OPUS FINANCIAL SOLUTIONS LLC | OPUS OPINIONS : 2018 JULY
Bull Market Long in the Tooth? Why that’s the Wrong Question.
A MESSAGE FROM LISA BAYER, CFA, CFP
There’s a saying in our industry, “Sell in May and Go Away” which relates to the historically lower seasonal returns between Memorial Day and Labor Day. Interestingly, the phrase originated from an English saying, “Sell in May and go away, and come on back on St. Leger’s Day.” It referred to the market impact of reduced business activity among bankers and merchants who would leave London during the hot summer months, returning for the St. Leger’s stakes, the final leg of the British Triple Crown horse race in September. While these patterns may have at one time existed, it no longer seems to routinely be the case, but the important point of this story is that’s not the point at all.
If you’re like most of our clients, your investing horizon is not just one year, where one might be focused on seasonal trends or short-term tactical opportunities based on geopolitical developments, short term economic reports, or quarterly earnings announcements. But if your time horizon is a 10-30-year time frame, your portfolio lens and investment approach should be different. In that case, it makes more sense to focus on trends that evolve over time, such as demographic tailwinds in developing economies or technological developments that will impact future production, consumption and productivity.
Now, if your investment horizon is more in the 1-10-year range, you might put more focus on business cycle stages and, for example, whether the record bull market we’ve
observed still has legs. As we’ll discuss in our market update, economic expansion is slowing and global economic growth could be stymied by monetary tightening, rising interest rates, and less-than-constructive emerging trade barriers. In this environment, a sector oriented focus might be in order since corporate sectors perform differently during different phases of economic cycles. For example, in an early economic recovery, one might overweight real estate or consumer discretionary sectors, whereas later in the business cycle—or in a recession—one might increase allocations in higher quality companies with strong balance sheets, consumer staples, utilities, and investment-grade bonds. While we don’t advocate market timing, we do believe in the value of customizing our clients’ portfolio allocations based on their unique goals, financial considerations and investment time horizons.
IN THIS ISSUE
Investment Perspectives:
• Bull Market Long in the Tooth? Why that’s the
wrong question
• Quarterly Market Update
• The Upside of Downside Protection
• Perspectives from David Booth: E+R=O. A Formula
for Success
Tax Perspectives:
• Can “Married, Filing Separately” Save you taxes?
Personal Perspectives:
• Helping your Children get Smart about Money (Plus
Bonus Videos from Ben and his kiddos)
OPUS FINANCIAL SOLUTIONS LLC | OPUS OPINIONS : 2018 JUL
For the second quarter--looking at broad market indices--the US posted positive returns, outperforming non-US developed and developing markets. This was a reversal from 2017, when US equities underperformed non-US equities across the board. Amid US tax cuts, fiscal stimulus and tightening by the Federal Reserve, almost all currencies depreciated against the US dollar, accentuating lower effective non-US returns. With the sharp rise in oil prices, energy related holdings led 2Q performance, followed by consumer discretionary stocks and small company stocks overall. Digging a little deeper, however, besides FAANG-like stocks (i.e. Facebook, Amazon, Apple, Netflix, Google), the overall US market struggled, with multiple US indexes, including the Dow Jones Industrial Average, falling during the quarter. As interest rates increased somewhat during this period, bond returns were more limited, yet positive nonetheless. The chart below breaks down the most recent quarter’s performance along with historical quarterly index performance since 2001.
Market Summary – Index Returns: Q2 2018 STOCKS BONDS
While we are observing a continued global expansion, the pace of this expansion has slowed, and many developed economies, including the US, are showing signs of maturing. The corporate tax cuts enacted in 2018 have contributed to solid corporate profits, though the combination of tighter labor markets and recent trade restrictions pose real inflationary and political risks. If
the tariffs and trade tensions escalate, we would anticipate reduced profit margins and capital investments in the future, particularly among industries and companies most dependent on global trade. Meanwhile, we are watching closely developments relating to the looming March 2019 Brexit deadline and an eroding European coalition. All of this is to say that the combination of monetary tightening, deteriorating geopolitical policy trends, and slowing “synchronized” global growth is likely to produce more volatility ahead and warrants growing caution for those who are investing with a shorter than average time horizon. (See next article, The Upside of Downside Protection).
