January 14 Town Hall Webinar
Mike: Hello everybody. This is Mike Hengehold. We are getting set for the first call of the New Year. First, I would like to welcome everybody. Thanks for joining us today. Doug Johnson joins me. As you all know, Doug is a partner here with the firm and he chairs our investment committee. Just two or three brief administrative announcements, and then we will get on with the show.
First, if you have any questions during the presentation, you can go to the bottom of the screen and hover. You should see a Q and A button pop up. You can submit questions through that. Second, if you would like a copy of the slides, let us know, and we will be happy to get those out to you. And finally, a replay of the webinar will be available on our website by midday tomorrow. And that does it. So let us get started.
Within the last year, a little less than a year actually, we have had three pretty significant pieces of legislation that affect retirement planning, taxes, and financial planning. We had the Secure Act at the beginning of last year. Then when COVID broke out, the Cares Act was passed with a lot of stimulus and various benefits for people. And just recently in December, the COVID Tax Relief Act was passed, which has several benefits for individuals. And this is what I want to touch on tonight. But, I also wanted to mention that there are likely two other stimulus programs that will be coming, so that will make a total of five that we think we know about.
The latest will be announced tonight. President-Elect Biden will be making a speech tonight at 7:15 pm. It is expected he will talk about the next wave of stimulus, as well as some of his ideas to keep the economy on track and keep it from slipping back into a recession, while we go through the vaccine rollout procedures. The speech he is going to make tonight is supposed to be very non-partisan. The idea is that the first bill they passed, they want to be very easy for Republicans to get behind. So, it is likely from what I have read, there was a lot of talk about, $2,000 checks. That is likely not going to be the case. They will be splitting the difference, but again, that's what the fifth bill will be for. This will be a bill that will come with more of the democratic ideals that the President-Elect Biden campaign has done.
What I would like to do though, is touch on, a handful of the most relevant, tax, and financial planning ideas or concepts that came out of the most recent COVID Tax Relief Act. The first one and the one that people are waiting for, if you haven't seen your check already, is that more likely than not, there is a $600 either deposit that is going into your bank account or a check that should be arriving in the mail. The $600 is for individuals. Married couples will get $600 per person. So a total of $1200 and you'll get an extra $600 for qualifying children. Those are kids under the age of 17. And, so, it's not unlike the last relief provision that happened earlier in 2020. And that also means that it comes with phase-outs. For instance, individuals with incomes of $75,000 or more will start to phase out. I think its $112,000 or $112,500, for heads of household and $150,000 for couples. So if your income goes over those thresholds, you will either get a reduced amount or potentially none whatsoever. Again, it's managed a lot, like the program was earlier last year. Here is the wrinkle though. It may be a little more complicated. The cutoff for sending out checks from the IRS is tomorrow. So if you haven't received your check yet, or haven't seen your deposit and you don't get it in the next few days, the odds are that you're still in good shape. You're still going to get it. But what that means is, you're going to have to claim it through your tax return.
So this is really in effect, a credit on your 2020 taxes. It always has been, and what you would need to do then, is claim the credit when you file your tax return. (And of course, there are administrative snafus as all of this happened so quickly. And at the last minute, they realized that the criteria for qualifying were your 2019 tax return. And the process for filing and reporting was right upon us. That's why the quick cut off. After the stimulus payments and unemployment benefits, this is something that is being reinvigorated. Those who have exhausted their regular benefits will be entitled to an extra $300 per week, and that will run for an 11-week period. That will exhaust itself about the middle of March. I think the program's beginning date was Friday after Christmas. So, qualifying individuals will receive an extra $300 a week for the next two and a half months or so.
The next item is flexible spending accounts. If you participate in these, you know, these are sort of the, “use it or lose it” accounts. So you put money in and if you don't get it all spent, then you effectively lose those dollars that you were not able to spend on qualified expenses. What the bill last year did, and what this bill extends is the ability to carry those expenses over to another year. So you don't have to worry about losing them. Why would they do this? Well, obviously, to make life a little bit simpler, but one of the big benefits that people pay for is childcare, and if somebody set money aside for childcare and then the kids didn't go because of being quarantined then that money could be lost. So, it gives you the ability to carry these expenses forward, carry this money forward, to use on expenses in a future year without losing them.
