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March 7, 2017

Dear Clients and Friends,
 
Investment Commentary - The Role of Animal Spirits
 
The U.S. stock market, as measured by the Dow Jones Industrial Average and the Standard and Poor 500, has reached all-time highs.  What is driving the market?  Are investors behaving rationally, taking into consideration available quantitative information, or is there some other, more basic, explanation for the market's advance?
 
Investor behavior has been an area of significant research and competing theories.  The famous economist John Maynard Keynes wrote:
"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic.  Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits-a spontaneous urge to action rather than inaction and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."
 
Translation: Actions are often driven by psychology/emotions and not by estimating the probability of future returns using available quantifiably evidence.
 
If we agree that prices for stocks will eventually reflect their underlying fundamentals, such as profits and cash flow, what is quantitative evidence showing us now?  The U.S. market has performed so well over the last eight years that it is now the most expensive stock market in the world, as represented by a cyclically adjusted price to earnings ratio (CAPE) of nearly 29.  Valuations at these levels have resulted in negative ten-year prospective returns close to 50% of the time.
 
In contrast to the U.S. market, international (non-U.S.) equities continue to trade at more reasonable prices.  The S&P 500 outperformed the MSCI EAFE (international) index by 85.1% from November 30, 2007 to December 31, 2016.  As of year-end, developed international equities were trading at prices 30% below their 2007 highs.  U.S. equities, on the other hand, were trading at 44% above 2007 highs.
 
The following charts help to highlight the relative attractiveness of international equity markets compared to the U.S.
 
 
Source:  MSCI as of 12/31/2016
 
 
 
Source:  MSCI, Thompson Datastream
 
 

Just as optimism and confidence can increase risk-taking and help markets reach new highs, pessimism and fear, as shown during the financial crisis, can lead the market into a downward spiral. 

While animal spirits have clearly driven the U.S. market higher, data driven analysis would suggest that foreign stocks, and especially emerging market stocks, will significantly outperform over the next decade. Client stock portfolios are allocated to take advantage of this valuation disparity.

Brokerage Account Reporting of Unrealized Gains and Losses

The unrealized gain/loss and cost basis information that is shown on monthly brokerage account statements can easily lead to confusion. The reported cost equals the original purchase price, plus purchase fees, plus the value of any re-invested dividends and capital gains, less the cost of any sales or redemptions. Here is an example:

 

Tax or Statement Reporting

Performance Review

 

 

 

Mutual Fund Purchase Price

$50,000

$50,000

Transaction fee

+20

+20

Reinvested dividends

+1,000

 

Reinvested capital gains

+1,500

 

Cost of shares sold

-2,000

-2,000

Remaining Cost of Shares Held

$50,520

$48,020

 

 

 

Market value of Shares Held

$50,400

$50,400

Unrealized Gain/Loss

-$120

+$2,380

 

The statement might summarize the above activity as follows:

 

Mutual Funds

                                                          Price                     Total                                      Unrealized

Description           Quantity             Per Unit                Market Value       Cost         Gain/Loss

 

XYZ Fund               1,373.525           36.69                     50,400                   50,520           -120

The -$120 represents the unrealized loss for tax purposes. Had the position been sold at the end of the month at the price shown, the investor would report a loss of $120. This assumes the investment was held in a taxable account (e.g. individual, joint, trust). If the investment was held in a qualified retirement account or IRA, the gains and losses would not be reportable.

It is important not to jump to conclusions on performance when reviewing monthly brokerage account statements. If you have any questions, please contact your service advisor.

Securities and Exchange Commission (SEC)

We were visited by a team of SEC investment advisor examiners in late October and continued to comply with information requests throughout the remainder of the year. This is only the third such routine examination we have experienced in over 30 years, so we were due for a review. We await the final report, but do not anticipate any material findings.  

Cyber Security Email Alert

You may be aware that commonly used email systems, like Gmail, Yahoo, and AOL have been compromised (hacked). If your email account is hacked, it is possible for individuals with criminal intent to read emails and learn enough to impersonate you. Criminals can redirect emails intended for you and communicate with others without your knowledge.

As a result, we are asking that you avoid putting anything in an email that you would not want known by someone with criminal intent. This includes important financial information and travel plans.          

Annual Net Worth Statements

We are preparing personal Net Worth Statements as of December 31, 2016. Taking an accurate picture of assets and liabilities on an annual basis is an important financial planning tool that improves our ability to serve you. These statements allow us to answer these questions: 

·         Should any existing financial accounts be consolidated in the interest of simplification?

·         Should there be any changes in asset ownership that will minimize income taxes?

·         Should there be any changes in asset ownership that will minimize estate taxes or probate expenses?

·         What is the nature of any current debt? Should any debt be paid off or refinanced? Was personal spending supplemented by an increase in debt, which could impact retirement feasibility or retirement security? 

·         Have there been any additions to personal property requiring insurance coordination? 

·         Were there any purchases, sales or gifts of real estate interests? 

·         Were there any changes in asset ownership not communicated to us? Ownership changes impact insurance, taxes and estate planning.

Please respond promptly to our request for this information if you have not already done so. Contact your service advisor if you have any questions or need assistance in completing this request.

Information for Tax Return Preparation

Most of us have already begun the process of gathering the information needed to prepare 2016 tax returns. It is a good idea to keep a current year tax file and fill it with any documents you know will be needed to prepare your returns, such as charitable contribution receipts, out-of- pocket medical expenses, property tax bills, and copies of estimated tax payments made. Financial institutions, including Fidelity, should have already sent Form 1099s with information on interest, dividends and capital gains. 

We have sent out reports of 2016 planning fees paid from taxable accounts. Note that fees paid from IRAs have already provided you with a tax break, since payments are not treated as taxable withdrawals. Therefore, they were not included in our annual fee report and are not deductible on Schedule A of your Form 1040. 

If you made a Qualified Charitable Contribution (QCD) from your IRA as part of your required minimum distribution, make sure your tax preparer handles the distribution correctly on your return. The IRA custodian does not reduce the reported distribution by the amount of the QCD because they cannot vouch for the validity of all charities receiving these donations.

Annual Delivery of Privacy Statement

We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.  

Information Filing - SEC

The SEC requires all registered investment advisors to update the information on file with the agency on Form ADV within 90 days of year end, or March 30. We intend to revise the form and post it on our website by that date. If you do not have access to our website and desire a copy of that form, please contact us.

2017 Income Tax Planning

This year will be unusually challenging since there is a possibility of material changes to both personal and business taxation. In addition, those changes could be retroactive to January 1, 2017. We will continue to monitor the situation and incorporate any changes in the tax law into our recommendations to you.

We continue to work daily to earn your trust and confidence.
 

Best Regards,                                     

Vincent A. Schiavi, CFP®, CPA/ PFS                            Ravi P. Dattani, CFP®, CPA

President                                                                       Vice President

 

 

 
 
 
 


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