Why this Bear Market Feels so Different, and What Not to Do Now

It’s official – the almost 11 year bull market is over thanks to a couple of “black swans”: COVID-19 and the oil price war.

Quick terminology recap here:

  • Pull-back – a falling of a price from its recent high, typically 5%
  • Correction – typically 10% from recent high
  • Bear Market – 20%+ from recent high

Within a few weeks, we zipped past just a pull-back and correction and are officially in a bear market. Further, a recession is imminent with businesses about to take a hit from “social distancing” and broken supply chains. The US government is trying to get its arms around this threat and is working to eventually restore life back to normal. In the meantime, uncertainty continues. The market hates uncertainty and investors’ portfolios reflect that.

We’ve had pull-backs, corrections, and bear markets before. What’s different this time is the personal impact or the “human effect”. I think all of us have personally felt the coronavirus impact us in the last couple of days with upcoming plans being altered. Many are coping with tough travel decisions with Spring Break around the corner. Handshakes have turned into elbow bumps. Many employees are working from home. And our cherished past time of watching sports gets disrupted with major sports suspending their play. Heck, even Tom Hanks and his wife have tested positive for COVID-19.

Yes, this is certainly different from the Great Recession of 2008 as that didn’t impact personally like this threat has. And because of it, the level of emotion is stronger. And the emotion of fear is dominating right now. And with the help of the media, the fear is building upon itself and, for some, creating panic.

This downdraft has happened so fast – it was exactly one month ago that the stock market was hitting its all-time high – that even if you wanted to, it was almost impossible to react. Stock benchmarks are down over 25% as of this writing. This volatility for most is stressful, unnerving and can be tough to stomach. Fortunately, a balanced portfolio that holds multiple asset classes – not just equities, but fixed income and alternatives – has helped cushion the blow, but not by much given that most investment styles are down.

Emoji Graph

People struggle to separate their emotions from their investment decisions. See the slide above which shows how emotions relate to the different stages of the market. These emotions cause these investors to sell and buy at the worst times as this “recency bias” influences undisciplined investors to chase performance through buying high and selling low.

Now see the slide below which shows what happens when an emotional investor who went to the sidelines and missed the best ten days. The average annual return dropped from 6% to 2.4%. If that investor missed the 30 best days, their return goes negative.

Impact of Market Timing

The moral of the story is you don’t want to try to time the market. You should stay the course and stick with your long-term asset allocation target mix. We have had multiple discussions with our clients about risk. Risk tolerance, risk capacity, and risk perception. And from those discussions, we have identified appropriate long-term asset allocation target mixes. This crazy environment is a test of character to stay with that disciplined strategy and not give in to fear. It sounds hard to do, particularly, in scary times like now, but disciplined investing has ALWAYS paid off. The market inevitably always bounces off its lows to eventual new highs.

We aren’t calling this the bottom, by no means. We don’t know exactly what tomorrow brings. No one has a crystal ball. The market could trade lower, but if you have faith in our country pulling through this pandemic like it has in the past and understand this threat will be beaten, then remain disciplined and fully invested in your long-term asset allocation. We understand that everyone is wired differently and based on your current perception of the risk today, that may be hard to do. If so, please contact us so we can discuss further.

 

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DWM’s 4Q19 Market Commentary & A Look Into 2020

Happy 2020! No doubt you have heard the term “20/20 vision” over the last several weeks as we enter this new decade and all of the imagery that comes with it. As you probably already know, 20/20 vision is synonymous with perfect vision. As financial Sherpas, we are always striving to provide our clients with that – to observe, to envision, to help foresee, to project, and to be on the lookout! We can’t guarantee that our outlook will be spot on, but we certainly can help our clients plan and make projections for what’s next on the horizon.

But before telescoping ahead, let’s look back on fourth quarter 2019 (“4Q19”) and calendar year 2019 and the bedazzling year it was! We’ve put the magnifying glass on this investment landscape panorama so you can visualize the details!

Equities: No, it wasn’t a hallucination… Equities, as evidenced by the MSCI AC World Index, rallied to close the year, up 9.0% for 4Q19 and an eye-popping 26.3% for the year! Domestic large cap stocks*, particularly the growth-oriented FAANG group**, kept outperforming, up 9.1% and 31.5%, 4q19 and YTD, respectively. International equities* also participated in the 4Q19 rally, +8.9% for the quarter, to finish the year +21.5%. Unlike the growth and momentum-driven environment of late, we and many other experts expect valuations to actually matter in 2020.

