It is high time for our political leaders to make some key decisions.  And that translates into large uncertainties for investors that have held the market in a range and with low volume. We do not know whether “Cap and Trade” legislation will pass the Senate and we do not know whether and any healthcare bill will pass through Congress, or what that bill might entail.  And these two issues are paramount for the future of America.  

As we discussed earlier, cap and trade could cause incremental costs in energy for all of the United States, particularly in all carbon-based generation of electricity.  Increasing these costs will make carbon-based energy less competitive with alternative sources, like solar and nuclear.  The benefits of this legislation will be less carbon emissions, cleaner air, less dependence on imported oil and the creation of new jobs in the alternative energy sector.

However, this all comes at the expense of jobs in the traditional energy sector, which is currently the backbone of our energy policy. It also means higher job losses in the rest of the economy due to higher energy costs.  Remember that the United States is the “Saudi Arabia of coal,” given its abundance here.

All of these uncertainties are huge, as are the stakes for a multitude of sectors.  I have been surprised by the unpredictable decisions of our legislators many times.  In addition, legislative add-ons that tack hundreds of pages onto a bill right before it comes to a vote make prior analysis nearly impossible.  Therefore, unless the outcome is almost a foregone conclusion and the details are clearly spelled out well beforehand, making strong bets on their legislative outcomes is just plain gambling.

The unemployment rate rose to 9.5% in June as the economy shed 467,00 jobs. That’s up from 322,000 in May.  Jobs are a lagging indicator and tend to peak well after the economy has peaked.  But they are the best coincident indicator of economic activity.

Warren Buffet recently said that he has not yet seen any green shoots in the economy.  Conversely, General Electric Co. (NYSE: GE) Chief Executive Officer Jeffery Immelt said that all the pieces are in place for a recovery in the United States.  Yet the only areas of strength he mentioned were abroad:  China, some areas of the Middle East and other emerging economies.

But what we can all agree on right now is that there is no inflation in sight, despite the massive amounts of quantitative easing from the U.S. Federal Reserve.  But it won’t be long before inflation does rear its ugly head.

Like the people in Germany who were deeply affected by hyperinflation, I remember living and analyzing companies in Argentina in the 80s with inflation rising at a rate of 1% a day.  It was not fun, and the distortions to economic activity and financial statements were amazing.

Although the Fed has repeatedly indicated that it is ready to remove the monetary stimuli at the appropriate moment in an aggressive-enough fashion so as to preclude an inflationary spike, neither we can be sure that the central bank’s actions will meet with immediate success.

Federal Reserve Chairman Ben S. Bernanke is very capable and his resolve gives me comfort, but as former Fed Chairman Alan Greenspan told us when he was running the central bank, there are important variables in monetary policy that the Fed cannot know for sure: Among them are the lags between the Fed’s actions and the response in the economy and the precise sensitivity of the economy’s response to the Fed’s actions.  It is like steering a large transatlantic ship while watching in the rearview mirror.  By the time you see an iceberg, the ability to reverse or alter the course is very limited.

If we observe that the level of both monetary and fiscal intervention in the economy is at historic highs, then we have to understand that applying the just doses of intervention and reducing those doses as the economy gains a “self-sustaining” pace is a very tricky exercise.  Even allowing for the best of intentions and the immaculate professional abilities of the Fed, this will be a very difficult task to pull off.  And what is self-sustaining growth, anyhow?

We also need to understand that the current reflationary policy, which was employed to prevent the country from falling into a deflationary spiral, is actually seeking to create a little inflation.  And it would be unpardonable to see the country fall back into a double-dip recession after all this intervention, should the Fed pull on the reins too soon.

In fact, the Fed and the Treasury Secretary Timothy F. Geithner have repeatedly led us to believe that they intend to see the recovery ingrained before withdrawing significant amounts of stimuli.  It makes all the sense in the world.  The logical implication is that they would rather see an unpleasant reading or two on the inflation front than see an unpleasant reading on the growth side.  It is a very difficult situation to manage and they are not perfect.

