[Season 2 Ep.3] Market Update Podcast

Laila Pence: (00:00)

Good afternoon. This is Laila Pence. Today is Thursday, April 29th, and we are on season two, episode three of our podcasts. We have a lot to cover today. We’re going to start by covering the market. Then I’m going to go into details about the proposed Biden tax plan. We’re going to talk about some of the budget items that he has and some of the wishlist of spending that he still has. Then we’re going to talk about some things to consider. We do have some questions, and then we’ll have some closing remarks. So we have a pretty full agenda. With that, I’m going to start by asking Dryden here to tell us – well, this has been quite a bit of change every month. We saw early on interest rates rising and then the Fed staying put, and we have a tremendous amount of stimulus. So Dryden, tell us some details. What’s going on with the stimulus? Tell us about earnings, tell us about GDP. What is your outlook?

Dryden Pence: (01:16)

There’s a lot to digest, folks, but I think one of the key moments as we look at the big things going on, as we’ve said before, we see 2021 as a tale of two halves. You have a tremendous amount of government spending in the first half of the year. Then you have a lot of excess consumer demand because not only do we have government spending right now, we have a lot of government spending coming in the future, and we also have the fact that consumer balance sheets are as strong as they’ve ever been. More people have more money saved up during the pandemic. Realistically, you have just the leisure and hospitality sector of the economy dragging behind. As a result, we kind of come out of this variable speed recovery from COVID.

Dryden Pence: (02:09)

Now I talked last time about some of the inflation risks and some of the things that people have talked about – what moves some prices around. We’re kind of at the end of the quarter here. So, so as we get into that, remember I talked about a supply-constrained price movement. You’ve seen all those things about the ports getting backed up and stuff like that. Well, what happens is when the supply chain becomes constrained, prices go up, which also triggered some inflation statistics, which pushed interest rates up, and you saw a bubble about that. Then we talked about that as supply chains become more normalized and things kind of catch up, you would see interest rates come back. That’s kind of what’s happened, some softening of that.

Dryden Pence: (03:02)

Here’s the other side of that. What we see now is you have pent-up demand. As we get into the second half of the year, people can get out and do things, and they have plenty of liquidity. So you’ve got a ton of money and demand. That’s going to drive up what we call aggregate demand that drives up prices. That’s why nothing’s on sale. If you go out and try to buy something right now – you try to buy a car, or you buy something – things are back-ordered. There’s no excess inventory. When you don’t have a lot of inventory, things don’t go on sale. So that means that prices are firmer than they have been in the past, and demand is greater than it has been in the past.

Dryden Pence: (03:53)

Prices are moving up because there are fewer things on sale. There are two sides to this, as it affects companies. If you do not have to dictate discount the price on anything, what happens to a company’s earnings is that they go up. So the higher prices are actually giving margin expansion to earnings. We’ve seen that in the earnings of the S&P 500 so far this year, with 57% of the companies reported, 72% of them had beat on sales estimates and 87% on earnings. So you’re seeing all of this recovery combined with tremendous stimulus and excess liquidity showing up in the market in the economy and prices. So as we move forward, what does all this mean? It means that by the third or fourth quarter, enough people are going to have the vaccine or the disease, we’re rapidly getting back to a fully functioning economy, and we’re doing it at a time where there’s tremendous stimulus in the market.

Dryden Pence: (05:04)

We’ve already approved $5.4 trillion in the stimulus, so in one year, we added more stimulus than we did to the entire cost of World War II. World War II is about 5.1 trillion, adjusted for today’s numbers that we’ve already put in. The financial pandemic released about 5.4 trillion. So that’s really about 25% of our nominal GDP. If you take 25% of your entire nominal GDP, and you throw $5.4 trillion at the wall, some of it’s going to stick, and it’s going to turn into earnings. You can’t throw that much money at an economy and not have it be highly stimulating. So we think that as we move forward throughout the rest of this year and into next year, you’re going to see strong consumer demand.

