[Season 2 Ep.8] Market Update Podcast
Laila Pence: (00:00)
Welcome everyone to today’s podcast. Today is December 2nd, and this is season two, episode eight. We have, as usual, a lot to cover, especially with this new virus and the market volatility. So I’m going to get started. We have a full schedule. We’re going to start by talking about the virus and what’s going on there. And then, as you know, there’s an infrastructure bill and the AB-150 bill that passed. I will talk about what’s in them. Then, the next subject of the day is inflation, inflation, inflation. There’s a proposed “Build Back Better” bill that passed the House but has not passed the Senate yet. I will talk about that. Then we’re going to talk about some of the changes, what we’re doing and what to expect. We’ll also have a few kind questions and to-dos. So with that, I’m going to hand it to Dryden because we are getting a lot of calls. This is a big thing on your mind: what is going on with this new Omricon variant? How will that affect the market, and what can we expect?
Dryden Pence: (01:24)
Good afternoon, everybody. And you know, as, as Laila said, we’re, we’re in, you know, season two, episode eight. For almost 20 months now, it has been all about the virus, and we’ve talked about this in the past that whatever is up with the virus will create volatility in the market. It becomes a headline circumstance. The point of the matter is that the virus comes in waves and mutates. A couple of months ago, we talked about Delta, and now we’re on Omicron. So the important thing is that we now have 18 months, almost two years of data around this virus.
Dryden Pence: (02:46)
It comes in waves. It’s probably not going to go away. This has moved from pandemic to endemic. It moved from being something that we have to deal with and worry about all the time to something that becomes a flu shot. We still deal with the virus of the 1918 Spanish flu from time to time. I don’t want to be flippant about this at all. This is very important. Some people get very, very sick. If you look at Europe right now, they have more virus cases than they ever did at any point, right? It’s worse now than it was at any point in the last two years. Vaccination hasn’t ended it because now it penetrates through, and we have to update the vaccination and boost it.
Dryden Pence: (03:51)
Lockdowns have not stopped this. We now have almost two years’ worth of history saying that this will not necessarily end or contain the virus. So the virus is important because it creates volatility in the markets. We have to be aware of that. We’ve seen that in the last couple of days; you’ve seen this market of volatility that’s important. However, the second thing is that you have to ask questions. What’s the governmental reaction to the virus? It affected us so much in a year and a half ago because we did these shutdowns, and it was the shutdowns that affected the economy, not the virus necessarily in and of itself. So the real question here is, what is the policy response to or wave of the virus? It’s not an outbreak; it’s another wave, another mutation.
Dryden Pence: (04:45)
So the real question becomes policy response. And we have a history now that recognizes you can break it down state by state. I do not think that further lockdowns are warranted; people will adapt, but the fact that it becomes a headline will create volatility in the markets. And that’s volatility that we think we can take advantage of if we keep cool heads about it, pay close attention, look at the companies that will be resilient or resistant to the volatility, and then position portfolios accordingly. That’s kind of the long and short issue on the virus in and of itself.
Dryden Pence: (05:43)
As I have said many times before, human beings are the most adaptive species on the planet. That’s why we’re at the top of the food chain. We tend to get through this. And I brought this up in the last time we had this call; it was about 18 months after 9/11 when passenger airplane loadings got back to where they were because that’s about how long people will suffer the inconvenience that they had to go through before they get back to getting on with their lives. Well, we’re about 18 months after this, and passenger traffic loadings are probably 85% to 90% of what they were before. So this human behavior has a pattern of resiliency, and we have sort of a halflife of inconvenience, and we’re seeing how we adapt and get through this. The whole thing about the virus is that it is crucial in that it creates psychological volatility to the markets in anticipation of further government policy intervention or lockdown. But we do not believe that those will be long-term or permanent. And therefore, we’re in for a couple more months and weeks of this crazy volatility, but we think it’s something we usually will overcome.
Laila Pence: (07:08)
The next thing we want to talk about is this infrastructure bill that just passed. It is something that we’ve been anticipating for a long time. It is going to be a lot of spending on an eight-year plan. They will do a lot of the expenditure on roads, airports, and everything we need. So we’re excited to have that. Finally, they did sneak one thing in there. If you wonder why cryptocurrencies have not done as well lately and have been more volatile, it is because they put a new information requirement in there for the first time. The provision states that any person who regularly executes transfers of digital assets, including Bitcoin NFTs, needs to report those transactions to the IRS and report any digital asset transaction over $10,000.
