IronBridge Private Wealth

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wealth management

A Recession or Not a Recession, That is the Question

“To be or not to be–that is the question: Whether ’tis nobler in the mind to suffer the slings and arrows of outrageous fortune or to take arms against a sea of trouble and by opposing end them.”

hamlet, act 3, scene 1

July was a nice month in the markets.

Which begs the question…have we seen the lows in this bear market?

Should we expect markets to continue to rise and suffer the slings and arrows of outrageous fortune? Or is this yet another fake-out like we’ve seen twice already this year and we go back into a sea of trouble?

The answer? It depends.

In most environments, it “depends” on a complex series of data points could shape the direction of the markets.

However, today’s environment seems more simple on the surface.

It depends primarily on only one variable: whether we are in a recession or not.

The reason is very simple…markets respond differently to pullbacks similar to what we’ve seen this year based solely on if it happens during a recession or not.

Let’s look at some historical context.

S&P 500 Performance: Recession vs No Recession

Markets can decline without the economy being in a recession. Since 2009, we’ve seen this happen a few different times:

  • 2011: US Debt Downgrade
  • 2016: Chinese Yuan Devaluation and Oil Crash
  • 2018: Random 20% decline in the 4th quarter

Each of these times, markets fell roughly 20%.

And each of these times, markets recovered losses within 18-24 months.

But there was no recession during these periods.

Our first chart below, courtesy of Ned Davis Research, shows this dynamic. The chart shows declines of at least 18% and separates it between two categories: whether it occurred during a recession or not.

The black line is the performance of the S&P 500 when there was no recession, while the blue dotted line shows the performance if there was an official recession.

We are currently two months past the recent lows, as indicated by the red dashed line.

Based on what the market has done historically, the results are very clear: if we’re not in a recession, we should expect the next 12 months to be pretty good. If we are in a recession, we should expect more volatility and a retest of the lows.

Which begs the question…are we in a recession or not?

Are We in a Recession?

Normally, determining a recession is pretty straight-forward: it is two consecutive quarters of negative GDP growth.

Both Q1 and Q2 this year were negative.

So by historical definitions, yes, we are in a recession.

But it may not be quite that simple this time.

We don’t like to get political in these reports, because the world focuses way too much on the self-absorbed, sociopathic political class.

But with mid-term elections around the corner, the incumbents are trying to change the definition of a recession.

It’s an overly transparent pre-election tactic. But we will reluctantly admit that in this case, they may have a point.

(To be fair to our politician friends, many economists agree that the first quarter did not resemble a typical economic recession.)

Let’s look at the data.

The first quarter GDP came in at a negative 1.4%, mostly because of two things:

  • Defense spending fell 8.5%
  • A trade imbalance due to a strengthening US dollar resulted in a negative 3.2% from total GDP.

Remove these two factors, and GDP is positive. In fact, if you simply remove the trade imbalance, GDP is positive.

Economic data in the first quarter was fairly positive as well, led by consumer spending, which was up 2.7%.

While the first quarter showed relatively good economic data, the second quarter was recessionary without question.

Second quarter GDP was negative 0.9%. And the negativity was more widespread.

  • Inventory investment decreased 2.0%
  • Housing investments decreased 0.7%
  • Federal and State spending both decreased slightly
  • Business investment decreased 0.1%
  • Consumer spending rose by a more moderate 0.7% (down from 2.7% in Q1)

With the underlying strength in the first quarter, it’s not out of bounds to assume that we’ve only seen one quarter of truly negative GDP growth.

(For the record, we don’t think we should change the traditional definition of a recession, but we should always put GDP data in context, both positive and negative.)

Which makes the current quarter especially important.

If we have negative GDP this quarter, there is no question that we are in a recession. The question then becomes how bad it is and how long it lasts.

Atlanta Fed GDPNow

One way to keep track of current GDP estimates is through the Atlanta Fed’s “GDPNow” tracker. (You can view the site HERE.)

As of Thursday, August 4th, they are projecting a 1.4% GDP for Q3, as shown in the next chart.

Granted, the estimate has steadily declined since the start of the quarter, and we still have almost 2/3 of the quarter left. So anything can happen.

And this data is also based on human estimates, which can be skewed.

But it should at least give us some hope that maybe we don’t see a formal recession this year. And if we do see one, it would likely be fairly mild.

This morning’s jobs report adds to the hope that we may not be in a recession just yet. The economy added 528,000 new jobs this quarter, and as of July has officially recovered the number of jobs lost during COVID.

However, we shouldn’t get too complacent at this point.

While GDPNow is showing positive estimates for current GDP, there are huge warning signs right now that should give us cause for concern.

Inverted Yield Curve

Historically, one of the best recession indicators has been an inverted yield curve. This occurs when the 10-year yield on US Treasuries are LOWER than the 2-year yields.

The next chart, courtesy of Bloomberg, shows this inversion.

When the line goes below zero, the curve is inverted.

Right now, it is more inverted than at any time since Paul Volker started fighting inflation the early 1980’s.

It is more negative than COVID, than the global financial crisis, the tech bubble, and various recessions during the 80’s and 90’s.

We strongly believe that it is imprudent to ignore this data point.

But this data point isn’t a very good timing indicator of when a recession may happen.

In reality, it is when the curve starts to steepen AFTER it has been inverted that is a better indicator that a recession is imminent, and we haven’t seen that happen yet.

Housing Market Concerns

While the inverted yield curve is a bit more theoretical in nature, there are real economic data points that are showing signs of stress.

The housing market plays a huge part in economic activity, accounting for 15-18% of US economic activity on average.

Leading indicators in the housing market are showing reason to be concerned.

One of these is cancellation rates, as shown in the next chart from Redfin.

Cancellations happen when an accepted offer is withdrawn by either party.

In this case, the majority of cancellations are due to buyers backing out.

There are legitimate reasons for this happening:

  • Mortgage rates have increased, making it unaffordable for a buyer to proceed;
  • Property taxes have been reassessed higher, increasing the cost of housing;
  • People anticipating that prices may fall, causing buyers to withdraw offers.

