Municipal bond dealers like to say, “It’s now how much you earn.  It’s how much you keep.”  

The muni dealer marketing perspective might be something to consider when making political and voting decisions in the next U.S. presidential election.  

Arguments about capital gains being larger or smaller for stocks, bonds and real estate under one party or the other are separate from issues of taxation of realized gains and income.  However, with respect to realized income, Democrats promise to increase  taxes for investors to fund social objectives.  Republicans promise to maintain or reduce taxation of realized gains or income, while claiming that will create jobs and improve the social situation.

Democrat rhetoric tends to divide the world between millionaire/billionaire investors and everybody else.  Republican rhetoric tends to describe investors as everybody.

Democrats focus on wealth redistribution to raise overall national prosperity, while Republicans focus on wealth creation to raise overall national prosperity.  You have to decide who you believe is correct.  Think carefully.

The relative market valuation of high yield versus low yield stocks, as well as the fate of equity-income investment funds may hang in the balance. 

If investment taxes stay the same or decrease, current behaviors will like stay essentially the same.  If taxes on realized gains and income follow Democrat platform ideas, behaviors will change.

The proper account type for dividend stocks would change from regular taxation accounts to IRA’s and other tax deferred accounts.

Portfolio turnover should decrease in portfolios to delay realized gains.  Tax efficient mutual funds should gather relatively more assets than others.  Tax efficient passive broad index funds would likely gain assets relative to actively managed funds which are not tax efficient due to turnover.   The shift to lower turnover would favor fundamental research for multi-year, long-term approaches over chart based decisions which are less useful for very long term decisions.

Municipal bond prices would rise and their yields would fall as investors scramble to generate tax-free income (assuming that their tax-free status does not also become a political target).

Here’s where two top Democratic and two top Republican candidates stand on taxation of investors. 

Barack Obama on Investment Taxation 

Bloomberg (September 18, 2007), “Democratic presidential candidate Barack Obama will propose cutting taxes by more than $80 billion for middle-class Americans that would be funded by increasing the burden on investors, his campaign said.

The plan, which Obama will announce in a speech in Washington today, would give a $500 tax credit to 150 million working Americans and create a universal mortgage credit for homeowners. The proposal calls for raising the top rate for capital gains and dividends, eliminating ‘corporate loopholes” and cracking down on overseas tax havens.” 

The following information is from:  http://www.ontheissues.org unless otherwise noted.

Hillary Clinton on Investment Taxation 

• Voted YES on $47B for military by repealing capital gains tax cut. (Feb 2006)
• Voted YES on retaining reduced taxes on capital gains & dividends. (Feb 2006)
• Voted YES on extending the tax cuts on capital gains and dividends. (Nov 2005)

PBS All-American Presidential Forum (June, 28, 2007), “We are paying a very big price for this because middle-class and working families are paying a much higher percentage of their income. That was Warren Buffett’s position…. And he’s honest enough to say, look, tax me because I’m a patriotic American and I want to make sure our country stays strong and is fair. So, yes, we have to change the tax system…”

Rudy Giuliani on Investment Taxation

• Letting Bush tax cuts expire means economy would decline. (Aug 2007)
• Reducing taxes is a way to raise MORE money. (Aug 2007)

CNN (July 7, 2007) Giuliani said, “I don’t think a flat tax is realistic change for America. Our economy is dependent upon the way our tax system operates … I have a real question whether it would be the right transition for our economy.”

BusinessWeek (April 30, 2007)  [Do you support extending the 2001 and 2003 tax cuts?] “I support continuing the level of taxation where it is, certainly not letting it increase. I would try to look for additional tax cuts that stimulate the economy. … For example, the capital gains tax is a really smart tax to cut because if you cut it the right way, you could end up with much larger growth.”

Mitt Romney on Investment Taxation

• End taxes on interest, dividends & capital gains. (May 2007)

AP Interview (Yahoo September 17, 2007) “Republican presidential candidate Mitt Romney is filling in the blanks in his proposal to eliminate taxes on interest and dividends for families earning less than $200,000 a year. … A former business executive and Massachusetts governor, Romney said the plan would benefit 95 percent of American families — 56 million that earned interest in 2005, 28 million that earned dividends and 23 million with capital gains from real estate, stocks or bonds.”

