In the microeconomic environment of a single household, we make regular decisions about how much of an item or service to purchase. These decisions tend to be driven by our needs, our preferences, social norms, limitations, or by the price. We might purchase eight bananas at the store based on how many we expect to consume or 16 gallons of fuel based on capacity limits. We might purchase a house based on how much we can afford or tip an Uber driver based on social norms.

Individuals are faced with a similar dilemma when it comes to portfolio construction. Consider one of the most foundational decisions: how much should an investor allocate to foreign stocks? The only limitation is the amount of money available to invest. There is no consumption preference to guide this allocation decision or a fundamental “need” for any foreign stocks. How best to determine the amount to allocate to foreign stocks?

Because of the importance of this decision, it merits a robust decision framework rather than a glib gut-feeling or rule of thumb. We start below with the justification for foreign diversification and then summarize the framework for how we think about the foreign stock decision and the appropriate target level.

The Benefit of Foreign Diversification

The fundamental argument for diversifying to foreign markets is not that foreign countries are less risky or that they experience higher growth or have higher expected returns. The benefit is that foreign markets experience different ebbs and flows and these differences result in a significantly smoother portfolio result. There are different risks in the Swedish stock market or different factors impacting stocks in Brazil. Diversifying the risks, the factors driving returns, and the ebbs and flows results in a smoother ride. It’s more than just theoretical. The chart below demonstrates, based on historical evidence, the reduction in volatility by adding foreign equities to a portfolio of US stocks. Notably, the greatest benefit over this period of more than five decades comes from 40% foreign equity exposure.¹

The same benefit is evidenced by historic risk-adjusted returns where the optimal allocation for an all stock portfolio over the same time period (Jan 1970 – May 2020) was 55% US stocks and 45% foreign stocks (based on the Sharpe Ratio – a useful measure of risk-adjusted returns)².

Not only does this addition of foreign stocks dampen the volatility over the stretch of more than 50 years, it also increases the return as evidenced below with the addition of 40% foreign stocks to a US-only portfolio. This win-win outcome is the quintessential benefit of diversification.

How Much Diversification?

Historical evidence over the last 50 years suggests that an allocation of 40-50% to foreign stocks results in the highest risk-adjusted returns in an all-stock portfolio. Another way to evaluate the appropriate allocation to foreign stocks is to start from a humble place with the admission that the stock market reflects all available information and the best estimate of the right price. Based on this foundation, we can simply use the aggregate value of all stocks in all markets around the globe – the global “market capitalization” – as a reflection of how collective wisdom values the appropriate size of the US market relative to foreign markets.

Based on the market capitalization approach, US stocks represented 55.6% of the global market at the end of 2019.

Everything up to this point suggests a foreign stock allocation of somewhere between 40-50% in an all-stock portfolio. But there are pertinent justifications to consider deviating from that weighting.

The Case for Overweighting Foreign Stocks

The Supply/Demand Distortion of Home Country Bias – One of the most well-documented behavioral mistakes that investors consistently make is the tendency to favor investments from their own country – termed “home country bias”. It is a derivative of familiarity bias – our inherent tendency to favor what we know best – the reason that people who frequently fly Delta overinvest in Delta stock or that people who work for Southern Company overinvest in Southern Company stock. US investors are more familiar with US companies and so they overinvest in US stocks. And it is not just US investors. This bias invariably exists in every country around the globe. The data below from a 2017 Vanguard study reflects a few examples.

Because of the large size of the US relative to every other country, the home country bias creates a distortion that results in excess demand for US stocks and excess supply of foreign stocks.³. As a result of home country bias and this supply/demand distortion, US stocks are inherently overvalued (reducing the expected long-term returns) and foreign stocks undervalued (increasing the expected long-term returns). This dynamic can be expected to persist as long as home country bias remains and as long as the US investment market remains significantly larger than the rest of the world.

US Residents are Overexposed to the US, Outside Their Portfolios – Most US residents investing in stocks have a job in the US, own a house in the US, and will receive Social Security from the US government. That is to say that if we consider the broader portfolio of US residents, most – if not all – of their real estate and human capital wealth is tied to the US. If the US market does well, US residents are likely to see appreciation in their home values and better job security and/or compensation. The opposite is also true. As a result, there is a strong argument that US residents should increase foreign exposure in their financial portfolios to better diversify their domestically-concentrated non-financial portfolio.

Valuation – The strongest case for overweighting foreign investments – albeit a potentially temporal one – is valuation. Robust evidence across sectors, countries, asset classes, and time periods clearly indicates that starting valuation is the best determinant of future returns. One example is evidenced below – showing the cheapest periods of US stock valuation on the left to the most expensive periods on the right and the subsequent 10-year returns.⁴

US stocks today are expensive by nearly every valuation metric whereas foreign stocks, in aggregate, offer much more attractive valuations.

Because starting valuation level plays such an important role in the forecast of 10-15 year expected returns, most institutions that produce long-term capital market assumptions show a notable difference in the return expectations of foreign stocks relative to US stocks. Although the nominal numbers in the forecasts below are different, the trend of foreign stocks having a significantly higher expected return over the coming decade is consistent.⁵

The Case for Overweighting US Stocks

Hedging – Revert back to the home country bias concept and the reality that most US investors are over-invested in US stocks. If your fellow neighbors are the ones competing with you for goods and services and they are all egregiously over-invested in US stocks, then the price of local goods and services is likely to be correlated with the rise and fall of US investments. The case for overweighting US stocks relative to their market capitalization weight is simply to hedge the possibility that US markets perform better than the rest of the world and that your purchasing power for scarce resources is diminished relative to your neighbors because of the biased mistake that everyone else is making.

Lower Transaction Costs – Another case for favoring US stocks relative to their market capitalization weight is that transaction costs and investment costs are higher for foreign investments. While still worth mentioning, these transaction costs were far more of an impediment to international diversification 40 years ago as the transaction cost-barriers to foreign investing have consistently declined over recent decades.

Debunking Lousy Excuses for Overweighting US Stocks and Underweighting Foreign Stocks

As we cover the possible justifications for under- or overweighting foreign stocks, it is appropriate to dispel several of the misguided arguments for favoring US stocks.

Europe and Japan are struggling with bigger issues than the US and. as a result, US economic growth is likely to be stronger and stocks returns higher. Among the most pervasively flawed investment concepts is the idea that measures like GDP growth or GDP/capita growth foretell investment returns. Despite the weak relationship between economic growth and stock returns, the concept continues to be promoted as it makes for an easy story. In fact, empirical evidence indicates that it works the opposite way – that there is a negative correlation between GDP growth and stock returns. As with individual stocks, it is actually the difference between consensus expectations and reality that best foretells future returns. Countries with high expected growth rates are priced to reflect lofty expectations. Vice versa for countries with low expected growth rates. Because there is a strong bias of investors to overpay for growth and erroneously extrapolate the recent past into the future, stocks in countries with low expected growth tend to outperform stocks in countries with high expected growth over long periods. The rationale of higher US growth and the resulting lofty expectations actually presents a compelling argument to underweight US stocks relative to their market capitalization, not overweight them.

Large US companies are multinational and get their revenues from around the globe. As a result, I get enough exposure to foreign markets simply by owning large US multinationals. Let’s start with the fatal flaw of this logic – it is completely arbitrary to only own multinationals that choose to headquarter in the United States. One might as well elect to only own multinationals that headquarter in states that start with the letter ‘N’. Diversification is the free lunch of finance and when there is a free lunch, you generally want as much lunch as you can get.