Fixed Income: Don’t get bleary-eyed just yet, as the positive readings keep coming! In a blink of the eye, the Fed went from a hawkish stance to a dovish one which amounts to massive liquidity support and lower rates, which in turn pushes bond prices up as evidenced by the Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index turning in a solid quarter, up 0.2% and 0.5%, and an eye-catching year-to-date (“YTD”) return of 8.7% and 6.8% respectively!  The Fed appears to be on hold for the foreseeable future, thus barring a setback on trade, we expect Treasury yields to move higher as recession fears fade.

Alternatives: Sometimes this asset class goes unnoticed or invisible, but not in 2019 as alts produced some very good returns. In fact, the Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, showed a 2.2% gain on the quarter and finished up 8.1% for the year! Standouts include infrastructure*** (+2.9% 4Q19 & +27.8% YTD) and gold**** (+2.8% on 4Q19 & +18.0% YTD). Such spectacles!

Recall that in 2018 almost every asset class and investment style went down; 2019 was pretty rare in the sense that it was just the total opposite of that – virtually everything went up, i.e. no blind spots! In fact, the balanced investor – those with sizable allocations to equities, fixed income, and alternatives – should be seeing double-digit returns in the teens! Pretty amazing! The key is not to be short-sighted and getting caught up in recency bias. One needs to be realistic when planning for the future. If you are thinking that the environment is as pretty as the light prism above, you have blinders on. Alas, here is some near term darkness:

Investor sentiment is really high now with all the recent good news. That typically is a leading indicator of less-than-stellar times. And because of this high investor sentiment and recent stock market rally, valuations in certain areas, particularly the S&P500, are getting uncomfortably high. The market seems almost priced to perfection. So far the market has shrugged off scary news like the recent US killing of Iran’s most famous military commander. But it’s only speculation that that can continue. Further, manufacturing and business investment is still struggling, which will most likely continue until we get a more comprehensive trade deal, more than the vague preliminary one being discussed now. The good news is that it appears that US and China are both working on a resolution, but don’t be dazed and confused if talks fall apart. And, of course, we have an upcoming Presidential election which brings more uncertainty into the mix.

In conclusion, it’s a beautiful scene right now with most investors’ portfolio values near all-time highs. But like rays of light, the direction of the markets and portfolios don’t forever stay the same. We are here to help now and also when the light ray inevitably bends.

DWM enjoyed watching out and doing all it could for its clients in the last decade. And as we now start into this new decade, we continue to be on the lookout over our clients, their portfolios, and their wealth management needs. Serving our clients make us smile. On the flash of light, we say “cheese”!

Cheeky Smiles

As always, don’t hesitate to contact us with any questions or comments.

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

*represented by the S&P500 Index

** FAANG = Facebook, Amazon, Apple, Netflix and Google

***represented by the Frontier MFG Core Infrastructure Fund

****represented by the iShares Gold Trust

 https://dwmgmt.com/

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.

 

Indiana Jones and the Fountain of Wealth

With current markets swirling with questions of trade deals, recessions, inverted yield curves, and various other political and financial uncertainties, should we be fearing a near future “Temple of Doom” scenario like intrepid archaeologist Indiana Jones in the much acclaimed 1984 movie?!? Perhaps we can learn some tidbits of info – clues, per se – from Indy that can help us in our quest for our prized possession: financial serenity, wealth management’s version of the Holy Grail. While this ultimate goal may look a little different for each of us, and the journey this may be wildly different, some of the steps we take will likely be extremely similar, and the clues below, inspired by Indy, can provide some guidance as we take those steps!

Clue #1: Diversifying your arsenal, and your portfolio!

You’ve heard it before. In fact, diversification is a word that has been mentioned so many times in TV and movies that it’s become hard to think about investing without discussing how diversified one’s portfolio is. We’re here to tell you that this relationship makes sense! Various studies have shown over the years that having a well-diversified portfolio can significantly benefit investors in the long run.

