The Roth Opportunity is Knocking

It’s very difficult to watch the value of your portfolio decline. We’re all feeling that pain right now. But please don’t overlook a potential opportunity – imagine a substantially lower tax bill in the future. Have you thought about moving funds from your traditional IRA to a Roth IRA? Nobody likes to volunteer for a tax bill – the amount “converted” must be included in your taxable income. However, once the funds are converted to a Roth IRA, future withdrawals are tax-free.[1] There are three timely reasons why you should consider a Roth conversion.[2]

Reason #1 – Falling stock prices. If a Roth conversion otherwise makes sense for you, then you would be wise to consider a conversion while stock prices are low. Without getting into the math, lower stock prices mean a lower tax bill on conversion. Rebounding stock prices inside of a Roth IRA eliminate future gains from taxes.

Reason #2 – Higher tax rates in 2026. The tax cuts of 2018 are scheduled to “sunset” in 2025 – meaning that we will be facing higher tax rates in 2026 (unless Congress changes the law or extends the tax cuts). You probably know that all pre-tax traditional IRA funds must eventually get taxed – but a Roth conversion can ease that future burden for you.

Reason #3 – SECURE Act passed last December. Congress passed the SECURE Act during the last week of 2019, and this eliminated the “stretch” IRA concept. Through 2019, your children inheriting a traditional IRA could “stretch” IRA distributions over their lifetimes – thereby minimizing the tax impact. Not anymore – now your children inheriting your IRA must empty it within 10 years. Many children inherit IRA funds during their peak earning years – therefore, much of your traditional IRA could be diverted to the government in taxes. A Roth conversion doesn’t eliminate the new 10-year distribution rule, but it will eliminate taxes for your children or grandchildren.

One last reason to consider a Roth conversion: there are no required minimum distributions on Roth IRAs for you and your spouse. You determine when to take distributions, not the government.

I know it’s difficult to look at your account values right now, but now could be a very good time to take some positive steps to strengthen your financial future.

[1] There are certain age and time-period rules that must be followed to obtain all tax-free benefits from a Roth IRA.
[2] Please consult with your tax advisor before converting to a Roth IRA. Higher taxable income from conversions can cause unintended consequences, such as higher Medicare part B premiums. This doesn’t mean that a Roth conversion doesn’t make sense, but it’s best to go into a conversion with an understanding of all tax issues.

By |2020-06-11T04:20:56+00:00March 30th, 2020|Uncategorized|0 Comments

Please…Just Give Us the Bad News!

One of the main problems with markets right now is the massive uncertainty. Market participants and business leaders loathe uncertainty. They would rather hear the bad news any day over uncertainty. At least they can plan when they know how bad it is.

We should start getting meaningful news – good or bad – in the next 2-3 weeks. And that news is going to be three-fold: first, we will begin to know the extent of this virus by the number of emergency room visits and, with expanded testing, the number of Coronavirus cases in the country. The news might be bad – very bad. But at least it will be news. Second, we will start getting a sense of the economic devastation that these shutdowns and social distancing measures are causing based on unemployment filings and other data. Lastly, we should have more clarity on the government response. As market participants and management teams begin to digest this news and rework their plans, my hope is that markets can then begin to stabilize.

Berkshire Hathaway released its annual report last week. In his letter to investors, Warren Buffett wrote: “Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But…The American Tailwind, about which I wrote last year…will make equities the much better long-term choice for the individual…who can control his or her emotions. Others? Beware!” (emphasis firmly added).

Trying to time markets when your emotions are in play is foolish. It’s not investing – it’s speculating. Markets are forward looking, and I have found that they tend to bottom 3-6 months before a recession ends. We are now undoubtedly in recession. We got here in record time, so it’s possible that we’re already close to when markets will begin looking past the destruction. And don’t forget that it’s quite possible we could get some great news any day. Imagine something announcing a new vaccine has been developed – or that the cases in the U.S. have peaked. I would envision a market relief rally like no other.