Second, being diversified in the stock market means more than just diversifying revenue streams. It means diversifying country-specific risks, industry-specific risks, and stock-specific risks. A negative corporate tax law change in the US negatively impacts companies headquartered in the US, irrespective of how diversified the revenues are. Owning Boeing (US based) but not Airbus (Netherlands based) means adding uncompensated company-specific risk that could easily be diversified. Buying only US-based automakers means ignoring most of the global luxury car market that is largely European-based. Buying only US-based companies means losing many benefits of currency diversification. This is all to say that US stocks provide global exposure but they don’t give the full benefit of global diversification.

US stocks have widely outpaced foreign stocks since the financial crisis due to the changing landscape and the innovation advancements of US-based companies like Amazon, Apple, and Google. Famously, the 4 most dangerous words in finance are said to be “this time is different.” The inescapable truth is that US stocks have outperformed foreign stocks over the past decade. But this is not unusual. US stocks have experienced extended periods of strong outperformance in the past. To suggest that this time is different makes a dangerous supposition. Strength of the US dollar over the past decade presents a future headwind for US companies just as weakness of foreign currencies over the past decade provide a future tailwind for those countries. The same can be said of lofty US valuations versus more attractive foreign valuations. There are persistent economic factors that drive the cyclicality evidenced below.⁶

Closing Thoughts – The Appropriate Foreign Mix

This is – to be clear – not just a fun thought exercise. Determining the mix of foreign stocks that belongs in a portfolio is one of the paramount decisions of portfolio management.

It is our humble belief that the global market capitalization provides the most useful starting point for this decision – one that best incorporates all the relevant information and a starting point that fits well with historical portfolio optimization evidence. There are reasonable cases to deviate towards a higher US stock allocation than the market portfolio or, conversely, towards a higher foreign stock allocation. That said, we believe that the current valuation divergence between US stocks and the rest of the world – one that is significantly elevated compared to history – presents the strongest case for tilting slightly above the 44.4% market capitalization weight for foreign stocks. History may not repeat itself – but it often rhymes. Valuations may not converge over the next week or the next year but we believe history will look unfavorably on investors who ignore the powerful historical tendency of valuations as a predictor of long-term returns.

The most common question I hear these days is a variety of “Why isn’t the stock market reflecting the carnage in the broader economy?”. I broadly addressed this topic in a recent post but one part of that answer deserves a little more explanation.

Importantly, when people talk about “the stock market”, they are generally referring to the S&P 500 Index and/or the Dow Jones Industrial Average. These two benchmarks are ubiquitous and hard to avoid. Ask someone how the stock market did today and you will assuredly get a response that directly or indirectly references one of those two indices.

This 2016 article explains why the Dow is a terrible accident of history and that it is only history, name recognition, and habit that cause the world to continue using this index as a reference point. The other index that we collectively use to represent the stock market – the S&P 500 – is a far better representation of the domestic stock market. Yet it is far from perfect.

One big issue with identifying the S&P 500 Index as “the stock market” is that the S&P tends to be overwhelmingly influenced by a handful of large companies within the index. That concentration has never been more impactful, historically, than it is right now. Just five companies – Microsoft, Apple, Amazon, Facebook, and Google (Alphabet) – represent approximately 21% of the Index. The larger these companies get relative to the rest of the stock market, the more dominant of an influence they have on the index.

As a result, these five stocks skew our perception of how the stock market, in a broad sense, is performing. Consider, for example that cruise line stocks are down 70-80% this year. Retailers have generally lost 50%-65%. Oil and gas exploration and production companies are down 55% – 65%. These industries have justifiably been devastated by the pandemic but the devastation is being obscured by the way the index is constructed. While 14 stocks representing these industries have declined by an arithmetic total of 869% this year, their total impact on the S&P 500 is offset entirely by Microsoft’s 14% gain in 2020.

A similar phenomenon holds true for the airlines in the S&P 500 – all of which have lost between 50% and 74%. The aggregate decline of all the airline stocks in the S&P 500 during 2020 – an arithmetic loss of 311%- is entirely offset by Apple’s 4% gain.

This tends to be an important source of confusion when people question why the “stock market” is not depicting the carnage on Main Street, The reality is that most stocks are reflecting the harsh realities of the pandemic. Airlines, retailers, apparel makers, lenders, cruise lines, hotels, financials, automakers, leisure and entertainment companies, and oil and gas companies have all been devastated this year. As of May 20th, over 1/3 of the stocks within the S&P 500 have lost more than 27% of their value.

But that carnage is being masked within what we define as “the stock market” by the performance of five stocks that have a dramatically disproportionate impact and have, for different reasons, continued to do well amidst the pandemic. Just something to keep in mind the next time you’re confronted by someone who questions why the stock market isn’t reflecting the harsh economic realities of Main Street.

The relatively brief history of qualified charitable distributions (QCD) goes back to 2006 when Congress first authorized the QCD in the Pension Protection Act – but only for two years.  It lapsed in 2008, 2010, 2012, 2014, and 2015, only to eventually be reinstated each time.  In late 2015, Congress permanently reinstated the QCD.  It was not until the Tax Cuts and Jobs Act of 2017 (TCJA) that consumers really started to take notice of the QCD. By dramatically increasing the standard deduction and limiting the deduction of state and local taxes, the TCJA significantly expanded the pool of QCD beneficiaries. Although public awareness of the QCD has grown since then, we find that many consumers are still not aware of the QCD or just do not understand the simplicity and benefits well enough to put it to use.   

What is the Qualified Charitable Distribution?

Despite its lack of use, the qualified charitable distribution is not a complex tax planning vehicle or a tax strategy that only applies to a small fraction of taxpayers.  The QCD rule simply permits taxpayers over age 70.5 to make IRA distributions directly to a public charity without treating the distributions as taxable income.  That is, money goes directly from the IRA to the charity without passing go.  

How Does the Qualified Charitable Distribution Work?

In the 1040 example below, note line 4.  Under normal circumstances, this taxpayer with a $35,000 required minimum distribution reports 35,000 on line 4a (IRA distribution amount) and then the same 35,000 on line 4b (taxable amount).  In this example, the taxpayer directed all of the $35,000 required distribution to charity which, in turn, meant that line 4b – the taxable amount – was $0.  This has important ramifications, which will be explained later. 

What are the Requirements of the Qualified Charitable Distribution?

 There are several important (but easy to fulfill) qualifiers:

• The owner of the IRA must be at least age 70 ½ at the time of the distribution.
• The distribution must go directly to a public charity (not a donor advised fund or private foundation).
• The distribution must come from an IRA. Distributions from a 401(k) or 403(b) are not eligible.
• There is no minimum QCD amount but there is a $100k limit per individual taxpayer. Note that a married couple, both over age 70.5, each qualify for the $100k limit so they would be able to use up to $200,000, in aggregate.

What are the Tax Benefits of the Qualified Charitable Distribution?

Without the QCD, a taxpayer would take his or her required minimum distribution (RMD), donate the amount of the distribution to charity, and then take a charitable deduction to offset the income.  In some cases, this would result in a perfect offset and no net impact to the tax liability.  However, with more than 90% of taxpayers now claiming the standard deduction and many of the remaining taxpayers losing some of the itemized deduction benefit because of the increased standard deduction, the offset tends not to be dollar-for-dollar.

What is the Primary Benefit of the Qualified Charitable Distribution?

Some examples will help to answer this question.

Example 1: Consider the case of a 72 year-old married couple, Jack and Diane, who have taxable Social Security income, dividends, and interest of $90,000 plus another $35,000 of required minimum IRA distributions from Jack’s IRA for total adjusted gross income of $125,000.  They pay $5,000 of state taxes and $7,000 of property taxes, and have no mortgage or major medical expenses.  

