The Margin of Safety Quarterly Winter 2018

 In Client Bulletins, News

Fourth Quarter 2017

Key Takeaways 

  • The fourth quarter capped yet another stellar year for U.S. stocks
  • The broad driver of the market’s rise for the year: rebounding corporate earnings growth, solid economic data, synchronized global growth, low inflation, and accommodative monetary policy 
  • By year end, the S&P 500 Index had rallied for more than 400 days without registering as little as a 3% decline
  • Foreign stock returns were stronger than the U.S., with developed international markets gaining 26.4% and emerging markets up 31.5% for the year
  • The core bond index fund gained 3.5% in 2017
  • The year 2017 was a very good one for most global financial markets

Fourth Quarter 2017 Investment Commentary

Larger cap U.S. stocks gained 6.6% for the quarter and ended the year with a 21.7% total return. This was the ninth consecutive year of positive returns for the index—tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008 financial crisis.

U.S. stocks got an additional catalyst in the fourth quarter with the passage of the Republican tax plan (more on that later), presumably reflecting investors’ optimism about its potential to further boost corporate after tax profits, at least over the shorter term.

For the fourth quarter, non US stocks trailed the S&P 500, gaining 4%–6%. However, for the year, they materially outperformed the US, returning over 26% (developed international) and over 31% (emerging markets). Our portfolios benefited from meaningful exposure to emerging market and European stocks.

The core US bond return of 3.5% was close to the index’s yield at the start of the year, as intermediate term interest rates changed little during the year. Although the Federal Reserve raised short term rates three times, yields at the long end of the Treasury curve declined and the yield curve flattened. Corporate bonds across all credit qualities and maturities had positive returns. High-yield bonds gained 7.5%, floating rate loans rose 4.1%, and our emerging market (local currency) bond manager returned over 15% for the year. Investment grade municipal bonds rebounded from a flat 2016, returning 4.5%. Lastly, our investments in liquid alternative strategies fulfilled their portfolio diversification roles while generating 4.50% in returns for the year.

While the “big picture” outlook remains positive, unprecedented central bank policy shifts could trigger increased volatility, a stock market correction, or even a recession sometime in this business cycle. During this uncertain time, it is all the more important to stay disciplined and patient. We remain confident in our diversified portfolio positioning looking ahead over our long term investment horizon.

Looking Back: Key Drivers of Our 2017 Portfolio Performance

Our globally diversified balanced (stock/bond) portfolios generated strong returns for the year, consistent with the positive overall return environment for most financial markets and asset classes. Our meaningful exposure to European and emerging market stocks was a significant contributor, as foreign stocks outpaced U.S. stocks in 2017.

However, after a strong rebound in 2016, value stocks and many valuation sensitive managers struggled to keep up with the surging market. We are confident our diversified active manager lineup remains strong and believe our value oriented managers will be rewarded once this growth oriented cycle turns, as it historically has.

Putting it All Together: Our Portfolio Positioning

We have not made any changes to our asset allocation for client portfolios. U.S. stocks as a whole are priced today such that we expect low future returns. However, we are not buying the “U.S. market” and our active U.S. managers buy individual stocks that meet their buy criteria, without regard to any benchmark. We remain defensively positioned in U.S. stocks and tilted toward European and emerging market stocks as we have for some years now, where our return expectations are materially higher. We were heartened to see our investment thesis of a European earnings rebound coming through strongly last year. However, we don’t believe our portfolios have been fully rewarded for this yet given European stocks lagged the U.S. market in local currency terms, so we’re maintaining our tactical overweight to Europe. We also remain comfortable overweighting emerging market stocks although valuations are less compelling than they were a year ago.

Our fixed income positioning also remains unchanged. In light of the particularly low expected returns for core bonds, along with the risk of rising interest rates (which correspond to lower core bond prices), we have meaningful exposure to flexible, actively managed bond funds. While a base case five-year expected returns for these funds are several percentage points above that of core bonds, they do carry more credit risk than core bonds. We factor this into our overall portfolio risk exposure, and it’s why we still maintain a meaningful allocation to core bonds in our more conservative risk sensitive portfolios. Despite their poor longer-term return outlook, we expect core bonds to perform well in a traditional bear market/recession.

Lastly, most of our portfolios have allocations to alternative strategies. These strategies are “alternative” in that they have different drivers of return and risk than traditional stock and bond investments. We believe they have superior risk adjusted return potential relative to the mix of stocks and bonds from which they are funded. While the “insurance” value of these investments hasn’t been realized during the strong equity market run up, we remain confident their relatively low correlation (or no correlation) to other investments in our portfolios is a valuable long-term benefit.

