Inflation’s Good News, Worrisome Trend

When Federal Reserve Board economists kept insisting that 2022’s inflation levels were ‘transitory,’ it sometimes elicited derisive laughter from reporters. But it turns out they were right. As the Covid pandemic eased and supply chain problems were worked out, inflation fell from 9% back down to more normal levels, even as wages and interest rates (normal drivers of inflation) ticked upward.

Now that the December inflation numbers are in, the picture looks even better. The Fed looks most closely at the ‘core personal consumption expenditures’ price index, which tracks what households are actually spending, and by that measure, the inflation rate is running at 2.9%.

The more widely-followed Consumer Price Index came in at a 3.4% inflation rate for all of 2023. The chart shows the Covid decline (when everybody was hiding in their homes) and then the subsequent bulge when it became difficult for imported goods to get to market—and you can see inflation’s gradual retreat since the middle of 2022 as all of this got sorted out.

But you might notice that the rate has remained fairly steady for the past year, suggesting that price increases have settled in at somewhat higher levels than the 2%-2.5% historical numbers. That means that the Fed might eventually decide to give interest rates another nudge upward in hopes that that a higher Fed Funds Rate slow down spending enough to bring us back to the longstanding 2% inflation target. Nobody knows if or when that will happen, or what inflation might do to surprise us in the coming months, but for now it appears that inflation is no longer wildly out of control.

New Highs. Now What?

We’re all reading headlines telling us that the stock market has reached all-time highs, something that never happened in 2023. Many investors who have a worrisome mindset will think that means that there’s a high likelihood that we’ll see a downturn in the near future. The markets have nowhere to go but down from here, right?

There’s a kind of logic to this assumption, but history says that it’s actually wrong. Since 1973 (the modern stock market), the markets have achieved an average 10.1% positive return over the 12 months following an all-time high, which is actually higher than the average 12 month return from any random day during that time period (+9.5%). Going back further, for shorter time frames, since 1950, 80% of record highs have led to at least one more record high the following week, and the markets generally hit a new all-time high (again, on average) every 19 days.

If you go back 60 years (since 1964) the average one, two and three-year returns after a record high are 12%, 23% and 39% (these are aggregate, not annual returns), which is surprisingly close to the 12%, 25% and 38% average aggregate returns for all other one-, two- and three year time periods.

This is not to say that the markets will not or cannot go down from here; they can and they might. But the most consistent thing about the markets is that, no matter where you start, the overall long-term trend has been positive, and all-time highs are, perhaps surprisingly, no exception.

The Optimus Approach to Investment Management

Optimus Capital Advisors strives to provide our clients with a successful investment experience. That means more than just returns. It means offering peace of mind to investors that every investment decision is made in their best interest, tailored to meet their objectives, with no conflicts of interest, and a transparent process backed by decades of research powering every decision. For almost two decades we’ve seen the difference our approach has made in people’s lives. Our goal is to help people live better today, and in the years ahead.

But returns do matter–so we want to sketch here a quick outline of our investment approach. There’s two core components to this approach: an enduring belief in the power of markets, and applying insights from financial science. Given our complete alignment in philosophy, we choose to partner with Dimensional Fund Advisors to inform our portfolio management strategies.

Read below to learn a bit more about our shared thoughts about managing investments for our clients.

An enduring belief in the power of markets 

At Dimensional, their investment approach is based on a belief in markets. Rather than attempting to predict the future or outguess others, they draw information about expected returns from the market itself—leveraging the collective knowledge of millions of buyers and sellers as they set security prices. Trusting markets to do what they do best—drive information into prices—frees them to spend time where they believe they have an advantage, namely in how they interpret the research, how they design and manage portfolios, and how they serve their clients. They take a less subjective, more systematic approach to investing—an approach they can implement consistently and investors can understand and stick with, even in challenging market environments.

