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!
Jonathan Clements: Hi, this is Jonathan Clements. Director of financial education at Creative Planning here in Overland Park, Kansas. I’m here with Peter Mallouk. The president of the firm, and we are, Down the Middle. It’s August 1st, it’s the dog days of summer. I hope that doesn’t offend any of our canine listeners. And we are here, initially to talk about market valuations. By almost any measure this is an expensive market. Should clients be worried?
Peter Mallouk: Well, I think it depends on what we talk about with what is the market? So, if we look at the bond market, very expensive, I mean, you’ve got yields are very, very low. If you bought a bond a few years ago, it’s selling at a very big premium, we’re nearing levels that are approaching unprecedented globally. If you’re looking at international bonds, Western Europe, the average investor is actually paying the government to loan the money, you give the government a hundred thousand dollars, 10 years later, you’re going to get less than a hundred thousand dollars back. If you put money in a bank, you have a negative interest rate. I mean, there’s interesting things happening in the bond market. Even exceptionally selective. If you look at the US stock market, we have a premium, it’s not a dramatic premium. And I think it accounts for the fact that we have record low unemployment, corporations are making good money.
Businesses have debt under control and the consumer feels pretty good. So, I think it reflects what’s going on. And I think the most interesting part is if you look at the premium of the large cap us market and you back out the Fang stocks over the last few years, you have a market that is about fairly valued. So it’s very heavily skewed by large cap US stocks that are tech based and in part in particular about four to six of those stocks. And so I look at the US as about fairly valued, internationally, very steep discounts, but for very good reasons, I mean a lot of problems in Western Europe and Asia. And I think because of that, you see them trading at 20, 30% below the US valuations.
Jonathan: So, you’ve painted this picture, right? International bonds, not a good deal in the high quality sector, large cap, US stocks, particularly those big tech stocks that you talked about, maybe overpriced, or at least certainly driving up market valuations on average, and then international stocks, add a heavy discount, but you’re buying into bad news. Should that influence the way you-
Jonathan: Allocate your portfolio?
Peter: You know what I think? I think that the markets are pretty efficient. I mean, one of the things that you and I have agreed on, for I think decades, is the market’s pretty good at pricing things. And if it’s not perfect, it’s certainly better than everyone else is, right? And the collective intelligence of everyone in the markets. And I think that in every single asset class we talked about, you could make a case of why it is where it is. Let’s just carve out these bank stocks. All of these stocks could literally take over the world. So you still have a couple million people coming online. If Facebook’s really allowed to release a currency, it could probably triple or quadruple in value. Amazon still has a lot of runway left. They don’t just do selling, they do storage and everything else, but they also have very big risks associated with them.
If you see administration change, a lot of the Democrats are running on the idea that, “Hey, we’re going to break these up.” Right? If you’re in one space, maybe Amazon, you could be the distributor, but you can’t create a product to compete with others at the same time. If they start to do things like that, you could see the values dramatically diminished. There’s two sides to these stories, whether you look at the individual stocks or whether you look at the broader markets, and this is the point of diversification, because you really don’t know how it’s going to play out. One thing I will tell you is that there’s nobody a couple years ago that thought there were going to be negative rates all over the world. And that the US treasury would be where it is today. I mean, it’s just… We didn’t predict that, nobody predicted that. Because it’s impossible to, the markets are just too dynamic.
There are too many factors that go into them. This is the idea of spreading your eggs among several baskets and in particular matching them to your needs. So if you’ve got money you need in the next five years, we want to have it in something where we can get to it in the next five years and not be dependent on who’s president. And what happens with Facebook or what happens with large US stocks. We’ve got to have a place to go to meet your needs one year from now, five years from now, ten years from now, and not be dependent on any one market.
Jonathan: I think there are two things that I would add to that, Peter. I mean, I pay a lot of attention to market valuations and valuations are pretty rich on both the bond side and on the stock side, but have to say valuations have been rich for the past three decades, right? I’ve had grumpy old men shouting at me that you should get out of stocks, “The end is nigh.” And they’ve been doing it for three decades. I mean, valuations on average have been high for the past 30 years. And I think it’s a reality of not just this particular situation, but of the long term. At this point, we live in a world where there is huge amounts of capital floating around the world, trying to find investment opportunities. We live in a world that seems far less risky than it did four or five decades ago.
