[Season 2 Ep.7] Market Update Podcast

Laila Pence: (00:00)

Well, hello, everyone. Welcome to our podcast. Today is Thursday, October 21, and we have a lot to cover today. We’ll first cover inflation and then I’ll cover the proposed tax law changes. We will talk about earnings, cover a market update and then some year-end tax planning. Then, we’ll try to answer some of the questions that we’ve received from clients. So with such a full agenda, I’m going to get started by asking Dryden to talk about inflation. That’s all I get asked right now; every time I speak to a client, it’s about what will happen with inflation and the supply chain disruptions. Are we going to have double-digit inflation or what? So we obviously keep very close attention to that and we have a lot of studies and a lot of views. So I’m going to turn it over to my darling husband to answer.

Dryden Pence: (01:13)

Well, good afternoon, everybody. So about inflation, there’s always this massive debate about whether inflation is transitory or permanent in nature. And the answer is yes. It’s a bit of, well, you can’t take $5.4 trillion and dump it into the economy in one year (which is what we did) and not have things happen, right? That’s more money than we spent in all of the four years we were involved in World War II. So you had this huge money supply increase, giving in too many dollars and chasing too few goods. And simultaneously with that, you have these supply chain disruptions occurring for various reasons. So those two dynamics are creating both some transitory or supply chain disruption inflation and then this increased money supply inflation.

Dryden Pence: (02:29)

We expect to see inflation go up to the mid-fives through the end of 2021 and moving into 2022. And there are vital sectors here that you have to pay attention to. We see inflation going up; it is not surprising, but it’s real. And when you see energy prices going up 20 percent, it begins to cause an effect. And this is the thing that I want people to pay attention to. It’s not just inflation in general, but it’s inflation by sector. The two most important prices for Americans are what they pay for gasoline and what they pay for rent (or equivalent). You probably don’t know what you pay for peanut butter, but you do know what you pay for a gallon of gas and what you pay as your interest rate on your mortgage or your rent every month.

Dryden Pence: (03:34)

We see some aggressive movements in these areas, mainly energy and rents, that dramatically affect how certain consumers behave. The other side of this is that supply chain disruptions are going to level off over time. We think that this will continue to be a supply chain disruption scenario for probably a year or more. You can’t take a very efficient supply chain system, stop it and then have it recover in three months; it’s just not going to work that way. So, we’re going to continue to see this for a while. I bring these things up because I want to point out to you the things one has to be aware of and what you have to worry about. We’re going to see higher energy prices.

Dryden Pence: (04:32)

Well, that also translates to higher profits for integrated oil companies. You’re going to see higher rents, and that’s going to affect home builders. Also, these things affect consumers. However, in the backdrop of all of this, the other thing you have to remember is that much of this is also driven and supported by a tremendous amount of money that’s been pushed into the economy. So as inflation goes up, there’s also money there to help pay for it. That puts us in a situation where we don’t see it at this moment as what one would call stagflation, nor do we see it as recessionary. Just understand that your investment team is looking carefully at these at the commodity and choke point levels. The other thing that I want to bring up about what you’re going to be hearing a lot is the supply chain disruptions.

Dryden Pence: (05:31)

When you tear apart all of these things, quite frankly, it breaks down to truck drivers. We don’t have enough truck drivers. We went into the pandemic short about 30,000 truck drivers that we needed in this country. We haven’t replaced them. So what’s happening is everything is getting delayed at the ports due to this massive shortage of truck drivers. Look, it’s very kind of simple how this happened. It takes seven or eight weeks or more to be trained as a truck driver. You have to be licensed by the Department of Transportation. You have many people who retire every year; there’s a lot of turnover in the truck driving industry. Then, we shut down all the truck driving schools and weren’t educating anybody for almost 20 months in this space.

