Front Street Wealth Management

Fee Only, Proactive Wealth Managment

The Season for Financial Planning Strategies

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It’s the season to do some year-end financial planning. If you haven’t spoken with your adviser in a while, this may be a great time to engage in a conversation about any changes in your financial life.

Throughout my career I’ve seen a number of opportunities lost due to a lack of coordination between clients’ many different advisers. Please don’t let this happen to you.

To prod you forward, I recommend you first review any major changes in your financial life during 2015. For example, did you incur unusually large medical expenses this year? Have you sold something that resulted in an extraordinary gain or loss? Has your income increased considerably? Or has it possibly decreased due to a job loss or job change? The list of possible changes in your life is vast.

With this information in hand, there are many opportunities to save money. Unfortunately, many are connected to a deadline of December 31 involving our overly-complex and often unforgiving tax code. It’s clearly too much for a normal, busy person to follow. Therefore, if you’ve engaged advisers for your investments, tax planning and legal affairs, encouraging a coordinated level of service can work wonders.

For example, do you know that federal capital gains are taxed at a 0% rate if your taxable income falls below the 15% federal tax bracket threshold? If you are sitting on unrealized capital gains from years worth of gains, you may be able to take advantage of super low capital gains taxes in a year in which you earn less than typical.

In addition, if you are able to show less taxable income this year than normal, it may be intelligent to consider a partial Roth IRA conversion from part of your regular tax-deferred retirement accounts. Of course, the analysis required for Roth conversions is not simple and does involve making a reasonable set of assumptions about the unknowable future. Doing that analysis is a smart move.

Another possible retirement savings strategy is available to self-employed individuals who have the desire to save more and pay less tax today. If you qualify, a high-earning small business person can save much more through a little-known vehicle called an Individual 401(k) than they can through a regular IRA. Unlike a regular 401(k) plan for a small business, these special use 401(k) plans are not complex or costly to set up or maintain.

However, if you don’t make the right moves with this information by December 31, you stand to miss out on these planning opportunities and more. As the famous Nike ad once said, just do it – before the busy holiday season. Amazingly, it’s once again just around the corner.

There’s Value in Warning Signs

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The Chinese panicked, stock markets around the world choked and the Fed blinked. What a quarter it was, replete with swings only a die-hard baseball fan could enjoy.

After a 6% drop in broad US market indexes, is this just the beginning of a deeper decline or only a long-awaited, run-of-the-mill correction with continued gains ahead?

It’s true, some headline data describes an economy that is still growing. Following a weak first quarter affected by the cold, the government’s official guess for the second quarter showed nearly 4% growth. The unemployment rate is down to almost 5%. Inflation, excluding energy prices, is still well below the Fed’s arbitrary 2% target. And, with rates low, auto and home sales are doing just fine. All in all, the view from 30,000 feet looks fine enough.

Now, to the on-the-ground view. We all know financial markets don’t operate on how things appear today. Instead, they focus on that never-to-arrive and always-uncertain, tomorrow. Given this, I think markets are flashing yellow warning signs.

First, risks are rising in lower-rated corporate bonds. Lower-quality bonds have declined about 5% in short order. This is raising concern among investors as weakness in junk bonds has traditionally been a leading indicator for periods of weak stock markets.

Next, stock prices are way down for companies most sensitive to cyclical economic shifts, such as industrial companies, big-ticket equipment manufacturers, commodity- and basic material companies as well as transportation companies. Compared to the market as a whole, these sectors have felt a much bigger brunt of the recent market downdraft.

In the midst of this under-the-surface activity, what’s catching my eye?

To begin, despite the uncertainty in the oil and gas market, I feel strongly there is value to be found in the massive carnage. Choosing even among the blue chip companies, such as Exxon Mobil, investors can benefit from large dividends at today’s low prices.

Next, there are a number of financially-strong industrial companies, such as Dow Chemical, that actually benefit from low energy prices. At a 4% dividend yield today, Dow provides the type of income that helps to battle this inhospitable rate environment. In addition, companies in the midst of corporate transformations, like Alcoa, offer good prospects. I also see tremendous value in a much-improved General Motors that currently pays a dividend of almost 5%.

Lastly, many blue-chip tech companies are just flat-out bargains today, in my view. With huge cash piles and serious earnings power, I think companies like Apple, Cisco and Microsoft are too hard to ignore for long-term investors.

Now, if the current yellow warning signs turn into bright red stop signs, you should also fully expect to see bargains go lower still. That’s the way markets work, of course, so please be sure to diversify and use common sense.

I do believe a change is afoot in markets today. Navigating it is going to require skill and investors might just want to get re-acquainted with seeing some red figures in their quarterly statements. If managed properly, for the prepared investor, yellow and red are not colors to be ignored or to be feared.

First and Second Level Thinking

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Regular readers know I often express myself in tones of varied skepticism. While I admit this tendency comes naturally to me, you should know it serves a deeper purpose. Let me briefly explain.

There is something inherently comforting when things sit in a state of balance. In investment markets, however, things are constantly in a state of flux, to one degree or another. Given this, an intelligent investment management process is often lonely and rarely involves broadly following the crowd. Skeptical investors love to ask questions and test the consensus view.

Influential investor and market thinker, Howard Marks of Oaktree, recently wrote about what he refers to as first-level and second-level thinking. His memo did a nice job of highlighting a concept that helps to explain why I feel a healthy sense of skepticism is beneficial as an investor.

First-level thinking tends to reflect the obvious facts already in the news. China’s slowing, commodity prices are down, sell oil stocks, avoid multinational companies and own the US dollar. With gas prices so much lower now and with interest rates still so low, buy consumer-oriented stocks that cater to domestic shoppers.

