Category: BRAVE Quarterly Letter

Dear Clients and Friends,

Both stock and bond markets are on pace for an excellent year with the S&P 500 up almost 20% and the U.S. bond market returning over 5% so far. The continued rally in stocks has driven valuation extremes even further while traditional recession indicators appear to have ceased working. This has caused many observers to wonder whether “this time is different” …the four most infamous words in investing. In this letter we share an update on BRAVE, recent clarification on required distributions from inherited IRAs, our current view on the markets, how we are implementing that view in managing our client portfolios, and a few administrative items.

BRAVE Family Advisors Update

BRAVE has continued to experience solid growth this year through both new clients joining the firm and existing clients growing their relationship with us. We are working on refreshing our website which should be finished by yearend. Anthony “Tony” Morrison, a senior at Montana State University majoring in Business Management and Economics, did a second summer internship with the firm and spent some of his time exploring how we might use artificial intelligence to improve our efficiency and client service.

Jamie’s role at the firm has been evolving. When he joined BRAVE in April 2019 his primary focus was on “institutionalizing” our internal functions. Up until then the actual business of running the company had been shared by Brett, Dave, and Suzie. Over the ensuing few years Jamie became the Chief Operating Officer, Chief Financial Officer, and Chief Compliance Officer and has brought both structure and efficiency to the activities within those roles. Now that that has been accomplished and he does not need to spend all of his time on those areas, he has also been increasingly focused on developing new business and working with existing clients including accompanying Scott on client visits.

Clarification on Inherited IRAs

The Internal Revenue Service (IRS) finally issued clarification last month on the law that was passed in 2019 which changed the treatment of inherited IRAs for most heirs. The new law eliminated the ability to “stretch” an inherited IRA over the heir’s expected lifetime and instead required it to be fully distributed within ten years of the owner’s death. This applied to most heirs other than spouses. However, no specifics were included as to whether distributions were required annually or whether the entire balance could be withdrawn in the tenth year. The IRS clarified that for non-spouse inheritors of IRAs that were owned by someone already taking required minimum distributions (RMDs) (over the age of 73 under the current law) they must take a minimum annual distribution until the account is drained. If the IRA was owned by someone not yet required to take RMDs, then the inheritor can wait to take the account balance out in the tenth year. Given the lack of clarity in the law up until now, the IRS has waived penalties on not taking an RMD from an inherited IRA through 2024. However, this does not affect the ten-year deadline which is still measured from the owners date of death. For ROTH IRAs, they must be drained by the ten-year anniversary, but there is no annual distribution requirement.

Market Thoughts: This Time is Not Different

We find ourselves often wondering of late whether those most dangerous four words in investing, “this time is different”, are actually appropriate to describe the current environment.

The story of the U.S. stock market is largely the same as it has been for much of the last several years: overall valuations are high; growth stocks are highly valued relative to value stocks; and large capitalization stocks are outperforming those of small companies. At the same time, the U.S. stock market continues to be valued much more richly than non-U.S. markets. For a while these conditions could be attributed to record low interest rates, but after short-term rates increased 500 basis points and the bull market in stock indices continued to roll along that argument obviously no longer has validity.

The CAPE (Cyclically Adjusted Price Earnings) Ratio has recovered to 35 which is closing in on the high reached prior to the correction experienced in 2022 (Chart 1). The ratio of U.S. market capitalization to GDP (Warren Buffet’s favorite valuation indicator) is also approaching the 50+ year peak of three years ago (Chart 2). Large capitalization stocks are more richly valued than those of small companies since 2000 (Chart 3). Growth stocks have blown through their relative valuation peaks compared to value stocks seen in 2020 and 2022 (Chart 4). Similarly, U.S. stocks are setting new modern valuation extremes relative to non-U.S. stocks (Chart 5).

Not only have stocks seemed to defy valuation norms, but typically reliable economic indicators have also been behaving differently this cycle. The index of Leading Economic Indicators has been declining for 29 months (Chart 6) and the yield curve had been inverted (short-term rates higher than long-term rates) for 25 months prior to recently dis-inverting basis the 2-year/10-year Treasury curve (Chart 7). Historically that type of behavior by these indicators has been a reliable harbinger of a coming recession, but not this time…at least so far.

