this year then that strategy is currently reaping dividends. Assuming all of the criteria we discussed yesterday apply-that is you still like the investment merits of the security in your portfolio and its decline is largely an issue related to a market correction or crash-that I believe you apply the same criteria on lowering cost basis as we discussed in taxable accounts.

Finally I realize that it is often hard to realize these losses and not everybody will agree with my approach. But losses are a part of the process and it is one each of us must become used to. Doing it in a correct manner can have major positive implications for investment portfolios over the longer term.

I hope you enjoyed this investment series and found it useful. Look for a new series on investment risk starting sometime after Labor Day!

We are covering in this series what we believe is the proper procedures regarding the application of capital losses for investors at Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor before implementing any of these strategies listed in these posts. Also you should consult your own tax professional before implementing your personal strategy for capital losses. This series is a general overview and should not be considered personal tax advice of any kind. Please note as well that tax laws could change in the future which could impact the implementation of these strategies or negate some or all of the advantages of harvesting capital losses. Finally you should be aware that we have not covered all of the possible risks to which ETFs could possibly be subjected. When discussing the risks regarding ETFS, we have no knowledge nor do we make any guarantees whether some of the same issues and risks particular to equities could ultimately affect ETFs as well. Again please consult your own investment advisor or do your own homework as to the appropriateness of these investments for your portfolio You can also visit any of the popular ETF websites for a further discussion of this topic.

On Capital Gains & Losses Conclusion-Taxable Accounts.

Today and tomorrow we'll finish our summer series on capital losses with a look on how to apply this to client accounts. For a past review of this series, please link here: http://lumencapital.blogspot.com/2009/07/on-capital-gains-losses-part-vii.html. Today I'll cover some thoughts of what to do with taxable investment accounts. Tomorrow we'll tackle the issue of tax-deferred accounts such as IRAs.
Earlier in this series I indicated that investors need to first assess the reason for how losses have occurred in their portfolios. If investing is done correctly losses principally are made from three causes: Bad investment timing, bad investment thesis and a market crash. Before doing anything investors need to review the nature of how their their losses occurred in order to determine what kind of investment tactics should be used. Of course investors should also review whether any of the principles we are about to discuss apply to their own personal situation. They should either do this on their own or with a financial or tax advisor. For now we are reviewing in general what we believe investors should consider. Their own personal situations may vary.

In the case of a bad investment thesis these assets should either be sold or marked for a sale at some more opportune moment. Investments that have declined largely due to poor market timing need to be reviewed on an individual basis. This review of the reason for owning a security in this situation should lead to a decision to lower the cost basis by adding to the security, removing it from the portfolio or leaving it alone for the time being. Finally we must deal with what we believe investors should consider in the current environment which is the results of a market crash.*

There is no better example of bad market timing than when owning an investment prior to a market crash. But a market crash is less about the issues with a single company or industry than a representation of a rapid and panicked reordering of the investment world. As such when the dust settles investors need to reassess their portfolios first with a renewed outlook on their own risk/reward profile {a subject not part of this series} and then reassess with an outlook towards three principles:

1. How has the world been reordered?

2. What are the winners and losers in my portfolio?

3. What steps can I take to lower the cost basis of that part of my portfolio I wish to keep?

The first step of reassessing the investment world post-market crash is also beyond the scope of this series but this is what I believe. Market crashes almost universally signal the end of an era. Sometimes it signals the change of investment leadership. Sometimes it signals a re-ordering of the social or political world. It is usually impossible to immediately understand what that re-ordering will look like. For instance the "Dot.com" bust in 2000-01 signaled the end of a nearly decade long out performance of technology stocks. Similarly Great Britain left the gold standard in 1931. It's doing so and the subsequent decline in world stock market prices signaled in retrospect a changing of the international political guard. This would not be fully recognized until the end of World War II. What we do know is that there will be winners and losers as the world changes. It is our responsibility to search these out for our clients. I would also note that almost every market crash-including our current situation-has at least been followed by some kind of rally where performing this readjustment is often possible.

Finally there is the issue of lowering cost basis. We have chronicled in past articles in this series the reasons for doing this in taxable accounts. First $3,000 of net capital losses can generally be deducted against ordinary income. This can be carried forward into the future. Second net tax losses can generally be carried forward to offset taxable gains in future years. Given the voracious need by governments at all levels for income and given that there is no current indication that these rules will be changed, then it is important to try and shield future gains from governmental confiscation.

This lowering of cost basis can be done in two different ways. One method is to exchange similar but not identical securities. For instance a growth oriented mutual fund carried at a loss on an investor's books can be sold and a similar fund from a different mutual fund family could be bought. Since these investments are not the same security they generally do not run afoul of the wash sale rule which we discussed previously. One caveat here {and again remember that I am not a tax advisor!} is that to me the rules on similar but not identical securities are somewhat opaque. I do not often recommend this strategy and I would strongly suggest you consult your personal tax or financial advisor before carrying out this strategy .

The second {and our preferred method for harvesting tax losses} is to either purchase or sell parts or the whole of a security, hold it for 30 days and then repurchase or sell out that same investment. Here the rules for establishing losses are pretty ironclad. Also so not as to run afoul of the code, my general rule is to wait one additional day before purchasing back or selling the security. Below, I'll give you a general example of how this works. There is more to this strategy but for this post a general example should suffice. Again consult with your tax advisor if you want a more thorough understanding of these rules.

100 shares of security "ABC" was purchased on 03.03.07 at a price of 57. It currently trades at 29. Investor A reviews the security and decides that it is still a good investment and one he wants to keep it as part of his portfolio. He buys another 100 shares on 7.01.09 at that 29 price. He must then wait 30 calendar days or by my rule 31 calendar days. He then sells 100 shares of "ABC" designating it versus purchase on that original 03.03.07 date. Let's say he sells it at 30.{Before some of you look at the calender and notice that the 31st day which would be August 1st falls on a Saturday, remember this is for illustration purposes only. In the real world I am aware that he would have to wait until August 3rd to actually complete this transaction under my rules.}

So what have we done. Assuming the investor waits the proper period, he has booked a loss of $2,700. {57-30= 27 points. 27 points x 100 shares = -$2,700}. He still owns the original security, albeit now at a lower cost basis and he has a loss on his books that based on current tax laws he can use to his advantage going forward. Forgetting the issue of offsetting personal income, if either this year or in the future he has realized capital gains then he will be able to use this to his advantage by offsetting his cumulative losses versus these gains.

