January 13, 2003

Dear Client:

2002 was a year to forget for stockholders. The U.S. stock market declined for the third consecutive year, a feat not matched since 1929-1931. The returns of 2000-2002 were -12%, -9% and -22%, an annualized loss of -15%. For the third year in a row bond returns have been phenomenal, exceeding 10% total return, interest plus appreciation, annualized from 2000-2002.

Although bond yields are low compared to the yields of the last twenty-five years we think that most portfolios benefit from at least a small allocation to fixed income investments. Adding a small bond allocation to an equity portfolio reduces the overall volatility. The stock and bond markets are usually not highly correlated, i.e., when the stock market rises bond values decline. So bonds are a partial hedge against a continued economic slump.

Low bond yields reflect the recent U.S. budget surplus, the likelihood of war and disruption of oil supplies, a continuing worldwide economic slowdown and the proposed tax-exemption for corporate dividend payouts (see below). It is hard to visualize a scenario in which inflation and bond yields increase significantly in the upcoming year. And if that is a concern of yours, the bond position itself can be hedged with inflation-protection bonds (TIPS).

A Look at Tax-Exempt Dividends

We now have another variable to throw into the mix. The federal government is controlled by an unusually homogeneous group that is committed to supporting the president's agenda. What President Bush wants these days, President Bush gets. And what he wants is to reduce the progressive structure of our income tax system, bringing down marginal rates, and to reduce taxes on investment income.

Bush has proposed that corporate dividend payments to shareholders become tax-exempt. Under current law, dividends are taxed at the recipient's marginal income tax rate. The effect of lowering capital gains tax rates has been to make dividend payments less desirable than stock appreciation.

Let's assume that a company earns $10 per share pre-tax, and pays tax at a 35% corporate rate. The net earnings are then $6.50 per share. If the company pays out the earnings as a dividend, an investor subject to a 35% personal tax rate would end up with $4.23. If instead the company retained the earnings and let the stock appreciate by the value of the retained earnings, the investor could sell the stock and net $5.20 after paying 20% capital gains tax.

The proposal would reduce yields of corporate bonds. Currently earnings are taxed at the corporate level, and again at the investor's level as dividend payments or capital gain upon sale. Interest payments, however, are deductible, and therefore taxed only once at the investor's level. The proposal would increase the appeal of dividends relative to debt. Less debt will be issued, decreasing supply and yields.

The effect of the proposal should be to lower the cost of capital for companies with large cash positions and cash-flow intensive companies and increase the relative value of these businesses.

A Shell Game

Investors who are excited about the windfall that exempt dividends represent should read the fine print. No mention has been made of exempting dividends from Alternative Minimum Tax (for example, tax-exempt interest paid by municipal bonds for "private activity" is not exempt for AMT purposes).

Many high-income investors in California and other high income tax states are already subject to the AMT. More taxpayers owe AMT each year. If dividends are not exempt for AMT purposes you will most likely owe AMT on the interest.

On Friday Governor Davis floated the idea of increasing the California top income tax rate to 11%. If you didn't owe AMT before, you sure are going to if this gets enacted.

So while Bush is promoting the idea of "tax relief" for high income taxpayers, many of the taxpayers in California, NY, NJ, and Massachusetts aren't going to see any benefit (any resemblance to political payback is purely coincidental). If the AMT regulations are corrected you will get a real tax benefit.

Increased Retirement Contributions

A true tax benefit has been the increase in retirement plan contribution limits. The new 401(k) contribution limit in 2003 is $12,000, and $14,000 for taxpayers age 50 or older.

IRA and ROTH-IRA contribution limits are raised to $3,000 ($3,500 for 50 and older). 403(b), 457(b), SIMPLE 401(k)s, SIMPLE IRA(s) and SEP-IRA limits have all recently increased.

Even if you are not eligible to deduct IRA contributions you can make non-deductible contributions to an IRA as long as you or your spouse has earned income. The benefit of non-deductible contributions is not huge but we still recommend after-tax contributions. The same goes for after-tax 401(k) contributions.

Statements Change (again!)

To provide more information on the asset allocation of your portfolio, holdings are now reported by market capitalization (large, mid, small), industry sector (health, information, energy, etc.), and fixed income security type (corporate, mortgage, municipal, etc.).

Back by popular demand is reporting by each account that we manage for you. If you have more than one managed account, we are providing a complete set of reports for each account. Apparently most of you want to see the detail of each account, even if it means longer statements. We can send yours either way upon your request.

I hope this new year is a healthy and happy one for you and yours. I appreciate your business and hope that you are satisfied. Please feel free to call anytime.

Regards,

Audrey Grubman, CFP^®