Figure 1: Hypothetical Growth of $100,000 showing Diversified versus Undiversified Portfolio*

As shown in Figure 1, having a globally allocated, well-diversified portfolio made up of investments that have low correlation to one another, with pieces of each being from the equity, fixed income, and “nontraditional investments” (or alternatives), can help investors try to protect their assets during market downturns, and participate in market upswings. Much like Indy’s arsenal of guns, knives, and his famous whip protected him, using multiple asset class holdings with low correlations can protect investors’ portfolios from extreme danger.

Clue #2: Be Educated!

As a professor of archaeology at Marshall College, Indy’s extensive years of research have provided him a wealth of knowledge to work off of when he begins each search for ancient (and sometimes alien) artifacts. Despite this, he learns quite a bit along the way on his quests that leads to his success in discovering these items. Much like Indy, our pathways to financial health and peace often seem clouded in mystery, and are often filled with confusing directions and puzzles that can lead us astray from the path to our goals. These puzzles and directions, luckily, can be illuminated in most cases by educating one’s self in the complex and intricate business of finance! Whether it’s subjects of Arks, mysterious stones, or crystal skulls, a.k.a. topics of investments, insurance and taxes in finance terms, a little bit of knowledge can go a long way towards creating the ever important map to the desired goal! Blogs like these help our clients become educated and better prepared for the financial journey ahead!

Clue #3: A Little Help From Our Friends

No matter which adventure he’s on, Indy always has a crew of fellow explorers with him to help on his search. Each play their own integral role in supporting his journey as he brushes with Nazis, Russians, and Thuggee cults. In a similar manner, wealth managers like DWM can act as your “Short Round” (an ally) in your continual journey to financial serenity and success, helping guide you through the sometimes dark and perplexing pathways. Our expertise in these “ruins” of sorts can assist with dodging the pitfalls in your financial plans and portfolios.

With or without headlines coming out about recessions or inversions or trade deals or anything else, by following these three clues, and sticking to them for the long-term, an investor can create a stable pathway to success. Just as Indy never gives up on his quests, neither should we.  Our steps may alter in ways over our lives, from accumulating wealth, to protecting it, and then to financially planning for our legacies, but each of these has the underlying pursuit for peace of mind. Please feel free to reach out to DWM if you have any questions about how we can accompany you on your hunt.

*Source: https://www.schwab.com/resource-center/insights/content/why-global-diversification-matters

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.

DWM 2Q19 Market Commentary

Carnival Pic

Summer is finally upon us! Weather is steamy, kids are out of school, and it’s the midst of carnival season. Merriam Webster has several definitions of carnival including:

  • An instance of merrymaking, feasting, and masquerading
  • An instance of riotous excess
  • An organized program of entertainment or exhibition

Sounds a little bit like the markets we’ve seen in 2019 so far: it’s certainly been an entertaining program with all asset classes parading higher. But does this Fun House continue or is it all just a House of Mirrors….

Equities: You win a small prize! Equities continue to be the most festive part of the fairground, with many stock markets up over 2-4% on the quarter and now up around 12-18% on the year! Domestic and large cap stocks continue to outperform value and smaller cap stocks, which is typical of a late-stage bull market, this one being over a decade-long!

Fixed Income: You can trade in that small prize for a medium prize!  Like a Ferris Wheel where one side goes up, the other side comes down; yields and bond prices operate the same way. With the 10-yr Treasury now down to around 2.06% at the time of this writing compared to 3.2% last November, it’s no surprise to see strong returns in bond land. In fact, the Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index popped another 3.1% and 3.3%, respectively for the quarter and 5.6 & 6.1%, respectively year-to-date (“YTD”).

Alternatives:  You can trade in that medium prize for the largest prize! The merrymaking continues as most alternatives we follow had good showings in 2Q19, evidenced by the Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, up 1.3% and now up 5.7% YTD.

It almost feels like you could go over to the Duck Pond and pick up a winner every time. There are indeed a lot of positives out there:

  • US stocks near record highs
  • A stock-market friendly Fed
  • Historically low unemployment with inflation that appears totally under control
  • Americans’ income and spending rising, leading to relatively strong consumer confidence

But this carnival has some roller coasters in the making given some riotous issues including:

  • US-China trade tensions most likely not ending with a solid deal anytime soon, which will fuel anxiety
  • A weakening European economy due to tariffs and other issues, which could bleed over to all markets
  • Slowing US economic growth here as the Tax Reform stimulus wears off
  • A relatively expensive US stock market, evidenced by the S&P500’s forward PE ratio now at 16.7 times versus its 25-year average of 16.2

It definitely wouldn’t be fun if the yummy funnel cake turns into spoiled fried dough…Yuck! We don’t know exactly when or what will happen, but we do know that at some point this bull market will indeed end. You cannot time the market so forget about getting out of the Cliff Hanger before the time comes. That said, you want to stay invested and continue to control what you can control. Don’t wind up being on the bottom end of a Whack-A-Mole game; make sure your portfolio is prepared for the next downturn, which includes making sure your risk level within is appropriate for your risk tolerance.