Applying insights from financial science

Dimensional’s investment approach is grounded in economic theory and backed by decades of

empirical research. Their internal team of researchers works closely with leading financial economists to better understand where returns come from. Research has shown that securities offering higher expected returns share certain characteristics, which they call dimensions. They structure broadly diversified portfolios that emphasize these dimensions, while addressing the tradeoffs that arise when executing portfolios. Every day, their portfolio managers and traders seek to balance costs against expected returns and diversification. They work for the slightest expected gain, as every incremental improvement can add up over time.

The Optimus approach, powered by Dimensional’s financial science, makes a significant difference for the portfolios of clients. We’re proud of the work we’ve done and continue to do on behalf of clients to enable their financial goals through experienced investment management.

Preparing for the Sunset

When the Tax Cuts and Jobs Act (TCJA) Act passed in 2017, we were told that all of the provisions—lower tax rates, much more generous estate tax exemption—would sunset at the end of 2025. That seemed a long way off back then. But now it’s 2024, less than two years before what could be a jarring shift in our tax regime. Soon, the top marginal tax rate is due to revert back to 39.6%. The standard deduction will drop to roughly half of today’s $14,600 (single) or $29,200 (joint). Most significantly, the estate tax exclusion—the amount that can be passed on to heirs without being taxed at the federal level—will drop from $13.61 million this year to somewhere around $6.5 million.

Of course, the sunset will not be all bad. After 2025, the $10,000 cap on state and local tax deductions will go away, the the limit on how much mortgage interest is deductible will go up from the first $750,000 in debt back to $1 million, and a bunch of miscellaneous itemized deductions, including investment/advisory fees, legal fees and unreimbursed employee expenses will be restored. People in lower income brackets will get back a personal exemption amount of (inflation-indexed) $4,700, phased out as taxable income goes up.

How should taxpayers prepare for these various changes, to take advantage of today’s rates or exemptions? The answer varies widely with individuals, but there are some strategies that are widely-applicable. Some tax experts with a terrible sense of humor say they are recommending that if their clients are in poor health, they should plan on dying before the sunset. Less macabre strategies include strategically taking capital gains out of taxable portfolios at today’s (and next year’s) lower tax rates, and holding off harvesting capital losses until 2026.

Families who might bump up against the lower estate tax exemption could gift assets from one spouse’s lifetime exemption while preserving the other spouse’s. Since these exemptions are portable, either spouse will be able to use the other one’s upon the death of one spouse, so nothing is lost by taking this route. There are various trust strategies that will move assets out of the taxable estate—the most-often-cited are the spousal lifetime access trust and the grantor-retained annuity trust, both of which use the gifted assets to provide lifetime retirement income to the donors.

But as you consider these strategies with your advisor, it’s helpful to remember that Congress might intervene between now and January of 2026, and pass entirely new tax legislation. As you can see from the chart, it’s happened a few times before.

Next Year’s Tax Brackets

The Internal Revenue Service has (finally!) released the tax brackets for 2024, which are annually indexed for inflation. The top bracket is always the strangest; you would think that the filing joint returns threshold would be double the single filer threshold, as it is for the other brackets, but… Single taxpayers with adjusted gross income of $609,350 will be in the 37% bracket next year, while joint filers making $731,200 or more will fall into that top bracket.

The 35% bracket will start at $243,725 for single filers next year; $487,450 joint; the 32% bracket will kick in at $191,950 (single) or $383,900 (joint); people will enter the 24% bracket starting at $100,525 (single) or $201,050 (joint); and the 22% bracket threshold will be crossed after $47,150 (single) or $94,300 (joint). The 12% bracket will start at $11,600 or $23,200, and anything below that falls into the 10% tax bracket.

The standard deduction will also go up fairly substantially, to $14,600 for single filers; $29,200 for join filers, with an additional $1,550 or $1,950 for married or unmarried seniors, respectively. People will pay no capital gains taxes on gains realized if their adjusted gross income is below $47,025 (single) or $94,050 (joint); above that, they would pay taxes on their capital gains at a 15% rate until they reach the 20% threshold at $518,900 (single) or $583,750 (joint).