Laila Pence: (08:17)
Before that, they didn’t have any reporting requirements about Bitcoin and provided secrecy and so forth. Since this bill passed, we’ve seen a lot of volatility in crypto because now it does have to be reported if there are any transactions over $10,000. That’s pretty much the most important thing that we saw in this bill besides the fact that spending will help the economy. It is going to help the roads. It’s going to make companies more efficient and people more efficient workers. There’s one other bill that I’m very excited about that passed. It is a bill called AB-150. It allows S-corporations, limited liability corporations, and partnerships (past entities) to pay an entry-level tax of 9.3% of their income as long as they pay it before December 31st for this year. So, for example, if you have an S-corporation and your net income after you pay your salary, what’s profitable, is $1 million. You can pay $93,000 to the state of California. You can use that towards your tax estimate and deduct it from the federal income from the business. So in effect, if you’re in a 37% bracket, you would save 37% of that $93,000. So it gets around the SALT deduction. So if any of you want more information about that, we have a sheet on it, but you should contact your CPA.
Laila Pence: (10:17)
You’ll be able to use that as your estimated taxes for your personal taxes; it’s an excellent workaround. I know I just paid my tax to make sure it’s done before the end of the year. I’m going to turn it back to Dryden and talk about the subject of the day: inflation. So Dryden, tell us really what the impact of inflation? Is it going to last? What effect is it going to have on the market?
Dryden Pence: (11:30)
We’ve talked about inflation as two components, and we still believe there are two components. One is somewhat transitory, and the other one’s permanent. Supply chain disruptions create transitory problems. The massive amounts of money we poured into the economy in a monetary policy fashion, or fiscal policy fashion, made a permanent change. As I’ve said before, we put $5.4 trillion more than we spent in World War II in the economy in one year. So that part of the inflation, we think, will be not short-lived, but with us for a while. At the same time, the supply chain disruption inflation will eventually settle out. And we think that that’s still probably a year.
Dryden Pence: (12:29)
We have noticed an improvement in what we call “Choke on the water,” the number of ships held at bay in the ports of Los Angeles and Long Beach. There are some improvements there, but it is also a little temporal because you don’t know how many ships are just farther out into the ocean. I think what’s interesting here is we see a policy response, whether they meant to do it or not. When you look at the infrastructure bill, the infrastructure bill contains a lot of money to improve roads, bridges, ports, and things like that. And what we see in these supply chain disruptions is the result of several years of under-investment in those critical logistical functions. So that portion of inflation is due to supply chain disruptions. We think we are in it for at least another year or more.
Dryden Pence: (13:27)
Then it will start to decrease, whereas the inflation that’s there from this massive amount of money that we put in will probably be a little stickier. Why is it important? You have to ask these questions. Why is inflation significant, and what does it do to the markets? If you think about why it’s important, the Federal Reserve tends to raise interest rates to cool off the economy in response to inflation. So now everybody’s talking about the expectations that we could get as many as three rate hikes next year, but that would be moving interest rates from zero in effect to 75 basis points—still, less than 1%. A 1% inflation rate from the Federal funds is still highly, highly accommodated. If you look at the average since 1954, it’s 4.6%.
Dryden Pence: (14:25)
So we need to recognize those of us who, if you’re old like me, have a very long time horizon. For us, Fed funds rates above 1% or 2% or 3% are not unusual. However, if you’re young and a millennial, you’ve never known a high interest rate. I want to get through to everyone that the Fed raises interest rates to change consumers’ behavior. And younger people will change their behavior at much lower interest rates than older people. Older people look at a house mortgage of 6%, and that’s something they would find. They’ve been aware of that for a while. Younger people look at a house mortgage interest rate of 4%, and that’s just completely crazy to them.
Dryden Pence: (15:23)
So what you’re going to see are some behavioral shifts with interest rates. You really shouldn’t panic about this because the behavior will shift at lower levels. That’s what we expect if the behavior will change at lower levels than it has in the past. So the Fed will get the economic response that they want at lower interest rate increases than they have in the past. That’s important. Now, do we have inflation? Yes, we do. Is it going to be with us for a while? Yes, it is. Do we risk the great fear of hyperinflation? I do not think so. I believe that what we will see is elevated levels of inflation. The average medium for the last since 1927 is about 2.6%. Now we’re running a little hotter of that.
Dryden Pence: (16:12)
We’re at around 5%. We think that, that over the next year, that’ll come down a little bit, but that we’re still going to be reasonably elevated. Still, you have to remember the Federal Reserve has wanted a 2% inflation rate for a long time and hasn’t been able to get there until recently; they can let this run hot. They can let it run at 3% or 3.5% for five years before they get back to the average that they want. So we must recognize that we’re in a transitory period and that inflation will be higher. Interest rates will be higher, but that does not necessarily mean it’s harmful to companies or negative for the stock market. But indeed, if you think about the period when the interest rates have been above the median ever since 1927, you’d begin to see tremendous growth and average returns in several sectors running 6% to 9% to 12%.