I've said in the past that nobody wants losses. However they are a part of the investment world. Above we've discussed how you can use these to your advantage in a taxable account. Tomorrow we'll discuss why I believe you should employ the same strategies in tax deferred accounts as well.

*We are covering in this series what we believe is the proper procedures regarding the application of capital losses for investors at Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor before implementing any of these strategies listed in these posts. Also you should consult your own tax professional before implementing your personal strategy for capital losses. This series is a general overview and should not be considered personal tax advice of any kind. Please note as well that tax laws could change in the future which could impact the implementation of these strategies or negate some or all of the advantages of harvesting capital losses. Finally you should be aware that we have not covered all of the possible risks to which ETFs could possibly be subjected. When discussing the risks regarding ETFS, we have no knowledge nor do we make any guarantees whether some of the same issues and risks particular to equities could ultimately affect ETFs as well. Again please consult your own investment advisor or do your own homework as to the appropriateness of these investments for your portfolio You can also visit any of the popular ETF websites for a further discussion of this topic.

Hedge Funds Back From The Dead

24/7 Wall Street out with a story about the rebound of the hedge fund business. They place a lot of the credit for this on the incredible run stocks have seen since March. I think there's something to that argument but I also think it needs to be pointed out that the hedge fund industry as a whole did better than the markets last year. Now that's not to say that they made money-for the most part they did not. It's also not to say that there weren't spectacular losses at some funds or to note that many went out of business. But I think one of the reasons for the interest in hedge funds is due to some of their investment strategies for both bull and bear markets which have been tested and found to work over time.

Firm marketing note. Like us, most hedge funds employ a variant view of the investment world. We employ certain hedge fund strategies for proper risk oriented private accounts. Please give us a call if you would like us to review for you what these strategies are and how they could be used in your investment portfolio.

Excerpt and link: http://247wallst.com/2009/07/21/the-remarkable-resurrection-of-hedge-funds/#more-41592

The Remarkable Resurrection Of Hedge Funds
Posted: July 21, 2009 at 6:07 pm
The recovery has really begun to lift all ships when the hedge fund industry can claim that it has risen almost instantly from the death that it suffered in the final quarter of last year......The quarter that just ended was one in which much of {their} bad fortune was reversed. Hedge Fund Research told the FT that assets under management rose $142 billion. Overall, performance of funds was the best it has been in 10 years.
There is a temptation to say that hedge fund managers got some of their skills back and that attests for the stunning improvement. What the industry has avoided advertising is that the S&P 500 rose from 676 in mid-March to 923 on July 1. A monkey throwing darts should have matched the 36% return in the index over that period.
The exciting performance has caused people who forecast hedge fund investments to assume that clients and potential clients will pour tens of billions of more dollars into these investment vehicles over the next quarter. That will undoubtedly happen as caution gives way to greed, the normal course of things after a huge market sell-off and partial rebound. Investors cannot stand missing the last train to the big party.
It will only be a big party if the market can run back up to where the S&P was two years ago at 1,200. This would mean that almost all of the money that evaporated in the collapse of equities would have returned, magically, in a short period of time......
The improvement in the prospects of hedge funds is a reminder of how short the memories of investors can be. March was as bad a month as most investors had experienced in a generation or longer. March is only a little over 100 days gone.
The risk that the market cannot go up much from here is rising. That is old news and something which is said by market analysts and economist every day. Their concerns do not seem to matter much. The broad indices are higher by over 6% during the last month. Each day that the market is supposed to pull back and catch its breath, it rises again. ............The chances for optimists to focus on more possibly good news could continue into the beginning of August.
Earnings may not be adequate to advance the market another 20%, but July unemployment numbers are only two weeks away. Job losses under 300,000 for the month could cause a frenzy of buying, no matter that 10% of Americans will be out of work. Hedge funds are for making money. Suffering is for those who are broke.
Douglas A. McIntyre

Picture Worth A Thousand Words. Tax Burden

A year old study from the Tax Foundation looking at the narrowing of the tax burden. When Reagan was President only 18% of tax returns carried no tax liability. That is only 18% paid no taxes. This study looked at both Obama and McCain's tax proposals. Under either a President Obama or a President McCain the tax burden continues to narrow. Under Obama the income tax burden will be born by 56% of the population. This does not include state or local tax analysis so that number is probably a lot higher.

Corporate Earnings.

This from the folks at "Chart Of The Day". It shows earnings falling off a cliff. Remember though that the market at this point really only cares about earnings looking forward.

"Today {Thursday}, several companies (i.e. Ford, eBay and AT&T) reported better than expected earnings and as a result the stock market rallied on the news. While some companies have reported better than expected earnings for Q2 2009, others have struggled. Today's chart provides some perspective on the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. Today's chart illustrates how earnings are expected (38% of S&P 500 companies have reported for Q2 2009) to have declined over 98% since peaking in Q3 2007, making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.

Link to their website. {subscription required}: https://www.chartoftheday.com/

an tSionna: Where Has All The Volume Gone

The question asked above refers to the divergence in volume from price. Usually the divergence between rising prices and declining equity volume is considered a negative for future price action. I'm not so sure any more. I can't prove this but my instincts are telling me that ETFs are soaking up most of investors' equity today. It seems to me that with over 700 ETFs that its possible investors prefer their diversification to the single stock risk of individual stocks. The more money that goes into these is less money available to purchase stock.

Not the only possibility out there. But it is one to consider.

*Long ETFs related to the S&P 500 in client and personal accounts.

Link: http://pragcap.com/chart-of-the-day-where-is-the-volume

Stocks Held

Stocks held their gains into the last hour. Just an amazing move these past two weeks. Longest winning streak for the Nasdaq since 1992.

*Long ETFs related to the NASDAQ 100 in client and personal accounts.

WOW!

I wish I know what to say about today's trading. Anything could of course happen in the last hour but we've got equities breaking out all over. I truly don't know if this is a big breakout or a big head fake. I know this is a big move but I also know we're over bought. Volume has also not been heavy which is worrisome. We'll see what the last hour brings! Probability isn't always correct! {See yesterday's chart!}

*Long ETFs related to the S&P 500 for client and personal accounts.

ETFs Continue To Take Market Share.

From the Street.com's contributor Don Dion on ETFs.

