October 2020 Newsletter

Table of Contents

• Investment Management – 3Q 2020 Investment Letter

• Estate Planning – “You, or Your Parents, Probably Should Have a Revocable Living Trust”

• Disclaimer

Investment Management

3Q 2020 Investment Letter

Glass Lake Clients and Prospects:

The past three months were another strong performance period for U.S. equity markets, but not without some renewed volatility. The S&P 500 closed the quarter up 9% and was up as much as 16% through September 3. It suffered a nearly 10% correction through September 23 as the mega-capitalization stocks that have powered the market rally since the March 23 low cooled off from overheated levels. Still, the S&P 500 put up its best two-quarter performance since 2009, and the Nasdaq since 2000 with its 45% gain since March.

There continues to be a dichotomy between Main Street and Wall Street in which many people and small businesses are suffering through the pandemic, yet major market indexes are making all-time highs. In my opinion, there are five big forces driving market action currently: (1) strong Federal Reserve support; (2) Covid-19 case, therapeutic, and vaccine progression; (3) the upcoming election; (4) companies’ earnings reports; and (5) growing retail investor participation and speculation. 

The Fed
The Federal Reserve is keeping a substantial bid in the markets through its low interest rate policies. On September 16, the Federal Reserve indicated that it intends to keep its overnight federal-funds rate target at 0%-0.25% until 2023 and continue its current monthly purchases of $80 billion of Treasuries and $40 billion of agency mortgage-backed securities. It plans to maintain its extremely accommodative stance until unemployment approaches the 3.5% pre-Covid rate and inflation moderately exceeds its 2% target to offset previous shortfalls.

The Fed’s guidance has pushed 10-year treasury note yields to ultra-low levels of 0.5%-0.9% since March, down from 2.0% at the start of the year and 3.0% at the start of 2019, per Factset. Because many financial instruments are closely tied to treasuries, interest rates in certificates of deposit (CDs), corporate bonds, and mortgages, to name a few, have also come down significantly. Since investors have substantial difficulty achieving meaningful yield in their fixed income portfolios without taking undue principal risk, the stock market is often the best alternative. Further, low rates juice stocks’ valuation multiples by reducing the rate at which investors discount future projected cash flows.

My Take: I expect the Fed’s aggressive monetary policy will keep stock market corrections to a minimum for the foreseeable future, barring a catastrophic development.

Covid-19
The Covid-19 situation is highly dynamic, with positive and negative headlines on almost a daily basis. On one hand, it appears likely that one or more vaccines will be approved by the end of the year, allowing for administration to the most vulnerable patient populations and front-line health care workers in relatively short order. Further, death rates continue to come down as mostly younger people have become infected and as we make advances in treating the disease. Preliminary data released by Regeneron (REGN) on September 29 for one of their antibody cocktail trials provided more encouragement because it could provide significant infection prevention and treatment benefits over the current standard of care.

On the other hand, we have also heard warnings from Dr. Anthony Fauci and others that vaccine distribution constraints could delay a resumption to normal living for some time, with Fauci saying “well into 2021, maybe even towards the end of 2021.” There is also widespread concern that vaccine approval is being rushed for political purposes, making many people unwilling to take the vaccine until there is longer term safety data. In the meantime, national case counts are beginning to increase again, up 11% over the past 14 days, and colder weather could drive a feared spike in fall and winter cases, potentially reversing states’ reopening efforts.

Figure 1: Covid-19 Cases Are on the Rise Again

Note: Includes confirmed and probable cases where available. 14-day change trends use 7-day averages. Updated on October 1.
Source: New York Times

My Take: I strongly believe it is a matter of when, not if, our lives largely get back to normal. I am hopeful that science and American ingenuity will allow that to happen by early summer 2021.

