Feb 14

Key Insights Into Understanding Equity Market Corrections

By Eric Weigel | Capital Markets , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

Corrections, Recoveries and All That Jazz

Stock Market Corrections are tough on equity investors.  Over the last couple of weeks, there has been nowhere to hide – normally defensive strategies provided little relief.

After a long period of minimal equity market hiccups investors were reminded that the opposite side of the return coin involves risk.

Equities do better than bonds, on average, precisely because investors require compensation for the additional risk of their investments.

If risk and return are tied together why do investors get so nervous when suddenly equity markets go haywire?  Memories of 2008 come flooding back and investors get hyper fixated on relatively small market movements.

As of Friday, February 9, the S&P 500 had dropped 8.8% from its high of January 26.  Granted the drop has been swift and intraday market action (the difference between the high and low of the day ) has been off the charts, but you would have thought that we were on the verge of another Financial Crisis.

Figure 1 depicts the rolling 12 month returns on the S&P 500 as of the end of 2017. There are more periods of positive rather than negative returns as expected. We can also see that the downdrafts in recent years have been painful for investors – the implosion of the Technology Bubble (2000-2002) and the 2008 Financial Crisis still very much linger in investor minds today.

Figure 1

The key insight that investors need to come away with from looking at the history of stock market returns is that to get the good (those returns averaging 10% a year) you must be prepared financially and most importantly emotionally to endure the bad (those nasty corrections).

Investors need to remember that risk and return are the opposite side of the same coin.  They also need to understand the context in which market corrections take place.  While history always rhymes every equity market correction possesses unique elements that shape its ultimate effect on investors.

Understanding the market and economic context is incredibly important for everyday investing.  It is, however, absolutely critical for understanding the implications of equity market corrections and most appropriate course of action.

The point is that not all equity market corrections are made of the same cloth.  Some are deep and lasting. Some are deep and over before the eye blinks. Others last for a year or two and progress at a slower rate. And, finally other corrections turn into cataclysmic events that leave investors bruised for a long time.

Given the events of the last couple of weeks we understand the skittishness of equity investors. Last year was fantastic for investors.  We hardly had a hiccup in the last year. Investors started adapting to the environment – high returns and low volatility.

All the fireworks have come from Washington rather than Wall Street.  Yet, the lingering suspicion is that this party like all others before it must end at some time. Maybe it is just time, right?

We are professional wealth managers, not magicians or fortune readers. Nobody knows when the next big stock market crash will happen and least of all nobody knows the severity of the downturn.

At best, we can analyze the current equity market downturn and attempt to better understand the context in which current equity market prices started heading south.

While all equity market downturns are unique, for simplicity sake we categorize periods of extreme equity market distress into three distinct types of corrections – technical, economic and structural.  Each type of correction has its own distinct patterns and associated implications for investors. Not every moving animal in the woods is a Russian Bear!

Technical Correction:

This type of correction typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into 2 or 3 in a row and soon enough there is an avalanche of pundits predicting the next global crisis.

Maybe a bit surprising to some, pundits use perfectly logical arguments to justify their bearishness – inflation is about to spike up, the economy is tanking, earnings are coming down, there are no buyers left, and so forth.

All perfectly valid reasons for an equity market correction but the key characteristic of such prognostications is that they are mostly based on speculation and not rooted in contemporaneous economic trends. The arguments are more based on what we fear as opposed to what the current reality is.

Technical Corrections tend to occur on a regular basis especially for higher risk asset classes such as equities.  Long-term equity investors have seen these before and do not seem fazed by the market action.

Newer generations of investors, however, experience great fear and regret.  The immediate response is to sell down usually their most liquid holdings and wait for the market to calm down.  Maybe they will get in again after the panic is over.

Technical Corrections tend to last only about a week or two.  In the context of long-term capital market history they barely register to the naked eye. Boom they are gone, and people quickly forget what they just went through.  Technical corrections are learning opportunities but are most often quickly forgotten until the next blip.

Economic Corrections:

These types of capital market corrections are caused by the economic business cycle, i.e., periods of economic expansion followed by recession and eventual recovery.  Typically, the clues as to whether the economy is heading into a recession are present ahead of time.

Usually a large number of economic indicators will point in the same direction.  For example, the yield curve may become inverted (long rates lower than short-term rates), business confidence surveys start showing some downward trends, companies start hoarding cash instead of investing in plant and equipment and layoffs start accelerating in cyclically sensitive sectors.

In the last half century, business cycle recessions have been mostly shallow and short-lived. Economic recessions are, no doubt, painful but the implications to investors are fairly straightforward.

In the early stages of a recession, equity investments suffer the most while bond market strategies tend to provide the upside.  As the economy starts recovering, equity investments outperform marginally but with significant volatility.

Being early is never comfortable but it beats being late.  Some of the best equity returns happen during the late early stages of a recovery when the average investor is still too snake bitten to put any money at risk.

And finally, as the economy moves into full expansion mode equity investors typically enjoy a nice margin of outperformance relative to safer assets such as bonds.  As the uncertainty regarding the economic recovery fades in the rear view, capital markets tend to become less volatile as well.

Structural Corrections:

These are the most severe type and involve periods of real economic and financial stress.  Something has gone off the rails and public capital markets are the first to feel the brunt of the economic imbalances.

Structural Corrections are not merely stronger business cycle events. The integrity of the entire economic and financial system is at stake.  Without decisive fiscal and monetary policies there is a risk of total economic collapse.  Under these circumstances, equity investors are often completely wiped out and bond holders don’t fare much better.

Structural Corrections happen during periods of total economic unravelling.  The most usual signs of eminent economic collapse are massive unemployment, huge drops in productive output, and the unavailability of credit at any cost.  The financial system is usually at the root cause of the crisis and liquidity in the system suddenly disappears.  Faith in the system dries up overnight – the first stop are banks, next are capital markets.

The Great Depression of 1929-39 and the Financial Crisis of 2007-09 are prime examples of Structural Corrections that were felt across the globe.  History is, however, littered with other instances of more localized cases such as the 1997 Asian Crisis, the 1998 Russian Default and the Argentinian collapse of 1999-2002.

