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Dammed if You Do, Dammed if You Don’t

Highlights

  • The Federal funds rate can have a major impact on the U.S. economy and thereby the stock market.
  • There are pros and cons to raising and lowering the Federal funds rate.
  • It’s impossible for the Federal Reserve to please everyone.

You see, you can’t please everyone, so you’ve got to please yourself.

-Lyric from “Garden Party”, by Ricky Nelson

In 1907, America suffered through one of the worst financial crises of its history.  Known as the Panic of 1907, it was triggered by a failed attempt to corner the copper market, which led to a massive bank run.  The run triggered bank failures and cut the value of the stock market by half.

The following year, Senator Nelson W. Aldrich (John D. Rockefeller Jr.’s father-in-law) chaired a commission to investigate the crisis.  The committee’s findings and recommendations led to the adoption of the Federal Reserve Act, which President Woodrow Wilson signed into law on December 23, 1913.  Thus, the Federal Reserve System was born.  

“Monetary Policy” refers to Fed actions that are intended to promote national economic goals.  Congress has directed that monetary policy should (i) encourage maximum employment, (ii) promote stable prices, and (iii) moderate long-term interest rates.  The first two objectives are commonly referred to as the Fed’s “dual mandate”.

The Federal Reserve’s Open Market Committee (FOMC) is the central bank’s monetary policymaking arm.  The primary tool at its disposal is adjusting the Federal funds rate — the interest rate charged for overnight loans between banks to maintain reserve requirements. 

The Fed funds rate can have a major impact on the U.S. economy, and thereby the stock and bond markets.  There are always pros and cons to lowering (or raising) interest rates.  The benefits of an “easing policy” include:

  • A lower Fed funds rate can fuel economic growth by allowing banks to lend money less expensively. This, in turn, lowers the cost of mortgages, auto loans, and other lines of consumer credit, which encourages consumer spending and promotes economic growth. 
  • When commercial loans are cheap, the private sector has an easier path for financing growth and creating jobs. As a result, unemployment typically falls and wages rise as borrowing costs slide. 
  • Lower borrowing costs also improve banks’ profitability, and thereby their ability to lend.
  • The increased demand for assets brought on by the ability to borrow more easily and less expensively usually lifts asset prices, strengthens corporate balance sheets, and improves household wealth.

Unfortunately, there are also serious risks to keeping Fed funds too low for too long:

  • If rates are already low and the economy enters a tailspin, the Fed is without one of its most powerful tools for stimulating the economy.
  • Easy borrowing at low rates can encourage too much spending, which can in turn cause the inflation rate to soar above the Fed’s 2% inflation target. By comparison, higher borrowing costs and tightening credit encourages businesses and individuals to live within their means, and leads to more rational decision making.
  • Low interest rates on bank deposits discourages saving, which leaves the economy more vulnerable to future economic slowdowns.
  • If the yield generated by safe investments (such as bank deposits and Treasuries) is too low, investors may be tempted to invest in riskier investments such as stocks, causing stock prices to be inflated, and thereby increasing the risk of a market crash.

The FOMC meets eight times a year.  After each meeting it announces its decision on whether to raise, lower, or leave the Federal funds rate unchanged.   The FOMC’s most recent meeting concluded last Wednesday.  As had been expected, the FOMC announced to keep the benchmark lending rate at between 2.25 percent and 2.5 percent, where it has been since December 2018.  (The vote was 9-1.)  However, the Committee also signaled that it might lower rates later this year.  (The Fed has not cut interest rates in more than a decade.) 

The Fed’s announcement has already been praised and criticized by pundits and politicians alike.  President Trump has been pushing hard for a rate cut for several months, and recently has gone so far as suggesting that he may fire Federal Reserve Chairman Powell if he doesn’t ease the policy soon.  (The President’s authority to fire the Federal Reserve Chairman is questionable at best.) 

Trump and others who share his point of view think the time is right for a rate cut because economic growth has slowed recently, inflation is tame, and some leading economic indicators (most significantly, the flattening yield curve) are suggesting that a recession is looming. 

Opponents of a rate cut argue that employment is near record highs (and unemployment near record lows), GDP growth remains strong at a projected 2.5% for the first part of the year, borrowing costs are low, and banks are lending freely.

The reality is that there will be winners and losers whenever the Fed changes policy.  As a result, the central bank will always face criticism, no matter what the decision.  Perhaps the FOMC should open its next meeting by listening to “Garden Party” by Ricky Nelson[1] and heed the song’s wisdom that it’s impossible to please everyone.  You can find a vintage performance by Nelson here and the lyrics here.

Thank you for reading,

Mr. Market Commentator

[1]  For the uninitiated, Ricky Nelson was one of the top “teen idols” of the 1950s.  Like many rock-and-roll stars of the day, he had a squeaky clean image and rockabilly influenced pop songs.  In 1972, Ricky performed at a rock-and-roll revival in Madison Square Garden.  His hair was now shoulder-length and he wore bell-bottom pants and a purple velvet shirt.  Apparently, the crowd did not approve of his new image and booed him off the stage.  “Garden Party” was Ricky’s response.

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™.
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Beyond Belief

Highlights:

  • Beyond Meat’s IPO is a classic example of the mania that can surround an initial public offering.
  • Many IPOs jump to a fast start out of the blocks, but typically end up under-performing over longer time frames.
  • Psychology provides explanations for the irrational exuberance for IPOs.

“Most initial public offerings underperform the stock market as a whole.  And if you buy the new issue after it begins trading, usually at a higher price, you are even more certain to lose.  Investors would be well advised to treat new issues with a healthy dose of skepticism.”

– Burton Malkiel, economist, professor and author of “A Random Walk Down Wall Street”, a classic of financial literature.

Beyond Meat is the Los Angeles-based producer of vegan meat substitutes founded in 2009 by Ethan Brown.  The company has developed plant-based products intended as an alternative to chicken, beef, and pork.  Customers include Whole Foods, TGIF, Carl’s Jr., and Red Robin Food chains.  Beyond Meat hopes to become the market leader in the alternative-meat category, which is expected to become a multi-billion-dollar market over time and take a significant share of the $1.4 trillion global market for meat.

But there’s a glitch.  Beyond Meat has numerous competitors and has never made a profit.  Nonetheless, its initial public offering was a huge success.  The IPO offered to sell 9.5 million shares at $23 to $25.  To say the stock took off from there is a gross understatement.

