My own brother did not believe me…

Earlier this week I received an advertisement via email. Like so many advertisements I receive, it’s a reminder of everything that we believe is wrong with our industry. This one was from a company named Addepar. And I quote, “Does it take too much time to find each client’s bank exposure and make it difficult to be proactive during market volatility? Wealth managers using Addepar find this information in seconds.”

Let me reassure all of our individual clients: No one on the investment team at Iron Capital needed a software package to reveal our clients’ bank exposure. So, we are not a prospect for Addepar. There are multiple triggers in this advert: First, the realization that a company like this exists because the vast majority of “wealth managers” have no idea how each of their clients is invested; and second, the use of the term “wealth managers.” I often talk about the evolution of the financial services industry, and this example is a case in point. Historically, brokers evolved to be financial advisers because they were not allowed to call themselves investment advisers. In those days, most investment advisers actually referred to themselves as money managers, because that is what they do – manage their clients’ money. Brokers don’t actually do that and are thus not allowed to use that language, so the marketing departments came up with “wealth manager.” People often think I am just making this stuff up, until they get a taste of reality.

That email this week, triggered by the banking tumult, reminded me of similar email ads when our government rolled out the Roth IRA. Unlike a traditional IRA or a 401(k) plan, the Roth did not provide an immediate tax deduction, but the money could grow tax-deferred, as in a traditional plan, and it could be withdrawn tax-free. As an incentive to convert from traditional plans to the Roth, the government allowed a limited window in which investors could transition from traditional retirement plans into Roth IRAs and defer the tax consequence of doing so over several years. My brother, who is an estate attorney, asked me about it, as he was hearing from every broker he knew that this was a once-in-a-lifetime opportunity.

I explained that we did not think that the Roth made sense. The lure of tax-free income in retirement does not outweigh the loss of the immediate tax deduction today. He questioned our analysis, because all these other financial people were saying the opposite. I told him that it was a money grab. This was a once-in-a-lifetime opportunity, yes – but not for investors; for brokers. They could move large sums of money into Roth IRAs and get paid huge commissions on these transactions. He didn’t believe me; he thought I was exaggerating the nature of this industry.

Shortly after that conversation with my brother, I returned to my office to find an email advertisement waiting for me touting the once-in-a-lifetime opportunity to collect huge commissions on the Roth conversion frenzy. I sent it to my brother. He believes me now. Iron Capital was then and still is fee-only, but we still get those advertisements, just as we get advertisements today targeted to brokers who don’t know what investments they sold when. Not much has changed.

Our view that investors are better off in traditional retirement plans than in Roth plans was in the minority. The problem with judging things like this is that one must make assumptions about the future of tax policy. Those in favor of Roth assume that tax rates will rise; that is the only way one can get the math to work. To assume one is better off in the Roth, then she would have to have a higher tax rate in retirement, or at least be taxed the same.

We do not think that is a realistic assumption. Those who disagree point to the current fiscal mess that is our government and simply say that taxes must go up. Fair enough, but taxes in general going up is much different than an individual paying more taxes in retirement. The vast majority of retirees will make less money in retirement than when working and will be in a lower tax bracket. This is consistent with the current reality. To successfully retire, the rule of thumb is that one must replace approximately 70 percent of the pre-retirement income. Tax rates could go up across the board and it would still be unlikely for a retiree to pay more in taxes than when she was working.

That is, of course, if politicians just decide to raise taxes on everyone. When was the last time you witnessed that? Politicians don’t just raise taxes honestly, they look for back doors. They raise only on the “rich,” or they do away with a deduction, or they add a tax onto consumption, and so on.

A perfect example is the new Secure Act 2.0 retirement legislation that passed at year-end 2022. One of the 90+ clauses of this law is an increase in the so-called catch-up contributions in retirement plans: Participants over the age of 50 are allowed to contribute an additional $7,500 over and above the maximum of $22,500 to “catch up” as they are getting nearer retirement. Starting in 2024, those catch-up contributions will have to be deposited into a Roth-type account for any employee making $145,000 or more.