Here’s a link to the article discussing cancellations:

The Deal Is Off: Home Sales Are Getting Canceled at the Highest Rate Since the Start of the Pandemic

Another reason for cancellations is a drop in consumer confidence, which has a big effect on economic conditions in the US.

Consumer Confidence

While the housing market is a large part of the economy, the consumer as a whole is much more important. Approximately 70% of the US economy is driven by the consumer in one way or another (this includes housing).

So when consumer confidence slows, economic activity typically slows along with it.

And the consumer is in the dumps right now, as shown in our next chart.

Right now, the consumer is the least confident they have been at any time in the past 60 years. This includes the Vietnam era, the inflation of the 1970’s, the tech crash, the global financial crisis, and COVID.

That is concerning.

But what does all of this tell us about the near-term direction of the market?

S&P 500 Index

All of the data listed above is not news to the market.

Despite these concerning data points, markets have rallied over the past seven weeks.

But the move higher since June looks almost identical to the one in March, as shown in the chart below.

Specifically, the pattern is a three-leg move higher into previous highs.

There was an initial leg higher, a move lower of roughly the same timeframe, then an extended move higher in both time and price.

The move in March followed the Ukraine invasion.

The move in June really didn’t have any catalyst, other than the overall market being incredibly pessimistic.

In addition to the S&P 500, nearly every major US stock index looks identical.

The next chart shows the S&P 500, the Russell 2000 small cap index, the Nasdaq Composite and the S&P Mid Cap index.

Every one of these indices are at the same resistance level. This means that the market thinks these levels are important.

Regardless of the reason for the move in June, it has been strong. Earnings reports have been more positive than expected, and the market is starting to predict that the Fed will become more accommodative and “pivot” by slowing the rise of interest rates.

If the market is going to do it’s own pivot and head back lower, it must do so very quickly.

If it breaks above this resistance area, then we can begin increasing equity exposure in client portfolios, at least for a period of time.

If it heads lower, then we should expect a fairly quick move to test the lows from June.

Bottom Line

While a big consideration for the market is the current recession debate, markets are extremely complex systems. Relying on only one data point for decision-making would be foolish.

When looking at a variety of data points, it truly is a mixed bag out right now.

Recent market strength and earnings reports have been mostly positive. As such, the market seems to believe the Fed will slow down the pace of interest rate increases. (Frankly, this expectation seems to be unwarranted, especially after today’s employment numbers.)

For now, the move higher over the summer appears to be a typical bear market rally. As such, we have been intentionally slow to add equity exposure.

Why?

Mainly because there is still plenty of upside if the market wants to keep pushing higher. For example, the Nasdaq is down nearly 23% this year, even after a big rally over the summer.

And big stocks like Google, Microsoft, Facebook and Netflix still have massive upside potential at current levels.

If the market can get above the levels noted in the S&P chart above, there starts to be more proof that this rally may be more than just another temporary rally.

But if we do go into a recession, all bets are off. And there are many indications to suggest we are headed in that direction.

Bottom line is that we believe it is prudent to underweight risk right now, given the massive uncertainties in the market and the economy.

Invest wisely!

7 Lessons for Any Bear Market

Vienna, Austria - May 20, 2017: Main hall of the historical Austrian National Library in Vienna (Austria) on may 20, 2017, with an ancient globe map

That is the great fallacy: the wisdom of old men. They do not grow wise. They grow careful.

Ernest hemingway, “A farewell to arms”

Bear markets are not fun.

We all know that.

But there are valuable lessons from bear markets if you learn them.

Fortunately (or maybe unfortunately), we’ve lived through quite a few over the past 25 years. And given the volatility experienced during that period of time, our investment “age” would place us as old men. (The women of IronBridge remain obviously youthful.)

So Hemingway’s line from “A Farewell to Arms” resonates with us.

Bear markets may or may not create wisdom, because each one is different.

We don’t know how this one will play out. No one does.

But we have learned to be careful.

This got us thinking about various lessons we can learn from previous bear markets, and how we can apply them to today.

Below, we look at some higher-level lessons that relate to you and your well-being, as well as those learned from financial markets directly.

Let’s dig in.

Lesson #1: Keep Your Financial Plan on Track

The worst possible outcome of market volatility is not a decline in your wealth…it is a decline in your LIFESTYLE.

Don’t let that happen.

A good financial plan will factor in volatility in your portfolio. It is called stress-testing, and it is a statistical analysis using variable portfolio returns.

The chart below shows an example of hypothetical return projections for an actual client’s financial plan.

Real life future return projection including variability in returns and statistical analysis of a financial plan.
Source: IronBridge

This is just one of a thousand different potential scenarios our planning software uses to stress test someone’s probability of success in a financial plan. (Please do not hesitate to reach out if you would like us to update your individual financial plan.)

Two major things we notice about this projection:

  1. Returns are not linear. Our software does not assume the same return every year.
  2. Returns aren’t always good. Four of the first five years in the chart show negative returns. The worst projected decline is negative 28%.

Assuming variability makes your plan more realistic.

By projecting that bad years will happen, your portfolio can better weather the storms when they happen.

Lesson #2: Avoiding Large Declines is Key

This seems like the most obvious lesson, but avoiding large declines is the SINGLE MOST IMPORTANT thing you can do when investing.

Why?

Because when you experience large declines (which we define as 25-30% or greater), you don’t only sacrifice your financial plan, you lose the most valuable investing commodity there is: time.

You lose time by requiring huge gains to get back to where you were before the bear market began.

The next chart shows the return needed to get back to breakeven for various portfolio declines.

Returns needed to recover after various portfolio declines on a percentage basis.
Source: IronBridge

This chart shows that if your portfolio is down 10%, you need an 11% return to breakeven.

What stands out to us is that if your portfolio declines 30%, you need a whopping 43% return to breakeven. This is a huge return that takes multiple years to accomplish.

If you have a 40% or 50% decline, you need incredible future returns to get back to where you were.

