In keeping with the news and the season, there are several topics to discuss this month. Here a just a few.
NEGATIVE INTEREST RATES.
The focus of media has been on the Federal Reserve decision to hold interest rates near zero. As investment advisors, our focus is on the open market as investors bid down the rate by bidding up the price of bonds. Many investors typically have a hard time even thinking about negative interest rates, much less actually paying the bank to hold their funds. Yet negative interest rates have become fairly common in some European and Scandinavian countries.
We recently asked our friend Ed Easterling, author of Unexpected Returns and Probable Outcomes, to comment. Ed responded, “In my work, I state that interest rates are compensation for financial inflation. In periods when the inflation rate is near zero or negative (deflation), interest rates, in theory, should not decline below zero—investors have the tradeoff of holding cash at zero return.” He goes on, “Yet that tradeoff requires that investors hold currency. For some investors – especially very large ones—it is costly and impractical to hold such large sums in currency. That would require transportation, storage, security, etc. As a result the most efficient tradeoff is to bid securities to a level that drives the effective return into negative interest rates. The negative interest rate is a fee for service to hold and protect the funds.” The prospect of deflation in our own economy raises the question of whether we may be faced with a similar circumstance in the not-too-distant future.
Pundits and self-styled experts are quick to point out the causes for the recent market declines. Popular reasons include: 1) China’s issues, both financial and economic; 2) the realization that the EU is an experiment looking for a scientist; 3) our own Fed playing kick-the-can; and 4) the implosion of emerging markets and their failure to fuel worldwide growth. We have written before about our belief that the fundamental cause of decline is the low rate of growth in global GDP. The key statistic for 2014 might have been that there were more closures than startups of small businesses. I am sure that I don’t need to tell our readers about the adverse effects of over-regulation on an industry. The upcoming election cycle will provide us an opportunity to listen for the possibility of structural reform and redesign of our incentive structures. Rather than simply focusing on cyclical recovery, as has been the focus of policymakers, we need a refocus on what will restore growth. This is especially important now that we live in a world of very low commodity prices. With proper incentives our growth rate could likely be twice the current reading. Low growth portends tough sledding ahead.
VOLATILITY OF STOCKS.
If you have been in hiding since August, you might need a reminder that volatility is back. The third quarter of 2015 was the worst quarter since Q3 of 2011 and the first week of October was the best week for stocks all year. Stocks were still down for the year as of this writing in mid-October. As volatility increases late in a bull cycle, the probabilities of nearing a top in the cycle begins to mount. This leads us to other technical indicators, such as market breadth and sentiment, for confirmation. We measure the breadth of the market by looking at the advance decline line of the New York Stock Exchange. The 50 day moving average of the A–D line recently crossed down over the 200 day moving average for the first time since 2008. While this is not conclusive, it is certainly worth keeping a watchful eye.
Increased volatility also gives an opportunity to make money by trading. Ed Easterling once again: “Most investors, especially those with traditional stock and bond portfolios, profit when the market rises, and lose money when the market declines…They are, in effect, simple sailors in market waters, getting blown wherever the market wind takes them.” Rowing, on the other hand, is analogous to an absolute return approach to investing that attempts to make money in both up and down markets. This is accomplished by trading (trying to buy low and sell high) rather than the traditional approach of buy-hold-and-rebalance. The increase in volatility is a signal that it may be time to move from sailing to rowing, especially if your time frame is relatively short. One can either fear volatility or embrace it.
The filing of last year’s tax returns should all be complete by now since the extended due date was October 15th. Time is quickly running out on tax planning opportunities for 2015. At this point for our planning clients, today we generally make it a practice to project 2015 and 2016 tax consequences with the known data and assumptions. Already we have modeled tax scenarios such as taking capital gains (or losses), making charitable contributions, or even getting married before year end. There are several things to consider: Investments in fixed assets can reduce taxable income for many physicians by claiming Sec 179 depreciation. Contributions to retirement plans can usually be postponed until the filing of the return, but many new plans need to be established by filing of paperwork prior to year-end to be effective for this year. If you pay estimated taxes it is usually, but not always, a good idea to pay the state taxes before the year end. Bunching deductions in one year for such things as discretionary medical procedures is often a good idea. If required to do so, be sure that you have taken your required minimum distribution (RMD) from your retirement plans before December 31st. The penalty for not taking the RMD is steep. Be sure to review the provisions of the tax code that are due to expire this year and keep up to date on any late extensions passed by Congress. If you would like a tax planning checklist, simply drop us a note.
Scott Neal, is President of D. scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Write him at firstname.lastname@example.org or call 800-344-9098.