Before getting into downfalls of the market, it’s worth pointing out that corporate earnings in the first quarter have shown that consumers and businesses are once again willing to buy and invest. A very broad example of this can be seen in the hardware sector. Apple’s stock price is up more than 7% due to strong iPad and iPhone sales. This has also benefited Sandisk, a supplier of flash memory for mobile devices.  The company returned 21% in the quarter.

There is still an elevated unemployment rate, and job growth may be slow or delayed for months or even years in the future. The uncertainty among the American population regarding their job security and employment prospects makes it difficult to stabilize the housing market and boost consumer spending. Recent housing data has shown that even though mortgage rates are at record lows, the demand remains significantly down. Of course, it’s just common sense that people unsure of future cash flows will hold off on purchases that require a large monthly obligation, so investors are left skeptical of the housing market’s ability to recover fully after the expiration of the housing tax credit.

In the Manufacturing Sector, energy companies have been harmed by falling oil prices, the drilling moratorium, and fear over increased regulation in the wake of the Gulf oil spill. The anxiety over increased regulation seems to be a common denominator across the market, as there has been a weak performance of the financial sector as well. This is due to Washington and Wall Street turning their attention to financial reform. With this news of government intervention, bank and financial stocks were sold off as investors feared the impact of reform.

Large-cap companies have also been subject to substantial headline risk in 2010 as well. When the public focuses on large companies like banks, oil companies, and healthcare, Congress does so as well. These negative headlines not only affect investor sentiment, but can also affect the company’s underlying business. A general idea of the impact of the financial reform bill being passed should become clear in the upcoming month, as the financial sector gains a little more clarity on what it faces in terms of new regulations and compliance.

Excessive government debt is another uncertainty that has been at the forefront throughout 2010. The flight from the troubled European debt of Portugal, Italy, Ireland, Greece, and Spain has led to a historic rally in the U.S. treasuries. The U.S. dollar, like in the past, has been seen as a safe haven to invest in despite growing borrowing needs and fundamentals that might suggest a rise in interest rates. The Federal Reserve, though, has committed to keep interest rates low for the foreseeable future. Although the U.S. still holds AAA status and should be in no immediate danger of a downgrade, the mounting debt issue with the US government will come under pressure unless measures are taken to reduce the record budget deficit, according to Moody’s Investor Service.

Granted, uncertainly will always be a factor in the market. Accurately predicting the future in the midst of reform, regulation, unstable governments, and future debt obligations is an extremely difficult proposition. In these times of negative feelings and general uncertainty, though, we can be certain that the different sectors will react negatively as they have this past quarter. In these subsequent quarters many of these unknowns will begin to come to light and the uncertainty driving the market currently will be clearer to investors.

By Paige Slusser

Casey Smith and Kyle Waller had their article on Fiduciary Responsibility posted at www.tabbforum.com.

Top 5 estate planning mistakes

I recently read a report that suggested that only about 20 percent of the population has a formal estate plan. After reviewing the points below, please take a minute to consider whether it’s time for you to create or update your estate plan.

Here are a few of the top 5 estate planning mistakes that people make that can be avoided.

1. Dying without a will or trust – If you die without a will or trust, the state in which you reside and the IRS will simply make one for you.  Of course, they have no interest in avoiding or reducing estate taxes, minimizing estate administration costs or protecting your family and legacy. The distribution of your assets will just be turned over to the Probate Court. The probate process is needlessly time consuming, frustrating and expensive. It is also open to the public, meaning creditors, predators or anyone else will have complete access to all information about your estate. For the vast majority of people, the benefits far outweigh any initial costs.

2. Having an “I love you” will – An I love you will is one in which all the decedent’s assets have been left to the spouse. On paper, it might seem to be a caring, thoughtful gesture, but the reality is quite different, because such a will simply passes the complex issues and problems associated with transferring and protecting wealth onto the spouse or other loved ones.  It creates more problems than it solves, particularly for future generations.