These types of declines are not only painful emotionally, but will have hugely negative effects your long-term financial health.

Having the ability to move to cash is critical in our opinion.

Cash and short-term fixed income are the only predictable places to hide when major volatility hits the market.

Lesson #3: Diversification is Not Risk Management

Having different assets in your portfolio does not mean your portfolio is protected against large declines.

This year is a perfect example.

As of today, long-term bond prices have fallen MORE than stocks on a year-to-date basis, as shown in the chart below.

Stocks and bonds all down so far in 2022.

Maybe this changes in the second half of the year.

But relying solely on diversification as your primary risk management tool is not a good strategy to avoid large declines.

Lesson #4: Prices can Fall Further than You Think

There’s an old saying in the markets:

“How does a stock fall 90%? Easy, first it falls 80% then it gets cut in half.”

The lesson is that prices can be extremely volatile in bear markets, and can fall well beyond what may seem logically possible.

Let’s look at an extreme example of this today: Zoom stock.

Zoom was a darling of the COVID period as people abandoned the office and went remote. We at IronBridge became Zoom clients, and still use it many times per day.

Their earnings have consistently increased over the past two years, as shown on the bottom half of the chart below. The top half is price (blue line), and the orange is earnings per share.

Zoom stock has fallen 86% despite earnings increasing substantially.

Not only have earnings increased, but they have massively increased (up more than 8-fold).

Over the same period of time, however, the stock has been crushed.

It was down 86% from peak-to-trough. Ouch.

This illustrates perfectly that the market is not always logical. We would go a step further and say that more times than not it is very illogical.

But if you are prepared for it, both strategically and emotionally, you can handle the fact that it will probably do things that don’t make sense.

Lesson #5: Markets Lead, Economic Data Lags

One of the most common arguments during the early stages of a bear market is that the economic backdrop is strong.

The problem is that economic data is backward-looking.

In 2008, the initial GDP numbers were positive for most of the year. It was only until late 2008 (when the market was down nearly 40% on its way to being down over 55%), that GDP was revised lower for previous quarters.

It showed that the actual recession started nearly 12 months before, in late 2007. But in real time, GDP didn’t go negative until the market already declined.

Don’t rely on forecasters to give you any help, either.

Here are forecasts from the 12 largest investment firms in 2008. This was published in Barron’s magazine in early 2008 after the market had already peaked and was down nearly 20%.

Just over a year later, the S&P 500 bottomed at 666 (this still freaks us out a bit). Most of these forecasts were wrong by over 1,000 points. Nice work.

Instead of looking at the economic data itself, like the fine prognosticators above were, pay attention more to the trends of the data:

  • Is economic data improving or deteriorating?
  • Are companies lowering forward guidance, or do they foresee continued strength?
  • What are leading economic indicators doing?
  • Is previously reported economic data being adjusted higher or lower?

Markets will price in risk before the economic data reflects the risk.

Sometimes the markets are wrong. After all, not every bear market results in a recession.

But if you can identify how economic data is trending, you can better assess the overall risk in the market.

Lesson #6: Bear Markets Don’t Repeat, but They Tend to Rhyme

No bear market is exactly like a previous one.

But there are similarities.

For one, there tends to be excess speculation somewhere in the economy or markets.

In 2008, it was real estate. In 2000, it was tech companies. Today, central banks have printed our way into a complete mess. In addition, crypto is one area where we are seeing excess speculation turn into massive losses in value.

In addition to working off excesses, bear market patterns tend to look similar.

The first chart below compares 2008 to 2022.

Current market looks similar to 2008.

Looks pretty similar to us.

In 2008, there was a 22.5% drop before the bottom fell out of the market. Today, markets are down 23.5%. Maybe this suggests we are close to a similar outcome.

But there are plenty of chart comparisons that don’t result in massive declines.

In 1984, there was a recession, and the Fed was fighting inflation.

The next chart compares 1984 to today.

Current market looks similar to 1984

The pattern here looks pretty similar as well.

While both comparisons pass the eye test, each environment was different than today.

So while looking at these types of charts are interesting, they shouldn’t drive your behavior one way or another.

Lesson #7: Bear Markets can Happen in either Price or Time

When most of us think about a bear market, we naturally think of 2000 or 2008.

These were bear markets in PRICE.

In 2000, the Nasdaq fell over 70%. In 2008, the S&P 500 fell more than 55%.

Those of us in the markets then will remember those periods for the rest of our lives.

At their core, bear markets work off excesses of the previous economic and market expansion.

Prior to both 2000 and 2008, markets grew at rates that were were unsustainable. By the time these bear markets were done, prices collapsed and all the excesses were removed.

Price corrections tend to happen over the course of 1-3 years.

But markets can correct in TIME as well.

We haven’t seen a correction in time in quite a while.

In fact, the 1970’s were the last real sideways bear market.

The final chart looks at the Dow Jones index back to the late 1800’s.

Long term chart of the Dow Jones shows longer term bear markets.

This chart shows 5 major periods of sharp price declines: 1929, 1987, 2000, 2008 and 2020 (circled in red above).

The tamest of these periods was 1987, when the market “only” lost 34%. Each other time, markets fell well in excess of 40-50%.

Additionally, there were 3 major bear markets that occurred in “time” (the blue shaded areas above):

  • 1900-1915
  • 1934-1950
  • 1968-1982

Each of these periods lasted either 15 or 16 years. That’s a long time to have to wait for returns to start moving higher again.

Fortunately, these major bear markets don’t happen all that often.

But one thing in common with the previous bear markets that corrected in “time”: rising interest rates.

If we are going into a period of rising rates, which seems like a good assumption, the likelihood of a bear market in time seems to be a higher likelihood than a bear market in price.

Don’t let that scare you, though…there are ways to make money in a choppy sideways market.

It requires two components:

  1. Tactical exposure in the markets.  You don’t want to buy-and-hold in a “time” bear market.  The volatility will chew you up and spit you out.  You must have the ability to move to cash to limit volatility when downturns happen, but be able to increase exposure to areas performing well.  This is the basis of our investment philosophy at IronBridge.
  2. Increase exposure to yield-generating assets as interest rates rise.  As yields go up, you can earn more on a variety of assets to compliment your tactical market exposure.

