Hoosier Advisor

Howard Marks has long been one of the most influential thought leaders to me throughout my career.  One of his analogies always top of mind is that of the market swinging on a pendulum.  As much as things evolve in financial markets, we haven’t yet escaped the perpetual cycles of the market pendulum swinging from optimism to pessimism.  While stocks may be the most commonly considered market, this pendulum effect is ubiquitous across all financial markets, including stocks, bonds, commodities, and more.  Lately, the pendulum action has been particularly pronounced in markets trading interest rate instruments.  

The swinging action since the bottom last Oct

The fixed income pendulum in fixed income markets remained in full force through much of the last 2 years and reached a point of max pessimism last fall.  Maximum pessimism refers to market participants selling assets in anticipation of additional Federal Reserve interest rate hikes, leading to downward pressure on prices and upward movement in yield. Federal Reserve rate hikes are adjustments made to the Federal Funds rate, which serves as the benchmark for overnight interbank lending rates. In turn, this rate will become a reference point for fixed income instruments, a concept for which we’ll soon dive deeper. You can see the pessimism manifested in yields for the 2-year US treasury note (purple on chart below) which peaked in October near 5.2%. Then, the pendulum pinged off the pessimism end and rocketed back to the optimism end as the Fed pivoted from a regime of rate hikes and opened the door for cuts beginning in 2024. The shift was fast and dramatic, persisting into the early parts of this year as investors in rate markets continued to price in more and more cuts. At one point, a total of 7 cuts for 2024 were priced in by rate traders. It was here the 2-year note bottomed out at 4.1%, having fallen over 100 basis points (or 1%) in just a few short months.  Just how aggressive and optimistic was that take? The Fed’s pivot and indication was just 3 cuts for 2024.  

For nimble investors, this divergence offered opportunities for adjustment, with the big question we were asking as the pendulum swung into full optimistic mode being just how tethered we wanted to be to securities requiring 3-4 more cuts than the Fed had forecasted to be a good deal. To clarify the concept of tethering (especially since it’s not an official industry term by any stretch), I’ll take a minute to explain so we can use it as a simple framework to discuss market navigation.

Bonds Tethered to Fed Rates: Understanding Degrees of Constraint

Think of each category as representing a different degree of “tethering” to Federal Reserve policy. The Fed establishes a target for the overnight rate banks charge for lending out their excess reserves, which becomes a key reference point for financial markets. For simplicity, we’ll categorize investments into three types based on their relationship to this reference rate: handcuffed, leashed, and loosely tethered.

Handcuffed: In financial markets, some investments are akin to prisoners, tightly bound to the Fed’s target rate like inmates under watchful eyes. Money market funds, very short-term (1 year or less) treasury bills, and instruments with fluctuating variable rates fall into this category, where any attempt to stray is met with restraints.

Leashed: Moving along the continuum, other investments resemble leashed pets, enjoying a degree of freedom, but with limits enforced by their proximity to the Fed’s target rate. Short-term (2-5 year) bonds squarely fit this bill.

Loosely tethered: Finally, imagine longer-term bonds (10-30 years until maturity) as tethered astronauts floating in space. While they enjoy greater mobility compared to their short-term counterparts and may even chart their own course, diverging from the forecasted trajectory of Fed rates, there’s still a reference point tying them to the Fed’s policies.

This foundation will guide us as we evaluate the current dynamics in economic data, bond values, and portfolio positioning.

Untethering Leads to Opportunities

In most markets, it’s important to remember that prices can diverge significantly from what may be considered “fair value” or sound reference points. These concepts may vary for each investor. Whether it’s price-to-earnings ratios for stocks or the Federal Reserve Funds’ current rate and forward-looking Fed forecast for fixed income markets, these benchmarks can guide investor decisions. Let’s delve deeper into this in just a moment.

For example, in the stock market, optimism may drive prices higher as investors anticipate earnings exceeding current analyst expectations. This forward-looking nature of stocks means prices can continue rising even if official earnings forecasts remain unchanged. However, this dynamic is less common in high-quality fixed income investments—especially for handcuffed categories and to a significant extent for leashed short-term bonds and notes.

This is where the opportunity lies: adjusting portfolio positioning as our data intake and viewpoint diverge from the market’s pendulum swing. The rapid 1%+ drop in 2-year yields to its bottom of 4.1% (as shown in the chart above) is typically reserved for unexpected shocks. Investors heavily invested in these instruments needed near-perfect conditions to justify the 4.1% rate, leaving little room for error compared to less volatile instruments offering higher interest rates. Nimble investors seized this opportunity by capitalizing on the price increase and transitioning to shorter-dated maturity instruments with higher yields and less volatility.

As expected, data emerged to temper the optimistic swing in the market pendulum, leading to a shift in direction—a trend that continues today (February 22, 2024).”

This version maintains the assumed familiarity of readers with financial concepts while addressing the suggested revisions.

Strong Data

Robust economic indicators, such as strong payroll figures and sustained low unemployment rates, alongside unexpectedly firm inflation, have been pivotal in triggering reversals in market sentiment. The decline in inflation figures, as illustrated in the chart below, served as a catalyst for the Fed’s initial pivot. It’s unsurprising that any deviations from anticipated data would provoke significant market reactions. Notably, the chart depicts a downward trend characterized by lower highs and lower lows, emphasizing its significance. However, there’s also a noticeable uptick at the start of this year, prompting market reassessment.

Crucially, we must acknowledge the impact of shelter costs, a primary component of inflation readings, particularly in the core index. Softening rents, while not immediately reflected in official data, could introduce a notable lag, influencing our positioning framework as we navigate market dynamics.

Importance of Inflation in Fed Outlook

Understanding the foundation for interest rates begins with the Fed’s pursuit of either restrictive (tight), easy (loose), or neutral policies at any given time. The clearest indicator of which policy stance they are adopting is the positioning of their Federal Funds rate relative to the natural rate of interest, often denoted as R*. All these rates are evaluated in terms of real rates, which account for inflation. Put simply, if the Fed perceives the natural rate to be 1%, we might observe a 1% real rate alongside a 5% nominal rate and a 4% inflation rate, or a 3% nominal rate and a 2% inflation rate. Their policy stance—tight or loose—is then determined based on these real rates. Currently, the situation reflects a need for restrictive policy.

Presently, the federal funds rate stands at 5.3%, where it has remained since August 2023. Fed Chair Powell has indicated their preferred inflation measurement as the 1-year expected inflation rate. Last August, when the rate was last hiked to 5.3%, the 1-year expected inflation rate was 2.6%, resulting in a real rate of 2.7% (5.3% – 2.6%). This placed monetary policy at the desired level of restrictiveness, nearly 200 basis points or 2% above its 0.5% natural rate or R*.

The prospect of rate cuts emerged as months of declining inflation data filtered through the system, lowering the 1-year expected inflation rate. This decline pushed real rates even higher from where the hiking campaign paused, effectively surpassing the levels observed when hiking ceased. A visual representation provides a clearer illustration:

What will be crucial for all markets in the coming weeks to months is whether the firmness in inflation data over the last couple of months begins to wane and rolls over, indicating a continuation of the overall downtrend in inflation data. Additionally, it’s important to monitor whether this trend begins to influence readings for the 1-year expected inflation data series closely monitored by the Fed.

A significant consideration for those on the pessimistic side is the potential that the Fed’s estimation of R* is too low. This discussion is legitimate and will be a key aspect of our ongoing analysis. If R* were 75 basis points, or 0.75% higher than their 0.5% estimate, it would offset the decline in the 1-year inflation reading and negate the basis for rate cuts.