The government is doing this because they know they will get more taxes from a Roth than a traditional account. This is how taxes are raised. It is far more likely that the government will tax the income from one’s Roth than it is that they will raise taxes on every rank-and-file voter. For those saving for retirement, the traditional plan is the best option.

However, the Roth is not without some benefits. For those who are not just defined as “rich” by the IRS but are actually well off and in no need of retirement plan income, the Roth is an excellent estate planning tool to pass along wealth to the next generation. Traditional accounts have required distributions as the investor ages, but Roth accounts do not. In addition, under current law, a non-spouse (children or grandchildren) who inherits a traditional retirement account must take the money out of that account over a 10-year period and pay taxes on those distributions, yet as of now, the same beneficiary of a Roth would not pay taxes on those distributions.

So the Roth could be an attractive option for someone with no plans to use his retirement account to fund his retirement, but for the average retirement investor, the traditional account is still the way to go. Secure Act 2.0 should put an end to any doubt.

Warm regards,

Chuck Osborne, CFA
Managing Director

~To Roth, or not to Roth?

“We hold these truths to be self-evident, that all men are created equal….” Banks? Not so much. Last Friday Silicon Valley Bank failed, and as is the nature of the financial media, they have stoked fear at every turn. There are laws against yelling fire in a crowded theater, and there should be laws about trying to frighten people in the financial markets for ratings.

One of the lessons we obviously did not learn from the 2008 financial crisis is that the term bank can apply to all different kinds of financial firms. The retail bank is where most of us have exposure: They hold personal checking and savings accounts and provide loans for things like cars and home purchases.

The next bank is a commercial bank. Often part of the same bank, the commercial bank provides loans and banking services to businesses. They tend to be very conservative, and most small businesses must find financing elsewhere until they have been able to establish good credit. Both retail and commercial banks are frankly boring, and when it comes to something that should be stable and reliable, boring is a good thing.

The next bank type is the investment bank; this is where the action is. These bankers are deal makers, helping startups get funding, bringing private businesses to the public market and funding mergers and acquisitions between companies. This is the heart and soul of Wall Street (assuming Wall Street has a soul).

There are also mortgage banks that do nothing but home loans, and there are trust companies that custody assets held in trust for various types of beneficiaries. We often do not get into this detail because it is needlessly complicated, but most 401(k) plans are actually trusts, held by a corporate trustee.

What is my point? Silicon Valley Bank is not a typical bank. They were a commercial bank that specialized in providing banking services to technology startups. This is not your grandparents’ savings and loan; this is just about as risky as a commercial bank can get. In addition, they seem to have been incompetent. I know Californians march to a different drumbeat, but were they unaware that the Fed had been raising interest rates for a year now?

They went under because of losses in their bond portfolio. Were they unaware of hedging strategies? Did they not realize the yield curve has been inverted, meaning shorter term bonds actually pay more? Well, they did have an unfilled opening for a risk manager…won’t need that anymore.

The other failures over the last week are all crypto-related. One of them had Barney Frank, former congressman of Dodd-Frank financial reform fame, as a board member…this is why I don’t see the need to read fiction – no author would have dreamed of that.

These failures are all very risky endeavors and not indicative of any problem in the normal banking system. However, all banks are always vulnerable to a run. As Jimmy Stuart taught us, the banking business model is to take deposits and loan that money out. Your money isn’t here, it is in Martini’s house – are you going to foreclose on your friend Martini? If every customer comes to the bank at once and asks for all of their money, the bank will fail. This is why we have FDIC insurance.

This is also why it is even more irresponsible than usual for the financial media to be stoking fear. We are not in a financial crisis, but we can be by the end of this week if everyone sells everything and hides the cash under their mattress. The banking system is built on trust, and while trust takes years to build, it can be destroyed by a simple rumor – which may be good for ratings, but is dangerous for society.