This year, they moved $35,000 from Jack’s IRA to their joint bank account to fulfill the required minimum distribution.  Later in the year, they will write a check from their bank account for $15,000 to their favorite charity.  Based on all their income and deductions, they will owe $8,444 in federal taxes.

Example 2: Now, assume everything stays the same except for the way in which Jack and Diane make their $15,000 charitable gift.  Instead of moving $35,000 from Jack’s IRA to their bank account, they move $20,000 from the IRA to their joint bank account.  Additionally, they give the same charity the same $15,000 but these funds come directly from the IRA.  That is, the charity gets the $15,000 check directly from Jack’s IRA instead of going from Jack’s IRA to the bank account and then to the charity. 

Financially, nothing changes for Jack and Diane and nothing changes for the charity.  Check that – one thing changes for Jack and Diane.  Instead of paying $8,444 in taxes in our initial example, they pay $6,644 in the second case.  Their tax liability drops by $1,800 or 21.3% simply because they were wise enough to make use of the qualified charitable distribution.  

What caused this significant reduction in federal taxes?  In example 1, Jack and Diane made $15,000 of charitable contributions but they did not get any benefit from these contributions because their total itemized deductions of $25,000 were less than their standard deduction of $27,000.  Had they given away $5,000, $10,000, or $15,000 or zero to charity, they would have faced the exact same federal tax liability. 

In the second example, because they made the gift directly from their IRA and utilized the qualified charitable distribution, what would have been a taxable $35,000 mandatory IRA distribution was reduced to a $20,000 taxable distribution.  In turn, their adjusted gross income and taxable income in example 2 were both $15,000 lower than in example 1.  Yes, their itemized deductions were also $15,000 lower because they didn’t get to claim any charitable contributions but that’s the whole point.  Reducing their income by $15,000 was far more valuable than increasing their itemized deductions by $15,000. 

A married couple without major medical expenses or without a primary mortgage interest expense that exceeds $17,000 per year are likely to benefit from utilizing the qualified charitable distribution for the same reasons as Jack and Diane.  It is a tax savings tool, unavailable to anyone under age 70.5, that effectively allows for the shifting of charitable deductions from the Schedule A, where they may not be entirely useful, to the front page of the Form 1040, where they’re going to be useful for anyone who pays taxes.        

Who else might benefit from the QCD?

Couples with more than $170,000 of modified adjusted gross income and individuals with more than $85,000 of income can use the QCD to avoid higher Medicare premiums.

Medicare B and D premiums are tied to the modified adjusted gross income (MAGI) of taxpayers.  Single taxpayers with modified adjusted gross income of more than $87,000 and married filing jointly taxpayers with MAGI of more than $174,000 pay an additional Medicare premium amount, known as income related monthly adjustment amounts (IRMAA).  For example, a married taxpayer with modified adjusted gross income of $174,001 would pay an additional $115.60/month or $1,387/year compared to a couple with $174,000 of income – just $1 less.

The income thresholds in the leftmost column above are based on modified adjusted gross income – which means they are not reduced by itemized deductions (i.e. charitable gifts).  A married taxpayer with $175,000 of adjusted gross income who donates $10,000 to charity via checks has to pay the higher Medicare premiums.  However, if the same taxpayers use the QCD to donate the same $10,000 to charity, MAGI is reduced to $165,000 and the tax filer does not face the additional Medicare premiums – a simple and quick one year tax savings of $1,387.  

Married tax filers with over $250,000 of AGI or single filers with over $200,000 of AGI can use the QCD to reduce the 3.8% Medicare tax.

The 3.8% Medicare tax on investment income only applies to married filers with more than $250,00 of AGI or single filers with more than $200,000.  Utilizing the QCD technique can either relieve taxpayers of that tax completely by reducing AGI below those levels or can reduce the amount of investment income that is subject to the 3.8% tax.

For example, a taxpayer with $50,000 of charitable contributions who is subject to the 3.8% Medicare tax on $125,000 of income beyond the thresholds can save $1,900 in taxes ($50,000 x 3.8%) by simply making use of the QCD. 

Rental property owners who actively participate in the property’s rental activity can use the QCD to qualify for a larger taxable rental loss.

If you own a rental property and meet the requirements to qualify for active participation (make management decisions related to the property, etc.), the tax code allows you to deduct up to $25,000 of rental property losses each year.  Importantly, to claim the rental losses as an offset to other income, your AGI must be below $150,000 (or $75,000 for single filers).  Since the income threshold is determined by AGI and not by taxable income, this presents another opportunity for the QCD to reduce income and, resultantly, to allow the taxpayer to claim a larger tax loss.

Tax filers who receive Social Security and have limited other income sources can use the QCD to reduce or eliminate the amount of Social Security that is subject to taxation.

The IRS looks at something called “combined income” to determine how much of your Social Security will be subject to taxes.  Combined income consists of AGI (less Social Security) plus tax exempt municipal bond interest plus ½ of Social Security benefits.  If your combined income is below $44,000 (for a married couple; or $34,000 for a single individual), then the amount of Social Security subject to taxation is reduced.  Anyone close to these thresholds could benefit from utilizing the QCD to reduce combined income.

Tax filers who are constrained on the size of their charitable deduction can use the qualified charitable distribution to realize a larger tax benefit from their charitable giving.

For taxpayers who itemize deductions, the IRS limits the size of the charitable deduction to no more than 50% of adjusted gross income and, depending on other factors, sometimes 30% or 20% of AGI.  As a result of these limits, taxpayers who make large charitable gifts each year can have their deduction limited.  The QCD allows taxpayers to make charitable gifts without being subject to these limits.    

Closing Comments

Importantly, none of the advice above suggests giving more dollars to charity simply for tax benefits.  The amount of charitable giving is a personal decision that should not be determined or driven by potential tax savings.  However, the method of gifting can often be optimized to have a profound impact on the tax benefit of the gift.  

The intent here is not to suggest that the qualified charitable distribution has benefit for all individuals who are over age 70.5.  In fact, the QCD is not going to be of any value for some tax filers.  Individuals who do not make charitable gifts, who don’t fit any of the criteria above, or have large, low basis stock positions are likely not going to benefit from the QCD.  

Instead, the intent here is to expand awareness on what the QCD is, how it works, and how you might benefit from its use.  Simply understanding that it exists and how it can be utilized likely separates you from the majority of Americans.

The economy just lost 30 million jobs over the past six weeks – an incomprehensible figure that likely understates the actual damage because of slow and archaic state processing. The White House warned that unemployment could reach 20% by June. Real GDP fell by an annualized 4.8% in Q1 and forecasts suggest annualized real GDP could contract by roughly 40% in Q2. Consumer spending – the lifeblood of the economy – suffered its worst monthly decline (-7.5%) since measurement of this metric began in 1959. The Federal Reserve Chairman described this economy as “the worst ever”.

Oh, and the stock market just enjoyed its best month in more than 30 years and its third best monthly return since World War II. Of course it did.

How does this make any sense? Have investors lost their minds? When is the stock market going to wake up and catch up with all this horrific data? Why are stocks going up when the economy is not getting better – it’s getting worse? Why not get out of stocks and wait until the stock market catches up with the economy? What in the world is going on here?

Do not despise if you have asked yourself one, some, or all of these questions over the past several weeks. Look, the stock market does not make sense at times. And that statement alone should be reason enough to avoid trying to “time the stock market”. But you should also appreciate that a lot of what happened in April does make sense. It makes a lot of sense if you step back and appreciate how the stock market works. It makes sense if investors embrace the truth that the stock market does not behave like they think it behaves.

So, let’s step back and collectively address all the questions above as one: Why did the stock market rally in April?