Bonds continue to appear to offer compelling value relative to stocks. The yield on the 10-year Treasury note is at the widest premium to the dividend yield on the S&P 500 index in almost twenty years (Chart 8). The 10-year yield is also approximately in-line with the earnings yield (the inverse of the price earnings ratio) on the S&P 500 for the first time in almost twenty-five years (Chart 9). As mentioned above, this is happening at a time when the risk of a recession seems to be high based on some historically reliable indicators. A continued economic slowdown should be positive for bonds as inflation would likely continue slowing while being negative for stocks as corporate earnings would come under pressure. Further the level of uncertainty on both the domestic political and global geopolitical fronts seems higher than normal.

Our conclusion is that this time may be different in terms of the durability of high valuations and the short-term behavior of economic indicators, but valuation realities and economic laws have not been permanently repealed and ultimately both of those will eventually revert to “normal”. There is an old saying, “Markets can stay irrational longer than one can remain solvent”. We fully expect that with the Federal Reserve now set to continue lowering short-term rates in the coming months that current valuation extremes in certain areas of markets will likely reach new heights before any meaningful correction.

We do not make outsized bets for or against a market regardless of how undervalued or overvalued we view it to be; however, we do view our role as adding risk when markets look cheap and reducing risk when markets look expensive. We believe this is one of those times as large capitalization U.S. growth stock appear very overvalued and long-term U.S. Treasury bonds look attractive. That could work against relative performance for a period of time, but we believe that it is more important to protect clients from outsized risks than to try to chase every bit of late-cycle performance.

We believe that it is also important to note that despite the apparent extremes in their valuation, U.S. stocks should still offer positive returns based on history as the current level of the CAPE ratio has seen annual average returns of -1% to +5% (Chart 10).

Chart 1: Long-term Historical Cyclically Adjusted PE Ratio with Recessions

Chart 2: Wilshire 5000 Total Market Capitalization to US GDP

Chart 3: U.S. Large Cap versus Small Cap 

Chart 4: Russell 1000 Growth Index vs. Russell 1000 Value Index 

Chart 5: U.S. Stocks versus European Stocks

Chart 6: Index of Leading Economic Indicators

Chart 7: 10-Year Treasury Minus 2-Year Treasury

Chart 8: S&P 500 Index Dividend Yield Versus 10-Year Treasury Note Yield

Chart 9: S&P 500 Earnings Yield Versus 10-Year Treasury Note Yield

Chart 10: Next 10 Year Annualized Returns of S&P 500 (Vertical Axis) vs. Beginning CAPE Ratio (Horizontal Axis)

Chart 11: U.S. Dollar Index

Portfolio Management

We have made some changes to most client equity portfolios in the last month or two. Following our belief that U.S. growth stocks are quite stretched from a valuation basis, we liquidated our holdings of the Invesco QQQ Trust (Ticker: QQQ) which we had purchased almost a year ago on our expectation at that time that moderating inflation and interest rates would favor growth stocks. We also liquidated most of our holdings of Walt Disney Corp. (Ticker: DIS) as we continue to be frustrated by management’s inability to achieve sustained earnings growth relative to the level of capital that has been expended. We have redeployed the proceeds of those sales into the iShares Gold Trust (Ticker: IAU) and the Vanguard FTSE All World ex U.S. ETF (Ticker: VEU). We believe that the likely downward trend in domestic interest rates will remove the major support for the U.S. dollar (Chart 11) which should benefit hard assets priced in dollars, such as gold, and non-U.S. stocks which are at a historical discount from a valuation basis.

In our fixed income portfolios, we increased the duration of our holdings a few months ago by swapping a significant holding of a 2027 Treasury note into a 2044 Treasury as we became increasingly convinced that the economy and inflation were going to continue to slow. Portfolio durations are longer than benchmark and quality remains investment grade with the majority being U.S. Treasuries. This should result in outperformance if interest rates continue to decline.

Administrative Items

Please be sure to always inform us of any changes to mailing addresses, email addresses, or phone numbers. Also, if you have any issues with logging into NetXInvestor or Tamarac, please contact Suzie or Angie. They are happy to help you and can usually get any issues resolved relatively quickly.

Suzie and Angie will be working on processing the remaining 2024 required minimum distributions that are not on automatic distribution. If you are planning to make any direct charitable contributions from your IRA distributions this year please let them know ASAP to ensure they get processed well ahead of the end of the year to avoid a penalty.

