Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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Election Year Upset: The Trump Effect on Markets

November 27th, 2016

I find that once again, rather than writing on the idea of financial plenty, thankfulness for that abundance and charitable giving, events in Washington, D.C. dictate that I discuss other topics. Last year, it was the impact of a Congressional budget deal on Social Security claiming strategies. This year, it is of course, the election results and the market’s reaction.

This month’s post looks at the following topics:

  • A Trump presidency and its potential impact on:
    • Government spending and inflation
    • The markets
    • Your portfolio
  • Charitable Giving
  • Kulig Financial’s Holiday Schedule

Potential Ramifications of a Trump Presidency

Many of you have asked me what, if anything, to do differently with your portfolios in an election year. Those questions came before the election, and I responded that if you had a portfolio risk level that was right for you, then you did not need to do anything differently. That risk level should take into account poor markets, if they occur, for whatever reason. As you know, I also believe that it is impossible to time markets—i.e., make short term tactical moves, consistently successfully. It is very easy to make investment mistakes, and there have not been many (any?) investors shown to consistently get that right.

What prompted those questions were prognostications by market “experts” who pounded the table for exiting the market just prior to the election. I do not know what they were recommending after the election, or what signposts they would be looking for to re-enter the market.

I am also not sure which candidate they all expected to win. If it was Trump, their forecasts were right for exactly one day, as the market plunged. But then it turned completely around the following day, erasing the previous losses and then some for a total gain of 1200 points for the Dow Jones average.

The bond markets were also volatile. During the stock market decline, US Treasury yields plunged, with the 10-year note falling 17 basis points, then climbing 37 basis points (a basis point is 1/100th of a percentage point).

So what caused these manic-depressive shifts in the market? Initially, the markets were behaving in a typical “risk off” trade, which is typical in times of uncertainty–investors tend to desert stocks and rush toward high quality bonds. But then the markets took another look and decided that Trump’s presidency would be more like Ronald Reagan’s, with buoyant government spending and tighter money. Some think markets were also soothed by Trump’s conciliatory acceptance speech, assuaging concerns about his previously erratic behavior.

Trump has proposed infrastructure spending to jump start the economy, along with constructing the infamous “wall” and other agenda items. With control of both houses of Congress going to the Republicans, the markets decided some of Trump’s proposals may actually happen. The scenario reflected in its sharp swing upward is one of fiscal stimulus with a positive impact on the economy and stock market, rising inflation, and a corresponding increase in bond market yields (depressing bond prices).

There are several problems with this scenario, with one of the biggest being that there is a lack of detail on the proposals. How Congress will act is also unknown. We do not know whether Republicans will rally around a Trump agenda, or hold onto deficit reduction goals which caused so much sparring with a Democratic administration. The Republicans also narrowly outnumber Dems in the house, so it is possible that Democrats may act as a barrier to Trump proposals. There simply is so little we really know at this point.

I think this recent example of mistaken short-term forecasts demonstrates the folly of basing portfolio strategy on that type of outlook. I think it also proves the worth of a diversified portfolio. If you have invested according to strategies designed at Kulig Financial Advisors, you have an appropriate allocation to stocks, and since they are diversified, you have exposure to the groups which have performed well in the recent upswing. Your bond portfolio does not include long term bonds, which were most negatively impacted by the recent tick upward in rates. It also included TIPs (Treasury Inflation Protected bonds), which did relatively well in the Make America Spend scenario recently favored by the markets.

I anticipate another question, which is now that markets are embracing a higher growth, more inflationary scenario, would that merit a change in portfolio strategy? My response is mostly no. We certainly would not recommend buying more stock, unless you are underweight that asset class; you may find you are overweighted after the last upswing in stock prices, and in addition, they have factored in a lot of economic growth in a very short time and are highly valued. Neither would we recommend leaving the bond market; growth outside the US remains low, and there remains slack in the economy, which could mean that we do not experience high inflation. In addition, you will want your bond money to reinvest at higher rates, should they occur. Also, as mentioned earlier, we have not ventured into long-term bonds and generally do not due to their higher interest rate risk.

