1. 1. When they come back in session after Labor Day and before they go away for the elections in November;
2. 2. In a lame duck session after the elections and before this Congress adjourns;
3. 3. Next year after the new Congress convenes in January, if it were to pass legislation retroactive to
   January 1, 2011.

Our view is that nothing will get done by this Congress this year (indeed, so many incumbents are likely to get defeated in November that they may decide not to have a lame duck session, and the chances of anything except talk happening before the election seems remote in our view).

If we are correct, then on January 1, 2011, the following happens:

• - Income tax rates go up for everyone, with the top bracket going from 35% to 39.6%
• - Long term capital gains tax rates go to 20% from the current 15%
• - Taxes on dividends go from the current 15% to 36.9%
• - Estate taxes are re-imposed at 55% with a $1 million per person exemption compared to the 2009 rate of 45% with a $3.5 million per person exemption (there is no estate tax in the United States in 2010)

Thus you may want to meet with your tax advisor to discuss the following:

• - Should you accelerate income into 2010 and defer deductions to 2011 (the reverse of the usual advice)?
• - Should you take more than your required minimum deduction from your tax-deferred account(s) in 2010, paying at the lower 2010 income tax rate and lessening the amount in those accounts that will be withdrawn in later years at higher income tax rates?
• - If you are younger than 70 years and 6 months and older than 59 years and 6 months, should you take money out of your IRA account for the same reason?
• - Should you convert some or all of your IRA money into a Roth IRA for the same reason?
• - Should you take capital gains in your taxable account(s) before December 31st in order to take capital gains at this year’s lower rate?
• - Do you need to make any changes to your estate plan in light of the significantly lower exemption ($2 million per couple vs. $7 million per couple in 2009) and the higher estate tax rate?

For Starmont clients, we would be happy to be part of those conversations, either in person or by phone.

In publication for more than 37 years, The Wall Street Transcript is a paid subscription publication and website that publishes bi-weekly industry reports that feature equity analyst, money manager and CEO interviews. Starmont has arranged to post the interview on the Starmont website. Click here to read the full interview.

Equities are undervalued if you look at their projected price-to-earnings ratios at the end of this year, based upon projected earnings. But the projected earnings may be overstated if the economic recovery slows down or stops altogether. Emerging market equities are the new hobby-horse of the investment community. Our clients’ portfolios hold some, but the attention of the “what’s hot” crowd probably means they will do badly for a while until the investors with ADHD move on to some other “hot” product.

Bonds were the best-performing asset class in the decade just concluded and are the best so far in 2010. But when the Fed starts to raise interest rates (not a 2010 likelihood at this juncture), the value of outstanding bonds will fall. Our two Morningstar award-winning bond managers, Bill Gross at PIMCO Total Return and Dan Fuss and his team at Loomis Sayles, have produced positive returns so far this year while trying to position their funds for interest rate increases down the road.

Cash and cash equivalents are yielding almost nothing, unless you are willing to tie up your money for an extended period of time. We think that this would be a bad idea in an environment where interest rates are expected to rise. Starmont is using short-term bond funds as cash substitutes since they give better yields than money market funds and can be liquidated in one day with no penalty. They do carry some interest rate and credit risk but not much given their duration and the quality of the investments inside those funds. For clients who want what they perceive as zero risk, we can do CD ladders like we did in 2008. The risk there is inflation if prices rise while you are in low-yielding CDs.

Residential real estate may have bottomed, but there does not appear to be an upturn in prices. We have been approached by a number of newly created residential real estate funds that are designed to purchase and own homes, lease them out to cover the cash flow and then sell them when the prices go up and distribute the profits. But we have very little appetite for illiquid real estate investments, given what has happened with commercial real estate funds, particularly with the managers of these new funds having little or no experience in investments of this kind.

Commercial real estate in the form of domestic Real Estate Investment Trusts (REITS) had a good first quarter this year and a lousy second quarter. International REITS did even worse. Recovery in the commercial real estate market depends on the recovery of the economy. The jury is still out on that.

