Category Archives: Blog Post

Post Election Outlook

The election is finally over. Markets are beginning to price in the upside potential of a shift to a pro-growth government led infrastructure-led fiscal spending. This is something I have cited over the past couple of years as the missing piece of policy that could stimulate the economy, given that monetary policy has run its course.

Trump didn’t include a lot of detail in his campaign rhetoric. Maybe he doesn’t know the details, but we can certainly ascertain his drift. We do know an administration is a lot more than one person, and collectively, these others will bring the expertise to Trump’s agenda.

We can expect an increase in infrastructure spending.

Trump is known for putting his name on large buildings. Just imagine if he were President. According to Capital Group, the spending he has suggested would add up to half a percent per year to GDP over the next four years.

Trump has pledged to lower tax rates for individuals and corporations. One way to pay for cuts would be to expand the amount subject to tax, which points to a deal for repatriation of the estimated $2 trillion of US corporate earnings held overseas.

Trade is the area most directly controlled by the President. Trump’s threats to bully concessions from trading partners might work, but also carry the risk of starting trade wars or worse. However, as occurred with Brexit and Grexit, the votes and threats created leverage, and pressure for concessions. Perhaps he can negotiate a better deal.

Trump likes to negotiate from a position of strength and has emphasized the need for a strong military. Increased defense spending to beef up homeland security and offensive capabilities should benefit defense contractors and industrial suppliers.

Health care is another area of focus. Trump campaigned on repealing the Affordable Care Act. It is unlikely the 20 million people added to health insurance rolls will be dumped, but the program will be rebranded and modified to reduce the worst imbalances. Insurance companies will muddle through changes and pharmaceutical companies will still contend with pressure for price regulation. While more positive than we would have expected a Clinton administration, the outcome is not clear.

He says he wants to repeal Graham-Dodd. Banking regulation has placed serious regulatory burdens on financial companies. Some question whether the regulations are adequate, but there is evidence of overreach and unnecessary compliance overhead. It would be nice to see fewer rules based institutional regulations and more principles-based enforcement of laws to control individuals that compromise the public interest.

It might be best to view the Trump impact as a change in drift, not a full overhaul.

Managing Volatility in Growth Portfolios

In normal times you might own bonds for either of two reasons. You might enjoy the regular income from interest payments, or you might own them for the stability they add to an equity portfolio.

Neither of those reasons carry the usual appeal with today’s ultra-low interest rates. If you’re counting on bonds for income, you are going to need to own a lot more bonds. While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels. Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.

The bond market is not uniform. Some parts of the bond market have less exposure to interest rate risk. Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.

Much has been written about various types of risk, and that is not the focus of this essay. My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.

Liquidity is important. Let’s take the case of the Brexit induced market decline that began last Friday. Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode. If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.

If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day. Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete. If you wait until the next day, the price could be higher. It could have gone lower too, but that’s speculation. If you want to control the trade, you want to make timely buy and sell decisions.

Using hedge positions in ETF format eliminates the liquidity problem. Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format. There is no perfect solution. If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin. If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.

Then again, in a rich market, cash is an attractive asset class. To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.

When Regulations Become Tyranny

The U.S. Treasury Department introduced new regulations targeted at the Pfizer – Allergan deal, which was designed to capture tax benefits by inversion. Pfizer planned to adopt Allergan’s domicile for tax purposes. The new regulations are crafted to specifically address this deal, using a 3 year look-back to qualify how capital is represented for the purpose of qualifying for the inversion.

Regulations with look-back provisions are typically not retroactive, but give guidance for future decisions. The U.S. Treasury is going after, and trying to publicly humiliate, 2 companies that are making rational decisions in the legal framework the Government established. Pity investors that invested in these companies based on the legal, economic and regulatory framework only to have the Government change the rules (without due process)!

Sure the incentive for the deal was tax reduction. Obama says the companies want the benefits of being in the U.S., but don’t want to pay their fair share. Maybe the broken tax code is the problem? Why do we have to pass regulations to keep companies in the U.S? Isn’t that the way totalitarian governments operate? If the laws aren’t working, fix the laws, or the tax code; but don’t pass retroactive regulations to persecute specific companies. THAT, seems un-American.

As noted by Ian Reed, Pfizer CEO:

If the rules can be changed arbitrarily and applied retroactively, how can any U.S. company engage in the long-term investment planning necessary to compete? The new “rules” show that there are no set rules. Political dogma is the only rule.

– Pfizer (NYSE:PFE) CEO Ian Read

A Vital Sign for the Economy

When the stock market gets stressed by a correction, emotions are magnified. Commentators attribute daily swings to the headline of the day.

One data point worth reviewing is from the American Association of Railroads (AAR). The AAR publishes weekly data on rail traffic.

According to the report for the week ending February 13, 2016, “total U.S. weekly rail traffic was 505,148 carloads and intermodal units, down 3.8 percent compared with the same week last year.” Total freight cars and intermodal units are down 5.8 percent compared to last year for the first 6 weeks this year. But of the 10 carload commodity groups, miscellaneous was up 27.4 percent and motor vehicles and parts were up 12.6 percent.

The sectors posting decreases compared to the same period in 2015 included, “coal, down 32.5 percent to 75,249 carloads; petroleum and petroleum products, down 23.4 percent to 11,303 carloads; and metallic ores and metals, down 15.4 percent to 19,196 carloads.”

