Letter to Clients: 1st Quarter 2018

Dear Clients and Friends:

Happy New Year! Are you one of the many Americans who consider the beginning of the year to be an opportunity to refresh, adjust, and improve? The New Year’s Resolution has become a staple of our society. The first of January also defines an easy period to “start fresh” in regard to investment performance which creates listeners to countless pundits and soothsayers who offer up specific roadmaps for stocks. I prefer to use simple math as a guide as we enter 2018.

The S&P 500 Index advanced 21.83% in 2017[i]. No doubt about it, 2017 offered rich rewards to those invested in a well-diversified stock portfolio. The only thing to question would be if a sharp upward advance in one year set the stage for a pullback in the following year. Historical data seems to say no.

From 1950 through 2016, the S&P 500 has risen at least 20% 24 times. The following year the S&P 500 finished higher 19 times. Put another way, in the year that followed a 20% or greater advance, the S&P 500 went up nearly 80% of the time with an average gain of 18.1%. When the S&P 500 declined following a 20%+ advance, the average drop has been 6.5%. During the same period, the S&P 500 had positive returns approximately 4 of every 5 years with an average advance of 19.1% in those positive years.[ii]

This tells us that last year’s impressive advance has little predictive value other than stocks have an inherent upward bias over the longer term. Upward bias is a key component embedded in your financial plan.

If we can’t use the S&P 500 as a predictive indicator, what can we use? Longer term, it’s always about the fundamentals, i.e., the economy and growth of corporate profits. Low inflation and low interest rates only helped sweeten the pot last year.

The momentum generated by a growing U.S. and global economy is likely to carry over into the new year. While a 2018 recession can’t definitively be ruled out, leading indicators suggest the odds are low. However, unexpected events create short-term, emotional responses in the market that are best ignored by long-term investors.

Last year’s lack of volatility was simply remarkable. According data from LPL Research and the St. Louis Federal Reserve, the biggest drop in the S&P 500 amounted to just 2.8%. It was the smallest decline since 1995. The average intra-year pullback for the S&P 500: 13.6%. It’s an excellent reminder that volatility is typically a part of the investment landscape. It can sometimes be unnerving, but it is incorporated into the investment plan we’ve recommended for you.

Key Index Returns

MTD % YTD % 3-year* %
Dow Jones Industrial Average +1.8 +25.1 +11.1
NASDAQ Composite +0.4 +28.2 +12.8
S&P 500 Index +1.0 +19.4 +8.5
Russell 2000 Index -0.6 +13.1 +8.0
MSCI World ex-USA** +1.7 +21.0 +4.6
MSCI Emerging Markets** +3.4 +34.4 +6.6
Bloomberg Barclays US 

Aggregate Bond TR

+0.5 +3.5 +2.2
Source: Wall Street Journal, MSCI.com, MarketWatch, Morningstar.
MTD returns: Nov. 30, 2017—Dec. 29, 2017. YTD returns: Dec. 30, 2016—Dec. 29, 2017.  *Annualized   **In U.S. dollars

The New Tax Code

“Don’t tax you, don’t tax me, tax that fellow behind the tree,”

– Senator Russell Long, Senate Finance Committee Chair 1966 – 1981

Halloween was barely over when House Republicans introduced their version of tax reform. Few observers thought such a massive undertaking could be signed into law within seven short weeks but that is exactly what happened. In the hectic days that preceded Christmas, the president signed into law the most sweeping change in the tax code since 1986.

The often-stated goal of tax reform was simplification, but lower tax brackets can only be achieved if cherished deductions and credits are eliminated which is easier said than done.

Simplification is a lofty ideal, but, “Don’t take my deductions or credits from me,” has always been the taxpayers’ battle cry. While some deductions will disappear, others remain or have been reduced. Senator Long probably would have sported a grin when President Trump signed the massive bill because over 80% of Americans will get a tax cut next year, while just 5% of taxpayers are expected to pay more.[iii] In most cases cuts are expected to be modest, however much will depend on individual circumstances.

I am always happy to talk with you but due to the complexities of the new law I also encourage you to check with your tax advisor. Many experts are struggling with the details of the bill, and that’s to be expected this early in the game. Remember that the changes will not take effect until the 2018 tax year. Some of the highlights of the law include:

  • The 10% bracket remains unchanged, while the 15% bracket declines to 12%, the 25% to 22%, the 28% to 24%, the 33% to 32%, the 35% holds steady, and the 39.6% slips to 37%. The thresholds are modestly adjusted above the new 22% bracket.
  • The standard deduction nearly doubles to $12,000 for single filers and $24,000 for married filers, reducing the incentive to itemize and simplifying for some taxpayers.
  • The $4,150 personal exemption is eliminated, and the $1,000 child tax credit doubles to $2,000. In general, rules for charitable contributions remain unchanged.

