Rainmaker or Storm-maker? Is this roller coaster coming from Trump?

Recently we in the investment world have been coping with the uncertainty related to the combative trade negotiations between the USA and China. When faced with the Trump regime’s caustic approach to trade negotiations, other nations (e.g. Canada and Mexico) have taken more of a placating approach. Conversely, China’s leader Xi Jinping has fought back aggressively and very publicly against the US stance. For example, state-run news agency Xinhua recently ran an article entitled “Forcing ‘America First’ on others will lead to ‘America Alone’” as a counterattack.

Through the winter the US government routinely released comments on how well the trade negotiations with China were going. Notably all through that period China was NOT releasing similar upbeat comments. Once talks fell apart this spring, there was a broadening of the issues tabled from trade alone to a long laundry list including issues such as Taiwan’s independence, Muslim minorities in China, Belt-and-Road Project’s alleged predatory lending, and control of the South China Sea. This morphed the narrowly scoped trade negotiations into an overall battle about America’s global dominance. The scope expansion and the entrenched positions of the two parties tell me we will wait a long time before seeing headway.

Adding yet another layer of geopolitical turmoil, the US government’s approach toward Latin American refugees has been all stick and no carrot but has not made progress on the issue at hand. The latest response was to target Mexico by threatening a stairstep series of tariffs on all imports starting June 10th.

What has been the result for investors? It seems like the negotiation rainmaker has become more of a storm-maker (let’s hope it’s a tempest in a teapot). If you look at the chart below of the S&P500 Index (US stock market indicator) you will see that in early 2019 the market rose up from the Dec 2018 lows but after the May 2019 selloff the US market is now roughly where it was almost a year and a half ago at the beginning of 2018!

Meanwhile let’s take a look at the VIX index (below). This index shows the implied monthly volatility levels expected in the S&P500 stock index. You can see that through 2017 the expected volatility was generally confined to the 10-12 range but starting in 2018 it really rose up. Now the expected volatility tends to be in the 12-24 range with occasional spikes up into the 30s.

Some pundits claim we should not be too overly concerned by these sensational political headlines and just focus on what is happening in the real economy. I disagree. Solely monitoring the real economy is like looking in the rear-view mirror instead of looking toward the future. The real economy is driven by spending (mainly consumer spending and business investment spending). The ebbs and flows of spending depend on consumer and business confidence. The link to the real economy is that headlines can sow the seeds of worry, then worry can spook confidence, and weakening confidence can soften spending, both at the consumer and the business level.

But let’s not be chicken little; the sky’s not falling. In the world of finance here are a few tidbits I have learned over more than two decades in the industry:

  1. At the core of the investment process, prioritized above regular stock selection, first come strategic asset allocation and diversification. While we constantly search for specific investment opportunities, we start with setting the right strategy and ensuring diversification as the top two priorities. This implies staying strategically focused on the long term.
  2. Bear cases are seductive arguments. Because the media tend to grab sensational, often worrying stories, it is always easier to put together a so-called ‘air-tight’ hypothesis based on downside than on upside. Despite these fearmongers, over many decades markets have risen as companies continuously invent and create. Thus, we need to beware of falling prey too easily to bear case hypotheses.
  3. If you can tolerate volatility, then volatility can be your friend. We aim to buy stocks where the stock price undervalues the business and sell stocks where the price overvalues the business. To do this we rely on the twin emotions of fear and greed in the market pushing around stock prices until they reach unreasonable levels (too low or too high). If the market did not have this emotion and volatility it would be harder to find mispriced stock opportunities.
  4. If you watch the news media, the primary advice is to get out of this industry/sector; get into that one; get out of equities; get into bonds; get into equities; time to buy gold. This approach to investing is referred to as market timing. Market timing is one of the most difficult tactics in investment management. While this may make good news fodder, most people trying to implement it will not get the timing perfect and analysis shows that if your timing is off by even a little bit, you don’t make the profits and potentially lose money. That’s why many experts call overall market timing ‘a mug’s game.’
  5. Indirectly a value investing approach will often automatically adjust asset allocations to reflect the ever-changing economic cycle by looking at company valuations. This can lead us to buy industrials when the time is right, and likewise utilities, etc. When we sell a business and raise cash, we are looking for places to reinvest that cash. Often the stocks most out of favour will have the lowest prices and look the most appealing. This value-focused process often leads to buying out-of-favour stocks and naturally preparing for what will do well in the future rather than what has done well in the recent past.

