Hevel Capital: Monthly Newsletter - June 2024

Welcome to the second official newsletter of Hevel Capital!

Introduction

Welcome to the second edition of the Hevel Capital newsletter! As we move forward, our commitment at Hevel Capital remains unwavering: to empower you with the knowledge and strategies you need to achieve financial success. In upcoming issues, we’ll continue to explore new topics, share an overall market update, and provide financial planning strategies that may be useful to your unique circumstances. I truly appreciate your consideration and time!

Hevel Capital Baby Jonah Update

Hevel Capital is going well, but it’s too hard not to start with an update on little Jonah, although he is not so little anymore at over 18 pounds (82^nd percentile) at five months old. He’s been such a blessing in our family’s life and no matter how your day is going, he can cheer you up when he smiles at you as he pulls your hair or tries to eat your arm.

Market Update: US Stocks Remain King of the Hill

Tech Titans: The Driving Force Behind the US Stock Market Surge in 2024

We are off to the races again this year in the US stock market led by technology stocks once again (+17.3% YTD, S&P Global). Companies like Facebook (+32% YTD), Alphabet/Google (+24%), Microsoft (+11%), Amazon (+16%), and Nvidia (+121%) have delivered exceptional returns due to their dominance in areas such as artificial intelligence (AI), cloud computing, and digital services.

In fact, the tech sector is one of the key reasons why US stocks have materially outpaced International stocks over the past decade. While the official S&P classification results in a roughly 30% weight for the technology sector (~20% ten years ago) in the S&P 500 Index, adding tech-focused powerhouses such as Alphabet (GOOG/L), Amazon (AMZN), Meta (META), Netflix (NFLX), Tesla (TSLA), and others, pushes that weighting to around 40%, nearing levels not seen since the ‘dot-com’ era, LPL Research.

AI has revolutionized multiple industries, from healthcare to fashion to finance, driving demand for advanced computing solutions and will continue becoming mainstream. In many ways, the future is here…now. For example, Nvidia has benefited immensely from this trend (stock price +3,138% over the past 5 years as of 5/31; 3^rd largest market cap in the world at ~$2.7 trillion, yahoo finance) as it manufactures the main chips used for generative AI. Its chips (known as GPUs) are essential for training AI models, leading to a surge in its stock price. Other companies, like Microsoft and Alphabet, have also capitalized on AI, integrating it into their products and services, which has boosted investor confidence and stock prices​.

AI stocks are crucial to the overall stock market due to their role in driving innovation, market growth, and economic development. The technology sector’s dominance, the competitive advantages provided by AI, and the future potential of AI-driven advancements underscore the importance of these stocks to investors and the broader market. As AI continues to evolve, its influence on the stock market is expected to grow, making AI stocks an integral part of any forward-looking investment strategy.

Let’s touch on three topics surrounding AI: Economic Impact, Labor Markets, and Stock Market

Revolutionizing Industries: The Economic Impact of AI Across Sectors

The economic impact of AI extends beyond individual companies to entire industries and the global economy. AI-driven productivity gains, cost reductions, and new market opportunities contribute to economic growth, which in turn supports the stock market. In the short term, generative AI is expected to boost labor productivity, leading to lower inflation and reduced interest rates. Historically, increased productivity correlates with faster GDP growth and lower inflation. According to a report by PwC, AI could contribute up to $15.7 trillion to the global economy by 2030, underscoring its transformative potential and the resulting positive impact on stock markets. To put this number in context, the US economy is currently ~$25 trillion and the global economy is ~$107 trillion, IMF.

The use cases for AI are endless and can provide noteworthy savings across multiple industries. Below are a few examples.

• Transportation: The global autonomous vehicle market is expected to reach $1.6 trillion by 2030. AI-driven autonomous vehicles can reduce traffic accidents by up to 90% and save millions of lives, McKinsey.

• Healthcare: AI applications in healthcare could save the U.S. healthcare industry up to $150 billion annually by 2026. These savings come from various AI-driven efficiencies, including improved diagnostics, personalized treatment plans, and streamlined administrative processes, Accenture.

• Marketing: AI enables hyper-personalized marketing campaigns, improving engagement rates by up to 20%. Companies using AI for personalization have seen a 10-20% increase in sales, Boston Consulting Group.

As we continue to integrate AI into various facets of our economy, its potential to drive growth, efficiency, and innovation becomes increasingly apparent.