So right now, when inflation expectations are well subdued, it is a good idea to add a position in Treasury Inflation-Protected Securities (TIPS).  The easy way of doing this is by buying the iShares Barclays TIPS Bond Fund (NYSE: TIP).

All of these pending uncertainties that I mentioned are adding to the traditional summer doldrums and we are seeing very low stock trading volumes.  So we are going to take advantage of the situation to get a good valuation on these bonds well before inflation expectations pick up.

Also, adding bonds to the portfolio has a stabilizing effect.  And the two traditional worries with bonds: A drop in the value of the U.S. Dollar and an increase in inflation are actually hedged, at least in part, with TIPS.  Because inflation is fully hedged as the principal is indexed by the consumer price index (CPI) index.

Recommendation: iShares Barclays TIPS Bond Fund (NYSE: TIP)at market (**).
(**) - Special Note of Disclosure: Horacio Marquez holds no interest in the iShares Barclays TIPS Bond Fund. ]]> http://www.contrarianprofits.com/articles/the-ishares-barclays-tips-bond-fund-is-a-good-way-to-brace-for-imminent-inflation/18728/feed 0 http://www.contrarianprofits.com/articles/four-ways-to-immunize-your-cash-against-the-ravages-of-inflation/18285 http://www.contrarianprofits.com/articles/four-ways-to-immunize-your-cash-against-the-ravages-of-inflation/18285#comments Wed, 24 Jun 2009 17:00:10 +0000 Keith Fitz-Gerald http://www.contrarianprofits.com/?p=18285 Right now, there’s more than $9.5 trillion in cash on the sidelines – or more than twice the amount of money currently invested in stock mutual funds, according to MoneyNet.inc and the U.S. Federal Reserve. Private equity firms alone are believed to hold as much as an additional $1.3 trillion.

While I’ve always doubted that the “money on the sidelines” argument is really all it’s cracked up to be, one can hardly argue with a recently released report from Harris Private Bank of Chicago [part of the U.S. arm of the Bank of Montreal (NYSE: BMO) that notes that stocks have rallied for the next two years whenever money market assets have exceeded 25% of the capitalization of the Standard & Poor's 500 Index. According to the Los…

1) Gold

David recommends investors hold 5% of their portfolio in gold to hedge against a declining dollar and an inflationary economy. He says investors can easily buy gold through the SPDR Gold Trust ETF (NYSE:GLD). This tracks the price performance of gold bullion without the hassles of finding and storing the physical metal.

2) Inflation-Adjusted Treasuries

Also known as TIPS, these government bonds are actually guaranteed to beat inflation. That’s because the bond principal and the amount of interest paid increase in step with the Consumer Price Index. David says the easiest way to buy TIPS is through the iShares Barclays TIPS Bond Fund (AMEX:TIP). This year Treasuries have lost 3.9%. TIPS have returned 3.6%.

3) Energy Stocks

Oil and gas are priced in dollars. This means they tend to rise in an inflationary economy. David says an easy way to buy into energy stocks is through the Vanguard Energy ETF (NYSE:VDE), which is up 29% since its March low. VDE includes companies that specialize in drilling; equipment provision; exploration; refining; and marketing, production and transport of oil and gas products.

4) Commodities

David recommends investors consider the PIMCO Commodity RealReturn Strategy Fund (MUTF:PCRDX) as an easy way of tapping into commodities. This fund matches the return of the commodities futures market by buying commodity-linked index notes.

This from Eric:

The flaming embers of inflation have already landed atop the thatched roof of American finance. And yet, investors can still buy inflation insurance on the cheap. In the next 1,373 words, we’ll examine a few of these “insurance policies”to assess their virtues and drawbacks.

Since a powerful new inflationary trend is very likely to occur, the prudent investor should probably take steps to guard against it. “But wait a second!” some readers be saying. “What if a powerful deflationary trend occurs first?”

Good question. It might. But we’d begin preparing for inflation anyway. Why not prepare for the near-certain arrival of inflation, rather than the uncertain timing of it.

If an infallible clairvoyant told you that your house would burn down in one of the next five years, would you say to yourself, “Gosh, maybe I should try to figure out which year it will be and not buy fire insurance during the other four years.”

