The can has been kicked down the road for a long time, and now the market is addressing the reality of higher interest rates. Of course, the idea of rates increasing has been a concern for years, but today—with inflation what it is—the Fed is between a rock and hard place. But again, let’s keep things in perspective; as of today, even with all the talk about the Fed’s intentions, they are STILL buying bonds every month.
Last week, the Fed announced that they were intent on calming inflation and maintained their intention on raising rates in the near future. Again, the Fed has been forecasting and talking about higher rates for months, and for a while now, the market has been pricing in what this new environment will mean: That is, in a backdrop of higher rates, all assets will face a “re-pricing”; however, those companies without earnings and trading at excessive valuations will be severely punished, while those companies with high quality earnings will likely outperform.
Over the past several weeks, this is how the market action has been playing out. Value has been outperforming growth by a wide margin. And while value has not been immune to the market volatility, in relative terms, the amount of destruction in high-flying tech and discretionary names has been significant….(and there still may be more to come.) Meanwhile, many value names in financials, healthcare and energy have reacted much more favorably---again, not “untouched” from the downturn, but in relative terms, their performance has been extremely stable.
Fundamentals always matter; in some markets, more so than others. These days, with changing monetary conditions, we feel earnings and profitability will have increasing importance. And as we enter full earnings season, we are seeing some positive announcements. Are they as incredible as last quarter? In some cases, no. But overall, are companies still announcing pretty impressive numbers? Absolutely. J&J, IBM, PG, MSFT and VZ to name a few. These are quality names that offered very positive guidance. In the case of American Express, the CEO said it was the best past quarter in his 37-year career!
There was an article in yesterday’s Wall Street Journal titled, “Dividend Stocks Back In Fashion Amid Turbulence.” In a very difficult month of January for the markets, once again dividend stocks proved their strength and resiliency as dividend payers in the S&P 500 outperformed non payers by 6.6%, the biggest margin in 17 years.
So the markets are in the midst of being weaned off this drug called “easy money”. No matter how long or how deep this correction goes, it’s something that had to be done eventually. The silver lining in this is a lot of the speculation and froth has been removed from the market-probably not all of it though. But these overvalued, speculative areas of the market needed a good punch in the face. Better now than later.
Time Horizons and Benchmarks
In a recent article, Tale of the Tape, author John Lim addresses a number of good topics as it relates to investor expectations, time horizons and market returns. We believe these are extremely important to remember for every investor regardless of their situation.
The first point is having the appropriate expectations. That is, if your portfolio is heavily invested for long-term growth, you should not be tracking the US 30-yr treasury for comparison to your performance. Similarly, for most others who have diversified portfolios, evaluating your portfolio against the popular S&P 500 is not appropriate either. As Lim illustrates, last year (2021), large cap US Stocks (i.e. S&P 500) outperformed bonds, international holdings, gold and cash by a wide margin. Does this suggest that someone holding these positions was wrong? No, because it largely depends on what that individual’s goals are.
Important: Do not compare your portfolio to someone else’s or to a benchmark that is inappropriate to your own. This is a second point Lim makes. Your portfolio is “not a beauty contest or a competition.” Neighbors, friends and family members will all have different goals and different risk tolerances. As such, their portfolios SHOULD look different from yours. Not worse, not better, just different.
The third and fourth points are ones that we’ve always stressed ourselves: People constantly focus on the short-term, but it is the long-term that matters. And judging performance over one calendar year is just….arbitrary. With respect to short-term thinking, it should not be a surprise. Media headlines, immediate gratification, etc. al encourage investors to live in the “here and now.” Unfortunately, this type of thinking is exactly the opposite when it comes to investing. Not only does long-term planning make things easier in the future, but predictions about investments may be much more accurate the longer out you make them. What really matters are your compounded returns over decades. But we live in a very impatient society!
Lastly, the idea of measuring performance year-to-year can be very misleading. After all, in the whole scheme of one’s life, what is one 12-month period’s worth of data? Of course, this seems silly, but when you also factor in the fact that investment returns are often “lumpy” it makes it that much more nonsensical to judge any investment over one year.
As one of our favorite financial writers Nick Murray stated, “Beating an index is not a financial goal.” We are convinced that an investors success or failure is not so much about if you own Apple or Microsoft, but much more because of the following “intangibles”:
- Do you have the right expectations for your portfolio?
- Do you understand why the S&P 500 is not an appropriate benchmark for most investors?
- Do you have the mental fortitude to block out short-term noise and short-term performance?
- Do you have the ability to block out the “bragging” we all hear from our friends/family etc. about how they always seem to own the “hottest” stock? But never the losers. Just like nobody ever loses money in Vegas…
- Do you have the discipline to stick to your strategy when it’s not working or when markets decline?
If you can answer these questions correctly, financial independence can be achieved.
