AI Mania Drives First Half of Year
| 2023 | 2Q 2024 | |
| International Stocks (EAFE) | +18.85% | +0.68% |
| Gold (GLD) | +12.7% | +3.46% |
| US Stocks (S&P 500) | +26.3% | +4.49% |
| Agg Bonds (AGG) | +5.5% | +0.76% |
| Real Estate (VNQ) | +11.8% | -0.28% |
| Cash (Money Market) | +5.1% | +1.31% |
Many investors follow the S&P 500 Index as a gauge of the US stock market. If the news says that the market is up 10% or down 10%, they’re usually referring to the S&P 500. The S&P 500 Index is a market-weighted index of approximately 500 stocks. While owning 500 stock positions in your portfolio may seem like diversification, because the S&P 500 is market-weighted, the bigger companies in the index -like a Microsoft or an Apple- have a much larger impact on the overall index performance than the smallest companies, such as Etsy or Walgreens. In fact, the 10 largest companies account for 36% of the total index, and the 25 largest companies account for 50%, or half, of the entire index performance.
As a result, when one of the larger companies has a big move up or down in price, it can have an inordinate impact on the overall index, even if other stocks in the index are not moving in the same direction. This was the situation in the first half of 2024, and the company propelling the movement was Nvidia, which manufactures the chips used for Artificial Intelligence (AI) applications. Nvidia, along with the other 6 tech companies making up the so-called “Magnificent 7”*, drove 61% of the returns for the S&P 500 Index during the first half of the year, increasing on average 33%, while remaining companies in the index increased an average of only 5%.
In this edition of our quarterly newsletter, we’ll talk about what this means for your portfolio, talk about the impact of it being an election year, remind you about how Required Minimum Distributions work, and share some updates at our firm.
More On AI Mania and Bubbles
The price increase over the past two years of these seven stocks, and resulting increase in the S&P 500 Index, has pushed valuations to very high levels (some would say bubble territory), with an average annual return of around 20% since the start of 2021. Should we be concerned? While those with concentrated positions in those seven stocks may have reason for concern, we think broadly diversified investors do not need to panic. As discussed on the previous page, those other 493 stocks in the index have averaged a gain of around 6% per year since the start of 2021: hardly the stuff that bubbles are made of. This is very different from the situation in 2008 when both the larger and smaller companies within the index had similarly high valuation levels.
While news talk from most sources and in conversation seems to center around the election (more on that later), among financial professionals the hot topic has been that inflation has remained stubbornly higher than the Federal Reserve had hoped and expected. Many professionals had anticipated that decreasing inflation would have already allowed the Fed to start cutting interest rates. A silver lining of the delayed rate cuts is the higher payout that short-term debt investments have enjoyed. Investors holding CDs and short term bonds have been able to continue earning attractive yields on those investments. Investment Grade Corporate Bonds are paying around 5.5% interest, with High Yield Corporate Bonds around 8% Interest. We’ve seen many clients, particularly those uncomfortable with high levels of stock market volatility, taking excess and otherwise idle cash in checking and savings accounts, and moving it into higher yielding vehicles, like CDs and bonds.
Outside of the U.S., international stocks are currently trading at a significant valuation discount to domestic stocks. For the technical folks, the current discount is more than 2 standard deviations away from the average discount. For the rest of us, that means, compared to US stocks, international stocks have only had this much of a discount about 5% of the time. Low stock prices usually mean higher dividend yields, and that is the case for international stocks right now, with their dividend yield averaging 3.2%, compared to the paltry 1.4% of the S&P 500. As we’ve said in prior newsletters and continue to believe, the combination of the low valuation and high dividend yield make international stocks a good place for equity investors concerned about the US market but still wanting stock exposure.
This leads us to think that while US market valuations are elevated, these high valuations are concentrated in a small number of names. Thus, an investor with holdings in other parts of the stock market – small caps, value companies, international stocks – should capture much less of the market downside in the event of a market pullback. Simply put, since these equity holdings have valuations that are much closer to historical averages, they have less room to fall, in the event of a broad market correction.
