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It’s All About the Earnings

Peter Mallouk Portrait

Peter Mallouk

President & CEO
Jonathan Clements Portrait

Jonathan Clements

Director of Financial Education
PUBLISHED
February 01, 2022

2022 has seen the return of market volatility and concern about interest rate hikes. What should an investor make of it? In this episode, Peter Mallouk and Jonathan Clements offer perspective on recent events and discuss where they see value in the markets. (Hint: It’s still not meme stocks and NFTs.)

Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect

Have questions or topic suggestions?  Email us @ [email protected]

Transcript:

Jonathan Clements: Hello. 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. After 2021’s rip-roaring U.S. stock market rally, 2022 has seen share prices sound the retreat, with the S&P 500 falling for three consecutive weeks before steadying itself last week. But before we get to the broad stock market, I want to ask you, Peter, about cryptocurrencies, non-fungible tokens (NFTs), and meme stocks. Two months ago when we talked, you compared the mania around these things to the late 1990s dot-com bubble, and you said there was going to be a fallout and a lot of people were going to be hurt. Do you feel vindicated?

Peter Mallouk: Well, that’s definitely obviously happened here in the beginning of the year. And I think that it’s unfortunate, and it did remind me of the dot-com bubble in the sense that everyone would say, “Well, you have to believe in these because the Internet is going to change everything.” And you can believe that the Internet was going to change everything and not believe that all the dot-com companies were going to work out. That some of these companies, it would be helpful if they had earnings, right? And eventually things caught up with those speculators, or we might call them investors. But we saw the same thing here with NFTs and SPACs and cryptocurrencies that had no earnings. And yes, you can believe that the blockchain is going to change everything, and you can believe some new investment vehicles are innovative, but that doesn’t mean everything in that space is going to work out.

I still think there will be lots of NFTs that are worth a lot of money. There will be cryptocurrencies that will eventually work out. But I think what we saw in the last couple weeks, I described it a few months ago as, there will be blood. And we’re seeing the blood. It’s everywhere, whether it’s the meme stocks that are down 60%, 70% from their highs, the cryptocurrencies that are down 60%, 70%, 80% from their highs, or the NFTs, many of which have gone to zero. These spaces can be interesting if you’ve got speculative money, you’re having fun in this space, you want to place a bet. There will be a few winners, but as we saw, when things unfold, things that took years to build up, they can unravel in a matter of weeks.

Jonathan: Well, I think one of the important distinctions that you make and that listeners should keep in mind is that we shouldn’t tarnish all investments with what’s happened with NFTs or cryptocurrencies or with these meme stocks. And the key notion here is intrinsic value. We know that stocks have intrinsic value. We know bonds have intrinsic value. We know real estate has intrinsic value. I have not the slightest clue what the intrinsic value of a cryptocurrency is, or of an NFT, or of gold in terms of precious metals. And with something like a meme stock, which doesn’t have any earnings, it’s really hard to get a handle on what the intrinsic value is. So don’t you think this distinction is really important and people should try to separate the two in their minds, Peter?

Peter: That’s right. There are stocks with no earnings. So, I’m not saying all stocks are good. And no expected earnings, and they eventually will go to zero. This applies a lot more in the cryptocurrency and NFT space. And look, there are lots of things without intrinsic value that retain their value and transfer higher wealth to people over time. We’ve seen it with art and baseball cards and so on. And some of these things will prevail in NFTs and cryptocurrencies. I think the best way to look at it is, when the market is down, if you own a bunch of stocks and you have confidence in those stocks, you usually feel good because you know it’s an opportunity to potentially buy more.

If you own 15 different cryptocurrencies and they’re down an average of 75%, you probably feel bad because you are just hoping that somebody comes back in and buys it. You may not necessarily believe there’s an intrinsic value there that’s going to carry forward. And again, because I get so many messages after this, there will be a few that prevail, but you need a collective buy-in into this for one or two of these to wind up working out.