Gold. Jurrien Timmer, the manager of the Fidelity Dynamic Strategies Fund, has about 10% of that fund invested in gold. We are happy to let him do the investing for us as this is an asset class with no metrics—it goes up or down based upon sentiment. (The lower the sentiment, the higher the price of gold, which accounts for its current high price.)

Hedge funds are just funds that invest in various securities, which many times take different forms, such as private equity or the equity of companies that are being acquired or in debt such as distressed debt, and are in some manner hedged against downside risk. Rick Lake and his Aston/Lake Partners Alternatives Fund invests in many of these asset classes for us while being a mutual fund and subject to mutual fund regulation. Our San Francisco program with Rick was recorded and is up on Starmont’s website in three fairly short segments, with each segment labeled by topic. Go to www.starmont.com and click on the link in the What’s New column on the home page.

As one researcher said, “No asset class offers table-pounding opportunities…we are faced with ho-hum upside in a risky world.” But things change and there will be better opportunities at some point. We want to make sure that we are prepared to recognize and take advantage of them when these changes occur. In the meantime, we want to work with our Clients’ other professionals to ensure that they receive excellent advice in areas of their personal balance sheet such as tax planning, estate planning and mortgage assistance, designed to help them deal with upcoming issues and to take advantage of opportunities. This is part of what we do to achieve our goal of preserving and growing our Clients’ net worth so that they can have the life they want to lead.

Through June 30, the year was a tale of two stock markets. The first part of the year through April 25 was a continuation of the strong 2009 bull market. Indexes were up and it appeared that the recovery was taking hold. But things turned, and from April 26 through June 30, the market (as measured by the S&P 500 Index) dropped over 17%.  May was horrible (the worst May for the Dow Jones Industrial Average since May 1940). June was bad as well but not as bad as May.

The questions now are:

     – Whether the economic recovery will continue in the United States and globally, and if so, at what pace, or will the US and/or the global economy slip into a double-dip recession?

     – Where will growth come from?

     – What asset classes present the best opportunity to add value going forward? (This question will be addressed in Part 2 of the First Half Market Update coming tomorrow.)

Economic Growth

 Growth in any economy comes from one or more of the following sources: 

1. Individual consumption. Indeed, consumer spending in the United States made up a large portion of GDP in prior years. But with unemployment still high and housing prices and consumer sentiment still low, consumers have cut back on their spending and are saving more and de-leveraging their individual balance sheets (i.e., paying off debt).
2. Corporate spending. As of March 31, non-financial companies in the U.S. were sitting on $1.84 trillion in cash and other liquid assets as a cushion against continued economic malaise. When these companies gain confidence in the U.S. and global economies and start spending that money, it can add fuel to U.S. and global growth.
3. Government spending. The Obama Administration got a stimulus bill through Congress early in the Administration. But it appears that any further stimulus bills will run into opposition by both Republicans and Blue Dog (conservative) Democrats who do not want to add any more to the U.S. deficit. It appears that there will be no stimulus legislation at least until after the November elections.
4. Exports. U.S. companies are increasing their exports, but the U.S. continues to import far more than it exports (oil to be refined into gasoline being a leading import). The U.S. is talking to a number of countries to try to improve existing trade treaties. China allowed its currency to float a smidge after pressure from the U.S., so that U.S. imports into China would be a bit more competitive. That is not going to help in the short run unless China is willing to float its currency to a larger extent, which it does not appear to be willing to do. And with the Eurozone and Japan having economic difficulties and the Eurozone apparently committed to their own de-leveraging programs at a country level, it is hard to see to whom U.S. companies are going to be selling their goods and services in sufficient quantities to provide a growth engine for the U.S. economy.