While seeing juicy short-term returns on some of these companies may look tempting, remember the old investment adage: Bulls Make Money, Bears Make Money, Pigs Get Slaughtered.
Election Year Jitters
In the past six months we’ve noticed that roughly half of our client meetings start with almost the exact same concern being voiced. That’s usually a good indicator that a topic deserves a newsletter article to give a fuller context to the matter and explore possible outcomes in an even-handed, data-based approach. So far this year, one concern we tend to hear repeatedly from clients is the possible impact of the presidential elections on the stock and financial markets. Regardless of the client’s political affiliation, the question usually goes like this: “I’m really worried about this country and think that if ________ wins in November, everything is going to fall apart. Should I sell all my investments?” Panic -or an attempt at market timing- is seldom the proper course of action. So it should not surprise you that the answer (regardless of which name fills in that blank) is a resounding, No. Let’s take a look at what the data says.
The graph at the bottom of this page shows stock market performance since 1950 as measured by the S&P 500. The graph is further demarcated by presidential terms and is annotated Red and Blue. During this time, the average annual return was 8.05%. If you had only invested during Republican presidencies, your annual return would have been 2.8%. If you had only invested during Democrat presidencies, it would have been 5.1%. That both of these returns are less than the return from staying invested, regardless of which party is in the White House, should be telling. Staying appropriately invested over time yielded better returns for your investments than trying to time the market based on potential election results. It’s worth noting that this data is skewed a bit by the timing of when market corrections happen. Both President Trump and President Biden had years in the middle of their terms where the market was down more than 20% and it took more than a year to recover, but the recovery occurred before the next election. Compare that to the 2008 crash that occurred one month before the election, giving President Bush all of the drop but none of the recovery. But in this circumstance too, staying invested appropriately with a long-term view led to many positive years of return after the crash and a Bull market that spanned multiple presidencies.
While election coverage tends to focus the most on the White House, data shows that Congressional elections have had a far bigger impact on actual investment returns. Let’s look at the data.
According to Gallup polls, only 16% of Americans approve of the way Congress is doing their job. Perhaps then, it is no surprise, that historically, regardless of which party has controlled the White House, the stock market has performed best when Congress is divided, with the House and Senate controlled by different parties, typically resulting in political gridlock.
Drilling deeper, regardless of which party has controlled the White House, the stock market has performed best, when both the House and Senate are controlled by Republicans. This is somewhat interesting, given that, ignoring Congress, the market has had higher returns under Democrat presidents. Just as the coinciding of the 2008 crash with the election negatively skews Bush’s data, here, the timing of the 2008 crash skews the market performance with a Republican president and Democrat House and Senate.
If now you’re asking, what is the point of using this information to try and make predictions about what the stock market will do based on November’s election results, then you have understood the primary takeaway: you shouldn’t. No one should. The reality is that the majority of short-term stock market returns, up or down, has little to do with who controls the government. This is not to say that elections don’t matter to investments. Long term ramifications of government policies, including taxes, trade policies, and spending programs (both good and bad) all ultimately have very real impacts on the economy and resulting performance of stocks, but these impacts take years and sometimes decades before they are felt in GDP data, company earnings, and ultimately your investment portfolio.
Having established that investment returns in the short term have little to do with who the President is, let’s shift to the long term, and discuss why we would never tell you “This time it’s different” (the most dangerous phrase in finance!). It is true that the next few administrations face a number of significant long-term policy decisions that, due to the unavoidable march of time, must be made over the next decade. We will leave social issues and the majority of other policy positions to discussions around the dinner table and the pundits on TV, and focus strictly on the policies that have the biggest potential impact to investments and your personal finance.
One of the biggest of these financial impacts of the election that will impact all our clients is that, regardless of who wins the election this year, the incoming Congress will need to address the expiration of the 2017 TJCA tax cuts, which temporarily reduced taxes, and will expire at the end of 2025, before mid-term elections in 2026.