Tax Cuts and Jobs Act: Impact on Individuals

On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, a sweeping $1.5 trillion tax cut package that fundamentally changes the individual and business tax landscape. While many of the provisions in the new legislation are permanent, others (including most of the tax cuts that apply to individuals) will expire in eight years. Some of the major changes included in the legislation that affect individuals are summarized below and attached are the 2018 vs 2017 tax brackets. Individual should start to see the benefit of reduced taxes with their February 2018 paychecks.

Standard deduction and personal exemptions

The legislation roughly doubles existing standard deduction amounts (the amount for single filers is $12,000 vs $6,500 for 2017 and married filing joint, $24,000 vs $13,000 for 2017), but repeals the deduction for personal exemptions. Additional standard deduction amounts allowed for the elderly and the blind are not affected by the legislation and will remain available for those who qualify. Higher standard deduction amounts will generally mean that fewer taxpayers will itemize deductions going forward.

Itemized deductions

The phase out on itemized deductions that applied to higher income taxpayers (commonly known as the “Pease limitation”) is repealed, and the following changes are made to individual deductions:

State and local taxes — Individuals are only able to claim an itemized deduction of up to $10,000 ($5,000 if married filing a separate return) for state and local property taxes and state and local income taxes (or sales taxes in lieu of income). The IRS put in place rules to limit the 2017 prepayment of certain 2018 taxes as well.

Home mortgage interest deduction — Individuals can deduct mortgage interest on no more than $750,000 ($375,000 for married individuals filing separately) of qualifying mortgage debt. For mortgage debt incurred prior to December 16, 2017, the prior $1 million limit will continue to apply. No deduction is allowed for interest on home equity indebtedness. Tax Planning thought: individuals need to reassess the use of a home equity line of credit in their personal financial planning now that the interest is no longer deductible.

Medical expenses — The adjusted gross income (AGI) threshold for deducting unreimbursed medical expenses is retroactively reduced from 10% to 7.5% for tax years 2017 and 2018, after which it returns to 10%. The 7.5% AGI threshold applies for purposes of calculating the alternative minimum tax (AMT) for the two years as well.

Charitable contributions — The top adjusted gross income (AGI) limitation percentage that applies to deducting certain cash gifts is increased from 50% to 60%.

Casualty and theft losses — The deduction for personal casualty and theft losses is eliminated, except for casualty losses suffered in a federal disaster area. Tax Planning thought: remember that here in Florida, hurricane Irma casualty losses can potentially be deducted in either 2017 or 2016 as the limitation on a casualty loss was removed for this natural disaster.

Miscellaneous itemized deductions — Miscellaneous itemized deductions that would be subject to the 2% AGI threshold, including tax preparation expenses, investment advisory fees and unreimbursed employee business expenses, are no longer deductible. Tax Planning thought: Small business owners should ensure that the business is properly paying for business expenses, not the individual; individuals should seek reimbursement for expenses from their employer, whenever possible; we are reviewing for our clients which account our cost of services comes from and due to the law change, will use tax deferred accounts whenever possible.

Child tax credit

The child tax credit is doubled from $1,000 to $2,000 for each qualifying child under the age of 17 (this compensates for the removal of the personal exemption). The maximum amount of the credit that may be refunded is $1,400 per qualifying child, and the earned income threshold for refundability falls from $3,000 to $2,500 (allowing those with lower earned incomes to receive more of the refundable credit). The income level at which the credit begins to phase out is significantly increased to $400,000 for married couples filing jointly and $200,000 for all other filers. The credit will not be allowed unless a Social Security number is provided for each qualifying child.

A new $500 nonrefundable credit is available for qualifying dependents who are not qualifying children under age 17.

Alternative minimum tax (AMT)

The AMT is essentially a separate, parallel federal income tax system with its own rates and rules — for example, the AMT effectively disallows a number of itemized deductions (in 2017 for example, deductions such as taxes and miscellaneous itemized deductions), as well as the standard deduction. The legislation significantly narrows the application of the AMT by increasing AMT exemption amounts and dramatically increasing the income threshold at which the exemptions begin to phase out.

Other noteworthy changes

The Affordable Care Act individual responsibility payment (the penalty for failing to have adequate health insurance coverage) is permanently repealed starting in 2019.

