Last week, the largest U.S. Banks reported earnings. Since then, sellers of news have been scouring the information in an attempt to entertain their viewers and readers with insights into the future of stocks and the economy. Let them, but know the real value to the investors is not in the headline earnings miss, the increased provisions for loan defaults, the updated economic outlook, or what might happen to tier 1 capital ratios and subsequent dividends. The real lesson is from the part of the banks that did well, their trading revenues.

Trading revenue is an abstract concept. When a bank sells a bond for $1,010 you might think that would equate to $1,010 of revenue but it doesn’t. If the bank had bought the same bond for $990 earlier in the day, that would equate to $20 of revenue. Trading revenue is the net the firm makes from being a market maker. Higher trading revenue was seen across all banks, with JP Morgan reporting a 32% increase for the quarter relative to Q1 in 2019. That’s a large increase, especially when you remember that volatility didn’t hit the markets until the last week of February.

The cause of the increase in revenue is from more volume and wider bid/ask spreads. More volume is straight forward, banks make money when people trade, and when people are trading more, they make more money.

Bid/ask spreads are more confusing. Banks are what are known as dealers, meaning they are willing to buy or sell a security at any time and hold it on their books. That exposes banks to the possibility that they won’t be able to get back to risk-neutral at a favorable price. As dealers, banks try to put a price on anything, so when markets get volatile, they charge wider bid/ask spreads to compensate themselves for the greater uncertainty that they won’t be able to get out of the position. When everything is averaged out, the greater risk generally means greater return which is what we saw this past quarter.

A good example of banks profiting off bid/ask spreads is seen with a corporate bond from CVS. CVS’s 3.7% maturing on 3/9/2023 is a very liquid bond. It has $6 billion outstanding and is heavily weighted in many bond indexes and funds. It’s the largest holding of one of our favorites, Vanguard’s Short-Term Corporate Bond Index Fund (VCSH). This is not an obscure bond; this is a very mainstream security.

The data from Charles Schwab in the following table shows how volatility can affect the spreads and subsequent profitability by banks trading securities.

In February and April, trading volume was average, and spreads were reasonable. But March! As views of the world diverge, profits explode. There are desperate sellers who only know they want out and are willing to sell at $89/share, a 15% discount from recent levels. Meanwhile, buyers view $98 as an easy way to get a safe, investment-grade bond maturing in three years, at a 7% discount. The colossal difference between $89 and $98 is profit for the banks – Wall Street loves volatility.

What is the lesson here? When the urge is greatest to do something, the best action is often doing nothing. Our advisors received numerous calls and e-mails in March asking what adjustments we were making to our portfolios to address these changing/uncertain times. We could have created a plan of actions that would have sounded sophisticated but the only one guaranteed to benefit from that would have been trading desks.

It’s important to remember the distinction between investing and playing the investment game. Investing is providing capital to entities who use the funds to create wealth. In exchange for providing the capital and enduring the ups and downs of the economy your funds appreciate over time. Playing the investment game involves keeping “dry powder” and “staying nimble.” It sounds sophisticated and exciting, and it may be good fun, but it’s a zero-sum game, akin to poker, and the banks are the house. At Rockbridge, we try our best to ensure you’re investing.

In the last quarter of 2018, the market was down 20% from previous highs and we had many clients reaching out concerned about declines and high volatility. But when we examined the market’s movements, we found the volatility to be higher than normal but far from extraordinary. Recently, we have gotten similar questions from clients again on returns and volatility. Here we examine historical daily price movements of the S&P 500 to try and see if the market has really been crazy or if people are overreacting.

The average daily price movement in the last 30 trading days of the quarter was 4.10%. In terms of 30-day stretches, this is the third most volatile period in history, behind the 4.41% seen on November 15, 1929 and the 4.13% on  November 21, 2008. In terms of acute volatility, what we’ve recently seen is not unprecedented, but we’ve never seen anything much higher.

