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- (01:11) Trump Administration Mulls a Unilateral Tax Cut for the Rich
- (08:01) Big Changes to Your 401(k) and IRA — and more retirement news
- (11:30) Second Quarter 2018 Market Update with Brian Perry, CFP®, CFA®
- (24:47) Meb Faber: Choose One Stock and One Investing Style Forever, and Why $1 Trillion Will Flow Into Chinese Markets
- (34:38) Meb Faber: US vs Foreign Markets, the Value Premium, and Behavior
Coming up: If you had to buy and hold one stock for the rest of your life, or if you had to choose one investing style and stick with it for the rest of your life, what would you choose? Meb Faber from the Meb Faber Show podcast answers those questions and talks about his upcoming book, The Best Investment Writing, Volume 2. Plus, we’ll check in with Pure Financial Advisors’ Director of Research, Brian Perry, CFP® and CFA® for a 2018 second quarter market update. Finally, Joe and Big Al talk about big changes that could be coming to our 401(k)s and IRAs, and more possible tax cuts from the Trump administration? Here to tell us all about it are Joe Anderson, CFP® and Big Al Clopine, CPA.
JA: Hey, what’s this going on with the Trump administration with a new tax cut?
AC: Well, this is just announced this week, that Steven Mnuchin, our Treasury secretary, he was talking about changing the capital gain rates, Joe. The best that they can figure, this would be about a $100 billion tax cut, mainly to wealthy individuals, because those are the ones that are buying and selling investments and capital gains. A capital gain is when you have an asset outside of retirement, you buy it at one price, you sell it at a higher price, and you pay a special capital gains rate. And that rate depends on your other tax bracket, it could be 0%, it could be 15%, it could be 20% – but that’s a lot lower than the highest tax rate, which is 37%. And that’s why, years ago, remember Warren Buffett, there was a big article about how he paid a lower rate than his secretary? That’s because his income was capital gains, and his secretary was ordinary income. So at any rate, here’s what they’re suggesting, is that they want to add an inflation on to the cost basis. And I’ll give you an example, Joe, which is this: so this is a high earner, spends $100,000 on a stock, bought in 1980, and it sold for a million dollars today. So that would be a $900,000 gain under current law. And you’d pay capital gains tax on that, which likely would be, mostly 20%, and then that course there’s a Medicare surtax, another 3.8% tax on top of that, plus state. So it’s not free, but it’s a lot better than the regular, ordinary rates. But here’s what they’re saying is that if they add an inflation adjustment, maybe depending upon what the inflation was from 1980 to when it sold, maybe the cost basis would be increased to say $300,000 from the original $100,000. And so, therefore, you’d only pay tax on $700,000 of gain.
JA: I’ve never heard of anything like this.
AC: (laughs) Actually, it was discussed under the time of President Bush. It didn’t go anywhere.
JA: Because I read that in the same article in the New York Times and I’m like, “I don’t remember that.”
AC: I don’t either. I think that was just something they discussed and then they dropped. And I’m going to give you my opinion right now. This will not go anywhere. Because this is completely contrary to everything the IRS does, in terms of dollars in, dollars out, cost basis, in terms of a dollar that you receive that wasn’t a gift, it was earned – it’s taxable. And you can’t change your basis, your cost basis. There is an exception, Joe. And that’s when someone passes away, there is a step up in basis. That’s the only time when there’s a change in cost basis that I have been aware of in the history of the tax law.
JA: Right. I don’t know how they would… So you’ve got to look at the purchase date and then use a certain inflation rider?
AC: Yeah, presumably the IRS would announce what it was for that year, and what do you do if it’s mid-year? I don’t know.
JA: Right. So what they’re trying to do is increase the cost basis to reduce the tax that people would have to pay if they held an asset for a very long time. So that happens if you have highly appreciated assets, such as real estate, such as stocks. But here’s another thing that’s kind of interesting: with real estate, you can avoid the tax with a 1031 exchange. But you cannot exchange stock. So there’s all sorts of different kind of weird loopholes in the tax code that don’t make a lot of sense to a lot of people.
AC: Yeah and even the 1031 exchange, you’re not getting out of the tax, you’re just deferring it to when you actually sell that final property – except if you die with the property, then there’s a step up in basis for your beneficiaries. And then it depends upon what state you live in – if you live in California, which is a community property state, even your spouse gets a full step up in basis. But if you live in a non-community property state and your spouse takes over, it’s only a 50% step up in basis. It gets kind of complicated. But Joe, I guess Penn Wharton did a model on this to figure out what the impact would be, and they came up with a $102 billion reduced taxes over the next decade. And they said 86% of the benefits would go to the top 1% of taxpayers.
JA: Well, I mean the top 1% too, they always kind of throw that out there. Because here’s the problem with all this, is that I would say most Americans save money for long-term growth in a retirement account or potentially real estate. You and I have been doing this for a long time, and we very rarely see an individual that has accumulated a lot of wealth outside of a retirement account, unless they sold a business, unless they inherited the money, or unless they sold some real estate.
