3rd Quarter Client Note

Equity markets continued their record run in the 3rd quarter. The S & P 500 (Total Return) Index gained 4.48% in the quarter, bringing its return to 14.24% for the year-to-date. The index hasn’t had a down quarter since the third quarter of 2015 and only one losing quarter since 2013. In the US, Small Growth was the winner at 6.22%. Large Growth came in second at 5.90%. And Large Value was the laggard at 3.11%

For the second straight quarter, foreign stocks outperformed. The MSCI World (ex USA) (net dividends) Index returned 6.16%. Emerging markets gained 7.89%. International equities remain relatively cheap compared to US equities on a price/earnings and price/book value basis.

All of the quarter’s data can be found in the Quarterly Market Review from or friends at Dimensional Funds Advisors (DFA.) There’s also an interesting essay on the relative merits of dart throwing versus a systematic and purposeful approach to portfolio construction

What We (Personally) Did About the Equifax Breach

By now, just about everyone is aware of the cyberhacking of Equifax; the largest of four credit bureaus who maintain credit histories and credit scores of millions of people used by lenders to determine creditworthiness. The other three credit organizations are: Experian, Transunion and Innovis. Names, social security numbers, birth dates and addresses of upwards of 150 million people were stolen. This is a system of data collection that we have virtually no choice but to participate in if we ever want to obtain a credit card, home mortgage or auto loan.

The risk posed by this hack is identity theft: a stranger can impersonate you and obtain credit in your name; sullying your actual credit rating and creating the aggravating and sometimes expensive task of extinguishing those false debts and getting this erroneous credit off your record.

There is a great deal of information and advice floating around as to how to respond to this hack. We read all the articles, and I’m happy to share with you our course of action.

You can try to ascertain from Equifax whether you are a victim. We just assumed we were and proceeded to the next steps for both of our accounts.

First, we obtained a credit report to determine if there is any unusual activity in our history. There wasn’t any. (You are entitled by law to one free report per year from each of the bureaus.) Equifax offers a year of free credit monitoring (TrustedID); which is fine. And you can place a 90 day fraud alert on your accounts.

But the gold standard, which we initiated at all four credit bureaus, is to freeze your credit. A credit freeze denies access to your account by prospective creditors until you unfreeze your account at whichever bureau the particular lender uses. You are provided a unique PIN number (keep it in a safe place) that you can use online to temporarily unfreeze your account for the few days that a lender needs access. And then you can re-implement the freeze. At some of the bureaus this is free. Others charge $10. And one made us send in a freeze request by mail.

Of course this is a pain. But we thought this was the most prudent course; particularly because we rarely seek new credit.

Trump Tax Plan: Early Returns

With the release of the nine-page Unified Framework for Fixing our Broken Tax Code, the Trump Administration and Congressional Republicans are on parallel tracks to produce some kind of tax legislation before the end of the year. Whether it ends up being “tax reform” (with major changes in the structure of the tax code) or more of a simple “tax cut” remains uncertain.  And it’s still possible that no significant changes emerge at all.

For individuals, the basic structure is to double the standard deduction to $12,000 for single taxpayers and $24,000 for married taxpayers – while at the same time eliminating the personal exemption and most itemized deductions; including those for state and local taxes and medical expenses. The home mortgage interest and charitable deduction would be preserved, at least in part; but may not be practically available for many taxpayers due to the higher standard deduction.

Tax brackets would be reduced from seven to just three. And the Alternative Minimum Tax would be repealed. The framework is silent on the question of capital gains.

The plan also calls for lower corporate tax rates and for a lower rate on businesses structured as pass through entities such as partnerships, S Corps and LLC’s.

The outline also calls for repeal of the federal estate and generation skipping taxes (which under current law only affects estates valued in excess of $12,000,000 for married couples.) This necessarily requires reconsideration of the cost basis at death step up rules and the attendant complications. Full estate tax repeal can hardly be characterized as populist, which may be a barrier to remaining in the final bill.

And there are many other obstacles. A predicate for tax legislation is Congress coming to agreement on a budget – both because of the basic math and because Senate rules require a budget in order to pass tax legislation via “reconciliation” – avoiding a filibuster and requiring only a simple majority vote in the Senate. But under the so-called “Byrd rule” reconciliation requires that legislation not increase the deficit ten years out. So, whatever tax legislation is passed by reconciliation won’t be permanent; similar to the Bush tax cuts, which sunseted in 2010 after ten years. There are factions in Congress who insist on permanent tax reform. And there are other factions who insist that any tax cut be paid for and not add to the deficit at all. Negotiations satisfying all of these demands will be arduous.

Moreover, each of the itemized deductions slated to be reduced or eliminated represents a sacred cow on somebody’s farm and has a strong lobby fighting to preserve it.

And it’s not even clear what the effective date would be. January 1, 2018? Sometime in 2017? All of which makes planning well-nigh impossible.

Memories of Black Friday

The upcoming 30th anniversary of the crash of (October 19) 1987 is a good reminder both that: 1) stocks don’t go up forever and 2) downturns are to be expected and planned for.

On that fateful day, the Dow Jones Industrial average dropped 508 points, or 22.6% – the single largest one-day drop in history. (Mythology has it that today’s accepted definition of the term “bear market” – as a 20% drop – originates with Black Friday.) Stories of panic selling that day, by both professional and individual investors – as well as newfangled computerized “program trading” – are legendary. The drawdown (top-to-bottom decline) from August 25, 1987 to Black Monday was 36%. But the Dow rallied 5.9% and 10.2% during the following two days and was up 5.81% for the year.

The market drawdown in the Great Recession of 2008/2009 was over 50%. And the market is up 250% therafter.

Since 1928 there have been double digit drawdowns, on average, every two years.

Investing for the Long-Term

Capital markets have rewarded patient, long-term investors. The US stock market has delivered an average annual return of approximately 10% since 1926. But interestingly, in only nine of those ninety-one years has the actual return landed between 8 and 12%.

Many people claim to be long-term investors. But few really are. It is tempting to try market timing – being in the market when it’s going up and out when it’s going down. We think the better approach is to adopt an appropriate, globally balanced asset allocation (which may change as you get older or when you achieve certain goals) and adhere to it via rebalancing. Such an approach, which may include a healthy sleeve of lower-return, less volatile asset classes like short to intermediate-term, high quality bonds, will produce lower overall returns – but with less volatility – than an all stock portfolio. But, by definition, this will force you to sell stocks in bull markets like the one we are experiencing and consequently be less exposed during the inevitable correction.

Footnote – Warren Buffett Wins His Bet

Warren Buffett is one of the greatest active investors of all time. During a good part of the period after he purchased Berkshire Hathaway to utilize as an investment holding company, his stock picks and company acquisitions handily beat the market. (Of course, we have since learned that one can emulate Buffet’s strategy by systematically investing in the kinds of companies Buffet prefers in a strategic, evidence based passive manner.)

But in a “do as I say, not as I do” moment, Buffett recently collected on a 10-year, $1,000,000 wager with hedge fund manager Ted Seides in which Buffet bet that over the period from 2007-2017, the return of the S&P 500 Index would beat the return of a portfolio of hand-picked hedge funds. Over that period, the S&P 500 has gained 7% annually while the five funds picked by Seides gained only 2.2% per year. The money will go to charity.

The lesson, which Buffett has been touting for years, is that for most investors a strategy of low cost passive investing makes far more sense than trying to identify managers (with their exorbitant fees) who will beat the market.

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