The Fed made it too easy to borrow money and they did it for too long. The crypto meltdown and SVB are symptoms of a lack of actual business maturity. It is a combination of apparent ignorance and astonishing arrogance. There will be more to report on this scenario, but meanwhile we should be thankful for prudent investing. Markets react negatively to shocks, but quality companies bounce back quickly. As I said often during the 2008 financial crisis, panic is never a good strategy, and this too shall pass.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Created Equal?

They say the shortest distance between two points is a straight line. I wouldn’t know because, for some strange reason, I chose a profession and hobbies in which there is no such thing. I’m not sure what this says about my personality…although I did take one of those personality tests in college and it labeled me a wanderer.

I was never sure what that actually meant, although the description that came with it made me sound awesome. (Isn’t funny how every one of those personality descriptions sounds awesome?) I am not sure if “wanderer” really sums me up, but I have been an avid golfer for most of my life, and wanderer would summarize my golf game perfectly. I am not sure if it is possible for the golf ball to travel in a straight line, but I can assure you that none I hit ever did.

Later in life I picked up sailing as a hobby. I was inspired by one of my favorite uncles, who was also the reason I am a Wake Forest Demon Deacon. One thing that frustrates non-sailors about sailing is that the use of the wind for propulsion means it will be a rare day when the boat heads straight to its destination.

I have spent my professional career investing other people’s money. Over that 30-year span, the direction has been primarily up, but I can assure you it has not been a straight line. Straight lines just do not happen in my life. So it was of little surprise, after seeing inflation drop for the last several months with each month’s reading lower than the month before, that the January numbers came in a little higher. Previous months were revised upwards as well.

That brings us to Fed Chairman Jerome Powell’s testimony to Congress yesterday and the market reaction. Powell’s remarks were as expected, and really, little changed. He did say that rates may have to be “higher than previously anticipated,” but what else was he going to say? The Fed will react to the data when they meet, which will be March 21-22. The focus right now is that January’s data, which came out after their February meeting, showed inflation was higher than expected. So, Powell says they will raise rates higher. February’s data, which comes out next week, could change his tune, or not.

The big question I have is: Who expected inflation to just drop in a straight line? In truth, I doubt anyone did, but that doesn’t stop short-term traders from playing their games. Inflation has long stopped being the story for the market; The story is that the Fed raising rates will cause a recession. We believe that story is just wrong. The Wall Street Journal got in the act this week with a story suggesting much the same. However, the traders still believe that higher rates equal recession.

The problem with the rates-recession view is that it makes good news seem like bad news: When the recession doesn’t come, instead of saying, “Guess we were wrong,” the punditry just pushes off the onset. Meanwhile, one important thing Powell said yesterday – which was conveniently ignored – was, “We are not close to having a recession.” It is not a coincidence that market rallies keep occurring when companies are actually reporting results. The real world is doing okay.

If the Fed going from 0 to 4.5 percent on the Fed funds rate did not cause a recession, then a few basis points higher this year is not likely to have an impact. The pundits then say, “Yes, but how long will these high rates last?” My answer is five years, and yes, I am still bullish.

We have had two recessions in the last three years. We are not in the late stages of the business cycle; we are at the beginning, and the normal cycle is five years. Until then, the Fed’s focus will be on fighting inflation, not on fighting a recession.

Too many on Wall Street can’t remember a normal business environment. Their entire careers have been spent with the Fed in what was supposed to be emergency mode. They believe everything is about what the Fed does. They are wrong. Sometimes (I would argue most of the time), the price of a stock is not determined by Fed action, but by the actual value of the company, a portion of which the stock investor owns.