On May 2nd, Beyond Meat’s stock began trading on the Nasdaq under the symbol BYND.  The first trade was executed at $46 a share.  By the end of the day, BYND was trading at $65.75, or 163% above its IPO price.  By June 10th, the stock had soared further, rising nearly 600% over its initial offering.

By June 11th, reality began to take hold.  Beyond Meat’s share price fell by 25% following a downgrade by J.P. Morgan from “Buy” to “Neutral”.  In a note to clients, J.P. Morgan analyst Ken Goldman warned the stock is “beyond our price target”.  On Wednesday, Bernstein also downgraded the stock from “Market Outperform” to “Market Perform”, saying the stock had “limited upside potential from a valuation perspective”.  By the end of the day Wednesday, there wasn’t a single “Buy” recommendation on the stock.

Despite the dram, irrational exuberance for IPOs is common.  Unfortunately, not all IPOs have a happy ending.  Some of the most infamous IPOs include:

  • Pets.com’s IPO raised $82.5 million only to close its doors less than a year later.
  • CIT Group was founded in 1908. Its 1997 IPO raised over $850 million.  In 2009, the company filed for bankruptcy protection.
  • In their first year of being traded publicly, Groupon’s stock price declined by 85%.

Academic studies regularly show that on average IPOs tend to underperform the overall market once the initial mania surrounding the IPO settles down.  For example, Jay Ritter, a professor at the University of Florida who has done extensive research on IPOs, has found that while IPOs tend to start off with a bang, over the next 3-year period they tend to lag the overall market. 

Given the challenged history, why do so many investors clamor to invest in IPOs?  Behavioral economists may have the answer. 

As I discussed in this earlier post, evolution has hard-wired certain behaviors or tendencies (cognitive biases in academic-speak) into our brains.  Some of these biases offer an explanation for the love given to so many unworthy IPOs.

One example: representativeness bias, which refers to the tendency for good outcomes to garner more attention than bad ones.  For example, while there has been a great deal of attention given to Beyond Meat’s IPO, far less has been paid to security provider ADT’s 2018 IPO flop.  ADT’s IPO was supposed to price between $17 and $19 per share, but the stock ended up at $14, and at the time of this writing is trading at $6.50 a share.  Investors who know only one side of the story regarding successful IPOs can have an overly favorable impression of them.

A second is hindsight bias, which refers to the natural tendency to believe in hindsight that an unpredictable event was predictable and completely obvious at the time it occurred.  Also referred to as the “I-knew-it-all-along” effect, hindsight bias can cause investors to feel foolish for “missing out” on an IPO that proved to be profitable for early investors, without due regard for the risk of loss that existed when the IPO was launched.  Such selective memories can lead to an irrationally strong desire to invest in future IPOs.

Another bias is the bandwagon effect.  As its name implies, this is the tendency to believe in something (such as an IPO) simply because many others do.  In other words, if an IPO is in high demand, it’s got to be a good deal.

Venture capitalist Aileen Lee coined the term “unicorn” to refer to a privately-owned start-up that beats the odds and is valued at over a billion dollars by its IPO.  While searching for unicorns might be a worthy pursuit for speculators, prospectors, and day traders, I believe investors with a longer-term investment horizon are better served by utilizing a logical, intelligent and systematic approach to portfolio management.

Back in 1984, Wendy’s launched a humorous and highly successful commercial campaign to promote the beef in its burgers.  You can see the first of the commercials here, and my personal favorite of the series here.  What’s true for hamburgers is true for investing, at least if you’re searching for something other than fluff.  In short, before you invest, don’t forget to ask: Where’s the beef?

Thank you for reading,

Mr. Market Commentator

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™.
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It’s a Matter of Trust

Highlights:

  • Trustees who manage investment portfolios are held to high standards.
  • Trustees must adhere to the principles of modern portfolio theory or risk being surcharged for unprofitable investments.
  • Trustees who prudently delegate investment responsibilities are not liable for the actions of the trust investment advisor.

“Trusting you is my decision.  Proving me right is your choice.”

– Prakhar Sahay

I used to do a good deal of public speaking.  More recently, however, I have not been able to find the time to do so.  That changed this past week, when I was honored to speak to The Milwaukee Estate Planning Forum.  The subject of my presentation was the expertise and higher standard of care required when managing investments that are held in the name of a trust. 

Once reserved for the wealthy, trusts have also become a common-place component of estate plans for a broader demographic of individuals and couples. The increased popularity of trusts is well deserved.  The establishment of a trust can (i) simplify the management and investment of assets during life, (ii) help avoid the time and expense associated with court-administered probate upon death, and (iii) protect the assets we leave to our loved ones from creditors, ex-spouses, as well as their own poor decisions.  

One of the most difficult aspects of establishing a trust is to decide who will succeed you as trustee after your death or in the event of a disability that keeps you from serving as the trustee.  A trust company can be an excellent choice, but not always.  Some trust companies require large account balances, impose restrictions on what types of assets the trust can own and, in some cases, charge prohibitively high fees. 

A second common option is to name a professional advisor, such as an attorney, accountant or a financial advisor as the successor trustee.  At the same time, many advisors are understandably reluctant to take on this responsibility for a variety of reasons.  Employers often prohibit advisors from serving as a trustee.  An advisor who serves as a trustee has to be very careful to avoid conflicts of interests.  (Attorneys who draft trust agreements naming the attorney as the trustee need to be especially cautious in this regard.)  Financial advisors that serve as a trustee of a trust-client must comply with the SEC’s “Custody Rule,” which can be expensive and time consuming.

A third choice is to name a descendant, trusted family member or friend as the successor trustee.  This option can make sense if the individual chosen will be the sole beneficiary of the trust, and can be counted on to administer and distribute the trust wisely.  If not, an alternative choice for trustee is advisable.

Finding a person who has the wisdom to decide when trust assets should be distributed to a beneficiary, and is also qualified to manage the trust investments, can be difficult.  As I discussed in an earlier blog post, trust law imposes a high standard on trustees who manage investment portfolios.

The degree of expertise required to comply with those standards is often underappreciated.  Under the laws of virtually every state, trustees are directed to manage trust portfolios in a manner that is consistent with Modern Portfolio Theory (“MPT”). 