Now, a second level thinker, in reaction to a first-level thought, might sound very different. Yes, energy and commodity prices are down a ton and it does look like China is headed toward a rough slowdown. But, US oil and gas producers are busy lowering their costs and are finding ways to innovate. With their stock prices down so much and – as long as their balance sheets can hold up – I think they’ll make it through this down cycle. These companies might now be trading at bargain levels.

First level thinkers tend to feel more confident with validating information. It creates a comfortable emotional feedback loop as it follows a seemingly, logical, straight-line relationship. As their confidence builds, they seek safety in the crowd. Soon, ever larger numbers of investors adopt the same comforting view. And, over time, it becomes the consensus view of far too many investors.

The second-level thinker can appear allergic to the consensus view of the day. As uncomfortable as it can feel, second-level thinkers know that following the consensus is not how money is made or how losses are avoided in investment markets. Actually, just the opposite tends to be true over time.

Second-level thinking can appear counterintuitive and can come across as skeptical or stubborn and can be viewed as somewhat pessimistic. Instead, I’d argue that second level thinking is inherently optimistic about the fact that – because things are always changing and are never in balance – great opportunities are always around the bend.

So, the next time you look at your portfolio or begin to make an investment decision, ask yourself if you are making a first- or second-level decision. And, if the decision feels a bit tough or uncertain, you’ll very likely have a good idea.

 

Is the Bull Market Still Alive?

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The stock market has recently delivered quite a ride for many investors. The word I hear most to describe the volatility is, roller coaster. However, the most common advice I hear in my industry is, don’t be emotional, don’t panic, the bull market is still alive.

Before addressing the common refrain that this recent market blip is/was just a correction in the midst of a continuing bull market, I too agree that panic is not wise behavior. Panic often leads to poor decisions, unless you really are being chased by a wild animal.

It is often cited that China is the reason for the recent market volatility. We all like to find a proximate cause for any change in our surroundings. Yes, the Chinese stock market is down nearly 40% in three short months. But, this has only erased a 60% gain during the three months prior to that.

Rather than pin the market downturn on China alone, I view it as a symptom of a larger, global economic ailment; one rooted in the very prescription used to quell the ‘08 credit crisis and subsequently slow global economic recovery.

I remember back to the ‘80s when my “little brother” – who now towers over me – used to play a simple computer game, SimEarth. In this game, the goal was to tweak the elemental makeup of the environment in order to spur the sustainable development of plant-life and the animal kingdom in a simulated world.

I had no interest in SimEarth back then and, voila, my brother became a scientist and I became a money manager! Who knew that SimEarth would now indirectly apply to my life’s work?

Since late 2007, central bankers around the world have been playing their own version of SimEarth. Their prescription was no less than a change in the basic rules of capitalism; zero interest rates for almost a decade.

Like the basic makeup of our natural atmosphere, interest rates act as the driving force behind all asset prices. The world of financial markets operates in a constant state of comparative analysis. Every investment choice is measured against an alternative with interest rates sitting at the center of the analysis. For at least the past decade, central banks have manipulated capitalism’s atmosphere.

Viewed in this context, the frantic chase for global riches in China, along with large amounts of capital rushing into other developing markets, is simply an outgrowth of the desperate reach for investment returns in a world of suppressed interest rates. The likely effects are artificially high asset prices and greater volatility near the end of the experiment.

With the US stock market, as measured by the Shiller P/E ratio, still valued at levels only seen in 1929, 1966 and during the tech and housing bubbles, it might not be such great advice to bank on the resumption of six-year old bull market. Panic, never. Plan and prepare, always.

Markets: Where and When, What and Why?

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As an investor, it’s important to ask the right kind of questions. Especially during periods of markets in stress, forget the “where and when” questions and try to focus on those that begin with “what and why.”

Over the span of four successive days from last Wednesday through Monday, the US stock market dropped 1%, 2%, 3% and 4%. The total decline was fast and furious and resulted in a long-awaited 11% drop.

It’s about time. I’ve been expecting this. You should expect more ups and downs along the way. If this quick drop has left you a bit shocked, there is always time to reevaluate your overall risk in your portfolio.

I’ve personally seen a number of people who are far too invested in the stock market. When I pointed it out, they largely appeared unaware. I suspect it was due to a lack of asking the right type of questions.

At times like these, the questions I get most begin with where and when. They also tend to be formed by fear and greed and often focused on fortune telling.

Where is the market headed? When is the selling going to stop? Where is the bottom in oil? When is China’s government going to stop the contagion? Where’s the Fed now?

The reality is most investors – including professional advisors – don’t know much about where markets will be tomorrow, next week, next month or even next year. Honestly, many don’t have a clue about much at all.

While questions of when and where tend to lead to emotion-based decisions, I’ve found the best action-leading questions start with the words what and why. These are the questions that tend to drive deeper thoughts and fact-based decisions.

What’s trading at bargain levels now? Why not own more energy stocks after such huge declines? What dividend does this company pay based on today’s stock price? Why not sell that stock with it now priced for such good news? What’s management going do with that huge pile of cash? Why shouldn’t I buy more with it down over 20%? What level of exposure to China does this company really have?

Over the years, my view is, people have distanced themselves from an understanding of the investments in their portfolios. I cannot entirely blame them for this. The cloud of complexity can get pretty thick in the financial industry. The cynic in me wonders if the pile of acronyms and flurry of buzzwords are secretly designed to intimidate the public.

In moments like these, my advice is to take note of the types of questions you’re asking yourself and others. What exactly do you have to lose by doing that?