Fourth Quarter 2013 PerspectiveDecember 2013
How easy it is to underestimate the impact of less bad. In May and June, markets succumbed to a vicious rotation away from bonds and high-yield equities and into growth equities. US equities recovered all their May/June losses by the second week of July and have gone on to reach new all-time highs. Indeed, US equities, measured by the S&P 500, are now +16% above their pre-recession peak reached in early October 2007 and +19% above the March 2000 high water mark (CHART 1).
NOT AT THE TOP—YET
What do we make of this? For one, the Federal Reserve vigorously recommitted itself to supporting asset prices, although the official reason given is to stimulate job creation. Call it quantitative easing or whatever; the impact placed a floor under markets backed by frequent statements by Fed governors and the Chairman himself that the support would continue. This assurance was all investors needed to begin rebalancing portfolios away from cash and bonds toward equity. Although prices are high, we believe that the signs of a market top are not present (CHART 2).
Merger and acquisition and IPO activity is increasing, as are inflows into equity funds, but there is no deluge. Earnings revisions are picking up, suggesting optimism. S&P 500 earnings are expected to grow just +0.75% over 2012, but accelerate to +10.2% in 2014 over 2013 and +10.7% in 2015 over 2014.1
INVESTORS ARE WILLING TO PAY MORE, BUT CAN EARNINGS SUPPORT HIGHER PRICES?
What has changed are the valuations investors are willing to pay for these earnings. Last December 31, investors were happy to pay 14.2x the S&P 500’s collective earnings to own leading US companies; in June the P/E was 15.5x and today it is 17x. The average multiple over the past 10 years is 16.4x, virtually identical to the 50-year average of 16.5x,1 and not far below the current P/E (CHART 3).
The data suggests equities are not way out of line with history. Estimates of earnings for 2014 and 2015 show the current market trading at 14.8x and 13.3x. If investors continue to value these earnings at the long-term level, prices likely have room to rise.
EQUITIES: STILL THE MOST VIABLE DESTINATION
The question for investors remains: can slowly rising earnings support a market valuation that has surpassed the historical median P/E and is approaching a multiple that, in the past, left little if any cushion to soften the blow to prices when lofty expectations are inevitably missed? While these words indicate caution, where else can an investor go? The Fed has been clear that the next policy move is to allow interest rates to rise, but it has been opaque when it will do so. This is not the same as tightening. Rates will rise as the Fed just stands aside, buys fewer Treasury bonds and mortgage-backed securities and allows rising demand to raise the price of money. Overtly raising rates—tightening—will come later. The opportunity cost of holding bonds and cash, at least today, will only rise.
This leaves equities as the only viable remaining destination for most investors. Many stocks pay a dividend and many companies are using their rising cash flows to increase them. Indeed, the market’s dividend yield has topped the Treasury 10-year yield several times in the past year. Corporations are also using this cash to buy their own stock so that rising earnings are applied to fewer shares. The hoped-for result is that the shares appear less expensive as the now higher earnings-per-share stimulates a higher price; and it has. A composite of the companies in the S&P 500 who most aggressively reduced their share count is up +44% this year versus the benchmark’s +27%.1 We expect this confluence of expediencies to continue into 2014. The Fed is mandated to support employment, but has done all it can through the mechanisms of controlling the cost of money. Its toolbox is empty, short of outright entering the equity markets. By doing so the Fed might then be in a position to “suggest” strategies to increase a workforce. Yes, this is imaginary thinking; but what else is left? More likely, the Federal Open Market Committee will go on pushing money into the financial system and hope it becomes loans and then real assets: factories, houses, etc., and then ultimately jobs. Regardless of how treacherous this policy may be for the future, it is good for financial assets, particularly equities.
THE GLOBAL BACKDROP CONTINUES TO BE FAVORABLE FOR INVESTORS
China’s new leadership presented a broad menu of reforms that if they can be widely implemented—a big if—will sustain growth in the range of 7% and base that growth on a more sustainable foundation. Relying on Chinese internal growth and consumption will gradually displace the current imbalanced reliance on exports. We shall see, but the signals from the ever-opaque leadership are encouraging.
Europeans’ patience and forbearance is nothing short of amazing in the face of such elevated unemployment across the southern tier and in France. Banks still hold massive “zombie” loans that their US counterparts have aggressively reserved for or written off. Spain, Portugal, Italy and Greece actually appear to be reviving. An index of Spanish house prices reached a low on June 30 and recently showed its first increase since March 2008. The Athens Stock Exchange index, after falling -83.6% from October 2009, made a low in early June 2012 and has since risen +151%.2 Global bond investors agree things seem to be getting better. The cost of buying default insurance on Italy’s 10-year bond has fallen -59% from a high in June last year.1 Troublingly, there have not been any fundamental institutional changes in Europe.
