Recently I’ve seen a few studies and charts on Twitter that lend favor to Tax Efficient Investing. These are portfolios where each holding is designed to be held for more than one year. This stragegy allows them to qualify for reduced taxes as a Long Term Capital Gain. The articles I’ve seen generally advocated by financial planners and advisors who see Tax Efficient Investing as their way to add value or have an edge for the clients of their practice. But not once have I seen a credible article playing the role of Devil’s Advocate for Tax Efficient Portfolios. Today the Dow Jones Index was down 660 points at mid-day. It would seem apropos to highlight a few of the disadvantages of Tax Efficient Investing.
The points I will make are from the perspective of a Growth-oriented investment advisor whose primary investment vehicles are stocks, ETF’s and ETN’s. Municipal bonds are a different animal altogether and not the subject of this blog post.
Are the lower taxes worth the losses?
The primary objective of Tax Efficient Investing is to own an investment for at least 12 months. Our primary objection to this strategy is prioritizing time of ownership over gains. Investment gains can disappear or be significantly reduced by the goal of hanging on for one year. For example, you buy a stock at $50 on January 1, 2017 and perhaps by April 2017 the stock is $65. But by January 2, 2018 the stock could be anywhere. A major sin of investing that you open yourself up to is not taking the gain in April. If the market goes into a sell-off where the stock goes back to $50 or below, your gain has been negated. It reminds me a bit of the game show “Let’s Make A Deal” with Monty Hall. Monty would offer a contestant a sure deal right off the bat, but with the caveat of “Would you be willing to give up the sure deal for whats behind Door 1”. It could be a brand new living room or dinette set (hey I watched it in the 1970’s). It could also be a rusting bucket of used auto parts. At that point Monty would offer the bizarrely dressed contestant the consolation prize of the home version of the game show. Cue sad trombone.
The stock could also have gone to $75 in good market as well, up 50%. If the stock continues to rise without any major setbacks, an experienced Trend Following methodology as well as a Tax Efficient investor would likely continue holding on to the stock. There is a primary difference between a Trend Following system – which we employ – versus a Tax Efficient strategy. We’d take a profit should the stock decline below important benchmarks. Declines below certain sell points raise the question of whether the stock is even in an uptrend. By the way, how hard it is to find a stock that can smoothly rise throughout the entire year? This means the company must produce 4 good earnings reports in a row and not sustain large pullback. 2017 was an easy year for Trend Followers. Even then almost 95% of the stocks we bought could not sustain 12 months of positive performance.
Are the drawdowns tolerable?
In point 1 I discuss a scenario of a single stock. But if Tax Efficiency is the goal along with long term Growth, you can now envision how volatile that portfolio would become. By not exerting proper risk controls, the portfolio would likely have longer and more significant drawdowns. Is that something you really want? Most investors, especially those who are new to investing cannot endure declines of 30% or more to their portfolios. This begs to ask: “Would you pay a bit more in taxes for less volatility?” In my experience which is based on client retention, the answer is “yes”. People hate losing money more than paying higher taxes.
What about lagging holdings?
Digging down deeper into portfolio management is the issue of what to do with lagging holdings. A lagging holding is the stock that you have had a gain on, but is now going nowhere. Our view is to sell laggards in a rising market. We don’t see the value of holding an investment unless its producing for you. A major advantage to this is to look for new potential winners. But the Tax Efficient portfolio may hang on to the stock till it clears the one-year hurdle. This is another factor contributing to underperforming portfolios.
To sum it up: Tax Efficient Investing can be a proper strategy for some investors but for most it isn’t. Investment methods must not just make financial sense. The methods must also be cognizant of the investor’s risk profile and emotional impact. One size does not fit all and every investment method has some inherent weaknesses. Most investors would probably feel more comfortable knowing the achilles heel of any strategy.
Cheers,
Brad Pappas
Not since 1995 has the S&P 500 not had at least a 10% pullback. Normally, you can count on a 10% pullback within an ongoing bull market to a great time to add funds or bring new accounts online. But 2013 is the year of the relentless rally where 2% pullbacks are new 5% pullback. Extreme bullish investor sentiment which is normally a good barometer of when to ease up on portfolio exposure has been pointless, as previous blog posts have demonstrated.
So, whats going on you ask? Why is this year different from the others and what does it mean going forward?
Markets are clearly being driven higher by the Federal Reserve current policy of Quantitative Easement and its by product of 0% short term interest rates.
Its no coincidence that when the Fed ended QE1 and QE2 markets fell apart with declines of -16% and -19% respectively in 2010 and 2011.
Its fashionable right now to analyze each economic tick (especially the recent positive employment data) to determine when the Fed will end QE3. But the truth is we really don’t have an accurate guess for when that will happen.
