Titanic and the concept of Situational Awareness

April 15th each year not only marks the deadline for income tax returns but also the anniversary of the sinking of the Titanic and the tragic loss of the lives of over 1,500 passengers and crew (sinking at 2:20am on the 15th, after striking an iceberg less than twenty minutes before midnight on the night of the 14th).

It is worth reflecting on the events of that fateful night, and the catastrophe which continues to hold a powerful place in the popular consciousness. Such reflecting should not slip into the tendency to pass judgment on those caught up in the disaster itself, or to revise history in light of some social or political ideology, although even now nine decades later many seem compelled to do so. And yet, even so many years after the event, there is much that applies to situations individuals continue to face, and the valuable concept of situational awareness.

The various branches of the US military have used the term "situational awareness" for over a decade to describe the difficult task of obtaining a true picture of what is actually taking place in a given situation. The military employs this term because they recognize that it is quite possible to carry a picture in one's mind which is not aligned with the actual situation. Often, particularly in situations in which real danger is involved, the picture of what is going on at the time resembles the pictures produced by the old Polaroid "instant cameras," which would spit out a black square that slowly developed, revealing in greater and greater clarity the image you just photographed.

While in hindsight and with the benefit of time (and safety) the picture seems clear and the details easy to put in their proper perspective, being able to perceive the true situation and have an accurate perspective at the time is very valuable -- and the same is clearly true in the world of finance and investing as well.

In the Titanic disaster, the ship had received six messages on April 14th via Marconi wireless (a relatively new technology, yet related to many of the technological advances at the leading edge of today's wireless developments), but only two of these actually made it to the bridge, for a variety of reasons. Because of this, although the captain had an inkling of the danger posed by the ice in the area and had in fact altered his course southward in response, he did not have an accurate picture of the true situation or the fact that the ship was steaming directly into an ice field detailed in a message that was still sitting under a paperweight in the wireless room that night.

We have written already about the under-appreciation of risk that took place over the past five years with investment banks involved in mortgage-related and CDO securitization. That chapter has now been clearly revealed to be a case of having a more optimistic picture than the situation justified. But it is also entirely possible to erroneously have a worse picture of the situation in one's mind than actually exists -- and to take a wrong turn because of it. In fact, as we argued in that previous post, the over-allocation of capital to real estate and related securities was in part a reaction to fallout from the dot.com collapse and the erroneous perception that the technological advances that drove it in the first place were just a big trap and that telecom and technology were suffering from overcapacity and were all but dead.

Similarly, today there is a widespread perception that the worldwide economy is on the brink of a cliff, that the shocks the system has encountered are just the beginning, and that it is time for investors to "batten down the hatches" if they haven't done so already.

In fact, however, it is our assessment of the situation today that there are important growth drivers in the economy (beyond the carnage in the financial sector) which will continue to develop in 2008 and over the next several years. Among these are the situational awareness-enhancing technologies that have begun to enable data, maps, video and the connecting power of the internet to become more mobile. The power of these developments to help not just consumers but also businesses of all sorts to navigate through dangerous waters with greater awareness of both obstacles and opportunities should not be underestimated, although in the aftermath of the financial sector's recent shocks few investors are looking to the future right now.

The concept of situational awareness is one that deserves important consideration. On this noteworthy anniversary, it is worth pausing to consider the events of April 14th and 15th, 1912.

For later posts dealing with this same topic, see also:

"It's a panic, not a Great Depression" 01/21/2009.

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Don't be misled by the media's Great Depression quotations

The general media continues to bombard investors with sensational headlines about the slowdown in the economy, such as the quotation from a speech delivered today at the Brookings Institution in Washington DC by Britain's Chancellor of the Exchequer, Alistair Darling.

In the beginning of his speech, Darling said: "Today I want to make the case for urgent action by the world's major economies to deal with what is the biggest economic shock since the Great Depression."

The line was perfect for the news media, who have been repeating it on the radio and television news, combining it with the release of a negative consumer confidence reading and leaving the impression that we are facing the most severe downturn since the 1930s.