As always, we welcome your comments and questions.  Please don’t hesitate to call, visit, or email at any time.

Dear Clients and Friends,

Happy 2024!

Last year was an excellent year for stocks as the major averages regained most of what they lost in 2022. We are not expecting 2024 to see similar returns as the economy slows and the U.S. market is once again pricey. However, a continued decline in inflation and interest rates will likely provide support to equity and bond prices with growth stocks and non-U.S. stocks poised to do best. In this letter we share an update on BRAVE, some recent changes that affect retirement savings and gifting, our current view on the markets, how we are implementing that view in managing our client portfolios, and a few administrative items.

BRAVE Family Advisors Update

BRAVE had a strong year of growth in 2023 with another year of record revenues.

Later this winter our team will be holding an offsite meeting. We’ll be reviewing the year that was, setting goals for the future, and hearing from at least one outside expert to help us continue to improve the company to serve our clients better.

A big “THANK YOU” to those of you who referred family members and friends to BRAVE last year. We continue to be excited to be able to work with additional individuals and families who can benefit from our services.

Increased IRS Limits

The Internal Revenue Service again increased the 2024 limits on gifting and the annual contribution limits on certain types of retirement savings plans as a result of the recent heightened inflation rate.

SECURE ACT 2.0 IMPACTS

A new law that contained a package of enhancements to retirement savings, titled SECURE Act 2.0, was signed into law in late 2022. We want to remind you of a few notable changes that may affect you and a modification of one important provision:

• Raised the age at which RMDs from retirement accounts begin to 73 in 2023 and 75 in 2033. If you turned 73 in 2023 then you need to take a RMD by 4/1/24 for last year.
• Catch-up contribution limits to 401k plans will be increased beginning in 2025 for workers aged 60-63 from the current $7,500 to $10,000.
• Up to $35,000 can be rolled over from a 529 plan that has been open for at least 15 years into a ROTH IRA account for the 529 plan beneficiary.
• The original legislation required that catch-up contributions for workers earning in excess of $145,000 would need to be ROTH contributions beginning in 2024. However, the Internal Revenue Service issued guidance last year that moves the enactment date to 1/1/26 due to difficulties in implementing the change.

Market Thoughts: Back to the Future

After an excellent year in the U.S. stock market in 2023, it is back to being expensive and some of the areas of recent relative overvaluation have reasserted themselves after correcting in 2022. This is occurring at a time that economic growth seems likely to continue decelerating and geopolitical risks around the world appear higher than typical. Long-term interest rates appear to have peaked as the market is increasingly confident that the Federal Reserve has succeeded in its battle against inflation and that a reversal in its monetary policy stance is inevitable.

The S&P 500 Index was up 26.3% last year which brought it back to almost exactly the same level where it ended 2021. During the stock market correction in 2022, valuation in general and some of the areas of extreme overvaluation saw significant corrections. The ratio of growth to value (the way we measure it) experienced a 20% decline; the U.S. stock market relative to non-U.S. stock markets fell about 15%; the U.S. total market capitalization as a % of GDP declined by over 25%; and the CAPE (Cyclically Adjusted Price Earnings) ratio fell from 39 to 27 (Charts 1-4).

The recovery last year reversed those healthy corrections to varying degrees. U.S. growth stocks are nearly back to the extreme levels of valuation relative to value stocks seen in 2020 and early 2022. The U.S. market has retraced approximately  75% of its earlier correction relative to non-U.S. stocks. The ratio of U.S. market capitalization to GDP remains well below the peak of two years ago as the result of the high rate of nominal economic growth. However, the valuation level is well above all other times in the last 50+ years other than that seen in the last four years.

The current CAPE ratio suggests that U.S. stocks remain priced more richly than at any time in modern history other than the late 1920s, the dot-com bubble, and most of the last seven years. The fact that they are only a bit above the average of the last 25 years obviously raises the question of whether we have entered a new era of “permanently” higher valuations and that “this time is different” …the most dangerous four words in investing. The argument had been that high valuations were justified by low and declining interest rates. Now that those valuations have largely withstood an historic increase in interest rates calls that into question unless a significant further correction in valuation is to come.