To recap and summarize:

1. With the economy on solid footing and at full employment (the other half of the Fed’s mandate), inflation remains a primary focus, with current levels still well above their target of 2%. Few would question the need to maintain tight policy to bring inflation back to 2%.
2. While inflation remains above 2%, the primary trend for inflation prints has been downward. As long as this trend continues, the Fed will likely need to lower policy rates simply to maintain their desired and elevated level of real rates.
3. The market eagerly embraced the narrative of rate cuts, not only factoring in the initial decline in inflation readings but also projecting a swift return to the target rate of 2% for inflation. However, this extrapolation was likely overdone as optimism swung back full force.
4. The January inflation data released mid-February acted as a reality check, causing Mr. Market to reassess and swing back from optimism. Projected rate cuts have been scaled back, and the 2-year note yield has bounced back from its low of 4.1% to 4.6% at the time of this writing.

Fair Value

This may seem like a lackluster conclusion to such a lengthy post, but even seemingly mundane insights have significant implications for portfolio positioning. In my estimation, the market pendulum for pricing in Fed policy is currently near the middle after reaching its optimistic peak and beginning its journey back. This places “leashed fixed income” instruments around fair value. For instance, the 4.6% yield on 2-year notes aligns closely with the Fed’s projection for the fed funds rate next year. Considering a couple of years of tight monetary policy, it’s reasonable to anticipate that inflation could be much closer to the 2% target in the future, allowing the Fed to further cut rates and alleviate tightness. This places the 4.6% yield between the current 5.3% policy rate and the 3.8% rate that would reflect two years with 0.75% worth of cuts each.

This forms part of the rationale behind viewing the purchase of 2–5-year notes at current prices as a fair deal compared to remaining invested in shorter-term rate vehicles. However, this assessment has fewer implications for those invested in loosely tethered longer-term bonds. Their yields are subject to greater freedom, capable of diverging or even trending upward while their shorter-term counterparts decline. I’ll delve further into this when discussing portfolio positioning shortly. Several factors contribute to this conclusion, but I’ll highlight a couple. The term premium is likely to increase, rewarding long-term bond holders with higher interest income for the greater risks taken. Additionally, an aging population drawing on their savings, coupled with the government’s increasing need for borrowing to fund budget deficits, further complicates the landscape. Despite the abstract nature of these concepts and estimates, our task remains to align with the factors the Fed considers and adjusts policy accordingly.

Thus far, our analysis of Fed policy and investment strategies among instruments “tethered” to such policy has been largely mechanical and mathematical. However, it’s essential to recognize that there’s more at stake beyond this dual mandate when assessing the pendulum swing.

Desire to Avoid Future Regret

Foremost on Powell and Co.’s agenda is avoiding a repetition of the mistakes made by the Arthur Burns-led Fed in the early 1970s. Pulling back on monetary tightening too soon in the battle to restore inflation to normal levels could jeopardize their credibility. A central bank without credibility wields less-effective tools, akin to wielding a hammer without a head. This concern has been central as the market confidently backs away from previously optimistic rate cut projections, indicating a shift in sentiment.

However, it’s increasingly evident that they also wish to avoid historical patterns of holding rates too high for too long until repercussions arise. Real yield analysis highlights the current tightness of monetary policy, while the yield curve indicator, showing the difference between 10-year and 2-year yields, has been inverted for 18 months—a sign of concern shared by both the Fed and market participants.

This relationship between short- and long-term rates reveals the incentives within the banking system. As banks borrow at short-term rates and lend at long-term rates, prolonged periods of higher borrowing costs and lower lending returns incentivize banks to restrict lending. This banking tightness plays a role in cooling inflationary pressures but historically takes time to manifest fully, often with unforeseen consequences.

On Their Radar

Although the catalyst for trouble typically emerges unexpectedly, the Fed undoubtedly has its eye on the commercial real estate (CRE) sector. With office space particularly hard hit, upcoming loan refinancing poses a challenge, especially under a tight monetary policy regime. Concerns extend beyond office space, but it’s crucial to note that CRE encompasses various categories, each with its own fundamentals. However, lingering concerns among lenders remain a factor in the Fed’s risk assessment, as confirmed by their recent January meeting minutes.

Positioning and Summary

Despite the seemingly benign conclusion that we’re at a more balanced status and nearing fair value for many rate-sensitive investments, there are implications for nimble investors. Adjusting to the market’s oscillations between optimism and pessimism offers opportunities for yield and risk management. Recent adjustments in our portfolio reflect this balanced outlook, with reduced exposure to rates closely tied to Fed policy. This shift is significant after years of maintaining a low-volatility stance.

Furthermore, it’s essential to differentiate among fixed income categories, with a preference for holding shorter-term notes over longer-term bonds due to looming risks in the CRE sector. While the management of overall market sensitivity is a broader topic for discussion, the availability of ETF tools allows for more precise positioning without overexposure to longer-term bonds.

In conclusion, we remain flexible, ready to adjust our strategy as the story unfolds further.

Open a major financial publication for the past several months and I’d offer you good odds that you’ll run across a piece warning of the looming demise of commercial real estate (CRE).  Commercial real estate posited as “the next shoe to drop” has been a recurring theme and every once in a while, of course, it actually is.  And oh boy does the story have teeth this time as covid delivered a sizeable shock to the office space system. Work from home ramifications are continuing to present an existential threat to the need for office space leases.  Just think for a moment about your circle of friends and family, how much office space sits either partially or fully unoccupied now versus pre-pandemic just within your circle?  The troubles are real and painful circumstances are all but certain to continue to be the result. But they aren’t enough to prohibit real estate as an active option for your diversified portfolio….and I’ll tell you why in the following paragraphs.

The broader case for inclusion

The compelling case is most easily seen from the chart below.  The asset class not only pays a steady stream of growing income but has a very consistent track record of appreciation in value as well.  Over the past 25 years, only the 2 years containing the Great Financial Crisis saw price declines.

Furthermore, when income is considered for a total return, 2009 was a net positive and 2008 wasn’t all that bad, especially compared to other risk assets. But along with this seemingly ever positive rising tide come questions as for when the gravy train is set to end, or when the shoe will drop. 2023 is shaping up to be a down year in prices as there is often a lag effect for when valuation adjustments actually hit CRE prices. More on that later.  In the meantime, this present softness, when combined with the downright scary possibilities for some office properties can give pause to anyone considering whether now is the right time to be in the asset class.

Unfortunately, Commercial real estate and Office Properties are often conflated.  As a result, it becomes all too easy to associate the problems and nasty headlines in the office space with the broader asset class of CRE. The National Council of Real Estate Investment Fiduciaries (NCREIF) maintains what is essentially the S&P 500 index of real estate. Just like stocks inside the S&P 500 are broken down by sectors, The NCREIF index is broken down by property type. As of July 2023, just 24% of the market value of the index is office property. The other 76% contains multi-family apartments, retail and industrial (think warehouse) properties. If you were to own the NCREIF index, or a portfolio of real estate that resembles its multi-sector approach, then you are diversified and have a better chance at being insulated from the problems brewing from just one of those underlying sectors. Case in point is the work from home dynamics that have put office properties in peril, have, in a way contributed to strength in apartments as household formations have increased.

Practicalities for building portfolios

For individual investors – save from the ultra-wealthy – I realize that it isn’t practical for financial, legal, and tax reasons to accumulate a diversified portfolio of direct real estate holdings.  A large number of individual investors do own some pieces of CRE.  You may think of someone who owns the building that houses their small business or perhaps owns a small number of homes or apartments.  But a self-sourced and financed broad, NCREIF like portfolio isn’t realistic.  However, it can absolutely be done and relatively painlessly through good financial partners who invest funds on behalf of clients. I’ll stop short of giving advice on specific ways and partners to go about this (I can’t give away everything for free – so feel free to contact me to further discuss!) just know the industry is chock full of both good and bad ones.  Some may point to publicly traded REITS as a way to get this diversification, but I don’t hold this view.  Yes, publicly traded REITS represent sound investment options from time to time but stop short of the tax, diversification and risk mitigating benefits that can be acquired through direct CRE exposure.

