InSight

Market InSights:

There Is Too Much Money

You read that right, there is simply too much cash in the capital markets to not see a handful of effects that could impact your investments and plan. The supply of money floating around is massive right now. There is a lot of risk, COVID has us concerned about the economics of the coming year, but it’s getting harder and harder to ignore how much cash has been made available.

Even relative to itself, it’s a volume of cash in the money supply that will take at least a decade to settle into long term investments, or be recaptured by the Fed. At the beginning of the year there was roughly $15T in circulation held in cash and cash equivalents. We are in December and the number is closer to $19T of more highly liquid cash in the world. This $4T expansion in only 12 months is remarkable.

Here’s some history on money supply. It took until 1997 to reach the first $4T in circulation, the decade from 2009 to 2019 saw that supply double from $8T to almost $16T (the fastest doubling ever), resulting in a major part of the expansion of the stock market for that decade. Now, in twelve months we have seen a flood of almost 27% more money in the supply than there was at the beginning of the COVID-19 pandemic. 

One of the best leading indicators for where capital markets are headed, can be found in how much money, especially highly liquid money like cash, is available in the system. This is a reflection of how big the pie is. Usually in investments we are focused on cash flow, and a companies market share – or how effective a company is at capturing cash flow from a given size of market. That’s becoming less relevant as the sheer volume of cash has exploded. The pie is so big right now that there will have to be a a few notable adjustments to make:

InflationWhile I have heard that Jerome Powell has not registered an increase in inflation yet, it is hard to believe that as the newly introduced money will not have an expansive effect on the costs of goods and services. Many mark the inflation rate off the CPI, grievances with that benchmark aside, it would be irresponsible to assume that the basket of securities they mark to market does not see an above average increase as more money finds its way into the same number of consumer goods. Additionally, elements like rents will see a disproportionate increase in the coming decade because while supply of say consumer goods will increase quickly to capture this cash, construction of rental properties is a less reactive market and a slower roll out to correct the market. In the meantime expect rental costs and revenues to see above average inflation figures. 

Interest Rates – Permanently impaired. As I write this the current observation, the 10 year US Treasury is paying 0.9%, a third of where it was even 2 years ago. It is heard to believe that such a robust introduction of cash doesn’t become a permanent downward pressure on fixed income assets for the foreseeable future. Unless there is a formal and aggressive contraction of the money supply, it will take decades for the amount of cash in circulation to let up that downward pressure on bonds. Interest rates in short term assets will be particularly affected as the demand has become less appetizing in contrast to long term debt, and the supply of cash is chasing too small of demand. 

EquitiesThe real benefactor here. It is hard not to believe that over the course of the coming decade, this cash infusion doesn’t trickle its way up and into the stock market and other asset values. Generally the most “risky” part of the market is the historically the benefactor of excesses in cash. Companies will do what they do best and capture this supply of cash through normal operations, this will expand their revenues and ultimately the bottom line. Additionally, the compressed borrowing costs from low interest rates will lower their operating costs. Compound the poor risk reward ratio in bonds and you will see more of those investments seek out stocks, real estate, and other capital assets. This sector will see a virtuous combination of more revenue, and more demand for shares. Expect permanently elevated P/E reads for the time being. 

 

More related articles:

boulder colorado financial advisors, financial planning and risk management
Articles
Kevin Taylor