We are preparing for this exact scenario, and have already begun having discussions with a number of our clients about what this means in your particular situation.

Bottom Line

In summary, there are always lessons to learn from any market environment.

But it does appear that we are in a bear market that may not reverse as quickly as those that have occurred since 2008.

Thus, us battered old investment men at IronBridge will echo Hemingway’s quote and be careful and cautious until the situation tells us not to be.

Invest wisely!

Value Your Business like it’s Your Retirement Plan, Because it is.

Building a successful business can take decades. While working to grow, it’s common to use all available assets above the salary you pay yourself to fund future expansion. Where does that leave you on the retirement side of things? For most business owners, the retirement plan is some form of exit and monetization of your investment.

As you get close to a transition, valuing the business is paramount. The value comes first, and then the sale, and only then do many business owners think about how the sale proceeds will fund retirement. 

There’s a better way. Start with the amount of money you need to live the retired life you want. That’s your benchmark of the value you want to get for your business. Then work from there to create the value you need.

A Different Valuation Metric: What Do You Need to Retire?

Creating a retirement lifestyle should be about your goals, dreams, and plans for what you want to accomplish in the last several decades of your life. It shouldn’t be about plugging a number into a glorified spreadsheet and then eking a life out of whatever income pops out.

Think of it in three stages:

  1. What’s most important to you in the early stages of retirement? Travel? Family? Starting another business? How much will that cost?
  2. As you age, what do you want your life to look like? Where will you live? How will you spend your time? Do you want to be able to help children and grandchildren? Do you want to devote time to philanthropy? What level of income do you need in these years?
  3. What will your legacy be? How will you fund it?

Once you’ve thought through what your retirement looks like, you can begin to think about the amount of money you’ll need to make that happen.

As you begin transitioning your business to an exit, you’ll want to get a comprehensive, accurate valuation. Bridging gaps between what your business is worth and what you need should be your focus. It should guide your timeline and business investment decisions for several years before getting to a liquidation event.

Increasing Your Value

You’ve likely been focused on the long-term growth of your business and are used to planning and taking steps to keep a consistent upward trajectory in place, even if it’s not profitable right away. Value is a different mindset. You want to position your business to be the most attractive to a buyer, which means focusing on profits and getting everything else in place and ship-shape.

Increasing value breaks down to making improvements across several essential functions:

  1. Improve cash flow – lease instead of buy, reduce expenditures
  2. Increase profitability – improve margins from both cost and revenue
  3. Lower your risk – diversify revenue streams and create recurring revenue streams
  4. Streamline operations – inventory management, payroll control, etc.
  5. Attract and retain high-quality talent – qualified retirement plans, cash balance plans, stock plans
  6. Build or refresh your sales/marketing process
  7. Get your books in perfect shape

If you’re wondering how you’re supposed to do all that while running the business, that’s where it gets interesting. You’re not. The sales process has a very truncated timeline. The value of bringing in outside expertise is correspondingly greater. Even if you could do all those things yourself, you can’t do them all at the same time.

Creating the Team You Need

The best approach to getting ready for a sale is to create a team that can work with you to determine what needs to be done systematically, build a schedule to do it, and identify the right sources. Whether outsourcing or hiring in-house, you’ll need to create a working group of consultants – business, marketing, pension, etc. – along with investment bankers, CPAs for the company and those focused on tax structures, and a legal team that can handle the transaction.

Because your business, both now and in the future, is your source of wealth, it makes sense to work with a financial advisor that specializes in transitioning business owners to liquidity. Decisions should be made with your long-term wealth in mind, whether it is valuation, taxes, sales structure, monetizing assets, or your compensation for ongoing involvement. A fee-only financial advisor doesn’t have a conflict of interest, so they can develop the needed expertise to look across the entire transaction, quarterback your team, and then structure your resulting liquidity to create the retirement you want.

The Bottom Line

Selling a business to fund a retirement should start with the retirement part – that’s the goal. Everything else should be in service to that, and good planning can ensure that takes place. Working with a financial advisor to get your ducks in order can help you navigate the transition.

This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

Thinking Through “Life-Changing” Wealth

my new life chapter one. planning considerations when selling a business, receiving an inheritance or a successful investment.

Incorporating a large lump sum of money into a financial plan requires thinking through a series of impacts that happen over time.

There are financial, emotional, tax, legacy, employment and a host of other issues to be addressed.

Whether the influx is due to an inheritance, an asset sale, or an IPO, taking some time to adjust before making any decisions is a good idea.

We get into some immediate implications, and then some further down the road.

Take Time to Breathe

Before you address the changes a large sum of money will bring, you may want to process the events that led to the inflow.

The loss of someone you care about, the sale of a business you’ve built, the monetization of the work you’ve put into a career are all emotional events.

The cardinal rule of investing is to remove as much emotion as possible. So taking time to work through the underlying feelings before you think about the ongoing changes to your life is a healthy approach.

Prioritize

By far the most important part of this process is to prioritize your actions.

There are some issues that require your immediate attention:

Following the death of a loved one, for example, there is the ugly “business” of processing and settling the estate. Good planning can help make this transition a smooth one, but there are still steps you must take those first few weeks and months.

Selling a business or having a large inflow of stock options require careful tax analysis, which we discuss below.

With any inflow of wealth, you’ll need to address these immediate deadlines.

However, you shouldn’t feel that you need to develop an investing plan right away. Yes, there may be opportunity costs of not immediately getting funds invested, but it is far more prudent to develop a disciplined investment plan to avoid making costly investment mistakes with large sums of money. And the volatility you may be used to with your portfolio takes on a different meaning when you add a zero or two to the end of the values.

Also, if possible, you should avoid any large amounts of spending right away. Your needs, wants, goals, etc. may change as you get used to your new reality, and you don’t want to do anything that can’t be undone.

