The turbulent first half of 2020 will be remembered for years to come. As we continue to navigate through a global pandemic, the economic and financial implications evolve daily as individuals, families, businesses, investors, and governments across the world adapt to our new reality. While financial markets have regained much of the losses experienced during the first quarter, unemployment remains elevated and economic growth will be impacted by COVID-19 for months, if not years, to come. Notable market events in the second quarter were plentiful:

• The S&P 500 Index had its largest quarterly gain since 1998, rising over 20%.
• The Federal Reserve (Fed) maintained its ultra-low interest rate policy, and in early June reaffirmed its intention to keep rates low through 2022. The Fed also restarted its quantitative easing (QE) program in which it directly buys fixed income assets, such as U.S. Treasury bonds, mortgage-backed securities, and corporate debt.
• Government support for the U.S. economy and workers continued as fiscal and monetary measures were enacted to soften the economic damage from the coronavirus. Specifically, “Phase 3.5” of the government stimulus added over $480 billion to replenish the Paycheck Protection Program (PPP) for small- and medium-sized business, as well as to provide additional funding for hospitals and COVID-19 testing.
• Apple and Microsoft became the first-ever $1.5 trillion companies by market capitalization. Interestingly, the two crossed the line nearly in sync after over four decades of rivalry.
• Amazon also continued its torrid growth, reaching a $1 trillion valuation in January, returning 49% year-to-date and 34% annualized over the last 15 years.

Overall, second quarter returns for the major equity asset classes were much rosier than the first quarter, although returns remain negative for the year. Intermediate-term government bonds continue to buoy diversified portfolios, rising nearly 3% during the quarter. Real estate securities hovered in bear market territory as shutdowns continued and new bankruptcies emerged.

 

Index	Asset Class	Second Quarter 2020	Year-To-Date 2020
Barclays U.S. Govt./Credit—Int.	Fixed Income	2.8%	5.3%
S&P 500	Large U.S. Stock	20.5%	-3.1%
Russell 2000	Small U.S. Stock	25.4%	-13.0%
MSCI ACWI ex-USA	Foreign Stock	16.1%	-11.0%
S&P Global REIT	Real Estate Securities	11.2%	-21.1%

 

One notable observation this year is the performance gap between the NASDAQ Composite Index (NASDAQ) of predominantly technology stocks and the S&P 500 Index of large U.S. company stocks. Although the NASDAQ is comprised of over 2,500 companies across many industries, its outperformance has been driven by five technology stocks that comprise about 40% of the NASDAQ’s weighting. Despite the COVID-19 pandemic, these stocks have enjoyed positive returns in 2020, on the heels of many years of strong returns since the financial crisis of 2008-09. Year-to-date, Microsoft is up 30%, Apple is up 25%, Amazon is up 49%, Alphabet/Google is up 6%, and Facebook is up 11%. The positive returns of these already large companies contributed to the higher returns of the NASDAQ (and to a lesser extent, the S&P 500) relative to the overall US stock market.

Although it may be tempting to “chase the winners,” we strongly believe in diversification and avoiding large concentrations in any one company or industry sector. This belief is founded in the very high probability that diversification pays off over longer periods in the form of higher risk-adjusted returns. Some of you may remember the dot-com boom-and-bust of the early 2000s in which the NASDAQ fell over 75% in the 30 months following its peak in March of 2000. Diversification paid handsomely in the decade following the dot-com peak, and we expect that it will reward investors once again in the future.

Portfolio Rebalancing

Given the rebound of risk asset classes since late-March, many of our clients have noticed us trimming equity positions in their portfolios shortly after we were buying equities at depressed prices. This is not a market call but simply an effort to move portfolio’s asset allocation closer to the target originally established in the personalized Investment Policy. Rebalancing occurs when the allocation between stocks and bonds becomes meaningfully different than the desired target asset allocation. When the stock market rises more than the bond market (as was the case last quarter), stocks become overweight relative to their target allocation. In these situations, we generally trim stocks and reinvest the proceeds into fixed income (bonds) to move the portfolio closer to target. Conversely, when the stock market declines more than the bond market (as was the case in the first quarter), the bond portion of the portfolio becomes overweight. In this case, we may sell a portion of the bond holdings and add the proceeds to stocks. This disciplined approach forces us to buy stocks at relatively lower prices and to sell stocks at relatively elevated prices.

Portfolio rebalancing has always been a foundational part of our disciplined investment process. Rebalancing helps control portfolio risk and may improve long-term returns. Maintaining portfolio targets in the face of volatile market moves dictates the sale of strong relative performers and purchase of poor relative performers. Stated differently, disciplined rebalancing sells what is “hot” and buys what is not. When markets make extreme moves as they have thus far in 2020, rebalancing requires substantial amounts of discipline and fortitude.

