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QUA R TER LY RE V I E W OF T H E C A PITA L MA R KE TS | A PRI L 2014 “I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself by the handle” — Winston Spencer Churchill As has been our custom each year, the April issue of the Review & Outlook will include commentary on the U.S. tax code. More on this subject later. Against the backdrop of the past two years during which domestic stocks posted strong double digit gains, the results for the first quarter were more humble. After a brief and modest (-5%) sell-off in January, the domestic stock market recovered and the bull market remained intact at quarter end. During the first quarter, the S&P 500 gained 1.8% while the MSCI-EAFE Index rose by 0.7%. If we can momentarily dial back our expectations, these modest results can actually be viewed as a positive to the extent that it allows earnings to catch up to last year’s dramatic increase in stock prices. Investors continue to watch with interest the timing and magnitude of the Fed’s tapering process. Thus far, Fed policy under Ms. Yellen does not appear to differ materially from the course established by former Chair Ben Bernanke. Moreover, higher rates per se are not necessarily a bad thing. They are a negative if they are due to higher inflation. They are a positive if they reflect stronger economic growth without concomitant inflation. Investors, and more importantly, traditional savers will enjoy higher real yields. Equity investors’ stock portfolios should benefit from the catalyst of stronger economic growth. With the mid-term elections looming on the horizon, 1 MARKET REVIEW & OUTLOOK | APRIL 2014 the state of the economy will be a major element of the political rhetoric in the months ahead. Due in part to 2013’s 32% advance in the S&P 500, domestic equity valuations are somewhat less attractive than those available overseas. While profit margins in the U.S. are near all-time highs, there is still room for margin improvement in developed foreign markets. At the same time, P/E ratios are lower in both foreign developed and emerging markets. Reflecting the wide disparity of performance during 2013, the P/E ratio of just 12x in emerging markets reflects a 30% discount to the same metric for the S&P 500. While quarterly comparisons might sometimes disappoint, the valuation disparity between emerging market equities and the S&P 500 warrant retention of the former for the disciplined long-term investor. While equity valuations could expand somewhat by further increases in P/E ratios, the primary driver from current levels needs to be higher earnings. With profit margins currently at or near all-time highs, the prerequisite for higher earnings needs to be improvement in top line revenues. Most of the companies within the S&P 500 have reported their numbers for 2013, and results reflect profit gains averaging 10.7%. As has been the case in recent years, most of the gain is the result of improved margins, with revenue growth remaining subdued at +0.7%. Global Considerations There are several macro factors that could make a positive contribution to both stronger domestic economic growth, as well as improved earnings. The first is the possibility of a more synchronous global recovery. In recent years, global performance has been uneven and there has been an imbalance between nations that spend too much, and those that save too much. Economic growth in Europe will once again be modest during 2014; however, this is currently reflected by more modest valuations for European stocks. While Europe continues to show gradual economic improvement, inflation levels remain lower than desired by the European Central Bank. Latest readings show Eurozone inflation running at 0.7 percent, and there is increased concern that the Eurozone is slipping into a deflationary environment similar to that experienced by Japan in recent years. One area where Europe could experience higher costs is energy. Europe depends heavily on Russia for its energy needs, with Russia providing Europe with 31% of its gas imports. A milder than normal winter has resulted in reserves currently being at high levels; however, if the Russia-Ukraine crisis worsens, the “costs” threatened by President Obama could end up being paid by Europe in the form of higher gas and oil prices. Current weakness in commodity prices, as well as other negatives affecting emerging markets, have been well-documented and in our view are more than adequately discounted in current valuations. Last year, with the S&P 500 and MSCI-EAFE index rising 32.4% and 19.4% respectively, the MSCI-Emerging Markets Index declined 4.3%. Key to improvement in the E.M. space will be China’s ability to successfully decelerate its GDP growth from the recent level of 9% to a more modest 7.5% target. As reviewed at the recently convened National People’s Congress, the lower GDP target is a key element in China’s desire to institute reforms, establish a more sophisticated financial system, and lessen the risk of inflation. With China representing the world’s second largest economy, any problems incurred implementing this strategy would have negative ramifications extending well beyond the confines of the emerging market economies. 