Report From Paris

Paris was cold.  Reading reports of a deep freeze in Europe is one thing.  Walking on the Rue de Rivoli with hat, scarf, gloves, and three layers and having to avoid ice is something else.  Even the highest-end jewelry sellers’ plaza in the world, the Place Vendome, could not keep its sidewalks clean and safe for venturesome visitors.

Three elements surfaced in our conversations with fund managers and bankers. 

Russia, Ukraine, and the natural gas cutoff make it to the top of most lists.  Putin is trying to unseat President Yushchenko and establish Russian influence over this pro-western country.  This is consistent with Putin’s behavior regarding Russian expansionism.  Readers are well advised to follow these events closely.  The outcome will affect European economic policymaking.

The natural gas cutoff is now impacting half the European Union member countries and reaching as far as Italy and France.  The Ukrainians cannot pay what Russia demands, and their ability for energy substitution is quite limited.  Either (1) the Russians have to relent and “back down” or (2) achieve political success in Ukraine and establish hegemony as they have in Georgia or (3) the EU members have to pay the bill and submit to this extortion.  Stay tuned.

Most investors and bankers are looking for the European Central Bank (ECB) to cut interest rates along with more cuts from the Bank of England (BOE).  Expectations are rising that worldwide rates will be converging toward the very low levels already seen in the United States and Japan.  We believe this expectation is reasonable and underway.  Most of the debt in the world is denominated in these four currencies: euro (30%), dollar (39%), pound (4%), and yen (13%).  A convergence means that the global short-term policy interest rate will be somewhere around 1% and the global bond interest rate will be around 2 to 2½%.  We expect that to be the case for all of 2009. 

The biggest unknown is how the currency exchange rates (FX) will adjust.  Agreement is nearly universal that the adjustment process will be in the FX markets.  Japanese intervention is expected, and some of the conversations I had were about why we haven’t seen heavy Japanese intervention yet.  The ECB, BOE, and our Fed are unlikely to intervene, so all eyes are on Japan.  Ranges of dollar-euro forecasts are as wide as I have ever seen in the ten-year history of the euro.  I heard cases made for a dollar collapse, and a $2-dollar euro argued.  Four hours later I heard the other side; he made a case for a $1.20 euro. 

Cumberland’s present position is for a stronger dollar over the intermediate term.  We base that on the fact that the US became more stimulative faster than the other major economies and therefore the US will experience recovery sooner.  We believe that currency strength will gravitate toward the faster-growing economies as we morph from recession worldwide into recovery worldwide.

The last point that struck me is how damaging the Madoff affair is to the image of the United States.  Revelations like the failure of the Austrian Bank Medici are front-page stuff in Europe.  Madoff’s tentacles reached far. 

In my view, the regulatory failure is now a bigger issue than the massive swindle itself.  It seems that in Europe there was a sense of trust in the Securities and Exchange Commission.  There was a view that the US was the most reliable of the capital markets.  Everyone knows that markets are not perfect, but the perception was that the United States was more honest or more transparent than the others. 

Reports of the Markopoulos memo and others elements that show the SEC ignored warnings over a period of years are, perhaps, the most damaging.  Europeans cannot trust US capital market functionality to the degree they could in the past.  This structural issue is very serious and not well understood in the United States. 

We do not yet know how much it will impact relative pricing of financial assets.  We do know that the new Obama Administration and the restructuring of financial regulation in the US must be highly sensitive to effects that are global.  The Congressional Barney Frank-Christopher Dodd nexus are rewriting our financial rules.  There is much potential harm that can come from poorly conceived legislation or from US home bias or the protectionist influences that are working in Washington. 

This last point is probably one of the most serious one that markets face in 2009.  Global financial integration can proceed and that will mean a resumption of growth worldwide.  To do so we must overcome the US-led financial failures of Lehman, AIG, Bear Stearns, etc.  Success will require that the United States is believed and that our financial markets are trusted.  The Federal Reserve knows this and is following a policy in that direction.  Obama seems to know it and his close advisors like Volcker and Summers certainly do.  

The risk is in the Congress.  In Europe there is low confidence in elected politicians there.  Their eyes are now focused on us, and they are watching the Congress closely.  This is a bigger risk than many in America think.  Reminder: it was the congressionally passed Smoot Hawley protectionism that took a recession and turned it into a depression in the 1930s.  Woe to us and to the rest of the world if a modern congressional version is applied in finance instead of import goods.

Lastly we offer a restaurant review.  Our friend Lillianne, chef-owner of her exceptional bistro, is still our first choice.  This is not a fancy place.  It’s just a superb meal of traditional French food in a charming 300-year-old room.  She cooks everything herself.  If you are not careful you can walk right by it and miss the entrance.  The place is called Aux Anysetiers du Roy, and it’s found in the center of the Isle St. Louis at number 61, Rue St. Louis en L’Isle, local number from Paris 01-56-24-84-58. Tell her David sent you. 

Looking Ahead by Looking Back

The previous commentary “Looking Ahead” focused on the risks to the outlook for 2009. However, we are now officially in a recession, with some trumpeting it as the worst economy since the Great Depression, and policy makers have responded with extraordinary measures. Therefore, it seems appropriate to take a hard look at exactly where we are in the business cycle and how our present situation compares with previous recessions.

What we will do is to look at the previous six recessions and compare where we are today on a relative basis with those downturns. In some instances, comparable data are also available for the Great Depression, and these are also compared with the current situation. The discussion looks at aggregate output as measured by real GDP and industrial production. It then breaks down the key components of GDP into consumer spending, investment (including non residential and residential investment), imports and exports, and government spending. Then we turn to the employment situation and consumer prices. The comparisons will present two panels, one showing the current data and each of the previous six recessions and the second showing current data and the average for those six earlier recessions. Sometimes a third panel is also provided if a comparison with the Great Depression is available. The timing and duration of the recessions considered are detailed in the following table.

Recession Dates and Their Duration

Start of Recession

End of Recession

Duration – Peak to Trough in Months

Dec 1969 Q4

Nov 1970 Q4


Nov 1973 Q4

Mar 1975 Q1


Jan 1980 Q1

July 1980 Q3


July 1981 Q3

Nov 1982 Q4


July 1990 Q3

Mar 1991 Q1


March 2001 Q1

Nov 2001 Q4


December 2007 Q4






Great Depression

August 1929 Q3

March 1933 Q1


Source: NBER Economic Cycle Dating Committee

Because the size of the economy has increased over time, the data are scaled and are all aligned at zero at the start of each recession in order to provide meaningful comparisons. In the case of GDP, for example, the graphs tell us at each recorded date how much larger or smaller in percentage terms the value of real GDP was relative to the start of the recession. Notice too that virtually all the comparisons are based upon the levels of economic activity rather than changes in it. While economic growth is important, obsessing over small rates of growth or decline in an economy rather than focusing on the level of activity can sometimes lead one to conclude that economic conditions are much worse than they really are.

To give away the punch line of this story, it does appear that now, 12 months into the recession, the current real-side situation looks very much like your average garden variety recession. Certainly, there are differences, since every recession tends to be unique in terms of both its causes and what leads us out. Additionally, regardless of the rhetoric, the current situation is not the next Great Depression. And if we are to plunge into the next Great Depression, then the path will have to be very different from the current trajectory of the economy.

Real GDP

Chart (Link is no longer available) shows the paths for real GDP. In the top panel, real GDP for the current period exceeded that at the start of the recession and was clearly better than it was for virtually all of the previous six recessions. In the bottom panel, it becomes clear that for the average recession, by two quarters into the recession, GDP was on average 1% below where it was at the start of the recession. In contrast, during the Great Depression, real income (Chart 1A)(Link is no longer available) was already off by about 10% twelve months into the depression and hit a bottom down 60%.

Chart 2 (Link is no longer available) looks at output from another perspective, which is industrial production. Industrial production has fallen since the start of the recession, but the decline may have either bottomed out or temporarily stalled. The current path is below the average path shown in the second panel, but still in line with the declines experienced in 1969, 1973, and 1981. However, the declines can’t compare with the ultimate decline in industrial production experienced during the Great Depression, as shown in Chart 2A (Link is no longer available). Then, production began a precipitous decline 12 months into the depression, and was off nearly 50% at its low point. The current experience, one year into the recession, actually shows a greater decline in industrial production than we experienced during the Great Depression, but the Great Depression experience was clearly exacerbated by a monetary contraction and poor initial fiscal policies.

Personal Income and Consumption

Personal consumption is driven mainly by personal income, so we turn first to income. Chart 3 (Link is no longer available), derived from data provided by the National Bureau of Economic Research, shows real personal income, but without transfer payments, to capture how well production is actually helping to support personal consumption. Clearly, individuals can consume out of both income they earn as well as any unemployment, welfare, or other governmental transfer payments they may receive. But excluding transfer payments enables us better to gauge how well the economy itself is supporting personal consumption. Clearly, personal income is off slightly – by less than .5% some 10 months from the start of the recession. This performance clearly exceeds that of three of the previous recessions. However, by the third quarter of the ’80 and ’69 recessions personal income had already begun to accelerate and was above that of the start of the recession. Looking at the second panel of Chart 2 (Link is no longer available), we can see that when compared with the average recession, personal income is at the average, and that average remained below the previous peak for another 10 months. Personal income for the Great Depression (Chart 3 A) (Link is no longer available) is only available as quarterly estimates and includes transfer payments. Personal income held up somewhat better during the first year of Great Depression, but fell by nearly 50% at the bottom. Again, the pattern of personal income for the current recession is presently not tracking that of the Great Depression.