Dryden Pence: (06:09)

You’re going to see the continued profits and earnings of companies. You’re going to see tight supply chains and plenty of liquidity. The Fed is on hold. They’re ready to continue pumping money into the economy. We think that this robustness of stimulus, whether it’s coming from the government or for consumers, will continue throughout the rest of this year and into next year. It’s going to have some collateral effect, but the economy we think will move forward. Now, what we see happening in the market. You see the big four or five companies, and most of your portfolios have all have blow-out earnings. They’ve all done exceedingly well. So, you see them catching up where what I call the quality of prices is better. The prices may be a little ahead of themselves and the market a little toppy, but the earnings component is catching up.

Dryden Pence: (07:06)

So the quality of those prices becomes better. That will help when eventual volatility comes and other things like that. That’ll provide solid fundamental support for some of the prices that we have. With the estimates of GDP growth for 2021 being at 6.5% and then 2022 being 3.3, we see the economy continuing to grow and companies continuing to grow. However, I want to urge caution. As you think about the market in this environment, it will be a company by company market. They made all the easy money. The market has recovered dramatically and gone up. As you get into the rest of this, it’s going to be company by company. We’re going to be very careful about how we look at it because there will be pockets of volatility that will come from this.

Dryden Pence: (07:59)

This is why we like our strategy of picking individual companies rather than broad-spectrum mutual funds or ETFs in the equity space, which is more driven by both sectors or individual companies. That’s where we see things going. It’s a positive viewpoint. Certainly, there are some headwinds to pay attention to, but a lot of this gets driven by new government proposals and other things in the future. I want to let Layla talk about Biden’s tax proposal and how this might affect you guys as clients because there’s stimulus, and there’s the other side of that is how you pay for it.

Laila Pence: (08:45)

I think you want to mention that the state and federal government spending – they thought that would be a poor year for state and federal government in 2020. It actually came out positive, and now they’re pumping $350 billion more in state spending.

Dryden Pence: (09:06)

Exactly. All this money that the government put into the authorizations for bailing out the states certainly got overstated. All these states said, “We need all this money.” They got it from the federal government, only to find out that they didn’t need it or need as much of it. Now the states have surpluses they’re spending on projects. So you don’t have just federal stimulus, but you have state and local stimulus coming to you.

Laila Pence: (09:41)

In the state of California, if you’re a low-income taxpayer, once you file your taxes this year, they have another $1,400 they’re going to send out to lower-income bracket individuals. This will mean more spending because they’ve actually had a surplus in their budget, and then they’re getting so much more money from the federal government.

I want to talk about the one subject that we’re getting more questions about because this hits everyone’s pockets. With all this funding and all these new things proposed, how will the tax law change to pay for it? I’m going to go into detail about this. Remember, these are all just proposals; nothing has passed yet. There’s a chance we don’t think everything proposed will pass.

Laila Pence: (10:40)

There’s going to be a lot of going back and forth. All I can do today is go over what they are proposing and give you an idea of what I think might happen. One of the crucial things that have to do with the stock market valuations is corporate taxes. Corporate tax rates right now are at 21% Biden has proposed a 28% tax bracket. We think it may wind up being 25% because Joe Manchin, the Democratic senator who votes a bit more Republican, wants 25%. So the streets right now are thinking maybe it would be 25%, which is already showing up in earnings. This is one reason the earnings are coming in so much better than analysts estimate because tax rates have not gone up yet.

Laila Pence: (11:43)

They thought it might go up, but they haven’t. We believe that that’s something that Wall Street can certainly live with. Now, let’s talk about personal. So the significant personal tax increase is that they plan to raise marginal tax rates to 39.6% for couples earning $400,000. Does that mean just a couple, or just that means a single taxpayer as well?

The indication we have is that families are only $400,000. So it’s highly likely that an individual tax rate may go up. If they make over 200,000, it might go up to the higher marginal rate. We don’t know for sure, but that gets implied in some of the information we’ve read. The one that gets the most questions is a capital gains tax increase. First, what they propose right now is that if you have a couple and you add up your income from working or dividends or total income dividends and capital gains right now get taxed more favorably.

