A Newsletter from Dec. '07

The objective of managing your investment account should be: Don't lose in down markets so it is easier to gain in Up markets. The Bible refers to this as "Occupation". You protect what you've already gained and then go out to get more. Militarily you are to never give up what you've already conquered on the promise of gaining more in the future.

Following is a newsletter I sent to my clients in December of 2007, which was near the top of the market. I was notifying them we were going to begin a conservative approach because I thought we could be moving into a recession.

The Market. . . According to John

No Short Term Views

The market was in an overbought condition last week, but the latest pullback has fixed that. At this point, the next short term move is a toss-up. This suits our hedge position perfectly. Yesterday, for example, the Dow was down over 170 points. Most of our acccounts, however, were pretty close to break-even. Today, the market was slightly up, but we enjoyed a very nice increase in account values.

Why hedge? When the market hasn't shown a clear sign what it is going to do next, it would be nice to have positions that will do BETTER than the market if it advances. Since it may also go the other way, it would be nice to have positions that will make us money there as well. By effectively buying positions that help offset each other, we are taking a "Market Neutral" stance. If we are lucky enough to do it right, in an increasing market, our out-performers will beat the market enough that they will pull our hedge positions along well enough to at least match the upward return of the market.

If the market decides to go south, our hedge positions will increase in value and hopefully our stock positions won't go down too dramatically, thus decreasing our overall account value less than the market declines. Properly executed, our hedged portfolio should give us major market return with substantially decreased volatility. The perfect answer for a time when the market is giving us no short term direction.

Intermediate Term: Down

An ominous scenario is potentially setting up. If the market decides to pull back further and break the lows it just set a couple weeks ago (remember the last low broke the lows set this summer) and then immediately spikes up 200 to 400 points -- then look out. This is the pattern that historically has preceeded crashes. I have no idea if this will follow through, but I will definitely be watching.

In the end of November, the Dow broke a major support level before bouncing back (see #1 in Figure 1). The piercing of this major support level changed our long term trend from positive to negative. Now, we would expect any upward movements in the market to top out lower than the high of the last upward movement (notice last top in Figure 1 is lower than previous top). On the same hand, the next low should be lower than the last. Lower highs and lower lows are the definition of a down trend.

Figure 1

Let's look at how the Dow acted through the last recession and compare how it is setting up now. Figure 2 shows how the major lows consistently broke below the low prior to it. These are numbered from 1 to 7. The highs were initially trying to go higher, but were turned away at the previous highs. Eventually they began to top out lower than the previous highs.

Figure 2

Recession Watch

Partial reason for the nice bounce off the support levels last week were news from the Fed. They hyped further liquidity to the financial markets by buying back $40 billion of treasuries (known as "repos"). Unfortunately, the rest of the story is that these were coming due anyway this week. $39 billion of repos were due and will be simply getting a different maturity date. The market finds this out and we get a couple major down days back to back. We've heard the heralding of hundreds of billions being pumped into the market to prop up the ailing financial system. In all reality, only about 18 billion has been added.

The Fed is doing us a great disservice. They are inflating our currency at rates that haven't been seen for 30 years. This results in DECREASING it's value. This causes the economic hangover to be worse when they slow down the inflating process. The opposite of inflating is depressing. Yes, depressions are the natural product of wild, out of control periods of inflating. Historically, the Fed won't let the cycle take it's full course and it will begin inflating again before a full blown depression occurs, causing a mild depression or "recession".
Where do we go from here?

I truly believe we will be taking off long positions soon and replace them with further shorts such as SKK, SKF and MZZ.

Small/Mid Cap Component

The small/mid cap component represents half of our 401k management program. The above returns represent the return you would have experienced in the Fidelity Low Priced Stock Fund had you not used our system vs. if you DID use our system. The period of time represented is the top of the market in Oct '07 until today, Oct 7 '09.

The way our system works:

• Determine which investments in your 401k represent the small / mid cap asset class.
• When we let you know the market is good, invest half of your 401k into one or more of these funds.
• When the status of the market changes, we will notify you. At this point you would switch the small/mid cap funds into the money market.

The entire idea is to protect your 401k in bad markets and capitalize in the good markets.

