Portfolio Issues - Taxes
Around this time of year, taxes demand our attention, so they are perhaps worth a word or two. We don’t recommend re-ordering your life based upon taxes, but we do think a little awareness can perhaps save some money somewhere down the road.
Remarkably, one month after the IRS started accepting tax returns for 2020, Congress changed the taxation of unemployment benefits. This was confusing for many folks, including the IRS, as 2020 was a year of higher unemployment than normal. After a brief scramble, the IRS said not to amend already-filed returns, that they would adjust the returns themselves. For us, the whole episode served as a reminder that tax laws are continuously subject to change. We often write about how difficult it is to predict the ups and downs of stock markets, even as we predict decent long-term returns for stocks. So with taxes: Predicting the future of tax laws is difficult, but we have some confidence that the tax we pay in the future will have to rise, to pay for current debt and future spending.
With that broad understanding in mind, you can consider different strategies to deal with those probable tax hikes. For example, instead of putting all your retirement savings toward tax-deferred accounts (401K and IRA), you might put some in a taxable account, or in a Roth IRA or Roth 401K (no tax deduction today, but earnings grow tax-free). That might give you some options in the future, as to which accounts to draw from in order to meet your spending needs in retirement. Essentially, you are diversifying your assets for tax purposes.
Paying taxes is inevitable. Exactly how much you pay isn’t.
"The primary agenda item is: what can we do this year to confuse everyone on taxes?"
Market View - Transition
You might think professional investors are cold, calculating creatures who constantly assess the value of everything on earth. But the truth is that this group can be remarkably lemming-like. Some have the job security to go a different direction, but many feel they have to march with the rest of the market if they want to keep their jobs. The market has been marching in the direction of big technology companies for the last couple of years, but that may be changing.
Why? For three intertwined reasons. In part because the pandemic is receding. In part because wealthy nations, and particularly the US, have chosen to open up the spigot of fiscal policy and shower us with cash. And in part because investors are starting to demand higher interest rates for fixed income (bond) investments.
As the pandemic recedes and consumers have readily-available cash, the next logical worry is inflation. There’s the short-term issue of consumers now having fat wallets and the economy opening up, so a lot of cash chasing a limited supply of goods; and the long-term issue that if you were the US government, and you had a very large pile of debt to pay back, inflation would help you do that. Not crazy inflation, but maybe inflation that’s higher than the current market expectation of about 2.5%.
Indeed, the interest rate on the 10-year US Treasury Note has risen to about 1.7%, not high by historical standards, but quite a bit higher than the 0.5% of last August. As interest rates rise, bond prices fall, so the average bond fund is down about 3.5% so far in 2021.
Rising interest rates also pose a problem for the valuation of those large technology companies and those profit-less companies for which everyone expects gobs of profit some day in the future. As interest rates creep up, those future earnings become less valuable, so the stock prices of those companies fall.
Stocks and bonds typically provide diversification: when stocks fall, bonds rise (or at least don’t fall), and vice versa. But with rising interest rates, if you own growth stocks and bonds, you’re not getting much diversification—both are rising or falling at the same time. Strikingly, value stocks have held up much better, and have retained their diversifying role relative to bonds.
The big question is what’s next? Of course any prediction is based on a whole host of unknown factors: a resurgence of Covid-19 or some variant; policy responses from various governments, such as tax hikes or more spending; and policy responses from central banks, such as interest rate increases to limit inflation. Our sense is that we will have more of the same into next year: fading Covid, continued government spending, and an accommodative Federal Reserve. In that environment, the US and world economy should perform well, and many stocks that were beaten down in the depths of the pandemic will continue to recover.
All of that makes stocks with decent earnings growth and reasonable valuations a good place to be. It also means that bonds will not add much to returns, and may even continue to be a drag on performance. But if interest rates continue to creep up, as we suspect they will, then bonds start to offer more income, and start to look better as long term investments. Investors don’t own bonds right now for their return potential, but as a hedge in case the world economy takes a dive.
A phrase we hear with some frequency is “I know you can’t time the market, but…” The “but” implies that sometimes you can time the market. We don’t think that’s the case. There is no “but”. If you try to time the market, getting in and out based on whatever factors you might use, you will get burned. So, please, stick to that long term plan. Rebalance when necessary. It’s simple. Not easy, but simple. That’s the way you will build up your wealth over time.
Sources: Economist, Wall Street Journal, Value Line, Vanguard, Applied Finance Group