October is not off to a good start for stocks in the tech sector. After a weak September, the tech-heavy Nasdaq 100 index is down today (Monday 10/4) about 2.3% as I write this, and it is down about 10% from the highs it reached in early September. There are several reasons that pundits say are causing this sell-off, but there is one reason that is not given that could mean that this sell-off will be short-lived. Let’s examine.

Rising Interest Rates

One stated reason for the tech sell-off is rising interest rates, and specifically rising US Treasury rates. This is not because investors are going to sell their tech stock holdings and take their money and buy 10 Year US Treasury Notes because the yield on those Notes has risen from 1.3% all the way to 1.5%. Instead, rising Treasury rates cause a tech sell-off because the “risk free” rate is now higher. Remember that the value of a corporation today is its projected future earnings stream discounted back to the present day, with the discount factor equal to the “risk-free” rate (i.e., US Treasury rates) plus a risk coefficient specific to that corporation. When the risk-free rate goes up, even by 20 basis points, then the discount factor also goes up, and the resulting corporate valuation goes down. Rising interest rates are therefore a valid reason why sky-high tech valuations could tumble, because those sky-high valuations were previously justified based corporate earnings being discounted at such a low rate.

Facebook Issues

Last month, the Wall Street Journal ran a series of articles from “inside” Facebook that portrayed Facebook as a corporation focused solely on profits at the expense of teenage girls and their self-esteem and of political consensus and continuity, among other issues. Then, last night on CBS 60 Minutes, one previous Facebook employee went public with information she had copied and taken while she worked there. All of this is bad for Facebook and its stock. FB is down 5.7% today and 15.7% from early September as I write this. Radio silence so far has been the reaction from Facebook management. Also, as Facebook goes, so go the stocks of derivative companies whose models and future prospects are tied to Facebook. What companies will want to advertise on a platform that knowingly proceeds with a business model that causes harm to teenage girls? Is Facebook in the process of being canceled by pop culture? This could go either way, but I believe Facebook management is pretty savvy and that a sincere mea culpa would go a long way toward healing. Too much is at stake if they don’t show some remorse.

Political Uncertainty

A third reason stated as to why tech stocks are selling off is uncertainty as to the Federal Budget, debt ceiling expansion, infrastructure spending, and even tax and capital gains rates for next year or even, unbelievably, this year. Specifically, these are issues that the Democrats in the House and the Senate need to reach not just consensus but unanimity on. Unanimity because their majorities in both chambers are razor thin, and the Republicans are in near unanimity that any Democrat plan is a race car speeding in the wrong direction. Infrastructure may be bi-partisan but that’s probably all that is. If we don’t know what tax rates are going to be, then how is that good for investment? I believe this will drag out for quite a while because there is limited political incentive otherwise. The longer this uncertainty does drag out, the worse it will be for the stock market.

Supply Chain Disruption

As I live in Newport Beach, CA, and it was a beautiful morning yesterday, my wife and I went for a walk on the beach. Before our eyes were two of the biggest news stories in the country: the very sad oil spill off the Huntington Beach coast that is due to a leaking pipeline from an offshore oil rig, and also the queue of cargo ships waiting to unload at the ports of Los Angeles and Long Beach. Your and/or your kids’ Christmas presents could very well be sitting out there on a ship that is temporarily anchored off of South Orange County. Tech stocks are suffering because of this shipping and unloading bottleneck because a lot of high-tech stuff is manufactured and/or assembled in Asia. Delays in shipping that stuff means delays in booking sales by the companies selling that stuff. If you view Amazon as a high-tech company, its stock is actually virtually unchanged for 2021 as of today specifically because of supply chain disruptions. This is quite a reversal for AMZN after the barnburner 2020 stock performance (up about 80% for the year). Though the supply chain may not be as important for software companies, it certainly is for the hardware companies that require the software as well as vendors such as Amazon that are part of the supply chain. These supply chain disruptions are a result of the Covid economic shutdown worldwide, and though these issues should gradually go away as more people worldwide get vaccinated and Covid becomes endemic, it could take a long time for this to happen; years instead of months.

Corporate Earnings

The big nullifier with all of these could be corporate earnings. Poor current corporate earnings is not being given as a reason why tech stocks are selling off. Certainly, any and all of the reasons given could negatively affect corporate earnings in the future. The extent to which these mega-mega-cap high tech companies avoid all of the minefields out there and continue to produce earnings that are at or above expectations will ultimately drive the market.