So don’t wind up being a carny clown. If you want to continue hearing “winner-winner-chicken-dinner!”, work with a proven wealth manager and you’ll be the one controlling the Zipper!

 

Zipper

The Beauty in Roth Accounts

iStock-514516902.kroach.roth-5c575504c9e77c000132a17b.jpg

The most common type of retirement accounts are traditional Individual Retirement Accounts (IRAs) and company sponsored traditional 401(k) plans, both of which are funded using pre-taxed dollars. The goal of these accounts is to accumulate retirement assets by deferring current year taxes and reducing your taxable income. Later, when funds are withdrawn, either voluntary or as part of a required minimum distribution upon reaching age 70.5, the accumulated earnings and contributions are subject to ordinary income tax. In addition to this, if you are below age 59.5 and you withdraw funds you could be subject to an additional 10% tax penalty.

“Cue the Roth IRA.” One alternative to popular IRAs and traditional 401(k) plans is the Roth IRA and Roth 401(k) (“Roths”). Contributions to both consist of after-tax funds. The accumulated earnings and contributions are not subject to income tax upon withdrawal. In addition to this, there are no required minimum distributions for Roths until the account has reached a non-spouse beneficiary. Although no current tax break is received, there are several arguments as to why Roth accounts can be a significant attribute to your portfolio and to your estate planning. As we will discuss below, the Roth has the ability to grow income tax-free for future generations.

 Contributions:

Funding a Roth account can occur in one of two ways; either through yearly contributions, currently limited to $6,000 per year if below age 50 and $7,000 if above age 50 for 2019 Roth IRA accounts. In addition to this, contributions may be limited for Roth IRAs if your income is between $193,000 and $203,000, for married filing jointly, and you are ineligible to contribute if your income is higher than these figures. Roth 401(k) contributions limitations are currently set at $19,000 per year per employee, with an available catch-up contribution of up to an additional $6,000 if age 50 or older. Contributions to Roths are typically more beneficial for young people because these funds will likely grow tax-free for a longer period of time and they generally have a lower current income tax bracket.

Conversions:

The IRS allows you to convert traditional IRAs to Roth IRAs without limitation. You simply have to include the converted amount as ordinary income and pay the tax. Converting traditional IRA funds to Roth is certainly not for everyone. Generally speaking, conversions may only be considered beneficial if you are currently in a lower tax bracket now, than when the funds will be distributed in the future. If you are in the highest tax bracket, it may not make sense to complete a Roth conversion. If you do not have available taxable funds, non-IRA funds, to pay applicable taxes, then a conversion may not be the best strategy for you. Lastly, conversion strategies are not usually recommended if you will have a need for your traditional IRA or Roth funds during the course of your lifetime(s).

Example:

In the right circumstances, a Roth conversion strategy may hold great potential to transfer large sums of after-tax wealth to future generations of your family. For example, let’s assume a conversion of an $800,000 traditional IRA. Of course, this would typically be done over the course of several years to limit the amount of taxes paid on the conversion. However, following the completion of the conversion, these funds will continue to grow tax-free over the course of the converters’ lifetime (and spouse’s lifetime). Assuming a 30 year lifespan, at an average rate of 5% per year, this would amount to close to $3,500,000 at the end of 30 years; a $2.7 million tax-free gain. For the purpose of this example, let’s also assume these Roth funds skip over the converters’ children to a future generation of four potential grandchildren. Split evenly, each grandchild would hypothetically receive $875,000. At this point, the grandchildren generally would be required to take a small required distribution, however, the bulk of these Roth funds would grow-tax free until the grandchild reaches 85 years of age.  Assuming they receive these Roth funds at age 30, it’s possible each grandchild could receive $5,600,000 of tax-free growth, assuming a 6% average yearly returns. For this example, the estimated federal tax cost of converting $800,000 in IRA funds may be close to $180,000, assuming conversions remain within the 24% tax bracket year-over-year. An estimated state tax cost may vary by state, however, some states such as IL, TN and FL do not tax IRA conversions. Now, if we multiply the $5.6 million times 4 (for each hypothetical grandchild) and add the $2.7 million of appreciation during the first 30 years, this is a total of $25.1 million of potential tax-free growth over 85 years. This obviously has the potential to be a truly amazing strategy. Note that because of the rules that enable people to stretch out distributions of an inherited Roth, the people who benefit the most are young.