Dryden Pence: (17:12)
The economy adapts to higher interest rates and higher inflation; companies adapt to higher interest rates and higher inflation. Indeed, profits are currently at an all-time high; companies are making more money now than they ever have before. People who are working are making more money than they ever have before. So if you look at these things in the aggregate, it’s a pretty decent pitch picture. That’s the important thing for everyone to know. It’s tough to have a bad economy when you add $5.4 trillion to it. There’s going to be some inflation, yes. They will have to raise interest rates in response to that, but we do not see it as excessive. We do not see it being about recession, nor do we see it bringing back a severe constriction in corporate profit. We think the corporate profitability and the stock market will continue to do pretty well all through next year. If you were to ask me to say, what do we think will happen in all of this? We believe we are probably looking at a market that can be in the high single digits next year.
Laila Pence: (18:28)
And isn’t it true, Dryden, that in 2019, the Federal Reserve raised interest rates, and we had a great market year? Jay Powell has let us know when he will raise interest rates and is very transparent. So the market reacts to it and then adjusts and goes on. So I think that’s the message here. We will have interest rates higher next year, but they will be measured.
Laila Pence: (19:18)
So this proposed Build Back Better bill. If you remember, last time I spoke, there was another much bigger bill they were trying to pass with all kinds of tax changes. They were trying to raise $3.5 trillion. Now they’re looking at trying to raise about $1.9 trillion or around $2 trillion. So the tax changes in this proposed, and again, that’s proposed plan, have dramatically different from what I mentioned last time. So, for example, they don’t anticipate any state tax changes. They don’t anticipate capital gain changes or income tax rate changes. That’s with the new one that passed the House. Of course, now’s going to the Senate, and we don’t know whether it will pass. It did pass the House, and of course, the Senate will make many changes, but I’m going to tell you just what passed so far.
Laila Pence: (20:16)
The big thing is they are going after is the very high-income bracket individual. If you make over $10 million, they will increase by 5%. If you make over $25 million, you’ll have 3%. The thing that would hit many of you here, or anyone with a business, is an Obamacare tax of 3.8%. You pay if you have capital gains or investment income over $250,000, but you never had to pay this Medicare 3.8% tax if you have a business and business income. In this bill, what’s proposed is that you will be subject to the 3.8% tax. A lot of people changed their business structure to avoid that.
Laila Pence: (21:15)
Now, they might have to rethink this again. There’s also a 15% minimum tax on corporations and a 1% excise tax on corporate stock buy-backs. But the area that we’re most interested in, we don’t know if that will pass or not. I talked about what Governor Newsom has done for corporations for the SALT deduction. In this Build Back bill, they are talking about increasing the SALT deduction (which you see state and property tax deduction) as not limited to $10,000; they would increase that possibly to $80,000, but they would limit it to people making less than $400,000. Many high-income tax states like California and New York have weighed in on this.
Laila Pence: (22:20)
So that would certainly be welcome news if that passes. I want you to know about this. It’s for those paying your property taxes right now and considering if you get both installments or wait and pay just the first installment. Now we think just in case we do get some relief. I would recommend that you pay your first installment now and don’t pay the second installment until it’s due next year. You might be able to get a better SALT deduction permit.
Dryden Pence: (23:13)
So, as I tried to lay it out here, we are in for a period of some volatility driven again by the virus. It’s going to be whatever way that comes and whatever Greek letter they want to throw at it. So we’ll probably have one or two or three more of those. As we roll through this, those moments will give us the opportunity because the market tends to overreact. Those moments allow us to take advantage of volatility rather than be its victim. That’s what we try to make sure that we do. We are going to see inflation. That’s going to run a little bit higher than everybody is used to in the last couple of years. And we think that that’s going to be true throughout next year. That does not mean the market’s going to be horrible.
Dryden Pence: (24:00)
That means that certain companies can raise prices, maintain their margins, and become more efficient. And yet, remember that COVID made many companies far more efficient than they were going into it. They learned how to do things with fewer people and more significant restrictions. So we will focus, stock by stock, on companies that could operate better in an inflationary environment and companies whose stocks are not quite as sensitive to hikes and interest rates. So you will begin to see some changes in the portfolio. You’ll start to see a little wider array of stocks driven more by fundamentals. We’ve already discussed the fact that we like infrastructure because there’s a big policy push behind it. Financials tend to do a little bit better in raising interest rates environments.
