Inflation vs. Deflation: What’s next for the economy? What does the recent surge in COVID cases mean for markets? Is stock market volatility here to stay? Pure’s Executive Vice President and Director of Research, Brian Perry, CFP®, CFA® answers those questions and more in this financial markets update webinar.
Transcription
What’s Next for the Economy
Andi: Thank you all for joining us for this market update webinar. Your presenter today is Bryan Perry, CFP®, CFA. He’s the Executive Vice President and Director of Research here at Pure Financial Advisors. Now, please welcome him.
Brian: Yeah, let’s dive on in. What I wanna do today is kind of just give a little overview of- it seems to me that there’s really two big kind of a tug of war going on right now in the financial world. And on the one hand, you’ve got an economy that’s absolutely humming along both on its own as it rebounds from the depths of the shutdowns, but also stimulated by the government. And that’s prompting fears of overheating and inflation. I think the flip side of that is that you’ve got fears of this resurgence of Covid and what that might do and that could lead to a slowdown. And markets are kind of telling you different things. And really, what’s the answer? And, you know, I don’t necessarily know the answer, but I can tell you some of the questions to ask and some of the things to evaluate. So we’ll talk a little bit about that tug of war. I want to talk a little bit about the impact of this resurgence of Covid potentially on financial markets. And then we’ve gone through a period of almost straight up in the markets for the last, I don’t know, year or so, year and a half. And I want to talk a little more about we’ve seen a touch of volatility lately and what might continue in that front and how to navigate volatility really. And, you know, some of that will come back to that boring old advice about kind of buying different types of asset classes and investments. I know you’ve all heard it before. I want to show you some visuals to reinforce that. And we’re going to start here with looking at what’s next for the economy. And again, I talked about the battle between inflation and deflation.
The Case for Inflation
And I want to start by making the case for inflation. There’s an old joke about there’s no such thing as a one-armed economist because they’re always saying on the one hand, but on the other hand. And I’m going to go that route, I’m to say on the one hand and on the other hand and try to make a compelling case for both inflation and deflation. And I’ll let you make up your own minds. And so when it comes to inflation and you see the picture- here is a picture I love. This is from Zimbabwe. And you see it’s a $100,000,000,000,000 note. There- this is, I think, a really good example of the dangers of hyperinflation is when you start needing 100,000,000,000,000 of anything to go out and buy, you know, a loaf of bread or whatever, your economy is probably not doing real well. I want to be completely clear. I have trouble foreseeing a scenario in which the US goes any sort of route along those lines. The worst bout of inflation we’ve seen in the last century-plus was in the 1970s. And there you saw not the kinds of inflation we’re talking about. I mean, there are examples of countries around the world where people get paid twice a day, once at lunch and once after work. Because the dollars they’re getting or the currency they’re getting would be worth so much less by the end of the day. They want to get paid at lunch so they can go rush out and use it. The U.S. has never experienced that. But we did experience in the 1970s very high levels of inflation in the double digits, the teens. One of the challenges, I think, when it comes to that is that so many people in our society grew up during that time.
And there’s something known as an anchoring bias where what you see, what you experience becomes the norm and you wait to revert back to that. And so if maybe your formative years experienced a 18% mortgage on your first house or you bought a CD at the bank for 12%, or you saw prices spiraling out of control for whatever you wanted to buy, that almost becomes not the normal, but an expectation for a reversion. And so you spend a lot of time waiting or expecting that wherever we are today isn’t the normal level. You’re going to go back to the 1970s.
The US Debt Clock as of July 8, 2021
And here’s the argument for why that might happen. Is the US debt. Right? That’s the big one. A lot of people are worried about- a ton of numbers on this slide. You- most of you are probably aware the government’s been spending a lot of money. Up here in the top left, you’ll see the US national debt, $28,500,000,000,000. That’s trillion with a T. It’s a big number, folks. I also want to highlight two other numbers and think of a business. If you have a business, you have income, that’s revenue, and then you have expenses and hopefully your income is higher than your expenses and you make money. Same thing on your personal level. You have income, you have expenses. Hopefully there’s a surplus or at least a break even. Take a look next to the US national debt at the figure for the debt per citizen. Each and every person in this country owes the equivalent of $85,000 in debt. That’s a really, really big number. So imagine you’re on your personal balance sheet, you owe another $85,000 due to the US government debt. Then if you shift over to the green numbers, you can see US federal tax revenue, $3,500,000,000,000. That’s what comes in an annual year. And then next to that, the revenue per citizen of $10,000. Right. So if you’ve got a business and you’ve bringing in $10,000 and your debt is $85,000, those aren’t great numbers. Right. And so that’s the argument for inflation is that somehow the government needs to inflate their way out of this scenario that they’ve created. And much of it has been created just in the last few years.
The Federal Deficit – Federal Net Debt (Accumulated Deficits)
Percent of GDP, 1940 – 2031, CBO Baseline Forecast, end of fiscal year
This next slide takes a look at what the debt has done over time. And starting back in 1940, you see the big spike in debt, that’s from financing the war, the World War II, and then a long period where it was paid down, was pretty stable. And then you see it begin to creep up around 2003, 2004 and go from approximately 40% of GDP, so approximately a quarter or a fourth, 40% of the overall economy was represented by debt to 102% as of right now. And so that’s a big increase from 40% to 102% in the last 15 years. The challenge to me or the problem isn’t where we are today, it’s where we’re going to go in the future. The Congressional Budget Office, according to this, the official forecast is that over the next 10 years, the debt is going to go from 102% to 106%. Right. I’m not an expert. I don’t know what the CBO, the Congressional Budget Office does, how they calculate that. But call me a skeptic, guys. If in the last 15 years under both Republican and Democratic presidents, we’ve managed to increase the debt steadily from 40% of GDP to 102%. I have a trouble envisioning too many scenarios where all of a sudden we go sideways and don’t add any more debt in the next 10 years, regardless of who’s in office.
Inflation – CPO and Core CPI
“Transitory Inflation”
But as that leads to inflation and here we look at a slide of inflation going back to 1971. And again, I mentioned those big spikes in the 1970 ,double digit inflations of 12%, 14%. And then a long tapering and a very muted period for inflation over the last 30 years or so, although again, we had those high levels in the 70s. If you look at more recent experience, people in their 30s, 40s, 50s haven’t necessarily experienced in their adult lives high inflation. It’s been muted, 2%, 3%, 4% for most of the last 3 decades. A recent spike, though, you see back at the right end of that screen. Just recently, we’ve spiked up in inflation to north of 5%. So some of the highest readings we’ve seen in quite some time. And the big argument is whether or not that’s transitory. Right.
Cost of Living Increase Since WWII
And what you see here is the cost of living since World War II and the gradual increase. You can see that in that time, what used to cost maybe $20 now cost $250. So about a 12 or 13 time increase in the cost of living. That’s why when you go to the movies, it used to be $1. I can remember it being $6 or $7 and now it’s $14. Right. That’s inflation. It’s been gradual over time. The big argument right now is whether or not- there’s no doubt that where you have higher inflation, the markets know that. Is that inflation temporary? Is it transitory? That’s the word that the Federal Reserve has been using. Or is it permanent? The answer to that still to be determined. What I will say is if the inflation is transitory because of supply chain bottlenecks following Covid, because of people rushing back out to live their lives after being shutdown, if this spike in inflation is transitory, markets are fine, everything will continue along. All else being equal. If it’s not transitory, if it turns out to be more permanent, I think you’ve got a problem. If this spike in inflation is going to be around for longer than the experts forecast. If we’re going to 5%, even 4% inflation for the next couple of years, 3, 4 or 5 years, I think markets need to reprice and you’ll see that happen. Right. That’s the case for inflation, especially centering around government debt and spending.
The Case for Deflation
Let’s shift gears and talk about deflation and the picture here from the Great Depression. And this is just people lining up for- for a soup kitchen or whatever, staggering levels of unemployment back then. This right here, folks, is why the Federal Reserve wants inflation. You know, you’ll always hear that the Fed targets 2% inflation. And it’s like, why do they want prices to go up? And that’s a really good question. Here’s the answer. The answer is because the Fed targets 2% inflation because they’re working with blunt instruments. They’re not a scalpel. They’re more a hammer. They want to control inflation, but they do it plus or minus. Right. So if they target 2%, they’re not going to get 2%, they might get 1%. They might get 3%. Their worries, if they targeted, let’s say, 0% inflation, they might miscalculate. And all of a sudden, you fall into deflation and central banks, the Federal Reserve, the European Central Bank, the Bank of Japan, they know how to control or how to fight inflation. You raise interest rates, you tighten monetary supply, the economy contracts rate, inflation comes down. The problem is deflation. Japan’s been fighting deflation since 1990. It’s really hard to get out of. The 1930s in the United States, you saw deflation or falling prices. It’s really hard to get out of. Why you ask? Think of the mentality. If any of you need to go buy a new refrigerator, a new washer/dryer, a new couch, a new car, even- even jeans. Right. You want to go buy jeans. If you think it’s going to be cheaper a couple of weeks from now or a year from now than it is today, why wouldn’t you hold off on that purchase? That’s logical. But if the entire society delays purchasing things because they think they might be cheaper in a year, well the economy slows down. And as the economy slows down, producers lower prices further and then there’s more incentive to wait to buy. And nobody’s spending in the entire economy hits the skids and it’s really hard to restart it. And so that’s why central banks fear deflation. Markets- I want to differentiate between deflation and low inflation or disinflation. Markets- I don’t know if they think deflation is coming, but they certainly think inflation is going to remain low, as evidenced by government bonds.
The US Treasury Yield Curve
This is the yield curve. So it’s just a map of government U.S. Treasury bonds from 3 months out to 30 years at 3 different time spans. The dark blue in the middle there is recent, it’s the end of June, June 30th of this past year of 2021. Then you can see the bottom. The lowest we’ve been in interest rates is August 4th of last year. So about a month- or a year ago. And then you can see just another time pick from December of 2013 with higher rates. And that shaded gray is the span of where rates have been in the last 10 years. And you can see that it certainly moved around. Rates are higher now than they were a year ago, lower than there were several years ago. But the entire range has been pretty low. If government bonds, if the bond market thought inflation was going to remain high and not be transitory, you would see rates much higher. But in fact, what’s happened is that recently they’ve declined.
10 Year Treasury Yield, Decade Ending July 8, 2021
You can see that in the last several years, the 10-year Treasury went from 3.25% down to a low of about .5% during the depths of the Covid shutdown and rebounded to 1.75% back this past Spring. And I think at that point, everybody was talking about higher rates. Are they going at 2%, 3%, 4%? What’s going to happen? And as often occurs, the consensus was wrong. Rates did an about-face and the 10-year Treasury’s actually fallen from 1.75% down back to about 1.25%. Why? Well, mostly because of fears that the economy will slow down again due to a resurgence in Covid. There’s also some technical issues going on where the government, the Federal Reserve is buying treasuries. There’s a lot of demand for safe assets. So regardless, interest rates have stayed quite low.
“Real” Yields
Which brings up one conundrum is that there’s something called real yield. So this gets pretty technical, but there are nominal yields and there are real yields. And at the simplest level, a nominal yield is the return you’re getting.
So let’s say that you bought a 10-year Treasury. Today you’re getting 1.25%. That’s your nominal yield. The real yield is simply your nominal yield adjusted for inflation. Because if you’re buying a bond, you want to make sure that you’re getting something in excess of inflation. You want to keep your purchasing power. Well, recently as inflation has gone up and interest rates have fallen, what you’ve seen is that the real yield, the after-inflation return has not only declined, it’s actually gone negative. So people buying 10-year Treasury bonds right now are after inflation signing up for a negative return. And what that tells you is that one of two things has to happen. Either the bond market is wrong and interest rate and inflation is going to come down a bunch rate, right, inflation is transitory. Or the bond market is right and the economy is going to slow down. Right. Or the bond market is wrong and then interest rates are going to go up. So you either need to see an increase in interest rates or a weakening economy. I don’t think you can stay with bond buyers signing up for negative returns after inflation indefinitely. The Goldilocks scenario for markets is moderate inflation, moderate growth and low interest rates. That’s what markets want, that kind of glide path of consistent growth, but not too strong, not too weak. So hence the Goldilocks, the porridge isn’t too hot or too cold. There’s certainly a probability of deflation in the economy slowing back down. I also think that inflation may not be quite as transitory as the Fed thinks it’ll be. ,So we’ll see which scenario we get. The worst possible outcome, I don’t think this will happen, but this is the bad outcome is the 1970s you saw stagflation, and that refers to an economy that’s weak but with high inflation. And that would occur in the sense of, let’s say that you had this resurgence of Covid, renewed restrictions on day-to-day living and now the economy weakens because of it. But due to supply chain constraints, demand for certain kinds of goods, you continue to see high inflation. So now you’ve got a weak economy, people out of work, stagnant wages, but higher prices. That’s the worst-case scenario for the economy. I don’t know that it’s likely, but that would definitely be a negative scenario. I want to go on and move on and talk a little bit about Covid-19 and the recent experience in markets, how they’ve done over the past several months. But before I do, let me pause and see if Andi has any questions.
Questions
Andi: We do have a couple of questions. Actually, you just answered Richard’s question. He wanted to know “if you think our inflation will be transitory or longer term.”
Brian: My opinion, and I want to be clear that it’s my opinion, is that inflation won’t be as transitory as maybe the Fed thinks. And now granted, they know more than I do. I’m- I guess I qualify as an expert, but I’m not going to pretend to know more than the people making monetary policy. I think that there’s a lot of pent-up demand and the economy is humming along and there’s so much stimulus. I think inflation may stay. I don’t know if it- I’m not saying it won’t come down, but I think it could stay above that 2% target for- for longer than expected.
Andi: All right. And then also, Angela wanted to know “In the past, have most markets fallen when inflation has increased?”
Brian: You know, that’s a great question and it’s almost like a plant because I’ve got a slide and then we pull a slide back up? And what you can see is that whether it’s bonds, cash, US stocks, value stocks, small companies, big companies, real estate, commodities, gold, international, they’ve all done pretty well regardless of in the top left-hand column. That’s the high and rising inflation. The top right is the high and falling. And then you can see bottom left, low and rising and then bottom right, low and falling. And so across these various scenarios, really the only negative return you’ve seen is commodities when inflation is both low and falling. And that makes sense. I think right now we’re probably transitioning from that low and rising scenario, which is where we’ve been. You’ve had inflation going higher, but starting at a very low base, i.e. could probably make the argument we’ve transition to that top left-hand quadrant, which is inflation is high, but going higher. Again, we’ll see if that’s transitory or not. But the interesting takeaway here is that almost everything has done OK, regardless of the scenario that you’re in. But it’s often the case is the people that figure out how they want to invest and then stay the course tend to do OK, absent some Armageddon event. It’s the people that bail out or try to figure out exactly where inflation’s going and our interest rates, whatever, those are usually the ones that suffer. Cool. Let’s slide back to questions, Andi.
