The Margin of Safety Quarterly Winter 2020

 In Client Bulletins, News

Fourth Quarter 2019

Key Takeaways

  • Among global equity markets, larger cap U.S. stocks were once again at the top of the leader board.
  • Foreign equity markets were also strong.
  • The core bond index was flat in the fourth quarter but gained 8.6% for the year.
  • Why did both stocks (risky assets) and bonds (defensive assets) appreciate sharply in 2019? The key driver was the Federal Reserve’s sharp U-turn toward accommodative monetary policy.
  • Ultimately, the Fed ended up cutting rates three times in the second half of 2019.
  • Meanwhile, inflation (and inflation expectations) remained at or below central bank targets.
  • U.S. equity investors responded to the Fed policy reversal and stimulus much as they have during the past 10 years – by bidding up stock prices and valuations.

Fourth Quarter 2019 Investment Commentary

Our portfolios generated strong returns for 2019, a bullish year for nearly all financial markets. The positive broad based returns marked a dramatic (and welcome) turnaround from 2018, a year in which nearly all asset classes faltered. This year’s surprising returns were fueled by a U-turn in monetary policy, as policymakers shifted gears to support a weakening global economy. After tightening financial conditions (raising short term rates) four times in 2018, the Federal Reserve reversed course and began implementing a more dovish monetary policy (lowering short-term rates three times). Other major central banks also cut rates or provided additional stimulus to the markets via quantitative easing during the year, lessening global recession fears.

The S&P 500 Index posted gains in every quarter and surged 9% in the fourth quarter to end the year at an all time high. Its 31% total return was its second best year since 1997 (it was up 32% in 2013). Smaller cap U.S. stocks rose 25.4% for the year.

Foreign markets were also strong. European stocks gained 9.9% in the fourth quarter and 24.9% for the year. After a weak third quarter, emerging-market (EM) stocks shot up nearly 12% in the fourth quarter and returned 20.8% for the year.

The 10 year Treasury yield dropped from 2.70% at the start of the year to as low as 1.45% in September, ending the year at 1.92%. The core bond index was up 8.6% for the year, its best annual return since 2002. Investment grade bonds gained nearly 9%. Credit markets also rallied amid this supportive monetary policy environment: high yield bonds earned 14.4% and the floating rate loan index rose 8.6%. Our international bond manager returned over 17% for the year. Lastly, our multi strategy alternatives position return 8.5% for the year.

A détente in the U.S. China trade war late in the year (the “phase one” deal) was an added boost to market sentiment. Importantly, earnings growth did not drive U.S. stocks higher; the majority of the S&P 500’s return came from expanding valuations. Thus, the valuation risk in U.S. stocks, which we’ve highlighted for some time now, has only gotten worse.

Given that, we think recent positive developments have largely been incorporated into prices and valuations are stretched for U.S. stocks and bonds, markets are particularly vulnerable to any disappointment or negative surprise. If that comes to pass, we stand ready to take advantage of any potential opportunities that come of that volatility.

Portfolio Positioning and Outlook

While we watch and weigh the ramifications of short term risks, it’s important to reiterate that we don’t invest based on 12 month market forecasts. The uncertainty is too high and the unknowns too many. More importantly and most relevant for our investment process is our outlook for the next several years, not months. In this respect, our assessment of the risks and opportunities remains consistent with what it’s been in recent years.

With U.S. stocks expensive and high risk, we continue to see better investment opportunities elsewhere: in foreign stocks, flexible bond funds, and alternative strategies which we think will produce returns in excess of bonds but with lower volatility than stocks.

Should the positive global growth outlook for 2020 play out, we’d expect foreign stocks to outperform U.S. stocks, given their higher cyclicality and sensitivity to overall GDP growth. Receding Brexit uncertainty should also help prop up European markets, in particular. Furthermore, to the extent the U.S. dollar weakens in this environment that will help foreign stock returns as well as our international bond position (for dollar-based investors). Along with US stocks, the US dollar appears expensive relative to other currencies. It is not possible to predict currency movements but we believe the US dollar does go in cycles and the length of the current cycle is such that it is prudent to have currency diversification in our client portfolios and we could get a positive tail wind if the dollar declines.

Our tactical exposures to flexible bond funds and alternative strategies run by skilled managers are particularly attractive in this environment given their ability to actively manage their portfolio risk exposures (e.g., dialing down risk when the reward is not commensurate) and take advantage of market inefficiencies and opportunities when they appear. Not only do these strategies provide valuable portfolio diversification, but we also expect them to deliver better medium term returns than a traditional mix of U.S. stocks and core investment grade bonds.

These tactical opportunities are relatively attractive, but none of them are without their own risks. There are few table pounding, valuation based fat pitches in the investment markets these days. Ten plus years of unprecedented central bank stimulus and interest rate repression have inflated the prices of most financial assets, if not the actual global economy.

Given this backdrop — weighing the shorter and medium term risks and return opportunities and considering the economic fundamentals versus financial market valuations — we think the wisest course for balanced investors continues to be a broadly diversified, moderately defensive posture.