A word on our media. Regardless of whether you have confidence in our business, health care and government leaders, we don’t have a choice, people – it’s who we’ve got. They’re not perfect – leaders never have been. Unfortunately, both mainstream and social media seem to magnify every real and perceived flaw in our leaders. Would Eisenhower have succeeded on D-Day if he had to concern himself with Twitter mobs or endless analysis of whether he’s xenophobic? He was, after all, killing foreigners. But here’s one thing I know – a crisis can bring out the best in people. I remain hopeful that our leaders will rise to the occasion. Please be careful what media you consume.

Lastly, whenever you get lost in the fearful details of this story, it’s worth remembering that the fundamentals of private property rights, freedom to contract, and the rule of law will survive this virus. Be of good cheer. We will get through this mess. Stay well.

By |2020-06-11T04:21:21+00:00March 25th, 2020|Uncategorized|0 Comments

Optimism vs. Pessimism on the COVID-19 Virus

At times, it’s easy to move between optimism and pessimism on this quickly evolving virus story. The economic impact for the next few months is going to be dramatic. A modern-day economy cannot be on lock down and “social distancing” for long without destroying wealth. But there are reasons for hope in the stories below.

Please remember that an optimist and a pessimist show up every day in the stock market. In other words, there is a buyer for every seller – and lately there have been more sellers showing up! Maybe the buyers have been busy buying toilet paper, guns and hand sanitizer. But the point is that there is always an optimist-buyer on the other side of every transaction.

As for the larger investment perspective, it’s important to match your investments to the time when you need your investment funds – i.e., for needs in the next 5-8 years, it’s prudent to hold cash, bonds and income-oriented investments. For needs beyond that, then holding stocks for their capital appreciation and dividends is generally appropriate. For now, I don’t see anything in the COVID-19 virus story to change this investment approach.

As for the virus, here are both divergent pessimistic and optimistic views that I have come across this week.

Pessimism

First, simply watch the news or get your information from social media. Bad news sells – this hasn’t changed.

Second, I am attaching a paper from a working group of apparently very smart people from Imperial College in London. This paper has made a big impact in England and the U.S. this week. It’s not an easy read. But in a nutshell, it paints a grim picture. They believe that this pandemic is most appropriately compared to the 1918 influenza that killed 675,000 Americans (rather than the 1957 and 1968 flues). They are calling for an aggressive interventionist approach. Even then, it will overwhelm hospital systems in Great Britain and the U.S. either in June or later in the fall – later if we implement extreme containment measures now. And without a vaccine, this virus could come in waves and keep us in rolling lock downs and quarantines – not a comforting thought given the economic damage they cause.

Optimism

First, viruses are clearly beyond my expertise. But having spoken to several medical professionals and doctors this week, I understand that the virus has mutated from its inception and might now be less virulent than initially thought. If so, then it’s possible that the death rate in the U.S. will end up being lower. This might help explain why some younger people were dying in Wuhan when the outbreak began – that, and it’s thought that they were exposed to larger quantities of the virus. Unfortunately, without adequate testing, it’s impossible to know the fatality rates in the U.S. Fingers crossed.

Second, I follow a gentleman named Peter Diamandis. He and his staff are focused on what is going right in the world – and we could use more of that! I am copying and pasting an email that I received from him on March 18th. Here it is in its entirety with links:

How about some good news for a change? There have been A LOT of facts going around regarding COVID-19, and a flurry of “positive news” items to lift our spirits.

Here are a number of major victories from the Pandemic line. I’ve had my team fact-check these wins with links you can follow up on.

