Brian Perry, CFP®, CFA®, Chief Investment Officer at Pure Financial Advisors, provides a forecast of what the financial markets might hold in 2022. What could be next for the economy? What investment opportunities are available to you during volatile times? Are there financial moves to consider making now? Find out in this webinar. An open question and answer session follows the presentation. Click to view the slides.
– What’s the outlook for the Federal Reserve?
– How do I protect against inflation? Inflation at 40-year highs – Is gold a good inflation hedge? What about Bitcoin?
– What happens to bonds when rates go up?
– What about stocks?
– Should I buy stocks right now?
– Have all stocks done well? NASDAQ, emerging markets
– What’s next in 2022? Another election, geopolitical turmoil, tax changes
Andi: This is our 2022 market outlook webinar. With recent market utility, we’ve actually decided to bring in Brian Perry, CPF®, CFA®. He is the Chief Investment Officer here at Pure Financial Advisors. Now, as I understand it, you’ve had recent back surgery?
Brian: I did. It was a couple of weeks ago. This is actually my first day back in the office. I’ve picked away at home a little bit. This is my first day back. For those of you that have been paying attention, the market’s been a little bit rough. You may see me squirming a little bit on my seat. You may even see me grimace from time to time. It’s got nothing to do with the price of my bitcoin portfolio or anything like that.
Andi: Wait a minute. You have a bitcoin portfolio?
Brian: I do not. I was trying to sympathize with those that do. Stocks are down. Bitcoin is down some more. It’s nothing to do with the market but I may shift and squirm a little bit. We’re here to focus on the volatility in the markets. I thought this would be a good opportunity, as we look ahead to the year, there’s a lot going on. Full disclosure, I don’t have a crystal ball, but I’ve been doing this a while. I think I’ve got a couple of insights, a couple of opinions and I’d like to share them with everybody. What’s the outlook for the Federal Reserve? That’s really the name of the game right now is the Fed and what’s going to happen there. The Fed actually just met, probably an hour ago or so. It came out of their meeting and announced no changes necessarily, but in their messaging announced that they will increase interest rates in all likelihood at the March meeting and begin scaling back their portfolio of securities as well. The answer is why? If we just flip to the next slide, I think we can see why. It’s that inflation is at 40 year highs. We’ve got astronomically high inflation by recent standards. For those that were around in the 1970s and 80s, you might remember the double digit inflation that we had back then during the Carter years. Since then, we’ve had really pretty low inflation. The 100 year average is about 3.7%. The 50 year average is about 3.7%. For the last couple of decades, we’ve been running sub 3 for the most part, a couple of pokes above 4, but mostly sub 3. Indeed, in the last 10 or 12 years, mostly below 1, 2.5% or so. The Fed targets 2% over time. What we’ve seen is this spike up to 7% or whatever number we’re at right now in the consumer price index. All last year prices were going up and up. The Federal Reserve kept saying it’s transitory. That was their word, transitory, meaning that this was just because of COVID. As soon as COVID went away, a lot of the impacts from that were going to dissipate and inflation was going to come back down. I think this is my opinion, but shame on the Fed. I don’t want to presume to know more of them. I’ll back seat drive for them anyway and say, I’m not sure what they saw that made them think inflation was transitory. Maybe it’ll come down over time, but I think they’re pretty far behind the curve to have record setting inflation, highest in 40 years, and we’ve got interest rates at 0%. Sounds like they’re finally coming around to that and taking some action. Frankly, it’s about time there. This is not the first time the Fed has raised interest rates. It’s also probably not the first time they’ve been behind the curve, either.
Let’s look at the next slide here and some of the past cycles that we’ve had. This is just a summary of over the last several decades, some interest rate cycles that the Fed has done. The left hand column is basically all the cycles both rate increases and rate decreases. The right hand column is just the rate increases. You can see that since the mid 90s, there have been five other periods where the Fed set out to begin raising interest rates anywhere from 1994, where they raised them 3% and then you can see some of the others. 1994, for those that remember, is a key difference. What the Fed did then was there was a lot less transparency. I would argue and maybe a topic for another day, that the Fed’s actually too transparent now and that harms monetary policy. Back then, they weren’t telling anybody anything. They would just come out and do it. All of a sudden you went from interest rates set by the Fed at 3% and they blew them up to 6% in about less than a year. What happened was that markets were caught completely by surprise and interest rates skyrocketed, the markets dislocated and stuff. Since then, the Fed has begun to communicate their intentions a lot more. If you look at subsequent interest rate cycles, the Fed tends to tell you what’s going to happen, what they’re planning. Right now, what they’ve told us is that in all likelihood, they’ll begin raising interest rates in March at a quarter point clip and do 3 more increases across the course of this year. A lot of market professionals are saying 4 increases. I would tend to say, 3 would be a minimum, 4 or even more would be likely just given where the economy is. Unless something changes drastically, we are in for higher interest rates going forward at the short end. The Fed only controls the short term overnight lending rate. Markets determine those longer term interest rates.
Let’s talk a little about the next slide on our next question here. The reason the Fed is raising interest rates, like I said, is inflation. The question is “How do you protect against inflation?” The answer, and it’s boring and dull, but it’s a diversified portfolio. We get questions. Hey, should I buy gold as an inflation hedge? I don’t know, but if you look at this chart. The last year I just mentioned, we’ve seen the highest inflation in the past 4 decades. Some of you out there may not have even been alive the last time inflation was this high and yet gold is flat. If you look at the chart, over the last 12 months gold is exactly flat. I’m not sure that if I’m buying something as an inflation hedge, I get the highest inflation in 40 years and it goes nowhere that that makes a great inflation hedge.