These relatively rich valuations are occurring at a time of heightened economic, political and geopolitical uncertainty. A significant decline in the index of Leading Economic Indicators has been a virtual fail-safe indicator of a looming recession over the last 65 years. We have experienced a 3+ year decline in that index which would suggest that the current economic slowdown will lead to a recession (Chart 5). This year seems likely to have its share of domestic political volatility with the Presidential election in November. Also, the risks of a broader conflict in the Middle East, uncertainty in Ukraine, and the China/Taiwan situation are all percolating in the background.

Chart 1: Russell 1000 Growth Index vs. Russell 1000 Value Index

Chart 2: U.S. Stocks versus European Stocks

Chart 3: Wilshire 5000 Total Market Capitalization to US Annual GDP

Chart 4: Long-term Historical Cyclically Adjusted PE Ratio with Recessions

Chart 5: Index of Leading Economic Indicators

Bonds on the other hand appear to offer value relative to stocks after their significant declines last year. The yield on the 10-year Treasury note is at the widest premium to the dividend yield on the S&P 500 index in almost twenty years (Chart 6). The 10-year yield is also approximately in-line with the earnings yield (the inverse of the price earnings ratio) on the S&P 500 for the first time in almost twenty-five years (Chart 7). As mentioned above, this is happening at a time when the risk of a recession seems to be high based on some historically reliable indicators. An economic slowdown should be positive for bonds as inflation would likely continue slowing while being negative for stocks as corporate earnings would come under pressure.

Chart 6: S&P 500 Index Dividend Yield Versus 10-Year Treasury Note Yield

Chart 7: S&P 500 Earnings Yield Versus 10-Year Treasury Note Yield

We remain of the belief that the continued high valuation of U.S. stocks doesn’t necessarily mean that disaster for stock returns lies ahead; however, it does suggest that future equity returns are likely to be below historical averages. There is a strong correlation between current valuation levels and future returns. Typically, the cheaper stocks are, the higher future returns will be and vice versa. This relationship can be seen in Chart 8 which illustrates the relationship between the beginning CAPE ratio and stock market returns over the next 10 years. A beginning CAPE ratio of around the current level of 31 has yielded 10-year future annual average returns in a range of -4% to +9% over the last 95 years with most being in the +3% to +5% range. This combined with the likelihood of positive returns from the bond market suggests that balanced portfolios have a good chance of seeing positive intermediate- to long-term returns.

Chart 8: Next 10 Year Annualized Returns of S&P 500 (Vertical Axis) vs. Beginning CAPE Ratio (Horizontal Axis)

Portfolio Management

We made some changes to most client equity portfolios in the fourth quarter of last year to reflect our thinking that economic growth will likely continue to slow and interest rates will generally decline with that trend. U.S. stock markets are definitely expensive, but they have been expensive for years and have continued to perform in-line with or better than their historical averages. There is an old investing saying, “Markets can stay irrational longer than you can stay solvent!”. Late last year we took losses on a high dividend exchange traded fund and a gold fund, neither of which performed as well as we had expected. We redeployed the proceeds of those sales into the Nasdaq 100 exchange traded fund (ticker QQQ). This security provides exposure to the 100 largest Nasdaq-listed stocks with a heavy weighting in large capitalization technology stocks. Although this segment of the market is not cheap, we feel that with slowing economic growth these companies have the best opportunity to continue growing revenues and earnings due to their dominant market positions in mega trends like cloud computing and artificial intelligence.

In our fixed income portfolios, we increased the duration of our holdings last year as we became increasingly convinced that the economy and inflation were beginning to slow. Portfolios are approximately in-line with benchmark duration and quality remains investment grade with the majority being U.S. Treasuries.

Administrative Items

The 1099s for regular investment accounts will be issued by Pershing LLC between February 1, 2024, and March 15, 2024, by Pershing. Please log into the NetXInvestor site to obtain your tax documents. You can find the tax documents under the Communications tab. We are happy to help your tax advisor as long as you provide us with authorization to speak to them. We can also set them up on our client portal so that they can directly access them. Please send an email to Suzie or Angie with their contact information.

We can provide you or your tax advisor with an estimate of your 2023 gains/losses and dividends/interest income for planning purposes.
Please be sure to enroll in on-line access with Pershing if you would like to avoid the new charges for paper copies.

You have until April 15 or when you file your tax return, whichever is earlier, to make a 2023 contribution to a ROTH or traditional IRA.