If you look at the entire quarter, which had 62 trading days, the average daily movement was 2.28% which is the eighth most volatile quarter on record. The greatest quarterly volatility was at the end of 2008 (3.34%), and the other six were between 1929 and 1933. Three of those came in 1932 when the average daily movement for the year was 2.59%!

These are only a few ways of looking at volatility, but regardless of how we measure it, the recent volatility in the stock market is very high and very unusual. However, it is important to remember that volatility can be brief. On Friday October 16, 1987 the market dropped 5.2%. The following Monday it dropped 20.5%. The Monday after that it dropped 8.3%. Despite this unprecedented volatility and huge daily drops, the market finished 1987 up 5.3%.

We don’t know how long this type of volatility will last, but we know enduring it is worth it. Investors earn years like 2017 (+21.8%) and 2019 (+31.5%) by sticking it out during times like this.

Rebalancing the allocation among risky assets in your investment portfolio is an important discipline.  It provides a structured way to maintain consistent risk exposure over time and forces us to “buy low and sell high” when it is not always the comfortable thing to do.  This quarter is a good example, in the midst of crashing stock prices, and record volatility in markets, we have been selling bonds to buy stocks in our portfolios.  Buying stocks during all this uncertainty can feel uncomfortable if not downright frightening, but here are a couple of things to keep in mind.

Cash never “goes to the sidelines.”  If you listen to the talking heads of financial news-media, it can sound like all investors are reducing their exposure to stocks, and hoarding cash to buy back in when prices are lower.  But that’s not the way markets work!  Whenever a share of stock is sold, another investor buys it.  When there are more sellers than buyers, prices fall to clear the market.  Warren Buffet’s famous saying bears repeating now, “Be fearful when others are greedy, and be greedy only when others are fearful.”  Another famous quote strikes a chord as well, “In bear markets, stocks return to their rightful owners.”  Long-term investors want to be the owners of stocks and down markets are an opportune time to buy.

When stock prices drop, expected returns increase.  It may at first seem counterintuitive, but the math is fairly straightforward.  The value of a stock, or any other asset, can be described as the discounted present value of all future cash flows.  There are two factors that influence the value of a stock:  future cash flows and the discount rate.  When cash flows become more uncertain, we apply a higher discount rate.  Logically, a rational investor would pay less for an uncertain stream of cash flows than a stream with greater certainty.  The discount rate is a reflection of expected returns.  When risk and uncertainty increase, investors demand a higher expected return.  Over the past two months many stocks have decreased in value by 30% or more.  Some of the decrease in value is driven by an expectation of lost revenue and profits (future cash flows) resulting from Coronavirus’ shutdown of the global economy.  However, some of the decline is due to fear and uncertainty, which translates to a higher discount rate.  Both of which have a negative impact on stock valuations.  In turn, buying stocks at today’s prices comes with the expectation of higher rates as compared to two months ago.

Rebalancing is a valuable and important discipline.  If you still have questions about rebalancing, or worry about the appropriateness of your target allocation, talk to your advisor.

Stock Markets

The damage to stocks from the Coronavirus pandemic is shown in the chart below as all markets are down dramatically. The domestic large cap stock market (S&P 500), driven by the largest tech companies, held up a little better.  Except for this market, this quarter’s falloff brought the five-year returns to essentially breakeven and we must look to the ten-year numbers for returns that generally compensate for risk.

We are in uncharted territory and will be for a while.  It’s not the usual economic “slowdown”, but a “shutdown”.  Ben Bernanke, Fed Chairman during the 2008 financial crisis, likens to a natural disaster not a depression. Markets are clearly discounting the massive uncertainty of the trajectory of the Coronavirus pandemic, the global economic impact and government’s response.

It is reasonably clear that this health crisis and our response will alter the future economic landscape. There will be ups and downs as we move from where we are to where we are going. Today’s prices reflect current information about what is known and what is unknown about this journey. The expected return implied by these prices is not only positive but is apt to be better than what we have seen in the past to compensate for the greater risk in this period of heightened uncertainty. There is no reason to conclude this expected return won’t be realized eventually. To earn these returns means to remain committed to established investment plans.