Three things we know for sure at the moment:
1. We are in the midst of the strong season for equities and that will last until March 2014.
2. The economy as measured by employment is improving. Contrary to politically biased media outlets job growth is not coming from part time employment. GDP growth in the 3rd quarter was stronger than expected. This is market friendly.
3. Bob Dieli’s Aggregate Spread and RecessionAlert.com are both at benign/miniscule odds of recession. Market friendly again.
My best guess of what will happen? Eventually the Fed must end QE3 and the markets may anticipate this ahead of time by churning nowhere or showing internal deterioration in strength. My thinking is that the Fed will do nothing till at least after congressional budget talks in January but by the time March comes around and temps here begin to melt some snow we should be decreasing our equity exposure in a meaningful way.
A quick update on our current status:
The major market indices are at or near major market highs which will likely be a difficult hurdle to surpass in the near term.
In addition, investor sentiment is extremely positive which has negative implications going forward in stock prices.
To our way of thinking the combination of negative investor sentiment with markets at historical highs implies either a sawtooth churning market with little or no gain or a moderate decline in prices in the near term. We don’t believe at this time that a major market top is playing itself out, we believe based on Ned Davis’s market cycle analysis that a major top is due in the Spring of 2014.
All recession indicators remain in positive territory.
So, we are essentially playing defense for our clients by selling off stocks falling in our ranking systems and raising cash rather than reinvesting on the long side. We have added a significant amount of inverse exchange traded funds that should aid in buffering downside volatility in client portfolios.
Should a decline emerge to the degree that overwhelming positive sentiment is reversed we will reverse our course and liquidate the inverse ETF’s and add new long stock positions for a potential new leg up in the indices that could last to March/April 2014.
Brad Pappas
Despite a terrific first quarter, 2011 morphed into a miserable year as the combination of US political bickering and misplaced worry over the prospects of a European debt contagion caused both professional and individual investors to flee to ultra safe alternatives. What made 2011 especially maddening was that investors who did stick with equities chose to hold their assets in the Dow 30 stocks which became almost bond surrogates at the expense of small and mid cap equities. This bifurcated situation created one of the largest spreads ever in performance between the Dow Jones Industrial Index of 30 stocks (+1%) and the Russell 3000 (-7%).
Consistently ignored in second half of 2011 was improving domestic economic data: Improvements in Housing, Consumer Confidence, Auto Sales and Jobs was ignored by the deafening, attention grabbing headlines from Europe. Corporate earnings which are the primary driver of stock prices continued to grow at an approximate 10% pace and look to repeat this performance in 2012.
Despite the improving data, the consensus of opinion amongst investors is gloomy and that is where I believe the opportunity for 2012 is. Professional and individual investors have abandoned equities with a ferocity unseen since 2008 and are settling for yields in Treasuries in the 2% range. Simply put, at a yield of 2% it will take 36 years for the principal to double in value.
Investors having sold heavily in the second half of 2011 have likely discounted the bad news from Europe and the unfounded fears of a US recession. I seriously doubt renewed fears of European recession or budget issue can muster a second similar selloff. Domestic and European issues are well known and have a likely probability of diminishing in consequence.
It’s a frequently commented upon topic that the consensus view of economics and investing will usually be the strategy that bites you the hardest since it’s rare that the consensus view actually comes to fruition. Investing would be quite easy if that was the case, since you could simply find what the prevailing opinion was and invest accordingly.
For 2012 I offer what I believe will be five minority/contrarian views that have a better than average chance of being accurate in 2012.
1. The stock market has a very good year and our models and client portfolios have a very good year. The long term top of 1500 on the S&P 500 is a very good possibility by 2013 as
investors realize the fear driven mistakes of 2011 and move assets from bonds back to equities. A Romney victory would likely be a significant market positive (I am a Democrat) and could propel stocks to 1500 sooner than expected. Newt, on the other hand would likely be a major market headwind while the re-election of President Obama (the likeliest possibility) would be a moderate positive for stocks.
Investors who shunned small and mid-cap sized equities in favor of Index mutual funds and bonds had either minute gains or losses while the vast majority of Value portfolios had a terrible 10 months. The biggest groups of investors: Institutional, Hedge Funds and especially Individual investors are very poorly positioned with very high allocations to cash, gold and bonds.
It’s my belief that 2012 will be a year of mean reversion, where the investments that performed poorly in 2011 will produce outsized gains while bonds post negative returns and Indexes lag managed portfolios by a wide degree.
The 50 year average yield on the 10-year Treasury note is 6.6% and now its 2% while the 50 year average multiple on stocks is 15 times earnings, now it is at 12.
As mentioned in my blog previously: The US market risk premium (earnings yield minus the risk free rate of return) is at a 37 year high. This is another statistical metric highlighting the unusual value and upside potential in equities at present.