Charitable contributions. In the CARES Act, we got an “above the line”, which means you don't have to itemize to take a charitable contribution deduction. And so people were allowed to deduct or will be allowed to deduct on their 2020 tax returns, $300 of charitable contributions, even if you don't itemize. That benefit has been extended. And if you are a couple filing a joint return, then that amount becomes $600 for 2021. So that is a change. A lot of people thought because of the way these rules work, there's one limit for a single file or another limit for a head of household and another limit for joints, something like that. That's not the way this worked. In 2020 it is $300 for everybody, and then in 2021, that jumps to $600. Now the proviso here is the services made it crystal clear that they intend to police this hard. They're concerned that, since all people have to do is write the number $300 in the block on their tax return, that they will easily claim a $300 deduction, whether they're entitled or not. So, expect the IRS computers to be sending out confirmation letters. The moral of the story is to keep your receipts for this. It's an easy thing to qualify for, but they are going to chase it hard.
Educator expenses. Teachers are allowed to take an expense, a deductible expense for certain costs when they're setting up their classroom, if they are not reimbursed by their school. What this law does is clarify that personal protective equipment or the PPEs that the teacher might buy also qualifies for that.
The definition of earned income has been given a carryback or a look back period for those who are trying to qualify for the earned income credit, or the child tax credit. And what happens is the earned income credit is actually what's referred to as a refundable credit, which means you can get a refund on your tax return, even if you didn't pay any tax. But to qualify for these credits, you need to have some earned income. And the concern here was that someone might have been put out of work because of COVID, but they might have had qualifying income in 2019. What this provision allows is to look back and use whichever is better your 2019 income or your 2020 income to qualify for these credits.
This last piece is sort of inside baseball, but should it apply to you, it is important to know
Money purchase plans are traditional pension plans. Most people these days have 401k plans, things of that nature. And these rules were already applicable there, but in the Cares Act, the provision was made to allow taxpayers to borrow up to a hundred thousand dollars from these plans, penalty-free. So most people know that if you take money out of your retirement plans too early, you have to pay a 10% penalty. And it's taxable. This provision allowed people to take a hundred thousand dollars out. If you have a COVID-related expense, that's the important part, but let's assume for the sake of discussion that you do. You were allowed to take that money without penalty; you could spread the taxation of it over three years. Anybody who is old enough to remember income averaging remembers that concept. But, basically by spreading it over three years, you were able to reduce the tax by having it taxed at lower brackets. So it doesn't pile all up into one higher bracket. Or you have the option of repaying it within three years so that it wouldn't be taxable at all. It was unclear whether money purchase plans qualified for that. It is now clear that they do. That's the law that was made that makes that explicit.
And that covers some of the planning points that we wanted to touch on. So Doug one of the things with this being an election year that we're just exiting and it certainly lived up to its hype. There is always a lot of political rhetoric, coming out of these types of years. Things can get pretty hot and people's opinions about the markets and how they want to invest are often manipulated by the political activity. Do you have any thoughts about that, and secondarily, how has HCM, positioning our portfolios, and why?
Doug: Sometimes you hear, you know, the phrases, “does the narrative drive the market or does the market drive the narrative?” And I think it's probably somewhere in between. If you remember our last webinar, we talked a lot about price action and sentiment after the election. And what came out of that was a lot of optimism around the fact that everybody was excited about a divided government. So you can see these headlines here, Why The Prospect Of A Divided Government Send Stocks Soaring; Wall Street rallies, global investors who are relishing the prospect of a Biden, White House Republican Senate.
You may not be able to read these dates, but all of these are on November 5th. So let's fast forward to January 6th, the day after the Georgia runoff. And here we are with Blue Wave Bets Revive Inflation Rates All Over The World. So it seems like we've gone from the market. Loved what we had before, and then it changed its mind and now really loves what we have now, which is unilateral control of government by the Democrats. It's not a massive control, some would say, but it's control nonetheless. As we see that play out, we have to start to think, “all right, what is the world going to look like over the next two years?” Specifically, while Democrats are firmly in control. How's that going to look from a fiscal standpoint? How's that going to look from a monetary standpoint? And then, how is that going to look from a market standpoint, in terms of positioning? So, if you recall back to our last webinar, we had a chart that showed these specific returns. starting on November 3rd. November 3rd was significant because that was the day of the election. What you saw out of that, was this kind of explosion in returns of reflation asset classes. So things like value, small-cap international to a certain extent, and then we kind of chartered those against the NASDAQ 100, which has kind of been the darling of the market for a lot of investors and then just the regular broad market.
