Smaller Tax Refund? Big Deal!

The mainstream media is abuzz about the smaller tax refunds being sent out by the IRS this tax season. The New York Times says, “Smaller tax refunds surprise those expecting more relief”, CBS News says, “Americans shocked by impact of new tax law”, while Fox News says, “Smaller tax refunds are a good thing”. Each media outlet has their own spin depending on their agenda, but the real issue is the lack of financial literacy and planning to avoid surprises that could have easily been avoided.

The new tax laws effective for 2018 were well communicated if anyone took the time and energy to understand them; certainly the tax and planning industry was well-versed in the impacts. The elimination of tax deductions due to the $10k limit on state and local taxes (SALT) and the limit on the interest deduction on high value mortgages became a new tax burden for residents in high tax and high property value states. The almost doubling of the standard deduction was intended to lessen that burden, but some high income earners with large SALT and mortgage interest were sure to see an increase. So, taking the lowered payroll withholdings due to the lowered tax brackets was a flawed assumption if you ignored the loss of those large deductions in your tax planning.

Alternatively, if you were NOT a high income earner, your total Fed taxes likely went DOWN, but you simply got a smaller tax refund because you took a portion of your end-of-year refund in smaller bits during the year due to the lower withholding amounts. Effective planning could have easily avoided this “surprise”. Moreover, consistent with the Fox News article, a Treasury spokesperson said in a statement, “Smaller refunds mean that people are withholding appropriately based on their tax liability, which is positive news for taxpayers.” Unfortunately, this seems to have happened to some taxpayers due to inaction and ignorance instead of through conscious planning.

Keeping more of your money during the year with an effective saving and investing strategy makes much more sense than giving the government an interest-free loan during the year. Hopefully, this kind of event will cause a more focused interest in financial education and planning.

"V" gets a Vote of Confidence!

“Buy the Dip” appears to be alive and well! After the abysmal October leading into the horrid December, things have recovered quite nicely! From the recent plateau on December 3, 2018, the S&P 500 (per the ETF, SPY) is only 0.77% off that level per the above chart. Not a pure “V”, but pretty close!

Though the mainstream media does a good job pitching its dire Koolaid to drive ratings and eyeballs, the doomsayers have not been too accurate thus far. On these pages, I have commented on weaknesses in the predictive ability of a yield curve inversion to forecast a recession, identified underlying strength through the important PMI (Purchasing Mangers Index) levels, talked about positive technical factors such as seasonal rebalancing into equities after the large Q4 and December drawdowns to get back to equity targets, and highlighted some well-thought out (and positively-leaning) forecasts from Northern Trust Asset Management and my prior firm, Sun Life Financial.

It is a very rare situation, indeed, where it would be prudent to rebalance away from a strategic allocation to “risk” assets. The situation through December indicated a reasonable case to be cautious, but not fearful, while waiting for some key economic statistics to show their hand. Happily, hanging onto your hat and weathering the storm appears to have paid off this time - for now.

Tactical Manager Update: GMOM

Last month I reported that Cambria Investment Management, a popular tactical investment strategist, put out an update titled “Red Light” indicating their cautious market stance. They put their money where their mouth was and positioned their tactical ETF, ticker: GMOM, into mostly bonds and precious metals. So, how have they done so far this year?

Based on results from Morningstar year-to-date through yesterday, Feb 7, they are up +1.89% compared to the S&P 500 of +8.09% and the Morningstar Moderate Target Risk of +5.48% and the World Allocation of +5.40%.

Since this is an ETF, we can track their actual holdings every day. As of yesterday, they have kept a 7% allocation to precious metals, but shifted to a 30% equity weighting mostly in emerging markets, global utilities/healthcare and real estate. So, still cautious, but holding some risk assets in a barbell manner with both risky and traditionally defensive sectors.

