Looking Ahead: The Butterfly Effect

As the world moves away from emergency COVID-19 support, can extreme high valuations continue to be justified? A variety of catalysts may be the flutter that sets a negative market ripple into motion.
Butterfly Effect

For decades, scientists have pondered whether a butterfly flapping its wings in Brazil might cause a hurricane to form off the coast of Africa. The butterfly effect is the idea that small actions can have massive, unforeseen impact far from the source. So too can seemingly isolated factors ripple outward and wreak havoc on the market, and our investments, if we’re not prepared.

In our November Thirdly events, we discussed current trends that may contribute to our financial hurricane warning forecast. Below is an overview of the key factors we’re watching as we emphasize the value of keeping a cool head and leaning on sound investing philosophy.

Current Trends

COVID. No surprises here. The global pandemic has upset nearly every aspect of our lives and caused major economic upheaval.

    From the standpoint of investing, the two most important factors to watch are COVID cases and hospitalizations. The case rate in the U.S. was dropping, but since the arrival of the Delta variant, we’ve had a flatline and then a slight uptick. These numbers—approaching 200K new cases per day and more than 100K hospitalizations per day—mirrors data from the United Kingdom, where the Delta variant had a devastating effect. At this point it’s unclear if the Delta variant is waning or pausing.

    And, as they say, winter is coming. Statistics show that case rates increase as the temperature decreases and we move our activities indoors.

    China. The second-largest economy in the world is always one to watch. We are keeping a close eye on China’s booming real estate market, which is so hot that the country is home to the four highest property-to-income ratio cities in the world. However, the Shenzhen-based real estate giant, Evergrande, has been making the news as it risks defaulting on $305 billion in debt. Evergrande’s massive default could trigger a chain of other delinquencies, perhaps setting the stage for a significant stock market correction as well. Multiple incidents in the property sector would likely lead to a full-blown national economic crisis in China. To put that in perspective, it would be the biggest default since Lehman Brothers folded—bigger than both Argentina in 2001 and Greece in 2012.

    The Chinese real estate market could very well go the way of Japan in the late 90s, when the bubble burst and land prices plummeted. As that crisis showed, central banks can’t always save the day – and the aftereffects would undoubtedly ripple into the world economy, creating instability in our markets here at home.

    U.S. fiscal and monetary policy. We’ve seen a much larger and quicker response to the COVID-19 pandemic than to the financial crisis of 2008. While stimulus checks did their job of injecting capital into the economy, they also led to a massive rise in national debt levels in the U.S. and around the world. The federal government’s balance sheet exploded to $1.8 trillion over just 16 weeks; a faster rise to a higher nominal value than the response to 2008’s “Great Financial Crisis.”

    As this extra aid dries up and central banks taper their economic supports over the next eight months or raise interest rates, it could leave the economy in a sort of fiscal and monetary “hangover.” And it leaves analysts wondering, what will happen without that unprecedented stimulus and support?

    Taxes. The only sure things in life are death and taxes, and taxes are always contentious. A number of political factors play into exactly which new taxes will stay on the table, but the bottom line is that higher taxes are coming, and they’ll be largely targeted at corporations and high-net-worth individuals. High taxes on corporations are not great for market valuations which are already sky-high. For individuals, it’s not a time to panic, but to prepare – which we’ll be talking more about in the coming months.

    Inflation. Supply chain and consumer spending are both pushing inflation up. Here at CWM, we believe the unprecedented rate of inflation is transitory and will dissipate next year (watch our inflation video and read our analysis from earlier this year here). One reason is that price hikes in raw materials aren’t being passed on to finished goods. Companies themselves believe inflation is transitory, so they’re keeping prices low to avoid losing customers. Another reason is that the U.S. is sitting on a significant amount of manufacturer capacity. Once people are able to get back to work, there’s a lot of potential to rev up operations to meet pent-up demand.

    And remember this: While inflation is indeed unprecedented right now, it’s nothing in relation to the 1970s. The numbers just don’t support that comparison, and we see it as alarmist at this stage.

    Greed. Of the six factors we consistently monitor to forecast economic growth, greed has risen to the forefront. One of our favorite measures of greed is the CBOE Volatility Index (VIX), also known as the “market fear gauge.” This measure is currently suggesting market complacency has set in (i.e. a lack of fear). Learn more about the VIX in this post. Greed is high at the moment, which has historically shown to lead to future returns. The key is to respond to crises with discipline, not panic. When markets turn from greed to fear, panic often ensues, which can create better investment opportunity.

    Year-End Planning

    Washington State Cares Act Update. Effective January 1, 2022, a 0.58% payroll tax will be assessed on all W-2 wages in Washington State. The funds from this tax will go into the WA Cares Fund, which is designed to address long-term care expenses for state residents – with notable limitations, as we outline in our analysis in “Understanding Strategies for Long-Term Care Planning Under Washington State’s New Payroll Tax” and accompanying video “Three Things to Know About the Washington State Long-Term Care Trust Act".

    Importantly, if you’ve already secured private long-term care insurance coverage that will enable you to opt out of this tax, you’ll find detailed instructions on applying for an exemption here. It’s best to complete these steps right away, ahead of the January 1st deadline.

    Charitable Giving in 2021. As part of the SECURE Act, the rules regarding a qualified charitable distribution (QCD) coming from your annual required minimum distribution (RMD) have changed. Under the new rules, you are not required to take your RMD until you are 72; however, you can still take advantage of the QCD at age 70.5. As we discuss in our latest video on charitable giving, the benefit of this strategy is that you don’t have itemize your taxes to get the deduction and there are no taxes owed on the amount donated. The caveat is that you must donate directly from your IRA to the charity.

    If you are 70.5 or older and would like to take advantage of this strategy, please let us know right away. Anna Doll and Molly Winney on our admin team can help ensure your QCD funds are directed appropriately to the charity of your choice. Remember the nonprofit needs to receive your QCD (and cashes the check) before the end of the year, otherwise, if you are subject to the RMD rules you could owe a 50% penalty on the amount donated.

    What’s next?

    As we say goodbye to 2021, much remains uncertain – and so, at CWM, we are following our investment philosophies and taking steps for protection against that uncertainty. Ultimately, we should focus on the areas we can control – risk, cost, time and our own behavior – rather than focusing on what we don’t control – the movements of the market and size of the returns. As we’ve shared before, we fully believe that downside protection is more important than trying to beat the market and capturing all of the “up” – and that’s how we are able to pursue the real returns that support our clients’ financial and lifestyle goals.

    In this post – and in our Thirdly (view recording here) – we shared a host of market factors that we’re tracking so that you don’t have to. Of course, we’re always happy to discuss further. If you’d like a deeper dive into any of these factors and how they could affect your investments, please call us at (425) 778-6160 or fill out a contact form here and one of our team members will reach out to assist you.

    Important Disclosures: There is no assurance that any strategy will achieve its objectives. The opinions expressed in this material is for general purposes only. This material is not intended to be a substitute for professional financial, tax, or legal advice. Always consult your investment, tax, and/or legal professional for details regarding your specific situation. Past performance is no guarantee of future results.

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