Turning to personal consumption expenditures (PCE) (Chart 4) (Link is no longer available), spending has been well maintained and at the end of the third quarter of 2008 was still above what it was at the start of the recession. Interestingly, PCE began to exceed the pre-recession peak for all the recessions by the time the recessions were about five quarters in duration. When compared with the average, aggregate PCE seems to be on par with previous recessions. However, when looking at the components of PCE, while Chart 5 (Link is no longer available) suggests that spending on consumer services has been well maintained, as it appears to have been during most of the other recessions, spending on durables and nondurables fails to exhibit the same pattern. Chart 6 (Link is no longer available) examines consumer nondurable expenditures. There are no clear patterns of consumer nondurable spending in recessions. In some instances, the top panel shows, spending dropped off almost immediately, in the first couple of quarters of recessions, but then began to pick up. In other recessions there was no significant slackening of spending on nondurables. In the case of the current recession, however, while spending initially seemed to be on a positive trajectory, it now appears to be contracting. The contraction in consumer durable spending Chart 7 (Link is no longer available) is also evident, and began almost at the start of the recession. Interestingly, despite the strong expansion in the housing industry, which typically is associated with growth in durable goods spending, growth in durables actually was below that for previous expansions that led to subsequent downturns. Having said that, the contraction in durable goods expenditures in the current recession is less severe after three quarters into the contraction than for three or four other recessions. The pattern most like the current one was for the 1973 recession, in which durable goods spending was off its peak by 10 percent four quarters into that recession, which lasted for 16 quarters.


Investment consists of both residential and nonresidential investment and is one of the key determinants of increases in productivity, expansion of per capita income, and sustainable economic growth. Probably the most extreme pattern in all the data is the path for residential investment Chart 8) (Link is no longer available). Residential investment was clearly at a peak about two years before the start of the recession and has been on a steady linear decline that has continued almost unabated since then. Residential investment declined in ’73, ’80 and ’81 more severely after the start of those recessions than it has in the current period. But the peak this time was much higher, the decline more steady and, of course, the impacts on the financial system have been unique.

Nonresidential investment (Chart 9) (Link is no longer available) has performed much better than residential investment and also better than in previous recession periods. In only the 1981 recession did business fixed investment increase following the start of the recession, but then it quickly began to decline. When compared to the average of past recessions, the relative strength of business fixed investment is even more apparent.

Looking at the two components of business investment (Charts 10 and 11) (Link is no longer available), business structures investment this time was relatively less when compared to all previous recessions, leading up to the downturn, but has been on a steady upward trend since then. In virtually no other recession has this component fared as well as it has to date.

Business equipment and software investment (Chart 11) (Link is no longer available) was stronger than in the periods leading up to most previous recessions, and the decline after the recession began has been among the mildest when compared to other recessions. This is particularly clear in the lower panel of Chart 11 (Link is no longer available) when the current period is compared to the average of the previous six recessions. Equipment and software investment has been on a path that was more steady than most previous recessions, both leading up to and after the downturn. However, reports are that businesses have pulled back significantly on their investments in Q4 of 2008 or have temporarily put plans on hold for the first part of 2009.

Corporate Profits

A key determinant of business investment spending is corporate profits (Chart 12) (Link is no longer available). Corporate profits have fallen off significantly, and performance is only slightly better than experienced during the 1981 recession. Corporate profits fell off even more, before picking up sharply, during the 1973 recession. Overall, the second panel indicates that profit performance has been worse this recession than for the average recession; and should this pattern continue, then a recovery led by investment spending will be a ways off in the future. As bleak as the profit picture appears now, however, Chart 12A (Link is no longer available) shows that the falloff has been mild compared to what was observed during the Great Depression. Profits were down more than 130% at the worst point of the depression and took a long time to recover.

Imports and Exports

Categorizing what happens to imports and exports during recessions (Charts 13 and 14) (Link is no longer available) is difficult. In general, imports tend to decline and exports pick up, but there have been recessions, such as 1969, when both imports and exports increased, and one like 2001, where both imports and exports decreased. This time around, US imports have slightly decreased while exports have expanded, just about in line with the average experience for the past six recessions.

National, State, and Local Government Expenditures

For all but two recessions, 1969 and 1973 (Chart 15) (Link is no longer available), government expenditures began to increase before the outset of the recession and continued to expand during the contraction that took place. During the current recession, government expenditures virtually tracked the average experience going into the recession, and subsequently, this spending has continued to increase such that it now is about 6% greater than when the recession began in December of 2007. This is consistent with the automatic stabilizing role that government can play, and suggests that government spending is actively supporting aggregate demand, even without the stimulus programs the new administration is contemplating.


A lot of attention has been paid recently to the job creation numbers and new claims for unemployment insurance as providing meaningful indications of the employment situation. But perhaps the best place to start in comparing the current recession with past ones is with the people who are actually working (Chart 16) (Link is no longer available). Non-farm employment peaked at about the start of the recession in December of last year and then has declined, but by less than 1.5% as of November 2008. The decline to date has been less than in three of the past recessions (’69, ’73 and ’81) and about equal to the average, as the bottom panel of Chart 16 shows.

The unemployment rate was also lower going into this recession (Chart 17) (Link is no longer available) than for all but the ’73 and ’69 recessions. The increase in the unemployment rate has paralleled that of the average for the past six recessions, which peaked at about 16 months after the start of the recession. Looking at the recent changes in unemployment on a relative basis (Chart 18) (Link is no longer available), the current recession is about on pace with the average for the past six recessions. It is currently less than the recessions of 1969 and 2001, but the 1981 and 1973 experiences suggest it could get even worse. The unemployment rate experience largely mirrors data on the relative number of people who were unemployed (Chart 19) (Link is no longer available).

The unemployment patterns for the Great Depression (Charts 17A and 18A) (Link is no longer available) show a marked acceleration at the start of the depression and by a year into the depression the unemployment rate was already well over 10% and ballooned to over 25% at the end of three years.

The unemployment record so far has been about average for past recessions, and this is a bit unusual, given that the duration of unemployment for those seeking jobs has proved to be substantially longer, both going into the recession and since the recession began (Chart 20) (Link is no longer available). Unemployment duration has been longer than in any of the past six recessions and has been greater than the average for those six recessions by about two months.


Usually, going into a recession, inflation is not a major problem, since recessions are typically thought to be associated with declines in prices because of the large increase in resource slack and the increase in unemployment which is thought to take pressure off wages. However, this view is not generally supported by the data (Chart 21) (Link is no longer available). On average, the price level continues to increase after a recession begins, and this is true of all six of the past recessions. The only exception is the current recession, which has exhibited first a continuing increase in prices and then a subsequent decline after about nine months. This is largely a consequence of the increase in energy prices in 2008, which was followed by a significant decline in oil and natural gas prices. One of the drivers of inflation is the increase in the money supply that usually accompanies policy actions to offset a recession. The monetary aggregates, but especially M1 (Charts 22 and 23) (Link is no longer available), have increased substantially during the current expansion, and other sources of liquidity have been made available in both foreign and domestic markets as well. The increase in M1 relative to the average increases observed during past recessions, when combined with policy interest rates which have been cut to near zero, means that the future inflation risks appear to be very large.


This recession was precipitated by problems in the real estate market which disrupted financial markets and devastated many of the US’s major banks and investment banks. Commentators and many policy markers reacted as if the real economy was entering a recession that was worse than previous ones – certainly worse than all but the Great Depression. However, comparisons of the real-side performance of the US economy suggests that to date – a full 12 months into the recession, when the longest of the last six recessions was 16 months – with the exception of housing, the current experience is about like the average recession experienced since 1969.

Policy makers have responded to the perceived crisis by substantially increasing the money supply, by cutting the target Federal Funds rate to less than 25 basis points, by significant injections of capital into financial institutions, and through direct lending by the Federal Reserve to nondepository institutions.

While the effectiveness to date of some of these measures may be questioned, it is a fact that the current recession seems little different from the average of past recessions in most key dimensions; and by the comparisons made, it is also not close to the Great Depression. It is true that incoming data on sales, especially home and auto sales, suggests that the 4th quarter of 2008 will be worse than the 3rd quarter, but how the coming quarters will stack up against history remains uncertain. However, if the feared negative feedback effects from the financial problems are to have a significant impact on the real economy, those effects are largely prospective and have yet to be realized. When we consider the extent of fiscal and monetary stimulus already in the pipeline and on the horizon, governmental responses to the current recession are both unprecedented and likely to turn the economy around promptly as their full effects are felt. If, however, the risks are realized, then the current recession will be atypical in several dimensions and will clearly prolong a slowdown that already is longer than average.

Thanks to Ellis Tallman, Oberlin College for the suggestion to look at industrial production and for providing the data.

GM Subsidies

The Wall Street Journal editorial on Jan. 2, 2009 commented on the looming consequences of the injection of government money into the tottering auto giant GM.  GM announced that it would employ part of the TARP money it received to provide 0.0% financing in order to spur sales of its sport utility vehicles (the ones that it has had trouble moving during the gasoline price problems of this past summer).  The editorial made two points.  The first was that the government support gave GM (and presumably Chrysler, if it decides to follow GM) a financing advantage that would favor GM over its competitors.  It is these competitors that are currently less financially pressured and the ones producing cars that people actually want to buy.  The second point was that the government’s rationale for injecting capital into GM was to preserve jobs, and by inference, the Journal suggests this means that jobs at GM are viewed as more valuable than those at competing auto producers. 