Some people say, Hey, should I buy bitcoin as an inflation hedge? If we look at bitcoin on the next slide for the last six months, bitcoin is flat at the same time that we’ve had super high inflation. Again, I don’t know. I’m not saying that gold is good or bad or that bitcoin is good or bad. As inflation hedges, you would think that if you get high inflation, that inflation hedges would do well. We’re actually not seeing that. We’re seeing these prices move independently of inflation, which I think diminishes their value as inflation hedges.
If we shift to traditional bonds, we can say, What about bonds? What happens to bonds if rates go up? Let’s take a look at where interest rates have been. They’ve essentially been stuck in a range; the top is about 10 years ago, the bottom is the low for this cycle back in August of 2020, and then the middle is the end of last year. Interest rates are a little bit higher than that blue line. Broadly speaking, that’s where we are. You can see that the short interest rates there have stayed pretty low throughout this period. It’s the longer term interest rates the market set interest rates that have fluctuated. You can see that back in 2013, you had the 10 year Treasury at 3% and the 30 year Treasury at roughly almost 4%. You can see that back in 2020. You had the 10 year Treasury at 0.05% record low level. Even to go out 30 years, you only got a little bit over 1%. You can see that now we’re in the middle. This again at the end of the year, at 1.5 on the 10 year Treasury. Now we’re at more like 1.8. We’ve come up, but we’re right in the middle of the range. I don’t necessarily know if interest rates need to go outside of this range. We’ve been between, again, that top line and that bottom line. I do think that the bottom line is artificially low based on a global pandemic and also extraordinary monetary action. I think that migrating towards the top end of that range is probably a more likely path for interest rates over the rest of this year. Even if we move towards the higher end of that range, we’re still in a relatively low interest rate environment.
We always get the question of how do I find yield? How can I get income from my bonds in this environment? We can ignore for the moment the top part of the chart and just focus on the bottom part, which looks at different asset classes in the kind of yields they provide. These are yields as of the end of the year. Some of these are a little bit higher now. You can see as you shift to the left hand side of that chart; Emerging market bonds, U.S. dollar denominated 5.3%, preferred securities 4.5%, and high yield bonds 4.2%. Again, they’re a little bit higher now. The point is, look at how much higher those are than a lot of other asset classes. What we’ve been recommending to some of the folks that we work with that can take a little bit more of an aggressive stance on their fixed income portfolio is maybe it makes sense to sprinkle in a little bit of these emerging market bonds, these high yields, these preferred. It’s a way to pick up the income of your bond portfolio a bit. Now, full caveat: It’s really important to know those asset classes are much, much more volatile than your traditional short term, high quality bonds.
If you’re going to buy these more high yielding type bonds, you’re also taking on more risk. If you have at the top of the risk spectrum stocks and at the bottom bonds, these more aggressive fixed income instruments sit in the middle. If you get a stock market sell off or risky assets sell off, you will see these assets decline in value. They do provide more yield. We don’t suggest that you go in and switch all your bonds to them unless, if you’re 35 years old saving for retirement, maybe that makes sense. For many of you, it’s sprinkling these in like spices on your food just to pick up your yield a little bit.
I also want to touch on what historically has happened to bonds when the Fed raises interest rates. The past is never a perfect prologue. Like George Santa Anna said history doesn’t repeat, but it rhymes. No guarantee this is going to happen. If you look at 1994, you look at 1999 to 2000, 2004 to 2007 and then 2015 to 2019, those are 4 periods during which the Federal Reserve was raising interest rates. You can see the first period was 3%, then 1.75, 4.25, 2.25. A variety of regimes in which the Fed raised interest rates. Those bars are the performance of different fixed income asset classes over that time. Whether the light blue is investment grade U.S. fixed income. The yellow is global bonds, the dark blue is more aggressive U.S. bonds, and then the green is a mix of everything. You can see those are annualized returns, and even when the Fed raised interest rates, these things did pretty good. I think that’s one of the key takeaways that you want to have from this presentation. People think that when the Fed raises interest rates, bonds automatically get killed. If the Fed surprises the market, bonds will fall in value. As the Fed is raising interest rates, it’s possible that the value of bonds may temporarily decline. Across the cycle, bonds tend to go up in value when the Fed is tightening monetary policy, raising interest rates. Why is that? There’s two reasons. One is that a big portion of the value of bonds is generated by the income they give you. You want income from bonds. What the Fed is raising interest rates. If interest rates are going higher, you’re getting a pay raise, you’re getting more income. So that’s a good thing. The second is that if I lend you money for 30 years, there’s 2 risks. One is that if you don’t pay me back? The other is that you pay me back with dollars that are worth less. That’s inflation. Inflation is the bond market’s boogeyman. It’s their biggest risk. Why does the Fed raise interest rates? They raise interest rates to lower inflation. It’s a mindset shift because when the Fed raises interest rates, all else being equal, it’s better for a bond holder than if they didn’t. All else being equal, future inflation is going to be lower. That’s good for bond holders.