THE UPSIDE OF DOWNSIDE PROTECTION: A
REVIEW OF ACADEMIC RESEARCH
Author: Lisa Bayer, CFA, CFP
This article explores the mathematical constructs that support the value of risk managed investing and downside protection as one approach to earning higher long-term returns than market indices themselves. To read the original White Paper from Jerry Miccolis and an updated summary, visit the links at the end of this article. Since the most recent financial crisis of 2008-2009, investors have sought solutions to protect their portfolios or limit their volatility given that market corrections are frequent and unpredictable. Unfortunately, some of the very asset classes that historically helped buffer these drawdowns are no longer able to provide that historical level of protection. Meanwhile, there are a great number of “indexers” who believe the optimal investment strategy should be to simply combine low-fee stock and bond indices in combinations that reflect their growing intolerance for risk as they approach retirement. While this may have worked to a limited extent in the past, the multi-decade decline in interest rates has made it mathematically improbable for traditional bonds to achieve the level of returns or risk reduction they provided in the past. And the search for fixed income “yield” has led investors to take on increasing credit risk in their fixed income portfolios, thereby increasing the correlation of their equity and fixed income securities and reducing the diversification “protection” that bonds provided during corrections.
OPUS FINANCIAL SOLUTIONS LLC | OPUS OPINIONS : 2018 JUL
While there are multiple approaches to addressing the desire for downside protection beyond simple fixed income/equity combinations, let’s first review some historical market data of the S&P 500 for a 77-year period prior to the first publication of this research. Then we will look at the conceptual pros and cons of incorporating downside protection into a portfolio. If we look at historical returns, equity markets have experienced repeated periods of declines and recoveries, with a “correction” of more than 10% occurring roughly every 2.7 years, and an average decline of 21%.
Return Asymmetry It is a known but underappreciated realty that positive and negative returns are not symmetrical. This is to say that every 1% decline in a portfolio’s value requires a greater than 1% recovery to get back to zero. As such, reducing one’s losses in a portfolio is equivalent to capturing gains of a larger magnitude. An example of this concept is demonstrated in the table below.
If we were to successfully implement a strategy that provided 50% downside protection against a -10% threshold, the ending portfolio value over a full average market cycle would have increased the long-term return of the portfolio by 3% annually. If you would like to review the math behind how to compute the allowable cost for this protection, you can jump to the links at the end of this article, but it essentially concludes that it is worthwhile to implement if the cost of this protection
doesn’t exceed 4.1% annually over one full market cycle. And over numerous market cycles, the benefit of incorporating a defensive posture in a portfolio focused on downside protection can be substantial. The chart below generalizes the analysis to incorporate higher and lower levels of downside protection and the tolerable costs of incorporating it into your portfolio. Note that certain “outlier” statistics were excluded from this generalized analysis.
How Do We Do This? The number of strategies available to incorporate downside protection and “volatility dampening” is immense and not the core focus of this review, though they tend to fall into the following general categories:
• Low or minimum volatility securities or mutual funds that attempt to reduce volatility through the exclusion of higher risk sectors or securities.
• Market neutral, long/short strategies
• Hedging “tail risk” with derivatives such as put options, put spreads, put collars.
• Traditional strategies employing diversification with low-correlated asset classes
• Adding long “volatility” securities such as volatility (ex: VIX) futures or variance swaps.
