Perspectives | First Quarter 2013
From RiverPoint Capital Management
IN THIS ISSUE
Quarterly Economic and Capital Markets Outlook: Play Ball!
Stock Market Outlook – It Was the Best of Times…Thank You, Ben, Mario and Shinzo
Portability: Is it Time to Bypass the Bypass Trust?
Quarterly Economic and Capital Markets Outlook
Play Ball!
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RiverPoint Advisors
Valerie L. Newell, CPA
Leon H. Loewenstine, CPA
Victor R. Lassandro III
Pamela F. Schmitt, CFA, CDFA
Ryan L. Brown
Anthony Roberts III, CFA
M. Patrick Richter, CFP ®
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Leon H. Loewenstine, RiverPoint Capital Management, Managing Director and Chief Investment Strategist
William B. Greiner, CFA, Mariner Wealth Advisors, Chief Investment Officer
Our overall economic and capital markets
theme for the year has been “Play Ball,” in
which the world continues to find its way
through the process of unwinding disinflation
and fighting the tendency towards deflation.
Societies worldwide are making decisions as
to the shape and form of long-term social
contracts. Over the last 90 days, these
decisions have been significant. For example:
• In the U.S., the Fiscal Cliff was avoided as
tax rates increased for all taxpayers – more
notably for some. It appears to us that
progress (albeit choppy and not without
drama) is slowly being made to address
our nation’s most pressing issues – social
contracts which involve retirement and
health care delivery expectations.
• In Europe, we have seen that given the
right circumstances, bank deposits are not
sacrosanct, as bank depositors in Cyprus
have been levied a “fee” simply because
the banks needed it and the more wealthy
countries were unwilling to support
that system. This obviously isn’t a good
event. However, we hold the view that
the process of fiscal integration (which is
where, in our opinion, Europe is heading) is
never a pretty, or straight-on process.
• In Japan, the election of Shinzo Abe has
brought a revival in that country’s hopes
of ending their decades-long fight with
deflationary forces.
• In China, new leadership is taking over –
with renewed hopes of reigniting growth.
So, the “ball-game” of the world winding
through the process of growth realignment
and with it newly minted social contracts, is
proceeding.
On balance, we favor stock investments over
bonds, and are therefore maintaining equity
weightings towards the higher end of the
target ranges within our clients’ balanced
portfolios. Eventually, interest rates will rise,
driven by higher sustainable economic growth
combined with a push upwards in inflationary
pressure. This environment is a ways off – in
our opinion – but still visible. It is with this
sluggish, yet positive backdrop we offer our
detailed view for the equity markets.
Stock Market Outlook – An Update
It Was the Best of Times…Thank You, Ben, Mario and Shinzo
It seems like some time ago when we were
concerned about the election results, the
Fiscal Cliff and the Sequester. All of those
potential landmines have come and gone
over the last 150 days – less than half a year
– and stock values have soared. During the
1st quarter of 2013, the Dow Jones Industrial
Average surged to a new all-time closing
high, generating a total return of 11.9% for
the quarter – this would be a good return
for an entire year in most cases. The 11.9%
return was strong enough to eliminate bad
memories of the fact that the Dow had
generated a total return of only 1.5% for
Stock Market Outlook – An Update
It Was the Best of Times…Thank You, Ben, Mario and Shinzo (Continued from front cover)
the previous 9 month period, which brings
the market’s return for the last 12 months
to 13.4%. Is this type of upward move
sustainable? To answer this question, we
need to understand what has driven the
market higher. We turn to our traditional
Four Cornerstone analysis for some clues as
to what have been the drivers over the last 3
months and where we can expect the market
to go from here.
Cornerstone #1 - Sentiment
Skeptics of this market’s upward shift
abound – at least that is what we are hearing
from various quarters. You would never
know it from Ned Davis’ “Crowd Poll” which
simply asks
folks if they
are “bullish”
or “bearish”
on U.S. stocks.