Andi: Martin says, “How can I protect my portfolio against both inflation and an economic slowdown?”
Brian: Now, that’s a great question and it’s an important question. And the answer is that you need to own- if anybody’s- I’m the least handy person around. If I had a hammer right now in my hand, I’d probably use it to try to screw something in. So I don’t know what I’m doing. But most of you know that you need to use the right tool for the right job. Right? So if it’s a nail, you use a hammer. If it’s a screw, you use a screwdriver. If it’s you need to cut something, you use a saw. Portfolios are the same way. They’re different kinds of investments that have different goals. Right. So in a portfolio, stocks historically have done pretty well if inflation goes higher. Right. Maybe not immediately if there’s an inflation shock. But over time, good companies have pricing power. If you’re a U.S. investor, historically, if inflation tends to increase, the dollar declines a little bit, so your international stocks should do OK. So you own assets like that or maybe natural resources that do OK if interest- if inflation increases. And then bonds are really your hedge against deflation or a weak economy where you see historically, they don’t always move inversely of stocks. But what you see is times when either there’s a crisis or the economy is weakening. You could just go back to Covid when the 10-year Treasury fell to .5%. Right. Those bonds tend to be your ballast for a weak economy, you know, so again, it’s just having different parts of the portfolio to accomplish both of those. But I’m going to acknowledge here and everybody I’ve ever met said everybody loves diversification when everything’s doing well. But the concept of owning different things is that if you’ve got a tool for inflation and a tool for deflation and you get inflation, the stuff that’s there for inflation is going to do OK. The stuff that’s there for deflation probably is going to be sucking wind. Right. And then everybody’s like, hey, let me get out. I don’t want that garbage. Right. You got to remember that there’s different parts of the portfolio trying to do different tools. They’re not all going to go up at the same time. But that’s by design, because then they’re also not all going to go down at the same time. You got to kind of take the good, the bad right. Like the facts of life. And then focus on what the overall mix is doing. Is that helping you meet your goals over time? And is a position to do OK if you get a stronger economy, higher inflation, weaker economy, lower inflation?
Andi: All right. We’ve got another question. This comes from Ricky. He says, “If building a portfolio where you need an asset class to be as balanced to equities, which would be best in all different inflationary scenarios, a short-term Treasury fund, short-term TIPS? And do you believe the risk parity folks who think long-term treasuries are the best hedge against equities because they have the lowest correlation to equities? Not sure if that takes into account a high inflationary environment.”
Brian: Yeah, so there’s a lot there to unpack. You know, I’m not convinced that there’s one tool that is better in all scenarios, you know what I mean? It’s Lord of the Rings. I was watching with my kids, right. The one ring to rule them all. I’m not sure that there’s sort of one defensive mechanism to rule them all. There are times when long-term treasuries are going to do better as a hedge. And there are times when I don’t know, really short-term TIPS could do better. Right. And so I think it depends. I think what you’re looking for is some sort of defensive mechanism that will do well or OK in most scenarios. And I think that’s the best you can hope for. Unless you just want to have a portfolio with so much stuff in there that, you know, you almost get overwhelmed with the minutia. Right. I mean, to use that tool analogy, you could have a tool for every single conceivable job, but you need like a second helper just to carry the tool bag along. Right. That might be more trouble than it’s worth. It’s the same thing in a portfolio. You could put in a little bit of everything so that over time you’ve got the right tool for every possible scenario, but it might be that the allocations are so small it doesn’t actually do any good. So what I would do is I would look at something like historically high quality investment grade bonds of, let’s say, an intermediate maturity have done OK in most defensive scenarios. And so I’d probably start there as a foundation and kind of build on for more specific scenarios from there. But I would say, all right, here’s a pretty much- that’s like a universal tool that generally does OK.
Andi: All right. And then we’ve got another question on inflation. This is from Ben. He says, “Is Bitcoin a good inflation hedge?”
Brian: Yeah, good question. I don’t know. I mean, yes, to be kind of glib. You know, inflation’s gone up quite a bit here in the last 3 months. And at one point, Bitcoin had fallen from what was a $50,000 or something to like $30,000. So, you know, most good inflation hedges don’t fall 40% while inflation is rising. You know, I think that probably sums it up. I’m not saying Bitcoin doesn’t have a role in a portfolio or that it can’t help in some scenarios. I don’t know yet whether or not it’s an inflation hedge. I think the jury’s still out. At this point, it seems to move independent of almost anything.
