Celebrating 15 Years of Service

August Newsletter

Aug 15, 2022

Markets

Heading into earnings season, investors were very concerned that company profits would fall short of expectations and that forward guidance could be meaningfully cut going forward. Bracing for underwhelming results, earnings came in better than expected with, 77% of S&P 500 companies having reported better-than-expected profits. Revenues were also reported to be growing at 13%, which helped support earnings above expectations. While forward guidance has been revised lower, large cuts have mostly been avoided. Given the positive earnings results, and stock price declines during the first half of the year, stock valuations have improved from a price-to-earnings perspective (see chart right).

Also supporting markets in July was the less hawkish commentary from the Federal Reserve. While the Federal Reserve raised the Federal Funds Rate an additional 0.75 basis points in July, markets rallied on Chairman Powell’s commentary. Powell said, “as the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases.” Powell went on to say that now that interest rates are in a range of 2.25% to 2.5%, that they had likely reached “neutral”. This infers that the Fed believes that the current interest rate policy is neither accommodative nor restrictive. While we likely have seen the peak in inflation, we believe that inflation will remain higher and more persistent than currently expected by both the markets and the Fed and this will warrant continued interest rate hikes to help curb demand. If that happens, deteriorating demand would negatively impact sales, which would squeeze margins, and company earnings would fall.

Are we in a recession?

The Bureau of Economic Analysis reported on July 28th that real GDP decreased in the second quarter by -0.9%. This was the second consecutive quarter of negative Real GDP growth as the economy contracted by -1.6% in Q1’22 (see table next page). While two consecutive quarters of negative growth fits the “standard” definition of a recession, the NBER’s Business Cycle Dating Committee, the official judge of US recessions disregards that simple definition.  A recession is the period between a peak of economic activity and its subsequent trough, or lowest point. Between trough and peak, the economy is in an expansion. The NBER committee defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” In order to meet the committee’s criteria of recession “more than one or two indicators would need to be currently showing weakness, and it would need to be significant and lasting more than a few months”. The six monthly indicators used by the committee to determine a recession are not currently flashing red. According to committee member and Northwestern University professor Robert Gordon, “there is currently a conflict between the robust growth of payroll employment and the modest declines in some other monthly indicators.”

The six indicators the NBER business-cycle dating committee review include, 1) Real Personal Income Less Transfers, 2) Nonfarm Payrolls, 3) Real Personal Consumption Expenditures, 4) Real Manufacturing and Trade Sales, 5) Household Employment, and 6) Index of Industrial Production

Nonfarm payrolls have continued to be strong, and an additional 528,000 jobs were added in July, easily beating not only the consensus expected 250,000. The service sector continues to lead the way, with the fastest gains for education & health, leisure & hospitality, and professional & business services. This is an example of the resilient economic data that may force the Fed to continue to raise interest rates.

Mutual Funds – Common Misunderstandings

Historically, mutual funds were advantageous tools for investors and offered a simple way to diversify a portfolio, especially for smaller accounts. However, there are a number of problems associated with mutual funds, such as taxes and expenses, that are not present in other investments such as ETFs (exchange traded funds), individual stocks or bonds. To better understand the expenses associated with mutual funds we’ll review the various mutual fund share classes and the common costs associated with each class.

Mutual Fund Share Class Types and Expenses:

Share classes of the same mutual fund offer various fee and load charges to shareholders. Expenses are a major issue for mutual funds when compared to ETF alternatives, or individual stocks or bonds. Mutual fund expenses and fees are generally higher, and more complex.Common share classes include:

Class A: These shares typically have a front-end load, which means there is a fee charged upon purchase of the mutual fund. This sales charge comes right off the top of the investment. Typically, the maximum front-end load is between 4% and 5.75%. These and the maximum 12b-1 fee up to .50%.

Class B: While these funds do not have front end loads, Class B shares have deferred sales charges (also referred to as back-end loads) between 4% and 5% and have 12b-1 fees between 0.75%-1.00%. These deferred sales charges are applied if an investor sells shares before specified time periods, typically within five years. Although the sales charges decrease over time, the surrender charge is higher in year one than it is in year five. These high costs and expenses discourage investors from selling shares.

Class C: Typically, C shares do not include a front-end sales charge like A shares or have deferred sales charges like B class shares, but they do typically have higher expense ratios and charge high recurring fees.

What Is a 12B-1 Fee? A 12b-1 fee is an annual marketing or distribution fee on a mutual fund in addition to the sales charges.

Mutual Funds and Taxes:

Unfortunately, mutual funds are not very efficient from a tax perspective and in fact can be very costly for investors. The key point is when you buy a mutual fund you are potentially buying a built-in tax liability. For example, suppose a mutual fund bought Microsoft in 2009 for $20 per share. In January 2022 you buy shares of the mutual fund. In March 2022 the mutual fund sold Microsoft for $280. You have a tax bill based on a gain of $260 per share. Of course, the more successful the mutual fund the greater the potential for taxes. It was not uncommon to buy into a successful fund and pay taxes on a previous gain in which you did not benefit. Paying someone else’s taxes, we find this unattractive. Although, mutual funds can offset gains with losses they cannot pass on a net capital loss to investors. So, you only receive net capital gains which are taxable.

The bottom line is mutual fund and insurance investment products can be very expensive and tax inefficient. They are sold to the public by salesman for high commissions. You are much better served by working with a fiduciary firm, like Pacific Coast, that designs portfolios suited to meet your needs. Serving our clients as a fiduciary sets as apart from other advisors associated with banks, brokers or insurance companies. The interests of our clients always come first and we are never motivated to sell products based on receiving a sales commission. If there is anyone you know that is still being sold investment products, we’d welcome the opportunity to discuss the benefits of working with a fiduciary like us.

Tax Losses

We recently doubled positions in several stocks, which are currently trading below their initial purchase price. We will wait 31 days and sell the higher cost shares to realize tax losses. Once the tax loss is realized (for taxable accounts) we will still own the same company at the same percentage in the portfolios.

We have also sold our position in the iShares MSCI Emerging Markets ETF (Symbol: EEM) and purchased Schwab Emerging Markets Equity ETF (Symbol: SCHE). The underlying portfolio of stocks is  similar between the ETFs, but SCHE offers a lower expense ratio and higher dividend yield. We expect that international stocks will do better as the US dollar declines. The strong US dollar has been a headwind for emerging markets as the Federal Reserve has hastened its pace of interest rate hikes faster than other central banks. For taxable accounts, we were also able to realize a tax loss.

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