Currently 70.5%
of respondents
claim they
Ben Bernanke
Mario Draghi
are bullish – a
significant majority. As a market indicator,
this is one where we take a contrarian view.
More people buying stocks will make stock
prices rise, while more people selling stocks
will make stock prices fall. If the majority
of people are feeling positive about stocks,
this implies that they have already purchased
their share of them, leaving potentially
less upward movement in stock prices.
Therefore, as one data point, we count
this cornerstone as a negative.
Cornerstone #2 – Valuation
As our regular readers are aware, when
we are viewing valuation, we lean on
longer-term data with more seriousness than
shorter-term values. In the case of valuation,
more data is normally better – so we look
at valuations (both domestic and global) as
far back as possible. The MSCI EAFE was
created in the 1970’s and is considered
by many as a hallmark foreign equity
index. Consequently, we look at valuation
information for the past 37 years to help
guide our thoughts.
Overall, global stock valuations don’t appear
dramatically over or under valued, but
rather appear to be largely “fairly” valued,
and nowhere near extremes. Of the major
markets (U.S., Europe and Japan) the U.S.
currently has the highest valuation relative to
itself and the others. By and large, the Asian
markets appear the most undervalued, in
our opinion. We currently count valuation
measures as neutral to slightly negative
– depending on your geographic focus.
Cornerstone #3 – Economic Growth
and Corporate Profit Growth
Our equity philosophy pivots on the belief
that earnings drive stock prices. Indeed,
over the long-term, corporate profits and
stock prices have been positively correlated
71% of the time. We therefore believe
earnings growth to be the most powerful
of the four “cornerstones” in our arsenal in
its predictive power. The actual expected
growth rate
is important,
along with
the direction
(increasing or
decreasing).
Thomspson
IBES survey
currently shows
Shinzo Abe
an expected
growth rate of S&P 500 earnings to be
7.6% over the next 12 months (survey as of
the end of February). Consequently, we
consider earnings growth a positive
indicator, and believe it will support
higher stock prices during 2013.
Cornerstone #4 – Central Bank
Monetary Policy
The title of our piece includes the first names
of the two most powerful central bankers in
the world (Ben Bernanke and Mario Draghi
of the Fed and ECB respectively). Both
bodies have let markets know through their
words and actions that they intend to wage
a serious war on deflation – the dreaded
economic disease of falling prices – and win
this war.
The main weapon in their arsenal is liquidity
– so much liquidity that the world’s economy
cannot absorb it in normal economic activity.
If the world’s economy doesn’t need liquidity,
that liquidity finds its way into assets. The
Fed has been infusing roughly $80 billion
of fresh liquidity monthly into the financial
system – since the launch of QE3. With
their purchases of Treasury and mortgagebacked bonds, the Fed is deliberately
keeping long-term interest rates low, thereby
encouraging increased investment in other
(higher-yielding) assets. This is expected to
©2013 RiverPoint Capital Management. All Rights Reserved.
continue until unemployment falls below 7%
or inflation reaches 2.5%. Consequently,
we count money supply and central
bank activities as very constructive for
higher stock prices.
Other Factors – Upward Spike!
The fact of the matter is that we have just
experienced what many would consider a
“spike” in the US stock market. The S&P 500
generated a price return of 10.2% during
the last 3 months. Historically speaking, on
a “normalized” level since 1949, the average
3-month price change in the stock market
has been 1.9%. A return of 10.2% over any
three-month period is rare. Since the end
of 1949, the S&P 500 Index has generated
a 10% or higher return over any calendar
3-month period 11% of the time, or on
average 1.3 times per year. These types
of major upward moves were much
more common in the bull-market 1980’s
and 1990’s. Indeed over the period of
1980–1999 these moves occurred almost
twice per year. During the last decade
the frequency slowed to one occurrence
every 1.4 years – welcome to the world
of the Long, Hard Slog.
