DAFS, QCDS, ROTHS AND 2019 TAX PLANNING-2020 IS COMING

Hope everyone had a great Halloween. Now, it’s time to finish your 2019 Tax Planning. You know the drill. You can’t extend December 31st– it’s the last day to get major tax planning resolved and implemented. This year we will focus on three key areas; Donor Advised Funds, Qualified Charitable Distributions and Roth accounts. And, then finish with some overall points to remember.

Donor Advised Funds (“DAFs”). For charitable gifts, this simple, tax-smart investment solution has become a real favorite, particularly starting in 2018. The concept of DAFs is that taxpayers can contribute to an investment account now and get a current deduction yet determine in the future where and when the money will go.

The Tax Cuts and Jobs Act of 2017 increased the standard deduction (up to $24,400 in 2019 for married couples). Couples with itemized deductions less than the standard deduction receive no tax benefit from their contributions. However, they could get a benefit by “bunching” their contributions using a DAF.   For example, if a couple made annual charitable contributions of $10,000 per year, they could contribute $40,000 to the DAF in 2019, e.g., and certainly, in that case, their itemized deductions would exceed the standard. The $40,000 would be used as their charity funding source over the next four years. In this manner, they would receive the full $40,000 tax deduction in 2019 for the contribution to the account, though they will not receive a deduction in the years after for the donations made from this account.

Now, what’s really great about a DAF is that if long-term appreciated securities are contributed to the DAF, you won’t have to pay capital gains taxes on them and the full fair market value (not cost) qualifies as an itemized deduction, up to 30% of your AGI. Why use after tax dollars for charity, when you can use appreciated securities?

Within the DAF, your fund grows tax-free. You or your wealth manager can manage the funds. The funds are not part of your estate. However, you advise your custodian, such as Schwab, the timing and amounts of the charitable donations. In general, your recommendations as donor will be accepted unless the payment is being made to fulfill an existing pledge or in a circumstance where you would receive benefit or value from the charity, such as a dinner, greens fees, etc.

Many taxpayers are using the DAF as part of their long-term charitable giving and estate planning strategy. They annually transfer long-term appreciated securities to a DAF, get a nice tax deduction, allow the funds to grow (unlike Foundations which have a 5% minimum distribution, there are no minimum distributions for DAFs) and then before or after their passing, the charities they support receive the benefits.

Qualified Charitable Distributions (“QCDs”). A QCD is a direct transfer of funds from your IRA to a qualified charity. These payments count towards satisfying your required minimum distribution (“RMD”) for the year. You must be 70 ½ years or older, you can give up to $100,000 (regardless of the RMD required) and the funds must come out of your IRA by December 31. You don’t get a tax deduction, but you make charitable contributions with pre-tax dollars. Each dollar in QCDs reduces the taxable portion of your RMD, up to your full RMD amount.

For taxpayers 70 ½ or older, their annual charitable contributions generally should be QCDs and if their gifting exceeds their RMDs, they can either do QCDs up to $100,000 annually or, instead of QCDs,fund a DAF with long-term appreciated securities and bunch the contributions to maximize the tax deduction.

Roth Accounts. A Roth IRA is a tax-advantaged, retirement savings account that allows you to withdraw your savings tax-free. Roth IRAs are funded with after-tax dollars. They grow tax-free and distributions of both principal and interest are tax-free. Roth IRAs do not have RMD requirements that traditional pre-tax IRAs have. They can be stretched by spouses and beneficiaries without tax. They are the best type of account that a beneficiary could receive upon your passing.

A taxpayer can convert an IRA to a Roth account anytime, regardless of age or income level- the IRS is happy to get your money. A Roth conversion is especially appealing if you expect to be in a higher marginal tax bracket in retirement. Conversions make sense when taxable income is low or negative. In addition, some couples interested in Roth conversions make DAFs in the same year to keep their taxes where they would have been without the conversion or the DAF.

2020 is coming. You still have almost two months to resolve your 2019 tax planning and get it implemented. Make sure you and your CPA review your situation before year-end to make sure you understand your likely tax status and review possible strategies that could help you. At DWM, we don’t prepare tax returns. However, we do prepare projections for our clients based on our experience and knowledge to help them identify key elements and potential strategies to reduce surprises and save taxes. Time is running out on 2019. Don’t forget to do your year-end tax planning. And, of course, contact us if you have any questions.

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Old Adages Die Hard: What Worked in the Past May Not Work Today!

More people are renting (not buying) houses, particularly millennials. The old adage that “paying rent is foolish, own your house as soon as you can” is no longer being universally followed.  Lots of reasons: cost of college education, student debt, relative cost of houses, flat wages, more flexibility and others.  Today we 327 million Americans live in 124 million households, of which 64% (or 79 million) are owner-occupied and 36% (or 45 million) are renter-occupied. In 2008, homeownership hit 69% and has been declining ever since.

It starts with the increasing cost of college.  Back in the mid 1960s, in-state tuition, fees, room and board for one year at the University of Illinois was $1,100.  Annual Inflation from 1965 to now has been 4.4% meaning $1,100 would have increased 10 times to $11,000 in current dollars.  Yet, today’s in-state tuition, room & board at Champaign is $31,000, a 28 times (or 7.9% average annual) increase.  Yes, students often get scholarships and don’t pay full price, but even a $22,000 price tag would represent a 20 times increase.

