The economy is up, bonds are down and stocks are waffling. But what should investors do? Creative Planning’s Peter Mallouk and Jonathan Clements take a look at the latest market action.
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 in Overland Park, Kansas. With me is Peter Mallouk, President of the firm and we are Down the Middle. So, Peter, we’re two months into the year and there’s this growing sense of optimism. The economy appears to be picking up steam. The unemployment rate is coming down. Every day, more and more Americans are getting vaccinated against COVID-19 and yet in the last couple of weeks we’ve started to see the stock market become a little bit sloppy. The gains haven’t been coming nearly as easily as they were in the initial weeks of the year. What do you think is going on here?
Peter Mallouk: I think the market has always been about earnings. We talk about that all the time, but most importantly about future expected earnings. When someone buys a stock, you’re looking and saying, what am I going to make on this in the future? If I’m buying a small business from you, I don’t really care what happened in the past. I don’t care what happened in the middle of the pandemic. I want to know after I buy the business from you, what do I expect going forward?
So, the market’s anticipatory, it moves ahead of the economy. And if you look at back in March and April when the market was free falling, it anticipated a lot of businesses were going to go under because remember, we had a 3% mortality rate that was advertised. Now as it became clear that the Federal Reserve and Congress and the President were really going to support the economy and kind of unprecedented ways, and it became clear the mortality rate was actually 1% or less, and that we kind of had a sense of how to protect ourselves, who it was and then as it became clear there was going to be a vaccine, the market responded really well to that saying, hey, there’s a way out of this. Things are going to get better.
So, you saw this extremely sharp recovery of all of that had been priced in that we thought would be very dismal. Now we’re here and so the markets fully priced in a positive outlook going forward. It looks ahead and says, look, unemployment was less than 4% before, it was at a record low. In the midst of this pandemic, it was over 11. Now we’re down around six, it’s probably going to work its way back down to four.
We have a consumer sitting on record cash, corporations sitting on record cash. They’re going to start to deploy this cash and that’s very positive too. There’s a lot of pent-up demand, pent up energy. There’s this feeling that I concur with that the average American is going to be unleashed. That cruise lines will be booked, airlines will be booked, concert halls will be booked, restaurants and bars will be booked and on and on. So, all of that’s already baked into the case. So, anything that gets introduced that disrupts that narrative at all is going to get priced in the other way. That would be things like inflation or even a little bit of hiccup in growth expectations.
Jonathan: Should we be worried about inflation at this point?
Peter: Well, there’s definitely indications for the first time in a very, very long time that inflation is starting to rear its ugly head. There’s always been inflation prices going up a little bit every year. But a lot of people have theorized, a lot of economists and pundits that, hey, when we flood the system with money like this, when we give people, when we give businesses the PBP money, when we give the consumers checks, when we lower interest rates and make it easier for people to borrow, that will naturally cause inflation. And we’ve never seen it in the last 10 years, despite all the times that we’ve kind of pulled all these monetary tricks. Well, that’s changing now. We really are starting to see signs of inflation. And you could see the market anticipate this, and not the stock market, but the smarter market, which is the bond market.
So, there’s more bond trading done in the first hour of a day than the stock market all day. But no one likes to talk about bonds because they’re boring. And including me, bonds are very boring. Bonds are just loans. If we look at long term bonds, so where people are loaning money to corporations or government entities for 20, 30 years, these bonds are now down 19%, so on the brink of a bear market. This is the bond market telling us that, hey, we think inflation is coming. And so, this is the first real indication that’s happening. I think we’ve seen some false starts in the past. This might be the 20th false start in a row, but I think people should be prepared for inflation coming. Our clients are definitely prepared for it the way the portfolios are positioned.
Jonathan: And do you think that is because the markets are anticipating that all this pent-up demand is going to lead to a buying binge? I mean, I looked last year, the savings rate last year was over 16% of disposable income. Americans probably have better financial balances than they’ve had in decades. And as we all know, people are anxious to get out there and do stuff. Do you think it’s going to be this demand that’s going to drive prices higher or is there something else in the system that’s going to push up from super prices?