You might actually guess correctly, in which case you would have saved yourself four years worth of insurance premiums. But you might guess incorrectly, in which case you would have lost your house.

Your call.

To this market observer, inflation seems like a near-certainty. Not an absolute certainty, mind, you, just a near-certainty, sometime within the next three years. So why not beat the rush to buy inflation insurance? Why not buy some now?

The nearby chart displays a sampling of inflation hedges, and how they performed during the last eight years of the infamous 1970s. Gold was clearly the standout winner. But we’d put an asterisk next to this result, due to a performance-enhancing assist from the U.S. government. During most of the preceding four decades, the US government had been artificially suppressing the gold price, while also forbidding private citizens from owning it. Therefore, once the government stopped its meddling, the gold price partied like a teenager whose parents had just left town.

Aside from gold, very few assets managed to keep pace with inflation, as measured by the Consumer Price Index (CPI). Hard assets like the CRB index of commodity prices and the Swiss franc did outpace the CPI, but stocks and bonds both lagged miserably.

Skipping ahead about 30 years, we can see that the modern versions of the 1970s inflation hedges have performed quite poorly during the last 14 months. Clearly, inflation is not a widespread concern. But that’s part of the reason it concerns us, and also part of the reason why we’d be inclined to take action now, while inflation hedges remain relatively cheap.

Our contrarian instincts lead us –rightly or wrongly – to distrust the consensus, especially when the consensus trusts in an idea as stupid as deflation…just kidding. We don’t think deflation is stupid, just unlikely. (More precisely, we suspect that deflationary indicia will be seasonal, like daffodils. For a while, they will seem to be everywhere. Then, just as suddenly, you won’t be able to find a single one).

So with that biased and unscientific preface, let’s sweep through a Reader’s Digest review of ETFs that might provide some kind of hedge against inflation:

1. Gold – The “Old Faithful” of hedges. It’s always worked before. Enough said. ETFs like the SPDR Gold Trust (GLD) provide easy access. With a $30 billion market capitalization, this is the “go-to”gold ETF. The next largest entrant is the iShares Comex Gold Trust (IAU) with a market cap of $2 billion. Both ETFs enable an investor to buy gold with a mouse-click. No muss. No fuss. But purists may wish to buy bullion coins like Krugerrands or Maple Leafs. As a gold investment, bullion coins have the advantage of being shiny, pretty and portable. But they have the disadvantage of costing 6% to 10% more than bullion itself, while also being so shiny and pretty that someone might want to steal them.
2. Gold Stocks – The bastard brood of gold and the stock market. As inflation hedges, gold stocks can be somewhat unpredictable and capricious. Over a multi-year span of time, they tend to reflect that gold side of their heredity. But during shorter time spans, gold stocks can behave much more like stocks than like gold…and that’s not always a good thing. That said, ETFs like the Market Vectors Gold Miners (GDX) provides a handy way to buy a basket of gold stocks.
3. Commodities –Like gold, a basket of commodities that includes crude oil, copper, wheat, gold etc. tends to provide a very reliable hedge against inflation. Unlike gold, a basket of commodities provides diversification across multiple assets and therefore, much lower volatility than gold. The largest commodity ETFs available are the PowerShares DB Commodity Index Tracking Fund (DBC) and the iShares S&P GSCI Commodity-Indexed Trust (GSG). DBC holds only six commodities: Crude oil, heating oil, aluminum, corn, wheat and gold. GSC holds a much broader collection of commodities.
4. Commodity-focused stocks. See comments on #2 above. The iShares S&P North American Natural Resources Sector Index Fund (IGE) provides broad exposure to commodity-focused stocks. Alternatively, the DWS Global Commodities Stock Fund (GCS) is a small closed-end fund that holds a similar portfolio. But GCS is selling 12% below its net asset value, which means that a buyer at the current quote controls one dollar worth of resource stocks for only 88 cents.
5. Non-Dollar Bonds – The Swiss Franc performed quite admirably during the last Great Inflation in the United States. But we are hesitant to bet on a repeat performance. Indeed we are hesitant to bet on ANY foreign currency as a way to hedge against US inflation. The Swiss economy, for example, no longer features a bunch of pocket-watch-toting gnomes guarding vaults full of gold bullion. Instead, the modern Swiss economy features pocket-watch-toting gnomes masquerading as hedge fund managers. The predictable result is that Switzerland’s two largest banks have amassed questionable derivatives exposures that exceed the GDP of the entire country. Many other bankers speaking many other languages have achieved equally enormous feats of stupidity. No one knows how these feats of stupidity will influence the values of their native currencies. Not knowing, therefore, we are disinclined to guess. But those readers who suspect that the dollar will be one of the first currencies to go down in flames, rather than one of the last, might be interested in the one of the many ETFs that hold foreign currencies. The CurrencyShares Swiss Franc Trust (FXF), for example, holds Swiss francs. Alternatively, the dollar-phobic investor could purchase the SPDR Barclays Capital International Treasury Bond ETF (BWX) that holds a basket of bonds issued by foreign governments. Its largest allocations include a 23% weighting in Japanese government bonds, 12% in Germany and 12% in Italy.
6. TIPS –No discussion of inflation hedges would be complete without mentioning TIPS, short for Treasury Inflation-Protected Securities. [To learn more about how they work, check out the November 26, 2008 edition of the Rude Awakening]. Investors may purchase a basket of TIPS by buying the iShares Barclays US Treasury Inflation Protected Securities Fund (TIP). In theory, TIPS provide a direct and reliable hedge against inflation. But like so many other seemingly brilliant ideas, TIPS work better in theory than in practice. The first risk is an overt one – deflation might persist for longer than expected (by us). In which case, the principal value of a TIP could decline below par. And even though the holder of the TIP would receive par at maturity, the interest payments that the holder would receive between now and maturity would decline in concert with the declining principal value. The second risk is a covert one: the federal government controls the calculation of the Consumer Price Index (CPI). Therefore, if the CPI, as currently constructed, were to get out of hand and produce very high inflation readings, the government’s bean counters would probably spring into action to create a “new and improved”CPI that would deliver much lower inflation readings. It has happened before.

