With 2024 almost in the books, what will the year ahead mean for investors? Peter and Jonathan discuss the four major investment asset classes — cash, bonds, stocks and private investments — and what investors can reasonably expect. Plus, a reminder to practice gratitude and what to look for before making a lump-sum investment in a stock fund within a taxable account.
Hosted by Creative Planning’s 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. With me is Peter Mallouk, President of the firm, and we are Down the Middle. 2024 is almost in the books, and our thoughts are now turning to 2025. What will the year ahead mean for investors? Today Peter and I are going to discuss the four major investment asset classes — stocks, bonds, cash and private investments — and what investors can reasonably expect from 2025. Peter, let’s start with the easiest of the three asset classes: cash investments. We’re talking here about things like Treasury bills, money market funds and savings accounts. The yields offered by cash investments are driven by short-term interest rates, and there’s widespread expectation that the Federal Reserve will cut short-term interest rates over the next 12 months. Peter, doesn’t that mean that those with substantial cash holdings are looking at disappointing returns in the year ahead?
Peter Mallouk: That’s right. And not just the year ahead, but basically all the time. So when interest rates go up, cash yields go up. And when they come down, they go down. But, in general, cash should not be thought of as an investment. It’s a terrible investment. You basically have money earning a very low yield, then you pay taxes on it, you wind up with almost nothing. The vast majority of the time you are lagging inflation, so if you’ve got money sitting in cash at the bank, you can expect your purchasing power to erode over time. And sometimes, as we see in the last five years, very, very rapidly.
So not only is cash not a good place to be right now, it is going to get much worse. Let’s not confuse investing with need, just a reminder for all our listeners out there. You should always have access to cash to cover the next three to six months, because life has twists and turns, and there can be an emergency, and people lose jobs, and all kinds of things happen. And you can’t have your money in stocks because stocks could be down; anything can happen that drives stocks down. So you have to have cash.
For those of our listeners that maybe have investment accounts or are on the wealthier side of things, you don’t even need the three to six months, because it’s not really about having cash, it’s about having access to cash. And if you’ve got a big investment account, you could always borrow against the account in an emergency. And yes, no one wants to pay interest when they borrow against the account, but doing that for brief periods of time is better than having low yielding cash all of the time. So cash is not doing well today, it’s going to get worse as rates likely decline, and should not be thought of as an investment as part of a portfolio no matter where rates are.
Jonathan: All right, Peter, next one for you, bonds. When you buy bonds, typically the biggest driver of return is the initial yield. Today, high quality U.S. bonds are yielding around 4% or 5%. Do you think that’s a reasonable guide to bond returns in 2025?
Peter: It’s interesting, when people talk about bonds and just say, “Well, what’s the expected bond market return?” Well, bonds are just loans, and there are all kinds of loans. If I loan money to you, I would charge a very low rate. Or if you were loaning money to me, you might charge a low rate because you’d have a reasonable expectation I’m going to pay you back. But if you’re loaning money to somebody you don’t know at all, they have a history of defaulting on their credit card, you’re going to charge a very, very, very high rate. So you would charge different rates on your loans, and the bond market works the exact same way. So lowest yielding loans are always the Treasuries, because when you loan money to the U.S. federal government, the U.S. federal government is going to pay you back. They might print more money to pay you back, they might tax everybody else to pay you back, but one way or another they’re going to pay you back.
So that’s what we call the risk-free asset, that’s the lowest yielding bond. Of course, municipal bonds, you’re loaning to counties, states you expect a better after-tax rate of return because they have a higher default risk than the federal government. Then you get to corporate bonds, which is what many people think of when they think of the bond market. And then you get to high-yield bonds, which are just corporate bonds that are companies that have as likely a chance to pay you back. So there’s a return spectrum here of the low end in the fours to the high end well above 10. And if you see a bond paying more, it’s because there’s more risk. And the expected return on a bond is very, very simple. And this surprises people, because there’s all this stuff that people talk about with bonds around the coupon, and the duration, and the credit quality and all of that.
