Hosted by Creative Planning Director of Financial Education Jonathan Clements and President Peter Mallouk, this month’s podcast looks closely at why the markets are performing in ways that are surprising – and even counterintuitive – to what many investors and observers might expect. On a macro level, Peter and Jonathan discuss how the upcoming election season may influence the markets, and on a micro level, steps that individuals and families can take if they’re feeling insecure in their employment or their ability to meet their monthly expenses.
Time Stamps:
[0:00] – Why markets are still up amid the uncertainty
[3:05] – How high-tech stocks are getting big-time results
[6:58] – The market tensions of election season
[11:05] – Avoiding financial overreaction to changes in leadership
[14:00] – What to do if the hoped-for recovery (or your job) falls through
[20:40] – Peter and Jonathan’s tips of the month
Have questions or topic suggestions?
Email us @ podcasts@creativeplanning.com
Transcript:
Jonathan Clements: Hi. It’s August 1st. This is Jonathan Clements, director of financial education with Creative Planning. With me is Peter Mallouk, and we are Down the Middle. Peter, it’s been a crazy couple of months in the stock market, and I keep hearing the same question from investors. “How can it be that the stock market is hanging in there despite all the bad news?” The economy remains rough. The coronavirus is not under control here in the United States. Why is the stock market so close to its all-time high? What’s going on?
Peter Mallouk: What’s interesting is we got a couple of different things going on. One is, this week we’ve got congressional hearings with some of the big tech companies. We’re going to hear from Bezos and Zuckerberg and Cook, all the folks from the big tech companies that dominate the market. And if you take the S&P 500, five of these big tech companies make up 22, 23% of the market capitalization. And if you take the Nasdaq, it’s more than half. And so while you own the S&P 500, you own around 500 stocks. I think today it’s about 505. Just five of them have had enormous positive returns as the coronavirus has forced more adaptation of this technology, where we had these people already winning, and now their organizations are winning even more. So they obviously have overwhelming positive returns, and they’re hiding the fact that most stocks are negative year-to-date. And I think that would surprise most people.
We came into this year with record-low unemployment, corporate earnings at record highs, economies firing on all cylinders. And here we are today. Most stocks are down. And so, I think part of it is it’s being masked. The second part is, even when you remove that mask, it wouldn’t be a horrible market. We would just have stocks slightly down. And I think the reason is, in the beginning, in March, we saw this huge drop of everything as everyone worried the world was going to collapse. When it became clear that wasn’t going to be the case, right, the Federal Reserve was going to step in, that was part of it, was government intervention.
The second part of it is we realized that the mortality rate’s not 3% and affecting everybody equally. It’s considerably less than 1%, and we know which groups are more at risk than others, and we have some hope around a treatment. We understand better how it spreads. And so we realize that, for all the people that say, “Well, it could never be worse,” it could certainly be worse. The mortality rate could be 3%. It could infect every people of all ages. The market sees some hope that there’s promise to get out of this, that there’s a way to navigate through it. And the market sees that consumers are doing things that indicate that, so that there are certain companies that are winners here, and there are certain companies that are losers. And we’ve moved from everyone losing, in the beginning, to a winner and loser environment.
Jonathan: So, one of the sorts of general investment principles, and this reminds us of, is this notion of skewness. And we see it every year in the stock market. And the notion of skewness is this. The most a stock can lose is 100%, but its potential gain is infinite. And in any one year, those stocks that have these great returns tend to drive the averages higher. And so, this year it’s been those big five tech stocks that have driven the S&P 500 higher. And to a lot of people, they look at that and say, “Well, what that means is I should buy those five stocks.” And the answer to that is no. What it means is that you should diversify because you don’t know which of the S&P 500 stocks are going to do well in any given year. And so the only way of ensuring that you keep up with the market average is to own the entire market.
Peter: Yeah. I was talking to our clients. For most of our clients, their largest position is in the US, and it’s in large company stocks. And in that position, we favor the index. So the biggest individual stock positions of our clients are these big tech companies, but we don’t necessarily know that’s what’s going to be the case in the next 10 years. There’s been times it’s been financials. There’s been time it’s been energy. There’s been time it’s been big tech. It’s been tech before. It always finds a way to come undone, no matter how invincible companies seem. If you look at these companies, they’re trillion dollar entities now, some of them close to multi-trillion. They earn just 7% a year. I mean, they’re going to earn just 7% a year, to go from 1.5 trillion to 3 trillion over the next decade. This is very tough to sustain over the long run. So there will be a new five at some point, and they’ll seem obvious in retrospect as well.