This system has done exactly that. You don't have to wait years just to break even after a bad market. This system allows you to exercise good judgement as it pertains to your 401k.

401k Allocation

Our 401k allocation system has two components. One is International / Emerging Markets and the other Small / Mid Cap. The chart above is a history of Fidelity Emerging Markets Fund utilizing our International/Emerging component. The line depicts the Fund by itself from October 2007 through today. It is down over 40% in this period of time. The line is red when the system told you to be in cash (money market) and green when it told you to be invested in the emerging markets fund. Had you done as it recommended your investment would have looked like the followingchart:

The flat periods depict while you were in cash and the jagged periods while you were invested in the emerging markets fund. Had you simply held onto the fund you would be down over 40% today but had you utilized this system you would be up over 50%. What a huge difference.

This system was designed in the mid '90s so the results are real. Not backtested.

If you're interested in looking further at this service goto http://www.ewatch401k.com or simply click on the rescue helicopter in the left margin.

Empower Your 401k

have you ever received your 401k statement in the mail and without even opening it put it in the file pile? Being in the investment business I speak with people all the time who have no idea how to invest their 401k. Most of them have many investment options to choose from but have no idea which ones to use or not to use.

After years of being asked "what should I be doing with my 401k?" I finally decided to create a solution. The idea for the solution came from a website that had over 5000 subscribers. The developers of the site had created a "Mechanical Investment System". This system took risk out of market in downturns without taking the opportunity for good returns in up markets. These people didn't address the 401k issue but I was highly impressed with their approach. The mechanical approach took all the emotion out of the decision to invest. This only made too much sense so I started on a journey duplicate their effort but have it focus on people's 401k plans.

This idea hit me in 2006. Learning to duplicate their effort would require my learning to write computer programs. Fortunately for me this was what I studied in college so many years ago. I had already spent the last 14 years as an investor and now I had the opportunity to learn programming all over again! What a pleasant surprise to how advanced the programming languages are today compared to then!

After at least a couple thousand hours (no kidding) of learning coding and it's relationship to stock market data I had a good idea what worked and what didn't. I realized many things along the way. Some people build mechanical investment systems that "Fit the market". This is called Curve fitting. These programs have backtest results that look astounding but don't work in whatever kind of market that is coming up next. What is next is the only thing that matters in the world of investing. Everybody gets caught up buying what did best LAST only to buy it and find it is the worst thing for what was next.

Mechanical Investment Systems that are robust (work in any kind of market) are those that were tested using many different types of markets and "Walked Forward". Whenever you build a system you want to test it on one type of market then on another and then another. You "Walk Forward" through time and different markets to see how it would have worked AFTER it was designed.

I built this exact type of system to help people manage their 401k. The site is at http://www.ewatch401k.com/. The algorithms used were actually developed back in the mid '90's. This gives plenty of time and opportunity to see how it has performed since. In fact in the last 10 years it has returned over 15% compound annual return. It was down only 5% in 2008 when the general market was down over 40%.

I will detail more about this system in future posts but it is online and ready to be used.

Status of SSG

We bought SSG at the same time as DXD and QID. The latter two have broken support and had to sell them this morning. SSG seems to be bouncing off it's support level which is promising for this position. Also, if this support level holds, it speaks poorly for the market in general. This position is short the semi-conductor sector. This sector usually goes south prior to the rest of the market. SSG bottoming at this level would say that the market is going to go south shortly.

SOLD DXD and QID

Just sold DXD this morning since it closed below it's support level last Friday.



Also sold QID this morning as it also broke it's support level on Friday (the lowest red line).

Bought GSG (Commodities Index)

GSG is the ETF representing the Goldman Sachs Commodities Index. We just purchased this at $31.59 and expect it to reach $34.00 without too much resistance. This would be about an 8% gain. It has much greater potential in the longer term. We aren't going to give it much room to go the wrong way before we would get out. I have set the stop at $30.59 which gives a two to 1 risk to reward ratio. In the worst case it should be supported by the increasing red line but I expect it to advance more in line with the yellow line.