The return you can expect to get from a bond is very simple, it’s the yield. 99% of the time the yield you see on the bond is the return you’re going to get. So if you loan money to McDonald’s, the loan $10,000,” McDonald’s says, “We’re going to pay you 5% a year for the next 10 years.” That’s the return you’re going to get. The only way you’re going to get a different return is if McDonald’s goes bankrupt, in which case you’ll lose all your money. But if McDonald’s doesn’t go bankrupt, that’s what your return is going to be. It will fluctuate on your investment statement all the time, but at the end of the day you’re going to get all your money back plus the yield that was on that. Now, it’s a long way to segue into your question about, well, what do bonds look like?
Well, bond yields are better than they were for the most of the last decade. So there was the longest period of time Treasuries were 1.5 to 2.5%, and all these other bonds were at 3% and 4%, and it was impossible for an investor to get anything out of the bond side of their portfolio. And with all the inflation that happened post-COVID, we saw bond yields rise too. And so investors suddenly found themselves getting 4 or 5 plus percent on very, very high quality bonds and sometimes much more. As we see the Federal Reserve lower rates, we are going to see all of these bond yields come down. And that’s because the Federal Reserve lowering rates impacts what the Treasury yield is, and everyone else prices off the Treasury. If the Treasury is paying 6, everyone else has to pay more because you won’t lend to anybody else. If you can get 6% from the federal government, they have to pay more.
If the federal government’s going from 5% down to 3%, everyone else can pay less. So we expect to earn a little bit less from the bond side of the portfolio across the board. But having said that, the guidance from the Fed is that they’re going to go lower, but the Fed is often wrong about their own prediction of what they’re going to do.
So they’ll often say, “We are going to raise rates or lower rates.” And then circumstances change, and they change their mind. We may be in that environment now, you have unemployment is staying persistently low, and the economy looks pretty good, but they’re still worried about inflation. The average consumer’s still getting killed going to the grocery store, and just trying to pay for their car insurance, and things like that. If you lower rates, you feed inflation. So it’ll be interesting to see if the Fed could lower rates as often as they said. Just a few months ago, they said they expected seven rate cuts. I’m not buying that, I do think we’ll see bonds go lower, but I don’t know that the yields will go as low as everybody thinks. So in general, if we’re guessing, we expect yields to be a little bit lower, but don’t bet the farm on it.
Jonathan: All right, Peter, so now we come to the tricky one, stocks. We’re more than two years into the current rally, plus U.S. stocks are richly valued, so big increase in stock market valuations doesn’t seem like a great bet. On the other hand, the economy appears to be growing nicely. I mean, the Fed is saying we’re going to get 2% real GDP growth in 2025, so we should continue to see decent increases in corporate profits. Where does that leave us, Peter?
Peter: Well, with stocks, the answer you alluded to is no one ever knows. And the reason is the stock market is positive three out of four years. So the odds they’ll be negative next year, 25%. If we’re doing a podcast exactly a year from now, the odds the market will be down are 25%. And sometimes people say, “Yeah, but the market’s at an all-time high, are the odds different?” And surprisingly, not substantively so. We don’t know just because the market’s doing really well, is it time to take a breather? Unfortunately, it doesn’t work like that, it doesn’t ring a bell. Oftentimes it can be red-hot for a decade, and it can be ice-cold for a decade. So it doesn’t very nicely go up three years and then down one. What we do know is if you play the longer game, over three years the market’s positive 93% of the time. Over 10 years, it’s 95 to 98% of the time and so on.
If you’re going to play the long game, it will work itself out. You are right that valuations have expanded. So part of the stock market run has been, to your point, the country’s doing well generally economically. Unemployment’s low, interest rates are modest, and corporations for the most part are posting record earnings. And part of that is what’s driving the stock price. But the part that concerns some people is that some of the return is coming from what we call multiple expansion. A company might’ve been selling for 15 times earnings, and now it’s selling for 25 times earnings. Their earnings didn’t go up, people are willing to pay more for it. The way to think about it is, let’s say that when you buy a commercial property, you buy a rental property, and normally you would pay a million dollars, you’d get 10%. Instead today you’ll pay 2 million dollars for that property for the same return, which would now be 5% because you’re paying double.