The Patriots and Investing

Very good article on Seeking Alpha relating to the New England Patriots and investing. Refences to long term value, not overpaying for talent, and looking for “alpha” in young talent. See link for a good read:

https://seekingalpha.com/article/4238165-patriots-investing?ifp=1

The Verdict is In on Stable Value Funds...

The past three years have been very good for the Vanguard Stable Value option in 401-k plans compared to core bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index.

Check out the chart from Vanguard’s website - A much less bumpy ride over the past three years to end in about the same place!

PMI Jumped in January!

It is hard to overlook a dramatic increase in one of our most important economic statistics, the ISM Purchasing Managers Index (PMI). Observers were warning to be cautious when the December value came in at a weaker growth level of 54.3, down from the 58.5 level of November. Values over 50 indicate growth and under 50 indicate contraction. So, it was surprising when January came in at a level of 56.6, improving to close in on the November level! The current level of 56.6 is still below its 12-month average of 58.5, but the upward trend is a positive result.

Most interestingly, this growth in the PMI can be correlated to a 4% real GDP growth, so underlying strength in the economy seems robust if it can be maintained. Some observers are calling this the “Goldilocks” economy, harkening back to a time when stable interest rates, low inflation, strong job growth, strong dollar, and strong earning growth all coexist without any observed stresses. We shall see.

How Good was January?

The mainstream press is agog over the capital market performance in January 2019. “The best January since 1987”, “Best Month in three years”, and “Best Monthly Performance in Decades” are plastered all over as headlines. Yes, the markets had a great month with all major indexes making big moves upward, but lets take the performance within the proper context.

As we all know, December was very weak! Though there were many factors flashing a warning sign, but nothing in the tactical tool box indicated despair and anything resembling a prolonged massive selloff. I believe it was fair to be cautious, but no reason to be risk off. So, it is quite logical to recover from an “oversold” position with a strong move in the opposite direction. Also, I have been a fan of supply and demand aspects occurring in January where most institutions and client accounts get rebalanced to their long term strategic targets; and given the October and December equity drawdowns, it certainly made sense that equities would see a “buy” sign to get back on side.

The Dow Jones Aggressive U.S. Portfolio Index, a 100% equity index including large, medium, and small cap stocks was up +10.20% in January recovering from a -9.97% December; not quite a full recovery, but close. We will see if the market has enough confidence in the new dovish Fed stance and potential for easing of China trade tensions to recover from the October drawdown to approach new highs.

Bond Ladder? Yes or No? When?

There has been a lot written about bond ladders over the recent past. Unfortunately, lots of what has been written is misinformation.

The idea of a bond ladder is to buy bonds with different maturity dates in sequence; i.e., 1-year, 2-year, 3-year, etc. so that they mature at scheduled dates at their full par value. You get all the interest and the full principal back at par value. The thought is that in this way you will never lose money in bonds if rate rise (since that is when bonds decline in value).

The problem arises when you compare a bond ladder to a traditional bond fund or ETF. The comparison usually starts with the naïve view that the bond ladder didn't lose money and outperformed the bond fund/ETF over a certain rising rate environment. However, that comparison only makes sense if the maturing pieces of the bond ladder were taken out of the ladder and spent on something like an expense. In essence, you were shortening the duration of your bond investment and of course that would outperform a bond fund with a longer duration. If the bond ladder were instead reinvested in a manner similar to an equivalent bond fund at inception maintaining its target duration, the results would be exactly the same.

The only times that a bond ladder makes sense is when the interest cash flows and maturing pieces are to be used to fund some liability or expense, immunizing the liability or expense cash flows. In that case a bond fund/ETF would be inferior since you would be taking on interest rate risk when you instead needed to shorten the duration of your assets to match the duration of your liabilities/expenses.

If you could "market time"...

Morningstar Advisor magazine, a publication from Morningstar tailored to the advisor population, consistently produces high quality commentary and analysis on investment topics. One of my favorite articles was published way back in 2013 relating to market timing; I.e., the ability to be in the right asset class at the right time to pick off every inflection point in market volatility.