By prioritizing what decisions you need to make first, you can more easily process the inflow of wealth to help you avoid costly mistakes.

Understand the Cost of Taxes

The money may be yours – but the government most likely has a claim on some of it.

Having a very clear accounting of how much tax is due and when, and how you are going to pay it, is the first step. The taxes due may come out of the lump sum, or it may be more advantageous to pay the taxes from other sources of funds. You’ll need a plan to understand the right choice for you.

For example:

  • An inheritance may include very low-basis stocks that you do not want to sell. But it could have a step-up in cost basis that may warrant selling them first. Tax laws change over time, and understanding what you need to do to is critical.
  • You may choose to structure the sale of a business in a deferred sales trust, so that you can minimize taxes. You’ll need to set up and implement that structure, and plan for gaining access to the funds over time.
  • Post-IPO, you’ll be subject to taxes on your shares, and you’ll have some timelines you need to be aware of and taxes you’ll need to pay, whether you hold on to the stock or not.

Be sure to identify all tax strategies with a tax professional, because there may be ways to reduce your overall tax bill in the year that the event happens.

For example, if you have charitable inclinations, you might want to consider a gift in the year you received the lump sum. One example is via a Donor Advised Fund. Learn more HERE.

The ideal situation is to discuss potential tax implications prior to a large liquidity event when possible.

Rethink Your Approach to Risk Management – Both Investment Risk and Asset Risk

Adding a large sum to your overall financial picture will change how you think about risk.

You’ll need to assess your liability and protect your overall assets. This may mean an umbrella policy, structuring or titling assets differently, or in the case of an inheritance, it may mean a different insurance strategy.

Your investment goals may also change with time.

If you’ve sold a business and this is your retirement fund, your risk profile will look different than it did when you had a business creating income.

With an inheritance, an IPO, or other lump sum, you may decide to change, cut down, or stop work. This will create different time horizons for investing and different risk tolerances.

It may take time to understand what you want to do and put a plan in place.

Keeping assets as flexible as possible is the key to giving yourself choices as you move forward. You’ll want to minimize risk and avoid locking up funds until you have a clear understanding of your new goals.

Create a New Path Forward

Once you get used to your new situation, many people decide to make big changes.

These could include creating a legacy, actively gifting to help others, or using your funds to provide income for yourself so that you can devote your most valuable resource – your time – to causes you care about.

Or it may mean making a big purchase you’ve always wanted, travel, or just taking time to spend with family.

Most likely it is a combination of these dreams.

In the case of a business owner, you worked hard to get to where you are. You most likely made sacrifices that no one sees or knows about.

It is okay to enjoy your new wealth while still using it to positively impact others in whatever way you choose.

The Bottom Line

Thinking through your options means working carefully to create a financial plan that maximizes your assets, minimizes your taxes and provides for you and your loved ones.

The new plan may be bigger and more complicated, but the basic principles will still apply. You’ll still need to take the time to work with your team to set out what you want, and then put it into action.

We’re always here to talk it through with you.

Houdini’s Hole

The Paramount Theatre in Austin, Texas is a city treasure. It has an amazing variety of shows, and the list of notable performers is unmatched. It was built in 1915, and began mostly as a vaudeville house.

Just a few of the notable performers in its history are Miles Davis, the Marx Brothers, George Carlin, Ray Charles, Billy Joel, Don Rickles, Chuck Berry, Gladys Knight…the list goes on. Learn more about the Paramount Theatre: https://www.austintheatre.org/

Harry Houdini

One of the most famous performers to grace the Paramount stage was Harry Houdini. And his presence can literally be seen to this day.

Houdini performed there in 1916. At the time, he was one of the most famous people in the world. His slight-of-hand tricks mesmerized audiences worldwide.

One part of his performance was a suspended levitation trick.

He would dangle from the ceiling and escape a straightjacket or chains or some other kind of concoction.

He most likely performed this trick at the Paramount during his eight shows in Austin. To accomplish it, the theater operators drilled a hole in the ceiling of the Paramount and dangled the global superstar over the audience.

The hole they drilled is still in the ceiling today, over 100 years later, as shown in the picture below.

Houdini’s hole can be seen in the green area to the top-right of Saint Cecilia’s right hand. Photo courtesy of the Paramount Theatre website.

The details of Houdini’s trick that night are unknown.

But as with any kind of “magic” trick, it’s not about how the performer escapes. It’s all about distracting the audience to create an illusion of making the impossible possible.

This same type of “magic” is happening in financial markets today.

Suspended Levitation

Harry Houdini mastered the art of the suspended levitation tricks.

In today’s markets, there appear to be two Houdini’s: the Fed and the mega-cap tech stocks (such as Tesla, Facebook, Google, Amazon, Apple and Microsoft).

We’ve discussed the Fed a LOT in these reports.

But we came across a new chart that shows just how big of an impact the Fed may have had in market growth over the past decade.

Bank of America Global Research did some very interesting analysis.

What they did is look at how much of the market growth can be explained by earnings growth, and how much can be explained by the Fed’s balance sheet.

The first chart below shows how much of the returns of the S&P 500 can be explained by changes in the earnings of the companies within the index.

Earnings Contribution to changes in the S&P 500 Market Cap

This chart paints an interesting picture.

Traditional investors assume that when earnings increase, so should the stock price. That’s what we’re buying after all, right? Shares in a company whose business should grow?

But the chart above tells us that’s not quite the case.

It tells us is that from 1997 to 2009, only 48% of the changes in the index can be explained by earnings growth.

And after the 2008 Financial Crisis, earnings only accounted for 21% of the changes in the S&P 500!

That’s pretty amazing. Only 21% of the increase in the market over a decade-long period is due to earnings?

What would explain the rest of the growth?

There are a variety of things that impact stocks:

  • Earnings: Higher profits or revenue can lead to more valuable companies.
  • Flows: More money chasing stocks makes it go higher, less money makes it go lower.
  • Sentiment: Optimism creates more buyers, while pessimism means more sellers.
  • Investing Alternatives: When stocks have competition for returns, less money goes into the stock market.
  • Liquidity: When there is more money in the system, there is additional capital to put to work that is not tied up in other areas like inventories.