The data points to a fairly healthy consumer sector and a supply correction in raw materials commodities. As supply adjusts to demand, prices stabilize and rebound. These are healthy adjustments for an economy on course for the old normal.

For the full AAR press release, click https://www.aar.org/newsandevents/Press-Releases/Pages/2016-02-17-railtraffic.aspx.

Random Thoughts on Investing and Politics

Which way is the market going? If you listen to the news, you will be a pessimist, since most news is negative. But if you pay attention to quarterly earnings reports and long-term earnings trends, you will be an optimist.

Businesses are organizations of people who get up every day to create value for customers, with profits flowing to the owners of the company as the reward for their ingenuity and placing capital at risk. If and when profits decline, the owners and management take corrective action. In the extreme, they might liquidate the business to avoid further loss of capital, freeing capital and labor resources for redeployment in more productive enterprise.

In 1776, Adam Smith coined the term “Invisible Hand” in a book “An Inquiry into the Nature and Causes of the Wealth of Nations”. In it he wrote, “Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it … He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

Government intervention often impairs the efficient deployment of resources and the creative destruction of inefficient enterprise. Subsidies and taxes distort economic incentives and reduce the efficient allocation of resources. The invisible hand is not an outdated classical concept. It is the natural phenomenon that guides free markets. Capitalism drives scarce resources to their most productive use.

Socialism short circuits the resource allocation process of capitalism, removing the invisible hand from sectors of the economy. Without a profit motive, inefficiencies tend to grow unchecked. While segments of society may be protected, you end up with a smaller pie.

The political pendulum swings between the left and the right.

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.

Dear President Obama:

The Wells Fargo Economics Group summarizes the state of the US economy in its Monthly Outlook, 7-8-2015:

Halfway through 2015, and now six years into recovery, the U.S. economy remains in strange territory. Real GDP growth has proceeded on a narrow path, averaging just a 2.2 percent pace. Even this modest pace, however, has been sufficient to pull the unemployment rate down to levels near most conventional measures of full employment. Despite the low unemployment rate, the economy and labor market are anything but a picture of health. In fact, the feeble gait of this expansion has kept the economy vulnerable to the slightest misstep, be that bad weather, labor strife, or foreign events.

Your administration stands for social justice. You value taking care of the poor and disadvantaged above all else. Greedy capitalism that created the financial collapse in 2008 has been met with stiff retribution, penalizing banks and other perpetrators. Moreover, by your virtual executive fiat, we now have Obamacare.

Giddy liberals deride “trickle-down economics” as failed policy. By metrics such as income equality, it most certainly was. Policy may be corrupted by politics, and there are few effective checks and balances for executive compensation.

It is time for a reality check. Can we afford to subsidize services and extract capital from banks (effectively penalizing innocent investors for someone else’s misdeed’s, and exacerbated by government policy encouraging home ownership), rather than encouraging investment and growth? Is it unreasonable to focus on creating wealth first, so we have something to fund social programs? Or should we handicap wealth generation to do good now? Regardless of your answer, we shouldn’t be surprised by the economic situation summarized above based on policies of the past 6 years.

When the economy falters, the middle class suffers.

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.

Observations on Variable Annuities

A 64-year-old woman asked her financial advisor, “Why is the annuity a good idea?” He replied that it gives her what she wants, a guaranteed income. That is the key. His approach solves problems by giving people what they want. Wants are emotionally based. Needs are comparatively fact-based.

Rather than pander to emotional desires, I try to convince clients to do what I would do if I were in their situation. A fiduciary does not begin with the emotional component as the objective.

As interest rates increase over the next few years, it will be easier to generate income from a diversified portfolio. While interest income will be taxed as ordinary income, capital gains and qualified dividends are currently taxed at lower rates. Lower expenses, the step-up in basis for non-qualified (not in a retirement plan) assets, and access to a much wider investment universe are benefits of regular investing versus an annuity.

She is concerned about negative media. She believes everyone is expecting a market correction. I responded that if most people are bearish, then that would be baked into prices already, reducing the risk of a correction. Negative sentiment is healthy. Exuberance is dangerous. Markets are counter-intuitive, which explains why emotional investing is a bad idea.

As reference, the above chart illustrates a popular, low-cost balanced fund (the blue, top line). The 2000 – 2002 correction barely registers as a dip with the balanced fund. The blue line shows that a 3 to 5-year reserve fund would have been sufficient to avoid selling at a loss during the 2008-2009 crisis. The fund’s performance suggests that concerns referencing the last 2 major bear markets are more about the unknown than they are grounded in fact. This is not unlike children being afraid of the monster under the bed.

The orange line below the blue line represents the S&P 500. Investing in only the S&P 500 is not a good idea, but that seems to be the straw man argument many insurance companies use to sell annuities.

Finally, consider the commission. How much is it and where does it come from? This is not alchemy.

Past performance is not a guarantee of future results. Investing involves the risk of principal. The chart illustrates the performance of a popular balanced fund from January, 1999 to April 27, 2015. The fund may hold up to a 75% equity allocation. The chart is intended to illustrate the performance of a diversified portfolio relative to the S&P 500 during the 2000 – 2002 and 2008 – 2009 bear markets. Diversification does not guarantee against loss. The balanced fund is the Dodge and Cox Balanced Fund, and the data is from Morningstar.

Dalton Financial LLC

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