The Markets	9/30/12   Close	6/30/12   Close	3rd  Qtr.  Change	9/30/11    Close	12 Mo. Change	YTD       Change
Dow	13,437	12,880	+4.32%	10,913	+23.13%	+9.98%
NASDAQ	3,116	2,935	+6.17%	2,415	+29.03%	+19.62%
S&P 500	1,441	1,362	+5.80%	1,131	+27.41%	+14.55%
MSCI EAFE	1,511	1,423	+6.14%	1,373	+10.01%	+6.95%
10-yr Treas. yield	1.64%	1.66%	-0.02%	1.92%	-0.28%	-0.23%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

The quarter began inauspiciously, with the scandal of banks conspiring to fix LIBOR interest rates, San Bernardino joining the California cities to declare bankruptcy and yet another computer glitch that threw the stock market off its track and almost took down another trading firm. But slightly improving jobs data, improving housing markets, another round of Fed stimulus and strong corporate earnings pushed the Dow to a four-year high in mid-September. European markets also continued their recovery and bond yields stayed extremely low after the 10-year Treasury hit another record low of 1.46% in the July auction.

Speculation in July that Spain would need a full bailout was quickly followed by a European Central Bank (ECB) pledge to do whatever it takes to keep the euro intact. The ECB made clear that the euro countries must take responsibility and announced a plan to three-year bonds of any country that complies with its conditions. Left unclear, however, was whether and how the ECB would enforce those conditions. German courts approved Germany’s participation in the EU bailout funds but seemed to put limits on future rescues. China took a more traditional stimulus approach and announced 25 major subway projects. The Bank of England held its stimulus program at the current $610 billion, but the Bank of Japan expanded their asset purchases by another $126 billion. The quarter ended with new riots in Spain and Greece against austerity measures, the killing of the US ambassador to Libya and unrest over a movie deemed an insult to Muslims.

Mush of the quarter was consumed with daily focus on whether the Fed would implement another stimulus effort. After playing coy for two months, in September the Fed announced that they would be buying $40 billion of mortgage-backed securities each month until the economy, and the job market in particular, has improved to their satisfaction. The Fed also made clear that they intend to keep interest rates very low into 2015 and they lowered their 2012 growth outlook from 2.4% to 2%. Second quarter growth was revised down to 1.3% from the original 1.5% due to the effects of the prolonged drought.

Manufacturing contracted for three straight months until expanding for September and new orders were particularly strong. Non-defense spending excluding aircraft, considered the best measure of business spending, was also up. Services strengthened throughout the quarter and productivity and unit labor costs were both up higher than expected for the second quarter. As the housing market continued to solidify, homebuilder confidence soared and prices showed slight increase in most metro areas. However, real median household income for 2011 was down 1.5% from 2010 and the poverty rate was unchanged at15%, still near the highest in 40 years.

The focus for the markets and the presidential candidates was on jobs. Weekly jobless claims have been stuck in the high-300,000’s and while August unemployment was down to 8.1% the reduction was largely due to people who have stopped looking for work and are no longer counted as “unemployed”. The labor force participation rate was down to 63.5%, the lowest in 31 years. However, 114,000 nonfarm jobs were added in September and the unemployment rate fell further to 7.8%, the lowest since January, 2009.

Looking Forward

Last quarter the impending “fiscal cliff” was the topic of Looking Forward. Well, it’s now a month until the presidential election and less than 90 days until the precipice is reached and the fiscal cliff is even more critical.

Estimates range from a 0.5% to 1% hit to growth if the fiscal cliff hits at full strength. This is on top of already slowing growth, a persistently sluggish job market, a slowdown in China and the ongoing European debt crisis. The real damage, though, would be the continued inability of the political process to deal with obvious problems, the loss of whatever confidence may be left that we can deal with larger long-term fiscal issues and the ongoing uncertainty that complicates business and personal financial decisions.

The consensus seems to be that the 2% reduction in the employee portion of the Social Security tax will expire, raising the cost for an employee at the $110,000 earnings limit $2,200 over the course of the year. (This is called a tax increase even though it just gets us back to where we had been for the prior 22 years.) Some kind of measure to “patch” the Alternative Minimum Tax (AMT) will likely go through so the AMT does not reach deep into the middle class. It is also hard to imagine that the deep cuts to the military will be allowed to take place immediately, although there could be support for phasing them in over time.

