Tag Archives: financial planning

Press On

Last year we wondered about the biggest risk to the markets. Was it the threat of persistent low-interest rates and the implied inflation threat, Government budget deficits, tax hikes, or valuations? Media and headlines covered pundits’ messages illustrating what could go wrong.

In retrospect, none of that mattered. The problem was something no one talked about because no one knew about it. A virus-induced pandemic ensued and led to a shutdown of large parts of the economy.

The important takeaway is that the greatest risk might be what you do not see coming. If you are not aware, it is hard to prepare. However, I will point out one more time that I covered the bases by listing plagues among several caveats to my sanguine outlook.

Like earthquakes in California, you know they will happen. You will not know when. In the stock market, we seem to have a big one, a 40 to 50% decline, about once every 10 years. We also average about two recessions every 10 years. Despite dramatic declines, the long-term trend continues up as billions of people around the world get up every morning to do something productive to improve their lives.

I do not know when the market will go down, but history shows that it always comes back. Most of the time recoveries occur within a few years if not months. Some risks are more apparent than others. But for whatever the reason for a correction, the important thing is to avoid selling into a distressed market.

Source Yahoo Finance, S&P 500 Total Return 1/1928 to 1/2021, Monthly, Log Scale

Planning requires anticipating how much money you are likely to need from your portfolio and reducing risk in part of your portfolio to reduce your potential need to sell in a distressed stock market.

Now what about 2021? The 5 key drivers of current market strength include Federal fiscal stimulus, vaccine rollout, divided government, dovish monetary policy, and no double-dip recession. Each of these factors favor continued gains, but none is certain. Near term, I can make the case that the market is on the expensive side. I do not think the options (cash, bonds, hard assets, real estate) are more attractive on a risk-adjusted basis.

As Calvin Coolidge observed, “Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.” I remain focused on long-term value creation.

With 2020 behind us, we’ll press on.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns.

And Now a Word from Our Sponsor

I was watching CNBC with the sound muted when I noticed an interview. I saw a woman and the graphic, 30 Years of Industry Experience. Wow! That’s all CNBC can say about their distinguished guest? While experience is necessary, it is hardly sufficient. One might expect something more substantive. It’s true that I only have 25 years of industry experience, so what do I know?

I know that the length of time I’ve been a financial advisor says very little about me. In my case, I think the 13 years as a financial analyst, before the last 25 years in financial services, was far more influential in my professional development. The role of a financial analyst is that of a paid devil’s advocate.

A corporate financial analyst is a gatekeeper. Any advocate in a company promoting a project or strategy that requires investment needs to demonstrate the financial effects of the idea to management. That requires a financial analysis of the project to determine the net present value and internal rate of return based on projected investment and the resulting cash flows. The financial analyst must be sold on the assumptions that will drive his models. Garbage-in, garbage-out.

The analyst must drill into the underlying data to verify everything. The marketing, engineering, and new product folks become emotionally invested in their ideas. The analyst must vet the projects as the gatekeeper to funding and balance the interests of zealous advocates against the numbers.

I view investing like project analysis. They both need to pass the expected return on investment hurdles and scrutiny of the underlying assumptions.

Many financial advisors, in fact, the most successful ones in my experience, are successful because they are well-connected and are great relationship managers. They impress, like any good salesman.

Who’s watching your wallet?

An autobiographical perspective from Robert Higgins

Risks to the Market

Two risks to your financial future include inflation and market declines triggered by asset price bubbles.

Inflation has not been a problem in the U.S. for over 30 years. Three of the biggest market declines in the last 100 years included in the Great Depression, the tech bubble and the more recent Financial Crisis. Each of these events was related to price bubbles. High stock valuations preceded the 1929 and 2000 corrections, and real estate speculation precipitated the 2008 crisis.

The fuel for asset bubbles is cheap credit that encourages risky behavior through leverage. Why does this matter? There is widespread concern, not unfounded, about the effect of rising interest rates on stock prices. But presently, short-term rates are still less than inflation. We need a positive real interest rate to support healthy economic incentives and to discourage speculation. Normalization requires more interest rate increases, contrary to President Trump’s tweets. The improving economy supports current market valuations.

The real risk of higher interest rates occurs when it begins to limit investment in otherwise productive projects. The problem with low rates is it encourages bad investment.

The Risk of Cash

The S&P 500 is up 21.54% (Morningstar, intraday 11/8/2017) since the Trump rally began one year ago. While corporate earnings are up, price multiples have also expanded with growing optimism of policy reforms that could further improve earnings growth. This leaves many investors wondering if they should simply go to cash to lock in the gains.