Laila Pence: (13:01)

However, if you’re making an income and including your apartment distributions and everything, and your income exceeds $1 million, then they’ll go back and say, okay, half of that million is maybe capital gains and dividends and a portion of your income. Everything’s going to get taxed at 39.6%. In addition to that, you know, capital gains and dividends also have a Medicare tax increase of 3.9%. However, what I’ve read is that they will make that Medicare tax, regardless of whether you have capital gains or not, anything you make over $400,000 they’re going to charge Medicare tax over that whether or not you have capital gains income.

That is coming; this is what’s proposed, but it is a significant number – a million dollars of total income. If you’re planning to sell anything or if you know you get any money and you need to sell, this may be an excellent year to take the capital gains because we know what the rates are today.

Laila Pence: (14:10)

There probably would be some of the lowest rates we’ll have for a long time because even if they don’t, even if they raise that, I think there will be some increase in capital gains. Those used to be 28% under Obama and so forth. He wants to raise them to 39.6%.

So there may be some compromise, but they will go up. We don’t know what it will be – a million, or how else they’re going to define it, but this is definitely where the planning opportunity is. We have a certain amount of capital gains that we take for your portfolio. If you think you need the money and you want to have us take more capital gains this year to take advantage of today’s lower capital gains rate, then you need to let us know. Also, it’s not just capital gains. Rates would go up on capital gains and dividends. This is for families with income over a million dollars. So that means joint filers; that’s what we see right now.

Dryden Pence: (15:21)

One thing I want to add about that. People talk about market volatility because of the increase in corporate taxes and that. They think corporate taxes go up, then the market will be really volatile because people will say corporations get affected, and there’ll be a lot of incentive to do that. So one thing to pay attention to is that absolutely, you can see that there will be some pressure selling pressure perhaps in this year if they do have a capital gains tax raise. However, you also have to recognize it’s not a hundred percent effective because a vast amount of money in the stock market is in retirement accounts. Those are not subject to this. So all the things that we’ve been talking about over time are essential, whether it’s switching to a Roth, whether it’s any of the things you got to do. Consider that taxes are probably cheaper this year than they’re going to be in the next couple of years.

Dryden Pence: (16:23)

We probably need to take a look at that. The sooner you look at that, the better it is; that’s a planning consideration, but we see some effects from a market standpoint. However, we are also balancing between this concern of taxes affecting net earnings and then demand affecting earnings. So at this point, I don’t think we see a big pullback in the market based on tax policy.

Laila Pence: (16:58)

In addition to this capital gains and increase, many people say that they’re going just not to sell at all. I’m going to wait until I pass away. That means I’ll avoid paying the capital gains altogether because of the step up. Well, the proposed amount right now would only allow two and a half million dollars to step up. So if your estate is over 2.5 million, then anything over that, you will not get the capital gain step up. At least that’s what’s proposed. It’s not likely to pass in that low number; we think it’s probably going to be a bigger number. That is a consideration that we’ve had forever about just waiting and leaving it for your heirs, and then they’ll get a step up.

Laila Pence: (17:47)

Now there’s some planning to be done there. Any assets not donated to charity up to $2.5 million with only get stepped up. They will make exceptions for closely-held businesses and farms. They will allow those to step up, but not necessarily as stocks or real estate. Along those lines, another not-so-good piece of news that I’m bringing today is they want to do away with 10-31 exchanges. They will only allow you to exchange up to $500,000 of gains in a 10-31 real estate. Again, that’s just the proposal. They may increase that amount or do something else, so they may not have it all together. However, that is right now is a proposed item is eliminating 10-31 exchanges for any real estate beyond $500,000 worth of gains.

Laila Pence: (18:49)

They are also want to apply net investment income tax or S-corporation and limited partnership income. So basically, as you know, many people who have businesses in S-corporation or an LP will take a lower salary, so they don’t have that Medicare tax. They’ll take the income from distribution.

Well, they’re trying to close that loophole. Believe it or not, they project all these tax laws here to increase taxes over ten years by 1.59 trillion. The most significant change is one that I haven’t talked about. What they think they’re going to get the most money out of is to increase enforcement. They project out of the 1.5 trillion that the documents show that $700 billion of it will come from IRS enforcement. They want to double the budget for the IRS to go after people and audit them.