So are we doomed to a double-dip recession or a long, slow recovery without much growth? Maybe or maybe not. It is possible that we will get some help from each of these growth sources, as consumers start to spend a little more, corporations begin to use their cash hoard, the government is able to help some and exports are increased. But it could take us the rest of this year, until a new Congress is elected and any lame duck session of the existing Congress is concluded, before a clearer picture might emerge.

While we wait, we will continue to have our Clients own a diversified portfolio of stocks and bonds, along with some managers who can short as well as go long and who are able to buy alternative investments like gold and currencies as their research and experience dictate.

So says Richard W. Fisher, president and chief executive officer of the Federal Reserve Bank of Dallas, with whom I had breakfast on Thursday, July 22.

Mr. Fisher says that the problem is not a monetary one that can be addressed by the Fed. Rather, he believes that while there is plenty of money in the economy, it is not being deployed because decision makers are uncertain about the future.

Mr. Fisher says there is over $1.5 trillion in cash sitting in companies throughout the United States that isn’t needed for cash-flow purposes. However, these companies are not utilizing this cash because they are uncertain what the landscape will look like in a wide variety of areas, including costs associated with the health care legislation, the financial reform legislation (costs of capital) and other areas upon which Congress is legislating or considering legislation.

Further, he says that banks have over $1 trillion in unneeded reserves at the Fed, where these funds are earning very little. Yet the banks are not lending out because of future uncertainty over issues ranging from regulation to taxes to loan defaults.

He believes that we are a strong country, with resilient people, but that legislation like the 2,000-plus page health reform bill and the 2,000-plus page financial reform bill create so much uncertainty that decision makers in the private sector are reluctant to commit capital to their businesses until some of the fog of doubt lifts.

This translates into slow (1% to 2% GDP, in his view) to no growth in the United States economy, and in much of the world outside the United States, for some period of time.

As Starmont has said, this is a time when investors have to be patient while things work themselves out. Investors must also be vigilant to opportunities and be prepared to act upon them, while understanding that we live in “unusually uncertain” times (Fed Chief Ben Bernanke in Congressional testimony). This is Starmont’s current posture.

Part 1—Alternative Funds—What are they?  How are they used in a portfolio? (7 minutes 47 seconds)                     Part 2—Asset Allocation, Diversification and Performance (8 minutes 4 seconds)
Part 3—Volatility, Managing Risk, and the New Normal (9 minutes 50 seconds)

- Congress passed the financial reform legislation, designed to prevent the kind of behavior by investment banks, commercial banks, and other kinds of financial institutions that led us to the brink of the worst depression since the 1930s; and

- Goldman Sachs settled their case with the Securities and Exchange Commission, agreeing to pay a fine of $550 million because of double-dealing with their Clients.

All of this came about because of the belief of many people in the financial services industry that if their behavior with their Clients wasn’t illegal, it was acceptable.

At Starmont we have a very different point of view. 

We believe that we are the guardians of our Clients’ dreams.  Based upon that belief, our behavior must not only be legal, it must be moral and ethical.  Our Clients must always know that we will do what we believe is best for them. In our view there is no other way to behave when you are dealing with other people’s money.

 To Our Valued Clients:

We are lowering portfolio equity allocations so that no Starmont Client has more than 40% of his/her/their/its portfolio in equities—down from 50%.

The decision over the weekend of June 26-27 by the G-20 to forego any further stimulus and to start cutting budgets (firing people) has made the market very nervous about global growth going forward, as was evidenced in recent stock market declines.

While President Obama said that the United States would follow a somewhat different path and keep stimulating now, and then half the US deficit by 2013 once we were out of the recession, it is unlikely that he can get any further stimulus legislation through Congress. This raises the question of where jobs are going to come from, and without jobs, what will drive growth in the United States and abroad?

On the positive side, the current concern about growth has in all likelihood delayed the Fed from raising the Fed Funds rate until sometime in 2011. The proceeds of the equity sales we are now making will go into fixed income, which is showing positive returns for the year, and we should not have to worry about rising interest rates (and lower values on outstanding bonds) for a while.

Best Regards,

Harvey Rowen