We could write dissertations about each of these categories.

But let’s focus on the last item, liquidity. This is the main avenue where the Fed has an impact.

Fed-Driven Market Growth

Bank of America also did the analysis on how much of the price changes can be explained by changes in the Federal Reserve balance sheet, which is shown in the next chart.

Fed Balance Sheet Contribution to changes in the S&P 500 Index

Here we really start to understand just how much impact the Fed has on markets.

From 1997 to 2009, literally zero percent of the return of the S&P 500 can be explained by changes in the Fed balance sheet.

Granted, the Fed’s balance sheet wasn’t that big before the financial crisis. But that’s kind of the point.

Since 2010, a whopping 52% of market performance can be attributed to the Fed. That’s even more of an impact than EARNINGS had in the 12 years leading up to it.

No wonder the Fed is nervous about what happens when they start to reduce the size of the balance sheet. (Read our article earlier this year The Fed is Stuck.)

They are creating an illusion, just like Houdini.

What started in 2009 as proper policy to keep the financial system operational, has since turned into a permanent juicing of the markets to keep them chugging higher.

The Fed starts to talk about tapering, and reverses course at the slightest whiff of risk.

Case in point…the Fed started to talk about tapering right before Thanksgiving. Markets fell a quick 5%, and next thing we know it’s off the table.

We’re not talking about the COVID Crash, where stocks plummeted 40% in a few short weeks. We’re talking about a normal 5% correction. They blamed the Omicron mutation, but that was just an excuse to postpone making tough decisions.

Our job as investors is to make money. So we appreciate what the Fed is doing.

And it may continue to work for a long time still. But we have to think about what happens next.

But the Fed isn’t the only one doing the heavy lifting. Tech stocks have helped tremendously this year.

Big Tech Stocks

The other market magician is the biggest-of-the-big tech stocks.

There have been increasing acronyms that represent these stocks:

  • First it was FANG. Facebook, Apple, Netflix and Google.
  • Then it became FAANG. Add Amazon to the mix.
  • Then it was FANMAG. Microsoft needs love too.
  • Now we can include Tesla and Nvidia. Who know what that will spell.

Whatever it spells, it’s yet another way the market is levitating.

We discussed the 5 largest stocks in our Strategic Growth Video Series, which you can view HERE.

To view just how much of an impact the 5 largest stocks have had this year, look at the following chart from S&P Global Research.

This chart is quite shocking.

As of December 6th, when this chart was published, the Nasdaq index was up almost 20% for the year.

Without the largest 5 stocks, the index is DOWN over 20%.

Let’s hear that again. The index goes from UP 20% to DOWN 20% by removing only 5 stocks.

(By the way, these 5 stocks are Amazon, Google, Tesla, Facebook and Nvidia.)

Jiminy Christmas, Houdini, that’s some trick.

We can interpret this two ways. And these two ways have extremely different outcomes.

On the one hand, this could be positive.

The fact that so much of the index has fallen means that a large majority of stocks have actually gone through a pretty tough stretch. Many have gone through outright bear markets when viewed individually.

Maybe these stocks are ready to begin to move higher.

That would provide excellent investment opportunities outside of these big tech stocks.

On the other hand, if these stocks do start to falter, watch out.

If these handful of stocks start to weaken, and there is NOT a rise in the majority of the other components of the index, we could start to see a market that shifts from slowly drifting higher to quickly falling.

Reality is probably somewhere in between.

If the magicians of the market stop rising, but a majority of the other stocks start to do better, we could see an environment where the overall indexes are choppy and flat, but without any major losses.

That seems like the likely outcome while the Fed remains accommodative.

So far, every little dip has been bought. The scary 5% correction that we saw a couple weeks ago really didn’t amount to anything.

So the slight of hand continues and the performance goes on.

The market Houdini’s have escaped harms way for quite some time now. But if the Fed doesn’t continue to escape, they could leave a hole that we will be able to see for generations to come.

Invest wisely!

Safeguarding and Passing on Your Digital Assets

cryptocurrency theft concept on smart phone screen. Big red hacked message and empty wallet. Phone on a laptop computer.

Google searches for “cryptocurrency” hit all-time highs in May. A survey from CNBC found that 1 in 10 people now invest in crypto. Of that group, 65% got in the crypto market within the past year.2

As crypto becomes a more significant part of the financial picture, it’s essential to ensure that the assets are safely and appropriately stored and that you have a plan for the eventual transfer of them – but this process doesn’t work the same way as for traditional assets.

Taking Careful Inventory

One of the first steps to safeguarding your digital assets is taking inventory of what you have. With how many ways there are to purchase and store crypto, it’s easy to forget where all of them are located and since the space is still new, there isn’t really an easy way to keep track of them all.

Taking inventory looks different for everyone, but one of the most common ways is using a simple Excel or Google spreadsheet. You would want to include a few things: the name of the asset (bitcoin, ether, etc.), how much of it you own, your original purchase price(s), and where it’s located. This information will help you keep everything in order and makes the information easily accessible for when tax time rolls around.

There is software out there, such as CoinTracker, that can help keep track of your digital assets, but not every software integrates well with others. Right now, it may be easiest to keep it simple and stick to manual input until more sophisticated solutions exist.

Storing Crypto in Your (Digital) Wallet

There are two different kinds of wallets. Hot wallets (also known as ‘soft’ wallets) live online and are usually an extension in your web browser or an app. These would be brands such as MetaMask, Rainbow, or Strike.  The other kind is a cold wallet (also known as a ‘hard’ wallet). These exist offline, and are like a USB drive. A hard wallet plugs into your computer and because it’s not always connected to the internet, it’s generally considered to be more secure than a hot wallet. Some common hard wallet providers are Ledger and Trezor.