The seller of that property didn’t get more rental income to sell, just people are willing to make more money per rental dollar. So some people are concerned about that multiple expansion, although historically we know it’s not predictive in the short run. The other thing is there could be things driving this multiple expansion that are unique. So if we really look at the globe, there are problems across the world. The Chinese market has fundamental problems, the demographic trend is for their population to be cut in half over the next 50 years. It’s really stunning what may be happening with China. We have war in Eastern Europe, Africa continues to suffer, the Middle East is in absolute turmoil with everything that’s going on there. I heard a multibillionaire leader of one of the largest money managers to ever exist on earth describe Europe as a museum, and they’re not going to be investing there in the very near future.
And so you really look and go, “Well, where does the money have to go?” So now you’re left with very few markets. And we used to have 8,000 plus publicly traded companies, those have almost been cut in half, the market has gone largely private, now 12,000 businesses in the United States are owned by private equity instead of the public markets. So you have more money than ever, there’s more money in the system than ever before chasing fewer companies in a smaller geographic area.
Part of that is what’s driving the multiple expansion. I think the other thing driving the multiple expansion is a very, very big part of the market is technology now, technology stocks generally trade for a higher multiple. So that part of it is normal. Having said all of that stuff, it doesn’t matter. All this stuff for a stock market investor over one year, nothing matters. You can get COVID, you can get 9/11, you can get the tech bubble, you can get ‘08-‘09, you can be right about everything and still lose over one year. If you’re in the stock market, that money needs to be five year plus money. If it’s five year plus money, the odds are overwhelming it’s going to work out. But it’s fun to think about, it’s fun to prognosticate about and guess about what’s going to happen.
Jonathan: Well, Peter, you should feel free because people have short memories. When we do this a year from now, they’ll never remember what you said.
Peter: That’s very, very true. I don’t know if you saw, there were … I think it was 15 of the top Wall Street analysts all at the beginning of the year predicted what the stock market would do. The market passed all of their predictions months ago. And so it just shows how hard it is to even guess correctly every now and then.
Jonathan: So Peter, you mentioned about how increasingly the economy has become privatized, companies being taken private and so on. So do you have a return expectation for private investments?
Peter: Private investments are just like they sound, the private version of public market. So some people like to call them alternative investments, so anything that’s not a stock or a bond is an alternative investment. So if you own a duplex, you rent it out, you’re in the alternative investment business. If you own a franchise, you’re in the alternative investment business, you’re putting your money into something to get a return that’s not a stock or a bond. The most popular one most people are familiar with is private equity. So instead of investing in public stocks, you can invest in private companies through a private equity fund. Over the last decade, this has really risen. It’s a whole new economy now. I mean, the majority of larger companies are owned by private equity, they are not going public, that’s why we see the public markets shrink.
And if you want to be diversified, you kind of have to look at getting exposure to this space. You know, if you look at the research around, it looks like private equity should do 3% or so better than public markets. I don’t view this research as very reliable, because it doesn’t go back very far. Private equity started in the 80s, really became more commonplace in the 90s and early 2000s. But the bottom line is do I think private equity’s better than public stocks over a long period of time? I think if you’ve got the right private equity funds, the answer is correct. The stock market’s efficient, focused on keeping your taxes low, be passive — in the private markets be very selective about who your managers are.
It appears indicative that managers that have done well in the past will continue to do well going forward. This makes sense to me based on my experience with private equity, because seeing my clients when they want to sell their business, there’s 8,000 or 9,000 private equity funds, but they go to the ones that have the bigger brand names, that have more equity. So those firms are seeing more opportunities. All things being equal, they should do better. Those bigger firms have more specialists in-house too. They buy 50 companies, negotiate one deal with UPS, negotiate one deal with FedEx. “We’re going to have somebody who’s a professional at negotiating leases do it across our whole portfolio. We’re going to have a 401k provider drive down costs across our whole portfolio.” So a good private equity fund that’s larger can implement best practices that drive revenues and use their negotiating power to drive down costs.
