Finance, Insights

Messy Tax Season

PaulNolte-2There are only two certainties in this world, death and taxes. Taxes may be best summed up as death by a thousand cuts. This year, unlike many in the past, tax law and interpretations were not official until well into tax season, making the tax return process that much more difficult. Of course understanding taxes has been given up years ago when it was actually possible to read the law. Taxing too has been the financial markets, as their decline of last week is getting pundits excited about “calling” the next big decline. The economic data, as of yet, does not support more than a correction in the markets. The weekly jobless claims are now at lows last seen in the booming 2006-07 period, indicating the employment numbers will continue getting better in the months ahead. The Fed should be heartened too by the recent inflation figures showing producer prices rose by a hefty 0.5%. Consumers are feeling it too, as food and energy prices, due to drought and the summer blend in the Midwest, are rising quickly. Earnings season will be in full swing over the next two weeks, while economic data will likely be relegated to the back page. It could be another taxing week in stocks.

The broad selling in the OTC markets are getting investors excited, and “calling” this decline as the beginning of a broad market decline, similar to the 2000/01 decline led by technology stocks. The most dramatic declines have come from the former market darlings: social media and biotech. The broader markets have begun to suffer as well, but remain well within the “normal” range that defines a correction. The market internals still indicate some additional selling could be in the offing, but the hard-hit OTC market is getting into the range where buyers have historically stepped into the fray. What is disturbing about the market action is that the “safe” sectors, bonds, utilities and to a lesser degree, consumer staples, have been outperforming the market. This flight to safety also occurred during the January swoon, last September’s decline as well as in the fall of 2012. Each of these periods lasted from a few weeks to a month or two before reversing. This year, bonds have been gradually showing a better performance profile over the past six weeks. Were that to continue and that gap widen further, the “modest correction” that we have been experiencing could morph into something more dramatic. It is a part of the market that we are watching closely.

The reports of the death of the bond market have been greatly exaggerated. As investors dump bond funds in favor of stocks through the first quarter, bonds have regained their footing and are among the leading asset classes so far in 2014. Even in the face of the Fed tapering program that was expected to push yields significantly higher, investors have forgotten that bonds are the safe haven investment of choice during turbulent markets. That doesn’t mean it is clear sailing, as the release of inflation data is showing that inflationary pressures are beginning to build. Commodity prices have now increased on a year/year basis for the first time since May 2013.

In an effort to figure out where the market is going, we are seeing many more comparisons to markets in the past. From 1929 to 1987 and recent references to the technology crash in 2000, analysts are trying to see what template fits the markets today to prognosticate the future better. Unfortunately there really isn’t much of a template as the events of the past five years have put the financial markets in unchartered waters. From the Fed’s various QE programs to legislation changes to “the taper”, investor’s are merely guessing as to what could happen next. There are a few “known’s”, among them are valuations, which remains high by historical standards and earnings growth that is below historical norms. This combination means that future market returns are likely to be below average, however it says nothing about when or how they get there. Much like the Fed, investors are taking the data as it comes and adjusting accordingly. For our part, the increase in market volatility and poor future prospects are forcing us to reduce some equity exposure over the short-term and allow some of the dust to settle before venturing in a meaningful way, back into the markets.

They daily 100+ point swings can be nerve-wracking, however they also provide investors opportunities to buy quality stocks at bargain prices. As a result, we are holding a bit more cash than usual to take advantage of those situations as they arise. Bond investors should not be scared out of their positions, as rates should remain relatively low for most, if not all, of this year.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.