And it’s a consequence. People are more willing to take risk and they’re more willing to put their capital in long term investments. And that’s, what’s driven down bond yields and that’s, what’s driven up stock market valuations. And the second thing I think about a lot is how important valuations are in driving long run returns. And there was a great Vanguard study that came out seven or eight years ago that looked at valuations in the stock market and how predictive they were of 10 year returns. And what they found was the things like price earnings ratios, or the so-called Shoo le pied. Price earnings ratios based on 10 year normalized earnings, you look at those measures and they are somewhat predictive, but the only predict 40% of tenure returns. And what that means is 60% is up in the air, right? You’re you cannot save with any certainty that just because the market is rich that you’re going to get poor returns. So, I’m not saying people shouldn’t pay attention to valuations, you should be aware of the risks that’s out there, but it may not mean more than a hill of beans.
Peter: Yeah, I mean, you do get that regression, but it’s over very, very long periods of time where things will return to the norm. And I think what people think is if something’s priced high, it has to come down and that’s not how it works. So, let’s say you have a company and its valued high, it’s trading 20 times its earnings. Well, it doesn’t have to come down to what may be normal. Let’s call it 15. What could happen is it could stay flat while their earnings rice, and it grows into its multiple. And I think this is a concept that’s lost on a lot of folks that there’s a way to get back to a normalized return without the market coming down. It can go sideways and wait for earnings to catch up, or it can go sideways and interest rates drop. And that impacts the relative valuation. And so there’s just so many things other than, like you mentioned, things like PE or dividend yield that will drive valuations and returns.
Jonathan: Peter we’re heading into an election year next year. And a lot of people are talking about Donald Trump and his impact on the stock market, his impact on the economy, and whether it’s been good or bad, what do you say to people when they ask you about that?
Peter: I think people overestimate the president’s impact on an economy. But on the other end, I see people particularly on social media. I think the president has no impact on the economy. Both of those are not true. The president has some impact, but not anywhere near what the average, I think layperson believes. So, if you look at what’s driving markets, there are very few things say President Trump could do, or beforehand President Obama could do that are as impactful as what The Federal Reserve does. So think about The Federal Reserve. Let’s just say tomorrow, they said interest rates are 3% higher. There would be a global epic crisis. I mean, the markets would go to bear market within minutes, you see 20% plus drops. Just the world would be in chaos. That’s where the real, I think power is.
I think the second level of power is just all the dynamic factors that happen that have nothing to do with the president, whether it’s Congress or a terrorist event, or a war, or just tariffs, or we get into it with some other country. And then all the things no one’s thinking about like some weird financial product. That’s a brokerage house made 22 years ago. That’s a going to blow up any day now. All of those things have a much bigger impact on the market than anything else. And then after that, I would put the business cycle, right? Businesses expand and contract, the economy expands and contract. This is why they call them cycles because that’s what they do, they cycle. But then the president has some impact. So if you look at President Trump, for example, he pushed through the corporate tax cuts.
Well, if you take the 500 biggest companies in America and you say your taxes are going to be lower, what happens to that money? Well, it becomes more earnings, right? Becomes more profit. And since the market is priced on a function of earnings, right, we take the earnings and we multiply it by something and get a value. There’s more earnings. You have a bigger value. Well, that was driven by the president’s policy. And so presidents can have an impact.
You’ve got a lot of the top democratic candidates talking about, “Okay, we’re going to have free healthcare. We’re going to pay off all the student loans. We’re going to have free college.” Let’s say all of that stuff passed the first month of office, the market would react negatively. I’m not saying whether they’re good or bad policies, that’s a different podcast, but the market would say, “Hey, we’re going to have to tax people a lot more to do that. That will impact earnings of businesses. And so the multiple will contract. And the average listener here might get less earnings because they’re going to be taxed more and they’re going to have less money to spend and go to Chipotle and buy iPhones. And that will impact earnings.” So you do have a political impact, but it is pretty far down the list on things that really drive markets day to day.
Jonathan: Yeah. I think when people think about this they should think about the fact that US corporations have a fundamental profitability. And when you think about actions by Congress, by the president, by The Federal Reserve, they only marginally influence that profitability. In the end the US economy is going to continue to grow, continue to be dynamic, and continue to produce astonishing profit. But to a degree what the president does, and Congress, The Federal Reserve is important because these marginal changes do make a difference to the market in the short term.
So, for instance if interest rates go up, people are going to discount future earnings at a steeper rate. So consequence, the market would probably trade down. But that hasn’t fundamentally changed the profitability of US corporations. All it’s done is influence short term market results. And then if you’re in this game for the long term and everybody should be, you shouldn’t be in the stock market if you don’t have at least a five year time horizon, preferably 10 years or longer, it doesn’t really matter what the government does, what The Federal Reserve does, doesn’t really matter. It may influence your short term results. It may make you feel a little queasy tonight, but longer term just doesn’t matter.