(1) Vaccine development: An experimental vaccine developed by Moderna Inc. began the first stage of a clinical trial on Monday, with testing on 45 healthy adults in Seattle. [link]

(2) China’s new cases plummet: China has now closed down its last temporary hospital built to handle COVID-19. Not enough new cases to warrant them. [link]

(3) Drugs that work: Doctors in India have successfully treated two Italian patients with COVID-19, administering a combination of drugs — principally Lopinavir and Ritonavir, alongside Oseltamivir and Chloroquine. Several are now suggesting the same medical treatment, on a case-by-case basis, globally. [link] [link]

(4) Antibodies to the rescue: Researchers at the Erasmus Medical Center claim to have found an antibody that can fend off infection by COVID-19. [link]

(5) 103-year-old recovery: A 103-year-old Chinese woman has made a full recovery from COVID-19 after being treated for 6 days in Wuhan, China, becoming the oldest patient to beat the disease. [link]

(6) Stores re-opening: Apple has reopened all 42 of its Apple retail stores in China. [link]

(7) Test results in 2 hours: Cleveland’s MetroHealth Medical Center has developed a COVID-19 test that can now deliver results in just two hours, rather than in a matter of days. [link]

8) South Korea’s dramatic drop in new cases: After its peak of 909 newly reported COVID-19 cases on February 29th, South Korea has now seen a dramatic drop in the number of new cases reported daily. [link]

(9) Mortality rates inflated? Experts predict that Italy has seen a higher mortality rate of COVID-19 given its significant aging population, as well as its higher percentage of COVID-19 patients with pre-existing health conditions. This might suggest that COVID-19’s fatality rate may have been slightly more inflated than previously thought for the general population. [link]

(10) Israeli vaccine development: More than 50 scientists in Israel are now working to develop a vaccine and antibody for COVID-19, having reported significant breakthroughs in understanding the biological mechanism and characteristics of the novel coronavirus. [link]

(11) Full recoveries: Three patients in Maryland who tested positive for COVID-19 have now been reported to have “fully recovered.” [link]

(12) Isolated virus: A network of Canadian scientists isolated the COVID-19 virus, which can now be replicated to test diagnostics, treatments, and vaccines. [link]

(13) Yet another vaccine in the works: San Diego biotech company Arcturus Therapeutics is developing a COVID-19 vaccine in collaboration with Duke University and National University of Singapore. [link]

(14) Treatment protocols: Seven patients who were treated for COVID-19 at Jaipur’s Sawai Man Singh (SFS) Hospital and Delhi’s Safdarjung Hospital in India have recovered. The treatment protocol will be widely scaled to other hospitals. [link]

(15) Another treatment: Plasma from newly recovered COVID-19 patients (involving the harvesting of virus-fighting antibodies) holds promise for treating others infected by the virus. [link]

Some of COVID-19’s hardest hit nation victims are already emerging strong after peak infection, and biomedical innovators are tackling the virus at unprecedented speeds. IMPORTANT TO REMEMBER… While everyone is concerned about the super-high mortality rate of this virus — which is calculated by the “number dead” divided by “the number who have tested positive” (currently ~8,000/200,000) — the denominator, i.e. the number infected is actually VERY hard to know because so few people have been tested. It may well be that 10x more are infected but subclinical. So is the mortality rate 4% or 0.4%? We will find out as large scale-testing comes reliably online. Wishing you the best. Remember that our most important tool during times of panic and crisis is our mindset. Best, Peter

By |2020-06-11T04:23:38+00:00March 20th, 2020|Uncategorized|0 Comments

A Brief History of Flus and Viruses in the U.S.

As fear works its way through financial markets, it might be helpful to review a brief history on pandemics to help keep things in perspective.

Spanish Flu of 1918-19

The world was a different place in 1918. Europe was ravaged by World War I, and antibiotics had not yet been discovered. The flu is a virus, but people often die from secondary complications caused by bacterial pneumonia. The Spanish Flu killed an estimated 675,000 Americans – and this was when the U.S. population was only around 106 million! A deep recession set in during 1920-21 that is attributed mainly to the after-effects of war and returning veterans. The Dow Jones Industrial Average fell 35% in 1920 to close the year at 72. But it rebounded and soared to 381 by the end of the decade.