The groundwork for MPT was introduced in 1952 by Nobel Laureate Harry Markowitz.  MPT is based on the premise that (i) the stock market is efficient, (ii) investors are rational, and (iii) rational investors will seek the highest return possible for a given level of risk.  MPT eschews focusing on the risk and return outlook of investments individually and instead favors developing integrated portfolios of diversified investments that maximize total expected return for a given level of risk.

The principles that underlie MPT aren’t universally accepted.  Behavioral economists have asserted that investors often act irrationally, and that MPT underestimates the major impact that human behavior and biases can have on market behavior.  Other researchers have suggested that the stock market is not perfectly efficient.  Rather it appears that there are certain risk factors that can drive above-market returns, and that some market sectors are more effective at capturing those factors than others.

MPT has evolved in response to this research.  Today, a more advanced version of MPT is available, informed by insights developed on several fronts, including tactical asset allocation (“TAA”) and so-called smart beta, which utilize quantitative models founded in academics, statistics, and historical evidence to direct how portfolio investments are allocated.  

TAA, for example, is a rules-based investment approach that attempts to tactically adapt investment portfolios to reflect changes in economic and market conditions.  You can learn about The Milwaukee Company’s Tactical Asset Allocation strategies HERE.

Most individuals and even some corporate trustees do not possess the investment acumen that is required by current law to manage trust portfolios.  As a result, unqualified trustees run the risk of being surcharged if the trust’s investments perform poorly.  Accordingly, for many trustees it is more prudent to delegate the responsibility for portfolio management to a professional investment advisor whose management style is consistent with the principles of modern trust law.

Fortunately, unlike the common law, modern trust law supports a trustee’s decision to delegate investment responsibility to a trust investment advisor.  Further, in most cases the trustee will not be liable for the investment decisions of the trust investment advisor — provided the trustee exercises reasonable care, skill, and caution in (i) selecting the advisor, (ii) establishing the scope and terms of the advisor’s engagement, and (iii) periodically reviewing the agent’s performance.  Trustees who delegate investment responsibility should also require the management agreement provide that the trust’s investments will be managed in accord with MPT.

Thank you for reading. 

Mr. Market Commentator

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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An Inverted Yield Curve Can be a Pain in the Back

Highlights:

  • When short-term bond yields surpass long-term rates, trouble for the economy often follows.
  • Investment decisions should not be driven by a single economic indicator.
  • A broad set of leading economic and market indicators suggests it may be premature to deviate from a sound, long-term investment approach.

Several months back, Mrs. Commentator suggested I try yoga (which I prefer to call stretching) for relief from my chronic lower-back pain.  While I was skeptical at first, after a few weeks I noticed considerable improvement.  Especially helpful: inverted poses stretches, such as the so-called Downward-Facing Dog (shown below). 

Like the pain in my back, interest rates have also been topsy-turvy of late.  Yields on some shorter-term Treasuries have risen above longer-term counterparts. 

Under normal market conditions, bond investors demand higher yields from long-term bonds relative to short-term bonds because, all else being equal, there’s more risk lurking over longer stretches of time.  A bond holder with a relatively lengthy time horizon must wait longer to be repaid and longer means more possibilities of adverse changes in market conditions that negatively impact bond prices — increases in interest rates and higher inflation, for instance.  Compensation for bearing that extra risk typically arrives in the form of higher yields.  But sometimes the market misprices this risk with an inverted yield curve.

To understand how this mispricing works, consider a graphical illustration.  The chart below shows a normal curve: interest rates paid on bonds (with the same credit quality) rise as maturity lengthens.

The yield curve is said to be “inverted” when rates on longer-term bonds (such as the 10-year Treasury Note) are below the yield on shorter-term instruments (2-year Treasuries, for instance).  An inverted yield curve may look like this:

Inverted Yield Curve

The reason the shape of the yield curve is widely followed is because an inverted yield has often been an early warning of economic recession.  For example, the chart below shows that the rate on 2-year Treasury Notes rose above the rate paid on 10-year Treasuries before each of the last five recessions (which are shaded in gray).

Why does the yield curve tend to invert ahead of economic contraction?  Perhaps the leading catalyst is the central bank.  The Federal Reserve has a habit of raising short-term interest rates a bit too much.  Sensing trouble ahead, investors are inclined to seek safety as well as look for ways to profit from an upcoming recession.  In turn, the market tends to bid up the prices of longer-term bonds, which pushes longer-term bond rates down.

However, by many measures America’s economy seems quite healthy at the moment.

  • The U.S. grew at a robust 3.1% in the first three months of the year.
  • The U.S. labor market is the strongest it’s been in decades.
  • On a year-over-year basis, retail sales are up 3.1% and non-store retail sales have grown by 9%.
  • The Conference Board’s Consumer Confidence Index is near a record high.

It’s also important to recognize that an inverted yield curve does not provide insight on how severe a recession will be.  Additionally, if a recession does follow an inverted curve, it can take as long as 24 months to start.  Moreover, the curve’s inversion often ends before a recession begins. 

Keep in mind that while the yield curve’s track record on forecasting recessions is impressive, the yield spread should not be regarded as a flawless forecasting tool.  And while some sections of the curve are inverted, some widely followed maturity combinations are still positive.  Notably, the spread is negative at the moment for the 10-year and 3-month yields, but the 10-year and 2-year gap remains positive, albeit just barely.

Given the foregoing, altering your investment portfolio in response to the shape of the yield curve, or any other single indicator, seems misguided.  Accordingly, The Milwaukee Company has developed The Milwaukee Company’s Economic Index (MCEI) to identify the current state of the economic cycle.  MCEI uses a combined reading of the Chicago Fed National Activity Index’s (“CFNAI”) three-month moving average and a probit model of numerous economic indicators to determine if the economy is expanding, contracting, or somewhere in between.  Based on the latest numbers, output is still growing.  For details, you can find MCEI’s latest reading here.

In addition, The Milwaukee Company has developed The Milwaukee Company Hedge Index (MCHI) to forecast the expected risk of the U.S. stock market in the near term (roughly one month forward).  MCHI also uses a probit model similar to that of MCEI, but analyzes a set of market and economic indicators (as opposed to MCEI, which uses just economic indicators) to estimate if the U.S. stock market is facing a high or low probability of a bear market (i.e. recession).  MCHI is currently forecasting a low risk of a bear market.