Election
The stock market prefers the lower taxes and regulations that would be guaranteed with a Donald Trump presidency. Presidential candidate Joe Biden has been steadfast in his commitment to lift the corporate tax rate to 28% from 21%. Goldman Sachs estimates that the tax hike, combined with an expected drag on GDP, would cut S&P 500 earnings per share by 12%. However, the market would likely be fine with a Biden presidency if Republicans maintain control of the Senate. It is unlikely that any Republican senator would vote yes to a tax hike, so Democrats would not attain the requisite 50 votes to pass the legislation. As of September 29, election betting site PredictIt pegged odds of a Biden presidency at 60%, Democratic control of the Senate at 58%, Democratic control of the House at 83%, and a clean sweep for Democrats at 54%.

My Take: Polling again exaggerates Trump’s voting deficit, but Biden still easily wins the presidency by taking a majority of the swing states. Within a few days of election night, Trump concedes due to margin of loss, averting chaos. A blue wave extends to the Senate, giving Democrats a clean sweep. The stock market starts to more fully anticipate this as the election nears, leading to a 5-10% correction in October into early November. 

Earnings reports
Although second quarter earnings from S&P 500 companies declined by a substantial 32% from year ago levels, the latest batch of earnings reports in late July and early August came in better than analysts’ expectations by a historical margin. Of the 90% of S&P 500 companies that reported second quarter earnings through August 11th, an all-time high 59% of them beat on both sales and earnings per share (EPS), with the average EPS beat a record 17%. Stocks rallied throughout the reporting period because the market’s forward-looking discounting mechanism incorporated a shallower earnings trough and sharper earnings recovery. Companies’ fortunes have improved alongside a host of better than expected economic data, from jobs to manufacturing to housing, despite continuing to operate in a pandemic. 

Many companies have indicated that although there has been a faster than expected snapback in their business, results may not meaningfully improve further until there is a safe and effective vaccine that allows the economy to fully reopen. Consensus estimates now have S&P 500 EPS declining by 19% for the full year, better than the 23% decline expected three months ago, according to Factset.

My Take: Earnings slowly recover further from second quarter levels, with a third quarter earnings “beat” relative to consensus expectations more in-line with historical averages. The wide gulf in business fortunes between the Covid-19 beneficiaries and those companies challenged by the pandemic continue through at least year end.

Retail investor participation
Non-professional investors have played an increasing role in the stock market, driving outsized movement in some stocks and introducing speculative froth. During the first half of the year, individual investors accounted for 19.5% of the shares traded in the U.S. stock market, up from 14.9% last year and nearly double the level from 2010. There are many explanations for this, including the move to zero-dollar commissions by most brokerages in 2019, the work-from-home phenomenon, lack of sports to bet on for much of the year, and rising markets that have drawn people in. It has been called the Robinhood effect, the idea that hordes of investors using the popular investing app are driving irrational stock moves in select names. Dramatic price moves have been seen in the likes of Tesla (TSLA), up over 400% this year, Nikola (NKLA), which epically spiked to $90 in June from $10 in March before crashing to $20 on September 30 amid fraud allegations, and Eastman Kodak (KODK), up almost 23 times in two days in July before losing over 80% of its value.

Small investors are likely behind the big jumps in options activity, as illustrated below. Option buying is important partly because it forces Wall Street banks, which sell options to investors, to hedge their positions by buying shares, accelerating stock price trends in either direction. Small investors have also flocked to special purpose acquisition companies (SPACs), another red flag. SPACs are blank-check companies set up to raise funds from investors before an announced acquisition or merger, with minimal disclosure requirements.

Figure 2: Ratio of Single Stock Options Trading Volume to Shares Volume

Note: Refers to the average daily notional traded for options versus the underlying stocks
Source: Wall Street Journal citing Goldman Sachs

My Take: Retail investors will continue to be engaged in the stock market until either stocks go through their next bear market or people are required to return to their workplace. Speculative activity will continue to occur in select names, driving above average volatility, with painful lessons likely learned before it is all over.

Client Positioning
Although I have spelled out the forces I see dictating market action, I remind you that at Glass Lake we take a long-term view focused on compounding returns in a tax-efficient manner. You will not see us make dramatic asset allocation changes based on our views for nuances in the Federal Reserve’s policy, the economy, or the election. Further, we strive for the bulk of our clients’ equity allocations be comprised of “quality growth” names that have strong and sustainable competitive advantages, above-average long-term growth prospects, and prudent levels of debt. I believe this investment philosophy affords my clients the best shot of generating maximum after-tax, risk-adjusted returns compounded over the long run. 