There are other key points that the Journal might have pointed out which illustrate the kinds of perverse incentives that such government aid conveys.  The first is that the way to think about the financing advantage that GM now enjoys is that it is equivalent to a taxpayer subsidized price cut on the cars to which the 0.0% financing applies.  Just how much of a price cut are we talking about? indicates that last Friday’s market rate on a 60-month loan (the kind GM is offering) was 6.79%.  Over the life of the loan, the 0.0% financing would save the borrower approximately $3500.  The present value of this interest saving would be less and would depend, of course, upon the discount rate applied.  However, the point is that government support has enabled GM to significantly lower the effective price of the cars covered by the arrangement by as much as $3500 (price impact would be greater for low-income borrowers, since the rate they would pay in the market would be substantially higher than 6.9%).

The second point is that government support will competitively distort the car buying decision toward less fuel-efficient vehicles and also away from automakers that are relatively more efficient in producing automobiles.  Part of the value of the subsidy has also already been transferred to the existing shareholders of GM, whose share price appreciated approximately 16% on January 2, 2009. 

Finally, the subsidy will also have a negative impact upon the US workers who are employed by the more efficient auto producers, to the extent that production and sales are diverted to GM from its competitors. 

This support of GM directly parallels government action during the S&L crisis which offered forbearance to failing zombie thrifts who then went out and used their government support to take on more risk and to raise the cost of funds to the disadvantage of healthy institutions.  This is just the first of many negative consequences that will have to be considered in assessing the true net benefits of government bailouts.

US Stock Markets and 2009

There are signs that the 2008 year-end stock market rally may continue into 2009.  Internal market dynamics have changed since the November 20 low.  In order to grasp these new dynamics it is important to study three key dates and the transitions in between them.

The first date is October 10, when the US stock market appeared to show signs of a selling climax.  Subsequently, the market tested those October 10 trading lows several times.

The second key date is November 20.  This is the day that the market retested the lows of the climax in October and established an even lower reference point.

The third key date is December 15, when the Federal Reserve’s most recent policy action established a zero-bound low target for the Fed Funds rate.  In the same action, the Fed articulated a complete commitment to liquidity provision in whatever amount and by whatever means is necessary to liquefy the economy and unfreeze credit markets.  The Fed’s commitment to avoid deflation and depression is now certain and clear.

October 10 appeared to be the selling climax of the post-Lehman failure waterfall.  The accelerating global downturn actually started in earnest in mid-July during the Fannie-Freddie crisis, and the depressing accelerator hit the floor with the failure of Lehman Brothers.  Between Lehman’s mid-September demise and the mid-October climax, all stock markets of the world fell in a highly correlated manner.  The correlation among global markets had been rising since mid-July.  After Lehman it became a single global contagion-driven waterfall.  Credit markets seized; raw panic ensued.

After the October 10 climax, markets experienced a tug-of-war between those who forecast a multi-year period of gloom and doom and those who expected governments and central banks to intervene powerfully to avoid that fate.  The movement of stock markets worldwide between October 10 and November 20 was much less correlated than in the immediate period following Lehman’s failure.

In order to believe that the stock market lows were reached in the autumn of 2008, we need to observe transitional changes during and after that time frame.  The first transitional change is observable when market behavior begins to relax after the peaking of highly correlated movements.  In other words, when markets are selling off worldwide with the intensity of raw panic, one must look for signs that the panic has reached its extreme peak.  This can only be done after the fact.  This peaking point determination is necessary in order to set the stage for the next observation. 

Panic selling was at its extreme between Lehman’s mid-September failure and October 10.  Panic selling was still very intense after October 10 but not as extreme between October 10 and November 20.  We conclude that observation because we can measure the correlation of the selloff in global markets.  That correlation peaked between September 15 and October 10.

Signs of panic selling intensity include outperformance by the very large-capitalization stocks.  In other words, lesser-cap, smaller- and mid-cap stocks get hammered more than the largest-cap stocks because the largest-cap stocks are viewed as being safer.  Remember, this is during a period when all stocks, large- and small-cap, are falling.  This is a relative performance comparison. 

Between October 10 and November 20, the capitalization-weighted S&P 500 index fell 16%.  The reference exchange-traded fund (ETF) is the "Spider," symbol SPY.  SPY’s total return was negative 14.75% between October 10 and November 20.  SPY tracks the index closely.  The numbers are not exact, due to tracking error and internal ETF costs and also due to the fact that the total return of the ETF includes dividends.  The raw price change of the index ignores dividends and has no internal attributable costs.

During the same October 10-November 20 period of time, the Rydex equal-weighted S&P 500 ETF (RSP) declined by 22.5%.  In other words, we are measuring the same 500 stocks by two methods:  capitalization weight and equal weight.  Capitalization weight went down but not as much as equal weight.  This demonstrates the observation that large-caps didn’t decline as much as small- and mid-caps during the October 10-November 20 market waterfall.

Let’s now examine the period between November 20 and December 15.  We are looking for evidence to confirm the assumption that November 20 was the bottom.  SPY rose by 16.3% between November 20 and December 15.  RSP rose by 18.2% during the same time frame.  In other words, the equal-weighted S&P 500 reference outperformed the capitalization-weighted index reference by about 2%.  The implication is that the market recovery since the November 20 low is broadening beyond the very large caps.

Let’s examine this issue of broadening to see if there’s more evidence to support our observation.  To do this, we will compare the S&P 400 mid-cap index ETF (symbol MDY) and the S&P 600 small-cap index ETF (symbol IJR).  Between November 20 and December 15, MDY achieved a total return of 18.5%.  In the same period, IJR achieved a positive total return of 17.3%.  The conclusion is that between November 20 and December 15, SPY performed the worst.  RSP outperformed SPY.  MDY outperformed RSP and IJR outperformed SPY.  Note that we have just examined the relative performance of the components of the S&P 1500 stock index with four different reference index ETFs.

Let’s examine what happened after the Federal Reserve policy action and statement issued on December 15.  Between December 15 and December 31, SPY delivered a total return performance of 3.7%.  RSP resulted in 5.9%.  MDY delivered 8.3%, and IJR derived 9.8%.  Notice how the transitional trend that began on November 20 and continued through December 15 became even more robust after December 15.  Notice how the market broadened and extended to smaller- and mid-caps.  In the US, stock markets have interpreted the Federal Reserve policy statement on December 15 with a positive response.

Disclosure:  Cumberland’s US ETF accounts now hold more RSP than SPY in the broad ETF category.  In addition we are now overweighted in MDY and IJR

As we enter 2009, we are looking for additional affirmations that November 20 was the low for the stock market and that the post-Lehman failure period of September 15 through October 10, and then to November 20, represented the most acute degree of panic.  In addition to broadening markets we also see margin debt as a percentage of GDP reaching the historic low range that corresponds to bottoms.  We see insiders buying.  We see the VIX Volatility Index falling; it still has a long way to go to return to the levels that have corresponded with complacency.  And finally we see $3.8 trillion in money market funds earning zero interest.

Of special note is the Ned Davis Research Multi-Cap Institutional Equity Series Absolute Index.  This complex and relatively obscure measure has an 85% successful batting average.  It logged great buy signals in 1982, 1987, and 2002.  Last month, it logged a record value and reversal.

Our outlook is positive.  We expect the central banks and governments of the world to continue aggressive monetary and fiscal stimulus.  We anticipate credit markets will improve in 2009.  Spreads will narrow.  Tax-free Munis and taxable corporate bonds will rally in price.  We are avoiding US Treasury notes and bonds.

Our current allocation is 50% bonds, fully invested with long duration (both tax-free and taxable), and 50% stocks using ETFs.  Cash is currently allocated at zero.

As markets improve, we would expect the stock market allocation to rise over time and the bond allocation to fall commensurately.  This adjustment process may occur during the entire year of 2009.

A normal allocation over strategic time periods would have 70% in the stock market and 30% in bonds.  These are very uncertain times as we enter 2009.  While we expect central banks and governments to succeed, we acknowledge that risks are very high.  Therefore, our present allocation to the stock market is below normal and allocation to bonds is higher than normal.

We’re flying to Paris for two days of discussions about European markets, the dollar-euro exchange rates, and the fallout in Europe from the Madoff scandal.  For those who rise early, we will be the guest host of CNBC’s Worldwide Exchange from the Paris studio on January 5 between 10am and noon Paris time (that’s 4am to 6am NY time).

We wish our clients, their consultants, our friends, and all of our readers a happy and healthy 2009.

Looking Ahead to 2009

Economic forecasting is at best an imperfect art, whether using econometric models, informed judgment, or a combination of both.  There are almost as many different forecasts out there as there are economists.  Witness the wide dispersion of views in any of the collection of surveys conducted by the National Association of Business Economics, the Wall Street Journal, or USA Today, just to name a few. 