Let’s switch to the next question. Stocks. What about stocks? Look at the next slide and see what about stocks? Let’s talk first about long term stock returns. This looks back over the course of several decades or more, actually quite a long period of time at stocks and says, OK, what are the ten year average returns? When you look at this, you can see peaks and troughs, and all the numbers aren’t important. What you notice is that basically when returns are very high, you’re robbing Peter to pay Paul. If you look at each of those peaks, that represents a time when investors and stocks have done really, really well over a period of 10 years. Over time, stocks averaged 9 or 10%, sometimes higher, sometimes lower. If you get in a period where you get much higher than average returns that means stocks are relatively expensive and subsequent years present lower returns. Then the same thing if you get in an environment where stocks have had very low returns over a period of years, that usually sets the table for higher returns going forward. Looks like bad news. Returns have been pretty good on this chart for stocks in the last decade. Most of you probably know that. There’s a couple of things. One, does that spell doom for stocks? The answer is probably not. Sometimes stocks go sideways or continue to produce high returns. I think you still need to be invested in stocks. The question then becomes what kind of stocks. We can talk a little more about the different kinds of stocks that are out there and what the outlook for the stock market might be.
Before we get to that, though, I think it makes sense to talk about why returns have been so good in the last decade or so. Across the bottom there, in the light gray, that’s the Federal Reserve’s assets. That’s the liquidity they’ve been pumping into the market by buying securities. It was pretty consistent, pretty flat until the aftermath of the financial crisis. We jumped up in 2009 and then continued at very high levels throughout the subsequent decade. With the COVID crisis, we jumped again. Huge injection of liquidity by the Federal Reserve. The blue line is commodities. The Fed has had very little impact on commodities. Then you look at the purple line.The purple line is bonds. The Fed hasn’t had much of an impact on bonds. Look at the red line, that’s the S&P 500. Look at what the S&P 500 has done in the last 25 years and look at how the returns took off at the same time that the Fed started injecting liquidity. If you want to know what the Fed has been doing in the last 15 years, they’ve been juicing stocks. They started buying assets that depressed interest rates across the board that forced people out across the risk spectrum to buy stocks. The Federal Reserve has become the world’s greatest stock proponent. It’s almost like a pumping mechanism. You can see that the Fed has had a big impact. That gives you a little bit of pause for stocks going forward if the Fed is going to be less accommodative. It’s important to keep in mind that although the Fed is going to be tightening monetary policy, in a relative sense, in an absolute sense. They’re not going to a tight monetary policy, they are just incrementally tighter.
Let’s look at the next.
Andi: Actually, Brian, I wanted to mention that if people have questions, they can ask those just by typing them into the chat. And Beatrice has already done so this morning. First of all, she wanted to ask if you would please slow down so she can keep a little better track.
Brian: I see what you’re saying, I’m going to talk fast. You’re right. I’m hyped up. Beatrice, I apologize if I’ve been talking very quickly and I will slow down. You do need to remember that I’ve spent the last two weeks cooped up in my house with only my wife and my dog to talk to and my kids, but they’re not around. I’ve been convalescing and I have a lot of words in me that have been waiting to come out for the last two weeks. I’m in a rush to get them out, but I will work on slowing down. I apologize.
Andi: In the meantime, Beatrice also wanted to know what classification of stocks or funds would you recommend for retired people?
Brian: That’s a pretty broad question. We’ll get here in a couple of minutes to maybe what looks a little bit more relatively attractive right now. If you’re asking for retired people, I think the answer is a lot of them. I don’t think in general, it makes sense to concentrate just on one kind of stock. If you do that, you’re explicitly saying, I think this kind of stock is going to do better than all else. What we recommend is a pretty broad diversification across big and small U.S. and international growth and value for almost everybody, including retired people. We’ll talk a little bit more about some of the reasons why and what looks relatively attractive here in a couple of minutes.
Andi: We have a couple more questions. Would you like to take those now or do you want to continue?
Brian: Fire away.
Andi: All right, let’s see. Rodney says “Volatility should be a lower concern for the buy and hold bond strategy even in the high, higher risk bond categories?”
Brian: If I understand the question correctly, there’s really two kinds of risk when you invest in anything, whether that’s higher risk bonds, whether it’s stocks, or whatever it is. The first is the risk that you’re going to lose money across a long period of time. One of the reasons people make money in housing is because they don’t look at the price everyday. Sometimes it’s worth more today than it was yesterday. Sometimes maybe it’s worth less. Historically, over time, the price has gone up and people bought it in 1990. They’re selling it in 2020 and it went up a bunch. That’s true with most stocks. There are broad baskets of stocks as well, or investments of any kind. The problem is that along the way, the price bounces up and down, and unlike houses, you can see the value of your investments every day. My view is that you should worry a lot less about volatility than you do about what the value is going to be in the future. You don’t want to be on a pogo stick. If you get on a plane to go from California to New York, your primary concern is actually getting where you’re going. The turbulence along the way is a little bit less important than whether or not you get diverted to Florida instead of New York. Volatility is important to keep an eye on, it shouldn’t be excessive, but it shouldn’t be the primary driver either. This is key, provided you can stomach it. If the portfolio is so volatile that you’re panicking and selling out and not getting to that point where you’ve actually made money, then that’s a problem. You need to find a mix that you can live with and close your eyes at night and go to sleep.
Andi: The next question comes from Russell, “the Fed is subject to these projected higher rates when repaying national debt. Won’t they be inclined to keep rates low? How does this impact inflation? And what is the likelihood the Fed will invert the rate curve if the rate increases 4 or more times?”