A critical question for fundamental investors like us is always, “What’s in the price?” In this regard, we note that it wasn’t corporate profit growth that drove U.S. stocks higher in 2019. Reported earnings for the S&P 500 were actually flat over the first three quarters, and mid single digit percentage growth is projected for the fourth quarter. The lion’s share (roughly two-thirds) of the S&P 500’s 31% return came from a sharp expansion in valuations – in other words, what we saw as an expensive asset class has gotten more expensive.

We are not making any changes to our asset class weightings and continue to be patient, looking for an opportunity or even better, a “fat pitch”, to invest in assets that trade at an attractive price.

SECURE Act Becomes Law

Our Summer 2019 newsletter talked about the SECURE (Setting Every Community Up For Retirement Enhancement) tax legislation that was pending at that time. Much of what was in the legislation became tax law late in 2019. The $1.4 trillion spending package was enacted on December 20, 2019 and represents the most sweeping set of changes to retirement legislation in more than a decade.

While there are provisions that offer enhanced opportunities for individuals and small business owners, there is one notable drawback for investors with significant assets in traditional IRAs and retirement plans. These individuals will likely want to revisit their estate planning strategies to prevent their heirs from potentially facing unexpectedly high tax bills.

Below are our preliminary thoughts on the recently passed law. The provisions discussed take effect on or after January 1, 2020, unless otherwise noted. Unfortunately, as of the date of this newsletter, we do not yet have IRS regulations or other guidance, which will be forthcoming as the year progresses. The comments below are not meant to be a full and complete discussion of the new law – the goal is to provide a general summary and you should contact our office to discuss the impact on your specific financial and tax situation.

Elimination of the “stretch IRA”

Perhaps the change requiring the most urgent attention is the elimination of longstanding provisions allowing non-spouse beneficiaries who inherit traditional IRA and retirement plan assets to spread distributions — and therefore the tax obligations associated with them — over their lifetimes. This ability to spread out taxable distributions after the death of an IRA owner or retirement plan participant was often referred to as the “stretch IRA” rule. The new law, however, generally requires any beneficiary who is more than 10 years younger than the account owner to liquidate the account within 10 years of the account owner’s death unless the beneficiary is a spouse, a disabled or chronically ill individual, or a minor child. This shorter maximum distribution period could result in unanticipated tax bills for beneficiaries who stand to inherit high value traditional IRAs.

This is also true for IRA trust beneficiaries, which may affect estate plans that intended to use trusts to manage inherited IRA assets. If you have a trust as a beneficiary for your IRA we strongly suggest that you go back to your estate planning attorney and discuss with them how the new law will affect your beneficiaries. One of the biggest issues is that there are no RMDs now with inherited IRAs and so the language of your trust may mean that income would not be distributed annually to the beneficiary and the only distribution would be in year 10. If you think about a $1,000,000 IRA this could significantly affect the heirs tax picture vs. taking one tenth of the IRA out each year. The language of your trust may need to be amended to take this into consideration.

You should also consider making changes to your beneficiaries to take advantage of the remaining stretch provisions, in certain situations. For those with disabled children or where a spouse is not the primary beneficiary you could consider making them such. Your estate plan can also be revised for any remaining heirs, using other assets such as taxable accounts, real estate, or Roth accounts.

In addition to possibly reevaluating beneficiary choices, traditional IRA owners may want to revisit how IRA dollars fit into their overall estate planning strategy. For example, it may make sense to consider the possible implications of converting traditional IRA funds to Roth IRAs, which can be inherited income tax free. Although Roth IRA conversions are taxable events, investors who spread out a series of conversions over the next several years may benefit from the lower income tax rates that are set to expire in 2026. Tax bracket management was important under prior law, as we worked with clients to take money out of an IRA at currently attractive tax rates and trying to stay within certain tax brackets. This strategy may be even more important than before given the expiration date of current tax law as noted.

Another potential strategy that is more important under the new law is using IRAs for charitable giving for individuals age 70 ½ or older. You can give up to $100,000 a year from your IRA tax free. If you are currently giving from other sources then switching your giving to your IRA could make sense. This is especially true with standard deduction amounts having risen over the past few years to $12,000 for an individual and $24,000 for a married couple which makes it harder for many to itemize.

Also, the above strategy related to Roth conversions can be combined with the setup of a Donor Advised Fund for those with charitable intent. This can shelter some of the tax impact from the conversion process. We have the ability to setup Donor Advised Funds on your behalf with Schwab. Donor Advised Funds give you the ability to take multiple years of future donations and accelerate those to one year without giving your money outright to the underlying charity and worrying that they will spend it all in one year.

For younger clients that are deciding between Roth or traditional IRA contributions, there is under the new law an added benefit of choosing a Roth. This will minimize tax in later years if heirs receive the Roth.

Benefits To Individuals

On the plus side, the SECURE Act includes several provisions designed to benefit American workers and retirees.

People who choose to work beyond traditional retirement age will be able to contribute to traditional IRAs beyond age 70½. Previous laws prevented such contributions. There must be earned income in order to make an IRA contribution.