As always, we welcome your comments and questions. Please don’t hesitate to call, visit, or email at any time.

Dear Clients and Friends,

Happy 2023! 

Looking out over the next twelve months we are not bullish overall on market prospects, but, rather than a year ago when virtually all markets were overvalued, we believe that there are pockets of opportunities in both the stock and bond markets. In this letter we share an update on BRAVE, some recent changes that affect retirement savings and gifting, our current nuanced view on the markets, how we are implementing that view in managing our client portfolios, and a few administrative items.

BRAVE Family Advisors Update

BRAVE had a strong year of growth in 2022. We increased our employee count by one-third with the addition of Angie and Will to the team. We moved into larger and more modern office space in Summit (albeit across the hall from our former office!). Despite the market declines we experienced one of our best years for new business in the firm’s thirty-year history. 

Later this month our team will be holding a day-long offsite meeting. We’ll be reviewing the year that was, setting goals for the future, and working with an expert on client experience in an effort to continue to improve ours.

A big “THANK YOU” to those of you who referred family members and friends to BRAVE last year. Our increased capacity allows us to continue working with additional individuals and families who can benefit from our services.

Increased IRS Limits

One of the few positives of the current high inflation rate is that the Internal Revenue Service again increased the 2023 limits on gifting and the annual contribution limits on certain types of retirement savings plans.

SECURE ACT 2.0

A number of enhancements to retirement savings were signed into law just before the end of last year. The package, titled SECURE Act 2.0, included numerous changes with the most significant to our clients likely being:

• Raising the age at which RMDs from retirement accounts begin to 73 in 2023 and 75 in 2033.

• Catch-up contributions to 401k plans will be increased beginning in 2025 for workers turning 60, 61, 62, or 63.

• Catch-up contributions for workers earning in excess of $145,000 will need to be ROTH contributions which may have adverse tax consequences.

• Up to $35,000 can be rolled over from a 529 plan that has been open for at least 15 years into a ROTH IRA account for the 529 plan beneficiary.

Market Thoughts: Cheaper But Not Cheap

Our current outlook for markets is significantly more nuanced than it was this time last year as the recent declines have begun creating pockets of opportunity. In our 2022 Outlook letter we described our approach to markets at that time as KISS, which is an acronym for Keep It Simple, Stupid. We believed that markets were historically expensive and the primary factor that justified those valuations, massive government stimulus, was in the process of being taken away and that would result in increased volatility and lower returns. That obviously was exactly what played out in most financial markets. 

This year is not so simple. Equity markets have gotten cheaper but are not cheap at a time when most companies are likely facing increased headwinds in the areas of slowing demand and higher capital costs. Growth stocks and international stocks have begun to unwind their historical overvaluation relative to value and U.S. shares, respectively, but likely have further to go. The Federal Reserve appears unwilling to heed increasingly clear signs of economic weakening which may mean that the yield curve will invert further creating divergent performance within different parts of fixed income.

Last year U.S. markets arguably had their worst performance in at least 100 years. The combined returns of the stock market and the bond market were the lowest since 1931 (Chart 1). This chart is a scatterplot of the annual returns of the S&P 500 (horizontal axis) and the 10-year U.S. Treasury note (vertical axis). However, what set 2022 apart was that there was virtually nowhere to hide. In two of the worst years in modern stock market history, 1931 and 2008, bonds suffered only a small decline or were a positive offset. Last year, bonds performed nearly as poorly as stocks. This was because both markets had been driven to overvaluation by low inflation and extreme levels of government stimulus. When those influences reversed, both markets felt the pain.

Chart 1: Scatterplot of Annual U.S. Stock and Bond Returns

U.S. stocks are significantly less overvalued than they were a year ago, but are still a long way from being cheap. In most cases the market only looks attractively valued relative to other peak periods such as a year ago or the peak of the Dotcom bubble in 2000 or 1929. The S&P 500 is currently trading at 17.0 times forward earnings which is marginally above average; this multiple has declined in recent months from a high in excess of 22.0 times during late 2021. The risks in declaring equities fairly valued on this basis are 1.) earnings estimates for 2023 have only recently begun to be revised lower and may have significantly further to go and 2.) the interest rate environment has become much less supportive than it had been in recent years.  The U.S. total market capitalization as a % of GDP has declined by over 25%, but is still above the level reached at the peak in 2000 (Chart 2).  The current CAPE ratio (Cyclically Adjusted Price to Earnings ratio) of 27 is down by almost one-third from the recent peak, but is still higher than almost all modern periods other than just before and just after the 2000 peak and 1929 (Chart 3).  U.S. stocks also remain very expensive relative to those in other regions of the world still trading about three standard deviations above their 50-year valuation mean relative to European stocks (Chart 4).  Within the U.S. market, growth stocks have finally begun unwinding their extreme overvaluation relative to value stocks, but are only slightly below their previous peak and are significantly above the long-term average (Chart 5). 