Since the start of our current decade,
however, the frequency of these outsized
moves has again accelerated. Over the last
3.25 years we have witnessed six 10%+
3-month moves in the market, back in-line
with the frequency of these types
of price-spikes last seen during the
1980–1990 bull market, or about twice
per year, on average. Looking over a
shorter period of time, history again may
be a good teacher as to what to expect
going forward. Given what we know
about mass psychological behavior, some
would think that, on average, the 3-month
period following an outsized upward move
in stock prices would bring weakness – as
profit-taking occurs and stock prices decline
– right?
On the contrary, the average return
historically after these types of spikes
has actually been higher than the
market’s “normal return,” and when
the market has continued to climb in
price following a 10%+ price spike, the
gain has averaged 5.4% over the next
three-month period. In other words,
3-month 10%+ price moves have tended
Stock Market Outlook – An Update
It Was the Best of Times…Thank You, Ben, Mario and Shinzo (Continued from previous page)
to generate follow-on momentum. This
analysis is instructive in forming two
thoughts – that the frequency of 10%+
stock price spikes is starting to occur on
a secular bull-market timing basis, and
selling stocks immediately following a
10%+ move in stock prices has been the
wrong thing to do – historically
Long-Term Outlook – Bonzai Pipeline
Our regular readers know of our “Bonzai”
theme – one which was first introduced by
Stan Salvigsen of Merrill Lynch in the 1980’s.
Are we heading back to another “secular”
long-term bull market? Yes. Has this
long-term bull market started? The evidence
is building to support that contention. It
appears to us we are not seeing this yet – but
the weight-of-the-evidence is starting to
point in that direction.
We will be addressing this issue along
with some other very meaningful issues
over the next few months regarding not
just stock prices, but other asset allocation
issues. We see the world’s markets making
significant shifts over the next few years
as we eventually leave the “Long, Hard
Slog” environment and return to the Bonzai
Pipeline.
Leon H. Loewenstine, CPA
RiverPoint Capital Management,
Managing Director and
Chief Investment Strategist
William B. Greiner, CFA
Mariner Wealth Advisors,
Chief Investment Officer
In the meantime, we hear the markets calling
“Play Ball!”
Special Report
Portability: Is it Time to Bypass the Bypass Trust?
In the days following the passing of the
American Taxpayer Relief Act of 2013, much
of the national discussion was focused
on tax brackets, deductions, capital gains
and dividends. But one topic that has thus
far received much less attention, yet is
profoundly impacting the estate planning
community, is portability. Portability refers
to the ability of one spouse to pass his or
her unused federal estate tax exemption to
a surviving spouse at the time of their death.
The American Taxpayer Relief Act (ATRA)
made the portability rules permanent and
also set the gift and estate tax exemption
amount. Currently, that amount is $5.25
million, which will be adjusted annually for
inflation. These new rules have caused many
in the estate planning industry to question
whether or not the classic Bypass Trust
(also referred to as a “Marital” or “A” trust)
strategy is still the preferred technique for
couples to transfer wealth to one another,
and ultimately to their heirs. At RiverPoint
Capital Management, we believe it is
important to understand the benefits, as well
as the drawbacks, of using a Bypass Trust as
an estate planning tool in light of the new
portability rules.
The Bypass Trust
The federal estate tax exemption refers
to the amount of property an individual is
allowed to pass to beneficiaries without
incurring federal estate tax. Historically, a
well-designed estate plan took advantage of
both spouses’ exemptions to maximize the
amount of property that could be transferred
without being subject to federal estate taxes.