What should investors do during a correction?

The answer depends on the context surrounding the capital markets at that moment.  For example, the implications of a Technical Correction are very different from those of a Structural Correction.

Misdiagnosing what type of correction you are in can have severe consequences for your financial health.  Becoming too risk averse and selling everything can be as harmful as not being risk-aware enough and always expecting the markets to recover irrespective of business and capital market conditions.

Finding the right balance is key. In reality, after many years of watching markets one is never really 100% sure of anything.  In fact, if anybody says that they have perfect certainty all it means is that they either have not done all their homework or that they fail to understand the statistical concept of probability.

Our preferred approach is based on a solid understanding of capital market behavior coupled with hands-on experience under a variety of capital market situations.  Understanding capital market history is the prerequisite but experience is the key extra ingredient to gain confidence in properly evaluating the context in which markets are experiencing distress.

Table 1 provides a checklist as to the type of issues that we consider when evaluating the type of correction we might be in.

Table 1

Where are we today?

As of February 12 we have already seen signs of recovery, but the S&P 500 is still down 7.5% from its January 26 peak. Investors remain nervous. The CBOE Volatility Index stands at close to 27% which is significantly higher than where it was before the equity market started convulsing.

A 7.5% drawdown on the S&P 500 is not that uncommon. Investors should be wary but also keep their eye on their long game of growing risk-adjusted portfolio returns.

We believe that the current equity market downdraft falls under the category of a Technical Correction. Why? The numbers back up our assertion.  Our view is that equity markets remain healthy and will out-perform lower risk alternatives such as bonds.

Let’s start with a rundown of the negatives about equity markets.  The biggest knock on equity markets is that they are over-valued relative to historical norms such as price-to-earnings ratios. Agreed, the current Shiller P/E stands at 33.6 relative to a historical average of 17.  For access to the latest Shiller data click here.

On an absolute basis the S&P 500 is over-valued.  When considered relative to interest rates the picture changes.  Estimates by Professor Domadoran at NYU, for example, yield fair valuations on the S&P 500.

What else? Interest rates are too low. Agreed again, but low yields are the problem of the bond investor. A low cost of money is actually good for equity investors.

What about rising interest rates? The 10 Year US Treasury Note hit a low of 2.05% in early September and has been rising since. It currently stands at 2.84%.  Higher, for sure.  A real danger to equity markets? Not quite, especially in light of low rates of inflation.

Inflation-adjusted yields (sometimes called real yields) are still significantly below historical norms.

Higher real rates imply lower equity values.  We agree, but we see the current upward progression of interest rates in the US as fairly well telegraphed by the Federal Reserve.

We also still believe that US monetary policy is accommodative.  For example, Federal Reserve Bank of Atlanta estimates generated by the well-known Taylor rule show current Fed Funds rates about 2% too low (read here for a review).

What about the positives regarding equity markets? For one, we have a strong global economy.  Every major economy in the world is in growth mode.  The IMF recently raised their estimate of global GDP growth to 3.9% for both 2018 and 2019.

Inflation seems under control as well. The IMF estimates that global inflation will run 3.2% in 2018, unchanged from last year. Inflation in the US ran at 2.1% in 2017.

Monetary policy remains accommodative.  In the US the Fed reserve is slowly weening investors off artificially low interest rates, while in most other parts of the world (Europe and Japan in particular) central banks have yet to embark on the process of normalization.

The recently enacted lowering of the US corporate tax rate is also a positive for US domiciled companies.  Lower corporate tax rates translate immediately into higher cash flows.  Higher cash flows translate into higher corporate valuations. The main beneficiaries of lower corporate taxes are ultimately shareholders. 

What should investors do today?

Our analysis of the data leads us to the conclusion that the current equity market correction is driven by technical considerations and not fundamental issues.

We do not know how long the equity downdraft may last, but we expect this blip to barely register in the long-run.

Our advice may be rather boring but plain-vanilla seems the best response to the current state of investor panic.

  • If you were comfortable with your financial plan at year-end, do nothing. Don’t obsess over every single market gyration. There is not enough evidence to merit an increase in fear or a significant re-positioning of your portfolio towards safer asset classes such as bonds
  • If you did not have a plan in place, don’t go out and sell your equity holding before figuring out the status of your financial health in relation to your goals. Consult a certified financial planner if you need help.
  • If you have some cash on the sidelines, deploy some of it in the equity markets. Given that all major equity markets have taken a beating spread your money around a bit. We still rate International Developed Markets and Emerging Markets as attractive.  Consider whether it makes sense for you to put some money in the US and some abroad.

Whatever you do don’t panic. Focus on your asset allocation in relation to your needs, goals and appetite for risk. Don’t let that Russian Bear get to you!

Taking risk and suffering the inevitable equity market drawdowns is part of investing. Be cautious but be smart. Talk to your Advisor if you need help. Make your money work for you!

Feb 06

Market Correction? Hold on to your socks!

By Chris Chen CFP | Capital Markets , Financial Planning , Investment Planning , Risk Management

Market Correction? Hold on to your socks!

As of the close of the market yesterday February 5, the S&P 500 has suffered a loss of 6.2% from its high on Jan 26, 2018 .  All other major indices have followed this downward trend. After we have been telling you for months that the market was going to be due for a major correction, has the time come?

One of the ways that we gauge market risk is by observing our proprietary Risk Aversion Index . It has started to show “normal” behavior compared to the last few years when  it was indicating a lot more complacency to risk than average.  Clearly market participants are feeling antsy.  However, according to the risk measure, it is too early to draw conclusions.

We have not experienced meaningful corrections in the recent past. However it is worth remembering that according to American Capital historically 5% corrections happen 3 times a year on average, and 10% corrections happen once a year on average .  The current correction may just be a long overdue reminder that we are not entitled to volatility free financial markets.

Just two weeks ago the consensus was that we were going to experience a continuation of the bull market at least into the early part of this year. This is still our view. Although the stock market is a leading indicator, at this time this correction does not appear to be a recession driven correction.