AC: Yeah, typically that’s correct. So typically, the clients that we see, and for most people out there, the highest gains are in their stock portfolios in their 401(k), their IRA, their retirement accounts, which gets taxed as ordinary income. So this potential change would not affect that. This is only assets outside of retirement accounts, and so it’s typically those that have money to invest, or maybe you were fortunate enough to start a business and then you were able to sell that business down the line and got a big capital gain that way. So I would guess, and I want to dive too much into politics, but I would guess the Republican Party would be thinking this would be a good idea, because then there’ll be less tax on capital gains, and there would be more reason to do investing. Investing in companies and stocks create jobs, and so that’s what one side of the hall…
JA: Yeah, but what the article was stating is that it could free up some capital, because no one’s selling this stuff, because they don’t want to pay the tax. And so it’s just sitting there, highly appreciated stock, and they’re not going to sell that stock. But hey, if we give them a benefit to sell the stock, now they sell the stock, they’ve reduced their taxes and they re-deploy that capital to other ventures. They buy more stocks, or they invest in more stuff, or they buy more goods and services to spur the economy.
AC: Right. And you can imagine, the Democrats see this a little bit differently.
JA: They could.
AC: Yeah, they do. (laughs)
JA: Oh, do they?
AC: And I’m not going to even dive into that. But anyway, that’s what’s being discussed right now, and one of the interesting things that I find is, it would seem to me this would have to be approved by Congress and Senate.
JA: Yeah, they’re saying they could try to push it through without any approval?
AC: They’re looking into that, which is interesting, to say the least, and I’m not going to go there, but at any rate, I guess apparently, the Bush administration looked into the same thing – whether they could do it on their own, and they concluded that they could not. But anyway, who knows – but I personally think this is not very likely that it’s going to happen.
JA: What other change is coming up?
AC: Well, some other things that have been discussed, probably over the last month or two, and I’ll just run through some of these things that may affect your 401(k), may affect your IRA. The first one is this: 401(k) sponsors might have to show you on each statement how much income your balance would generate with an annuity. In other words, the idea is to show you, “All right, if you’ve got $100,000, what does that mean in terms of annual income?”
JA: So that’s like Financial Engines type of thing. A quasi-… I was going to say something that will not be legal to say on the air. (laughs) A not-very-good calculator. A financial calculator that will say, “hey, you have this much, you can anticipate this much in income.” And they’re just using some arbitrary numbers.
AC: Yeah and I think that the concept is not necessarily bad, because I think there’s a lot of misconceptions. Some people think that if the stock market, over the last 100 years, has averaged 10% per year, which is true – it’s a little bit under 10%, but roughly – that’s through busts, the roaring times, busts and everything. So if you’re thinking you can pull out 10% out of your portfolio each year and be OK, you’ve got another think coming, because the market doesn’t go in averages, it goes all over the place.
JA: Yeah, but we’ve also run into people where they think it’s a guaranteed income stream. So now if we’re showing, “if you purchase an annuity, then that would be a guaranteed income stream.”
AC: It would. So anyway, that’s one thing that’s being discussed. Another thing Joe, is to potentially lift the age limits on IRA contributions. Right now, you can only do IRA contributions if you’re under 70 and a half, so they’re actually talking about changing that to where anyone can do it. Now, the Roth IRA contribution, you can do at any age. You just have to have earned income between you and your spouse.
JA: Right. You can contribute to a 401(k) if you’re in your 70s, but you can’t contribute to an IRA in your 70s.
AC: Yeah and why is that?
JA: Well, I would imagine they’re trying to track down the required distributions. So if I’m still making contributions – well they could probably back check that with earned income on your tax return?
AC: Yeah. With computers. It’s not that hard. (laughs) Third thing and we’ve talked about this I think a week or two ago, is a new type of universal savings account that would offer more flexible withdrawal rules on existing retirement accounts, such as an emergency fund, such as a down payment, such as kids’ education. Which, I don’t think you or I are really in favor of that, because then the tendency is to take what should be a retirement account and spend it on things you shouldn’t, and then you’re trouble later.
JA: Yeah. So I don’t know. They’re always monkeying around with this, and I don’t know who comes up with some of this stuff. But anyway.
You know we’ll always update you on the latest news and changes affecting your portfolio and your retirement savings, so keep your ear on the podcast – we’ve got a quarter 2 market recap coming up momentarily. And if you didn’t see it on our Facebook page, Joe and Big Al have started recording season 5 of the YourMoney, Your Wealth TV show! Brand new episodes on how the new tax law will affect your retirement, Social Security secrets, managing risk in retirement and more will start to hit YourMoneyYourWealth.com at the beginning of September. If you’re in San Diego, you can catch the show on Sunday mornings at 6:30 am on CBS 8.
11:30 – Second Quarter 2018 Market Update with Brian Perry, CFP®, CFA®
JA: Alan, you know we just finished second quarter, did you know that?
AC: I did know that, Joe. And it’s probably time to get sort of a market update.
JA: I think so. Let’s see what the markets did. We got Brian Perry. He’s the Director of Research at Pure Financial Advisors, he’s a Certified Financial Planner and a Chartered Financial Analyst. Brian, welcome to the show.
BP: Thanks, guys.
JA: Can you tell us what the hell happened in the markets this past quarter, and maybe just sum some stuff up for us of what we can anticipate?
AC: And you have to make it so we can understand it.