3. Giving property outright to your children – Here is another solution that might sound good at first, but ignores several important realities. For instance, what if the child in question is too immature to handle the responsibility of a large sum of money on his or her own? What if the child suffers a severe financial setback that puts the inheritance at risk to creditors?  What if the child marries a fortune-hunter, is addicted to drugs or alcohol, gets divorced or remarried? You may need to protect your children and heirs from their own poor decisions.  These assets are also gifted assets which carry potentially large IRS penalties if not handled properly.

4. Owning property jointly – There are two types of joint ownership, Joint Tenancy with Right of Survivorship (JTWROS) and Tenants in Common (TIC).  Problems with JTWROS include postponement of probate only until last tenancy, the loss of the double step-up in tax basis creating more to pay in capital gains taxes, and outright distribution.  With TIC, you also lose the double step-up in tax basis where it’s available, and your property is subject to the estate plan of each tenant as well as probate for each tenant.

5. Not having a trust – A trust is the single most effective estate planning tool available. There are many different types of trusts.  Among the better known and more commonly used are revocable trusts, irrevocable trusts and testamentary trusts. A Trust protects your privacy, and will help you leave what you want, to whom you want, in the way you want at the lowest possible cost overall.

Standard deviation measures the risk of an investment. For example, the Growth Fund of America has a 5 year standard deviation of 16.45 and a 5-year average annual return of 4.76. This means that the portfolio historically has moved 16.45% above 4.76 and 16.45% below 4.76 over a 5 year period. This gives you an idea of your downside risk and upside potential. In comparison, the PIMCO bond fund has a 5 year standard deviation of 4.25 and a 5 year average return of 7.17. Adding these two funds to a portfolio at a 50/50 ratio would give the portfolio a 5 year standard deviation and rate of return of 10.35 and 5.96, respectively. In this scenario, we just lowered the risk of the overall sample portfolio by adding bonds. You can use Morningstar.com, a free and independent research firm, to find the standard deviation and rate of return of each fund within our 401k plan. As you will see, some funds in our 401k plan, while they may be in the same asset class, do not have the same risk.

By Kyle Waller, Research Analyst Wiser Wealth Management, Inc & Casey T Smith, ASA ALPA 401k Specialist

In 401K investing, there is a major asset class that does not get the respect it deserves. In fact, it is largely ignored both by investors and plan sponsors. This asset class, small cap stock funds, is a very important element in a 401K plan.

Throughout the history of the stock market, small cap stock funds have significantly outperformed their larger counterparts.  There are some reasons for this that make small cap funds a category that should not be overlooked in your plan. That being stated, the potential for excess long-term performance comes with some serious risks that should also not be overlooked because of downside risks and excess volatility.

The JPMorgan ASA employee 401K plan has three small cap funds. Two of those funds have a management strategy designed to invest in growth stocks, while one fund is designed to invest in value stocks. Below is the Morningstar Style box, which simply categorizes large, mid and small in rows, while placing the “styles,” (value, blend and growth) in columns. Style is something to consider when choosing funds, but size is more important to consider. Size tends to be a larger determinant of returns relative to style. However, most mutual funds have both size and style directives and both should be taken under consideration before choosing one.

Small Cap Stocks as Building Blocks

Building a solid portfolio can be done with many different strategies, but most professionals believe that having a diversified portfolio based on asset allocation is most appropriate. Asset allocation would mean that a portfolio would include diversified investments from different categories, and apply different weighting based on the investor’s individual risk tolerance and how risky each investment is. Most allocations are based on age or years to retirement.

The three small cap funds in the ASA employee 401K plan are the Buffalo Small Cap, Columbia Small Cap Value II Z and the LKCM Small Cap Equity Advisor. When reviewing these funds, it is important to study risk, cost and track record, among other factors. Cost takes away from return, and there are hidden costs to consider like turnover, which is the fund’s trading frequency. This is an important consideration, because these trades incur cost for the mutual fund. A random track record statistic alone should not be the deciding factor; it should be compared with benchmarks. For example, it would make sense to compare a small cap growth fund’s return with a small cap growth benchmark. There are several ways to look at a fund’s risk. One way is to simply look at its standard deviation, which is a measure of variability from the mean. The higher the standard deviation, the higher the risk is perceived to be. Often, standard deviation is just called risk, like you see in the scatter-plot below.

