Market Update 10/15/2014

I don’t have a crystal ball and can’t tell you where the market is going, but I can tell you why I think it has fallen recently. Here are my top pain points in reverse order of concern/impact over the short-term (#6 having the biggest impact in my opinion):

1) Geopolitical Tensions / Civil Unrest – press on these has eased recently just because there seems to be worse news in other areas to take the headlines, but they’re still very present. Middle East, Russia / Ukraine, Hong Kong… all these sorts of issues threaten global economic growth through lower productivity and inefficient use of resources. Protests, sanctions, wars, fear, and loss of life around the world that seems like it will be ongoing indefinitely.

2) Central Banks – the US Federal Reserve is ending Quantitative Easing (QE), their bond buying program that essentially amounted to printing money to purchase treasury bonds (finance government debt spending) and mortgage backed securities (finance home purchases). Many worry that the end of QE and the ultimate beginning of an interest-rate hike cycle will put the brakes on a recovering US economy. So far, long-term treasury rates and mortgage rates have stayed low despite the Fed pulling back on QE as a potential economic slowdown tends to lower rates on its own. Other major economies of the world are also moving in the opposite direction, embarking on further monetary stimulus programs as the US pulls back. This forces their rates lower and acts as competition for US rates, dragging them lower as well. 10-year government bonds in Germany are paying less than 0.7% right now. US ending monetary stimulus while Europe and Japan extend stimulus tends to push the US Dollar up vs. the Euro and the Yen, making our exports less competitive which can also act to slow down the US economy. As one of very few sources of global economic recovery for the last few years, a lot is riding on continued US growth and the end of QE combined with a stronger dollar jeopardize that.

3) Europe – the majority of the continent’s economy is still a disaster and there aren’t any signs of improvements. Many suspect a QE-like program launching in Europe soon, but the legalities of such a program in a common currency with so many different jurisdictions involved make it difficult to pull off. There’s also no way of knowing how it effective it would even be given how low interest rates in the Euro zone already are. Additionally, some concerns from a few years ago are roaring back. Greece wants to end its participation in its bailout program, but doing so means it won’t be able to borrow at the low euro-zone rates, and potentially means it will need to exit the Euro completely which threatens the stability of the currency as a whole. If Greece reverts to its issues of a few years back, Portugal, Spain, and Italy (maybe even France) can’t be far behind.

4) Oil – the price of oil has been plunging in the past few weeks. While this is good for global economic growth in general (lower prices at the pump, lower heating oil this winter, lower costs for airlines, etc.), a portion of the US recovery has been led by the energy sector and our progression toward oil independence from the Middle East though domestic production and Canadian imports. It appears that OPEC is putting on a sort-of price war now with the US, keeping their production high despite falling prices because their drilling costs are lower than our more complex ways of extracting oil (oil sands, fracking, etc.). If they can push the price down for long enough, they may be able to force a reduction in US / Canadian production and maybe even put some US / Canadian companies out of business which will ultimately push prices back up with a larger share of oil production coming from the Middle East again. As energy prices dramatically fall, hedge funds that are dedicated toward energy investments, sometimes in a leveraged way, are forced to liquidate which causes further drops in energy prices and ultimately in other assets as well. Forced selling begets forced selling and the price of everything tends to fall in a whoosh until leverage is managed, markets clear, and price stability resumes. If oil continues to fall, it’s likely the rest of the market will fall with it until oil stabilizes. The good news is that once the forced selling is done, we’ll be left with lower energy prices overall and as long as the US / Canadian producers survive, that will be a stimulus to the economy in additional discretionary money in the pockets of consumers.

5) Ebola – this is one of those very low probability of extreme catastrophe events that makes it very hard for financial markets to price risk. When markets can’t price risk, then tend to avoid it, and that means short-term traders selling just about everything other than the safest assets (treasuries). Ebola has been around for a long time and there have been other outbreaks. There will be other outbreaks after this as well, since it is carried by animals that can transmit the virus to humans, without illness by the animals. If contained, as it has been in the past, it will come and go again as any other flare up of disease (remember SARS?). If not controlled, given a 70% mortality rate with the latest outbreak, it threatens large sections of the population. The concept of confident long-term market growth is based on population growth and productivity increases over time. If a disease eliminates substantial portions of the population, that premise fails and even over the long-term, economies will shrink and equity markets will shrink with them. Even if the most likely scenario happens (a minor breakout with no epidemic-like results), fear of the disease can temporarily cause fear of being out in public, traveling, shopping, etc. Each time more negative ebola news comes out, stock markets take another leg down. With a 10-14 day incubation period, It could take several weeks to see that the breakout is controlled before some confidence is restored. As I write this, details have emerged about a 2nd healthcare worker in Dallas having ebola and having flown on a commercial jet the night before her symptoms began. Sure enough the market fell to new lows shortly after the news. The US CDC needs to instill confidence soon or ebola will take the economy down in the short-term (best case) and could take it down in the long-term if it truly does become an epidemic. Again, very low probability of extreme catastrophe, but until it’s a zero probability, it will have an impact in financial markets.