My own research with former colleagues at the Federal Reserve Bank of Atlanta developed methodologies to evaluate the accuracy of economic forecasts, and these are now employed by both the Wall Street Journal and USA Today in constructing their rankings.  A few important conclusions follow from that work.  First, predicting turning points is extremely difficult, and the dispersion of forecasts tends to increase during turning points.  Second, some forecasters tend to do well consistently while others are consistently less accurate.  However, the research also demonstrates that even the best forecasters tend to make big errors at times – sometimes because of weaknesses in their models or methodologies, or simply because unforeseen events do happen.  Third, even when looking at the consistently best forecasters, consensus forecasts tend to be better with smaller average error rates than those of  the best performers, and this includes the Federal Reserve staff forecasts.

With that preamble, what are the consensus forecasts saying about 2009?  And what factors may be critical in determining the realization of those forecasts?

Both the WSJ and NABE surveys were completed in November of 2008.  Survey panelists saw negative real growth in Q4 of 2008 and a continuation of that path into Q1 of 2009.  The NABE panel predicted -2.5 negative real GDP growth in Q4 of 2008 and continuing into Q1 of 2009 with -1.1%.  Thereafter, the panel saw growth slowly picking up in the second half of the year.  Inflation was not seen to be a problem through 2009, but unemployment was.  By the end of 2009, the unemployment rate was seen as being nearly 1 percentage point higher than it currently is, at about 7.4%.  The drag on growth and employment was viewed as being driven by sharp declines in consumer spending and business investment.  The downward pressure was predicted to continue well into 2009, but the negative impact from housing was seen as subsiding by the middle of next year.  Despite the housing problems, the view was that the recession, which started in Dec. 2007, would be relatively mild, with the peak-to-trough decline in real GDP predicated to be about 1.5%.  Finally, the panelists were lukewarm on the likely impacts on GDP growth of most of the emergency Fed and Treasury programs that have been put in place.

The WSJ forecasters had similar views to those of the NABE forecast panel, but less detail was provided.  GDP growth was expected to be zero for the years 2008 and 2009, with the recession toping out by mid-2009.  The WSJ panel was more pessimistic than the NABE panel when it came to the unemployment picture.  They saw the unemployment rate at 8.1% by December 2009. 

Given the choice right now of locking in those consensus forecasts, as compared with the prospect that economy would perform even better, my guess is that virtually all of us would willingly lock in the sure thing.  The reason is that the majority of risks to the forecasts appear to be to the downside – that is, worse outcomes are more likely than better outcomes.  What are those risks and other considerations?  The following is my list, in no particular order of importance, of key factors that may affect both the timing and pace of the recovery.

The Consumer – The consumer was the driving force behind the last expansion, with spending increasing at an even faster rate for most of the period than GDP growth.  Consumer spending fell off drastically in Q3 of 2008 and most likely has not recovered in Q4.  I believe that spending has shut down because of uncertainty about the financial crisis, concern about the worsening employment situation, and the failure of housing prices to stabilize.  It would be extremely unlikely for the economy to be able to recover significantly without a pickup in consumer spending.

Housing – There remains an excess supply of housing, and that inventory needs to be worked off.  Housing prices are still falling, but the expectation is that this will moderate in the first half of this year as mortgage interest rates decline.  However, just because housing prices have stabilized doesn’t mean that spending on either new construction or related durables will return to anywhere near their past boom levels. Home ownership rates are only slightly off their all-time highs, so any increase in demand will have to come from either population growth or new family formation.  Most likely, we will first see a pickup in multifamily housing as low-income individuals and families move into rental properties until their job and income prospects improve.

Business Investment – Another critical driver of sustainable economic growth is business investment.  It is the main source of improvements in productivity growth and per capita income, and the associated accelerator effects can drive increases in employment as well.  Investment by business has been in a near-steady decline, both in terms of equipment and software and commercial real estate, for nearly every quarter since the start of the recession.  These two components will likely continue to be a major drag in 2009 and will respond more to increases in demand and corporate profits, when they materialize, than to declines in interest rates or increased availability of credit.  It is unlikely that we will experience a significant recovery until those components turn around and businesses begin to invest again.

The Financial Sector – Most of the efforts by the Federal Reserve and Treasury have been directed at addressing what they perceived to be a liquidity problem as manifested in a significant widening of credit spreads.  Only belatedly has it been recognized that financial market problems have been due to inherent questions about institutional solvency and asset quality.  Consequently, early efforts to address these problems met with, at best, marginal success.  Deleveraging must take place and institutions must rebuild their capital with private sector injections and not government money.  Lending will not pick up until losses are recognized and purged from balance sheets and needed recapitalization takes place. 

Stimulus Packages – Consistent with past fiscal stimulus efforts to jumpstart consumer spending, the 2007 stimulus package was largely ineffective.  The Obama administration is considering somewhere between an $800 billion to $1 trillion stimulus package, with the goal of creating 3 million jobs through infrastructure spending.  Such massive directed spending efforts will take time to put in place, perhaps even a couple of years before money begins to flow.  It simply takes time to create the bureaucracy to administer the programs and to design and engineer infrastructure projects of sufficient scale and volume to have a major effect on economic activity.  If history is any guide, such plans are likely to be costly and not very effective.  Again, research suggests that the most effective programs are automatic stabilizer initiatives, such as the extension of unemployment benefits and tax cuts, which put money immediately into the hands of consumers.

The Value of the Dollar – The dollar had recovered against most foreign currencies before the Fed’s December rate decisions. In the short term, the cut in interest rates means that the dollar is likely to continue to decline in value.  The good news is that this will act to stimulate exports again and discourage imports, and help to cushion the decline in real economic growth. The US is probably further into the current recession than most of our major trading partners, and the US economy is likely to recover from this downturn before other countries and recover more quickly as well, because of its inherent flexibility.  This will strengthen the dollar relative to other currencies and reverse the decline in the exchange rate.  Timing here is critical for those wishing to make the trade.

Inflation – Most economists have looked at the recent declines in inflation and have suggested that the most important policy focus in the short run should be on stemming the decline in real GDP.  However, the Fed and foreign central banks have injected massive amounts of funds into financial markets, and there are no announced plans for how this liquidity will be withdrawn as money velocity begins to pick up.  The recent decline in inflationary pressures has everything to do with what has happened in the energy market, which will continue to be a significant source of risk in coming years, and nothing to do with current policy.  If monetary authorities react preemptively and do so in error, then we could easily truncate whatever expansion might be underway.  The more likely error, however, is that central banks will wait for signs of solid increases in inflation and then will act to counteract inflation pressures.  They will react too late and too much, with predictable negative consequences. 

Regulatory and Policy Risks – Once the new Congress starts up in January, its first priority will be finalizing a fiscal stimulus package.  However, close behind that will be a series of efforts to reform the financial system and its regulatory structure.  Right now the mood of the country is anger at having to bail out financial firms.  People are especially upset at the large Wall Street firms, which are perceived as having paid outrageous salaries and bonuses to managers who ran their companies into the ground.  Such perceptions, regardless of whether they are right or wrong, are easy to address with tightened regulations and restrictions on executive compensation.  The Madoff Ponzi scheme could not have come at a worse time with regard to investor confidence in the information they are receiving about investment prospects and performance.  The events will embolden legislators and prompt them to “do something.”  History again suggests that reforms conceived in haste and anger oftentimes have unintended consequences which take years and even decades to be corrected. 

Conclusion – The list of risks seems long and potentially severe.  Adverse realizations of even a few could pose a threat to the forecasts for even modest growth for the second half of 2009.  Volatility will be with us until it becomes clear that policy uncertainty has been resolved, the course of the stimulus program of the new administration is set, and aggregate demand and investment have begun to pick up.  It is also the case that most significant new businesses tend to be born in tough times, in part because established firms overreact and spurn or abandon investment opportunities that they might have otherwise undertaken.  In addition, there are also significant anomalies and asset mispricing in the market that astute investors can take advantage of.  For example, Cumberland has long been interested in the unique opportunities that the municipal securities market has offered and has been able to find safe and extremely attractive tax-free returns in that market throughout this financial crisis. 

Pondering Madoff as we enter 2009

"This is a major disaster for a lot of people.  You work all your life, you finally manage to save up something, and somebody who’s entrusted with it, it turns out suddenly he’s a crook. Lots of people are getting fully or partially wiped out." 

Lawrence Velvel, 69, Dean of the Massachusetts School of Law who said he and friends had lost millions among them.

“Those with the biggest financial gains generally had their money managed by Madoff. It was an honor having him handle your fortune. He didn’t take just anybody. He turned down all kinds of people, and that made you want to give the man even more of your money. When he took your fortune, he told you that he would tell you nothing about how he achieved his returns.” 

Laurence Leamer, a Palm Beach based journalist, writing in the New York Post, December 13.

First to the structural business issues.

Cumberland Advisors did not and does not have a single penny in any fund directly or indirectly positioned with, having custody with, or in any way associated with Madoff.  The Madoff structure violates all of our internal disciplines.  Madoff required that investment management, brokerage, and custody all be with him under the same roof.  At Cumberland we require that each of these three functions be separated by task, separately evaluated, and separately reported.

Cumberland will not invest in any conduits or vehicles where the sponsor refuses to disclose the contents of the investment.  Furthermore, we recommend that our clients avoid any investments they do not understand.  We also avoid any investment about which we cannot obtain a full and completely clear description, so that the investment’s merit may be independently evaluated.

Moreover, at Cumberland, all discretionary managed accounts separate asset custody from brokerage and from Cumberland as manager.  Our performance reports and asset lists are separate and independently compiled from those of the custodian broker or bank.  Managed accounts that are in custody at a broker have explicit permission for us to trade “street wide” when it benefits the client.  We will not accept a managed account where the brokerage transactions are captive to the broker custodian unless there is a specific pricing of transaction costs and the client knows what their broker will charge them.  Cumberland never acts as broker and never mixes commissions with fees.  We are a fee-for-service only manager.