2 MARKET REVIEW & OUTLOOK | APRIL 2014 Wall Street A second positive surprise could develop if business spending should increase above recent levels. In what has all too often been a somewhat uncertain political and tax policy environment, capital spending by businesses has been modest in recent years. Currently, corporate balance sheets are in much better condition, and in the aggregate, companies are sitting on a mountain of cash. Companies within the S&P 500 currently have cash and short-term investments in an amount equal to 11% of total assets. In addition to these funds not earning anything in the current low interest rate environment, this surfeit of cash has attracted the attention of corporate raiders; AKA “shareholder activists.” These individuals have argued vociferously that companies should use their cash to repurchase shares and/or increase dividends, both of which are positive to shareholders in the short-run. The repurchase of shares reduces shares outstanding, which for a given level of profit, increases earnings per share. It does not, however, do anything to add jobs and/or increase the future productive capacity of the company in question. Share repurchases during 2013 exceeded $470 billion. To the extent that some of this cash is deployed on plant and equipment and/or infrastructure spending, it should lead to improvement in what has been a moribund job situation. As such, it helps to benefit the overall economy and complements the benefits of higher dividends, share repurchases and/or merger and acquisition activity. Any combination of the aforementioned should prove positive for shareholders. It is likely that the first quarter macroeconomic conditions will have been negatively affected by the unusually severe weather. Consensus economic forecasts for the full year once again project real GDP growth of less than 3%. If this is in fact the case, it will be the ninth year in a row that the economy has failed to attain this target level. This is the worst string of poor results for the past 80 years. Main Street On a brighter note, the Federal Reserve recently announced that U.S. household net worth increased by $9.8 trillion, and reached a new all-time high last year at $80.7 trillion. Major contributors to this milestone included improvement in home prices, continuation of the consumer deleveraging process of reducing debt, and a soaring stock market. The companies within the S&P 500 alone increased in value by over $4 trillion during 2013. Total household debt has fallen by over $2 trillion during the past several years. Unlike the federal government, the household sector is doing a much better job of currently living within its means. History will measure the Fed’s quantitative easing program by many different standards. Measured solely by the objective of achieving growth via benefits associated with “wealth effect,” the program was a success. million Americans with jobs. As a side note, and seldom included in the rhetoric about inequality, much of the incremental wealth realized during the past several years has accrued to the benefit of older Americans. Demographically they have less mortgage debt and are more likely to save and invest. The 76 million strong “Baby Boomer” cohort group represents 26% of our population. On January 1, 2011, the oldest of that group turned 65 and according to the Pew Research Center 10,000 baby boomers will reach 65 each day for the next 16 years. By 2030, 18% of the U.S. population will be 65 or older. Hopefully, further advances in medicine will further increase that percentage. An unintended consequence of the Fed’s quantitative easing program is the fact that very low interest rates are a catalyst to substitute capital for labor. This has contributed to both the intractable high unemployment rate and the broader topic of income inequality. Hardest hit have been the young and minorities. If the trend cannot be reversed, it will likely also have negative unintended social consequences. If we enjoyed rap music, we might express the issue: All of this is great news unless, of course, you do not own stocks or a house, and worse, do not have a job. Rather than excoriate those who are more fortunate, we need to create a more business friendly environment in Washington that will lead to job formation. As we mentioned earlier, this has been the weakest recovery from a recession since the Great Depression. For the 40 year period ending in 2008, U.S. GDP growth has averaged 3.28%. Final GDP growth for 2013 will not only fail to reach 3%, it will likely come in below 2%. Annual growth during the past six years has never been above 3%. Economists estimate that if the post 2008 recovery had been equal in magnitude to the average of the last 10 recoveries, there would be an additional 7 3 MARKET REVIEW & OUTLOOK | APRIL 2014 It is my current impression, that the Fed interest rate suppression, is meant to avoid a depression. But the labor force regression, is hurting my progression, unless it’s all a misimpression, So, please stop the repression, or else my oppression, might lead to a transgression! But, we don’t like rap music. (Please forgive the digression.) Pennsylvania Avenue As the mid-term election draws nearer, the topic of income inequality will surely gain more attention. It has been suggested that this is a clever attempt by some to misdirect attention from the poor economic growth and job loss of the past six years. Perhaps, but we think the issues are actually very much related. At the risk of sounding insensitive, we always assumed that income inequality was an obvious by-product of the system we know as Capitalism. As we recall, the communist alternative as practiced by the former Soviet Union did not work out that well. The issue is complex. Perhaps it is akin to debt or alcohol, where the question is not right or wrong, but how much is enough and how much is too much? If Washington policymakers wish to seek out those who have contributed to income inequality, the search will not take them far. As alluded to earlier, the issue has been exacerbated by weak economic performance for much of the new millennium. As part of a solution, President Obama has proposed raising the minimum wage by 40% to $10.10 an hour. According to the Department of Labor, only 2.5% of the American workers (3.6 million out of 143 million workers) were earning the minimum wage at the end of 2012. At the same time, many states now offer unemployment benefits that equate to an hourly wage rate that is 50% higher