COVID-19 and the Markets
Andi: All right. And then the next question, actually, I think this ties into your next topic. Let’s see. This is from Nina. She says, “What will happen to stocks if Covid cases keep on rising?”
Brian: You know, we had the worst of the shutdowns last year and then some of those were eased. And then finally, for many people, I think for most people, masks came off. And that was kind of like a really good symbol of kind of, I don’t know, that we defeated Covid. But we’re coming out the other side and now we’re getting the Delta variant coming back.
COVID Cases Since March 5, 2020
And you can see here the spike in cases. Markets are clearly spooked by a resurgence in Covid and particularly this Delta variant. There’s all these mutations. How long is it going to be around? How long are lives going to be impacted and how ultimately do people adapt their lifestyles? You know, I think that’s still to be determined.
And if there are renewed shutdowns or restrictions on social activities, let’s say that restaurants have to close again or have to go back to only outdoor dining as Winter is coming up. Right. Well, again, you’re back to where in the Northeast or the Midwest, maybe you can’t eat outside and that restaurant shuts down. So I certainly think that this story is not over with Covid and the impact on the economy, on the markets. I think the final chapters are still to be read and- and could still be really impactful. And I think sometimes that the second blow is almost more damaging than the first, because it’s like, you know, you’ve gone through something difficult. You kind of come out the other side. Hope springs eternal. And then it turns out to be like a Fall summit. And there’s more ahead of you and that can be pretty painful to deal with psychologically. So we’ll see how markets react. But I can tell you that in the interim, as cases started spiking, markets didn’t like it.
S&P 500 and Germany Dax 30 – One Month as of 7/21/21
Here’s the S&P. You can see going up over the course of June and then a pretty sharp spike or drop in July due to fears about a resurgence in Covid. We’ve since bounced back as the news has faded into the headlines. And then similarly, I just pulled Germany, the DAX 30, their equivalent of the Dow. You can see the same thing, where kind of going sideways and then a sharp drop with fears of a resurgence of Covid. So certainly markets are sensitive to it. And as the news cycle continues to develop, I do think- I’m not making a prediction for whether markets will fall sharply or what’s going to happen with Covid. I do think we’re going to see more volatility ahead. That doesn’t mean that markets won’t go higher. It doesn’t mean we’re not going to close higher in the Fall than we are now or next year or over the Winter. But it does mean I think the ride is going to be a little bumpier with- with news about Covid.
Market Performance – Week Ended 7/16/21
If we look here, you can see that this is through the end of the week, last week when I put this presentation together. You can see a column, the equity indexes and then the level and the one-week performance, quarter to date, year to date in one year. You know, so certainly last week, a bad week. If you look for the Russell 2000, that’s the third from the top small company stocks for the week, down 5% and quarter to date. So over the course of a couple of weeks, down about 6%. Over one year, though, they’ve done pretty well. So if you scan to the second from the right column, up about 49%. So but markets year to date, I would- I would kind of focus- this gets back to my volatility argument. If you look at the year-to-date performance over the first 6, 7 months of the year, pretty strong returns across the board there, 16% for the S&P, value stocks up 16%, International stocks, the MSCI ___ up 9%, NASDAQ up 12%. So strong performance almost across the board. Those are pretty good numbers for the year, I think people will be happy with. You get them in the first half of the year. Maybe that continues. We’ll see.
Financial Markets Summary
You know, if you look at the quarter. So this is for the second quarter ended in June. Again, green arrows across the board there for US Stock market, international developed emerging markets were up 5%, Global real estate bonds- You know, if you start analyzing those quarterly numbers for stocks, you’re looking at 20% and 30% returns and even 40% for real estate for the year. Obviously, those would be exceptional returns and difficult to repeat. So in some cases,
you’re getting significant outperformance. I’d also- circling back to bonds here, this is the Bloomberg Barclays Aggregate. So again, this is an intermediate, high-quality bonds. What I want to highlight is if you look across the bottom, you’ve got best quarter for these various indexes and the worst quarter. ____ across the worst quarters, you can see that the US stocks were down 22% in 2008, last quarter- first quarter of last year, then Covid, international stocks were down 23% in the quarter. But look at the worst quarter for bonds was actually this year, Q1 of 2021, down 3.4%. So again, that gets that idea of that diversification. While everything else was going up in the beginning of the year, your bonds fell. Again, not everything’s going to do well at the same time. Sometimes what’s defensive doesn’t do well when markets are strong. The corollary there, though, is that a 3% decline as your worst quarter ever is very different than the experience of the stock market index, is that in a single quarter, a fallen 5, 10, 15 times as much.
This is the different countries. And so I think that this is instructive, too, is that you can see the developed markets and then in the right hand column, the emerging markets, a little more of a mixed performance in emerging markets with some red as well as some green. Most developed markets did well in Q2. I can see about halfway down there in the U.S., 8.25%, really strong. But again, not the best. The best was your Denmark and your Switzerland and stuff. So, you know, the U.S. did OK. The U.S. did really well. Other places did even better, which I think, again, is why you sprinkle positions around a little bit. And then you go through these periods when you talk about international.