Brian: There’s a few questions in there. If interest rates go up, the cost of paying back the rather large national deficit does go up. Theoretically, the Fed’s an independent political body that makes decisions just based on what’s best for the economy. Over the last 15 years, and certainly increasingly in the last several years, the Fed’s become subject to increasing political pressure. More kind of weighing in from Congress and other politicians and even the public. Where 20 years ago, nobody had ever heard of the Fed that wasn’t in this business, and now everybody knows about it. All of that argues for across time; the Fed being more hesitant to raise rates, the Fed being slower to raise rates, and for higher inflation. I’ve been saying that for several years, and I think inflation will run a little bit higher in the future than it has in the past. Partly because the Fed isn’t going to be as willing to raise interest rates as much. What we do is when we run financial plans for people, like I said, the last decade, inflation’s been more like 2%, we actually run inflation at 3.7% in order to put in a little bit of conservatism on their side. If inflation runs a little bit higher than it has been, they’re still OK in their plan and you can do things like that in your own financial planning.
What was the second part of that question?
Andi: The second part is “what is the likelihood the Fed will invert the rate curve if the rates increase 4 or more times?”
Brian: Inverted yield curve usually short term rates are lower than long term rates because you want to be compensated for lending out long. When the Fed raises interest rates what happens is if they’re doing that to slow the economy and the market thinks the economy will slow, sometimes the short rate actually goes above the long rate, which is called a yield curve inversion. Sometimes it is an indicator of a recession. Not always, but sometimes. My guess is if they raise interest rates 4 times, they will not invert the yield curve because that would put the short term rates at about 1%. I don’t see long term rates coming down that low unless COVID absolutely surges and we all have to go back home and the economy just craters. I think long term rates, if anything, will continue to hold steady or even go up a little bit and you might actually see a steeper yield curve as opposed to an inverted yield curve. That’s speculation on my part, but that would be my best guess.
Andi: Sharon would like to know “why are the markets so volatile right now?”
Brian: Good question, Sharon. There’s two reasons. I’ll give you the answer nobody ever wants to hear first, and then I’ll tell you what the story is. The reason is because sometimes markets go up and sometimes markets go down. It’s just the nature of things that sometimes there are more buyers and sellers. Sometimes people are worried about stuff, and then it begins to feed on itself. As market participants or as market professionals, we need to craft a story to it or a proximate cause. I think there are a couple of proximate causes right now. One is some of the tensions over the Ukraine and whether or not Russia will invade. One is just uncertainty around COVID and the omicron variant and what that means and stuff like that. But the biggest one is the Federal Reserve and interest rates. A lot of times what happens is that as the Fed moves closer to tightening monetary policy, you see volatility. One of one of the downsides I said is that it’s good that the Fed telegraphs what they’re going to do. It doesn’t surprise markets. One of the downsides is that once they start telegraphing, the market almost starts to price in those rate increases. It kind of moves that forward and leads to some volatility. I said this last year, I think in the year end wrap up, I think 2022 will be more volatile. 2021 was an unusually calm year for financial markets. I think 2022, I’m not saying it’s going to be a bad year. I could certainly see reasonable returns in markets, but I just think it’s going to be a bumpy ride.
It’s going to be again important for people to find a mix they can live with and sleep with even through the ups and downs. But I think the outcome will be OK. I do think we’ll see more volatility as the Fed begins raising interest rates as markets begin to more closely track inflation and what’s happening there. What’s the latest inflation print? As COVID continues to evolve, geopolitics, I think there’s a number of things that could cause markets to be volatile. Not to mention the fact that by a lot of measures, some parts of the stock market are somewhat expensive, which enhances volatility, too.
Andi: We’ve definitely started the question asking. We’ve got a lot of questions here. Sam says “what frequency of evaluation of volatility should one look at in determining how aggressive you want to be for long term investment in stocks, but also bonds?
Brian: It starts with really, I would almost flip that question on its head, and say that it starts with what return do you need to meet your goal? It gets back to my travel analogy where if you’re going on vacation, the most important part is not the traffic delays or the setbacks, it’s whether or not you actually get to your vacation destination. What’s your financial goal and what return do you need? What’s going to happen is that there’s going to be a combination of portfolios. It fits on what’s known as the efficient frontier once you run a capital assets pricing model. What that is is different mixes of stocks and bonds or cash or real estate or whatever that would theoretically get you. Let’s say you run your projections, then you decide you need 7% from your portfolio over the next 20 years to meet your goal. Well, a 100% stock portfolio will probably get you 7%. A 90% stock portfolio will probably get you 7%, a 50% stock portfolio, probably if history is any indicator, won’t get you 7%. There’s portfolios you need to exclude because they won’t get you where you want to go. Then there’s a bunch of portfolios that will. Then you start looking at how important it is to you to sleep at night because usually you want the least amount of risk possible. Maybe that 70% percent in stocks instead of 90 because it’s a little bit less risky. Maybe you’re like, Hey, I’m okay taking a little more volatility because I want to leave more money to my kids. Once I’ve taken care of myself so then maybe you get a little bit more aggressive. It starts with the required rate of return. Then, in general, it’s the least amount of risk possible and the most kind of sleep a night money, the most safe money possible. Individual considerations could shift that a little bit.
Andi: I’ve got two more questions for you before we get back into the slides. Following on from that, Stephen says, “Is it prudent then to ask my financial advisor to buy on the dips with new money in this environment?”