When it comes to your investments, verify that your investment profile matches your financial planning profile . That would not insulate you from market corrections. However, matching investment and financial planning profiles would help ensure that you are taking the appropriate amount of risk given your goals and time horizon . If you haven’t measured your risk profile in a while, you may do so at this link.  Unlike the stock market, it is risk free!

Jan 16

Is 2018 the Year of the Roth 401(k) or the Roth IRA?

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Tax Bill Analysis: Is 2018 the Year of the Roth 401(k) or the Roth IRA?

Much of the emphasis of the Tax Cuts and Jobs Act (TCJA) passed in December 2017 affected individual income taxes. However, there are also impacts on investment strategies.

From an individual standpoint, the major feature of the TCJA is a reduction in income tax rates.  Except for the lowest rate of 10% all other tax brackets go down starting with the top rate which drops from 39.6% to 37%.

2018 MFJ Tax Table

 Table 1: 2018 Tax Rates for Married Filing Jointly and Surviving Spouses

Even then, not everyone’s income taxes will go down in 2018 . That is because some of the features of the bill, such as the limitation on State And Local Taxes (SALT) deductions,  effectively offset some of the tax rate decreases.

However, in general, it is safe to say that most people will see a reduction in their federal income taxes in 2018. Of course, this may prompt a review of many of the decisions investors make with taxes in mind.

Retirement is one area where reduced income taxes may have an impact on the decision to invest in a Traditional or a Roth 401(k) or IRA . The advantages of tax-deferred contributions to retirement accounts, such as Traditional 401(k) and IRAs are also tied to current  tax rates. In Traditional retirement accounts, eligible contributions of pre-tax income result in a reduction in current taxable income and therefore a reduction in income taxes in the year of contribution.

Most people expect to make the same or less income in retirement compared to working life, and thus expect that their retirement tax rate will be equal or lower than their working year tax rate. For those people, contributing pre-tax income to a Traditional retirement account comes with the possibility of reducing lifetime income taxes (how much you pay the IRS over the course of your life).

Most people are pretty excited to see their taxes go down this year! However, the long term consequences of the tax decrease should be considered.  While the TCJA was passed with the theory that it would stimulate growth such that tax revenues would grow enough to make up for the increased deficit created in the short term by tax cuts, few serious people actually believe that.  The most likely result is that we will experience a small boost in growth in the short term, and that federal deficits and the National Debt will seriously increase thereafter.

In the opinion of the non partisan Committee for a Responsible Federal Budget, not even the expectation of additional short term growth is enough to temper the seemingly irresistible growth in the federal debt.

TCJA impact on the National Debt

Increased deficits will make it more difficult to fund our national priorities, whether it is defense, social security, health care, or investment in our national infrastructure.  Therefore, I expect that we will initiate another tax discussion in a few years, most likely resulting in tax increases, in addition to the automatic tax increases that are embedded in the TCJA.

With federal income tax rates down in 2018, and our expectation that individual taxes will start increasing  after 2018, now may be the time to consider a Roth instead of a Traditional account. The consideration of current and future tax rates remains the same. It just so happens that with lower tax rates in the current year, it becomes marginally more attractive to consider the Roth instead.

Consider the case of Lisa, a married pharma executive, making $225,000. This places  her in the 24% federal tax bracket. In 2018, her $10,000 Traditional 401(k) contribution reduces her income taxes by $2,400. In 2017, Lisa would have been in the 28% tax bracket. Her $10,000 Traditional 401(k) contribution would have resulted in a $2,800 reduction in income taxes. Hence, Lisa’s tax savings in 2018 from contributing to his 401(k) goes down by $400 compared to 2017.

Federal income tax impact on a $10,000 Traditional 401(k) contribution Table 2: Tax savings on a 401(k) contribution with $180,000 taxable income

From a tax standpoint, contributing to a Traditional 401(k) is still attractive, just a little less so.  In order to optimize her lifetime tax liabilities, Lisa may consider contributing to a Roth 401(k) instead, trading her current tax savings for future tax savings. If Lisa were to contribute the entire $10,000 to the Roth 401(k), her 2018 income taxes would increase by $2,400 compared with 2017. Why would Lisa do that? If she expects future income tax rates to go back up, she could save overall lifetime taxes. It may be an attractive diversification of her lifetime tax exposure.

For instance, suppose now that the national debt does grow out of hand and that a future Congress decides to increase tax rates to attempt to deal with the problem. Suppose that Lisa’s retirement income places her in a hypothetical future marginal federal tax rate of 30%. In that case, she will be glad to have invested in a Roth IRA in 2018 when she would have been taxed at a marginal rate of 24%: she would have saved on her lifetime income taxes.

Of course, if Lisa’s retirement marginal tax rate ends up being 20%, she would have been better off saving in her Traditional 401(k), saving with a 28% tax benefit in her working years and paying retirement income tax at 20%.

Note also that Lisa would not have to put the entire $10,000 in the 401(k). She could divide her annual retirement contribution between her Roth and her Traditional accounts, thus capturing some of the tax advantages of the Traditional account, reducing the tax bite in the current year, and preserving a bet on a future increase in income tax rates.

Another possible course of action to optimize one’s lifetime tax bill is to consider a Roth conversion. With a Roth conversion, you take money from a Traditional account, transfer it to a Roth account, and pay income taxes on the distribution in the current year.  As we know, future distributions from the Roth account can be tax-free, provided certain conditions are met . A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you have reached age 59½, become disabled, you make a qualified first-time home purchase, or you die. (Note: The 5-year aging requirement also applies to assets in a Roth 401(k), although the 401(k) plan’s distribution rules differ slightly; check your plan document for details.)  Because tax rates are lower in 2018 for most individuals and households, it makes it marginally more attractive to do the conversion on at least part of your retirement funds.

Consider David, a single pharma marketing communications analyst. With $70,000 in taxable income he is now in the 12% marginal federal income tax bracket, down from the 25% federal income tax bracket in 2017. He is working on his part time MBA in 2019, and expects his income to jump substantially as a result. Additionally, David, a keen student of political economy expects his retirement taxable income to be higher than his current income and overall tax rates to go back up before he reaches retirement.  David now has a sizeable Traditional IRA.