Chart 2: Wilshire 5000 Total Market Capitalization to US Annual GDP

Chart 3: Long-term Historical Cyclically Adjusted PE Ratio with Recessions

Chart 4: MSCI United States Index vs. MSCI Europe Index

Chart 5: Russell 1000 Growth Index vs. Russell 1000 Value Index  

Bonds on the other hand appear to offer value relative to stocks after their significant declines last year. The yield on the 10-year Treasury note is at the widest premium to the yield on the S&P 500 index in fifteen years (Chart 6). This is happening at a time when the likelihood of a recession seems to be very high based on historically reliable indicators such as the inversion of the yield curve and the downturn in the Index of Leading Indicators (Charts 7 and 8). An economic slowdown should be positive for bonds as inflation would likely slow more quickly while being negative for stocks as corporate earnings would come under more intense pressure.

Dear Clients and Friends,

What a difference a year makes! We hope you and your family are happy and healthy as we continue to exit one of the most challenging periods of our lifetimes.  In this letter we share an update on BRAVE, some thoughts on potential tax changes and what you may want to think about doing with your portfolios and other assets in light of those, a discussion on ROTH conversions, the continued current expensive state of U.S. equity markets, and how we are managing our client portfolios.

BRAVE Family Advisors Update

As the COVID fog continues to lift, operations at BRAVE have continued to return to a bit more normalcy.  The Summit office reopened earlier this year and Suzie, Jamie, and Lisa are back in the office most days.  We are in the process of doing and planning some client meeting travel this summer.  This is the first long distance business travel for us in almost eighteen months.

We moved into a new office in Tiverton this month.  We are at the same address but have moved into a larger and even more attractive space.  The new office has sufficient room for additional employees and will allow us to have a conference room.  

We are excited to have our first summer intern this year! Will Swart, who is a rising senior at Bryant University, is working in our Rhode Island office for ten weeks helping with a number of projects.  Will is studying international finance and is Bryant’s starting goalie on their Division One soccer team.  Welcome Will!

Update on Potential Tax Policy Changes

Despite tax policy changes being a significant feature of President Biden’s proposed economic policy during his campaign, the proposals that have been announced by his team in recent weeks seem to have surprised many people.  Whether you support them or not, they will clearly result in a significant increase in income, capital gains, and estate taxes for the “investor class” if they are enacted.

To summarize the four major changes that have been proposed so far: 

1.) Raising the top marginal ordinary income rate back to the Obama-era 39.6% from the current 37.0%.  

2.) Increasing the tax rate on long-term capital gains and dividends to 39.6% from the current 20.0% for taxpayers with annual income in excess of $1 million.  When the 3.8% Medicare surtax on high levels of unearned income is included the tax on capital gains for those taxpayers will be 43.4% versus the current 23.8%.  State income taxes (where applicable) would be in addition to that.

3.) Cutting the lifetime Federal estate tax exemption to $5.0 million or $3.5 million per person (or $10.0 million or $7.0 million per couple).  The current exemptions are $11.7 million per person and $23.4 million per couple.  He also proposed increasing the estate tax rate to 45% from the current rate of 40%.  

4.) Taxing unrealized gains at death.  The current policy “steps-up” the cost basis on appreciated assets at death to the value at the time of death thus eliminating the potential capital gains tax for the heir(s).  Under Biden’s proposal the unrealized gain would be taxed.

We do not know at this time whether any or all of these proposals or alternative policies will make their way through the narrowly divided houses of Congress and get signed into law.  If changes are made that are retroactive to January 1, 2021, then there will be little that can be done to mitigate the potential impact of them.  However, if the changes take effect prospectively, then we will communicate strategies to try to “get ahead” of their becoming effective.  