On Jan 1, 2026, absent a new tax law passed by Congress, income tax rates will increase, estate tax exclusion amounts will decrease, and the standard deduction will decrease. Small business owners will lose a significant deduction on business income for certain types of businesses. Offsetting these increases will be a return of a number of popular deductions which had been suspended, including the $10,000 cap on deducting state and local taxes, personal exemptions, and miscellaneous deductions on Schedule A, including deductions for investment fees.
Both parties have started to propose a new tax bill to replace the expiring cuts, extending some of the provisions of the 2017 TJCA and eliminating others. While not really talked about in the news or first debate, this election will have bigger ramifications than most for tax changes as whoever wins Congressional elections will need to pass a new tax law, which may or may not be vetoed by a White House, if they are under divided control.
Though any change in tax law has a potential impact on most people, we focus more on the long-term challenges for government. These include the unsustainable trajectory of national debt and the solvency of our largest social programs including Medicare and Social Security, which are projected to run out of money in around a decade. Resolving these funding deficiencies require either an increase in revenue or a decrease in spending, policies that neither party seems ready to embrace.
Regardless of which political parties control the White House or Congress over the next twelve years, the unavoidable fact is that there is no magic bullet (and any politician saying otherwise should be laughed at). Simple math says that either tax revenue must be increased or social program benefits be reduced. Either one of these approaches will mean ultimately less money in consumer pockets, less money being spent in the economy, and consequentially, slower corporate earnings growth and reduced equity returns for investors.
In summation, we don’t believe the upcoming election will have a major impact on the financial success of individuals who are appropriately invested. The financial challenges our country faces will remain regardless of who sits in the Legislature, or in the Oval Office. Japan and Europe have already grappled with some of the same difficulties, and we have the benefit of seeing what has worked and not worked and applying those lessons to our own country. Most importantly, we continue to have confidence that by remaining invested for the long-term, and by focusing on diversified investments that include certain Bond or Fixed-Income Securities, International Value Stocks, and selective U.S Equities, our clients will continue on their financial journey with a portfolio that is designed to outpace inflation and to weather the ups and downs of the economy regardless of who holds office.
IRA Required Minimum Distributions
As you navigate retirement, one critical aspect to manage is your Required Minimum Distributions (RMDs). Understanding and effectively handling RMDs can significantly impact your retirement finances, ensuring you make the most of your hard-earned savings.
RMDs are mandatory withdrawals that must be taken from certain retirement accounts, such as traditional IRAs, 401(k)s, and other qualified accounts starting at age 73. The amount of your annual RMD is based on the account balance as of December 31 of the previous year and your life expectancy as determined by the IRS.
Managing RMDs requires careful planning and a strategic approach in order to minimize the tax impact and maximize the amount of after-tax money you receive from your investments during retirement. By understanding the rules, leveraging strategies like QCDs, and considering Roth conversions, you can optimize your retirement income while minimizing taxes and penalties. Here, we’ll explore the essentials of RMDs, including Qualified Charitable Distributions (QCDs), penalties for non-compliance, and strategic approaches to managing these withdrawals.
Qualified Charitable Distributions (QCDs)
One effective strategy to manage RMDs and support your philanthropic goals is through Qualified Charitable Distributions (QCDs). A QCD allows you to directly transfer up to $100,000 annually from your IRA to a qualified charity. This distribution counts towards satisfying your RMD but is not included in your taxable income, providing a dual benefit: fulfilling your RMD obligation and reducing your tax liability.
For example, if you are required to take a $20,000 RMD but choose to donate $10,000 to a charity through a QCD, only $10,000 will be included in your taxable income. This approach is particularly advantageous if you do not need the full RMD amount for living expenses. It also applies regardless of whether you itemize or take the standard deduction on your taxes.
Penalties for Non-Compliance
Failing to take your RMD can result in significant penalties. The IRS imposes a 25% excise tax on the amount not withdrawn (reduced to 10% if corrected timely). For instance, if your RMD is $20,000 and you fail to take it, you could face a penalty of up to $5,000. This substantial penalty underscores the importance of timely and accurate RMD management.
