From worries about political upheaval to the viability of the traditional balanced portfolio, Peter Mallouk and Jonathan Clements tackle four key questions currently on investors’ minds. Plus, a reminder about paying down debt and advice for staying calm in the face of market volatility.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Transcript:
Jonathan Clements: This is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm, and we are down the middle.
Like a whiny child, the financial markets are constantly demanding our attention, whether it’s rising interest rates, roller coaster stock prices or publicity seeking pundits of their extreme market forecasts. Today to make sense of all that’s going on, Peter and I are going to tackle four key investment questions. So Peter, question number one, we’ve got political upheaval at home. We’ve got conflicts in Ukraine and in the Middle East. When it comes to our portfolios, should we worry about such things?
Peter Mallouk: Well, I think when you look at where the market’s reaction right now is it’s not paying a lot of attention to what’s happening. And the reason is it’s not having an impact today on the economy, but the markets are looking ahead and carefully looking and saying what could happen? And so you have things that are possible. For example, Iran entering the conflict is something that a lot of people put at anywhere from 20% to 50%, depending on which strategist you want to listen to. If they enter the conflict, different story, you’ll immediately see the markets react. And the reason is, number one, that would greatly impact oil prices. And oil prices are a very big part of inflation.
The Federal Reserve can’t do anything about oil prices. They can raise rates all they want. If there’s less supply coming into the marketplace, not going to have an impact. And then oil impacts everything. It’s not just driving your car, flying a plane, it’s in a lot of products we use and it also delivers the ingredients to the grocery store. It delivers the cheeseburger stuff to McDonald’s. So basically it just gets reflected in everything in the economy and very, very high oil prices that are prolonged tend to be recessionary, lead to recessions.
Also, if you have that happen, then the market’s got to then factor in the probability does it expand even further? Does this make us more vulnerable to an expanded conflict in the region? More aggression from Russia, does it invite Chinese invasion of Taiwan? I mean, the market starts to look at these things as more probable and you would see more of a market reaction. But if it can stay between dealing with the Middle East and the Ukraine right now, I think the markets are going to continue to behave the way they behaved, which is be less focused on this and more focused on other things.
Jonathan: I think whenever we get these geopolitical issues, a good question for investors to ask themselves is, what does this mean for corporate earnings? Are the profitability of the S&P 500 companies going to be badly affected by what’s going on? And the point you’re making, Peter, as of right now, the impact on corporate profitability is de minimis, and that’s why we haven’t seen a huge reaction from the financial markets. But as you made clear, if it does spiral out of control from here, if it does become a wider conflict, obviously there is that potential.
Earlier this year, Peter, there was much talk about recession. Now, if anything, folks are worried that the economy is too hot, especially after the recent third quarter GDP report, which put growth at an annualized 4.9%. That brings us to our second question. Peter, should investors really be concerned about an economy that’s growing rapidly?
Peter: It’s interesting because good news has been bad news in this environment, like low unemployment, the market doesn’t like it. Great annualized growth rate, the market doesn’t like it. Now why is that? Because the market then thinks the Federal Reserve to slow down rapid growth, rapid inflation will have to continue to raise interest rates. I do think though the Federal Reserve may have navigated its way to as soft a landing as it possibly can get to. If we look at what they’ve accomplished, they’ve taken interest rates from 2% to 8%, if we want to call that an accomplishment, when you look at say, mortgages. And they’ve done a good job of getting the housing market to slow way down, buying new cars to slow way down. Major purchases of one business to another to slow way down. And they’ve done it while unemployment has remained low and growth has stayed in place.
So inflation in certain parts of the markets has been controlled. If we look at inflation in real estate, for example, which is a big piece, it has been controlled, and that was basically their mission. Now what they’re not able to do is control healthcare costs, oil and food costs, and we are seeing those continue to rise, but they’re not going to take action because of that. So I think if we look at basically the growth in GDP, I consider it positive. At the end of the day, it comes back to what you said, which is future corporate earnings. Those look very strong. Inflation seems under control, so I don’t think we’re going to see the Federal Reserve need to raise interest rates another couple percent to accomplish anything.
Jonathan: So one of the points that you’ve made in previous podcasts, Peter, is that one of the upsides of the degree to which the Federal Reserve has raised interest rates is that the Fed now has more firepower, it has more room to maneuver in terms of bringing down the Fed funds rate. When the Fed funds rate was down around zero, it took away a major weapon at the disposal of the Fed. Which brings me to my third question. Many folks are saying that the big obstacle for stocks right now are these high interest rates. To get a new bull market, do we really need to see the Fed cut interest rates from the current level?
Peter: Well, the way that we look at how interest rates impact things is what you were talking about. We look at corporate earnings. So if you’re a corporation, most corporations have some money that they’ve borrowed, just like most households have money that they’ve borrowed. And if interest rates go up for a corporation, their cost of that debt has gone up. So if I make a million dollars a year and the interest of my debt’s 100,000, well my profit is 900,000. If I make a million dollars a year and the cost of my debt is 200,000, well now my profit’s only 800,000. I have less profit. So when I apply a multiple to that, that’s how we get to the stock price. The more I’m paying an interest, the less profit there is. So it hurts stock prices. So that is the concept of higher rates.