BP: Well, that’s going to be tough, but I might be able to make it to the average listener can understand it at least.
AC: Even for us, because we’re not necessarily average.
JA: The market’s been flat.
BP: It has been flat, but it’s been going up and down in order to arrive at a relatively flat destination. So it’s definitely been a little bit different than the last few years. 2017, a one-way ride higher. We started the year and more or less went straight up with limited volatility. This year we started gangbusters in January, had a sharp sell-off, went back up, went back down, and then Q2 actually turned out to be pretty good. We’re up about 4% in the U.S. in second quarter, which has continued actually into the third quarter as well. That’s if you’re invested in the U.S. Emerging markets were a whole different story. Emerging markets were down almost 8% in Q2.
JA: Just (Joe gets tongue-tied) can I speak?! Just for the few months of the second quarter, that’s not for the year, this is just a quarter!
BP: Exactly – down 8%, and that’s the old principle, what goes up can go down, and emerging markets had been the best performing asset class last year in 2017, having a horrible year this year, and in fact, Q2 saw a lot of reversals of what had done well started not doing as well. The old reversion to the mean principle that we see so often, time and again in the markets.
AC: How about other international markets?
BP: You know, more muted, but also down. The U.S. was the star performer in the second quarter, international developed, in general, down about 1%. A big part of that was the U.S. dollar. So the U.S. dollar strengthened against most currencies in the second quarter, and what happens is when the U.S. dollar strengthens, that hurts the returns of foreign stocks for U.S. investors.
JA: Why did that happen?
BP: (sighs, laughs) Because sometimes markets go up and sometimes markets go down would be the honest answer? But a lot of it has to do with, if you want me to weave a narrative, interest rate differentials. The traditionally U.S. and, say, core European bonds, like Germany and France, tend to trade relatively close in alignment, and right now you can get close to 3% on a 10 year U.S. bond, and probably a half of 1% under German bonds. So there’s a lot of international investors seeking exposure to the U.S. because of that. The U.S. is also perceived in the face of these trade wars that we have, or I guess we don’t have trade wars, but we have tariffs going on and hoping not to have a trade war. The U.S. is perceived as a little bit of a safe haven. Not that we would win a trade war, but we might lose less, and so those things as well make the U.S. an attractive haven and seeing some in-flows, which is likely leading to a stronger dollar.
JA: There was a good narrative.
AC: (laughs) That was really good. So I got a question. So tariffs and trade wars, how might we expect that to affect the market, or will it, or won’t it? Or what would we expect?
BP: Yeah, despite some political rhetoric, there are no winners from a trade war. There is just, as I mentioned, those that lose less. And if you look, as a percentage of GDP, trade for the United States, because we’re such a large, diverse economy and such a big place, trade is a much smaller percentage of gross domestic product in the U.S. than in most other countries. So relatively speaking, the impact should be relatively smaller, and you’re hearing more and more stories come out now that the tariffs and whatnot are beginning to impact China a little bit more in stories – and who knows the truth of them or the veracity of them, but about a little bit of political upheaval, are people beginning to complain about the economy slowing over there because of this? The impact on markets so far has been relatively muted, and it’s been contained to, when a tweet or a new announcement about a tariff comes out, markets seem to sell off for about 15 minutes and then recover and go on their merry way, and it’s really quite a tug of war now between solid economic growth, where unemployment’s near a three or four-decade low, the economy grew 4.1% last quarter, which was the highest that we’ve seen in four years and one of the highest rates since the financial crisis. So, on the one hand, you’ve got a strong economy and strong corporate profits. And then on the other side of that, you’ve got these trade wars, which all else being equal, could be very bad for the economy. And most of the time, right now, it seems like markets are focusing on the good news – the glass is half full. Every once in a while, as a new development occurs, markets turn their attention to trade wars. You know, this isn’t a prediction, but my fear would be that maybe markets are discounting the possibility of a trade war, where right now the tariffs are designed to get fairer trade deals for the United States and other countries are retaliating in kind. I don’t think any country wants a trade war. But if things get out of control and we do actually wind up with one, I think that the market could at that point see a significant correction.
JA: With the amount of trade that we do, is China the largest participant in our trade? Is that why we always hear about China? Or Canada? Or Mexico? I thought we had this North American Treaty, where we will always keep our brothers in line?
BP: Yeah, so the last I looked, we are the biggest trading partner for Mexico and Canada – kind of more local. If you think about it, when you’re going to do trade, something like cement, for instance, you’re probably not going to import from China just because of the cost of shipping would outweigh the value of it per cubic foot or something like that. So you’re going to import something like a cell phone from China that the value to weight ratios a little bit higher. But when we’re importing raw materials and stuff like that, or other goods, a lot of that comes from Mexico and Canada because of proximity. And there, a lot of it is the auto industry, quite frankly, a lot of the trade deficit that we’ve seen with them. China, you get a high profile trade deficit, and it definitely attracts attention, but they are not our biggest trading partner.
JA: What else happened this quarter that we should be aware of, if anything?
