The markets have recovered significantly since the crash of 2008, but the journey has been anything but smooth sailing. This exasperating ride is not likely to end anytime soon. Unemployment is not coming down…there is still much uncertainty about taxes…we may still be facing a double dip recession…housing problems abound…and the mid-term elections have thrown us into gridlock.

The latest adventure is QE2 by the Federal Reserve. Let’s go through a very quick economics lesson: Quantitative Easing (QE) 101.

In a normal economy, the Fed affects monetary policy by increasing or decreasing the Fed Funds Rate, the interest rate banks charge each other for loans. To stimulate, the Fed lowers rates. However, with the rate essentially at zero today and banks not lending, the Fed has to try alternative measures, i.e., Quantitative Easing (QE).

The primary goal of QE is to stimulate the economy and eliminate the possibility of deflation. But how?

Successful QE relies on the fact that banks will “lend” these additional dollars into the system. It is likely that QE2 will have the following impact:

• Lower long term interest rates.
• Lower mortgage rates to help the housing problem.
• Increase equity/stock prices by making them a more attractive investment than bonds.
• Weaken further the “dollar”. This will stimulate exports.

Will QE2 work? No one really knows, but the Fed has very few bullets left in the gun. And the $600 billion stimulus over 8 to 9 months is their attempt to stimulate an economy stuck in a deep hole. We hope that it will stimulate inflation, which is much preferable to deflation. It is also likely to push commodity prices higher and further undermine the dollar.

This is a bold, complex plan with plenty of risks. Predicting future interest rates is impossible. But it is likely that short term rates will stay low at least through 2011. We also risk alienating our foreign investors, such as China and Japan, who buy 40% of our Treasuries. How long will they continue to lend us money at a near zero rate, especially when the dollar is getting weaker every day?

The Mid Tem Elections = Grid Lock

GOP picks up 60 seats in the House, 6 in the Senate. The 2010 midterm elections are over and frustration has prompted change in Capitol Hill. Republicans will control the House with at least 239 seats; Democrats will retain a narrow majority in the Senate with at least 51 seats.

Here comes gridlock. “We’re determined to stop the agenda Americans have rejected and to turn the ship around,” Senate Minority Leader Mitch McConnell (R-KY) told the press after the election. So will President Obama’s health care reforms be rolled back? Will federal spending be severely reduced?

Through 2012, you may not see much change at all. With Republicans controlling the House, Democrats controlling the Senate and President Obama’s veto pen at the ready, you can expect plenty of legislative stalemates.

Could gridlock benefit the markets? It could be bullish for stocks. With a conservative majority in the House, Wall Street could breathe a collective sigh of relief over the next two years, feeling less regulatory pressure and seeing fewer threats and a more business-friendly environment.

Much of the gains in September and October were likely in anticipation of this event. What we have found to be even more interesting are the reactions from both Republicans and Democrats. Republicans seem to be more optimistic in gaining the house and many new governors, while Democrats seem to be relieved that they were able to retain control of the Senate; and Harry Reid won reelection fairly easily. Let’s hope relief on both sides of the aisle leads to more optimism.

Taxes – will the “Bush” tax cuts be extended?

Both parties want to preserve the Bush-era income tax cuts. Analysts now think Congress may act to extend the EGTRRA/JGTRRA tax cuts through at least 2011. Will they be extended for all Americans, as Republicans want? Or just to households with incomes of less than $250,000, as Democrats want?

Two (lame duck) Democrats have proposed extending these tax cuts for all but the really rich. Senate Banking Chairman Chris Dodd (D-CT) would like them extended for households making less than $500,000; Sen. Blanche Lincoln (D-NE) has proposed setting the break at $1 million. In September, 31 House Democrats wrote a letter to their party’s leaders urging the extension of the cuts for all Americans.

Riddle: Joe and Paul both live in the same town, on the same street. They both visit the same hardware store and purchase the same type and brand of product on the same day and at the same time. Paul spends $3.00 on 102, but Joe is charged only $2.00 for 98. Assuming Paul has not been overcharged and Joe has not been undercharged, what have they purchased?