We recommend this structure for all of our institutional consulting clients where we are not the discretionary manager but only consultants on the strategy.  We also recommend this for those whom we are advising on boards and as trustees.  In fact, we advise that those who place funds as a fiduciary in any other format should consult their legal counsel before doing so, in order to ascertain if they are in compliance with fiduciary standards.

The Madoff affair’s implications for lawyers, accountants, trustees, boards, etc…

How the dean of a law school (quoted above) or the trustees of the charities that were allegedly burned by Madoff acted based on a standard that concentrated all the exposure with Madoff is incomprehensible to us.  Placing investment management, custody, and brokerage in one institution and agreeing to opacity about the activity is viewed as the riskiest structure by skilled professionals. How their lawyers and accountants and advisers allegedly sanctioned that decision also triggers many questions.

A separate issue is the role of those conduit funds that were the alleged “feeders” to Madoff.  Some of them allegedly charged investors separate fees and then placed the money with Madoff; they allegedly did so without doing full diligence.  They failed to ascertain that the above separation structure was in place.  Alternatively, they determined it was not in place and took no action.  We expect many investors in “fund of funds” structures will assert claims against those funds for money lost by them.  One case describes how one of these funds allegedly placed 100% of the money under its supervision with Madoff while charging its clients incentive fees for doing so.

This raises many more questions about custody.  The FT reports that $1.4 billion of Madoff money was placed in a form where there were conflicting sets of instructions.  In one set, the client waived the bank custodian’s requirement to due diligence and to provide “safekeeping.”  The other document sets out the obligation of the bank to do so.  If not settled, that will make for an interesting court case.

Lawyers are going to have a field day as the alleged losses from the collapse of the Madoff scheme become the substance of claims against trustees and custodians and accountants and other professionals who had co-fiduciary responsibilities.  Daily we are seeing more and more revelations as the investigation unfolds.

Madoff and the aftermath will consume media attention for a whole year.  And while we naturally tend to feel compassion for victims because they were innocent and acted in good faith, we need to remember that our emotional response must be accompanied by the realization that no one was forced to invest with Madoff.

Madoff was allegedly involved in a criminal fraud.  He purportedly practiced skilled seduction and deception.  He used his communal and charitable relationships to expand his scheme.  His victims were all motivated to grow their money.  Some were driven solely by greed.  True: they were seduced and are now hurt.  But also true: they acted volitionally.  We argue that the true victims are the innocent millions of people throughout the world who are the beneficiaries of the charities that have now have lost their funding because of their board’s or trustee’s decision to place money with Madoff.

The Securities and Exchange Commission and other regulators.

We have already heard remarks from SEC Chairman Christopher Cox and former Chairmen Harvey Pitt and Arthur Levitt.  We see their admissions that the SEC had received information about Madoff for years and that it had been ignored.  We see their recommendations for transparency and their prediction that the new SEC under Chairwoman Designee Mary Schapiro will be proactive in changing the way the SEC acts to protect investors.  And we see them repeatedly state that a designed and intentional fraud is hard to detect.

But what about the depth of this embarrassment for the SEC?  We see evidence that the SEC used Madoff as an example of compliance achievement.  No SEC audit found any wrongdoing.  This is true even though the structure of combining investment management, custody, and brokerage is a “red flag” on the SEC checklist, according to many experts in the compliance field.

The SEC’s embarrassment is even greater when one considers that the SEC received warnings as long as a decade ago.  Furthermore, there is evidence that many prospective investors refused to place money with Madoff.  They suspected the returns Madoff represented were not possible, and they advised the SEC of their suspicions.

Why did the SEC and other regulators fail to find Madoff’s flaws?  And were there other regulators who had supervisory roles and also failed?  Questions must also be asked about what the regulators’ liabilities are when they fail.  If a state or municipal government fails to perform an assigned and legislated role, it can be sued for negligence and may have to pay damages to innocent victims for its governmental failure.  What is the obligation of the federal government?  Will that subject be tested here?  Can the United States avoid all liability for its failure?

The Madoff case certainly opens these issues to legal inquiry.  It also requires Congress to address them.  We expect both to occur in 2009.

In that spirit we worry about a regulatory backlash.  In an effort to redeem itself, the SEC may impose rules that have unintended consequences.  And they may add costs to the law-abiding practitioners.  History is replete with examples of regulators chasing the horse after it left the barn and wounding the well-meaning and honest instead.

Congress, Madoff and money.

We expect the new Congress to hold hearings on the Madoff affair.  And the new SEC chair will get the usual earful from Senators and Representatives.  This is our system and these are the folks we elect to represent us.  They are supposed to be acting in the interest of the citizens and to be concerned for the country’s welfare.  Their supervisory role and legislative role are supposed to be in that direction.

They fund the budgets of the enforcement agencies.  They write the laws that the regulators are empowered to enforce.  In the Madoff case, they determine the depth and strength of the SEC. There are 11,000 registered investment advisers and 8,000 hedge funds.  In addition there are the so-called self-regulatory organizations (SRO), of which Madoff was certainly a pre-eminent member.

So why is this Madoff story so filled with failure and why is the system so sick?  And why is the legislative oversight provided by the Congress so poor?  And why do Americans have such a low opinion of the Congress?

Here goes.

Madoff’s political contributions included several for $25,000 each to the Democratic Senatorial Campaign Committee.  Other contributions were made to individual campaigns of folks like former Senator Hillary Clinton and present Senator Charles Schumer, as well as Congressmen like Charles Rangel.  Madoff did nothing illegal in making those contributions.  At least that is how it looks from the cursory review we conducted on disclosure services.

The recipient politicians argue that these contributions were only individual in nature and are legal.  They do not discuss what motivated Madoff.  Maybe it was Madoff’s sense of citizenship and his patriotic concern for the ethics of the United States.  Ok, I admit sarcasm.  More likely these contributions were part of the collective enterprise of political fundraising from the very industry that lacked the transparency and regulatory supervision to prevent an alleged Madoff-type swindle to occur.  We see the political money everywhere and intertwined with the financial industry and its problems.  It plainly stinks.  We will leave it to others to dig into the amount of political influence Madoff had over the years.

How Ponzi schemes work and how they collapse.

So far, it appears that Madoff’s undoing was driven by European investors who withdrew money because of their fear of the US dollar weakening.  That triggered the large withdrawals that ran this alleged Ponzi scheme out of money.  History shows that the end of a swindle can be triggered many ways, but the result is nearly always the same.  The swindler runs out of cash and the house of cards collapses.

The end of the original Ponzi swindle ended the same way.  In 1920, Charles Ponzi established the fraud of using one investor’s money to pay another while advertising that the payment was the result of a little-known investment idea.  Ponzi’s undoing came because he promised a 50% return in less than two months’ time. Ponzi ran through millions of his suckers’ money.  When the scheme collapsed he had $61 left. 

Madoff was telling his investors the investment results were much lower (10% to 13%) and were derived from a “proprietary” method involving stock option structures.  His scheme was sold to victims who were looking for consistency.  Professionals who could not replicate the strategy warned the SEC as much as a decade ago.  Madoff persisted for years because he promised a lower return and, therefore, his need to raise new funds to pay off older investors was not as acute as the original Ponzi’s. As with all such schemes, he ultimately exhausted his cash and failed.

We do not yet know how many years of effort were applied by Madoff to this fraud.  We do know that it was a protracted period.  We know it grew and grew over time.  We know Madoff used subtle and social relationships to attract more investors.  We know he turned some away, and that only made him more desirable.  Oh, how the seduction works.  And in the very high-profile social circles of Palm Beach it developed its own momentum.  And it appears that Madoff played the crowd quite well.

Unanswered questions about Madoff and Ponzi.

In the business area there are many lawsuits ahead.  A bankruptcy judge will rule on who got paid out with a “preference.”  Those parties will be asked to return the money to the general fund for redistribution.  This is a lawyer’s field day.  So is the litigation to come against the funds of funds and the board trustees and other co-fiduciaries.  Accountants will be busy, too.  Many thousands of tax returns will have to be amended and refiled for multiple years.  For those who received payments from Madoff, these are “ill-gotten” gains.  Their tax treatment is different from what they reported to the IRS.  International arrangements and multiple national jurisdictions make this accounting/legal complexity extraordinary. That is the cleanup that lies ahead.

What history doesn’t tell us is how these things start.  What gets in the brain of a crook and when does it first get there?  Do swindlers really believe they can continue forever?  Does the scheme’s momentum create its own force and overwhelm the perpetrator?

Was Madoff a cheat and faker when he was born in 1938?  Was he a cheat in college?  Was he a crook when he started his firm in 1960?  When he brought his brother, Peter, into the business?  Or when his sons Andrew and Mark first reached young adulthood?  Or when they joined the firm with him?  Was he a thief when he used internet technology to move quotations from the “pink sheets” to what eventually became the NASDAQ that he chaired?

By the time the Madoff affair recedes into history, there will have been books and movies and TV specials about it.  Millions of words will have been written.  Many victims will be revealed.  Their stories are already being told in TV interviews.  One at a time, we see the journalists asking how the victims “feel” and inquiring about their sense of “trust” and “betrayal.”