To be clear, my case here is to push back against the narrative that CRE is a ticking time bomb across the board.  Instead, it remains worthy of a spot in a diversified portfolio (especially where tax considerations are a priority).  That isn’t saying that loading up the truck on equity pieces of direct CRE is right at this moment either.  But an entry point looks bright amidst the prevailing angst.   The dramatic rise in interest rates during 2022 created a generational bear market in bonds, pushed down stocks and by no means left CRE unscathed.  Property valuations have been declining as incoming appraisals and/or transactions reflect the impact of higher interest rates.

This August 2023 entry point gains support by the fact that, outside of office, those valuation pullbacks are indeed nearly entirely driven by the rise in interest rates. The fundamentals are sound: vacancy rates are low and lease rates are strong (a factor thoroughly reinforced by the recent bout of inflation). These lease rates are a brewing positive for CRE owners out there who have leases coming due in the near term and should be able to obtain higher rates of income as those leases are “marked to market”.

Is the worst priced into office?

I have no doubt that there is a contrarian or two reading this and asking whether it’s time to go against the grain and just go out and buy up the beaten down office properties with seemingly poor prospects.  I hear you and we are kindred in spirit. Who knows, 2023 may very well turn out to have been a moment, as is often the case, where the “blood in the streets” meant it was truly a time to buy. However, offices have the opposite problem as the rest of the CRE field with leases and rather than having the inflationary benefit of marking up, they will very likely be marked down to market as they come due.  The need for less office space will keep the bargaining power firmly on the side of tenants.  Furthermore, many office buildings will be defaulted on as they are unable to refinance their debt and the property is handed over to the banks.

If you are adventurous and have the skill, then have my admiration for your ambition.  After all, Voya recently shared that 90% of office vacancies around the country are within 30% of the properties! But my opinion is there isn’t a need to rush, and many innings of this office property cycle need to play out. Various regions and assets vary, but I believe COVID simply expedited an inevitable trend. Instead of the work from home trend that was modestly under way and set to play out over a decade or so, it was dropped on our doorstep in an instant. WFH won’t be ubiquitous but is here to stay in a major way and we’ll need time to grow into office space. Instead of jumping in, one strategy might be to figure out how to line yourself up to participate in financing the handoff as buildings get handed over to banks.

Conclusion

To wrap up, if you haven’t already, you are quite likely to encounter incoming headlines about problems in the commercial real estate market.  Many of these articles will have truth to them and many properties will indeed blow up. Is it the next shoe to drop? I’m more of the mindset that if the shoe fits, then wear it. I can’t emphasize this part enough, CRE is not like the S&P 500 where you can drop your money into an index and get exposure to the asset class. Real work must be done (by you or through trusted financial partners) because bad projects go to 0.  But the juice is worth the squeeze as they say given the tax advantages and return enhancing/risk reducing features virtually demand CRE remains in the conversation of well-built portfolios.  And again, I’ll reiterate that if you don’t know where to start to reach out. I could talk about the subject for days and would be happy to take the call.

It is a healthy time to be asking whether stocks are expensive or cheap.  I say that because of the huge drop through the first three quarters of 2022 followed by the subsequent healthy rebound ever since. Did stocks get too cheap in the selloff? Have they returned to fair value? We will get to those answers, but the short answer is that it really depends on what the inquisitor means by “stocks”.  That is always the case (i.e., different pockets of the stock market are in favor at various times), but the phenomenon today is particularly acute.

Each investment environment is unique and one of the ways I’d characterize this period as unique is the progression of valuation in this market. One would have expected a more severe correction and “cheapness” in stock valuations given the severity of the price decline, but instead the healthy premiums to own stocks have endured. Yes, the bear took out some excesses and knocked down the substantial premium stocks were carrying through ’20 & ’21. Specifically, the forward PE ratio (which is simply the price at any given moment for the underlying earnings) on the S&P 500 has a long term average of 14-16 (depending on the period) but held firmly above 20 for 2020 and 2021; levels only seen during the dot com boom.

At this point, the valuation adjustment appears much more like a partial mean reversion than the typical shakeout that ends up overshooting into a trough.

Decomposing market returns

The starting point in answering the question as to whether stocks are expensive or cheap entails a decomposition of how the S&P 500 went from point A to point B. We never fully know why price levels are where they are, but we can X-ray into the S&P which can in turn, more fully illuminate our current situation. The movement in the S&P price from any point A to any point B can be broken down into these explanatory components:  

1) Earnings expectations rising (or falling)
2) Changes in the PE; changes which can stem from one of two primary drivers:
                                a) changes in interest rates
                             b) changes in risk taking preferences (the net composition of all investor concerns)

If S&P 500 earnings are 200 and the level is 4,000, then the multiple is 20. If earnings rise to 220 and the 20 multiple is held, the level goes to 4,400.  Calculating these figures and studying this relationship helps shed light on the character of the advance and whether investors are swinging too far on either end of the optimistic or pessimistic end of the pendulum.

The S&P 500, at 4,137 at the time of this writing, is down 13.2% from its start of 2022 after briefly being down as much as 25% in late 2022. At the start of 2022, analysts collectively were expecting approximately $230 in earnings per S&P 500 unit over the following 12 months. The going forward expectation here in late April ’23 is for earnings of $227 (Factset data), or little changed during the time of the 13.2% drop. If earnings are unchanged, then the PE ratio is left as the sole driver of the 13.2% decline, observed by the fall in the ratio from a forward PE of ~22+ to ~19.

Higher rates or Lower risk tolerances?

To answer the question of whether it’s 2a or 2b from above, we can use some mathematical relationships to test whether it’s the rate or risk influencing the PE change.  In this case, we really don’t need fancy regression math to understand the driver behind that PE drop is interest rates or one of the two main drivers of changes in PE levels (but yes, that fancy math does indeed affirm this).  The breakneck pace of interest rate increases has introduced a host of low risk choices to compete with stocks for investment dollars. Money markets going from 0% to 4% gave equity markets little choice but to get cheaper.

Tagging higher rates and not rising safety preferences by investors as the culprit is corroborated by the relative sanguineness observed in credit spreads. Credit spreads tell us how much additional interest investors requires to invest in its basket of riskier corporate bonds in lieu of US treasuries and can be measured by the US High Yield Master II OAS index measures. That spread is higher than the rock bottom levels found in early 2022, but at 4.47% is right at its 10 year average of 4.48%. If the PE hit were more due changes in risk preferences, we would expect to have seen some more fireworks here.

Where earnings go from here is anyone’s guess and will depend on how the economic cycle takes shape (do we continue slugging out positive GDP quarters or do we have a recession?). According to Bloomberg, the average earnings decline during a recession 16%. So, if a recession does take shape, earnings could take the baton from valuation as the driver to S&P 500 price adjustments.  But a recession isn’t set in stone and the odds of whether we do or not is a topic for a different day.  The focus from here is on what we do know, which is that stocks are priced at a 15% or so premium to their long term averages (18x now vs. 15 avg).

Look Deeper

However, there is more to the story. An important part of the story that looks deeper across the 11 sectors that comprise the index. It is not that all sectors are on the expensive side, the technology and consumer discretionary sectors are carrying the entire S&P 500 premium. Keep in mind that the sectors are not equally weighted. In fact, the tech sector is larger than the basic materials, utilities, energy, consumer defensive and real estate sectors combined!

So, when you combine the relative size of the tech and discretionary sectors with how expensive they remain, it tells us that most of the S&P 500 is closer to fairly priced rather than expensive. An equal weighted approach remains compelling compared to a capitalization weighted one.

To be clear, valuation data like this is not predictive or useful in any near term tactical ways.  It can, however, assist in repositioning portfolios towards better risk and potential reward combinations. The S&P 500 being expensive should not lead to a prediction that a price decline is imminent; it just means probabilistically that appreciation from here will need to lean more heavily on earnings growth. A healthy optimistic outlook is potential relative upside in the other 9 sectors if their valuation levels were to gravitate towards the tech and discretionary duo. in the sectors that could return to the premiums held on to by the tech sector. Or, conversely, be more of a protective floatation device if tech and discretionary continue the long and winding road to their average that began early last year.