Reminder: The stock market already plummeted based on the dire forecasts. Remember March 2020? In a 23-day stretch that began in late February, the stock market plummeted by 34%, marking the fastest bear market ever. This happened – mind you – while the unemployment rate (3.5%) was at its lowest level since 1969 and while weekly unemployment claims were near their lowest level since the 1960’s. The first blip in the weekly unemployment claims – 3.3 million new claims – was reported on March 26, 3 days after the stock market reached its nadir and was already recovering. 

What’s that you say…the employment data was lagging and the stock was out in front of it? Exactly the point. The stock market sold off in anticipation of the lousy data that we would get in April and May and June and July. You know…the data that we actually got last month.     

Reminder: The stock market only cares about today’s data that reflects yesterday’s news if it impacts tomorrow’s outlook.

April was the best month for stocks in more than three decades because the dramatic uncertainty we faced in March became less uncertain in April. Uncertainty did not go away. It never does. It was just that the extreme range of possibilities we faced in March became less extreme. The curve flattened. Covid-19 cases did not go to zero but we also were not experiencing over 1,000,000 new cases a day – which was a real possibility in March. Suggesting that the stock market needs to catch up with the economy completely misses the point.

Reminder: The stock market reflects large publicly traded companies in many different industries making profits in many ways.

Are most companies impacted by Covid-19? Without a doubt. However, the impact of this pandemic is clearly different for Microsoft than for Delta Airlines. It is different for Amazon than it is for Gap. And the stock market eventually baked in the differentiated impact of this pandemic. So, while the stock market may have recovered some of the losses in aggregate, it is worthy of reminder that cruise line stocks are down 70-85% since the beginning of the year; that oil and gas companies are down 50-70%; and that most brick-and-mortar retailers and airlines are down 50-70%. This is to say that the stock market is behaving like it is supposed to behave – dramatically penalizing the companies that have been and will be most negatively impacted by the coronavirus – a reality that gets lost in the aggregate.

Reminder: Investors were panicked in March. They behaved like panicked people behave.

This is a blurb from the Golden Bell Financial investment commentary to clients on March 11^th:

“One underappreciated yet important item of note is that the selling during these past three weeks has been largely indiscriminate – a sign that investors aren’t being entirely rational.  Stocks of companies with less debt or better cash flow that should be better prepared to weather an economic storm have sold off more than the companies with heavy debt loads or weak balance sheets.  Most of the ugly selling days have been a sell-first, ask-questions-later environment where fear dominates and the institutional investors are just selling what they can get out of easily.  That creates opportunity for patient, long-term investors who are not forced to sell.“

It is hard to say how much of the recent recovery in stocks has simply been the result of the fear and panic subsiding but it is clearly a component of the recovery. That is how this tends to work – panic causes irrational selling where prices fall based on deteriorating fundamentals but they go below the intrinsic, fundamental value because of the fear. Eventually, the fear subsides and prices find their fundamental value. This is the stock market’s way of transferring wealth from individuals who wait on the sidelines “for things to calm down” to investors who stay disciplined.  Investing in the stock market is not a free lunch and it is the scary periods that provide the reward for the disciplined investors.  That reward just came really quickly this time.   

Reminder: The impact of monetary and fiscal stimulus cannot be overstated.

It is difficult for households to fully appreciate how monetary and fiscal stimulus impacts the economy because we are used to a reality where job loss or loss of income means that a family can’t spend as much, has borrowing sources cut off, and struggles to pay bills. That’s the reality a family faces. But in in an economy where the government can borrow more at extremely low rates or print more dollars to buy goods and stimulate demand, the household constraints don’t apply. The unprecedented levels of stimulus we have experienced since mid-March – both fiscal (Congress) and monetary (Federal Reserve) – are likely to have an enormous impact on the economy – a point that does not get anywhere near the attention it deserves from individual investors.

Many readers are now saying, “Yes, but all this borrowing and printing of trillions of dollars has a cost.” To be clear, it does. This is not a free lunch. What the current stimulus effectively does is pull forward future growth and future demand into the present resulting in higher stock prices today at the likely expense of tempered future economic growth and compressed returns (for not just stocks but also cash and real estate and bonds) over the next 10-20 years. In this case, consuming too much on Friday night doesn’t necessarily result in a terrible Saturday morning hangover – it more likely results in a sluggish week to follow.

Reminder: Relying on any “expert” predictions about the future is foolish.

This really does not address the initial question and seasoned clients are tired of hearing it. However, it is important to note: Save for some “market prognosticator” who publishes daily market predictions to his nine Twitter followers and who correctly called 14 of the past 1 bear markets, no economists or forecasters or equity strategists predicted the dramatic impact that Covid-19 would have on the economy and the stock market in March. In the same vein, no forecasters or equity strategists predicted the immediate and robust stock market recovery we would experience in April. Just another reminder of the value of forecasts.

Look, the stock market is unpredictable and sometimes confounding. If it was easily predictable and always made complete sense, long-term stock returns would look more like long-term cash returns. But all told, the stock market makes a lot more sense than investors give it credit for.

When the history books are written, March 2020 will merit its own chapter.  Maybe two.  Lengthy chapters.  Among other notable items, March 2020 will be remembered as the longest month on record.  Officially, it measured 31 days.  Unofficially, it lasted 97.  So it felt.

In this forever-month, we witnessed the culmination of the longest bull market in history (132 months: March 2009 – March 2020), the fastest bear market in history (16 trading days: Feb 20 – March 12), and – by some measures – the shortest bear market in history (3 days: March 23 – 26).

On average, the twenty-five prior bear markets since 1928 have required 255 trading sessions to achieve the objective bear market requirement of a 20% decline from market peak.  It bears (no pun intended) repeating – this one required just 16 days.  Among other noteworthy items about the 16 trading days starting on February 20^th is that three of the fifty best trading days since World War II came within this stretch (+4.9% on March 10, +4.6% on March 2, +4.2% on March 4).  That means that to lose 26.7% over 16 days, the stock market needed to absorb three of its best days ever during the stretch.

Consider a few other metrics that help put the recent volatility in some historic perspective. 

1. The stretch between February 24 and April 6, 2020 accounted for 31 of the 18,759 trading days since World War II.  In those 31 days, the stock market (S&P 500 Index) experienced 9 of its 100 best days since World War II and 11 of its 100 worst days. 
2. One way to compare volatility for a month is by taking the absolute value of each daily return and adding them together. Do that for March 2020 and you get a result of 109% – an average movement of 5.0% per day.  By this measure, March 2020 goes down as the most volatile month ever and it’s not even close. The 5.0% average daily move is 28.2% higher than the previous record set in November 1929.

We can go on about the historic volatility or the Q1 market experience but instead choose to reflect on eight important lessons from this unprecedented environment that we can all appreciate, remember, and follow so as to be better investors in the future.

1) We never repeat the same crisis.  This time is always different. 

You have heard and will undoubtedly again hear how this crisis is different than any crisis in the past.  It most assuredly is.  It is historic.  The abruptness of this economic contraction is unprecedented.  The unemployment claim numbers over the past three weeks – nearly 17 million in total – provide shocking evidence.

Now pause for a moment to consider a sampling of some crises over the past 30 years: September 11^th, the financial crisis, the European sovereign debt crisis, the Russian default crisis, the Asian currency crisis, the Gulf War, the Flash Crash, the Fiscal Cliff, Y2K, the dot.com crash, Brexit, Fukushima, Katrina, and two impeachments.  To name a few.  They were all different. 

