facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast blog search brokercheck brokercheck
%POST_TITLE% Thumbnail

May 2019 Newsletter

As we are in the midst of 1st quarter reporting, corporate earnings have been “good enough.” Though it is true that expectations were muted for most companies going into this earnings season, nearly 75% of the companies that have announced have surpassed estimates.  And, although company profits for first quarter 2019 will be lower than last year in the same period, the decline has been much less than expected.  

While earnings’ results and overall economic data have been generally better than expected so far in 2019, there is only one significant difference in the overall market environment in our view between the collapse in stock markets in late 2018 and the remarkable recovery in 2019, and that is the message being sent from central bankers around the world, most notably the US Federal Reserve bank.   

To summarize simply, the new message from the Fed is to expect a much less restrictive interest rate policy compared to what was telegraphed to markets in 2018. And believing that there would be no further increases in rates in 2019, the markets took this even further, as up until this past Wednesday, it was forecasting an interest rate DECREASE in 2019! Of course, after the Fed’s meeting on Wednesday where it was announced that rates probably would not get cut, guess what happened? Markets sold off. Yes, the global stock markets may still be addicted to low interest rates.

Everyone has their own opinions for why the markets have recovered so strongly in 2019….Our view is that it is primarily explained by the abrupt shift in interest rate policy by the Fed.

Industry Conferences

There are so many advantages to being an independent, fee-only, fiduciary-based wealth management firm (for both advisors and clients.) We could devote a whole newsletter just on this one topic! One benefit is that we get to decide how to spend our time; no wasted time in corporate meetings going over sales goals or new products to promote.  One of the things I do several times a year is attend financial conferences. It’s always hard to spend time out of the office, but it’s crucial for any advisor to stay on top of the latest developments in this industry as it’s changing so quickly.

I recently attended two of them. One was sponsored by a firm that specializes in options. As we’ve written about several times, options strategies such as the covered call strategy are very misunderstood and valuable strategies. One highlight I want to share with you from this conference was from a presentation by Danielle DiMartino Booth who is a global thought leader on monetary policy and economics. Her background includes nine years working for the Federal Reserve Bank of Dallas. She gave an educational presentation on what is going on behind the scenes at the Federal Reserve.

Circling back to the interest rate pivot by the Fed, Danielle’s opinion is that Fed chairman Powell did not cave to politics, but was scared of what was happening in the credit markets.  December was the first month since 2008 without one single junk bond deal getting done and the market went 41 days without a deal being done---the longest stretch since 1995! Perhaps Powell feared the credit markets would freeze like they did in 2008. If the credit markets are not functioning properly that would almost surely spill over to the stock markets.

The other conference I attended was Blackrock’s Factor Council workshop. Factor investing is becoming very popular and Blackrock is doing some exciting and interesting things with factor funds. Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. Examples would be the momentum factor, the low volatility factor, the size factor, and the value factor. We are believers in factor investing and invest accordingly for clients. You can put together a very well-diversified, low-cost, and tax-efficient portfolio using factor-based funds. They are also taking big market share from the higher cost/ less tax efficient actively managed mutual fund space.

Finding Yield in a Low-Rate Environment

For borrowers, low interest rates are a positive; for individuals who are relying on income from their investments, low interest rates present a challenge.  And in some cases, investors can find themselves “stretching for yield” and taking undue risk for what they are ultimately being compensated.  As illustrated in today’s environment, the spread between high-yield bonds and treasuries or high-grade corporates is very narrow; in other words, investors in high-yield bonds should be receiving a much greater yield (i.e., interest rate) for the risk they are taking in holding “below-investment grade” bonds.

So what are some alternatives for investors to consider?

Well, for one, high-grade corporate bonds are preferable to the aforementioned high-yield bonds.   Again, it may be tempting to reach for higher yielding fixed-income products, but be mindful of the credit risk.  And staying with short-term bonds may be more advantageous than locking into longer term maturities.

Another option is cash.   In a recent Wall Street Journal article, one strategist suggests holding more cash as it “may soften the impact of gyrations in the equity area of a portfolio, making it easier for an investor to ignore volatility and stick with the plan.” For the first time in a long time, cash rates are very competitive with other fixed-income products.

Another area to consider is preferred stocks, which have similar characteristics to common stocks and bonds.   Preferred’s have slightly lower risk than common stocks, but do have interest rate exposure as other fixed-income investments (such as bonds).  When investing in preferred stock, just as we suggest with their bond allocation, investors may want to consider actively-managed funds over passive funds or ETF’s.

In addition, we have always been a proponent of dividend stocks which may be a very appealing alternative in this low interest rate environment.  First, stocks in general offer the best way for investors to achieve not only capital appreciation which will grow their assets over time, but also will help combat inflation.  And second, dividends will help cushion returns during slowing or declining markets.   Even blue-chip stocks will go down in a bear market, but may not fall as hard as those that do not pay a dividend. However, it is important to note that dividend stocks are still stocks and not bonds! We see many investors replacing their fixed-income with dividend stocks entirely; be careful with that as this changes the risk profile of the portfolio.