Brian: I would say yes. Stephen not knowing your exact situation, I hate to caveat it, but it depends a little bit on your time frame and this and that. In general, dollar cost averaging is a really good investment strategy for people that are accumulating. That’s one of the reasons 401(k)s are pretty powerful. Where you have money going in every paycheck you’re buying when prices are high, but you’re buying more shares when prices are down and over time, that tends to work out. I’m not calling a bottom here. I wouldn’t be surprised to continue to see volatility, at least in some of the large cap U.S. companies. If you have a longer time horizon buying a little bit. That’s what I usually do. I’ll buy a little bit every time the market falls, you know, 5 or 10%. If I have any cash, I’ll put in a little bit, I won’t commit all of it, but I’ll commit some of it at a time.
Andi: One more question before we get back to the slides, James says “if interest rates keep moving up, what will happen with housing? Will we have another crash like in 2008 and 2009?”
Brian: That’s a great question, and one we get a lot. This is my opinion. Rising interest rates are a problem for the housing market. It leads to higher mortgage payments, but it’s also happening at a time where you have exceptionally high house prices. I think there’s a little bit of a conundrum where affordability becomes an issue. If there was a $500,000 house, 3 years ago, that is now $750,000. That may still marginally be affordable if interest rates are really low. If mortgage rates go to 4 or 5% all of a sudden, can people afford that house price? I could see housing softening a little bit. Maybe it stops going up as quickly as it has. Maybe it kind of moderates or even steps back a bit. I don’t necessarily know if we’ll see a housing crash, at least Broad-Based. The reason I would say that is just supply and demand. One thing that you saw in 2007, 2008 was rampant overbuilding and a ton of supply. Right now, we don’t have a lot of building going on. The supply of homes on the market is at all time lows, and there’s a lot of demand from household formation among millennials and stuff like that. There is a little bit more of a floor under housing than there was in 2008. There’s also a lot less crazy mortgage products, no interest down ninja loans and stuff like that are a lot less common now. I could see housing softening. In fact, I’d probably call for housing to moderate at best and soft and at worst, but I don’t see a collapse like 2008.
Andi: All right, so let’s get back to the slides we left off with what about stocks right now?
Brian: We talked a little bit about that. Let’s take a look at the next slide here.
I mentioned the stock market sell off is down 12, 13, 14%, depending on when you measure it, what index you’re looking at. It’s certainly been a rough month for stocks. The worst January, I think they say, since 2008 or something like that. It’s been a tough start to the year. Let’s look under the hood a little bit at that. It’s important to remember that stock market declines are really common. This chart, there’s a ton going on and there will be a quiz on whether or not you’ve memorized these numbers. The gray bar on this slide is the stock market performance every year since 1980. I’m going to spend some time talking about different kinds of stocks. When I say stocks, I’m talking about the S&P. The gray is the performance for the year. The red is how much the stock market fell at some point during that year, from top to bottom. You can see that in almost every year, including all those years where stocks were higher, you had a point at which stocks fell pretty significantly. You’d have a year where the market was up, was flat, but at some point it was down 12% or it closed up 20%, but at some point fell 30% and stuff like that. The point being that market declines are really common. Last year again was unusual in that the worst decline we had was 5%. What we’re seeing right now is completely normal. Even if it were to continue into a bear market, which is generally down, considered more than 20%decline, that’s still relatively calm. I don’t think market declines should cause panic as long as you have that proper asset allocation and the stomach to withstand it.
Should I buy stocks right now? Let’s talk a little bit about that. To start with, stocks are a little bit expensive. This is another slide with a lot of numbers on it. Let’s focus on the right hand block here. This looks at different kinds of stocks across the top, value, blend and growth. Growth stocks are like Tesla. Expanding very quickly, selling lots of cars. I don’t know about anybody else, but on the Cul-De-Sac I live in, there’s like 4 houses and like 6 Teslas, so they seem to be doing pretty well. You pay a lot for that growth. Value companies aren’t growing as quickly. They’re more boring. Their business model may not be as exciting, but you pay less for that. Then there’s large companies, mid-sized companies and small companies. These are publicly traded companies. These aren’t fly-by-night entities. A large company might be McDonald’s. A small company is smaller, but it’s not a taco stand on the corner. Denny’s would be considered a small company. Price earnings ratio is a measure of how expensive stocks are. The percentages here are the percentage of the average PE ratio, price earnings ratio, over the last 20 years. You can see that growth. Large growth stocks are 165% of the average. They are 65% more expensive than they historically have been. Small growth stocks are 20% more expensive than they have been. As you get down into small value stocks, they’re less expensive than the historical average over the last 20 years. The point here is simply that there are some parts of the market that are very expensive. It doesn’t mean you want to abandon them, but it does mean maybe you want to put money in different kinds of stocks, some of which are less expensive than others.
Here’s just another example of performance varying. This is last year. The yellow line is the Russell 2000, so that’s the main small company stock index. It was up about 15% for the year last year. Look at the difference between growth stocks within that index and value stocks. If you bought just the value stocks, you’re up 28%, you’re feeling pretty good about yourself. That’s a great year. If you bought the growth stocks, you’re not feeling so good, you’re up 2%.
It’s a pretty crummy year. You could have almost bought bonds and gotten that. Then you mash them together and you get what the index did. Again, this is just an example. That performance varies. The reason we hammer away at this is because a lot of people focus just on growth stocks because a lot of times are the names in the press. They’re the companies people are hearing about on CNBC and stuff. While recent performance sometimes might be good, that’s why they’re being talked about a lot of times as you stretch out the time horizon, that performance isn’t quite as good.