The Importance of Small

Below, we see the difference smaller companies can make. Over last 15 years, we see that small cap companies significantly outperformed the large cap S&P 500, despite underperformance during the tech bubble. Going back further would reveal that this pattern does exist over long periods of time.

So, what is the cause of this higher performance? Put simply, smaller companies tend to grow at a faster rate and, over time, larger companies still grow, but much more slowly. Smaller companies have less economies of scale, less complex capital structures, less debt and lean more on a competitive advantage, which can quickly change. What it all boils down to is that smaller companies are more risky and the investor is compensated for that risk in the long run. This works just the same way a bank demands a higher interest from a person with a lower credit score or a higher risk of default. The market demands that same kind of compensation.

Below is a scatter-plot showing the risk of each investment, plotted against the return. Notice that the small stock index has more risk, (being further to the right) but a higher return as compensation for that risk relative to the S&P 500.

Source: Morningstar

Small cap stocks should not be a centerpiece for a portfolio, but certainly a building block. There is a case for small cap stocks outperforming larger stocks, but we need to remember that larger stocks tend to be more stable, which is why investors, over the long run, are compensated less. Of course, over short periods of time, we could expect small cap stocks to be punished more by the market for not being stable. We could say that many smaller companies’ stock prices reflect the potential for growth or future cash flows while larger firms typically have more established assets, which generate cash flows more steadily.

In this way, a solid investment portfolio will include small cap stocks in relatively modest amounts, while core holdings will be built using larger stock funds and bond holdings.  Small cap stock funds are typically considered satellite holdings.

Building With Small Cap Funds

“Investing has and always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of the financial history to those who have one.” William Bernstein

Knowing your history is the key to building a portfolio that will get you to retirement and into retirement. Small Cap stocks have a place in portfolios. They are riskier than other investments and therefore should be limited in even the most aggressive portfolio. Where your personal portfolio falls in the risk spectrum is up to you, but should be based on the reality of your situation and not an attitude or appetite for risk and speculation.

By Casey Smith, ASA ALPA R&I Committee 401k Specialist and

Kyle Waller, Research Analyst, Wiser Wealth Management, Inc

The saving rate among Americans is decreasing, yet the need for income in retirement is as crucial as ever with pensions and social security becoming scarce and not as guaranteed as they once were.

There is a real cost to not saving, and that cost increases as retirement approaches. This is a particular concern for us as pilots with forced retirement ages, since we will not be able to choose to continue working into our 70s.  That being said, there is still hope at any age and it is never too late to start getting out of debt and saving for future needs. No matter the state of the nation’s economy, focusing on your personal economy should come first.

As we can see above, the saving rate among Americans has been on a sharp downtrend since the late 1980s, dropping to record lows during 2008. Recently, it has risen to just under 4% on average in 2009 and this year.

Saving has risen again recently due to the lower availability of credit. Since credit is never a guarantee, Americans need to adjust their dependency on easy access to credit and put away a higher percentage of what they earn. In general, the upcoming generation of retirees is more accustomed to widely available credit and is more optimistic than previous ‘thriftier’ generations.

Financial Knowledge vs. Time

Financial wisdom is an important key to having a successful portfolio. However, the more valuable factor that is often overlooked is time. Time gives the investor the ability to make it through both economic downturns and market booms. Historically, the market has behaved with large gains or losses over short periods of time. The secret to financial success is having a good strategy and the time to see those investments through the long run. You can see the value of time and saving sooner rather than later in the scenario below.

How Much To Save

A good rule of thumb is for an individual to be able to withdraw 3-4% in retirement without touching principle. This would generate $40,000 annually from a $1,000,000 portfolio.