Thus concludes our review of inflation hedges. We hope all readers will utilize the delightful deflationary interlude we are now enjoying to prepare for what may lie ahead. Hostile inflationary forces may be amassing their forces at the borders of our economy at this very moment. In short, we think it’s a good time to risk being paranoid about the threat of inflation.

Source: Inflation Gestation

We’re “officially” in a recession and the panicky markets are bracing for deflation. But what most investors don’t realize is that inflation – not deflation – is the real threat that they face.

For more than a year now, I’ve been telling readers and attendees at financial conferences around the world that the United States has been in a recession since last November.

I was wrong.

But only by a month: According to the National Bureau of Economic Research (NBER) announcement last Monday, we “officially” entered into a recession last December.

Now, I realize that stocks have taken a drubbing in the past few months. And the odds are good that share prices will get beaten down further in the weeks ahead. But that’s actually good news – and for three reasons:

• The NBER, which called the recession — apparently from its suite in the “Better Late Than Never” Department — is not known for being timely. In fact, its timing is so consistently bad that this latest recession pronouncement might actually be viewed as the light near the end of the tunnel. Indeed, of the four recessions since 1980, the NBER announced that we were in a recession in a (somewhat) timely fashion only once. That was in 1981, a full six months after the recession actually started.  But in each of the other three recessions – 1981-1982, 1991 and 2000 – the NBER didn’t officially label the deteriorating economic conditions a “recession” until the downturn was nearly over.

• In three of the past four recessions – 1980, 1991 and 2001 – the Standard & Poor’s 500 Index had already reached its recessionary lows at the time the announcements were made.

• Since 1900, the average length of a U.S. recession is 14.4 months. Assuming that historical relationships hold true, the NBER data, despite the fact that it’s a year late, falls in line with our suggestions of a few weeks ago that a late springtime rally may be in the works.

(Whether we believe that last point is another point entirely for reasons we’ve written extensively about in recent months. So we won’t rehash those today.)

