What's Going on in the Markets for August

When I take a step back from what is happening in the economy and look at the major U.S. market averages, I see an incredible disconnect. And I am not alone.

U.S. Gross Domestic Product (GDP), which is the broadest measure of the value of goods and services in the economy, fell at an annual rate of 32.9% in Q2 2020, the largest decline on record (Source). The prior record, a 10.0% annualized decline, occurred in 1958 and coincided with the Asian flu pandemic.

The contraction can be blamed on the unusually swift decline in the economy that began in March and quickly accelerated in April.

It does not take an economist piecing together a complex puzzle to discover the culprit.  Simply look at the lockdowns designed to slow the spread of Covid-19. They stifled economic activity and threw tens of millions of people out of work. 

In April alone, employment fell by a record 20.8 million (source). For perspective, 152 million individuals were employed in February.

However, May and June saw a significant improvement from these very depressed levels. 

The economy generated a record number of jobs in May and June, erasing one-third of March and April’s job losses (source).

We also saw big gains in retail sales following a record decline in April (source), as businesses began to reopen, furloughed employees returned to work, and stimulus money ($1,200 checks and generous jobless benefits) found its way into the economy.

Nevertheless, the economy remains far below its pre-coronavirus state, as evidenced by the steep decline in Q2 GDP.

Here is another way to look at the economy with one simple data point. In February, the unemployment rate was at a 50-year low of 3.5%. In July, the jobless rate dropped once again to 10.2% (below April’s 14.7% peak). (Source) This is positive news that may be signaling the recovery in the economy.

Yet the major market averages tell a different story. 

As July ended, the broad-based S&P 500 Index turned positive for the year, while the tech-heavy NASDAQ Composite is having an impressive year (Table 1). Some of the larger tech stocks appear to be more insulated from the initial impact of the Covid Recession, and investors have taken notice. These large tech stocks being insulated frankly makes sense when you think about the nature of their business. Some of the businesses (Amazon for example) not only survived but thrived in a lockdown environment. 

We also wanted to point out another historical comparison to what is seemingly going on now. That is the tech bubble of the early 2000s. Are these tech giants pushing the markets into over inflated territory? Are we seeing another tech bubble growing? Perhaps to both fronts. The markets (especially the NASDAQ) have been hitting levels not seen before. It does seem that the market may be over inflated, and it does look eerily like what was going on in the early 2000s. 

However, we also think things are markedly different. Consider what was going on in the tech bubble of the 2000s. This new internet thing was getting everyone excited to build a tech company. So excited in fact, that you literally had companies go public and get millions of investment dollars simply because they were a technology company! The bubble in the end was created because you had many companies build wealth and grow with no real business/revenue/profit to show for it. Hence the bubble forming and eventually popping.

In comparison if you look at what is happening here, these tech giants that are leading the market rally, are they overvalued? Perhaps. Are they getting massive investment? Perhaps. Do they have little to no profit/revenue to show for it? Probably not. These companies are massive because they are making massive amounts of revenue! In fact, one of the companies (Apple) became the first trillion-dollar company! (source)This situation is different because these companies are not capitalizing on the new fad of the internet, which many people in the early 2000s were still figuring out. These companies are making massive amounts of revenues because their business models are successful. They are good companies. So, we do not necessarily think that we are seeing another bubble, but a new age in the market.

The Federal Reserve’s massive response to the crisis, coupled with a strong response by the federal government, has also encouraged buying. In addition, investors may be looking beyond a dismal Q2, both in terms of GDP and profits, and attempting to price in more favorable conditions later in the year and into 2021.  

Very Limited Visibility

The recession that began in February (per the National Bureau of Economic Research) appears to have ended in April, which would make it the shortest on record. However, it may be months before the NBER, which is the official arbiter of recessions and expansions, decisively calls the bottom.

I do not want to dismiss May and June’s upturn in the economy. It has been encouraging to see economic activity bounce higher and millions return to work. Still, the outlook remains unusually uncertain. 

As states around the country began to reopen, the number of Covid-19 cases has spiked, injecting a new round of uncertainty into the outlook.

To contain the virus, some states have slowed reopening and others have implemented new restrictions.

If we look at what is called “high-frequency data,” such as daily air travel through TSA checkpoints, daily restaurant books via OpenTable, and daily requests for directions via Apple Maps, economic progress slowed or stalled in July. 

These metrics do not correlate perfectly with the economy or the larger S&P 500 firms, but they approximate what is happening in the broader economy.

Further, layoffs remain at historically high levels as measured by weekly jobless claims (source). Yes, a record number of people are going back to work, but layoffs remain high.