It’s no surprise that in the last 20 years, many students following the old adage “get a college education at any price” found it necessary to incur debt to complete college.  Today over 44 million students and/or their parents owe $1.6 trillion in student debt.  Among the class of 2018, 69% took out student loans with the average debt being $37,000, up $20,000 each since 2005.  And here is the sad part: according to the NY Fed Reserve, 4 in 10 recent college graduates are in jobs that don’t require degrees.  Ouch. In today’s changing economy, taking on “good debt” to get a degree doesn’t work for everyone, like it did 50 years ago.

At the same time, houses in many communities have increased in value greater than general inflation.  Elise and I bought our first house in Arlington Heights, IL in 1970 when we were 22.   It was 1,300 sq. ft., 3 bedrooms and one bath and cost $21,000.  I was making $13,000 a year as a starting CPA and Elise made $8,000 teaching.  Today that same house is shown on Zillow at $315,000.  That’s a 15 times increase in 50 years. At the same time, the first year salary for a CPA in public accounting is now, according to Robert Half, about $50,000-$60,000. Let’s use $60,000.  That’s less than a 5x increase.  Houses, on the other hand, have increased at 5.6% per year. CPA salaries have increased 3.1%.  The cost of living in that 50 years went up 3.8%. Wages, even in good occupations, have lagged inflation. Our house 50 years ago represented about one times our annual income.  Today the average home is over 4 times the owners’ income.  That makes housing a huge cost of the family budget.

In addition, today it is so much more difficult to assemble the down payment. We needed 20% or $4,200; which came from $3,500 savings we accumulated during our first year working full-time and a $700 gift from my mother. A “starter” house today can cost $250,000 or more.  20% is $50,000, which for many is more than their first year gross income.  And, from that income, they have taxes, rent, food and other expenses and, in many cases, student debt, to pay before they have money for savings. Saving 10% is great, 20% is phenomenal.  But even at 20%, that’s only $10,000 per year and they would need five years to get to $50,000.  No surprise that it is estimated the 2/3 of millennials would require at least 2 decades to accumulate a 20% down payment.

Certainly, houses can become wealth builders because of the leverage of the mortgage.  If your $250,000 house appreciates 2% a year, that is a 10% or $5,000 increase on your theoretical $50,000 down payment. But what happens when real estate markets go down as they did after the 2008 financial crisis?  The loss is increased.  Many young people saw siblings or parents suffer a big downturn in equity 10 years ago and are not ready to jump in.

Furthermore, young people who can scrape up the down payment and recognize the long term benefits of home ownership, may not be willing to commit to one house or one location for six to seven years.  With closing costs and commissions, buying, owning and selling a house in too short a period can be costly and not produce positive returns.

Lastly, many people want flexibility and don’t want to be tied to a house. They want flexibility to change locations and jobs.  They want flexibility with their time and don’t want to spend their weekends mowing the grass or perform continual repairs on the house. In changing states like Illinois, with a shrinking population and less likelihood of significant appreciation, their house can be a burden.  For them, renting provides them flexibility and peace of mind.

It’s no surprise then that the WSJ reported last week that a record number of families earning $100,000 a year or more are renting.  In 2019, 19% of households with six-figure income rented their house, up from 12% in 2006.  Rentals are not only apartment buildings around city centers, but also single-family houses.  The big home-rental companies are betting that high earners will continue renting.

Yes, the world has changed greatly in the last 50 years and it will keep changing.  When I look back, I realize we baby boomers had it awfully good.  The old adages worked for us. But today, buying a house is not the “slam dunk” decision we had years ago, nor is a college degree.  The personal financial playbook followed by past generations doesn’t add up for many people these days.  It’s time for a new plan customized for new generations and that’s exactly what we do at DWM.

Equity Trades are Free – But there is no Free Lunch

Broker price wars

Before 1975, brokers had it really good. Commissions were fixed and regulated-at very high levels. It would sometimes cost hundreds of dollars to buy 500 shares of a blue-chip stock. That changed in 1975 when the SEC opened commissions to market competition.   A young Chuck Schwab and others became discount brokers- often charging ½ or less of the old rates. Since then, fees have continued to fall and earlier this year, trades could be made for $5 or less. Now, Charles Schwab & Co. as well as TD Ameritrade, E*TRADE and others have cut stock and ETF trades to zero. Free trading of equities has arrived.   Please be advised, though, that there is no free lunch- brokers profit from you even if they don’t charge for equity trades.

Here are some the main sources of income for brokerage firms:

  • Trade commissions
  • Brokerage fee- to hold the account
  • Mutual fund transaction fee-charges when you buy or sell a fund
  • Operating Expense Ratio-an annual fee charged by mutual funds, index funds and exchange-traded funds (“ETFs”)
  • Sales load- A sales charge or commission on some mutual funds paid to the broker or salesperson who sold the fund
  • Uninvested cash- brokers become bankers and lend it out

Let’s focus first on uninvested cash. In 2018, 57% of Schwab’s income came from loaning out its customers’ cash. As is typical in the brokerage business, uninvested cash is swept to an interest bearing account. However, sweep accounts typically earn almost nothing- usually ½ to ¼ of 1% or lower to the investor.