The euro is based on a federation of independent states who must agree to having it as a common currency— or be intimidated by the heavy cost of breaking away; continent-wide bank regulation remains a hope, as does a common fiscal policy. Perhaps black markets are the salve suggesting the official data is not a true measure of the daily pain.
Japan continues to evolve policies to blunt deflation and revive growth. An index of real estate equity security prices has made a double bottom, in March 2003 and again in March 2009, moved sideways until December 2012 and with the advent of Prime Minister Shinzõ Abe’s growth policies, leapt 187%.1
And lastly, there is Iran. The six-month agreement is important to markets due to the possible impact on the price of oil. The crude oil price has risen by a scant +2.4% annually, 11% in total, since the recession’s end in June 2009.1,2 The agreement suggests Iran can continue to increase oil production that has already grown from a low of 2.5 million barrels annual rate in May to over 2.6 million today. With a peak annual production rate of nearly 4.1 million barrels in August 2008, there is considerable room for production to continue to increase from today’s levels.1 More oil suggests downward pressure on the world price, in effect a lower tax on corporate and consumer costs and a boost to growth.
SO FAR SO GOOD FOR 2014
We love any 12-month period when world equities rise +21% and US stocks return +27%. But our job is to be wary of the risks lying in the current benign outlook. Clearly incipient inflation is not one. The Cleveland Fed reported on November 20 that the “latest estimate of 10-year expected inflation is 1.72%. In other words, the public currently expects the inflation rate to be less than 2% on average over the next decade.”3 Might stagflation, that miserable combination of relatively high inflation, low economic growth and high unemployment be ahead? Even inflation of 1.72% could be “high” if growth and unemployment stay as they are today. Worse would be deflation, a general decline in the price level of all goods and services. In our 21st century economy where high debt levels abound, actual deflation would be toxic because the real value of these debts would increase. Yes, bond prices would likely increase, but the burden on heavily-exposed debtors would be intolerable and likely lead to recession. Neither bond holders nor equity owners would prosper from bankruptcies and declining earnings. Only a sharp increase in productivity arising from technological innovation could offset the adverse impact of deflation. This is possible. After all, deflation and rapid, although volatile growth, coexisted through much of the 19th century when railroads, electricity, the telegraph and telephone, among other innovations, drove productivity and growth. Perhaps the ever-expanding promise of the internet and cheap US-based energy from shale gas will turn out to be the 21st century redux? But markets operate in the here and now, and while aware of such an adverse longer-term trend, investors are influenced by shorter-term events.
As long as earnings estimates continue to accelerate and then be validated by the actual company reports, and the Fed and partner central banks remain overtly committed to injecting liquidity to keep interest rates low, there is little reason—other than fear—to abandon our commitment to equities. The benign investment climate will inevitably change for the worse. When? We do not yet know. As equity valuations creep above their long-term averages, we are watchful and alert to change, and remain invested.
STRATEGIC ASSET ALLOCATION
A Strong Bias toward Equities
EQUITIES TAKE CENTER STAGE, DESPITE HIGHER VALUATIONS
- Our equity allocation recommendation remains overweight, especially to US stocks.
- Many factors including the continued accommodative Fed policy, low inflation and strong corporate balance sheets are strongly favoring equities, despite today’s higher valuations.
- Cyclical stocks are outpacing both defensive-sector stocks and dividend-payers, suggesting investor confidence in growth is trumping caution.
- Although emerging market valuations are attractive, we maintain neutrally weighted as many of these markets are facing lower growth prospects coupled with higher interest rates and inflation.
- Our fixed income allocation recommendation remains underweight due to low present yields and reduced total return potential.
- We view our core fixed income allocation as reducing overall portfolio risk.
- We are still identifying select opportunities within the municipal bond market, though they are bottom-up and security specific.
- We are recommending portfolios remain fully invested, with cash positions at no more than 5%.
FIDUCIARY TRUST FORUM
Managing Director and Director of Tax Services
Navigating Today’s Higher Income Tax Rates
Even if you are earning the same amount as you have in the past, your tax liability may be significantly higher under today’s laws. Two separate tax rate increases became effective in the 2013 tax year that impact top taxpayers. Our Fiduciary Trust Forum provides insight into strategies that may help minimize your tax burden.