IMO

I have not sold any of my holdings in the Nasdaq 100 index (I do not own individual stocks in that index). All of the stated reasons given as to why tech stocks are selling off are valid reasons, but I am not convinced that any of these will be bad enough to tank any one stock or the entire sector. I view the Facebook troubles as pretty severe but Facebook’s management must know the peril they are in and I believe they will make it through, bloodied but not broken. Batten down, but ride out the storm. That’s my opinion, and you can use it however you want.

It’s probably too much to ask for but it sure would be nice if we could get some long-term stability in tax rates and tax policy in this country. The Biden Administration’s tax plan and the (Democratic) House Ways and Means plan that was revealed last week would significantly raise a number of tax rates and would reverse the Trump Administration’s rates that were enacted just 4 years ago. To boot, President Biden wants the capital gains tax rate increase (to 25% and to 28% for taxpayers with $5 million of AGI) to be retroactive to April 2021. How’s that for changing the rules after the game is already underway? Totally unfair, in my opinion. Last weeks revelation of the House plan caused a mini sell-off in the stock market due to the uncertainty of the capital gains rate, as well as of other provisions such as the step-up in basis rule and the combined lifetime gift rule. Financial advisors and planners are at a loss for how best to advise their clients going forward because of this uncertainty and the potential retroactive nature of the proposal. With taxes, the lower, the better, but just as important is stability in rates and policies across administrations and the ability therefore for planners and their taxpayer clients to make long-term plans and be at least somewhat confident that the rules of the game won’t change significantly and especially retroactively along the course.

House Plan

You can Google “House Tax Plan” and find any number of summaries of the House Tax Plan that was revealed last week. Here is one good link that leads to several other good links: https://taxfoundation.org/biden-administration-tax-proposals/. I am not going to go into the whole plan here, but let’s instead look at the capital gains tax rate plan that will affect many investors. Remember that capital gains taxes kick in upon the gain on the sale of stocks (and real estate and other investment assets) that have been owned by the seller for 1 year or more. (Otherwise any gain is taxed at ordinary income rates). Here is a chart published at a leading financial planning website called Kitces.com that shows the proposed increase in capital gains taxes (effective immediately, per the House plan, as opposed to April 2021 per Biden):

You can see that the capital gains rate moves from 15% to 25% for MFJ’s with AGI over $450,000. That’s a big increase and understandably a cause of uncertainty for this group of taxpayers. “Boo Hoo,” you might say if your AGI is under $450,000, but such a change is disincentivizing – why would someone strive to make over $450K if they are just going to pay more in taxes? Maybe you wish you had that problem, but if you did, how would you act? My point is that the “current” rates have been in effect only for 4 years, and now we are proposing a radical change in rates, which could easily be followed by another change in rates downward should the Republicans prevail in 2024. Such a roller coaster with tax rates makes it really difficult for taxpayers to plan their financial futures.

Filibuster

One provision of our government intended to address this specific subject is the filibuster rule that requires a 3/5’s majority in the Senate to pass a law. One would think that a requirement that 60 senators need to vote in favor to pass legislation would prevent these major changes in tax law, right? However, since the late 1970’s, the senate has not abided by the 3/5’s rule and has instead passed budget and tax law through “reconciliation”, which requires only a simple majority to enact budget and tax law. As the parties have become more divided since then (maybe doing away with the filibuster rule for budgets and taxes is part of the reason why? Just sayin’. ), administrations of both parties have used reconciliation to enact budget and tax legislation, as well as other major legislation such as the Affordable Care Act. Now there are thoughts to do away with filibuster altogether, which I believe would be a big mistake and would lead to major swings in government policy in areas even not related to the inflow and outflow of federal funds.

IMO

Putting the filibuster back in as it relates to tax and budget laws would go a long way toward stabilizing our federal tax rates and would really help with long-term planning. Keeping rates lower rather than higher would help even more, but I believe the stability at any level would really help. Perhaps another way would be to make any changes good for 10 years, which is what the George W. Bush administration tried to do, but even that could be overturned by a subsequent administration of the opposite party. True, the right to vote is there for a reason and tax policy is a major reason why voters opt for a certain party or candidate in every election. However, changing the rules, and especially changing them immediately or even retroactively before any legislation is actually passed and signed into law is really unfair to taxpayers and it needs to change if we want to be able to make long term (meaning more than a year) plans for our future.