Schwab had a total of $3.7 trillion of deposits, with about 7% of it ($265 billion) in cash earning nice returns for them. Assuming a return of 2.5 % on the uninvested cash, that’s a return of $6.6 billion. The cost of that money was likely ½% or about $1 billion, with Schwab netting about 2%. $5.7 billion of Schwab’s $10 billion net revenue in 2018 was earned on its customers’ cash. Virtually all the brokers use the same model with uninvested cash.

Robo- advisors generally use the same format. Virtually all of them charge lower fees but require a certain amount of cash, between 4% and 30% in their pre-set asset allocations. Yes, there is a small sweep account interest paid on those funds, but not much. And, this is all typically disclosed. The rate paid on clients’ cash “may be higher or lower than on comparable deposit accounts at other banks” is a typical warning.

The use of uninvested cash is income for the brokers and reduction in performance for the investors. Let’s say your portfolio has 10% cash generating a 0% return. If your annual return on the invested 90% in your portfolio is 6%, then the return on 100% of the account is only 5.4%. A huge difference over time. As an example, the difference between earning 5% per year versus 6% a year on $100,000 for 30 years is $142,000.

Now, let’s look at the operating expense ratio (OER). OERs are charged by mutual funds, index funds and ETFs. If a fund has an expense ratio of 1%, that means you pay $1 annually for each $100 invested. If your portfolio was up 6% for the year, but you paid 1% in operating expenses, your return is actually only 5%. The OER is designed to cover operating costs including management and administration.

The first mutual funds were actively traded, meaning that the portfolio manager tried to beat the market by picking and choosing investments. Operating expenses for actively managed funds include research, marketing and significant administration with OERs often at 1% or more. Index funds are considered passive. The manager of an index fund tries to mimic the return of a given benchmark, e.g. the S&P 500 Index. Index funds should have significantly lower operating expense ratios. Evidence shows that actively managed funds, as a whole, don’t beat the indices. In fact, as a group, they underperform by the amount of their OER.

Operating expense ratios, primarily because of increased use of index funds and ETFs to minimize costs, have been getting smaller and smaller. In fact, we have seen some funds at a zero operating expense ratio. However, for these funds, a substantial amount (10% to 20%) of cash is maintained in the fund.

Conclusion: Set a target of 1-2% cash in your portfolio. Stay invested for the long term.   In addition, the investments in your portfolio should have very low OERs, wherever possible. However, in selecting investments, you need to look at both the OERs and the typical cash position of the mutual fund, index or ETF. Even if the OER is zero and the security holds 10% in cash, your performance on that holding will likely only be 90% of the benchmark, at best. Remember, when equity trades are free, brokers will continue to look for ways to make money, often at your expense.

Climate Capitalists to the Rescue?

Record heat has hit the South. On October 1, it was 101 in Montgomery, AL. Record highs were hit in AL, TN, MS and KY. An acute lack of rainfall has dried out the Southeast as well and residents and farmers are hurting. Planet Earth continues to get warmer.

Look at the chart above showing the changes in temperatures from the 1850s until now. Each stripe is one year. Dark blue years are cooler and red stripes are warmer. The period 1971-2000 is the base line. At the same time, extreme events like Dorian are becoming more severe, more glaciers have died and seas and lakes are getting higher. The climate has changed.

The past century has seen major changes in the world. The Industrial Revolution has brought riches to some, higher standards of living to many, and the population has increased from 2 billion to 7 billion in that last century, and carbon dioxide (“CO2”) emissions have skyrocketed. Fossil fuels have been used to produce industrial power, electricity, transportation, heating, fertilizers and plastic. In 1900 about 2 billion tons of CO2 went airborne. For 2019, 40 billion tons per year will be emitted, with the biggest increase in the last 30 years.   Expanding use of fossil fuel and related increasing emissions of CO2 have gone hand in hand with the expansion of world growth. See the chart below.

GDP CO2

We humans also produce CO2, breathing and eating.  Trees and plants absorb CO2 and, with sunlight and water, convert it to food.   Compared to 1900, we have 5 billion more humans, expanded use of fossil fuels and, because of deforestation, we have less flora to absorb the CO2.

The first half of the 20th century scientists believed that almost all of the CO2 given off by industry and humans and not absorbed by plants would be sucked up by the oceans.  By 1965 oceanographers realized that the seas couldn’t keep with the CO2 emissions.   Climate change shouldn’t come as a surprise; we’ve known about it for decades.

There are lots of predictions about the impact of climate change in the future. No one can predict the future. But certainly, as our beloved Yogi Berra always said, “The Future is not what it used to be.”

The Economist recaps it this way: “Climate change is not the end of the world.”  Humankind is not poised teetering on the edge of extinction.  The planet is not in peril.”  However, climate change could be a dire threat to the displacement of tens of millions of people, it will likely dry up wells and water mains, increase flooding as well as producing higher temps and more severe weather.  The Economist concludes that “the longer humanity takes to curb emissions, the greater the dangers and sparser the benefits-and the larger the risk of some truly catastrophic surprises.”