Private Equity has been a hot topic to start 2023, which makes perfect sense given the steep drop in prices during 2022 for public markets.  This drop brings into question the valuations of privately held companies and more specifically the marks those companies carry in private equity funds (the value that is reported to the investors in such funds in their statements). This is a complex topic divisive more on philosophical rather than ethical or factual grounds. I’ll do the best I can to simplify and explain why we should care.

The topic really heated up with Cliff Asness’s provocative piece in the influential publication Institutional Investor titled “Volatility Laundering”.  Cliff has long been a crusader against what he and others in his camp believe to be the absurdity in private equity funds not adequately marking their portfolios to market. Private equity managers, in turn, retort that marking their portfolios to prices of publicly traded stocks that are “artificially” lowered under market duress should not have bearing on the values of their portfolios because they don’t have to sell!

It might help to put an example forward to illustrate the difference…think of company A and company B who are identical in every way except that A trades on the NYSE and B is a privately held company owned by XYZ Private Equity Fund. We’ll say that both of them closed the year 2021 worth $1B. Company A would be worth $1B simply by taking the number of shares outstanding multiplied times the closing stock price – which would be the last transaction as the NYSE closing bell rings.  Company B would be worth $1B because that’s what analysts responsible for valuing the fund’s assets say it’s worth (based on book value, future cash flows, etc).  Fast forward to the end of 2022 and all of a sudden Company A is worth $800M while company B is still worth (or perhaps after a valuation adjustment, near) $1B.    Before casting too many stones at the advantage XYZ company has for its 2022 reporting, think about the inverse and what the case would if the hypothetical applied to 2021 instead of 2022. Company A might have jumped to $1.2B while company B held back closer to around the $1B mark. 

That’s just a real loose example and different funds have different processes for valuing portfolios, but it does shine light on the major thrust of the argument.  Some argue that the investors in the XYZ fund are done a disservice by their statement values not reflecting the fulness of reality in their underlying investments. They might even say, and would have a decent argument, that they are doing broader society at large a disservice by promoting misallocation of capital with potentially stale asset prices.  On the other side of the debate will be those that argue the XYZ fund investors are there for the long term and the fact that animal spirits are driving publicly traded stock prices wildly up and wildly down have no real bearing on them.  The fund owns company B and will collect its cash flows along the way and / or sell it when it is ready to do so.  The very structure of the fund is set up to avoid selling when it isn’t ready to do so.  To this I say that both sides of this debate (far richer than a brief blog post can serve) have valid points.  Both can hold pieces of truth in application that when viewed correctly can benefit all investors.  

First, I strongly endorse the notion that Private Equity funds should NOT be added to your portfolio for the very reasons they are often pitched to us by the fund sponsors. Sales pitches often come our way that basically all carry the same punch line: “Low correlation with public markets with stronger returns”.  The low correlation is solely due to the lack of valuation updates and the stronger returns are essentially now due to extra leverage (so, the extra returns do not hold up as much on a risk adjusted basis).   As Cliff points out in his article, this wasn’t really always the case, but as money has flooded PE over past couple of decades the extra returns have likely come down leaving – leverage as the primary driver of extra returns. 

Yet, private equity remains a valid option for appropriate (and usually accredited only) investors.  I am happy to share the principles we apply for when and where private equity can still make sense.  We do this only after arriving at the understanding that there is underlying volatility whether or not we see it and that future returns should be viewed as fairly symmetric on a risk adjusted basis between public and private market investment options.  Here are the simple things we are looking for:

*Enter the market through the secondary market for private equity funds (at least for now).  This means buying funds at a discount to their reported value, usually because the seller of the private equity fund has a liquidity need and must accept a lowered price to exit.  Think of this investment scenario as another form of supplying liquidity, an investment style profitable to the suppliers dating back to Genesis.  As markets found distress towards the end of Q3 2022, discounts became increasingly attractive.  

*The world has changed in the past two decades with the number of public stocks dwindling and the number of private stocks swelling. According to Pomona Capital, there are now just 4,000 public companies and over six million private ones.  In my opinion, this has to be considered in terms of what universe is available to us for which to invest in.  Can you be fully diversified among public market stocks only? Probably, for the most part – but likely won’t be a question settled any time soon and (at least in my opinion) worth consideration.

*Part of the Private Equity return can come from value added techniques through specialized skill sets.  Some private equity funds can create value by improving marketing, others through better management and others through putting multiple companies together in order to find synergies.  Granted, when viewed on an after fee, after leverage, after tax basis the return outlook shouldn’t be all that different from public equities, but it can produce that return from a different risk stream.  In other words, its purpose is primarily diversification.

*Perhaps most of all, we are taking advantage of the psychological edge that can come from longer term decision making.  This happens by having dollars invested with managers who are focused on beneficial long-term outcomes and by taking away the buying / selling at wrong times that plague all of us human investors. Referring back to Cliff’s article, which is worthy of all the attention it received, he does acknowledge the appeal to the smoother nature (artificial or otherwise) of private equity.

These principles were written with private equity in mind, but many apply to private credit as well.  Neither asset class deserves blind allocation for the reasons they are often pitched.  But the reasons listed above serve as compelling reasons for a portion of investible dollars in most investors’ portfolios.

My primary (career) role is as an investor, no doubt evident by the plethora of nerd laced posts. Simply put, my job is to work with fellow asset management teammates to optimize our portfolio holding, balancing their inherent risks and rewards.  However, I am thankful for the structure of Financial Enhancement Group, which forces the intersecting of my role with the financial planning side as well. 

Gratitude

It might be helpful to paint a small picture of what it means to intersect with financial planning – which may sound like an odd statement to those outside the industry. That picture of FEG firm structure starts with a state-of-the-art financial planning team built over the years at FEG. A team that has deep roots and origin through the thought leadership from our managing partner Joe Clark and organized around his curriculum for years of teaching financial planning at that other big ten university in northern Indiana. The team and its planning curriculum has grown from those roots and blossomed under the leadership of the team Director, Aaron Rheaume.  The team also wouldn’t be complete without the nurturing development of individuals by Grant Soliven.

Part of the intersection I have to this team is through the role I continue to carry as a financial advisor to a small number of client relationships.  Perhaps the best way I can complement this team and describe the job they have done is that over the past several years it became evident that it was no longer possible (at least for me) to do both – be fully in tune with the investment side AND keep up the training necessary to carry out a financial plan.  What’s great though is that this financial planning team is there to sit on those client meetings for the long-held relationships I cherish and ensure that not only their investments are in line, but their financial planning bases are covered as well.

Separate Functions? (financial advisor sounds fairly ubiquitous to me)

I understand it may sound odd or confusing to talk about these two roles (planning and investing) so separately.  A “financial advisor” can easily be seen from outside the industry simply as the one who does it all (investing and planning). Sure, that can be true, but planning and investing each have their own deep sets of skillsets and knowledge banks to master.  As a result, a number of shops in our industry are planning-oriented and outsource the investment to shops that are strictly asset managers.  The other choice is to do both in house, which is the model FEG has used for over two decades now.  My biased opinion is that this is a great choice (Yes, primarily because this means I have a job as CIO). But also think it works better in general to have it under one roof, especially when taxes are involved. Recently, I shared some thoughts with Grant and Aaron for one area where my investment focus and their financial planning squarely intersect: retirement income projections.   

I’ve spent my entire career at FEG, so I say with the conviction that we have always taken distribution seriously.  For those of you reading for whom we currently have the pleasure of serving – you’ll be acutely aware of this. Specifically, Aaron, Grant and I were recently working through the dynamic part of the process of factoring in (very rapidly) adjusting investment assumptions into methods that serve to both safeguard AND optimize spending.  This is no small task as these are often competing goals (“safer” levels of portfolio income will mean leaving spending on the table) and different people have different preferences; but keeping realistic and up to date investment assumptions is key.  An essential consideration to keep in mind is that investment assumptions are critical for the distribution phase.  Investment assumptions that aren’t as key to those still accumulating or have distribution further off because for them long term averages will tend to smooth things out.