Dryden Pence: (06:28)

Now you have a shortage of truck drivers, and it’s going to take probably a year for this to straighten itself out. So thinking that Christmas will fix the supply chain disruptions or that we’re going to open the ports and let them run 24 hours–it still doesn’t solve the fundamental issue. Now, supply chain disruptions are not going to be fixed by Christmas. You’re going to continue to see this problem all the way through for the next 12 months. You’re not going to see a bunch of things go on sale; the only reason why something goes on sale is that there’s too much of it. So, recognize that we’re in this era of rising prices for two different reasons.

Dryden Pence: (07:26)

I want to repeat this: I do not see this getting out of hand. I see the supply chain disruption piece of inflation falling off after about a year. So, then we get into the latter part of 2022. You’re going to see things even out and it’s going to clean up a little bit. Another essential thing: the Federal Reserve wants inflation above two percent. They’ve been trying to get it above two percent ever since 2007. They haven’t been able to do that very often. You can get to three percent or three and a quarter percent for almost five years before the Fed ever gets onto the trend line that they want. So the reason why this is important, ladies and gentlemen, is that the Fed will be hesitant to raise interest rates dramatically in response to inflation because they want some inflation.

Dryden Pence: (08:34)

Does this mean they won’t raise interest rates? No. They’re going to raise interest rates. Does it mean they’re going to raise them a whole lot? No. They’re going to raise them a little bit. And the reason why is people react at much lower levels. It’s price elasticity, a demand for interest. The bottom line is if you’re old like me, you remember the 10-percent interest rate. You remember the six-percent interest rate, and you can remember that being a bargain. Most of the purchasers out there are much, much younger. They’ve never known that high of an interest rate. So when interest rates or mortgages get up around four percent, housing demand falls off. So, what’s going to happen is if we look at here for 2023 and into 2024, expectations are that inflation goes up and then it begins to settle off and come back down. We’ll see interest rates go up gradually, but not dramatically.

Dryden Pence: (09:32)

You’re going to see volatility in the marketplace for stocks, and it’s going to bounce around and react to these two major themes. But, we do not expect them to get out of hand. It doesn’t make sense. And, the Fed will probably stop raising interest rates at a much lower rate than people are expecting. So I want to leave you with this. Are we going to have inflation? Yes. Is it going to get out of hand? Probably not. Is it going to be uncomfortable for a little while? Yes, particularly for younger people because they’re not used to it. This is the thing you’ll have to kind of watch. So there’ll be a lot of headline volatility around this, but the fundamentals are that we think inflation will go up.

Dryden Pence: (10:26)

We could get five to six and then it goes back down to a four-ish. And we’ve lived many years in this economy with that kind of inflation rate. Then interest rates will go up, but not as dramatically as people think they will. And so we’re able to navigate this. In fact, the volatility that these moves will create through the fourth quarter and early part of next year will give us ample opportunity to take advantage of it as we stick to fundamental investing, not at the sector level but the individual company level. So, Laila, I’ve covered those significant issues. But can you cover some of these major tax law changes that are going to affect people?

Laila Pence: (11:19)

Also, remember that we do have the highest savings rate out there and people have a lot of money and they can afford to pay some of the higher prices. It’s not going to affect them as much because they do have the money to pay them. All right, with that, I’m going to go over these proposals that were passed by the House and Means committee. They don’t seem to have the votes to pass all of these, but I do want to go over them and let you know what they’re proposing right now. The big one is that they plan to raise the individual income tax rate from 37 percent on $650,000 of joint income to 39.6 percent on joint filers with $450,000 worth of income.

Laila Pence: (12:07)

So, that’s a much lower level to go into the higher tax bracket. For the head of household, it’s $425,000, and single filers will be $400,000. So you get to the higher tax rate a lot quicker, but that’s pretty much what those tax rates were under Obama. They also want to create a three-percent surcharge on modified adjusted gross income for people that make over $5 million. So they would get to pay an extra three percent of a particular tax. The other thing is that they seem not to like that people have been accumulating and doing very well under retirement accounts. If you have IRA accounts that reach over $10 million, they consider requiring you to make distributions the minute you reach $10 million, regardless of age.

