Soak the Tax Man

The stock market may have a hard time getting traction in 2019, or it may shoot higher from here after its 2018 breather. We all have our opinions as to what Mr. Market might do, of course. But none of us actually know until it happens.

One thing we can all be certain of? The IRS is letting us sock back a little more cash free of current-year income taxes.

The contribution limits for 401(k) plans, 403(b) plans and most other employer-sponsored retirement plans will be rising from $18,500 to $19,000. If you’re 50 or older, you can continue to make an additional $6,000 in “catch up” contributions, bringing the total to $25,000. These numbers include only salary deferral; any employer matching or profit sharing is icing on the cake.

If you’re self-employed and contribute to a SEP IRA or individual 401(k), you can save a little more as well. The limits on these plans is being raised from $55,000 to $56,000.

Let’s put some numbers to it. If you’re married filing jointly with your spouse and your combined incomes amount to $168,401 to $321,450, you’re in the 24% tax bracket. So, if the two of you contribute $19,000 apiece to your 401(k) plans, that’s $38,000 in savings safely deferred from the tax man. At the 24% bracket, that’s $9,120 in tax savings.

If you’re worried about the market, no problem. You can keep the funds in your 401(k) plan’s stable value or money market option. But be sure you stuff as much as you can into the plan because the tax savings alone make it worthwhile.

Look to Emerging Markets … Within Reason

U.S. stocks may or may not have a good 2019. We can only wait and see. In any given year, guessing the direction of the market is a crapshoot. We also know that, over the very long-term, stocks historically have returned about 7% per year after inflation.

It’s over a more intermediate-term horizon that things look dicey. You can make a reasonable estimate of stock returns over a seven- to 10-year period based on valuations, and it’s not pretty.

As an example, consider the cyclically adjusted price-to-earnings ratio (CAPE). At a recent level of 29.6, this implies annual losses of about 1.7% over the next eight years based on historical precedent.

Jeremy Grantham, co-founder of GMO – a Boston-based money manager with about $70 billion under management – slices the numbers a little differently. And based on his firm’s proprietary asset-class forecast, the next seven years look lean. Grantham projects annual losses of 5.2% on U.S. large-cap stocks, losses of 2.1% on U.S. small-cap stocks and flat returns in U.S. bonds.

In fact, Grantham is projecting flat or negative returns in every major asset class but two: emerging-market stocks and emerging-market bonds. GMO forecasts EM stocks and bonds to return 3.2% and 2.2% per year, respectively, over the next seven years. That’s not get-rich-quick money, but it’s a positive return in a global market priced to disappoint.

It’s easy to understand Grantham’s enthusiasm. Over the past five years – a period that has seen the U.S. market rise by nearly 45% – the iShares MSCI Emerging Markets ETF (EEM) is actually down by about 3%.

The short-term outlook for emerging markets is cloudy, particularly with Chinese growth slowing. And you should never put a large chunk of your portfolio in something as volatile as emerging market stocks. But given the outlook on the sector, it might make sense to have at least a modest piece of your portfolio invested in emerging-market stocks, mutual funds or exchange-traded funds.

Value over Growth

Along the same lines, consider tilting your portfolio toward value stocks.

The past decade has been all about tech stocks, and specifically big data and social media companies such as the “FAANG” stocks – Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Google parent Alphabet (GOOGL).

But this is more exception than rule.

Over time, growth stocks have generally tracked the broader market. Value stocks have outperformed.

Dimensional Fund Advisors (DFA) ran the numbers for the 90-year period between 1926 and 2016 and found that large-cap growth stocks returned about 9.6% per year, a little better than the S&P 500’s 10.3%. Large-cap value stocks, by comparison, returned a whopping 12.5%.

These small amounts make a huge difference over time thanks to compounding. By DFA’s estimates, a dollar invested in large-cap growth stocks in 1926 was worth $3,382 by the end of 2016. That same dollar invested in the S&P 500 was worth $6,031. And invested in large-cap value stocks, it was more than double that amount, at $13,591.

Consider more recent experience. Growth stocks have outperformed value stocks by a wide margin since 2009, but value outstripped growth by a wider margin between 2000-08. The pendulum naturally swings from a value bias to a growth bias and back again. There’s no fixed time limit that says when the pendulum must swing, but the recent outperformance by growth stocks is one of the longest in history.

So, rather than buy the dip in tech stocks, consider looking to value stocks in the energy, financial and materials sectors instead.

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