Laila Pence: (19:55)

There’s going to be substantially more audits for higher-income earners, for big corporations, for estates. They also feel that there’s a lot of income that is not taxed. So they want to have banks and institutions report in and outflows. They feel that that is how they’re going to get the $700 billion. So the biggest increase comes from that, which is really interesting. They’re even talking about giving the IRS the authority to regulate paid tax preparers to ensure that the CPAs doing the taxes are doing them right. So that is a lot of information. Again, these are just proposals. Nothing has passed yet, but there are certainly some planning ideas we may want to do. I’ll talk about that a bit later.

Dryden Pence: (21:06)

One thing to mention: all the taxes and stuff like that proposed, you know, things don’t go through exactly the way they first get presented. There’s going to be some horse-trading with it, but I want to remind everyone we’ve been doing this for about 30 years in multiple different tax rates, multiple different tax regimes, raising tax environments, lowering tax environments, rising interest rate environments, lower interest rate environments. One thing that’s important for you to please realize about how we handle investments is that this is why we are more individually stock-focused. When you’re individually stock-focused, you’re managing it securely. You’re able to control some of these issues and the net effects. So this is an important thing to realize: we’ve been through this before we can navigate it.

Dryden Pence: (22:06)

Once we have a little clarity, I don’t think there’s anything to panic over. And I don’t believe that it’s going to create a vast downdraft in the market. The reason is there are enough pockets of the market where all of this money is going somewhere, and it’s going into a stimulus of certain things. I want to pick an example, the infrastructure. Now we’ve talked about infrastructure a lot over the last couple of years. Some of these trillions of dollars that they’re trying to put out there a certain amount of it – whether it’s the Republican proposal or the Democratic proposal – will end up in infrastructure. This is an important thing to pay attention to when we talk about big noble themes, choke points, and how we invest. If you took all the structurally deficient bridges in this country, and you lined them up in to end, it would, it would stretch from Seattle to Las Vegas.

Dryden Pence: (23:06)

It’s 1100 miles. There are 171 million crossings a day on structurally deficient bridges in this country. If you drove across a bridge today, you probably were in danger. So the critical thing to pay attention to is that we’ve got to spend a tremendous amount of money on this. So there are only about 12 big companies that are eligible to do this work.

So you can clearly identify those. We’ve done that. Most of you already own those. The point of the matter is that in these policy activities, there are opportunities. That’s what we do. We’re going to follow the money, and we’re going to watch where money will go, and we’ll try to get in front of that.

Dryden Pence: (23:56)

So you’ll see changes in your portfolio that may accommodate some of these policy decisions just as we try to change the portfolios to accommodate changes in consumer behavior. I also want to say that we’ve got tons of questions about ESG, which is environmental, social, and governmental. So here’s the thing to know. It is a trendy term right now. The thing is, is no one has a good definition around it. Many people are trying to sell you ESG portfolios or ESG investment ideas that aren’t really ESG. They just kind of put a big name on it. So we’re working very hard to do some real fundamental due diligence. As we make decisions around ESG, that’s a good thing.

Dryden Pence: (24:53)

There’s going to be a lot of money subsidy to it. That’s coming through. So we follow the money. The government’s going to spend a lot of money on ESG. So we want to have to be there. Also, we want to make sure that if we are going to say this is an ESG holding that we’ve considered these two things: first, that it really is ESG, and second, that it has a fundamental catalyst for being profitable. That’s what we have to pay attention to. Those are the two things we’ll look at. More news to come on that in the latter part of the year. I just want to share with you all that we are doing a tremendous amount of research about that. So, Layla, I know we’re getting tight on time.

Laila Pence: (25:41)

One thing I forgot to mention about the taxes is that 18 Democratic congressional representatives will not sign off on any new taxes unless they bring back the SALT deduction, which is the State and Local Tax deduction because it hurts a lot of the blue states. So there could be some better benefits to us,

Dryden Pence: (26:06)

Believe it or not, I met with two Republican Congresswomen today who are Congresswomen from here in Orange County. They are both supportive of the SALT deduction.