"Within the next few years, exchange-traded funds will likely overwhelm a sizeable chunk of the mutual fund universe, according to a recent study conducted by the research and consulting firm Novarica. The New-York based firm anticipates that by 2015, nearly half of all mutual funds will be replaced by their cost-efficient brethren. The number of mutual funds is projected to drop from 8,022 to 4,237, with assets falling from $9.0 trillion to $6.75 trillion over that period. Meanwhile, Novarica anticipates a steep increase in ETF quantity (up to 2,618 from 728) and assets ($500 billion to $1.15 trillion).
To account for these ambitious predictions, Novarica has pointed to the cost-effective and transparent qualities of ETF securities. For instance, ETFs trade throughout the day, as opposed to being limited to single daily trading values with mutual funds. Furthermore, passively managed exchange-traded funds commonly offer lower expense ratios than their mutual fund equivalents. All in all, these savings net superior long-term portfolio performance, and that may help explain Novarica's extreme statistical projections.
As of 2009, Novarica's findings do have some grounding. This year marked Pimco's transition into the ETF realm (Pimco's first ETF, the 1-3 Year U.S. Treasury Index Fund (TUZ) , hit markets in early June). Meanwhile, Charles Schwab (SCHW) carried out a preliminary filing for its first ETF this past January.
While a steady inflow of 25 ETFs per month (based on Novarica projections) may sound a bit overzealous, these firms have surely set the stage for a paradigm shift in investment preferences."

Link: http://www.thestreet.com/b/rmoney/etf/10542861.html

*Disclosure: We own many different ETFs for clients and personally in accounts. Charles Schwab & Co. also is the custodian for many of our client accounts.

an tSionna 7.21.09

Double click on chart to enlarge.

Crashes & Outside Events.

Reprint of an article I did a few years ago about an unlooked for event that smacked New England back in 1938. If, rather I should say when, a baby like this hits again, the markets will likely get clobbered.

http://lumencapital.blogspot.com/2006/02/long-island-express-nbbt-part-iii.html

On Capital Gains & Losses Part VII

Today and next week we will wrap up our series on Capital Gains & Losses. I guess it really should have been titled dealing with capital losses due to what we've covered. Today I'm posting a quick link of all our previous posts on this subject. A one stop shop so to speak of everything we've covered so far.

We began back in June with a Barron's article that served as the genesis for this series. http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-i.html. After that we laid out the reality of how long term investors are carrying losses on this book for most of the past ten years: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-ii.html. We then held a Q& A on some questions I'd received: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-iii.html Next we discussed the frustration that investors have likely been feeling http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-iv.html and then we broke the issue of losses into three categories: bad investment timing http://lumencapital.blogspot.com/2009/07/on-capital-gains-losses-part-v1.html wrong investment thesis & accounting irregularities http://lumencapital.blogspot.com/2009/07/on-capital-gains-losses-part-v2.html and finally http://lumencapital.blogspot.com/2009/07/on-capital-gains-losses-part-v3.html market crashes. Last week we gave a brief overview of the tax laws regarding capital losses. Next week we'll finish up the series by discussing how to implement tax harvesting in portfolios.

Detroit: Q & A.

Last week we covered a story from The Nation Magazine on Detroit. I was asked by several readers about the photo in the post. Specifically they wanted to know what building this was and where is it located. It is the Michigan Central Depot. This from City Magazine in June of 2007: http://www.city-magazine.com/intransit/archive.html#06/11/07/12:50/PM This is an excerpt from that post.

"One of Detroit's major "attractions" is its breathtaking and heartbreaking collection of pre-Depression brick skyscrapers dotting its skyline. Grand Circus Park, which lies just to the west of Comerica Park and Ford Field (the home of baseball's Tiger's and football's Lions, respectively) has long been described as a "skyscraper graveyard" thanks to buildings like the Kales Building, Broderick Tower, and the demolished Statler Hotel. Gorgeous Art Deco towers that would have been converted to condos 20 years ago anywhere else are finally beginning to undergo some restoration (with the Book-Cadillac Hotel leading the way).
But there is no hope for the Michigan Central Depot.
Opened in 1913, and designed by the same architects who built Grand Central Station, the MCS has sat abandoned far from downtown for nearly 20 years. Ransacked over and over by vandals and scavengers, with every single window on its 18-story facade busted, it is the Ozymandias of urban architecture, and a tombstone on the grave of urban density. Built far away for the purpose of luring Detroit's central business district to the area, that plan backfired when the Depression hit and the city closed both trolley and streetcar service across the city. (When everybody has a nearly free car from their Big Three employer, who needs mass transit?) The station entered immediate decline. The advent of Amtrak helped it stick around until Jan. 6 1988, when the last Amtrak train pulled away from the station. There are no current plans to either restore or demolish the building."

Asset Allocation: Some New Numbers.

Some interesting tidbits on asset allocation.

STOCK AND BOND REBALANCING - If you had invested $100,000 on 1/1/79 and split the money 70/30 between stocks (S&P 500) and bonds (Lehman Brothers Aggregate Bond Index) and never rebalanced, the total would have been $1.96 million after 30 years (1/1/09). If you rebalanced back to a 70/30 split at the end of each year, the final accumulation would be $2.07 million. The Lehman Brothers Aggregate bond index, calculated using 6,000 publicly traded government and corporate bonds with an average maturity of 10 years, was used as the bond measurement (source: BTN Research via Direxion Funds-By The Numbers. 6.29.09).

USING BOTH ASSET CLASSES - In the last 30 calendar years (1979-2008), a 70/30 mixture of stocks to bonds (with annual rebalancing) produced an average annual total return of +10.6% with the worst year being a 24.3% loss in 2008. A 100% stock portfolio produced a +11.0% average annual total return with the worst year being a 37.0% loss in 2008. Thus the stock/bond combination produced 96% of the return of the all-stock portfolio with less volatility. The S&P 500 was the stock proxy while the Lehman Brothers Aggregate bond index was used as the debt proxy (source: BTN Research via Direxion Funds- By The Numbers. 6.29.09).

Detroit: Touring Empire's Ruins.