2. Treasury bonds will post negative returns in 2012.
I expect 10 year Treasury bond yields to rise in excess of 3.25% resulting from an expanding economy and less worldwide fear. The decline in bond values should provide the impetus for an asset allocation shift away from bonds and into stocks.
3. There will be no recession in the US and we will have at least one quarter where our GDP growth is in excess of 3%. Earnings growth in 2012 remains at a moderate 10% growth rate and the US Federal Reserve leaves interest rates unchanged which is very friendly to a rising stock market.
4. President Obama is re-elected. In my opinion the President’s electability will have much to do with the comparative un-electability of the Republican opposition. Be it Romney, Gingrich, Paul or Santorum, they all have major comparative flaws and would be hard pressed to gain the important Moderate electorate. If I’m wrong and Romney is elected, there is the possibility of reaching 1500 on the S&P 500 earlier than expected as his election would be viewed as a market positive.
5. The European Union will not crash. Problem solving in Democracies is almost always a messy proposition. Seamless and definitive political decisions are the hallmark of Authoritarian rule. Only until a crisis is upon the decision makers do they generally drop their political biases and come to an agreement. I don’t think that there will even be a defining moment when the Euro crisis has been solved; it will be from a series of decisions and actions rather than an all encompassing point in time.
Deep discounted financing (loans provided by central banks at very low interest rates) worked in 2008 to avert our banking crisis and they will likely work again for Europe. The import issue is that their banks simply get financing, the rate is of secondary importance.
Investment Status: Equity markets at present are in excellent shape with all major US indices breaking out to new rally highs. I believe it’s quite possible that that the rally will continue for several more months at least and that 1500 on the S&P 500 are attainable. As you can see in the chart below the SPX has been making a series of higher lows since September but our portfolios really began to out-perform in early December.
Another positive factor for equities over the next several months is that volatility continues to subside. This is necessary for investors to feel secure to deploy funds into equities and is frequently common in the early stages of new market rallies.
One of the biggest factors that I see driving markets higher in 2012 is that the alternative investments, particularly money market funds, CD’s and US Treasury Bills all pay under 1%. Should markets continue to move higher there will be a tremendous amount of cash coming out of those investments to seeking a higher rate of return. Investors may actually panic at the thought of being left out while their present fixed income returns so little.
All in all I expect that 2012 will result is a good year for our clients. Investor expectations are virtually nil and the masses have parked a huge amount of capital in ultra low yielding money markets and short term bonds. 1% returns are not going to help anyone in their retirement or capital growth plans. If equity markets continue to show strength and reduced volatility I do expect a very large asset allocation swap out of low-risk investments and into equities. Regarding equities, I am especially in favor of equities that had a rough year in 2011 due to their expected better than average risk / reward rather than the much beloved darlings like Apple and Google.
RMHI Model: There was no surprise that our investment model took a beating last year. Since my own retirement accounts are invested in the model as well, I can certainly identify with investor pain.
The chart above is the hypothetical back-test of the RMHI model (without hedging) dating back to 2001 till the first week of 2012. Actual client portfolios have tracked very closely to the chart below and while 2011’s decline was severe the performance began to curl higher in December. The chart is divided into thirds and the blue line is the S&P 500, which appears as a simple flat line over 10 years due to its lack of net progress.
The best way to gauge the model will be to track its progress during our current rally and all appears positive at this present time. As of today (1/23/2012) equity portfolios year to date are up an average of 7.5% net of fees and expenses versus 3% for the S&P 500.
All in all, I expect a good to very good year.
Brad Pappas
This letter does not constitute an offer to provide investment advisory services or attempt to effect securities transactions in any state or jurisdiction where such an offer or the provision of such services would be prohibited. Such an offer can only be made in states where we are registered or where an exemption from registration exists. The purpose of this letter is solely for the dissemination of general information on products or services. Investment advice or the rendering of investment advice for compensation will not be made absent of compliance with the state investment advisor requirements. For information concerning the licensure status or disciplinary history of an investment advisor a consumer should contact their state securities law administration. The information contained on this website should not be construed as financial or investment advice on any subject matter. Rocky Mountain Humane investing expressly disclaims all liability in respect to actions taken based on any or all of the information on this letter. Rocky Mountain Humane Investing, Corp. does not warrant the accuracy of the materials provided herein, either expressly or impliedly, for any particular purpose and expressly disclaims any warranties of merchantability or fitness for a particular purpose. Rocky Mountain Humane Investing, Corp. will not be responsible for any loss or damage that could result from interception by third parties of any information made available to you via this site. Although the information provided to you on this site is obtained or compiled from sources we believe to be reliable, Rocky Mountain Humane Investing, Corp. cannot and does not guarantee the accuracy, validity, timeliness or completeness of any information or data made available to you for any particular purpose.