Jonathan: So let’s set aside what I think of as fringe investments. They’re so big now… it’s maybe unfair to call them fringe investments. But let’s talk about the broad stock market, Peter. We saw weakness in January, and the most commonly cited reason has been the Federal Reserve and specifically paring back its bond buying program and the prospect of higher short-term interest rates later this year. Let’s go back to Investing 101. Why is it, Peter, that rising interest rates are so bad for stock prices?

Peter: Well, one of the things that the stock market looks at is earnings, but really not today’s earnings, but future earnings. So when someone buys a stock, they’re basically saying, “What stream of income am I going to get down the road?” So, if I am buying somebody’s sandwich shop and the sandwich shop makes $100,000 a year. Well, I’m going to look and go, “Well, what’s it going to look like going forward? Is a roadblock going up for construction, it’s going to be there for a year? Did they just get cited with a bunch of health violations that are public?” I probably am not looking at the $100,000 a year, I probably assume it’ll be a smaller amount. I would pay less. The opposite if this sandwich shop’s making $100,000 a year, but this huge national headquarters for a business opened right next door, and several hotels without food in the hotels opened right next door, and they just got an award for how good their food is. I would probably assume their future earnings would be higher.

So, when the stock market looks at interest rates they say, “Well, okay, what does the higher interest rates mean for earnings in the future?” So if I’m a business, most businesses, especially publicly-traded businesses, have borrowed money. So if you’ve borrowed money and your cost of borrowing is 3%, it doesn’t impact your earnings as much as if your cost of borrowing is 4% or 5%. So that’s one really simple thing, is if the cost of borrowing is higher, there’s less profits. Just look, if you have a house, if your mortgage is higher, there’s less money coming into the household. If you’ve got a floating rate mortgage and interest rates go up, well, it’s less money that’s going to wind up in your pocket.

Also, the markets look at, “Well, what can I do with my money?” Well, today if bonds are paying less than 2%, it pushes people over to the stock market where they go, “Look, yeah, it’s volatile, but the dividends are about 2%. So as long as it goes up a little bit over five years I come out ahead.” Well, as interest rates rise, new bonds will pay more and it makes bonds look more attractive relative to stocks. So there’s many reasons, but these are two of the very big reasons that the stock market tends to go down in anticipation of future rates.

Jonathan: So, one of the things that was interesting about last week, last week would have been our fourth losing week in the stock market until Friday. And Apple came out with strong earnings and it almost seemed like a reminder to investors that what they own when they buy stocks is not a piece of paper but something that generate earnings. And the fact that Apple had such strong earnings seemed to be a wake-up call to investors, who said, “Hey, these aren’t just notations on an account statement. They aren’t just numbers that I see on my computer screen when I log into my brokerage account. These are companies that have real earning, and those earnings are really pretty spectacular.”

And that led to this huge stock market rally on Friday. And it seemed to me a little bit it was a reminder to people what they owned. But I want to go back to another comment of yours, Peter, from last year. Late last year you talked about how, even though the indexes had a great 2021, we saw a lot of weakness within the indexes, that even though we had some stocks that had a great year within the indexes, there was a lot of underlying weakness. Do you think that’s playing out again in 2022?

Peter: Yeah, I think it’s very interesting. As I’ve talked about a lot in this podcast and on social media, is we had a lot of stocks in the S&P 500 that had a terrible year. Many of them were in a bear market, same thing with tech stocks. And there was just a lot more weakness than it appeared. But so much of the index is made up of a few stocks. You just mentioned one of them, Apple. Five or six stocks make up 1/4 of the index. And these had very, very strong earnings and anticipated earnings, so the returns were so high they lifted up the index return. This is one of the great advantages of being a diversified investor, is you can have a bunch of stocks down 20%. If one goes up 300% it offsets a lot of things, and that can really lift your returns up.

But the concern was around, with all of this weakness that really the indexes were being carried just by a few names. And how long would it take for broader weakness to impact everything? Well, we saw that within weeks of 2022. I think as we look going forward, I think that we’re going to find that the same thing that’s happened in the past will happen with interest rates this time. Why does the Federal Reserve raise interest rates? They raise them when the economy’s too hot; companies are doing too well. And so they’re able to raise their prices because the consumer is making money, too. They’re less sensitive to their meal at McDonald’s going up in price or their iPhone going up in price, and you have higher inflation and the Federal Reserve, to start to control that, raises rates so we don’t have runaway housing prices and car prices and everything else.

