The Markets	09/30/17 Close	06/30/17 Close	3rd Qtr. Change	09/30/16 Close	12 Mo. Change	YTD Change
Dow	22,405	21,350	+4.94%	18,308	+22.38%	+13.37%
NASDAQ	6,496	6,140	+5.80%	5,312	+22.29%	+20.68%
S&P 500	2,519	2,423	+3.96%	2,168	+16.19%	+12.51%
MSCI EAFE	1,974	1,883	+4.83%	1,702	+15.98%	+17.22%
10-yr Treas. yield	2.33%	2.30%	+0.03%	1.61%	+0.72%	-0.12%
Fed funds rate	1.0% to 1.25%	1.0% to 1.25%	N/A	0.25% to 0.5%	+0.75%	+0.50%

(stock indices are before dividends; yield and rate changes are absolute changes)

What’s not to like about the markets this quarter? Strong earnings supported US stock prices, foreign stocks fared well from global demand despite the stabilizing US dollar and the interest rate environment remained stable. Large technology stocks again led the way, offsetting some weakness in consumer staples. The third week of September, in fact, was the least volatile for the S&P 500 in 45 years.

The biggest developments in the quarter were in weather and politics rather than the economy. Two major hurricanes hit Texas and Florida with a third hurricane nearly wiping out Puerto Rico. Mexico suffered two major earthquakes with the second hitting the heart of Mexico City on the anniversary of the last major quake to hit the city. These events could have damages exceeding $100 billion in Texas and Florida alone, following short-term impacts on jobs and energy supply. North Korea detonated a hydrogen bomb that was exponentially more powerful than any previous blast and flew a missile over part of northern Japan. The saber-rattling from both North Korea and President Trump reached scary levels but thankfully cooler heads prevailed, at least for now. Any option other than continued negotiations would have global repercussions.

After two failed attempts to repeal Obamacare the Republicans turned to tax reform. The initial sketchy plan is billed as helping the middle class but most analyses show most of the tax cuts accruing to corporations and wealthy individuals. Still, the underlying claim is that reform will spur growth which will help everyone. The status of “dreamers”, undocumented young adults who were brought to the US as children, is being reviewed and the administration has suggested that our immigration policy transition to a skills-based system found in other countries as opposed to the current system based on family unification.

Almost all economic indicators were either flat or positive. Services expanded for the 92nd straight month and food prices continued to slide. Inflation stayed well below the Fed’s 2% threshold and the Fed acknowledged its understanding of inflation this year is “imperfect” and the low inflation rate is a “mystery”. Consumer spending was up a strong 3.3% with wages up 2.5%, resulting in a lower savings rate of 3.8% from the peak of 6.3% two years ago. Consumer confidence was only slightly influenced by the hurricanes and one survey showed 65% of consumers believing stocks would go up in the next year. The final reading for second quarter growth was up 3.1%, the best since the first quarter of 2015 and finally touching the administration’s “target” of 3%. The job market stayed robust with unemployment at 4.4%, an under/unemployed rate of 8.6% and continuing jobless claims under 2 million for 22 weeks.

Home sales present another quandary with supply of existing homes for sale declining for 27 straight months. Housing starts have shifted from multi-family to single-family homes but new home sales are still below the year prior. The tight supply has been further soaked up by Wall Street firms creating portfolios of homes to rent, resulting in first-time home buyers making up less than a third of purchases and median prices increasing nearly 6% from a year ago. Homeowner equity increased over 10% in the past year to over $8 trillion, double the level of five years ago. “Underwater” homeowners who owe more than their home is worth declined 22% in a year to only 3.6 million homes.

The Fed left interest rates unchanged but did give October as the start of unwinding its balance sheet, starting with selling $4 billion of mortgage securities and $6 billion of Treasuries each month and increasing to $20 and $30 billion, respectively. The Fed currently owns 27% of government-backed mortgages and 17% of Treasuries. The Fed policy remains “accommodative” with gradual rate increases over time (one more this year and potentially three in 2018) but without a set formula to influence rates. Another budgetary crisis was temporarily averted as President Trump cut a deal with Democrats for a three-month extension to the federal debt limit.

Looking Forward

In addition to the debate over whether the administration’s tax reform proposal actually “helps” the middle class, there are plenty of details yet to be announced and far from resolved.
• The initial proposal calls for combining the personal exemption with an increased standard deduction. It is not clear how families with more than two exemptions will be treated, with possibilities including an increased child tax credit or some other mechanism to help families with additional dependents/exemptions.
• If the estate tax is repealed, what will happen to the current benefit of increasing (“stepping up”) the cost basis of an estate’s holdings at death. This reduces capital gains taxes for estates of all sizes while repeal will only help large estates and the elimination of the step up could increase taxes for beneficiaries of all estates.
• If the corporate tax rate is reduced (the initial proposal calls for a 20% rate), how much of the corporate tax system will be streamlined and loopholes reduced. The effective tax rate paid by corporations is considerably less than the 35% official rate because of so many provisions, so a 20% rate without these loopholes may not really be such a big tax reduction for corporations.
• Will measures to repatriate foreign earnings really spur growth, especially since interest rates have been extremely low for years, corporations are already sitting on hordes of cash in the US (using it more for stock buybacks than capital investment) and there is little indication that corporations have been unable to undertake large projects if they so choose. In other words, those foreign earrings may be a tax issue but maybe not a growth issue.
• Likewise, it’s far from certain that a lower tax rate for business owners who receive “pass-through” income (partnerships, LLC’s, etc.) will encourage those businesses to create more growth and jobs.
• The impact on charitable donations and the housing market is unclear, since those deductions are retained but may be made less attractive with a higher standard deduction.