This article appeared in The Nation June 23, 2009. While The Nation is usually way out there as far as I'm concerned, I thought this was a good story about what has happened to Detroit and decided to Excerpt it for you. This is a long article so I've only posted the parts regarding Detroit itself. As an aside I went to law school in Toledo, Ohio { a town also not in great shape} and since Detroit was only about an hour away, used to go up there all the time to Tiger's baseball and Redwing's hockey games. Even then the sections of Detroit we used to pass through on the highway looked like parts of Berlin circa 1945-47. A doctor buddy of mine who did part of his residency in inner city Detroit tells of being chased by packs of dogs. {Excerpt}

Touring Empire's Ruins: From Detroit to the Amazon
By Greg Grandin, June 23, 2009 This article originally appeared on TomDispatch.

The empire ends with a pullout. Not, as many supposed a few years ago, from Iraq....But from Detroit. ..... Of course, the real evacuation of the Motor City began decades ago, when Ford, General Motors and Chrysler started to move more and more of their operations out of the downtown area to harder to unionize rural areas and suburbs and, finally, overseas. Even as the economy boomed in the 1950s and 1960s, fifty Detroit residents were already packing up and leaving their city every day. By the time the Berlin Wall fell in 1989, Detroit could count tens of thousands of empty lots and over 15,000 abandoned homes. Stunning Beaux Arts and modernist buildings were left deserted to return to nature, their floors and roofs covered by switchgrass. They now serve as little more than ornate birdhouses.
In mythological terms, however, Detroit remains the ancestral birthplace of storied American capitalism......Forget the possession of a colony or the bomb, in the second half of the twentieth century, the real marker of a world power was the ability to make a precision V-8.
There have been dissections aplenty of what went wrong with the US auto industry, as well as fond reminiscences about Detroit's salad days......Few of these post-mortems have conveyed, however, just how crucial Detroit was to US foreign policy--not just as the anchor of America's high-tech, high-profit export economy, but as a confirmation of our sense of ourselves as the world's premier power......
......Detroit not only supplied a continual stream of symbols of America's cultural power but offered the organizational know-how necessary to run a vast industrial enterprise like a car company--or an empire. Pundits love to quote GM President "Engine" Charlie Wilson, who once famously said that he thought what was good for America "was good for General Motors, and vice versa." It's rarely noted, however, that Wilson made his remark at his Senate confirmation hearings to be Dwight D. Eisenhower's secretary of defense. At the Pentagon, Wilson would impose GM's corporate bureaucratic model on the armed forces, modernizing them to fight the cold war.
After GM, it was Ford's turn to take the reins {Former Ford CEO) Robert McNamara.....used Ford's integrated "systems management" approach to wage "mechanized, dehumanizing slaughter," as historian Gabriel Kolko once put it, from the skies over Vietnam, Laos and Cambodia.
Perhaps, then, we should think of the ruins of Detroit as our Roman Forum......Among the most imposing is Henry Ford's Highland Park factory, shuttered since the late 1950s. Dubbed the Crystal Palace for its floor-to-ceiling glass walls, it was here that Ford perfected assembly-line production, building up to 9,000 Model Ts a day--a million by 1915--catapulting the United States light-years ahead of industrial Europe.
It was also here that Ford first paid his workers five dollars a day, creating one of the fastest growing and most prosperous working-class neighborhoods in all of America, filled with fine arts-and-crafts-style homes. Today, Highland Park looks like a war zone, its streets covered with shattered glass and lined with burnt-out houses. More than 30 percent of its population lives in poverty, and you don't want to know the unemployment numbers (more than 20 percent) or the median yearly income (less than $20,000)......

......Ford preached with a pastor's confidence his one true idea: ever-increasing productivity combined with ever increasing pay would both relieve human drudgery and create prosperous working-class communities, with corporate profits dependent on the continual expansion of consumer demand. "High wages," as Ford put it, to create "large markets." By the late 1920s, Fordism--as this idea came to be called--was synonymous with Americanism, envied the world over for having apparently humanized industrial capitalism.
But Fordism contained within itself the seeds of its own undoing: the breaking down of the assembly process into smaller and smaller tasks, combined with rapid advances in transportation and communication, made it easier for manufacturers to break out of the dependent relationship established by Ford between high wages and large markets. Goods could be made in one place and sold somewhere else, removing the incentive employers had to pay workers enough to buy the products they made.
In Rome, the ruins came after the empire fell. In the United States, the destruction of Detroit happened even as the country was rising to new heights as a superpower.
Ford sensed this unraveling early on and responded to it, trying at least to slow it, in ever more eccentric ways. He established throughout Michigan a series of decentralized "village-industries" designed to balance farm and factory work and rescue small-town America. Yet his pastoral communes were no match for the raw power of the changes he had played such a large part in engendering......

The Great Reset-One Firm's Perspective.

Comstock Partners report on why the economy will remain weak. Another firm's illustration with actual numbers of what we call the "Great Reset".

Link:http://www.comstockfunds.com/(X(1)S(gtfqqa45nhrmof2wkvlbsmiy))/screenprint.aspx?newsletterid=1464

The term "green shoots" appears destined to go down in history with other unfortunate themes such as "a goldilocks economy";......Whenever a herd of investors latches on to a popular theme, that theme most often proves to be wrong. So far the "green shoots" theory merely signifies that the economy is declining at a slower pace after the global credit crisis that emerged last fall. From this point we will see either continued recession or a recovery so weak it will still seem like recession.
The key factor to consider is that the current recession was caused by a credit crisis following an artificial boom and therefore bears more resemblance to the great depression following 1929 or Japan after 1989.than it does to the series of recessions experienced in the post World War ll period. After the collapse of the dot-com boom in 2000-to-2002 the Fed held interest rates at historically low levels for an extended period of time, and with the help of lax mortgage standards, complex securitized financial instruments and irresponsible ratings agencies, fostered a climate that resulted in a massive housing boom. Households were able to cash out their vastly increased home values through refinancing and home equity loans that allowed them to spend freely and reduce their savings even though wage growth was exceedingly sluggish. The consumer boom also led to the global buildup of capacity to satisfy the demand that was artificially induced by the free flow of credit that was mistaken for an abundance of liquidity by most economists and strategists.
Now the piper must be paid. ......{T}he consumer is being forced to adjust to a far lower level of spending. When that level is eventually reached the economy can again grow in a robust manner, but we are not near that point now. The massive fiscal and monetary stimulation put into effect over the last nine months has mitigated the credit crisis and prevented a global collapse, but has not avoided the need for the economy to readjust to a new set of circumstances. We are still faced with historically high debt levels, a low household savings rate and a subdued housing industry. Reducing debt and getting the savings rate up will take an extended period of time. Furthermore, as a result of reduced consumer spending there is also an excess of capacity that will impede capital expenditures as well. And let's not forget that foreign nations that have become dependent on the U.S. consumer for growth (read China) will have to find another way.
......{C}onsider the following. From 1955 to 1985 consumer spending accounted for between 61% and 64% of GDP. On March 31st, this percentage had risen to 70.5%, an amount that is unsustainable given the artificiality of the boom that caused it. For the percentage to drop to a more traditional 65% of GDP, spending would have to decline by 7.8%.......
Similar reasoning is applicable to household debt and savings. Household debt has averaged 55% of GDP over the last 55 years and was still at 64% as late as 1995. It has since soared to 100%, giving a big boost to spending. Even if debt remains at a high level the absence of any further increase takes away a significant past source of growth......
....All in all the recession we are now experiencing is not a typical post-war decline, but the end of an era, and getting the economy back on its long-term growth trajectory will take an extended period of time. For the stock market this means a reduced level of corporate earnings and subdued price-to-earnings ratios........

