In this episode, Peter and Jonathan discuss
- The election
- Have the markets really moved beyond COVID-19?
- Bond yields
- Record home sales
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!
Have questions or topic suggestions?
Email us @ podcasts@creativeplanning.com
Transcript:
Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education for Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, President of the firm. It is October 1st, and we are Down the Middle.
So Peter, the financial markets, earlier this year, all they cared about was the coronavirus, and it seems like the uncertainty of the coronavirus has now been replaced by the uncertainty of the election, and that is the only thing that investors appear to be talking about. Is that what you’re finding?
Peter Mallouk: I think that absolutely the investors are talking about the election now 95% of the time and coronavirus 5% of the time. But in reality, what’s impacting the markets is the same as it ever was. As much as we, or I’m bored talking about, it’s the coronavirus.
I mean, all the market cares about is future earnings. That’s all it cares about ever. And the biggest thing that’s going to drive future earnings are can people go about their business? Can they get back on planes? Can they go on trips? Can they go into restaurants? That’s what’s going to drive earnings, and therefore it’s what’s really driving the markets. And that’s the money movement that we’re seeing in the markets is around coronavirus, even though the narrative and the media and among all of us has really shifted to the election.
Jonathan: But in terms of the coronavirus, a lot of the uncertainty, and that’s, of course, the thing the market hates the most, a lot of the uncertainty has gone away. We have the federal government to a large degree focused on propping up the economy. We have greater certainty about the development of a vaccine even if we don’t know the exact timeline or the effectiveness of the vaccine. And so that uncertainty is starting to diminish, whereas the uncertainty related to the election, if anything, seems to be ramping up.
Peter: I think that’s true that the uncertainty around the coronavirus has been lifted a little, and that in March we thought maybe everybody’s going to die and the mortality rate’s going to be 6% and Goldman Sachs is saying three million-plus people. And you’ve got projections coming out of places like Johns Hopkins that were harrowing. I think we know now we’re going to get through this one way or another.
But there’s still a lot of uncertainty about is there going to be a second wave? When is the vaccine going to come out? Are people going to take the vaccine? Is it going to get distributed quickly enough? Does this go several quarters? Does this go all the way to 2022? Is it halfway into 2021? Are we really going to be home free in November or December? Nobody really knows the answers to those questions. And that length of time has serious implications.
There’s a lot of retail, there’s a lot of businesses in general, I mean, 12% of restaurants have closed already. And now what’s going to happen when you can’t eat outdoors in the winter and this goes into the middle of next year to the travel industry and hotels and airlines and so on? And it won’t be confined if it goes on that long because if all those areas of the economy suffer, those are people that become unemployed and then they’re not buying in the other areas.
So I think that’s what’s holding the market back more than anything is we don’t have the end of the world uncertainty anymore. Okay, we’re no longer debating that. But we’re debating is there going to be sustained damage or not?
If we have a vaccine and everything’s fine in November and there isn’t a second wave, then we’re going to see another wave of recovery all else being equal, which is never the case. But we don’t know that that’s what’s happening. And I think that’s the real uncertainty weighing on the markets.
Elections, I know everyone’s going to want to punch their radio device when I say this, but they don’t have that big an impact on the market. They just don’t. The market went up under Clinton, it went up under Reagan, it went up under Obama, it went up under Trump. And it’s going to go up probably no matter who wins this election. And as much as both of these candidates are despised by so many people, they’re among the most moderate in their party.
When President Trump was running, he was running against people like Ted Cruz. He was more moderate than most of the Republican party. And when Biden was campaigning in the primaries, he was more moderate than Elizabeth Warren and Bernie Sanders. So you have two people that were not talking about very crazy economic differences. And I think the market when it looks at that, it’s just going to do what it did under Obama and Trump and just move on. And that’s the most likely outcome. And we’re going to be much more focused on what drives earnings, which is the ability of people to freely move about in an open economy.
Jonathan: So, when you think about investments for folks who are focused on the long term, and we look at this array of assets available too, stocks, bonds, cash investments, and alternative investments. At this point, it really seems like there is no viable alternative for the long-term investors other than the stock market, if assuming you want inflation being after-tax returns. Do you think that’s the case? Is there a viable alternative to stocks at this juncture?
Peter: Yeah, I think it’s an interesting way to look at it because part of it is does it make sense to buy stocks just in and of itself? The other question is, what’s my alternative?
So Warren Buffet always talks about he looks for future earnings, but then he compares it to what he can get from the Treasury, the 10-year Treasury, what can he get from the bond market. And I think that’s part of what’s going to drive stock market returns. We have record low interest rates now. And the two really big asset classes where you can use your computer and buy them are stocks and bonds, and where you own a company or you’re loaning money to a company or a government agency. And when bonds are paying such a low amount and the dividend on stocks in many cases is greater than bonds, you can earn 0% on your stocks for 10 years and still do better than a bond. That’s going to drive a lot of smarter money from the bond market to the stock market.