Jonathan: So, amid this surprisingly strong stock market we’ve had, we’ve also seen the 10-year Treasury down pretty close to the all-time low it hit back in March. Back in March, the 10-year Treasury note was at 0.54%. In recent weeks, it’s been sloshing around 0.6%. And normally, when you see the 10-year Treasury at such low levels, it’s an indication that people expect bad economic times ahead. Do you think that’s what the market is telling us, Peter? Or is it that this is a reflection of all that the Federal Reserve has done to pump money into the economy?
Peter: I think it’s likely a combination, but it’s mostly everything that the Federal Reserve has done. I think we’re seeing a lot of things happen at once. The Fed is lowering rates to stimulate the economy and to get people to do things. And it is working. I mean, if you’ve got a $300,000 house in the United States in a reasonable city, and you put it on the market, it’s going to be gone in 48 hours. It is really working, in terms of getting people to come off the sidelines in what would otherwise be a very uncertain time. At the same time, there is a big group of investors that is very, very fearful, and now we’re starting to see indications that people are worried there’s too much money in the system as they start to move towards other asset classes. So we’re seeing a lot of tension here in the markets, and really watching this next stimulus, and how long COVID goes on, is going to help play out the story. How do you see this, Jonathan?
Jonathan: Well, I always take comfort in the emails that I get from readers. And so, of late, I’ve had readers who’ve written to me about, “Oh, what the Fed is doing, it’s going to lead to hyperinflation.” And then I get emails from other readers saying, “What’s going on in the economy? This is going to be deflationary.”
Peter: Right. Right.
Jonathan: And so, my feeling is, yeah, we’ll probably be okay. I think whenever you start to hear those extreme economic forecasts, while those are the forecasts that tend to catch the attention of the TV talking heads and will get you on Fox Business and get you on CNBC, those are the least likely to play out. And something in the middle is what we’re going to get. We will muddle through, one way or another. We always have, and I strongly believe we always will. Talking of muddling through, it’s election season, Peter. And this has also been a big source of emails to me, and I’m sure to you as well. As investors, should we be focusing on the election, and will the outcome make a big difference to what happens in the stock market?
Peter: It’s interesting. I think every election of my career… And obviously, elections don’t happen that often, so it’s probably been four times I’ve written letters on this. But always, as you start to approach the election, there’s a lot of tension around, “Oh, the economy’s going to fall apart” or “The world is going to fall apart if this person gets elected.” And it was, I think, more intense with President Obama and President Trump than before. Maybe I just, as I’m getting older, get more sensitive to it, or as we have more clients become more sensitive to it.
There were a lot of people that used to call me or email me and say, “Well, if Obama becomes president, the economy’s going to fall apart,” and, “How is the economy going to function in socialization?” and all that. And a lot of people telling me if Trump became president, “The economy’s going to fall apart. All these things he’s going to do. It’s going to be so terrible for the economy.” In both cases, I wrote letters saying, “There is an economic prism with which political candidates think and have influence.” And President Obama did, and President Trump did. But my letters to clients back then showed the history under Democrats and Republicans, and the market tends to go up over both. And for whatever reason, it actually has gone up more, historically, in the modern era under Democrats.
Now, so many events happen that you could argue have nothing to do with either party, like the ’08, ’09 crisis. Is it President Bush? Some people would say, “Yes, he was president for eight years.” Some would say it’s policies that came in before then. And some would say it has nothing to do with any president. I’m not going to debate that point. The point is, whether it’s a Democrat or Republican, the market tends to find a way to go up, because part of it’s the dividends the companies are paying. Part of it’s a reflection of inflation. Part of its earnings, which are impacted by corporate taxes.
Having said all of that, I will likely write a very similar letter this time. We know what we’re going to get with President Trump. I mean, it’s just more of the same. And so the question becomes, “If you get President Biden, what happens?” Well, first of all, if you get President Biden and a Republican Congress, you basically get nothing. The markets really love nothing. And it doesn’t matter if it’s a Republican president or Democrat president. It loves nothing, in general, because then it has the certainty it needs of what’s going to happen. So the question isn’t just who going to be president, but is there going to be President Biden with a Democratic Congress? which seems today, while we’re doing this, it’s something that could very likely happen.
