Market Update

Volatility returned to the stock market with a vengeance last week. The S&P 500 lost 1.2%, closing Friday at 4538.43. The Nasdaq took the bigger hit falling 2.6%. High-priced growth stocks were especially weak. The Russell 2000 fell 3.9% and the small-cap index is now in correction territory. It has lost 12.4% since early November. The dominant narratives haven’t changed. Inflation is high. Investors are worried that it is not temporary. Covid-19 won’t stay out of the news. There is a fear that the Omicron version may slow the economic recovery. The Federal Reserve is signaling a more rapid taper, finishing its bond-buying as early as March. The Fed Funds Futures market is predicting at least two rate hikes in the second half of next year. A June rate hike isn’t out of the question. It is all enough to make investors nervous.

Yet the economy is signaling renewed strength. The Institute for Supply Management’s non-manufacturing survey hit 69.1, a record. The manufacturing index is still above 60. Readings above 60 are considered strong. The Atlanta Fed’s GDPNow estimate for Q4 growth is 9.7%. Goldman Sachs is forecasting 4.5% growth in Q4 and Q1 of 2022. It is forecasting a 4.0% growth for 2022. Strong numbers up and down the line.

The bond market is another matter. It is signaling slowing growth and lower inflation. The 30-year yield has fallen to 1.684%. The 10-year yield has dropped to 1.350%. Meanwhile the two-year has risen to 0.64%. The yield curve is flattening. The spread between the long and short end is the narrowest in years. The bond market is predicting that the Fed’s tightening campaign will be short-lived; terminated due to a slowing economy and falling inflation. The heavy debt load is the most likely explanation. An economy weighed down by debt cannot long survive rising interest rates. Norwood Economics expects the Fed to finish tapering by the spring and start raising rates by September. Our base case is a Federal Reserve on hold by the middle of 2023 as it becomes obvious that the economy can’t handle higher interest rates. Inflation should have fallen to 3.5% or less by then as well.

Economic Indicators

Pending home sales bounced back, increasing by 7.5% in October after a decline of 2.4% in September. The Case Shiller home price index rose 19.5% in September. Home prices are increasingly out of reach for first-time home buyers. The Chicago PMI was 61.8 in November down from 68.4, still strong. The U.S. Consumer Confidence index sank to a nine-month low of 109.5 in November. Consumer confidence has not matched the strengthening in the labor market and economy. The leading theory is Covid. The ISM manufacturing index was 61.1% in November up from 60.8% the prior month.

Initial jobless claims were higher at 222,000, up from 194,000 the prior month. Still a good report. The payroll number was less than expected at 210,000 new jobs. The household survey showed 1.1 million jobs created though. Another good sign for the jobs market was the rise in the participation rate to 61.8% from 61.6%. People are re-entering the job market, a positive for future consumer spending.

Taxes and Investing

Mutual funds rarely practice tax-sensitive investing. The average turnover rate for an actively managed mutual fund is around 100% annually. The average holding period for a stock is 12 months as a result. Short-term capital gains are taxed at the investors' income tax rate. The top marginal tax rate is 37%. Long-term capital gains are mostly taxed at 15% or less. Only investors earning more than $501,600 filing jointly pay the 20% long-term gains rate. For individual filers, the cut-off is $445,850.

Tax-sensitive investing takes more work, but it is worthwhile to clients if done right. Norwood Economics has started to trim a handful of stocks back to normal weight. Our stock positions are 3% for Aggressive Growth, Growth, and Growth & Income portfolios. We take 2% positions for our Income and Balanced portfolios. We have been trimming some stocks held in qualified accounts over the last month or so. We have sold shares in a few energy names, a healthcare stock, and a British marketing and advertising company so far. We are waiting until January before trimming those stocks in taxable accounts. The risk is that those stocks fall between now and then. It does happen sometimes. None of our positions are overvalued though. They are all paying nice dividends as well.

And you must take the taxes into account. A stock trading at $90 per share bought at $60 per share has $30 in capital gains. The long-term gain tax owed if the position is sold is 15% of $30, or $4.50. The short-term gain tax owed is $11.10 for someone in the 37% tax bracket. The $6.60 difference is meaningful. You don’t have a $30 gain in your $90 stock but an $18.9 short-term gain after taxes or a $25.5 long-term gain after taxes. Your stock isn’t really a $90 stock. It is only a $78.90 stock after subtracting short-term gains taxes. It is an $85.5 stock after subtracting long-term gains taxes.

Norwood Economics is mindful of the fact that our clients can only spend after-tax money. The extra effort to minimize taxes is worthwhile.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist