Market Rules to Remember

As you know, at Pauley Financial we don't subscribe to the sensationalism of the financial press or prognostications about future market returns. We happened upon two of Bob Farrell's rules recently that reinforce some of the rationale behind this philosophy and approach. These rules may help to rationalize volatile sentiments that are increasingly rampant in investor behavior.  Additionally, new tax planning opportunities await us as "Obamacare" moves ahead (new Medicare tax).

Bob Farrell: Market rules to remember
In the 1950s, Bob Farrell attended the same Masters program at Columbia as Warren Buffett, studying under Benjamin Graham, considered the father of value investing. In 1957, Farrell joined Merrill Lynch as an analyst and stepped down as Merrill’s chief investment strategist in 1992, although he continued to provide his perspectives through articles and media interviews.

In 1992, Farrell penned 10 rules on investing. Two of those 10 are particularly pertinent today and give us encouragement about stock returns for the mid- and long-term period ahead.

Rule 1: Markets return to the mean over time
“Returning to the mean” is another way of saying that over time performance on stocks will revert to historical averages. The long term annual return in the US stock market going back to 1926 is 9.8% before inflation and 6.6% after inflation, what’s called the real return. Whenever you have an extended period in which returns exceed the long-term average, chances are a period of underperformance will follow. And the opposite applies as well; a long period of underperformance will be followed by a period of above average returns. The 1990s saw average real returns of 14.9% annually, the best decade on record. Then reversion to the mean kicked in and the following 10 years saw an average annual loss after inflation of 3.4%. Add the two decades together and you get a real return that’s 1% below the long-term average. In essence, it’s taken the last decade to rectify the valuation excesses of the previous 10 years – but with that behind us, history (and Bob Farrell’s rule on reversion) suggest that long term real returns going forward may be closer to the 6.6% above inflation average. We are required to remind you that past returns are never a guarantee of future returns!

Rule 5: The public buys the most at the top and least at the bottom
Our disciplined rebalancing approach enables our clients to offset this rule. By selling “excesses” in asset classes that are above target range (having done well recently on a relative basis), our system forces us to sell while those asset classes are “high.” Then, we use those proceeds to purchase the asset classes which are relatively undervalued (buy "low“). Buy low / sell high is a recipe for making money. This rule Mr. Farrell discovered over his career is just the opposite.

New Tax Planning Opportunities
At the start of next year (barring Congress and the President are actually able to agree upon something), America's tax system is set to change appreciably. As the Bush-era tax rates shift back to their previous (higher) levels, and preferential (lower) rates on capital gains and dividends phase out. The estate tax rates will go up and the exclusion amounts will go down.

While we all wait to see what happens, the recent Supreme Court ruling on the 2010 Patient Protection Affordable Care Act (sometimes colloquially referred to as "Obamacare") has taken one uncertainty off the table. We now know that a new tax will have to be planned for as of January 1. As a way of shoring up the shaky finances of our country’s Medicare Trust Fund, the budget reconciliation bill that was passed in conjunction with the health care reform bill imposes a 3.8% "Medicare Contribution" tax starting in tax year 2013.

What does that mean to you? For 97% of all households--individuals whose current taxable income falls below $200,000, or couples with a joint income below $250,000--the tax is irrelevant; it only applies to persons above those income thresholds. (Technically, the actual number would be a modified adjusted gross income, with any net foreign income exclusion amounts added back in.) Feel free to stop reading here if you are not in this group.

People whose income does exceed those thresholds will pay the 3.8% tax on the lesser of two calculations. You would first calculate your overall taxable income minus the threshold amount; the amount above this would be subject tax if it happens to be lower than the second calculation. The second amount is your net investment income--that is, how much you made, in aggregate, on taxable (but not muni bond) interest, plus dividends, distributions from annuities, royalties, net rental income (after deducting for expenses, property taxes, interest expense from debt service and property depreciation), income from passive investments like partnerships, from actively trading financial instruments and commodities, plus the gain from selling non-business property. Of course, you get to subtract losses and expenses related to those investments.

So, for example, suppose a husband and wife completed their tax return and found that they had adjusted gross income of $400,000 in 2013. The first number that the 3.8% tax might be applied to is $150,000 ($400,000 - $250,000). Moving to the second test, let's suppose that they earned interest income amounting to $40,000, and had sold some stocks for a capital gains profit of another $40,000. But they had also sold some stocks at a loss, amounting to $15,000. Their net investment income comes to $65,000. That's obviously lower than $150,000, so that is what the couple pays the Medicare Contribution taxes on. Their MC tax comes to $2,470.

Suppose the couple only earned $265,000 in that same year. They would pay taxes on $15,000 ($265,000 - $250,000) rather than on the investment income.

You might have read that this tax will be imposed on the gains from the sale of your house, but that may not be true. If your income is above the threshold limit, you and your spouse would still have to make a profit of more than $500,000 ($250,000 for singles) on the sale of your house before the tax becomes applicable.

The investment calculation does not include payouts from a regular or Roth IRA, 401(k) plan, Social Security or veterans' benefits, or any income from a business on which you are paying self-employment tax. It also doesn't apply to the appreciation of your stocks or mutual funds until or unless they're sold and gains are taken. However, IRA and qualified plan distributions DO raise your modified adjusted gross income, and this, of course, can put you over the threshold. In years when you have is little investment income, this income amount above the threshold may become the applicable tax base--so you could end up paying taxes on these amounts.

Because the amount of investment income determines, in part, your total income, this is one tax that is rich with planning possibilities. Suppose, for example, that the couple mentioned earlier, whose total taxable income would have been $265,000 if they had taken gains on stocks, decided to take fewer gains, so their total taxable income fell to $249,000? The 3.8% would no longer apply to them, even though they had other investment earnings.

Since the Supreme Court decision, advisors are talking about doing just the opposite of what we normally do: deliberately taking gains this year and deferring losses into next year, either to lower 2013 income below the income threshold or to lower 2013 investment income hit by the 3.8% tax and take advantage of the 15% long-term capital gains rate. Others have mentioned the new attractiveness of municipal bonds, whose income isn't affected by the Medicare Contribution tax. A longer-term strategy is to convert IRA assets to Roth IRA assets in 2012, and pay the taxes out of outside assets – again, at the (likely) lower 2012 rates.

Still, it is important to remember that taxes are only one component of your total investment picture. A strategy that simply tries to lower your payments to Uncle Sam may not be the best one for your personal needs, or for building retirement income.