than the proposed $10.10 minimum wage. Recently, these benefits have been extended to up to 76 weeks. Therefore, it is not surprising to find that there are three times as many people receiving unemployment benefits than there are working at the minimum wage. While an increase in the minimum wage would be beneficial to this very small group of workers, the impact on the economy and nation as a whole is far less positive. According to the non-partisan Congres- sional Budget Office, implementing the President’s proposal will cost the private sector $15 billion and increase the deficit by $5 billion over the next 10 years. More troubling is the CBO’s estimate that such an increase would also result in the elimination of between 500,000 to 1,000,000 jobs. The President used his executive privilege in February and issued an order raising the minimum for federal workers. This was largely symbolic as the CBO estimates that fewer than 4,000 federal workers make less than $10.00 an hour. We would be more impressed if the policy makers in Washington focused more on education and job training than further expanding our entitlement system. As seen by the following charts, the correlation between higher education and better job opportunity and higher wages is irrefutable. Unemployment Rate by Education Level 18% Less than High School Degree High School No College Some College College or Greater 16% 14% Nov. 2013: 10.8% 12% 10% Nov. 2013: 7.3% 7 3% 8% 6% Nov. 2013: 6.4% % 4% Nov. 2013: 3.4% 2% 0% '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 Source: BLS, FactSet, J.P. Morgan Asset Management. Unemployment rates shown are for civilians aged 25 and older. Guide to the Markets – U.S. Data are as of 12/31/13. Average Annual Earnings by Highest Degree Earned Full-time workers aged 18 and older, 2011, USD $90,000 4 MARKET REVIEW & OUTLOOK | APRIL 2014 $80,000 $87,981 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 Source: BLS, FactSet, J.P. Morgan Asset Management. Unemployment rates shown are for civilians aged 25 and older. Guide to the Markets – U.S. Data are as of 12/31/13. Federal & Ohio Effective Rates Average Annual Earnings by Highest Degree Earned Full-time workers aged 18 and older, 2011, USD Federal & ACA Tax* $87,981 $90,000 2012 2014 2012 2014 Short-term Gain & Ordinary 35% 43.4% 38.9% 46.5% Long-term Gain & Dividends 15% 23.8% 18.9% 26.9% $80,000 +29K $70,000 $59,415 $60,000 Federal, Ohio & ACA Tax* *Affordable Care Act Tax Rate = 3.8% (new in 2013) $50,000 +27K Few readers will be surprised to learn that we are very much in the camp that prefers that we have more new millionaires to tax, rather than tax current millionaires more. With that in mind, and as April 15th nears, we will close with the following “tax facts”: $40,000 $32,493 $30,000 $20 ,000 $10,000 $0 • High School Graduate Bachelor's Degree Advanced Degree Source: Census Bureau, J.P. Morgan Asset Management. • As reflected later in the report, income inequality is by no means the exclusive purview of what some want to pejoratively label the “1 percent.” Some have even gone to the extreme of suggesting that this group is a budding oligarchy akin to the 11 Russians who control much of Russian industry. Since there are 143 million American workers, the top 1% of workers must by definition have 1,430,000 members. Some oligarchy! Paul Krugman’s aspersions notwithstanding, they can’t all be bad people. If we more equitably divide the issue into the top and bottom 50% of all taxpayers, we find that there still exist radical differences in who receives most of the income, as well as who pays most of the taxes: Income Category 5 Percent of All Income Percent of All Taxes Paid Top 50% 88.5% 97.1% Bottom 50% 11.5% 2.9% MARKET REVIEW & OUTLOOK | APRIL 2014 To rank on top 1% of Net Worth, requires net worth of $6.8 million. To rank on top 1% of Income, requires income of $389,000. Source: Federal Reserve • The total number of pages of Federal Tax rules has increased by 34,108 pages to (74,608) since 1995. Source: IRS • An average high income American couple who retired in 2010 paid $765,000 lifetime Social Security taxes, but will receive only $693,000 in benefits. Source: Urban Institute • In 1980, the top 10% of U.S. taxpayers paid 49% of all federal income tax paid. In 2011, the top 10% of U.S. taxpayers paid 68% of all federal income tax paid. Source: IRS • • In 2011, 46,100,000 tax payers paid NO federal income tax. Source: IRS Breakdown of Income and Taxes Paid by Category Income Category 2011 AGI Percent of All Income Percent of Income Taxes Paid Top 1% Over $388,905 18.7% 35.1% Top 5% Over $167,728 33.9% 56.5% Top 10% Over $120,136 45.4% 68.3% Top 25% Over $70,492 67.8% 85.6% Top 50% Over $34,823 88.5% 97.1% Bottom 50% Under $34,823 11.5% 2.9% Source: IRS We hope you find all of these tax facts of interest as we approach the 15th. Richard C. Hyde Director, Wellspring Financial Advisors Wellspring Financial Advisors, LLC is an independent personal wealth management and multi-family o ce. We 5885 LANDERBROOK DRIVE, SUITE 205 CLEVELAND, OH 44124 216.367.0680 5885 LANDERBROOK DRIVE, SUITE 205 w w w. w e l l s p r i n g a d v i s o r s l l c . c o m CLEVELAND, OH 44124 216.367.0680 MARKET REVIEW & OUTLOOK o ernancial holisticand nancial torisk highmanagement, net-worth individuals estateservices planning, and multiand families. Our comprehensive o erings include family o ce services. investment advisory, income tax planning and compliance, nancial and estate planning, risk management, and multifamily o ce services. w w w. w e l l s p r i n g a d v i s o r s l l c . c o m 6 o er holistic nancial services to high net-worth individuals Wellspring Financial Advisors, LLC is oanerings independent and families. Our comprehensive include personal wealth management and multi-family ce. We investment advisory, income tax planning ando compliance, | APRIL 2014