Future of Work: AI's Role in Shaping the Workforce of Tomorrow

By automating routine and repetitive tasks, businesses can free up human workers for more complex and creative tasks. For instance, AI can generate reports, write content, and design products, reducing the time and cost associated with these activities. According to a study by PwC, AI could boost labor productivity by up to 40% by 2035.

While there is concern about job displacement, AI is also expected to create millions of new job categories, particularly in tech development, data analysis, and AI system management. The World Economic Forum predicts that AI will create 97 million new jobs by 2025, even as it displaces 85 million.

Generative AI has the potential to create new economic activities and professions while simultaneously disrupting existing job structures, according to Morgan Stanley. The authors compare GenAI to two transformative technologies: the tractor and the spreadsheet. The tractor, introduced in the early 20th century, revolutionized agriculture by meaningfully increasing efficiency and reducing the need for manual labor. While this led to job losses in farming, it also freed up labor for emerging industries, paving the way for the modern economy. In contrast, the introduction of spreadsheets in the 1980s displaced clerical roles but created new jobs in finance and management. This technological advancement increased productivity and efficiency, highlighting how technology can shift labor demands rather than merely reducing jobs. The report suggests that GenAI resembles the spreadsheet more than the tractor, with the potential to create new job categories and augment existing roles.

Despite its potential, the adoption of GenAI faces several challenges. The report identifies "frictions" such as return on investment (ROI) concerns, data protection issues, skill deficits, and regulatory hurdles that could slow down widespread implementation. However, the potential market for AI applications is substantial. Currently, AI affects about 25% of occupations in the U.S., a figure that could rise to 44% within three years, representing $4.1 trillion in labor costs, Morgan Stanley.

As GenAI becomes more integrated into various sectors, the demand for specific skills over traditional credentials will increase. In fact, over half of the labor force will need significant training or reskilling to keep up with AI and automation advancements, World Economic Forum. Healthcare, professional services, and education are industries likely to see notable impacts, where worker activities can be augmented or automated, Morgan Stanley. This shift will necessitate a focus on developing core skills that align with the needs of an AI-driven economy.

Tech Overvaluation: Is the AI Surge Setting Up a Market Fall?

In recent years, the stock market has experienced a remarkable boost partially driven by advancements in artificial intelligence (AI). The market capitalization of a few tech giants has now become a significant portion of the overall market. This concentration means that any downturn in these stocks could have outsized effects on the broader market. The "Magnificent Seven" (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla) now account for over 25% of the S&P 500's total market cap, Bloomberg. However, this rapid growth has sparked concerns among investors and analysts about potential overvaluation and the risk of a market fall.

Timing market corrections is typically a fool’s game. The statistics and research overwhelmingly suggest that market timing is a difficult and often unproductive strategy. The data supports a long-term, buy-and-hold approach, which tends to yield better results by allowing investments to grow without the disruptions caused by trying to predict market movements. However, there are strategies that investors can deploy to mitigate the risks associated with market timing and to manage investments more effectively.

• Dollar Cost Averaging involves regularly investing a fixed amount of money into an investment, regardless of market conditions, reducing the risk of poor investment decisions based on timing and smoothing out the purchase price over time.

• Asset Allocation involves spreading investments across different asset classes like stocks, bonds, and real estate based on risk tolerance, investment goals, and time horizon, thus reducing risk through diversification and balancing risk and return.

• Rebalancing entails periodically adjusting your portfolio to maintain your desired asset allocation, helping to keep your portfolio aligned with your risk tolerance and encouraging a disciplined approach to buying low and selling high.

We have covered many of the positive attributes that the stock market is pricing in for AI stocks which is euphoric in many ways. Based on economic projections and widespread adoption across multiple industries, the excitement and positive stock market impact may be warranted. However, we must remember that the stock market is a basket of individual stocks whose price is determined by individuals (retail and institutions) that value companies based on expected future earnings discounted to today. Since expectations for AI stocks are currently through the roof, even if and when AI continues to transform the world it doesn’t mean that these stocks (and the overall market) will keep going higher. In fact, several indicators suggest that the current valuations might be overly optimistic.

As of mid-2024, the technology sector's valuation is markedly higher than the broader market. The forward price-to-earnings (P/E) ratio for the S&P 500 technology sector is around 25x, compared to the overall market's forward P/E ratio of ~20x. This indicates that investors are willing to pay a premium for tech stocks, reflecting their growth potential and the transformative impact of technologies like AI and cloud computing, Morgan Stanley.