The sole area where we do not have much portfolio exposure, which we have been reviewing for a while, is in the commodity arena, which could benefit from a Trump inflation scenario. If we do add this asset class to portfolios, it would be a small percentage as a hedge against an inflationary scenario that may not be kind to stocks or bonds. However, we have found the structure of most commodity funds troubling, as they are heavily weighted toward oil, making oil prices the dominant driver of returns to these products. Also, they do not offer income, which clearly does not meet the needs of some clients. We will keep you posted on our thinking as it develops, either in this newsletter, or individually as seems appropriate for your portfolios.

Charitable Giving

Despite the unpredictable world we live in, I am grateful to be in a profession where I may add to the abundance of my clients. In turn, we may share that abundance with others, whatever our level of income or assets. I also know I am grateful for all of my clients. I truly enjoy each and every one of you.

We are also grateful to be building our business year after year, thanks to you. To give back to the community and commemorate all of you, we are donating 10% of Kulig Financial Advisor’s profits to the Foundation for Financial Planning, which is a non-profit devoted solely to pro bono financial planning. For more on this organization, please see http://www.foundation-finplan.org/ and know a part of every dollar you spend here goes to support a worthy cause.

Kulig Financial’s Holiday Schedule

We plan to be closed both the week of Thanksgiving (week of November 21st) and December 19th through January 1st. Then we will be back at it, refreshed and ready to start another year.

A happy Thanksgiving to all!

 

2016 Q2 Market Review: Brexit Creates Market Uncertainty

July 13th, 2016

This is our second quarterly review of the markets for 2016. As you know, we do not believe in making forecasts, but we comment on cross currents influencing the markets. As usual, our goal is to look at recent market results, put them in perspective, and see how that experience should set our expectations going forward.

We look at the following topics:

  • 2016 Q2 Markets Review
    • Summary of Returns
    • A European Political Earthquake that’s felt at Home
  • What Does all This Mean?
  • Conclusion

2016 Q2 and Year-do-Date Market Review

Summary of Returns

Volatility continued into the second quarter after a tumultuous start to the year. How quickly investor focus has changed from China’s slowdown to Brexit, the UK’s decision to withdraw from the European Union. Consensus thinking that the Fed would hike interest hikes also shifted to perceptions of “lower for longer” given uncertainties abroad. Commodities came roaring back, and along with them, the junk bond market, which had sunk in the first quarter, since many energy companies had borrowed high yield debt.

Barron’s put it well, when it said “A perusal of returns for the first half shows an investment world turned upside down. Investors have been turning to stocks for income, while bonds have been the biggest source of capital gains.”

Overall, investors made a flight to quality in uncertain times, which boosted high quality bonds, US stocks and gold as safe havens. Given perceptions of a more relaxed Federal Reserve policy, income securities of all types did very well. Some additional observations are from the table of returns, which follows:

  • Despite volatility surrounding Brexit, US stocks ground out gains for June, the second quarter and the year.
  • US midcap and small cap companies have had the advantage for the quarter and the year-to-date.
  • Non-US stocks have continued to trail US stocks given concerns with Brexit.
  • Emerging markets solidified gains last quarter, and they now have lead for the year-to-date. Part of this is due to the rebound in commodity prices.
  • Bonds of all types turned in strong results not only for the quarter, but for the year-to-date. Long-term Treasury securities, which are not shown in our table, were particularly strong, gaining 15.1% for the first six months, as measured by the Barclays Aggregate Government Treasury Long Index.
  • Real estate investment trusts (REITs) have turned in rather astounding returns this year, continuing on strength late last year.
  • Master limited partnerships have had a terrific rebound after a terrible year in 2015 and a tough start to 2016. They benefitted from both a rebound in energy prices and investors’ continuing hunt for income.
  • Commodities in general had another solid quarter, solidifying their gains for the year-to-date.
  • Gold had another terrific quarter, leading to a large gain for the year-to-date.
Market Returns
Market Index June Q2 2016 2016 YTD
Stocks        
Large Cap S&P 500 Index 0.3% 2.5% 3.8%
Midcap S&P Midcap 0.4 4.0 7.9
Small Cap S&P Small Cap 0.6 3.5 6.2
Non-US Developed Markets MSCI EAFE -3.4 -1.5 -4.4
Emerging Markets MSCI Emerging Mkts. 4.0 0.7 6.4
US Bonds Barclays US Aggregate 1.8 2.2 5.3
REITs S&P US REIT 7.0 6.6 13.3
MLPs Alerian MLP 5.1 19.7 14.7
Gold Dow Jones-UBS Gold Sub index Total Return 8.5 6.8 24.3
Commodities Dow Jones-UBS Commodity Index TR 4.0 13.5 14.2

Sources: AJO Partners, Factset, Dow Jones Indexes

A European Political Earthquake that’s felt at Home

On June 23, the UK voted in a nonbinding referendum to exit the 28-nation economic and political bloc called the European Union. Though “Brexit” was chosen by a narrow margin, the people had spoken.