  • Retirees will no longer have to take required minimum distributions (RMDs) from traditional IRAs and retirement plans by April 1 following the year in which they turn 70½. The new law generally requires RMDs to begin by April 1 following the year in which they turn age 72.
  • Part-time workers age 21 and older who log at least 500 hours in three consecutive years generally must be allowed to participate in company retirement plans offering a qualified cash or deferred arrangement. The previous requirement was 1,000 hours and one year of service (the new rule applies to plan years beginning on or after January 1, 2021).
  • Workers will begin to receive annual statements from their employers estimating how much their retirement plan assets are worth, expressed as monthly income received over a lifetime. This should help workers better gauge progress toward meeting their retirement-income goals.
  • New laws make it easier for employers to offer lifetime income annuities within retirement plans. Such products can help workers plan for a predictable stream of income in retirement. In addition, lifetime income investments or annuities held within a plan that discontinues such investments can be directly transferred to another retirement plan, avoiding potential surrender charges and fees that may otherwise apply. Annuities are complicated and generally expensive products, which require appropriate analysis. We do this for our clients and we do have access to lower cost, no commission annuity products for our clients. We expect this provision to be subject to increased marketing efforts by high cost annuity companies.
  • Individuals can now take penalty-free early withdrawals of up to $5,000 from their qualified plans and IRAs due to the birth or adoption of a child (Regular income taxes will still apply, so new parents may want to proceed with caution).
  • Taxpayers with high medical bills may be able to deduct unreimbursed expenses that exceed 7.5% (in 2019 and 2020) of their adjusted gross income. In addition, individuals may withdraw money from their qualified retirement plans and IRAs penalty free to cover expenses that exceed this threshold (although regular income taxes will apply). The threshold returns to 10% in 2021.
  • 529 account assets can now be used to pay for student loan repayments ($10,000 lifetime maximum) and costs associated with registered apprenticeships.

Benefits To Employers

The SECURE Act also provides assistance to employers striving to provide quality retirement savings opportunities to their workers. Among the changes are the following:

  • The tax credit that small businesses can take for starting a new retirement plan has increased. The new rule allows employers to take a credit equal to the greater of (1) $500 or (2) the lesser of (a) $250 times the number of non-highly compensated eligible employees or (b) $5,000. The credit applies for up to three years. The previous maximum credit amount allowed was 50% of startup costs up to a maximum of $1,000 (i.e., a maximum credit of $500).
  • A new tax credit of up to $500 is available for employers that launch a SIMPLE IRA or 401(k) plan with automatic enrollment. The credit applies for three years.
  • With regards to the new mandate to permit certain part timers to participate in retirement plans, employers may exclude such employees for nondiscrimination testing purposes.
  • Employers now have easier access to join multiple employer plans (MEPs) regardless of industry, geographic location, or affiliation. “Open MEPs,” as they have become known, offer economies of scale, allowing small employers access to the types of pricing models and other benefits typically reserved for large organizations (previously, groups of small businesses had to be affiliated somehow in order to join an MEP). The legislation also provides that the failure of one employer in an MEP to meet plan requirements will not cause others to fail, and that plan assets in the failed plan will be transferred to another (this rule is effective for plan years beginning on or after January 1, 2021). We expect that this will allow for many smaller businesses to start offering 401(k) plans in the future.
  • Auto enrollment safe harbor plans may automatically increase participant contributions until they reach 15% of salary. The previous ceiling was 10%.

We will share additional thoughts about the SECURE Act and related planning opportunities in future newsletters.

River Capital News

Tax season has begun for 2019 returns and the SECURE Act adds to the 2017 tax law changes, making taxes and tax planning even more important for our clients. The combination of Smoak, Davis & Nixon LLP, the firms affiliated CPA firm, and RCA makes us unique in the financial services industry – a single firm, of practicing CPAs and CFP practitioners – that can help individuals in all areas of their financial life. We have access to and use low cost and no commission products for our clients, when appropriate. We are financial fiduciaries and are fee only – our only source of income comes from the services that we provide to our clients. Lastly, throughout the firm (including the CPA firm), we invest our own capital and in some instances, those of family members, in the same investments as our clients. There are not many financial services firms that can make these claims.

The start of 2020 has also brought a number of important changes to the firm. First, Rob Simon, CFP®, who has been with the firm for over nine years and has played an important role in the firms growth, was promoted to partner January 1, 2020. Rob has also been instrumental in our technology and client service improvements since he joined River Capital Advisors. We are honored to have Rob as a partner.

Anh Nguyen, who has interned with the firm for the last two years, will join us full time in May. Anh will graduate from the University of North Florida in the spring, with a double major in finance and financial planning and a minor in economics. Anh is bilingual as well. Anh will take on client service responsibilities and will also pursue obtaining her certified financial planning designation. The firm has enjoyed working with a number of excellent interns over its history and Anh will be the second (Bradley Miller, CFP® being the first) intern to join the firm full time.

We appreciate the increasing referrals that we are getting from clients and friends of the firm. As we have said before, referrals are our main source of new clients and it is an honor when existing clients, friends of the firm and our network of trusted professionals thinks of RCA when talking to someone about how to get help with their financial life.

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

Recent Posts

Leave a Comment