And so let’s look at his policies. The number one policy that tends to influence things is income tax rates. And his income tax proposal, and I can just see the hate mail now, is not radical. Right? He’s talking about taking the highest income tax bracket from 37% to 39.6%, where it was before President Trump, and the economy was doing just fine. Unemployment had gone from 11% to around 5% at that point. He is proposing a corporate tax increase. The reality of it is, if you have a corporation that’s making a million dollars a year, and it’s tax rate’s 20%, then it’s going to have 800,000 to give to shareholders. If you take that tax rate, and say you raise it to 30%, well, it’s going to now have less money to give to shareholders, and that will be reflected in the stock price.
So if we saw a corporate tax increase, we would see a one-time adjustment in the market. After that, we could just argue about how all these other policies, are they going to get through, and how will they be paid for, and what their implications would be to the markets. But really, we look at corporate tax rates and income tax rates as the big drivers of the economy. And right now, we don’t see any indication that, as far as income tax rates, we’re going to see big changes.
Jonathan: I remember, in the morning after Trump was elected, getting emails from readers saying, “I’m selling everything-”
Peter: Yeah.
Jonathan: “… and getting out of the stock market.” And of course, that turned out to be a huge mistake. You should have stayed in the stock market. I remember the same sort of reaction back when Obama was elected. There were certain people who said, “This is a disaster. It’s going to be socialism, and I’m getting out of the stock market.” That sort of reaction is absurd because it assumes that somehow this giant thing called the US economy is going to be turned upside-down overnight. And one of the reasons it doesn’t get turned upside-down overnight is that the president, while important, is only one part of the Washington establishment.
And even if we ended up with a President Biden and a thoroughly Democratic Capitol Hill, what will happen? Well, the Democrats will start fighting with one another, and they will start trying to finesse policies that are more to their liking. And Democratic senators who are thinking about their reelection, and they’re from more conservative states, will start to object to more extreme policies and will end up on the path to moderation. And the path to moderation is what the stock market likes. So I would say that anybody out there who’s fearful about the election results, whichever way it goes, is don’t overreact. Stay the course. Because if you make a big change to your asset allocation, if you put more into stocks, take more out of stocks, whatever it is you do, you’re probably going to end up regretting it.
Peter: Yeah, I mean, at the end of the day, all of this stuff, we see usually the changes are a few percentage points in tax rates. And yeah, we can leave out these outlier policies like taxing billionaires huge… The market does not care about that. Right? The market’s just saying, “What are you going to do to the corporations? And what are you going to do to consumers that buy stuff from corporations?” I remember talking to somebody who did end up going to cash, and wasn’t very successful with his call, after Trump was elected. And I just said, “Where do you eat… How often does your family go to these places?” “Are you going to stop going to those places? Are you going to stop going to work? Are you going to stop earning…”? I mean, what’s actually changing here? Occasionally you have governments really change radically policies that impact the economy, but it’s very, very rare.
And I think for all of the rhetoric around the economy, both sides have not been radically different. Socially they are on opposite ends of the spectrum, but when it comes to the economy, they tend to each move the needle just a little bit to the left and a little bit to the right. And we don’t see one side saying the highest income tax rate should be 70% and the other side saying it should be 15. We’re arguing about is it in the mid-30s or the high 30s? This is not as much of a divergence as most people, I think, give credence to.
Jonathan: So, let’s shift gears here a little bit, Peter. We’ve been talking about the fact that there is some economic uncertainty. And while I believe we’re going to figure this out, I also believe that people should be prepared for rough times because we don’t know what the future will bring. We have all kinds of possible futures, and we just don’t know which one we’re going to get. So if you go back to the Federal Reserve, back in June, they forecast that the economy was going to shrink 6.5% this year, but then it was going to bounce back 5% next year. Meanwhile, they’re saying that unemployment, which is currently at 11.1%, will finish the year at 9.3, and then it’s going to fall to 6.5% next year, which suggests that 2021 is going to be a year of, not full economic recovery, but we’re going to have a really nice bounce back. What if it doesn’t happen? What if the economic recovery proves to be slower? I’m not forecasting it, but I think that people should think about their household finances and make sure that they’re prepared if this current recession drags on longer than expected.
So, let’s say you’re in that mode. You want to make sure your family’s finances are going to be okay, Peter. What would be on the top of your list of things to do?
Peter: So, one, I would look at all of my debts, and I would say, “Am I paying the lowest cost possible across these debts?” So it’s great time to look at refinancing a home. The rates aren’t as good as getting a home with original loan, but you should be looking at that. Look at potentially borrowing against your investment account, where rates are at record lows, and using that to pay off other, higher cost loans. Get your debt in order and make sure you’ve locked in all the lowest rates you possibly can, would be one consideration. I know you’ve got a few ideas as well, Jonathan.