In the article titled, “The Existence of Market-Timing ‘Intelligence’”, they quoted a study showing what could be gained if an investor had perfect foresight. In other words, what is the best someone could do if they called every market rally and dip. The article states that from 1926 to 2011, if an investor correctly chose the right bond or stock mix each month the total return would have been 31.9% annualized; a value much higher than the long term stock-only portfolio of about 10%.

The difficulty remains, however, to be able to find the manager “ahead of time” who has the ability (or luck) to be successful in this endeavor.

Tactical Managers Trending to Defensive Bias

I make it a point to follow all competing views in the tactical manager space to gather a balance insight and view on the capital markets. I don't take scientific polls, but I certainly have seen a shift to “defensive” positioning in that space.

One popular tactical manager, Cambria Investment Management, sent a note around yesterday titled, “Red Light?” They make the point that they don't know if the market is going up or down, but their signals are indicating a defensive posture. They have put their money where their mouth is, too. The current positioning of their tactical ETF (GMOM) is invested almost entirely in bond funds and precious metals, as opposed to equities (http://www.cambriafunds.com/gmom-holdings). YTD their total return of +0.58% compared to the Morningstar Moderate Target Risk of +2.29% and the S&P 500 of +3.10%. Yesterday, when the S&P 500 was down -0.51%, the GMOM ETF was up +0.02%. Curious to see how this works out? I will check back and post an update in a month! Follow me to see.

Single-Stock and Single-Sector Risk

A couple of weeks ago, I wrote about how the S&P 500 index is the “sum of its parts” and made up of different industry sectors. I specifically referenced the Utilities sector as a traditionally “defensive” sector that is used by one tactical manager to give signals for strength or weakness in the markets.

Well, news today makes it hard to call the Utilities sector “defensive”! Pacific Gas & Electric (PCG) today indicated that it plans to file for bankruptcy due to potential liability for the fires in California. No telling where this may end for PCG at this early stage, but this simply highlights the trouble with single-stock and single-sector risk. PCG stock was down -50% during today and the Utilities sector ETF (XLU) was down -2.2%. Though this did not come out of nowhere, it is a shock to the system and a more broadly diversified portfolio would help insulate against this occurrence materially impacting your portfolio performance.

Lies, Darn Lies, and Statistics!

You have all probably heard this title’s saying before; statistics can be misleading if not thought through carefully.

While updating some client materials, I noticed an interesting anomaly relating to S&P 500 returns. The phenomenon of “time period bias” has reared its ugly head!

For the 10 years ended December 2018, the S&P looks like a great winner with 13.01% average annual returns (even including the large drawdown in Q4); much higher than its longer term historical trend of about 10%. This compares to the 10-year period ended in 2017 that showed only 8.45% average annual returns. This large discrepancy in returns is due to the difference in the starting points surrounding the Credit Crisis in 2008-09. The 10-year returns for 2018 starts with a much lower base (December 2008) compared to the starting point for the 10 years ended 2017 (December 2007).

This might qualify more as trivia instead of significant investment info; but, it is important to be aware that the 10-years ended 2018 is an anomaly that significantly deviates from longer term historical returns. For anyone running investment projections, it is best to either use more realistic projections or a longer time horizon.

Market Outlook from Northern Trust Asset Mgmt

This is the time of year when all the investment houses promote their market outlooks for the coming year. I don’t usually listen for whether the market is going to be up or down, but what underlying factors could cause concern or opportunity.

I listened to a webinar from Northern Trust Asset Management today. They are taking a “neutral” risk stance since they would rather protect the downside instead of missing a large upside. Their key rationales for this positioning focus on the uncertainty of increased Fed tightening and potential for disruptions in global trade due to U.S./China trade negotiations.

For their “target” long term strategic portfolio, they have minor tweaks in risk and risk-control assets: they underweight cash, TIPS, and EM equity and overweight high yield and U.S. investment grade debt. They are “at target” for U.S. and Developed ex-U.S. equities.