Yet while all crises are different, they ALL have the same four common denominators: 

1. When we are in the middle of each crisis, things are scary.  Often, very scary.  And uncertain.  
2. In every crisis, there are purported experts – plenty of them – opining on how bad it’s going to get. And because pessimism sells, they are overwhelmingly given airtime and megaphones to do so.
3. Every crisis eventually winds down, economies grow, corporate profits return to pre-crisis levels, the stock market fully recovers, and life returns to normal.
4. A few years removed from each crisis, our hindsight fools us into underappreciating how uncertain it was when we were in it and misremembering how obvious it was that we would get past it.

2) The stock market does not need good news to rally.  It just needs a less bad future than was expected yesterday.

Consider that the S&P 500 just completed its best week since 1974 – posting a +12.1% return in the shortened trading week ending April 9th.  To be clear, 16.8 million Americans filed initial unemployment claims over the past three weeks and the domestic stock market recorded its best week in 46 years. Including the two prior weeks, the S&P 500 is up 24.7% from its lows.    

In the course of this dramatic 3-week rally, I heard several variations of the following:

“I do not understand why the stock market is rallying.  This Covid-19 pandemic is going to get a lot worse.  The resurging market fails to appreciate that many more businesses are going to go bankrupt, that the parabolic rise in Covid-19 deaths is going to continue, that the horrendous unemployment numbers will get worse, and that this will be a historically bad economic downturn like none other.  The stock market rallying in light of all this seems foolish.”    

Make no mistake – we are in the most telegraphed recession in history.  It will not be official for several quarters to come but the stock market knows this is more than a garden variety contraction.  And while few, if any, saw this pandemic coming at the start of the year, it is not a secret now.  The stock market is well attuned to the dramatic economic impact that this pandemic will have.  

Importantly, the stock market reflects the present value of anticipated future corporate profits.  The S&P 500 Index, for example, reflects the expected future profits of large companies such as Apple, Walmart, AT&T, Microsoft, Google, and Proctor & Gamble discounted back at a reasonable discount rate.  A simpler way of reflecting this is the following formula:

Stock Market Value = Future Corporate Profits / Uncertainty

When the S&P 500 fell by 34% this year, it was the result of reduced corporate profit expectations (lower numerator) in the future and high uncertainty about the future (higher denominator). That move was the stock market factoring in all the bad stuff – the Covid-19 deaths, the bankruptcies, the job losses, the future uncertainty.

But the stock market moves higher when one or both of two things happens: the expectation for future corporate profits increases and/or uncertainty decreases.  The global impact of quarantines and social distancing to slow the spread of coronavirus did not eliminate uncertainty but it did reduce the enormous range of likely outcomes, thereby reducing uncertainty. Moreover, actions by global central banks to strengthen credit markets and unprecedented fiscal spending helped to reduce the chances of a more severe depression both helped to reduce uncertainty about the future.  And the stock market just needed less uncertainty to move higher – which it got. Still really high uncertainty – just a little less uncertainty.  

3) The market knows more and is more forward-looking than investors give it credit.

Public backlash arose when reports surfaced that members of Congress profited based on their unique knowledge of the coronavirus pandemic.  These Congressional members were briefed by intelligence officials on the severity of the impending crisis in early February and immediately engaged in aggressive stock sales, collectively selling millions of dollars of stock before the public was aware of how severe the coronavirus crisis would become.   

While Congressional members taking such action while simultaneously communicating to the public that the coronavirus would not pose a massive health risk in the United States was undeniably wrong, there’s another important takeaway: the stock market reflects far more information than individual investors know or appreciate.

Congressional members were not the only ones who had access to unique information about the likely impact or spread of Covid-19. So did scientists studying the epidemic around the globe. So did the Chinese government. So did European governments. So did institutional investors paying millions of dollars to get earlier access to information and better information than you.

Maybe the important lesson here is that you’re always at a disadvantage. Arguably, the better takeaway is to eat a piece of humble pie and appreciate the idea that any of us knowing as much or more than the market is almost always a fallacy.     

4) Making market predictions is easy.  Getting them consistently right is difficult, if not impossible.  Following them is foolish. 

Even if you are able to predict how the future unfolds for this pandemic, you still have to determine how Congress will respond, how the Federal Reserve will respond, how the President will respond, how global central banks will respond, and lastly, how market participants will react.  Getting some of those predictions right, but not others, may be more destructive than helpful.

The next time that you find yourself puzzled as to why the market went up or down today based on specific news that seems antithetical to the latest market response, remember lessons 2 and 3. But also remember the paragraph above and that it’s about far more than today’s headline.  

5) Stocks provide a higher long-term return because the market compensates equity investors for bearing the risk of stocks and enduring the volatility. 

Unfortunately, stocks go down and sometimes they go down by scary amounts.  The month of March represented what the risk of equity investing looks like.  Without this risk, there would be no greater return from stocks than from cash.  This is called the equity risk premium. 

And because risk is elevated now, so is the equity risk premium.  It’s like wind insurance after a hurricane – premiums instantly increase providing a higher expected return for the insurer (risk-taker) and a more negative return for the insurance purchasers (risk-seller).  That’s where we are with the equity market now – there’s a higher expected return for buyers/owners than there was at the onset of 2020 because there is a higher equity risk premium.

Furthermore, this is why disciplined rebalancing works. It contra-trades relative to our emotions. Rebalancing inherently reduces risk when risk premiums are low (fear is low) and adds risk when risk premiums are high (fear is high). And where do the profits from rebalancing come? From the bulk of individual investors who do the opposite – trade based on emotions (buying when perceived risk is low, selling when perceived risk is high) rather than trading based on a discipline.

6) Making extreme portfolio changes or bets is not investing.  It’s gambling.

When you’re an investor faced with many unknowns – which encompasses every day since the beginning of time – it is better to focus on what is probable rather than what is possible.  Loading up on beaten-down airline stocks and selling 100% of a portfolio to cash both reflect binary outcome bets that draw analogy to playing craps in Las Vegas.  Entertaining?  Perhaps.  Consistently profitable?  Unlikely. 

The lesson to draw from every market reversal is that investors should embrace the uncertainty of markets – not just in good times, but also in bad.  Embracing that uncertainty means that the best approach is constructing a portfolio of diversified assets.  It means setting an appropriate risk level, establishing a discipline based on that risk level, and then consistently maintaining it.  In short, it means preparing for all possibilities – not just one possibility. That’s true when markets are going up just as much as when markets are going down.    

The best advice for investors who feel the desire to gamble? Do it in small chunks with gambles that won’t noticeably impact your financial plan.

7) Market reversals are often fast and not telegraphed. 

On March 22, a long-time client forwarded me an article from a major news publication with advice from financial advisors on how to handle the crisis.  In this article, one of the “expert advisors” suggested that she was “waiting for more certainty before buying” and that “volatility won’t be over until we’re finished with this virus”. I informally responded:

“God bless this advisor and her clients.  It’s naïve and/or incompetent to suggest that there is going to be a time to buy when we have more certainty.  When we have certainty, it will be the first time that we’ve ever had certainty in the history of financial markets.  When we have more clarity, the stock market will likely have recovered all that it’s going to have recovered and anyone waiting to invest will get much lower expected future returns.  There will be uncertainty related to this virus for many months and then there will be some other uncertainty that we don’t even know about right now.  And the market pays investors for uncertainty, not for certainty.  But let’s be thankful for this kind of advisor because her and her clients are the ones who transfer their wealth to the rest of the investors in the market.”

Over the next 13 trading sessions, the S&P 500 increased by 24.6% – a reasonable return for 3-5 years, let alone 13 days.  For historical context, quick reversals from sharp market selloffs also occurred in 2009, in 2003, in 2011, and in 1987. Going to cash to wait for more clarity or for a “clear market bottom” may feel appropriate but has historically meant losing several years’ worth of returns when the market eventually reverses.