So what you see here is just a year to date chart, but I think what you'll see are the themes are very similar, and specifically, the inflection point that we see, and I'm going to try to pull up this laser pointer right here around January 5th, which is again the date of the runoff. So, going into the year, you have these asset classes kind of clustered together except for this orange line, which is international. And then all of a sudden you get this explosion in a small-cap return. You get this explosion in value, and you get this explosion internationally while you have the U.S. kind of flat lining. And then actually the first day you have a tech sell-off a little bit. So as we see this, we think about it. Okay, what? Why is the market reacting this way?
It's a combination of a few things that we think have some staying power. So, the idea is that we're going to see easy monitoring conditions going forward, and that's been something present for a while. And then this idea that we're going to have unilateral stimulus across the board, is going to start to drive some of these sectors that used to be “unloved” and propel them forward. Now, some people might look at this and they might look at some of the older charts and say, “wow, we've come a long way”. Do we still have room to run? Well, I think we do. And, we're going to show that here in the next chart.
This is a chart that shows a long-term trend ratio. As you see this black line moving down, it basically just means the return for large-cap growth is greater than the return for large-cap value. If you want to color-code it based on these bars, the green shaded areas are when growth is outperforming. The white shaded areas are when values outperform.
Now there's a lot of information on this chart. I want to just focus on kind of this timeframe around here. What you'll see is we've just gone through the longest period of growth out-performance relative to large-cap value, since this data set started back in 1930, it's a very long timeframe. And what you'll see is over the past, probably 15 years, an aggressive move higher in large-cap growth of a large-cap value culminating last year, where we saw a few mega tech names really drive the market return and it's come up here to this inflection point right here. So when we think about this from a mean reversion, we look at this and say, wow, this has gotten to a kind of extreme level here, and you see this very tiny move, on the line. And that is the beginning of what we hope to be a long value rotation. That's going to start driving the value performance relative to growth downwards, meaning we're going to see higher, large-cap value growth.
Now, this next chart is the same chart, same concept. We are looking at small caps versus large caps. So once again, there is a lot of information on the chart. Let's focus on the recent past here. From about the year 2000, we'll call it 1999, you had a small-cap Bull Market over a large-cap up to this point here, in 2012ish. And since then, you've had this slow grinding outperformance of large-cap versus small, culminating again in what we saw in 2020. Now, again, you are seeing the line reverse right here. The last chart I showed is the beginning of conversion and value, and this chart is starting to show hopefully the beginning of conversion in a small-cap. Now, one interesting thing to point out, this chart is the time frames overlap. So if you were to go and look, and say okay, what was the last time that we saw a small-cap bull market? We can go down here. Periods of small-cap outperformance, right? This green bar goes from ‘99 to 2011. Let's go back to the chart we just looked at before. When was the last period of value outperformance? We have to chart 2000 to 2006, so it doesn't overlap perfectly. But what you'll see, in a lot of these timeframes, when the value is working, a small-cap is working as well.
Mike: Just one thing that is probably worth pointing out is that these trends, once they start to take place, often last for a long, long time.
Doug: That's a good point.
Mike: These, they can run for years.
Doug: Yes. I mean the one that we just saw on growth, as I said, was 15 years long. And, if we go to the small-cap chart, again, you're seeing, a decade long timeframe when it's happening. But what you're seeing is a small overlapping value and then a large-cap overlapping growth. We've just gone through a decade long period of outperformance in growth and outperformance in large-cap. We believe that you're starting to see the seeds being sown for this cycle to start to shift. And I'll give some more reasons why we think that is.
This is one of the big reasons; rates have a lot to do with this. As you see this chart, we can walk through these lines. This blue line here is something called the Five-Year Ford Inflation Expectation rate. There's a lot. Basically this is the market's implied expectation of inflation. 2%, not a lot, but you see where it comes from? Right after we came out of the COVID crash, it was under 1%. We have been slowly making our way up. The orange line is the Ten-Year Treasury. The green line is the ten-year treasury versus the two-year treasury spreads, so basically this orange line is subtracted from this purple line, which is the two-year treasury. So the two-year treasury rate hasn't moved at all. That is the rate that is controlled by the Federal Reserve. And they've been fairly adamant that they are not going to do anything to increase that rate in the immediate future. They don't necessarily control the tenure rate though. Some would argue that they're doing their best to try. So what happens right around January 5th, again, you see this big spike up in ten-year rates, right? It hasn't seen inflation yet, but the reason that the bond market is starting to price in higher rates is that there's an expectation that, if this entire stimulus catches, you could see a significant increase in inflation going forward.