Fewer interviewees were asked the question “why?”  Their choice of Madoff is not probed.  Why did they allow themselves to get “sucked in?”  Didn’t they realize that the results promised were not reasonable?  Weren’t they wondering how they could receive an investment return which was inconsistent with what they saw in the market?  Did they balance their desire for money with the risk they took when dealing without transparency and without separating the three functions that we outlined at the beginning of this commentary?

Going forward after Madoff.

The basic lesson remains, and the Madoff affair has affirmed it.  Separate custody from brokerage from investment management.  Have each reported differently and accounted for independently.  If you cannot understand the investment, beware of participation.  And remember, there are no free lunches.  Clichés become so because they are true.

This is the season of festivities in Western traditions.  Holidays affirm faith and ask those who are more fortunate to give to those who are less so.  We then pass the solstice, enter the New Year, and begin the process of renewal.

Madoff has dealt a huge blow to charity.  We’ve talked about the trustees and boards who failed to review his activity and who breached their fiduciary requirements.

But what about the beneficiaries of those charities?  They did nothing wrong.  They are sick or hungry or poor or isolated or weak. They are global, since Madoff’s tentacles reached afar.  And, in this year of global recession, they need assistance in great numbers and with earnest commitment from the donors.

Perhaps we can remember an ancient teaching as we thankfully close this year of 2008.

“For this reason, man [i.e. the first human being] was created alone to teach that whoever destroys a single life is as though he had destroyed an entire universe, and whoever saves a single life is as if he had saved an entire universe. Furthermore [the first man was created alone] for the sake of peace among men, so that no one could say to another, ‘My ancestor was greater than yours.’” 

Mishnah: Sanhedrin 4:5

For our clients, colleagues, readers, friends, and others, we wish peace, good health, and prosperity for 2009.  Travel in safety.


Give the Gift of Education

Carol Mulcahy is a Client Relationship Manager at Cumberland and a Chartered Retirement Plans Specialist SM designee. She was recently approved to be an arbitrator with FINRA.  She has over 23 years experience in the banking and investment industry both in retail and institutional sales and marketing.  Her bio can be found on Cumberland’s home page,  She can be reached at

It’s never too early to start saving for college. So when thinking of gift giving by year end, think of your grandbabies, your children, nieces or nephews, and give the gift of education.

History of the 529 Plan

As many other investment vehicles are named after the Internal Revenue Code in which they appear, this one is no different: IRC 529 was first introduced to us by Congress in the Small Business Job Protection Act of 1996.  It has had modifications over the years, including the Economic Growth & Tax Relief Reconciliations Act of 2001 (EGTRRA), which made it more attractive by allowing distributions for qualified higher-educational expenses to be federally tax exempt. Most recently, the Pension Protection Act of 2006 made this tax exemption permanent.  The federal tax exemption for the 529 Plan was due for a sunset provision in 2010, and many were skeptical of investing for the long term until the exemption was made permanent in 2006. 

What is the 529 Plan?

A 529 Plan is a tax-advantaged college savings plan. It allows the earnings derived from contributions made to an account from the account owner (participant) for a beneficiary to grow tax deferred and ultimately income tax-free, provided they are used for qualified higher education expenses at an eligible educational institution. It is a revocable gift (participant retains control of assets) and can be taken back if needed at a later date (certain rules apply to this, check with plan manager).  In most cases, the student’s choice of school is not impacted by the state in which the 529 Plan was established.  So in the case of a family moving from one state to another or a grandparent opening an account in their own state, as opposed to the beneficiary’s state, state residency should have no impact on the choice of school.

The 529 Plan can be used for accredited U.S. (and selected foreign) private and public colleges or universities, graduate schools, junior colleges, or vocational/technical schools. 

Qualified expenses usually include tuition, books, supplies, mandatory fees, equipment required for enrollment, room and board, and certain expenses for “special needs” students.

There are two types of 529 Plans

1) Savings

Contributions are made with your after-tax dollars (no securities transfer) to the 529 Plan of your choice. Many plans will include mutual funds that offer an age-based asset allocation. This is where the underlying investment will become more conservative as the beneficiary gets closer to the target date of starting college. The risk/performance is directly associated to the performance of the underlying investments. There is no guarantee that the necessary dollars to cover all college costs will be there once the beneficiary goes to college.

The Savings plan is offered for sale in two ways, either Broker/Advisor-Sold or Direct-Sold

Advisor or Broker-Sold Plans

This type of plan is sold through your financial professional.  It means you will get advice on the type of plan and investment options available, but you will also pay commissions and/or fees which may impact your portfolio’s performance.

Direct-Sold Plans

This type of plan is purchased directly from the plan manager. You will need to do your own research and make decisions on what is best for you; however, you would not be paying the commissions you would in the advisor/broker scenario.

2) Prepaid

A prepaid plan allows you to purchase tuition credits or units. You could potentially pay for all or at least part of future in-state public college costs at today’s prices.  Many of these plans can be converted for use for out-of-state schools or private schools. It best to check with the plan you have chosen to see the benefits that will convert over.

One other type of prepaid plan for participating private colleges is the Independent 529 Plan. See link below under “Helpful Sites.”


To avoid federal gift taxes you could invest, for 2008, $12,000 per beneficiary per donor. However, if you choose to take advantage of the special five-year election, you could, for 2008, contribute $60,000 ($120,000 per married couple) per beneficiary without federal gift taxes. This will increase to $65,000 ($130,000 per married couple) in 2009.  This works as long as you do not make any other annual exclusion gifts to the same beneficiary in the five-year election period.  Once the contribution has been made to a 529 Plan, the assets are generally considered removed from the account owners’ (participants’) estate.

For most plans there are no age or income restrictions on giving or being a beneficiary of a 529 Plan. The maximum dollar amount you can contribute may vary from state to state. Remember, we are dealing with sheltering assets and potentially avoiding some taxes; therefore there are some parameters around the maximum dollar amount allowed to be contributed.  It can be realistically based on what a college education is anticipated to cost. Some states will allow over $300k per beneficiary.


A beneficiary can be changed for a variety of reasons. Please check with your plan provider for a list of who qualifies as a “member of the family” to whom the 529 Plan can be changed, without the distribution being treated as taxable.

Distributions not used for qualified expenses are subject to a 10% penalty plus ordinary income tax at your tax rate on the earnings portion.  If you are in a state that allowed for a deduction of a portion of the principal you contributed, you may have to report that “recapture” income on your taxes.  

There are certain cases when the penalty would not apply:

* Death of the beneficiary

* Beneficiary becomes disabled

* Beneficiary receives scholarships, veteran’s or employer-provided educational assistance

Check with your provider for more in-depth details on these exclusions.

Financial Aid Impact

If a parent is the account owner, the 529 Plan is considered their asset and FAFSA (Free Application for Federal Student Aid) will take into consideration only 5.64% of the account value. If the student owns the plan, FAFSA will take 20% of the account value into consideration when calculating awards. If a grandparent is the account owner, this may exclude the plan from reporting on a financial aid application – check with your accountant.

Keep in mind, though, that a lot of financial aid is given in the form of loans, and you will need to pay these back eventually. Loans and loan interest are not qualified distributions under a 529 Plan.

Every case is unique, and each state offers its own form of the 529 Plan. Many have slightly different provisions and state tax implications that make it necessary for you to do research, either on your own or with a financial professional to see which state plan works best for you. We at Cumberland are not tax advisors, we recommend that you consult with your tax professional before investing.

Helpful Sites

At First Blush

Markets responded overwhelmingly positively to the Fed’s policy announcement yesterday.  At first blush, the Fed appeared to pull out all the big guns.  The Wall Street Journal characterized the move as Bernanke having gone all in, to draw upon a poker analogy. 

The FOMC cut its policy target rate to a new low and also expressed it as a range instead of a single rate.  The Committee stated that its new target for the Federal Funds Rate was a range of between 0 and 25 basis points. Furthermore, it indicated that it will employ “all available tools” to ensure a resumption of trend growth of the real economy.  These tools would include, but were not limited to, enlarging the Fed’s balance sheet by purchasing agency debt and mortgage-backed securities, and wide use of its Term Asset-Backed Securities Loan Facility to support the extension of consumer and small business credits, as well as possible purchase of long-term Treasury debt.  The Board of Governors, in addition to lowering the discount rate to 50 basis points, lowered the rate it would pay on reserves to 25 basis points. 

What has been overlooked in the market’s euphoric reaction is how little was actually new in the FOMC’s announced policies.  In reality, what the Fed actually did was to make public what it had been doing de facto for the past two weeks.  For example, the Federal Funds effective rate has not exceeded 20 basis points since December 4.  The asset purchase programs were previously announced or were minor extensions of existing programs to accept agency and mortgage-backed securities as eligible collateral for many of its new liquidity programs.  And the intention to provide direct funding to consumer loans and small business-related paper was a restatement of existing policy. 

What the FOMC’s actions really have done is make explicit that it had changed its policy implementation regime.  The Fed Funds Rate is no longer a target, but rather it will fluctuate within a range – which it has been doing for some time now, anyway.  Interestingly, the Fed has set the rate that it will pay on reserves at 25 basis points, setting up a risk-free arbitrage for those banks able to buy funds at the effective funds rate, to increase their reserve balances at the Fed.  The policy focus is now not on interest rates but on the size of the Fed’s balance sheet or, equivalently, the money supply.  And we can count on this for “some time.”  The rationale for this regime shift is to provide whatever funds are necessary to ensure well-functioning financial markets.  Call it quantitative easing, if you wish. 