Secure your crypto in three ways; private keys, public keys and a seed phrase

Public keys

Every wallet comes with a set of private & public keys and a seed phrase. Wallet keys are a long string of random numbers and letters assigned to your wallet, and your public keys are like your home address. Just like how you would give out your address to someone if they wanted to send you a package, you give out your public address if someone wants to send you crypto.

Private keys

Your private keys are like the keys that unlock your home. You never give them out to anyone, and their primary purpose is to allow you to complete a transaction. So, if someone had both your public and private keys, they could drain your wallet of all funds.

Seed phrase

Finally, your seed phrase is a 12-word phrase generated from the private keys to make it easier to remember, and its purpose is to serve as a backup if you were to misplace or forget your wallet credentials. If you have the seed phrase but lost the keys, all the assets in that wallet can typically be restored.

Custodial wallets

With both hot and cold wallets, you’re in control of the private and public keys, giving you full access to the funds. This is important to note because the last type of wallet does not grant that same ability.

Custodial wallets are provided by exchanges, such as Gemini and Coinbase, and the key distinction between custodial wallets and non-custodial wallets is that with custodial wallets, you generally do not have access to the private keys. The exchange keeps them private, and because of this, some investors prefer not to store large amounts of crypto on their custodial wallet after purchasing.

Using a custodial wallet comes with less responsibility than a non-custodial wallet, but the tradeoff here is security. With a custodial wallet, in the event of a hack or data breach of the custodian, your crypto would be unsecured and vulnerable. With non-custodial wallets, you’re the only one who has access to the private keys and data (unless you were to give them out mistakenly). However, one positive attribute that custodial wallets hold over non-custodial wallets is that they are generally FDIC insured up to $250,000.

Whatever route you decide to take with wallets and storage, the main thing to remember is never to give out your private keys or seed phrase. Doing this can make all the cryptocurrency you hold in that wallet accessible to whoever gets ahold of them.

Planning to Transfer Assets

Suppose you’ve thought about investing in crypto or you currently own some. In that case, you may be wondering how these assets can be passed down since there are no standard legal procedures and holding crypto and moving it around looks different than the traditional finance framework.

The main issue in passing down digital assets and cryptocurrencies is the storage and transfer of the private key. Since it must be stored in a private location, it’s not recommended to write the private phrase in a will as it can become public record after death. In certain situations, the contents of safety deposit boxes may also become part of the public probate record, so storing the keys there may not work either.

So, how can you store the private key and ensure that the assets are passed on securely? Luckily, technology solutions have been built and are constantly being developed.

One of the best solutions currently available is using a multi-signature (or multi-sig) wallet. These wallets have multiple sets of keys and the wallet requires several of those signatures to complete a transaction. For example, if a wallet had 5 keys, two of them could be given to your attorney and the issuing company, and the remaining three could be held by you, your spouse, and your child. Then upon death, the assets in that wallet could be accessed by using a combination of 3 of the 5 keys. This allows for more security and helps mitigate the risk of someone inappropriately distributing or accessing the assets.

If you are holding your crypto assets in a non-custodial wallet, your estate planning may be better accomplished with a trust. This avoids probate and can allow the original owner to maintain control. And depending on the type of trust, the original owner may also set certain rules for how the assets are managed after death.

Custodial wallets (those provided by exchanges) generally don’t have trust support, meaning that the assets held in those wallets would be subject to probate. This is another reason why some investors prefer to hold their larger amounts of crypto in their private, non-custodial wallets.

The Takeaway

It’s estimated that 20% of bitcoin is lost forever due to forgotten or misplaced seed phrases or simply not keeping inventory and forgetting it was owned in the first place. As cryptocurrency and digital assets make their way into more investing conversations, the need for education and proper asset management is becoming more important.  This is because cryptocurrencies are managed from a security and estate planning aspect is different from their traditional finance counterparts.

Keeping track of your holdings, ensuring the cryptocurrency you hold is in a secure wallet, and beginning to think about estate planning solutions are a few ways you can begin safeguarding and building a plan to pass down your digital assets.

  1. Manoylov, MK. Google Search Volume for Cryptocurrency Topics Break All-Time High. The Block. May 20, 2021.
  2. Reinicke, Carmen. One in Ten People Currently Invest in Cryptocurrencies. CNBC. August 24, 2021.

This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here. The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation.

Donor Advised Funds: Tax Benefits, Growth and Control

Alphabet letter wooden blocks with words GIVE in child and parents hands. Family and charity concept

Donor advised funds have been around for decades, but they’ve only become wildly popular vehicles for charitable giving over the last several years. They offer immediate tax benefits as the assets or funds in the donor advised fund convey a tax deduction in the year in which they are gifted. Inside the fund, the assets can grow tax-free and not have to be distributed immediately to a charity. 

How popular are they? Total assets in donor-advised funds have more than quadrupled over the past decade, to more than $140 billion. Roughly $1 of every $8 given to charity in America now goes to a donor-advised fund.1

The funds offer an extremely flexible way to craft a gifting strategy that can allow for the gift to be invested and managed, to potentially grow over time, and for the gifter to maintain control over the assets.

Understanding Donor Advised Funds

A donor advised fund (DAF) is a savings vehicle that allows for charitable donations and tax benefits, all while the donor still has control over where the assets are to be donated. Donor advised funds are irrevocable, meaning that you can’t withdraw funds after donating. Still, you can specify how the donation is to be invested and to which charity you’d like to donate.

Given their versatility and flexibility, DAFs have become a popular choice for those with a charitable heart. According to research from the National Philanthropic Trust, contributions to DAFs in 2019 totaled almost $39 billion, an 80% increase since 2015.2

With donor advised funds, you aren’t limited to donating just cash. Acceptable donations range from stocks and bonds to bitcoin and private company stock. Donors can deduct up to 60% of adjusted gross income if donating cash and up to 30% of adjusted gross income if donating appreciated assets.3

To make sure a donation qualifies for the full benefits, the fund administrator must be a public charity that falls under the qualifications of a 501(c)(3) organization.

How They’re Managed and How to Contribute to One

First, it must be opened at a qualifying sponsor. After selecting a sponsor, donors must make an irrevocable contribution to the fund. At that time, they can take the immediate tax deduction and begin naming beneficiaries and successors for the account.