6) Fear / Self-Fulfillment – Fear of all of the above having a negative impact on the economy causes markets to fall which causes confidence to fall which causes spending to drop and layoffs to begin, which causes the economy to contract. It can be self-fulfilling and can happen very quickly. The more the stock market falls and the longer the fall drags on due to fear of a recession, the higher the potential that the recession occurs as a result. This is the biggest concern for the stock market short-term. This correction, so far, has happened quickly and hasn’t taken market levels to a point that the fall will impact the economy. That doesn’t stop the market from starting to worry about though.

Remember, markets tend to climb the wall of worry. As long as there are reasons to worry, there’s room for the market to go up. New worries will push it down temporarily (no one was talking about ebola a year ago), but the lower prices go, the better the price you get if you’re using a consistent plan of buying over time. This is why people are so successful with 401ks. Volatility creates wealth for those who don’t fear it (see https://blog.perpetualwealthadvisors.com/2013/06/20/the-value-of-volatility/). While we can’t control the aggregate market going through a fear-cycle, I hope that understanding the reasons that cause the fear helps you avoid it.

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Perspective

The stock market has hit a rough patch over the last couple of months and that has intensified over the last couple of weeks… Just some quick charts on what’s happened since the March 2009 bottom in the stock market for perspective:

Seeing stocks pull back 10-20% from highs is completely normal from a historical perspective. It’s also not predictive of what will happen in the near term future. Stocks could go sharply lower from here, could flat line, or could snap back to new highs. The volatility inherent in stocks, especially over a short period of time, is the price you pay for the long-term expected returns that stocks have historically provided. Any equity investor has to be prepared to lose 50% of their portfolio’s equity holdings at any time in return for those long-term expected gains. As long as money that’s needed for the short-term isn’t primarily in stocks, losses on that money will be muted. For money that’s invested for the long-term, as long as it really isn’t needed until the long-term, short-term performance is not relevant (sign up for the roller-coaster when you invest and hang on during the ride).

After-Tax 401ks & Rollovers To Roth IRAs

The IRS recently clarified rules surrounding rollovers of qualified plans (401ks, 403bs, etc., all of which I’ll refer to as “401k”s for the rest of this post for simplicity) to IRAs which can have a dramatic impact on a plan participant’s ability to save for retirement in some situations. For those of you who want to read the official IRS notice, it is Notice 2014-54, released on September 18, 2014. For everyone else (which is probably everyone), I’ll summarize what changed and what it means for you. First some background…

Virtually everyone understands the pre-tax portion of a 401k. You defer a portion of your salary as a deposit to your 401k and that amount is not taxed in the period it’s earned. Instead, it grows tax-deferred until retirement, at which time you can withdraw it (usually after age 59 ½ without penalties) and pay tax at withdrawal. Another, newer type of 401k is a Roth 401k. In a Roth 401k, you are taxed on the income that you defer to your 401k, but it grows tax free and is not taxed at all (under current laws) at withdrawal in retirement. If your tax rate is the same at the time of deferral as it is in retirement, then both types of 401ks produce the same amount of after-tax money in retirement. For most people who are into their mid-earning years, the premise that they’ll earn less in retirement and have more ability to control what portion of their retirement savings is subject to tax each year means they’ll probably be in a lower tax rate in retirement. This means they’d favor the pre-tax “Traditional” 401k. While the generalization is true, in general, like much of financial planning, the details of choosing between a Traditional 401k and a Roth 401k are complicated and really need to be evaluated on a case-by-case basis. Regardless of whether you contribute to a Traditional 401k, a Roth 401k, or a combination of the two, the IRS limits contributions at $17,500 per year (indexed to inflation and likely to increase to $18,000 for 2015) + $5,500 more if you’re over age 50. If your employer makes contributions to your 401k via matching, profit sharing, or direct contributions, a second limit applies. That is that your contributions plus your employer’s contributions cannot exceed $52,000 for 2014 (again indexed to inflation).