Strategies for Managing RMDs
Strategic Withdrawals: Plan your withdrawals carefully to manage your tax bracket. Taking distributions from other accounts or spreading your monthly distributions between taxable and non-taxable sources over the year can help avoid a large tax bill.
Roth Conversions: Consider converting a portion of your Traditional IRA to a Roth IRA. While the conversion is taxable, Roth IRAs are not subject to RMDs, potentially reducing future RMD amounts and associated taxes possibly for decades into the future. Additionally, Roth accounts are generally not taxable to your heirs unlike traditional qualified retirement accounts, which often come with a hefty tax bill to beneficiaries.
Splitting Distributions: If you have multiple IRA accounts, you can take the total RMD amount from one or more accounts, allowing flexibility in managing your investments and withdrawals.
Reinvesting Distributions: If you do not need the RMD for living expenses, consider reinvesting the funds in a taxable brokerage account. This strategy allows you to continue growing your assets while maintaining liquidity.
Coordination with Other Income: Align your RMDs with other income sources to manage your overall tax burden. For instance, coordinating RMDs with Social Security benefits and other retirement income can optimize your tax situation.
Plott and French Updates
It has been a busy year at Plott & French and we have a number of things going on, we want to take a moment to update you on.
Happy Retirement Paul!
First off, as many of you know, Paul French is one of the original co-founders of our firm. Paul has been gradually transitioning into retirement over the past few years and he has decided to now officially retire from day-to-day operations. Paul originally started in Financial Services in 1997, before joining with Mary Plott in 2005 to form Plott & French Financial Advisors.
While Paul will no longer be meeting with clients or regularly in the office, he will continue to provide guidance and advice on the direction of the firm. Paul has incredibly fond memories of all the great relationships he formed with his clients over the years and hopes to maintain those relationships in retirement. Though Paul is no longer physically in the office, if you’d like to reach out to him on a social level, just give us a call and we’ll put you in touch with him.
New Galax Office Location
Justin Stone, our newest advisor, has been working hard getting our satellite office in Galax up and running. Having spoken to clients and other professionals in and around Galax, we observed a lack of and desire for more comprehensive financial planning and holistic wealth management in the area. Comprehensive financial planning -as opposed to commission-based selling of financial products- is one of the hallmarks of our firm’s philosophy and we’re excited that our new office will allow further opportunities to bring our client-focused financial management approach to the Galax and surrounding communities.
We are pleased to have Justin as the primary servicing advisor for clients wanting to meet in the Galax office. But just like at any of our offices, our firm takes a team approach to client success. Our Galax office will benefit from the same collaborative pool of advisor expertise and have access to the same excellent professionals in our network with whom we routinely consult and to whom we refer our clients.
Client Appreciation Baseball Night
For the second year running, we have enjoyed an overwhelmingly positive response to our client appreciation nights with the Pulaski River Turtles baseball team. Over 200 people have attended or plan to attend one of the three games this summer.
We love the opportunity to see so many of you in a more casual setting and we welcome any suggestions or feedback on other client appreciation events you would like to see.
As mentioned in the past, the best way to stay up to date on events and activities is to follow our Facebook page, which you can find by scanning the QR code on the back page of this newsletter.
2024 “Best Of Virginia” Winner
We were thrilled to learn that we have been named as the 2024 Best Financial Planning Firm in Southwest Virginia by Virginia Living Magazine*, beating out a number of larger national firms with offices in Roanoke, Abingdon, and Martinsville.
Thank you to all of our clients who voted for us, and for the trust and confidence in us that your support shows. We don’t take that trust for granted and will continue to spend every day justifying it.
*Awards & recognitions by unaffiliated publications are not an endorsement of Plott & French Financial Advisors and may not be indicative of an investor’s future experience. “Best of Virginia” winners were chosen based on a voting survey of reader favorites in a category. Plott & French did not solicit votes and has not paid a fee for inclusion on the list or recognition of the award. https://virginialiving.com/best-of-virginia/2024/