Distribution types (different strokes for different folks)

I like to keep it simple by categorizing a few different types of distribution for investors. 

Type 1: for many, their goal is straightforward and is to generate a smooth level of income that can be withdrawn each year and increased over time with inflation.  As straightforward as this sounds, it does carry the major drawback of leaving a good chunk of principal behind. For those with heirs that have bequests as a secondary goal, this isn’t a drawback at all.  Otherwise, this is an often-overlooked result, which leads us to the second type. 

Type 2: which I’ll simply call “cautious principal spenddown”. Cautious because this is a tricky and inherently imperfect goal due to the wide uncertainty around life expectancy, inflation, and ever looming potential for unknown expenses.  But it remains imperative to reach beyond the relatively simpler safe withdrawal rate methods if the goal is more about maximizing spending than it is about leaving money behind. 

Type 3: a more obscure method I call a bridge period; whereby the investor is simply going through a temporary period of large portfolio withdrawal percentages before reverting back to one of those first two types. Commonly this method is employed when the goal is to maximize social security income, so benefits are delayed, relying on that extra portfolio income until those benefits kick in.

Dynamism (Adjust to market conditions and update personal distribution outlook)

First, let’s start with a deeper look at the safe withdrawal rate method where it’s imperative that the conversation has some dynamism.  That may sound peculiar given the amount of academic research that has gone into validating and testing the durability of that 4% withdrawal rate (at least for a portfolio well balanced between stocks and bonds). Our view over the prior few years has been to be respectful of the uniqueness of the then investment environment.  An environment characterized by a long period of ultra-low interest rates coupled with historically high stock prices.  We had to at least consider that a lot more juice had already been squeezed from markets. As a result, we began guiding the initial withdrawal rates lower.

The math can be complicated or simple, but they all pointed at the same risk.  Sticking with a preference for the simple, we’ll look at a 60/40 balanced portfolio (which is simply going to be 60% of the dividend yield of the S&P 500 plus 40% of the yield on long term treasury bonds). 

Yield certainly isn’t everything since part of distributions will likely come from capital gains too, but it’s a beneficial starting point.  In the early 90s, the 60/40 yield was well above 4%, then spent the better part of a couple decades around 3%. Think about that for just a second, at 4% -the full distribution is being kicked off from income.  But look at what happened in ‘20/’21…the yield plunged near 1% on the backs of soaring stock prices and rock bottom interest rates, which we could think of as akin to buying a pig in the poke. With the double whammy happening this year to stocks and bonds, the yield has moved back up near to its norms of the previous decade. 

Distribution Danger Zone (confronting and managing the fear of running out)

Being dynamic doesn’t mean adjusting income or spending with every ebb and flow of the market.  We do, however, want to recognize seismic shifts and adjust if necessary.  Think about how the adjustment process in terms of how it likely played out this year:

-You enter distribution phase with $1M on December, 2021 invested in a balanced 60/40 portfolio and commencing the standard 4% withdrawal ($40,000)

-That split was down around 20% at the end of last quarter, making that $1M worth around $770,000 (assuming ¾ of the withdrawal also made).

-Now, had you taken the withdrawal rate down to a starting rate of 3.25% – the balance would have been closer to $775,000

This $5,000 difference in balances in these examples may not sound like a lot, but when you look at the updated withdrawal percentages the initial 4% withdrawal amount would now be 5.2% vs. 4.2% rate for the lowered initial draw amount. If the markets were to rebound quickly, say as they did in 2020 then this episode would have turned out to have been just a scare.  On the other hand, if markets were to stay down here for a while (or worse, take a next leg down) then the higher withdrawal rate against a lower balance could continue to grind against that underlying principal and carry too high of a risk of you running out money before you run out of time. In finance, that risk is called sequence risk.  The lower withdrawal rate is not a guarantee of survival either, but the updated 4.2% withdrawal rate with today’s fatter dividend yield and higher interest rates looks to be right in the comfort zone.

Alternate Ending (how would you have handled an earlier, more lucrative start to distribution phase)

Another way to look at dynamism is to flip the script to look at a scenario where you started this process a few years earlier.  Instead of losses on that initial $1M, you’d have substantially more because the gains had far outstripped the distributions in ’19 – ‘21.  Perhaps that initial 4% income (plus inflation increases) started in years prior had trekked down to something like 3.25% or 3.5%.  In this case, it would not have been recommended to boost the income beyond the inflation bump. Naturally then, it would stand to reason that it works the same for someone starting out distribution and accounting for those recent gains.

Dynamism for Type 2

So, what may be dynamic about that type 2, the one who wants to cautiously spend down principal? That is a lot more challenging scenario, but just because it’s challenging doesn’t mean it’s not worth the effort.  After all, for the same $1M starting portfolio this different ending goal means that $32,000 -$40,000 income you’d have using a safe withdrawal method could be something closer to $50,000 or $60,000.  And since that’s over the rest of your life, I’d venture to say it’s worth the finesse.  The full scope of that effort is better handled in individual one-on-one meetings with our planners and involves using computer simulations and updating them frequently (i.e. = dynamic).  In fact, it bears repeating, no substitute exists for any of these methods for a full plan and simulation.

Annuities should always be in the conversation for this type of Distributee and warrant a couple key words about annuities (esp. as a product that over time I have thrown a lot of shade at). I really wished we had different words for the different annuity products.  When I use the word, I am talking about them in the traditional sense.  I am talking about using an insurance vehicle to do what investment portfolios cannot do: pool risks with others.  Annuities are not a one sized fit all solution (With health, family history, bequest preferences all being factors), but with the right needs to those factors, a portion of the portfolio in a product that perfectly matches the competing risks of you outliving your money and your money outliving you is not only sensible but will be hard to beat in terms of maximizing income.  It also highlights the underlying theme of dynamism.  It’s been a few years since annuities should be strongly considered, because buying such a product over the last few years effectively meant locking in ultra-low rates for the rest of your life.  But with rates back up, you once again have an option to incorporate them into an optimal winddown scenario.  

Conclusion

Coming back to gratitude – one of the great things about having investment and planning intersect under the same roof is for the math heavy and cold analysis of investing to be parlayed into the real lives of those we serve. This industry doesn’t come with many perfect answers and is often more about recognizing and balancing inherent tradeoffs.  Tradeoffs such as balancing higher portfolio withdrawals against lower odds of survival probability.  Most importantly, it’s important to know what it is you are trying to get done (creating a sustaining income or maximizing principal as well).  With goals identified (and in this case type of distribution) we then stay dynamic, adjust, and employ all tools at our disposal.

Welcome to the third of a promised series to force some perspective and sharing here these few late summer / early fall weeks. Last week was the heaviest hitting material with a long look at when and how to stay the course.  In particular, we took a square look at investing in the Great Depression.  There really is no way to summarize that piece – I will shed modesty in suggesting you simply give it 20 minutes of your time. At least if you fear your investments going through a repeat of that nasty era.  Here I turn to areas within the market to focus on but stick with the quote from the great Mariana Rivera again with “simpler is better” (Though this time I’ll lace with brevity as well).

We’ll always favor real diversification first and foremost but will also tilt towards areas representing the most favorable risk/reward asymmetry.  The three areas that are worth sharing on this are high grade CLOs, value stocks and small caps. The value and small cap slant is the easiest to cover so I’ll start with those. 

Small caps usually trade at a premium to large caps.  This means that for every dollar of earnings, a higher price will be paid for small caps than their large peers. That’s because in the aggregate, small companies are poised to grow at a faster clip than large companies who are, again – in the aggregate, more established and matured.  However, at this time small caps trade at a very large discount to large ones, seen easily on this chart from Yardeni Research. 