8) We would all be better served to divert our energy and time to controlling the controllables.

There will always be stories of investors who sold everything at the top or bought aggressively at the extreme bottom.  What will not be reported is the seven times before when they sold prematurely and sat mostly in cash during a market rally.  That is not newsworthy and even if it was, no investor is going to the media to tell that story.  The commonality of nearly all successful investors is that they took a disciplined approach, not that they were consistently prescient in nailing the top and the bottom.      

The path to financial success is to largely ignore what you cannot control (the stock market, politics, interest rates, economic data, etc.) and focus on what you can control (budgeting, rebalancing, saving, tax planning, estate planning, strategic asset allocation, etc.).  From a non-financial perspective, we can further help ourselves by focusing on what we can control right now: following CDC guidelines, enjoying quality time with our families, healthy eating, exercise, leveraging technology to check on friends, and limiting our diet of news from all sources.

Participate in the financial markets long enough and there will be challenges and crises – plenty of them. If we’re humble about what we know and don’t know, if we learn from the past, if we appreciate the investment markets for what they are, if we appreciate the differences and commonalities of each crisis, and if we control what we can control, then we will be better for it – financially and emotionally.

The PPP, which goes live tomorrow (April 3), is considered the most generous stimulus program in the history of the Small Business Association (SBA) and should have the attention of every small business owner, independent contractor, or self-employed individual who has been adversely impacted in any way by COVID-19.  I hate to use the term “free money” that others have used to describe this program.  At worst, this represents the most generous loan offer that businesses have ever seen or will ever see.  At best, the PPP is a grant from the federal government to pay 8 weeks of expenses for small businesses that need financial assistance during these unprecedented times.

The CARES Act outlined the general PPP terms and then Treasury issued guidance on March 31.  Banks, however, are still waiting on yet-to-be-released guidance from the SBA.  As a result, there is still uncertainty on several items and banks may not begin taking applications right away until the SBA issues formal guidance.  I will update if there are any important changes but here is a summary of advice on PPP based on what is known right now.  

Who qualifies for this stimulus program?

Small businesses with less than 500 employees; sole proprietors, self-employed individuals, independent contractors, and 501(c)3 non-profits that have been in operation since at least February 15, 2020 (along with a few specific other entities).  The applicant must attest that economic uncertainty related to COVID-19 makes the request necessary and that proceeds will be used to support ongoing operations of the business. 

What are the unique loan terms that make this so attractive?

• Up to 100% of the principal amount may be forgiven if used for payroll (including owner compensation up to $100,000), rent, utilities, employee benefits (including medical insurance), and interest on existing mortgage debt over an 8-week period after loan approval.
• Loan forgiveness is not taxable
• 0.5% 1.0% annual interest rate on any loan proceeds that do not qualify for forgiveness (SBA updated 4/3/2020 from 0.5% to 1.0%)
• No payments for the first 6 months of the loan followed by an 18-month amortization (2 year total term)
• Streamlined funding process (the simplified application should require no more than 10-30 minutes to complete)
• No collateral or personal guarantees
• No prepayment penalty
• All borrower fees are waived

How much can I borrow?

2.5x your average monthly payroll measured over the twelve months before the date of the loan ending December 31, 2019 (revised in updated application 4/3/2020).  Notably, there is a per-employee cap of $100,000 for this calculation.  Seasonal businesses and new businesses established in the last 12 months have slightly different formulas.  A business with an owner who makes $200,000 per year and four employees who get paid $50,000 per year is eligible to borrow $62,500 (average monthly payroll = $25,000 since owner’s comp is limited to $100k; $25,000 x 2.5 = $62,500).  There is a maximum loan size of $10 million.

What counts as payroll for this formula?

Salaries, medical benefits, tips, commissions, bonuses, retirement benefit payments, and payment of state and local tax on compensation, among other items.  For self-employed or independent contractors, net earnings of the business is treated as payroll.

What are the eligible uses for loan proceeds?

Payroll expenses (including benefits noted above), rent, utilities (including cell phones, Internet), and interest on existing mortgages.

How does the loan forgiveness work?

In the eight-week period following the loan proceeds being disbursed, any of the expenses noted above (payroll, rent, utilities, etc.) are eligible for forgiveness.  The forgiveness amount is formulaically reduced for businesses that reduce the number of employees as of June 30, 2020 and/or reduce the wages of employees earning less than $100,000 by more than 25%.  Provided that your headcount is not reduced, the program effectively pays all your operating expenses for an eight week period.  And to the extent that you do not have 100% of the loan forgiven based on the formula, you’re still borrowing money at a whopping interest rate of 0.5% 1.0%.

Should I apply?

There are going to be some businesses that have not been adversely impacted by COVID-19 (i.e. truckers, bankruptcy attorneys, toilet paper manufacturers).  The overwhelming majority of small businesses or self-employed individuals have been or will be negatively impacted by COVID-19 to some degree and should pursue this opportunity.  Moreover, there is no size that is too small – because of the simplified and streamlined underwriting process, banks have indicated a willingness to lend to borrowers of any size for any amount.

How do I apply?

The PPP is being administered by banks and other financial institutions approved by the SBA.  Because of the enormous demand for these loans and the uncertainty for lenders, most banks are expected to loan only to their existing customers – at least in the first few weeks.  As a result, the best approach is to reach out to your current bank to inquire about applying.  The loan terms are standardized by the SBA regardless of lender so there is no need to “shop around”.  Only if your banking partner denies your application should you reach out to another lender.

How soon should I apply?

The program is supposed to go live tomorrow (April 3^rd; although self-employed and sole proprietors cannot apply until April 10^th) but it is unclear on when regulations and guidance will come from SBA so applications may not begin until sometime during the week of April 6^th.  The PPP is capped at $349 billion as a first-come, first-served lending program so some lenders are suggesting that businesses should apply as soon as possible.  There is some debate here.  Other lenders have gone on record saying that there is no way Congress lets this program run out of money before June 30^th without catastrophic consequences and that it’s likely to be expanded, as needed.  Businesses that have been already been forced to lay off or furlough most employees may want to delay applying until closer to June 30^th since the loan forgiveness formula will be more favorable if and when the business is operating at closer to capacity.

Hope this helps provide a rough outline of the program.  If you have any questions, want to discuss this program in more detail to see if it applies, or just want to better understand some of the technicalities of the program, I encourage you to reach out or comment below. 

The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law by the President on Friday evening (March 27), providing the largest stimulus package in history. The historic 880-page bill provides expanded unemployment benefits, generous small business loans, cash payments to American taxpayers, and a number of other stimuli to aid individuals and businesses impacted as a result of the Coronavirus outbreak. 

With a massive stimulus package thrown together this quickly and with this much money at stake, there are naturally lots of questions and financial planning opportunities.

Importantly, families in this country face cases of real economic peril caused by this pandemic (not to mention the immediate health impact to individuals who have contracted the virus).  Such families and individuals are concerned with health and/or financial survival in the here and now – not how the rules for required minimum distributions (RMDs) or student loan payments will change in 2020.  Moreover, individuals with multi-million dollar portfolios who face only minimal economic impact from this pandemic may not feel deserving of a $2,400 stimulus check.

The objective here is neither to opine on the “fairness” of the legislation or to tirelessly outline all the details as there are plenty of good online sources that address the frequently asked questions about the Recovery Rebate checks or the new “Coronavirus Related Distributions”. Additionally, the following does not attempt to address new strategies for small business owners resulting from the CARES Act (which may be covered in a follow-up post).  Instead, this post is simply intended to describe several of the immediate and near-term financial planning strategies for individuals that arise from the CARES Act, several of which have broad impact.  Lastly, for clients of Golden Bell Financial, you can expect to receive guidance if one or more of these items directly impacts you and you are encouraged to reach out if you have questions about the application of any strategy to your circumstances.