Section 1031 Exchange and Your Primary Residence: How They Can Work Together

When it comes to a 1031 exchange, your primary residence is generally excluded. According to the rules of Section 1031 of the Internal Revenue Code (IRC), property used for personal purposes, like a primary residence, doesn’t qualify for tax deferral. The law only applies to properties that are “held for productive use in a trade or business or for investment.” However, there are situations where your primary residence is part of a property with business or investment land, and in these cases, a Mixed-Use 1031 Exchange may apply. Mixed-use property and a 1031 Exchange A mixed-use exchange happens when the property being sold includes both a primary residence and land or structures used for business or investment purposes. Part of the property may qualify for a 1031 exchange in these scenarios, while the residential portion could be eligible for Section 121 benefits (more on that in a minute). Examples of mixed-use properties include: A home office where a business rents space in your house. A farm or ranch where you work the land as a business but live on the property. A duplex where you live in one unit and rent out the other. A single-family home with an accessory dwelling unit (ADU) that you rent out while living in the main home. As long as part of the property is used for business or investment, it could potentially qualify for a mixed-use 1031 exchange. The IRS Code: Section 1031 and Section 121 Here’s the breakdown: Section 1031 allows you to defer capital gains taxes on properties used for business or investment when you exchange them for similar properties. Meanwhile, Section 121 allows homeowners to exclude up to $250,000 ($500,000 for joint filers) of capital gains on the sale of their primary residence if they’ve lived there for at least two of the last five years. So how do you take advantage of both sections? It’s all about identifying your “principal residence”—which is typically your primary home (not your vacation home). Your primary residence can also include parts of a property that are used for business or investment. Key Questions About Combining Sections 1031 and 121 How is the Section 121 exclusion calculated? The calculation of the exclusion for your primary residence involves determining the original purchase price of your home, the cost of improvements, and the value of the residential portion of the property being sold. You can determine the value with a market analysis from a realtor or an appraisal. For joint filers, the exclusion can be up to $500,000, while single filers get a $250,000 exclusion. A common issue arises when a property has both a personal residence and a 1031-eligible business portion, and no value is explicitly allocated between the two. A current market analysis or other valuation methods can help. Consider factors like the per-acre value of the residential part compared to the larger investment property and the home’s insurance value. How is the homesite defined? When valuing the residential portion of a mixed-use property, it’s helpful to think of the land and features that contribute to your enjoyment of the home—this could include gardens, septic systems, small pastures, and more. Using aerial photos is often a smart way to determine the homesite’s boundaries and help make the valuation more precise. A Hypothetical Example Let’s walk through a simple example: Total sale price: $2,500,000 Residential portion: $800,000 Basis in the primary residence: $300,000 Section 1031 portion: $1,700,000 In this case, the primary residence portion is valued at $800,000, so the taxpayer could exclude the gain on that amount (up to $500,000 for joint filers, $250,000 for singles). Applying the 121 Exclusion to Debt Payoff One of the benefits of using the Section 121 exclusion is that you don’t have to reinvest the sale proceeds in another property. If there’s debt associated with the property, the Section 121 exclusion can help cover the debt payoff. In our example above, if the taxpayer owes $500,000 in debt, they can apply the 121 exclusion to cover that, meaning they don’t need to replace the debt with new debt in the 1031 exchange portion of the transaction. How is the 121 Exclusion Documented? The key to documenting the allocation of proceeds is ensuring there’s a clear separation between the 1031 exchange portion and the personal residence exclusion. The settlement statement from the sale will have line items showing both: one for “cash to exchanger (personal residence)” and another for “exchange proceeds to seller” (handled by the qualified intermediary). When Doesn’t Section 121 Apply? Section 121 won’t work if the property is part of a business held by a corporation or partnership—since these entities can’t own a primary residence. However, if you’re an individual or a disregarded entity like a single-member LLC or sole proprietorship, you can use the exclusion. It’s also possible to distribute the personal residence out of a business entity before the sale, but you’ll need to plan ahead—this needs to happen at least two years before the sale. Final Thoughts The Section 121 exclusion can give you a significant tax break by putting cash in your pocket without the need to reinvest. For mixed-use properties, taxpayers can use the Section 121 exclusion for the residential portion of the sale, while using Section 1031 for the business or investment portion. Keep in mind, though, that when participating in a 1031 exchange, your intent must be to hold the replacement property for productive use or investment in the long term. It’s crucial to consult with a tax or legal advisor when structuring a 1031 exchange or when considering any changes to your investment property.

Read More »
Articles
Kevin Taylor

Should you own Zombie Apocalypse Insurance?