For a long-term investor, someone who doesn’t plan to use the money for at least 5 years, this might not be a clever idea. To illustrate, let’s assume that we perceive an elevated risk of a 15% correction to get back in line with normal growth from where we were a year ago. From that level, we might expect 8% to 10% average annual growth. If we are correct, and the market goes down 15%, and then grows at 8% per year for 3 years, it would still be worth more than if it were left in cash.

To illustrate, a $100 investment that declines by 15% is worth $85. Then if it grows by 8% per year for 3 years (85 x 1.08^3), it would be worth $107.07. That implies cash would have to earn 2.3% per year to keep up, and that is not available in today’s low-interest rate market without material risk.

As a short-term tactical move, cash can serve as an effective hedge against a falling market, but only if an investor has the fortitude to use it and invest when fear is at its height.
Perhaps the greatest risk for a long-term investor is selling out, not taking advantage of a market correction, and then reinvesting when higher prices signal all clear. It happens all the time.

How High is too High?

What difference 3 quarters makes! The S&P 500 is up 14.2% year-to-date, and 4.5% in the 3^rd quarter. After the initial Trump rally, nearly everyone, myself included, expected some type of correction. The market continues to brush-off geopolitical concerns. While North Korea might make for scary headlines, the markets are voting that it is unlikely to have a real adverse impact on corporate earnings.

Stocks sell at a multiple of current earnings. The multiple depends on how the market views future earnings. The question of how high the market can go is to ask how much the businesses in the index are worth.

The good news is that there really is not a limit. If a working man puts $5 in a jar every day and does not die, how much is the jar worth? I can calculate how much you should pay for this man’s savings today, but over time, the answer is unlimited.

This is not to suggest the market can’t be overvalued because it can be. Rather, there is no number that represents an absolute limit. I believe the market is moving higher because we have an administration that is pro-business and focused on tax reform. Fiscal spending is also becoming a factor.

There is room for further gains, but corrections will happen. Volatility is the price of equity returns, and that’s been missing for the most part. Stay the course but plan for liquidity.

The Oracle of Charlotte

It’s been eight years since the market hit bottom. As Morgan Housel of The Motley Fool wrote, “If you went back to 2008 and predicted that over the following eight years the stock market would triple, unemployment would plunge to 1990s levels, oil prices would fall 80%, and inflation would stay tame even while interest rates stayed at all-time lows — I’m telling you, not a single person would have believed you.”

Ok, I didn’t say that exactly, but I got the part right that mattered most. It was in December 2008. I was onboarding a new client. His portfolio was in cash equivalents. I believed that while we were in the midst of a financial crisis, stocks were oversold compared to intrinsic value. I told my new client that I believed he had a unique opportunity to triple his money in 5 to 8 years. Few people are so fortunate as to find themselves with cash at the bottom of a market.

in April of 2009, he fired me. My mistake was to buy equities in the last days of February, within a week of the absolute bottom. In retrospect, my timing was nearly perfect, but he couldn’t handle it. I called him a couple of years ago. He told me firing me was the biggest mistake he ever made. I’m guessing it hasn’t gotten any better for him.

Beware the Pundits

Not much has changed since my last blog post, and I don’t have any revelations to share. Trump is still talking about the same issues he mentioned in his campaign. Real change happens slowly. But the drift is real, and that has unleashed animal spirits in the markets.

The gains to date are not purely about valuation. Currently, 70% of companies have reported 4Q earnings, and 2/3 have beaten estimates, according to Forbes. Earnings are improving and the real question is how steep and how long the trend will run.

All things being equal, higher valuations increase risk. If price-to-earnings multiples expand faster than earnings growth, the risk of a correction increases. Without calling names, geopolitical risk seems to be an ongoing factor, so it seems a matter of time until a crisis scares the bejeepers out of the market and everyone scurries to cash.

A Buffet saying comes to mind, “Be fearful when others are greedy, and greedy when others are fearful.” I’m sensing an increase in the greed factor as investors hate missing a rally. This might be a good time to think about harvesting positions you wouldn’t buy at today’s prices, and be very picky about your reinvestment options. Dry powder can go a long way in a correction.

Longer-term, the table is set for sustained and perhaps accelerating, earnings growth. In the 90’s, everyone thought the market would average 12% forever. Now the pundits agree 8% seems ambitious. When have the pundits ever gotten it right?

Finally, recognize that volatility is the price we pay for equity returns. Plan accordingly and stay the course.

