For those who tend to bury their head in the sand when markets get ugly, you might be surprised by what’s happened over the past six months.

Back in early October, the stock market rout seemed to be picking up steam. Inflation worries were raging and the Fed was talking tough about more interest rate hikes to come. As a result, many saw a recession just around the corner. And, then, as if a switch was flipped, stocks bounced and bonds popped.

At its lowest point last fall, the stock market was down about 25%. After the recent rebound, stocks are now only 10% off their highs. Similarly, back in October, bonds had dropped an unheard of 15%. Despite their recent recovery, bonds are down a still-dismal 8% from their highs. But, it’s been a really good run for bonds lately. Overall, you could say that roughly half of last year’s pain has been recouped, but, not at all, forgotten.

So, what has spurred the market’s recovery? As always, the answer is complicated, counterintuitive and possibly questionable.

The consensus expectation of a coming recession seems to have caught the attention of the Fed. Inflation is showing clear signs of declining, albeit very slowly. This trend has given the Fed some justification to turn more of their attention to the health of the economy and signal a “pause” in future interest rate hikes. Like everyone else, they want to see how the economy is faring.

Once the Fed started to speak in calmer tones, things shifted. The market adopted the mindset of “some bad news might actually be good news.” With each economic headline pointing to a slowdown, not only are future rate hikes taken off the table, the possibility for rate cuts goes up. That alone boosted both stocks and bonds. And, now, with the recent mini-banking crisis throwing a wrench into the system, the probability of future interest rate cuts is now the base case.

This can be seen in the shape of the yield curve. Longer-term interest rates are far below short-term rates. Today, you can safely earn around 4.5% just sitting in a money market fund. But, if you choose to lend to the government for 2 years, you’ll only earn about 3.8%. The yield is even lower still on the 10-year Treasury. That shows how confident investors are of future rate cuts. This phenomenon is known as an inverted yield curve and it’s historically been a bad sign. It has a perfect record as a recession indicator.

If the economy does go into a recession, the question is how deep will it be and how long will it last. There is little way to know for sure. On balance, and especially given how quickly the mood can shift, I’d say being a bit cautious with your portfolio is probably prudent.

Q: I read your column from Sunday, February 26th and you got one thing wrong. Lower income taxpayers should provide their tax preparers with the amount of property tax levied as well as the taxable value of their home. This information is needed to apply for the Homestead Property Tax Credit on Form 1040-CR. In addition, lower income renters can benefit from this property tax credit, too!

A: Actually, I got two things wrong in that column! I incorrectly stated that the 2022 standard deduction for those married filing jointly was $27,700. That’s for 2023, not 2022. The standard deduction for married filers in 2022 is only $25,900.

With my conscience now clear, let’s go through the details of the Michigan Homestead Property Tax Credit. First, I’ll address homeowners and then move on to renters.

For homeowners: If your income falls below $63,000 and the taxable value of your homestead is less than $143,000, you qualify for a potential tax credit. Note, the taxable value of your home is not what your home is worth today. Your taxable value is what’s shown on your property tax statements. You can also look it up online.

The Homestead Property Tax Credit generally works like this. Let’s say your income was $50,000 and you paid $3,000 in property taxes. First, multiply $50,000 times 3.2%. This sets a threshold of $1,600. In this case, your $3,000 in property taxes exceeds this $1,600 threshold by $1,400. To figure your tax credit, you multiply $1,400 by 60%. Your property tax credit amounts to $840. Better yet, even if you happened to pay zero state income tax, the State of Michigan will still send you a tax refund check for the $840!

For renters: The same income test above applies for renters, too. But, since you don’t own a home, you instead use your annual rent expense to figure your tax credit. Multiply your annual rent expense by 23% and then compare it to your 3.2% of income threshold. Just like a homeowner, you are entitled to receive 60% of the difference as a tax credit.

Keep in mind, the maximum Homestead Property Tax Credit you can get is $1,600. And, one final tip, if you overlooked the Homestead Property Tax Credit in the past, the State of Michigan allows for you to go back a whopping four tax years to get your tax credit. Go take a look in your tax files. It might amount to some real money!

Q: I filled out my tax preparer’s organizer. As usual, my pile of documents included our property taxes, medical expenses, mortgage interest and donations, plus a few other things. But, I just got an email from my tax person saying I really didn’t need to gather all of that stuff. Why is that?

A: As they say, old habits die hard! It is true, if you are like most people, your effort to gather all of those receipts and statements to document your itemized deductions is probably no longer necessary. Since 2018, under the current tax law, they basically doubled the standard deduction. This effectively eliminated the need for most taxpayers to even think about claiming itemized deductions.

For example, for those who file as a married couple, the standard deduction for 2022 is $27,700. If you both happen to be over age 65, it jumps to $30,700. This dollar amount is the bogey to compare to your level of itemized deductions.

There are four main categories of itemized deductions to consider. You might not even come close to needing to itemize your deductions. The categories are the taxes you paid, your mortgage interest, your donations to charity, and your medical and dental expenses. If you are moderately good at math, you can probably tally them all up in your head to see if gathering up all of the necessary documentation is worth your effort.

