October, 2010
By Darren Nyce
Senior Research Analyst, Castle Investment Advisors®, LLC

Ever notice how a 40 degree day feels different in October than it does in March? Or how a football team can dominate a game statistically yet still lose? Or how people describe a visit to Vegas or Phoenix in the summer when its 110 yet insist on the description, but it’s a dry heat? Things do not always feel the way that the data describes the situation. Context and personal experience play a role in our perception of reality.

Our current economy is the same way. The arbiter of U.S. economic cycles, the National Bureau of Economic Research (NBER), determined this past quarter that the recession which began in December 2007 officially ended in June 2009. But for millions, it sure doesn’t feel like it. This is not criticism of the NBER; they aren’t making forecasts or describing the magnitude of the recovery, only that the data shows a trough last summer.

Recapping the stock market performance for the 3rd quarter, the S&P 500, powered by its best September since 1939, returned 11.3% leaving it up 3.9% for the year. The economy does continue to be a mixed bag with both positive and negative elements:

  • Positive
    • Delinquency Rates for Commercial and Industrial Loans are falling
    • Business to Business Activity is growing
    • GDP growth is positive
    • Inflation remains under control
    • Retail Sales Numbers are showing improvement
  • Negative
    • Unemployment remains high at 9.6%
    • Consumer sentiment continues to sag
    • GDP growth is meager
    • Housing prices continue to fall
    • Deficit problems remain

It is a valuable skill to be able to maintain an appropriate emotional equilibrium, in all aspects of life, but particularly in regard to investing; letting neither the highs nor the lows completely engulf your spirit and take over sound thinking. While there are plenty of things to be pessimistic about, here are some quotes from three influential business leaders at a recent conference in Montana that give a more uplifting view of our current situation.

Warren Buffett:

“I’m a huge bull on this country … we won’t have a double dip recession. I see our businesses coming back almost across the board … … it’s night and day from a year ago.”

“I’ve seen sentiment turn sour in the last three months or so, generally in the media. I don’t see that in our businesses. I see we’re employing more people than a month ago, two months ago.”

“The things that worked for the country through a century of two world wars, a depression and more — all while increasing the standard of living — will work again.”

Steve Ballmer, Microsoft:

“There soon will be more technological advancement and invention than there was during the Internet era and that will help drive business growth.” “I am very enthusiastic what the future holds for our industry and what our industry will mean for growth in other industries.”

“We will see new technologies that move beyond the Internet to tie together computers, phones, televisions and data centers to create amazing new products. And the pace of innovation will increase as technology makes workers more productive.”

Jeff Immelt, GE:

“Angry political rhetoric is not helpful and headlines are too focused on finding negative indicators.”

“Business at GE is improving. Signs across the world show growth improving as evidenced by a rise in GE’s orders.”

“GE is now finding it profitable to build manufacturing and service centers in the United States rather than overseas, because it is more competitive to do so.”

We at Castle Wealth Advisors® work hard to analyze both the positive and negative information that is out there to guide our investment decisions; striving to manage your risk as we weigh the unavoidable challenges against the opportunities that they disguise.

Some of the things we will be watching in the coming months are:

  • The tension between deflation and inflation
  • The Fed’s implementation of another round of Quantitative Easing (QE2) and its affects particularly on the U.S dollar and treasury yields
  • Europe’s navigation of its debt crisis
  • The ability of state and local municipalities to handle their own financial challenges
  • The overall state of the economic recovery

As we head into the 4th Quarter, we will be diligently examining our clients’ portfolios for opportunities that may exist to do some tax loss harvesting and other year end planning, as is typical. What is not typical this year is the uncertainty around what the tax code will look like for 2011.

This uncertainty is magnified by the tenuous nature of our current economic condition as well as the impact that the upcoming midterm elections will have on the balance of power in Congress.

One thing we feel confident in predicting is that taxes in some form will be going up in 2011. With Federal debt and deficit levels (when viewed as a percentage of GDP) at levels not seen this high since the 1940s, it stands to reason that the government will look at ways to increase tax receipts. Whether or not you agree that increasing tax rates is the optimal way to accomplish this, the current political climate seems to be leaning in that direction.

The chart below which is provided with a hat-tip to Michael J. Zinkand of the Managers Investment Group outlines 12 key areas that affect investors and taxpayers and compares the current rate structure with the structure that will exist if no legislative action is taken and the current proposal by the Obama administration.

DescriptionCurrent 2010 RatesScheduled Rates for 2011Obama FY 2011 Budget
Ordinary Taxable Income Rates 10%, 15%, 25%, 28%, 33%, and 36% 15%, 28%, 31%, 36%, and 39.6% 10%, 15%, 25%, 28%, 36%, and 39.6%
Standard Deduction $5,800 (single - S) and $11,600 (married filing jointly - MFJ) $5,800 (S) and $9,700 (MFJ) $5,800 (S) and $11,600 (MFJ)
Qualified Dividends Rate 5% (10% and 15% tax brackets) and 15% (for other brackets) Taxed at individual income tax rate 5% (for 10% and 15% tax brackets) and 20% (for other brackets)
Long-term Capital Gains Rate 5% (10% and 15% tax brackets) and 15% (for other brackets) 10% (for 15% tax bracket) and 20% (for other brackets) 5% (for 10% and 15% tax brackets) and 20% (for other brackets)
Itemized Deduction Phase-out Threshold No Phase-out $170,150 (S) and $255,250 (MFJ) $203,650 (S) and $254,550 (MFJ)
Personal Exemption Phase-out Threshold (PEP) No Phase-out $170,150 (S) and $255,250 (MFJ) $203,650 (S) and $254,550 (MFJ)
Further Limit on Itemized Deductions (Pease) None None Max tax value limited to benefit received in the 28% income tax bracket
Child Tax Credit $1,000 $500 $1,000
Refundable Child Tax Credit Refundable to the extent of 15% of AGI in excess of $12,800 Refundable only for families with 3 or more children, with restrictive income requirements Refundable to the extent of 15% of AGI in excess of $3,000
Making Work Pay Credit None None Maximum of $400 per wage earner, begins to phase-out for those with income over $75,000 (S) and $150,000 (MFJ)
AMT Exemption Level $33,750 (S) and $45,000 (MFJ) $33,750 (S) and $45,000 (MFJ) $47,500 (S) and $72,200 (MFJ)
Estate Tax 0% 55% top rate, $1 million exemption 45% top rate, $3.5 million exemption

A couple of areas to draw your attention to are qualified dividends and long term capital gains, which are facing a 5% increase for most taxpayers. The change in the AMT (Alternative Minimum Tax) exemption level could also snare an increasing number of investors (and while not addressed in the chart, we are also watching closely for changes that are made to “step up in basis” rules when an investment is passed from one generation to the next).

So what are the tools we have to combat this complicated situation? Keep in mind that each family is unique with their particular situation so blanket statements will not apply to all, but here are some of the things we are considering:

  • An increase in the use of ETFs (Exchange Traded Funds) due to their more favorable treatment of income.
  • Evaluate the benefit of year end selling – keeping in mind that a loss might be more valuable in 2011 under higher rates, while it might be more beneficial to capture a gain in 2010.
  • Emphasize investing in municipal bonds
    • There are multiple benefits here including tax free income, historically low default rates, and increasing portfolio diversification by adding low correlating assets.

Thank you for the opportunity to partner with you on your financial journey. If you have questions about anything in this update or any other matter, feel free to give us a call.

The Castle Investment Advisors®, LLC Investment Team

Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.