Addressing climate change will also provide substantial business opportunities in the coming years.  Already some countries are abandoning coal to generate electricity. Britain, e.g., has developed a thriving offshore wind farm industry used to generate power. Germany recently announced that it will spend $75 billion to meet its 2030 goals to combat climate change, primarily in the transportation area with electric vehicles.

In addition, “climate capitalists” want to do good for the planet and well for themselves.  Elon Musk has invested billions into batteries and electric vehicles.   Chinese BYD’s Zhenzhen sprawling campus is a major provider of solar cells, electric cars, heavy machinery and other items needing energy storage.  Warren Buffet has invested $232 million into BYD.  American billionaire Philip Anschutz has spent a decade promoting a $3 billion high-voltage electric grid. Bill Joy, a co-founder of Sun Microsystems, is now backing Beyond Meat, a maker of plant-based alternatives to burgers.  Microsoft’s Bill Gates established a $1 billion company to bankroll technologies that “radically cut annual emissions.”  Even Pope Francis is using the Vatican Bank’s $3 billion fund to help fight climate change.

The UN’s one day climate summit last week concluded with a number of new announcements.  65 countries and the EU have committed to reach net-zero carbon by 2050.   Unfortunately 75% of the emissions come from 12 countries and 4 of them, India, American, China and Russia made no commitment.  However, certain businesses such as Nestle, Salesforce and have made commitments to reach net-zero by 2050 or before.

2050 will be here before we know it.  Yet, technological change can be adopted quickly, particularly when people are provided a better alternative.  In America, the shift from horse-drawn carts to engine-driven vehicles took place within a decade, from 1903 to 1913.  Let’s hope climate capitalists all over the world do well for themselves and good for planet as soon as possible and we humans and our countries do our parts as well.

 

REINVENT CAPITALISM?

Kraft Heinz (KHC) and Unilever (UL) have many things in common. Both companies own hundreds of global consumer brands- KHC includes not only Kraft foods and Heinz Ketchup but also Planter’s peanuts and Grey Poupon mustard. Unilever owns Dove soap and Hellmann’s mayonnaise, Lipton’s tea and Ben & Jerry’s ice cream. Both have been in business since the 1920s. Both employ tens of thousands of employees.

In early 2017, KHC offered to buy UL for $143 billion. UL’s then CEO, Paul Polman, fended off the takeover attempt because of a “corporate culture that couldn’t have been more different from Unilever’s.” Since then, KHC’s share price has dropped 70% and UL’s has increased about 35%. If we look at some of the differences between KHC and UL we will see why Mr. Polman didn’t want to merge with KHC and why he would like to see capitalism “reinvented.”

After receiving his M.B.A., Mr. Polman joined Procter & Gamble which provided the foundations for his leadership approach. In his recent NYT interview, Mr. Polman indicated that “P&G has enormous values that permeate all levels and all places in the world that it operates. Ethics, doing the right thing for the long term, taking care of your community is really the way you want a responsible business to be run.”

Fast forward to 2009. After 10 years of decline, UL hires Mr. Polman as CEO. Annual sales had dropped from $55 billion to $38 billion. Mr. Polman felt UL had good brands and good people but had become too “short-term focused.” A change was needed.

Mr. Polman brought back values from the 20s that were at the roots of Unilever’s success. He felt a more responsible business model was needed. He came up with a bold plan to double Unilever’s revenue while cutting the company’s negative impact on the environment in half. And, he committed his entire team to focus on the long-term, not the short-term, in solving important issues.

In short, Mr. Polman believes “We need to reinvent capitalism, to move financial markets to the longer term.”  He felt that “KHC is clearly focused on a few billionaires that do extremely well, but the company is on the bottom of the human rights indexes and is built on the concept of cost cutting.”

This long-term vs. short-term focus is at the heart of a recent best seller, “Prosperity” by Colin Mayer, a former dean of Oxford’s Said business school. Dr. Mayer believes that a great shift in businesses, here in the U.S. and abroad, started about 50 years ago with the overwhelming acceptance of Chicago economist Milton Friedman’s simple doctrine that “the one and only responsibility” of a business is to increase its profits for the benefits of its shareholders, as long as it stays within the rules of the game.” This has been a “powerful concept that has defined business practice and government policies and has molded generations of business leaders.” It has resulted in a huge emphasis on quarterly reporting and quarterly behavior.

Dr. Mayer believes, on the other hand, that the purpose of a corporation should consider its customers, employees, suppliers, and communities as well as its shareholders. Historically, family-owned businesses were cognizant of and responsive to all the constituencies that compose a business and focused on the long-term. Today, almost all corporations in the UK and many US corporations are no longer owned by the founders or their families. This change has accelerated due to the focus on short-term profits, often by simply merging and cutting costs. Dr. Mayer also pointed out that corporations can also have dual-class share structures (typically voting and non-voting shares) which can allow the founders and their like-minded successors to control the company and therefore focus on its long-term purpose rather than quarterly earnings reports. Ford, Google, and Facebook all have this structure. This is a positive trend.