Now what’s interesting is that’s how it impacts a business. Higher interest rates impact the profits of a business, but the stock market, if we look at the prediction of a stock price, is not really dependent on interest rates. And the reason is the market is very forward looking. So for example, today interest rates are much higher than they were five years ago — many, many times higher, but we have no difference in our predicted outlook of stock market performance. The odds of the stock market will be positive in the next 12 months is still 75% regardless of where interest rates are because the market is looking at what will things look like in the future? And what the market thinks things are going to look like in the future is rates will eventually come down a little bit. We can see that in the pricing of the bond market.
So it’s one thing to say, “Hey, corporate earnings are going to be impacted by higher interest rates.” That’s true. It’s a whole other thing to say, “I should be making a stock market decision based on that,” because the stock market is number one forward looking. And number two, interest rates is just one of many, many, many factors that go into a corporation’s profitability. If my cost of debt goes up a little bit, but I’m growing faster than normal, the stock price should eventually follow, and that might be the environment we’re looking at now.
Jonathan: So really we’re looking at two levers. On the one hand, there’s interest rates, which is the rate at which investors will discount the future profits of corporations, and then there are those actual profits. And given how well the economy is performing, we are at least seeing growth in corporate profits. So even in the absence of a cut in short-term interest rates by the Fed, we could see the economy start to recover because those corporate profits are rising at a handsome rate, throwing a cut of interest rates by the Fed, and presumably things could really take off.
Peter: That’s right. Like you said, the gun is loaded for the Fed again. I mean, if you looked after 9/11, after the tech bubble, after ’08, ’09, they lowered rates so much. They really had no solutions left. If something went wrong, now they’ve got such high rates. If they’ve overshot a little bit, if we had a mild recession or something negative happen, they’ve got a long way to go to lower rates, so much room to lower rates to reinvigorate the economy. They haven’t been in this strong of a position in a long time.
Jonathan: Okay. So time from my fourth and final question, once again, hearing commenters say that the classic balanced portfolio of 60% stocks/40% bonds is dead. Is it dead, Peter?
Peter: Well, here’s something interesting, is I think I was one of the first to say this on a Jeremy Siegel podcast many, many years ago that I thought 60/40 was dead. And at Creative, we really tend to lean more heavily towards equities. I do think that the 60/40 portfolio today is more attractive than it’s been in a decade plus. And the reason is the 40 is bonds, the 40% in bonds. Well, it wasn’t that long ago bonds were paying 2%, well now they’re paying five. So if you look at an overall portfolio of 60% in stocks and the rest of it’s earning 5%, you can actually get somewhere today if you go implement that portfolio today. So I still think on an after-tax risk-adjusted basis, you’re going to do much, much better in stocks for the long run. But the 60/40 is no longer dead. It’s now a viable option for a conservative investor. How do you feel about it, Jonathan?
Jonathan: Well, I think to your point Peter, that when we see what’s going on in the financial markets and we get bothered because stocks are down, we get bothered because bonds are down. What we should realize is that, yeah, we may be suffering in the short term, but what we’re also doing is raising expected long run returns. And now that the interest rate on bonds is significantly higher, the expected return from that portion of your portfolio is significantly higher. To your point though, yes, if bonds are offering higher returns, then stocks should be offering returns that are even greater than that. We should expect stocks to perform better than bonds because after all, we are taking more risk.
So anyway, Peter, it’s that time on the podcast. It’s time for your financial wellness tip of the month. What have you got for me?
Peter: Well, interest rates are higher and a lot of the debts that households carry are variable. Some have credit card debt, some have home equity loans, some have student loans. This is a good time to just pause and look at all of your different loans and make sure you are still tackling the highest interest rate debt first. You might have been in a pattern, an automatic pattern where some things were lower than your… Maybe you have a fixed mortgage and another debt had a lower rate, but that other debt is variable, is now higher than your fixed mortgage. Make sure you’re throwing your extra dollars at the highest interest rate debt.
Jonathan: So for me, Peter, one of the things I’ve been hearing from everyday investors is there’s some queasiness about the financial markets. They’re worried because of what’s going on in the Ukraine, because of what’s going on in the Middle East. They are bothered by the recent stock market volatility. So what I would encourage people who are listening to do is just think about how much you have in conservative investments and how soon you’ll need cash from your portfolio and how much you’ll need and see if there is a mismatch. And in all likelihood, there isn’t. In all likelihood, particularly if you’re in the workforce, you probably don’t need much cash from your portfolio in the years ahead, and you probably have at least some portion of your portfolio in more conservative investments. So you have no reason to be bothered by the current volatility in the stock market.
Similarly, if you’re retired, you probably have a significant sum in cash investments, in bonds that would easily cover your living expenses for the foreseeable future. So again, there’s no reason to feel queasy just because we’re getting some volatility in the stock market. So run the numbers and calm yourself down rather than panicking simply because all does not seem right with the world. So that’s it for this month. This is Jonathan Clements, director of Financial Education with Creative Planning. I’ve been talking to Peter Mallouk, President of the firm, and we are down the middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels.