Peter: I think you have a couple factors, and you’d like to think that everyone just became better at saving, right? They got better at building an emergency reserve and buying stocks and bonds in real estate and so on. But we know better. We know that when you give consumers money and corporations money that they’ll spend it. And the reason that consumers are sitting, Americans are sitting on more cash than ever before is not because they suddenly became more fiscally conservative with their money in their households, but because they haven’t had an opportunity to spend it and the day you give them the opportunity they will. I think that’s part of it. The market sees that coming. I think on top of that, we already have very real inflation in some areas. You can’t buy a home or try to remodel a home and not see that inflation is being reflected in all kinds of commodity prices and in various marketplaces.
And I also think we have a lot of economic policy that’s going to unfold that the market thinks are going to happen. That will drive some inflation too. So regardless of where you sit on, say the minimum wage as an example of one of the topics. If McDonald’s has a minimum wage and it’s $15 and they’re used to paying $11 in some community, well they’re going to have to price that into their menu. And so that also is part of inflation. So, you have a couple different things that are all happening at once that will start to drive, that will certainly lay the foundation for there to be inflation.
Jonathan: So presumably with interest rates going up, it’s one of the reasons that we’ve started to see this softness in the stock market over the past couple of weeks because for investors there are really basically only two asset classes. You’re going to not have your money in stocks or your money in bonds. Bonds become more appealing than stocks, may lose some of their attractiveness. But even as we’ve seen this softness in the stock market, it’s also been interesting movement within the sectors. You go back to last year and the year before that it was large cap US stocks all the time. There was nothing else you needed to own to make good money in the market. This year that’s changed. Large cap US stocks are not doing so well. Instead, we’re starting to see small stocks do well, we’re seeing value stocks doing well, we’re seeing foreign markets doing well and especially emerging markets. Emerging markets have been on fire. Do you think this is going to continue? What’s the lesson for investors when we look at what’s going on in the stock market and so far in 2021?
Peter: I think that there’s certainly more value in all the spaces you talked about growth beat value for a long, long time. The US beat overseas for a long, long time. Large cap beat, small cap for a long, long time. And one thing that a lot of the great investors agree on, whether it’s Warren Buffet or John Bogle, they all talk about this concept of regression to the mean, that eventually stuff works out the way it’s supposed to. And for regression to the mean to work out, you’re going to grow, or value has to have its day, small cap has to have its day, overseas has to have its day. That day doesn’t have to be today. But I think rising interest rates is a part of it because rising interest rates just don’t mean something to the investor, right? Investor to your point, looks at bonds and stocks.
If bonds are paying two and 80% of bonds today are paying 2% or less, and in stocks I can get a 2% dividend. And if it goes up 1%, I’m ahead of than bonds. Yes, stocks look more attractive than bonds. This is why Warren Buffet always says, when you look at the value of a stock, you have to compare it to what you can get from the 10-year treasury, loaning money to the federal government for 10 years. But the other thing is it impacts the earnings of companies, right? If the cost of borrowing is higher for McDonald’s and Nike and all these companies, it starts to impact their earnings. And so, I think that this combination of factors that is coming into play that will impact corporate earnings, inflation maybe being better off being in emerging markets, emerging economies over the next few years.
But this last five months, that’s how it’s been. Is this the beginning of a new cycle? No one knows the answer to that. We don’t know the answer to that. And so, the way you have to look at it is risk, reward. Why do we not own long-term bonds in our client portfolios? Not because we’re certain inflation is coming, but because the consequences of being wrong are so significant. If interest rates go down a little bit, they get a little bit better return. But if they go up, they get absolutely destroyed. And that’s not really the risk profile of a bond investor. And so, it’s really trying to navigate the space from a risk reward basis rather than a guessing where we’re going basis.
Jonathan: So, Peter, what you’re talking about is rational investing. Why you should diversify, comparing stocks and bonds, thinking about regression to the mean, and then there’s Game Stop. So, while we’re having these rational financial markets over here on the left, in the right-hand side in the corner, there’s this craziness going on. I mean, this is the sort of stuff that makes people think that the stock market is a casino, and it feels like a casino. I mean Game Stop, AMC, less crazy but all the hoopla over cryptocurrencies, over specs, special purpose acquisition companies. What should people make of all of this?
Peter: Well, there are most markets, there’s pockets of mania. It’s been around for forever. When people are talking about it now like its brand new, aren’t familiar with the Volkswagen story or all of the tech stock, the .com stocks. I think what’s different here it’s being driven by social media and postings online that generate a narrative that people start to invest in. And then because we can’t agree on anything in America, we’ve politicized it. We have to somehow politicize the trading. And so, I think when you look at Game Stop, AMC, Tesla, cryptocurrencies, they’re very, very different. They have some things in common. And I think what a lot of these areas have is they have things that are fueled by social media, people feeding off each other and buying into a narrative. Could be true, could be not true. And then you’re bringing in a large number of retail investors.