Do today’s circumstances represent a rare occurrence? While some commentators like to blame the entire situation on President Trump, the reality is that if we look back through past economic cycles we see that this has happened before. Often, early in an economic recovery the market rises up relatively smoothly. Then later in the cycle when the recovery becomes more “mature” we tend to see more volatility and periodic pullbacks. Later stages of an economic recovery are never as smooth as the early stages. For example, if I look at my own personal portfolio I see that after the winter’s rise up, the portfolio was down 4.5% in the month of May. Then from May 31 to June 11th it was back up from the 1.3% in the next 7 trading days! I expect these bigger routine moves will generate opportunities on both the stock buying and the stock selling process.

Paul Fettes, CFA, CFP
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.

Posted in All Archives, Financial Planning, Investment, Risk Management Tagged with: , , , , , ,

Market Pullbacks

In the past couple month, the increased volatility of investment markets has led two clients to write to get my sense of the market situation and how/if we should react to that. With the sense that the voices of a couple might represent the thoughts of others, I wanted to share with all clients some reflection on recent markets.

If we zoom into the relatively short-term perspective of the last 12 months the chart below shows what things have looked like for the US stock market index (in blue) and for the Canadian index (in purple). In 2018 we have seen the first big ups and downs in the beginning of the year and then the second time again in the last couple months, predominantly in October with follow-on tremors in November and December.

We can point the finger at several different factors but they largely fall into two groups. First there is the geopolitics. This group includes issues such as the US-China tension, American sanctions against Iran, rumours of a military coup-d’état in Venezuela, concern about a rough Brexit, OPEC oil negotiations, Russian meddling investigations, and more.

Secondly there is the maturing economic cycle. The USA and China are the largest two economies in the world. In the USA, strong economic growth, low unemployment, and the risk of rising inflation has led to a series of interest rate increases to cool the hot economy. Thus, prognosticators are predicting slower growth ahead. In China, a tightening of lending, among other factors, is slowing the multi-decade growth that had become the norm in China.

Ultimately the concern is that the global economy will cool too much and tip into recession. Combining the first and second group of factors I would draw your attention to the following:

  1. In general, the factors of the first group (geopolitics) do not trigger recessions. Geopolitical issues do garner major headlines and make the stock markets more of a wild ride but typically cooler heads prevail and some resolution is achieved even if it is no more than a tense temporary truce. Even with President Trump’s supposed willingness to cancel NAFTA during negotiations, compromises were made and it eventually got signed. Nonetheless those geopolitical issues trigger continuous regular cycles of market fear and euphoria.
  2. There is a well-researched body of research regarding investors’ mental processing that shows the average person’s analysis of anything distorts facts by putting much more emphasis on the recent past than the distant past. It may seem that there are a lot of geopolitical issues on the table right now and that they are all significant but if I asked most people how many issues and which issues were of concern back in say 2005, few people could list more than 1-2. Does that mean 2005 was much more stable than now or does it mean that memories fade?
  3. The second group of factors (which I will call bank credit tightening) is the group that more typically drives a recession because it is tricky to precisely cool off the economy enough but not too much (a Goldilocks economy). It is like trying to thread a needle. In that sense we have seen various central bankers soften their message in the last couple weeks on credit tightening so things are looking better on that front.
  4. During an economic expansion like we have witnessed over the past few years there are a series of scares and market pullbacks that happen during the economic rise.

Take a look at the chart below. I showed only the US index for the past 20 years, excluding the Canadian index for simplicity. You can see the dot-com triggered recession of 2001 (1) and the sub-prime lending recession of 2008 (2). You can also see the pullbacks in 2004, 2006, and later in 2010, 2011, 2015, and most recently in the autumn of 2018. The major recessions drove two big declines where the S&P 500 US market index retrenched 49% from the dot-com bubble and 57% from the sub-prime crisis before recovering. Furthermore, the sample pullbacks that happened in between recessions showed retracements in the range of 8%-19% (see table). In the fall of 2018 we have experienced a pullback of around 10%.

Of course, every recession starts with what basically looks like a small mid-cycle pullback so given what we’ve seen this fall some people will wonder whether we should be running for cover.