Historically, the P/E ratios for tech stocks have fluctuated quite a lot. During the dot-com bubble in the late 1990s, tech stock valuations soared to unsustainable levels before crashing in the early 2000s. Today’s valuations, while high, are supported by substantial revenues and profits from leading tech companies, which distinguishes the current market from past bubbles. However, the tech sector's current P/E ratios relative to the overall market are still higher than their historical averages, suggesting potential overvaluation, Advisor Perspectives.

Experts like those from BlackRock and Morgan Stanley caution that the exuberant rally in tech stocks has left little room for error. Analysts emphasize that while AI and other technological advancements provide robust growth opportunities, high valuations mean that any disappointment in earnings or economic conditions could lead to a market correction. Investors should remain cautious and consider the possibility of market corrections if future earnings do not meet high expectations.

While the AI surge has undeniably driven impressive gains in the stock market, it is essential to approach the current market conditions with cautious optimism. Investors should be mindful of the potential for overvaluation and the risks associated with speculative investments. Diversification and a focus on fundamentals remain key strategies for navigating this dynamic and rapidly evolving landscape.

Maximizing Your Retirement Savings: Strategies You Need to Know

Retirement savings can feel like a daunting task and the average retirement savings gap in the U.S. is noteworthy, with many falling short of their retirement needs. Fidelity recommends having 10x your final salary saved by age 67. For a $100,000 final salary, that’s $1 million compared to the average 401(k) balance for those aged 60-69 is only about $195,500.

However, with the right strategies, you can maximize your nest egg and ensure financial security in your golden years. Here’s a comprehensive guide to the best ways to maximize your retirement savings if your income allows for it, including 401(k) investments, IRAs, Backdoor Roth IRA, Mega Backdoor Roth, and a Health Savings Account (HSA).

401(k) Contributions

A 401(k) plan is one of the most powerful tools for retirement savings. Contributions are made with pre-tax dollars, which can lower your taxable income and allow your investments to grow tax-deferred. Take full advantage of your employer’s matching contributions. This is essentially free money that can significantly boost your retirement savings. For 2024, the maximum contribution limit for a 401(k) is $23,000, with an additional catch-up contribution of $7,500 for those aged 50 and above. By consistently contributing to your 401(k) and taking advantage of employer matching, you benefit from compounding interest. For instance, contributing an extra $5,000 annually over 25 years could add up to an additional $316,000, assuming a 7% return on investment​.

Individual Retirement Accounts (IRAs)

IRAs are another cornerstone of retirement planning, offering both traditional and Roth options.

• Traditional IRA: Depending on your income and whether you have a retirement plan at work, contributions to a traditional IRA can be tax-deductible. For instance, if your modified adjusted gross income (MAGI) is less than $123,000 (for married filing jointly) in 2024, you can fully deduct your IRA contributions (max contribution of $7,000 or $8,000 if above age 50), reducing your taxable income and potentially saving hundreds to thousands in taxes annually. Additionally, investments grow tax-deferred meaning you don't pay taxes on the investment earnings until you withdraw the money in retirement. This can potentially result in substantial growth over time as your investments compound without the drag of annual taxes​.

• Roth IRA: A Roth IRA offers numerous benefits that make it an attractive option for retirement savings. Contributions are made with after-tax dollars, allowing investments to grow tax-free, and qualified withdrawals in retirement are also tax-free, providing significant tax savings over time. Unlike traditional IRAs, Roth IRAs do not require minimum distributions at any age, allowing investments to grow for as long as you choose. Additionally, beneficiaries can inherit a Roth IRA without owing federal income taxes on withdrawals, provided the account has been open for at least five years, which is advantageous for estate planning. The tax flexibility in retirement is another benefit, as withdrawals do not count as taxable income, helping manage tax liability and potentially keeping you in a lower tax bracket. Furthermore, there is no age limit for contributing to a Roth IRA as long as you have earned income, enabling continued savings into senior years.

For the 2024 tax year, you can contribute up to $7,000 to either a Roth IRA or a traditional IRA, and if you are 50 or older, you can contribute an additional $1,000, making the total $8,000. However, this limit is the maximum amount you can contribute across both types of IRAs combined. In other words, you cannot contribute the maximum amount to both a Roth IRA and a traditional IRA within the same tax year; your total contributions to both accounts cannot exceed $7,000 (or $8,000 if you're 50 or older).