And what we mean by retail investors is not a university pension investing a hundred million dollars, but somebody on Robin Hood and just, it’s a small amount, but it’s a lot of those people trading. If we look at say, Game Stop, AMC, that narrative, you had a bunch of people buying those stocks up. Game Stop, definitely not worth the price it was at when people kept buying it up and buying it up and buying it up. AMC had a period where it was definitely not worth what it was at. Silver Lake, a private equity fund had these loans, they could be converted to stock and sold. And in the full disclosure, we use, Silver Lake is one of the private equity groups we use at creative planning with our very high net worth investors. They’re the ones that made the money, not the little guy. I mean when the little guy is going in and throwing money at AMC and Game Stop and driving it up, 100%, 200%, do some of them buy in it, $20 and sell at 30?
Of course, there’s going to be those stories. The vast majority of them are transferring their wealth to the wealthy because the sophisticated investor is saying, well this is crazy. I’m selling my, I thought I was stuck with this thing and I’m going to sell it. Now when we go over to Tesla and cryptocurrencies, Tesla has a real narrative to it, right? Elon Musk is a genius and what they’ve done has done more for the environment and the car industry and so many incredible narratives that are amazing. Now, should their market cap be more than every other automaker in the top 10 in the world? Maybe? I don’t think so, right? Now we own it. It’s in the S&P 500, our clients own it. But to really keep buying Tesla at these levels where Elon Musk himself says it’s overvalued, you have to believe that they’re going to be the only people that are doing this at any scale for a very long period of time.
Is it possible they put everybody else out of business, then become globally? Of course, it is. But the valuation becomes very hard to grasp and it carries the same principle that cryptocurrencies do. So, I wrote a letter maybe five years ago about cryptocurrencies and I talked about, look, there’s about 3000, 95 to 99% of them are going to go to zero. That’s already happened, right? Then I said a couple of them may emerge, Bitcoin may be the one, but Bitcoin’s pretty inefficient in terms of a cryptocurrency even. And it’s hard for me to see that being the emerging cryptocurrency. But what you need for something to emerge is you need regular everyday people to buy into the idea that this is going to be a new currency. There are some indications that may happen. Some public companies like Tesla and Square and so on, but Bitcoin, because of that, our clients now own Bitcoin.
So, they have exposure to Bitcoin in their portfolios because some of the companies that they own in the portfolio in a pretty substantive way, in turn, own Bitcoin. But this is speculation, right? You’re basically guessing or betting that this is going to be the real currency and that’s a bet that may work out and it may not work out. If it does not work out, the investment probably becomes worth zero. And if it does work out, it depends where you got on the train. So, these pockets of mania, they all have different narratives, whether it’s crypto or stocks like Tesla or kind of the politicized retail investor deal of transfer of wealth, of Game Stop and AMC, they’re getting a lot of attention because of the world we live in. But there have always been these narratives existing within the markets throughout all of time.
Jonathan: So, anybody’s listening to this conversation Peter, and they say, well, stock market’s been going up like crazy according to a lot of valuation metrics. It’s way overvalued. You’ve got all this speculation going on. Meanwhile, the bond market doesn’t seem so hot. We’ve got interest rates going up that’s driving down bond prices. Is there any alternative? Should people own anything other than stocks and bonds?
Peter: Well, what’s interesting about stocks and even bonds, when we say bonds, bonds are just loans. And so, they are not all the same. There are loans where you’re loaning money for a short period of time to a high-quality borrower and there’s where you’re letting it to a long period of time for a poor-quality borrower. Same with stocks. There are stocks that do well in the high higher interest rate environment like financial stocks where these banks make money, more money when interest rates are higher. And so, I think what it does is it says what parts of the market are more likely to perform better going forward and not should I exit it completely? And so, I don’t really buy the narrative that the stock market is high and therefore I should go buy cryptocurrency. If you believe a certain cryptocurrency is going to emerge as the national, the worldwide currency, okay, that’s a better reason.