Given that it is a nonbinding referendum, British lawmakers could ignore the results. While there has been some talk that a UK exit will never happen, at this juncture, it doesn’t seem likely the referendum will be ignored.

Nonetheless, a victory by the “Leave” camp wasn’t supposed to happen. While the vote was expected to be close, pollsters, analysts, and even the bookies who took bets all projected “Remain” would squeak through with a win. In advance of the vote, stocks rallied in anticipation “Leave” would go down to defeat. With hindsight, the markets were complacent.

Recall from our past posts that markets dislike uncertainty. More accurately, short-term traders dislike added uncertainty and are much quicker to hit the sell button than longer term investors, who are more tolerant of disappointments.

Why might this be viewed as heightened uncertainty? Well, we’re in uncharted waters. No nation has ever asked to leave the EU.

Could Brexit fuel other separatist movements and create additional economic uncertainty in Europe? Might we see the euro currency, which is shared by 19 nations, begin to unravel? How might this pressure an already fragile European banking system? And will the dollar begin to strengthen as global investors see the relative safety of the U.S. as a shelter from the stormy global environment?

While these are potential outcomes, we also see analysts asking what if Brexit doesn’t happen? Is it possible that the UK will not act on Article 50, which would be required to begin their exit process? As a result of the Brexit vote, will the EU become more willing to be less bureaucratic with its member countries, making it easier for the UK or other countries to stay?

As with many other macro events, there really is no way to predict how events may turn out.

What Does All This Mean?

Immediately following Brexit, we wrote that we did not recommend making changes to portfolios in reaction to the UK vote for many reasons; many analysts pointed out that the economic impact in the US could be relatively small, even if it was a much bigger deal for UK citizens.

Indeed, in the volatility following Brexit, clients of ours benefited from holding high quality bonds as a bulwark against stock volatility. You may also recall that we sent some capital market history showing that stocks tend to rebound following large jolts such as Brexit created. So far, that is how it has played out. We think this continues to validate having a well diversified portfolio and resisting the temptation to trade based on short term events.

In addition, many of the themes that have kept stocks near highs continued to play out over the quarter that just ended. On the plus side, U.S. economic growth appears to have accelerated in Q2 and interest rates remain low. While Brexit may muddy the picture, earnings are forecast to begin rising again in Q3 (Thomson Reuters).

Meanwhile, the increase in oil prices has not only reduced the strong headwinds in the troubled energy sector, but it has reversed the surge in yields among junk bonds. Still, a fill-up at the gas station remains quite reasonable, helping US consumers.

Conclusion

As we noted in previous quarterly market reviews, we expect volatility to continue as markets sort things out. Not only do we have shifting perceptions of Federal Reserve policy and the state of the EU to sort out, but we are also in a presidential election year. We would reiterate to make sure you are at your recommended risk level and asset allocation for your portfolio. If you are, then all is well, and you can focus your attention elsewhere. If not, please make adjustments so that you are. And last but not least, if you are not sure, please call and let’s see where you need to be.

I hope you’ve found this review to be educational and helpful. If you have any questions or would like to discuss any matters, please feel free to give me a call.

Thank you very much for your trust and confidence.

Roth Savings Strategies for High Earners: Strategy #1 – the Back Door Roth IRA

May 30th, 2016

Roth IRAs and 401(k)s are wonderful savings vehicles. Although you cannot claim a tax deduction for them, their earnings are untaxed and there is no income tax due when withdrawn in retirement, providing some requirements are met.

Whenever possible, we recommend some portion of savings be devoted to Roth accounts. Ideally, entering retirement, one would have a mix of tax deferred savings (traditional IRAs and employer savings), taxable money, and Roth money. This provides multiple ways to draw down your accounts in retirement and provides much more flexibility in tax planning.