When this green line goes up, that's called, the “yield curve steepening”. So just think when the spread between the ten-year and the two-year is high, that's a steep yield curve. For the past 10 years, we've got an extremely flat yield curve. And in fact, we had a brief inversion two years ago and an inversion just so that the ten-year rate, or I'm sorry, the two-year rate is higher than the ten-year's, and it's usually a precursor of recession. So now you're starting to see rates moving up. You're starting to see the yield curve get a little steeper. And normally when you get a steep yield curve, that is beneficial for value and it's beneficial for small.
So you think of things like financials. You know, financials make their money off the yield curve. They lend long rates and they borrow short. And as that spread widens, they make more money. This works across the value side. So you're starting to see those tailwinds and the mix of all these things starting to come together. And what we're thinking is the possibility of this perfect storm of ingredients, is starting to cause these very long-term trends to turn and, we have made portfolio moves accordingly. So going back to May, when we first started our risk portfolios, we began to add more value-focused names in there. Just recently, towards the end of November, we re-established a small-cap position. We hold international currently, but we've looked at the possibility of increasing that allocation a little bit, because of what we're seeing right here. Two charts on here, this one to the left, the purple line shows the value of the dollar. This line goes up, the dollar is doing well. This line goes down because the dollar is doing poorly. This is against other currencies. Now what you'll notice is the orange line is the performance of international assets. You can see that almost whenever you see significant performance of international assets, it corresponds with this purple line moving low and vice versa. What we've seen coming out of the COVID response is the amount of stimulus is being thrown into the economy. And the market is causing trepidation around inflation and causing people to be concerned about the dollar moving lower. So again, you're seeing a peak here in the value of the dollar, the dollar starting to come down and down and down, getting close to the low levels that we saw at the beginning of 2018. And you've seen a subsequent recovery in international assets. If you recall back to the chart we looked at in the beginning, you have a year to date, and really over the last three months, we have international assets starting to outperform the U.S. And again, we think this has some legs to it, because of this chart right here as well.
The orange bar shows valuations of three different markets: U.S., developed markets and then emerging markets. What you'll see here is in the U.S.; you have the highest valuation in terms of price to earnings working down to emerging markets, which has the lowest valuations. Now compare that to emerging markets that have the highest expected earnings growth per share versus the U.S., which has the lowest. When we think about it in terms of timeframes, and kind of how we scaled these trades, we leaned into value first, then in the small-cap and then international maybe; the last kind of area that we looked at additional funds to, but all of these kinds are co-mingled into one bucket to where we think the conditions are right to start to see these assets performing well, not only versus the market, but a lot of the growth stocks that have gotten so much attention over the last 12 months. Now, I'd say that we paint a fairly bullish picture, and I think that's a fair statement. But not everything comes up roses in this situation.
This shows a chart that on the top pane has, the S and P 500 composite. It goes back to 2007. And then on the bottom here, this orange line, you have something called the Crowd Sentiment poll. So really what we were seeing is that markets probably have gotten a little bit ahead of themselves in the short term. You're seeing a tremendous amount of optimism. You're seeing a lot of short-term technical indicators that are telling you the market is overbought. You're seeing deviations that are in some cases historically wide. So when we look at the sentiment chart down here, what you'll notice is that these two horizontal dotted lines represent different ranges. Anything above that range is deemed very optimistic and by contrarian nature, somewhat bearish, and then you see the opposite down here. So the last few times we have gotten north of 70 here, here, and here. You'll notice that up here you had the correction.
We're not saying that this is going to resolve itself tomorrow, or we're not saying that this is necessarily going to resolve itself from the 10, 15, 20% correction. You could see the market just kind of gyrate sideways for a while to work some of this off. But in our situation, we would like to see some of these extremes go away before we reallocate accounts. And we think that we have seen such a tremendous run over the past few months, we are taking the opportunity to take some chips off the table. Not necessarily reducing risk per se, but selling off some of the excess gains that we have seen in account areas that we feel have gotten a little bit overdone. And like I said, when that situation normalizes itself a little bit, it'll open the door for us to rebalance accounts and possibly look to go into an equity overlay if conditions present themselves. So, I know we're right up against time here. I want to summarize this; so for stocks, the expectation for future stimulus based on the government or democratic control should continue the rotation into value and small-cap.
We've already begun to allocate money to those sectors. We're probably going to look to do that continuing here over the next few weeks as opportunities present themselves. You have a weaker dollar in favorable valuations that are supporting owning international stocks. But in the short term, you haven't extended market sentiment that we think will result, either in a correction or an opportunity to rebalance, over the coming months or even weeks. Bonds; you have inflation expectations and rates moving higher. So bond portfolios will need to be adjusted to counter that. We're also actively working on adjusting the makeup of our fixed income portfolios right now, to insulate the possibility of higher inflation and higher rates going forward.