Source: Morningstar, Inc using a 7% interest rate

Life isn’t as simple as the illustrated example since a professional pilot will most likely receive significant pay increases throughout his or her career. Another thing to consider is that as retirement approaches, it makes more sense to alter the investment portfolio to become more conservative, taking less risk and avoiding major market swings. This is another reason a younger person saving for retirement is at an advantage; they can take an aggressive investing approach and see that strategy through bad market cycles to success.

The ASA matching schedule is given below:  A healthy amount to save each month is 15-20% of your income. The sooner retirement is for you, the higher this percentage should be. At the very least, an ASA employee should be putting 6% into his or her 401K account out of every paycheck. Not doing so is taking a voluntary pay decrease. If you’re not saving this much, stop reading, log onto your account and change the percentage to at least 6%.

The ASA matching program matches a portion of the first 6% of your contribution based on completed years as an employee. Therefore, a second year employee (one year completed) will be matched 1.2% if they put at least 6% away in their 401K account (20% of 6%), this is in contrast to a 5% contribution rate which would be matched 1% (20% of 5%). Therefore, the real cost of not saving at least 6% is 1.2% for a second year employee.  The incentive is increased as the employee completes more years.  The program is designed to make a monetary incentive for saving through the program.

Behavior and Success

When making a plan for saving, it is important to note that good saving and investment behavior is as important as anything else. Saving should become systematic and so should the way you invest. This means no matter what the stock market is doing, you should be putting the same amount into your 401K and investment accounts every month. You should begin to think the same way about investing as you think of your monthly mortgage, a required bill.

Long term investing success really depends on playing great defense, which is sticking to the plan. This involves patience and endurance through market crisis, which will always come and go. An investor with a great strategy and the time to see it through will be successful and profitable in the end.

Why is behavior important? There is a gap in the stock market return and the average investor return, coined the behavior gap (see www.behaviorgap.com).

This behavior gap is caused by investors reacting to the ups and downs of the stock market, and can be very significant. When an investor reacts to the stocks market, i.e. buying stocks when they are rising, that investor is buying high. In the same way, selling stocks when they are falling is selling low.  A profitable strategy is obviously just the opposite, selling high and buying low. To pull off this strategy successfully, a great amount market insight and forecasting is required. Even with good information, it is difficult do profitably over the long run. The better strategy is choosing funds to create a diversified portfolio and sticking to that plan no matter what happens in the market. This is a simplified version of a buy-and-hold strategy, but the “behavior gap” will be completely erased when an investor properly employs a no-nonsense buy and hold strategy.

In Conclusion

Investment and retirement savings success does not depend on financial knowledge or complex strategies. When you are saving for retirement, create a hands off plan for saving, get on board with that plan and see it through to retirement.

You can view more 401k articles, the pilot retirement calculator, 401k model portfolios and research at www.wiserinvestor.com/resources/asa

What does that have to do with you, a US investor? Over 50 percent of the the revenues of the S&P 500, the 500 largest companies in the US, come from overseas. Declining foreign sales and a declining euro hurt our mega corporations. You might be wondering what you should do with your 401k. If you are properly allocated according to your age and risk tolerance, the answer is nothing right now except possibly increasing your contribution to take advantage of the sale. You should also make sure that your portfolio is properly diversified. Is your 401k in all cash? Do you have more than 30% in any one fund?

The biggest risk to your retirement is not saving. The second biggest risk is how you invest. Print off a copy of this connection email as a reminder to look at your 401k allocation. You can also visit www.wiserinvestor.com/resources/asa for tips on allocating your portfolio. Of course, you may also call me anytime to discuss your individual situation.

Casey Smith ASA ALPA 401k Specialist

Gravitating towards shorter duration bond holdings in the TIPS marketplace will mean choosing a higher correlation with inflation, lower volatility, and only small yield differences.  PIMCO is currently the only ETF issuer with a full family of TIPS exchange-traded products.