By itself, the combination of these first three items should provide modest tax relief for most families but actual effects depends on individual circumstances.

  • Those in high-tax states could see a big hit as there will be a $10,000 cap on state, local and property tax deductions.
  • For investors, the preferential treatment for long-term capital gains and dividends remains intact.
  • Once you convert into a Roth, there’s no going back. The new law repeals rules that allow for recharacterizations of Roth conversions back into traditional IRAs.
  • The 3.8% Medicare surtax on investment income for high-income taxpayers was retained. Since the tax survived tax reform it is likely to remain a permanent feature of the tax code going forward.
  • The Alternative Minimum Tax (AMT) for individuals was not repealed, but exemptions have been widened. Congress passed the AMT in 1969 after the Secretary of the Treasury said 155 people with adjusted gross income above $200,000 had paid no federal income tax on their 1967 tax returns. The AMT was never adjusted for inflation and grew into an onerous feature for many Americans. In inflation-adjusted terms, those 1967 incomes would be roughly $1.2 million in today’s dollars.

Ideally, we would like to have seen the AMT eliminated from the tax code but as Michael Kitces points out, “While the AMT commonly impacted those around $150,000 to $600,000 of income, in the future, AMT exposure will be much smaller, and it will be extremely difficult to be impacted at all, especially given more limited deductions.[iv]

  • The estate tax survived, but the exemption will double from $5.6 million to $11.2 million, and $11.2 million to $22.4 million for couples.
  • The new tax bill also repeals the Obamacare mandate that requires all individuals to obtain health insurance which becomes effective 2019.
  • For businesses: Given that the 21% corporate tax rate applies only to C-corps, there will be a 20% deduction for pass-through entities, such as S-corps, partnerships, and LLCs. I believe this will be a welcome benefit for many business owners, but complex rules may limit the pass-through for some entities.

Finally, it’s important to point out that many of the more popular changes in the tax code for individuals will sunset in 2025. While many may eventually be made permanent, as we saw with the Bush tax cuts of 2001 and 2003, there is no guarantee this will happen again.

 Final thoughts

 Every major legislative action produces unintended benefits and unexpected consequences. From an economic standpoint, Congress and the President hope to unleash the “animal spirits” that have been lethargic for much of the economic expansion. They hope that changes, especially as they relate to business, will encourage firms to open new plants, expand in the U.S., and level the playing field with the global community. Prior to reform, the U.S. corporate rate was the third highest among 188 nations.[v]

Will it work? About 90% of economists surveyed by the Wall Street Journal expect a modest boost to growth in 2018 and 2019, but after that, opinions diverge.

If tax incentives boost productivity, it could lift long-run GDP potential, which would yield a significant benefit. If the economic benefits end after a two-year sugar high, it will likely be deemed a failure.

Early anecdotal data offers encouragement as several large firms announced year-end bonuses or wage hikes tied to the lower corporate tax rate. At a minimum, the lower tax rate increases longer-run after-tax earnings, which played a big role in the late-year stock market rally. It could also boost corporate stock buybacks and dividends going forward, which would create an added tailwind for stocks. We are cautiously optimistic it will encourage entrepreneurship and economic growth, which would benefit many Americans.

Uncertainty breeds questions and concerns. I am never more than an email or phone call away, and can be reached at adinkin@dvfin.com or 515-255-3354. I’d be happy to talk with you and answer any questions you may have.

As always, I’m honored and humbled that you have given us the opportunity to serve as your financial confidant and advisor. As 2018 gets underway, the DV Financial team wishes you and your loved ones a happy and prosperous new year.

Sincerely,

Art Dinkin, CFP®

 

This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.

The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures.

The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value.

The Russell 2000 Index is an unmanaged index that measures the performance of the small-cap segment of the U.S. equity universe.

The MSCI All Country World Index ex USA Investable Market Index (IMI) captures large, mid and small cap representation across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 23 Emerging Markets (EM) countries*. With 6,062 constituents, the index covers approximately 99% of the global equity opportunity set outside the US.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Barclays Aggregate Bond Index includes U.S. government, corporate, and mortgage-backed securities with maturities of at least one year.

[i] All references to S&P500 Index performance assumes reinvested dividends
[ii] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
[iii] Tax Policy Center, Washington Post
[iv] http://www.kitces.com
[v] Tax Foundation
[1] All references to S&P500 Index performance assumes reinvested dividends
[1] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
[1] Tax Policy Center, Washington Post
[1] http://www.kitces.com
[1] Tax Foundation