So international performance relative to the US has been terrible for the last 5 years. I mean, it’s just been awful for the last 5 or 10 years even. They haven’t been awful in a vacuum, they’ve been OK. But relative to the U.S., it hasn’t been that good. And what you can see that there have been these long periods historically. In purple, that’s when international stocks have outperformed and in grey is when US stocks have outperformed. And you can see these cycles where for a couple of years, international, a couple of years, U.S., international, U.S.,. Right. And so on. And then you see this big 13-year period here where US stocks have outperformed. I think part of the reason for that has been that the markets were really driven, particularly a lot of these numbers are impacted by short periods of time. And if you think of 2018, 2019, it was really the fang stocks, the big technology stocks that drove markets, your Google, your Amazon, your Apple. Those are all located in the US. And I think that really drove US market outperformance relative to other countries. I don’t have a crystal ball. My argument for international diversification right now would be the continued diversification, but also the fact that in a lot of cases they’re cheaper than US stocks. US stocks in some cases are expensive. In some cases they’re kind of fully valued. International stocks in a lot of cases are a little bit less expensive. And let’s talk a little bit more about that volatility that I mentioned and how to manage it. And how to manage it in a lot of cases comes back to diversification. Right. It’s, again, that boring word that you hear all the time from finance people like me. And you’re like, oh, my God, you roll your eyes. Why? You know, I want what’s best. And well, the problem is, is that what’s best is hard to predict. Right. I’ve spent time with the most famous money managers in the world. They don’t know what’s going to happen next. They play probabilities. Right.
Managing Market Volatility
Asset Class Returns Fluctuate (2006 – 2020)
And when you look at this, this chart, we call it a quilt chart, has different asset classes stack ranked year-by-year from what did best to what did worst in that year. And the pattern varies significantly. It’s really hard to pick the best versus the worst. And then you see the line through the middle. That’s asset allocation. That’s just a mix of everything. Never the best. Never the worst. Right. And then if you look, those are asset classes.
Sector Returns Fluctuate
If you look at sectors, it’s the same thing. Right. So across the top here, you’ve got different sectors. IT, consumer discretionary, materials, utilities, energy. And then you’ve got some staggering from best to worst. This is just over the last 12 months, from June of ‘20 to May of ‘21. Right. And you can see again, there’s no pattern. It’s not like you could have just said, hey, in October of 2020 utilities did the best. Let me jump in utilities. Well it turned out that the next quarter they did the worst. Right. And then you look at like energy. Well energy did the best in January and February of this year. Let me jump in energy. Well then all of a sudden the next quarter, it was the second worst. And the quarter after that, it was the worst. Right. There’s no real pattern. These things jump all over the place. Right. And then you look at it and like financials were only the best performer once. And yet for the whole year they were the best. So it’s really difficult to jump from investment to investment.
And that brings me to one of my favorite analogies, which is that when you’re investing, I like to consider the game where if you go to the fair, there’s a wall of balloons and you pay $1, you get a dart, you throw the dart, you pop a balloon and you get a crappy plastic whistle. You paid $1, you got something worth a nickel. Right. But behind a few of the balloons, there’s like a big panda bear that you really want to win for your girlfriend or boyfriend, right? So if instead of throwing one dart, you go up with $20, you give it to the to the vendor and you say, hey, give me 20 darts and you throw them. Your odds of getting the panda bear have gone up a bunch. Right. So the more darts you throw, the better your chances of getting the outcome that you want. But the single best outcome is to throw one dart and get the bear. Right. So by throwing more darts, you’ve eliminated the possibility of getting the best outcome. You’ve lowered the ceiling. That’s the same as diversifying. Your best returns would have been to buy IT in June, consumer discretionary in July, IT again in August, materials in September and so on. That would have been your best. If you bought more than one sector, more than one asset class, you lowered your ceiling. But you also raised your floor because you eliminated the possibility of getting utilities and only in June and energy in July and so on. So when you diversify, you lower the ceiling, but you raise the floor. For some of you, that might not be acceptable. You might want to shoot the lights out and get the best possible return. That’s fine. Have at it. If you succeed, you’re going to build significant wealth. But for others of you, if you’ve already built some wealth or if you’re approaching retirement, you want to keep what you have, grow it at a reasonable rate. That diversification, that lowering the ceiling, raising the floor is usually the path to the kinds of returns people need to make it to and through retirement.