However, if you are a high earner while employed, it can be difficult to contribute to Roth accounts because:

  • There are limits on income for direct contributions to Roth IRAs. In 2016, Roth IRA contributions phase out starting at $184,000 for married filing jointly taxpayers, and they are completely eliminated at $194,000.
  • High earners frequently need to take full advantage of salary reduction plans at work to lower their taxes; thus, even if their employers offer Roth options, they may not feel they can take advantage.

The Back Door Roth IRA

Starting in 2010, Congress changed the rules for converting from a traditional to a Roth IRA. Beginning with that tax year, there is no longer an income limit on converting a non-deductible traditional IRA to a Roth IRA.

So how do you do this? There is one potential pitfall to be aware of, but with some planning, you can take advantage of this strategy for additional tax savings.

Important Condition Prior to Making the Contribution

Before using this approach, make sure that you do not have any SEP-IRA, SIMPLE IRA, traditional IRA, or rollover IRA money.  The total sum of these accounts on December 31st of the year in which you do Step 3 must be zero to avoid a “pro rata” calculation that can eliminate most of the benefit of a Backdoor Roth IRA.

The pro-rata rule is often referred to as the cream-in-the-coffee rule. Once the cream and coffee are combined you cannot separate them; in the same way, blending before-tax and after-tax funds in any Traditional IRA(s) cannot be separated. This is true even if you keep the before-tax amounts in a different Traditional, IRA from the after-tax amounts, as the values of all Traditional IRA(s) are combined for purposes of determining the percentage of any distribution or conversion that is taxed.

So how to deal with existing traditional IRA money?

  • Convert the entire sum to a Roth IRA. This approach is really only practical if it does not bump you into a higher tax bracket and you can afford to pay the taxes out of current earnings or taxable investments with relatively high cost basis.
  • Roll the money over into a 401K, 403B, or Individual 401K.  401Ks don’t count in the aforementioned pro-rata calculation.  Some people have even opened an Individual 401K that accepts IRA rollovers in order to facilitate a Backdoor Roth IRA.

Contribute to a non-deductible IRA

Next, make a $5,500 ($6,500 if over 50) non-deductible traditional IRA contribution for yourself, and one for your spouse.  You can use the same traditional IRA accounts every year, leaving the account open after you make the conversion.  (Most fund companies don’t close the account just because there is nothing in it most of the year).  I do this every January and place the contribution in a money market fund. Since it yields next to nothing, you will not have much in the way of gains that could be taxed at conversion; you will also not have any losses.

Convert the non-deductible IRA to a Roth

Convert the non-deductible traditional IRA to a Roth IRA by transferring the money from your traditional IRA into your Roth IRA at the same fund company.  If you don’t already have a Roth IRA account, you’ll need to open one.  This can easily be done online at most fund companies.  The transfer is considered a taxable event, but the tax bill should be zero if you initially put the money in cash as described earlier.  Once the money is transferred to the Roth, you can invest the money according to your investment plan.

The Step Transaction Doctrine

Some people are concerned that the IRS will have a problem with the Backdoor Roth due to an IRS rule called The Step Transaction Doctrine.  This rule says that if the sum of several legal steps is illegal, then you can’t do it.  Since a high earner can’t legally make a direct Roth IRA contribution, then some have wondered if the IRS will really allow them to use the back door Roth strategy.

Some experts recommend waiting a short period of time (anywhere from a day to six months) before doing the conversion so you can prove that wasn’t really your intent.  Another method to avoid the Step Transaction Doctrine is to convert last year’s non-deductible contribution this year, then make a new non-deductible contribution for this year to “introduce economic uncertainty” as to whether you’re going to convert or not.

Fortunately, many fund companies will not let you do your Roth conversion immediately; mine will not allow a conversion for about two to three months (I have not tracked the actual time, but have just gone back periodically to see if I can do the conversion yet). This helps safeguard against tripping the Step Transaction Doctrine.

When you do your Taxes

When you do your taxes for the year of the conversion, remember to fill out Form 8606 for each person funding a non-deductible IRA.

Congratulations, you are now accumulating Roth money! There are a few steps and things to be aware of, but it is not too difficult and provides you a tax-free source of money in retirement. Make it a habit to fund one every January for both yourself and your spouse if married, and head for financial independence!

 

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.