Tax Planning-Managing Capital Gain Distributions
Capital gains distributions are a part of owning most mutual funds; when the fund needs to meet redemptions, take profits or otherwise, in general, raise cash by selling a holding, any capital gain is distributed to all current shareholders. All investors need to be conscious of such distributions and when they are scheduled, but those who hold the funds in “taxable” accounts need to be especially alert.
As an example of how impactful this can be, it was definitely a bad surprise when Vanguard recently left many individual investors who held a popular target retirement fund with a huge tax bill. In summary, Vanguard made changes to the minimum investment requirements in this fund’s institutional class (which has lower fees); by lowering the requirement, many bigger clients (billions of dollars) left the retail class, rushing into the newly accessible institutional class. This caused massive redemptions for the fund, which, in turn, caused it to liquidate holdings, triggering large capital gains. Unfortunately, this distribution was borne by the existing “smaller” shareholders of the fund and those who held it in taxable accounts faced big tax bills.
While this latest event represents an unusual instance when Vanguard disadvantaged its retail customers, it also provides a good lesson why investors not only need to focus on asset allocation, but also on asset “location.” Selecting which funds to buy is important; it is also smart to be tax-efficient in where you put particular investments. For taxable accounts, we try to choose those funds that are managed to minimize capital gains, those that are tax-efficient. Additionally, we pick exchange-traded funds (ETFs) which do not typically make capital-gains distributions. However, from time to time we do encounter the situation where a fund we own is scheduled to pay a larger than normal distribution. They key is to be aware of it and plan for it. We own a fund that just last year paid a large distribution and in cases like this, we assess the impact for each client’s tax situation. We ended up selling the fund before the distribution for some clients and holding it for others. Again, the decision was based off of each client’s particular tax situation.
Overall, investors in the Vanguard fund took a big tax hit due to the actions of the firm not considering the implications of their actions…..or just not caring. It is likely that Vanguard did not think about the repercussions, but given the competition for assets, no one knows. Either way, the main lesson for investors is to recognize that proper planning is necessary for not only WHAT assets you buy, but WHERE you put them.
2021 Tax Filing Considerations
The volatility in the stock market should not distract us from making sure that we only pay our fair share of income taxes in April. Even though we are already well into 2022, there are still items that should be considered when preparing to file your 2021 tax return. We have outlined a few items to consider below:
- Retirement plan set up and contributions – the SECURE Act of 2019 included provisions that extend the deadline for setup and funding of certain retirement plans (401ks for example), which may allow you to still set up a 401k and fund it to reduce your taxable income for the 2021 tax year – this can be a very powerful way to reduce your 2021 tax liability
- Take advantage of above-the-line deductions – these deductions will reduce your Adjusted Gross Income (AGI) and consist of expenses like HSA contributions, contributions to qualified retirement plans, contributions to a traditional IRA, up to $2,500 of student loan interest, part of self-employment tax & health insurance premiums for self-employed individuals
- Itemizing deduction vs. the standard deduction – these deductions will reduce your taxable income which will reduce the amount of your federal tax liability. You will either take the standard deduction of $12,550 for singles, the $25,100 deduction for couples filing a joint return or you can itemize your deductions if these are larger than the standard deduction. As you review and compile your tax documents, it is imperative that you make sure you account for all expenses that qualify as an itemized deduction. These typically include medical expenses (subject to a 7.5% AGI hurdle), state and local income and real estate taxes (subject to a $10K maximum deduction), home mortgage interest, charitable donations & casualty or theft losses.
- Consider a home office tax deduction – this deduction will apply if you use a part of your home for regular and exclusive business purposes. Please note that the IRS has previously stated that employees who receive a paycheck or W-2 are not eligible for the deduction, even if they are currently working from home. If you are self-employed and eligible for the deduction there are a few different ways it can be calculated – a simple way that uses an IRS prescribed rate ($5 per square foot in 2021) multiplied by the allowable square footage (max of 300 sq. ft.) and a more complex way, which calculates the percentage of your home which is used for business and then prorates applicable expenses – mortgage interest, utilities, property taxes, rent etc. to find the total deduction.
- Consult a professional – even if you like doing your own tax filing, we certainly encourage having a tax professional review your return prior to submitting it to the IRS and your state.
With the tax filing deadline right around the corner, we figured it would be helpful to share our thoughts on some common tax planning strategies that can help you reduce your 2021 tax liability. As always, please feel free to reach out directly to us here at NCM with any questions.
All the best,
DISCLOSURE: This newsletter contains general information that may not apply to everyone. The information above should not be construed as personalized investment advice and should not be considered as a solicitation to buy or sell any security. Past performance is no guarantee for future results. There is no guarantee that the opinions expressed in this newsletter will occur.
Investment advisory services are offered through NCM Capital Management, LLC, an SEC-registered wealth advisory firm domiciled in New Jersey. This communication is not to be construed or interpreted as a solicitation or offer to sell investment advisory services to any residents of any state other than the State of New Jersey, the State of New York, the State of Texas, or where otherwise legally permitted. For additional information about NCM Capital Management, LLC, you may request a copy of our disclosure statement as set forth on Form ADV.