For David the opportunity is to convert some of his Traditional IRA into a Roth IRA. To do that, David would transfer some of his Traditional IRA into a Roth IRA. He would pay income taxes on the conversion amount at his federal marginal rate of 22%. David would only convert as much as he could before creeping into the next federal tax bracket of 24%. If he feels bold, David could contribute up to the 32% federal tax bracket. Effectively this means that David would stop converting when his taxable income reaches $82,500 if he wanted to stay in the 22% tax bracket, and $157,500 if he wanted to stay in the 24% tax bracket.

In this example, if David were to convert $10,000 from his Traditional IRA to his Roth IRA, he would incur $2,200 in additional federal income taxes. If David expects to be in a higher tax bracket in retirement, he would end up saving on his lifetime income taxes.

David could combine this strategy with continuing to contribute to his Traditional 401(k), thus reducing his overall taxable income, and increasing the amount that he can convert from his IRA before he hits the next tax bracket.  If he were to contribute $10,000 to his Traditional 401(k) and convert $10,000 from his Traditional IRA to a Roth IRA, you could view this as a tax neutral transaction.

Federal tax impact on a $10,000 Traditional 401(k) contribution and $10,000 Roth conversion

Table 3: Balancing a Traditional 401(k) and a Roth Conversion

This strategy may work best for people who expect to have a reduced income in 2018. Maybe it is people who are back in graduate school, or people taking a sabbatical, or individuals who are no longer working full time while they wait to reach the age of 70 and start collecting social security at the maximum rate.

It is worth remembering that Roth accounts are not tax free; they are merely taxed differently. That is because contributions to a Roth account are post-tax, not pre-tax as in the case of Traditional accounts. You should note that the examples in this article are simplified. They do not take into account the myriad of other financial, fiscal and other circumstances that you should consider in a tax analysis, including your State tax situation. The examples suppose future changes in taxes that may or may not happen.

If you believe, like I do, that tax rates are exceptionally low this year and will go up in the future, you should have additional incentive to analyze this situation. The decision to contribute to a Roth IRA or 401(k) works best for people who expect to be in a similar or higher tax bracket in retirement, and have at least 5 years before the assets are needed in order not to pay unexpected penalties. Is that you? The financial implications of whether to invest in a Roth instead of a Traditional account can be complex and significant. They should be made in consultation with your Certified Financial Planner.

 

Jan 11

5 Risk Factors for Investors in 2018 – 3 Bad and 2 Good

By Eric Weigel | Capital Markets , Investment Planning , Portfolio Construction , Risk Management

5 Risk Factors for Investors in 2018 – 3 Bad and 2 Good

2017 came and went without nary a whimper. None of the big concerns at the end of the previous year happened or at least global capital markets did not seem to be disturbed by much of anything.

Stocks went up in a straight line, bonds did ok, volatility was super low and at the end of the year exuberant expectations were in full bloom as everybody and their aunt became fixated on Bitcoin.

The global economy keeps doing well and memories of the 2008 Financial Crisis are receding.  Consumer sentiment remains upbeat.

Being an investor is wonderful when markets are calm and statements show gains month after month.  Everybody is an investment genius. We forget how painful  it is when capital markets experience stress and things get a bit crazy.

The mental picture I use is that of flying.  The six hour trip from Boston to LA is great when it is all smooth sailing.  The plane seems to be flying itself and you pay more attention to the movie you are watching than thinking about the age of the aircraft or training of the pilot and crew.

But the first time there is a little air bump and maybe lighting strikes your plane you immediately tense up and fix your gaze on the crew.  Are they calm? Do they seem competent? Is this their first rodeo?

You form a mental image of what you want your pilot to look like.  Calm and collected for starters. But mainly experienced. We all want to see Captain Sully at the helm.

Clearly, we all would love smooth capital markets forever. But the close friend of return is always uncertainty.  The two are inseparable even though they may not always be in direct contact.  In times of turbulence you want experience at the helm and a solid understanding of how the two are intertwined.

How do we think of uncertainty in the capital markets? There are as many ways of defining uncertainty as there are opinions as to who the greatest quarterback in history is (we all know it is Tom Brady, right)  but without hopefully appearing too cavalier we think that it is useful to think of uncertainty as a normal distribution of potential outcomes.

We fear the left tail where things go terribly wrong, we accept the middle of the distribution as textbook risk/return, and we think that our own brilliance (just joking) has led us to the right tail of the distribution.

In 2017 equities, in particular, had a monster year with the S&P 500 up over 25% and many international markets up even more.  The year turned out much better than expected.  What do we expect for this coming year?

Our baseline assessment is fairly benign as we discussed last month in our Capital Market Overview. A quick review is in order.

We expect equities to again do better than bonds.  We also expect international assets to outperform domestic strategies.  We expect robust global growth.  Our most likely scenario for this year is for continued growth, subdued inflation and no major equity or bond market meltdown.  In our judgement there is about an 80% probability that such a scenario plays out in 2018.

On the downside we expect the low volatility that has accompanied capital markets recently to once again revert back to risk on/off.

Our baseline assessment is fairly benign

We expect to see more large jumps in market prices caused by low probability events lurking in the left hand side of the distribution.  The press calls these events Black Swans. Our best assessment is that there is about a 15% probability of seeing a Black Swan event in 2018.

On the other end of the uncertainty distribution you have what we call Green Swans – events, low in probability that when they happen are wildly positive for investors. We attach a 5% chance of experiencing such extreme positive events over the current calendar year

What could cause a Black Swan in 2018?

1. An inflation spike caused by a sustained rally in commodity prices

Inflation in the US is currently running a bit above 2% and market participants do not expect to see any major revisions over the next two decades (see the Philadelphia Federal Reserve estimate of inflationary expectations).

In our view, forecast complacency has set in and the risks are to the upside. Traders would describe the low inflation trade as over-crowded.  Maybe it is time to re-think what happens if the consensus turns out to be wrong.

The immediate effect of an upward spike in inflation would be a rise in bond yields.  Equities would probably take a short-term hit but the primary casualties would be found in the fixed income market.