Peter: That’s right. I think the only thing that really in the very long run politically that can impact earnings is if we start to overregulate big companies, and I don’t know where that line is specifically, but I think if you look at the United States versus the rest of the world, and let’s just assume that everyone wants to work hard and make money, why is it that all of these great companies have come out of America? If you look at the great technology companies and internet companies, it’s Apple, it’s Facebook, it’s Twitter, it’s coming out of the United States. And I think it’s coming out of the United States because it’s easy to take an idea, turn it into a business and grow it. And if you get in the way of that, then I think it gets a lot harder for everything else to work out.
I mean, you can go look at everything else and say, we’re going to have these social programs, and we’re going to do these other things. As long as you’ve got the golden goose to lay that golden egg. And I think that’s the area where I get less concerned when I hear politicians talk about frankly, covering something completely for free than I do. When we talk about that big businesses are bad because big businesses are driving. A lot of these things and are making America be in a position to consider these other things.
Jonathan: So, we’ve talked about investing, the impact of government on the markets, we’ve talked about valuations. So that brings me to the next topic we’re going to discuss, which is, so Peter, how did you get started as investor?
Peter: So, when I was a teenager, we had this deal at school. There was an organization called Students Against Drunk Driving. And I’d come up with an idea for a t-shirt that the teacher found offensive and our listeners, no eight-year old’s listening this podcast. So on the front, it says, See Dick drink. See Dick drive. See Dick die.” On the back it said, “Don’t be a Dick”. So they said, “You can’t do that.” So I went home and I told my mom about it and she said, “Go ahead and just do it.” So I took my lawn mowing money and I made the t-shirt and I went to school and everyone bought the first hundred t-shirts. And before I knew it we’d sold like 20,000 t-shirts and some local distributor picked it up and it got a lot of press coverage and it became a whole business, which subsequently became my first of many businesses to fail.
So, a lot of people know about the music stores and things like that, but that was the first one to fail. But it did really well for a while. And I found myself a teenager with like $20,000 or something in the late ’80s. And my dad walked me to American Century, which is a company in, based in Kansas city that is a mutual fund company. I opened up the brochures and I went to the highest performing fund and I said, “That’s the fund. I’m going to put my money in.” And you know what that worked in the ’80s and ’90s, picking a high performing growth fund because everything went up 20% a year. And so it was kind of remarkable. I was watching it day to day. The thing we tell our clients not to do and that I don’t do anymore myself.
And I’m not kidding. Like every quarter, it just went up. I mean, 5%. It was a crazy period of time that went on for years and years. So I thought that’s how the investing world worked. It’s how it did back then. It’s obviously become a lot harder to fight your way through today, but that was my entry into investing. And I’m just grateful that it was different than my nieces. My niece made $500 and she asked for a stock tip. I gave her, let’s just start with S&P 500 and the international index. And of course this was two years ago and everything immediately plummeted. So she’s wondering why in the world would anyone want to invest in the markets? So that being fortunate enough to have a positive impact in the beginning was something that got me really excited about investing.
Jonathan: Yeah. We used started with a lot more money than I did. When I started investing in the late ’80s. I moved across from England. I had a newborn, I had a wife who was in graduate school and I was a junior reporter working one of the most expensive cities in the world, and to find any money to invest I had to really tighten up on the budget and find somewhere where I could get in for an extremely small amount of money. So actually the 20th century funds used to be that way you could open an account with no money. But where I went initially was with the dividend reinvestment plans, you could get into dividend reinvestment plans often for as little $10 initially. So, I went out and I bought these six individual stocks, I think you know, American family, Life Insurance, Aflac was one of them. I bought a grocery store called Hannaford brothers. I had some shares of Aetna.
Anyway, I bought these six stocks and I sort of… I went through the old value line surveys and sort of somehow justified buying these stocks. And it was an experience, some of them made money, some of them didn’t, but it got me really interested in investing and then slowly but surely I moved out of those and into mutual funds, mostly focusing on mutual funds I could get into for extremely small amount of money. Which is why I also went them in the 20th century. But it was in a sense, a good way to learn about the markets, because it was relatively small sums, only individual stocks is instructive. I wouldn’t encourage people to do it today, but it is instructive. And it really turned me onto investing so that when I started to earn serious money, I had a much better sense of what to do with it, which was diversify and stick it in index funds.
Peter: Yeah. I think that first experiences are really interesting. And I agree with you that when you’re starting out really seeing the volatility that comes from certain mutual funds and individual stocks and getting really severely punished or rewarded, it can really educate you on if you’re really goal oriented, that’s a harder way to get to where you want to go. You want things to have a higher probability and less risk of blowing up. And it was a trial by fire. And I’m glad it was small sums for us.
