October 2019 Newsletter
The 3rd quarter was a rollercoaster of optimistic peaks and troughs of doubtfulness regarding a trade deal with China. Throughout the last few weeks, it has been a more-than-likely safe bet that each time the market shifts significantly higher or lower, the move was usually attributable to a leak about trade talks: headlines of restrictive tariffs evoke selling, while the random announcements (and tweets) about a possible deal bring in buyers. Coupled with the political issues in the US, interest rates, global growth outside the US...and the markets are dealing with a lot.
Of course, while all the aforementioned items are in many ways interrelated, what generally leads the market—above all else in the long run-- are corporate earnings. We’ve had mixed economic numbers lately, but how companies report their own numbers in the coming weeks should dictate the direction of the market over the final quarter of 2019. Currently, expectations are that earnings will be off about 4% for the 3rd quarter; and as the market tends to do, this has already been--or will be--priced into stock prices.
We view investor sentiment as a contrary indicator and we would characterize investor sentiment as quite negative. There are constant fears and predictions of a recession and a coming significant correction in stock prices. We see this negative sentiment confirmed in fund flows; according to DataTrek, cash in money market funds is 14% higher than in 2018 and has been rising nearly every week since May. Also, according to the Investment Company Institute, in the third quarter alone $60 billion was withdrawn from stock funds and $100 billion was plowed into bond funds!
Other good news in our opinion for the stock market is that investors seem to finally be paying attention to price (valuations). IPO’s, high-flying super expensive tech stocks, and cannabis stocks are all being revalued (their stock prices are coming down.) Meanwhile, the cheaper stocks in the marketplace (so called “value” stocks) have been performing better. This could be a healthy rotation in the markets.
Dividend Stocks Continue to Be Attractive
Concerns about current economic growth and the apparent lack of inflation (by government measures) have led central banks, including the US Fed, to keep interest rates historically low. This has buoyed the bond market and emboldened corporate borrowing, actually sparking some to question whether a bond “bubble” may be on the horizon. But while lower rates have frustrated yield-seeking investors, pushing some to look more and more towards riskier, high-yield products, low bond yields have also helped make dividend stocks that much more appealing.
When the average yield on a 10-year treasury is around 1.6% (annually!), investors may be challenged to see much in capital appreciation over time on that investment. In other words, as bond PRICES move inversely to bond yields, there is significantly less growth potential than when interest rates were much higher.
Conversely, many high-quality, dividend-paying stocks not only offer higher yields, but also provide a number of other advantages. First, “quality” stocks are defined as those companies that have solid, reliable earnings, lower debt and the ability to sustain their profitability year over year; not only do these companies have the ability to pay out their dividends to shareholders, but in many instances, they are able to INCREASE the amount of dividends paid out. For example, just recently, a number of companies announced that they would RAISE their dividends—increases ranging from single digit to double digit percentages. In other words, for an investor in a company who raises its dividend by 10%, he/she would see a 10% increase in income; for retirees or other fixed-income investors, this is a tremendous boon! There is nearly no other investment that will offer this type of benefit as a meaningful way to keep pace with inflation.
For a retiree, this is akin to an increase in your “income paycheck”!
Next, owning dividend-paying stocks either individually or through an ETF certainly costs a lot less and may be more tax-efficient than holding a mutual fund; investors can buy or sell at their own discretion, strategically taking gains or losses as their own situation dictates.
Lastly, perhaps the greatest distinction of dividend-paying stocks, is the potential--if not the high probability—for capital appreciation in these assets over time. As outlined, bonds are created to make fixed interest payments; investors generally do not—or should not—expect to receive substantially more than their initial investment when they sell a bond. For dividend-paying stocks, however, which are usually comprised of “quality” companies that are presumably expanding their businesses and growing their revenues year after year, not only are investors receiving a steady flow of the profits (in the form of dividends), they should also enjoy rising share prices over time.
And again, dividend-paying stocks are one of the more consistent ways for an investor to keep up with inflation.
Commission Wars: Good for Investors
Last week Schwab announced that it was lowering client commissions to zero; other brokers like TD-Ameritrade and E*Trade quickly followed. And at NCM, we were happy to learn that just this week, Fidelity also decided to waive commissions on equity and options trading. While some firms will gain more than others in this “race to zero,” it is unquestionably a huge positive for investors at all levels.
Commissions have been declining over the years; competition, technology, and even passive indexing have all led to reduced transactional costs. For Schwab, as the first to announce the “zero” rates, this was a very smart move. Currently, trading commissions only account for a small percentage of their revenues. For TD and E*Trade, commissions are a much larger piece. Needless to say, these firms will need to rely on alternate sources to generate revenue.
Of course, at NCM, we are thrilled to be able to pass on lower costs to our clients. However, we also remain mindful that these transactional costs are just a small piece in the financial planning process; for example, when a building is being erected, it is an advantage if the building materials fall in price, but it is the architect and the contractor who actually do the design and construction who are still the essential factors in the equation.
At NCM, solid, unbiased financial advice remains our sole focus. And every day we are motivated by the subpar guidance that has been given to those who come to us seeking help. For example, one young woman in her 40’s, recently came to us explaining that it had been recommended that she fully fund a permanent life insurance policy, while completely foregoing any educational savings for her kids, as well as any contributions to her own 401k.
Does this client need insurance? Yes. But is it wise to do this at the expense of the other areas of saving—which she also needs? Absolutely not. Clearly, the advice that she was given may have been motivated by something other than her best interest. The recommendation for her to stop funding her 401k and not even consider a 529 for her children and direct all cash flows to a life insurance policy is 100% not in her best interest. It is wonderful for all of us to see transaction costs come down significantly, but how does one value unbiased, independent, high quality financial advice?
Financial Planning Strategy-Changes to Inherited IRA’s
For those that inherit an IRA, it is required that they take distributions using one of two options: A) withdrawing the entire amount within five years; or B) taking distributions payable over the beneficiary’s own life expectancy (aka, the “stretch” IRA technique).
From a planning standpoint, certain strategies relating to Option B (listed above) are intended to limit the taxes that are paid out by the named beneficiaries. For example, a grandparent may choose to leave an IRA to a child, rather than a spouse; this would allow the younger grandchild to take his/her small required distribution over time and allow the assets to grow tax deferred over many years. Going one step further, if a grandparent wishes to leave a traditional IRA to a grandchild, the grandparent may convert the traditional IRA to a ROTH IRA and pay the taxes on the conversion, but shield their grandchild from paying taxes on the required distributions for their lifetime.
New legislation, however, is potentially changing the rules and will possibly eliminate such practices on stretch IRA’s.
In May, Congress passed a law that would limit the number of years that certain non-spouse beneficiaries can take their distributions from an IRA. Again, in the past, a non-spouse IRA beneficiary could previously choose to take required distributions over the five-year option or at a rate determined by his/her own life expectancy. The new law will limit this to 10 years, with no required annual withdrawals during the 10-year term, only at the end.
While the House has already passed this legislation, the Senate is still coming up with its own bill. That bill which has not passed yet does include a provision for non-spouse beneficiaries like grandchildren to use the stretch IRA up to $400,000, while assets beyond that must be withdrawn within five years.
In summary of these changes, although some may have to adjust their strategies, everyone should be reminded to ensure that they have a plan. Roth conversions still may be an option for some, but maintaining updates to beneficiary information is essential for everyone.
All the best,
Nick