Of course, all forecasts are based on historical data and so we can never rule out the possibility of surprises.  The future, in short, is uncertain.  However, a thorough consideration of leading economic and market indicators suggests that this is not the time to abandon a solid, long-term investment plan.

Thank you for reading,

Mr. Market Commentator

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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The Lesser of Two Evils

Highlights:

  • History has demonstrated that trade wars can have unintended, and potentially disastrous, consequences.
  • While most economists agree that trade wars are harmful to both sides, the consequences of shooting wars are far worse.
  • Some have argued that trade wars can lead to violent conflict, but the need to protect property rights is much more likely to trigger traditional warfare.

Successful diplomacy is an alignment of objectives and means.

– Dennis Ross, director of policy planning in the State Department under President George H. W. Bush

In the year 751 AD, Chinese forces, defending the Empire’s small and outlying city of Talas, were defeated by a greatly superior Persian force.  China had defended this small outpost for days with everything they could muster, including tens of thousands of mercenaries.  The Chinese defended Talas to virtually the last man (of the 30,000 Chinese, only around 2,000 escaped). 

The Chinese defended the city not only because of Talas’ proximity to the “Silk Road,” but because of the secrets some of its residents held.  China had, for centuries, been the only economic power to have figured out how to make paper.  Talas was one of the few cities in China that had been granted the technology for making paper.  When the Persians took the city, they captured several papermakers and transported them back to their capital in Baghdad, where they forced the captives to divulge their secrets, which ended China’s century long monopoly on paper.

China and the U.S. have been engaged in a diplomatic battle of historic proportions as of late.  The causes for the fight include America’s trade deficit with China, allegations of unfair Chinese trade practices, and China’s theft of U.S. intellectual property rights.

The ongoing feud escalated last week when President Trump tweeted his intention to raise tariffs from the current 10% to 25% on more than $200 billion of Chinese imports.  The threatened hike is in response to China’s supposed failure to live up to commitments it had made during prior negotiations.  China also stands accused of using foreign-ownership restrictions to compel American companies who wish to do business in China to transfer patented technology to Chinese firms.  There is also evidence that China has supported and conducts cyberattacks on U.S. companies to access trade secrets.[1]

A couple days after the President’s tweet, China’s government-controlled media launched a counter-attack, using strong nationalist language to criticize President Trump’s trade policies in the hopes of enlisting popular support for the struggle to come.  China has also announced retaliatory tariffs on some $60 billion in U.S. goods, which are scheduled to go into effect on June 1st.

Most economists agree that trade wars are harmful to both parties.  Tariffs lead to higher prices, triggering inflation.  (The San Francisco Federal Reserve estimated tariffs on Chinese imports will raise the inflation rate by 0.4%.)  Because tariffs are essentially a tax on consumption, trade wars can be expected to negatively impact the GDP of the warring parties as well.  (The Tax Foundation estimates that the tariffs on Chinese goods, and China’s tariffs on U.S. goods in response, could lead to a 0.75% reduction in U.S. GDP).  Tariffs can also lead to a misallocation of the imposing country’s resources, as domestic labor and resources are redirected to the production of goods and provides services that could more efficiently be produced overseas. 

From an economic perspective, then, negotiations — not tariffs — are a better way to resolve trade disputes.  But here’s the rub: in the present case, tariffs are being used as a weapon to address a more serious concern, namely, China’s long history of pilfering U.S. intellectual property. 

Most civilized nations have long-established legal systems in place to protect the intellectual property rights of their trading partners.  The Chinese court system, however, has a long history of being lax at enforcing patent laws and treaties.  Making matters worse, the World Trade Organization has been of little help, in part because of its long-standing policy to support the economies of “developing nations”, and in part due to its reluctance to take sides in a dispute between two of its most powerful members.

There is a great deal of evidence that China has wrongfully appropriated billions of dollars’ worth of U.S. intellectual property.

  • Hanjuan Jin, a Chinese engineer working for Motorola, was secretly working for a Chinese company that developed telecommunications technology for the Chinese military. On February 28, 2007, Jin was stopped by customs agents at O’Hare Airport.  In her possession was a one-way ticket to Beijing and a carry-on bag with more than 1,000 electric and paper Motorola documents, including some that were marked “confidential and proprietary”.
  • In 2014, six Chinese nationals were arrested as part of a plot to steal genetically modified corn seeds from Dupont and Monsanto experimental farms in Iowa on behalf of Beijing Dabeinong Technology Group, which is controlled by the Chinese government.
  • Chinese telecom giant Huawei has a long history of stealing U.S. intellectual property. In one such instance, two Huawei engineers who were touring T-Mobile’s labs in Seattle attempted to steal confidential information regarding “Tappy the Robot,” whose fast-moving fingers were used to test the performance of the smartphones.  Not only did the perpetrators take photos of Tappy, they went so far as to steal one of his fingertips!  (Last Wednesday, President Donald Trump signed an executive order barring U.S. firms from using telecom gear from sources the administration deems national security threats.)

That’s not to say that the U.S. is prepared to engage in a shooting war with China to protect America’s intellectual property rights.  China’s nuclear arsenal and standing army of an estimated 2 million plus troops would seem to make that very unlikely. 

Nonetheless, given China’s history of not honoring its promises regarding trade and information technology protection, and the lack of meaningful legal remedies available to the U.S. to protect its intellectual property, tariffs may be the least violent weapon the U.S. has left in its arsenal to protect its property.

Thank you for reading,

 

Mr. Market Commentator

[1] See Findings of the Investigation into China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation Under Section 301 of the Trade Act of 1974, by the Office of the United States Trade Representative.

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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Do you Qualify as a Prudent Investor?

Highlights:

  • Trustees who undertake the responsibility of managing trust investments may be liable for portfolio losses to the trust beneficiaries if they fail to abide by the tenants of Modern Portfolio Theory (MPT).
  • As a result, trustees should adopt a rules-based investment approach that relies on academically supported principles to tactically adapt investment portfolios to reflect changes in economic and market conditions.
  • For many non-professional trustees it is more prudent to delegate the responsibility for investment management to a professional portfolio manager whose management style is consistent with the principles of MPT.

The prudent heir takes careful inventory of his legacies and gives a faithful accounting to those whom he owes an obligation of trust.