BP: There’s always a lot, I think the key is not so much what happens, but what do you pay attention to. And I think the challenge for investors is always to filter out a lot of the noise and focus on the core of what’s actually occurring, and what’s actually occurring is a little bit of a rotation from what happened in 2017 towards what started working in 2018 and in Q2. Also, frankly, a return to more normal markets. Where 2017 was very abnormal, a very calm ride higher like I mentioned, that’s not normal. Normality is a strong market followed by a sharp-sell off followed by a strong market followed by some volatility. Diversified portfolios doing well but some assets going up and some assets going down. We’ve seen bonds this year have one of their worst years on record. Now, fortunately, high-quality bonds are relatively muted as far as their price movement, so one of the worst years on record, they’re down about 1, 1 and a half percent, depending on the portfolio. But I think one of the notable developments there in the second quarter was that interest rates didn’t go significantly higher. And so, while everybody is worried about rising interest rate,s and they’ve continued to kind of bump along in that two and three quarter to 3% range for the 10 year Treasury, we haven’t seen that sharp spike higher that so many people have been predicting for so long, and so many people asking, “hey, should I get out of bonds? What happens when they go higher?” And my response always being, “well, you could have asked me that question two years ago, or five years ago, or 10 years ago, and we’re still waiting for that to occur.”
JA: So worst record for bonds. So didn’t we call this? That interest rates were gonna go up, so bond prices were going to go down, so shouldn’t we just get out of bonds? And now we see that we had the worst record in bonds?
AC: And then you combine that with stocks near all-time highs, and it’s like, that that’s the question – bonds no good? Stocks no good? Now what?
BP: Yeah, I mean, maybe take it to Vegas or bitcoin or something like that, right? (laughs) No, it’s a challenge when everything is expensive, what do you buy? I think when you look at valuations, first of all, it’s pretty clear that at the market-wide level, international stocks are less expensive than U.S. stocks. And so the old story of global diversification, you’ve got a U.S. market in the last 20 years, only one time has the U.S. been the best performing developed market. The other 19 years another country did better. So global diversification giving you a better opportunity to be where the winners are. Less expensive right now on a relative basis, International developed as well as emerging markets – so maybe that’s a place for some allocation. In the U.S. I also think that if you look at value versus growth, right now, growth stocks are the most expensive compared to value stocks that they’ve been since 2000. And 2000 was the very end of the tech bubble, where the S&P 500, the large tech stocks, had done so well. That burst, and then value stocks did very well in the years to follow, and so, obviously, I don’t have a crystal ball around the timing of it, but when you look at relative valuations, value stocks are attractive relative to growth stocks right now. So maybe it’s a time for transition over to there, and then in bonds, to circle back to that, even in “one of the worst years we’ve seen,” in the second quarter U.S. bonds were down 0.16%. So that’s the kind of volatility I think most people can stomach. With diversification, I think it’s always important to realize too, that it works both ways – and so everybody I’ve ever met loves the diversification bonds provide. In a 2008 scenario when stocks fall 40% and their bonds are up 5%, people are all for diversification. When stocks are up 15% or 20% and bonds are up too, people, all of a sudden the idea of diversification isn’t as appealing – but it does work both ways. And the idea isn’t that you get the good without the bad. The idea is that you build a portfolio that gives you a smoother ride and hopefully gets to your destination with less volatility.
AC: Let me ask you another question with regards to bonds, because I think some people at this point think, “I get the need for safety, but why not just go into cash right now? Because interest rates are going to go up and my bond prices are going to go down, why wouldn’t I just be in cash right now?” What’s the advantage of being in bonds?
BP: Yes. So if interest rates are going to go up, there’s no advantage to being in bonds and you should sit in cash. So all the people with a perfect crystal ball that know exactly, for a fact, that interest rates are going to go higher, that know how much higher they’re going to go, when they’re going to stop going higher and turn around and reverse, those people should sit in cash until the magic day when interest rates are going to reverse and go lower, and then move into bonds on that day. Those people are also billionaire bond traders in all likelihood. For the rest of the people, and for Joe and Al here, the idea is that cash doesn’t yield much, and even with higher rates recently, you can get maybe 1% on cash or something like that. You can get 3% on a bond portfolio. And in an environment where interest rates go higher over time, the yield on that bond portfolio is going to go up. So as long as you don’t need the money in the short term, you’re going to be just fine owning bonds. And in fact, higher rates are a bondholder’s best friend. Conversely, in an environment where rates go lower, and despite the fact that everybody kind of “knows rates have to go higher,” it’s certainly possible rates go lower. We’re late in an economic cycle. At some point, we’ll turn around and have a recession. At that point, rates could go lower. At that point, the people that own cash are going to see their yields go back down because as the Fed turns around and cuts interest rates, returns on cash are going to fall again and go back down towards zero where it was previously. People that have bought bond portfolios are going to be locked in at that 3 or 4% yield or whatever they’ve gotten, and be very happy that they’re in bonds with appropriate maturities as opposed to cash.
JA: I think some people get confused too when they hear the Fed is increasing rates. What rate? It’s the Fed funds rate, it’s not necessarily going to affect your bond portfolio tomorrow.