Laila Pence: (13:07)

There’s a lot of noise about that. Again, we don’t know if they’re passionate about it, but that’s what they’re thinking right now. The big one I get asked quite a bit about is capital gains taxes. As you know, right now, the maximum capital gains rate on the federal side is 20 percent. They are talking about raising that to 25 percent. Again, you get to the 20 percent in a much lower income level right now; if you’re a joint filer, you have to be over $500,000 of adjusted gross income.

Laila Pence: (13:58)

They would bring that down to $450,000 as a joint filer, where you would get to the 25 percent tax bracket, and for a single taxpayer, it would go down to $400,000 and for the head of household down to $425,000. So it’s not as bad as they initially talked about. This is a much more acceptable rate if that happens. So, that is what they’re talking about at this moment. The big other ones that people are constantly asking me about are state and gift taxes. So right now, the exemption this year is if a person passed us $11.7 million per individual; it’s estimated to revert to the old law before Trump came into office.

Laila Pence: (15:01)

And, in 2026, if they don’t do anything, it’s going to revert to $6 million. As an exemption, they’re talking about not waiting until 2026 to go to $6 million. They would like to have the $11.7 million drop to six million this next year. So basically, moving it up five years. But the other thing is, right now, a person can give away the $11.7 million and use up the exemption. If it changes back to the old law next year, the only time you can give money away without paying a gift tax is $1 million. That’s what it was under the old law. So that is a pretty significant change that would happen.

Laila Pence: (16:02)

Since the September 13 tax changes, there was no change to the step-up basis. It was a huge relief for many of us because if they had done away with that, I think that would be a much bigger tax than reducing the state tax exemption as it is right now. It would probably go to $6 million from $11.7 million. That would be sometime next year if that happens. The other thing too, if you remember, if you’re a business and you have a pass-through business, there’s a 20-percent qualified business income to the tax deduction. It’s not for everyone; it’s for businesses manufacturing and so forth and it excludes things like financial services and lawyers and doctors. But most major businesses were getting 20 percent of their income as a tax deduction under pass-through income.

Laila Pence: (17:04)

Well, this new law would hamper that. If you make over $500,000, you would not have that deduction. So they would only give it to you for up to $500,000 for a joint filer and $400,000 for single filers. So it would pretty much do away with this big tax reduction available right now as an S-Corp or LLC. Many companies change to that type to get that 20 percent qualified business income; they would do away with that. Another one that would really hurt us would be expanding the 3.8 percent net investment income tax base. There’s this 3.8 percent tax, which is like a Medicare tax. They would apply that to active business income or pass-through income, which would be quite a penalty. They’re doing that because many businesses, you know, have an S-Corp and they only take a percentage as salary and the rest as profits.

Laila Pence: (18:09)

So they’re saying, well, if you’re making a profit, you should pay this 3.8 percent on it. So that may discourage the S-corp status for many people if that happens. So we’ll have to wait and see; on the other hand, they’re also talking about raising the corporate tax rates for C-corps. As you know, right now, for C-corporation, the maximum tax rate is 21 percent. They would make it a graduated plan for the first $5 million of C corporations. So basically, for small corporations, the rates go down from 21 percent to 18 percent, but once you go over the $5 million, they’re proposing raising the rates between 6.5 percent from 21 percent.

Laila Pence: (19:08)

There’s a lot of resistance to increasing it that much from many senators. So, they are talking more about 25 percent, what we’ve heard recently, instead of 26.5 percent. It would not be a massive increase from the 21 percent mark, but it would undoubtedly increase corporate tax rates. So the big one, in my opinion, that would affect a lot of our clients is the Roth conversion. Right now, no matter how much is in your IRA, you can convert the whole thing if you want to, pay the tax and have that money grow tax-free for the rest of your life and for 10 years for your beneficiary. They finally realize how tremendous this benefit is. They want to limit it to just you. If your income as a joint couple, including a Roth conversion, exceeds $450,000, then you will not be able to convert.