S&P 500 Index peak trough percent decline
1: 2001 dot-com recession 1527 777 49
a: 2004 pullback 1156 1063 8
b: 2006 pullback 1326 1224 8
2: 2008 sub-prime recession 1565 677 57
a: 2010 pullback 1217 1023 16
b: 2011 pullback 1364 1099 19
c: 2015 pullback 2131 1829 14
2018 autumn to 13 Dec 2931 2633 10

Does that work? Imagine investors exiting the market in 2016 just after a 14% decline in the market. Those investors would have missed out on the recovery of 2016 which basically offset the losses of 2015. At what point would they have reinvested? Likely after the market had shown substantial recovery such as in late 2017. How would their performance compare to the markets? Not too well, to say the least! A lot of research has shown that trying to time the tops and bottoms of the market is almost impossible for even the best experts.

That said, should we be doing anything differently late in the economic cycle than early in the cycle? We need to differentiate between strategy and tactics. First and foremost, we should always make sure we are in the right place with respect to long term strategic asset allocation. Crudely speaking, this relates to two factors we need to balance: our return expectations versus all kinds of constraints we face such as our investing time horizon, our financial ability to tolerate various outcomes, and how much volatility we can stomach along the way.

Once we have the strategic asset allocation right based on the long term, then the investment approach doesn’t change but as we progress through the cycle some things become self-adapting and result in natural tactical changes.

Fundamental investing is about finding stocks worth more than the price they are trading at right now. Together we have purchased many stocks that analysis has indicated could be worth a lot more than the purchase price. As the economic cycle progresses some company shares rise in price and we have to sell them. Sometimes the economic cycle heavily influences which companies or industries are in favour (expensive) and which are out-of-favour (cheap). That is how the selection of out-of-favour stocks is to some extent self-adapting to the economic cycle so it shifts somewhat naturally without us having to try to predict the cycle.

We still have our ups and downs but we are generally confident in the businesses we own, something that helps when Mr. Market seems to bounce stocks around more than usual. Here is an internal test I perform: When a stock goes down am I inclined to buy more or to sell? During the recent pullback we bought a variety of stocks, highlighting confidence in the underlying business fundamentals, despite the daily gyrations of Mr. Market.

Paul Fettes, CFA, CFP
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.
Registered Agent, Verico Reliance Mortgages, FSCO #10357

Posted in Financial Planning, Investment, Risk Management Tagged with: , , , , ,

Real Estate Capital Gains Tax: Budget 2017

What’s your game plan for winding down your Capital Gains tax liability?

Yesterday Canada’s Finance Minister presented the government’s latest budget. there had been many fears about the potential increase of capital gains taxation. To do so would not only disproportionately affect the wealthy but also those who have chosen real estate instead of traditional stock and bond investment portfolios as their core investments.

Almost a decade ago the feds introduced the TFSA. Between that and the RRSP, many Canadians of modest means will recognize no capital gains to the extent they channel all their savings into one of those two accounts. Of course those restrict investing directly in investment properties so that really only helps traditional stock and bond investors.

Furthermore, once you have a little more wealth you are likely saving/investing far more than your TFSA and/or RRSP will allow so likely you have direct tax exposure (capital gains and otherwise). Adding to that the recent strong rise in Canadian real estate and many high net worth Canadians are sitting on a dramatic unrealized taxable capital gains.

This means increasing the capital gains taxation would fulfill the current government’s aim to have the wealthy pay a bigger share. Don’t forget this may also apply to your cottage, condo, or hobby farm.

Delayed but not Allayed

In large part to wait for the outcome of US tax reform, the government has stalled any significant changes to Canada’s Income Tax Act but that doesn’t mean it isn’t still coming down the pipeline.

Foresight is leading prudent Canadians to have a financial plan for winding down the tax exposure from their recent investing success, whether in non-sheltered stock and bond investments or in directly owned real estate.

Eliminate-no, mitigate-yes!

Posted in Estate Planning, Financial Planning, Investment, Risk Management, Tax, Uncategorized Tagged with: , , , , , , , ,

TFSA limit boosted – does it change your estate planning game plan?

In the just-released federal budget, the TFSA limit was increased from $5,500 to $10,000/person/year. The new $10,000 amount is not indexed so don’t expect it to rise annually. Does this impact your financial plans?

Consider this: Historically spouses often held non-registered investments in joint accounts but the size of the TFSA reduces the need for that. Upon death a TFSA can bypass estate and hence bypass probate fees but only a spouse can receive the account whereas a joint account could be joint between any two (or more) adult people (eg parent and child), not just between spouses.