– John F. Kennedy

John McLean died on October 23, 1823.  John’s will left $35,000, personal property and a house to his wife, Ann.  He also left $50,000 in trust for her benefit.  John’s will directed that the trust’s income was to be paid to Ann, in quarterly or semi-annual payments.  On Ann’s death, the fund was to be split evenly between Harvard College and Massachusetts General Hospital.

Jonathan and Francis Amory were appointed as trustees.  Francis predeceased John, and when John resigned as Trustee in 1828, Harvard College and the Massachusetts General Hospital sued him, seeking to recover losses realized on investments that he and Francis had made on behalf of the trust.  Specifically, the College and the Hospital alleged that this choice of investments was speculative and negligent, and were made in an effort to generate excessive income for Ann, without regard to interests of the charitable remainder beneficiaries.

The probate court found in John’s favor, and the charitable beneficiaries appealed.  The Supreme Judicial Court of Massachusetts affirmed the decision of the probate court.  Justice Samuel Putnam wrote the Appellate Court’s opinion, stating:

All that can be required of a trustee is …to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested.” 

            Justice Samuel Putnam, Harvard College v Amory (1830) 26 Mass (9 Pick) 446, 461

This historic decision established a precedent known as the “Prudent Man Rule” that was followed by courts throughout the U.S. and elsewhere when evaluating a trustee’s investment decisions. 

In 1992, the Third Restatement of the Law of Trusts (Restatement) proposed that the Prudent Man Rule be replaced by the Uniform Prudent Investor Act (UPIA).  Most significantly, UPIA adopts Modern Portfolio Theory (MPT) as the basis for assessing whether a trustee has invested trust assets prudently.  The comments to the Restatement indicate the reason for doing so was “to update trust investment law in recognition of the alterations that have occurred in investment practice.  These changes have occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as Modern Portfolio Theory”.

Under the common law Prudent Man Rule, the merits of each investment by a trust are to be evaluated independently.  By comparison, UPIA obligates trustees to consider a trust’s investments collectively, not individually.  UPIA also requires trustees to consider not just a particular investment potential return, but also the impact a particular investment will have on a portfolio’s overall risk.

Accordingly, trustees should avoid stock picking, market timing and the like when managing trust assets.  Instead, trustees should adopt a rules-based investment approach that relies on academic research and theory to tactically adapt investment portfolios to reflect changes in economic and market conditions.

Fortunately, unlike the common law, modern trust law supports a trustee’s decision to delegate investment responsibility to investment advisors (like The Milwaukee Company) with the requisite knowledge and skill to comply with the UPIA.  UPIA relieves a trustee who delegates investment management functions to a professional portfolio manager from liability for a trust portfolio’s performance, provided the trustee exercises reasonable care, skill and caution when:

1)         Selecting the agent

2)         Establishing the scope and terms of the agent’s engagement

3)         Reviewing the agent’s and performance

Trustees who opt to engage a trust investment advisor would also be prudent to require the trust investment advisors to commit to manage trust investments in a manner that is consistent with the UPIA in their investment management agreements.  As Robert Duvall demonstrated in the 2007 movie “Lucky You”, it can pay to be prudent.

Thank you for reading,

Mr. Market Commentator

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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What do Big Foot, the Loch Ness Monster, and Modern Monetary Theory all have in Common?

Highlights:

  • Big Foot, the Loch Ness Monster, and Modern Monetary Theory are all delusions with an ardent following among otherwise clear-thinking adults.
  • Modern Monetary Theory asserts that the government can and should spend as much money as is needed to solve societal problems.
  • Unfortunately, the law of supply and demand dictates that if a government engages in unchecked deficit spending over the long term, the value of its currency will be devalued, resulting in hyperinflation.

“… [F]or it is a habit of mankind to entrust to careless hope what they long for, and to use sovereign reason to thrust aside what they do not fancy.” – Greek historian Thucydides.

My grandfather was a factory worker who operated a drop forge at night and a farmer by day.  He was a hard worker for sure.  He was also a bit hard headed.  Once he believed something, it was rare for him to change his mind, regardless of evidence to the contrary. 

Psychologists have demonstrated in a litany of academic studies that many of us have a deep-seated and powerful emotional need to believe in theories or ideologies that are consistent with our existing opinions and beliefs, even in the face of strong evidence to the contrary.  Psychologists refer to a partiality for theories and arguments that support our own beliefs and predilections as “confirmation bias”.  The rest of us call it wishful thinking.

Economists are not immune to wishful thinking, and as a result brilliant economists have been known to persuade themselves (and others) that what they would like to be true is in fact the case, even if the desired belief contradicts fundamental economic principles.  Modern Monetary Theory (“MMT”) is an example of when an economist’s predisposition trumps logic.

MMT is an economic theory that has been around for years, but has been enjoying a surge in popularity as of late as a result of the recent endorsement by Representative Alexandria Ocasio-Cortez and Senator (and presidential candidate) Bernie Sanders.  In simplest terms, the core tenants of MMT are:

  1. Monetary sovereign countries (that is, countries such as the U.S. whose debt is payable in their own currency) can never go broke because such countries can always print more money with which to pay off their debts.
  1. As a result, there is no reason for the government to shy away from printing as much money as is needed to provide free housing for the poor, free healthcare and college education for all, and to protect the environment.

The first of these principles is, technically, irrefutable.  Technically, the U.S. can never go bankrupt because it can always print as many dollars as it needs to pay off its debts so long as those debts are payable in U.S. dollars.

The second tenant of MMT is where wishful thinking runs afoul of perhaps the most fundamental concept in economics: the interplay of supply and demand.  Stated simply, price is determined by the intersection of demand and supply.  Water is in high demand but there is a lot of it and so it’s cheap (unless you buy it at a professional sporting event or a concert).  Diamonds are both treasured and rare and so the price is high.  

All other things equal, value falls as supply increases.  As a result, if the U.S. prints currency to pay its bills, the amount of currency in circulation – the “monetary base” – increases.  However, simply printing more money does not increase the amount of goods and services that are produced in the U.S. 

The law of supply and demand mandates that all else equal, if the monetary base grows faster than GDP, and as a result there is more money chasing the same number of goods, it will take more money to buy those goods.  In other words, the value of money will decline, which in turn causes inflation, which in turn means the government will have to print more money to pay its bills, and so on, and so on.

The link between the monetary base and inflation can be seen in many historical cases.  

