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Investment Commentary: September 30, 2020

Summary:

  • Given all the negatives in 2020, we are fortunate not to be losing money.
  • Portfolios are defensive with quality stocks, Treasurys, T-bills/cash, and a small amount in gold and Australian dollars.
  • COVID-19 and the historical stimulus efforts remain market drivers.
  • Markets should soon be anticipating election outcomes, and perhaps many will make financial and tax strategy changes with a Democratic win.

***

It is easy to forget that in a once-a-century global pandemic with historic drops in GDP and employment, the stock market should be down a lot this year.

We know that should often has little influence over markets in the near term. This year has been unlike any other by a long shot. There is no playbook or precedent to reference, and experience alone feels insufficient to navigate confidently and skillfully.

No doubt scholars will be studying 2020 for decades to come. Scores of PhDs will be minted for insights into the pandemic and the extraordinary policy response from governments. Many will find explanations and meaning in the Donald Trump presidency.

U.S. Daily New Cases with 7-Day Moving Average [1]

losing money

For now, it makes sense for us to keep cautious and defensive, both with the virus and in our financial affairs and keep searching for information and insight regarding COVID-19, which should continue being the stock market’s primary threat.

Of course, the economic and market harm from the pandemic has been diminished by a historic and rather bi- partisan effort to “do whatever it takes” to borrow, spend, and print as much money as needed. Over $5 trillion of stimulus has been injected so far (or ~25% of GDP), with more to come. Details on another stimulus bill are being negotiated; the total package should be $1.6 and $2.2 trillion. The Federal Reserve has printed nearly

$3 trillion in 2020 to buy numerous obligations and fund lending facilities administered by Treasury. The Fed has promised to print more dollars while keeping any interest rate increases off the table until at least 2023.

With the rebound in stocks and an upcoming election that will stir anxieties, we have recently lightened up equity exposure. Our Core portfolios are defensive and balanced, with quality stocks with earnings growth, Treasurys, Treasury bills and cash equivalents, and small allocations in gold and foreign currency (Australian dollars).

Our attention is also now focused on the election, now less than a month away. We think markets will increasingly speculate on the outcome and anticipate the likely policies and tax code to come.

Polls and prediction markets, like PredictIt.org, a website where people bet on election outcomes, indicate the odds favor a Biden victory (64% probability) and Democrats taking over the Senate (66% probability).

Together, the market thinks a Democrat sweep (including retaining the House) has a 59% likelihood. [2]

Curiously, institutional investors seem to maintain a forecast that Trump will prevail. In a recent survey by Strategas Research Partners of its large clientele of institutional and money managers, over 57% predict a Trump victory and 78% predict Republicans will retain control of the Senate.

The Senate may be the most important result of the election as far as stocks are concerned. A Democratic majority would likely mean a Democratic sweep and policy inflection point, and the stock market would begin discounting higher taxes. Markets have been fairly consistent in re-pricing stocks for changes in taxes, especially prospective tax increases. That is because taxes affect what investors ultimately reap in capital gains and income, and because many investors would want to take advantage of today’s low capital gains tax rate and book profits before 2021, and do so before others do the same. Most investors will not wait until December 31 to take gains.

Biden’s tax plan calls for higher individual (for higher earners) and corporate taxes. Some changes include:

  • Raise individual income taxes for those with income above $400,000 from 37% currently to pre-2017 levels of 39.6%. The current top bracket of 37% starts the $518,000 income level (for individual filers).
  • Impose the 12.4% Social Security payroll tax for wages above $400,000.
  • Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on income above $1,000,000.
  • Eliminate step-up in cost basis on death and allow the scheduled reversion in estate tax exemption to

$5 million per individual in 2025 (the per-person exemption is $11.58 million in 2020).

  • Cap the tax benefit of itemized deductions and limit deductions for higher earners.
  • Phase out the qualified business income deduction (Section 199A) for incomes above $400,000.
  • Increase the corporate income tax rate from 21% to 28%.
  • Create a minimum corporate tax (an alternative minimum tax) for corporations with book profits of $100 million or higher.

The biggest immediate change on the margin for high net worth individuals could be the change in capital gains taxes. Today’s maximum tax rate of 20% increasing to 39.6% (both rates are stated before the Obamacare tax surcharge) would represent a near-doubling in capital gains taxes for certain individuals who represent a material percentage of total ownership of stocks, real estate, and other assets. This tax increase would apply to some of our clients. To be sure, commentary on taxation is not about advocacy or agenda, but rather an approach to analyze effects in the dispassionate way a mechanic approaches a car engine. Regardless of one’s politics or sense of how taxes should be structured and what is fair, buying and selling decisions are generally guided by profit maximization. Numbers are numbers. And people pay what the laws require; no one volunteers a bigger payment to the IRS because she feels her tax rates are too low. From a market perspective, the implications of prospective tax increases could be a headwind for markets in the short term. Then again, any downward pressure would prompt even more money printing, and that money would chase assets, all things equal. There is quite a chicken-or-the-egg dynamic at work.

This prompts a question: If Democrats win, are high earning/wealthy clients better off if they take even more long-term capital gains in 2020? Possible tax changes are worth discussing now with your CPA before the election and before CPAs (and tax and estate planning attorneys) face a deluge of client calls. Depending on your situation, you may want to formulate a Plan A, Plan B, etc. between your tax and legal professionals and your investment/financial advisor to take advantage of possible outcomes and increase financial and tax efficiency.

We are defensive in allocations, which serves to protect and preserve. But it is important to remember defensiveness can aid in clearer thinking and being opportunistic. We have our eye on a number of great assets we are eager to get better deals on. Volatility also provides opportunities for the long-term investor.

We will keep you updated in an action-packed finish to 2020.

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[1] Source: Johns Hopkins Coronavirus Research Center, https://coronavirus.jhu.edu. Great data and studieshere, including state-by-state information. For Hawaii: https://coronavirus.jhu.edu/region/us/hawaii.

[2] In election markets like PredictIt, winning bettors win $1.00 per contract while the losing bettor gets zero. Thus, the price of the election winner bet is expressed in cents and corresponds to probability.

About the Author


Neil Rose, CFA
President & Chief Investment Officer
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