Bob’s Journal for 2/3/22

Watch Bonds, Not Stocks

The financial media focuses on the stock market, but you can learn a lot more by watching the bond market.

Usually, when stock prices head south, bond prices do the opposite. So far in 2022, things have been different.

Stocks and bonds declined at the same time. The S&P 500 was down 5.27% in the first month of 2022, and the long-term treasury bond was down 3.91%.

Bonds were the first to decline, starting in late 2021. Stocks resisted, having a strong rally in the first quarter of 2022.

Eventually, stock investors realized interest rates would continue to rise and liquidity would be reduced.

The S&P 500 had its worst month since March 2020 in January 2022. Because bonds also declined, the traditional portfolio of 60% stocks and 40% bonds had its worst month since March 2020. The Vanguard Balanced Index (VBINX) fund was down about 4% for the month of January.

The rise in interest rates is global. The number of countries with negative interest rates declined significantly the last few months.

In the United States, the decline in bonds is widespread. Tax-exempt bonds had their worst January since 2011, and investment-grade corporate bonds also tumbled.

The yield on Treasury Inflation-Protected Securities (TIPS) increased more than the yield on nominal treasury bonds. In a time of rising inflation, TIPS would be expected to at least hold their value, if not increase in value.

It is likely that the yield on TIPS rose so much because investors expect a return to historically normal growth and inflation.

If so, that’s not good for stocks in general but especially for highly valued stocks. Those valuations depend on low interest rates and strong growth.

The Federal Reserve is likely to tighten monetary policy and raise interest rates until the economy begins to look fragile or inflation is contained.

As long as the Fed is in tightening mode, bonds and highly valued stocks are unlikely to do well. The first sign that the Fed will stop tightening is likely to be a decline in market interest rates.

Another Blemish Appears for Target Date Funds

Target date funds have become the most popular investment option in most 401(k) plans, but there are pitfalls in target date funds that most investors don’t realize.

Leading up to the financial crisis, the major fund companies wanted to generate higher returns in their target date funds than their rivals. The result was many target date funds increased their allocations to stocks and reduced allocations to bonds and other assets.

Once the financial crisis hit, many target date funds suffered significant losses. Even investors who were close to or in retirement found that a high percentage of their funds were in stocks and incurred significant losses.

In late 2021, a new problem arose. Investors who purchased target date funds in taxable accounts found some of the funds might not be appropriate for taxable accounts.

The main known problem was in some Vanguard funds.

Vanguard has several share classes for the funds. There’s an institutional share class and one or more investor classes. The institutional share class has the lowest fees.

Before 2021, the institutional share class had a minimum investment of $100 million. Because of that, many smaller retirement plans didn’t qualify and used one of the investor share classes.

In 2021, Vanguard reduced the minimum investment for the institutional class to $5 million. In response, many retirement plans sold their investor class shares and bought the institutional shares.

That was a problem for people who owned the investor class shares in taxable accounts. The significant switch of investors out of the investor shares forced the funds to sell assets to raise cash to meet the redemptions.

The sales generated a lot of capital gains that had to be distributed to the remaining shareholders at the end of 2021.

That wasn’t a problem for shareholders who held the funds in 401(k)s and IRAs, because profits in those accounts are tax-deferred. But investors in taxable accounts suddenly had a large portion of their investments distributed to them as taxable capital gains.

They incurred tax bills without any warning or any action on their part.

The Massachusetts Securities Division is looking into whether the funds adequately disclosed this risk to taxable account investors. It has asked Vanguard and four other large target date fund providers to submit information about their disclosures to investors. In the meantime, the investors must pay some sizable tax bills.

Don’t Distribute Estate Assets Too Soon

Many estate executors focus on estate taxes and forget about income taxes. That can be an expensive mistake.

An estate is subject to income taxes much like an individual is. The estate must file an annual income tax return for every calendar year it is open for at least part of the year. This is separate from the estate tax return, which is based on the value of the property in the estate.

Some executors distribute income to estate beneficiaries as it is received. This ensures the estate doesn’t owe taxes on the income; the beneficiaries do, because the estate takes a deduction for income it distributes.

But if the estate doesn’t distribute income before the end of the year, the estate is taxable on it.

In addition, sometimes an executor is surprised by an income or tax item and finds the estate owes income taxes after all the estate’s assets have been distributed. Then, the executor is personally responsible to pay the taxes.

For example, some of the expenses the estate pays might not be deductible on the income tax return. If the executor doesn’t realize that until after the estate has been distributed, the estate will have an income tax liability but won’t have the cash to pay because all the remaining assets have been distributed.

Another fairly common situation is the estate receives property that is taxable as income. A stock dividend is a good example. The estate receives stock, and it is taxable income based on its value on the date of the distribution.