Our rebalancing process generally involves two initial steps. First, we compare a portfolio’s current allocation to the target allocation and determine whether rebalancing is necessary. Rather than rebalance on a strict schedule, we allow portfolio allocations to “float” within bands around the target. For example, if the portfolio allocation to U.S. large company stocks drops below the lower band, we will need to add to U.S. large stocks; conversely, if the allocation exceeds the upper band, we will need to reduce this asset class. Second, once we decide that rebalancing is required, we choose the most tax efficient means of doing so.

Some of the benefits of rebalancing can be nullified by taxes, so we are sensitive to the tax implications of trimming appreciated securities while seeking to maintain the appropriate level of portfolio risk. Our rebalancing plan typically consists of a combination of the actions listed below. In order of preference, we may:

• Use new cash deposits to purchase underweight asset classes. Because this approach results in no tax liability and relatively low transaction costs, it is a preferred rebalancing method.
• Sell securities in a tax-advantaged account such as an IRA or a Roth IRA. Tax-advantaged accounts are often ideal for rebalancing since selling can be done without incurring any current tax liability.
• Gift appreciated securities in taxable accounts to charity. Gifting appreciated stock held for more than one year to charity has a four-fold benefit:
  • Reducing the balance of a highly appreciated position in the portfolio
  • Creating a charitable tax deduction based on the market value of the gifted securities
  • Avoiding capital gains tax on the gifted securities
  • Accomplishing philanthropic objectives
• Sell securities in taxable accounts. Because of the income tax implications, this is typically our least preferred means of rebalancing. However, after extended bull markets and for clients without significant tax-advantaged accounts, selling appreciated securities in a taxable account may be the only viable option for maintaining the target asset allocation. If this method is used, we may mitigate the overall tax impact by a) rebalancing towards, but not all the way back to, the target allocation; b) ensuring that realized gains are long-term, and, therefore, receive the preferential federal capital gains rate (which could be as low as zero for some taxpayers); and c) utilizing current-year realized losses, or capital loss carryforwards from prior years, to offset gains.

Tax Loss Harvesting

Whenever we discuss tax loss harvesting, we first need to clarify that we certainly do not set out with a goal of generating losses when investing. However, when a client owns a diversified set of assets in a taxable account, we can use the periodic and inevitable price declines of specific securities to lower the client’s current or future tax bill by “harvesting” tax losses. Tax loss harvesting is the intentional selling of a security at a loss to offset a capital gains tax liability in the future. It is a critical and strategic tool for reducing taxes within a taxable portfolio, and if not deliberately recognized, tax loss harvesting opportunities can be missed.

Even in years with positive returns when a portfolio increases significantly in value, opportunities to sell individual positions at a loss for tax purposes may arise. For example, suppose an individual stock was purchased for $50,000 in a taxable account and declined in value to $45,000. In this case, we can sell the stock and “book” a $5,000 loss for tax purposes. If we want to continue to hold the stock for the long-term (which we typically do), we can buy the stock back after 31 days, buy a stock that we believe is a comparable alternative (i.e., Pepsi vs. Coca-Cola), or employ other strategies to maintain exposure to the asset. The objective of tax loss harvesting is to keep a portfolio on its target allocation (percentage allocated to stocks vs. bonds) while strategically trading to capture tax losses during opportune time periods.

The losses that were “harvested” during the stock market volatility in the first half of 2020 may allow many clients with taxable accounts to avoid paying capital gains tax due to rebalancing later in the year — and potentially carry forward remaining losses to use in future years. The IRS allows you to write off losses against capital gains and/or use up to $3,000 of realized losses to offset ordinary income. Any losses not used to offset gains may be carried forward indefinitely until they are exhausted.

Required Minimum Distributions from Retirement Accounts

Lastly, we would like to make you aware of recent changes to the Required Minimum Distribution (RMD) rules for 2020. Generally, due to the pronounced economic impact of COVID-19, distributions are not required from any IRAs or retirement accounts during 2020. Additionally, if you took required minimum distributions from your retirement accounts this year and would like to return the money, you may be able to do so. The IRS announced this extraordinary waiver in June that those who had already taken withdrawals in 2020 may return that money by the end of August if they wish. Please discuss the logistics of this process with your Lead Advisor.

We appreciate the trust our clients and colleagues have placed in us to guide you through these challenging times. We encourage you to call or email anytime you would like to discuss your portfolio or your financial plan.