Sold Silver

Our Silver position (SLV) was sold yesterday after it broke support of the last pivotpoint (See the red line marked "Stop Line". It seems to have stopped what was a somewhat organized new trend. Historically silver and the market in general move differently from each other. As of late they have been moving in tandem. I don't think this position is offering enough return potential in the intermediate time period for the risk it is showing. Maybe we will have another day. Made an 8% profit over the course of 25 days.

New Positions

Click on any chart to get a closer view.

SSG: This is short the Semiconductor sector. You can see that price has made a swooping bottom and has started up. The red line projecting from the last price bar to the first target price is at the same slope most of the other "up" moves this ETF has made. You can also see on the bottom indicator that this is very oversold and has just moved up through a level that says we should expect an up move now. The first target is based from the last previous resistance level. The red line just beneath the price is our stop level. If price ever closes below this line we will absolutely and completely sell. The stop is 8.5% away. The first target price is at $32.71 which would be a 20% gain. This gives us a risk to reward of 2.3:1 which is enough to take a position. We need to be right less than half the time in order to at least break even.

DXD: This is an ETF that shorts the Dow. This looks similar to SSG in the fact it appears to have put in a bottom. The indicator below has also turned up and gave us a buy signal. We bought at $39.40 which is only 3% from our stop level and 13% to our first target. This gives us an excellent risk to reward ratio of 4:1.

QID: This is an ETF that shorts the Nasdaq. We bought at $27.25 with a stop level at $25.80 and first target of $31.50. This gives us a risk to reward of 3:1. Again, if price closes below our stop we will absolutely sell the position.

I expect our first targets to be hit within two weeks time based upon the slope that previous advances have taken. This would be in the neighborhood of 15% return on these positions in that period of time.

May the force be with us!

How much will the tax be on cashing out a 401k?

Due to massive downsizing during this economic downturn people are wondering How much will the tax be on cashing out a 401k. Let's go through the process of calculating an example.

Our example is a married couple who are earning One hundred thousand dollars per year. One of them just got downsized and now they only expect to make $75000 per year.

Remember when you cash out a 401k prior to age 59 1/2 you will not only pay Federal and State income tax but also a Federal and State penalty. The total of the 4 items will determine your total taxes due upon early termination of your 401k plan.

First we need to calculate where this couple is in their tax bracket. We will need to determine how much their exemptions and deductions are. Each personal exemption is worth $3650.00. Since this couple has no kids their first ($3650.00 X 2) $7300.00 of income has no tax.
We next will assume they get no more than the standard deduction which should be $11400.00 in 2009. If we add the exemptions and deductions up we get $11400.00 + $3650 = $15050.00. This means the first $15050.00 of income has no Federal income tax attached to it.

From here we start paying taxes in incremental tax brackets:

• The next $16700 is going to be taxed at 10% (once we use all this we will still have $43250 left).
• Then the next $51200 will be taxed at 15%. (Since we only have $43250 left we won't fill up this tax bracket. We will still have $7950 left over).

Now we know that we are in the 15% tax bracket prior to cashing out our 401k. Let's say their 401k has $100000 in it. If it is all pulled out we will continue to fill up more expensive tax brackets. Remember we only have $7950 left over in our 15% bracket. Once that is used up we almost double our tax rate:

• Next $69150 is taxed at 25%. (we still have $22900 left for the next bracket).
• Next $71800 is taxed at 28%. (thank goodness we only use $22900 of this bracket).

To summarize:

Federal taxes due from regular income:

• $16700 x 10% = $1670
• $51200 x 15% = $7680

Sub Total $9350 Federal Taxes due to income.

Now lets add our 401k cashout:

• $7950 x 15% = $1192
• $69150 x 25% = $17287
• $22900 x 28% = $6412

Sub Total $24891 Federal Taxes due to 401k cashout.

Now lets add in State income tax. Each state is different. In Wisconsin we pay around 7% and the exemptions and deductions are very different. So I will make a ballpark guess of $4200 taxes due to income and another $7000 due to the 401k cashout.

Now we must finally add the Federal and State tax penalty to our total. The Federal is at a 10% rate and the State (at least in Wisconsin is 1/3 of the Federal. we will call it 3%). This makes a Federal penalty of 10000 and a state penalty of $3000.

