With our book well under way, we’re going to take a turn to personal finance for a bit to give our view on the current state of the economy. Specifically, we think 1) tax reform will take place, 2) we are waiting for interest rates to go up like a dehydrated man in the Mojave Desert and 3) risk tolerance appears to be reaching herd level mentality. With that we’ll start with the positive side of the coin first… Tax reform.
Trump Tax Reform
Within the next month or so there is a high likelihood that the Trump administration will adjust the overall tax plan for both individuals and corporations. Before any changes take place we’ll outline a few things to look for once the adjustments are announced.
Individual Taxes
Investing in Munis: The primary benefit of munis is the tax free nature of the security. Assuming you buy munis that are linked to the state you live in, the returns are 100% tax free. Therefore a reduction in taxes would cause the value to come down. Munis become less valuable when tax rates are reduced because the returns on a Corporate bond likely yields a higher return on a post tax basis. As a reminder the basic calculation to find comparable yields is below:
Taxable Equivalent Yield = Tax-Exempt Yield/ (1-Marginal Tax Rate)
The interesting item here is which tax bracket you will fall into. Assuming Trump’s tax rates adjust downward across the board (all incomes) then we should see a near-term pull back in munis. This could create a nice buying opportunity.
*Treasuries are not federally tax exempt like muni’s. Treasuries are only exempt of state income tax, but subject to federal taxes.*
Deferred Tax Assets: Deferred tax assets also become less valuable in a lower tax rate environment. The best example of this is any 401K plan as the main benefit is tax deferral. While we think there is a high likelihood of a repeat Trump presidency, the chances that low tax rates sustain over a 20-year period are unlikely. Therefore, if taxes are adjusted downward in a meaningful way (especially if you’re in the top bracket), you should absolutely look into rolling over your 401K plans into Roth IRAs. Sure you take the tax hit now… but… chances are that rate is going to be higher in the future if tax reform actually occurs.
Real Estate Investment Trusts: This investment vehicle should benefit from tax reform as dividends from REITs are taxed at the individual income level. With tax brackets potentially falling across the board this would lead to high post tax payouts. Negatively, if interest rates do continue to go up we could see a shift to bonds if the returns become more meaningful (we’ll see).
Quick Tax Conclusions: The quick answer here is we’re ready to buy a ton of Municipal bonds on the day of the dip. Why? We really doubt that a low tax environment will sustain for a 20-year time period. Typically when a new president is elected, there is an emotional over-reaction to this being the “new normal”. How many people actually thought he would win? (besides us and a few others) Very few. Similarly, now that he has won people believe we may have some long-term Republican administration for the next 20 years (also significantly unlikely due to the psychology of people in general). When the tax changes occur look at Munis, your deferred tax assets and REITs.
Interest Rates Are Going Up
Make no mistake, this low rate environment is going to change. The messaging from the Fed is clear. We’re likely going to see interest rates go up and… we might even see MULTIPLE raises! This means it may be time to make a big shift towards bonds. We’re separating this from the tax items due to the stock market returns.
S&P Returns Have Been Enormous: On January 2, 2009 the S&P 500 was at 931.80 as of January 3, 2017 we’re at 2,257.83 (and today we are even higher!!!). Lets look at what that means… it means the stock market has seen a 142.3% return over the last 8 years… or a compound annual growth rate of 11.7%. From a long-term perspective the stock market should see a return profile of around 7-10%!
It does not take a genius to figure out where we are going with this. If you’ve been smart (investing aggressively into the S&P 500 with a dollar cost average strategy) you’re sitting on a lot of money. If you can get a yield of around 5-6% without worrying about fluctuations in the stock market… You should jump ship into bonds with every single cent up to your *cost of living*.
Lets crystalize this point. Since we know the last 8 years have generally been *above* historical averages… this means you’ve gotten a return in excess of the average S&P500 return. It is time to cash those chips in (up to your cost of living).
Quick math says… If you’ve got $1 million invested in the S&P 500 but have a cost of living of lets say $50K a year… Then you’re going to look to liquidate that and shove it all into bonds if you can get yields around 5-6%. Essentially, you’ll now have complete peace of mind that your cost of living is protected by ONLY your bond portfolio! Up until now it was incredibly silly to do this. Over the last 8 years interest rates were far too low making it idiotic to have any exposure to the bond market. Now? The tides are finally turning!
While we’ll still throw some excess cash into the S&P 500 (tickers: VOO or SPY) the bond market will likely become attractive. If you’ve got minimal bond exposure (you should at this point) then its time to dust off the old portfolio management strategies.
Herd Level Risk Tolerance
We’re not quite there but we’re getting close. The move to passive and the overall sentiment “everything is great!” is becoming a bit redundant. We’re sitting in an echo chamber where the only thing heard is “stock prices must go higher!” which is pushing multiple valuations well beyond their intrinsic value.
Snap Chat IPO: While we don’t care much for individual stock investing within the technology sector, the recent IPO is making us realize that risk tolerance is becoming unreasonably high. Again. We’re not saying SNAP is a good or bad investment. We don’t know the stock closely enough. What we do know is the implied valuation.
Snapchat generated $404M in revenue and a net loss of $515M, this means the Company loses more money than it makes in total top-line revenue. This is 100% normal for a technology company (losing money pre-IPO). What is a bit abnormal is what the market is willing to pay for it! With a market cap of around $35B post IPO we’re looking at a valuation of 86x Sales. If we assume that revenue is going to triple this would imply valuation of 29x sales.
Sure the Company has $3.4B in cash and won’t be going bankrupt any time soon (yes we realize the enterprise value should be adjusted slightly lower) the point is that investors are willing to say “this Company will generate more than $35B in today’s dollars”. When you look at “market caps” the best way to think about it is a “back door” to present value. If you believe SNAP will generate more than $35B in today’s dollars (cash generation) then you buy it, and if you don’t then you’re on the sidelines.
To reiterate, SNAP is known to be a best of breed Company. As we understand it, the Company is the primary competitor for Facebook at this time given Twitter’s downfall (Instagram and WhatApp all belong to Facebook now). Maybe this means the stock is the next Facebook. Maybe not. All we know is investors are willing to risk (today) $35 billion dollars on a Company with less than a billion dollars in sales.
Price to Sales Ratios: The second metric to look at for overall euphoria is price to sales. As of today the Price to Sales ratio on the S&P 500 is around 2x… in the 2000-2001 time frame it was around 1.5-1.7x! Again we’re not saying things can’t go higher. If fundamentals continue to improve the market could continue to rock and roll to higher valuations (or sales numbers increase making the multiple reasonable again).
It seems that we’ve seen an aggressive move to equities over the past 8 years. This has been the right move no doubt as we’ve recommended and done the same thing ever since we started this blog and talked briefly about the market. That said, 2x price to sales is starting to look high IF we can get 5% returns on bonds in the near future.
Concluding Remarks and Summary
While we will still be investing small amounts of money into the S&P 500 in case numbers continue to move up we think there are a few things our readers should now look for:
1) We recommend watching the bond market aggressively. This means we’re now opening up the door for potential investments here if tax rates decline.
2) We’re going to watch personal tax rates and see if old 401K accounts should be rolled over during a tax cut period (we think it would be temporary)
3) We are also recommending looking at the REIT market to see if there is a buying opportunity post tax cuts and interest rate increases
4) If the bond market begins to yield a return of around 5%, we think it is now time to take a serious look
5) Continue to dollar cost average into the S&P… But. As rates go up we should shift more into bonds.