Capital Gains and Dividends

If the Bush cuts aren’t extended, the top rate on long-term gains will rise to 20% from 15% and dividends will revert to being taxed as ordinary income, with a top rate of 39.6%.

The fate of these rates is likely tied to the income-tax outcome, except that the Obama budget has requested a top rate on dividends of 20%.

Outlook

Whether the market will continue to advance over the next several quarters is, of course, impossible to predict. Although we would like to believe otherwise, it seems like Congress operates with a level of careless insouciance, being more concerned with re-election than important legislation. The U.S. consumer continues to work through substantial debt problems. The economic reality is that high unemployment and massive government debt may condemn us to slow growth for years to come.

Fortunately we at Kohlhepp Investment Advisors, Ltd. have investment strategies which can be effective in all climates.

As always, please contact us if you have any questions.

Have a wonderful Fall and a Happy Thanksgiving.

Best regards,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

 

Sources:

www.wsj.com
Aetna Capital Mgt, LLC

www.Navellier.com

Dear Clients,

Here is some encouraging information.

You may have heard that stocks tend to rally in fall and winter. That has often been the case. In fact, the S&P 500 and the Dow have gained repeatedly after the elections occurring in the third year of a first-term presidency.

These elections seem to elate Wall Street. While past performance is no indication of future success, consider this: Wall Street has witnessed rallies after every mid-term election since 1942.¹

The Leuthold Group, a Minneapolis-based investment research firm, has determined that the S&P 500 has gained an average of 18.3% in the 200 days following such elections. Widening the window of time, Goldman Sachs finds that the S&P has averaged an 18.1% advance during the 12 months following each of the 15 mid-term elections since 1950. (The gain averages 11.0% when control of Congress changes hands.)^1,2

Consider another intriguing statistic regarding mid-term election years: in the five instances since 1942 when an incumbent first-term president was a Democrat, the S&P 500 has gained an average of 21.3% for the year.³

The Dow may get a tailwind from the “third-year effect”. Since 1945, the third year of a presidential election cycle has tended to be very positive for the Dow. As MarketWatch columnist Mark Hulbert noted recently, the DJIA has averaged +24.7% in such 12-month periods (usually measured in fiscal years, i.e., 4Q-1Q-2Q-3Q) since the end of World War II. In fact, the Dow’s average returns in other fiscal years of a presidential term have been puny in comparison: +4.0% in year one, +1.9% in year two and +3.3% in year four.⁴

Last month, Standard & Poor’s chief investment strategist Sam Stovall told the Wall Street Journal that the DJIA has risen an average of 17.1% in calendar years following mid-term elections since 1945, with less than 10% of these years seeing selloffs.⁵

Will 2010 follow the historical pattern? Excellent question – after all, no one is clairvoyant. This year, stocks have not followed the longstanding trends. Stocks typically do badly in September, yet September 2010 actually turned the market around. When it comes to November, let’s hope history repeats.

As always, please feel free to pass this newsletter along to friends and family. If you have any questions or would like to more about your portfolio or the economy, please call.

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

10/19/2010

Investors entered the month of September fearful of past downturns, still haunted by the catastrophic decline in 2008. But yet again, the markets did the opposite of what many were expecting, posting the highest returns for the month since 1939, and the third best single monthly return in 10 years, according to the Associated Press. The Russell 3000 rose 9.44% in September, up 4.78%--for the year. 

The good news could be seen in all sectors of the Stock Market - large caps, mid caps, international and emerging markets. 

Some of the market gains appear to reflect good news in the economy. The Bureau of Economic Analysis reported on September 30 that it was revising its estimate of second-quarter growth in the economy: up 1.7%, after an increase of 3.7% in the first three months of the year. Corporate profits increased $47.5 billion in the second quarter after rising $148.4 billion in the first quarter. 

International investors are beginning to recover some of the losses from earlier in the year. The MSCI EAFE index, which measures the composite returns of the developed nations (although it excludes Canada, for some reason) was up 15.79% for the quarter, but the index is down overall 1.25% heading into the fourth quarter. Meanwhile, emerging markets are still booming. 