Duration is a measure of the average life of a bond.  The duration of a bond is the percentage change that a 1% change in interest rates will move the bond’s price in the opposite direction.  For example, a bond with a 5-year duration will decrease 5% when interest rates increase 1%, all things being equal.

Currently, PIMCO 1-5 Yr US TIPS Index Fund (NYSEArca: STPZ) is the only TIPS ETF giving investors access to the short end of the yield curve in the TIPS marketplace.  The ETF in this space with the 2^nd lowest duration is the iShares Barclays TIPS Bond (NYSEArca: TIP).  The iShares Barclays TIPS Bond (NYSEArca: TIP) has an effective duration of 4.15, while PIMCO 1-5 Yr US TIPS Index Fund (NYSEArca: STPZ) has an effective duration of 2.55.

TIPS ETF funds are great to compare since the US government equally backs up the income and principle from the bonds held by these funds.  Of the two lowest duration funds, SPTZ and TIP, the yield difference is important when looked at in relation to duration and risk.

Here’s a breakdown of the ETFs on the market today that compares average coupons and duration.  The chart below is similar to a risk/reward scatter-plot, replacing risk with duration and return with the average coupon payment.   Data is from Morningstar, Inc.

There is a very clear pattern formed in that duration is rewarded with risk, but not in an efficient way.  This is not a yield curve, since maturity and yield are not being measured, but rather a measure of maturity and a measure of yield (average coupon).

Inflation Correlation

TIPS, or Treasury Inflation Protected Securities, have a built in feature that adjusts the principle of the bond based on changes in inflation. When investing in TIP Securities, the lower term the bond is, the higher correlation to inflation the bond will have.  This is because shorter-term bonds are effected less by interest rate movements and investors’ interest or inflation sediments.  Therefore, a change in inflation is more clearly reflected the shorter-term TIPS bond.

According to PIMCO’s research, The BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index (the index PIMCO’s STPZ tracks) has a .27% correlation to inflation, while the Barclays Capital U.S. Treasury Inflation Protected Securities (TIPS) Index (the index for iShares’ TIP) has a .07 correlation to inflation. In the current low inflation and interest rate environment, now is a good time to buy inflation insurance and dial down on duration exposure.

TIPS have another unique usage by investors that relates to inflation.  Investors often purchase commodities as a way to protect against inflation and use TIPS as collateral for their commodity futures positions.  For instance, PIMCO uses TIPS as collateral in its Commodity Real Return mutual fund.  Since the yield from TIPS is a real return, meaning inflation is included, investors do not need to worry about losing in a high inflation environment

Scenarios With TIPS

The main case for TIPS would be during an inflation spike.  The Federal Reserve appears to be committed to low inflation and low rates for the time being, aiding the US Government with a low borrowing rate.  The question is whether or not this is an artificial environment.  Will inflation begin to happen despite the Fed’s best effort because of the country’s growing debt-to-GDP level, currently at 54%?

There are some particular market scenarios where TIP Securities do great and some others where TIPS can be a scary investment and lose a substantial amount of value.

In a scenario mentioned by Anne Lester, a senior portfolio manager at JPMorgan Funds in a May 2009 WSJ article, interest rates rose from 10% to 15% while inflation (CPI) fell from 14% to 10% from July 1980 to July 1981.  She refers to this time (TIP Securities did not exist at the time) as the “perfect storm’’ that could cause TIPS to lose 20% in value.

It is important to note that with TIPS indexes, bonds are being rolled in and out as they fit into or become excluded from the indexes target ranges, and many indexes do not just hold bonds until maturity.  Also, it should be noted that the par value of bonds is changed based on the change in inflation.  Like the situation above, in a high inflation environment where inflation moves down, par values of these Treasury Bonds would decrease.

PIMCO’s TIPS Family ETFs

Although PIMCO is firm about active bond strategies being more efficient than indexing, they seem to be dedicated to running an effective indexing strategy with the ETF vehicle offering a full family of indexed TIPS ETFs, ranging from long, broad, and short term.