But we will point out something that’s vitally important right now: There has not been a recession in history that wasn’t followed by inflationary pressure. And that, in turn, suggests that investors would be wise to shore up their defenses now while everybody is looking the other way … at deflation.

Why?

The U.S. Federal Reserve is expanding our monetary base by more than $11 billion a day since September to nearly $1.5 trillion, which represents an increase of 79.02% since October 2007.

What they are doing is unprecedented in recorded history.

On an annualized basis, the run rate in just the last few months alone works out to more than 369.92% per year – which means the monetary base is accelerating dramatically (See accompanying chart).

According to the Federal Reserve’s latest H.3 report, dated Nov. 28, bank non-borrowed reserves fell to -$362 billion, more than doubling the -$158 billion reported in September. Meanwhile, the preliminary Nov. 19 two-week figures reflect total borrowings are now $652 billion, up 11.85% over the same time period.

At the same time, total borrowings (TOTBORR) of depository institutions from the Federal Reserve have spiked dramatically, which signals still more money is working its way into the system. Note how smooth the TOTBORR chart has been historically for the last 22 years and how dramatically it’s spiked as a result of the financial crisis. When I say unprecedented, this is the kind of chart I’m referring to.

And we’re not done yet. In addition to all the infusions we’ve already mentioned, Club Fed is poised to inject another trillion dollars to bail out banks, insurance companies, Wall Street, possibly Detroit’s “Big Three” automakers and just about anybody else who “needs” a handout to overcome years of inept management,financial malfeasance – and plain old greed.

That’s why – more than any other single reason – deflationary pressures that might exist in the next six months or so aren’t really the enemy.

Carnegie Mellon University economist Allan H. Meltzer was much more in a recent interview with Forbes, stating that “people who say deflation is a threat are either rumormongers or ignorant.”

Added Meltzer:  “They need to take a refresher course in economics.”

As much as we’d like to dismiss Meltzer’s comments, we can’t. At least not entirely, because interest rate swaps are currently pricing in deflationary expectations.  And that speaks to something I’ve pointed out repeatedly: Any time the Fed squares off against the markets, the Fed loses. And it’s clearly fighting a losing battle now.

That’s why the bond markets are indicating deflationary expectations of 1.5% over the next two years and inflation of just over 0.0% over the next five years. Over the next 10- and 20-year periods, the markets are pricing in inflationary expectations below 2.0% respectively.

With an expanding monetary base already screaming inflation, this connotes opportunity.

The best way to capitalize on this in the long term is through Treasury Inflated Protected Securities, or TIPS. Right now they’re comparatively cheap because investors have fled to straight Treasuries, preferring their immediate liquidity. But TIPs are rising nicely and are likely to rise much further and faster with the first whiff of inflation.

Speaking of which, we think there is a 50-50 chance of so-called “core inflation,” which excludes food and energy prices, rising to 4.0%. That doesn’t sound all too bad, but that’s 2.3% more than the recent 1.71% yield on five-year U.S. Treasuries, which means TIPS are a better bet today.

Our favorite, the iShares Lehman TIP (TIP), sports an attractive 8.21% yield and plenty of upside. So it’s not only the good defense we’ve mentioned in the past, but one with plenty of inflation protection built in.

It’s up 14.35% from the low of $84.14 set Oct. 10. That’s something most investors are not focused on right now, but they should be.

Source: Inflation – not Deflation – is the Threat, Now Here’s What to do About it

But Eric says TIPs buyers must be cautious: a prolonged spell of deflation would be devastating to both prices and yields.

More from The Rude Awakening:

Everyone knows that a deflationary deep-freeze is paralyzing the global economy. Everyone also knows, therefore, that inflation is as good as dead. The sellers of stocks know it; the buyers of long-dated Treasury bonds know it; and the sellers of TIPs (Treasury Inflation-Protected bonds) know it better than anybody. When so many financial market participants are certain about anything, a forward-looking investor might want to challenge the thesis…and try to make a few bucks in the process.