On Raising the Fed Funds Rate

When you’re drinking beer, the goal can be to drink more. That’s a problem for some people. They do not recognize their disequilibrium. Putting the glass down might not bring immediate gratification, but it is simply the right thing to do with any normal, long-term perspective. fredgraph Fed Funds Rate

The Fed needs to get off the sauce. Current interest rates compromise reasonable capital allocation, and encourages uneconomic decisions. The longer the distortion persists, the greater the risk. Any investment decision that gets squeezed out because of a .25% interest rate increase, at current rates, was a bad idea anyway. That represents net positive for the economy by discouraging inferior projects and speculation.

Interest rates are the cost of money. It shouldn’t be virtually free.

Estate Tax Planning – A Legacy of Unintended Consequences

Estate taxes are likely remain in a state of flux for as long as Congress plays politics. Combining this popular topic for procrastination (planning for death) and change, the result may be an accident waiting to happen.

A bit of housekeeping may be in order for those who took the good advice of their attorneys and financial advisors several years ago, and set up a Credit Shelter Trust, By-Pass Trust or AB Planning, as part of their estate planning to minimize estate taxes. Changes in the law over the years have rendered much of that planning obsolete, and potentially dysfunctional.

Trusts can serve many purposes including creditor protection and control and management of assets after death. From an estate tax perspective, however, many trusts were setup solely to receive and hold assets from the 1^st spouse (of a married couple) at his or her death, preserving his or her estate tax exemption which would have been lost if all assets passed directly to the surviving spouse. Assets in this Credit Shelter Trust could grow free of estate tax for the benefit of the surviving spouse and the couple’s children.

Legislation passed on January 2, 2013 renders this type of estate plan obsolete for a majority of married couples. Just ten years ago, an individual could transfer only $1,500,000 to a non-spouse beneficiary.

Under current law, that amount increased to $5.43 million and a surviving spouse can “port” the 1^st-to-die’s estate tax exemption taxes by making an election on an estate tax return. Portability of the federal estate tax exemption means that a surviving spouse gets to use what their deceased spouse did not use as well as their own estate tax exemption. In other words, a married couple may now pass up to $10.86 million without having to pay estate taxes.

For the married couples who have not reviewed their estate plans since the passage of this new legislation, a Credit Shelter Trust may no longer be necessary and probably presents complexities and potentially avoidable capital gains taxes. For example, a common problem for the Credit Shelter Trust approach was the need to divide assets between spouses so that individually owned assets could fund the trusts. There is no need to separate assets to fund AB Trusts with the advent of portability.

Perhaps the most onerous unintended consequence of ignoring your old Credit Shelter Trust is the potential for unnecessary capital gains tax. Consider that a person’s assets receive a step-up in basis at death. However, assets that fund a Credit Shelter or By-Pass trust at a 1^st spouse’s death will not be stepped up again at the 2^nd spouse’s death, subjecting any appreciation of such assets to capital gains taxes when sold by the children after the surviving spouse’s death.

To illustrate, assume a couple’s estate is worth $2,000,000, with $1 million in each spouse’s name. The husband dies. His will says that his Credit Shelter Trust will be funded up to the “applicable exclusion amount,” so all of his assets go into trust for the benefit of his surviving spouse and children. If his wife lives another 10 years, the trust assets could reasonably double. Upon her death the trust’s assets will be paid to their children, but without the step-up in basis on the $1 million of gain. The children will pay about $200,000 in capital gains taxes that could have been avoided if their parents had eliminated the Credit Shelter Trust planning.

If the objective of your Credit Shelter Trust planning is to minimize estate taxes, it might be a good idea to review your plans. Relying on portability rather than a Credit Shelter Trust requires careful analysis and thought (and there are pitfalls for the unknowing!), but an estate plan providing for distribution of all assets outright to the surviving spouse combined with the portability provision in the American Tax Relief Act of 2012, might accomplish the same estate tax relief without creating capital gains taxes unintentionally.

Many thanks to John W. Forneris, an estate planning attorney at Robinson Bradshaw & Hinson for reviewing this essay.

¹ About Money.com, Exemption from Federal Estate Taxes: 1997-2015, Table Showing Federal Estate Tax Exemption and Rate: 1997 – 2015, http://wills.about.com/od/understandingestatetaxes/a/estatetaxchart.htm

² Nothing in this essay should be construed as tax or legal advice. This information is intended to highlight a potential issue with estate plans established in prior years. Consult your attorney, tax, or financial advisor to discuss your circumstances in the context of these developments.

Dalton Financial LLC

Robert Dalton Higgins – Principal | a North Carolina Registered Investment Advisory firm