an-tSionna: Sound & Fury

So I go away for a few days and the market does......nothing. As represented by the S&P ETF SPY, in a week of ups and downs, the market gained maybe 15 cents. Just more of this trendless listless summer markets we've been chronicling for awhile now. I'd also note that stocks are currently trading at the same levels they first visited back in October, 2008. One negative to note is that there is an emerging downward sloping trendline just above current prices that we'll have to watch. The trendline is on the chart but I forgot to mark it. It would be nice to see stocks take that line out to the upside. On a positive basis we are becoming oversold {see bottom of chart} so it is possible that we might add on to yesterday's rally in the coming days.

*Long ETFs related to the S&P 500 in both client and personal accounts.

Bastille Day 2009

Happy Bastille Day to those of you manning the ramparts at The Hotel California in Division 6-CMA & to Lt. English in Division 1-CMA.

For a treat here is "La Marseillaise" scene from Casablanca.

http://www.youtube.com/watch?v=_iYbEPZVVIA

Le jour de gloire est arrivé !

On Capital Gains & Losses Part VI Basic Tax Rules.

In this installment on Capital Gains & Losses were going to lay out the basics of the main parts of the tax code that deals with Capital Losses. Please note that this is not an exhaustive review of the tax code. It is just an overview. Also since I am not an accountant you MUST discuss any of these strategies with your own financial planner or tax advisor if you are not a client of our firm. Also Please note this is a brief review of how the tax rules currently work. At this time there does not seem to be any legislation moving through Congress that would change this part of the tax code. However that is not to say that these laws might never change. Certainly with the amount of money need by all governments it is a distinct possibility that these laws at some point could be revised or changed.

The first excerpt takes us back to the original article from Barrons which laid out the basic tax loss rules. {Rules highlighted in Green.}

IT'S AN ILL WIND, AS THE SAYING GOES, THAT BLOWS NO GOOD. Consider, for example, the capital-gains tax. While Congress agonizes over the rate of tax on net long-term gains, the question is largely academic -- because in the downturn, most of us have accumulated mountains of capital losses, and many years, if not a lifetime, of immunity to this tax.
The basic rule, under no apparent threat of change, is that you can deduct only $3,000 of net capital loss against your ordinary income on any year's return; any excess can be carried over onto your returns for the following years, subject to the same annual $3,000 limit, until the loss is exhausted.
The value of excess losses (those not immediately deductible against ordinary income) as a reserve against future taxes isn't always appreciated. "What good," a friend complained, "is $3,000 a year? I hope to pick up lots more gains once the market improves." She overlooked the potential of the entire backlog of losses as an offset to future capital gains.
Thus, suppose you incur $70,000 of net capital losses in 2009; after applying $3,000 against your ordinary income, you carry over $67,000. If you have a $40,000 net capital gain in 2010, it will be completely wiped out by $43,000 of the $67,000 you carried over from 2009, $3,000 of which will be applied against your 2010 ordinary income. That in turn will leave a $24,000 backlog ($67,000 less $43,000) loss to be carried over to 2011.

Link: http://online.barrons.com/article/SB124303130732448469.html {Subscription May Be Required}

Here from Smart Money is an explanation of the Wash Sale Rule:

THE SAVING GRACE of making a poor stock or mutual fund investment is that you at least get a capital loss when you sell. The loss can then offset gains from your more successful investments, unless the dreaded wash sale rules disallow your writeoff. Here's the scoop on this nasty little piece of the tax code.
The Skinny on Wash Sales. Your anticipated tax loss is disallowed if, within the period beginning 30 days before the date of the loss sale and ending 30 days after that date, you acquire "substantially identical" stocks or securities. For purposes of this article, let's call them replacement securities.
According to the tax law, your loss transaction and the purchase of the replacement securities are a "wash," so you shouldn't be allowed any tax benefits. Please understand, however, that this righteous concept applies only to losses. If you sell for a gain and buy back identical stocks or securities within the above time frame, Uncle Sam is happy to collect his due with no qualms. (Among us tax professionals, this is known as a "heads I win; tails you lose" rule.)
Options are included in the definition of stocks and securities, so you can also have a wash sale when you unload options at a loss.
But for the wash sale rules to come into play, the stocks or securities must truly be substantially identical. Stocks or securities issued by one corporation are not considered substantially identical to stocks or securities of another.
What about replacing one S&P 500 index mutual fund with another? Unfortunately, the IRS begs the question by saying only that all circumstances must be considered in evaluating whether stocks or securities are substantially identical. What the heck does that mean? Nobody knows. In my opinion, no mutual fund is substantially identical to another. That said, you should be wary of selling, for example, one S&P Index fund for a loss and then buying into another S&P 500 index fund within 30 days.
Also, don't think you can have your spouse buy identical replacement securities without running afoul of the wash sale rules. Your tax loss is still disallowed. Ditto if your controlled corporation or IRA makes the buy, according to the IRS.
What Happens to Your Loss? The only good news about wash sales is that your disallowed loss doesn't just go up in smoke. Instead, it gets added to the basis of the replacement securities. When you sell them, your disallowed loss effectively reduces your gain or increases your loss on that transaction. Also, the holding period of the wash sale securities is added to the holding period of the replacement securities, which increases your odds of qualifying for the favorable 15% rate on long-term capital gains.