To review if Roth strategies may be a good addition to your overall planning, please contact DWM and allow us to assist you in this process.

Ask DWM: Should We Invest in Real Estate?

real_estate_investment_dollar_bills.png

Great question.

 

Let’s start with some basic concepts.  Real estate is an illiquid investment. You can’t buy or sell it in a day or two like liquid investments. It is somewhat uncorrelated to the stock market returns- which is good.  While it is smart to consider adding real estate as a portion of your overall investment portfolio, you don’t want to have too much in illiquid investments. We suggest a rule of thumb is that real estate, excluding your house, should be at the very most 40% of your overall investment portfolio.  So, if your investment portfolio (both liquid and illiquid) is $1 million, real estate should at most be $400k.

Location. Location. Location. Appreciation in value over time is key. This will impact the ultimate sales price when you sell your investment property and the rental income amounts while you hold it. Historically, US real estate has increased, on average, about 3% per year, similar to inflation. However, location can produce tremendous differences. Charleston real estate has done very well in the last ten years, though some areas of the Lowcountry haven’t done so well. Chicago’s market overall has been flat for the last ten years, yet there are areas that have done very well and areas in the suburbs that have lost significant value.  Investing in a piece of real estate is not like buying shares in an S&P 500 index, where your investment will rise as the market will rise. Rather it is a singular investment in one piece of property, subject to both the general market risks and the specific risks of the property.

Would you be prepared to self-manage the investment property? Do you have the skills, time and patience to handle phone calls or texts, perhaps in the middle of night, from an upset tenant?   If you decide to have someone else do the property management, it won’t be cheap- likely 10% of your rental income.

Let’s look at the key metric- your likely return on investment. We start by calculating the “net operating income” (“NOI”), which is the cash flow of the property, assuming there is no financing, and compare this to the purchase price.  For example, let’s say you think you can buy a property for $500,000 that will rent for $3,000 per month. You need to include an amount for estimated vacancies/rental commissions- let’s use 8%. So, the hypothetical annual net rent would be $33,120. Now, let’s look at expenses- taxes might be ½% to 1% or more of the property value. There may be homeowner association fees and/or repair costs. And, there will be insurance-perhaps an amount equal to the real estate taxes. Just for simplicity, let’s say all of those expenses combined are 1 ½% of the value of the property. Based on a $500,000 property, expenses might be $7,500, assuming you do the property management yourself. Therefore, in this example, NOI would be $25,620 ($33,120-$7,500) or 5% of the investment.

The hypothetical total return on the investment is NOI + expected appreciation. Let’s say this property would be sold in 6 years for $650,000. Assuming you sell it using a broker, there would be a 6% commission. So, net proceeds of $610,000. This would represent a 3.5% annual appreciation on the property. Therefore, your total expected return in this example would be 8.5% (5% net operating income + 3.5% appreciation).

We haven’t talked yet about financing and taxes. If you get a loan at less than your NOI (5% in our example), your total return will increase slightly as you are benefitting from leveraging. If the rate is higher than NOI, the total return would be a little less. Depreciation is a non-cash expense that can reduce the taxable income on the property during your ownership. Any depreciation taken has to be “recaptured” (given back) when you sell the property. Depending on your personal circumstances, you may be able to take losses on rental property and you may be eligible for a 20% Qualified Business Income Deduction. Financing and taxes are generally not the key determining factors in deciding to buy the property, but may have some impact on the total return.

We generally suggest a minimum threshold for expected total return on real estate investments to be 9% or more. If a balanced liquid investment portfolio is expected, over a long-term, to have a total return of 5-7% net of fees, a real estate investment should be at least 3% more. Real estate investments are illiquid, riskier (due to lack of diversification) and, if you self-manage, will require time, skill and patience.