These could include:

A.) Realizing long-term capital gains: Since your capital gains tax rate may nearly double if you make more than $1 million per year, locking in a gain at the current rate could represent a significant tax savings.

B.) Gifting assets: You can take advantage of the current $11.7/$23.4 million exemption to move as much as that amount of value out of your taxable estate to heirs or irrevocable trusts before the exemption is possibly cut in at least half.

C.) Making charitable contributions from your IRA: The IRS allows direct charitable contributions from IRAs of up to $100,000 per year.   Using IRA funds to make charitable donations this year that you would otherwise make from other sources could provide a benefit if the top marginal ordinary tax rate is increased.  The tax write-off at current tax rates could very well be less than the tax you will pay on the future IRA distributions that you and your heirs will be required to take at future higher tax rates.

D.) Converting 401(k) contributions to after-tax from pre-tax:  Unlike with IRAs, there is no income limit on making ROTH contributions in a 401(k) plan.  If the tax benefit of making a tax-deferred contribution is reduced, then high earners may get a greater benefit of making an after-tax contribution at current tax rates and having the money grow tax free for the rest of their lifetimes.

Please do not hesitate to contact us with any questions and look for further communications from us as tax policy changes become clearer.

Do ROTH Conversions Make Sense for You?

With the increased focus on the likelihood of higher income taxes over time and the elimination of the “stretch IRA” by the SECURE Act, we have been spending a lot of time in the last few months working with clients to help them understand whether converting traditional IRA and 401(k) assets to ROTH accounts makes sense.  In some cases, the amount of tax savings over their and their children’s lifetimes can be shocking.

Tax-deferred retirement savings accounts are a very popular tool for Americans to save for retirement and defer income taxes on those savings.  However, paying the tax is only delayed; it is not eliminated.  The IRS requires that a minimum amount is withdrawn every year once an account holder reaches the age of 72.  The annual percentage begins at about 3.9% the first year, but rises each year as remaining life expectancy declines.  The required minimum distribution (RMD) reaches almost 6% at age 82 and 10% at age 92.  Once the account owner dies and someone other than a spouse inherits it, then the government requires that the entire balance be withdrawn within 10 years and ordinary income taxes be paid on the entire balance.

In some situations, converting tax-deferred accounts into ROTHs during years in which the account owner’s marginal tax rate may be lower than it will be in later years can be a very effective tax planning and estate planning strategy.  For example, we recently reviewed the situation for a couple who are both 60 years old, have household income of around $190,000, plan to retire at 62, have tax deferred retirement assets in excess of $2 million, and much smaller taxable investment account balances.  If we assume that they only take the required minimum distributions from the retirement accounts and then leave the balance to their children when they pass 30 years after retirement, the potential Federal income tax that they and their family might owe on the retirement assets could be over $3.6 million dollars due to the potential growth in those assets.  This couple has an opportunity to possibly manage their income over the next several years before they must take Social Security benefits and RMDs to allow them to convert proceeds from the tax-deferred savings into ROTH savings and pay the tax while they are in a lower marginal tax bracket than they and their children may be in the future.  Based on one set of assumptions, the tax savings over the next 40 years for this family would be approximate $3.0 million!

Please let us know if you would like us to analyze your family’s situation to see whether ROTH conversions and/or making ROTH contributions to your 401(k) may make sense.

Market Thoughts

U.S. stock market remains at an interesting juncture.  There are a number of positives: the major uncertainties of the last year, political- and COVID-related, have largely been eliminated; additional fiscal and monetary stimulus will likely be provided; and corporate earnings news should remain favorable.  However, valuations by most measures remain stretched suggesting that much of the positive news may have already been discounted.  We strongly expect that equities will continue to provide the best long-term returns, but would also suggest that the present is a good time to pare back risk profiles at the margin.    

Despite earnings estimates having risen faster than stock prices in recent months, U.S. stock prices remain at historically expensive valuation levels and signs of speculation have become common place.  By many long-term measures, the U.S. equity market is as highly valued as it was at the peak of the dot-com bubble in 2000 and the high in 1929; by some measures it has even exceeded those historical peaks.  The primary valuation support remains stocks’ attractiveness relative to bonds, although that gap has begun to shrink.  Developments such as the recent gyrations in “meme” stocks, the tidal wave of initial public offerings in SPACs (Special Purpose Acquisition Companies) earlier this year, and the unprecedented speculative activity in options suggest that animal spirits are once again reaching a frenzied level.  