That idea might be old-fashioned, but then again so are 4 percent bond yields.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Straight Lines

The market doesn’t know what to make of an optimistic Fed. Last week the Federal Reserve’s Federal Open Market Committee (FOMC) met and raised interest rates by 0.25 percent as expected. Then, something strange happened: Jerome Powell started talking and was actually optimistic. The Fed recognizes that the “disinflationary” process has begun. Inflation is still high, but the rate is coming down.

This is happening without the economy going into a recession. In fact, last Friday the Employment Situation Report revealed the economy created 517,000 jobs in January. Powell was clearly stating his optimism that inflation can come down without a job-killing recession. The stock market rose on the news, and if all one ever looks at is the headline index return, then all is well.

However, as I have often stated, the real story is not in the headline number – it is in the action underneath. The stocks that rallied were the large technology stocks that the market now sees as defensive. Traders buy these stocks because they believe the economy will be weak, and these companies are believed to be able to grow even if the economy is weak.

The bond market followed suit, with interest rates on longer term Treasuries dropping. In other words, while Powell gives the most optimistic speech since his “inflation is transitory” talks, the market takes this as a signal that we are heading to a recession. This makes no sense, as the data show the very opposite.

Enter the spin machine. This week the pundits have come up with another story: They now say this market reaction shows that the market believes we are headed for a low interest rate, low-growth environment, and that is why longer rates dropped and tech stocks led the way.

The only issue with that theory is that with all the positivity, Powell was clear on one thing: The Fed is not stopping its rate hikes. “Further Fed rate increases are needed,” he has said repeatedly. We are not about to enter a low-rate environment unless the Fed cuts rates after inflation is back down to its target of 2 percent.

I suppose the idea here is that the Fed raises rates to get inflation under control and once that job is done, they will then lower them back. That makes sense, except it never happens that way. Granted we have had more experience over the last 30 years with the reverse – the Fed lowers rates to fight a recession, and once the economy is growing again, they go back to “normal.” That hasn’t happened – they never go back to “normal.” In fact, that not happening is part of why we are in this inflationary mess: the Fed pulled out all the stops during the reaction to the pandemic and never went back to “normal.” This was after a decade-plus of not going back to normal after the 2008 financial crisis.

If we get the slow-but-steady growth that the pundits are now calling for, then the Fed would have exactly zero incentive to lower rates. They never raised rates simply because the crisis was over; why would they lower them just because the crisis is over? The only way rates are coming back down in the future is if the Fed goes too far and puts us into a recession.

So, what is going on? I can’t really tell you in regard to the bond market; they are usually the smart ones, and their actions over the last week are puzzling. It may be as simple as we tend to read too much into the predictive power of longer-term rates.

The stock market is clearer to me. Tech stocks are the most beaten up, and if people believe we are finally in a lasting rally, then they are likely to bounce back first. If that is the case, then it will not last. What leads the way down almost never leads the next bull market.

It is early yet, but most economists are predicting negative GDP growth this quarter. The Atlanta Fed’s GDPNow, which is based on actual current data, says we are growing at a little more than 2 percent. There is still too much negativity in the market, and they either do not believe Powell or think he is wrong to be optimistic (fair enough, given his track record).

So where does all this leave us? While I personally find this saga fascinating, the confusion and mixed signals are really just reminders that the prudent way to make investment decisions is from the bottom-up. It is much easier to predict a positive future for a specific company than it is to figure out when the next recession will come and what interest rates will be ten years from now.

Still, it is amusing to see the pundits get it wrong and then change their tune as if they had never said what you just heard them say. Markets often act strangely in the short term, but they tend to get it right over time. Powell’s optimism was the only thing that made sense last week. We still have a long way to go, but so far so good for 2023.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Strange Reaction

Every market strategist seems to have the same outlook going into 2023: The market will struggle in the first half of the year, then rally toward the end. There is some difference in the degree and actual year-end estimates for the value of the S&P 500 index, but directionally, this is the forecast from every strategist we have heard.