At a multiple of 17.1X, the S&P 500 (Large caps) is near its long-term average.  Meanwhile, the S&P 600 (Small caps), at 11.9X, is closer to its bear market lows of 2008 or 2020 than anything resembling a “norm”.  This doesn’t mean small caps will be immune from any further pain.  In fact, if we are indeed headed to a recession, that could spell for outsized trouble small caps. However, it does suggest they have asymmetrical potential relative to their big brother large caps or perhaps the potential to recover their prior highs earlier.  Another of my all-time favorite charts was from the early 2000s where simply giving less weight to the big dogs of the S&P 500 paid huge dividends as those big dogs underperformed. Keep in mind both lines on the chart below are comprised of the same 500 stocks. It’s just that all stocks in the orange line are given an equal weight vs. the regular S&P 500 which gives a lot more weighting to the big dogs of the index.

These cycles of favoring large or small often play out over a very long term, so there is no rush to jump out and overweight them.  But, when signs of market healing occur, small companies should be aggressively considered.

The rationale for value is similar, but perhaps a little timelier.  Growth stocks relentlessly dominated value stocks following the 2008-2009 recession.  So much so that the valuation spread between the two reached levels only seen in the dot com boom era (another era of frothy growth stocks). 

You can see that play out below with the chart depicting the ratio of the level of S&P growth stocks to value (an increasing ratio would indicate value stocks outperforming growth, and vice versa).  This ratio remains well below its longer-term average of 0.69.  However, I say this is a timelier focus given that value stocks have begun the process of mean reverting by steadily outperforming since 2020.  It hasn’t been a straight line, and there is no guarantee that the old norms will once again apply.  But it represents another asymmetrical opportunity for a trend that would contain years of outperformance if it were to fully mean revert (or perhaps even overshoot to the upside).

The last area of suggested focus is more esoteric.   Of the three, it would also be the one most likely to have a short shelf life due to its being pegged to the interest rate cycle.  Rather than passively buying bonds or bond funds and holding them to maturity, tactically adjusting them can be rewarding if done consistently enough in conjunction with the cycle.  That’s due to the nature with which the Fed announces their intentions, has to follow through on them and then consistently overdoes it.  This creates a cycle where short-term rates go up too high, stay there for too long and eventually force the Fed to cut short-term rates to reverse that pain.  At that point the Fed inevitably overdoes it by keeping them too low for too long and perpetuates the cycle.  We’re very clearly in the part where they are reversing the implications from having been too low for too long.

If they follow through with their clearly laid intentions, short term rates should continue to rise….and stay there for a while.  When the situation turns (and we have all of history suggest that it will), asset classes with fortunes tied to higher short-term rates become less attractive.  But for the time being having highly graded tranches of Collateralized Loan Obligations represented in your portfolio is worth your consideration.  For decades, these securities were the exclusive domain of large institutions.  But ETFs have had brought democratized them for the masses like they have with many other asset classes. No shortage of scare tactics have been out there for the past several years about an imminent collapse in these CLOs like their CDO cousins from 2008.  While I absolutely believe some pain could be in store for the underlying senior or leveraged loans that comprise CLOs, I think an opportunity has been kept open (high yields relative to their credit rating) because these two products simply sound alike.  Lastly, I wouldn’t argue that all AAA or BBB tranches of CLO issues are the same, but the right ones done by the right CLO managers carry risk that isn’t quite to the degree that the parade of carnival barking internet authors would have you believe. Additionally, they are presently trading at a sharp discount to their par value, which could add to return when things heal.

I have intentionally avoided listing individual funds.  This gives my Chief Compliance Officer a little breathing room.  However, funds for all three of these areas can easily be located with some google searches to commence your own homework.  Or, if you are an FEG client – you can rest assured these are areas that have our attention and why.

It’s a long one but hear me out for the first (as promised) in a series of committed articles to be written over the next several weeks.  Also as promised, I’ll launch a direct hit on the two delicate questions of when and how to stay the course amidst a severe financial storm.

Section 1 – The first question…” When should you stay the course?”

When is the easy part.  To quote Mariana Rivera as he repeats so often in his 2014 autobiography “The Closer”, simpler is always better. As in most things it starts with the why.  In this case: Why is your money invested?

1. Are you in a savings/accumulation phase and simply needing the power of compounding returns? Then not only is staying invested in a stock heavy portfolio appropriate, but these down periods are just what the doctor ordered. Your deposits go farther in buying up shares than they would have at the start of the year. Stay the course.

• Are you at or near distribution and being financially supported by your investments? This phase is where stakes are the highest.  This may also be where the inclination to jump ship to preserve account balances is the strongest and also where the consequences of doing so are the gravest. The key is to take a step back, remove some emotion and try to objectively examine the consequences of bailing on the portfolio. That won’t guarantee you’ll be able to, but you owe it to your future self to do so.

Bailing out to the safety of short-term time deposits and their low or no interest rates will reduce earnings power. This much is intuitive.  But the brutal truth is that though your intentions may be temporary, the implications may be permanent. Unless your withdrawal percentage (size of withdrawals relative to the size of your portfolio) is de minimis, your plan likely factored in some appreciation and more importantly, dividend growth in order for your income stream to be sustainable over your life expectancy.  Abandoning the plan will elevate principal extinction risk to the extent that downgrades to your standard of living may now be required in order to adequately offset those higher odds of principal extinction down the road.  In no way do I suggest this judgmentally, choosing that option and safety of principal may be the right choice for you. If not, stay the course.  

• Some investors simply have a savings stockpile with really neither of those goals.  You simply are set with your sources of income and have this stockpile as a reserve and no real need for it to grow.  In this case, a desire to go to cash to avoid watching the stockpile decline will, needless to say, not be doing you any harm.  Yes, inflation will be slowly melting its real value like an ice cube, but with no big goals the consequences aren’t that grave in deciding to not stay the course.

Ultimately, it’s about goals and making sure investment decisions, especially the big ones like these, are in alignment those goals. If your portfolio has been thoughtfully crafted as such, then you’ll know yes, now is the time to stay the course. Now, I’m not talking about strategic or tactical adjustments to the portfolio.  Or perhaps you’ve built the portfolio yourself and unsure whether it still fits the bill. I’m talking about throwing in the proverbial white towel and jumping all the way out of their portfolio.  Many tend to want to believe they can exit into cash and return “when the coast is clear.” The problem with that are downturns like many recent ones: 2009, 2011, 2018, 2020 – all had recoveries that happened in a very short time frame and had recovered the biggest portions of their declines well before anything looked remotely good in the economy.  Sadly, we’ve seen far too many investors come our way that found that out the hard way, never having gotten back on course.

Section 2 -The Second Question “How”

Sadly, but truthfully, there is no holy grail of an answer.  I have found several great authors helpful who can do much more than I can to soothe nerves and will post links below to some of their excellent stuff. The common denominator among helpful content for making better investment decisions and successfully reducing the odds of a future regret comes down to how we are thinking.   That’s another reason for including the links below – if often boils down to finding the right voice with the right message to sink in.  The reason we (the investment advice business) are never able to stop attempting to tackle this investment decision beast is because of the stunning result of the chart below of actual investor returns vs. various assets.

Far too often, following our primitive instincts compels us to jump ship as things look bad and go to cash only to miss a rebound (and then only getting back in to chase what have been good returns).  The chart below from JP Morgan is one of my all-time favorites and demonstrates this notion in action.  By aggregating the publicly available flows of assets among various fund types, a composite of the “average investor” and his/her real life results can be calculated.   I have seen this chart updated several times over the years, and it never seems to materially change; despite all the assets readily available for investors to acquire and ride to solid returns, the “average investor” has only barely been able to outpace cash!