There are several measures that illustrate the current largely unprecedented valuation levels for U.S. stocks.  The S&P 500 is currently trading at 21.5 times forward earnings which is well above average in absolute terms; this multiple has declined slightly in recent months from a high in excess of 22.0 times as the economic recovery has been stronger than expected.  The U.S. total market capitalization as a % of GDP is at a new modern high (Chart 1).  The current CAPE ratio (Cyclically Adjusted Price to Earnings ratio) of 37 indicates that stocks are at among their most expensive levels in the last 100 years only exceeded just before and just after the 2000 peak (Chart 2).  U.S. stocks also remain expensive relative to those in other regions trading more than four standard deviations above their 50-year valuation mean relative to European stocks (Chart 3).  Within the U.S. market, growth stocks have seen some underperformance relative to value stocks in recent months but remain at levels above those seen at the peak of the dot com bubble twenty years ago (Chart 4).  

Chart 1: Wilshire 5000 Total Market Capitalization to US Annual GDP

Chart 2: Long-term Historical Cyclically Adjusted PE Ratio with Recessions

Chart 3: MSCI United States Index vs. MSCI Europe Index

Chart 4: Russell 2000 Growth Index vs. Russell 2000 Value Index  

The biggest valuation support for the current U.S. stock market continues to be “TINA” (There Is No Alternative).  The dividend yield of 1.35% for the S&P 500 is still attractive relative to interest rate levels available in the U.S. fixed income market and even more so relative to the trillions of dollars of negative yielding debt around the world (Chart 5).  The impact of extreme liquidity and low available interest rates can be seen in record M&A activity and margin debt, a recovery in share buyback activity, and very high levels of retail equity purchases.  We expect this support to diminish over time as rates maintain their gradual move higher due to the likely potent combination of further massive fiscal and monetary stimulus, the additional reopening of the economy as vaccinations and herd immunity reduce the virus’ impact, and the growing signs of a pick-up in inflation.  For the time being, though, liquidity may very well continue to overwhelm valuation.

We remain of the belief that the high valuation of U.S. stocks doesn’t necessarily mean that disaster lies ahead; however, it does suggest that future equity returns are likely to be well below historical averages.  There is a strong correlation between current valuation levels and future returns.  Typically, the cheaper stocks are, the higher future returns will be and vice versa.  This relationship can be seen in Chart 6 which illustrates the relationship between the beginning CAPE ratio and stock market returns over the next 10 years.  A beginning CAPE ratio of around the current level of 37 has yielded 10-year future annual average returns in a range of -1% to +4% over the last 94 years.  Due to the limited experience with valuations at this level there is not a lot of historical data; however, what is available suggests that investors may need to adjust their expectations to something less than the historical average equity return of close to 10% per year.

Chart 5: S&P 500 Dividend Yield and 10 Year Treasury Yield

Chart 6: Next 10 Year Annualized Returns of S&P 500 Index (Vertical Axis) vs. Beginning CAPE Ratio (Horizontal Axis)

Portfolio Management

We have not made any major changes in client portfolios in recent months.  We continue to be a bit overweight value and international stocks due to their more attractive valuations compared to growth and U.S. stocks, respectively.  After exiting a large gold position last fall, we have added some exposure to metal again as we believe that it provides diversification from expensive U.S. stocks and should benefit over time from the low real interest rates and growing government debt levels. 

In our fixed income portfolios, we have maintained relatively short duration since early spring of last year as we believe a potential generational low in interest rates has been seen.  We have been including the iShares Preferred and Income Securities ETF (Ticker: PFF) and a Nuveen national municipal bond closed-end fund (Ticker: NEA) in many portfolios to increase yields on a tax-advantaged basis.  The former fund holds preferred securities that have characteristics of both stocks and bonds.  Importantly, the fund pays an approximate 5% yield that is primarily taxed as a dividend rather than as corporate interest.  The latter fund holds municipal bonds and uses some leverage to increase the yield.  It currently pays interest at an approximate 4.5% rate and is Federal tax free and trades at a 3% discount to its net asset value.

Administrative Items

As always, we welcome your comments and questions.  Please don’t hesitate to call, visit, or email at any time.