This groupthink alone should be taken as evidence that there is a high probability of this forecast being wrong. When everyone on Wall Street agrees, then usually that means everyone is wrong…but not always. Just because it is the consensus doesn’t necessarily mean it is wrong. So, let’s try to figure this out for ourselves.

The almost universal reason for this forecast is the belief that we simply must have a recession in 2023. The argument goes that because the Fed is raising interest rates, the economy must go into a recession.  If we go into a recession, then corporations will make less money; therefore, earnings estimates need to drop, and when they do, the stock market will fall. This has been the steady drumbeat of market strategists for at least nine months now. The only change is that they keep getting frustrated by the fact that analysts’ earnings estimates are not dropping, or at least not dropping fast enough.

Why the disconnect between the earnings estimates of Wall Street analysts and the views of Wall Street strategists? I believe the disconnect comes from having very different perspectives. First, some translation into English would be helpful.

A strategist on Wall Street is someone who uses economic and market data to project the big picture of where the market (usually defined as the S&P 500) is going. They are often (though not always) trained economists. They look at the financial world from the top-down.

An analyst on Wall Street is someone who studies companies. Usually, they will follow every company in a specific industry. They look at each company from the bottom-up.

The strategist community sees the current situation as driven by the actions of the Federal Reserve. The theory goes that the Fed raising rates will cause economic activity to slow down, and the economy will go into a recession. When that happens, companies will make less money, and their stock prices will fall. They believe this will occur in the beginning of this year, and when it is over, the stock market will rebound.

This argument seems logical, but it ignores a significant factor and makes some assumptions that might not hold true. First, it ignores the fact that the market has already dropped well into bear market territory in anticipation of this very event; this seems to not matter to the strategist. Bad news should be priced into the stock market already, but strategists deny this. Secondly, it assumes that Fed actions have a significant impact on the real economy. There simply does not seem to be much evidence for this belief.

Let’s think this through. The Fed’s actions have been to raise interest rates. How much of your personal consumption is impacted by interest rates? Hopefully, none of our readers are borrowing money for monthly expenditures. If one is in the market for a new car or a house, then interest rates would have an impact, but most of us are not borrowing money to buy a new shirt or go to a movie.

How does the increase in interest rates impact companies? There are two possible ways: 1) If they sell a product that requires most customers to use financing. Housing and the mortgage business are certainly hurting with higher interest rates, but most businesses do not sell products that are so expensive that their customers must finance them. 2) If it has to borrow a great deal of money to run its operation. The interest expense on that debt would cause earnings to go down.

In the 1970s and 1980s when we last dealt with high inflation and an aggressive Fed, our economy was based on manufacturing. Manufacturing requires big warehouses and factories with lots of expensive equipment, which were usually financed, and therefore companies carried significant amounts of debt and were sensitive to the cost of borrowing money. Today our economy is based on services. Most companies do not carry a large amount of debt and interest expense is a relatively small item.

This brings us to the view of the Wall Street analysts who keep frustrating their strategist colleagues by not lowering earnings estimates enough. They view the world from the bottom-up. They are looking at individual companies and saying that the actual companies are doing just fine. They are not blind to what the Fed is doing, but most companies just are not seeing a significant impact, so the earnings estimates remain far more positive than the top-down strategists believe.

Who is right? Truth be told, neither group has the best track record, but if forced to pick one over the other, I will go with the ones who see the world from the bottom-up; that is how prudent investing is done – analyzing each investment on its own merits and not guessing where the entire market is going.

Our view is that 2023 may get off to a rough start (though the first two weeks would not indicate this) simply because so many on Wall Street believe the first half will be rough. We believe that by the second quarter, the realization will hit home that the most-forecast recession in history isn’t going to happen, or if it does, it will be so mild that no one will notice. Then we rally for real. If anything, we may be too pessimistic. I for one will be very surprised if 2023 is not a good year for investors. Happy New Year!

Warm regards,

Chuck Osborne, CFA
Managing Director

~2023: What to Expect?