Link: http://www.smartmoney.com/personal-finance/taxes/understanding-the-wash-sale-rules-9860/?hpadref=1

Next week to finish off this series we'll discuss the practical aspects of tax harvesting and why you must use this for longer term portfolio performance.

The Myth Of The Rational Market.

For most of my investment career the Efficient Market Theory-that markets were all knowing and rational-was the prevailing view of how markets functioned. That theory has come under increasing scrutiny and question in the past several years. I personally think markets are efficient up to a point but in the main they are subject more by other factors such as human emotion, especially in the short term. Economist Justin Fox is out with a book on this subject. It is entitled "The Myth of the Rational Market". His publisher has a promo blog interview with him on its web site. Since I'll be coming back to this subject over time, I've decided to excerpt it for you today.

Link: http://www.byjustinfox.com/the-myth-of-the-rational-market.html

The Myth of the Rational Market

Financial markets were supposed to know better. They were supposed to be near-perfect processors of information and assessors of risk. They were supposed to be steering us toward a more prosperous, less economically volatile future. Then they failed, spectacularly. Justin Fox’s "The Myth of the Rational Market" tells the story of how we came to believe that financial markets knew best, and how that belief steered us wrong......It’s also a tale of Wall Street’s evolution, the power of the market to generate wealth and wreak havoc, and free-market capitalism’s recurrent war with itself.
The efficient market hypothesis—long part of academic folklore but codified in the 1960s at the University of Chicago—has evolved into a powerful myth. It has been the driver of trillions of investing dollars, the inspiration for index funds and vast new derivatives markets. In its strongest form, the theory holds that the decisions of millions of investors, all digging for information and striving for an edge, inevitably add up to rational, perfect markets. That belief has crumbled.
....A new wave of scholars .... no longer teach that investors are rational or that markets are always right. Many now agree with Yale professor Robert Shiller that efficient market theory “represents one of the most remarkable errors in the history of economic thought.” Today the theory is giving way to new hypotheses of market behavior growing out of psychology, physics, evolutionary biology—and even traditional economics. In his landmark intellectual history, Fox uncovers the new ideas that may drive markets in the century ahead.
A Myth of the Rational Market Q&A {Again excerpted}
What is the myth of the rational market?

Most simply, it’s the belief that financial markets can be relied upon to get things right. In the context of my book, it refers to the academic theory most commonly known as the efficient market hypothesis—although I often refer to it as rational market theory because that’s shorter and, for those of us who aren’t finance professors, clearer.

What is main takeaway of your book?

That financial markets possess many wonderful traits, but that rationality is not always among them. And that relying on markets to be right all the time can be a very dangerous thing to do.

Does your book explain the current financial crisis or any aspect of it?

Yes. Financial decision-making and financial regulation had been restructured over the past couple of decades around the notion that market prices are correct. If market prices and formulas built around market prices said one thing, the thinking went, then who was a Federal Reserve chairman or investment bank CEO to say they were wrong? It was a suspension of judgment on a mass scale, and it turned out really badly....

What are some of the practical lessons of the book and do they have any application to economic recovery?

The most important practical lesson of the book in the context of the current economic situation is that financial markets don’t know everything. They know a lot, and the signals they send shouldn’t be completely ignored.......Our society (and our financial markets) cannot survive and thrive if all decisions are left to the market.Oh, and one another practical lesson: Stocks are a much better long-run investment when they’re cheap by historical standards (as measured by price-to-earnings or price-to-book ratio) than when they’re expensive.

{Why did the} rational market theory........become so widely accepted as standard practice?

First of all, because the facts seemed to back it up. For example: Finance scholars argued in the mid-1960s that the superstar mutual fund managers of the day were beating the market only by taking crazy risks that would eventually backfire. Within a couple of years, most of those stars had flamed out. More broadly, rational market theory offered straightforward answers—some of them correct—to a lot of questions that had long plagued investors, corporate managers and regulators.

In recent decades, you note the theory traveled beyond the stock market to apply to other securities and especially to what came to be known as derivatives. Do you think this played a major role in the current economic crisis?Yes it did. Although it’s not perfectly rational all the time, the stock market does process information quickly and handles even really bad news in a mostly orderly fashion. The same can usually be said for the {other} organized exchanges in derivatives....The off-exchange markets for mortgage securities and over-the-counter derivatives never developed the rules and contingency plans characteristic of well-established exchanges, yet were still expected to perform the same functions. When hit by adversity in the summer of 2007, many of these markets stopped functioning entirely. That, as much as anything else, was what turned a financial problem into a crisis.

What can today’s investors learn from studying rational market theory?

The market isn’t rational, but neither am I......I’ve become increasingly dubious that in my spare time I can pick stocks or investment managers that will beat the market after fees.

What do you see as the future of Wall Street?

We’ll have a long period of rethinking and relative sobriety, and then make all the same mistakes (or at least similar ones) again in 50 years or so.

How did you come upon the idea of writing this book?

The particular thing that got me started was encountering a book in 2002 by a finance professor, Peter Bossaerts of Caltech, that said the efficient market hypothesis had outlived its usefulness. What interested me was that Bossaerts sounded almost wistful about it—he wasn’t an efficient-market critic, just a realist. I knew there was a debate about the efficient market. This was the first hint I got that it was more or less over.It led to a 2002 Fortune article titled “Is the Market Rational? No, say the experts. But neither are you, so don’t go thinking you can outsmart it.” Which in turn led to a book contract.....Oh, and lots of staring blankly at a computer screen.

Summer Hours.

Because I think most of us have better things to do than be in doors in July & August I'm going to tone down the frequency of postings. We'll still post during the week but I'm going to take the weekends off from writing. We'll try to put material out during the business week but over the weekend "I'm goin fishin!". Not really but you get the idea. We'll pick up on the weekends again after Labor Day.

Please note we'll break this routine if something really important comes up.

The Great Reset-Wage Deflation

This was posted last week over at The Big Picture. It is another part of what I am calling " The Great Reset" Last week we discussed falling prices today I am excerpting an article on wage deflation written by David Rosenberg of Gluskin Sheff. David spent many years as Merrill Lynch's chief North American Economist.