Asian Flu of 1957

The Asian Flu of 1957 broke out early in the year and came in two waves. The first wave infected relatively few people, but the second wave was particularly devastating and killed an estimated 69,800 Americans.[1] According to the Federal Reserve Bank of St. Louis (FRED), real GDP dropped about 3.5% in the 4th quarter of 1957 and the 1st quarter of 1958.[2] The S&P 500 index finished the year down 14.3% in 1957 but rebounded 38.1% in 1958.[3] The total decline in the index – excluding dividends – from top to bottom (8/2/56 to 10/22/57) was 21.6%.

Hong Kong Flu of 1968

According to the CDC, the Hong Kong Flu of 1968 killed an estimated 100,000 Americans and 1 million people world-wide.[4] According to FRED, U.S. real GDP grew about 3% from mid-1968 through 1970. The S&P 500 index finished with a gain of 7.7% in 1968, a loss of 11.4% in 1969 and a small loss of .1% in 1970 before rebounding in 1971. The total decline in the index – excluding dividends – from top to bottom (11/29/68 to 5/26/70) was 36.1%.

The Other Viruses in the Last 40 years

Click image below to view PDF.

The Current Downturn in Stock Prices

At its peak in mid-February, the S&P 500 was trading around 19 times forward earnings of the companies that comprise the index. The 5-year average is around 16.7 – and a little lower for longer time periods.[5] In other words, perhaps stocks were getting a little ahead of themselves.

The virus undoubtedly will impact 2020 corporate earnings – we just don’t know how much. But if history is a guide, we will get past this Coronavirus, and investors will begin looking to 2021 earnings estimates, which are currently around 195 per share.[6] At a 16.7 P/E multiple, that would put the S&P 500 at 3,256. Given extremely low bond yields/interest rates, a multiple of 18 is arguably reasonable, and this would give us a potential valuation of 3,500. This is in no way a market prediction – simply a way of reminding you that numbers ultimately matter when it comes to valuations.

I know that staying the course during times like this are difficult. But please remember that reacting to market developments has historically been a bad idea. I remain confident and optimistic that investors will be rewarded for staying invested.

[1] https://www.britannica.com/event/Asian-flu-of-1957
[2] https://fred.stlouisfed.org/series/GDPC1
[3] https://www.macrotrends.net/2324/sp-500-historical-chart-data
[4] https://www.cdc.gov/flu/pandemic-resources/1968-pandemic.html
[5] https://insight.factset.com/sp-500-forward-p/e-ratio-hits-19.0-for-the-first-time-since-2002
[6] See Yardeni Research S&P 500 Earnings & Price Targets

By |2020-06-11T05:29:54+00:00March 13th, 2020|Uncategorized|0 Comments

The Coronavirus

Like me, you’re an investor – and you’re probably concerned. That’s understandable. This virus is troubling on many levels, and the media is now very focused on this story. But as an investor, we believe in people and entrepreneurs, we believe in their ideas, and we believe that human creativity and ingenuity can solve the most vexing of human problems. Collectively, we’re pretty darn good. And a lot of smart people are motivated to solve this problem. So please keep the long-term in mind. Your investments are matched to the time when you will need the funds (i.e., stocks for long-term goals – cash and bonds for shorter-term needs).

Nobody knows where this ends up, and uncertainty doesn’t mix well with markets. But here is what I do know – making investment decisions based in fear or reacting to media headlines has historically been a very bad idea. I believe this story will ultimately end in similar fashion, but that doesn’t mean there won’t be days when our faith is tested. Fear of loss and deprivation are powerful forces.

I know it can be difficult to keep the faith. But over time, investors have been rewarded for staying invested through difficult times. My sense is that our faith will again be rewarded. In the meantime, I cheerfully welcome your concerns and questions – I am only a phone call away.

By |2020-06-11T04:28:22+00:00February 28th, 2020|Uncategorized|0 Comments

Be of Good Cheer!