BP: It’s such a key point is that the Fed controls one interest rate, and there are hundreds or even thousands of interest rates out there. The Fed only controls, to your point, the overnight lending rates. And so for maybe cash or prime rate for your credit card, when the Fed moves it has an instantaneous impact. For longer-term bonds, there are a lot of factors that drive them, but ultimately, it’s growth and inflation expectations that are going to determine longer-term bond yields. Keep in mind, and this sounds counterintuitive, but if you own long-term bonds, the Fed raising interest rates is your best friend. Because why does the Fed raise interest rates? They raise interest rates to slow the economy and contain inflation. If you own longer-term bonds, five-year bonds, ten-year bonds, 30-year bonds, inflation is the boogeyman. That’s what you don’t want to have happen. And so the idea that the Fed is, all else being equal, restraining future inflation and future growth is your friend if you’re a bondholder. And what you’ve seen historically is, not always, but oftentimes, when the Fed raises the interest rate that they control, longer-term rates decline or stay approximately in place, and we’ve seen that – where short-term rates in the US have gone from zero to 2% or something like that, the two year Treasury now is at 2.6. The 10 year Treasury has drifted up a little bit higher, but the differential between two year and 10 year Treasuries has compressed quite a bit because short-term rates have gone higher. Longer-term bond investors still don’t see inflation out there, so bond prices have been relatively steady.
JA: Brian, appreciate you hanging out with us today.
BP: Thanks, guys.
Southern California listeners, you can join Brian Perry, CFP®, CFA in person at the Pure Financial office in San Diego for a free Lunch ’n’ Learn Halftime Report at 11 am on Thursday, August 23rd – visit PureFinancial.com/lunch to sign up. Brian will dive deeper on the current state of the economy and how tax reform is affecting you, and he’ll be available to answer your questions. The Lunch ’n’ Learn Halftime Report with Brian Perry on Thursday, August 23rd is free and lunch is included, but to attend you’ve gotta sign up at PureFinancial.com/lunch.
24:47 – Meb Faber: Choose One Stock and One Investing Style Forever, and Why $1 Trillion Will Flow Into Chinese Markets
JA Got a great guest, Alan.
AC: Yeah we do. And Joe as always the favorite part of the show for me because I actually get to learn something.
JA: Oh my God. You’re going to learn a lot today, my friend. We’ve got Meb Faber on the line. He’s co-founder and Chief investment Officer of Cambria Investment Management, and he’s got an awesome podcast, it’s the Meb Faber Show. He’s written several awesome books and he’s got a new book coming out very, very shortly. So I want to welcome Meb Faber, welcome to the show.
MF: It’s great to be here. Thanks for having me.
JA: Hey, I don’t know how much we’re paying you to get on this little rinky-dink show. But I’m telling you, I’m very excited. And this is a real treat for me.
MF: I take payment in pale ales and stouts and porters.
AC: (laughs) Perfect. That’s how we pay.
JA: Exactly. (laughs) I’ve got a few questions for you before we get into your book. Let’s say that you could only invest in one stock for the rest of your life and you could never sell it. What stock would that be?
MF: So, like I answer all my questions – my wife gets so tired of this. There’s like 10 qualifiers I have to ask. You say “stock” – is it allowed to be anything publicly traded? Because if it could be an ETF, that changes the criteria. Or does it have to be purely a listed security?
JA: Well, I think wherever you want to take this – let’s start with, we can go with an individual security that’s listed on an exchange, and then we could take this if there’s a certain style, because that was going to be my follow-up question, Meb.
MF: Okay. We could spend probably the entire show drilling down this rabbit hole by the way, because my perspective is look, first of all, I would love to invest – if it’s something I can hold forever, I want to diversify away my single stock risk. And so that means probably investing in some sort of conglomerate, like a Berkshire Hathaway. We just chatted, I was just in Omaha, and that business is nice because it owns quite a bit of private businesses, public businesses, all sorts of stuff mashed together. It’s got some groomed lieutenants after Warren and Charlie sunset. They’re getting in their 80s and 90s. So I’d probably buy Berkshire. Now, the caveat to that, and the reason I asked is I’ve kind of been well on the record the last few years in my belief that there’s more to investing than just what’s on our shores here in the U.S. And I’m of the belief that a lot of the rest of the world is quite a bit cheaper. And so if I was able to buy a region or entire market I would certainly prefer to do that in any number of countries or regions. But the problem is, I don’t know off the top of my head any great business there. And you run the same risk there, which is the kind of non-diversified risk of owning a single security. So I’ll go with Berkshire.
JA: With your latest book, it’s second coming, or second edition I guess is a better term. It’s The Best Investment Writing, which is phenomenal. So what you’re doing is, you’re taking all these little short stories, articles, that some of the best minds in finance have written, and you just kind of mash them up into a book. Now, there’s so many different people that are in this book, or both of your books now. And it’s from different styles – you’ve got people that are straight indexers, to hedge fund managers, to name the gamut. If you could choose any of those individual styles that you would have to stick with for the rest of your life, which one would that be?
