Although the fiscal cliff crisis was resolved a year ago, the price of the tax increase was not clear.  Now that April 15^th, tax day, is here, the impact can be assessed.  In the first quarter of 2014, tax receipts from individuals were up about 15%, for an additional $35 billion of Government revenue.  This is money that was not spent to help business create jobs.  This fiscal drag is reflected in consumers postponing purchases, and in many cases selling stock to raise the cash to pay their tax bill.  In contrast, last year tax refunds were up 15%, which might explain last year’s better than expected consumer spending and market performance early last year.

Last year’s fiscal cliff settlement raised payroll taxes and marginal tax rates for high-income earners.  Many exemptions and deductions continue to be phased out, and the maximum tax rate on capital gains was raised.  For many who pay estimated taxes, or pay through withholding, the increase was not collected during the year.  Finally, now in the first quarter of 2014 and the days leading up to April 15, the bill has come due.  The impact of the fiscal cliff is finally being felt with a one-year lag.

Moving forward, the worst may be behind us.  Consumer spending, first-time filings for unemployment benefits, (and the weather), continue to improve.  As the economy continues its upward trend and tax induce stock selling abates, the market may continue to track upward driven by improving corporate earnings.

Municipal bonds offer an interesting proposition for high income bond holders. Although muni yields are generally less than their corporate counterparts, for those in upper income tax brackets, the tax adjusted yield is often higher. What’s not to like about tax-exempt?

For one, there’s more than one way to generate tax-free income. For those with Traditional IRA’s, the income limitation on conversions has been eliminated. I think the most important variable in the Roth conversion analysis is the owner’s tax rate. If one assumes that income tax rates will increase, or that they will be in a higher tax bracket, they should probably convert. If they expect to be in a lower tax bracket, either due to lower income in retirement or a general reduction in income taxes, they probably should not convert from Traditional to Roth.

If the tax rate assumption does not move you, or if you think rates will stay the same, consider these other Roth advantages. Do not underestimate the added liquidity factor of the Roth. If an account has been open for at least five years, all contributions can be withdrawn without additional tax or penalty, since contributions have already been taxed. Additionally, there are no Required Minimum Distributions for Roth IRA’s. Considering these advantages, unless you expect your tax burden to diminish, you might consider a Roth conversion.

Now what about those muni bonds? If the idea of a Roth conversion intrigues you, ask yourself, why would anyone invest in municipal bonds for tax-exempt income and receive a lower tax rate, when they could have tax-free income from higher yielding corporate bonds in a Roth IRA account? Adding tax diversification to your portfolio is still another reason to consider that Roth conversion.

I expect this conversion to get more air time as interest rates increase and the notion of bond income in retirement gains relevance.

Investing involves risk of loss of principal. Please consult your financial advisor before investing. State tax exemption might depend on state of residence.

Today the Fed announced the beginning of the end of QE, aka “Taper”. I applaud this move. One key ingredient we need to return to “normal” is a market-based interest rate. Interest rates ration money to the most productive projects by raising the hurdle rate. The Quantitative Easing bond-buying program has served to artificially depress lending rates and spur economic activity. As economic activity accelerates, the Fed needs to allow interest rates to normalize and resume the role of pricing money to avoid capacity constraints and ensuing inflation. If economic activity remains weak, then demand for money will be weak and rates will stay low anyway (albeit maybe not on the floor).

I don’t get the sense that there’s a lot of lending activity outside of mortgages that will be stifled if rates drift back to the range of historical norms. As long as economic activity continues its slog to normal, I see the long-awaited tapering as welcome confirmation that recovery is intact.

I’d rather experience a bull market fueled by improving fundamentals and leading economic indicators than one premised on upside risks due to potential progress on entitlement spending and the possibility that QE stimulus withdrawal might prove benign.  While the future remains uncertain, the herd is on the move.   Whether they get spooked in another direction is a risk of running with the bulls.  In 1997, I thought stocks were expensive.  They doubled in 2 years.  Then they got cut in half.  I think a tactical approach can serve a portfolio well in this type of market.  Enjoy the ride.

Markets can be unpredictable and irrational, in case you haven’t noticed.  Sometimes they are driven by fundamentals, and sometimes by momentum stemming from fear or euphoria. In the late 90’s we witnessed a bubble based on speculation about the internet economy.  In 2008-09 we stared into the abyss and thought the end had arrived.  With the benefit of hindsight, the market overreaction seems clear.

If you want equity returns, you need to accept the irrational turns in the market.  In the long-term, meaning 5 years or more, fundamentals matter.  Any investment is worth the present value of the future cash flows.  The problem is, expectations of cash flows can change in a hurry, but time resolves most big questions.

Plan and set aside your cash needs for several years, and keep those funds in a safe place.  But don’t let fear keep you on the sidelines.  You could find yourself in a bear trap for a long time, waiting for the market to come back.

Chart source: Yahoo Finance, period July 2, 1990 to October 1, 2013. S&P 500 Index.  Investing involves risk of loss.  Past performance is no guarantee of future returns.

It looks like Congress will kick the can again, raising the debt ceiling and keeping the Government open.  That’s nice, since the failing to pay U.S. creditors is the equivalent of Russian roulette.  The potential consequences of default are difficult to imagine.  But if I had to imagine a scenario that could compare to the mortgage crisis, with all the unforeseen and little understood interrelationships, a Treasury default would be a good place to start.  So, that’s the good news. It looks like the risk of imminent crisis is diminished.

But kicking the can is not solving the underlying problem.  We have to contain our spending problem.  There is a tipping point, when servicing the U.S. debt crowds out our ability to fund programs we are accustomed to.  If Congress doesn’t take the initiative, the markets will do it for us.

Eventually interest rates will go up, and the cost of servicing our debt will grow even if we don’t raise the debt ceiling.

Several market commentaries I regularly review have observed that this March is the “four-year anniversary of the current bull market.” The significance of measuring the length of a bull market is that since they all eventually end, it makes sense to try to anticipate the next downturn.

Is it any different when a market is recovering from a risk-averse, fear-driven, over-sold condition, than when it goes up because of irrational exuberance? Implicitly, there is a mean valuation. Does time spent below the mean count the same as time at or above the long-term trend? If GDP is barely growing, and valuations are simply normalizing to average levels, should this count against the duration of a bull market? Is it simply a reflection of the depth and severity of the last bear market?

I think these are issues to take into consideration when evaluating the duration of the current bull market. I think valuation and earnings expectations are more significant.

The opinions voiced in the material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

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