Backdoor Roth IRA

If your income exceeds the limits for contributing directly to a Roth IRA, you can use the backdoor method to still take advantage of the Roth’s tax-free growth and withdrawals. There are a few steps involved but in essence a Backdoor Roth IRA is set up just as its name implies; open a traditional IRA and then convert those funds to a Roth IRA. This strategy allows high-income earners to sidestep income limits. You will pay taxes on any pre-tax contributions and earnings at the time of conversion, so it’s best to convert the amount to a Roth IRA shortly after making the contribution. Since the contribution was non-deductible, the conversion should generate little to no taxable income if set up properly.

Mega Backdoor Roth

The Mega Backdoor Roth IRA stands out as a powerful tool. It allows high-income earners to meaningfully boost their retirement savings in a tax-advantaged way, even when they exceed the income limits for traditional Roth IRA contributions. The Mega Backdoor Roth IRA is an advanced retirement savings strategy that allows individuals to convert after-tax contributions from their 401(k) plan into a Roth IRA. This process can increase the amount one can save in a Roth account beyond the standard contribution limits. In 2024, the IRS allows employees to contribute up to $23,000 to their 401(k) if they are under 50 years old, or $30,500 if they are 50 or older. This is the pre-tax or Roth 401(k) contribution limit. However, many 401(k) plans permit after-tax contributions beyond the standard limits. In 2024, the total combined contribution limit (employer and employee) to a 401(k) is $69,000 ($76,500 if age 50 or older). Once after-tax contributions are made, they can be converted to a Roth 401(k) within the plan (if the plan allows) or rolled over into a Roth IRA. This conversion is where the "backdoor" comes in, as it circumvents the usual income limits for Roth IRA contributions.

Health Savings Account (HSA)

An HSA offers a triple tax advantage: contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free. HSAs can also be used as an additional retirement account. For 2024, you can contribute up to $4,150 for individual coverage or $8,300 for family coverage (including employee and employer contributions), with an additional $1,000 catch-up contribution for those aged 55 and older. Unlike flexible spending accounts (FSAs), HSAs do not have a “use it or lose it” rule, allowing your contributions to grow over time. Many HSAs offer investment options similar to 401(k)s and IRAs.

Final Thoughts

By leveraging these strategies—maximizing 401(k) contributions, utilizing Backdoor and Mega Backdoor Roth IRAs, and contributing to HSAs, you can significantly enhance your retirement savings. Each strategy offers unique tax advantages and growth potential, so it's crucial to understand how they fit into your overall retirement plan. According to the Employee Benefit Research Institute, people who regularly maximize their 401(k) contributions can have over $1 million more in retirement savings than those who don't. It truly pays to maximize your contributions and take advantage of employer matching.

Ensuring a Financially Secure Retirement: Strategies for Sustainable Income and Tax Efficiency

Introduction

Have you ever considered how to maintain your current lifestyle after retirement without quickly depleting your hard-earned savings? There are strategies that can not only ensure a consistent flow of income but also meaningfully reduce your tax obligations.

Understanding Your Fixed Income Sources

The foundation of a financially secure retirement begins with understanding your fixed income sources. These sources can include Social Security benefits, pensions, and rental income. Fixed income is the reliable money that comes in regularly, regardless of market conditions. Start by listing all your fixed income sources and their expected monthly or annual amounts. This step provides a clear picture of your guaranteed income and forms the bedrock of your retirement finances.

Identifying Your Income Gap

The next step is to compare your fixed income with your actual expenses. For example, if your annual expenses are $100,000 and your fixed income is $45,000, you have an income gap of $55,000 that needs to be filled by your investment portfolio. Understanding your income gap is crucial because it highlights the role your investment portfolio will play in your retirement strategy. This analysis helps determine how much you need to withdraw from your savings and investments to maintain your lifestyle.

The Role of Your Portfolio in Bridging the Gap

Your investment portfolio is designed to bridge the gap between your fixed income and your expenses. A well-diversified portfolio, aligned with your risk tolerance and time horizon, is essential. The portfolio should aim to provide a steady income stream while preserving capital and growing with inflation. The conventional strategy is to use your taxable accounts first, followed by tax-deferred accounts, and finally, tax-free accounts. However, this approach may not always be optimal. A personalized strategy tailored to your financial situation can often yield better results.

Summary

By understanding your fixed income sources, identifying your income gap, and knowing the types of investment accounts, you can develop a retirement income strategy that minimizes taxes and maximizes your income. Effective retirement planning requires more than just diligent saving during your working years. It involves strategic planning to ensure a consistent income flow and tax efficiency in retirement. By carefully planning your income sources, understanding your expenses, and strategically withdrawing from the right accounts, you can achieve a financially secure and fulfilling retirement.