That said, there is room to pivot clients’ stock portfolios based on where we are in the economic cycle or because of individual stock level considerations. Indeed, some of the froth mentioned earlier has manifested itself in some of our long-held positions that became big Covid-19 beneficiaries, such as PayPal (PYPL), Amazon (AMZN) and Microsoft (MSFT), up 82%, 70%, and 33%, respectively, year-to-date. Further, some stocks purchased as Covid winners in the first couple months of the pandemic have also run considerably, such as DocuSign (DOCU) and MercadoLibre (MELI). We have slightly trimmed some of these positions across client accounts, and in the case of DocuSign, completely sold off for most client accounts. We also sold off Malibu Boats (MBUU) for clients that owned it, since the insatiable demand for boating will likely temper once social distancing is no longer required.

We used the proceeds to increase our weighting in stocks likely to perform well in anticipation of a full economy reopening at some point in 2021. These “value” or “cyclical” stocks now make up 12-19% of client’s equity positions, up from the 10-15% allocation that was introduced in June. Stocks in this bucket include home manufacturer Skyline Champion (SKY), Southwest Airlines (LUV), Royal Caribbean Cruises (RCL), commercial appliance maker Middleby (MIDD), hotelier Marriott International (MAR), gym operator Planet Fitness (PLNT), and windows & doors manufacturer PGT Innovations (PGTI). Some of our “quality growth” companies have a high degree of cyclicality as well – meaning they would clearly benefit from an economic rebound – namely credit card networks Visa (V) and Mastercard (MA), semiconductor Monolithic Power Systems (MPWR), industrial software provider PTC (PTC), and medical device company Edwards Lifesciences (EW). When adding these companies, the cyclical mix rises to 33-40% of client’s equity portfolios.

We have also used some of the proceeds to establish 3-5% combined positions in gold and silver through the iShares Gold Trust (IAU) and Aberdeen Standard Physical Silver Shares (SIVR). These exchange traded funds track the price of gold and silver and carry lower expense ratios than their larger ETF peers. Easy money policies by the Federal Reserves and potential for accelerated inflation are conducive to precious metal price appreciation. I anticipate holding these securities across client accounts for at least the next several years.

As positioned today, a client might expect their equity portfolio to outperform a flattish to down market in which economic optimism wanes and technology and growth-oriented companies continue to lead the market. There could also be some underperformance if the market surges because of rising economic recovery optimism, driving outsized gains in long-avoided banks and energy companies. The degree of variance relative to market benchmarks from this cyclical factor should be significantly constrained by the increased “barbell” approach of pairing the core quality growth names with companies that should strongly bounce back in a post-Covid world. I will continue to monitor the market environment, but do not anticipate going “all-in” on the cyclical names at any point, especially considering the tax consequences of selling highly appreciated stocks.

I remind you that although there is a lot of position overlap across client accounts, asset allocation and individual weights can vary considerably to reflect client’s unique situations. Valued clients, please contact me if your goals, values, or circumstances change so I can appropriately factor that into your asset allocation and security selection. Prospects, please let me know if you have questions about our asset management and financial planning services, or if you would like to schedule a complimentary portfolio review. I hope you and your loved ones stay healthy, happy, and wealthy during this fall season.

Sincerely,

Jim Krapfel, CFA, CFP
Founder/President
Glass Lake Wealth Management, LLC
glasslakewealth.com
608-347-5558

Estate Planning

You, or Your Parents, Probably Should Have a Revocable Living Trust

Do you have a revocable living trust? If not, you may be missing out on an incredibly useful tool used by many even modestly wealthy individuals and families. Dying with a revocable trust can spare your loved ones considerable time, money and stress as part of your asset transfer process. As you become more familiar with revocable trusts, perhaps you or your older relatives consider a revocable trust in addition to the more frequently utilized last will and testament.

What is a Revocable Living Trust?