What could cause a sustained surge in commodity prices? One, could be a supply disruption say in the oil market. Another could be related to the resurgence of global growth and continued demand for commodities such as iron ore and copper.  Third, a depreciating US dollar leading to commodity price inflation.

2. A spike in capital market turmoil caused by a geo-political blowup

The blowup could be anywhere in the world but most political commentators point to North Korea and Iran as the most likely centers of conflict.

Another possibility is a cyberattack endangering public infrastructure facilities especially if it is sovereign sponsored. Third, Jihadi terrorism on a large scale and on high profile targets. And last, the outcome of the Special Counsel investigation into Russian meddling.

All of these events have blowup potential.  While the probability of any of these events happening in 2018 is low, the magnitude of the capital market response is likely to be large and negative especially for equity markets.  Global economic growth would also, no doubt, loose some of its momentum.

3. An avalanche of bond defaults in the apparel and retail industries in the US and/or a debt bomb crisis in China

It is no secret that the US apparel and retail sectors are going through massive consolidation driven in part by the shift to online shopping.  It is widely acknowledged that the US retail market is over-built.

The number of apparel and retail companies expected to disappear is higher today than in 2008 during the Financial Crisis. Read here for a list of apparel and retailers at risk.

According to the Institute of International Finance global debt hit a record last year at $233 trillion.  Debt levels as a percentage of global GDP are higher today compared to 2007.  Figuring prominently in the debt discussion is China.

Global Debt Reaches a Record in Q3 2017
Source: IIF, IMF, BIS

The IMF recently issued a warning to the Chinese authorities about the rapid expansion of debt since the 2008 Financial Crisis.  The rapid expansion in debt has funded lesser quality assets and poses stability risk for global growth according to the IMF.

Estimates by Professor Victor Shi at UC San Diego put Chinese total non-financial debt at 328 percent of GDP. Other estimates are even higher leading to an overall picture of rising liabilities and numerous de facto insolvencies.  The robust GDP growth in China and the tacit understanding of the monetary authorities of the extent of the problem will hopefully keep the wolves at bay.

The implications of a debt scare for investors would be quite dire. Investors have had plenty of experience with debt crisis in recent years – Greece and Cyprus come to mind as Black Swan events that temporarily destabilized global capital markets.  A Chinese debt scare would no doubt be of greater impact to global investors. Emerging market debt spreads would certainly blow up.

What about the right hand tail of the uncertainty distribution – the Green Swans?

These are wildly positive events for investors that carry a low probability of happening.  What type of Green Swan events could we hope for that would lead capital markets to yet another year of phenomenal returns?

1. Positive global growth surprise possibly brought on by the recently enacted US tax reform

The US is the largest economy in the world and still remains a significant engine of global growth.  Could we be surprised by a spurt in US economic growth this year?

According to the Conference Board US real GDP is expected to growth 2.8% in 2018. Could we see 4% growth? The President certainly hopes so.  Not that likely. The last time that US GDP growth was above 4% was in 2000.

What could give us the upside scenario for growth?  Maybe a jump in consumer spending (representing 2/3 of GDP) driven by real wage growth and lower taxes.

Another possibility is a surge in investment by US corporations driven by cash repatriations and recently enacted corporate incentives.

We view both scenarios as likely but providing only a marginal boost to growth. As they say we remain cautiously optimistic, but would not bet the farm on this.

2. A spurt in exuberant expectations driven by the cryptocurrency craze

Fear of missing out (FOMO) takes over repricing all investments remotely tied to the cryptocurrency craze along the way.  We saw a similar scenario play out in 1999 in the final stages of the Technology, Media and Telecom (TMT) bubble.

In those days TMT stocks were no longer priced according to traditional fundamentals but instead on the idea that laggard investors would buy into the craze and drive prices even higher. Lots of investors succumbed to FOMO in the final stages of the bubble.

Photo by Ilya Pavlov on Unsplash

The recent price action of Bitcoin and most other cryptocurrencies has a similar feeling to the ending stages of the TMT bubble.  It is almost as if Bitcoin and its cousins are being discussed along with the latest Powerball jackpot.

No doubt fortunes have been and will continue to be made in cryptocurrencies.  Blockchain technology which underlies the crypto offerings is here to stay, but we worry about the lack of investor education and the speed of the price action in late 2017.  Whatever happened to Peter Lynch’s “buy what you know” approach?

What would be our best estimate for capital markets should the cryptocurrency craze gain further momentum in 2018? First, technology stocks would continue out-performing. Chip suppliers such as Nvidia and AMD would continue to see massive growth.

Companies adopting blockchain technologies would see their valuations increase disproportionally.  In general, animal spirits would be unleashed onto the capital markets making rampant speculation the order of the day.  The primary beneficiary would be equity investors.

Conclusion:

History tells us that it is almost certain that after 8 years of an economic expansion and stock market recovery we should see an outlier type of event in 2018.  What shape and form it will take (or Swan color) we don’t know.

Preparing for tail risk events is very expensive and under most scenarios not worth bothering with.

Black Swans create great distress for investors, but the opportunity cost of playing it too safe is especially high today given prevailing interest rates that fail to keep up with inflation.

The fear of missing out (FOMO) during Green Swan events is also a powerful investor emotion.  Again playing it too safe can result in many lost opportunities for capturing significant market up moves.

Investing in capital markets is all about weighting these probabilities and focusing on a small number of key research-driven fundamental drivers of risk and return.

How you structure your portfolio and navigate the uncertainties of capital markets is important to your long-term financial health. Putting a financial plan in place and having an experienced Captain Sully-type as your captain during times of turbulence should reassure investors in meeting their long-term goals.

 

 

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions.  We make no representation as to the accuracy or completeness of the information presented.  This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws and regulations are complex and subject to change, which can materially impact investment results.

Individual investor performance may vary depending on asset allocation, timing of investment, fees, rebalancing, and other circumstances.  All investments are subject to risk, including the loss of principal.

Insight Financial Strategists LLC is a Registered Investment Adviser.