However, there are some interesting side issues.  The first is how and by whom policy will be decided during this period.  The size of the Fed’s balance sheet is largely dependent upon the Board of Governors and its lending programs and is not the province of the FOMC.  Day-to-day decisions will be determined by the Open Market Desk and, presumably, Chairman Bernanke.  Will the guidance to the Open Market Desk be to keep the Fed’s balance sheet at a target level, or will that target change on a day-to-day basis?  From the current statement, all we know is that the balance sheet will remain at a “high level.”  If the balance sheet target changes daily, then those changes will affect the supply of reserves and impact rates, and consequently will affect the players in those markets in which the Fed operates. This looks an awful lot like the policy regime in the ’50s and ’60s, when then Fed Chairman William Machesney Martin, and the manager of the desk, set monetary policy daily, which they characterized as “responding to the tone and feel of the market.” 

This new regime also raises an important issue of transparency to the market, for several reasons. 

First, when Chairman Martin ran policy, markets were completely in the dark as to whether the Fed was pursuing tighter or easier policies and could only infer shifts in policy by carefully watching after-the-fact what had happened daily to interest rates.  Fed watching was a boon to economists who understood the tone and pulse of markets.  Since today’s Fed will be operating by increasing or decreasing the size of its balance sheet, information on changes in size and composition will be critical to market participants.  Right now the Fed only publishes a weekly balance sheet, ex post.  Will it announce a daily target for its balance sheet?  Will it publish a daily balance sheet, and if so, how detailed will it be?  The more transparent the Fed is as to what it is doing on a daily basis, the better market participants will be able to infer when policy has, de facto, been tightened or loosened. 

Second, we need to keep in mind that in the new regime, if the Fed relies upon the 17 primary dealers as sources of the non-traditional assets it will be purchasing, these institutions will have a real informational advantage relative to market participants without access to daily information on the Fed’s activities.  In addition, over half of these are foreign institutions or their affiliates. 

Third, because the Fed indicates that it will be operating in the markets for different types of assets, and perhaps not Treasuries initially, information on exactly what the Fed is doing on a daily basis will be critical to assessing changes in market rates in those markets.  Otherwise, by looking only at rate changes, one will not know whether they changed because of actions by the Fed to increase or decrease the supply of funds in those markets or because of changes in market perceptions of risk premiums.

Finally, there is the issue of what the role of the FOMC will be in policy formulation.  This new regime is not one in which the FOMC can meet and consult eight times a year, set the operating directions for the desk, and go home.  This is a regime that requires daily decisions.  It is neither feasible nor practical for the Reserve Bank Presidents to move to Washington and meet daily.  So it is likely that the FOMC will be de facto mothballed, until and if there is ever a return to “normalcy” in the policy formulation process

All of these issues seem to swamp the initial reaction to the Fed’s supposed rate reduction yesterday.

Today’s New York Times Editorial

As many of our readers know, my colleagues and I have written and spoken about the Lehman failure and the lack of forensics on the Fed’s Bear Stearns decision and the Fed’s Lehman non-decision.  We have articulated the risks to policy transparency that originate with  the US Senate Banking Committee under Senator Christopher Dodd’s chairmanship; he has kept the Fed’s Board with only 5 governors and therefore forced a unanimity rule instead of a super majority rule which was intended for Section 13 emergency power intervention.  Note that there are no records and no memorialized discussions other than when 5 votes were affirmatively cast.  

We have asked what happened during the 6 months between March when BSC was merged through the use of Maiden Lane, LLC and September when Lehman failed.  Those 6 months were the months when Lehman was using the Fed’s own treasuries to secure overnight repos and when primary dealers like Lehman were borrowing directly from the Fed and pledging collateral.   What was the Fed seeing in Lehman?  What was Lehman asked to produce besides collateral?  Was there any clue about Lehman’s growing insolvency?   Other questions still unanswered include if there were suitors among the primary dealers or elsewhere who would have taken Lehman?  Were they among the firms that have to answer to a foreign central bank or regulator; therefore they may have required the Fed to take a larger amount of Lehman’s toxicity onto the Fed’s balance sheet in the form of a Maiden Lane 2?

These and related questions remain unanswered.  Today some of them are being asked by the NYTIMES.   One might wonder where the Times was for the last 6 months as these events unfolded.   Where were the editorials calling for transparency between March and September?   Whatever the case, now the Times has awakened to the important role played by media.   We forward this editorial in case any of our readers missed it.  


New York Times

December 15, 2008


Questions for Mr. Geithner

Timothy Geithner, President-elect Barack Obama’s choice for Treasury secretary, has some explaining to do.

As president of the Federal Reserve Bank of New York, Mr. Geithner was a key decision maker last September when the government let Lehman Brothers fail and then, two days later, bailed out the insurer American International Group for $85 billion.

Those decisions proved cataclysmic. The markets and the economy have yet to recover from Lehman’s failure. The bailout of A.I.G. dealt a further blow to the Fed’s credibility — and, by extension, Mr. Geithner’s — because it was an abrupt reversal from the no-new-bailouts stance that had applied to Lehman and, initially, to A.I.G. Together, the decisions showed that several months into the financial crisis, officials lacked the information and the insight to correctly call the shots.

Making matters worse, the Fed and the Treasury have now changed their story about how the calamity unfolded. No one expects a perfect performance in the thick of a crisis. But an after-the-fact revision of what happened at best raises questions and worse, looks like an attempt to dodge accountability.

In testimony before Congress on Sept. 24, about a week after Lehman’s collapse, Federal Reserve Chairman Ben Bernanke gave an accounting consistent with comments and news coverage at the time. “The Federal Reserve and the Treasury declined to commit public funds to support the institution,” he said. He said that the failure of Lehman posed risks but that the firm’s troubles had been well known for some time and investors recognized that bankruptcy was a significant possibility. “Thus,” he said, “we judged that investors and counterparties had had time to take precautionary measures.”

Mr. Bernanke said Lehman’s default, “while perhaps manageable in itself,” combined with the “unexpectedly rapid collapse of A.I.G.” to create a global financial tempest. In other words, Mr. Bernanke, Mr. Geithner and Treasury Secretary Henry Paulson believed the system was stable enough to withstand Lehman’s downfall.

The story changed as they were proved wrong and as the government’s obligations to prop up the financial system rose precipitously. In a speech on Dec. 1, Mr. Bernanke said “legal constraints” had prevented the Fed from rescuing Lehman, making a bankruptcy “unavoidable.” Translation: Not our fault!

The law allows the Fed to make emergency loans when the financial system is in danger, provided that the lending is “indorsed or otherwise secured” to its satisfaction. The Fed has accepted all manner of dubious assets in exchange for its various loans as the crisis has deepened. In a speech on Oct. 15 and in his Dec. 1 speech, however, Mr. Bernanke said Lehman’s collateral was insufficient. Secretary Paulson also invoked a lack-of-legal-authority argument in a speech last month to explain Lehman’s demise. Why didn’t they say so at the time?

Mr. Geithner has made few public comments during the serial crises, but a spokesman for the New York Fed recently disputed this page’s characterization that the Fed “allowed” Lehman to fail, saying — you guessed it — that the Fed had no legal authority to intervene.

The lack-of-legal-authority line also surfaced in video interviews by Fortune magazine of executives at its recent Fortune 500 conference. Peter Peterson, the co-founder of the private equity firm Blackstone Group and a former chairman of Lehman Brothers, was asked about the prevailing view that Lehman’s collapse was “the straw that broke the camel’s back.”

Mr. Peterson said he had talked to Mr. Geithner about that and was told that the Fed did not have the authority to intervene. Mr. Peterson suggested that the media might want to explore the issue in more depth, “before there is too much criticism of what Mr. Geithner’s role was.” He added: “You can probably see I’m a little defensive about Geithner. I was involved in picking him” to lead the New York Fed.

The burden is on Mr. Geithner to clear up the matter. If legal constraints precluded a Fed intervention in Lehman, why weren’t they mentioned at the time? Did Fed officials consider asking Congress for the necessary authority? There was plenty of time to do so because, as Mr. Bernanke noted last September, the collapse of Lehman was a long time coming.

In the absence of an explanation, the changing Lehman story seems like an attempt to deflect public attention from what could go down in history as an epic blunder. It also reinforces the impression of bias created by the disparate treatment of Lehman and A.I.G. Lehman was left to die, while A.I.G.’s counterparties were saved.

The revised version of the story (in which there is no disparate treatment, only officials following the letter of the law in each case) sidesteps questions about whether the bailout of A.I.G. — arranged by Mr. Geithner — was influenced by the specific needs of some of the insurer’s counterparties, like Goldman Sachs.

The Times’s Gretchen Morgenson reported that Lloyd Blankfein, the chief executive of Goldman, was the only Wall Street executive at a meeting at the New York Federal Reserve on Sept. 15 to discuss the A.I.G. bailout. A Goldman spokesman said Mr. Blankfein was not there to represent his firm’s interests, but rather that Goldman “engaged” the issue because of the implications to the entire system.

Adding to the opacity, the Fed recently decided to keep confidential one of two reports that it made to Congress on the A.I.G. bailout. If the Fed had not insisted on confidentiality, that report would have been made public.