Recovery Rebates for Individuals

The stimulus checks (or direct deposits) that most of America will be receiving easy qualify as the most publicized element within the CARES Act.  According to Tax Foundation estimates, roughly 94% of Americans will qualify for these “Recovery Rebates” and because the determination is entirely income-based with no asset testing, retirees with multi-million dollar portfolios will likely qualify for the full rebate check provided they don’t have large taxable income sources. 

As you likely know by now, the full Recovery Rebate amount is $2,400 for a married couple filing a joint return or $1,200 for all other filers.  Each child under 17 in the household adds another $500 to that rebate amount.  A married couple with four children under the age of 17, for example, qualifies for a $4,400 rebate.  Better still, these rebates will not be treated as taxable income.

The catch is that there is an income test which begins to reduce the full benefit at $150,000 of adjusted gross income (AGI) for married couples filing a joint return and at $75,000 for single filers ($112,500 for head of household filers).  Any taxpayers with adjusted gross income above these amounts will experience $5 of reduced benefit for every additional $100 of income. As a result, a married couple with no kids will still receive some benefit provided their income is below $198,000 and a married couple with two children under 17 qualifies for benefits with income up to $218,000.  There are already several online calculators if you want to calculate your family’s potential stimulus benefit.   

The Recovery Rebate will initially be based on the income reported on your 2019 tax return if you have already filed or your 2018 tax return if your 2019 return has not yet been filed.  Notably, there will eventually be a “true-up” as the final determination of each taxpayer’s eligibility for the stimulus will be based on 2020 adjusted gross income.  If you receive only a partial rebate based on 2019 or 2018 income and then experience an income decline in 2020, you will be entitled to an increased true-up benefit once you file your 2020 tax return next year (probably long after you actually needed the benefit).  Alternatively, if you receive a rebate based on 2018 or 2019 income but then report increased AGI in 2020 which qualifies you for a lower benefit than you actually received, you will not be subject to any “claw-back” of the Recovery Rebate received this year.   

To be clear, these Rebates were designed to help people in need during a time of crisis.  And that will be true for many Americans.  But consider the individual taxpayer with no children who reported $100,000 of adjusted gross income on his already-filed 2019 tax return and then lost his job in early 2020 due to the Coronavirus epidemic.  This taxpayer will not immediately qualify for a rebate check because his 2019 income exceeds the qualification threshold.  Only this time next year, once he files his 2020 return in early 2021 and reports minimal 2020 income, will he qualify for a rebate check.

Aside from wanting to know if they qualify for the stimulus checks, the other popular questions being asked right now are when and how the stimulus checks will be sent.  According to Treasury Secretary Mnuchin, the first payments are supposed to be sent the week of April 6.  Based on staffing shortages at the IRS, experts believe this is an ambitious timetable and it may take several more weeks beyond this before the checks start going out. 

If you are entitled to a Recovery Rebate, the IRS will use the direct deposit information on your most recently filed tax return (2019 or 2018) and issue your rebate using those instructions.  If you have not provided direct deposit instructions to the IRS, you will receive a mailed rebate check.

Let’s now consider a few planning implications stemming from all these details based on your circumstances.

Your adjusted gross income in 2019 was lower than in 2018.  If you a) will qualify for a rebate; and b) you will report lower income in 2019 than in 2018 (perhaps because you retired in 2018 or 2019), you should plan to file your 2019 tax return immediately, if not already filed.  Unless you qualify for the maximum benefit using either 2018 or 2019 income, it is going to be advantageous to file immediately as the lower 2019 income will qualify you for a higher benefit amount.

You have a child who turned 17 in 2019.  If you a) will qualify for a rebate; and b) you had a child who turned 17 in 2019, you may want to wait to delay filing your 2019 tax return, if not already filed.  It is still unclear how the IRS will treat a child who turned 17 in 2019 but, while there is uncertainty, it won’t hurt to use the 2018 return – unless your 2019 income is markedly lower than 2018.

You are married and don’t qualify for a stimulus check based on your joint income but the lower earning spouse has income under $75,000 and would qualify based on his/her income.  Depending on other circumstances, it may make sense to immediately file separate tax returns for 2019 where one spouse is able to qualify for the Rebate Recovery check (and again depending on circumstances, treat any children under age 17 as dependents of the lower earning spouse).  If you are not in immediate need of the stimulus, you could simply consider filing separate tax returns at this time next year. 

Relaxation of IRA and Retirement Plan Distribution Rules in 2020

To provide financial relief to individuals impacted by the Coronavirus pandemic, the CARES Act draws on legislation utilized during the financial crisis, allowing individuals to take hardship distributions of up to $100,000 from a 401(k), IRA, or other qualified retirement account without the standard 10% early withdrawal penalty for individuals under 59.5 years old.  The qualifications to utilize this provision are broad and include anyone:

1. who is diagnosed with COVID-19;
2. whose spouse or dependent is diagnosed with COVID-19; or
3. who experiences adverse financial consequences as a result of being quarantined, furloughed, laid off, having work hours reduced, being unable to work due to lack of child care due to COVID-19, closing or reducing hours of a business owned or operated by the individual due to COVID-19, or other factors as determined by the Treasury Secretary.

The liberal definition of item three means that most working Americans will qualify for this relief. 

In addition to the suspension of pre-59.5 penalties for retirement plan distributions, there are some other attractive benefits of these “Coronavirus-Related Distributions”: no mandatory withholding on the distribution; the distribution can be repaid over three years; and the taxation of any distributions can be spread evenly over three tax years (2020, 2021, and 2022). 

While prematurely distributing from retirement accounts is generally discouraged, the Coronavirus-Related Distributions provide a viable liquidity option for anyone struggling to pay bills due to loss of income or other financial hardship.  Even for those not in need of a retirement account distribution to pay the bills right now, there are some planning opportunities to consider:

Use Coronavirus Related Distributions to Take Advantage of a 401(k) Match.  It appears likely that many employees will pause 401(k) or 403(b) plan contributions (or have already paused the contributions) in light of wage uncertainty related to COVID-19.  If you are in this situation and giving up some or all of an employer match by pausing retirement plan contributions, an alternative strategy would be to continue contributing to your employer’s plan and use a Coronavirus-Related Distribution to offset the 401(k)/403(b) deferral amount – creating a cash flow neutral payout but gaining the employer match. 

Consider the situation where your employer matches 50% of your 401k contributions up to the first $10,000 of deferrals.  Rather than pausing deferrals and losing this match, you would be wise to continue deferring the $10,000 for the remainder of 2020 while simultaneously withdrawing $10,000 from an existing retirement account as a Coronavirus-Related Distribution.  From a cashflow perspective and a retirement savings perspective, it is a net wash because you are effectively moving money from left pocket to right.  Except, there are three benefits:

1. You qualify for the employer match of $5,000 which would have been lost had you stopped making contributions.
2. You get the immediate benefit of the $10,000 tax deduction to the retirement plan whereas the offsetting tax liability from the $10,000 distribution can be spread over three years with the last 1/3 not due until sometime in early 2023.
3. You can elect to put the $10,000 back in your retirement account at a later date, within three years from the time of distribution, should your financial conditions improve.

Notably, since these distributions are available for the remainder of the calendar year, there’s no urgency to immediately distributing the funds.  In fact, since the optional three-year payback clock starts at the time of the distribution, it is better for anyone using the Coronavirus Related Distributions to only draw funds as needed rather than all at once, thereby extending the 3-year payback window by several months.