Treasury Bond prices rose slightly as the yield on 10-year maturities fell from 2.95% on June 30 to 2.51% at the end of the quarter. Remarkably, the yield on 6-month Treasury notes is still hovering at 0.19%. Yield to maturity on 30-year maturity issues were yielding 3.69% as the quarter ended.

It should be noted that the U.S. markets are close to finally climbing out of the deep holes they fell into in 2008 and early 2009. The 3-year performance of various indices, for the period ending September 30, is within striking distance of positive territory. If the markets offer gains in the last quarter similar to what we experienced in the third, investors who managed to stay in the market through the turmoil might be able to celebrate a full recovery of their portfolio value.

Meanwhile, it's helpful to remember that at the start of the quarter, people were questioning the viability of U.S. and global markets after the near-meltdown of Greece, Portugal, Spain and other Southern European economies. Each quarter, each year, seems to bring a new thing to worry about. But looking longer term, the U.S. equities markets have managed to post long-term gains despite some fairly serious disruptions, including World War II, the Cold War, the conflict in Vietnam, stagflation and the oil shocks of the 1970s, the market crash of 1987, the bursting of the tech stock bubble, and the subprime mortgage meltdown and collapse of Bear Stearns, Lehman Brothers and AIG in 2008. 

Indeed, if you look at the long-term movements in the stock market since the Great Depression, all of those events, which seemed pretty dire at the time, look like blips on the screen, small dips in the long-term growth of value in American and global publicly-traded enterprises. 

There is no doubt that there will be other events in the future which will seem to endanger--or at least derail--the long-term growth of capitalism. But based on the history of the past two centuries, one might feel confident that whatever challenges await us, people in all sectors of the U.S. economy will find ways to build additional value. 

The final three months of the year may bring the market indices back up to pre-meltdown levels, or they may disappoint. We simply cannot predict the short-term movements in stock prices and with all of the uncertainty in the political and tax arenas, we have chosen to focus our attention on protecting client’s portfolios. We shall see what the 4^th quarter brings as the markets digest the elections in November.

Best regards,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

The views expressed are not necessarily the opinion of Cambridge Investment Research and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Investing is subject to risks including loss of principal invested. No strategy can assure a profit nor protect against loss.

Sources:

GDP estimates, inflation and corporate profits: http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

Russell index data: http://www.russell.com/indexes/data/daily_total_returns_us.asp

S%P index data: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf--p-us-l--

Individual country data: http://www.emerginvest.com/WorldStockMarkets/Countries.html

Treasury market rates: http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Treasury Bond returns: http://www.latimes.com/business/la-fi-1001-markets-quarter-20101001,0,2854846.story

Best September since 1939: http://www.sfgate.com/cgi-bin/article.cgi?f=/n/a/2010/09/30/national/a121755D84.DTL&type=business

Dear Clients,

There has been a lot of conversation recently about the possible end of the Bush tax cuts, and we have received questions about it from some of you. Here are some comments and opinions worth noticing.

In July, Treasury Secretary Timothy Geithner said that very few taxpayers would be affected if the landmark tax cuts of 2001 and 2003 expired. “I do not believe it will affect growth,” he calmly commented on ABC’s This Week.¹ Many legislators and observers on Wall Street and Main Street are far less calm about their potential end.

Why should they end now? The federal government undeniably needs more revenue to help shrink the deficit, and Geithner feels that letting these tax cuts go would not trigger a double-dip recession, as they affect only 2-3% of U.S. taxpayers.¹ However, many Republicans and more than a few Democrats see danger here as the richest Americans are also the most influential in job creation.