MF: So, the nice thing about the book, by the way, is that – we all spend so much time dealing with his day-to-day noise, and bombarded with so much information on geopolitics, and economics, and investment, what’s going on every day. And the whole point of the book was sorta to take a step back, offer a curated offering – it’s like 400 pages, by the way, version 2. There was so much good writing, and say, “what is the single best thing that I read from a particular author or group of authors in the past year?” And also the goal of getting out of the echo chamber. You know, a lot of investors, just like a lot of people when it comes to politics or anything else, they have their particular style. So that maybe buy and hold, it may be risk parity, it may be dividends, it may be gold bug. Whatever it may be. And a lot of us spend almost all of our time looking for confirming evidence as to why we should continue to believe what we believe. So the nice thing about this book is it does offer a lot of varied opinions. And so I’m of the belief that there’s no one sure best way to invest. And so my firm manages all sorts of public funds, and we have different styles, like global value, and tactical asset allocation, but I’m on the record saying, “look, I have no problem with buy and hold too. And a globally diversified asset allocation – to me, if I had to pick one – this is the long winded answer to your question – if I had to pick one, it would be a globally diversified portfolio. What we call the global market portfolio. So if you just went and bought the entire world of publicly traded assets. You went over the portfolio, that’s roughly half and half stocks and bonds, and of that, about half and half US, and then the rest, global ex-US. And that, historically, has been a pretty awesome portfolio, and you own 20-30,000 securities around the world, and it’s kind of an all-in-one portfolio. The good news nowadays, you can usually get that portfolio through ETFs and other vehicles for pretty darn cheap.
JA: I have a couple bullet points here that Andi put together for me since the book, what, it releases August 13th. And so a couple of things here, it says, “why $1 trillion will flow into Chinese stock markets.” Tell me more about that, I’m very intrigued.
MF: Yeah, the concept of that is, if you look at the global equity market, this surprises a lot of people. If you were just to index the globe of stocks, you end up with about half in the U.S. And most investors, particularly in the US, have around 70-80% of their equity exposure in the US, and we call that “home country bias,” meaning you have a lot more invested in your own country. And the thing is it doesn’t really just exist here. If you go over to Italy, you go to Australia, you go over to Japan, Vanguard has all these studies that show that investors invest in those countries way too much in their own country, relative to the proportion of the globe. And so a lot of people don’t know, and we often say, “look, if you’re going to make that bet, that’s fine, but at least you should be aware of it, because it’s a very active decision to overweight something, and it’s actually much worse in some of these other countries, because if Canada’s only a couple of percent of the global market and you’re putting 70% in the Canadian market, that’s a huge, huge bet. So whereas the U.S. is 50%, most people putting in 70-80 is probably not as bad as the alternatives. Anyway, so the point of this article, written by my friend Steve Sjuggerud, was pointing out the fact – and this is actually pretty well known – that a lot of the indexes that had not historically included China and the various types of Chinese equities included in their indexes are starting to add them. And so by definition, a lot of these index funds out there will have to go out and start buying a lot of Chinese stocks. They don’t even have a choice. It’s capital that’s already there that has to follow these indexes. And so his belief system – and China is interesting because it’s obviously a developing country but one of the largest economies in the world, and when you have a lot of money sloshing around there certainly it’s pretty easy for her fraud to happen. But that’s the beauty of capitalism and financial markets is eventually you get found out. If you look at the examples here in the US, Enron and Theranos, people eventually find out. And so with China, it’s been hugely volatile. If you remember back to the mid 2000s, everyone was recommending China and the BRICs – Brazil Russia India China – but China and India got really expensive in the mid 2000s, they were trading with PE ratios in the 40s and 60s, and then of course, fast forward past global financial crisis, a lot of these foreign developed and emerging market countries stock markets never really recovered. So a lot of them got pretty cheap over the past few years, and we still think a lot of them are still pretty cheap, and China is probably, we’d consider it to be normally valued to cheap right now. So you have these two forces of, “hey, this is the market it’s quite a bit cheaper than the US,” and all things considered, yes, you don’t have the same controls as you do here, but realizing that there’s going to be a ton of money flooding into that market makes a pretty interesting argument for having a reasonable exposure there.
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34:38 – Meb Faber: US vs Foreign Markets, the Value Premium, and Behavior
JA: Hey, welcome back to the program, the show is called Your Money, Your Wealth®. My name is Joe Anderson, I’m with Big Al. Big Al, what are you thinkin’, man?
AC: I am loving this investment talk.
JA: We got Meb Faber on the line, check out MebFaber.com, and then it’s the Meb Faber Show – that’s one of my favorite podcasts. We get a lot of podcast guests on the show and I think Meb is one of the best so far.
AC: Yeah, I believe so.
JA: Hey Meb, you talked earlier about the U.S. market as being expensive. And I think Al and I would both agree with you. if you take a look at I guess the Shiller ratio and PEs. So what’s your viewpoint on that? Would you want to overweight more emerging markets and international type companies at this point, or is that more of a timing move? How do you go about with that ebb and flow?