Cathie Wood, the head of ARK Investment Management, was interviewed on CNBC last week. Ms. Wood is one of the most visible fund managers of this Covid and post-Covid era, and is renowned for taking large positions in firms where emerging but scalable technologies are central to their businesses. Tesla, for instance, is one of her funds’ top positions. Read this NY Times article if you want to learn more about Ms. Wood and where she comes from.

Wright’s Law

One notion that Ms. Wood addressed during the CNBC interview was Wright’s Law. I knew about Moore’s Law, but not Wright’s Law, so I looked it up. Theodore Wright was an airplane engineer during the 1930’s. Despite his last name and involvement with airplanes, Theodore does not appear to have been related to Wilbur or Orville, as the latter two did not have children. Anyhow, Theodore developed a formula that forecasted by how much the cost of manufacturing airplane components would decline as production increased. The “by how much” is the key. Whereas Moore’s Law posited that the number of transistors on a chip would double every two years, Wright’s Law predicts by how much the cost of components would decrease over time. As the concept of Moore’s Law has been broadened to address many other (mostly high-tech) industries, so too does Wright’s Law apply to industries other than the airplane industry.

ARK’s Usage of Wright’s Law

Ms. Wood and the people at ARK use Wright’s Law to calculate how much costs will come down over time as companies’ production grows. ARK has found that Wright’s Law is remarkably accurate in forecasting these costs. For instance, ARK uses Wright’s Law to calculate the cost of lithium ion batteries, which are central to Tesla. According to this article from 2019 on ARK’s website, ARK forecast that Tesla’s gross margin for the Model 3 would be 30% by the end of 2020. Guess what? According to its latest annual report, Tesla’s “automotive gross margin” as of Q2 2021 was 28.4%. Pretty darn close to the 30% forecast. It has helped also that Tesla has been able to maintain its sales prices, a function to which Wright’s Law does not apply. As a result, while other investors concern themselves with supply and production issues or with Covid and the likelihood that electric car sales would increase, ARK’s focus is mostly on declining production costs as calculated through the application of Wright’s Law.

Secret Sauce

The more I investigated, the more it appears that ARK’s use of Wright’s Law is really its secret sauce. By using Wright’s Law, ARK has calculated by how much costs should decrease in fields such as autonomous tech and robotics, genomics, FinTech, and Space. ARK looks far into the future but it may not look so hazy to them if they believe the costs of all of these futuristic technologies will decline and by a specific amount. As a result, ARK’s assets under management in its principal Innovation Fund have grown from about $8 Billion a year ago to about $21.6 Billion currently.

IMO

I find it interesting that this theorem was devised not from the professorial ranks but from an engineer who worked within the industry. Likewise with Moore’s Law. All of that practical, hands-on experience is invaluable. Also, that Cathie Wood and ARK use the Wright’s Law concept and apply it to all of these other industries is a good way to get a handle and focus on what the future may look like. Let’s keep watch on them.

FYI

Wright’s Law is as follows:

Y = aX^b

Where:

Y = cumulative average time or cost per unit

a = time or cost required to produce the first unit

X= cumulative number of units produced

b = slope of the function

I read a post titled something like “Top Mistakes People Make With Their Money.” One of the Mistakes was what the blogger called Icebergs, and I thought that was clever. When you think about an iceberg, what comes to mind? Perhaps the first thing is The Titanic. Hopefully the second thing is that most of the hazard is underwater, where you can’t see. This is why The Titanic sunk. In the financial planning field, icebergs are investments or purchases you make wherein the initial purchase necessitates substantial future purchases, such that you are on the hook for a lot more money than you forked up for the initial purchase. Icebergs are especially prevalent with hobbies, and I am guilty of iceberg purchases that have cost me. Let’s examine.

Boating

Lots of people go boating, but most of those people don’t really need the boat. Boating is an excellent example of an iceberg purchase. Once you buy your boat, you have to store it somewhere, either in the water or on dry dock. That costs money, as does gas and maintenance. Oh, yeah, gotta insure the boat, and also maybe your liability insurance goes up due to the boat. Maybe instead of just a boat slip, why not just buy a place on the water that has a dock? That’s more iceberg spending. Then, what are you going to do with the boat? Go fishing? Then you need special expensive fishing equipment. Water skiing? Same thing. Soon, you can see why people say the 2 best days of a boat owner are the day they buy the boat and the day they sell the boat. Boats are really fun, though.