Grassroots momentum gathering. A new website created by the conservative League of American Voters (ReviewTheTaxCuts.com) is gathering signatures in conjunction with a TV ad campaign starring ex-presidential candidate Fred Thompson. This effort comes on the heels of Rasmussen and Gallup polls showing increased concern about taxes. In a mid-July Rasmussen Reports poll, 68% of Americans surveyed said taxes had become a “very important” issue. In April, 63% of Americans surveyed by Gallup felt their taxes would rise in 2011, the largest percentage to respond this way since 1977.³

A battle this fall in Washington. Republicans on Capitol Hill ardently want the tax breaks to remain in place. Democratic leaders in the Senate are striving to introduce a bill in September that would seek to preserve the cuts for the middle class only. Most Democrats seem to favor letting the tax cuts expire for households earning more than $250,000. House Speaker Nancy Pelosi (D-CA) is among the voices contending that they didn’t aid the economy much in the first place. Closer to the White House, Secretary Geithner feels that letting the cuts expire would send a message to the world that America is serious about tackling its deficit.³

This is an election year for many members of Congress, and it wouldn’t be surprising if some seats changed hands as a result of the influence of this issue.

More voices. Former Federal Reserve vice-chairman Alan Blinder favors letting the cuts expire. “We couldn't afford them then (and knew it), and we can't afford them now (and know it),” he recently told the Washington Post. “What might be the argument for retaining the tax cuts even though the long-run budget is deeply in the red? That America needs more income inequality? Seems to me we have enough.”⁴

MoodysEconomy.com chief economist Mark Zandi calls for moderation. Zandi feels the 2001 and 2003 cuts “should be extended permanently for families with annual incomes of less than $250,000 and should be phased out slowly for those making more than that.”⁴

If the sun sets on these cuts, taxes revert to pre-2001 levels. EGTRRA gave us six tax brackets (10%, 15%, 25%, 28%, 33% and 35%). If EGTRRA went away, so would the 10% tax bracket (the lowest bracket would become 15%) and the 25%, 28%, 33% and 35% rates would be respectively bumped up to 28%, 31%, 36% and 39.6%. (Households earning more than $379,650 would pay taxes at the 39.6% rate.)⁵

Then we have capital gains, of course. The ceiling on capital gains tax rates would move back up to 20% if these cuts expired. Additionally, qualified dividends would again be taxed at a taxpayer’s regular rate … which could be as high as 39.6% (see above).⁵

The death of EGTRRA would also wipe out the child tax credit, restore the “marriage penalty” (married joint filers wouldn’t be able to take 2x the standard deduction allowed for single filers) and bring back the phase-out for the personal exemption and itemized deductions.

There is much to consider. This will, most likely, become one of the hottest issues on Capitol Hill and across the country as we get closer to November.⁵

It appears that Congress and the Administration are leaning in the direction of extending the Bush tax cuts at least for those families with incomes above $250,000 per year. This is mainly due to the need to avoid a double-dip recession. We are less certain regarding the position on the capital gains and dividends issues.

We do know that the stock market will not look favorably on any tax increases, especially regarding dividends and capital gains. Lets’ hope Congress makes the tax moves needed to help us avoid a double-dip. We will keep you informed as we know more in the coming months.

As always, please feel free to pass this newsletter along to friends and family. If you have any questions or would like to more about your portfolio or the economy, please call.

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

The views expressed are not necessarily the opinion of Cambridge Investment Research and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Investing is subject to risks including loss of principal invested. No strategy can assure a profit nor protect against loss.

This material was prepared by Peter Montoya Inc., and does not necessarily represent the views of the presenting Representative or the Representative’s Broker/Dealer. This information should not be construed as investment advice. Neither the named Representative nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information.. www.pet

ermontoya.com, www.montoyaregistry.com, www.marketinglibrary.net

Citations

1 – nytimes.com/2010/07/26/us/politics/26geithner.html [7/26/10]

2 – cnbc.com/id/38467149 [7/29/10]

3 – blogs.wsj.com/washwire/2010/07/27/tax-cut-debate-grows-louder/[7/27/10]

4 – washingtonpost.com/wp-dyn/content/article/2010/07/30/AR2010073004758.html [7/30/10]

5 - forbes.com/2010/07/22/expiring-bush-cuts-affect-personal-finance-taxes.html [7/22/10]