MF: So if we look at the US, and for perspective, we do use these long-term PE ratios, but any valuation metric says the same thing. And so we look at a long-term PE ratio in the US, it’s around 30, but it’s been as high as 45 and it’s been as low as five. And during normal, sort of mellow inflationary times like we’re in now, it’s usually around 20, low 20s. And so we’re not out there screaming,
“This is a bubble and you have to sell everything, it’s going to crash,” it really just means you need to lower your expectations from people expecting this historical 10% returns. We think it’s probably in the lower single digits, so it’s kind of like going to the doctor, taking your medicine, saying look, “spend less save more” with regard to the US, but with regards to your entire portfolio, we say, “look, the US starting point – starting point! – if you’re a die-hard indexer or Vanguard through and through, is you should only have half in the US. But for all these people that are on 70-80%, you say, “OK well maybe let’s dial that back to where we have 50% US and 50% in the rest of the world through foreign developed and emerging markets. And then if you really want to get a value bent, you could say, “we’re going to tilt even more towards value,” which ends up being right now emerging markets. Their long-term PE ratio is around 15, 16, foreign developed is around low 20s. And if you get the cheapest bucket, the most disgusting, nasty, awful stock markets that are probably all down 40, 60, 80%, like Greece and Brazil and Russia, that basket has a PE ratio of around 12. So I think there’s a lot of opportunity. Going back to your original question, if you said, “Meb, what would you buy for the next 10 years?” I would hold my nose, close my eyes and buy a basket of – and important to say “buy a basket” because if you just go buy Russia or Brazil, those markets are so volatile they could do anything, but buy a basket of maybe 10 of these countries – our largest bond ETF actually does this. I would buy that for 10 years, put it away, close my eyes and check back in and 2028. I’ll come back on your show and see how it did.
JA: (laughs) It’s funny, because I’ve I’m sure you’ve seen the Callan charts, and then they go through different countries. And I think what, over the last several decades, the US has only been the top performing market once maybe out of, what, 100 years or something like that? So that home bias I think is so real. But you’re right. You have to diversify out, especially if you take a look at valuations – US is a little expensive. So the portfolios that we look at, it’s probably 90% US and it’s usually just large cap.
MF: Yeah, you get some people often say to me, “Meb, the U.S. gets a certain percentage of sales throughout the rest of the world so aren’t I getting foreign exposure already?” And in my response to that is always, “Absolutely, but the world is much more globalized now. So if you own foreign companies, you’re also getting exposure to the US, and in that scenario where everything is an interconnected spiderweb, wouldn’t you want the countries that are the stocks that are cheaper?” And so it’s kind of being what we call “asset-class agnostic.” And it’s hard for people because again, going back to the earlier comment – some people just love gold, some people love dividend stocks, some people love bonds, whatever it may be, but every asset class has its time in the sun. You mentioned like US stocks, 2009 to 2014, one of the best performing stock markets in the world, if not the best performing, but historically, it’s been a coin flip. US versus foreign, they outperform about 50% of the time, and so you go through these cycles where something looks much better, then it has outperformance, and then it gets expensive, and that sets the stage for the next cycle when the opposite is going to occur. So I think we’re, certainly if I was a betting man, and I am, I would, looking out in the future, certainly want to have exposure to these cheaper foreign markets as well.
JA: Value, speaking of going through cycles, the value premium has not really shown its face over the last several years. What’s your take on that? You think it’s it’s going by the wayside because of technology, or?
MF: I agree with you, and first of all, saying “value” is also kind of like saying “dog,” where a beagle looks nothing like a Rottweiler which looks nothing like a basset hound, because there’s a lot of different ways to measure value, and a lot of different ways to measure it within a market, across markets, so value, globally, has worked fantastic the last two years, where a lot of these cheaper countries have vastly outperformed over the last two years. But for the U.S. stock market in general, you’ve had this market cap, large, tech, a lot of people talk about the FANGs, but outperformance that is really driven a lot of the performance, and so a lot of the stuff goes through cycles – let me give you a quick example. If you if you went back to 1999 and said, “I’m going to start tracking Warren Buffett stock picks.” One, they’re public, he doesn’t trade that much, pretty famous names, we all know ’em, Coca-Cola. All these classic names that he buys in the stock market, and say, “I’m just going to buy his stocks, top ten stocks when they’re public each quarter and rebalance once a quarter, takes me five minutes a quarter.” Well, since that period, since 2000 to now, he would have outperformed the S&P by like five percentage points per year, which would have made him probably top 1% of all mutual funds on the planet. So this monster outperformance, and it wouldn’t have cost you anything, any management fees. Now, the challenge with that is, all that performance came from 2000-2009, and in the past 10 years, this investment style of his, which is value, has underperformed the S&P eight of the past 10 years. And how many of us, and how many listeners, and how many institutions, have the fortitude to stick with an investment style that has underperformed for that long? Despite that fact, the style over the entire period has outperformed by five percentage points per year, and one of the best performing funds on the planet. So, it kind of goes to show, a lot of us in the media, and in writing and everything else, you want to look at things on a daily, weekly, quarterly, even yearly basis. But it’s pretty hard, even to judge things even on a decade-long time frame. Whether it’s an investment style, whether it’s an asset class, whether it’s a security. And so a lot of people say they have a long-term time horizon, but really it comes down to it, it’s probably two years or less. But we often say that the true value and alpha of Warren Buffett is not his actual approach or his stock picks, it’s actually pretty simple. Some friends at AQR that have replicated it with a formula – it’s basically buying value stocks that are high quality and adding a little leverage through the insurance float, and voila, you have an awesome portfolio. We’d say it’s true alpha and value-add is he sticks to his knitting. So despite it being 10 years of poor returns, he’s willing to stick to his style.