Use Coronovirus Related Distributions to Reduce 2020 Income and Qualify for a Larger Recovery Rebate Check.  Similar to the preceding strategy, the idea here is for anyone who won’t qualify for a stimulus check based on 2018 or 2019 income but who might qualify based on lower income this year to reduce adjusted gross income enough in 2020 via 401(k), IRA, or HSA contributions to qualify for a partial or full rebate amount.

For example, consider a married couple with three children where one spouse works but $250,000 of income in 2018 and 2019 disqualifies them from an immediate stimulus check.  Due to the Coronavirus pandemic, they expect adjusted gross income to decline to $182,000 in 2020 and have elected to halt all retirement plan contributions this year.  Rather than suspending their retirement plan contributions, the working spouse could contribute $19,000 in pre-tax deferrals to her workplace plan, the husband could contribute $6,000 to his IRA (since he qualifies to do so based on his spouse’s income), and they could make $7,000 of contributions to their health savings account (assuming they are eligible), thereby reducing adjusted gross income by $32,000. 

Lowering income from $182,000 to $150,000 in 2020 qualifies them for the full $3,900 stimulus payment – an additional $1,500 beyond what they would have received without these contributions.  To make up for the lost cash flow, they can simply withdraw $32,000 from their existing retirement account balances as Coronavirus Related Distributions (and there’s nothing to keep them from simply withdrawing the IRA and 401(k) contributions minutes after they are made).  Again, they even have the option to repay these distributions over the next three years should their financial conditions allow.

Use Coronavirus Related Distributions to Make 2019 IRA Contributions.  Consider a married couple who was eligible to make IRA contributions in 2019 ($6,000 each) but did not have liquid funds in order to do so.  This couple could (at any point until the extended July 15 tax deadline) withdraw $12,000 from their existing retirement accounts (in any combination – it could all come from one account) as a Coronavirus Related Distribution and immediately use the funds to make tax-deductible (or Roth) contributions to their IRA accounts for the 2019 tax year.  If they elect to make Traditional IRA contributions, they reduce 2019 taxable income by $12,000, thereby resulting in less taxes than would have otherwise been owed.  Moreover, taxes on the distribution can be split between payments in 2021, 2022, and 2023 or avoided entirely.

Required Minimum Distribution (RMD) Waived for 2020

The CARES Act suspends required minimum distributions (RMDs) for 2020, providing broad relief to include IRAs, 401(k)’s, 403(b)’s, 457(b)’s, and even inherited retirement accounts.  The suspension applies to any distribution that was required in 2020 – even for individuals who turned 70.5 in 2019 and used the special first year election to defer their RMD into 2020. This is obviously welcome news – especially for retirement account owners who live off of other income sources or assets and generally do not need the required distribution.

Let’s run through the different scenarios and outline what is likely to be the optimal strategy for each scenario.

You faced a required minimum distribution (RMD) for 2020 but have not yet taken the distribution.  For individuals who fit this case and are still working (perhaps with an inherited IRA) or who otherwise expect to have high income in 2020, it is generally advisable to use the opportunity to skip the distribution this year.   

You faced a required minimum distribution (RMD) for 2020 and already completed some or all of the distribution since the start of the year.  Provided that you have other sources of income or other assets from which to fund living expenses, you should plan to quickly replace the previously distributed amount.  There are a few exceptions or limitations noted below.  

• Non-spouse beneficiaries of an inherited retirement account who have already fulfilled the 2020 RMD from the inherited account cannot reverse the RMD and get the funds back in the account. 

• In situations where more than 60 days have passed since funds were distributed from a retirement account, the funds can only be replaced if the owner meets the liberally defined “Coronavirus Related Distribution” rules outlined above.  Anyone who fulfills this condition (and it is self-certification) will be able to replace an already distributed RMD, even if more than 60 days have passed since the distribution.   

You faced a required minimum distribution (RMD) for 2020, are retired, and have other sources of income or other assets from which to fund living expenses. If you will experience a one-year reduction in taxable income during 2020 due to the RMD suspension, it would be financially wise to consider a 2020 Roth conversion in lieu of the RMD to take advantage of the temporarily lower tax brackets. 

You faced a required minimum distribution (RMD) for 2020, will likely use the standard deduction, are over age 70.5, and intend to make charitable contributions during the year.  Even thought the RMD has been suspended in 2020, qualified charitable distributions (QCD) are still permitted.  Moreover, the QCD still provides a significant tax benefit for anyone over age 70.5 who desires to make charitable gifts so the suspended RMD rules do not mean you should suspend use of QCDs.

Closing Comments

Obviously, there are a lot of important financial and tax planning changes stemming from the CARES Act. It took more than 2,700 words to outline just three elements of the Act and that’s without covering the important changes for small businesses, unemployment benefits, or even significant changes relating to student loans and charitable giving for individuals.

We hope to add more color in the coming days on some of these other items but, in the meantime, questions, comments, or suggestions are welcome.

To remove any doubt, I claim no unique expertise in viruses, pandemics, or COVID-19, specifically.  I am not going to cite R0 transmission rates or reference virus mortality rates to appear well-versed on pandemics and make predictions about where stocks are going next.  Nevertheless, I will share a few comments regarding the recent stock market volatility, which is a decided reaction to the perceived threat of a global pandemic. 

First, this is the obligatory reminder that stock market volatility is normal.  Stocks go up.  And down.  Extended periods of calm as we enjoyed throughout 2019 do not change the fact that stocks have higher expected returns because they bear additional risk.  It is reasonable to be frustrated by market volatility but we should not be surprised by it.  The financial services industry is overwhelmingly littered with disingenuous fortune tellers making people think that they can avoid uncertainty that cannot be avoided. 

Second, assessing whether the recent market volatility is an overreaction or an underreaction to the coronavirus requires advance knowledge of how widespread the epidemic will become and the resulting economic impact.  If COVID-19 ends up as a global pandemic that causes hundreds of millions of people to stop travelling, eating out, shopping, or going to work for an extended time period, then the recent market selloff is likely just the beginning of a larger stock market selloff.  If, however, the epidemic plays out much like scares of the past such as bird flu in 1997, SARS in 2002, swine flu in 2009, or Ebola in 2014 and is eventually contained without long-term economic impact outside of a few countries, then the recent selloff is just another market overaction and a buying opportunity. 

Is this an overreaction?  Maybe.  Maybe not.  Any “investment expert” who suggests with confidence right now that the market is overreacting or underreacting to the coronavirus epidemic is blatantly fooling themselves and/or misleading anyone who listens to them.  What we know is that investors tend to overreact to negative risks.  Not always – but most of the time.  Bad news just gets amplified far more loudly than good news.  So purely from a probabilistic perspective, scares tend to result in overreaction.  But that doesn’t make this scare an overreaction.  It just makes it more likely to be one. 

Third, we should pay homage to and learn from history.  History teaches us that the stock market rewards patience.  It rewards discipline.  It rewards long-term perspective.  Those rewards are paid for by the impatient, by the undisciplined, and by the short-term investors.  The market transfers wealth from individuals who wait on the sidelines “for things to calm down” to investors who stay disciplined.  Investing in the stock market is not a free lunch and it is the scary periods that provide the reward for the disciplined investors.    

Fourth, most investors do not care about diversification and high-grade bonds and rebalancing and uncorrelated investments and maintaining an appropriate risk level when the market is going up.  If we are being honest, all of those things are boring and frustrating when the market is advancing.  But these same concepts are the hallmarks of a strong investment approach and they earn their value during periods of heightened market stress such as these past two days.    

As always, comments, questions, or concerns are welcome and can be posted in the comments section below.