Investors should be of good cheer! The long-term, “secular” bull market in U.S. stocks that began in March of 2009 continued as diversified portfolios of both stocks and bonds performed very well last year. Even international stocks piled on with some gains.

The years 2018 and 2019 are an interesting case study on why you probably shouldn’t get too focused on “the economy” to make your investment decisions. The economic data points were generally positive in 2018, yet stocks dropped 20% at the end of the year. Meanwhile, the data points were more mixed in 2019, yet U.S. stocks rallied strongly. And the media delights in delivering every piece of negative news to you.

While data is important, investor psychology is arguably more important in dictating the length and depth of market cycles. I continue to believe that the last two recessions of 2000 and 2008 (and deep declines in the S&P 500) have left a deep scar in the minds of investors, and this has set the stage for our current, long-running bull market.

Here are some fundamental investment principles that might help keep you focused in 2020.

  • A successful investor focuses on reaching financial goals set within the context of a financial plan. While performance, fees, and taxes are certainly important, the successful investor understands that emotions and behavior around investment decisions are the primary determinants of investment success. Therefore, he or she is keenly focused on his or her deeply-held personal, financial goals. With this in mind, he or she is more likely to stay disciplined and patient – and less likely to “misbehave” by allowing emotions to impact investment decisions. Trying to time the market, react to the “news”, or do anything else that diverts one’s attention away from financial goals is risky.
  • The financial media is not your friend – consume it at your risk. According to Dalbar, the average investor significantly – and consistently – underperforms because investors tend to make emotional decisions causing them to buy and sell at the wrong times. The media stokes these emotions.
  • Staying invested through the inevitable ups and downs of markets is the only way I know of making sure that we capture 100% of the upside when markets rise.
  • By my count, there have been 15 “bear markets” since WW II – about 1 in every 5 years. The average depth of these bear markets was a 30% drop in stock prices. The level of the S&P 500 was 18 in 1945 and is approximately 3250 today. And this doesn’t include dividends.
  • Risk is commonly defined as the probability that stock prices will fall. I would ask you to consider a different definition, which is this: risk should be defined as the probability that a family will not reach their financial goals. Investing within a financial plan should have the exclusive goal of minimizing that risk.
  • Bull markets do not die from old age. They generally die from excessive risk-taking and euphoria – or fear of missing out. Last year, individual investors pulled a record amount from stock mutual funds and ETFs (exchange-traded funds) while adding significantly to bond funds.[1] Investors clearly haven’t forgotten 2008 (or 2000-02). Pulling record amounts from stocks during a fabulous year is not exactly euphoric-like behavior. This might be a glorious contrarian indicator that could be telling us we still have a long way to go in this bull market. It’s worth remembering that the 1982-2000 long-term bull market started at 102 and ended at 1527 (S&P 500 index). That is almost a 15x increase (and does NOT include dividends). The current bull market that started in 2009 at 676 is currently around 3250 – about a 4.8x increase.

Bottom Line: Be of good cheer. Stay patient, stay disciplined…and stay invested.

[1] See https://lipperalpha.refinitiv.com/2020/01/equity-funds-suffer-largest-one-year-net-redemptions-on-record-despite-strongest-returns-since-2009/

By |2020-06-11T04:29:25+00:00January 21st, 2020|Uncategorized|0 Comments

It’s Time to Consider Converting
to a Roth IRA

I’ve never met a client who wants to pay more in taxes. But as the cliché goes, you sometimes must take a step backwards to take two steps forward. Converting part or all of your traditional IRA funds to a Roth IRA might cause some short-term pain – but it could be a very good strategy for you and your heirs. Even if you’ve considered a conversion in the past and discarded the idea, you might look again.

Why Convert?

Because once the money is in the Roth IRA and you play by a few rules, the distributions and growth in the account are tax-free – not just tax-deferred, but tax-free! In addition, you might find yourself in a lower overall tax bracket because now you have less taxable income if you’re withdrawing funds from your Roth IRA. Lastly, it might also lower the taxes you pay on your Social Security benefits and for Medicare Part B premiums.

