Dorato News, April 2017

A Quarterly Newsletter for the Clients of Dorato Capital Management, LLC.

Portfolio Issues

Complications

I complete a number of tax returns for people every year, not because I love taxes, but because I think taxes are an important part of any person’s financial life. Every year I learn something new, and what I learn can often help my investment clients.

One of my tax clients has an investment manager who invested part of her portfolio in limited partnerships. Apparently he saw an opportunity to make some money for her with these oil-related investments. What I think he never considered is that each of those partnerships generates a Schedule K-1 to report taxable income or loss. This poor woman with a modest investment portfolio had more than 10 K-1s to report on her tax return, an unnecessary complication for someone with her resources.

Then I noticed an article in the Wall Street Journal that described a woman who owned a chunk of a Kinder Morgan limited partnership in her IRA. When Kinder Morgan changed its business status from a limited partnership to a corporation, that change in status resulted in capital gains for owners of the limited partnership. What surprised most people, including the woman who owned the limited partnership in her IRA, was that she had to pay tax on the capital gain, even though the investment was in her IRA, due to something called unrelated business income.

I don’t love taxes, but it sure is useful to know the tax consequences of any investment. That’s why I’m highly unlikely to invest in anything that generates a Schedule K-1. It would be a needless complication in your life.

Jan 2017 Cartoon
"I don't know you, but I was wondering if it would be OK if I take you as a tax deduction."

Market View

THE BIG PICTURE

Still a Bit Nutty

Sometimes the world doesn’t change much in three months, it just becomes more of what it was. Regarding the stock market, I wrote in January that stock prices seemed a little nutty. Now, at the end of March, they still seem a little nutty.

US stocks are up about 6% for the year. I think this is simply an extension of the optimism for the US economy inspired by Trump’s election victory. In contrast, earnings estimates for US companies are quietly being revised downward, as they often are throughout the year, as analyst optimism meets the hard reality of actual profit performance. It’s hard to justify higher stock prices when estimates of profit growth are moving in the opposite direction.

And after an initial flurry of activity after the inauguration, the Trump administration is getting bogged down in the mucky Washington policy-making scene. The timetable for economy-enhancing policies, such as tax reform, and for an infrastructure spending plan, is being pushed back like an airline schedule in bad weather.

Respectable analysts estimate that a cut in the corporate tax rate from 35% to 20% could lead to a 10% jump in corporate earnings, which could justify some of the run-up in stock prices. But if Congress fails to cut the tax rate as much as investors expect, or not at all, expect stock prices to wobble.

The Wall Street Journal recently ran an article that showed the sentiment indicators—how people feel about things — are running hot. Consumer confidence and business confidence are both at lofty levels. Yet consumer and business spending have yet to show much improvement. The gap between sentiment and reality is the widest it’s been for many years. If confidence leads to spending, the economy would show improvement, and high stock prices could be justified. If spending fails to materialize, those confidence numbers will look like they were based more on hopes and prayers than on reality.

That all sounds somewhat precarious for the stock market, as though we’re driving a little too close to the edge of the road. But there have been some unexpectedly good surprises; things that could help us stay on the pavement. One area that’s been a pleasant surprise is Europe. The Eurozone is still under threat as a viable economic unit. But while the fractious politics have been getting most of the attention, Euro economies are quietly showing improvement, with slow but positive growth, and lower unemployment. In fact, growth seems to be picking up around the globe. This is welcome news, and could keep the US economy chugging along for longer than it otherwise would.

The bond market has been relatively flat for 2017. Short term rates are headed up toward 1%, as the Federal Reserve raises rates over which it has direct control. But longer term rates have held steady. The 10-year US Treasury rate has continued to offer an interest rate between 2.4% and 2.6%. This means that the main return from holding bonds has come from only the interest payment — little or no price appreciation. The average bond fund is up about 0.5% to 1% in 2017. For now, I expect bonds to continue that sort of performance. The primary long-term risk to bonds is inflation; but for now, inflation remains under control.

While we wait for the long term to arrive, stick to your asset allocation. You can hold a bit more cash than normal, given the above-average PE ratio for stocks, but otherwise stick to your long-term asset allocation. That’s how you build your wealth over time.

Sources: Economist, Financial Times, Wall Street Journal, Value Line, Vanguard