• Momentum strategies that incorporate sector rotation through market cycles
• Various combinations of the above No hedging or risk mitigation strategy is perfect in isolation, so it makes sense in some cases to incorporate multiple approaches which in and of themselves can be good diversifiers to each other. Beyond the measurable benefits of downside protection, there are also advantages to simply reducing the volatility of a portfolio, as “risk drag” can erode multi-period compound returns. An example of this concept can be framed by the question: What’s better: a stable 8% return or a volatile 9%? The answer depends on how volatile the 9% is. In the exhibit below, you can see that
OPUS FINANCIAL SOLUTIONS LLC | OPUS OPINIONS : 2018 JUL
the more volatile 9% return portfolio provided a lower ending wealth than the stable 8% return portfolio.
One way to help counteract some of the impact of risk drag is through constructing a well-diversified portfolio that is rebalanced regularly. Of course, the anticipated timing of an investor’s withdrawal from a portfolio should help define the risk mitigation techniques employed, as portfolio withdrawals after a significant market correction can have long lasting effects on the portfolio’s sustainability. To read the White Paper, “Is it Worth It? Quantifying the Value of Risk-Managed Investing, visit: The Value of Risk Managed Investing (Jerry Miccolis). For an updated summary of this research, “Quantifying the Value of Downside Protection”, visit the Financial Planning Association Website at: https://www.onefpa.org/journal/Pages/JAN16-50-Quantifying-the-Value-of-Downside-Protection.aspx.
E + R = O: A FORMULA FOR SUCCESS (REPRINT OF ARTICLE BY DAVID BOOTH, FOUNDER/
EXEC. CHAIRMAN, DIMENSIONAL FUND ADVISORS)
“The important thing about an investment philosophy
is that you have one you can stick with.”
Investing is a long-term endeavor. Indeed, people will spend decades pursuing their financial goals. But being an investor can be complicated, challenging, frustrating, and sometimes frightening. This is exactly why, as David Booth says, it is important to have an investment
philosophy you can stick with, one that can help you stay the course. This simple idea highlights an important question: How can investors maintain discipline through bull markets, bear markets, political strife, economic instability, or whatever crisis du jour threatens progress towards their investment goals? Over their lifetimes, investors face many decisions, prompted by events that are both within and outside their control. Without an enduring philosophy to inform their choices, they can potentially suffer unnecessary anxiety, leading to poor decisions and outcomes that are damaging to their long-term financial well-being. When they don’t get the results they want, many investors blame things outside their control. They might point the finger at the government, central banks, markets, or the economy. Unfortunately, the majority will not do the things that might be more beneficial—evaluating and reflecting on their own responses to events and taking responsibility for their decisions. Some people suggest that among the characteristics that separate highly successful people from the rest of us is a focus on influencing outcomes by controlling one’s reactions to events, rather than the events themselves. This relationship can be described in the following
formula: E + R = O (Event + Response = Outcome). Simply put, this means an outcome—either positive or negative—is the result of how you respond to an event, not just the result of the event itself. Of course, events are important and influence outcomes, but not exclusively. If this were the case, everyone would have the same outcome regardless of their response. Think about this concept in a hypothetical investment context. Say a major political surprise, such as Brexit, causes a market to fall (event). In a panicked response, potentially fueled by gloomy media speculation of the resulting uncertainty, an investor sells some or all of his or her investment (response). Lacking a long-term perspective and reacting to the short-term news, our investor misses out on the subsequent market recovery and suffers anxiety about when, or if, to get back in, leading to suboptimal investment returns (outcome). To see the same hypothetical example from a different perspective, a surprise event causes markets to fall
suddenly (e). Based on his or her understanding of the long-term nature of returns and the short-term nature of volatility spikes around news events, an investor can control his or her emotions (r) and maintain investment discipline, leading to a higher chance of a successful long-term outcome (o).
TAX PERSPECTIVES
CAN “MARRIED, FILING SEPARATELY” HELP
YOU SAVE ON TAXES?