The nearby chart shows quite clearly that prices of long-dated Treasury bonds (as represented by the iShares 20+ Treasury Bond ETF – NYSE:TLT) have been soaring, whiles the prices of TIPs (as represented by the iShares Treasury Inflation Protected ETF – NYSE:TIP) have been falling. Most long-dated TIPs have tumbled 15% in less than two months. Evidently, investors want nothing to do with inflation protection, but will stampede to obtain DE-flation protection.

But is deflation such an utter certainty that investors should be scooping up 10-year Treasury bonds that yield a near-record-low 3.11%?  To rephrase the question, is inflation such impossibility that investors should be unloading 10-year TIPs (Treasury Inflation Protected) that currently yield 2.40%, but could produce a vastly greater return if inflation heats up?

We ask these questions, not because we believe a deflationary episode is unlikely, but rather, because we do not believe that an inflationary episode is impossible. Investors in long-dated Treasury securities seem to have convinced themselves that inflation has been “deep-sixed,” not just for the next two or three years, but for the next 10 to 20 years as well.

The cost of taking the other side of that trade has never been cheaper. But TIP-buyers beware!…The other side of the trade is not without risks. A potent deflationary trend would depress the value of TIPs, both in absolute terms and relative to conventional Treasuries.  In such a circumstance, TIP prices could fall… a lot.  At maturity, of course, the TIP-buyer would receive at least “par” for his bonds.  But no investor wants to wait a decade or more to see the return of his capital.

[To better appreciate the virtues and vices of a TIP of security, consider the following brief primer: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm]

As noted above, the conventional 10-year Treasury bond yields 3.11%, which is 71 basis points more than the 10-year TIP yield of 2.40%. The TIP-buyer accepts yield penalties like these in exchange for the comfort of inflation protection.

But comparing current yields is only one small part of the calculus that leads an investor to either buy or shun a TIP.  The most important aspect of the comparative analysis is the “implied breakeven inflation rate.”  In other words, what would the average inflation rate need to be during the life of a given TIP to make it a better buy than a conventional Treasury of the identical maturity?

During the last decade, the implied breakeven inflation rate for a 10-year TIP has fluctuated around 2% – meaning, if the inflation rate averaged less than 2% during the life of the TIP, a conventional 10-year Treasury bond would have been a better buy.  On the other hand, if the inflation rate averaged more than 2% during the life of the TIP, the TIP would have been the better buy.

Lately, a very strange thing has happened in the TIP market: breakeven inflation rates have collapsed to all-time lows. The 10-year TIP, for example, is pricing in a razor-thin inflation rate of just 0.3% per year during the next 10 years.  I.e, if the inflation rate averages more than 0.3% per year during the next 10 years, the buyer of a 10-year TIP at today’s prices would be better off than the buyer of a conventional 10-year Treasury bond.  The inverse would also be true.

Let the reader decide, therefore, whether the average U.S. inflation rate will exceed 0.3% per year during the next decade. But before deciding, let the reader also do enough homework about the quirky world of TIP securities to avoid making unintended errors.  One of the easiest – and costliest – errors a TIP-buyer could make would be to underestimate the capital-destroying potential of a severe deflation.  If the Consumer Price Index were to decline sharply for a sustained period of time, the price of a long-dated TIP would also decline sharply.  Furthermore, the current yield provided by the TIP would decline at the same time – a deflationary double-whammy.

Thus, the TIP buyer’s world is very simple: inflation = good; deflation = bad. But therein lies the appeal of these unique securities as well.  Inflation is rarely a good thing for the value of a financial asset, but it is a good thing for a TIP.

When the central banks of the world flood the global monetary system with titanic quantities of credit and currency, an inflationary uptick does not usually trail far behind.  And when the US Federal Reserve pours so many trillions of dollars into the US financial system that an $800 billion bailout seems like nothing at all, an inflationary uptick becomes increasingly likely.

TIPs are risky, but inflation is devastating.

Source: Beat the Rush; Sell Treasury Bonds Now

This from Investment U:

With the stock market’s historic drop this year, some investors have fled to cash. Others are cautiously buying. Most, however, are sitting on their hands.

They shouldn’t be.