Under the right circumstances, investment real estate can be a nice addition for a portion of your investment portfolio. At DWM, we are very familiar with real estate. We understand the pluses and minuses for a portion of your investment assets. In 50 years of marriage, Elise and I have purchased and sold over 40 properties, some of which were our home and some were investment properties. Real estate investment has helped increase our income and net worth.

If you think you might like to invest in real estate, or, if you already own real estate and wonder if you should be adding more or subtracting some or all of it, give us a call. Once you’ve assembled all the facts (cost, income, expense, appreciation), we’re happy to help you review the NOI and total return and discuss how investment real estate fits into your overall investment strategy. We don’t do property valuations and we certainly can’t guarantee your future results, yet we’re happy to provide competent, independent and valuable input as you determine whether or not you should invest in real estate.

 

 

 

 

 

DWM 1Q19 Market “MADNESS” Commentary

In basketball, March Madness is a big deal. For those of you who aren’t familiar with the term, March Madness refers to the time of the annual NCAA college basketball tournament, generally throughout the month of March. In the market, it may appear that “Madness” is never confined to any one month. If you really want to talk about Madness, just think about the last 6 months: The S&P500 was at an all-time high late September, only to throw up an “airball” and bottom out almost 20% lower three months later on worries that the Fed was raising rates too fast, only to “rebound” to have its best first quarter since 1998 as the Fed shifted its tone to a more dovish nature. Is it the NCAA or the markets in a “Big Dance”?!?

Yes, the investing environment now is so much different than our last commentary. Then, it certainly felt like a flagrant foul after a tenacious 4q18 sell-off that had gone too far. We advised our readers then to essentially do nothing and stay the course. And once again, rewards come to those that stay disciplined. With the market back within striking distance of its peak, it almost feels like its “cutting down the net” time. (“Cutting down the net” refers to the tradition of the winning basketball team cutting down the basketball net and giving pieces to team members and coaches.) But of course, the game of investing is not just four quarters like basketball. Investing can be a lifetime. So if you’re thinking about your portfolio like you would a basketball team, let’s hope its more like the Chicago Bulls of the 90s and not the 2010s! (Where’d you go, Michael Jordan?!?)

Like the Sweet 16 of the NCAA tourney, your portfolio holdings are probably like some of the best out there. But there will always be some winners and losers. Let’s take a look at how the major asset classes fared to start 2019:

Equities: The S&P500 soared to a 13.7% return. Small caps* did even better, up 14.6%. Even with a challenging Eurozone environment, international stocks** climbed over 10%. In basketball terms, let’s just say that this was as exciting as a SLAM DUNK for investors! Of course, with a bounce-back like this, valuations are not as appealing as they were just three months ago. For example, the S&P500 now trades at a 16.4x forward PE vs the 16.2x 25-year average.

Fixed Income: With the Fed taking a more dovish stance, meaning less inclined to raise rates, yields dropped and thus prices rose. The total return (i.e. price change plus yield) for most securities in fixed income land were quite positive. In fact, the Barclays US Aggregate Bond Index & the Barclays Global Aggregate Bond Index jumped 2.9% and 2.2%, respectively. Further, inflation remained under control and we don’t expect it to be a pain-point any time soon. But TIME OUT!: Within the last several weeks we have seen conditions where the front end of the yield curve is actually higher than the back end of the yield curve. This is commonly referred to as an “inverted yield curve” and has in the past signaled falling growth expectations and often precedes recessions. To see what an inverted yield curve means to you, please see our recent blog.

Alternatives: Most alternatives we follow had good showings in 1Q19 as evidenced by the Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, up 3.9%. Two big winners in the space were Master Limited Partnerships***, up 17.2%, and Real Estate****, up 15.2%. The pivot by the Fed in terms of their attitude toward rates really benefited the real estate space as new home buyers are now seeing mortgage rates almost a point lower than just several months ago. Unfortunately, not all alts did as well. Gold barely budged. And managed futures†, down 3.1%, were tripped up by the last six-month whipsaw.

So if you think of your asset classes as players on a basketball squad, one could say that pretty much every one had a good game, but the star of the show was definitely “LeStock”. Moreover, there was no buzzer beater necessary this quarter, as your team flat out won. In fact, most balanced investors after just one quarter are up high single-digits! A definite nice start to the year. You have now advanced to the next round, but where does your team go from here?