Germany.  During World War I, Deutschmarks in circulation skyrocketed from 13 billion to 60 billion.  In the aftermath, Germany printed more currency to repay war reparations.  By the end of 1923, the inflation rate was 20.9% a day.

U.S. Civil War.  During the U.S. Civil war, the Confederacy could only raise 46% of the money it needed to finance its war effort from taxes and bonds so it printed more money.  At the same time, the South’s output of goods and services plummeted, causing inflation to peak at over 5,000% by the war’s end.

Venezuela.  The most recent example of hyperinflation is in Venezuela.  At the beginning of 2013, more than 90% of the country’s export earnings came from oil.  These export earnings enabled Hugo Chavez ‘s government to pay for popular (and expensive) social programs.  In 2014, the global price of oil dropped and the Venezuela’s oil production fell.  In other word’s Venezuela’s GDP fell but the amount of currency in circulation didn’t.  To make matters worse, in 2017, the government increased the money supply by 14%.  By 2018, inflation in Venezuela reached an estimated 80,000%.

Proponents of MMT argue that our modern U.S. economy is different and immune from inflation.  As proof, MMT theorists mistakenly point to the U.S. inflation rate remaining very low even though the Federal Reserve has pumped trillions of dollars into the economy in its effort to combat The Great Recession of 2008-2009.

There are three reasons why the Fed’s “quantitative easing program” has not caused inflation. 

  1. The U.S. economy was deflationary when quantitative easing began.
  1. The Great Recession led banks and financial institutions to hoard money instead of lend it, which kept the amount of currency in circulation (the “money supply”) relatively constant; and
  1. As the economy has recovered, banks have increased their interest payments on the debts the Fed purchased as part of the quantitative easing, and the federal government has begun repaying the Treasury bonds the Federal Reserve purchased. The result has been the monetary base has not spun out of control.

In short, a short-term spike in the monetary base will not necessarily result in inflation, but printing money indefinitely to pay for long-lasting, expensive government-entitlement programs (as MMT prescribes) almost certainly will.

The goal to help the less fortunate is a worthy one.  Human nature being what it is, the strong desire to accomplish this goal can cloud one’s judgment.  In the words of William Reville, University College Cork professor emeritus:

And so, the take-home lesson for today is that the ability to think analytically is a very fine thing but it’s not enough – you must also have the inclination to do so.[1]

Thank you for reading,

Mr. Market Commentator

[1] Why we believe what we want to believe, The Irish Times, May 3, 2019.

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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Stack the Odd’s in Your Favor

Highlights:

  • Quantitative finance refers to the development and testing of mathematically based investment strategies. 
  • One of the most powerful tools in a Quant’s tool box is the Monte Carlo simulation.
  • Monte Carlo simulations can be used to forecast the risk and return of rules-based investment strategies.

On my honeymoon I traveled out west.  When I visited the casino and saw all these smart well-dressed people participating in a game with the odds against them, it was then that I realized I won’t have a problem getting rich!

– Warren Buffett

Stanislaw Marcin Ulam was a Polish mathematician who immigrated to America in 1939.  In 1940, he became an assistant professor at the University of Wisconsin–Madison (Go Badgers!), and in 1943 he accepted an invitation to work on the Manhattan Project, the research program that developed the first nuclear weapons.  After the war, Stan suffered an acute attack of encephalitis, which required brain surgery.

During his recovery Stan passed the time by playing solitaire.  He began to wonder if a computer program could be written to simulate the possible outcomes of a game of solitaire and thereby determine the probability of the outcome in advance.  He shared his idea with two of his colleagues from the Manhattan Project.  Together, the three mathematicians developed a computerized method to estimate the probability of future uncertain outcomes, which they named a Monte Carlo simulation.

As every investor should recognize, just like solitaire the future outcome of investment strategies are uncertain because markets behave unpredictably at times.  As I noted here and here, it is this uncertainty that can cause individual investors and investment advisors alike to make rash and regrettable decisions when markets are behaving badly.  Accordingly, it is very important for investors to have a solid understanding of how the value of their portfolio might be impacted by a bear market or by a disaster, war or similar dramatic occurrence (referred to as a “black swan” event), because that knowledge can provide the confidence needed to stay the course during a storm.

Quantitative finance is the name given to the development and testing of mathematically based investment strategies, and the use of math to give valuable insights as to the impact a recession or black swan event have on an investment portfolio.  Quantitative finance professionals (commonly called “quants”) use software such as R and Python to create computer-run algorithms that have the potential to forecast returns and calculate the level of risk that can reasonably be expected from an investment strategy over a given time period.

One of the most powerful tools in a quant’s tool box is the Monte Carlo simulation.  A Monte Carlo simulation (also known as probabilistic modeling) uses a large number (typically 10,000 or more) of computer-generated hypothetical results (simulations) to develop projections of future possible outcomes.  The results of these hypothetical situations can be used to provide estimates (for a given degree of confidence) of an investment approach’s risk and return over various time periods and in a variety of market conditions.

“Tail Risk” is the term quants have coined to describe the largest decline a portfolio might experience as a result of a bear market or losses due to unfamiliar market conditions, such as a disaster, war or similar dramatic event.[1]  Investors and portfolio managers can (and should) use Monte Carlo simulations to calculate a variety of statistical measures for insight on an investment strategy’s tail risk.

Drawdown: Refers to a decline in a portfolio’s value from the previous high to its lowest value prior to regaining the former high.  As such, it is a good indication of downside risk over a specified period of time. 

Recovery Period: The time it takes for a portfolio to return to its previous high after a drawdown.

Value-at-Risk (VaR): Value-at-Risk attempts to estimate, for a specific confidence level, the point to which the value of a portfolio might decline for a given time period.  We calculate VaR for the 1-month, 3-month, 6-month, and 9-month time frames based on Monte Carlo simulations.

Expected Shortfall (ES): Expected Shortfall attempts to estimate the extent of a decline in a portfolio’s value that could theoretically occur if losses exceed VaR estimates.  It does so by calculating a weighted average return of the worst returns.  I prefer calculating ES for 1-month, 3-month, 6-month, and 9-month time frames.

Worst Return (WR): This method uses Monte Carlo simulations to calculate the lowest rolling returns generated by Monte Carlo simulations to estimate the worst returns for 1-year, 3-year, 5-year, and 10-year time frames.  Estimated Shortfall’s predictive power weakens for longer time frames.  As a result, I use the Worst Return method to estimate the worst-case scenario for portfolio returns for periods of 1 year and beyond.