Now, are there other asset classes? Of course. The next big one is real estate. So you think about a company like McDonald’s. You can buy their stock and own part of the company. You could loan them money in a bond. And if there was a real estate fund that had McDonald’s franchise locations in it, you could own the real estate. But they’re all part of the same economy, which is why they’re all somewhat tied together. Real estate, a lot of people think is not correlated to stocks at all. It’s 85% correlated to stocks. Real estate went down in March just like stocks did. And it generally kind of moves in the same direction. And then there are a lot of derivative asset classes, but these are the big ones.
So one of the things that makes the stock market so attractive is the alternative doesn’t look that appealing right now.
Jonathan: And I think that’s one of the things that people miss when they scratch their heads and say, “How can the stock market be up for the year when we have all this bad news? Corporate earnings have fallen apart. We have sky-high unemployment. How can the stock market be at the level it is?” And the answer is because the alternatives are pretty wretched.
Peter: Yeah.
Jonathan: The alternatives looked a whole lot better at the beginning of the year than they do now. So as unnerving as the state of the economy might be to a lot of people, stocks still look like a better alternative compared to the alternatives.
So Peter, I want to ask you a question that I’ve asked you before, but you always have fascinating stuff in response to it. New clients coming in, any interesting horror stories that you’ve heard about the way clients have been treated elsewhere?
Peter: Well, I’ll give you one, not about treated elsewhere, but just a horror story. It’s really sticking with me. I met with somebody in February of this year, and most people won’t personally relate to this, but it’s a lesson that applies to everybody. And this person was worth over $500 million. Most of their money was in one of the 20 largest energy companies in the United States, probably in the world, and had about 80% of the wealth in there. Seemed to feel very diversified, also had 50 million of private real estate, 10, 15 million in a diversified portfolio.
And they’d come in February and we’d laid out a plan to divest, diversify, and so on. He thought the stock had a little bit longer to go. By March, 100% loss across the board of his net worth. The stock had gone down about, I think today it’s still 85, 90% off of its high. There was a margin call. His payment on his real estate was so significant he couldn’t sustain that. And all of the money will be gone in less than five months by just the burn rate on maintaining everything.
And it just shows this lesson applies to people, whether they’ve got $10,000. One of my son’s friends bought a lot of Tesla stock at the top on the Robinhood app. I’m not making a comment on Tesla stock. I’m just saying that wasn’t the time to buy it apparently, right?
If you have all your eggs in one basket, you really need to make sure you have a fallback position. And sometimes owning other stuff in and of itself is not enough if you’ve got payments to make, whether they’re mortgages or you have margin against your account or you’ve got payments to make on that other real estate. You want to make sure that your assets are not really a series of dominoes.
And I just see it play out every year or two with people who have small amounts or just enormous amounts. And it’s hard to get off that horse that got you there. A lot of people don’t want to sell that stock that is the reason that they’re wealthy. But always make sure, always make sure you have a safety net.
Jonathan: Well, I guess in this case, the fallback position was the field position.
Peter: Right.
Jonathan: That’s probably not what you should say to the person.
Peter: No, definitely not. Definitely not.
Jonathan: Switching gears. One of the things that has been going on, even amid the astonishing stock market rally that we’ve seen since March 23rd, has been a boom in home buying. One of the things that I would not have expected from a pandemic, but apparently it has indeed spurred lots of people to go out and buy houses. According to the National Association of Realtors, existing home sales are up 10.5% over the past 12 months, and prices of existing homes are up 11.4%.
It seems, and I’m sure you’ve heard the stories as well, anecdotally, that people are buying second homes. They certainly are here in the New York area. They’re wanting a place outside of the city. You hear about people wanting to buy larger homes with larger yards because they basically want their kids to be able to go out and play without actually being with their friends. And meanwhile, people are abandoning open areas. They don’t want to be in cities anymore.
Peter: It is amazing just how the narrative changed in 12 months, from everyone’s fleeing the suburbs, everyone’s going downtown, the cities are going to go straight up for 20 years, to you have the pandemic and the social issues happening. And people have very differing views on all of these things. But it’s stunning the speed with which everyone’s behavior changed.
We have clients that make boats. They say they can’t keep up with the orders. It’s going to take them three years to fulfill the orders. You can’t buy an RV. You can’t buy weightlifting equipment. People are buying oceanfront properties and lake home sight unseen. I’ve seen clients sell properties that were sitting for years in May and June sight unseen. It is incredible how quick… I took my daughter to go buy a bike. And you would think that there was a law that you had to ride a bike for the next 20 years. I mean, there was nothing left in the store at all. So people’s behavior has really changed radically. It’s amazing.
But what you’re touching on, you have a third factor. You don’t just have coronavirus and people wanting more space. You don’t just have people wanting to move out of the city. You have on top of those things interest rates, mortgage rates dropping to their lowest ever for first-time home buyers, to where many people who are renting, it costs them less per month to own a place.
Now, I’m a big believer in owning homes. But I know you have written a lot about this and you’ve got a lot of thoughts around it. So tell our listeners how you see this and making sure people can get into a home they can afford.
Jonathan: So one of the things that we often talk about when it comes to buying home is making sure that you have a long enough time horizon to come out of this deal whole, because it costs a lot of money to buy a house, it costs a lot of money to carry a house, and it costs a huge sum thanks to that 5 or 6% real estate commission to sell a home.