Laila Pence: (20:17)

For a single person, the tax rate would be $400,000. So, this is a significant change because it really will hamper a lot if your income is that or if you have a required minimum. It’s going to limit what you can convert. And so, this would be a big change that happens, but that’s what they’re proposing right now. In addition to that, they’re also prohibiting all employees from making an after-tax contribution in qualified plans and prohibiting after-tax IRA contributions from being converted to Roth, regardless of income level. Today, many employees could put after-tax contributions into a 401(k) and then later convert it to a Roth; this would be prohibited. The other thing is with this backdoor Roth, which we use a lot, if you have all your money in Roth IRAs, you don’t qualify for regular Roth IRA contribution.

Laila Pence: (21:18)

A lot of our clients would put their $7,000 in and then within a few weeks, convert it to Roth. That would be a prohibited transaction. You know, as you know, you probably have never heard me speak ever without talking about Roth conversion for years and years and years and years. And I continue to talk about it, and it’s even more important now to talk about it because it could be constrained after this year if this proposed law passes. We don’t know if those limits will be the same, but they’re certainly, for the very first time, are looking at doing away or limiting it. So I’m going to hurry up here. Any grant or trust and discounts would also be affected; it’s one of the positive things they talked about. A lot of the Democratic Congress wants to bring back some of those top deductions. So with that, I am going to turn it back to Dryden and have him comment about earning season and, you know, what do we think the market will do?

Dryden Pence: (22:39)

We’ve talked about the fact that with everything that’s gone on, the comparisons that we see third quarter, fourth quarter and then into next year are in this abnormal area because we have a tough time looking at the landscape when we stopped the economy. Things went down so much, and we moved everything so quickly to down and up and all the volatility that took place during last year and this year so far. So when you think about looking at comparisons, it’s tough to grab meaning from anywhere because it doesn’t make as much sense. So I think that when we look at going into third-quarter earnings, you have about 109 out of the S&P 500 reported. That’s about 20 percent. About 70 percent of those have beat sales, about 82 percent beat earnings expectations.

Dryden Pence: (23:33)

So all of that is still positive and it breaks down in various sectors; some do better than others. Industrials and consumer staples tend to beat sales and earnings expectations. But I think what we had in technology has lagged a little bit, but still, about half the companies beating sales estimates and then about 80 percent on earnings. So what I think you’re going to see going into the third-quarter earnings report is that the companies will have done well and earnings will be good, but the earnings will be less than some of the expectations. And the forward-looking guidance will be somewhat less than people were expecting. So, this hyperbole that goes on in the headlines, you’ll begin to see these reactions in price overnight, right, or before or after earnings.

Dryden Pence: (24:33)

It’s just going to create some volatility, which is why we look at stocks at the individual level. Now, what I think you’re going to see is that individual stocks are going to outperform. There’s going to be price volatility through the third quarter, all from respecting the third-quarter earnings. In the fourth quarter, you’re going to begin to see that these supply chain disruptions will show up, affecting some companies. And then we get into the first quarter of next year. The big thing that I want to say about the market is that we believe that we’re moving into this period where we’re shaking off all of the big moves for the last year, year and a half. Things will begin to bounce around a little bit, but we’re also moving to some stabilization.

Dryden Pence: (25:23)

And this is the crucial thing to remember. We’ve had two, maybe three years of a 20 percent run in the stock market where this volatility is creating crazy massive movements in markets. I don’t think it’s reasonable to expect a double-digit market next year. I think it’s going to take some time for all of this to work itself out. We believe it will be positive, but we don’t think it will be a double-digit year. What I talked to the team about is we’ve moved from moving in sectors to moving to hand-to-hand combat. This is what we’re going to work through for the next 18 months. The stock market is going to be a hand-to-hand combat mode. There’s going to be a lot of positiveness around it because you have so much money in the market that it’s positive, but it’s really at the company level that you have to look.