The Prescription

The spread of Covid-19 is hampering the recovery and creating a new round of uncertainty. Might this be temporary? Might new cases begin to slow in August and September? Could we see a second wave in the fall and winter? There are no clear answers.

Today, the path of the economy is linked to the virus. Hence the unusual degree of uncertainty.

Yet, there has been encouraging news regarding a vaccine. When developed and readily available, a vaccine could be just the right prescription that could greatly increase confidence to venture back into restaurants, movie theaters, airplanes, and sports arenas. 

As Fed Chairman Jerome Powell said in prepared remarks in late July, “The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in keeping the virus in check.” (source)

Social distancing, masks, and all CDC-recommended safety protocols are a step in the right direction. However, a vaccine and/or an effective treatment are probably the best way to enhance mobility and help us move past this difficult chapter in our country’s history.

The economy may not be the same when the pandemic is eventually in the rearview mirror, but we are a resilient people, we will persevere, and we will adapt.

Table 1: Key Index Returns

Source: Wall Street Journal, MSCI.com, Morningstar, MarketWatch

MTD return: Jun 30, 2020-Jul 31, 2020

YTD return: Dec 31, 2019-Jul 31, 2020

*in US dollars

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing.

Considering a Roth IRA

There are many vehicles to choose from as you travel the road to retirement. One of them you may consider to utilize to build a nest egg is the Roth IRA. 

A Roth IRA is an Individual Retirement Account that allows you to contribute after-tax dollars into a savings or brokerage account. (source)

The after-tax dollars won’t allow you to claim a tax deduction as you might on a traditional IRA, but withdrawals are not subjected to federal income taxes when withdrawn after 59 ½ years of age, as long as the account has been opened for at least five years. (source) Depending on state law, Roth IRA distributions may be subject to state taxes.

Like a traditional IRA, interest, dividends, and capital gains are sheltered from taxes inside the Roth. 

We here at Centennial Financial Group, LLC are becoming more and more aggressive with using these Roth IRAs. We are doing so because we think that taxes have a good chance of increasing at some point in the future. The simple explanation is this massive stimulus and other actions the government is implementing must be paid for somehow.

Tax Time 

Subject to income limits, you may contribute up to $6,000 per year if you are under 50 and $7,000 per year if you are 50 or over. (source)

We are past the tax deadline for 2019, but it is not too early to begin thinking about 2020. However, let us be aware of income limits. (source)

For someone who is single (or head of household), you are eligible to make the full contribution to a Roth if your modified adjusted gross income (MAGI) is under $124,000 for the tax year 2020. The limit gradually declines between $124,000-$139,000. Above $139,000, Roth contributions are not allowed.

If you are married and filing separately, the rules become a little more complex so let us talk if you are in this category.

If you are married and file jointly (or qualified widow/widower), MAGI must be under $196,000 for the tax year 2020, while the contribution limit is gradually phased out between $196,000-$206,000. Above $206,000, Roth contributions are not allowed.

You may contribute to a Roth and a traditional IRA, but you may not exceed the prescribed annual limits.

In addition to tax-free withdrawals, Roth IRAs are not subjected to required minimum distributions. 

Further, under the SECURE Act, an inherited Roth IRA (and a traditional IRA) must be distributed within 10 years if the beneficiary is not your spouse (in most cases). (source)

Unlike a traditional inherited IRA, the distributions are tax free. And beneficiaries may let the Roth account grow tax free until year 10, when the distribution is required.

High-Income Taxpayers and the Backdoor Roth

If you have a healthy six-figure income, hard limits prevent you from contributing directly to a Roth. But income limits do not exist for converting a traditional IRA into a Roth, which leaves a loophole for high-income taxpayers. 

Long story short, you may contribute to a non-deductible traditional IRA, open a Roth IRA, convert the contribution into the Roth IRA, and pay the taxes on any appreciation. Converting from a traditional IRA to a Roth IRA is a taxable event.

Conceptually, the backdoor Roth strategy is relatively straight-forward if you have no other IRAs. If there are other IRAs in your name, taxes may be pro-rated. We will avoid getting into the minutiae, but we would be happy to work the numbers out for you, as that is what we are here for. (source)

Or, before considering a Roth IRA or a backdoor Roth, you may want to consult with your tax advisor. 

I hope you have found this review to be helpful and educational. 

I understand the uncertainty facing all of us. We are grappling with an economic and a health care crisis. It is something none of us have ever faced. We have addressed various issues with you, but I have an open-door policy. If you have questions or concerns, let us have a conversation. That is what I am here for.

As always, we are honored and humbled that you have given us the opportunity to serve as your financial planning professionals. Please do not hesitate to reach out if there is anything we can help with.

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