Link: http://www.ritholtz.com/blog/2009/07/wage-deflation-in-our-midst/#more-30658
{Important points highlighted.}

A survey conducted by YouGov for the Economist magazine found that 5% of respondents had taken a furlough this year and 15% had accepted a pay cut......As wages deflate, workers are looking for ways to supplement their shrinking income base, for example, by moonlighting. Indeed, a poll undertaken by CareerBuilder.com and cited in the USA Today found that one in every ten Americans took on an extra job over the last year; another one in five said they intend to do so in the coming year......
Most pundits.....don’t realize......that the deflationary aftershocks that follow a post-bubble credit collapse typically last for 5 to 10 years. Businesses understand better than the typical Wall Street or Bay Street economist and strategist that everything from order books, to output, to staffing have to now be restructured to adequately reflect a permanently lower level of leverage in the economy.
Indeed, by our estimates, there is up to another $5 trillion of household debt that has to be eliminated in coming years and that process is going to require that consumers go on a semi-permanent spending diet. Companies see this, which is why they are not just downsizing their payroll, but have also cut the workweek to a record low of 33.1 hours.......
Companies are finding other ways to save on the aggregate labour cost bill as well, which may be a factor reinforcing the uptrend in the personal savings rate..... For example, a rapidly growing number of employers are now suspending contributions to worker 401(k) plans...... Again, how we end up squeezing inflation out of the system when the labour market is clearly deflating wages and benefits for the 70% of the economy called the consumer is going to be interesting to watch.
The op-ed column by Bob Herbert in the Saturday New York Times really hit the nail on the head on this whole ‘green shoot’ issue — how can there be ‘green shoots’ when the labour market is deteriorating at such a rapid clip fully nine months after the Lehman collapse. The full brunt of the credit collapse may be behind us, but please, the other two shocks, namely deflating labour markets and deflating home prices, are very much still front and centre. For every job opening in the USA, there are more than five unemployed actively seeking work vying for those jobs........

The official ranks of the unemployed have doubled during this recession to 14 million and if you take into account all forms of labour market slack, the unofficial number is bordering on 30 million, another record.......
.....When the recovery does come, the record number of people that have been pushed into part-time work are going to see their hours go back up, which will be good for them, but not so good for the 100,000 - 150,000 folks that will be entering the labour force looking for work with futility. The unemployment rate is probably going to rise through 2010, which is going to pose a challenge for incumbents seeking re-election in the mid-term voting season........
As we said above, companies have permanently reduced the size of their operations with the knowledge of how much credit is going to be available to them in the future to survive.....which means the funds available to support a given level of GDP is going to be measurably smaller than what we had become accustomed to during the secular credit expansion, which really began in the mid-1980s, only to turn parabolic during the ‘ownership society’ era of 2002 to 2007.
What makes this cycle “different” is that three-quarters of the workers that were fired over the last year were let go on a permanent, not a temporary basis. A record 53% of the unemployed today are workers who were displaced permanently — not just temporarily because of the vagaries of the traditional business cycle. This means that these jobs are not going to be coming back that quickly, if at all, when the economy does in fact begin to make the transition to the next expansion phase. In turn, this implies that any expansion phase is going to be extremely fragile and susceptible to periodic setbacks. There may well be job growth in the future in health care, infrastructure, energy technology and the like, but we can say with a reasonable amount of certainty that there are a whole lot of jobs in a whole lot sectors where jobs lost this recession are not going to come back.......

Long Term Capital Management {A review}

I wrote this post about Long Term Capital Management a few years ago. I'm including a link to it since we seem stuck talking about market crashes yesterday.
http://lumencapital.blogspot.com/2005/05/19-years-long-term-capital-management.html

On Market Panics.

After I wrote about market crashes I came across this piece on panics & the new proposed regulations put forth by the Obama Administration. It's by Robert Samuelson in the Washington Post. I'll excerpt it for you with a link at the end.

Since its earliest days, the United States has suffered periodic financial crises. The first dates to 1792...... Now we're in the midst of another crisis. It would be reassuring to think that the Obama administration's financial "reforms" -- or, indeed, any conceivable alternative -- would prevent these collapses for all time. Dream on.
Every financial crisis originates in a failure of imagination. It's not that, before the crisis, no one foresees problems, "excesses" and losses. There are usually warnings. But what's routinely overlooked are the fatal interconnections that transform problems into panic. People panic because the future goes dark. They don't know what to expect, so they expect the worst. Markets cascade uncontrollably downward.
The current crisis did not occur merely because "subprime" mortgages experienced unexpectedly large losses or even because many of these loans were "securitized" in complex bonds, argues Yale economist Gary Gorton. The crux of the matter, he says, was the failure of the "repo" market. The term comes from "repurchase agreements" -- short-term loans (usually overnight) that require the borrower to pledge collateral (usually bonds) in return for cash; the collateral is then "repurchased" by repayment of the loan.
No one knows the size of the repo market; Gorton thinks perhaps $10 trillion at any moment. Banks relied heavily on repo loans, which were routinely renewed. But when doubts arose about banks' subprime securities, the repo market panicked......Deprived of credit, Bear Stearns and Lehman Brothers failed; other institutions were vulnerable. Hardly anyone expected the panic; once it happened, large -- but bearable -- losses became a crisis.
In a crisis, government is the last bulwark against a complete financial collapse.....Just because all crises can't be prevented doesn't mean that some can't. Though complex, the Obama plan would essentially broaden regulation in three ways.
First, it would empower the Federal Reserve to designate some financial institutions.....as so important that their failure would "pose a threat to financial stability." These institutions would face stiffer capital requirements -- capital being mainly shareholders' investment. More capital would provide a larger buffer against losses and a crisis.
Second, it would create a Consumer Financial Protection Agency to police unethical lending practices and to ensure that loan documents for mortgages, auto loans and other types of consumer credit are understandable. (The Securities and Exchange Commission would retain power over stock markets.)
Third, it would change some rules of financial markets. For example, financial firms issuing securitized bonds -- bundles of mortgages, auto loans and other credits -- would be required to hold 5 percent of the bonds themselves. Because they would have to keep some bonds, it's argued, sellers would scrutinize the underlying loans more carefully.......
{R}egulation isn't a panacea against future crises. The idea of "enlightened regulators" who are vastly more perceptive than the bankers, traders and money managers they regulate is a fiction. Even in early 2007, when the problems of subprime mortgages had emerged, few regulators or economists foresaw a wider financial meltdown. They didn't see the impending chain reaction. The problem wasn't a lack of regulation; it was a lack of imagination.
So the next crisis could come from anywhere -- perhaps the follies of government, not finance. Between now and 2019, the U.S. federal debt could rise to $11 trillion , projects the Congressional Budget Office. U.S. Treasury bonds are the bedrock of the global financial system; they're considered safe and reliable. What if a glut of bonds causes investors to lose faith? What are the implications? Good questions. The seeds of the next crisis almost certainly won't be found in the debris of the last.