Dryden Pence: (26:21)

So, research is going to be massively important. And again, we’re still positive, but I don’t think it’s realistic to expect us to have four years in a row of double-digit growth. So, I think we’re going to see that kind of level off here going into next year. Some things could surprise me, but I believe we need to focus on reality. That’s what next year begins to look at as we get through this. In the earning season, again, you’re going to have, one day, a company is going to be doing great. The next day, the expectations are different and you have to kind of turn off a lot of the noise. It will be another year, year and a half before we have any actual data to base this on.

Laila Pence: (27:04)

So some of the things that you know we are planning for: the potential of maybe having some SALT deduction, which is the deduction for state and property taxes. A whole group of congressmen wants to have that back into this new tax law change. So, just in case they do and they allow us to deduct some of the state income tax and the property taxes: I would recommend, if you usually pay both parts of the property taxes in December for California residents, maybe you pay half that was due and wait to pay the other half next year, just in case it might be deductible, which it is not this year. Suppose you have the money in after-tax accounts. In that case, if you have a lot of money in your trust account after tax, this may be a perfect time to go ahead and do some major conversions before year end. Even if they don’t change the tax law, it is potentially a lower tax rate year than the future.

Laila Pence: (28:23)

Anytime you can grow the money on a tax-free basis, you should consider it. So if you have a large IRA, you should consider doing some more Roth conversions. And also, if you have not taken your required minimum distributions yet, I would suggest that you contact us; the market is doing pretty good right now. You may want to process your RMD sooner than later. Of course, for estate planning, consider meeting with your state planning attorney. We do think sooner or later, these exemptions are going to go down; indeed, if they pass any of these changes when it comes to grant or trust or the discounts, this may be the last year you might be able to take advantage of those planning ideas.

Laila Pence: (29:15)

So with that, we have pretty much almost run out of time. Our next podcast is December Thursday, December 2, at 3:00 PM Pacific Standard Time. So mark it now on your calendar; that will be our last one for the year. Of course, if any tax law changes have passed or anything else changes, I will go through them in detail and let you know what’s happening at that time.

Dryden Pence: (29:58)

We’ve had a few questions. I’ll try to summarize some of them, but again, very quickly, we think the economy will do alright. There’ll be inflation, maybe some interest rates rise. That’s going to create a massive recessionary activity. We think the stock market will continue to be positive, not at the rate that it’s been over the last two years, but rather a move into a kind of a single-digit high market going forward. We’re going to have volatility here in the fourth quarter and probably in the first quarter, but those are the things that we want to take advantage of, not being a victim. We want to be prepared for that. We know that there are sectors that are going to benefit from inflation.

Dryden Pence: (30:45)

We’re going to take advantage of that as we have the opportunity. So it’s always good for us to have some dry powder, as we say, some availability of cash to work on your behalf. So the big thing to look to is that as we move forward into this next year and the next several months, you’re going to see all sorts of news, all kinds of proposals and all kinds of crazy headlines. The best thing to do is to wait and see what reality comes out to be. So don’t be overly hyped or worried about many things out there because we will have to move to what the final legislation says. There are many, many variabilities in all of that.

Laila Pence: (31:39)

As far as the tax law: there are many objections by many members of Congress to the large bill. So there may be some changes here. I know the big one is the corporate tax rates; they are not happy about raising it to as much as what’s proposed.

Dryden Pence: (32:03)

I have one question about the IRS invading your bank account. We kind of think that that’s probably going to be unlikely. There’s too much activity around personal privacy around that. So while they’re going to try, there are other ways to go off trying to get at the non-cash economy. So we think some of those invasive things are not as serious as they’re coming off to be. I want to sum up: we don’t think the volatility will be too awful, but there will be some and we’re going to take advantage of that. We believe the economy is doing okay and that’s why you have a little inflation. You get inflation when you have a good economy and you put a lot of money into it. So we’re going to learn how to take advantage of those things, working through the rest of the fourth quarter, charging into the end of the year and going forward in the next year. Thank you so much for listening and being with us today and we will talk to you on December 2. Thank you.