The game we saw in the first quarter cannot continue. With the Tax Reform stimulus starting to wear off, economic growth has to decelerate. In fact, companies in the S&P500 are expected to report a 4% decline in 1Q19 vs 1Q18; their first decline since 2016! World trade volume has really slowed down, so there’s a tremendous focus on a US-China trade agreement happening – if not, watch out! The good news is that the Fed seems to be taking a very market-friendly position, and unemployment and wage growth are under control.

As always, there are risks out there. But with the bull market on the brink of entering its 11th year of economic expansion, the end-of-the-game buzzer need not be close as long as you have a good coach at the helm. Just like within NCAA basketball, to succeed, you need a good coach on the sidelines – someone like Tom Izzo of the Michigan State Spartans who always seems to get his players to work together and play their best. The same way a wealth manager like DWM can help you put the portfolio pieces and a financial plan together for you in an effort to thrive and succeed.

So don’t wind up with a busted bracket. If you want a lay-up, work with a proven wealth manager and you’ll be cutting down your own nets soon enough. Now that’s a “swish”!

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

 

*represented by the Russell 2000

**represented by the MSCI AC World Index Ex-USA

***represented by the Alerian MLP ETF

****represented by the iShares Global REIT ETF

†represented by the Credit Suisse Managed Futures Strategy Fund

Ask DWM: What is an Inverted Yield Curve and What Does it Mean to Me?

inverted_yield_curve.jpg

 

Great question. Historically, an “inverted yield curve” has been a signal that recession was on the way. As with so many things these days, though, the old “rule of thumb” may not apply. Here’s why:

yield curve is a graph showing interest rates paid by bonds. The chart is set up with the horizontal axis representing the borrowing period (or “time”) and the vertical axis representing the payments (or “yield”).   We all would typically expect that loans over a longer period time would have a higher interest. That’s “normal.”  For example, if a 30 year mortgage rate is 4%, a 15 year mortgage rate might be at 3.25%.   A one year Certificate of Deposit might earn 1% or less and a 5 year C.D. might be 2%. The situation is referred to as a “normal” or “positive” yield curve in that interest rates are higher as the borrowing period gets longer and the curve slopes upward, see below:

Normal

 

However, rates don’t always work that way. At the end of last week, the three-month Treasury bills’ yield 2.46% was higher than the yield (2.44%) for 10-year treasuries. This situation technically produced an inverted yield curve, since a shorter period had a higher rate. This also happened three months ago. Historically, “curve inversions” have tended to precede major economic slowdowns by about a year.

inverted

 

Inverted yield curves are unusual because they indicate lenders (or investors) are willing to earn less interest on longer loans. This is most likely to happen when the economy is perceived to be slowing down and faces a meaningful risk of recession. Historically, curve inversions have occurred about a year before the each of past seven recessions in the last five decades, though a recession doesn’t necessarily occur every time we see a yield curve inversion.

The U.S. economy has slowed already from the average growth rate of 2018; mainly as a result of the 35-day government shutdown and reaction to the Federal Reserve’s (“Fed”) reports of slower growth and a moratorium on interest rate hikes. Some economists feel the economy may slow even more due to the tax-cut stimulus being only a one year spike, headwinds from trade tensions with China, political uncertainties and global polarization and fragmentation.

However, other factors point to strong economic growth. We do have a solid labor market which drives consumption. Average monthly job creation is well above what might have been expected this late in the business cycle. Further, more workers have been attracted back into the labor force and wage growth has been 3%; a rate in excess of inflation. Business investment should rise and government spending is higher.

In short, an inverted yield curve is not a perfect predictor of recessions. A different portion of the yield curve inverted three months ago in December and the markets in early 2019 have rebounded sharply as fears subsided. Also, many economists believe the drop in 10-year Treasury yields is due to non-U.S. economic headwinds, like Brexit as well as the unwinding of the Fed’s balance sheet after Quantitative Easing. They believe it’s not because of serious weakening of U.S. economic fundamentals.

The current inverted yield curve may or may not be the bellwether of a coming recession. These days, there is not a simple cause and effect relationship between an inverted yield curve and recession. More likely will be the resolution or non-resolution of uncertainties such as Brexit, trade tensions, political matters and global peace. Stay tuned and stay invested for the long-term.