July 2020 Newsletter
Table of Contents
Investment Management – 2Q 2020 Investment Letter
Retirement Planning – “Health Savings Accounts Are an Underappreciated Retirement Vehicle”
Disclaimer
Investment Management
2Q 2020 Investment Letter
Glass Lake Clients and Prospects:
This past quarter was one to remember, or forget, depending on your perspective. In a period of surging Covid-19 cases, unemployment rates spiking to a highest-since-Great Depression level of 14.7% in April, according to the U.S. Department of Labor, and significant social unrest, the S&P 500 had its best quarter since the fourth quarter of 1998 at up 20%, as reported by the Wall Street Journal. What explains this dichotomy? In two words – the Fed. The Federal Reserve fully exercised its monetary policy authority by increasing its M1 money supply by 28% from February to May. And where did the money go? A lot of it found its way into the stock market. With interest rates bouncing around all-time lows – the 10-year treasury note finished the quarter at 0.65% versus 0.68% entering the quarter, according to Factset – the TINA (There Is No Alternative) argument got even stronger as low rates drive incremental flows to the stock market. Low rates also served to juice stocks’ valuation multiples by reducing the rate at which investors discount future projected earnings or cash flows.
So where do we go from here? I see three primary drivers to second half market performance: (1) Covid-19 developments, (2) monetary & fiscal stimulus, and (3) the November elections.
It is difficult to overstate the importance of the evolving Covid-19 situation. The market appears to be anticipating an ongoing case resurgence in the back half of the year, but not enough to force a reversal of reopening activity in more than a handful of states. The market also seems to expect that an effective vaccine will become available in the first half of 2021 that would allow the economy to mostly return to pre-Covid activity. The key risks are governments working to shut down aspects of their economies, citizens not feeling safe to move about and engage with others, and an effective vaccine proving elusive, forcing a longer period of enhanced social distancing and invariably less spending.
Significant uncertainty prevails, but with efforts by myriad companies and countries to tackle the issue, I am optimistic that further treatment options will make people less sick with faster recovery times, alongside far-lower mortality rates that we are already experiencing. Perhaps more importantly, I am also encouraged that an effective vaccine might become widely available within the original timeline of 12-18 months from March 2020 that medical experts suggested, potentially even sooner. Pfizer is starting a major phase 3 trial for its vaccine in late July which showed encouraging antibody levels in a small amount of test patients. Moderna, AstraZeneca, and Johnson & Johnson also expect to start big phase 3 trials by July, August, and September, respectively. Although Dr. Anthony Fauci has expressed his high concern regarding the current outbreak in the U.S., he has also said he is “cautiously optimistic” on an effective vaccine being available by early 2021.
The Federal Reserve and government stimulus measures are a close second driver to second half market performance. As the old market adage goes, “don’t fight the Fed”. Federal Reserve Chairman Jerome Powell has been clear in public remarks that he will do whatever it takes to support the economy. Besides the dramatic increase in the money supply, he has taken the unprecedented step of buying corporate bonds, even those from junk or non-investment grade issuers. If Covid cases spiral out of control and much of the economy succumbs to a second shutdown, we can count on the Fed will be there to do everything it can to support the economy.
We could also get another round of fiscal stimulus for the unemployed (currently extra $600/week through end of July), low-to moderate-income earners (potentially upsized stimulus checks from $1,200 per person in round 1), small businesses (forgivable loans under the paycheck protection program), and state and local governments. A long-awaited infrastructure bill could also be passed that would reduce the ranks of the unemployed and stimulate the economy. Whereas the Covid-19 situation has more risk of downside surprise, I believe the monetary and fiscal situation is more likely to surprise to the upside, as it has nearly every time the economy has been under any stress.
As November gets further within view, the presidential election will take on increased importance. The stock market received a big boost from the Tax Cuts and Jobs Act of 2017 that lowered corporate tax rates from 35% to 21%. Joe Biden has signaled he would like to lift the corporate tax rate to 28%, which combined with an expected drag on GDP, would cut S&P 500 per-share earnings by 12%, according to Goldman Sachs. Further, business regulations would likely ratchet up, negatively impacting certain companies’ earnings and valuations. Still, some companies could benefit from a Biden presidency, namely those involved in clean energy and infrastructure. According to betting site Action Network, a Biden victory is pegged at 59%, and the odds of a Democratic sweep across the Oval Office, the House, and Senate are on the ascent.
Given all these puts and takes, how have I positioned clients’ assets? First and foremost, each client has a different set of objectives, risk tolerances, and circumstances that dictate asset allocation and security selection. What that means is that equity allocations can vary greatly from one individual or family to another, and that certain stocks are only held by certain clients, or with very different weightings.
With that caveat in mind, 85-90% of clients’ equity allocations are invested in core “quality growth” names. This aligns with my long-held investment philosophy of owning companies with strong and sustainable competitive advantages, above-average long-term growth prospects, and prudent levels of debt. A meaningful proportion of this bucket has been comprised of companies that clearly benefited from the stay-at-home environment, such as PayPal (PYPL), Amazon (AMZN), DocuSign (DOCU), and MercadoLibre (MELI). These stocks surged 82%, 41%, 86%, and 102%, respectively, during the quarter, using Factset data. Meanwhile, the quality growth companies with moderate levels of economic sensitivity that got hit during the March market sell-off also generally bounced back well during the second quarter. These companies typically have margin profiles and capital structures that can withstand a negative shock.
