Founder & Chairman
To taper or not to taper? I know what you’re thinking, what the heck is a taper? No, it’s not a sewing term, well it is but just not in this newsletter. Lately, whether the Federal Reserve will begin to “taper off” its bond purchasing is all the market can seem to focus on. The big question: can the economy stand on its own without the support of the Fed? Nobody knows the answer to that question, but I’d be surprised if the Fed actually begins to taper this month. Not shocked, but just surprised. There is evidence that the economy is better, auto sales have been pretty brisk as an example, but you have to wonder what higher interest rates would do to the finance market for big purchases such as cars and houses. The housing market has cooled off in the last couple of months. Is that because summers end has people doing everything but looking for a house, or is it perhaps that mortgage rates are a full percentage point higher today than they were in June?
Regardless of when the Fed begins to taper, the fact is, they will at some point. From our standpoint, we expect an increase in volatility over the next month or two. On top of the tapering debate, there is that little issue of the debt ceiling lurking around the corner. The likelihood of the U.S. Government defaulting on the U.S. debt is remote however the media will do its level best to make you think it could really happen. They can be pretty convincing when they want to. There are a couple of key negotiating concessions that we believe may resolve the impasse. The republicans are looking for a change in the way CPI is calculated to determine future increases in social security payments to recipient called chained CPI. Chained CPI acknowledges that when the price of an item gets too high, people do not simply pay that higher price, they substitute something cheaper. If the price of beef gets too high, people buy more chicken. Chained CPI does not grow as quickly as conventional CPI. Thus, using chained CPI would slow the rate of growth of Social Security payments.
The democrats are looking for an end to the “stretch out” IRA for non-spouse beneficiaries. This means anyone other than a spouse who inherits an IRA will have to withdraw the entire IRA balance within five years of the owner’s death. There has been a significant amount of IRA planning to engage the stretch-out for children, and it looks like that may be off the table. This will open the door to other strategies, and we think if it takes place, the next best way to handle the tax burden may be the purchase of life insurance for those who are inclined and healthy enough to qualify.
None of this is set in stone, but we think at this point it’s the most probable outcome. To reiterate, while we think these are the likely concessions, there will be talk about much more drastic changes, and both parties are likely to ask for the moon and stars before it’s all over. It’s the negotiations over the celestial bodies that will probably lead to an increase in volatility in the market. We believe that it’s all noise, and relatively short lived. If you really believe that the U.S. will default on its debt, that could be a game changer, and would increase the odds of a prolonged market decline and would call for a different strategy. That is not what we expect. The increased volatility would just be an inconvenience and possibly even an opportunity to increase equity exposure a bit. Too early to call just yet, but we are watching the situation closely.
The algorithm updated over the labor-day weekend, we’ve made some adjustments to the portfolio as a result. Most of the models changed to some degree, and for those of you who have given us authorization to make changes without prior contact, those changes have already been made to your account. If we do not have a discretionary agreement in place for you, then you will have to notify our staff that you would like the changes to be made.
Lastly, I would like to address the bond market. There will always be short-term volatility in the investment markets. The bond market is no exception. One of the easiest mistakes to make is to overreact to an abrupt change in any market. In June, the Fed made a reference to exiting their bond purchasing program earlier than expected. That roiled the markets, especially for bonds, interest rates moved up sharply, equities fell and bond prices fell even more. We viewed that commentary as a litmus test, the Fed saw that the markets weren’t happy with the result, and have since backed-pedaled a bit. That’s not to say that the Fed still won’t allow rates to move higher, but it’s probably not going to happen quickly. Equities have since recovered a good portion of their losses, while bonds have made up much less ground. It would be foolish to assume you know what is going to happen. There is simply no way to know for sure what the Fed will do and how bonds will react. The knee-jerk reaction would be to sell the bonds, but we think that would be a mistake right now. Rates could just as easily move back down in the coming months. Remember, the Fed is more concerned about job creation than anything else. Typically, you see rates rise when the economy needs to be cooled off, or the threat of inflation becomes a problem. Neither of those two conditions is present at the moment. In fact, you could make an argument that the opposite conditions are more the case. For now, the prudent course of action is to monitor the situation closely, and wait for the Fed to make their next move.
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