So the rule of thumb is that you generally need at least a five-year time horizon and preferably seven years or longer. And yet when I look at what people are doing today and what they’re reacting to, all of this could be over in a year. A year from now, people are like, “Why do I want to commute all the way out here in the suburbs?” “Why would I want to go to this rundown lakefront cabin?”
I worry that people are making big decisions now that they will regret, and that they will not have the sort of time horizon needed in order to come out of these deals financially whole. I’m sure you have the same worry, Peter.
And sort of related to that, with all these people rushing into real estate, one of the things that I’ve heard over and over again, I’m sure you have as well, is people claim their home is the best investment they’ve ever made. And this not only shows that they are mathematically challenged, but it also reflects the fact that they don’t understand the nature of real estate. If you buy a home for your own use, and let me emphasize for your own use, what you’re buying is part investment and part consumption. And the biggest part is the consumption item.
So you could look at a piece of real estate, and say that the price appreciation over time might be 3% a year. And it will be barely above the inflation rate. And once you knock off all those expenses that you required to pay owning this home, in other words, property taxes, homeowners insurance, maintenance expenses, there’s a good chance that you’re breaking even in nominal terms, you may even be losing money.
And then there’s the other part, which is the imputed rent, the fact that you get to live there. And that is the biggest part of the return. So the home price appreciation is 3%, the imputed rent might be 7%. The only problem with that 7%, which sounds pretty attractive, is you’re immediately consuming it. Nobody is putting that money into your bank account unless you decide to pitch a tent somewhere and rent out your house.
So a home, while it’s a great thing to own if you have a long-time horizon, is not an investment. And the reason it tends to be a good thing to own over the long haul is, one, because you lock in your housing costs, your mortgage payment shouldn’t go up, even if your homeowners insurance and property taxes do over time, and second, because you have to pay down that huge mortgage, it forces you to save.
Those to me are the two big wins from home ownership. I mean, obviously, Peter, I mean, there are other stuff like tax breaks and so on. But the biggest things, locking in those housing costs and forcing yourself to save.
Have you seen a lot of people buying their first homes among the younger clients at Creative?
Peter: I’m seeing a lot of people that thought they would always rent that are younger actually going and buying homes now. And I’m seeing a lot of our clients that used to use some of these homes as investment properties have kind of changed their mind about that as the prices have really gotten away from them. So you’re seeing the investment space move away from these single-family homes and you’re seeing young folks who thought they were going to rent in the city for a long time buy homes in the suburbs.
Jonathan: Maybe it’ll be the end of the Millennial IKEA mindset where you rent everything and the only things that you buy are stuff that’s disposable. Maybe the Millennials are now nesting and we’ll see a change. And the next thing you know, antique furniture is going to come back.
Peter: I wouldn’t hold my breath on that part of things. All right. So Jonathan, what’s your tip of the month?
Jonathan: So, we’re talking about real estate here, and one thing that people are doing other than buying new homes is they are refinancing their mortgage. And it’s a great time to refinance if you can still get mortgage rates below 3%. If you have a large mortgage and the numbers make sense, by all means go out and refinance.
But if you don’t, if you don’t, if you have a mortgage that’s 4% or more, it’s not worth refinancing because the size of the loan is too small, consider prepaying your mortgage, adding a little extra to every monthly check. It’s equivalent to buying bonds and you will get a higher effective yield than you would get by buying bonds.
So my tip of the month is if you’ve got a small mortgage, it isn’t worth refinancing, go ahead and make some extra principal payments every month and think of it like adding to your bond part of your portfolio.
So Peter, what’s your tip of the month?
Peter: So, I think a couple things happened this year that result in my tip of the month. And that has to do with the bear market, this little bear market we had that started in March with the 34% S&P 500 drop combined with interest rates hitting record lows. I think investors should reexamine their allocation. A lot of people are used to hearing the 60/40 portfolio or 40% of the portfolio’s in bonds. I think it’s going to be very, very hard to get where a lot of people want to be with bond yields as low as they are and they should really visit with their advisor. Or if they do it themselves, figure out how much do I really need to have in bonds and get the rest in equities where it’s far more likely to get the return you need to get where you need to be.
Jonathan: Yeah, I think that’s an excellent tip, Peter. Back in the late 1980s, the late Peter Bernstein, who’s famous for books like Capital Ideas and Against the Guards, wrote about this very idea. And what he said back then, and maybe it was sort of less timely then, but is super timely now, was that a 75% stock, 25% cash portfolio had a very similar risk-reward profile to a 60% stock, 40% bond portfolio.
So I’m not saying that you should necessarily go to 75% stocks and 25% cash, but you might want to think about 75% stocks and 25%, say short-term government bonds. So you get a little bit of extra yield. But what you’re really saying is I know my bonds are going nowhere long term, and if I want to make some serious money, I’ve got to have more in stocks.
Peter: Yeah, that’s great advice.
Jonathan: All right, Peter, so I guess that brings us to the end of this podcast. This is Jonathan Clements, Director of Financial Education from 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.