Bond Markets

A yield is what you earn by holding a bond to its maturity. It has been shown to be a reasonable proxy for the return expected.  Changes in yields drive returns – falling yields positive, rising yields negative.  The longer a bond’s maturity the greater the impact a given change will have on prices and returns.

You can see to the right how yields have dropped over the last quarter.  It’s only at maturities greater than five years when yields are better than zero.  The falloff in bond yields of over one percent since last quarter reflects the Fed’s reduction in interest rates and its announced commitment to provide liquidity during this crisis.  In addition to the activities of the Fed, yields at the longer end are consistent with a desire to avoid risk and the expectation of low rates well into the future.  We have the Fed’s playbook from the 2008 liquidity crisis to give a sense of how they will apply the various tools.

The impact of the massive stimulus package is another uncertainty. No doubt we’ll see increased deficits, which is usually accompanied by inflation.  However, inflation has been benign over the last ten years as we worked through the effects of the last recession. The same could hold true this time around, although the deficits are going to be greater. The bond markets are telling us to expect that inflation will remain in check.

Risk and Uncertainty

Uncertainty can’t be measured, but risk can as both are associated with an unknown future. The stock market, where investors buy and sell based on an uncertain future, is an example.  Using historical data, we can construct expectations and a range of outcomes, which can be used to measure stock market risk.  A pandemic is new territory and if we accept that how markets deal with uncertainty is reasonably consistent through time, then history provides some insight into describing what’s ahead.

Today it’s the uncertain trajectory of the Coronavirus.  As more data is gathered through the ongoing testing’ the uncertainty is translated into measurable risk, which is then reflected in expected outcomes and variability. While the stimulus package signals Congressional support in lessening the economic fallout, there is not much history in implementing a package of this magnitude. Be prepared for a trial and error process, and volatility.

Where are We?

It is hard to imagine what we are going through won’t have a lasting social and economic impact.  The level of expected unemployment claims and government spending is new territory. The highest priority right now is to reduce the uncertainty of the health crisis. It will take time to expand the testing to better understand this pandemic and for “social distancing” to begin to work.  In the meantime, commitment and perseverance is our immediate future.

Markets look to the future, which is significantly murkier than a month ago.  It may be a while before the future looks much clearer.  While especially difficult in the face of today’s falloff, the time-worn prescription for investing in these times continues to be apt – maintain established commitments, endure the volatility in the near term and expect positive returns for bearing these risks over the long term.

With much of the country in self-isolation, perhaps you’ve got time to read the entire H.R. 748 Coronavirus Aid, Relief, and Economic Security Act, or CARES Act. If you’d prefer, here is a summary of many of the key provisions we expect to be discussing with you in person (virtually), depending on which ones apply to you. Questions? Please be in touch!

In General

  • Direct payments/recovery rebates: Most Americans can expect to receive rebates from Uncle Sam. Depending on your household income, expect up to $1,200 per adult and $500 per dependent child. To calculate your payment, the Federal government will look at your 2019 Adjusted Gross Income (AGI) if it’s available, or your 2018 AGI if it’s not. However, you’ll receive an extra 2020 tax credit if your 2020 AGI ends up lower than the figure used to calculate your rebate. This Nerd’s Eye View illustration offers a great overview:

  • Retirement account distributions for coronavirus-related needs: You can tap into your retirement account ahead of time in 2020 for a coronavirus-related distribution of up to $100,000, without incurring the usual 10% penalty or mandatory 20% Federal withholding. You’ll still owe income tax on the distributions, but you can prorate the payment across 3 years. You also can repay distributions to your account within 3 years to avoid paying income taxes, or to claim a refund on taxes paid.
  • Various healthcare-related incentives: For example, certain over-the-counter medical expenses previously disallowed under some healthcare plans now qualify for coverage. Also, Medicare restrictions have been relaxed for covering tele-health and other services (such as COVID-19 vaccinations, once they’re available). Other details apply.

