Elean
Hi everyone. Welcome to the Podcast and thank you for tuning in. I’m Elean Mendoza and I’m here with Evan Shorten, the firm’s founder and principal.
Evan
Hi Everyone. Thank you for tuning in. Hopefully you’re finding ways to keep yourself sane in the wake of these down markets. In this episode we’re going to talk about why the markets have been continuing to push down and where we see things going forward in the near term.
However, before we get started, I want to ask you to subscribe to the podcast so you can stay up to date with each new episode. You can subscribe on the Apple Podcasts App, the Stitcher Radio App, or you can subscribe to our YouTube channel.
Elean
Ok, let’s recap the last few weeks. Markets have continued their prolonged decline well into the month of June so far. Inflation data on June 10th came in higher than expected and markets reacted negatively. In fact, on June 13th the S&P500 officially entered bear market territory as it dropped over 20% from its January all-time high.
Then on June 15th, Jerome Powell and the Federal Reserve board announced a 75 basis point rate hike, which means the Federal Reserve would raise interest rates by 0.75%. What seemed to scare markets is the commitment Jerome Powell expressed towards quelling inflation. Essentially, the markets took it as an admission that inflation is going to be a problem moving forward and the possibility of an inflation induced recession got very real really fast.
Evan
Or possibly a Fed induced recession.
Elean
So Evan. Why are we here with the Fed trying to engineer a soft landing? And before we really dive into the conversation, I quickly want to mention that in this episode we’re actually going to revisit some of the things we discussed in our previous May episode because the economic fundamentals we previously discussed are still in full force today. In fact, the economic fundamentals affecting markets have continued to deteriorate from what they were last month.
If you didn’t listen to May Market Update or if this is your first time listening to the Paragon Podcast, let’s quickly discuss why we’re here. Evan back to you.
Evan
First, we’re still dealing with the effects of the 2020 Covid-19 pandemic. I know it’s been two years, but at the time an estimated $10 trillion, with a “T”, was put into circulation while at the same time forcing the economy to shut down and essentially stop the production and movement of goods. Essentially, we were in a situation where a lot of money was introduced into the economy while physical goods and services were reduced resulting in price hikes that would become the inflation we’re dealing with today.
Second, we’re still dealing with the Ukrain/Russian conflict that has decreased the export of grains and other essential food around the world combined with sanctions on Russia creating a worldwide supply shock for oil.
In other words, we reduced the amount of goods and services in 2020, we reduced the amount of oil coming to the U.S. in early 2022, and there is less available food in the world, all while printing record levels of money.
Lastly, we have an ineffective administration that hasn’t done much to mitigate some of the supply issues we’re experiencing domestically. Since 2022 is an election cycle for congress, our elected leaders have chosen to not rock the boat, avoid the situation, and let the Federal Reserve deal with inflation.
Elean
Which actually presents a pretty big problem. See the Federal Reserve has a very limited tool set for fighting inflation. They can only increase or decrease the money supply in the economy, the Fed can’t actually increase the amount of food, fuel, or housing needed to meet the current demand. So with its limited tool set, the Fed is trying to fight inflation by attempting to reduce the amount of money in circulation, also known as quantitative tightening, to reduce demand.
In other words, since we can’t increase the amount of oil to meet the current demand level, the Fed is going to attempt to reduce the demand for oil.
Evan, what does that mean for markets moving forward?
Evan
Well it’s not good. The phrase “reduce demand” is a very light hearted way of saying, let’s create a small recession. Equity markets don’t like recessions and bond markets don’t like rising rates. If we are in fact moving towards a recession, which I think we are, if we’re not already in one right now, it means unemployment and lower corporate profits across the board that result in widespread market downturn. We’re only about 3 months into the Fed’s efforts to reduce demand and equity markets are down 20% as of today, June 28th.
If the Fed can’t reduce demand, aka create a small recession, then inflation could continue for a prolonged period of time forcing the Fed to keep raising interest rates. Elevated inflation is similar to a recession for corporate profits in that consumer spending for goods and products beyond food, fuel, and shelter diminishes substantially with the added burden of increasing operating costs. With that said, if you recall what we previously mentioned, congress isn’t about to act on inflation any time soon, and the Fed can’t produce food, fuel, or shelter, so prolonged inflation could be a very real scenario.
Lastly, we could even experience a period of stagflation, something American hasn’t experienced since the 70s, which would be the worst case scenario.