As an estate planning tool, the Bypass Trust
has long been used as a way for couples to
transfer wealth, usually at the time of their
death, by utilizing their estate tax exemptions
to avoid triggering potential federal estate
taxes for their heirs. To better understand
why people used Bypass Trusts prior to the
portability rule, consider the example of Jack
and Betty Jones. When Jack passed away
several years ago, he left $3.5 million in
assets to his wife, Betty. The assets passed to
Betty under the unlimited marital deduction,
which allows spouses to transfer an unlimited
amount of assets to each other without
incurring estate or gift taxes. By transferring
assets this way, Jack’s tax exemption went
unused and was lost. As a result, Betty, who
already had $3.5 million of assets in her
name, had a total estate of $7 million. Betty
passed away in 2009 when the estate tax
exemption was $3.5 million and the federal
estate tax rate was 45%; therefore, she was
only able to use her exemption to pass her
$3.5 million estate tax-free to her heirs,
leaving a 45% estate tax on the remaining
$3.5 million. Thus, the government received
$1.5 million of her estate instead of it passing
to the Jones’ heirs.
The Bypass Trust has helped to answer
the question of how each individual could
leverage his or her estate tax exemption
to transfer assets more effectively while
minimizing exposure to estate taxes. Using
the example above, let’s assume Jack had
established a Bypass Trust. At the time of
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his death, he would have utilized his estate
tax exemption to fund the trust without
incurring any federal estate taxes. So, instead
of transferring assets directly to his wife, he
has now funded a trust that can enable her
to gain access to those funds for support.
As in the example above, if she were to pass
away in 2009, her total estate would be $3.5
million, and she could utilize her personal
exemption of $3.5 million to pass her
property to heirs free of federal estate taxes.
ATRA and Portability
The 2013 enactment of ATRA made the
estate tax exemption permanently portable
between spouses, which has caused many
estate planners to wonder if the use of
the Bypass trust is still relevant. Under the
current tax laws, if Jack were to pass away
and leave his $3.5 million directly to Betty
without utilizing a Bypass Trust, his estate tax
exemption would carry over to Betty along
with his assets. This means at the time of
her passing, she would have her exemption
(currently worth $5.25 million) as well as
Jack’s, for a total exemption of $10.5 million.
Assuming Betty’s total estate was $7 million,
she would be able to pass the entirety of her
assets to her heirs and not pay any federal
estate tax. Considering this scenario,
why would a couple need to bother
establishing a Bypass Trust?
Benefits of the Bypass Trust
While the portability of estate tax
exemptions has left many to wonder if the
Bypass Trust is still relevant, there remain
Special Report
Portability: Is it Time to Bypass the Bypass Trust? (Continued from previous page)
other important factors to consider before
dismissing this strategy. In the example of
Jack and Betty, let’s assume Jack passes away
and does not establish a Bypass Trust. He
passes his $3.5 million to Betty, and she lives
for another 10 years. Assuming a 6% growth
rate, her $7 million estate would have grown
to $12.5 million. After applying Jack’s $5.25
million exemption and Betty’s exemption
after inflation, Betty’s estate would still be
susceptible to federal estate tax. By funding a
Bypass Trust at Jack’s death, those funds could
grow in value over time and be protected
from federal estate taxes. This should also
be a consideration for high-net-worth
families that are interested in transferring
wealth through multi-generational estate
planning. Unlike the estate tax exemption, the
Generation-Skipping Tax (GST) is not portable
and still requires the careful division of assets
during planning.
In addition to the tax considerations
surrounding the Bypass Trust strategy, there
are also several non-tax-related reasons
this strategy remains important. As a larger
estate planning tool, Bypass Trusts continue
to play an important role in asset protection.
For example, after Jack’s death, Betty may
decide to remarry. Should Jack pass his
assets directly to Betty, that property could
be in jeopardy should Betty’s new marriage
encounter financial challenges or end in
divorce. By passing his assets to a trust,
Jack is able to protect those assets against
unforeseen events and circumstances.