A revocable living trust, also known as a revocable trust, is a written document that determines how your assets will be handled after you die. Assets can include investments, bank accounts, real estate, and valuable possessions. They are called living trusts because they are created during one’s lifetime. They are called revocable trusts because you can change or cancel any of the provisions prior to death or incapacitation. Assets placed in the trust are transferred to designated beneficiaries upon death. Beneficiaries can be people, organizations, or other entities. The creator of the trust is known as the grantor.

Advantages of a Revocable Living Trust

1)     Avoiding probate

Avoiding probate is usually the main reason people choose revocable living trusts. Probate is the legal process of distributing assets of the deceased’s estate to his or her loved ones. There are three overall scenarios when one dies: (1) if there was no will, he or she is considered to have died intestate, and the court will determine who receives the assets; (2) if there was a last will (but no revocable living trust), the estate must still go through the courts, but the will provides a useful guide to the person’s stated intentions; (3) if a revocable living trust was created and contains all relevant assets, then the probate process can be avoided altogether. Note that estates under $100,000 in most states do not have to go through probate whether a revocable living trust is in place or not.

Why avoid probate?

a)    Time-consuming/hassle-ridden. If assets are small and uncomplicated, and the will is not contested by potential beneficiaries, the probate process might take a few weeks or months. However, the process can take much longer, even several years, if an estate is large and complicated, or the will is contested, with assets frozen until the courts decide on the property’s distribution. A will can be contested on grounds that the decedent did not know what he or she was doing when they signed the will, the decedent was under undue influence at the time of will signing, or it was improperly executed, such as not having enough witnesses. If assets are held across multiple states, such as having a vacation home in a state outside one’s principal residence, then the probate process must take place in each state in which assets are held. That is a lot of time and stress for the executor of the estate to deal with. With an all-encompassing revocable trust, the probate process is avoided and assets are able to be immediately dispersed and/or managed on an ongoing basis by the successor trustee (more on successor trustees in a bit).
b)    Costly. The overall cost of probate can range from 2% to 7% of the entire estate value, according to LegalMatch. It will typically be on the lower end of the range if a sound will is in place, thus minimizing attorney fees that make up the majority of the cost. There is also the court filing fees set by each state, with some charging a flat fee and others based on the value of the estate. Fees may also need to be paid to other professionals such as accountants to conduct a final tax return or real estate agents to liquidate real estate property. In my home state of Illinois, the total cost of probate is typically $4,000 to $6,000 for a relatively simple estate with no disputes and a competent executor or administrator. With an effective revocable trust, since there is no probate, there will be no attorney and court filing fees, saving thousands of dollars.
c)     Public. Probate files are public court records that anyone can read. That means anyone can see what stipulations are in your will, who your beneficiaries are and what each beneficiary is inheriting. With a revocable trust, assets are distributed in private.

2)     Increased flexibility

A revocable living trust also allows for a higher degree of flexibility and specificity than a last will. You can specify that assets are fully dispersed to beneficiaries at your death, or a certain percentage of the assets are dispersed per year, or that some portion of the principal is to be set aside for a future generation. Thus, a revocable trust can “live on” well beyond the decedent’s death, unlike a last will that has no power after you pass.

All sorts of conditions, if/then-type provisions can be inserted into the trust. For example, you could specify that your niece receives 5% annual income from her half of the estate, with her portion of the remaining principal dispersed equally among her born and unborn children at the time of her death. If your niece has no children, you might say that the principal goes to her spouse, if alive, another family member, or a charity.

As mentioned earlier, the creator of the trust, also known as grantor, can easily change or cancel any of the provisions prior to death or incapacitation. By contrast, making changes to an irrevocable living trust is much more difficult. A high net worth household utilizing an irrevocable trust sacrifices flexibility for tax minimization. Irrevocable trusts move assets out of an estate to minimize paying estate taxes, which are paid on taxable estates exceeding $11.58 million in 2020. The exemption limit is set to revert to the 2017 level of $5 million in 2026 as adjusted for inflation.

3)     Assets in revocable trusts receive FDIC protection.

