Welcome Back, Volatility


February 5, 2018

Do you remember the popular 1970s sitcom Welcome Back, Kotter? It was about a high school teacher who returns to his inner city alma mater to teach a remedial class of slackers known as the “Sweathogs”. The show was originally meant to be simply called Kotter, but the writer of the show’s theme song, John Sebastian of Lovin’ Spoonful, couldn’t come up with a rhyme. Instead, he penned “Welcome Back” which went on to become a No. 1 hit. We were reminded of that song last week as volatility returned to the stock market after a remarkably long absence.

To put this in context, by one measure last year was the least volatile year in the stock market since 1965. There were only eight days in 2017 where the market moved up or down more than one percent, as compared with the annual average since 1930 of sixty. Moreover, this period of low volatility has seen a gradual rise in equity prices with, for example, the S&P 500 being up for 15 months in a row. That has never happened before.

Then last week we ended the longest streak without at least a 3% fall in the market, with a pull back for the S&P 500 of about 3.9% from its most recent high. Things have been so smooth and steady recently that this volatility feels uncomfortable. If we look at the broader context, however, there have actually been an average of seven pull backs of this magnitude per year since the late 1920s. The fall in the Dow of 666 points on Friday was a big decline, but we should remember that it only amounts to a 2.5% drop. Volatility of this sort is quite normal for the stock market and should be expected.

What does this mean for investors? We follow a number of analysts and thinkers to stay abreast of insights into market behavior. Two are worth noting here. The head of the Capital Markets Team at Vanguard recently reiterated his team’s view that while a correction is quite likely in the U.S. stock market this year, a bear market is not on the horizon. As you may recall, a correction is a 10% pullback while a bear market is a 20% pullback.  Bear markets are typically (but not always) associated with recessions and Vanguard sees no recession for at least the next 12 to 18 months.

The other insight worth sharing is from Professor Jeremy Siegel of Wharton Business School, and author of the investment classic “Stocks For The Long Run”. Professor Siegel also sees a meaningful chance of a correction this year, but expects stocks to finish the year in positive territory. He points to strong earnings and continued economic growth as drivers and, like Vanguard, he sees no recession on the horizon.

We will continue to monitor developments as events unfold, while recognizing that more normal levels of volatility seem to have returned. Welcome Back?

Mike Masters


The Tax Code Made Me Do It

tax 2018

January 21, 2018

Changes to the tax regime have become a popular subject of conversation with the passage of the Tax Cuts and Jobs Act in late 2017.  Investors have been eager to learn how changes might benefit various asset types.  The centerpiece of these changes is a lower corporate tax rate, which should give some boost to corporate earnings.  Another investment-related change enables US corporations to bring home cash parked overseas at a reduced rate.  Individual taxpayers should generally have more disposable income, giving potential to lift consumption and thus the economy.  With 70% of US GDP driven by consumption, reduced tax rates from 2018 to 2025 for working Americans will likely fuel faster growth, although the economists cannot agree by how much.

Beyond these heavily-discussed headline changes, there are many lower profile changes that could have a significant impact on the behavior of individuals and corporations.  For example, a recent WSJ article observed that allowing corporations to immediately deduct new equipment purchases in full is anticipated to accelerate the use of robotics in manufacturing.

The change that will directly affect the most people is the increase in standard deductions for individuals.  For a married couple filing jointly, the standard deduction nearly doubles to $24,000 in 2018.  Higher standard deductions erode the advantage of itemizing, reducing the number of taxpayers who benefit.  Some may even batch deductions together in particular years and itemize less often.  While mortgage interest remains deductible, it is capped for new homebuyers.  Property taxes remain deductible, but only up to a new $10,000 limit, toward which state and local income tax also counts.

Higher earners, or those living in areas with high taxes or property values, will face an increase in the cost of homeownership. These changes will tend to make the relative cost of renting more attractive, which is of potential benefit to the owners of apartment properties. This could be most pronounced in higher tax states, and among higher end apartment properties.

Charities who rely on the middle class for contributions have reason to be worried.  The tax benefit of charitable contributions will be diminished or erased for those who no longer itemize their deductions.  As an alternative to traditional methods (i.e. “writing a check”), other more sophisticated charitable giving techniques may gain popularity. For example, with appropriate guidance from a tax advisor, those required to take taxable IRA distributions may see advantages in directing their annual required distributions IRA to a qualified charity.  If handled properly, this could enable the taxpayer to take both the new, higher standard deduction and avoid recognizing income that would otherwise be taxed.

Given the complexities of recent tax changes, we can be fairly sure that few taxpayers (corporate or individual) are acting in full knowledge of the impact of the new law.  Some will profit from being first to understand the benefits, and associated behaviors, prompted by the revised rules.  For most people, though, it will take some time for the dense fog of uncertainty generated by the tax changes to clear.

Cam Simonds