Author: Matthew Kunst, CFA, CFP, CPA
If you’re married and a pass-through business owner or have high medical expenses, you may be able to reduce your income taxes by changing your tax filing status. You also might want to change your tax filing status if you don’t want to be responsible for your spouse’s income taxes. Married taxpayers have the option of filing their income tax returns using either the status of “married, filing jointly” (MFJ) or “married, filing separately” (MFS). Using MFJ, one tax return is filed which combines the income and deductions of both spouses. MFS couples file two tax returns with each spouse claiming only their own income and deductions on their own return. Most married couples file with the MFJ tax status. The MFS tax status is seldom used, with only about 2% of returns claiming the status. A primary reason for the infrequent usage is that you will generally pay more combined tax on separate returns than you would on a joint return. This is the result of the special rules that the tax code imposes on MFS taxpayers. For example, if you use the MFS filing status:
• Your tax rate is generally higher than on a joint return
• You can’t take a number of credis, and other credits and deductions are reduced at income levels half that of a joint return
• If your spouse itemizes deductions, you can't claim the standard deduction.
• So why do taxpayers ever claim the MFS tax status? Under limited circumstances, the MFS
option could be a good choice. One reason would be to obtain a 20% pass-through deduction. The Tax Cuts and Jobs Act provides a 20% deduction to owners of pass-through businesses such as S-corporations and sole proprietorships. But limits are imposed above $157,500 of taxable income for single and MFS filers and $315,000 for MFJ filers.
How may this make it beneficial to file MFS? Suppose that one spouse earns $150,000 as a pass-through business owner and the other earns $300,000 of wages. The couple would be above the $315,000 MFJ limit. However, if filing MFS, the pass-through business owner spouse would be below the $157,500 limit and could claim the 20% deduction. The deduction would reduce taxable income by $30,000 and save the pass-through business owner thousands in taxes. Other reasons taxpayers might file MFS would be to sever liability, reduce a threshold, and lower state taxes. By signing a joint return, each spouse is liable for the other’s tax wrongdoing. Filing MFS limits liability for the other spouse’s taxes. If one spouse has expenses that are deductible only above a certain threshold, filing separately may also lower the couple’s taxes. For example, the threshold for deducting medical expenses is 7.5% of adjusted gross income. If one spouse has high medical expenses, filing MFS may increase the deduction. Some states have lower taxes if couples file separately. Couples filing MFS may save more from lower state taxes than they lose to higher federal taxes. So, when does it make sense to file MFS? It’s necessary to do the math in each case and compare the combined tax liability under MFS to MFJ and determine the more beneficial scenario. If you would like to further discuss the pros and cons of the MFS tax filing status and how it may impact your situation, please contact us.
OPUS FINANCIAL SOLUTIONS LLC | OPUS OPINIONS : 2018 JUL
In a prior newsletter this year, I shared a few things keeping me awake at night, including growing level of credit being extended to Americans, the fact that US consumers seem to be living beyond their means, and the exploding level of student debt (almost $1.5 trillion), which is funded largely by the US government. Remember this chart?
The mounting student debt crisis among young adults is magnified by higher relative housing and healthcare costs compared to what their parents faced. And while there are no simple solutions to addressing the financial plight of these folks, perhaps as parents there may be things we can do to help them as well as future generations get an earlier start to not just saving, but grasping core financial concepts that could make a genuine difference to their future. Concepts like:
• The power of compounding, the time value of money, and how saving as early as possible (think ROTH IRAs at 12 years of age) can make a profound difference in their future financial security
• Setting goals, and then establishing budgets to achieve those goals.