Mr. Geithner should be asked at his confirmation hearing to explain which firms were threatened by an A.I.G. collapse, in what amounts and how those entanglements justify an ongoing bailout. Mr. Geithner must also explain how such entanglements came to be the norm on his watch. His answers will help shed light on whether he is sufficiently distant from Wall Street to reform a system that has proved catastrophically unstable.

2009 Outlook – Markets Measure; They Don’t Forecast

We are starting this commentary with two quotes that superbly summarize the state of the wealth effect, economy, and the outlook for applied stimulus. Cumberland’s strategy and rationale follow the quotes. We specifically acknowledge the effort of Howard Simons of Bianco Research for his repeated seminal work on how markets measure well and forecast much less well.

“The Federal Reserve Flow of Funds report showed a marked deterioration in the state of household balance sheets in Q3. Household net worth fell 4.7% q/q in Q3, translating to a $2.8 trillion loss in household wealth and marking the biggest y/y decline in the history of the series. Household real estate wealth fell 2.8%, reflecting the sharp decline in home prices… The decline in household wealth was accompanied by a decline in mortgage debt, which fell 0.5% q/q, the first decline since 1983. Homeowner equity fell to 44.7% of household real estate, marking a new record low. Household balance sheets also suffered from a 4.5% q/q decline in financial assets, driven by a sharp drop in the market value of corporate equities and mutual fund shares.”

– December 12, Julia Coronado and Michelle Meyer, Barclays Capital

“The economy’s recovery depends critically on an energetic fiscal policy by the new Administration and Congress…President-elect Obama…will quickly enact significant stimulus for the economy. This is sure to include major new tax reductions…Also to be included is sizable additional spending on infrastructure, broadly defined to include support to state and local governments for a wide range of outlays.…On the monetary side, the Fed will soon be lowering its official rates close to the vanishing point…Yield penalties on investment-grade securities relative to Treasuries are likely to narrow once the extraordinary pressures created by year-end portfolio “window-dressing” pass, but if they do not, the Fed will broaden further the types of securities it buys…With such vigorous support, retail sales, housing starts, and business inventories may stop declining by mid-2009… even in such an environment of near-zero GDP growth, aggregate profits of non-financial firms (except those related to construction, autos, and, perhaps, oil), may actually hold steady or rise, cushioning the decline in capital spending. Net revenue will be well maintained as labor and import costs tend to decline…”

– December 12, Dr. Albert Wojnilower, Craig Drill Capital

Cumberland Advisors’ portfolio management strategy starts with a few assumptions. In the United States both financial policy engines are at full throttle: they are the fiscal engine (deficit spending of $1.5 trillion or more) and the monetary engine (see: for the weekly updated description of the Federal Reserve’s balance sheet and programs). As Dr. Wojnilower notes, and we agree, this “vigorous support” is expected to arrest the economy’s decline by the 2nd half of 2009. The Fed’s own forecasts are reasonably consistent with this conclusion; they argue that it is the target of Fed policy to bring this result to reality.

This massive stimulus is applied because there is (1) an extreme negative wealth effect (see the Barclays quote above) and (2) a decline in employment and (3) pressure on incomes. Note how this may not play out into a profits debacle (outside of the financial, housing, and consumer discretionary sectors).

Also note how the appearance of no positive outcome prevalent in many forecasts is dependent on the failure of the two-engine stimulus.

We are on the other side. Instead of saying that stimulus fails and the economy just sinks and sinks and sinks, we are saying that stimulus in this massive amount succeeds and that the economy will stop sinking and plateau. Subsequently it will start to expand as all the pent-up demand begins to convert to spending and economic activity.

We are saying that markets change their pricing because they are forward looking. They usually bottom in the midst of the bleakest outlook and they often bottom BEFORE the economics appear to turn. History shows that over time, financial markets are able to change prices to reflect forthcoming changes in economic data. That is why markets are viewed as leading indicators. They are not forecasting the change; they are measuring the behaviors and sentiment of the investors who are forecasting the change. Markets move as a result of actions by those who are seeing a change earlier than economists can compile the data to demonstrate that the change is at hand.

Financial Markets do NOT forecast well in a strategic sense. If they did the oil futures curve would have warned of $140 oil when the price was $40 and it would have warned us of 40 dollar oil when the price was $140. Markets did neither accurately.

Financial markets measure the present consensus sentiment. They price it every day as folks make their real money commitments. The price tells you what the existing psychology is; it doesn’t tell you what it will be and it doesn’t tell you when it will change. Markets measure; they don’t forecast.

Here are some samples of current measurements that are not forecasts. Readers may judge for themselves if these are market forecasts of doom or if they are measurements of market dysfunction and extremes of psychological damage. Then each reader may decide and act according to his/her own view. In doing so he/she will become one of the many agents that make up the very markets we are measuring. Readers and their actions will be measured along with all the others.

Here is the evidence. You decide.

When the 90-day T-bill trades at zero interest it is measuring something. It does that on the same day that the two commercial banks used by Cumberland Advisors for our firm’s own deposits are paying us over 3% on our cash. Both of those yields are backed by the United States of America. The risk of loss is equally nonexistent. So why are they so different? Because they are measuring two different things: zero interest on US government Treasury obligations is driven by one set of investors; 3% interest is driven by a different set. Each is measuring a unique subset of cash and cash equivalent yields. Market measure; they do not forecast.

You can loan your money to the United States of America for 30 years at 3% and that is a taxable instrument. You can loan your money to a high-grade state credit and get 6% (in some jurisdictions we are getting clients as much as 7%). The tax-free yield on long duration in the United States is double the taxable Treasury yield. Markets are measuring the psychology of fear. They are not forecasting that all states and local governments are going to default.

Those who do not accept this principle that markets measure are doomed to lose sleep trying to understand behavioral malfunction in the realm of sentiment. In dysfunctional market periods like the present one it is critically important to sort through this issue. Each investor has to determine what they are missing when they see an anomaly. Understanding what the market is measuring helps clear up the puzzle. Remembering that markets are measuring and not forecasting maintains the balance while the puzzle is being solved. Here are more examples.

The credit default swap on the State of California is priced higher than the credit default swap on the country of Turkey. Does anyone really believe that the US is more likely to default than Turkey? No disrespect for the Turks is intended. Maybe if California Governor Schwarzenegger had the Turkish parliament instead of his legislature, he would have a budget passed and his credit default swap would be priced differently.

The credit default swap price for the United States is higher than the credit default swap price for Campbell Soup. No disrespect to Campbell Soup. I like it on a cold winter day. But I think the US has a better chance of paying its debt than the soup maker. And both of them use the US dollar to make the payments. Campbell makes soup; I own some cans of it and bought it with my dollars. The US government makes those dollars and has unlimited dollar productive capacity and negligible cost of production or materials.

Markets measure; they don’t forecast. If they were forecasting, they would be saying that Turkey soup is more likely to pay the dollars it owes than is US Treasury and the US’ largest state.

Ok. Let’s sum this up as we approach 2009. We believe the economy will bottom in 2009 and the bottoming will be in the data during the second half of the year. We believe that the stimulus combination of massive fiscal and massive monetary will work. And we are applying that assumption in our portfolio management.

Clients who do not agree with us have asked us to take a more cautious view, and we do so for them. We are a manager of separate accounts. We are not a common fund. Our job is to meet the client’s objectives and not impose our will on the client. If the client asks, we offer what we think is our best guess of the future. If the client wants to be riskless and in US government credit only, we do it.

That said, we are recommending to our clients that they use an asset allocation of 50% stocks and 50% bonds. Cash is at zero. Remember that the classic efficient frontier is 70% stocks and 30% bonds. So we are 20 points under on the stocks side and 20 points over on the bond side. The reason is that bonds are soooooo cheap that they warrant overweight.

Both sides in this 50-50 stock-bond mix are fully invested. On the stock side we only use exchange-traded funds (ETF). We do this domestically in the US, and we do this abroad. And we do this in other asset classes like currencies and commodities and precious metals.

On the bond side we are emphasizing high-grade credits. The junk bond market is very cheap, but it requires a special set of skills and we do not apply them at Cumberland. Clients who use junk bond allocations are using other managers. We are in investment-grade bonds only, whether taxable or tax-free. On that note, our clients are also fully invested and favor longer duration.

As this financial turmoil period enters its third year in 2009, we expect the various sectors to heal and the spreads to narrow. This will occur piecemeal. We already see it in some areas. The results of the application of stimulus by the Fed will be seen sector by sector and will have its own accelerator. Investors who wait until the air has cleared are taking no risk, but they are also not going to get a reward.

Right now markets are measuring extremes in risk aversion by investors. That explains high cash balances and zero-interest T-bills. As each market clears it will gap to another level. It will not trade there calmly and slowly. The lesson to be learned from high-volatility measures like the VIX is that markets can gap. When they do so, an investor sitting on the sidelines has very little chance of getting in. The most money is made in markets when measures of risk aversion are extremely high and then markets turn.

Remember, when you see a parabolic curve you have no way to know when it will stop and turn. You can only learn that after the fact. Most markets today are showing us this parabolic formation. They are measuring extremes at several standard deviations from mean and at record levels, levels that have never been seen before.

I know this statement is redundant; I repeat it for good reason: Market spreads and risk indicators are at levels never seen before. They are measuring, not forecasting.

2009 may just work out to be a good year. 2010 may be even more robust. At Cumberland we want to be in it, not out. Stay tuned.