 

 

Dec 13

Doing Good While Also Doing Well

By Eric Weigel | Investment Planning , Sustainable Investing

Incorporating Sustainable Investing Principles Into Your Portfolio

 

The term “sustainable investing” is often used interchangeably with “socially responsible investing”. In general, these terms describe an approach to investing that combines traditional financial methods to portfolio construction with the desire to simultaneously create positive societal outcomes.

What might these societal outcomes be? The industry has gravitated to three broad areas of impact – Environmental, Social and Governance (ESG).

We are all exposed to these various areas in our daily lives and many of us care deeply about some of these issues.  For the most part, we have channeled our beliefs into action through charitable giving and volunteering efforts.

But a new way of “doing good while also doing well” has emerged in the last few years .  Investment strategies have been designed to deliver competitive financial returns while also impacting society in a positive manner.

Sounds too good to be true? Large institutional investors have been able to achieve both financial and societal returns for a long time, but only in recent times have investment strategies been designed to enable individual investors to achieve the same objective.

 

How did sustainable investing get started? In its early days socially responsible or what we now call sustainable investing took an exclusionary view to investing . For example, tobacco companies were often excluded from portfolio mandates. Another, probably more extreme example involved the divestment of South African investments during the apartheid era.  Companies selected under this form of exclusionary screening had to meet a minimum threshold of “do no harm” but that was about it.

How has sustainable investing changed in the last few years? More recently, investors have looked at ways to create positive social outcomes within their financial portfolios.  The focus has shifted toward emphasizing investments with the dual objective of superior risk adjusted financial returns along with demonstrably positive environmental, societal and/or governance outcomes.

Doing well while doing good

“Doing good while doing well” is the basic rationale why investors are increasingly interested in enhancing how they manage their portfolios by including non-financial metrics such as environmental, societal and governance factors.

Besides ethical and moral motivations, why have investors suddenly become so interested in sustainable approaches to investment management?   Simple – self-interest combined with the realization that currently disclosed financial metrics are insufficient to properly account for the long-term sustainability and valuation of companies.

Large and small investors have woken to the fact that environmental issues such as climate change and carbon emissions have significant implications for our global well-being as well as for the long-term financial health of companies. This is the E in ESG.

Investors are also becoming very interested in the societal impacts of corporate behavior. Issues such as workers’ rights, gender and diversity policies and human rights in general. This represents the S in ESG.  For example, recent sexual harassment scandals at various media companies highlight the impact of non-financial events on corporate valuation.

Probably the oldest way of using non-financial criteria to evaluate companies involves the area of corporate governance.  This is the G in ESG.  Board composition, executive compensation practices and sustainability disclosure criteria are just three areas of increasing investor attention.

Is it possible to achieve competitive returns and also deliver a significant impact? Research indicates that “doing good while doing well” is achievable if properly implemented.

One of the concerns of early investors in SRI approaches was that excluding companies deemed to be “bad actors” would significantly restrict one’s investment opportunities and returns would commensurately suffer.

Recent empirical studies show that returns need not suffer especially when risk-adjusted.

Research from Morningstar depicted below highlights a segment of socially responsible funds compared to the broad universe of US equity mutual funds. The general conclusion is that socially conscious funds tend to have a higher representation among 3 and 4 star funds and lower proportions in the tails.

While not a ringing endorsement, the Morningstar research at least points out that there is no empirical reason to suspect that socially conscious funds underperform the general universe of US mutual funds.

 

Research generally shows that sustainable investing strategies do no harm, but can you do better? Yes, when the issues examined have a clear link to financial performance.  This relates to the issue of materiality.

Certain ESG issues are important from a societal standpoint but have a tenuous relationship to financial metrics such as company profitability or asset valuation.  For example, preserving the Costa Rican Toucan is a worthwhile societal goal, but few publicly traded companies have a direct financial link to such an effort.

On the other hand, global warming has a direct effect on the severity of hurricanes and directly impact the financial performance of companies in the insurance and construction industries among others.  Such an effect would be deemed material and of great consequence to individual investors with allocations to sustainable investing strategies.

Recent research by Harvard professors Khan, Sarafeim and Yoon identified a large variation in long-term measures of company financial success when evaluating companies on material ESG metrics.   Their conclusion is that companies with superior sustainability practices outperform companies with poor practices. *

How can individual investors incorporate sustainable investing strategies into their overall portfolios?  Our take is that properly constructed portfolios incorporating financial as well as non-financial ESG criteria are competitive on a risk-adjusted basis over short holding periods while providing significant positive upside over the long-term.

Our belief is that investors will benefit long-term from lower levels of business risk in their holdings as well as potentially higher stock returns.

Companies with superior ESG practices tend to provide greater transparency in their disclosures, be better prepared to deal with adverse events when they happen, and be more open to adapting their business models around environmental, social and governance issues likely to be material over the long-term.

Are sustainable investing strategies different from traditional approaches? The same risk-return balancing issues that apply to any investment portfolio apply to an approach using sustainability criteria. The biggest difference at the moment occurs at the implementation stage.

Implementing ESG portfolios requires additional research and caution.  While a growing universe of investment vehicles exist in the form of mutual and exchange traded funds there are wide differences in liquidity, composition and cost.  Properly conducting due diligence on the various sustainable investing offerings requires an above-average experience and know-how of financial materiality issues.

At Insight Financial Strategists we have done significant research on sustainable investing and believe that these strategies are here to stay and will deliver on the goal of “doing good while doing well”.

Please schedule a time to discuss with us your financial planning and investment needs and how a sustainable investing approach might fit your requirements.

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions.  We make no representation as to the accuracy or completeness of the information presented.  This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws and regulations are complex and subject to change, which can materially impact investment results.

*  “Corporate Sustainability: First Evidence on Materiality” by Mozaffar Khan, George Serafeim, and Aaron Yoon, Harvard Business School Working Paper No. 15-073, March 2015.

Individual investor performance may vary depending on asset allocation, timing of investment, fees, rebalancing, and other circumstances.  All investments are subject to risk, including the loss of principal.

Insight Financial Strategists LLC is a Registered Investment Adviser.

 

Nov 10

Killing Alimony

By Chris Chen CFP | Divorce Planning , Financial Planning , Tax Planning

Killing Alimony?