And then lastly, the themes for 2021; we think a covert recovery and the stimulus is going to accelerate this rotation, and threading the eye of the fixed income needles is going to play a large role in that. So, with that, I'll pause. And Mike, did you want to add anything, while I scan the questions?
Mike: Well, concerning your last comments, I guess, you know the idea is that it's pretty easy to recognize an extreme situation. Doug has given you a couple of the indicators. There are plenty more, as we've said, since the beginning of time, knowing it and timing it is two different things. If we had to, if we were making bets in a bar or something, I think the sort of logical outcome would be, as long as we keep getting new stimulus programs, bringing in new sort of surprise money, for instance things that the market doesn't know about yet, and tonight's speech by President-Elect Biden will be one of those things, and what follows up after that. From what I understand a very heavily concentrated stimulus program around green energy, should also be very supportive of the market. But, assuming that the vaccines work well, and assuming that these new strains of the virus don't thwart that effort, and once the population is pretty well vaccinated, and assuming the economy is starting to run back normally, to the point where a reasonable person might look at it and say, we don't need more stimulus, then that would likely be the time that correction would likely occur. Conditions would be right because then the market is no longer being surprised by a new stimulus.
Doug: So we've got one question here, kind of regarding fixed income.
How do we plan on earning money in fixed income this year?
So I touched on it briefly in the summary. It's going to be a balancing act between finding areas that will generate you some extra income without taking too much risk, and also not owning a ton of very interest rate, sensitive debt, so to speak. We've already started to see the 10-year treasury move off, and for the first time, in a while, you're seeing bond returns with a negative sign in front of them through the first two weeks of the year. Our strategy is looking at other avenues. We have looked at the possibility of adding some inflation-sensitive, fixed income assets. We've looked at adding some managers who can work in a larger toolkit, can access markets globally, as well as, maybe some niche areas, that can kind of thread that needle between generating some additional income without generating too much excess credit risk.
It's certainly going to be a real challenge this year. I think the most important thing to remember is that bonds are there to be kind of a counterweight to the equity risk of portfolios. And, even with the expectation that fixed income could be challenging going forward, you certainly don't want to completely upend your bond allocation, and add too much risk to that and kind of take away one of the key tenets of owning fixed income, in the first place. Mike, do you have anything to add to that?
Mike: I guess just in terms of a frame of reference or a way to think about it; interest rates have been falling, since Reagan and Volcker were in the White House. I mean, if you remember, prime rates went to 20% in an effort, to break the back of inflation and rates have been declining ever since. And so bonds have been providing returns above expectation, in effect. We have borrowed returns. And now that the government has artificially depressed interest rates, we've borrowed returns from the future. It is not like the bonds aren't making the money, but the question makes an excellent point and one that we talk about a lot in the investment committee. It's going to be a very difficult year. So you're mixing asset classes to have fixed income asset classes, you're dealing with credit that tends to be where the yield is.
As Doug said, duration or long term, that's where, you're going to get burned. We're looking at inflation-protected securities that would benefit if inflation does spark a little bit early. But it's this; 20 years ago, bonds were easy. Today, bonds are hard.
Doug: Did you want to touch on the coat drive?
Mike: Yes, just briefly. This is something we're asking for everybody's help on, at HCM, we try to be in the community and do things to help people. Our current effort right now is, working with St. Vincent DePaul to collect coats, new or gently used hats, mittens, gloves, anything, any sort of cold weather wear would be much appreciated.
We have two barrels in our Western Hills office, one on the first floor and one on the second floor. So it's a touch-less contribution. If you want to clean out some closets and you have, some coats or some other winter wear that you want to get rid of, please, please, please, bring them over. If you can't get here, give us a call. We will arrange to get it picked up. Again, it's things you're not using. It's going to go to a great cause. We've been pretty lucky so far with winter, but we know it's coming, and, if we can help people, that's a great thing to do.
Okay. And so that does it for today's effort. Thanks, everybody for participating. As always, if you have any questions in between our calls, feel free to reach out to your advisor. If any news breaks, we will schedule a call, to give you our perspective. And if news doesn't break, we are tentatively scheduled for Thursday, February 11thSo if you want to circle your calendar, that's tentative, but we've been pretty good about hitting those dates. And, I think that does it.
So, again, if you need any help, give a holler, if you know anybody that needs some help, we'd be happy to do that otherwise until next time, that does it.
Thanks, everybody. Bye-bye.