This is another one of those important points. At the top, I labeled this slide a market of stocks. We spend a ton of time talking about the stock market, the bond market and the real estate market. What you really have is some companies, some individual bonds, some houses. It’s a market of stocks, not a stock market. The reason I say that is a lot of people want to go out and pick their individual stocks and buy this company or that company. If you’re really good at it, then have at it. It’s an extremely rare skill and those that can better pick the best stocks are paid $10s or $100s of million a year because it’s really, really difficult to do. Then there’s the indexes. When you look at the index right now, and this is as of last Friday, the numbers are a little different now. But look at the year to date return in the left hand column of the S&P, the Nasdaq in the Russell. S&P down 8%, Nasdaq down 12, Russell down 12. They’re down a little bit more now. But as we flash forward to the second from the right hand column, at least a 20% drawdown from a 52 week high. A 20% decline is generally considered a bear market. While the indexes aren’t in a bear market, they’re only down a little bit over 10%. Look at the number of the stocks within the index. In the Nasdaq, ¾ of the stocks and in the Russell ⅘ of those stocks are down more than 20% in the last year. While the indexes have been doing OK under the hood, a lot of the companies have been doing pretty crummy. If you look at a 50% drawdown, almost half the companies in the Nasdaq are down by half in the last year. At the same time that the Nasdaq was up last year a lot of the companies in it were falling. Because it was being dominated by a handful of companies. The lesson from there is that if you owned just the right companies, if you only owned Microsoft and Amazon last year or whatever, you probably did pretty well. How often and how consistently can somebody pick the single best stocks as opposed to maybe somebody was in the stocks that were down 50%. All of a sudden that meaningfully changes their finances? I’m not here to argue against picking individual stocks. I’m just saying that if you want to go that route, a lot of times, what makes sense is a core satellite approach where the corpus of your portfolio is maybe indexes or broad based mutual funds that represent the universe. Then you sprinkle in individual stocks so that if you’re right, it enhances performance. But if you’re wrong, it’s not catastrophic to your future.
Have all stocks done well? I just answered that question saying not really. The Nasdaq index has certainly done well. You could see the spike there in the 1990s, then the sharp decline and then the ramp up. Back in the 1990s, the value of the Nasdaq was 3X that of the S&P, and then it fell to about equal. Now you can see it’s back to about 3X. Tremendous rally in the Nasdaq over the last 15 years or so. It gets back to that old adage. When things go down a lot, a lot of times there’s value. The Nasdaq collapsed in the early 2000s, and then it did really well. Similarly, a lot of times when things are at very high levels, they don’t do as well. Not all stocks have performed this way. The Nasdaq has soared.
Let’s look at the next slide because emerging market stocks have not soared. In the last 15 years, they’ve been essentially flat. That’s at a time where billions of people have come out of poverty in some of these countries. Hundreds of millions of them have joined the middle class. World class companies have been created. We generally own a smattering of emerging market indexes for most of our clients. I personally own emerging markets. I think they’re less expensive than most developed markets at this point. They haven’t done as well, but I think they’re poised to do well going forward. You need to stomach some of the geopolitical volatility, You need to stomach the fact that crazy things happen in some of these markets. To be fair, crazy things have happened in the U.S. in the last couple of years, too. Maybe emerging markets aren’t unique in that regard, but you need to buckle up for a bumpy ride if you’re an investor in emerging markets. That’s an area where you could potentially get some more growth and you’re not paying as much for stocks.
Andi: Brian, we actually do have a question on that. I think you may have just answered that. But Greg wants to know, “why would you want to invest in emerging market stocks with Russia about to invade Ukraine and China seems to be clamping down on capitalism? What would be the benefit of having emerging market stocks at this point?”
Brian: That’s a really good question. I think a couple of things. One is, although we still use the term emerging markets, the reality is that these countries don’t necessarily have anything in common with each other that we lump together. Brazil is an emerging market and so is China. Those two countries don’t really have a whole heck of a lot in common. The Czech Republic doesn’t have anything in common with South Africa and they’re both in the index. You could try to pick just one country. South Africa isn’t about to invade Ukraine, and it probably won’t affect them at all. Or you could buy a broad basket of companies and say, Hey, I’m going to have some that have something going on right now, like China, and some that don’t. The other thing I think you can do is you can look at smaller companies. Especially in a place like China, when you look at where the government comes in and gets involved, a lot of times it’s the higher profile companies that are really prevalent in society and stuff like that. The government comes in and kind of stamps down on it or tries to dictate what they’re doing for social purposes. Smaller companies can fly under the radar. They’re a little less subject to state oversight. Small company stocks in emerging markets are a great place to be. I also think, honestly, and I’ll just reiterate this is, you know, going in that it’s going to be a bumpy ride and that there’s going to be some political things that are going to happen. If you invest in 20 emerging market countries, a few of them may collapse or something bad may happen. It doesn’t mean they’re never going to come back. Argentina and stuff like that has gone bankrupt half a dozen times and then they come back. As long as the companies within there survive, you’re OK. You’re not buying a country, you’re buying a company. Any one company could do poorly. In most of these countries, the companies that have been built have reached a level where they’re going to continue to succeed and consumers are going to demand access to their products. I think that cat is out of the bag and can’t be reversed, even in China,
Andi: Patricia follows on from that with “if the markets are going crazy and the world is so uncertain, why doesn’t it make sense to just sit in cash until things calmed down?
Brian: No, I think it absolutely makes sense to sit in cash. You definitely don’t want to invest when there’s an election in the US. You don’t want to invest when there is turmoil abroad.