Sometimes they raise them too fast and we go into a recession. The market worries about that, but most of the time that’s not what happens. Most of the time they raise them because the economy was too hot, the economy winds up not being too hot, and the stock market actually has positive returns after the rates have risen. The odds are we’ll see something like that again, but we might have to go through this very, very bumpy cycle where we see, is the Fed going to get it right?

Jonathan: So last year was very unusual here in the stock market. The largest pullback in the course of 2021 in the stock market was a 5.2% decline in the S&P 500. We talked about this before, how the surprise of 2021 was not only that the indexes were strong even as we had this underlying weakness, but also that the amount of volatility was very low, that we only got this very modest pullback. Looking ahead, Peter, what should investors have in terms of expectations of volatility? What sort of pullbacks should they expect going forward?

Peter: To your point, what was not normal about last year, and we saw that one year under Biden, we saw one year under Trump with just no volatility. It’s just incredible, and that’s not healthy for the market at all. Because what it does is it creates complacency and overconfidence in investors. They think that money can be thrown at anything and it will work out. And of course we know that eventually if something doesn’t have real value going forward, it will go down and often go down to zero. And you don’t want investors to have too much in those things when that happens. So you want there to be ongoing volatility, ongoing reminders like Apple gave us that earnings really do matter. That’s what gives investors some discipline. So, I think it will be healthy to go back to normal.

Now, to your question, what’s normal? Normal is a market that goes down pretty frequently. Almost half of days the stock market should go down. And over the year it should be down about one in four times. And along the way it should be pretty bumpy. There should be several 5% pullbacks. And on average every year there should be at least one double-digit pullback. That would just be normal. A normal correction would be a 13%, 14% drop from highs. We’re not even at normal yet and everyone’s freaking out because we haven’t had it in so long, but that’s healthy. And it also gives a disciplined long-term investor a chance to rebalance into weakness and to tax harvest. And if you’re not retired yet, you’re able to accumulate shares at a lower price. For a disciplined investor a volatile market is much, much better than one that just ticks along with no drama at all.

Jonathan: Yeah. In many ways to me as an investor, having to sit tight through, on average, a 40% pullback in any given year seems like a small price to pay in order to get the superior returns that the stock market offers. We talk all the time about this, in order to earn high returns you have to take high risk. And if high risk is a matter of sitting through the occasional 15%, 20%, 30% decline, it seems like for the disciplined investor a very small price to pay. Anyway, Peter, before we rattle on, because we always go longer than we promised you, it’s time for your tip of the month. What have you got for me?

Peter: Well, I think if you haven’t already, on your 401(k), try to accelerate your monthly contributions, to get as much in as early in the year as possible. You’ll want to check with your HR department and make sure that you don’t contribute too much. Sometimes you’ll lose the company match if you do that.

Jonathan: And so my tip of the month sort of is a reflection of what’s been going on in the stock market this year. Recent years, stock market has really been a sort of one-trick pony. If you owed large-cap growth stocks, you had great performance. If you had small stocks in your portfolio, if you had international stocks, if you had value stock, things were less cheery. But this year it’s been much more of a mixed bag. Growth stocks have not done as well. We’ve seen strength from value, we’ve seen strength from small, and we’ve seen international stocks do relatively well. So what I would say, my tip of the month is, look at your portfolio and look at it through three lenses. What’s the split between growth and value? What’s the split between large and small? And what’s the split between U.S. and foreign?

You should know what those numbers are, and you should make sure that you have some exposure to all of those areas. Because if you don’t, then what you’ll have is a portfolio that is not well-diversified. So that’s it for this month, folks. This is Jonathan Clements, Director of Financial Education with Creative Planning. I’ve been talking to Peter Mallouk, President 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.

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