Laila Pence: (26:28)

We might get some benefits there. So stay tuned again. I read every word of these tax laws and bills and so forth when they come in. We are tax planners, and I will come back and update you every month when we do these podcasts with what we think is going to pass and where things are going, and so forth. The most important thing is this in terms of actions: this is really a good year. A few of you, your income is going to be over a million dollars. Or your income is going to be over $400,000. So there are two numbers here. If your income will be over $400,000, you know, you really should consider this year to take the hit and convert your IRAs to Roth.

Laila Pence: (27:23)

You’re going to get taxed at a lower rate, but you also, if you have capital gains in the future and if your ordinary income is less and you may not get to that million-dollar mark, all these tax law changes and all these things that everyone’s panicked about might affect you. This is a good year. You have so little that you can control, but that is one thing you can handle.

If you have money in the non-retirement area of your accounts of your balance sheets, it may be a good use of that money to convert into Roth. I know we’re running out of time, and we want to cover what everyone’s asking about, which is how high inflation will get over the two years. What is your prediction, Dryden?

Dryden Pence: (29:09)

My prediction is it’s going to go up. They want about two and a half to three percent. I think they’ll get it. I think we’ll probably find ourselves over the next two years hitting a 3% inflation rate. We may run a little hotter than that, certainly in some sectors. However, we’ve had many, many years of outstanding success when we’ve had an inflation rate of two and 3%. So I’m not particularly worried about it. I know to the Fed inflation only matters if the Fed is going to raise interest rates, and they will not worry about it until it’s a three and a half, 4%. So I think I’m not overly worried about it or really worried about how it will affect things at a 3% level. So I think we’re good for a couple of years here.

Laila Pence: (29:58)

Okay. Well, we are running out of time. If you have questions about anything that we talked about today, about taxes, generally know that if we have any of these tax changes, they would not be retroactive to the beginning of the year. There could be, they could get implemented the day the bill gets introduced. They could say starting September 20th, and from now on, any gains you take, that’s when they go into effect. If you want to do some of this planning seriously, it is best to do it now, before they start things.

Dryden Pence: (30:38)

I’m going to take two moments of personal privilege here at the end of this. First of all, most of you know our daughter, Sarah. Sarah’s graduating from high school; today, she got a big award for academic achievement recognized by the entire school. So we’re really proud of our daughter. I just want to share that with everybody because a lot of you know her, and so she got the top award for academic achievement at St. Margaret’s. So we’re very, very proud of her. Now, the next thing is talking about our team. This last week, Barron’s named the Pence Wealth Management team to its list of the nation’s 100 top private wealth management teams. If you think about the 450,000 people out there that are investment advisors, all the people in this scene, the 26 members of the Pence wealth management team, all worked very hard to get this honor.

Dryden Pence: (31:40)

I’m very, very proud of them because, you know, being in the top 100 at number 85, we’re the highest-ranked in Orange County by far. We’re proud of our team, but more importantly, we’re very grateful and proud of you, our clients, who have been supportive of us. I want to say thank you for your trust. Thank you for letting our team work with your family. That’s what is exciting about the future. So I’m proud of our team. I’m proud of the clients. I’m proud of everybody. So thank you for letting me take a moment of personal privilege.

Laila Pence: (32:30)

The growth from $20,000, which was the first amount that my clients gave me to invest, to well over $2 billion that we have now … we couldn’t do this without you, our clients. We’re so thankful for you. We do this because we have a servant’s heart. We do it from the heart, and I think it is a testimony – besides having brilliant team members, it’s really our heart that gets us where we are and having great clients like you.

Dryden Pence: (32:58)

So thank you to each of you. The next podcast is going to be on Thursday, May the 20th. Also, mark your calendar. Saturday, September the 18th, is going to be the client luncheon, both in-person and virtual. And I will be doing a video here in the next several days that will have slides to back up much of what we said. So I look forward to that. In general, again, thank you very much. We appreciate all the support, and we look forward to the rest of this year. There will be many headlines, a lot of things will bounce around, but we’re staying on top of it. We’ll help navigate these waters and continue to move forward, as we have over the past several years. There are good things ahead. We’re pretty confident about that. So, thank you all very much, and we’ll see you next month.