First, add up the property taxes and state income taxes you paid last year. Remember, though, the maximum for this category is capped at $10,000. Next, add in the amount of mortgage interest you paid last year, if any. Then, total up your cash and in-kind donations made to charities. Finally, there’s one more complex category. Add up your medical and dental expenses. Do some mental math to see if they exceed 7.5% of your adjusted gross income. For example, let’s say your adjusted gross income is $100,000. Unless these expenses exceed $7,500, none of your medical and dental expenses will be tax deductible.

The bottom line is this. If you are married, don’t have a mortgage, or don’t give away a lot and you don’t have big medical and dental expenses, it’s highly unlikely your itemized deductions will exceed your automatic standard deduction. On the other hand, certain single filers, and even some married filers, might still end up itemizing their deductions. It only takes a little understanding to figure out if you can avoid the tax gathering work or not. According to recent stats, only about 10% to 15% of all taxpayers itemize their deductions. If you don’t fall into this group, welcome to the world of tax simplicity!

After last year’s pain, the start of 2023 has been nice. Stocks are up nearly 10% and bonds have bounced over 4%. The mood has quickly shifted from doom and gloom to optimism. Is this shift fully justified? 

For the past 18 months, almost everything has hinged on inflation. To vanquish the post-Covid surge in inflation, the Fed abruptly raised rates from zero to about 4.5% to 4.75%. After one more 0.25% expected interest rate hike, most investors now believe the Fed will finally pause. 

Why the pause? The outlook for inflation has really improved. According to the Fed’s preferred measure, we’ve seen a discernable decline in inflation from around 5.5% at its worst point last year to the latest reading of 4.4%. It’s likely heading lower still. But, it will take some time to get to the targeted 2% inflation rate the Fed wants. And, most expect it will take economic pain to get us there. 

With the hope for a Fed pause, investor focus has now clearly shifted to the health of the economy. Naturally, this is where things start to look fuzzy.

It’s awfully difficult to believe that cumulative rate hikes of about 5%, at such a quick pace, won’t push us into a recession soon enough. Interest rate hikes are seen as a blunt tool and they affect the economy with both “long and variable lags.” In normal language, they take time to really bite. 

Given this, investors have been bracing for the pain to come. But, lately, the optimistic idea that we can squash inflation without feeling real economic pain has once again taken root. The idea that the Fed can actually thread the needle is back in vogue, as it was last June. This optimism has translated into diversified balanced portfolios recovering roughly half of their losses from the market low in mid-October.

Other than simply breathing a sigh of relief when reviewing their monthly statements, how should investors react to this mood shift? 

Keep in mind that certain very reliable economic indicators, such as the “yield curve”, implies a looming recession of some depth. The 10-year Treasury now yields 3.4% as compared to the 3-month Treasury Bill yield of 4.5%. This upside-down relationship has a very good record as a recession predictor. If inflation proves to be stickier or the interest rate hikes start to kick in too strongly, the market rebound could easily reverse. 

In all humility, though, nobody really knows the short-term direction of markets. Nonetheless, after last year, taking a fresh look at your portfolio’s mix of stocks and bonds is in order. The time to do this review is from a position of strength. And, there’s absolutely no doubt things look quite strong right now!

Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com

Q: Last year was ugly. I’ve looked over my year-end statements and I think I lost as much in bonds as I did in stocks. To stop the bleeding, I’m thinking about selling my bonds and moving into cash or even buying CDs. Does this move make sense? 

A: You’re right, last year was particularly bad for bonds. Arguably, it was one of the worst years in modern history for investors with balanced portfolios. The Fed’s moves on interest rates caused bonds to fall a whopping 10% to 15%. Adding insult to injury, stocks fell about 15% to 20% last year. Clearly, there was no great place to hide.

Looking forward, while nobody really knows what 2023 will bring, I think the pain you’ve felt in bonds is likely a thing of the past. The bond market has largely “priced in” the impact of the Fed’s current war on inflation. Rather than moving out of bonds now, holding tight is probably smarter. Changing your portfolio based on recent pain almost always turns out to be a mistake.

Q: I’m starting to receive some 2022 tax documents. I’m really confused about my IRA distributions, as shown on Form 1099-R. I donated money to charity directly from my IRA believing those distributions wouldn’t count as taxable income. But, looking over my IRA’s 1099-R, it appears my donations were taxable distributions, nonetheless. Did my brokerage firm make a mistake or did I do something wrong? 

A: No, the brokerage firm didn’t make a mistake. And, no, you didn’t make a mistake. Form 1099-R is simply a summary of all of the money that came out of your IRA last year. Brokerage firms include a tally of every dollar that left your IRA, regardless of whether it was a charitable donation or not. 

Why aren’t your donation checks subtracted out? Because brokerage firms aren’t in the business of verifying whether you gave to a “qualified” charity or not. This leaves it up to you or your tax preparer to subtract your qualified charitable donations, or QCDs, from your total distributions as shown on your Form 1099-R. 

Q: For 2022, it turns out I’m in a much lower tax bracket than usual. As a result, I overpaid by a lot with my estimated tax payments last year. Since I’ve already paid in more than enough taxes, can I do a Roth conversion before I file my 2022 taxes?  

A: I’m sorry, you can no longer do a Roth conversion and have it apply to last year’s taxes. Unlike making a regular IRA, Roth IRA or even an HSA contribution by the filing deadline in mid-April, any Roth conversions had to be completed by the end of the calendar year. Unfortunately, this highlights the need to sit down and do your tax planning near the end of the year.   

Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com