Eliminating the deductibility of alimony payments from taxable income is one of the features of the Republican House Tax Reform bill. It is very significant to both payors and recipients of alimony.

The Goddess Nemesis

Written into the fabric of the GOP tax proposal is a change in how alimony is taxed. People paying alimony could lose “the greatest tax deduction ever.” And that could ultimately affect those receiving alimony, too.

Since details of the new tax overhaul bill were released on Nov. 2, people of all income levels and ages have been trying to figure out how they could be affected going forward. One group of folks not likely to be happy: those paying alimony.

Section 1309 of the House bill would eliminate the deductibility of alimony. Killing the alimony deduction is one of the smaller revenue targets for the House Republican tax bill, yet it is exceedingly significant to the people affected.

Under current rules, alimony payors may deduct their payments from their taxable incomes, thus lowering their income taxes. In return, recipients pay income taxes on their alimony income. Because payors are usually in higher tax brackets and recipients in lower tax brackets, families can save money on taxes by shifting the tax burden to the lower earner. The saving can help increase cash flow for divorcing couples. They can then decide how to allocate the savings: to the payor or the recipient … or the court can do it for them.

Killing the alimony tax deduction raises only about $8 billion over 10 years

According to the House, abolishing the alimony deduction would not be a large revenue generator. Killing the alimony tax deduction raises only about $8 billion over 10 years. That is because the tax increase on payors is offset by a tax decrease for recipients. For them, alimony income would no longer be taxable.

This wrinkle could have a significant impact on divorce settlements. For many payors, saving taxes on alimony payments is the one pain relief that comes with making the payments. According to John Fiske, a prominent mediator and family law attorney, “Alimony is the greatest tax deduction ever.” Without the deduction, payors will find it much more expensive and more difficult to agree to pay.

For example, in Massachusetts alimony payors usually pay 30% to 35% of the difference in the parties’ incomes. For a payor in the 33% federal tax bracket, the House tax bill increases the cost of alimony by nearly 50%.

The entire set of laws, guidelines and practices around alimony are based on its deductibility. Passage of the House Republican tax bill is likely to lead to a mad scramble in the states to change the laws and guidelines to adjust alimony payments downward to make up for the tax status change.

The likely net result: although recipients would no longer pay tax on alimony income, abolishing the tax deductibility of alimony is likely to reduce their incomes even further as divorce negotiations take the new, higher tax burden on payors into account.

A previous version appeared in Kiplinger

Sep 03

Roth 401(k) or not Roth 401(k)?

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Roth 401k or not Roth 401k?

Which is better, more money in your paycheck or more tax-free cash in your retirement? It’s an important question only you can answer. 

According to a 2017 research paper at Harvard Business School, employees who have the option to contribute to a Roth 401(k) instead of a traditional 401(k) tend to contribute the same amount to either account. Given that a Roth 401k tends to result in more money taken out of your paycheck every week or month than a traditional 401k, that’s unexpected!  

Traditional 401k contributions are made on a pre-tax basis while Roth 401k contributions are made post-tax . So, assuming a given level of cash flow available, most of the time contributions to a traditional 401k will be easier than contributions to a Roth 401k because traditional plans drive your annual taxable income lower. You’ll still have to pay taxes on the contributions later when you retire. but the “taxable event” is deferred.

Take the case of Priya, a 49-year-old single mom. She makes $135,000 a year and lives alone with her son.  Not counting her employer’s match, Priya saves $350 per pay period in her traditional 401k, totaling $9,100 a year.  Absent other considerations, her $9,100 contribution reduces her annual taxable income from $135,000 to $125,900.  As a result, since her taxable income is less, she will pay less income taxes.

Roth 401ks and Roth IRAs are not tax-free: they are merely taxed differently

What if Priya were to switch her contributions to her company’s Roth 401k? She is considering contributing the same amount: $9,100. However, because contributions to a Roth are post-tax , they would no longer reduce Priya’s taxable income.  Thus, she would pay taxes on $135,000 instead of $125,900.  Hence Priya would end up owing more taxes for the year.

No brainer for the traditional 401k, right? Wrong. Roth 401ks provide one major advantage. If Priva switched to the Roth and maintained her contribution level, she might end up with more income in retirement as Roth 401k distributions in retirement are tax-free , whereas traditional 401k distributions are taxed as income .  However, switching her contribution to the Roth would be at the expense of her current cash flow.  Can Priya afford it?

What if she would reduce her Roth contribution to keep her current cash flow constant? In that case, it is not clear that Priya’s after-tax income in retirement would be higher or lower with a Roth 401k than with a traditional 401k. Answers would require further analysis of her situation.

It’s important to remember that Roth 401ks and Roth IRAs are not tax-free: they are merely taxed differently . That makes the decision to invest in a Traditional or a Roth 401k is an important financial planning decision :  employees need to understand the benefits and drawbacks of both approaches to make an informed decision that balances current spending desires with future income needs.

According to John Beshears, the lead author of the Harvard study, one possible explanation for his finding is that people are confused about the tax properties of the Roth . Another possibility could be that people have greater budget flexibility than they give themselves credit for. Either way, employees should seek additional support before making this very important decision.

 

A prior version of this article appeared in Kiplinger and Nasdaq.com
 

Mar 12

Have you had a Second Opinion?

By Jim Wood | Financial Planning , Retirement Planning

Have you had a Second Opinion?

 

Second OpinionYou probably get a regular health checkup, you get your teeth cleaned twice a year, you get a second opinion for major health issues. You may even get a second opinion when you buy a boat or a vacation home!

But do you get checkups or second opinions for your investment portfolio? How long has it been since you have had a serious look at your investment portfolio? Is it more than 2 years? more than 5 years? If you look under the hood, you may find that your portfolio no longer meets your needs. You may find that changes in your life have evolved your risk tolerance and the asset allocation that’s appropriate for you.

You may find that the stocks, the bonds, the mutual funds, and the annuities that you have grown comfortable with, have reached a phase in their development that does not meet your needs anymore.

The asset allocation that worked when you were younger and carefree may no longer work

As you approach retirement your risk tolerance will change, and should be reflected in your portfolio . The asset allocation that worked when you were 45 or 55 and trying to grow your portfolio, may not work when you are 65 and planning for retirement income and other goals.