Other changes are more certain or have already had an effect. Because the exemption for mortgage-debt forgiveness is set to expire, homeowners looking to complete a “short sale” (selling the house for less than they owe, with the remaining debt forgiven by the lender) will have to take the tax impact into account if the sale is completed in 2013. The estate and gift tax rate, which has been all over the map the last 10 years, will increase from 35% to 55% and the amount exempt from the tax will drop from $5 million to $1 million. And as part of the Affordable Health Care Act, a new 3.8% surtax will be applied to investment income for married taxpayers with total adjusted gross income above $250,000 ($200,000 for single taxpayers). For example, if a couple had $50,000 of investment income and $220,000 of other income, they would pay the 3.8% tax on investment income of $20,000, the amount above the $250,000 threshold.

So, the suspense will be the degree to which we go off the cliff, as well as whether Washington is able to do anything other than some temporary fixes and further postponing the inevitable reckoning.

Our Portfolios

There are some implications of the expiring tax provisions that will apply to most investors in taxable accounts. The top rate for long-term capital gains will go from 15% to 20% and the 15% rate for “qualified dividends” (most stock dividends) will be eliminated so all dividends will be taxed as regular income (up to the new highest marginal rate of 39.6%). Will there be a rush to sell before year-end to lock in the lower capital gains rate and to reallocate portfolios away from what were “qualified” dividends?

The fundamental potential benefits of the investments will not change as a result of these tax changes. In other words, if an investment has long-term growth potential, it will still have long-term growth potential and selling simply to avoid a marginal tax increase makes no sense. Besides, selling also creates the problem of what to do with the proceeds, and trying to time the market is folly. If, on the margin, there is a compelling reason to make portfolio adjustments or to take some gains, it could be prudent to do so this year, but it is also important to make sure the gains are long-term (the investment has been held for one year) because short-term gains are taxed at higher income tax rates. And if there are losses carried forward from prior years, it makes sense to keep those losses to offset gains in the future in case the higher capital gains rate sticks.

Likewise, the tax rate increase on dividends seems particularly large, but it simply puts dividends on par with other income sources. If the income from dividends is higher before taxes than some safe options such as CD’s, it will still be higher after taxes. Most investors will continue to look at the underlying risk and return characteristics of the investment and act accordingly. Tax-free bonds may become marginally more attractive but the fiscal problems of state and local governments present another risk element. We don’t expect the markets to see upheaval solely from these tax changes and we don’t expect to make portfolio changes based on tax changes either.

Low Hanging Fruit

Just about everyone agrees that to fix the long-term deficit problem will require raising revenues, cutting spending or some combination of both. Even if the fiscal cliff is addressed, it still appears that any long-term structural changes will be made to address the growth in entitlements.

There is also plenty of talk about simplifying the tax code and eliminating tax breaks. Most of this simplification would barely make a dent in the deficit and simplification is an elusive goal, but it doesn’t take long to find some potential common sense changes.

Let’s just take the deduction for mortgage interest as an example. It’s commonly thought that this deduction came about after World War II and boosted the post-war housing boom and the rise of suburbs. Actually, all interest was deductible from the inception of the income tax in 1913. It only became part of the lore of home ownership as housing debt grew from the 1950’s until today and elimination of the deduction would create howls of protest from homebuilders, homeowners and realtors. And it could be argued that the public interest is served by facilitating home ownership, so let’s assume that the deduction for mortgage interest won’t be eliminated, but it could be limited in some ways.

Today, taxpayers can deduct the interest on up to $1 million of debt on two homes. That’s a lot of debt, even for high-cost areas on the coasts. And should it really be a priority for the public to support the purchase of second homes? Again, builders, realtors and politicians from vacation areas would decry the loss of jobs and economic activity but there is precedent for eliminating an interest tax deduction. As part of the Tax Reform Act of 1986, personal interest payments were no longer deductible, leaving mortgage interest as the primary interest deduction (business, investment and some student loan investment interest are also deductible). Far from crippling consumer lending, it didn’t skip a beat and grew exponentially until December, 2008. Only the greatest financial crisis since the Depression caused consumers to reduce their debt load.

And it gets better. If a recreational vehicle (RV) has permanent sleeping, cooking and toilet facilities, the interest on the loan used for purchase is also tax deductible. Some small percentage of RV owners use their RV as their sole residence, and they should be eligible for the same tax breaks as any primary residence. But what possible justification, other than inertia and narrow self-interest, could there be for the tax code to subsidize RV’s?

This is not to disparage owners of second homes and RV’s, and changing the tax deductions would certainly not prevent them from spending their money however they want. In fact, it would be equally wrong-headed to go overboard and somehow penalize these consumers beyond changing the deduction. Making these kinds of changes to the tax code, though, would help accomplish several major goals. First, it would force politicians to make hard decisions to define and reflect society’s priorities. Second, it would begin to align the tax code with those priorities. Finally, it may begin to rekindle some of the trust that has been so badly trampled in getting us where we find ourselves today.