JA: (laughs) Yeah. We’re talking to Meb Faber. If someone reads your latest book, 400 some odd pages, you have what, 42 different individuals, some of the smartest guys in the business, in Wall Street, or just in finance – if they read all of that, study it, still, it’s the emotions, I think. You could follow it to a T, but as you’re saying, how much fortitude does someone have, or discipline to continue with that particular strategy? It’s very, very difficult for most to do it.
MF: We spend most of our time trying to come up with behavioral ideas on how to keep people from doing dumb stuff. And Vanguard has tried to quantify this, and we often say that it’s one of the, if not the biggest benefit of having a financial advisor, is having that sort of Chinese wall between a client and the ability to make trades and do something foolish. Now of course, (laughs) that doesn’t mean financial advisors are also immune to what’s going on in the world, and it’s hard too. But really, this is also why we think it’s important to have an investment plan, hopefully, it’s something that’s written down, that you’ve shared with someone. It’s kind of like a diet. What good is a diet if you’re able to open up the fridge every day and go eat a cheeseburger? It’s the same thing as if you are going to turn on CNBC and watch stock picks, right? So unless you have a plan, and something that you share with someone else to keep you compliant, then it’s usually really hard to comply with.
JA: Yeah, without question. I mean that the diet industry, the diet books, and the exercise, I mean it’s a multi- multibillion-dollar business and all you’ve gotta do is eat right, exercise, get a little bit of sleep, I mean, it’s pretty simple. Same with, I guess, investing – buy a globally diversified portfolio, keep your discipline, control your cost, and manage your taxes. But it’s a lot easier said than done.
MF: That’s right. It’s the old phrase, investing is simple it’s not easy.
JA: You got that right. You know, one last thing. After the credit crisis of 2008, there was a study done, I forget what company. And don’t quote me on this, please, compliance, whatever. It was like 2010, they went back to financial advisors, and then they asked them, did they change their overall investment philosophy or investment strategies. And I think it was like an overwhelming 70-80% of advisors that they surveyed said yes they changed their strategy. So it’s like man, if these people are trying to help their clients stay in their seats, but they’re switching, moving back and forth, and they’re getting freaked out, that’s just a recipe for disaster – it’s just a lose-lose at that point.
MF: Yeah, there was a study, I think it was 89-99% of advisors said they would look to fire manager if they underperformed for two years. So that goes back to that old, there’s been an academic paper that looked at pension funds and it looked at 8,000 hiring and firing decisions. So they looked to the manager that was getting fired and the manager they were replacing them with, and not surprisingly, for the prior three years, the new manager coming in had much better performance and the one they’re firing had bad performance, but guess what? In the following three years, guess what happens? We all can speculate. They should’ve just stuck with the old manager. And so you had the mean reversion, where a style or a person was doing poorly, but then it kind of came back and so they would have actually been better off not even doing anything. And so I think it’s a challenge. It’s hard for people. And it’s something that doesn’t just exist on the individual level. We’re professionals. It’s easy to look down on individuals and say, “they’re so irrational,” but believe me, I see it every day at some of the biggest institutions in the country that suffer from the same behavioral challenges.
JA: Talking to Meb Faber, he’s got a new book coming out. It’s The Best Investment Writing Volume 2: Selected Writing from Leading Investors and Authors. It’s going to be released here August 13th, 2018. Andi, you know what I want to do, I want to give away 20. I’m going to personally purchase 20 of these books and give them away to all of our listeners.
JA: Great book. It’s phenomenal. Meb, I’m a huge, huge fan and this was a real treat. Last question. Herbalife: Ponzi scheme or not?
MF: You know, it’s a lot of fun, but for a quant like me it’s also a little curious. People get so obsessed by a lot of these stories – stocks, Herbalife, they become these hedge fund battlegrounds. Tesla, of course, is probably the most famous right now, and even certain things like cryptocurrencies. I think I tweeted this out a while ago, I said, “in a world of 30,000 securities, it’s odd to me that people get obsessed with one or two,” and the investments. I think people really want to look for are the uncovered rocks one, where no one wants to talk about it, it’s boring, the company’s making iron bridges or something, where no one’s following it. And so I am a pleasant sidelines participant – not participant, but onlooker for a lot of these stories. So Herbalife, I have no idea. Multilevel marketing companies have been very successful historically, but is it a righteous business model? I don’t know. It’s a totally separate thing to call it a straight up fraud, which is kind of a whole other commentary, so I will defer on that one.
JA: (laughs) All right well hey, thank you again. Have a wonderful trip up north. Have a couple of beers on me, and hopefully, we can get you back on the show again.
MF: Awesome, it’s been a blast, guys, love to do it any time.
JA: For Big Al Clopine, I’m Joe Anderson. I want to thank Andi Last for producing such a wonderful show.
AC: Yeah, and I second that.
AL: Thank you guys, I appreciate that.
JA: All right, we’ll see you next week, the show is called Your Money, Your Wealth.
Special thanks to today’s guest, Meb Faber. Check him out at MebFaber.com and don’t forget, the first 20 people to email email@example.com and ask for Meb’s book, The Best Investment Writing, Volume 2, will get a free copy after the book is released on August 13th.
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Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.