Even if you lack the cash – or the willpower – to buy into this market, there is still a very smart move you can make: switch.

Switch from your poor-performing, high-cost, tax-inefficient stock and bond mutual funds to index funds or exchange-traded funds (ETFs).

It’s a very smart move. Here’s why…

Why Choose Exchange Traded Funds Over Mutual Funds?

Compared to exchange traded funds, most mutual funds are a lousy deal, here’s why:

• Each year more than three-quarters of them fail to match the performance of their benchmarks.
• Many are loaded with front-end or back-end loads, 12b-1 fees, high management costs and other expenses.
• Moreover, even when these actively managed funds fall sharply, they still often distribute annual capital gains to shareholders, in effect handing shareholders a paper loss and a tax bill at the same time.

Don’t stand for it. Now is your chance to fight back.

Switching to Exchange Traded Funds Will Save On Taxes

Switch from your underperforming mutual funds to index funds and exchange-traded funds – and save yourself thousands of dollars in taxes in the process.

The IRS allows you to take losses each year to fully offset any realized capital gains. And also allows you to take capital losses to offset up to $3,000 in earned income.

In a year as nasty as this one, of course, you probably don’t have too many realized capital gains to worry about.

You should make this switch anyway. The IRS allows you to carry forward your losses indefinitely to offset future capital gains.

As bleak as the outlook is today, there will be capital gains in your future and, eventually, the tax on them is going to be higher than it is now.

Aside from the thousands you’ll save in taxes (and expenses) in the years ahead by making this switch to exchange traded funds, there is an important psychological reason to do it.

When you get your statements in 2009 and beyond, instead of looking at a smorgasbord of losing positions you’ll be looking at winners. You may not end up buying at the very bottom – few do – but you will have bought a whole lot closer to it than you did originally.

Exchange Traded Funds – Turning Market Lemons Into Lemonade

So take the lemons the market has handed out so abundantly this year and turn them into lemonade with exchange traded funds. Here’s how:

Sell Your Losing	Replace It With:
Gold Stock Funds	Market Vectors Gold Miners ETF (NYSE: GDX)
U.S. Large-Cap Stock Funds	S&P 500 ETF (AMEX: SPY)
U.S. Small-Cap Stock Funds	Vanguard Small Cap ETF (NYSE: VB)
International Stock Funds	iShares MSCI EAFE (NYSE: EFA)
Corporate Bond Funds	Vanguard Total Bond Mkt ETF (NYSE: BND)
Junk Bond Funds	iShares High Yield ETF (NYSE: HYG)
Inflation-Adjusted Bond Funds	iShares Lehman TIPS (NYSE: TIP)
Emerging Market Stock Funds	iShares Emerging Mkts (NYSE: EEM)

Using Identical Exchange Traded Funds As Smart Tax Moves

If you’re already invested in exchange traded funds, incidentally, you can still make the same smart tax move by selling your losers and moving into virtually identical funds.

For example, you can take a loss in one S&P 500 Index Fund (AMEX: SPY) and replace it with, say, this S&P 500 Index Fund (AMEX: IVV). Even though these funds have the same benchmark and are virtually identical, they are different funds, so the IRS allows the switch.

(For a complete list of ETFs at Fidelity.com.)

However, you cannot sell a fund and buy back the exact same one and qualify for this deduction (unless you wait at least 30 days). If you do, you run afoul of the wash-sale rule.

Incidentally, if you own individual shares that are down but for which there is no logical replacement (think Apple or Berkshire Hathaway) and you don’t want to sell and risk that the stock will be substantially higher 30 days from now – always a possibility from these depressed levels – you can double down on your stocks now, then sell your higher-cost shares the last week of December. (You will, of course, be doubling down on your risk for the next 30 days.)

If you plan to do this, however, you need to do it by the end of the month. Once November ends, it will be too late to do it for the year.

Bear in mind, you cannot take tax losses in an IRA, 401(k) or other qualified retirement plan. But you should still consider making the switch to ETFs and index funds for the cost advantages and psychological benefits I’ve described.

Source: Exchange Traded Funds: An Investment Move You Need to Make…