Should you own Zombie Apocalypse Insurance?: Four risk mitigation disciplines to get familiar with Zombie Insurance exists…yes really, if only as a marketing ploy for insurance shops. But it gives us a great reason to discuss the different types of risks, and the disciplines that exist to mitigate the given risk set. Zombie Apocalypse Risk is both an unmitigable risk, there is little if anything you can do to avoid an apocalypse. And it’s also not cost-effective, the replacement of anything lost in the apocalypse is unlikely – the insurer after all is very likely a zombie in this scenario. So it’s an easy “don’t buy it” recommendation. But how about others’ risks? Tax, fire, disability, market, etc. all exist daily, and all have nuanced methods for handling them. Cost-Effective Not Cost-Effective Mitigable Homeowners Insurance (Buy it) Annual Downside Puts for Market Protection (likely don’t buy it) Unmitigable Life Insurance (Buy it sometimes) Zombie Insurance (come on?!?!) Effective risk mitigation requires understanding both the financial risk at play and the full length of consequences that result from the strategy a person or family chooses. Tax Risk is a great topic to think about. Most investors “Accept” Tax Risk and pay their taxes at the end of each year depending on their income and gains from the year before. You bought the stock, it went up 20% forgo 5% as a cost of doing business and pay your income and gains tax on it. Some Investors might “avoid” tax risk by using investment strategies, 401ks, IRA’s, or other legal means of tax avoidance. Further, still, some may limit their tax exposure by using several different investment strategies and holding strategies by spreading out the tax risk over time or using income streams that are taxed in different ways. Further still, some may use tax risk transference through trusts, gifting, and other asset location strategies to manage it. Tax risk is just one flavor of risk, but almost every conceivable risk can be filtered through the strategies below to make the existence of risk far more tolerable. Risk Acceptance There are several risks you “accept” every day regardless of the calculus. The risk of an airplane part striking you at a wedding is really low, so you simply accept that risk and head outside. The risk of a single down month in the stock market is high, and so is the cost to insure against it. Risk acceptance as a strategy is about balancing the likelihood of that risk happening, the financial impact it would have, and properly pricing the below strategies to handle the risk. Risk acceptance does not reduce any effects however it is still considered a strategy. The “acceptance” strategy is a common option when the cost of other risk management options such as avoidance or limitation may outweigh the cost of the risk itself. A company that doesn’t want to spend a lot of money on avoiding risks that do not have a high possibility of occurring will use the risk acceptance strategy. Traditionally, risk acceptance can be the key to investment upside. The performance of the S&P 500 is a great example. If you simply accept the risk you will have more up years than down years, and the result will be net returns of about 9% year over year. If you used financial products to mitigate the financial consequence of a down year, it could cost you between 8-10% of the return to fully inoculate the risk. Leaving you with little to no return. So there are several times where risk acceptance is the more rewarding outcome. Risk Avoidance The risk management effort is a process to target and control the damages and financial consequences of threatening events, risk avoidance seeks to avoid compromising events entirely. This is equally an activity you likely engage in regularly. You, like me, may not attempt amateur base jumping daily for a myriad of reasons. This simple act of not participating is a risk management strategy. When determining how you will approach risk, it’s important to not confuse the strategies of risk avoidance and risk acceptance with a very different concept “risk ignorance.” Risk ignorance stems from two very different but connected problems. The first is a knowledge gap, this is a problem with risk-takers’ understanding of a market, investment, process, etc. where they simply don’t have the skill set required to uncover and handicap all of the potential risks. When I don’t work on the inner workings of my vehicle it’s an acknowledgment of that knowledge gap. The second gap, and likely harder to uncover, is a competency gap. This is the knowledge that the risk exists, but poor reconciliation of an investor or person’s skill to overcome the difficulties. Think about new building construction. The builder might know that the risk of financing can fall through, so they have crossed the knowledge gap, but if a project still falls through because of a lack of coordination, effort, or something else entirely it fell victim to mispricing of the competency gap. Risk avoidance is one of the least understood methods used by investors and as a result drives two negative behaviors. Rationalization or compartmentalization. In this first, investors fall in love with an idea, stated returns, or a story and begin down a path they believe is “risk avoidance” but is actually rationalizing them into risk ignorance. The second “compartmentalization” is a form of risk avoidance but for the wrong reasons. An investor may not understand a product or service and as a result, shut down a whole category of strategies. A great example is in derivatives, many people attribute the financial crises to derivative products and thus write off the whole group regardless of other tactics that might support their goals. A lack of sophistication and understanding of risk is a common source of aversion, failure to change advisors, or even seek investment advice in the first place. Risk Limitation Risk limitation is the most common strategy.