You don’t want to invest when the economy might be slowing down or speeding up. The problem is that you would never invest if you waited for those conditions. I don’t mean to be glib about it. But the problem is that the future is always uncertain. I always use the example, as I’m sitting here at this desk, back in October of 1962 kids were hiding underneath their desks because the world was on the brink of nuclear war. The generals in Cuba for the USSR had orders to launch nuclear missiles at the United States if U.S. troops set foot on Cuban soil. The world was this close to nuclear Holocaust. At that time, the future was about as uncertain as it could ever possibly be. The Dow was at about 600. Since then we have had Vietnam. We had Nixon impeached, social unrest in the 60s, stagflation in the 70s, Reagan got shot. We had deficits out of control, Clinton got impeached, and the tech collapsed. We had the collapse of the Berlin Wall and communism. 9/11 and on and on and on. Coronavirus. And yet the Dow is at 600 back then. Despite all this uncertainty today, it’s at what, 35,000 or something like that. You’ve seen this tremendous growth despite uncertainty. As investors, a big part of our job is essentially to hold our nose, close our eyes and just deal with it. We have to understand that there’s always going to be uncertainty. That’s part of the price for investing in stocks. That’s why they pay 9 or 10% historically over time. As opposed to cash, which pays 1 or 2% over time and doesn’t even really keep up with inflation. You need to be strategic and not put all your money in stocks. You need to have, in a lot of cases, a sprinkling of those other asset classes that are going to let you sleep at night and serve as emergency reserves if stocks are down at a time that you need to access your portfolio.
Ani: We have one more question before we get back into the slides. This is from Rick “What impact do you think that day traders are having on this market?”
Brian: It was about a year ago that the meme stocks really became a thing. I’m going to be honest, I’m of an age that I don’t even know what a meme is. I do know that AMC and GameStop and some of them went crazy. These companies, at the time were struggling to survive, saw their stock prices go up from a couple of dollars a share to $500 a share in the case of GameStop, driven mostly by retail traders. I think retail day traders can have a significant impact. As evidenced by GameStop, for instance, on a particular company or a smaller index for a period of time. In the instance of GameStop, if you were short GameStop, they would have driven you to sell the stock or go bankrupt. Over time that impact diminishes. There’s a famous saying, in the short term the market’s a voting machine, but in the long term it’s a weighing machine, and I think that’s important to remember. Day traders can vote in the short term and they can have an impact on price movements. If you’re truly an investor and your time horizon stretches into years or decades, in that case, day traders don’t have much of an impact. You’re really looking at weighing the fundamentals. If the fundamentals improve over the course of years and decades, you’re probably going to be OK. The day traders can cause some volatility, but they’re not going to impact long term value.
Andi: Let’s get back into those slides. What’s next for 2022?
Brian: Let me get out my crystal ball. I need a Swami hat. If anybody remembers that old, I think it was Chris Berman.
Andi: Carnac, the magician.
Brian: I think he used to put on like a Swami gig and he’d predict who is going to win football games and stuff. Hopefully, everybody caught some of those games last week. There was some excitement going on.
So what’s next? One thing is we have another election coming up. It seems like we just had one, and here we go again. We had a ramp up for the midterms. I’m not going to get into a political debate here. Right now we have Democrats in the White House as well as both houses of Congress. Who knows what will happen in the fall? I’m sure that we’ll have more comments and updates on that as we get closer. In the meantime, I just think it’s important to look at a chart that says in blue here, that’s when Democrats are in control of both houses. Solid red is Republicans and the lines, the stripes, are when you had split; Senate and the House. Then you look at the performance of the markets over the last 70, 80, 90 years, and you see that it’s a pretty significant upward trend. I don’t see a lot of correlation between who’s in office and the direction of the stock market. Long winded way of saying that, yes, we’re going to have another election. I guarantee you it will be contentious. It will be miserable. We will be threatened that the world is going to come to an end if somebody gets elected. That will be this November. Two years from now, it’ll be even worse. When we have another presidential election. They’re only getting more and more venomous in the threats of what’s going to happen if somebody gets elected. The reality is that markets over time, because of the upward tide of profits and capitalism, seem to do OK regardless of who’s in office. The President, Congress can have an impact, but they don’t seem to be able to halt that no matter what they do.
Geopolitical turmoil. This isn’t exactly going out on a limb, either, I’m predicting there will be turmoil in 2020 too. I talked a little bit about this, so I won’t read off this slide. The point is just that over time, markets have gone higher, despite a pretty crazy backdrop. A few things that we need to watch out for, obviously, Russia and Ukraine. I think China is almost a bigger one, and Taiwan and what happens over there. If we were to see another really significant armed conflict, my best guess would involve something to do with Taiwan and the US and China coming to loggerheads over that. That’s always a risk. In terrorism or upheaval in the Middle East is always a risk. There’s also the things that we don’t know. I don’t spend a lot of time quoting Donald Rumsfeld. But Donald Rumsfeld said that there are the things we know, there are things we know that we don’t know and there are things we don’t know that we don’t know. It’s really easy to say, Oh, if ABC happens, the market’s going to do this or that. Most of the time, that’s already priced in. A lot of times what knocks markets off its rocker. What causes significant turmoil is things that we’re not even talking about. I can talk about Russia and the Ukraine or China or this or that. A lot of times it’s something that we’re not discussing today that causes significant unrest in financial markets because it’s not priced into anybody’s models.