Application of the federal estate and gift tax is narrowed by doubling the estate and gift tax exemption amount to about $11.2 million in 2018, with inflation adjustments in following years. For 2018, the annual gift exclusion amount increased to $15,000 per person per year, up from $14,000 per person per year in 2017. Tax Planning thought: We recommend clients review their estate plan and trusts in light of the higher exemption limits, especially as it relates to the funding of family trusts, as a surviving spouse may not have as much access to family trust assets. Many individuals will not be facing an estate tax with the higher limits but estate planning is still useful to ensure that assets move to heirs in an efficient manner.

In a permanent change that starts in 2018, Roth conversions cannot be reversed by recharacterizing the conversion as a traditional IRA contribution by the return due date.

For divorce or separation agreements executed after December 31, 2018 (or modified after that date to apply this provision), alimony and separate maintenance payments are not deductible by the paying spouse, and are not included in the income of the recipient. This is also a permanent change.

529 education accounts can now be used for private and religious qualified school expenses for kindergarten to 12th grade. Tax Planning thought: Education planning and its impact on retirement planning is an important topic for our clients. Expanded use of 529 funds is a plus however, college costs continue to escalate and analysis is needed to assess the impact of education costs on financial plans. Also, higher 2018 annual exclusion gift limits means $75,000 (5 years worth of gifts) can be funded at one time.

Owners of “flow through” business entities, such as sole proprietors, partnerships, limited liability companies and S corporations, can potentially deduct up to 20% of flow through profits. The computations are complex and there are limitations. Tax Planning thought: Our affiliated CPA firm, Smoak, Davis & Nixon, LLP, is analyzing the computations required under the law at this time. The early thought is that most individual will continue to benefit from their flow through entity structure vs. moving to a C corporation.

We have been receiving many questions about the new tax law. A planning challenge is that changes to the individual tax rules are temporary and somewhat piecemeal. As a broad, general observation, individuals are given some new benefits under the new tax law (lower rates, as an example) but also lose certain benefits (lower itemized deduction thresholds, as an example). Your individual tax circumstance will dictate the amount of savings realized but generally we think a tax rate reduction of 3-5% may be the result (every little bit helps, however!).

The changes to the business tax rules are permanent and fairly comprehensive. The focus of business changes was to reduce tax rates for larger corporations and to make the U.S. a much more attractive place to conduct business, versus overseas. The expectations are that lower taxes will spur more wage growth, more business investment, providing more fiscal stimulus here in the U.S. Time will tell if the goal is achieved. If you want details on the business tax law changes, please contact our office.

River Capital Advisors News and Final Comments

2017 was a year of significant change here at RCA. We totally revised and updated our website (, to provide more educational and helpful financial information. If you know anyone that is in need of financial advice, please direct them to our website. Our website will also be the access point for both our financial planning and performance portals (see below for additional information on these topics). We continue to set up clients on our financial and life planning software portal. This software includes the ability to store a clients important financial documents as well as create spending plans and track expenses automatically with links to bank accounts and credit cards. This is a one stop shop to see everything about our clients financial life and whether they are on track to meet their goals.

We are also close to finalizing significant changes to our portfolio reporting. Starting with the first quarter performance reports, clients will receive an updated, refreshed report that we think provides improved information on the portfolio, along with graphics so that individuals can easily understand how their portfolio is on track to help them meet their financial goals. Most clients will receive their reports electronically, placed in a secure, dedicated portal that will provide additional data about their investments. The portal will provide up to date information on investments and will provide more details about how different asset classes and categories are performing compared to relevant benchmarks. This will also be available as a mobile app, for those that want access while on the go. Clients will be receiving additional information about the portal over the next few months as we complete our upgrade.

This major upgrade to our “back office”, in addition to the reporting and related portal changes, will allow the RCA team access to more portfolio information and allow us to better serve our clients. We also think that these changes improve transparency for clients as well, something that we strongly believe in and do not always see in the financial services industry. The major upgrade will also allow us to improve the experience of our client meetings. The end result of our investments in the firm will be to allow our clients more access to their finances, tracking the progress on their financial goals, more portfolio information and most importantly, help us with the financial planning needed to achieve a families financial goals.

We are humbled by the referrals we receive and the confidence expressed in us as our clients trusted financial fiduciary. We have the expertise and training to help them in all aspects of their financial life and the affiliation with the CPA firm of Smoak, Davis & Nixon LLP, one of Jacksonville’s oldest and largest regional firms, means that there is no area of our clients financial life that we can help with. Please contact us and let us know how we can help you and your family.

For our clients, we have also enclosed our annual Privacy Notice for your review.


Recent Posts

Leave a Comment