Client Update 2020
Dear Clients,
I hope this update finds you and your family healthy and eager for the coming new year.
PLANNING
Below is a list of notable planning items and reminders for the 2020 tax year:
- Roth conversions may be more attractive for you this year. Roth conversions allow the permanent transfer of investments from pre-tax Traditional IRA accounts into after-tax Roth IRA accounts. If your income was down in 2020, a conversion may be a smart move. I have spoken with all clients to whom I think it would make sense, but please reach out if you would like to discuss.
- Qualified retirement plan contributions for 2020 are due April 15, 2021 or October 15, 2021 if an extension is filed. Account types include Traditional IRAs, Roth IRAs, and SEP IRAs.
- The Illinois Bright Start 529 College Savings contributions must be made by 12/31/20 for those who want the Illinois State Income tax deduction for 2020. Keep in mind, there is a $10,000 deduction limit for individuals and $20,000 deduction limit for those married filing jointly. There are no income restrictions for deductions.
- Refinancing your mortgage to a lower rate or shorter maturity may offer significant savings. The 30-year fixed-rate mortgage with 20% equity is currently around 3.00%, down from 3.75% last year. The 15-year fixed-rate with 25% equity is currently around 2.5%.
INVESTING
On the investing front, 2020 was a reminder that the future is always uncertain, whether we think it is or not. It was a reminder that the macro economy, business performance, and stock prices are not always correlated, especially in the short term. Had you told me on January 1st a global pandemic was underway and shutdowns of the world’s largest economies would last months and continue throughout the year, I would not have predicted the S&P 500 would be up approximately 13%. European stocks, as measured by the Vanguard FTSE Developed Markets ex-U.S. ETF are up 4% and the total return (including dividends) is over 6%. Emerging Market stocks as measured by the Vanguard FTSE Emerging Markets ETF are up 9% with the total return over 11%.
From late February to late March, prices of equities, corporate bonds, commodities, and gold all declined as nearly all tradable securities sold off. During this period, the S&P 500 declined over 34%, U.S. small caps declined over 40%, and real estate and energy indexes over 55%. The Bloomberg Barclays Investment Grade Corporate Bond Index declined 10% and high yield bond averages declined 20%. Even gold declined 12%. The price of West Texas Intermediate fell to negative $37 a barrel in April. A few corporate bankruptcies ensued, particularly in the hotel, restaurant, retail (J.C. Penny, Neiman Marcus), travel (Hertz), and energy industries, but most were rescued by the liquidity programs. Unfortunately, small private businesses (gyms, nail salons, dry cleaners, Uber/Lyft drivers, restaurants, etc.) have suffered mightily.
Central banks and governments globally reacted by creating unprecedentedly large monetary and fiscal stimulus programs, dwarfing those of 2009. Interest rates on treasury bills declined from 1.5% in February to 0.05% in March. Banks cut deposit rates to 0%. Counterintuitively, mortgage rates dropped despite mortgage delinquencies increasing as the unemployment rate increased from an historic low of 3.5% in February to 14.7% in April.
Prices in the short term can be driven by fund flows and not long-term fundamentals between rational parties. We saw this in March, which gave us the opportunity to buy a handful of excellent businesses with stable and growing values at prices well below our conservative estimate of fair value.
I think it is fair to say fear was spreading quickly during this period and forced selling was occurring as unemployment was increasing, businesses activity declining, and cash becoming more valuable. Professional money managers may have high conviction that prices are too low and buying is likely to result in profits, but if their clients make redemptions, they are also forced to sell.
By the end of June, the S&P 500 was back into positive territory for the year and fear had flipped to exuberance. It was a remarkably fast price recovery and change in investor sentiment that displayed the power and scale of the stimulus programs. Bond prices also recovered to previous levels, despite worsening fundamentals. The current 30 day SEC yield for the Vanguard Total Bond Market ETF, which has an effective maturity of 8.5 years, is 1.16%. This fund earned an average of 4.1% the past five years, but if rates do not decline further, it will be lucky to earn more than 1.16%. If rates rise just 0.5%, investors will be faced with losses for several years. For balanced portfolios, I have taken a barbell approach to effective maturities. We own cash and short-term investment grade bond funds and a select few cumulative non-redeemable preferred shares that were purchased well below par in March and now trade well above par.
In April of this year, amid the massive government fiscal and monetary stimulus programs, (now estimated at $21 trillion globally in 2020), I increased the ownership in gold across all portfolios. Previous weights in the five model portfolios ranged from 0-3%. I increased the weighting to 4-5% at cost. The primary drivers of the decision were the amazingly large amount of money creation occurring, extremely low interest rates globally, under ownership among institutional investors and governments, and its historical function as a store of value. It is a potential hedge against inflation and provides diversification away from fiat currencies and business risks. Gold cannot be created with the click of a mouse like fiat currencies.
A FEW LESSONS FROM 2020
- Behavior is the dominant determinant of the investment returns earned by an investor over his or her lifetime. Several studies show that the returns investors actually earn significantly lag the returns of their own investments. That’s right, investors on average underperform the very index funds and mutual funds they invest in by making common, understandable, yet avoidable mistakes. The steep and swift price declines in early 2020 challenged investors not to sell low. Those who did not were rewarded.
- Adequate Liquidity encourages rational behavior. If cash is needed for current expenses, selling may be the only option, despite the low prices. Adequate liquidity provides peace of mind and allows clear thinking when prices inevitably decline, the ability not to sell, and hopefully to focus on buying opportunities. Therefore, we classify money designated for investment in equities as “long-term money.”
- Time in the market is more important than timing the market. Timing is nearly impossible and not something we attempt. My working definition of timing is selling a meaningful percentage of investments and keeping proceeds in cash with the intent to repurchase the same or similar investments, usually when the future “looks more certain.” Had we sold in March, we most likely would not have repurchased shares below break-even prices because prices recovered so quickly, permanently locking in losses. In brokerage accounts, selling unrealized gains creates a tax bill and a requirement to repurchase shares at even lower prices because less after-tax money is available to repurchase the same number of shares.
- Risk is a function of price relative to value. Excellent assets can be poor investments if the price paid is too high. Despite the uncertainty this spring, some prices dropped well below conservative estimates of fair value, providing us the opportunity to buy with less risk and more upside.
Operationally, Maple Street continues to grow its client base. I retained all service vendors this year and added Jay Greenstein and his team at JSG CPA and Advisors to perform accounting and record keeping services in addition to tax. My intention is to outsource where possible to focus on client service, planning, and investing.
On a personal front, Taylor and I welcomed Margaret Nell Meehan into the world in April. We call her Mae and are so thankful she is healthy. Our three-bedroom + office home in Winnetka, IL felt much smaller with everyone home, so we moved to Barrington, IL in August and have enjoyed the extra space and outdoor adventures. I have a dedicated first floor office and hope to present it as an optional meeting location for clients after the coronavirus ceases.
Thank you for placing me in a position of trust. As always, I love to hear from clients, so please feel free to call me anytime.
With Thanks
David Meehan