This and I think we could probably end with this. Take any other questions and then wrap, is tax changes. We talked last year a lot about potentially changing tax brackets. These are the married filing jointly brackets for 2021 as well as 2022 at this point. There’s a 10, a 12, a 22, a 24, a 32, a 35 then the top brackets 37. These are basically the lowest rates in our lives. For comparison’s sake, back in the 1970s, the top tax bracket was 70%. After World War II, it was 92%. Imagine going to work and seeing $0.92 of every dollar go to the government. These rates were cut in 2017 with the tax cut and Jobs Act. They are scheduled to sunset after 2025. After 2025, in just a few more years, the 12 will go to the 15. The 22 will go to 25; 24 to 28; 32 steps up to 33. The 35 remains consistent, as does the 10%, but the 37% bracket goes to 39.6. In a few years if Congress doesn’t act, we will see taxes go higher. There’s also a lot of talk that there are proposals to change some tax things that haven’t been passed yet. The top tax bracket was going to go up. There was talk about changing capital gains for some people. Limiting Roth conversion. I don’t think that talk has died down. They’ve had trouble getting that through Congress, but I would suspect that we’ll hear more talk this year as the White House tries to get some things passed and Congress gets to try to get some things passed ahead of the election. I don’t think some of the more aggressive proposals from campaign season and early last year will pass. We’ll see renewed talk about both tax changes, as well as potential additional spending on infrastructure or those less fortunate and that kind of thing. I think Congress will and the White House will try to get some laws enacted ahead of the election.
Andi: If anybody has any further questions, this would be the time to put them into the chat because we’re just about ready to wrap up here. If you have any further questions, you can send them in via the chat, or you can also email us at info@PureFinancial.Com and Brian will be able to answer those questions.
I just have one more comment for you. Sam says “this is about the best market analysis I have ever heard. Amazing. So thank you very much for that, Brian.”
Brian: Well, thank you very much, Sam, and please come to the next one because that’s the best feedback we heard in a while.
Andi: We do have one more question, Ken just slid this in, “What do you foresee about real estate?”
Brian: I touched on this a little bit earlier about housing. I think that higher interest rates as well as higher prices are historically not a good combination for anything that you’re financing. I think a lot of consumers will begin to be priced out or strapped on the ability to buy a house if interest rates go up at current levels. Obviously, it’s market dependent depending on where you live and what geography. I could see real estate moderating its increases or even softening in price a little bit. I don’t see a collapse. Like I mentioned, I think that supply and demand are a little bit different this time. I think that there aren’t as many risky mortgage products out there. Also just the presence of investors, I didn’t talk about this earlier. I don’t mean investors like mom and pop or like me owning a rental or something. I mean, large institutions that own 20,000 houses and stuff like that, it’s become a more institutional asset class. We’ll see what impact that has, whether when prices soft and they go out and they dump everything because our investors are calling for it. But I also think it puts in a bid for houses where there are people out there with large pools of capital that are just looking to buy as many houses as they can. That keeps some demand in the marketplace.
Andi: Suzanne sent in a question “Does the supply chain issues affect the market?”
Brian: Yeah, I think it does. The fact that some companies are having more trouble, basically building things because they can’t get the parts they need. Yeah, it certainly does. I mean, you look at cars. I was just talking to somebody recently that had a car that had a year to go on its lease and they turned it in and the dealership wrote them a $10,000 check. Because the dealership needs something to sell. It definitely has an impact. I think it’s more company specific than it is at the market level because it affects different companies in different ways. Where I really think it has an impact is on inflation. This gets back to my thesis, I’m not predicting the 1970s and I’m not predicting we stay at 7% inflation for the next 20 years. But I do think 3, 4, 5% is going to become more normal than the 1 or 2% we’ve been used to. Another reason would be supply chains. Both the issues we have right now are causing prices to be elevated. The Fed said they would be transitory. So far, it’s been a little bit stickier than they anticipated. I also think because of COVID, the difficulties, you’re going to see more in shoring. So you’ve seen offshoring for 25 years where companies are moving manufacturing to the lowest cost location. Now, I think a lot of those companies are going to bring that back home because of what they’ve seen, where they can’t get parts or things get disrupted because of COVID. There’s pros and cons to that, but one of the cons is that the cost of building some of those components might be higher in the U.S. than it is in Vietnam or something like that. Eventually those prices either get passed on to consumers or margins get compressed. It’s probably a little bit of a combination of both as far as how that flows there.
Andi: We have a number of other questions that have come in. I don’t think we’re going to have time to answer them today. You can go ahead and email info@PureFinancial.com, and Brian will be able to answer those for you directly. Brian, thank you so much for taking the time today given your condition. Thank you for coming back to work and putting forth the effort to make sure that everybody has what, what Sam called the best market analysis he’s ever heard.
Brian: My pleasure and I’m glad. It’s actually fun to do and it takes my mind off of a little bit of discomfort. We’ve seen a little bit of volatility lately. I don’t think it’s a big deal. We’ll see markets go up, markets go down. I think the key is to spread things around a little bit and not get too concentrated in what happened last year or the year before. That’s how people really get in trouble or by being more aggressive. There’s the risk tolerance people think they can have and then their risk tolerance they actually can have. When there’s a disconnect there, it never ends well. Because somebody takes on more risk when times are good and all of a sudden punches out when things are bad. That’s how people lose money over time in general. My pleasure, I hope everybody enjoyed this. Thank you. Sam, Sam, my fan. Any questions, please email them and I’m happy to answer them. We’ll probably be back here in a month or so to do this all over again. I’m sure the world will be in some ways the same and in some ways very different a month from now than it is today. That’s the beauty of living in a rapidly changing environment.
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