Elean
If you’re not familiar with the term “staglfation,” it’s an economic term combining both the term stagnation and inflation. In this scenario, the economy stagnates similar to a recession with rising unemployment and no economic growth, while at the same time experiences high inflation.
So with your belief that we may be in a recession and the outlook for stocks not looking all that great, what options are investors faced with? Is it time to start selling?
Evan
Well first and foremost it’s important to take a step back and breathe. Now more than ever, you want to avoid making emotions based decisions when it comes to your portfolio. If you want to allocate more towards cash or take some profits off the table, I wouldn’t be opposed to it – but I wouldn’t rush out trying to sell everything. Additionally, if you know you have a large upcoming expense, it’s not a bad idea to safeguard the needed cash, but again, this isn’t the time to abandon your portfolio. This isn’t the time to panic, but it’s a good time to review your portfolio and ensure you’re not diverging too far from your financial plan’s allocation.
Even though the next few months don’t look very rosy for the economy and the financial markets, anything can happen. I know it’s cliché to say no one can predict the future, but it’s true.
For example, if you recall back to 2020 when Covid-19 hit the US, stocks plummeted in early February as fears about our economy and our health took hold. However, two months later in April, stock markets had recovered and went on to post new all-time highs until January of this year.
Elean
Every time we experience a down market everyone wants to rush out and sell off their portfolio. And while everyone knows of someone, who knows of someone, whose nephew was able to successfully get out at the top and rebuy the bottom, the reality is most people, even professional investors, can’t time the market.
Evan
Even though we’re dealing with high inflation today and its hurting financial markets. We can’t foresee what happens tomorrow. Just as how markets recovered within two months back in 2020, Ukraine and Russia could come to an unexpected ceasefire or truce and instantly alleviate the supply shock on food and oil around the world. If that happened, we would see a face melting rally in markets – but again, no one can see or predict the future.
I also don’t want to come off too negative here. Market declines do provide us with a few opportunities I want to mention. First, is rebalancing. With the likelihood of a recession and/or rising rates, we’ve been experiencing a rotation from growth stocks to value stocks. When the market experiences large declines like the ones experienced over the past weeks, sometimes the baby gets thrown out with the bathwater. Meaning, this could be a good time to rebalance your portfolio.
Additionally, with rising rates, bonds become more favorable. While this podcast does not give investment advice or provide any recommendations, one should be mindful of treasury rates going up. As of the recording of this episode the 2 year treasury is yielding almost 3.2%.
A second opportunity that investors could consider are capital losses. I know that sounds counterintuitive, but capital losses can be used strategically to manage your tax liability throughout the year. For example, if you are holding some higher risk growth stocks that have taken a hit and perhaps are in the red, you can reduce up to $3,000 of your ordinary income by realizing capital losses. Realized capital losses can also be used to offset more than $3,000 if you’re using them to offset a capital gain you realized from a different asset.
Lastly, the third opportunity I want to mention is Roth Conversion. There is no denying that the tax benefits of a Roth IRA are far superior to those of a traditional IRA. Additionally, recent changes to IRA beneficiary and distribution rules stemming from the SECURE Act have also given Roth IRAs a more favorable treatment. The downside of Roth Conversions has always been that income tax must be paid on any amount you convert from a traditional IRA to a Roth IRA. Now, the taxable downside has not gone away, but with lower equity values across the board, you can convert more of your traditional IRA positions to Roth.
Elean
To clarify what we mean. Let’s use AAPL as an example. Let’s say you wanted to do a Roth Conversion of 100 shares of AAPL when the stock was $182 per share. Our total Roth conversion amount would be $18,200. If we assume you’re in the 35% tax bracket you could be looking at a tax bill of $6,370 for a Roth conversion of 100 AAPL shares.
As of the recording of this podcast the price of AAPL is around $137 per share. Today we could convert 132 shares of AAPL while incurring the same tax bill allowing us to convert an extra 32 shares.
Evan
However, as with anything that incurs a taxable event, please consult your financial advisor and tax professional before making any decisions. Yes, Roth IRAs can be more favorable than traditional IRAs, but it takes a few years before a Roth conversion can pay off and that needs to be discussed with your financial professional. Including how to pay the tax bill for the conversion.
Elean
Ok, we know market conditions are making a lot of you nervous and that’s understandable, so please don’t hesitate to reach out to us should you want to discuss or evaluate your financial situation. Hopefully, you took something away from this podcast as well. Please don’t forget to subscribe to the podcast to stay up to date with each new episode. We thank you for tuning in and look forward to seeing you here on the next episode.