The following chart gives a visual representation of Value-at-Risk and Expected Shortfall.  The x-axis (Returns) shows the performance for a hypothetical portfolio.  The y-axis (Frequency) shows the probability of the returns — the higher the green bar, the more likely a portfolio will experience the corresponding level of return on the x-axis.

The red line represents the VaR for a given confidence level.  Expected Shortfall, represented by the orange line, is the weighted average of the returns that are beyond (worse than) the VaR.

Banks, insurance companies, and pension funds have long recognized the benefits of using quantitative analysis to estimate the impact recessions and black swans can have on their portfolios.  Unfortunately, individual investors and financial advisors have been slow to adopt quantitative finance.  Perhaps this is because many advisors are not comfortable with mathematics, or because ad hoc investment approaches that are based on predictions (i.e. guesses) or beliefs (superstition) do not lend themselves to quantitative analysis.  As followers of this blog already know from my earlier posts, I am a firm believer in using rules-based investment strategies that are sensible, academically sound, and perhaps most – importantly, can be vigorously analyzed.

There’s an old saying that in every bet there is a fool and a thief.  It refers to the fact that unless the odds of winning or losing are 50/50, one person – the thief – is going to have an edge.  Monte Carlo simulations can help tilt the odds of dealing your portfolio a winning hand. 

By comparison, the poor guys in “The Hangover” never seem to have the odds in their favor.

Thank you for reading,

Mr. Market Commentator

[1] “Tails” refer to the narrow ends of the bell shape associated with a graphic illustration of a “normal” distribution of possible investment returns.  While traditional portfolio strategies tend to assume that returns will be distributed in a normal fashion, in reality markets frequently perform abnormally.

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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Trust But Verify

Highlights:

  • Trust and investing go hand and hand.
  • Investing requires trusting the exchanges used to make trades, the custodian that has possession of your investments, the advisors you rely on, and the advice you are given.
  • Asking the right questions of your investment adviser and doing some simple research to verify the quality of the advice you are given can ensure your trust is well-deserved.

“I’m not upset that you lied to me, I’m upset that from now on I can’t believe you.”

-Friedrich Nietzsche

In the mid-1970s, the Soviet Union and America’s medium-range nuclear arsenals were of similar strength.  Shortly thereafter, the Soviet Union began replacing its older intermediate-range SS-4 and SS-5 missiles with a new intermediate-range missile, the SS-20, effectively shifting the balance of power in favor of the Soviets.  In response, NATO adopted a “dual track” strategy to counter the Soviet’s SS-20 deployments.  One track called for the deployment of updated nuclear intercontinental ballistic missiles; the second called for arms control negotiations between the United States and the Soviet Union.

NATO’s strategy lead to the Intermediate-Range Nuclear Forces Treaty (INF Treaty) between the United States and the USSR.  President Ronald Reagan and Soviet General Secretary Mikhail Gorbachev signed the pact on December 8, 1987.  President Regan famously described the accord with the old Russian proverb: “Doveryai, no proveryai,” which means “Trust, but verify”.[1]

Peace between nations requires trust, and no less is required for prudent investing in stocks and bonds.  Investors need to trust the custodians who hold their investments; the broker-dealers and security exchanges that facilitate trades; and the advice received from financial advisors.  If that trust is betrayed at any point, large losses can result. 

The following are some steps you can take to make sure your trust is not misplaced.

  1. Verify the Exchanges that Handle Your Trades are Properly Regulated. While there is good reason for investors to trust well-established and highly regulated U.S. stock markets such as the New York Stock Market Exchange (NYSE) or the Nasdaq Stock Market, other less established exchanges may be less trustworthy.  For example, a London-based regulatory tech firm for digital currencies and blockchain found that just 14% of 216 global crypto exchanges were licensed by regulators.  Nonetheless, 43% of millennials trust crypto exchanges more than the major U.S. stock exchanges, according to a recent survey by cryptocurrency trading platform eToro.
  1. Verify the Custodian of Your Investments is Financially Secure. The bankruptcy of Lehman Brothers in 2008 brought to light just how important it is to take note of the financial strength and business practices of the institution that will have custody of your securities.  If you manage your own investments, it will be up to you to select a custodian.  If you work with an investment advisor, the custodian or broker-dealer that is used by your advisor will hold your investments.  Either way, here are steps you can take to ensure that the custodian of your investments can be trusted.
    • Check the custodian’s financial strength by reviewing its balance sheet, credit rating, and shareholder equity.  
    • Evaluate the account statements the custodian provides.  Are they understandable, and do they provide you with all relevant information regarding your portfolio’s performance and degree of risk?
    • Is the technology you will use to access your account easy-to-use, up-to-date, and reliable?  Will you be able to electronically access statements, confirmations, tax documents, and your transaction histories?  Does the custodian have a robust approach to cyber-security?
    • While it is not uncommon for an investment advisor to work for the firm that custodies their clients’ accounts, it is very important the advisor not control the custodian.  Bernie Madoff was able to swindle almost $65 billion from his clients’ accounts because his firm also custodied those accounts, making it possible for him to conceal his fraud by issuing bogus account statements.
    • Are the fees charged by the custodian reasonable and fully disclosed?
  1. Verify that Your Advisor is Trust-Worthy. Just 35% of respondents to a 2016 poll by the American Association of Individual Investors said that they trust investment advisors.  Of that 35%, just 2% trusted investment advisors “a lot”, while 15% only trusted them “a little”.

To evaluate a financial advisor’s trustworthiness, consider their competence, honesty and reliability.  Things you can do to determine if you should put your faith in a particular investment advisor include:

    • Does your advisor have the educational background to provide you with competent advice?  What licenses does he or she hold?
    • Does your advisor fly solo when giving advice, or does he or she use a team approach?  If the later, what are the qualifications of the team members?
    • Is your advisor acting as a “fiduciary” when giving you advice?  If not, then he or she is not obligated to tell you when a conflict exists between what is in your best interest and what is in the advisor’s best interest. 
    • Has your advisor acted badly in the past? You can look up their disciplinary history and other background data at Finra’s Broker Check website.  You may also want to conduct a background check using an accredited consumer reporting agency.  Some states host sites where you can search for criminal prosecutions.  Wisconsin’s Court System Case Search (“CCAP”) website is one example.
  1. Verify the Advice You are Being Given is Worthy of Your Trust. Honest, well-intentioned advisors can mistakenly give bad advice.  For example, many investment advisors have been trained to have faith in stock picking, market timing, and similar attempts to outsmart the stock market, even though there are countless academic studies that demonstrate this is nearly impossible to do.  To guard against this, be prepared to question your advisor’s approach to portfolio management, and then look into whether that approach is supported by independent academic research.