But suppose the estate doesn’t distribute the stock to the beneficiaries until later in the year. In the meantime, the value of the stock declined.

When the estate tax return is prepared, the estate has to recognize income equal to the stock’s value on the date the stock was received, but it deducts only the lower value of the stock on the date it was distributed to beneficiaries.

The estate is liable for income taxes on the difference, though it might have distributed all its assets.

Those are just a few examples of how an estate executor can be surprised by an income tax liability with no cash to pay it.

The best advice for executors is to retain some cash until after the final estate income tax return is filed to ensure any income taxes can be paid.

The Data

Job openings rose 1.4% to almost 10.92 million in December, which is greater than the 4.6 million Americans estimated to be unemployed, according to the JOLTS (Job Openings and Labor Turnover Survey).

The number of workers quitting jobs in December decreased 3.6% from the record high set in November. But layoffs and discharges declined by 10.7% to the lowest level in the history of the survey.

But the labor market took a negative turn in January, according to the ADP Employment Report. The report found there were 301,000 fewer private sector jobs in January than in December. Leisure and hospitality lost the most jobs of any sector, 154,000.

Also, December was downgraded to a 776,000 increase in jobs from the 807,000 jump that previously was reported.

The Dallas Fed Manufacturing Outlook Survey for January found factory activity continued to increase but at a slower rate than recently.

The Production Index derived from the survey hit an eight-month low of 16.6, but that level still indicates above-average growth. The General Business Activity Index fell six points to 2.0.

The Kansas City Fed Manufacturing Index was reported at 24 for January. December’s level was revised lower to 22 from the 24 initially reported.

The ISM Manufacturing Index for January was 57.6, a decline from 58.8 in December but still a reading that indicates high growth.

The PMI Manufacturing Index for January was 55.5, an increase from 55.0 in December.

The Chicago PMI for January increased to 65.2 from 64.3 in December, which was revised higher from the initial report.

New unemployment claims declined by 30,000 to 260,000 in the latest week. That’s the first decline in four weeks. The measure had hit its lowest level in five decades in December.

Continuing claims increased a little to 1.7 million. But the four-week average of continuing claims declined to the lowest level since August 1973.

Durable goods orders in December declined by 0.9%. But November’s orders were revised higher to a 3.2% increase from October’s level.

Excluding transportation, durable goods orders increased 0.4% in December. Core capital goods, a measure of business investment, were unchanged, and November’s 0.1% decline in core capital goods orders was revised to a 0.3% increase.

Gross national product (GDP) increased at a 6.9% annualized rate in the fourth quarter of 2021, according to the first estimate. That’s an acceleration from the 2.3% annualized growth rate in the third quarter.

The GDP increase for all of 2021 was 5.5%, the highest growth rate since 1984.

Personal consumption expenditures (PCE) as recorded by the Commerce Department declined by 0.6% in December. That follows a 0.4% increase in November.

The December PCE decline was the first monthly decline in almost a year. The decline in spending occurred despite a 0.3% increase in personal income.

The Fed’s preferred measure of inflation, the PCE Price Index, rose 0.4% in December and 5.8% over 12 months.

The core PCE Price Index, which excludes food and energy, increased 0.5% in December and 4.9% over 12 months. The 12-month increase for the core index is the highest since 1983.

The Employment Cost increased 1.0% in the fourth quarter and 4.0% for 2021. The increase for the year is the highest since 2001. The index measures both wages and benefits paid by employers.

This report and other recently issued data on salaries and prices reveal that while compensation has been rising at the fastest rate in decades, it hasn’t increased enough to keep pace with rising prices. Workers are losing purchasing power.

The Consumer Sentiment Index from the University of Michigan declined to 67.2 in January from 68.8 reported for mid-January and 70.6 at the end of December.

The latest reading is the lowest since November 2011. The index was 79.0 a year ago.

Pending home sales declined for the second straight month in December. The Pending Home Sales Index from the National Association of Realtors (NAR) fell by 3.8% in December, following a 2.3% decline in November.

The index was 6.9% lower than 12 months earlier.

The Markets

The S&P 500 rose 4.25% for the week ended with Tuesday’s close. The Dow Jones Industrial Average gained 3.20%. The Russell 2000 increased 2.27%. The All-Country World Index (excluding U.S. stocks) added 1.88%. Emerging market equities grew 1.91%.

Long-term treasuries lost 0.21% for the week. Investment-grade bonds declined 0.13%. Treasury Inflation-Protected Securities (TIPS) gave up 0.26%. High-yield bonds fell 0.08%.

On the currency front, the U.S. dollar rose 0.39%.

Energy-based commodities increased 3.16%. Broader-based commodities rose 3.73% but gold declined 2.45%.

Bob’s News & Updates

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