In addition to the Traditional and Roth 401ks, there is less well-known and less-popular type of 401k called the After-Tax 401k. Many plans do not allow an After-Tax 401k due to the difficulty in accounting for so many types of contributions. For those that do allow it, in this type of 401k, contributions are taxed in the year you earn them (they don’t go into the account pre-tax like a Traditional 401k), but at withdrawal in retirement, you only pay tax on the growth since you’ve already paid tax on the amounts you contributed. This is much less powerful from a tax perspective than pre-tax in (Traditional 401k) or tax-free out (Roth 401k), but is still advantageous in some cases because it means the growth (interest, dividends, and gains) is not taxed each year as it is earned and so that growth can continue to compound tax-deferred until withdrawal. The After-Tax 401k is not subject to the $17,500 employee contribution limit, but is subject to the $52,000 total contribution limit. This means that if you’re maxing out your Traditional/Roth 401k, and your employer isn’t contributing $34,500, and your plan allows an After-Tax 401k, there is room for you to contribute to your After-Tax 401k. Unfortunately, the tax on the growth of an After-Tax 401k is assessed at ordinary income tax rates rather than at lower, capital gain rates as an ordinary taxable brokerage account would be taxed. So, in general, an efficiently managed taxable brokerage can be a better option than an After-Tax 401k, especially when considering the liquidity advantage that comes with being able to access your money at any point for any purpose. This has been the root cause of the limited popularity and use of an After-Tax 401k.

Once you leave your employer, you can withdraw from your 401k and rollover the money to an IRA. Traditional 401ks go to Traditional IRAs and Roth 401ks go to Roth IRAs, all preserving their tax status. With After-Tax 401ks, it’s more complicated. If After-Tax 401k money is rolled over to a Traditional IRA, a portion of the Traditional IRA becomes “basis”, which is not taxed again at withdrawal and every withdrawal will be part growth (taxed) and part return of basis (not-taxed). If it’s rolled over to a Roth IRA though, the tax treatment used to be unclear. Many tax practitioners and plan administrators thought that the IRS would consider Traditional 401k money and After-Tax 401k money together in one rollover, assessing a prorated amount of tax if one were to try to roll pre-tax money to a Traditional IRA and after-tax to a Roth. This treatment would be consistent with the way the IRS taxes conversions from Traditional IRAs to Roth IRAs. If there are both pre-tax and after-tax (basis) dollars in a Traditional IRA, and you attempt to convert a portion of that Traditional IRA to a Roth IRA, you’d be taxed pro-rata on the amount. Others came up with complicated multi-step schemes to try to isolate the After-Tax portion of a 401k in its own account, such that it could be converted to a Roth tax-free. IRS guidance on Sep 18 clarified that effective immediately, After-Tax 401k dollars can be rolled over directly to a Roth IRA without any tax being due as long as it’s done at the same time as Traditional 401k money is rolled over to a Traditional IRA.

I find it hard to believe that this treatment will be around forever, but at least for now, this has opened the door for massive amounts of money to be tucked away in an After-Tax 401k and then rolled directly to a Roth IRA at the time service with that employer is terminated. Here’s an example of how it could work for someone earning $200k per year, maxing out her Traditional 401k with an 8.75% ($17,500) contribution, receiving a 3% ($6,000) employer contribution, and working for three years before moving on to another opportunity at a different employer:

 

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The person above would be able to stash away $85,500 in a Roth IRA after only 3 years while otherwise earning too much per year to be able to directly contribute to a Roth IRA. It’s clearly not for everyone since you need to have a lot of free cash flow in order to take advantage of the large contributions and your plan needs to include After-Tax 401k contributions as an option. If it can work for you, and you’re looking to tuck away large amounts of tax-advantaged money, this is a really big deal.

So here’s what to do: If you’re maxing out your $17,500 401k contribution each year and looking to put more than that away for retirement, send your 401k plan administrator a note (or call) and ask, “Does my 401k plan allow after-tax (non-Roth) contributions after I’ve hit my $17,500 maximum pre-tax contribution each year?” If the answer is “yes”, you can start to take advantage of this immediately.

One final note to keep in mind… tax rules are always changing. There’s nothing to say the IRS won’t change its mind or that Congress won’t pass a law to stop this treatment of After-Tax 401ks. That’s true of any tax law or IRS interpretation of that law. It’s prudent to monitor the tax landscape and adjust decisions accordingly. Contact your financial advisor before and while attempting something like this or if you have questions about it.