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STA Weekly Report – Tax Cuts Hopes and Market Observations

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Tax Cut Hopes and Market Observations
How the Trump Tax Plan Could Impact Investment Performance
Planning for Retirement the R.I.T.E Way
Weekly Technical Comment
401k Plan Manager


Last week was good for stock investors. The S&P 500 gained 0.7%, while the small cap Russell 2000 gained 2.8%. The top sectors on the week were energy, advancing 1.9%, and financials advancing 1.6%. Utilities lagged as they fell 0.4% while the U.S. Trade Weighted Dollar strengthened, gaining 1.0%.

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The S&P 500 notched a new high on Friday and has made it 8 straight quarterly increases (a stretch that has only occurred four other times since the index was created in 1928). We have also seen 6 months in a row of gains in this impressive winning streak – the longest in four years. Small-cap stocks have staged a huge come back, not only making new peaks but outperforming significantly – signs of the market repricing tax cuts ahead.

The top story of the week was the release of the tax plan by the President, and the markets are salivating over the prospect for stimulus. Not so much reform, but outright stimulus. The plan includes cuts to corporate taxes as well as changes to deductions for individuals. More detail is needed to fully understand the impact, but if stocks are a measure of sentiment, investor’s initial reactions are optimistic.

Small cap investors were especially pleased to see corporate tax rates on the cutting block; with a chance for rates to fall from 35% to 20%. The average effective tax rate of stocks in the Russell 2000 is about 10% higher than the larger companies in the S&P 500 Index. One can see how a cut like this could be a boost for smaller companies. In the weeks leading up to the announcement small caps began to rally in the anticipation of significant benefits. In the month of September alone, the small cap Russell 2000 outpaced the large cap S&P 500 by 4.1%.

The tax plan has the potential to positively impact other areas as well. In fact, large cap companies may still benefit if a one-time repatriation tax allows for U.S. Dollars to return home at a lower rate. The Technology sector would likely be a big beneficiary as it has stashed a lot of funds overseas.

Companies with heavy investment requirements may also benefit as they could write off their investments immediately. This would likely help lower costs and allow firms to increase productivity. The news is not so good for companies with high interest expenses. This group could lose the ability to take a tax deduction for those interest expenses, potentially boosting their tax burden.
The anticipation of tax cuts could send the markets higher in the short-term, but ultimately the fate of the plan is in the hands of Congress. If the past is any indication, the tax proposal will definitely see headwinds from both parties. There are simply too many deficit hawks in the House that will oppose any unfunded tax reductions, and the Democrats will continue to vote against any package that is perceived to benefit those at the higher income levels. Overall, we believe investors should favor bargain securities and maintain moderate equity levels.

How the Trump Tax Plan Could Impact Investment Performance

The Trump tax plan announced on September 27th, 2017 was presented as having four primary goals: simplifying the tax code to make it easier to understand, cut taxes in a way that effectively raises pay, make America a more attractive market to hire employees, and repatriate trillions of dollars back to the United States. While those broad objectives make it sound like the tax plan framework benefits just about everyone, the truth is that the tax cuts will likely impact people differently depending on a myriad of factors – income, state of residence, and business interests to name a few. Although the specific details of what the final tax changes may be (congress is tasked with figuring that part out) the framework provided this week does provide a blueprint.

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Marginal tax rates lower for most individuals

The chart below shows the current marginal tax rates for individuals at different income levels and the likely rates following a tax cut for a spectrum of income levels. For the most part, it appears that most individuals will see only a marginal change. For example, high income earners (those earning more than $418,400) could see their tax rates drop from 39.6% to 35%. However, for those earning between $191,650 and $416,700, they may actually see a 2% tax increase. The argument has been made that this marginal tax increase, will be offset from a combination of the child tax credit and/or an increase in the standard deduction.

Increased Standard Deduction

In the current framework, the standard deduction would increase for the most part, depending on filing status and child dependents. This might push up to 84% of filers to use the standard deduction according to estimates from the Tax Policy Center. More importantly though, is the role the higher standard deduction could play in offsetting increased marginal tax rates for certain income level earners.


Pass-through income to be taxed at 25%

While most pass-through businesses are already taxed at the 25% rate, approximately 1.7% of pass-through businesses will see their tax rates drop from the top 39.6% rate down to 25% under the new tax framework. This would amount to a huge benefit to high income pass-through businesses and their owners.

Source: Tax Policy Center model 2016

Lower Corporate Tax Rates

The big winners, along with individuals that own pass-through entities, would be both large and small businesses. As investors in public equities this is where you would likely see real benefits. The reason is that by owning shares and bonds in corporations, investors would benefit from potentially higher profitability for those publicly traded businesses under the proposed plan. Currently, corporate tax rates are 35% and would drop to 20% under the new tax regime. This could provide a sizeable jump in after-tax profits. However, it may not be quite as easy as just dropping the corporate tax rate and moving ahead. The reason is that it may be difficult to pay for the tax cut beyond a certain point. In fact, the Tax Foundation conducted an analysis that showed that it is impossible to get to a 20% corporate tax rate without cutting additional expenditures. The table that follows shows some of the options for making up for the short-fall and will likely be a point of contention when the details are debated by congress.