History tends to show that any candiate once elected will “discover” new facts and change their position somewhat or massively.  Legislative negotiation, constituency pressures and compromise also will come into play.  However, the general direction of their efforts will pretty well defined by the statements and voting records above. 

Richard Shaw
QVM Group LLC

It may be possible to explain away one situation at a time, but it is not easy to explain away one mess after the other.

Hedge funds have failed. A money market fund has failed. Mortgage companies have failed. Central banks have postponed rate increases and added liquidity to the system to prevent market chaos.

The Chinese government has tried to talk up the dollar by expressing confidence in it. The dollar is at all time lows.

House prices are falling. Marginal borrowers are in trouble with ARMs ratcheting up rates. Other borrowers can no longer rely on extracting equity from their homes to pay for lifestyle desires or life cycle needs. Both situations are negative signs for the economy.

Flight to quality has depressed many municipal bond prices and raised tax exempt rates to extraordinary levels relative to Treasuries.

Major banks have taken share price hits and now are beginning to announce expected earnings reductions due to credit market conditions.

Major institutions that routinely did repo financing have closed their windows due to lack of collateral or unwillingness to be in the collateralized debt market at this time.

Bernanke face the horns of a dilemma. Cut rates now to reduce financial stress, only to stoke the smoldering inflationary pressures, or keep rates where they are while the dominos fall, but perhaps reducing future inflation.

Now the UK government is guaranteeing bank depositors beyond established deposit insurance program limits for one bank to quell a run on that bank, and to prevent spill over to other deposit institutions.

The BBC reported the latest danger sign today as follows:

“Northern Rock deposits guaranteedThe [UK] government has said that it will guarantee all deposits held by the embattled Northern Rock bank.Banks are already covered by the Financial Services Compensation Scheme which protects 100% of the first £2,000 in any bank account and 90% of the next £33,000 - giving a maximum payout of £31,700 if a bank did go bust. But under the measures unveiled by Mr. Darling, Northern Rock savers would not lose a penny, regardless of how much they had deposited.

The decision to guarantee all deposits came, he said, because he wanted ‘to put the matter beyond doubt’ and ‘because of the importance I place on maintaining a stable banking system and public confidence in it’.”

The situation is still getting worse, not better.

We advise staying with highest quality securities and keeping significant powder dry for future buying opportunities — not now, later.

Yes, we are looking out the rear view mirror, but a problem with so much mass and momentum doesn’t stop just like that. The odds favor more trouble ahead rather than less.

Richard Shaw
QVM Group LLC

In our judgment, equity REITs are still significantly overvalued as a group and should be avoided.

REITs have been showing some life lately.  It’s tempting to participate.  We are regularly asked if the time to buy is now.  We aren’t market timers, but we do bide our time based on fundamental valuation.

On both a long-term and intermediate-term basis REITs are too expensive if you rely on the relationship of yield to total return.  That’s what we do, which means that we are still on the sidelines.

First, a momentum case for investing in REITs now.  Short-term charts of the key REIT index ETFs (IYR, RWR, ICF, and VNQ) have shown signs they may have stopped going down and are showing signs of going up.  That’s what an investor might say looking at the price chart below:

      click image to enlarge

However, it is a bit harder to be so comfortable with that conclusion looking at a longer-term chart like this one:

     click image to enlarge

That’s the chart perspective, but what about the more fundamental relative yield perspective?

A long-term view of equity REIT yield return, price return and T-Bond yield tells a different story.

Based on this chart covering more than 30 years, it appears that REITs are still in an historically overvalued position.

     click image to enlarge

The blue line is the 3-year moving average PRICE return of all equity REITs.  The orange line is the 3-yr moving average YIELD return of all equity REITs.  The red line is the 3-year moving average 10-year Treasury bond yield.

If you can accept that yield is a good long-term indicator of value for real estate (note that yield represents almost all of REIT income, because REITs must payout 90% of more of their income), then we see that REITs go through periods of significant overvaluation and undervaluation.