Music

You love music and you either already play the guitar or you want to learn, or maybe you want to be part of the new interest in vinyl. You buy your first guitar, and then soon you want a second. And then a third. All justified because they all sound a bit different, of course. Or you buy a nice new turntable, but you decide after playing them that those old LPs you saved from 40 years ago don’t sound that great any more, so you need to buy new ones. Pretty soon your high-end sound Jones starts to cost you a pretty penny. Guitar players are famous for their appetite for more and more guitars. Apple Music at $15/month sounds like a good deal by comparison. Music is a great example of an iceberg hobby.

Rental Property

Let’s turn to something that you think (hope) will make you some money in the future. You want to diversify your portfolio and so you decide to buy some rental property. Beware of icebergs here! Unless you are handy, you will have to hire others to do the upkeep and maintenance work. There is a labor shortage, so what does that mean for how much you will need to pay for your maintenance? Then there is the eviction moratorium: landlords cannot evict non-paying tenants due to the Covid-caused economic disruption. Now you have a property that you need to continue to maintain but you have reduced or perhaps no income from your tenants. Because of supply disruptions, the costs of lumber or plumbing that you need for your repairs are likely higher. There are icebergs aplenty with rental properties.

IMO

Everyone needs hobbies. Either undertake hobbies wherein the iceberg expenses are limited, or understand and prepare for the iceberg expenses of the hobbies that you do have. Be careful even with purchases wherein you hope to make a return at the end. Once you own something, there is a good chance you will need to have some further outlay in order to use your something or even just to make it run. Make sure your eyes are open to that likelihood.

This post is especially appropriate for younger readers, and you can determine for yourself what “younger” means. I recently read an article written by someone my kids’ age. The article said that saving money is a “bogus” financial planning recommendation, and that one should invest money rather than save money. Now, I will forgive the young lad who wrote the article that there is a serious flaw in his thinking – that one first has to save money in order to invest it. However, the more I thought about the article and and that it was written by someone my kids’ age, the point became clearer: Saving is boring, but Investing is exciting. If we change our focus from the boring part to the exciting part, perhaps things will improve overall.

Saving is Boring

Who wants to save? Where is the excitement in that? Save for what or for when? Many people, youngers especially, live only for today, either by choice or out of necessity. And, when you are younger, you likely don’t want to sacrifice a good time or a new purchase in order to stow away money for a rainy day that may never come. Moreover, if you save money, you might risk being labeled a Cheapskate. The peer pressure is on the side of spending money and not saving it. Your parents told you to save, but your parents also told you to clean up your room, and what fun is there in that? Yet, as everyone knows deep down that they should keep a neat room, they also know they should save some money. Perhaps what we need to do as planners is to change the focus from the “saving” aspect to the “investing” aspect.

Investing is Exciting

Investing money is now becoming cool, especially among the younger, just out of college demographic. Newly IPO’d Robinhood is a favorite among this group, as are chat sites through Reddit and other platforms that allow investors to brag about their success. It is a lot more interesting on social media to discuss your stock portfolio and winners therein than to talk about what you saved or didn’t spend. It is also a lot more interesting to earn a return on the money you save and invest, even if the risk is greater.

IMO

The young author of the article I read said that, although they have only a small amount of “savings”, they did own a sizable (for their age) investment portfolio. So, in a way, all we are talking about here is asset-class allocation within one’s portfolio. For younger people especially, and with the interest rates on money market or other savings accounts at banks near the 0% mark, it is more prudent to allocate a higher percentage of one’s portfolio to riskier asset classes such as stocks. If you take a hit on an investment, you have a lot of years to make it up. By changing the focus from less-exciting savings to more-exciting investing, perhaps we planners can persuade more younger people of all ages to put themselves in a better financial place, more able to withstand the challenges that life gives them.