After making a contribution, the sponsor firm then has legal control over the funds. It can invest the money in accordance with the donor’s recommendations, until the donor is ready to decide which charity they’d like the distribute funds to. Since the fund manages the money and handles the administrative tasks that come with donating to charities, administrative fees need to be considered when deciding on which sponsor to use, as those fees are deducted from the donor’s contributions.

When Does It Make Sense to Contribute to a Donor Advised Fund?

There are many situations where it may make sense to contribute to a donor advised fund, but some of the most common are:

  • If you own highly appreciated assets
  • If you’re looking for a tax-deductible transaction
  • If you want to make a sizable future donation

For example, let’s say someone bought Amazon stock when it was $10/share, and it grew to $3,000/share and they didn’t want to pay capital gains tax on the appreciation. With a donor advised fund, they could donate the stock, and no capital gains would be due.

The Pros and Cons of Donor Advised Funds

When contributing money to a donor advised fund, the donor receives an immediate tax deduction on the amount they contributed, even though the funds may not be distributed to a charity until a future date. This allows for greater control and flexibility when compared to making a regular donation directly to a charity.

Additionally, contributing to a donor advised fund makes record-keeping simpler than making multiple donations to different charities and keeping track of all the documents. This is because the fund can act as a “hub” for all donations, and it will record all contributions and provide a single tax document containing all information needed.

Though versatile, a concern amongst many donors is the fees associated with donor advised funds. For example, the fund might charge a 1% administrative fee, which is being taken directly out of the funds to be donated. The underlying investments may also have fees, so it’s important that you carefully evaluate where your money is going and how fees play a role in the donation.

The Takeaway

Overall, donor advised funds are a versatile tool when it comes to making donations. They provide tax benefits and allow donors to choose where their money goes, all while those donations can grow tax-free until a charity is chosen. However, there’s more to consider than just the benefits, so to make sure it’s the right move to make for your financial situation, it’s recommended to talk with a financial advisor before establishing a donor advised fund.

  1. Frank, Robert. Billionaire philanthropist John Arnold says donor-advised funds are ‘wealth-warehousing vehicles’. CNBC. August 11, 2021.
  2. National Philanthropic Trust. The 2020 DAF Report. NPTrust.org
  3. What is a Donor Advised Fund? Fidelity Charitable.

The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation.

Selling a Family Business: Preparing for a Transformational Event

Portrait of multigenerational winery owner family standing at wine cellar. Senior winemaker and young sommelier standing at background and holding in hands a glass of red wine while middle age businesswoman looking at camera and smiling. Small business.

It’s generally thought that there are several cycles that reflect where a business is in preparedness for a sale. These capture the economy, the market, and the mindset and planning of the business owners.

From an economic standpoint, the liquidity cycle is the one that matters. This cycle gauges the amount of available liquidity and the current appetite of investors to invest in companies.1 With record amounts of cash sloshing around looking for investments and interest rates continuing to be low, the liquidity cycle is currently at an advantageous point, and looks poised to remain so.2  While getting the right price is clearly a big consideration, there are a lot of other things to think through that are just as important.

From setting a realistic timeline to thinking about the implications of the sale on other family members, to planning for a life after the sale, each stage brings its own challenges. Assembling a team of advisors with specialized knowledge in every area will be critical, and since this will have a major impact on your wealth and your legacy, you’ll need a quarterback that can keep your big picture in focus all the way through.

The Timeline

Starting well before you want to complete a sale can allow for a productive series of negotiations. It gives you time to surface – and mitigate – any issues that come up, which can leave you in a stronger position. It also provides time to ensure that all shareholders and stakeholders such as creditors, vendors, and employees have time to adjust to the changes the sale may bring, which can facilitate a successful transition. Finally, a longer timeline means you can keep growing the business while you give thought to where you want to be after the sale.

Selecting Your Team

Selling a privately held business is a very specialized transaction. Depending on the size and complexity of your business and the market you compete in, you may need to hire an investment banker, business broker, or third-party business appraiser. Besides advising on the value and the sale, they should be able to help you structure the transaction. You likely already have trusted legal counsel, but unless they also have experience in purchase and sale agreements, you may want to engage an additional resource. The same is true for your tax accountant. You’ll need specific expertise on minimizing the tax consequences of monetizing a business.

Gauging the Cycles

We’ve already discussed the liquidity cycle. The other externally focused cycle to think about is the business cycle for your company’s sector. You’ll need to determine the potential for growth and whether the business is well-positioned to take advantage of opportunities as they arise, or if there are headwinds that can be mitigated.

The last cycle to think about is whether you are ready to sell. What will your life look like after the transition? If you’ve been very involved in the business, how will your new life be structured? Will you continue to play a role, or will you cut all ties? How do family stakeholders feel about the change? Even if the other cycles are at strong points – if you’re not ready to sell, it’s better to wait. It can make sense to assemble your team and proceed with information gathering even if you aren’t sure about an eventual sale. Once you have a clear idea of what the company is worth, you may be able to make a more informed decision.

Breathe

You’ve decided to sell, the cycles are lined up and the structure is right. Now what? This is where having a solid plan comes into play. Acquiring potentially life-changing wealth can be disorienting, to say the least. Imposing a period of time to create and assess various plans, get used to your new life, and have time to decompress can help you to avoid mistakes and when you are ready, you’ll have a better idea of what is really important to you. Eventually, you’ll need a good investment plan that protects your capital, provides you with what you want, and allows you to create the legacy you’d like. But initially, it’s important to maintain a flexible investment plan that can change as you explore your new life.

The Bottom Line

Selling a family business can be stressful and complicated. Assembling a strong team that works hand-in-hand with your financial advisor can smooth the road and ensure your new life plans get a good start.

  1. What to Consider When Selling the Family Business. Grimes, McGovern & Associates.
  2. 2021 Global Private Equity Outlook. S&P Global. March 2, 2021.

The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation. This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here.