Posts published in October 2012
At the end of the third quarter the S&P 500 was perched at 16.44% year to date, a stark contrast to where we were at the same time last year at -8.68%. Driving this rally, as we have noted in a handful of these market commentaries, have been the policy measures made by central bankers around the globe. The Fed initiated a massive undertaking with so-called QE3 (or QE4ever as the financial wags put it) by pledging to buy a theoretically unlimited amount of federal debt. That followed on the heels of the aggressive measures announced earlier in the summer by ECB head Mario Draghi to “do what it takes” to shore up the Eurozone. What has ensued is what we refer to as a synthetic rally – a rally that is not being driven by fundamental economic drivers, but rather by policies meant to stimulate the economy.
So why is it important to recognize the difference between a synthetic rally and an organic growth-driven rally? In large part because of the unique nature of the unknowns. Investors, analysts and sundry financial experts alike are struggling to anticipate and make sense of what factors are really driving current market conditions during this policy driven period. With the announcement of QE3, one would have normally expected treasury yields to rise – however, yields have still not reached the already meager levels seen at the beginning of the year. This is a prime example of the lack of rhyme and reason that keeps market observers perplexed as they look for signs of transition back to organic growth and a more “normal” valuation-driven climate.
This transitional period will likely be fraught with the kind of volatility that investors have become (reluctantly) accustomed to over the past 4 years. Contributing to the turbulence will be an unhealthy admixture of political factors and wagers about the unknown, but inevitable, end of spoon-feeding by the Fed. Most immediately the passing of the 11/6 election and pending fiscal cliff loom large, but renewed inflation risk and sharply higher interest rates also lurk in the copses in the not-too-distant future.
A real growth period will announce itself by headline numbers like GDP and unemployment rates – but we may expect fleeting glimpses of the promised land via economic indicators such as consumer confidence and the various housing numbers which, as they start to rise, reflect and also encourage improvement in public sentiment. Current numbers are beginning to show some of these tantalizing glimpses, and that could turn into a high-likelihood case for 2013.
But even if that becomes our likeliest-case scenario we are mindful that the path is not paved nor the way smooth. Many variables remain to play out, starting with an election whose outcomes will very likely be dominating influences in the days and weeks after November 6.
With less than one month to go until Election Day the political narratives are in full swing. Dead-center in the crosshairs of the economic debate is the subject of taxes: what will happen to the Bush-era rates on income and capital gains, what about the payroll tax, Medicare contribution taxes and all the rest that no doubt have the CPAs and tax attorneys of the world busily at work helping their clients make sense of what might happen. The questions that tend to come our way, as investment advisors, is how changes in tax policy may impact investment portfolios and what action, if any, one should take.
Wagging the Dog
When it comes to decisions around taxes the fundamental tenet of our beliefs is this: taxes are the tail, investment policy is the dog. In other words, your investment policy should drive tax decisions; tax decisions, or reactions to changes in tax policies, should not drive investment policy. The tail should not wag the dog. If you have a taxable, non-qualified portfolio then when evaluating two alternative approaches, all else being equal it makes sense to opt for the one that is more tax-efficient. But first make sure that all else is equal. As in: if both alternatives are equally prudent in view of my long-term return objectives, risk tolerance and other relevant considerations, and alternative A is more tax-efficient than alternative B, then alternative A is the right choice. That’s how to make investment decisions around taxes. Pay attention to those operands “if, and, then” – because they matter.
Uncertainties and Probabilities
Here’s how not to make investment decisions around taxes: make decisions today, irrespective of whether they are in line with your investment policy, because of tax policy changes that might happen tomorrow. Right now there is a great amount of uncertainty. We don’t know who is going to win the presidential election, who will be in control of the Senate or the House of Representatives, or what margin of control the majority parties have to work with, or any number of other variables that will influence how tax policies are fashioned. We don’t know what dynamics will be at play as opposing sides try (or not) to reconcile their differences to avoid the “fiscal cliff”. The possible outcome generating much of the debate among investors about what to do is the long term capital gains tax, which could go back up to 20% from the 15% level that was established as part of the Bush cuts in 2003.
In our opinion there is a logical way to address this question, which is simply this: If your investment policy doesn’t contemplate any necessary asset sales that would trigger a long term capital gains tax event, don’t create asset sale mandates just to “lock in” a 15% rate. However if, in the context of your overall asset planning and income generating plans over the next twelve months or so, you identify asset sales that are likely to take place, and you are relatively indifferent as to the timing now or one year from now, then perhaps it makes sense to think about selling when you are certain about what the capital gains rate is rather than when you don’t know what it will be. That’s prudent, and that is wholly in line with investment policy dictating tax actions – the dog wagging the tail, as it should be.
Election season brings out the snake-oil salesmen and Chicken Littles of the world, running around with hyperventilating headlines about how the sky is falling and you have to act now. Nonsense. Successful investors are the ones who ignore the breathless hype and stay disciplined and patient.
Every month for the past three years, economists and financial professionals everywhere have waited with bated breath to hear the U.S. employment reports – economic indicators that offer insight into the current economic state of the country. Lately though, these reports have provided more confusion than clarity.
Payroll Processor Automatic Data Processor (ADP) reported on Wednesday that private businesses added 162,000 new jobs in the month of September – 9,000 more than the 153,000 that was expected by economists.
The Institute for Supply Management released a separate report illustrating that new orders in the non-manufacturing industry boosted the services sector to 55.1, the highest level since March. Unlike its manufacturing counterparts, companies in the services sector have remained stable despite the still-perilous situation in Europe, slowing growth in China and the looming U.S. fiscal cliff.
On Friday the Bureau of Labor Statistics (BLS) will release nonfarm payroll data, which includes government workers. Economists are currently predicting a rise of 118,000 for total nonfarm payrolls and unemployment to remain at 8.1%, an estimate that is unlikely to change despite the better than expected ADP report released this morning. Over the past couple of years ADP reports have not been especially helpful at predicting nonfarm payroll data – just last month large gains forecasted by ADP data missed by a long shot – a mere 96,000 jobs were added in August.
So what do these numbers mean for the economy as a whole? Not a whole lot. The discrepancies among economists’ expectations and actual numbers suggest that we are unsure of when the economy will start improving on the whole. That is not to say that the economy isn’t growing however – the steady improvement in ADP numbers and jobless claims (which clocked in at the lowest level since July) clearly indicate that the economy is improving, albeit slowly.
As the presidential debates get into full swing tonight the employment numbers could have a significant impact for both the candidates. Another disappointing jobs number could put Obama in the hot seat again – last month the unimpressive report fell in the wake of the Democratic National Convention and probably muted at least part of the “bounce” these conventions tend to produce. However, “Nobama” supporters take heed – should the Friday numbers significantly exceed expectations it could provide the President with a boost regardless of who is deemed to have won tonight’s debate. Wait and see.