Read More »
risk management boulder colorado financial planners
Articles
Kate Palone

Retirement Account Rollovers

Land a new job? Don’t forget about your 401k! What’s great about a 401(k) retirement savings plan is that your assets are often portable when you leave a job. But what should you do with them? Rolling over your 401(k) to an IRA (Individual Retirement Account) or Roth IRA is one way to go, but you should consider your options before making a decision.  This information should help you decide. Option 1 – Leave your money in your former employer’s plan, if your former employer permits it:                                  Benefits: Any earnings remain tax-deferred until you withdraw them.  Under federal law, assets in a 401(k) are typically protected from claims by creditors.  Required minimum distributions (RMDs) may be delayed beyond age 73 if you’re still working. You’re age 55-59.5 and might need withdrawals – (Age 55 Rule intact) You want maximum creditor protection – ERISA protection stays. Examples of Protection: Sued for personal injury? Assets in your 401k cannot be touched. Filed for bankruptcy? 100% of your 401k assets are exempt. Divorce? It’s subject to division by qualified domestic relations order (QDRO), but otherwise protected.                           Things to Consider: You can no longer contribute to a former employer’s 401(k). Managing savings left in multiple plans can be complicated. Fees once paid by the employer for account management, hosting, management, etc. can now be assessed directly from the account.  Inaccessibility – You may need to contact the former plan administrator or employer to manage funds and make requests.  Must conform to the investment standards and practices of the existing plan and any future changes the plan makes. Option 2 – Roll over your money to a new 401(k) plan:                                  Benefits: The new 401(k) may have lower or higher administrative and/or investment fees and expenses than your former employer’s 401(k) or an IRA. Any earnings accrue tax-deferred. This keeps the Rule of 55 intact (last employer).                           Things to Consider: Rolling over company stock may have negative tax implications due to the potential loss of Net Unrealized Appreciation (NUA). Option 3 – Roll over your 401(k) to a Traditional IRA:                                  Benefits: Your money can continue to grow tax-deferred. You have access to investment choices that are not available in your former employer’s 401(k) or a new employer’s plan. You can consolidate multiple retirement accounts into a single Traditional or Rollover IRA to simplify management.                           Things to Consider: A Traditional IRA may have reduced protection from creditors and lawsuits, depending on your state. (Non-ERISA Account) Protection Level: Good in bankruptcy, weaker outside of it in which  Whether or not you’re still working at age 73, RMDs are required from Traditional IRAs. Rolling over company stock may have negative tax implications due to the potential loss of Net Unrealized Appreciation (NUA) Some IRA providers have annual fees for management and holding assets. Backdoor Roth Issues: Having pre-tax dollars in a Traditional IRA complicates the Backdoor Roth strategy. By keeping your pre-tax dollars in a 401(k) this avoids the pro-rata rule that can cause a tax hit. Option 4 – Roll over your Roth 401(k) to a Roth IRA:                                  Benefits: You can likely roll Roth 401(k) contributions and earnings directly into a Roth IRA tax-free. You can consolidate multiple retirement accounts into a single Roth IRA to simplify management.                           Things to Consider: A Roth IRA may have reduced protection from creditors and lawsuits, depending on your state. (Non-ERISA Account) Any Traditional 401(k) assets that are rolled into a Roth IRA are subject to taxes at the time of conversion. Some investments offered in a 401(k) plan may not be offered in a Roth IRA. Option 5 – Take a cash distribution:                                  Benefits: If you find yourself in extraordinary need, having cash could be helpful.                           Things to Consider: Taxes and penalties may be substantial. Withdrawals before age 59½ may be subject to a 10% early withdrawal penalty and will be taxed as ordinary income. Cannot “make up” those contribution years. Reach out to us for assistance in selecting the best option for your retirement plan- everyone’s situation is unique!

Read More »

Pin It on Pinterest