Lastly, we would suggest avoiding things like business development companies (BDC’s) and non-traded real estate. Many investors become attracted to them for their advertised yield, but we have rarely seen investors ever receive a reasonable total return from these investments. Yes, the yields look attractive, but almost every single time we take on a new client who holds them, they have a loss or mediocre total return. Just as bad, it is a nightmare to try and sell these because their markets are so illiquid.   

Defensive Investing Pays Off

Here is an interesting statistic:

The overall performance of the stodgy utilities sector has outpaced the tech-heavy Nasdaq index since 1971!

While equities have been touching on new highs, there is a growing temptation among many investors to feel more emboldened to take greater risks in their portfolio.  But as Dan Suzuki, an analyst from RBA, describes, “The best offense may be a good defense; defense generates wealth…Avoiding the frothiest parts of the market and compounding dividends is more important that owning the fastest growers.”  In essence, investing should almost be boring for most individuals; consistent, significant returns are not generated overnight.  

But conservative investing does not mean that returns have to suffer.  As Mr. Suzuki points out in a recent note: “Health Care and Staples have the best risk-adjusted long-term returns over the last 10 years (although Technology recently overtook Staples’.)”  Finding value in historically “defensive” sectors of the market has paid off.

As we’ve always emphasized at NCM, staying with your game plan is paramount.  Just for fun, we can use an analogous example of how important it may be in sticking to your strategy when we examine what happened to the NY Giants during the recent NFL football draft.

For the last couple years, the team’s general manager had been outspoken about the Giants strategy of “finding value” in the players that they choose:  That is, making sure the team picks the best available athlete at any position, irrespective of the team’s need at that given time.  (Think of creating a high quality, diversified portfolio at reasonable prices and not feeling pressured to overpay for a “hot” stock that may be overvalued by the market.)

So last year in staying true to his word---and despite the team’s “need” for a quarterback, the Giants’ GM stuck to his plan.  Rather than select a highly talented QB in last year’s draft, he selected a running back, claiming that that player presented a much better “value.”  In sticking to his guns, not getting caught up with the fanfare of picking a QB, he picked an extremely talented RB who—it should be noted--went on to win the Offensive Rookie of the Year honors!

Fast forward to this year, however, when the Giants were on the clock with the pressure of the 6th overall pick, this same GM seemed to panic; perhaps getting caught up in the moment, he seemingly changed strategy and went ahead and chose a quarterback, who--by nearly every measure---was NOT the most talented player available at the time.   Many NFL experts believed that he “reached” for this pick and could have picked up the same player much later in the draft.  (Think about overpaying for a stock or asset that does not hold commensurate value to its current price.)

Many Giants fans complained, perhaps justifiably, that in the heat of the moment, instead of staying the course with his predetermined plan, this GM chose to shift philosophies midstream and ultimately used too much draft capital to choose a QB when insteaad he could have drafted a better overall player and patiently waited for the (same!) QB to be available at a more reasonable draft position.  (Think of waiting on the price of an asset to fall to a more rational level before purchasing.)

Ultimately, we’ll see if this strategy ends successfully, however, in many cases, for GM’s (…or investors) who don’t seem to have a plan or do not stick with it, these decisions may put their team (…or their financial future) in a less desirable position than if they had stayed the course.    

Drawbacks of Custodial Accounts 

Custodial accounts are formed when a parent wants to set up an account in a child’s name.  Any income from this type of account belongs to the child so the prevailing belief has always been that it is a good way for parents to shield assets and minimize taxes, while benefiting the child.  At a closer look and with the new tax laws, the advantages to these accounts might be less appealing.

The current tax code requires that with any income from a custodial account that exceeds the annual limit (e.g., $1,100 in 2019), the child will have to file IRS Form 1040 and there will probably be taxes owed.  And due to the “Kiddie Tax,” income over a certain threshold (e.g., $2,200 in 2019) may be taxed at rates that apply to trusts and estates…unfortunately, rates which tend to be much higher than those for individuals.  

Further, in 2019, each parent is able to gift up to $15,000 to their child which is excluded from federal tax; this will not reduce your unified $11.4 million unified federal gift and estate tax exemption (for 2019.)  If it is more than $15,000, you will have to file IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.

And as always has been the case, when the funds are transferred to the minor child’s custodial account, those funds belong to that child.  The parent is the manager of the assets, but that money can only be legally used to benefit the child.  Further, this money cannot be transferred to another child name; in other words, it is permanent.

In most states, when the child turns 21 years old, full control of this account will be turned over to the child.  This can be a blessing…..or a regret.   

The bottom line is custodial accounts are still a viable planning consideration, but they are just not as attractive as they used to be.

As always, let us know if we can help.

All the best,