Background

Roth IRAs were introduced in 1998. There are two ways to get money into a Roth IRA: contribute each year or convert an existing traditional IRA. The roadblock for clients is that the converted amount results in taxable income. For example, let’s say Bob and Mary recently retired and have $80,000 of income in 2019. If they convert $100,000 in 2019, then their income would be $180,000 instead of $80,000. Bob and Mary’s income tax bill would be about $25,000 to $30,000 higher for 2019. Yes, Bob and Mary will endure some short-term pain, but now they have just removed $100,000 from any further taxation for them and their heirs.

Why Now?

Tax rates were lowered last year, especially for married people. Tax rates are scheduled to stay low through 2025 when the law “sunsets”. If Congress does nothing, then the new tax rates will “sunset” and revert to the higher levels of 2016. Therefore, you might say that Roth IRA conversions are “on sale” through 2025.

Second, there is an important estate planning issue for many Americans. It appears that the “Secure Act” will become law in some form. The House of Representatives voted on the Secure Act this last May with overwhelming bipartisan support by a vote of 417-3. It’s currently held up in the Senate. To “pay” for the more generous retirement provisions, the Secure Act eliminates an important estate planning tool for the middle market – the “stretch IRA” concept that will hit participants in 401k plans and IRAs the hardest. Under current law, your kids (or grandkids) can inherit your IRA and “stretch” the required payments out over their lifetimes. Given enough years, relatively small amounts in an inherited IRA can grow significantly for them. But the Secure Act will force IRA funds out of the account to your heirs within 10 years of your death. If your kids are in their high-earning years when you pass away – which is common – a large portion of those distributions will be taken by the government in taxes, especially if tax rates are higher in the future. However, if your kids inherit a Roth IRA from you, then the distributions are tax-free – even if the Roth IRA must be withdrawn over 10 years. I’ve often heard how clients don’t care whether their kids receive an inheritance. But seriously, would you rather it be transferred to your heirs or the government? With proper financial planning and follow-through, there is a good chance there will be assets left for your heirs – and you should control where these assets end up, not the government.

Strategy

If you have a large amount in a traditional IRA, you most likely would not want to convert the entire amount in one year – that would push you into the highest tax brackets and result in an expensive conversion. Instead, you probably should think about smaller amounts each year through 2025. Each conversion must take place by December 31st of each year.

Every situation is different, but couples are probably paying about 15% less in income taxes under the new tax laws. All things being equal, a Roth conversion should cost about 15% less now than it did in 2016. Again, these lower tax rates are scheduled to stay lower through 2025.

All things being equal, a good time to convert can be when stock prices decline. For example, a good time to convert would have been Christmas Eve of last year when the stock market delivered a stinker in everyone’s stocking and bottomed out in the “correction” last fall. Had you possessed amazing insight (well, luck really) and converted on Christmas Eve, then the rebound in stock prices this year would have taken place with the assets inside a Roth IRA (please note that markets don’t always bounce back this quick). And your tax bill would have been based on how much you converted – presumably a lower amount. Confused? Don’t be – I’m simply trying to say that, when the next correction or bear market sets in, think opportunistically. A future correction or bear market could be a very good time to convert funds from your traditional IRA to a Roth IRA.

Bonus Idea for Aggressive Savers

This is an interesting planning tool that is overlooked. Many employers are allowing contributions to a Roth account in a 401k. However, those limits might not be high enough for aggressive savers. If your employer allows you to make after-tax contributions to your 401k plan, then you can increase total contributions to $62,000 (over age 50) and $56,000 (under age 50). These after-tax contributions can then be rolled out to a Roth IRA when there is a qualifying event (i.e., separation from service or age 59 and 1/2). The earnings on your contributions must be transferred to a traditional IRA, but your contributions can be rolled out in a lump sum to a Roth IRA. This is a great way to get funds into a Roth IRA.