Another benefit of a trust in estate planning
can be the role of a trustee. Trusts are
required to name a trustee to manage the
assets and assist with the distribution of
those assets to the trust’s beneficiaries. And
while a surviving spouse may serve as trustee
for a trust in which he, she or the children
are a named beneficiary, there are certainly
circumstances in which a spouse may not
wish to serve in that capacity. By naming a
third-party as trustee, families can help avoid
potential issues or disputes that may arise
when distributing the trust’s assets.
Bypass Trust Drawbacks
One of the most notable drawbacks
associated with the utilization of a Bypass
Trust after portability became permanent is
the difference in the treatment of the cost
basis of assets transferring to the trust. Cost
basis is defined as the original purchase
price of a particular asset that is used when
calculating capital gains when the asset is
sold. Using the example of Jack and Betty,
let’s assume that at Jack’s death, his $3.5
million in assets transfer into a Bypass Trust.
At that time, those assets would receive a
step-up in cost basis. (In other words, the
assets would be revalued based on today’s
prices rather than the price when they were
originally purchased.) When Betty passes
away, her assets also receive a step-up in
cost basis, but the assets held in the trust do
not. Had Jack passed his assets directly to
Betty, those assets would get a step-up in
basis at his death and then again at the time
of Betty’s death. And if the total estate at
the time of Betty’s death was below $10.5
million, those assets would have passed
to her heirs without estate tax while also
receiving a step-up in cost basis.
Another drawback is the cost of creating and
maintaining the trust documents themselves.
While the creation of a Bypass Trust
strategy in addition to other estate planning
documents can be costly, the maintenance
of the trust can also be an expensive
consideration. Trustees are typically paid a
fee for the time required to act on behalf
of the trust, which generally varies based
upon the size of the trust. The trust also
requires ongoing financial reporting,
including an annual Form 1041 income tax
return for any income that was generated
and not distributed to beneficiaries, as well
as Form K-1s each year for income that was
distributed to beneficiaries. In addition, the
trust documents must be reviewed on an
ongoing basis by an attorney to ensure they
remain in good standing and are up-to-date
with the current law.
Trusts also have less favorable income tax
brackets than individuals. While beneficiaries
pay the tax on income distributed to from a
trust, most trusts pay tax on the accumulated
income and capital gains that remain in
the trust. What this means for trusts in
2013 is that, for any income not distributed
over $11,950, the trust will be subject to
the top 39.6% income tax rate and 20%
capital gains tax rate. The trust’s $11,950
distribution threshold also applies the recent
3.8% Medicare surtax on net investment
income. As a comparison, this matches
the income tax and capital gains currently
paid by individuals with an adjusted gross
income of $400,000 or more, as well as the
$200,000 threshold for the Medicare surtax.
Conclusion
With the recent laws enacted by ATRA
specific to the portability of estate tax
exemptions, the rationale behind using
the traditional Bypass Trust is the subject
of much debate. But regardless of the
arguments on either side of the issue, the
fact that remains that every family’s situation
is unique and careful considerations must
be made when determining the best estate
planning strategy. The permanence of the
portability rules and estate tax exemption
amounts need to be carefully weighed
against the protections and costs of a given
estate planning strategy. It’s also important
to note that any estate planning strategy
needs to be designed by an experienced
estate planning attorney. Should you have
any questions about your current estate plan
and how it affects your larger financial plan,
please don’t hesitate to contact your wealth
advisor at (800) 548-1625 or visit our
website www.riverpointcm.com.
This commentary is limited to the dissemination of general information pertaining to RiverPoint Capital Management’s investment advisory services and
general economic market conditions. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy
or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such. The views expressed are for commentary
purposes only and do not take into account any individual personal, financial, or tax considerations. There is no guarantee that any claims made will come to
pass. The opinions and forecasts are based on information and sources of information deemed to be reliable, but RiverPoint Capital Management does not
warrant the accuracy of the information that this opinion and forecast is based upon. Opinions expressed are subject to change without notice and are not
intended as investment advice or to predict future performance. Past performance does not guarantee future results. You cannot invest directly in an index.
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