• How forgoing some “wants” now and living beneath one’s means can provide them the freedom to choose how they want to live
• Avoiding debt and the importance of maintaining a positive credit history Smart money skills via conversations and activities could ideally be introduced at points the children are most developmentally ready to receive the lessons. For example, in earlier childhood years, parents might bring them to the grocery store and help them understand some of the factors involved in a purchasing choice. Or emphasize the value of working by pointing out the people around them doing their various jobs (grocery clerk, police officer, teacher, waiter, etc.), including those who started their own businesses. Encourage them to earn money doing odd jobs so that they can put other skills you will teach them to work. As they grow through middle school and into their teen years, help them truly understand the value of money while developing smart financial habits and understanding the consequences of choices they make. At this stage, it’s truly impactful for parents to talk with their kids about money regularly rather than hiding behind secretive veils. That includes talking about how much things really cost (your house, your car, your cable bill, air conditioning, etc.) and how that translates into hours one might have to work every week to have those things. Personally, I encourage parents to also share mistakes they made with money and how they overcame them. Most importantly, I highly encourage these folks to get some sort of job so that they can 1) save and invest early, 2) learn good financial habits, and 3) gain the self-esteem and freedom that comes with putting off short term “wants” for something even greater over time. Our own Ben Jones shared with me how he has incorporated some of the ideas above into daily life with his own 10-year old twins, which I’d like to share with you here. Some of these insights came from his lengthy financial education and passion to teach others what he has learned (links to some of his videos are included at the end of this article), but others came straight from his own parents. A Case Study: Ben’s Story Imagine graduating from a prestigious public university in Accounting ready to hit the ground running, when your
OPUS FINANCIAL SOLUTIONS LLC | OPUS OPINIONS : 2018 JUL
parents pull you aside to show you their spending ledger for the last four years of college—letting you know that it’s now time for you to pay them back for their generous 0% interest loan. That’s exactly where Ben found himself a few decades ago, knowing he had six months to find a job before he was required to begin making monthly payments. After about 8 years, Ben paid all those college costs, and was grateful for the opportunity. He shared that his parents were only willing to “pay” for his college if he chose a field with a license or certification to assure he got a solid job at graduation, which led to his CPA and a strong financial start. In the meantime, his parents encouraged him to start an IRA account out of the gate, even if he had to borrow the money and pay it back—again with 0% interest. All of this (and more) led to Ben’s passion to educate others about money, including his young twins, Grant and Makenna. Grant and Makenna were just six years of age when Ben decided to put a small amount of money into an account for each of them, allowing them to pick a few stocks to invest. They started by exploring companies with which they were familiar, such as McDonalds, Target, Apple, Disney, and Activision Blizzard, which showed up on the back of Grant’s video game. This provided them the opportunity to have ongoing talks over time about why the prices changed, why “money was added to their accounts” (dividends), how companies make money, and how or why stock prices move up and down. The twins were also paid small stipends for various chores and jobs, at which time Ben introduced the ideas of saving and investing. He told them that at the end of every month that they would receive 10% of whatever cash that was in their wallets. This required them to decide each time they were enticed to purchase something whether they should hold onto their money and wait for their monthly interest payment or spend it and get a smaller interest payment. What happened over time is they began comparing how much was in their wallets and became increasingly cognizant of the difference and the notion of holding off on a purchase until after their interest payment came in. The twins now earn some part time funds helping Ben with some of his educational videos aimed at other children. It is likely not a surprise to you that the funds
they earn go straight into their ROTH IRA accounts. Fortunately, Ben set up pre-paid tuition plans and 529 accounts long ago, so they will likely not have the same college payback scenario as Ben did, though even if they were in that predicament, my suspicion is that these kids would be on the road to financial freedom far earlier in life than they would have been without these insightful lessons and activities. Money with Mak and G As promised, here are a few links to educational videos for younger children with our very own Ben, Grant and Makenna: Paper or Plastic Burning Money Piggy Bank Intro to Money with Grant Let us know if you have stories like this to share, as there is much we can do to influence the direction of future generations, and we will do our best to spread the word about your insights. In the meantime, there are some excellent resources available from the Consumer Financial Protection Bureau on this topic, including research about developmental stages and skills that parents might want to focus on at each of these stages. Visit this link here for more information: https://www.consumerfinance.gov/consumer-tools/money-as-you-grow/. Or, stop by our office or reach out to us and we will gladly give you one of our favorite books on these topics, including “The 4 Laws of Financial Prosperity” (Harris/Coonradt), “The Minimum Wage Millionare” (Edgar), or “The Investment Answer” (Goldie/Murray). We only ask that if the book is helpful to you that you pass it on to someone else who could also benefit from it.