Two more corporate benefits: accelerated expensing and repatriation of foreign cash

In addition to the overall corporate tax cuts, the tax reform blueprint put forth by the President would also allow for immediate expensing of assets for a minimum of 5 years, a reduction in the deductibility of corporate interest expenses, and a one-time repatriation tax on profits held abroad. The last time we had a repatriation holiday in the US was in 2005, but this time around it could help US corporations bring more than $2 Trillion dollars back into the country that might be used to reinvest in the US and hire American workers.


What does it all mean for investors?

While still missing details, we would expect some of the following benefits to materialize. First, we could see a slight boost to corporate profitability. Second, investment performance in sectors that currently have higher median effective tax rates could improve. Small cap companies tend to have higher median effective tax rates and is why we saw a short-term pop in small-cap stock prices immediately following the tax plan announcement. However, the boost may not be limited to high effective tax rate companies. As the chart below shows, when marginal tax rates decline equity returns tend to improve.

Third, repatriation of overseas cash could provide additional cash for publicly traded businesses to boost buybacks. S&P quarterly buybacks are at a two-decade high but could conceivably go higher and provide some further lift to equity prices.

Finally, shareholders could see some of that repatriated cash also drive dividend payouts higher. This could be particularly beneficial to investors that need income in retirement.

That said, there is a long way to go before we get any tax proposal passed. It is likely to be a long and drawn out process that will require congress to set aside differences to come to an agreement on the details of the new tax regime.  Any surprises along the way could increase volatility and make equities susceptible to a correction. Like we have said before, a well-defined risk management strategy can go a long way to minimize long-term damage to your portfolio when surprises occur.


Financials Continue to Lead

Financial stocks continue to build on their strong September gains. Chart 1 shows the Financial Sector SPDR (XLF) hitting a new record high. Rising interest rates are the main force driving money into banks, brokers, and insurers. The black line just above the price chart shows the XLF/SPX ratio turning up during September. The green line in the top box shows the 10-Year Treasury yield also rising during September. If you examine the two lines, you’ll see that they generally rise and fall together. Right now, they’re both rising together. The upturn in bond yields has also helped push small cap stocks into new record territory (see below). The upturn in bond yields is also contributing to a rotation into value stocks. Financials are the biggest part of the value group. A lot of the money moving into financials is coming out of big technology stocks. Rising rates also have something to do with that.

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S&P 500 Value Stocks Show New Leadership

The subtle shift from big techs and into financials also helps explain the recent preference for value over growth stocks. The chart below shows the S&P 500 Value iShares (IVE) rising strongly into record territory. The IVE/SPX relative strength ratio (top of chart) has also been rising over the last month (while growth stocks have been lagging). That’s not a surprise since financials are the biggest sector in the IVE (27%), while techs are 36% of the S&P 500 Growth iShares (IVW). There again, value stocks are more cyclical in nature and usually require a stronger economy (with higher interest rates) to prosper. Both value and growth ETFs are also in record territory which is another positive sign.

APPLE, AMAZON, and GOOGLE Weigh On Tech Sector

In our previous reports, we explained why rising bond yields usually cause tech stocks to lag behind the rest of the market (and contribute to the rotation into financials). And they’re still doing so. The chart shows Apple (AAPL) still in corrective mode. The falling red line plots the APPLE/S&P 500 relative strength ratio, and shows how weak Apple has been relative to the broader market. Charts 3 and 4 show similar relative weakness in (AMZN) and Alphabet (GOOGL). Facebook (FB) and Netflix (NFLX) have held up a little better than the first three FAANG stocks.

Technology Sector Continues to Underperform

With those big tech stocks losing ground over the last month, it’s no surprise to see the technology sector underperforming the rest of the market. The chart below shows the ratio of the Technology Sector SPDR (XLK) divided by the S&P 500 losing ground since the start of September (when bond yields started to climb). Although the XLK gained +.8% during the month, it still trailed the S&P 500 gain of 2.2%. The PowerShares Nasdaq 100 QQQ ETF (which is dominated by large tech stocks) lost -0.3% over the same period and has yet to hit a new high. Those are relatively small losses. But they show that rotation is going on beneath the surface. That’s not necessarily bad for the market. It just means that money is coming out of one place and moving into another. The move into financials and small caps is actually good for the market. Because they’re the kind of stocks that usually do better in a stronger economy. That’s also true of value stocks in general.

Weekly Snapshot of Global Asset Class Performance

If you have any questions, please feel free to email me at


STA Investment Committee

Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)


Planning for Retirement the R.I.T.E. Way

Some Americans spend decades of their lives working and planning to save for retirement. However, when they get close, there is very little discussion on how to plan for retirement income and distributions.

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Most Americans spend decades of their lives working and planning to save for retirement. However, when they get close, there is very little discussion on how to plan for retirement income and distributions.