However, Darling was specifically referring to the financial system, which did indeed receive a great shock, although that is not the same as a depression or a recession, nor did Darling say it was. In fact, throughout the rest of his talk, Darling said a number of very sensible things which will not be picked up and repeated by the media, such as:

"It is more important than ever to promote openness to trade and investment [. . .] We just need the political will to do so -- all of us, wherever we sit, rejecting protectionism, breaking down barriers to trade" (page 7 of the speech transcript).

Meanwhile, protectionist sentiment grows in the US, as evidenced most recently by the shelving of discussion on trade with Colombia yesterday (see this article in the NY Times and this editorial in the Wall Street Journal).

Darling's speech also contained calls for restraint in regulation in the face of the recent shocks to the financial system. He said that while regulation and supervision are important, he advises against "more regulation," saying: "Not requiring more regulation -- though reform is needed -- but effective regulation" (3).

This is in line with what we wrote some weeks ago, in the post "What NOT to do right now about the economy." And yet in that post we noted links to the inevitable chorus of cries for greater regulation. While the media will repeat Mr. Darling's quotation about the Great Depression, you can be sure it will never repeat his call for "not requiring more regulation." During his talk, Darling noted that the innovation in financial markets (meaning securitization to diversify the scope of risk, which many criticize as inherently bad) in and of itself has considerable benefits, such as enabling more efficient flows of capital.

In short, Mr. Darling's speech was more about the need for economies to remain flexible and avoid retreating into a protectionist or regulatory shell than about a return of the Great Depression. "The evidence shows that economies which are both stable and flexible are more resilient in the face of shocks," he said (2).

As we wrote in our previous post, we believe that the re-assessment of risk will be a positive for well-run companies that are positioned in front of growth trends. We also believe that there are some very evident growth trends that are even now just beginning to take off (and that were delayed by factors we discussed in that same previous post), some of which we will touch on in upcoming articles.

For later posts dealing with this same issue, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.
  

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Stocks and the massive misperception of risk

The past five years saw a massive mis-perception of risk that rapidly came to an end over the last several months.

What were seen as good risks by the largest investment banks on Wall Street (companies with control of huge amounts of capital) turned out to be very poor risks indeed.

That is as much of the story as most people understand, but if you probe a little further you will discover some important insights. The fact that a massive amount of capital was directed into instruments such as CDOs means that capital was not deployed to other opportunities.

Beginning in 2003, there was a perception that real estate investment was the ultimate "safe" investment, a mis-perception that was at the heart of the problem. Conversely, in the lingering psychic aftermath of the 2000-2002 bear market, stocks were perceived as very risky.

The graph above, showing global CDO issuance, reveals a massive deployment of capital into mortgage-related securities over the same years that stocks in general have performed sluggishly.

As risk has been re-assessed on a massive scale, capital may well flow back towards companies with a demonstrated ability to provide value to their customers and a history of being able to grow their business.

We have written before that ownership of good companies should form the backbone of any system for long-term growth of capital (see also this post).

As those controlling the largest capital pools reevaluate the risk landscape, they may return to the conclusion that we have believed all along. If so, it will be good news for well-run businesses positioned in front of fertile fields of growth.

For later posts dealing with this same subject, see also:

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

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The important section 7520 rate

This month, the section 7520 rate that the IRS uses to value certain charitable interests in trusts is only 3.4%, making this April, May and June a good opportunity for moving assets outside of your taxable estate if it is appropriate for your overall wealth planning situation.

The section 7520 rate is very important because most estate planning strategies are designed to minimize what you "give" to the government (as opposed to beneficiaries you choose, such as causes you care about and members of your family), and the 7520 rate plays a key role in assessing how much of an asset gifted to an irrevocable trust will be exposed to estate taxes and gift taxes.

The IRS sets the section 7520 rate each month using the Federal Midterm Rate, which is determined using an average of the yields of government securities with terms of more than three years and less than nine years. The rate represents a rate of return by which assets in a trust can be reasonably expected to grow in future years, and so the section 7520 rate is basically the rate of return that the IRS projects onto those assets.

In the diagram above, for example, which depicts a charitable lead trust, a wealthy family has created a trust which will donate an annual payment to a charity (such as a college) for a certain number of years and then at some future time give the remainder to non-charitable beneficiaries (such as children or grandchildren). The IRS will use the section 7520 rate for the month in which the trust was established to determine the net present value of the (non-taxable) gifts to the charity, and how much would theoretically be left over for the remainder beneficiaries (a taxable gift). If the assets in the trust grow at a rate of return which is greater than the section 7520 rate, then the amount beyond the calculated "taxable gift" passes to those beneficiaries (the children or grandchildren in this example) free of estate taxes and gift taxes.

Therefore, the lower the section 7520 rate is in the month in which you establish the trust, the better it is for your non-charitable beneficiaries, because there is a greater chance that the trust assets will outperform the rate that the government foresees, growing outside of the tax system and not subject to estate and gift taxes.

Even better, you actually get to choose the most favorable (i.e. the lowest) of the section 7520 rates for the month you establish the trust or the two prior months. The lowest the section 7520 rate has ever been since it was established in 1988 was in July of 2003. The second-lowest was the following month, August of 2003, in which the rate was 3.2%. This month, April of 2008, is the next-lowest after that, at 3.4% (the two months previous to this one were 3.6% and 4.2%).

To see just how powerful the section 7520 rate is, consider the charitable lead trust described above and add some numbers. If a wealthy individual (the grantor of the trust, indicated by the figure on the left of the diagram) establishes an irrevocable trust into which he grants $1,000,000 (indicated by the first green arrow going into the trust), and the terms of the trust dictate that it will gift $75,000 per year to a certain charity (represented by the green arrow with vertical arrows on top of it) for a period of twelve years, then the IRS would use the section 7520 rate to determine the net present value of the original million dollars minus those twelve years of gifts, which would be the amount of the trust that is subject to estate and gift tax when it passes to the remainder beneficiaries.

At 3.4%, the amount subject to gift and estate taxes is $270,965.93. This is over a hundred thousand dollars less than if the trust had been established under a section 7520 rate of 6.2%, which is what it was as recently as August of last year.

By increasing the gift size or duration of the gift stream to the charity, the amount subject to gift and estate taxes can be brought to zero. Any remainder would then pass to the remainder beneficiaries completely free of estate and gift taxes. There would only be a remainder if the growth rate exceeded the section 7520 rate, of course. However, the lower the 7520 rate, the better chance to do so. And obviously, the lower the 7520 rate, the less you need to increase the gifts to the charity in order to leave the taxable gift at zero (at 3.4% in our example above, you could zero out the taxable gift by increasing the annual charitable gift to $100,000 and extending it to thirteen years).

Other types of irrevocable trusts, such as Charitable Remainder Trusts and Grantor Retained Annuity Trusts, also use section 7520 and benefit similarly from a lower 7520 rate.

Because the trust uses the lowest section 7520 rate of the current and prior two months, it seems logical that this June would be an even better month to establish this type of trust (because the rate may continue to go down, but if it doesn't you can still use the April rate of 3.4%). However, the stock market is also down right now, meaning that if you grant assets to the trust that are stocks and they are valued at a lower price right now, that will also work to lower the amount that ends up being potentially subject to estate taxes. There is no telling whether stock assets will still be low in June.

The combination of low asset prices and a historically low section 7520 rate makes this a potentially valuable confluence of events for drafting these types of trusts, if it is appropriate to your situation.

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Have you been adding to your equity strategy?

A few months ago, on January 21st, we published a post entitled "A few lessons from 2002."

In it, we noted that during significant corrections in the past, including the bear market of 2000 to 2002 as well as 1981 to 1982, diving three or even more times while testing for a bottom is very common, making it hard to call the actual bottom until afterwards.

We also noted that being aware of this pattern can present an opportunity, if your cash-flow situation permits you to deploy fresh capital into equities during significant corrections.

Here is the chart from that previous blog post:

Notice any similarities to the chart in today's post, which shows the Dow from April 20, 2007 through today?

In our earlier blog post, we wrote: "Remembering the three arrows in the chart above, you should be willing to add and then add again later during corrections (if your cash-flow situation makes that possible)."

The question for today is, "Have you been doing that?"

If not, why not?

Many investors, even wealthy investors, fail to take advantage of the opportunity to add to their equity strategy during periods of lower prices. While we don't believe that anyone, ourselves included, can predict market bottoms with any degree of consistency, history has shown that adding to your equity portfolio regularly, and stepping up those additions during market downturns, has been a successful long-term strategy.

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