Reversion to the Mean is Still a Thing
You know, and here’s just another example through Covid of reversion to the mean. Where in grey is the performance from the end of 2019, so really the start of Covid, through the following November. So the start of Covid through the worst of the lockdowns. And you can see that energy and airlines did really bad because people couldn’t drive or fly. Right. Hotels didn’t do really good and cruise lines because you couldn’t go to them. Conversely, what did well? Online retail. Well if I can’t go out, I’m going to shop online. Home improvement, if I’m stuck at home, I might as well make it nice. It makes sense. Then you look at the green, that’s 2020, that’s last November to the present. And look at how everything that did the worst did the best, right, as the economy reopened. And so, again, it gets back to the idea of if you can time these things, you can make a lot of money. But if you can’t time them, then you probably want to just kind of buy a little bit of each, get the good and the bad. I also want to touch on this as I move towards the close here is that- and this- this slide honestly was a little bit surprising to me, is we’re all familiar with the phenomenon of a market falling sharply and then rebounding sharply. Right. So the stocks crash and then because they’re so cheap, everybody rushes in to buy, they’re cheap and then they rebound significantly. If you think about a rubber ball, if you drop a rubber ball off a tall building and it falls sharply and it hits the ground, it’s going to bounce really high. So, again, that makes sense. But what I kind of sometimes lose sight of, and I don’t know if you do too, is the fact that that rubber ball bounces, but then it comes down to the ground and it doesn’t just stop. It bounces high again the second time, maybe not as high as it did initially, but still high and markets do the same thing.
Stock Market Momentum – Equity Markets
So if you look at this, this is the 6 times that stocks have fallen more than 30% since 1970. And then the light blue is the stock market performance in the year after stocks fell 30%. Not surprisingly, they usually did pretty good, right? The ball fell sharply, it bounced sharply, 34%, 26%, 17%, 50%, 56%. But again, that analogy of the ball bouncing a second time. The dark blue is the second-year performance following first a sharp decline and then a sharp rebound. The next year markets have tended to do pretty well also, 14%, 20%, 32%, 9%, 16%, averaging 18% in the second year. The story still to be written for the second year. We got the sharp 40% decline back in the Spring of 2020. The next 12 months we got the big rebound, 56%. We don’t know what the next 12 months will bring, but historically there’s no reason why it can’t be good. That leads me into the idea that a lot of people become worried when markets are expensive or they see high levels or markets make new highs. And so I sat down because it’s like- I remember- I’m old enough to remember- I’ve been around long enough in this business that I remember Dow 10,000 the first time. And it was a party. They had a celebration on the floor of the New York Stock Exchange. It was a big thing. It was like, oh, my God. 10,000 is a really big number. Right. Now we’re at 38,000, 39,000. Right. So markets go up and up. And I was like and sometimes people say the market’s too expensive.
Dow 34 Million?
The Dow at 40,000 is too much. And historically, the Dow has averaged about 10% a year. This is a chart of the Dow going back to 1900 all the way through today. It’s at about 34,000, 35,000. Right. So significant growth. People that were around in the 60s when the Dow is at 400, were probably like, oh my God, the Dow can never be at 1000. 10,000 would have been mind boggling. 20,000, right. Well, consider this. Historically, the Dow has returned about 10%. I cut that and said, what if the Dow returned 9% going forward? So lower growth for the rest of this century. So your grandkids, right? The Dow, if it grows for the rest of this century, the next 80 years at 9%, would close the century at about 34,000,000. Right. So imagine turning on CNBC and saying that the Dow fell 480,000 points today to close at 32,600,000. Right. Your eyeballs would probably fall out. Right. The reason I bring up that example is that numbers are continuing to grow. Markets making a new high is not unusual. Think about it like this on a personal level. Every single day, you personally make a series of new highs. Today, you set a record for the most times in your life you brushed your teeth, right. You’ve now driven today more than you ever drove in your life. You’ve taken more steps. Everybody every day makes new highs because we’re building on the foundation of what came before. Markets aren’t any different. That’s not a prediction for markets going higher or lower. It’s just a reminder that just because we’re making new highs, just because you’re seeing new numbers in a stock price or an index price doesn’t mean that we can’t continue to go higher. New highs are the norm, not the exception.
With that, I’m going to pause and take questions. I also just want to throw out that I hope you’re enjoying this webinar. Hopefully you do something with the information. The biggest mistake I see people kind of- they get information, but they don’t do anything with it. So incorporate what you’re learning today into your personal finances. Redo your- take a look at your investments, meet with your advisor. If you want, we’re a financial planning and investment management firm. We usually charge $275 an hour to meet with people. For people that have come to this webinar, we waive that fee and do a free two meeting assessment. So if you’re interested and you want to do an assessment where you can come in and we’ll talk about- we’ll take a snapshot of your portfolio, not just one portfolio, but all of it together. We’ll put it in there. Take a look at what kind of risk you’re taking, what kind of return you’re set up for it. Give you some thoughts on that. We’ll also take a look at your tax situation, where our CEO is a CPA. We have CPAs on staff, we’re very tax focused. We can give you some thoughts on your current tax status. But also, again, I talked about that national debt and national deficit. Chances are taxes are going to go higher in the future. They’re already scheduled to go higher. We do a lot of forward tax planning to help people minimize their taxes, not just today, but in the future. So we’ll take a look at that for you, give you some thoughts on your cash flow and what may be available to you as far as, do you have enough to retire? Again, usually we charge $275 an hour to meet with people. If you’ve come this webinar and you’ll put up a free offer, if you want to come in, you can meet with myself or one of my CFP®, CERTIFIED FINANCIAL PLANNER™ colleagues. We’re fiduciaries. We don’t sell anything. We just give good advice, good guidance without conflicts of interest. So- and with that, let me pause and take some more questions.