Robert Reich’s new book “The Common Good”, sums it up this way, “In the corporate world, the single-minded-pursuit of shareholder value has displaced the older notion that companies are also responsible for the well-being of workers, customers and communities they serve.” “The common good is no longer a fashionable idea.” He defines common good as “consisting of our shared values about what we owe another as citizens who are bound together in the same society.” Regardless of political party, all Americans should embrace contributions to the common good.

For 50 years, there has been a huge focus on financial capital with less attention paid to human capital, intellectual capital, material capital and environmental capital. All five of these components of capital should be considered for the overall long-term growth and common good of America and the world.

Reinventing capitalism would require companies to focus on more than quarterly profits. Consideration of all of its constituents- customers, shareholders, employees, suppliers, communities and the environment for the long-term-could certainly benefit the common good and likely produce even better stock market returns in the long-run as well.

Dealing With Investor Anxiety: Think Long-Term

Stock prices reflect a mix of emotions, biases and rational calculations. The bond market reflects the economy. Historically, bond markets had done a better job in predicting recessions.

The two big bond stories last week were 1) the “inverted yield curve”- when interest rates on short-term bonds are higher than long-term bonds, and 2) yields below 2% on 30 year treasuries- indicating investors expect low inflation and a weaker economy for a long time.

We all remember the 2017 income tax cut that boosted the economy and produced stock markets returns of 20% or more in 2017. These tax cuts were supposed to lay a foundation for many years of high economic growth. Since mid-2018, however, the economic data has been confirming what many of us expected. The tax cuts provided a short sugar “high,” which is now over. Instead, we have trillion dollar deficits and lack of large promised business investments, including infrastructure, which never materialized. The economy has reverted to its pre-stimulus growth rate of near 2%.

This shouldn’t surprise us. No major economy is growing as fast as it was before 2008. In almost every country, the national discussion focuses on what must be done to revive growth and ignores the fact that the slowdown is happening everywhere. The working population is declining in 46 countries around the world, including Japan, Russia and China. Demographics are a key driver of economic growth. So, we can expect to see recessions (two quarters of negative growth) more likely in the future as working populations contract. BTW- the U.S. population is growing at less than 1% per year.

Over the next few decades, we will likely see more growth decline. Ruchir Sharma, author of “The Rise and Fall of Nations,” suggests that new benchmarks for economic success should be 5% growth for emerging countries, 3-4% growth for middle income countries like China, and 1-2% growth for developed countries like the U.S. and Germany.

Yes, there are uncertainties in the market, including US-China trade tensions, a weakening European economy, and concern about a recession. These produce a huge dilemma for U.S. business owners, trying to make plans for the future. So, there are lots of piles of cash, waiting for clarity. We may or may not soon have a recession. Yet all of this uncertainty produces increased volatility and anxiety. And studies show that a 3% down day, like last Wednesday, feels about ten times worse than a 1% down day. What’s an investor to do to reduce anxiety?

We understand it is difficult to think long-term, but we highly recommend it:

1) Recognize that equities will likely produce lower nominal returns in the future. However, with inflation also likely lower, the real returns of equities will likely outpace fixed income and alternatives. Equities will continue to provide the primary engine of growth.

2) Use all three asset classes. A diversified portfolio composed on equities, fixed income and alternatives has been shown to reduce risk and increase return.

3) Review your long-term financial plan and determine what rate of return you need to meet your financial goals. The expected return of your asset allocation must be sufficient to meet your goals or you need to revise your goals and plan.

4) Review your risk profile to determine your appropriate asset allocation. Using the assumption that equities could drop 40% and you can’t tolerate a loss of 10% or more in your portfolio, then your allocation to equities should not exceed 25%. Of course, this allocation would severely limit your upside.

5) Stay invested. Don’t try to time the market. A recent report from Morningstar shows that “low cost funds”, (like those used at DWM), “lead to higher total returns and higher investor returns.” First, for efficient markets, the active managers in the high-cost funds overall produce gross results equal to the benchmarks, but then the additional costs of 1% or more is subtracted. Second, studies show that active managers attempting to time the market have failed and this subtracts another ½% per year from performance. Even highly-paid active managers can’t time the market successfully.

Lastly, in this time of overall investor anxiety, fee-only total wealth managers, like DWM, are here to rescue you. Yes, we execute a detailed process to add value every day in the areas of investing, financial planning, income taxes, insurance and estate planning. Yet, one of our most important tasks we have is to protect our clients from hurting themselves in the capital markets. Investors overall have a very human tendency to do exactly the wrong thing at the worst possible moment.

We understand it’s hard to think long-term. Today’s world moves at a very fast pace. And, the news is often designed to instill fear. Don’t succumb to emotions. Reduce your anxiety. Allowing your portfolio to compound quietly over time can be boring, yet very successful.   If your allocation or the markets are making you anxious, let’s talk.

Did You Ever Dream That You Forgot Your Pants? No Problem.

dream_not_wearing_pants.jpg

Have you ever dreamed that you are walking into a college final exam and you have done no studying for it?   Better yet, in the dream, have you walked into the exam and forgotten your pants? I can tell you from personal experience, I have had dreams where both events occur. Fortunately, I’m pleased to report, this has never happened in real life and likely and hopefully never will. More importantly, though, I now know that my dreams have served an all-important psychological function-working out my anxieties in a low-risk environment and preparing for the future.