Final Cautionary Thoughts

If you are considering a Roth conversion, do your due diligence. You always want to check with your tax professional prior to converting any of your funds. Increasing your income in any given year could cause some unintended consequences.

If you are clearly going to be in a lower tax bracket in retirement, then a Roth conversion probably does not make sense for you. But given the current tax rate structure, my clients are generally not going to see a meaningful reduction in their tax bracket when they retire.

If you’re under 59 and ½, beware a 5-year rule that limits access to the converted funds.

If you convert, pay the tax from the funds outside the IRA. If you convert $100,000, please don’t pull out $30,000 and put $70,000 in the Roth IRA thinking that you will use that $30,000 to pay taxes. Roth conversions work best when you have cash or other assets from which to pay the tax bill.

Once you convert, there is no going back. Up until 2016, you could undo the transaction the following year, but not anymore.

And, as always, conversions should be considered within the context of a financial plan to make sure that the impact to financial goals and heirs are being properly considered.

Sound interesting? Call us today – we’re here to help.

Content in this material is for general information only and not intended to provide specific advice
or recommendations for any individual. Traditional IRA account owners have considerations to make before performing a Roth IRA
conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal
limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.

By |2020-06-11T04:29:51+00:00October 8th, 2019|Uncategorized|0 Comments

Is The U.S. Economy Entering a Deflationary Boom?

Under Ben Bernanke, the Federal Reserve set a policy of targeting inflation at 2%. Bernanke is apparently a dedicated student of the Great Depression, which brought extreme deflation to the U.S. in the early 1930’s – the “bad” kind of deflation where people don’t spend money. Bernanke joked about dumping cash out of helicopters, if necessary, to avoid deflation (I know, central bankers aren’t that funny). But a 2% inflation target might be a difficult objective because technology is causing a benign form of deflation/disinflation, and this trend should accelerate in the coming years. The Fed might be “fighting against the wind” as technology overwhelms the Fed and foreign central bank efforts to create inflation in the U.S. and overseas.

Modern economic models suggest that interest rates and inflation should rise as the economy heats up and the unemployment rate drops. By most metrics, the U.S. economy is booming thus causing the unemployment rate to fall to its lowest level since the 1960s. Yet the yield on a 10-year U.S. government bond remains stubbornly low and has recently alarmed many market participants by dropping to around 1.7%. All this while inflation remains low. Federal Reserve officials have appeared perplexed at times – this isn’t supposed to be happening! But could it be that the U.S. economy is entering a deflationary/disinflationary boom? Is the bull market in stocks ending as so many experts are predicting? Or will this bull keep running as prices remain steadier than in the past and borrowing costs stay low?

Today, many innovative technologies are coming of age at the same time: robotics, artificial intelligence, 3D/4D printing, energy storage, the 5G network, genomic sequencing, nanotechnology, and blockchain technology. Quantum computing could be here soon, too. And don’t forget what fracking has done to the energy industry. Computing power has essentially doubled every 18 to 24 months for decades.[1] This growth is exponential – not linear – meaning that new, impactful technologies are now coming on board and being adopted quickly. And these technologies are beginning to disrupt a wide variety of industries that will transform how we live and work. From an economic perspective, these technologies are deflationary. In contrast, the Fed’s economic models are based on an industrial world dominated by inflationary concerns. Might these models be outdated? For example, how does gross domestic product (GDP) capture services that are now free, such as apps on your phone?

Please note that your writer takes no position on short-term market movements in stocks, so please don’t hear these comments as a market prediction. Rather, I think the longer-term uptrend in stock prices looks bright and will be driven by technological forces that are yet to be fully appreciated by investors.

Should We Fear an Inverted Yield Curve?

The financial media has been filled with stories about an upcoming recession and the ominous danger of an “inverted” yield curve. An inverted yield curve means that interest rates are higher for short-term bonds/debt than long-term bonds/debt. But could it be that an inverted yield curve is signaling healthy growth ahead in a deflationary world?