And then third, these private equity funds, these bigger ones, they’re just better at exiting. So smaller private equity funds just they buy, and they stay for the ride, and then they exit. But the bigger ones, they can sell to another strategic firm, they can sell to another PE firm, they’ve got big networks, they can take a company public, they have more capabilities. So I am a believer that if you’re in that group of private equity funds, you can expect to outperform the stock market over time. There’s no guarantees at all and there are a lot of negatives. It’s illiquid, you can’t get out of it whenever you want, it complicates your life a little bit, you might have a separate 1099 or K-1, and it might even delay your tax return — these are things to be aware of and you’ve got to make sure it’s worth it for you.
But my expectation would be better returns than the stock market. Private lending, the private version of the bond market, all these businesses that are private and not going public, if they want to borrow money, they can’t issue a bond and borrow 200 million, because they’re not public. They can’t walk to their local bank usually and borrow 200 million, they go to a private lending fund.
The private lending fund says, “Hey, you can’t borrow from the bank, you can’t issue a bond, we’re going to charge you more.” And they gladly pay it. So they have many clients that own businesses that they stay private and they pay 50% more than if they were public for bonds, because they want to stay private, they don’t want to deal with all the hassles of running a publicly traded company. And my expectation is that private credit, with the right manager should do better than bonds. But you have the same issues, it can complicate your life, might be illiquid, might have a separate tax form, you’ve got to make sure it’s worth it. So it gets a little more complicated when you get into that world, but for a lot of investors it can make some sense.
Jonathan: All right, Peter, as always at the end of these podcasts, it’s time for your tip of the month. What do you got for me this month, Peter?
Peter: All right, we just had Thanksgiving, we’re going into the big-time holiday season, and it’s a season of gratitude. And what I like about gratitude, is to have gratitude you have to actually stop for a second and think about what you are grateful for. We bring this to the financial realm when I’m sitting with clients and they’re doing reviews You know what I observe is what we all do, it’s human nature, is we are constantly resetting the bar, we are constantly dissatisfied, we’re constantly working towards something else. So it’s easy to forget that sometimes we have what we wanted just a few years ago. And I see this all the time with our clients, they go, “Okay, I want to have … These are my goals.” And then four years later, we’re in a meeting and all the goals have been achieved, and they’re adjusting the goals now.
That’s okay, you can adjust the goals. But take a moment, be grateful for where you are, how blessed we all are. It’s easy with all the noise to not feel this way, but we are living in the greatest time in human history. I mean, we have things like toilets that flush, plumbing is nice, heating and cooling is nice, the technology that makes our lives easier is nice, having cars instead of horse and buggies is nice. All of these things, we’re just really living in a good time to be alive. And for many people, where they are today was a goal they had a while ago. And so if you’ve achieved a goal along the way, take a moment, be thankful. We know that people that practice gratitude live a healthier life and a happier life. All of financial planning is about getting to a place where you’re content and you’re happy with where you’re at. So if you can bring gratitude into your planning life too, I consider that a positive thing. How about you, Jonathan?
Jonathan: Well, those are very wise words, Peter. And after that, my tip of the month seems a little pedestrian. But anyway, here we go. We’re coming up to the end of the year, and this is the time of year when mutual funds, and especially stock funds, tend to make large distributions. Now, people get a little wound up about this, you shouldn’t care about the distributions if you’re investing through a retirement account. If you’re a regularly sticking $250 every month into a stock fund in a taxable account, you shouldn’t cancel that regular investment just because a fund is going to make a distribution in December. But if you have a significant amount of money that you plan to invest in your regular taxable account, before you go ahead and make that investment, it’s worth going to the website of the company involved and seeing how large the distribution is likely to be.
And if it is going to be a large distribution, which means essentially the fund is going to give you back your own money and make you pay tax on it, then maybe you want to delay your investment until after the fund pays out that distribution. Otherwise, I would encourage people to carry on as usual. But if you’re making a large investment, do pay attention to what that distribution is going to be on that stock fund that you want to buy. So that’s it for me this month, that’s it for Peter. This is Jonathan Clements, Director of Financial Education for Creative Planning. I’ve been talking to Peter Mallouk, the President of the firm, and we are Down the Middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels.