Most of the emotions we feel in dreams are negative; including fear, helplessness, anxiety and guilt. Yet, this night-time unpleasantness may, in fact, provide an advantage during the day.

All sleep is not the same. Dreams typically occur in REM (rapid eye movement) sleep, when our brains are more active. You cycle between REM and non-REM sleep. First, comes non-REM sleep followed by REM sleep and then the cycle starts over again. Babies spend 50% of their sleep in the REM stage, compared to only 20% for adults. Deep sleep which is non-REM is known for the changes in your body, not your brain; when your body repairs and regrows tissues, builds bone and muscle and strengthens the immune system.

REM sleep is crucial for mental and physical health, yet we generally slough off the dreams as being silly, juvenile, and self-indulgent and simply get on with our day. Because dreams seldom make literal sense, it can be easier to discard them than to try to interpret them. In fact, according to Alice Robb, author of “Why We Dream,” dreams can help us “consolidate new memories and prune extraneous pieces of information.” Further, they may provide a time for the brain to experiment with a wider array of associations of the facts and outcomes and sometimes help solve problems.

Finnish evolutionary psychologist Dr. Antti Revonsuo studied the perplexing question of why our minds subject us to something so unpleasant. He reasoned that if our ancestors could practice dealing with dangerous situations, perhaps battling a mastodon, as they slept, they might have an advantage when they had to confront them in the next day. Research on animals fits into this theory. REM deprived rats struggle with survival-related tasks such as navigating a maze, while rats with REM sleep apparently dream about this upcoming challenge and perform better.

In 2014 researchers at the Sorbonne interviewed a group of aspiring doctors about to take their medical school entrance exam. Nearly all of the 719 students who replied had dreamt about the exam at least once beforehand and, understandably, almost all of those dreams were nightmares. They had dreamed that they got lost on the way to the exam facility, that they couldn’t understand the questions and that they had written their answers with invisible ink. Ouch. But, when the researchers compared the results of the exam with dreaming patterns, they found that students who dreamed more often performed better in real life.

Ms. Robb suggests that, while we tend to focus on and discuss dreams that are strange, most dreams are less bizarre than we think. A study in the 60s by psychologist Frederick Snyder of 600 dream reports showed that “dreaming consciousness” was, in fact, “a remarkably faithful replica of waking life.” He found that 9 out of 10 dreams “would have been considered credible descriptions of everyday experience.”

In another study, Dr. Revonsuo and Dr. Christina Salmivalli, analyzed hundreds of dreams from a group of their students and discovered that the emotions in the dream were usually appropriate to the situation, even if the situation itself was unusual. “The dreamer’s own self was ‘well preserved.’” Effectively, even in dreams, we know who we are.

So, go ahead and get a good night’s sleep tonight and look forward to the REM dreaming phase. It may feel negative and not be all that comfortable. However, it just might give your brain some time to work through some important matters and find solutions.

ECONOMY CELEBRATES 10 YEARS OF GROWTH: IS IT TIME TO PARTY?

Next week will mark the 121st month of the current bull market- the longest business cycle since records began in 1854. Based on history, a recession should be starting soon. Bond rates now form an “inverse yield curve” with shorter term rates above longer term, which typically signals a downturn. Business confidence is down. However, 224,000 American jobs were created in June and equities continue to soar, rising 16-20% year to date. Is it time to party or not?

The business cycle appears to be lengthening. The current expansion, coming after the worst financial crisis since the Great Depression, has been unusually long and sluggish. Average GDP growth has been 2.3% per year, as compared to the 3.6% annual growth in the past three expansions. The workforce is aging. Big firms invest less. Productivity has slipped. And, Northwestern Economics Professor Robert Gordon continues to assert that American’s developments in information and communication technology just don’t measure up to past achievements including electricity, chemicals and pharmaceuticals, and the internal combustion engine.

However, the changing economy may now be less volatile for a number of reasons. 1/3 of American’s 20th century recessions were caused by industrial declines or oil-price plunges. Today, manufacturing is only 11% of GDP and its output requires 25% less energy than in 1999. Services are now 70% of our GDP. Furthermore, the value of the housing market is now 143% of GDP, as compared to a peak of 188%. Banks have lots of capital.

Finally, inflation has been very low, averaging 1.6% in the U.S. (and 1.1% in the euro zone) per year during the current expansion. In earlier business cycles, the economy would surge ahead, the jobs market would overheat, causing inflation to rise and leading the Federal Reserve to put on the brakes by raising interest rates. Today, it’s different. Even though the unemployment rate is at a 50 year low of 3.7%, wage growth is only 3%. As the Economist pointed out last week in “Riding High,” American workers have less bargaining power in the globalized economy and are getting a smaller percentage of company profits, keeping inflation down. The Fed recently announced that it is less concerned about rising prices and more concerned about growth slowing and, therefore, will lower interest rates at its meeting next week.