Sure, you’ll find investors here and there who stayed the course and generated the 7.5% from the S&P 500 or the 6.4% from a balanced 60/40 portfolio.  However, the “average investor” composite is just that – the average net result which simply contains a large number of investors who jumped to cash at the wrong time and overwhelms the number of those that stayed the course. One famous example of a specific fund puts a bright spotlight shine to this phenomenon. Peter Lynch rang up a spectacular 29% compound annual return for the Fidelity Magellan Fund during his long stretch of running it. Yet, the average investor who bought into his fund LOST money!  See, you had to be there in the beginning, middle and end to earn that 29% average return. But again, too many simply shoveled their portfolios into the fund following its good years only to bail when it was down. These are the exact forces we must combat in order to succeed

Section 3 – Five Steps to help stay the course

Step 1:   Accept mediocrity

I know, that sounds more like a sensible goal for my Indiana Hoosiers football team.  But how we stay the course effectively starts on the up or later parts of a cycle, not at the usual point of desperation when we start asking ourselves if it’s time to flee.  The easiest path to earning those compound generating returns that place you in the middle/middle left on the asset class return chart as opposed to being near the average investor on the right is the acceptance of mediocrity.  When things look rosy, the temptation is to get comfortable with the juicy returns being created and bail on the underperforming parts of the portfolio to load up on the leading horses. And, to an extent you do want to ride those winners. But if you are concentrated in the portfolio enough to be at the top of the charts, you are concentrated enough to reverse too quickly and take too much heat on the way down.  It’s the degree of that pain that becomes the emotional source of trouble.

It may be too late to be thinking about step 1 at this point, but don’t let that stop you from starting where you are and moving on to (the potentially offensive!) step 2.

Step two: Stay skeptical of news sources (even if they make you feel better)

Stay off the cable news and be careful with information sourced from web. For the record though, this is not a liberal or a conservative point – the advice is the same for both sides of the aisle. As a practitioner, I have observed (especially lately) that questions from clients that were clearly provoked from cable news channels have gotten noticeably more dangerous over time. Yes, its natural and healthy to want to be informed.  Our desire to be at least periodically surrounded by those that think like us is soothing.  But that soothing comes with a cost of getting hooked into some fairly difficult to change positions.  That hook, again, is easiest landed through the fear. 

The internet can even be more dangerous.  None of us are immune.  I recently saw a financial industry name I hadn’t heard of in years, so I did a quick search to find out what he’s been up to and where he is currently writing.  Mistake! Ever since, I have been bombarded with outlandish ads from this author proclaiming some pretty far-fetched theories.  These are great for generating clicks, but horrible for any help at probability estimation (for my fellow math nerds, these are “tail risks” being presented as “highly probable”). 

I’ll throw out what I have found most helpful over time in cultivating news sources.  Sadly, I haven’t yet tracked down a good television source (so please tell me if you have a good one that I have missed). But I do find it easier to ground myself by reading news sources in a published collection (ahhh… an old school newspaper format) helps to avoid getting links thrown at me that was established by what was last read.  WSJ has a great reader.  Bloomberg preset 5 things you should know is also a good one.  One of those leans right, one leans left – which helps to balance out the political bias and noise.

Step 3: Look out, not down. 

I liken this to the same advice we might be given if high up in the air or are carsick where both cases call for looking out to the horizon.

Serious drawdowns are a part of the game of investing in risk assets.  Intellectually, you know that.  You may even remember that your financial plan was built with these sorts of drawdowns in mind.  A good advisor, or by your own stress testing, ran scenarios that included these types of environments. Emotionally, it’s a different story to see the losses in real time. I find another of my favorite go-to charts from JP Morgan to be a huge help.  They present the range of annual returns going back to 1950 for 3 different portfolio types: 100% invested in stocks (green), 100% invested in bonds (blue) and a 50/50 split (grey).

What we see is that short periods of time are going to expose us to severe declines. Partly why this year has been so stressful is that stocks and bonds have simultaneously had down years, giving that 15% low water mark a run for its money.  That’s where we need to zoom out.  And you don’ have to go out 20 years to make yourself feel better.  If you simply go out and look at the range of outcomes of all 5 year rolling periods, you’ll find that a 50/50 portfolio has not had a losing 5-year period in the modern era! That doesn’t mean it won’t happen going forward.  But there have been some pretty nasty periods during that time (The high inflation of the 1970s, the deep recessions of the early 80’s to end that era, the dot com bust, the Great Recession, the Covid crash, and more).

Step 4: Allow yourself to entertain the thought of the worst-case scenario. 

The fiercest challenge to historical stats of say the past 70 years (like the one above) is that they don’t include the Great Depression.  For some reason, I have been asked many times lately something along the lines of “Yeah, but what if this is another Great Depression?”  To that, I say fair question and exactly what step 4 calls for.  More commonly, the recommendation might be to consider how different this era is and how unlikely a repeat of a Great Depression is.  Yet, I say, let’s consider it.  But…. let’s do so by taking a good long hard look at the data.  We can have great appreciation for the harsh living standards many endured for the better part of a decade, but we want to objectively pivot from anecdotes and economic data to the realities confronted by investors.

THE stat that makes this the mother of all stock market comparisons is the Dow, after suffering an 89.2% drop, did not recover its 1929 peak until 1954! That’s what scares us….to consider the possibility that a 65-year-old with a $1,000,000 investment in a bucket of large cap stocks following that parallel beginning at the end of 2021 could conceivably see that investment temporarily drop below $100,000 before recovering that prior $1,000,000 level in 2046!!

That is terrifying, there is no way around it, and it is worthy to consider. But let’s dig deeper.

The first thing to consider is that until recent era, stocks were an income investment. The recent era has been dominated with price appreciation.  Prior to that period, returns were significantly more reliant on dividend income.  Take that hypothetical $1M portfolio above.  During that ’29 – ’54 period, it would have produced an average annual income of $37,500.   Only so much can be done to ease the sting from an 89% price drop, but an income of that magnitude is nothing to scoff at. You can see the impact that would in comparison to a pure price return if dividends are to be reinvested.

The second thing to consider is even more important.  Thus far, we’ve only been talking about stocks.  Especially for someone at or near a point of distribution, you’re going to be looking at a more balanced portfolio with a healthy dose of bonds to balance the risk.  The result isn’t that a painful decline is avoided as an approximate 50% wipeout was still in the cards.  The ~ 6-year recovery period though is distinctly less painful than the 25-year period it appears at first glance. In fact, as it turns out – even in the great depression that 5-year balanced portfolio return range holds!  Refer back to that JP Morgan chart from step 4 and recall that the range of returns for a 50/50 balanced portfolio experienced positive returns through all periods of the modern era.  Even though there is no assurance this holds going forward it somehow retrofits the great depression era.  

Last consideration is that we always preach that it is the real return that matters.  The real return is what your nest egg is worth after figuring the effects of inflation.  Whilst inflation is a main source of angst today, deflation was the great consternation of the 30s.  (Thus, why bonds were a strong diversifier).   As painful as the era was, a silver lining was the falling price levels to boost purchasing power of portfolios.

To be clear, I am not arguing the great depression resembled anything rosy.  For a 60/40 portfolio saw over 1/3 of its purchasing power wiped out.  Additionally, I wish to reiterate that the economic and human toil is not to be diminished. However, in this view with a balanced portfolio, it was just a few years later in 1933 that completed a full recovery when factoring in deflation.   I simply wish to objectively review that period from an investment standpoint and see a similar result.  Fear of a Great Depression repeat is unequivocally not a reason to jump ship.

Step 5: Avoid expensive and unnecessary products

Each time we see a decline of any significant magnitude, sales for high-cost variable annuities or equity indexed annuities skyrocket.  That’s because we, as humans, are shown that the fear of and pain stemming from declines is so severe that we will do just about anything to avoid it.  That leads us to products with insurance.  This phenomenon causes us to continually and appreciably overpay for the insurance embedded in products.  These products can be made to sound appealing, especially during a downturn.  But you have to consider the fact that all of us investors are picking from the same orchard.  You, me, the insurance companies.  They are investing your money in the same pool of assets, so it’s not as if they are able to produce a more bountiful or more efficient harvest.  It’s simply they can make the apples look shiny enough to make it look too good to ignore. I wrote extensively about annuities a while back, to read more click here.