Jonathan: Well, just on that issue of debt, one of things I would think about is, if you’re in a situation where you feel like your job security isn’t so great, and let’s say you’ve got an auto loan that is four months from being paid off, even if the rate on that loan is pretty low, I would pay ahead of on that, and get that loan paid off, because you’ll immediately improve your monthly cash flow. Similarly, this is pretty obvious, but if you have credit card debt, get it paid off. If necessary, you can always borrow on the credit cards again. So it may seem mistake to use your cash if you think you’re going to need it down the road to pay living expenses, but in the case of credit card debt, because you can always borrow again on those cards, paying off that credit card debt and getting out from under that high interest rate is, I believe, a smart thing to do. It’ll be good for your long-term finances, as well as in the short term.
One of the things that I think that people should also consider is if they end up in a financial squeeze, principally because they get laid off, they should take a close look at their discretionary spending and what they would cut if they suddenly found themselves without a paycheck. And for most of us, we have these fixed living costs that we have to pay every month, but then we have these series of discretionary expenses, eating out, going on vacation, streaming services, whatever it is. I think a useful exercise to sit down and say, “Well, what are those discretionary expenses, and what would I cut out immediately if I found myself in a tight situation financially?” You mentioned, Peter, borrowing against your investment account, setting up a margin account. If somebody was thinking about that, what rules would you put around that?
Peter: Well, you never want to borrow too much, or you can get what’s called a margin call. I mean, it’s that margin call where the custodian sells your securities to pay themselves, basically means you’re selling low. The market comes way down, and they sell your stocks to cover the loan. So when you do borrow, you want to make sure you’re borrowing an amount where you’re never going to get caught with that situation. So we like to keep margin loans at 25% or less of the value of an account. That way, even if the market gets cut in half, and you’re completely in the market, you can avoid a margin call. A lot of people don’t like margin loans because you don’t have to make monthly payments. You can kind of get lazy about it, let it just sit there. But if you’re disciplined, and you are going to pay it down, it is going to be your lowest cost of borrowing, almost all of the time. So it’s a great tool to use, for someone who’s very on top of things.
Jonathan: The nice thing about a margin account is if you don’t have it, you can set one up at pretty short notice. It’s not a long application process. By contrast, if you want to have a home equity line of credit, which is a great way to borrow money if you find yourself in financial difficulty, it can take a while to qualify for a home equity line of credit. And right now, with all the focus on refinancing, a lot of banks are reluctant to even consider setting up a home equity line of credit. So if you don’t have a HELOC, as they say, and you think you might need it, I would set it up now and hope you never have to use it, because the application process could take a while, and you’re going to want it on the day you lose your job.
And of course, the other thing that we haven’t even really addressed is you want to have some cash kicking around. Maybe you don’t need the full six months of living expenses, which is what the classic rule of thumb says for an emergency fund. But having some amount of cash will not only provide a buffer if you end up in financial difficulty, but it also just make you feel better about the world. I mean, I wouldn’t carry too much cash, because you’re not going to earn any interest on it, or very little, but having some pool of cash there, sitting there, that you can rely on in a pinch will certainly make you feel better about your finances.
Peter: Yeah, especially today, you’re not going to earn anything on cash. If you’re someone who’s got some job insecurity, and you don’t have a buffer with investments or a home equity line of credit, you definitely want to have the six months. If you’re somebody that’s got a home equity line of credit that’s untapped that you can go to, or a margin account that’s untapped that you can go to, you don’t really need that six months of liquidity. You need access to six months of liquidity, and the home equity loan or the margin account can give you that and still leave your money at work. So I’m using that margin loan consideration as my tip of the month. How about you, Jonathan? What’s your tip of the month?
Jonathan: So, coming back to talking about discretionary expenses, one of things that I think is a really useful exercise is sit down and figure out what are your monthly fixed costs. And what I’m talking about here is how much you pay every month in mortgage or rent, car loan payments or car lease payments, for Internet, cell phones, groceries, insurance premiums. Know what that monthly nut is. That is basically your cost of existence. You need to be able to come up with that money every month, come what may, and you’ll need to come up with that number if you find yourself without a paycheck. So as you think about applying for a HELOC or building up an emergency fund or setting up a margin account, knowing what that monthly nut is that you have to cover is a really useful piece of information, and it can guide the financial steps you take as you prepare yourself for potentially rough times.
Well, Peter, I think that’s the end of our monthly podcast. 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.
Peter: Thanks, Jonathan.
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.