We are perhaps witnessing the tipping point of massive disintermediation away from ownership in stocks of Chinese companies. Hong Kong’s Hang Seng Tech Index was down 8% today and is down 26% YTD. China’s CSI 300 Index was down 3.5% today. I believe there are 3 reasons why we are seeing this sell-off in Chinese stocks, although all three really boil down to the fact that the Chinese are Communists. Let’s explore:

More Regulations

The main media narrative, as reflected in this Wall Street Journal article, is that today’s selloff is due to increased regulations on big high-tech companies recently issued by the Chinese Communist Party (CCP). The CCP is growing wary of the increasing power of big high-tech companies in China, and so they are passing new laws to keep their power in check. As these companies have grown in status and have become more powerful, the CCP’s grip on its populace has become less powerful (sort of). New regulations as to how ride hailing company employees are to be treated (an issue also here in the US, by the way), as well as regulations on private tutoring companies have been unsettling, as was a short suspension of new users by WeChat.

No Audits

The new regulations by the CCP may be the narrative, but I believe there are deeper reasons why we are seeing this sell-off. One big reason is that, due to the backing of the CCP, Chinese “private” companies that are listed on American exchanges are not subject to the same audit standards as any other company that lists on American exchanges. DiDi Global, whose stock recently IPO’d here in the US, has gotten hammered because of the lack of audit standards. Referencing this article on Protocol.com, investors as well as US Government officials are ramping up demands that Chinese companies should be subject to the same audit standards as everyone else. Without a standard audit, how can an investor be sure that the financial results reported by Chinese companies are true? This is not a new issue, but investors now seem to be waking up to this issue even more, especially with the DiDi Global IPO and its negative performance since its IPO. By the way: US investment banks that have brought these Chinese companies to the US markets and have been paid handsomely for doing so have been complicit in this continued financial sham. I understand Caveat Emptor, but investment banks need to take a stronger stand on this issue.

Coronavirus

The real tipping point issue I believe has been Coronavirus, and specifically China’s and the CCP’s uncertain role with its origin and spread, and their continued efforts to obfuscate. I believe Coronavirus is causing a macro change in the way China is viewed, from China: Good to China: Bad. As long as China continues to act like Communists with respect to the Coronavirus, I believe China’s reputation will continue to worsen, and investors will treat Chinese companies with an increased level of skepticism.

IMO

When asked how someone goes bankrupt, Ernest Hemingway famously said with his economy with words, “Two ways: gradually, then suddenly.” I think we may be at the point now when the sense of ethical bankruptcy of Chinese companies may be moving from gradual to sudden. Investors start to sell positions in Chinese companies, and very soon a trickle becomes a flood. There could be very significant ramifications to world financial markets if I am correct.

There are so many options out there for investors and their accounts. How does one choose? An investor might choose where to open an account based on investment performance – this firm’s 5 year investment performance is the best of the lot, so I’ll open an account there. Other investors might open an account at a particular brokerage because they like the brokerage’s website. There might also be a recommendation from a friend or relative involved. All of these are valid ways to make that decision. However, should you take into consideration how a firm is organized, how it manages its profits and expenses, and how long it has represented a certain set of values within the investment world, you should consider opening an account with TIAA and/or with its subsidiary, Nuveen Funds.

TIAA

Why do I suggest that? Because TIAA (which stands for the Teachers Insurance and Annuity Association of America) has always been and still (kind of) is organized as a not-for-profit. Although it is technically not a not-for-profit today, TIAA does dividend all of its profits back to its account holders, in the mode of AAA and Costco. As its name suggests, TIAA was organized to help teachers and other public-sector workers with their finances, and though now anyone can open an account and/or buy an annuity or other insurance product from TIAA, its public sector accountholders remain at its core. Hand in hand with its not-for-profit mission is to keep expenses low. This goes for both its corporate expenses as well as for fees and expenses related to its investment products.

A major concern of retirees is having sufficient post-retirement income. Although I am not a proponent of annuities, they are good for those who risk averse and who want to be sure of their monthly income in retirement. To that end, TIAA has put an annuity calculator on the Home page of its website. Interest rates, and hence annuity returns, are low, but what’s unique about TIAA annuities is that they add TIAA corporate profits into the annuity payout, which means TIAA annuities can theoretically return a higher rate than comparable annuity products. If you are looking to purchase an annuity, I strongly consider looking at TIAA.

