Almost all risk assets enjoyed gains for the quarter, with the average diversified U.S. stock fund gaining +4.8%, international stocks +7.25% and emerging markets returning an impressive +11.49%. The exception was commodities, which declined -6.2%. The first quarter of 2017 saw an ex-tension of the stock rally that began after the 2016 elections. The U.S. and the U.K. briefly touched all-time highs. Many of last year’s underperformers outperformed in the first quarter and vice versa, reminding us once again that time in the market is superior to timing the market. Time in the markets with a prudently diversified portfolio allows capitalism to succeed in compounding wealth. As Albert Einstein famously said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”. Consistently succeeding at timing the market is near impossible. Recent research actually indicates investors that were fortunate enough to time the recent major declines like 2001 & 2008, performed poorly during the next bull cycle. Go figure! We prefer to build wealth wisely by prudent asset allocation and stock selection, and then let capitalism work its magic over time.

Growth out performed value in the first quarter. Not surprisingly, technology and healthcare shined for the quarter while energy, financial, telecommunication and REITs lagged. All four of the lagging sectors tend to be significantly weighted in value-oriented manager portfolios and value-tilted indexes. For context, the Russell 1000 Growth returned a robust +8.91% while the energy, telecom and financial heavy Russell 1000 Value returned a modest +3.27%.

The Fed delivered a widely anticipated +0.25% rate hike at its March meeting, but made no significant changes to their U.S. growth, interest rate or inflation outlook for the next couple of years. The March hike, weighed on higher-quality fixed income, while higher yielding emerging markets and high-yield bonds coped better as concerns over softening fundamentals continued to calm. What a difference a year makes for bond yields and long-term inflation expectations. The Fed now discusses the global economy with positive terms and predicts continued growth.

Global growth expectations are on the rise and we see room for more upside surprises. In our view, the rosier economic outlook for both foreign and U.S. economies should support the current equity valuation levels. Better global growth trends should persist despite ongoing Fed policy tightening this year. The U.S. economic growth rate may be lower than the rebounding international markets and, therefore, European and emerging market equities may continue to be a source of diversification and enhanced returns over the next few quarters. Like most Americans we remain focused on U.S. politics. Investors should be reminded that European and emerging market economic activity has perked up. Currently, many European and emerging equities have lower valuations than their U.S. peers. Lower valuations and increasing economic activity creates investment opportunities for internationally-minded investors as well as investors in U.S. companies that do significant business overseas.

Let’s be clear, a range bound U.S. GDP reading for the remainder of 2017 isn’t the end of the world. Many U.S. firms can generate reasonable earnings growth even with modest GDP expansion, especially if the recent rebound in global GDP continues. Many U.S. firms rely heavily on international business activities for their revenue and profits. On balance, the news appears to be improving in many key markets. Large U.S. firms continue to buy back stock which should be a source of earnings growth. We do however share the view of Larry Fink, C.E.O of BlackRock, that U.S. firms need to adequately reinvest in their businesses to protect their long-term competitiveness, something that simply buying back shares does not accomplish.

Despite Fed policy tightening in the near to medium term and some doomsday predictions for the bond market, selective bond categories still have an important role to play in diversified portfolios. In this environment, investors own bonds for modest income and to preserve wealth, not to grow wealth. Again, very important point – In this environment, investors own bonds to preserve wealth, not to grow wealth. Bonds are still necessary tools for certain investors, depending on their situation. Bonds make for a longer less volatile climb to the summit, but either way, you still get to the top.

Taxes and Patriotism

Most investors realize the need to develop a prudent invest-ment plan complete with an asset allocation decision i.e., how much of my portfolio do I want in stocks vs. bonds? However, most investors fail to realize the importance of asset placement. Asset placement is key to enhancing tax efficiency. We have witnessed investors leaving 10% to 20% more than was necessary to Internal Revenue Service by poor asset placement. As Judge Hand famously said:

“There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

Judge Billings Learned Hand, Helvering v. Gregory, 1935.

Case study: A long-term investor owns $40,000 in a high yield bond fund with a 6% yield in their taxable investment account and $10,000 each in 6 non-dividend paying stocks in an IRA. The total portfolio is approximately $100,000. If the investor is our typical client, they pay approximately 42% income tax. That puts the annual tax liability at $1,008. We are assuming the investor doesn’t sell any of the non-dividend paying stocks. If so, the investor will owe about 42% of the $2,400 generated by the bond fund in taxes [$2,400 X 42% tax rate = $1,008]. Let’s call this the random asset placement approach.

Now contrast with the intentional asset placement approach: The investor could rebalance the bond fund into their IRA and the two highest potential growth stocks into the taxable account. Individual non-dividend paying stocks that are held for the long-term are incredibly tax efficient. Since the stock doesn’t pay a dividend there is no income to report each year and the capital gain liability is incurred only when it’s sold (aka realized). The result is the investor shields $2,400 annually from being considered taxable income and keeps the growth stocks protected from capital gains. Essen-tially, assuming no changes to the portfolios, the investor low-ered their annual tax lability to zero from just over a thousand dollars annually.

Caution: When rebalancing for tax efficiency, it is important to avoid the 30-day wash rule which says you cannot sell shares of a security at a loss and then repurchase the same security within 30 days of the sale; if you do, any loss from the wash sale cannot be used to offset gains on your taxes for that year. The IRS clarified the rules in 2008 to include retirement accounts, making things more complicated. If interested please give us a call or come in. As always, we thank you for investing along side us as we continue building wealth wisely.

 

Comments are closed.