Another example: some well-intentioned advisors are comfortable recommending high-cost mutual funds and other expensive investment products because they’ve drank the Kool-Aid served by the promoters of those products; that is that they are worth the extra cost.  Be sure to ask your advisor to fully disclose all fees you could incur if you follow their advice.

In Evan Almighty, newly elected Indiana Congressman Evan Baxter (played by Steve Carrell) has to trust God (played by Morgan Freeman) when told he can change the world by building an ark.  Now that is truly a leap of faith!  You can watch a trailer for movie here.  (As always, ignore any pop ups that might appear during the video.)

I hope that helps.  Thank you for reading,

Mr. Market Commentator

[1] On February 1, 2019, the Trump administration announced the U.S will be withdrawing from the INF Treaty, in response to Russia’s purported building and testing of nuclear missile systems prohibited by the treaty.

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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Death Is Inevitable. Fortunately, Death Taxes May Not Be.

Highlights:

  • Estate planning is a critical component of sound wealth management.
  • Tax law changes could result in smaller estates having to pay estate taxes.
  • Careful planning today can help safeguard your assets from taxes tomorrow.

“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible.  Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions.  To demand more in the name of morals is mere cant.”

– Justice Learned Hand, senior judge of the United States Court of Appeals for the Second Circuit

In the latter part of the 19th century, Cuba, Puerto Rico, and the Philippines were struggling for independence against Spanish rule.  The U.S. was their ally in those efforts.  In the midst of these tensions, the United States battleship Maine was apparently struck by a Spanish mine on February 15, 1898 while at anchor in Havana Harbor.  (Questions still remain as to the actual cause of the explosion.)  The warship sunk, killing 260 American sailors.  Shortly thereafter, the United States declared war against Spain.  The War Revenue Act of 1898, which was signed into law on June 13, 1898, imposed a wide range of new taxes to raise revenue to finance the U.S. involvement in the Spanish–American War.  One levy was the predecessor to the current federal estate tax.

In last week’s blog post I offered suggestions on how to handle a large financial windfall.  One of my recommendations was to have a solid estate plan in place.  Strategic thinking on this front benefits the newly wealthy, and just about everyone else for a simple reason: a well-crafted estate plan is a critical component of prudent financial planning generally.

An estate plan is needed to (i) direct how assets are distributed after death; (ii) designate who oversees the distribution of assets at death; (iii) safeguard inherited assets from lawsuits, bankruptcy, divorce and other types of creditor claims; and (iv) name the person(s) who will act as the guardian(s) of minor children or incapacitated adults.

In the past, avoiding unnecessary death taxes was a major motivation for having an estate plan.  However, estate taxes have been less of a concern of late because of changes to state and federal death tax laws.  Currently, just 12 states impose a tax at death, and the federal government does not collect a federal estate tax on estates valued at less than $11.6 million (indexed for inflation) — double that amount in the case of married couples.

Death taxes could be making a dramatic recovery in the not-too-distant future.  Several members of Congress have proposed imposing death taxes on much smaller estates.  For example, Senator Bernie Sanders is sponsoring legislation entitled “For the 99.8% Tax Act” that would reduce the current federal estate tax exemption from the current $11.4 million per person to $3.5 million.  Mr. Sanders has also proposed raising the federal estate tax rate to a maximum of 77%, up from the current rate of 40%. 

Senator Sanders is not alone in looking at revising the federal estate tax in an effort to redistribute wealth and raise tax revenues.  President Obama consistently proposed reducing the federal estate tax exemption to $3.5 million during his presidency.  Senator Elizabeth Warren’s “American Housing and Economic Mobility Act” would return the death tax rate to 2009 levels and impose a maximum tax rate of 45% on estates as small as $3.9 million.

Another tax provision that has been under frequent attack is the basis adjustment that currently occurs when the owner of stocks, bonds, real estate and other capital assets dies.  This tax rule provides that the tax basis of appreciated capital assets to be increased (or decreased) to fair market basis at death.  This can be a major tax saver in the case of appreciated securities, as the following example illustrates.

In 1980 Willy Wonka buys 1,000 shares of Chocolate Factory Inc. stock at $5.00 a share, for a total investment of $5,000.  Willy holds onto the shares until his death.  When Willy died in 2018, those same shares traded at $500 a share, for an aggregate value of $5,000,000.  Willy’s estate plan leaves the shares to his son, Wally.  Wally promptly sells the stock to pay for a new yacht.  Under current tax, Wally would not pay taxes on any of the gain realized on the sale.  By comparison, some tax proposals would subject the entire $5,000,000 of sale proceeds to income taxes.  Moreover, some are proposing those taxes be imposed at ordinary income tax rates.

While the future of tax law is never certain, the risk of a significant increase in taxes at death appears elevated.  The good news: There is no shortage of legitimate ways to lock in the tax benefits currently found in the tax code.

For many investors, the time to act is now.  Just as hedging when economic or market risk is elevated can provide valuable protection against a subsequent bear market, estate planning can protect your assets from tax law changes.

“For Whom the Bell Tolls” is the Pulitzer prize nominated novel by Nobel Prize winning author Ernest Hemingway.  The movie adaptation starred Gary Cooper and Ingrid Bergman and was nominated for nine Academy Awards, including Best Picture.  The novel tells the story of Robert Jordan, a young American who volunteers to join the International Brigades, a guerrilla unit fighting in the Spanish Civil War, and is loosely based on Mr. Hemingway’s own experiences during the war.  Jordan (played by Cooper) is given the dangerous task of blowing up a bridge that lies behind enemy lines.  Things get complicated when Jordan falls for María (Bergman), a partisan supporter of Spanish dictator Francisco Franco.  You can see the official trailer for the movie HERE.  (As always, ignore any pop ups that might appear during the video.)

Thank you for reading,

Mr. Market Commentator

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™. 
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