Happy to send along the pitch book for this webinar if interested; just let me know

It's Not Easy Being Green!

The difficulty of active managers to outperform passive investments has been well-documented over the past several years. Those studies usually look at stock-pickers and not so much at tactical asset allocators. But now, looking at last year’s data from Morningstar, we can see how difficult it is for that class of investment manager.

According to Morningstar, out of the 269 Tactical Allocation funds in that Category, ONLY 2 funds had positive returns in 2018 (were green!). Of course, the S&P 500 was down -4.5% total return in 2018, so being negative isn't necessarily a bad thing. Even then, I only counted 19 funds that beat the S&P!

Tactical allocation managers usually use a combination of short term technical and fundamental methods to guide their fund positioning, such as quant methods, momentum, rich/cheap relative value, etc. This is in contrast to long-term strategic managers that takes into account longer term asset class relationships. But, long term buy-and-hold had a tough year in 2018, too; the iShares Moderate Allocation ETF (AOM) was down -4.0% in 2018. The active versus passive debate continues!

See this link for a complete list of all the funds in that Category: news.morningstar.com/fund-category-returns/tactical-allocation/$FOCA$TV.aspx

Lots of Reason to Rally...

Glad that Chairman Powell adopted the “data dependent” language that only makes perfect sense. Softening PMI shows there is some weakness in a still growing economy; less reason to tighten. Technical factors could be playing out for rally, too. Like most other investment advisers, I’m busy rebalancing accounts INTO equities (after large Q4 drawdown) to get back to targets; supply/demand technical forces at work.

Negative factors like Apple weakness could be unique to them. Selling highest priced products on the planet that were previously affordable luxury goods. At $1,000+ for a cell phone, only the diehards bought in early; no one else to grow that market. Other tech products by other manufacturers selling at discounts and rebates. Look for more of this from Apple (if they want to grow top line and market share). The stock market can go up without Apple; in 2013 AAPL was up 8% while the S&P was up 32%!

I’m happy to be bearish when it calls for that view, but not yet.

1- and 2-Year Yield Curve Inversion. Should we Worry?

Changes in the yield curve have been in the news when an “inversion” occurs; when shorter term bonds have yields higher than longer term bonds. Without getting into the math, yield curve inversions tend to precede recessions since Fed tightening at the short end (higher rates) reduces demand for credit thus causing lower rates at the longer end.

Another perspective on yield curve inversions has to do with forward rate math; the idea that a string of interest rates indicates what rates in the future will be. Without getting into the math, forward rates are not very predictive, except over very, very short time horizons. Though I respect the bond managers at PIMCO, I think they have it wrong here during this Bloomberg interview; they might be right, but I would not bet on it!

https://www.bloomberg.com/news/articles/2019-01-02/key-fed-yield-gauge-points-to-rate-cuts-for-first-time-since-08

Purchasing Manager's Index ("PMI") could move market

Investors looking for signs that the market volatility is preceding a weakening economy will be looking at the PMI statistic scheduled to be released on January 3.

The PMI has been strong throughout this bull market having been growing (over "50” index level) for 115 straight months. The November level of 59.5 was an increase from the 57.7 level in October.

Rebalancing needs could cause blip in demand for Equities

Given the weak Q4 equity performance, investors in balanced portfolios will find themselves underweighted in equities when they check their year-end balances. One factor that could push equities higher in the short term is the re-allocation of cash and bonds into equities to get back “onside.”

Just one of many factors that impact the market, though.

Thoughts for a New Year

Markets will be volatile, but we expect to be compensated for bearing the volatility. As long as we are comfortable with our risk profile and have a long enough time horizon, negative returns will recover (or, at least they always have!!). Accounts with more risk, over time, will out-return less risky accounts.

The book “The Rational Optimist”, by Matt Ridley, goes into great detail explaining how society has historically always figured out how to get past adversity. It is a good read if you are looking for some positive reinforcement in the New Year.