Link: http://www.washingtonpost.com/wp-dyn/content/article/2009/06/28/AR2009062802286.html

On Capital Gains & Losses Part V.3

Sometimes markets crash. That is they experience in a short period of time a violent negative price adjustment. We covered this originally in part IV of this series. {See link: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-iv.html} Above I've placed a chart showing extreme market dislocations in the past eleven years starting with Long Term Capital Management in 1998. You can double click on this chart to make it larger. Prior to 1998 stocks experienced these kind of dislocations twice during the Great Depression, after John Kennedy was assassinated in 1963, in 1987 and in the fall of 1990 after Iraq invaded Kuwait.

Markets crash due to unforeseen outside events which rapidly overtake the system. They are I believe the hardest environment for investors. Part of this comes from the shock of seeing such a rapid decline of portfolio value in short periods of time and the feeling among both investors and professionals that in retrospect the issues that caused a crash look so obvious.

Thinking that the majority of investors can sniff out a crash is flawed logic. Markets are discounting mechanisms. They discount price by analysis and by making educated guesses on future events. When events can be foreseen then it is likely that markets have already incorporated this possibility into their pricing mechanisms. Let's put it this way. Last fall's violent market correction (over 30% in about two weeks) had less to do with the issue of mortgage defaults then it did with the government letting Lehman Brothers go out of business and the near failures of so many other banks. The issue of housing and mortgages was pretty well known by September. The market was already down over 10% back then. Most of the major bank indices were down more than 15%. Very few investors anticipated that the problem was going to morph into a situation where the survival of the banking system was in question. Markets would have corrected much earlier and maybe over a longer period of time if they had suspected what was to come. We've covered this point and investor's reaction to it in an earlier post on who got last year's crash right; http://lumencapital.blogspot.com/2009/06/who-got-last-years-financial-crisis.html .

Markets will crash in response to an unforeseen outside event. For example if we wake up tomorrow morning and find that there has been an major earthquake in Southern California or that a giant asteroid will hit the earth next week or that North Korea has dropped a nuclear missile on South Korea then expect to see a pretty violent and rapid market correction. Since none of these events are expected, markets will not have had time to discount their possibilities and their initial reaction will be to panic by removing liquidity {selling}. They will do this until prices can discount what these events might mean to the economy. Then they will stabilize and often experience a rapid return in pricing once the event is priced in. This happened during the First Gulf War. Stocks corrected about 15% in a 5-6 week period in the fall as the world reacted to Iraq's invasion of Kuwait. Prices stabilized once markets gained confidence that Iraq would not be permitted to invade Saudi Arabia and experienced a rapid price increase when the Allies unleashed Desert Storm.

Markets will also crash when there is a shock to the financial system. These events often occur when a major financial institution collapses. Crashes like this occurred in 1911, 1929, 1932-33, 1987, 1998 and 2008. In the modern world such events usually prompt massive governmental intervention such as we are currently seeing.

Here is the Playbook for dealing with market crashes. The first thing is to understand that it is almost impossible to anticipate 100% such an event. Warren Buffett owned lots of stocks last fall. He still does by the way and added to his holdings at the end of last year. Hopefully, the events do not occur in such a vacuum that you haven't been able to play defense in your portfolio. Even so, unless you are 100% in cash you will have been savaged by events like last fall. For example we had higher than normal cash positions in almost all of our accounts last fall but we still experienced the pain just like everybody else. As I've often said since then, our systems are designed much like the pumps on a ship to remove as much water as possible from the bilge during a storm. However, no system will keep the boat from sinking when the bottom is ripped away. Last fall was one of those times.

You must begin by reassessing the present situation after a crash with your own risk tolerance. Then the portfolio needs to be restructured to take into account any changes in risk tolerance to remove investments that either will not perform going forward or to lower that exposure to risk. This is already a pretty lengthy post so the reasons for remaining invested in stocks will have to be discussed at some other time. However, assuming you are staying committed to equities in some form, then portfolios should be restructured over time to lower the cost basis of the assets that you want to continue to own. This should be done even if this means taking large investment losses! As we have indicated at the beginning of this series the losses have already occurred. Nobody wants them, but after a crash and after our investment environment these past 10 years, it is likely they will be in your portfolios in some form or the other. As we have stated, they can be used to an limited extent versus ordinary income and current law states they can be carried forward to lessen the impact of any capital gains going forward. Thus they need to be incorporated as a prudent part of the portfolio management process going forward.

If economic history holds the same, then at some point the economy will again grow and stocks will again be a representative way to participate in that growth. Most of us will want to use accumulated losses to offset future gains that should come when the economy recovers.

One last thing about crashes. They usually herald the end of some era. That is they usually signal that things both financial and social will be different going forward. The crash of 29 signalled the beginning of the Depression. The end of the Dot.com boom in 2000 told us that technology would not be the market leader going forward. It is likely that last years crash is signalling some sort of change like this. That is why we are calling this era the "Great Reset". We'll discuss this and what it means for investments much more in the coming months.

*We are covering in this series what we believe is the proper procedures regarding the application of capital losses for investors at Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor before implementing any of these strategies listed in these posts. Also you should consult your own tax professional before implementing your personal strategy for capital losses. This series is a general overview and should not be considered personal tax advice of any kind. Please note as well that tax laws could change in the future which could impact the implementation of these strategies or negate some or all of the advantages of harvesting capital losses. Finally you should be aware that we have not covered all of the possible risks to which ETFs could possibly be subjected. When discussing the risks regarding ETFS, we have no knowledge nor do we make any guarantees whether some of the same issues and risks particular to equities could ultimately affect ETFs as well. Again please consult your own investment advisor or do your own homework as to the appropriateness of these investments for your portfolio You can also visit any of the popular ETF websites for a further discussion of this topic.

Next week a brief review of the basic & pertinant rules on taking losses. In the final post of this series we will discuss what you do tactically in portfolios to address these losses.