The other obvious coming change is the Fed’s action to begin winding down their balance sheet. The Fed’s official position is that these sales of bonds may have some short-term impact but the markets and the economy will be able to absorb any consequences over the medium and long term. Fortunately the Fed is taking action before other central banks (central banks and Europe and Japan are still buying securities) just as the Fed was early to buy during the financial crisis.

These two developments could converge at some point as the effects of one could either amplify or negate the effects of the other. It’s a lot of moving parts and each is very difficult to predict.

Our Portfolios

We recently had a new client come to our little firm from another long-established comprehensive financial planner. In reviewing the account history, the client’s fees had increased significantly in January and per the other firm’s public disclosure it looked like the client had been erroneously moved into a higher fee category.

In response to repeated inquiries, the client was told:
• “We haven’t raised our fees in years” (not an answer but suggesting that this makes the recent increase okay),
• ”We are still told by our custodian (the brokerage firm that holds accounts) that our fees are the lowest they see among advisors” (the custodian, which is the same firm we use, would never say this and the fees are far from the lowest among comparable advisors), and
• “Why don’t you stop by and we’ll show you how your accounts outperformed the indices even after our fees” (a claim that is unsupported by the portfolio which was comprised of a large number of actively managed mutual funds, some of which had high expense ratios).

This last claim is a common technique used by advisors to confuse clients and justify fees. The comparison can be easily influenced by the mix of indices used, time frames and other factors. Such a comparison is valid only if the benchmark index used closely resembles the portfolio in its combination of US stocks, international stocks, bonds, etc.

Anyone who has engaged a financial advisor or planner should be aware of all fees, including portfolio management, financial planning, expenses for any investments, transactions and any referral fees. Those fees should be evaluated against the value provided by the financial professional, and the professional should be able to clearly explain what value they add.

Yes, fees matter, but what does this story have to do with our portfolios? Our portfolios are not entirely made up of index funds, which are extremely cost-efficient, but the combination of index funds and the lowest-cost share class of selected actively managed funds results in a portfolio with operating expenses of under 0.45%. Our fees, which include both ongoing planning and portfolio management, are clearly spelled out in a quarterly invoice sent to every client. And we welcome discussion of fees as it presents an opportunity for us to reinforce the value of comprehensive financial planning.

It turned out that the fees charged by our new client’s former firm may have been technically justified by a combination of a 20-year old client contract and a disclosure that changed frequently and was never sent directly to the client. The client is happy to be working with us and we aim to earn our fee.

Is “Moral Hazard” a Real Thing?

Moral hazard is a concept in which one party is protected against risk and another party will incur the costs of that risk. Behavior can change when there is no consequence from a loss, with people ignoring the moral implications of taking risks and behaving more recklessly than they otherwise would.

Moral hazard is a basic concept of insurance, whether this insurance comes in an actual insurance policy or from other risk protection steps like wearing a bicycle helmet or avoiding very risky behaviors altogether. (For example, we are avid hikers but I am not interested in high alpine hiking such as Mt. Rainier because the presence of crevasses presents an additional element of risk I am not willing to take.)

When there is a direct cost attached to a particular risk, such as the premium for an insurance policy, behavior is often adjusted accordingly. That’s why there are questions about hazardous activities when applying for life insurance and why drivers with lots of accidents have higher premiums, as they rightfully should.

The moral element becomes trickier when the costs associated with risky behavior are not borne by those exhibiting the behavior. (This usually means a wealthy benefactor or the government, which means the taxpayers, picks up the costs.) The dilemma is that the risky behavior is reinforced and repeated, increasing costs over time.

Moral hazard was a hot topic during the financial crisis for both the bailout of large banks and assistance for homeowners. As for banks, we seem to have institutionalized the “too big to fail” idea and even though there are new regulations to force banks to have more capital to absorb financial shocks, it is widely assumed that the government would again bail out an institution whose failure could ripple through the system. As for homeowners, mortgage guidelines were initially tightened considerably but recently more aggressive lending options have been introduced, again leaving some borrowers at risk if the real estate or job markets stumble.

The recent hurricanes and flooding of low-lying areas resurrected moral hazard. Congress established the National Flood Insurance Program (NFIP) in 1968 because it was very difficult to obtain flood insurance from private insurers. Part of the program was that communities would take steps to mitigate the risk of floods. NFIP spreads the flood risk across all homeowners in flood-prone areas but this means those with a modest risk “subsidize” those with the highest risk. So the most likely participants in NFIP are high-risk homeowners and the program has inadvertently supported more building in flood-prone areas. When disaster strikes, there is also disaster assistance for those who don’t buy NFIP coverage because we still a caring society that helps those in need.

NFIP already had a deficit of nearly $25 billion before hurricanes Harvey and Irma and that hole will now grow considerably. In the meantime, there are homes and areas that have had multiple claims over the years, far exceeding their value.

By some estimates there are 25 million homes that need this insurance and there are no other options for insurance, so rolling back NFIP could leave millions at risk of massive losses. That is a possibility few politicians want to accept even if the costs continue to escalate. While eliminating the program immediately is impractical, relocating the most at-risk areas, reducing building in low-lying areas over many years and making clear that the government will not support rebuilding in uninsured areas is a perfectly reasonable approach. How far should we go to fight Mother Nature, how much irresponsible behavior should we accept and how much suffering are we willing to tolerate in changing development and behavior?