Changes in the economy to slower growth, more reliance on services and lower inflation all contribute to longer business cycles. Yet, the changing economy, particularly globalization and technology, has also produced new risks.

Manufacturing that was formerly done in the U.S. is now outsourced to global producers. These chains can be severely disrupted by a trade war. This could produce a major shock- imagine if Apple was cut-off from its suppliers in China. Also, take a look at the impact that the prolonged grounding of Boeing’s 737 MAX is having on the U.S. economy. It’s hurting suppliers, airlines, and tens of thousands of workers, while $30 billion of the MAX sit grounded. Global supply chains are extremely interconnected these days.

IT is significantly linked as well. Many businesses outsource their IT services via cloud-computing to a few giants, including Alphabet (GOOGL).  85% of Alphabet’s $100 billion annual sales comes from advertising, which in the past has been closely correlated to the business cycle. GOOGL invested $45 billion last year, 5 times more than Ford. In fact, the S&P 500 companies invested $318 billion last year, of which $220 billion was spent by ten tech companies. The big IT companies are now facing regulatory issues worldwide. What would be the worldwide impact if GOOGL, Facebook or others get their “wings” clipped?

Also, finance issues could disrupt the expansion. Although housing and banks are in decent shape, private debts remain high by historical standards, at 250% of GDP, or $50 trillion. And, if the prime lending rate continues to decline, banks’ profits and balance sheets will likely weaken.

Lastly, politics is a big risk. There are the threats of trade wars with China and physical war with Iran. The big tax cut that pushed markets up in 2017 could now produce lower year over year earnings for companies. On Monday, July 22nd, Congressional leaders and White House negotiators reached a deal to increase federal spending and raise the government’s borrowing limit. This would raise spending by $320 billion, at a time when the annual deficit is already nearing $1 trillion, despite the continuing expansion.

Conclusion: Changes in the economy have produced reasons why business cycles are longer, yet more sluggish. Those changes have also added new risks for a continuing expansion and bull market. No one can predict the future. Focus on what you can control: Make sure your risk level is appropriate for your risk profile. Make sure your portfolio is prepared for the next downturn. And, yes, stay invested.

Pizza Meets Technology

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What’s your favorite pizza? In Chicago, I love Lou Malnati’s deep-dish, in the Lowcountry, Grimaldi’s Brooklyn Bridge, with ricotta and Italian sausage, is amazing. And, now, thousands of years after pizza was invented, it too is being impacted by technology. Recently, the WSJ, in their “The Future of Everything” section, focused on the impact technology is having at Domino’s Pizza.

But first, let’s take a look at the history of pizza. Archeologists in Sardinia have found ancient remains from the 1st millennium B.C. of flattened bread that was apparently very popular. Writings in the 6th Century B.C. mentioned soldiers baking flatbread and covering it with cheese and dates. Stone ovens are mentioned in the 3rd B.C. when Roman historians described “flat round of dough dressed with olive oil, herbs, and honey baked in stones.” Excavations made in Pompeii show that in the 1st Century B.C. retail shops were making and selling pizzas.

Modern pizza seems to have come from Naples in the 16th century. Tomatoes from the New World combined with bread and other products to produce the earliest form of modern pizza. The Queen of Naples in the mid-18th century had a special oven in her palace for making pizzas. Antica Pizzeria Port’Alba, the first modern pizzeria, opened in Naples in 1830. By the end of the 19th century, citizens of Naples were consuming pizza for breakfast, lunch and dinner.

In the early 1900s, the first Italian pizza in America was introduced by street peddlers who walked up and down Taylor Street in Chicago. New York City got the first pizza license in 1905. Pizzerias spread across the U.S. in the early 20th century. In 1943, Chicago’s Ike Sewell invented the deep-dish pizza. In the 1950s, celebrities of Italian origin, including Frank Sinatra and Joe DiMaggio, promoted pizza. The first frozen pizza was released in 1957. Pizza Hut started in 1958, Little Caesar’s in 1959 and Domino’s in 1967.

These days, pizza is a huge business. According to 2018 “Pizza Power” report, the worldwide pizza market was $134 billion, with U.S. the top country, at $45 billion annually. There are 75,000 U.S. pizzerias and the top 50 chains have average unit sales of almost $600,000, with annual growth overall at 12%. The big winners were reported to be those who focused on consumer needs by embracing “websites, social media, online ordering and delivery technology.”

Domino’s, with 6,000 U.S. outlets is the world’s largest pizza company. Yet, their just-issued 2Q19 quarterly report showed slower growth. Their stock has gone “cold”- investors have “lost their appetite” for Domino’s Pizza. Technology has fueled new and improved competitors, delivery apps, online ordering and quality.

The growth of online ordering through companies like Grubhub and Door Dash has impacted Domino’s business. Domino’s, with its own delivery drivers, has declined to form partnerships with them. Also, food delivery companies, such as Uber Eats and Postmates, have jumped into the business aggressively with free or discounted delivery during the March NCAA tournament period with great success. Even though Domino’s hasn’t raised their prices on pizzas in over a decade, increases in same-store sales are slowing.

Ritch Allison, CEO of Domino’s, was recently interviewed by the WSJ for its “The Future of Everything” section. Mr. Allison was clear that “Pizza will endure. However, almost everything about how a pizza is made and transported to the customer is undergoing a high-tech shift.”