For a 65 year old, retirement can easily last 20 or 30 years or longer . Will your investment portfolio carry you through? Will your retirement income from investments keep up with inflation? Will you be able to meet the increasing cost of health care? How will you be taxed? Will there be enough to leave to your grandchildren?

Call today to get peace of mind with a Second Opinion on your investment portfolio from a fee-only advisor. You will be glad you did.

 

Previously published in the Colonial Times

 

Feb 16

Rolling Over Your 401(k) to an IRA

By Jim Wood | Financial Planning , Investment Planning , Retirement Planning

Rolling Over Your 401(k) to an IRA

 

401(k) rolloverChanging jobs or retiring are two life events that provide opportunities to roll over your 401(k) to an IRA . If retiring, many 401(k) plan sponsors allow you to keep your 401(k) savings in their company plan. However, there are good reasons to consider a roll over of 401(k) assets to an IRA .

The first is to gain better control over your investment portfolio, once the assets are within the IRA. Company sponsored 401(k) plans may have limited investment options and restrictive trading and exchange policies. IRAs generally provide a broader range of investment options and more flexibility.

The second reason is the potential to obtain better guidance in adjusting the asset allocation to a more appropriate level that takes into account your own individual goals and risk tolerance. Although 401(k) plans may offer appropriate investments and some educational information about those options, 401k plan sponsors do not usually make available truly personalized advice to plan participants.

Regardless, there are mistakes that you need to avoid in the process of rolling over your 401(k). To avoid those mistakes, it is important to be able to recognize them. (Click here to receive the Top Mistakes in 401(k) Rollovers fact sheet.)

What are your 401(k) rollover options?

If you are changing jobs, you may have the option to roll over your existing 401(k) into your new employer’s 401(k) plan – be sure to verify that your new employer plan accepts rollovers. Regardless, you always have the option to roll over to an IRA that you can manage. And for the reasons noted above, rolling over to your own IRA may provide you with a better result .

It should be noted that one reason to keep your retirement assets in your 401(k) plan is that costs are often, but not always, lower in 401(k)s.  However, without an appropriate investment plan, lower costs may not bear fruit.

In general it is a good idea to get advice from a Financial Planner who is a fiduciary. You may think that your financial advisor is obligated to do what is best for you, the client. However, not all are not obligated to act in your best interest (whereas a fiduciary would be), and may advise higher fee products, or proprietary products sold by the firm he or she represents or products that do the job.

In April 2016 the Department of Labor rolled out a new regulation that is to take effect in 2017 mandating that all investment professionals working with retirement plan participants and IRA owners shall adhere to a fiduciary standard for all retirement accounts for which they provide investment advice. For purposes of the DOL rule, retirement accounts include 401(k)s, IRAs, and Roth IRAs among others.  The Department of Labor estimates that the investing public would save $4 billion a year with the new fiduciary rule. As you might expect, the fiduciary rule is opposed by affected Wall Street interests that are seeking to water it down or eliminate it entirely.

The Trump administration issued an executive order on February 3, 2017 to review the rule. While the Trump administration would like to roll it back, the industry is moving ahead with implementation, potentially regardless of possible regulatory about faces. Hence the future of the rule is unclear at this time.

you always have the option to roll over to an IRA that you can manage

Of course, whether or not this regulation takes effect in 2017, you can still benefit from working with a fiduciary advisor. If the advisor you are working with is not working to a fiduciary standard – i.e., with your best interests in mind, seek out someone who is. It’s important: after all you are dealing with your money and your future standard of living in retirement.

In the current regulatory environment, fee-only Financial Planners at Registered Investment Advisor firms usually serve as fiduciaries, and are required to always act in your best interests – they must avoid conflicts of interest, and cannot steer plans and IRA owners to investments based on their own, rather than their clients’ financial interests.  In contrast, brokers, insurance agents and certain other investment professionals only have a responsibility to recommend securities that are “suitable.”

Making sure that the investment professional you are working with is acting in your best interest may help you invest your retirement funds more appropriately. Note that the Securities and Exchange Commission (SEC) has not promulgated similar regulations for non-retirement investment accounts so if you are not dealing with a fiduciary advisor, you run the same risk of potentially higher costs or merely suitable investments. In fact if you have an IRA and a brokerage account with your financial advisor, he or she may end up being a fiduciary on one account and not a fiduciary on the other account.  How is that for confusing?

 

A previous version of this post has appeared in the Colonial Times.

Feb 07

5th Annual Symposium

By Chris Chen CFP | Financial Planning

5th Annual Symposium

Oakley CCThe 5th Annual Symposium on Divorce Financial Issues will be held on Friday March 24, 2017 at the Oakley Country Club in Watertown, MA. The Symposium provides a full day devoted to Financial Issues for Divorce Professionals such as therapists, coaches, mediators and lawyers.

This year, the Symposium is a fundraiser in support of the Community Dispute Settlement Center (CDSC), a 501(c)(3) not for profit mediation and training center dedicated to providing an alternative and affordable forum for resolving conflict. Part of the registration fee will be donated to CDSC.

The Symposium is offered by Insight Financial Strategists LLC, a Registered Investment Advisor with a focus and expertise in Divorce Financial Planning , in conjunction with the speakers and their respective firms.

This year’s presenters include

Ross Grifkin, a banker in Waltham, MA: buying out a small business in a divorce.

Kim Whelan a mediator in Newton, MA: tricks and traps of the middle income divorce.

David Kellem a lawyer and mediator in Hingham, MA: the post divorce budget and how it impacts divorce settlements and negotiation

Bill Coyne, a lawyer in Newton, MA: divorce as your last estate plan

Chris Chen, a financial planner in Waltham: divorce and disability insurance

The Symposium will be held at the Oakley Country Club in Watertown, MA on Friday March 24 from 8:30 to 4:30. Continental breakfast and a buffet lunch will be served. The cost of the Symposium is $195. Use code EARLY75 for a $75 early bird discount valid until March 5, 2017. Please register here

We look forward to see you there!

 

 

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