The blue REIT price return line was recently in the most overvalued position relative to yield than at any time since 1974.  Even now, after significant price declines (the bull argument), the blue price return line remains well in cyclic high valuation territory.

Then there is the matter of equity REIT yield relative to 10-year Treasury bonds.  Not since November 1990, has the Treasury yield been greater than the equity REIT yield until we reach 2006.  That’s a long time and that means it probably is an important fact to heed.

There was an eight year period from 1978 – 1986 where the REITs yielded less than Treasuries and again for three years in 1987- 1990.

Since REITs have yielded less than the 10-year Treasury only about  1/3 of the time, and that being a long time ago, we think prudence would dictate waiting for equity REITs to yield more than 10-year Treasuries once again, and for the equity REIT moving average price return to fall further relative to REIT yield.

The price return to yield return relationship can be “corrected” by a series of low price return years or a shorter period of price declines.

Richard Shaw
QVM Group LLC

Disclosure:  Author does not own any equity REITs at this time.

Ealier related articles:

August 2007 35 Year of REIT to Treasury Yields

January 2007 REITs Likely to Revert to Mean Return

The 10 sectors of the S&P 500 have substantially different portfolio statistics. Some investors may find the details helpful in portfolio construction.

The following chart provides the statistics for the 9 SPDR sector ETFs and the two iShares ETFs that breakout technology and telecom from the SPDR that combines the two, plus the SPDR S&P 500 (market-cap weighted) ETF and the Rydex S&P 500 Equal Weight ETF.

The 10 sectors are based on the GICS (Global Industry Classification System) developed by MSCI and S&P.

S&P 500 is highlighted in blue. The S&P 500 Equal Weight is highlighted in orange. The statistics for each sector ETF that are more favorable than the S&P 500 overall are highlighted in yellow.

This information might be useful to investors who wish to weight the separate sectors in their portfolio differently than the sector weights in S&P 500, whether it be the traditional market-cap weighted S&P 500 (SPY or IVV) or the S&P 500 Equal Weight index (RSP).

The recent and intermediate-term performance of the same sectors and ETFs are shown below:

The Sharpe Ratio (named for William Sharpe) is a measure of risk-adjusted return, where risk is defined as return volatility. It is calculated a follows:

(total return less the risk free return) / standard deviation of return

In this case the measurement period is 3 years. The risk-free return is often set equal to the 3-month Treasury return.

Larger ratios are better than smaller ratios.

The expense ratio is not specifically a measure of return, but it is an indication of return drag, or return loss due to “friction”, as Warren Buffet has described investment fees and commissions.

Richard Shaw
QVM Group LLC

[Securities mentioned in this article:

XLB XLE XLF XLI XLP XLU XLV XLY IYZ IYW RSP SPY ]

Disclosure: author does not own any security mentioned.

United States companies were once the overwhelming majority of very large market-cap companies.  That has been changing for some time.  Total U.S. free-float market cap is less than 50% (about 46%) of world free float market-cap, and even less of total world market-cap if free float is not considered.

This week Barron’s published a list of the 100 largest public companies in the world by market-cap (probably not based on free-float).  Only 43% of that list consists of U.S. domiciled companies.

According to total market-cap, free float market-cap and top companies, the U.S. accounts for less than 1/2 of public equities.  We think that is one fairly strong argument against putting 70% to 80% of an equity portfolio in U.S. companies.  Non-U.S. exposures within the equity allocation for many investors should be higher than 20% to 30%.

VTI is a good proxy for the total U.S. stock market (Wilshire 5000) and VEU is a good proxy for the total non-U.S. stock market (FTSE All World ex U.S.)

Here is what Barron’s had to say in its Monday September 10, 2007 issue;

“As in the past two years, the World’s Most Respected Companies survey sought investors’ opinions of only the 100 largest companies in the world, based on stock-market capitalization. … Because foreign markets have been on a tear in recent years, including some that have been fueled by the global bull market in commodities, a record number of non-U.S. companies now rank among the world’s largest. Indeed, a majority of this year’s top 100 — 57 companies, to be exact — are based overseas.”

Richard Shaw
QVM Group LLC 

Disclosure:  author owns both VTI and VEU