Domino’s has maintained that it won’t outsource delivery. Instead it will invest in operations to make delivery more efficient and better for customers. Low unemployment and rising minimum wages in some cities are pushing up labor costs and making it harder to find drivers. They’re working on a driverless vehicle smaller than a golf cart, with compartments that can be heated up or chilled. They are looking at drones and even deliveries by bike and scooter riders.

Mr. Allison indicated that they are working on upgrading their “Dom” automated telephone answering service. They’ve been missing customer calls during busy times. Their goal is to answer every call and hopefully build bigger orders as well. They hope improved data on customers will help them produce better menus, adding and deleting items over time based on demand patterns.

For Domino’s “Robots will help, but not replace human pizza makers.”   Robots can put dough balls on trays, but Mr. Allison wants to “keep the magic of pizza making” with humans. Domino’s is currently using, in locations in Australia and New Zealand, artificially intelligent cameras to photograph and grade each pie based on different criteria. This quality audit is designed to ensure that a subpar pizza never reaches a customer’s door. They hope to extend this quality method to operations worldwide.

Yes, even our beloved pizzas, that humanity has been eating for thousands of years, and hopefully for many more thousands as well, are being impacted by technology. Hopefully, that will make it easier in the future for all of us to get our perfect pizza at the perfect time.

Real Estate: Time to Sell that Large House?

American homes are a lot larger than they used to be.  In 1973, the median size of a newly built house was 1,500 square feet.  In 2015, that figure was 2,500 sq. ft. – 67% more. Plus, with smaller families, there is lots more room per person: 507 sq. ft./person in 1973, and, almost double, 971 sq. ft./person in 2015.

In addition, Americans aren’t any happier with bigger houses.  A study by PhD Clement Bellet found that “house satisfaction in the American suburbs has remained steady for the last four decades.”  His reasoning is based on the premise that people compare their houses to others in the neighborhood-particularly the biggest ones.  The largest homes in the neighborhood seem to be the benchmark.  Dr. Bellet tracked the “one-upmanship” by owners of the biggest homes from 1980 to 2009.  He found that the size of largest 10% of houses increased 40% more than the size increase of median houses.  Apparently, the competition never ends.

Fifty years ago, a one bathroom house or a bedroom that slept 3 siblings might have felt cramped- but it also probably felt normal.  Today, many Americans can afford more space and they’ve bought it. They just don’t appear to be any happier with it.

Dr. Robert Shiller, the noted Nobel Prize winner and co-author of the Case-Shiller index of housing prices, was interviewed recently by the WSJ for an article titled “The Biggest Ways People Waste Money”.  Dr. Shiller opined that “Big houses are a waste.”  He believes that modernization has reduced our space needs.  However, he recognizes, that for some, a big house is a symbol of success. Your neighbors may not know about your finances and achievements, but they can see your big house.

Dr. Shiller suggests books such as “The New Small House”- that talk about designing houses to look impressive as well as function on a smaller scale. Living smaller can be easier on the pocketbook, the owner’s time and the environment.  He concludes: “Just like Uber and Lyft and Airbnb, using resources more efficiently, we can also build houses that are better at serving people’s needs without being big”.

As a result, we’re seeing that fewer people want to buy large, elaborate dream houses.  We know that in the high-end suburbs of Chicago that prices today, in some cases, are ½ of what they were 10-15 years ago. In the Southeast and the Sunbelt, McMansions are sitting on the market, enduring deep price cuts to sell.  For example, Kiawah Island currently has 225 houses for sale, which is a 3-4 year supply.  Of these, the largest and most expensive are the hardest to sell, especially if they haven’t been renovated recently.

The problem is expected to get worse in the next decade.  Baby Boomers currently own 32 million houses, 40% of all the homes in America, and many of these homes are big ones. As the Boomers advance into their 70s and 80s, many will be looking to downsize and/or move to senior housing and therefore will attempt to offload their big house.

When we at DWM talk with clients about housing, we generally ball park a figure of 5-7% of the market value of the house as the annual net cost.  The costs include interest, if there is a mortgage, the opportunity costs of not investing the equity in the house, real estate taxes, insurance, and maintenance and repairs. From this total we subtract the expected appreciation.  For example, a $500,000 house with a $200,000, 4.5% mortgage, might have $9,000 in interest, $18,000 in opportunity costs, $5,000 in real estate taxes, $3,000 in insurance and $5,000 in repairs. Total costs of $40,000 less 2% appreciation of $10,000 nets $30,000 in annual net costs or 6% of the market value.  Of course, values differ across the country and by house. Furthermore, there are some sections of the country experiencing excellent appreciation and some that are experiencing deprecation in value.

As we look at our spending, it’s always good to compare the value received to the cost and, if the cost exceeds the value, a change might be in order.  In our example, if the couple owning the $500,000 house feels they are getting $30,000 or more per year of value from the house, that’s great.  If they are not, particularly if they have a bigger house that may not be appreciating and may be hard to sell in the future, they may want to think about a change now.  Give us a call if you would like to discuss this very important topic.