Q. What are the key income tax changes individuals should be aware of?
Craig: High-income taxpayers are facing two simultaneous income tax increases as they prepare to file their 2013 tax returns. The first increase comes from the American Taxpayer Relief Act of 2012, which increased the top ordinary income tax rate from 35% to 39.6% for single individuals with taxable income over $400,000 and married couples filing jointly with taxable income over $450,000. The Act also includes a higher 20% maximum tax on long-term capital gains and qualified dividends.
The second increase is the new Medicare Contribution Tax, which affects taxpayers filing as single with modified adjusted gross income (AGI) over $200,000 and married couples filing jointly with modified AGI over $250,000. The Medicare tax imposes an additional 0.9% tax on earned income (such as wages) and a 3.8% tax on net investment income (such as interest, dividends and capital gains) in addition to regular income taxes.
Q. What is the total impact on top taxpayers?
Craig: Together, these increases mean that taxpayers in the highest brackets could pay as much as 43.4% in income taxes on ordinary income going forward, and as much as 23.8% on long-term capital gains and qualified dividends.
The impact of these tax increases can be very significant. For example, on their 2013 Federal income tax return, a married couple with $500,000 in wages, $200,000 in qualified dividends, $600,000 in long-term capital gains and itemized deductions totaling $200,000 would have a tax liability of nearly $68,000 more in 2013 than in 2012—almost a 30% increase.
Scenarios like this will ring true for many individuals, including those with lower income than in this example, and many taxpayers are going to be very surprised when they see how much more they will owe.
Q. What planning steps should taxpayers consider this year?
Craig: Now that higher taxes are here, we recommend using traditional tax planning strategies that postpone income into future tax years and accelerate deductions into the current year to reduce the tax burden in the current year. For instance, where possible, postpone lump sum income such as bonuses or the sale of a business into a future tax year, especially near year-end. Conversely, plan to make charitable gifts and other itemized deductions before the end of the current year rather than the beginning of the next year to maximize current-year tax benefits. Of course, be careful if you are subject to the Alternative Minimum Tax because you may not derive any tax benefit.
Q. With higher rates on investment income, how can investors mitigate the tax bite?
Craig: While we never recommend making portfolio decisions for tax reasons alone, if you are planning on selling a security, selling at a loss at year-end rather than waiting until the next tax year can help offset gains and reduce your taxable income. Also, be sure to use any carryover losses from a prior year to further offset gains in the current year.
If you hold taxable bonds that you purchased at a premium, consider amortizing the premium on that bond beginning in 2014. Rather than taking a capital loss at maturity, you can amortize the premium over the life of the bond and use it to reduce the tax liability on the income you receive from the bond each year. Since interest income can be taxed at a much higher rate than capital gains, the tax benefit could be greater.
For example, if you pay $11,000 for a 10-year bond with a $10,000 face value and a 5% yield, you would have a $1,000 capital loss at maturity. However, if you elect to amortize the $1,000 premium over the 10-year life of the bond (approximately $100 per year), you can use the amortization amount to reduce the taxable income of the bond each year. Instead of owing income tax on all $500 of annual interest income, only $400 would be subject to tax ($500 interest received less $100 amortization). You would not have a capital loss when the bond matures, but since the maximum capital gains tax is just 23.8% compared to ordinary income tax rates as high as 43.4%, that capital loss would not be as valuable.
We recommend speaking with your tax advisor about how to make the appropriate election on your tax return to implement this strategy.
Q. How does the new itemized deduction limitation affect the tax benefits of charitable gifts?
Craig: The limitation is based on the size of your adjusted gross income, not on the dollar amount of your itemized deductions. Your otherwise allowable itemized deductions are reduced by 3% of the amount by which your AGI exceeds a threshold of $250,000 for single individuals or $300,000 for married couples filing jointly.
Despite the potential limitation, however, charitable giving can be an excellent tax planning tool, especially in today’s higher tax rate environment.
Q. How are trusts and estates affected by the new Medicare tax on net investment income?
Craig: The 3.8% Medicare tax is applied to any undistributed net investment income greater than $11,950 for 2013 and over $12,150 for 2014 earned within a trust or estate. Trustees and executors should determine if distributing income to beneficiaries who might be in lower tax brackets can help minimize the overall tax burden.
2. The National Bureau of Economic Research.
3. Federal Reserve Bank of Cleveland, Cleveland Fed Estimates of Inflation Expectations, 11/20/13.
This communication is intended solely to provide general information. The information and opinions stated are as of December 1 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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