Conclusion

As stated above, surviving rough patches is all about having the right mindset which often is all about connecting with a person that has the right words for you at the right time.  This post was a heavy commitment. I personally benefited, especially doing the research on the Great Depression.  But if this string of approximately 3,000 words landed with just one person and added just a little bit to their frame of mind for this cycle, then mission accomplished.

This piece started with the great closer and his success based on simplicity.  This was a lot of words, but really full of simple stuff.  Extremely difficult, but simple in nature.  Just as the great Mariana Rivera preaches. Enter Sandman:

“And never mind that noise you heard
It’s just the beast under your bed
In your closet, in your head”

You can look for the next piece in this series soon which will turn from when and how towards what we should be considering heavier doses of for the portfolio.

Links to better writers on the topic (as promised from above)

Barry Ritholtz: The Uncertainty Monster – The Big Picture (ritholtz.com)

Morgan Housel: Staying Put · Collaborative Fund

Blair Duquesnay: Don’t Panic Sell – The Belle Curve (blairbellecurve.com)

Thanks again to my friend Ryan Reid for encouraging me to continue/resume writing.  Plus, I figured with my kids going back to school, I suppose I can head that direction as well (though this was far from a “take it easy” summer – just for the record).  The purpose of this blog was never to build a brand or a large following of any sort (social media or elsewhere).  Rather, it was all about forcing posts to sharpen thinking on various topics through writing about them and sharing publicly that perspective with those who may be interested in Financial Enhancement Group.  To that end, its time to commit to a series of posts over the next series of weeks.  These are the planned topics you can expect to hit your inbox:

• When and how to stay the course during terrifying declines?
• What asset classes warrant our sharpest attention?
• Is the great bull market in bonds dead for real this time?

The first topic is of course timely and has been the center of many discussions thus far in 2022.  After having experienced a few weeks of calm and market rebound, it’s a great time and worth the effort to re-cast many parts of these conversations about when and how to stay the course.  Perhaps the stock market is simply in the eye of a financial hurricane and awaiting a devastating second blow.  Whether it is or not, being mentally prepared as best possible for those devastating second blows are what often determines the difference between a successful financial journey and one laden with devastation. No one has a perfect solution or approach but stay tuned for my thoughts on how to mentally prepare for round 2.

Cannabis stocks have been absolutely smoked over the past year (Sorry – pun intended).  A main reason behind the collapse is that growth stocks in general – stocks heavily reliant on an abundance of future earnings – have been broadly sold off since last fall.  Such growth stocks include tech, payments, crypto and “meme” stocks, among others.  After a very long and very successful stretch of eye-popping gains, the bottom fell out as interest rates began to rise (with more interest on the near-term horizon, a pig in a poke becomes much less appealing). The other reason for the collapse in cannabis stocks is political.  After receiving a huge bid after the 2020 elections where democrats won power in Washington; most investors, especially those bullish on cannabis stocks, would have expected more legislative progress in 2021.  Even if not full federal legalization, at least some work on the safe banking front was fully baked in (sorry – one last pun, I promise). I wrote about weed stocks back in 2017 about the hopes of finding the first “Green Chip” and thought this would be a good time to at least revisit the sector.

By early 2017, the number of states legalizing began to swell and crossed the halfway point in terms of number of US states laying the potential for an exciting new frontier for investing.   The 2017 article was setting the stage that investor interest should continue to grow, but the public companies involved at the time in the industry were unproven, unprofitable, and capital starved speculative opportunities.  The industry was set to inevitably grow but making money as a stock investor was likely to be far from anything easy. 

Fast forward a few years and we’ve seen a couple of boom-and-bust phases – with a lot of the early stocks folding or being picked up for pennies on the dollar.  One of the first exchange traded funds to invest in the sector soared nearly 100% over the next 18 months as investor interest reached a crescendo in late 2018.   The ensuing bear to the public companies at the time was brutal and eventually was trading at 80% losses at covid crash bottoms.  Since then, we’ve seen an enormous boom, with several hundred percent gains, followed by yet another brutal near 80% collapse.

That’s not all that’s changed, however.  The industry has grown up and recently seen a host of companies move from negative to positive cash flow.  This can be a pivotal time as companies reach scale and can begin to self-fund some growth opportunities while achieving the scale necessary to become further profitable.  Not every company in the Cannabis sector is going to fit this bill, but if you are willing to do your work, you’ll find some very well managed companies that have positioned themselves to do quite well as legal cannabis use continues to grow rapidly.  Further, US multi state operators (see MSOS as an ETF with many such companies), carry a potential call option (a stake in a step function higher) for when legislation at the federal and state levels continues to progress.  (Disclaimer: FEG has long positions in the shares of ETFS for MSOS and MJUS).

Consider this simply a public service announcement, but not a specific recommendation for a stock or fund because I may not know you or your overall portfolio and objectives.  The 2017 PSA was all about reinforcement that the industry warranted increasing levels of investor interest, but caution and prudence was warranted for the then current shares in public companies.  Today…. well…. I’m always cautious and advise prudence.  But today, I see a sector full of companies that are no longer the speculative lottery tickets as described stocks just a few years ago. It doesn’t look pretty out there on the heels of such losses, but this is to be expected for an infant industry going through the boom-and-bust part of their life cycle.  With no clue as to whether we are near the end of this bear market for the sector, many of these recently profitable companies merit roles with the right dosage in the right portfolios.

We typically think of interest rates at their surface level or simply as the rate posted on a CD or treasury bond.   Economists and professional investors will typically refer to these as nominal rates.  But real interest rates, or the nominal interest rate after inflation is subtracted, are what really matter.  Because the inflation rate whips around from month to month, looking at real rates in this manner, while useful and necessary, can be too volatile for a real time insight into how the market is pricing real interest rates.

Rather than deriving real rates as described in the opening paragraph, we have a convenient and effective tool for measuring the market priced real rate at any time.  All we need to do is simply look at the yield on Treasury Inflation Protected Securities (TIPS).  Because these bonds adjust for inflation, the yield on these bonds reflect the prevailing real rate in the market. For all the talk in the second half of 2021 of the Fed raising rates (of which they are now very clearly set on doing multiple times this year), markets entered 2022 with real interest rates stubbornly in negative territory. They did attempt a return to positive territory early in 2021 when the economy appeared to be on a straight line back to “normal” but returned to and remained much closer to -1% than they did 0 for the remainder of the year.

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The interpretation and implications of this phenomenon warrants emphasis.  The implications are that investors who were purchasing these bonds were accepting a locked in (assuming they don’t later sell) real return of ~-1% per annum on their investment.  In other words, $10,000 invested at those recent rates would have a purchasing power of ~$9,000 …..10 years from now!

2022 has started with a bang, bringing the sharpest weekly change since March of 2020 (which was recouping the apocalyptic drop at the very beginning of the pandemic).

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This change is so important – not only because of what may be a turning point in rates, but what it has spurred in market reactions. Market participants have clearly been underappreciating what a return to anything like normal real rates looks like.  One aspect of this underappreciation is the possibility that stocks, and bonds move more closely in the months or years ahead than they have for much of the past few decades.  Correlating more closely (having their below average weeks or months at the same time) has the potential for increased risk at the same time return outlooks are diminished.

That doesn’t mean this trend has to continue but its possibility warrants the utmost respect.  As such, portfolio construction needs to be made with this in mind. Inflation rates have now surpassed levels for long enough to have the Fed’s full attention.  Their recent meeting notes make that much clear. Whether it’s due to temporarily reduced supply capabilities or rapidly expanded money supply doesn’t really matter.  A major side effect of this shift in policy is a strong possibility that real rates find their way back to positive territory.  This, as it should be, is the Oz behind the curtain for the time being.