Nuveen

TIAA acquired Nuveen Funds during the 2008 Financial Crisis, and Nuveen is now a wholly-owned subsidiary of TIAA. Nuveen was formed as a municipal bond underwriter, but it is now a mutual and exchange-traded fund manager. Like its parent, Nuveen’s emphasis is on keeping expenses and accountholder fees low. Nuveen now emphasizes environmental, social, and corporate governance (ESG) investing, with several funds having that goal. Check out Nuveen’s website to see if they have a fund that fits your goals and needs. If you like the concept of TIAA but aren’t in the market for an insurance or an annuity product, then take a look at Nuveen.

IMO

Another good way to decide where to house a new brokerage account is to find a brokerage company whose stated values align with your own values. TIAA and Nuveen each have been catering to all clients, and especially to their public sector clients, in an empathetic way for over 100 years by operating as a not-for-profit, by keeping costs low, and by dividending any profits they do make back to their accountholders, while at the same time maintaining a high level of product offerings as well as customer service to their clients. Each has helped out its clients to reach their financial goals, and they can do the same for you as well or better than its brokerage brethren.

I trade options, mostly options on financial indexes such as the S&P 500 and the Nasdaq 100. Option premiums, which is what you pay to buy an option or what you receive if you sell an option, have been declining this year. Said another way, I have to sell at a strike price closer to the trading price of the underlying index in order to generate the same covered call revenue that I was able to generate last year. I believe current options premiums do not represent the full level of risk inherent in our economy, and hence are too low. Read on to see why.

Function of Risk

There are a number of components to the value of an option premium, and among them are Risk, meaning the likelihood that the actual result will differ from the predicted result. When the perceived level of Risk is higher, option premiums will be higher, and vice versa. One measure of Risk in the investing markets is the VIX Index, which I have written about before. The VIX is currently at 16.64, which is very close to its low since the start of Covid during 1Q 2020. It is higher than the 13-ish handle it displayed during most of 2019, by about 28%. One might conclude that the VIX has mirrored Covid infections: a spike during early 2020 followed by a decline to current lower levels, with several bumps along the way. However, I believe this is a simplified reading that misses one key element: government debt.

Increased Debt

Where did the US Government get all of the money it used to pay out to citizens and small businesses as part of the Covid stimulus plan? It borrowed, massively. The US Federal budget deficit in 2020 was $3.1 Trillion, and is projected to be an additional $3 Trillion in 2021. (Source: Congressional Budget Office). That’s $6 + Trillion dollars of additional leverage pumped into our economy. The effect of leverage is that it magnifies any change in the growth or shrinkage of economic performance. If corporate earnings improve, the magnitude of the improvement is enhanced by the leverage, and vice versa.

I ask you: Do you believe an additional $6 Trillion in Federal leverage would tend to enhance or diminish any risks that actual corporate performance matches projected corporate performance? My money says that the leverage would enhance risks, by a significant amount, or much more than the 28% that the VIX is higher now than in 2019. I don’t know by how much, but 28% seems low.

IMO

My argument is not that you should buy VIX Index call options because I believe it will rise; nor is my argument that you should buy Index call options for the same reason. Moreover, I am not arguing the merits of the $6 Trillion expansion of the Federal budget deficit one way or another. My point is that all of this additional borrowing makes projected likely outcomes more risky, and significantly so. If all goes according to script, then no harm and no foul. But when has the economy ever followed a script? As much as a script plays a role, so does improvisation. Consequently, I believe that current option premiums do not fully represent the level of risk commensurate with the higher level of debt in the economy. Perhaps what we will see is a lower base level of the VIX and option premiums, such as we have now, with intermittent spikes to significantly higher levels as incongruent data is released, such that the average over a period of time is heightened. We have a much different economy now than we had before Covid and we should adapt our expectations as a result.

I hope you all are having a good Summer so far, as my family and I are!

The release last week of CPI data that showed that May’s annualized inflation rate was 5% got a lot of media attention as well as rebuke from inflation hawks and my conservative brethren. If it were to continue for a whole year, 5% inflation would far exceed the Federal Reserve’s forecast and would be a big change in assumptions going forward. However, a deeper dive into the components of the data shows that things may not be as bad as the banner headline number indicates. Specifically, according to the US Bureau of Labor Statistics, almost all of the increase in May’s inflation reading was due to a rise in energy costs, which had been extremely depressed a year ago due to Covid. The Federal Reserve believes May’s 5% inflation level (as well as April’s 4.2%) is “transitory” and will be normalized once more of the economy opens up and energy production returns to pre-pandemic levels.