For Retirees (and Retirement Account Beneficiaries)

  • RMD relief: Required Minimum Distributions (RMDs) go on a holiday in 2020 for retirees, as well as beneficiaries with inherited retirement accounts. If you’ve not yet taken your 2020 RMD, don’t! If you have, please be in touch with us to explore potential remedies.

For Charitable Donors

  • “Above-the-line” charitable deductions: Deduct up to $300 in 2020 qualified charitable contributions (excluding Donor Advised Funds), even if you are taking a standard deduction.
  • Donate all of your 2020 AGI: You can effectively eliminate 2020 taxes owed, and then some, by donating up to, or beyond your AGI. If you donate more than your AGI, you can carry forward the excess up to 5 years. Donor Advised Fund contributions are excluded.

For Business Owners (and Certain Not-for-Profits)

  • Paycheck Protection Program loans (potentially forgivable): The Small Business Administration (SBA) Paycheck Protection Program (PPP) is making loans available for qualified businesses and not-for-profits (typically under 500 employees), sole proprietors, and independent contractors. Loans for up to 2.5x monthly payroll, up to $10 million, 2-year maturity, interest rate 1%. Payments are deferred and, if certain employment retention and other requirements are met, the loan may be forgiven.
  • Economic Injury Disaster Loans (with forgivable advance): In coordination with your state, SBA disaster assistance also offers Economic Injury Disaster Loans (EIDLs) of up to $2 million to qualified small businesses and non-profits, “to help overcome the temporary loss of revenue they are experiencing.” Interest rates are under 4%, with potential repayment terms of up to 30 years. Applicants also are eligible for an advance on the loan of up to $10,000. The advance will not need to be repaid, even if the loan is denied.
  • Payroll tax credits and deferrals: For qualified businesses who are not taking a loan.
  • Employee retention credit: An additional employee retention credit (as a payroll tax credit), “equal to 50 percent of the qualified wages with respect to each employee of such employer for such calendar quarter.” Excludes businesses receiving PPP loans, and may exclude those who have taken the EIDL loans
  • Net Operating Loss rules relaxed: Carry back 2018–2020losses up to five years, on up to 100% of taxable income from these same years.
  • Immediate expensing for qualified improvements: Section 168 of the Internal Revenue Code of 1986 is amended to allow immediate expensing rather than multi-year depreciation.
  • Dollars set aside for industry-specific relief: Please be in touch for a more detailed discussion if your entity may be eligible for industry-specific relief (e.g., airlines, hospitals and state/local governments).

For Employees/Plan Participants

  • Retirement plan loans and distributions: Maximum amount increased to $100,000 on up to the entire vested amount for coronavirus-related loans. Delay repayment up to a year for loans taken from March 27–year-end 2020. Distributions described above in In General.
  • Paid sick leave: Paid sick leave benefits for COVID-19 victims are described in the separate, March 18 R. 6201 Families First Coronavirus Response Act, and are above and beyond any benefits received through the CARES Act. Whether in your role as an employer or an employee, we’re happy to discuss the details with you upon request.

For Employers/Plan Sponsors

  • Relief for funding defined benefit plans: Due date for 2020 funding is extended to Jan. 1, 2021. Also, the funding percentage (AFTAP) can be calculated based on your 2019 status.
  • Relief for facilitating pre-retirement plan distributions and expanded loans: As described above for Employees/Plan Participants, employers “may rely on an employee’s certification that the employee satisfies the conditions” to be eligible for relief. The participant is required to self-certify in writing that they or a direct dependent have been diagnosed, or they have been financially impacted by the pandemic. No additional evidence (such as a doctor’s release) is required.
  • Potential extension for filing Form 5500: While the Dept. of Labor (DOL) has not yet granted an extension, the CARES Act permits the DOL to postpone this filing deadline.
  • Exclude student loan pay-down compensation: Through year-end, employers can help employees pay off current educational expenses and/or student loan balances, and exclude up to $5,250 of either kind of payment from their income.