There are right ways and wrong ways to plan for retirement income, and the best way is to have a R.I.T.E.® plan (retirement income taxed efficiently). With proper financial and tax planning, you’ll be better positioned to achieve your retirement goals and to close any retirement income gap you may have to reach them.

Setting Your Retirement Withdrawal Rate

The amount you take out each month or year from your portfolio (whether it be an amount or percentage) is known as your withdrawal rate. Planning and knowing an appropriate starting withdrawal rate is a key point for analysis when creating your retirement plan. Your goal and decisions should consider the balance of taking too much and possibly running out of money vs. not taking enough and failing to enjoy your earlier active retirement years. Knowing and targeting your appropriate withdrawal rate is very important early on in retirement, as it will most likely have the largest impact on how long your savings last.

The most often quoted rule of thumb states that you can withdraw 4% annually from a balanced portfolio of stocks and bonds. Many studies show that this can provide inflation-adjusted income for up to 30 years without running out of money. In my readings, many contend that you should budget withdrawing somewhere between 3% and 5% depending on life expectancy, tax issues and market performance. However, these rules were based on historical data and are not guaranteed. There’s no perfect rule of thumb that works for everyone in every situation. (For related reading, see: Will a Systematic Withdrawal Plan Work for You?)

In order to determine your safe withdrawal rate, you need to formalize your overall financial planning goals that include your retirement, investment and estate plans. In creating your formal plan, you are able to identify:

  1. All your sources (sometimes called “buckets”) of retirement income: IRAs, 401(k)s, pensions, Social Security, deferred compensation, and other assets.
  2. Your cash needs or retirement budget to help you determine the current and future withdrawals that you will need to supplement your expected and guaranteed income sources (i.e. pensions or Social Security).
  3. Tax issues and opportunities that may need to be addressed, especially for those in higher tax brackets or if retiring younger where you would be subject to distribution penalties. (For related reading, see: Avoiding IRS Penalties on Your IRA Assets.)
  4. Tax-efficiency in your overall portfolio allocation and tax placement by reviewing all of your accounts and the underlying holdings to make sure that, where possible, tax inefficient investments are held inside pre-tax (retirement) accounts while more tax efficient investments are held in after-tax accounts.
  5. Your needed or required distributions (such as RMDs).
  6. Your family and/or charitable goals.
  7. How much risk you want and/or need to take in terms of your portfolio allocation and ongoing investment strategy. To do this effectively, you should stress-test your plan and know your hurdle rate (the minimum return you need to reach your retirement distribution goals). (For more from this author, see: Retirement Planning: What’s Your Hurdle Rate?)

Proper planning will help you know what you can and should be able to distribute as a withdrawal rate from your retirement portfolio now and into the future.

Which Bucket Should You Drawdown First?

If you have been wise, you will have assets in multiple accounts that are taxable, tax-deferred, and tax-free. So how do you plan where to take money from first when you start retirement? The answer is…it depends.

If you are single and don’t have a goal of leaving a large estate to your beneficiaries or charities, many say you should start by withdrawing money from taxable accounts first, then tax-deferred accounts, and only then from your tax-free accounts. By waiting on taking money from your pre-tax and tax-free accounts, you’ll defer taxes as long as possible while keeping keep more of your retirement dollars working for you. (For related reading, see: Not All Retirement Accounts Should Be Tax-Deferred.)

If you are married or have family goals, it gets more complicated. You will need to coordinate your retirement and estate plans. For example, if you have rapidly appreciating assets and/or highly concentrated stock positions with a low tax basis, it may be beneficial to withdraw from tax-deferred accounts first (especially in low tax years) as these accounts will not receive a step-up in basis at your death. You also should consider the benefits of a rollover of your retirement plans.

Know How to Better Optimize Your Plan and Be Tax Smart

In addition, you can really turbo-charge your retirement plan by identifying appropriate strategies and by being tax smart (the “tax efficiently” part of the R.I.T.E.® plan). This can be done by planning for and knowing your:

  1. Options to maximize the value of your Social Security benefits – especially if you are married
  2. Pension plan distribution options and determining how to best choose options in light of your plan and goals
  3. 401(k) plan rollover options – especially if you have employer stock that could benefit from net unrealized appreciation (NUA) in a rollover/distribution and if you have after-tax dollars
  4. Expected tax brackets to better utilize retirement years where you would be in a lower tax bracket. When this is known, you can utilize various retirement rollover and Roth IRA conversion strategies that may be very beneficial while avoiding typical rollover mistakes.

Bottom Line

You have spent decades saving for retirement. Given that investment of time and money, as you approach or enter retirement you should take the time to review your available alternatives and opportunities to meet your financial planning goals and objectives. This will help you make the best decisions for you and your family.

If you have any questions please feel free to email me at


STA Financial Planning Department
Scott Bishop, Executive VP of Financial Planning, Partner
Patrick Fleming, Senior Director of Wealth Management
Elena Sharma, Financial Planner
Stephen Kirby, Financial Planning

Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.


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