Let's add it all up:

Federal income tax due on cashout: $24891

State income tax due on cashout: $7000

Federal penalty: $10000

State penalty: $3000

Total Taxes due to 401k cashout: $44891.00

You can see in this case that our normal couple would lose about 45% of their 401k due to taxes and penalties!!!

It is very wise when considering a cashout that you only cashout what you need. The rest can be rolled over to an IRA where no tax will be due. You can still keep the investment in the IRA liquid in the event you want to take another distribution next year when you might be in a more favorable position within your tax bracket.

How much will the tax be on cashing out a 401k? PLENTY!! Be wise and try to do a little over a few years in order to keep your amount owed to a minimum. Feel free to contact me if you have any questions. I'm happy to help. www.ewatch401k.com or john.norquay@gmail.com or www.pivotpointadvisors.net

Can I roll my 401k to a Roth IRA?

Since this downturn in the market many have been asking "Can I roll my 401k to a Roth IRA"? The simple answer is Yes. You must first ask yourself what the consequences are. The following are the basic questions you should be asking yourself before deciding to roll your 401k to a Roth IRA.

What is the difference between a 401k and a Roth IRA?
There are effectively 4 different places in life that trigger income tax. First When you EARN money Second when the money you've invested GROWS each year this growth can be taxed. third when you decide to SPEND the money and fourth at DEATH whatever is left for your heirs can be taxed. I mention these different times of taxation because the only difference between the 401k and the Roth IRA is WHEN you pay the tax.

Taxation of the 401k:

• When you EARN the money and put it into the 401k it is NOT taxed.
• When the money grows each year the GROWTH is NOT taxed.
• When you decide to begin spending the money (usually retirement) it IS taxed.
• Whatever is left over upon your death the balance goes to your heirs and IS taxed.

To summarize taxation of the 401k: You put a small amount away each year. This amount is tax deferred. You do this for many years and the money is all growing without taxation. Once you hit your retirement years it has turned into a LARGE amount of money (hopefully). This LARGE amount of money will all be taxed by either you or your heirs.

Taxation of a Roth IRA:

• When you put an amount away each year you first PAY the tax.
• When it grows each year the GROWTH is tax free.
• When you decide to spend it in retirement it is tax free.
• Whatever is left over for your heirs is tax free.

You effectively pay tax on the small amount of money that goes in and the big amount later is completely tax free! Personally I believe the Roth IRA is too good to be true. I believe when they decide to increase taxes this will be one of the first things to go. Hopefully they will grandfather all the money that is already in the account if and when they change the rules.

So should I or shouldn't I transfer all or some now?
First you should realize that you must pay the taxes due on any amounts that you rollover. They don't actually call this transfer a rollover. It is officially called a Recharacterization. Many are wondering if it makes sense to change to a Roth now since their account values have depreciated so much. The upside is if you switch and the account returns to the values it once had then you only paid tax on todays amount which in many cases is only half.
The downside is you need to have enough money at tax time to pay the taxes due. Usually it is best to have this tax money on the outside of your plan. Try not to use the money from your plan to pay the tax. It is a very expensive way to pay the tax.

How much tax will I owe?
Since I'm not a tax advisor I would have to refer you to one. What I can tell you is how the tax brackets work. You need to figure out what percentage rate you will be assessed on the rollover. Here's how taxes work:

• The first taxable income isn't taxed because you have personal exemptions to offset it.
• The next amount of taxable income isn't taxed because you have deductions to offset it.
• If you have more taxable income than allowed for exemptions and deductions you begin paying in the 1o% bracket. Each dollar here is assessed a tax of 10%.
• Still more taxable income? After the 10% bracket is the 15%.
• Next is the 25%
• . . .and up.

Hopefully you get the idea. Look to see which tax bracket you have gotten into without any rollovers. Check to see how much room you have left in that tax bracket. I usually try not to have people go above their current tax brackets. I prefer to have some transferred this year and maybe more next year. Slowly get it over through the course of a few years so that you are keeping taxes as low as possible.

I've developed a spreadsheet to help people with this planning. It is free of charge you just need to contact me if you would like a copy. I've also developed a website that helps you keep your 401k invested according to the market conditions at http://www.ewatch401k.com/ .

Once you go through this entire process yourself you will be the expert when someone approaches you and asks "Can I roll my 401k to a Roth IRA"?