Also, use of the TFSA for seniors rather than a joint non-registered account reduces the recognition of current income (interest, dividends, capital gains, etc.) and therefore reduces the tax plus reduces the risk of claw-back of benefits such as Old Age Security.

As you get older, and especially if you have no spouse, the benefit of bypassing probate with a joint account may outweigh the reduced tax benefit of the TFSA. This must be considered on a case-by-case basis. If this is an issue you are dealing with, we would be glad to provide assistance.

Posted in Estate Planning, Financial Planning, Tax

4 Ways High Earners Should Adjust for New Spousal Tax Laws

In recent months the Canadian government has mused about the potential for changes in the tax code so that Canadian couples can start filing their income tax returns jointly once the budget is balanced. Most people outside the financial planning profession probably don’t even realize we can’t already do this in Canada. Our neighbours south of the border have been able to do this for years.

Well, in fact there are a few minor ways spouses can share in Canada such as the spousal amount, spousal RSPs, medical expenses and pension splitting but in reality these help very few people in a meaningful way.

The big impact will be for high income professionals and business owners. The issue is this, using Ontario as an example: the combined federal and provincial taxes are about 20% on the first $43,000 of income, then 32% on the next $43,000, then 43% on the next $47,000, then 46% tax when you hit about $133,000 of income. That’s a lot of tax. For high earning professionals, you are giving almost half of every marginal dollar you earn to the CRA. So for example, if you earned total gross income of $200,000 then of the last $67,000 only $36,000 went into your pocket and $31,000 went to the feds.

The idea of getting some of that income reclassified into a lower earning spouse’s name really boils down to getting some income taxed at as low as 20% rather than at 46%, hence putting the difference, 26% back into your pocket. You can see that the biggest bang for your buck is when one spouse is earning substantially more than the other.

A big part of our financial planning service is to properly manage your taxes to maximize your long term wealth in situations like this.

Of course, many people have already come up with financial planning strategies to get around the old problems but those strategies take effort on the part of professionals and hence come with their own costs.

While we don’t know the exact text of the tax code changes yet because they are at least three years away (2016 at least), here are four things to think about to revise your plans now:

  1. On the surface this looks like a major opportunity to reduce taxes so it doesn’t seem likely that the government would do this without some other alterations to prevent the tax savings becoming too extreme.
  2. If you believe this is coming in the next three years you may want to use some income stall tactics between now and then to hold off until you can get your income taxed at a lower rate.
  3. There are a variety of structures that can reallocate income. If you are thinking about setting up something like this right now, you may conclude it is not worth the effort.
  4. Depending on the details of how the income is transferred in the new rules, there could be an increase in Canada Pension Plan contributions and hence an increase in the CPP you would collect in retirement. This may be another factor that alters your financial planning.

Many people will wait until the tax code changes are in place before they begin changing their strategy. What a shame. What a planning opportunity lost. If you want your plans to be on top of this opportunity now, contact us to see how we can help.

Posted in All Archives, Financial Planning, Tax

Buffett and Gates on Success

Posted in All Archives

Cars and Corporations

Many small business owners ask the perennial question of whether they should own their car within the corporation or personally. There are several factors that go into answering that question, such as:
-how many kms will you drive in the year for personal use and for business use.
-how much will the car cost
-how long will you keep the car
-what is the cost of liability insurance for a car owned by the corporation versus a car owned personally
-what is the cost of collision insurance for a car owned by the corporation versus a car owned personally
-how much collision insurance will you maintain and what will your deductible be
-what is the address of the corporation versus your personal address
-what are the fuel and maintenance costs for the car
-how roughly do you expect to treat it and will there likely be a loss on sale or a gain on sale compared to how much you’ve written it down?
-does the corporation have more than one owner
-what assets does the corporation have versus you, personally?

The question essentially boils down to a tax management element, insurance cost element, and a risk management element to the extent that you choose to self-insure.

Posted in Financial Planning, Risk Management, Tax

Is 4% an Unsustainable Withdrawal Rate

Historically, 4% was thought to be the withdrawal rate the average portfolio could withstand on a long term basis without eating into capital. Recent research indicates that in today’s lower investment return environment, maybe that’s no longer sustainable. We all think of our average long term portfolio returns as the determinant of the sustainable withdrawal rate but another big factor is the portfolio’s volatility because if you happen to take money out when the portfolio is facing a dip, it may never recover. Hence the need for more stable portfolios when withdrawing.

Posted in Financial Planning, Investment, Tax