I also recognize that the magnitude of outperformance of quality growth names versus “value” or “cyclical” companies has been stark, not only this year, but also over the last few years. When actual or expected economic conditions improve, whether it is because of optimism around a Covid-19 treatment or vaccine or some other reason, the beaten-down value/cyclical names are most likely to spike and outperform for some period of time. To account for the possibility of a faster-than-expected economic recovery in 2021, a 10-15% allocation to the value bucket was introduced. A portion of this has been put into “epicenter” stocks most impacted and last to recover from Covid-19, including airlines, hotels, and cruise lines. I have mitigated the likely dramatic stock price moves one way or the other over the coming months by keeping the epicenter stocks’ position sizes relatively low.
As positioned today, a client might expect their equity portfolio to outperform a flattish to down market in which the stay-at-home trend continues, but potentially underperform a rising market in which economic recovery optimism surges. The degree of potential out- or under-performance should be somewhat constrained by the partial “barbell” approach of owning some of the most cyclical companies. As always, I will continuously monitor clients’ positioning to take advantage of opportunities within an acceptable level of risk.
My closing thought is to avoid the temptation of trying to time the market by jumping in and out of stocks. It would have been easy to be scared out of stocks in March given all the nightmarish headlines, but the biggest quarterly rally in over 20 years would have been missed. Here is an eye-opener: if you had invested $10,000 in the S&P 500 at the start of the century, you would have had over $32,000 at the end of 2019. But if you had missed the best 10 trading days, you would have just $16,000 based on J.P. Morgan Asset Management’s research. With a 10+ year time horizon, the best advice is to stay invested in the strongest fundamentally positioned companies through good economic times and bad, minimizing taxable gains in the process. That gives you the best shot of producing the best inflation-beating returns.
As always, please feel free to contact me with any questions or if your goals, values, or circumstances change. You and your loved ones please stay healthy and enjoy the 4th of July weekend.
Sincerely,
Jim Krapfel, CFA, CFP
Founder/President
Glass Lake Wealth Management, LLC
glasslakewealth.com
608-347-5558
Retirement Planning
Health Savings Accounts Are an Underappreciated Retirement Vehicle
Health Savings Accounts (HSAs) were introduced in 2003, but only in recent years have people come around to the idea that they could be an effective means to save for retirement. With ever-increasing healthcare insurance premiums, a growing share of companies are offering high-deductible healthcare plans that are necessary to establish an HSA. In 2019, 58% of covered employees worked at companies that offered a high-deductible plan with a savings account, and 36% of covered employees were enrolled in a high-deductible plan, up from 18% in 2013. The IRS defines a high deductible health plan as any plan with a deductible of at least $1,400 for an individual or $2,800 for a family in 2020.
Figure 1: Percentage of Covered Employees Enrolled in High-Deductible Account-Based Plans
Source: Marsh & McLennan
It works like this – individuals and families can contribute up to $3,550 and $7,100, respectively, into an HSA (and an additional $1,000 “catch-up” contribution for individuals 55 or older) using pre-tax money. Some companies seed these accounts with $500-$2,000 to encourage their use and complement their benefits package. Like long-used Flexible Savings Plans (FSAs), one can use HSAs to pay for qualified healthcare expenses such as doctor’s visits, drug prescriptions, and prescription eyeglasses. (click here for a full list of qualified expenses) Unlike FSAs, the balance in an HSA fully rolls over form year-to-year, and the funds can be invested in the stock market. Almost all HSA administrators allow for investing in the stock market. Most will require you to keep $1,000-$2,000 in a low interest-bearing cash account.
The most powerful feature of HSAs is its triple-tax-benefits. One can not only contribute to them on a pre-tax basis, but savings also grow tax-free and withdrawals are tax-free if used to cover qualified medical expenses. No other retirement vehicle offers these tax benefits. With traditional IRAs and 401(k)s, contributions are made pre-tax and savings grow tax-free, but withdrawals are taxed. With Roth IRAs and Roth 401(k)s, savings grow tax-free and withdrawals are tax-free, but contributions are made with post-tax money.
Given these advantages, it is advisable to greater prioritize HSA contributions. After building a three- to six-month emergency cash fund to cover basic living expenses (or greater, depending on your unique situation, such as saving for a down payment on a house), one should contribute enough into a 401(k) to receive the full employer match. The employer match is truly “free” money after all, subject to a vesting schedule. Here’s some advice you probably have not heard before -- the next allocable savings should flow to HSAs up to the maximum allowed. Only then should one consider allocating the remainder of his or her available savings to the other typically-used options, such as contributing the full $19,500 limit to one’s 401(k), contributing to a traditional or Roth IRA, or contributing to a child or grandchild’s 529 plan.
When realizing a qualified medical expense, one might consider NOT tapping his or her HSA account. By not seeking reimbursement from an HSA, that money can stay in the investment account and grow tax-free for potentially many years. Suppose a 25-year-old contributes the maximum $3,550 per year at the beginning of each year for the next 40 years and earns 7% per year through investing the full balance in the stock market. At a theoretical retirement at age 65, the HSA balance would have grown to $758,314. Then in one’s later years the money can be used tax-free for qualified medical expenses.
Summing It Up
So next time you are evaluating what to do with your savings, give serious consideration to contributing the maximum to your health savings account if you are enrolled in a high-deductible plan, invest the maximum balance allowed, and let it compound over time.
Disclaimer
Advisory services are offered by Glass Lake Wealth Management LLC, a Registered Investment Advisor in the State of Illinois. Glass Lake is an investments-oriented boutique that offers a full spectrum of wealth management advice.
The investment letter expresses the views of the author as of the date indicated and such views are subject to change without notice. Glass Lake has no duty or obligation to update the information contained herein. Further, Glass Lake makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, whenever there is the potential for profit there is also the possibility of loss.
The investment letter and financial planning article are being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory, legal, or accounting services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends or market statistics is based on or derived from information provided by independent third-party sources. Glass Lake Wealth Management believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions in which such information is based.