For Unemployed/Laid Off Americans

  • Increased unemployment compensation: Federal funding increases standard unemployment compensation by $600/week, and coverage is extended 13 weeks.
  • Federal funding covers first week of unemployment: The one-week waiting period to start collecting benefits is waived.
  • Pandemic unemployment assistance: Unemployment coverage is extended to self-employed individuals for up to 39 weeks. Plus, the Act offers incentives for states to establish “short-time compensation programs” for semi-employed individuals.

For Students

  • Student loan payments deferred to Sept. 30, 2020: No interest will accrue either. Important: Voluntary payments will continue unless you explicitly pause them. Plus, the deferral period will still count toward any loan forgiveness program you’re in. So, be sure to pause payments if this applies to you, lest you pay on debt that will ultimately be forgiven.
  • Delinquent debt collection suspended through Sept. 30, 2020: Including wage, tax refund, and other Federal benefit garnishments.
  • Employer-paid student loan repayments excluded from 2020 income: From the date of the CARES Act enactment through year-end, your employer can pay up to $5,250 toward your student debt or your current education without it counting as taxable income to you.
  • Pell Grant relief: There are several clauses that ease Pell Grant limits, while not eliminating them. It would be best if we go over these with you in person if they may apply to you.

For Estates/Beneficiaries

  • A break for “non-designated” beneficiaries: 2020 can be ignored when applying the 5-year rule for “non-designated” beneficiaries with inherited retirement accounts. The 5-Year Rule effectively ends up becoming a 6-Year Rule for current non-designated beneficiaries.

There. You’re now familiar with much of the critical content of the CARES Act! That said, given the complexities involved and unprecedented current conditions, there will undoubtedly be updates, clarifications, additions, system glitches, and other adjustments to these summary points. The results could leave a wide gap between intention and reality.

As such, before proceeding, please consult with us and other appropriate professionals, such as your accountant, and/or estate planning attorney on any details specific to you. Please don’t hesitate to reach out to us with your questions and comments. It’s what we’re here for.

Reference Materials:

U.S. Small Business Administration, Paycheck Protection Program and Disaster Assistance

The CARES Act establishes a new loan program through the Small Business Association (SBA), to aide small businesses who have had to lay off employees, and or, suspend their operations. To be eligible for a loan under this section an entity must have less than 500 employees, which includes full time and part-time workers.

Eligible businesses include:

  • Sole proprietors, and certain self-employed individuals
  • Independent contractors
  • Nonprofit organizations under section 501(c)(3)
  • food service industry businesses with less than 500 employees per physical location

Loans will be administered by SBA-approved lenders, and are limited to the lesser of:

  • 2.5 times the average total monthly payroll costs incurred during the 1-year period before the date on which the loan is made. Seasonal employers, and employers not in business between February 15, 2019 and July 30, 2019, will use an alternative calculation period.
  • $10,000,000.

Payroll costs for determining the eligible loan amount include:

  • Salaries, wages, commissions
  • Payment of cash tips
  • Payment for vacation, parental, family, medical, or sick leave
  • Payment required for group health care benefits, including insurance premiums
  • Payment of any retirement benefit
  • Payment of State or local tax assessed on employee compensation

Payroll costs do not include annual compensation in excess of $100,000 per person, or compensation of an employee whose principal residence is outside of the United States. They also do not include Federal employment taxes imposed or withheld. Qualified family or sick leave wages for which a credit is allowed under the Families First Coronavirus Response Act, will also not count as payroll costs.