Base Year Effect

If you are comparing data from one year to the next and your prior or “base” year’s data was anomalistic, then you have what’s known as a base year problem. That’s what we have here with energy prices. 12 months ago we had the entire energy sector shutting down due to the pandemic economy. Recall that people weren’t driving to work or flying on planes and thus were not using gasoline or jet fuel. Recall also that during April 2020, May 2020 oil futures fell to below $0 because storage was full and producers needed to offload their production. Now, West Texas Intermediate Crude is trading at about $71, which is an incredible increase from just above $0 12 months ago but not that much higher than the $50 to $60 range that held during much of 2019, before Covid. And this is without worldwide production having reached full or near full capacity, as US production is down in part due to changes in government policy. The BLS data show that annualized inflation in energy components was 25.1% in April and 28.5% in May, compared with a year ago when producers were paying buyers to take oil off of their hands. Last year was an anomaly and we are hoping that the Fed is correct that we should be on more normal footing going forward.

Other Components More Normal

The BLS groups data into several components in addition to Energy, such as Food (in several subcategories), furnishings, apparel, medical care, sporting goods (?), and used cars and trucks. Of these, the only one (other than Energy) to have had an abnormal increase was used cars and trucks, which were up nearly 30% (annualized) in May. Ok, but again we had negative inflation a year ago (due to Covid) and supply chain issues with all automobiles. Specifically, the auto industry is going through a shortage of semiconductors. A lack of semiconductors means fewer new cars are being built, which means prices are up both for new and used cars. Assuming semiconductor production ramps back up (it will, right?), we should see auto prices leveling off. I can’t believe that car companies won’t try to take advantage of the increased demand for cars if they are able to do so. Food sector inflation is actually down from a year ago, from 4% to 2.2% currently. Remember meat plant shutdowns due to Covid a year ago? That’s not as much of an issue now and so food inflation is trending in the right direction.

IMO

This analysis leads me to believe that perhaps the Fed is more right than wrong and that the inflation Cassandras are more wrong than right. Though the US population is substantially vaccinated, that is not so for the rest of the world, including developing countries. Increased worldwide vaccination rates will mean greater production which will mean supply goes up and prices level off or go down. Bond investors appear to agree with this thesis as the yield on the 10 Year US Treasury has stabilized in the mid 1.5%-range. Let’s hope we are all right and inflation remains at an acceptable level.

Today is June 11. Don’t forget to pay your quarterly estimated taxes on or before June 15, which is next Tuesday. “Wait a minute! I thought my taxes aren’t due until April 15 next year”, you might think. That is correct, if you are a regular employee, someone who receives a Form W-2 at the end of the year. If you are a W-2 employee (as I call them), you likely don’t have to concern yourself with making quarterly estimated tax payments, unless you have a lucrative side gig. For most other people, however, making your quarterly estimated payments is an important thing. This includes gig workers, independent contractors, and anyone else who isn’t on a company’s payroll and who receives a Form 1099 at the end of the year. Although the 2020 tax return date was delayed until May 15, 2021, there has been no delay in the due date for 2021 taxes, so June 15 remains the next due date for quarterly estimates.

Growing Numbers

According to this posting in Forbes from a year ago, 28% of workers claim to be self-employed and 14% claim to be independent contractors. Earlier postings show the independent contractor percentage to be 8% to 10%. A lot of people signed up to be Uber drivers in the 2-3 years prior to 2020, and all of them are independent contractors. Both self-employed workers and independent contractors are subject to paying quarterly estimated taxes.

Safe Harbor

How much should you pay to avoid a penalty? The IRS provides a somewhat confusing (is there any other type for the IRS?) Safe Harbor rule, which is that you can avoid a penalty if you pay 100% of your tax bill from the prior year (in quarterly increments), or 110% if you made over $150,000. Your state will also have its own Safe Harbor rule that may or may not match up with the IRS’s rule. For instance, in California, where I live, the 100% rule is in place but the timing of the payments is accelerated such that 70% of the payment must be made by June 15. California penalties for underpayment are steep, so make sure you are aware of your own state’s rules – unless you live in a no state income tax state.

IMO

Paying a penalty is the pits, so please pay attention and make your estimated quarterly payment by next Tuesday if you are self employed or an independent contractor. Other links to read if you have time on your hands:

IRS page on independent contractors

TurboTax article reinforcing the same arguments I make here