Jonathan: Though, actually, I think I had the better experience than you, Peter, because you were initially successful, which is a terrible thing because you can end up as an overconfident investor and continue to believe that you can beat the market.
Peter: That’s true.
Jonathan: It’s much better to have mixed success and realize it’s mixed success so that you eventually say, “Okay, I’m not as smart as the collective wisdom of all investors as reflecting the market average is what I should do is just accept the performance of the market averages and buy index funds us.”
Peter: Yeah. I remember looking at our tube TV and watching CNBC during the Asian contagion. I don’t remember what year it was and watching my portfolio go down the 30% in like a couple of weeks. And that was my lesson that, “Hey, the party eventually will be over if you don’t diversify.”
Jonathan: So as always Peter, we end these podcasts by talking about our tip for the month ahead. So what’s your tip for the month ahead.
Peter: So, most of most folks have powers of attorneys. So if you don’t make a decision on who’s going to make a healthcare decision for you or a financial decision for you, then the probate court will make it for you. That can be an absolute disaster. We had a client, their daughter was driving back from college, got in a car accident. The mom was unable to make healthcare decisions at the hospital. The reason was that the daughter was over 18. So she would’ve had to have a healthcare private attorney naming somebody else to make healthcare decisions for her. A lot of people say, “Oh, it’s obvious that my spouse or my mom or my dad, or whoever would make the decision for me.” And the government’s view is, “Hey, you’ve got individual rights. This is America and if you wanted someone else to make decisions for you would’ve taken in 10 minutes and drawn up a two page document that said so.”
So, a lot of people have a healthcare power of attorney to name somebody, to make healthcare decisions for them. If they don’t make it for themselves. And a lot of people have a financial power attorney that says, “Here’s who’s going to make financial decisions for me if I can’t make it for myself.” But they forget to update them ever. And there are two reasons, maybe three, that you’d want to update, one is you might realize, “Hey, the person I’ve named to make decisions for me is dead or absolutely the last person on earth I want deciding whether I live or die or something else.” So we want look at that. Second, if you switch states, a lot of these, particularly with healthcare bars of attorney are very state specific.
States have very differing views on who can do what and when it’s triggered. So, if you move from New York to Florida, revisit those documents, and third, if an amount of time has lapsed, they’re considered stale, unlike wills and trusts. If you try to use a financial power of attorney, that’s more than 10 years old, you try to walk into a bank and use it. They’re going to look at you and go, “You know what? We’re not taking that. It doesn’t matter that it’s a legal document.” Same thing. If you’re at a hospital using healthcare power of attorney, that’s 17 years old, it’s going to raise an eyebrow and create some pause. If we’re making a serious decision, like moving somebody from one hospital to another.
So just take a look at those. We review them every year with our clients here at Creative Planning. But for most people, it sneaks up on them. Just take a look at them on occasion. I mean, this is a tip I’m going to implement myself. We’ve got interns following us today. And one of them is my son who is 18. And he does not have a healthcare power of attorney. So I think this is something I’m going to knock out for these guys that are tracking us today as well.
Jonathan: And so, my tip of the month, it comes down to cybersecurity. So most of us access to our accounts online. And most of us make the same mistake, which is we have the same username and password for all of our accounts and we never changed them and it’s could be a disaster. I mean, if nobody ever finds out your username and password you’re in the clear, but if you get hacked and remember, it may be a non-financial account that gets hacked. It may be your American Eagle online shopping account that gets hacked. They found out you’re username and password, and then they go and they hack into your Schwab account, your Fidelity account, and suddenly you’re in big trouble.
So, make it a point to one, have a different password for every one of your financial accounts, two, change those accounts passwords regularly, and three consider using a password manager. A password manager will allow you to aggregate all of your account information under a single app that you can then tap into using a super complicated super secure password, and then have easy access to everything else. Password managers are really the way to go at this point, if you want good cyber security.
Peter: That’s great advice because I would say weekly, we have one of our 30,000 or so clients have this issue, and it is an epic mess for people to unwind solving that problem. And I think a lot of people don’t realize that you’re right. If someone gets into the weakest door, you’ve used that password and it’s some website that gets hacked, they pull that and they go through everything else. And that’s the biggest danger, you can be using dual authentication on one account and a complicated password on another. But if you’ve got a simple password across two accounts and they get through that easy door, it can open up a lot of things.
Jonathan: So that’s the end of our time. This time around Peter, it’s always fun to talk to you until next time. 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 to future performance. The information contained herein has been obtained from sources deemed to be reliable but is not guaranteed.