When long-term rates drop, it is believed that the bond market is sending a signal that lower growth – perhaps recession – lies ahead. While that has been mostly true since WWII, it apparently was not the case further back in time. From the Civil War (1865) up until WWI (1914), we saw technological breakthroughs that radically transformed how we lived and worked. The internal combustion engine, railroads, telegraph, vaccines, telephone, electricity, etc. triggered the Second Industrial Revolution and a booming economy in the U.S. and Europe. While the data is less comprehensive back then, apparently the U.S. experienced an inverted yield curve for a majority of the time – and a mildly deflationary economy.[2] Perhaps today’s market prognosticators need to go back a little further in history. And maybe the bond market is not, in fact, signaling slower growth – just deflationary growth.

From 1865 through 1913, the average inflation rate in the U.S. was -1.03%. That’s right, prices fell about 40 percent over this time period.[3] And the good folks who were tracking inflation back then were not counting “quality improvements” and “substitution” like the government does today.[4] If those were included, then that time period was even more deflationary.

Final Thoughts on Inflation and Interest Rates

Mainstream economics says that our massive U.S. federal debt (current and projected) along with historically low interest rates should lead to inflation. But we haven’t seen inflation, so why is this? Perhaps the answer lies in the developing field of economics called Modern Monetary Theory (MMT). MMT essentially says that the U.S. does not have to be too concerned if we are purchasing goods and services in our own currency. This is because we can print money to buy these things (i.e., the Fed “keystrokes” money into existence). MMT proponents acknowledge that there is a limit to how much money can be printed before bad things happen, but they argue that this limit is much greater than is accepted by mainstream economics. In fact, MMT proponents argue that a large government debt leads to lower interest rates.[5] And interest rates and inflation tend to move together. MMT is controversial, to say the least. But it has some interesting ideas and is gaining momentum.

To be sure, there will continue to be pockets of inflation – for example, government policies (think tariffs), areas of the real estate market, long-term care expenses, and any other market that experiences temporary supply bottlenecks. But the overall trend should be towards steady to declining prices.

Bottom Line: The future might be brighter – and less expensive! – than many market experts are predicting. Stay patient, stay disciplined and stay invested.

[1] This has been called Moore’s law – the observation that the number of transistors in a dense integrated circuit doubles every 18 to 24 months. In other words, computing power doubles every 18 to 24 months. Some experts believe Moore’s law is coming to an end while others believe that it will persist as new technologies take over.
[2] In addition to technological advancements, the U.S. was on a gold standard during this time that held inflation in check. Franklin Roosevelt took the U.S. off the gold standard in 1933, and Nixon finished it off in 1971 when he closed the gold window to foreign banks. Sound money proponents argue that inflation is caused by our fiat money system and the Federal Reserve.
[3] https://www.officialdata.org/1800-dollars-in-2016.
[4] Inflation statistics in the U.S. are reduced to account for “quality improvements” and “substitution”. For example, car prices might increase by 3%. But if the 3% can be attributed to an improvement in the product, such as a safety feature, then there is no inflation in the official statistics. Likewise, if the customer can “substitute” another product, then the official government inflation rate is reduced. If the price of steak goes up, you might buy another type of meat – i.e., you substituted products and therefore avoided the price increase.
[5] Budget deficits increase bank reserves. When banks hold excess reserves, they will either hold them at the Fed to receive interest (currently 2.1%), lend them in the interbank lending market (loans to other banks), or lend them to the public. Lending excess reserves in the interbank lending market depresses interest rates because supply exceeds demand. And now interest rates have recently fallen below the 2.1% level, so there is an incentive for banks simply to hold excess reserves at the Fed. Some argue this is contracting the money supply – which is deflationary. For now, the money supply and commercial and industrial loan activity continues to expand at a healthy level.

By |2020-06-11T04:30:59+00:00August 25th, 2019|Uncategorized|0 Comments
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