An often-overlooked feature of a revocable living trust is that they receive enhanced Federal Deposit Insurance Corporation (FDIC) protection. The FDIC insures up to $250,000 per beneficiary, with a maximum of $1,250,000, equal to $250,000 for the owner and each of four beneficiaries.

What to Expect in Creating a Revocable Trust

As with other big life decisions like choosing a college or buying a house, creating a revocable living trust will require some time and effort on your part. The total process, from the decision to proceed to retitling the assets to the newly created trust, can take several months, with multiple conversations with your attorney in-between. Still, the effort required upfront likely pales in comparison to the stress and hassle faced by potential beneficiaries who are grieving with the loss of their loved one.

As with the probate process, the cost of setting up a trust can vary considerably based on asset size and complexity, and whether assets are owned across multiple states. I recently oversaw the trust creation process for a seven-figure client, and it cost $4,500. Although it is a considerable financial outlay, I expect that it will pay for itself by not having to pay attorney fees and courts as part of the probate process.

Once you have decided to create a revocable living trust as part of your estate plan, you will want to take inventory of all your assets that will be retitled to the trust. A nice byproduct of this process is that all your assets will be clearly identified, therefore your beneficiaries can avoid having to scour for accounts and assets owned. You will also want to think through your goals and wishes with the understanding that you can be highly specific.

Next you will want to hire a good attorney to help craft the trust. Many people start by asking a friend, family member, accountant, or financial advisor for introductions to estate planning attorneys in their community. Wealthy individuals will often meet with two or three attorneys before deciding which one is best for them. It is not advisable to create a trust on your own or download a relatively inexpensive template from a company such as LegalZoom. That is because there are various nuances between states that need to be accounted for, and based on my own experience, the templates are built to be as generalized as possible and are unlikely to accommodate your unique wishes.

When you meet with a prospective estate attorney, it will be helpful to provide three documents in advance: a family tree of living relatives including age and state of residence, a balance sheet of assets including investment assets, real estate, life insurance, and any other valuable property, such as coin collections, art, or antiques, and copies of any existing legal documents, such as your will or power of attorney for healthcare or property. When you establish a revocable trust, the attorney will typically update your will and powers of attorney at the same time.

Your attorney will also ask you that you select a trustee and successor trustee(s). The trustee manages the assets that are in the trust. Many people choose to be their own trustee and continue to manage their affairs for as long as they are able. At death or legal incapacitation, whichever comes first, the named successor trustee steps in to take over administration of assets. Administration of assets includes managing the assets, keeping detailed records of all transactions, tax filing for the trust (trust will have its own Employer Identification Number (EIN) upon grantor’s death) and distributing the assets according to the terms of the trust. If a trusted family member or friend cannot be identified, then one can hire a corporate entity such as a bank or trust company to serve as successor trustee. Typically, several successor trustees are named in succession in the event one or more is unable or unwilling to serve.

Finally, once the trust document is fully prepared, it is crucial that you retitle all relevant property to the trust. Your lawyer may offer to do this for you. If any bank accounts, investment accounts (other than some retirement account such as IRAs and 401(k)s), or owned real estate is not retitled to the trust at time of death, then those assets must go through probate, even if they are identified in the trust document. 

Figure 3: Comparison of Popular Estate Planning Tools

Source: Glass Lake Wealth Management analysis

Summing It Up

Setting up a revocable living trust can be an excellent estate planning tool, especially as we age and assets grow. Some nontrivial upfront effort and expense can easily be outweighed with our beneficiaries avoiding a long, potentially costly probate process while they grieve. Further, considerable flexibility is afforded in a revocable living trust with ability to makes changes as circumstances or wishes change.

Just remember that a revocable living trust does not completely replace a last will and testament. Some tangible assets may be impractical to transfer to a trust, such as automobiles, furniture, or jewelry. Wishes for these assets will need to be spelled out in a will. If you have children under 18, a will must also be used to designate a guardian. Further, final wishes such as end-of-life care or funeral arrangements will need to be specified in a will, or better yet, in a separate document.   

Talk to a financial planner or qualified attorney to determine which estate planning tools are most appropriate for you. He or she will help you create the best plan based on your goals and objectives, asset level, tax burden, and special considerations.

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.