But I wouldn’t go there thinking, well, the stock markets overvalued. This won’t be. If you look at March, stock market collapsed and cryptocurrency, Bitcoin collapsed at the same time. It was not this magical store of value during that period. So, I look at the stock market and say, when we say the stock market, we tend to talk about the US. Overseas has a long way to go to get anywhere near the valuations of the United States. Small cap stocks, despite their run, have a long way to go to get back anywhere near large cap and value has a long way to go to get back to where growth is. I think where you see a fully priced market is large cap US. And when we talk about the market, that’s all we tend to think about. But there’s still a lot of value to be had. There’s a great path forward. You never know in any year what’s going to happen, but there’s a great path forward for a very broad part of the market still.
Jonathan: I think one of the questions that we get all the time is what happens if there’s a recession? What happens if we get accelerating inflation? What happens? Valuations return to whatever historic norm you think they should be returning to. And the solution is actually always the same. You still want to own stocks for the long run. You just want to make sure that you can get to the point where you enjoy those long run returns. And so, you own a broadly diverse side stock portfolio, growth, and values, large and small, US and foreign. And then you make sure that if over the next few years there’s a problem because inflation spikes upwards or because there’s a recession or because there’s a compression valuation, that you have enough in conservative investments to give you a bridge to get there.
And all the portfolio building essentially comes down to that. We can get sophisticated and say, well, you should have some real estate in there. Who knows? Maybe you should have a small percentage in Bitcoin, maybe you should own some gold, whatever it is, you can get super, super clever. But in the end, that is what portfolio building comes down to. Making sure that you’re in the stocks for the long run and having a bridge to survive the periods when they’re not doing well.
Peter: That’s exactly right. And no matter what it is that’s out there, if it really starts to emerge as something really interesting, it will work its way into your portfolio. If you’re a diversified investor and just, I hate talking about Bitcoin this much, I just can’t stand it. But let’s take Bitcoin as an example. If people say, well, is it going to merge? Well, if it does, it’ll be in your portfolio and we’re seeing that today, right? So, all Creative Planning clients own Bitcoin because some of the biggest companies in their portfolio, in some of the indexes, they own, own Bitcoin.
And so, if you’re just a long-term diversified investor, those winners wind up in your portfolio. Apple, Amazon, Facebook, all of these stocks have gone up hundreds of percent since they wound up in our client portfolios because the narrative worked their way into the diversified, the outlook and the narrative worked its way to the diversified portfolio. So, the long-term investor, it’s time in the market, not timing the market. The long-term investor is on the winning side of this deal no matter what happens with inflation or anything else.
Jonathan: All right Peter, it’s that time of the month, your tip of the month, what have you got for me?
Peter: So, I think when I just had this happen recently, so I jotted this down as something to talk about today. So, we’re really good. I think one of the things I’m proud of is we do a good job of getting clients organized and really getting all their important physical records together in one place and helping them stay on top of that. But make sure that your loved ones, whoever your executor is, your kids, whomever, spouse, knows where your important records are. So, your Creative Planning client, this is probably pretty easy. But if you’re not, make sure you’ve got all those in some place that’s easily accessible and where people aren’t going on a hunt, tearing your house apart, trying to find basic things they’re going to need to get on with things when you’re gone. They’re already going to be going through the saddest time in their life because they miss you. So don’t make them look for a birth certificate or a marriage license or a title or a deed or an insurance policy. Make it easy for them so they can get on with more important things. How about you, Jonathan?
Jonathan: So, one of the things that we should all do if we’re parents is make sure that we raise financially responsible children. Because if down the road your kids get into financial trouble, I can almost guarantee that you’ll step up to the plate and bailed them out. So, the best thing to do is make sure it doesn’t happen in the first place. And so how do you teach your kids about money? And what I would suggest is that when you come home from the office with your pay stub or the financial statements arrive in the mail, show them to your kids, just show them the pay stub and say, hey kids, look how much I put in my 401k each pay period, or look how much I lose taxes. Show them the financial statement and say, here I own these two investments. Half the time they’re going to roll their eyes.
Most of the conversations will appear to go completely over their head. They won’t seem to be paying attention at all. But over time, doing this show and tell with your pay stub, with your financial statements will have a huge impact on your kids and you will turn them into financially savvy individuals. So, they don’t expect the big lecture to change the way your kids think about money. But if you, do it week after week with these small glimpses into what a decent financial life looks like, it should pay off. All right, Peter, so that’s a wrap for this week or this month I should say. This is Johnathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