Dryden Pence: (25:00)
So you’ll see some sectors that will begin to get greater exposure; these aren’t big moves. I think we liken next year to hand-to-hand combat; it’s going to be up close and personal, stock by stock, decision by decision as we go through, and we look at what’s happening in the economy. But again, I want to show in no uncertain terms that when you have as much stimulus as been poured into this economy, it’s tough for the economy to do poorly. Indeed, inflation is an indication of an economy that’s doing well. When the economy’s doing well, it’s tough for the market to do poorly. They don’t stay disconnected for a long time.
Dryden Pence: (25:54)
We think that we’re probably looking at high single-digit returns. As I said, this is hand-to-hand combat. It will not be the aggressive returns we’ve seen in the last couple of years because this is a period of adjustment as we move through and deal with the volatility. So there are going to be winners and losers. Our job is to spend more time helping you make sure you have the winners than the losers. And that’s where we’re going to be. This next year, as I said, is hand-to-hand combat, stock by stock, decision by decision. But we’ve been doing this for a long time. And it’s going to be something that we look forward to because we believe that it’ll be an opportunity to thrive. I also want to remind everybody that we have published our fourth quarter newsletter. A lot of work went into that, and it is very detailed. Go on the website and get it. It will give you a lot of background that will be very helpful for you going forward. Now let’s go ahead and get into some of the questions.
Laila Pence: (27:00)
So one question: this person planned to retire at 60. Will new taxes affect them now, and is there a sunset to the taxes during retirement? The tax law changes that President Trump passed will sunset in 2027. They will go back to where they were unless there are some changes. So we will see some changes. But as of now, you know, when they dropped the stimulus package from $3.5 trillion to $2 trillion, a lot of the taxes that we thought would go into effect next year will not be going into effect now. So, I think we’re okay on taxes; of course, we don’t know what will happen when there’s another election coming up and how that will change. But for next year, in this current bill, we don’t see many changes for most people, except for those I mentioned earlier, where it’s a 3.8% tax on a business income. Then there was another question about how much government waste is in the infrastructure bill. Well, you know, that is hard to answer.
Dryden Pence: (28:06)
Well, they broke it up and made the fundamental infrastructure improvements. If you took all the bridges in this country that are structurally deficient and lined them up, it would run from Las Vegas to Seattle, over 1100 miles. There are 170 million crossings on structurally deficient bridges in this country every day. So yes, there is some government waste, and it’s probably not small. However, again, the point is that they are fixing some very major infrastructure problems we need to fix. And like I said, one of the problems that we have in our ports is that we haven’t invested in improving our ports for the last 30 years. This is coming home to roost in, in some of these supply chain disruptions that we see.
Dryden Pence: (28:59)
So yes, there’s probably waste in that bill, but there’s also probably some things that will help in the long term. Think of the amount of time wasted, just being stuck in the supply chain or traffic. So I think that there are some positives in there. There are a couple of other questions in here. Here’s one on how we respond to long-term inflation and the 30-year loans. So, interest rates will go up, which will affect bond market portfolios. Those things are going to be limited. We’re going to be very short on the duration of the bond portfolios. If you think about interest rates in the next three months, if you’re planning on borrowing some money, it’s maybe a decent idea to go ahead and do that. Because somewhere in the next year, you’re going to begin to see some increase.
Dryden Pence: (30:03)
Over the next three months, interest rates will be lower than they will be over the next 9 to 12 months. So that’s the important thing; if you’re going to borrow money, now is probably a better time to do it than waiting another year and a half.
Laila Pence: (30:21)
With that, I want to let everyone know that the next podcast is on January 27th at 3:00 PM. And then please don’t forget about our luncheon on April 30th at the Irvine Marriott. That’s the last Saturday of April. So mark that down. A last-minute thing for year-end is if you plan to donate to charity and you are going to go over the standard deduction, bunch them up; donate now, and make sure (if you have not done your RMD to contact us as soon as possible), we only have so many days left. So please get in touch with us and complete your RMD as quickly as possible. And I think with that, we’re going to say happy holidays.
Dryden Pence: (31:11)
I’d like to take a second to thank everybody on the call. We want you to know how much we appreciate the faith and trust you put in us here to work with your financial future and your financial happiness. Not only are we grateful for you, but we appreciate being part of everybody’s lives and the friendships that we share as we move to this year. There have been many challenges, but I think that we can look forward to a continued year of continued recovery and a continued year of spending more time with our families and spending more time with those we love. So we want to wish everyone on the call happy holidays.
Laila Pence: (32:24)
We are going to have a Christmas video from the office. No Christmas card, just a Christmas video that is coming out. So watch for that! And we thank you from the bottom of our hearts for your trust and confidence in us. And we will talk next year on January 27th. Thank you so much.
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