NOWHERE TO RUN, FEW PLACES TO MOVE

MUNICIPAL BONDS FACE UNCERTAIN STATE INCOME TAX TREATMENT AT THE "LEARNED HANDS" OF THE UNITED STATES SUPREME COURT

In a post from December 28, 2005, "Municipal Bonds Face Challenge from new Retiree Healthcare Benefits Accounting Rule" , the Author addressed the potential disruption that a new accounting rule might cause the municipal bond market.

Another recent development could also bring undulations of uncertainty to the municipal bond market. The US Supreme Court "agreed on Monday to decide whether states can continue to exempt interest on their own bonds from their residents’ taxable income, while taxing the interest on bonds issued by other states," according to an article in the New York Times.

The NYT article goes on to state:

The preferential tax treatment for in-state bonds is longstanding and very common, offered by nearly all the states that have an income tax. State and local governments issued more than $350 billion worth of bonds a year from 2002 to 2006.

The practice was, in fact, largely taken for granted until it was declared “facially unconstitutional” in January 2006 by the Kentucky Court of Appeals. That state court, ruling in a case brought by a Kentucky couple, George and Catherine Davis, who own bonds issued by other states, said the preferential tax treatment erected a barrier against interstate commerce in violation of the Constitution’s commerce clause.

In the only previous decision on the subject, an Ohio state appeals court upheld that state’s preferential treatment of bond interest, in a 1994 decision that the Supreme Court declined to review. The fact that two state courts now disagree on such a fundamental question probably led the justices to conclude that the issue required their attention.

Municipal bonds, one of the safer investments for income investors, are debt instruments issued by cities, states and governmental units to pay for public buildings, schools and public projects. Municipal bonds are only attractive to high income investors, however, because they are free from federal taxes, and often free from state taxes. This favorable tax treatment allows municipalities to offer lower interest rates than comparable taxable bonds.

Municipal bonds are also safe investments because they are backed by either specific revenues or the taxing power of the city or state.

Many states engage in the preferential practices that the Supreme Court will apparently address. New Mexico, for example, exempts New Mexico (and its city and county units) municipal bond income from New Mexico State Income tax. However, New Mexico does not exempt income from the bonds of other states from state income tax.

Indiana, however, exempts from Indiana Income tax interest on all other states' municipal bonds.

There are intra-state benefits for states that only exempt their own bonds from state income tax. This treatment makes in-state bonds more attractive than out-of-state bonds. For small states that issue few bonds, this preferential treatment is beneficial to the marketability of its bonds.

The name of the case is Department of Revenue of Kentucky v. Davis, No. 06-666.

LIVING, AS HE DOES, IN THE DESERT OF THE REAL, THE AUTHOR HAS LITTLE INTEREST IN MUNICIPALITIES.

BUY AND HOLD OR HOLD AND FOLD?

This a 10-year graph of the NASDAQ Index. See you around 4500 again in 2045.

BUY AND HOLD OR HOLD AND MOULD?

This is a 10-year Graph of the S&P 500 Index. Wow, seven years later, from August 2000 to May 2007, and you are back where you started at around 1500. We Really Be Jammin' Now.

AARON BURR, VICE PRESIDENT OF THE UNITED STATES OF AMERICA, INDICTED FOR TREASON 200 YEARS AGO TODAY

Aaron Burr was the Vice President of the United States under President Thomas Jefferson from 1801-1805. He was charged with Treason in 1807 but was acquitted.

INVESTING 202

Many of the Author's latest posts have dealt with economic topics and not the daily work of investing. This next post is a repost of some material from the August 2005 Desert of the Real Newsletter.

IS FUNDAMENTAL INVESTING FUNDAMENTALLY UNSOUND?

Studies show that 70 to 80% of a stock’s movement can be attributed to the movement of the overall market and the movement in the particular stock’s sector. Yet most analysts concentrate their efforts on analyzing a stock’s fundamental indicia. And most portfolio strategists just conjure up newer quantitatively derived strategies for portfolio diversification. So most of what you read or hear about a stock from the analysts only influences 20-30% of its movement. How would you like a doctor that could only cure 20% of your ailments or a fire department that would only respond to 30% of fire alarms?

Diversification is a mantra in the financial services industry. Talk to nearly any broker or financial planner and they will tell you to just buy and hold a basket of stocks, bonds, cash instruments and maybe throw in a few alternative investments like managed futures, REITS (Real Estate Investment Trusts) and foreign equities. Some will do well sometimes, some will do poorly sometimes. But if you hang on long enough, we can guarantee that your investments will regress to the mean.

The author will be the first to say that buying investments based upon their fundamentals or holding a diversified portfolio is better than a poorer strategy, or no strategy at all. But if there were a way to buy the best performing investments at the best times, wouldn’t you like to try it?


Here is one way to do it:

1. When the market is moving forward, you are fully invested in stocks. When the market is reversing course, move to wealth preservation strategies. I am sure some readers are thinking ‘Yeah, right smart guy. How can you tell when the market is going to move up?’ The simple answer is you cannot predict when it will go up or down. But you can employ technical indicators that are trend tracking and trend following. You stay invested until these technical indicators reverse to negative.
2. Within all markets, some sectors will outperform others. Find the best sectors and find the best performing stocks in those sectors.
3. When you find the best stocks in those sectors find the best price points to buy, sell, and plot stop loss points. On this last point, proper implementation of stop loss orders is key to a good strategy. It sounds counterintuitive, but knowing when to cut losses is as important (if not more important) as knowing what to buy. Here is why:
a. If you are buying good stocks in a moving market, you are almost sure to get gains that beat, or at least equal, market-equivalent gains. If you do it well, you will substantially exceed the relevant indices.
b. Despite your best efforts, some of your picks will lose money. That is inevitable. Just keep your losses very small and put your money elsewhere. Being a stock trader is like managing a major league baseball club. The season stretches from April to October. You are bound to lose some games, but consistently win more than you lose and you will keep your job and your club will make the playoffs.
c. Put in stop losses and be mechanical about them. The author usually sets stop loss orders at 7% below the purchase price, or a point on the chart where short-term price support will break down. No exceptions. Also, when you have good gains in a stock, raise the stop-loss price to keep your profits.


The author did not create this methodology. It is the methodology used by Dorsey, Wright and Associates. It has worked well and is worth a look.

In some upcoming posts the Author will address some of these topics in more detail.

BETTER IS ONLY GOOD IN THE DESERT OF THE REAL!


IMPORANT DISCLAIMER: This we article is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The author may or may not buy or sell securities discussed in this newsletter.