Questions
Andi: Malcolm said that “The debt that you mentioned earlier that the government has accumulated. How do we pay all that back?”
Brian: There are four ways to pay back debt. I guess – technically, you don’t have to pay it back. You can continue to service it as long as you can make the payments. You don’t ever have to reduce the principal. But let’s say that you do want to pay it back. There are 4 ways. You can default. Just go bankrupt. There are times and I wouldn’t be surprised in future where you could see the government technically default due to some sort of debt ceiling issue or government impasse. But I don’t consider that a true default. And I don’t think there’s a scenario where the US just refuses to pay back its bill. So I don’t think that will happen.
You can grow your way out of it because revenue is just a function of the level of taxes times the amount of economic activity. So if the economy were to grow robustly, you’d have more tax revenue to reduce the debt. We saw that in the 1990s. That’s the best scenario. I don’t know if it’s likely. I think the two scenarios are, you inflate your way out. We talked a little bit about inflation. Right. You can pay back a debt with dollars that are worth less. That’s one way. And I do think moving past, hey, what’s going to happen in the next couple of years?
I think over the decade to come or the 15, 20 years ahead of us, I think we’ll have slightly higher inflation than what we’ve seen in the past. In the past 10, 15 years, we’ve seen inflation more like 1.5% or 2%. But the 100-year average is 3.7%. So when we do financial planning for clients, we actually to build in a measure of safety. We use that 100-year average of 3.7% just so that if inflation does turn out to be a little bit higher going forward, there’s a buffer in there. Right. So I think inflation is one way to get out of the deficit. And then the fourth one or the final one is higher taxes. Taxes are already scheduled to go higher in 2025 or after 2025. The tax cut that we got in 2017 was temporary. It wasn’t a permanent tax cut. So taxes are scheduled if Congress does nothing to go up after 2025. But the reality is, is that when you think about the direction of government and kind of the tenor of politics and the size of the deficit, I think when I poll people, most people feel taxes are going to go up, just Congress is going to act to move taxes higher, whether it’s this year, next year, next administration, it seems likely taxes have to go higher. The other thing to consider- and that’s the other way, right, to pay off the deficit. And just keep in mind, there are a lot of fallacies or misnomers in the financial world. One of the biggest pieces of misinformation many people have been told, is that you’re going to be in a lower tax bracket in retirement than you are when you’re working. If you haven’t saved any money and you don’t have a pension and you’re going to be living off of Social Security, that might be true. If you’ve got some savings, if you’ve got a pension, if you’ve got cash flow sources, rental property, you’ve saved in your 401(k), I can tell you we meet with thousands and thousands of people a year, and for the vast majority of them, they’re going to be in the same, if not a higher, tax bracket in retirement than they are today. And so a lot of people that we meet, many, many people have basically built themselves a tax time bomb where the easiest path for the government to get out of the debt that they’ve sort of accumulated is to raise taxes.
And people in the meantime have been building themselves this tax time bomb that’s going to put them in a higher tax bracket in retirement at the same time that Congress is going to be raising taxes to pay off the debt. So you might want to evaluate that. Again, you can talk to us in the free assessment if you want to take a look at that. If not, you should do that on your own because you could wind up paying quite a bit more in taxes than you otherwise have to.
Andi: All right. And then we do have one final question from Marguerite. “Are stock markets overvalued?”
Brian: If I knew that, I’d be a rich man, Marguerite. You know, I don’t think most markets are cheap, but I don’t know if that means that they’re overvalued. Profits have been growing so rapidly because companies are doing well that that helps really improve the valuation of stocks. So I don’t know if they’re cheap, but I don’t know if they’re all grossly overvalued. And then it depends too, as you look under the hood, we talk so often about the stock market, we miss out that it’s really a market of stocks. And so if at some level the index is expensive, that doesn’t mean that all the underlying constituents are expensive.
And so when you invest, you might look at buying not just the index or not just growth stocks, but also value stocks that are by definition, less expensive. You might also look at some kinds of markets like overseas and stuff that are a little bit less expensive than the U.S. and adding them in as well.
Andi: All right. And I think that is all the questions we have today.
Brian: Well, yeah, it’s been a pleasure. And always hopefully you all learned something today. And again, if you want to do the free assessment, kind of take a look at your portfolio, some of the things we talked about and also really evaluate your future tax status before taxes potentially go higher. Give us a shout, sign up for the free financial assessment. We’re happy to meet with you. No fee, no obligation. If not, do something with this information, put it to good use, continue to learn and continue educating yourself. And best of luck to everybody going forward.
Andi: All right. Thank you very much for joining us. Have a great day. And do contact us if you would like that free financial assessment.
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