by Donald Gould
We enter 2018 on the heels of a strong 2017 for stock markets worldwide. The S&P 500’s 21.8% return is well above the 12.1% average annual return for the index[1]. Foreign markets did better still, with the MSCI EAFE (foreign developed markets) up 25.6% and the MSCI Emerging Markets returning 37.8%, both in roughly the 75th percentile of historical returns.
Animal Spirits on the Rise
Lately the financial press is throwing around the word “euphoria” a lot, and with good reason. In just 11 trading days since New Year’s, the leading US large cap stock index, the S&P 500, is up almost 5%. To put this in perspective, we’ve seen close to one-half of a year’s average return in about 1/25th of a year. Clearly, this rate of ascent is not sustainable.
There are other signs that a bullish mania may be taking hold of investor psyches. Most obvious is last year’s 13,277% run-up in Bitcoin, a virtual currency with no objective yardstick for worth. (For more discussion on the cryptocurrency craze, see here) Along the same lines, we read that margin debt (money borrowed for the purpose of buying stocks) is at record highs, while many investors are abandoning the use of derivatives for hedging stock market downside risk.
The informal term FOMO (Fear of Missing Out) is increasingly invoked in financial market discussions. And why not? When the stock market seems only to go up, it’s easy to feel foolish for owning any conservative assets (for example, bonds) to protect against a risk that seems no longer to exist.
Be assured, the risk is always there. We like to say that the three most dangerous letters in investing are I, N, and G. As in, “this market is going up, up, up.” To view a stock market chart, it’s an understandable statement, but it’s also dangerous. All the chart really tells us is that the market has gone up. Where it is going next is anyone’s guess. Beware the natural tendency to extrapolate financial market trends.
Our concern with manias is that they always end badly. The 80% decline in the Nasdaq index following the late 1990s tech bubble immediately comes to mind. When investors throw caution to the wind, we run the risk that stock prices become unmoored from a rational basis of valuation. Inevitably, prices return to the real world, and the correction is often vicious.
To be clear, we don’t believe that major stock markets are yet in the manic phase. While some valuation measures suggest stocks are quite expensive compared to historical norms, others give a more sanguine view, and it’s entirely possible that future corporate earnings, combined with very low real interest rates, will justify today’s stock prices. The global economy and corporate earnings both continue to grow at a healthy pace.
The almost 9-year old bull market has been remarkable for its steady rise and the absence of euphoric upside blow-offs. Perhaps the emerging “animal spirits” (as economist Keynes called it) that are causing us concern will subside and we can avoid the boom-bust phenomenon a good while longer. In any case, we will monitor the situation with vigilance.
Should a mania move into high gear, our portfolio rebalancing will be of critical importance. That means that if the rise in equities takes your allocation beyond a level consistent with your risk tolerance, where applicable we will sell some stocks and buy other things to stay on track. (And we’ll do just the opposite in times of greater pessimism.) Second, we monitor market risk, both in terms of volatility and valuation. Should either indicate substantially elevated risk, we will consider reducing the target allocation to riskier assets.
Reflections on the New Tax Law
The legislation enacted in late December provides a massive tax cut for US corporations, with their tax rate dropping from 35% to 21%. The tax writers permitted themselves a net $1.5 trillion tax cut, which translates into a like-sized increase in the national debt as a result of higher annual budget deficits in the future. However, the projected drop in corporate tax revenue substantially exceeds $1.5 trillion, so the tax bill eliminates or curtails a number of tax deductions in order to meet the $1.5 trillion target.
Determining the impact of the new tax rules on individual investors is quite complex. Tax specialists we talk to still do not seem to have a good handle on all the implications.
Consider the case of a higher income California couple that owns an expensive home with a large mortgage. On plus side, their maximum marginal federal tax rate falls from 39.6% to 37%. If their income comes from a “pass-thru” vehicle such as an LLC, new rules that favor such income may result in an even bigger drop in their income tax rate. Indirectly they also benefit from the corporate tax cut that could boost the value of their stock portfolio and increase future dividend payments.
On the minus side, they are losing most or all of several key tax deductions—in particular, the deductions for California state income tax, mortgage interest and property tax. The loss of the state income tax deduction could easily cause their combined federal and state marginal income tax rate to be higher than before, despite the cut in federal rates.
Finally, we have to consider the ultimate impact of the new tax rules on the economy as a whole. If it stimulates economic growth, as its proponents claim, the result could be higher after-tax incomes, even if accompanied by higher taxes.
The Tax Cut is How Big?
One thing we are confident—and a bit worried—about is the predictable reaction of taxpayers and states to the new rules. For starters, we think the $1.5 trillion cumulative deficit impact may be greatly understated. That estimate essentially assumes that, despite major changes in the rules of the game, taxpayers make no changes in how they organize their lives. In reality, taxpayers and states will go to great lengths to minimize their federal taxes under the new system. A few hypothetical examples:
A physician employed by an HMO forms an LLC (Limited Liability Company; a “pass-thru” entity) and has the HMO pay compensation to the LLC, resulting in a significantly lower tax bill for the physician.
The State of California enables its taxpayers to make federally-deductible charitable contributions to a foundation that funds State activities, in lieu of paying non-deductible state income tax; this essentially restores the deductibility of state income taxes for taxpayers who itemize deductions. (Note: New York State is reportedly seeking to replace much of its state income tax with a payroll tax that would have a similar effect.)
A New Jersey entrepreneur relocates to Florida (where there is no state income tax), thereby depriving New Jersey of income tax.
Bigger budget deficits can both weigh on growth and push interest rates higher as government borrowing needs grow. The key question is whether the stimulative effects of the new rules on economic growth are sufficient to offset the budgetary drag. Stay tuned.
Heirs to Wealthy Parents Win Big
Unequivocal winners from the new tax bill are the heirs in very wealthy households. The bill doubles the amount of one’s estate that is excludible from federal estate tax. Previously, the individual exclusion amount was $5.49 million, and $10.98 million for a married couple. Now the amounts are $11.2 million and $22.4 million, respectively. So a married couple that leaves a $20 million estate to their children would have paid about $3.5 million in federal estate taxes in 2017, but would pay nothing in years 2018-2025. Unless there’s another tax bill in the interim (always a possibility), in 2026 the exclusion amounts revert to the 2017 levels, adjusted for inflation.
Annual Tax-Free Gift Amount Rises to $15,000
Note also that the amount one person can give to another without subjecting the giver to federal gift tax increased to $15,000 per year beginning in 2018, up from $14,000 previously. So, for example, a husband and wife could each give $15,000 per year to each of their children ($30,000 per child in total) without paying any gift tax. If you wish to give more than that, you simply use up some of your $11.2 million estate tax exclusion amount now—perhaps not a bad idea in light of the historically high level of the exclusion amount currently. (Keep in mind that because highly appreciated assets receive a “step-up” in cost basis at death, it is generally better to first give cash or other assets that have not appreciated much.)
2017 Company Milestones
Serena Lam and Kristine Hyer both joined our client service team in 2017, and we are thrilled to have them on board. Our client service capabilities have never been stronger.
Our congratulations to Gould team members on the following notable work anniversaries—Tom Carr, Partner and Senior Portfolio Manager, 15 years; John Bloom, Corporate Administration, 10 years; Johnny DeBiase, Partner and Senior Portfolio Manager, 5 years.
The company ended 2016 with more than $560 million in assets under management.
[1] 12.1% represents the simple average of annual S&P 500 returns since 1926. Because the year-to-year returns fluctuate, the compound average annual return is lower, at 10.2%. For the math-inclined, we’re talking about the difference between arithmetic and geometric means.