Proceeds from a loan under this program may only be used for the following purposes:

  • Payroll costs
  • Costs related to continuation of group health care benefits and insurance premiums
  • Employee salary/compensation
  • Rent and utilities
  • Interest on other debt incurred before February 15, 2020

Loans taken under this program are eligible for full or partial forgiveness. The forgiven amount will be equal to the amount actually paid for payroll costs (not including salary amounts over $100K), benefits, rent, utilities and mortgage interest during the eight weeks following disbursement of the loan. Additionally, amounts forgiven will not be included in gross income as cancelation of indebtedness income.

The amount forgiven will decrease ratably if the employer does not retain an equivalent number of employees between February 15, 2020 and June 30, 2020, as it employed between either February 15, 2019 and June 30, 2019, or January 1, 2020 and February 15, 2020. Further reductions to the forgiveness amount will be incurred if the employer cuts an employee’s compensation by more than 25% (for employees making less than $100K), as compared to the previous quarter.

Any amounts not forgiven will have a maximum maturity of 10 years from the date the borrower applies for loan forgiveness, and maximum interest rate of 4%. Payments on these loans will be deferred for 6 to 12 months.

In response to the COVID-19 pandemic, Congress has passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). This legislation is the third round of federal funding aimed at providing economic support for individuals and businesses. Below are some of the key provisions relating to small businesses and companies.

  • Paycheck Protection Program (PPP) – The CARES Act establishes a new loan program through the Small Business Association (SBA), to provide financing for businesses with less than 500 employees, including sole proprietors and independent contractors. Eligible businesses may borrow up to the lesser of $10,000,000, or 2.5 times their prior year’s average total monthly payroll costs (subject to some limitations). Loan proceeds that are used to cover certain costs over an 8-week period, may be eligible for complete or partial forgiveness. Amounts not forgiven must be paid back over a 10-year period and have a maximum interest rate of 4%.
  • Economic Injury Disaster Loans (EIDLs) – These disaster relief loans administered by the SBA have been around for a long time, providing working capital loans to small businesses. EIDLs offer 30-year loans up to $2,000,000, with interest rates of 3.75% and 2.75% for small businesses and nonprofits respectively. The CARES Act provides for an advanced payment of up to $10,000 for those businesses applying for this type of loan. The $10,000 advance will be paid within three days of the request, and may be used to maintain payroll, provide sick leave to employees, make rent/mortgage payments, meet increased production costs due to supply chain disruptions, or pay other business obligations. The $10,000 advance is not required to be repaid under any circumstances.
  • Small Business Debt Relief Program – The SBA will cover all loan payments for six months, for small businesses who have new or existing SBA loans, that are not EIDLs or PPP loans. Payments covered include interest, principal, and fees.
  • Employee Retention Credit for Employers Subject to Closure Due to COVID-19 – This provision of the CARES Act provides a refundable tax credit for businesses and nonprofits meeting at least one of the two criteria:
    1. A business whose operations have been fully or partially shut down due to governmental authority limiting commerce, travel, or group meetings due to COVID-19.
    2. A Business whose revenue (not profit) in 2020 is at least 50% less than revenue from the same quarter in 2019.

The credit is equal to 50% of wages paid to each employee, up to a maximum of $10,000 of wages per employee. The calculation of wages for purposes of determining the credit vary by business, employee, and payment type. Any business who believes they are eligible for this credit should consult with their tax advisor. Employers receiving assistance through the Paycheck Protection Program are not eligible for this credit.

  • Deferral of Payment of Payroll Taxes – This provision allows taxpayers (including the self-employed) to defer paying the employer portion of certain payroll taxes through the end of 2020, with all 2020 deferred amounts due in two equal installments, one at the end of 2021 and the other at the end of 2022. Payroll taxes that can be deferred include the employer portion of FICA taxes, the employer and employee representative portion of Railroad Retirement taxes (that are attributable to the employer FICA rate), and half of SECA tax liability. Employers receiving assistance through the Paycheck Protection Program are not eligible for this deferral.

Stay tuned for more in depth analysis on these, and other, provisions affecting small businesses.