The PIMCO 1-5 Year US TIPS Index Fund (NYSEArca: STPZ) is the most popular of the three with over $500 Million in assets.  The underlying index, the BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index, is capitalization weighted and is rebalanced monthly.  The PIMCO 1-5 Year US TIPS Index Fund (NYSEArca: STPZ) pays dividends monthly and has a low 20 basis point expense ratio.  Holding only 11 bonds, this ETF is set up to efficiently have low turnover.  The effective duration of this fund is 2.55 years.

Conclusion

With a specialized bond like TIP Securities, keeping maturities low is where the benefit of the inflation hedge is at its best.  The other factors that affect bond price can be minimized in lower maturities.  The primary reason an investor allocates into TIPS is to hedge against inflation.  Low duration TIPS will benefit from increasing inflation (CPI) and the expectation of inflation increasing.  Both of these factors will be directly affect these bonds’ prices and lower maturities will allow the highest correlation to these factors that the investor is looking to access.

This public debt isn’t anything new for our economy; it’s a part of our history. The only time when the U.S. was actually debt free was during Andrew Jackson’s presidency, when he ordered it to all be repaid. Today, our national debt remains at around 53% of our GDP. Compared to Japan’s public debt to GDP of 192%, the US doesn’t look quite as bad. Still, debt is borrowed and has to be paid back eventually.   The Federal Reserve could crank up their printing press and increase inflation to pay it all back, or default on government bonds.  Neither of these situations are likely, but since the Federal Reserve has done the ‘print more money’ trick before, it’s not improbable to think that something drastic couldn’t be considered.

Below is a comparison of the immense Federal Government deficit to American household debt. If public debt is increasing, it should follow that private debt is on the same path. When plotted on a simple graph, it is true and highly positively correlated at 97%:

Of course, just because two figures are highly correlated, there is not necessarily a cause and effect relationship. When public debt increases it doesn’t cause private debt to increase. There are numerous other factors that play a role. That being said, seeing the exponential explosion of debt and the relationship between the two figures on a graph can help put things in perspective and lends a little credence to the theory that overall, Americans are becoming desensitized to debt.

With the economic recession and high unemployment levels, it isn’t surprising that household debt has increased. Cardweb.com, a credit industry reporting website, states that American households with at least one credit card owe more than $8,000 in debt. However, this number has been found to be skewed by a portion of the population with a vast amount of debt. After analyzing the credit card debt of those surveyed, Bill Whitt at the VIP Forum, a Washington D.C. research firm, found that only 29% of households owe $1,000 or more on their cards. Although almost 75% of Americans owe less than $1,000 on their credit card bills, the effect on the economy can be huge. The collapse of the mortgage market is an easy illustration of how the default of a small portion of loans can have a tremendous effect on the economy.

How can you safely leverage yourself against the perils of debt? Unlike the Federal Deficit, there are ways to tangibly protect you and your family from debt and potential bankruptcy in your own home. One of the first and probably hardest lessons to learn is to not let your eyes be bigger than your wallet. Simply speaking, don’t buy things you can’t afford – especially if its monthly payments will max out your budget. Small amounts of debt over time will end up accumulating and eating away at your savings. Another couple of steps to take are in the world of credit cards. The best way to maintain good credit is by paying your balances in full and on time. If you are unable to keep track of your different balances, then you many want to consolidate into one or two cards.

There is no simple “cookie-cutter” answer on personal debt that would suffice for every personal situation. The best advice is common sense. Be fully aware of the combination of your personal credit balances (bills, loans, and mortgages), disposable income, and spending habits. From there, set a budget and adjust to your own wants and needs. You may find that you’re spending more than you’re making and need to cut back in a certain area, or that you should go ahead and pay off a high interest bill while maintaining the minimum payment on others. You may even find that you are able to save for retirement or other endeavors.

If the general population becomes more aware and averse to debt while they are still able to recoup, maybe the government will learn a lesson from its people – to cut out unnecessary spending and manage current resources wisely.

By Paige Slusser